Topic 1

Decision Analysis
(Chapter 3)

Source: Render et al., 2012. Quantitative Analysis Management, 11 editions, Pearson.

Learning Objectives
Students will be able to:
List the steps of the decision-making process.
Describe the types of decision-making
environments.
Make decisions under uncertainty.
Use probability values to make decisions
under risk.

Chapter Outline
3.1
3.2
3.3
3.4
3.5
3.6
3.7

Introduction
The Six Steps in Decision Theory
Types of Decision-Making Environments
Decision Making under Uncertainty
Decision Making under Risk
Decision Trees
How Probability Values Are Estimated by
Bayesian Analysis
3.8 Utility Theory

Introduction
Decision theory is an analytical and
systematic way to tackle problems.
A good decision is based on logic.

The Six Steps in Decision Theory

1.
2.
3.
4.

Clearly define the problem at hand.

List the possible alternatives.
Identify the possible outcomes.
List the payoff or profit of each
combination of alternatives and outcomes.
5. Select one of the mathematical decision
theory models.
6. Apply the model and make your decision.

Example: Thompson Lumber Company Case

John Thompson is the founder and president

of Thompson Lumber Company, a profitable
firm located in Portland, Oregon.
The problem that John Thompson identifies is
whether to expand his product line by
manufacturing and marketing a new product,
backyard sheds.

Example: Thompson Lumber Company Case

Define problem

To manufacture or market backyard storage

sheds

List alternatives

1.
2.
3.

Identify outcomes

The market could be favorable or unfavorable

for storage sheds

List payoffs

List the payoff for each state of nature/decision

alternative combination

Select a model

Decision tables and/or trees can be used to solve

the problem

Apply model and make

decision

Solutions can be obtained and a sensitivity

analysis used to make a decision

Construct a large new plant

A small plant
No plant at all

Example: Thompson Lumber Company Case

Decision Table
State of Nature
Alternative

Favorable
Market ($)

Unfavorable
Market ($)

Construct a large plant

200,000

-180,000

Construct a small plant

100,000

-20,000

Do nothing

Types of Decision-Making Environments

Decision making under certainty.
Decision maker knows with certainty the
consequences of every alternative or decision
choice.
Decision making under uncertainty.
The decision maker does not know the
probabilities of the various outcomes.
Decision making under risk.
The decision maker knows the probabilities of
the various outcomes.

Decision Making under certainty:

Decision makers know within certainty the
consequence of every alternative or decision
choice.
E.g.: You have $1000 to invest for a 1-year
period. Alternatives are to open a savings or a
fixed deposit account paying 3% or 5% interest
per year respectively. If both investments are
secure and guaranteed, there is a certainty that
a fixed deposit will pay a higher return.

Decision Making under Uncertainty: Criteria

Optimistic (Maximax)
Pessimistic (Maximin)
Criterion of Realism (Hurwicz)
Equally likely (Laplace Criterion)
Minimax Regret (Opportunity Loss or Regret)

Decision Making under Uncertainty

Example: Thompson Lumber Company Case.
State of Nature

Alternative

Favorable
Market ($)

Unfavorable
Market ($)

Construct a large plant

200,000

-180,000

Construct a small plant

100,000

-20,000

Do nothing

Decision Making under Uncertainty:

Optimistic (Maximax) Criterion
Example: Thompson Lumber Company Case
State of Nature
Alternative

Maximum in
Row

Favorable
Market ($)

Unfavorable
Market ($)

Construct a large
plant

200,000

-180,000

Construct a small
plant

100,000

-20,000

100,000

Do nothing

200,000
Optimistic
(Maximax)

Decision Making under Uncertainty:

Pessimistic (Maximin) Criterion
Example: Thompson Lumber Company Case
State of Nature
Alternative

Minimum in
Row

Favorable
Market ($)

Unfavorable
Market ($)

Construct a large
plant

200,000

-180,000

-180,000

Construct a small
plant

100,000

-20,000

-20,000

Do nothing

Pessimistic
(Maximin)

Decision Making under Uncertainty:

Criterion of Realism (Hurwicz) Criterion
Weighted Average = (best in row) + (1- ) (worst in row)
where: is the coefficient of realism (or the degree of optimism of the
decision maker), 0 1.

Example: Thompson Lumber Company Case (given = 0.8)

State of Nature
Favorable
Market ($)

Unfavorable
Market ($)

Weighted
Average in
Row
( = 0.8)

Construct a large
plant

200,000

-180,000

124,000

Construct a small
plant

100,000

-20,000

Alternative

Do nothing

Criterion
of Realism
76,000 (Hurwicz)

Decision Making under Uncertainty:

Equally likely (Laplace) Criterion
Assume all states of nature to be equally likely, choose
maximum Average.

Example: Thompson Lumber Company Case

State of Nature
Alternative

Average in
Row

Favorable
Market ($)

Unfavorable
Market ($)

Construct a large
plant

200,000

-180,000

10,000

Construct a small
plant

100,000

-20,000

40,000

Do nothing

Equally
likely
(Laplace)

Decision Making under Uncertainty:

Minimax Regret (Opportunity Loss) Criterion
Opportunity Loss Optimal payoff Actual payoff

Step 1: Create an opportunity loss table by subtracting each

payoff in the column from the best payoff in the same column.
Example: Thompson Lumber Company Case
State of Nature
Alternative

Favorable Market ($)

Unfavorable Market ($)

Construct a
large plant

200,000 200,000 = 0

Construct a
small plant

200,000 100,000 = 100,000 0 (20,000) = 20,000

Do nothing

200,000 0 = 200,000

0 (180,000) = 180,000

00=0

Decision Making under Uncertainty:

Minimax Regret (Opportunity Loss) Criterion
Step 2: Choose the minimum alternative out of all the
maximum opportunity losses.
Example: Thompson Lumber Company Case
State of Nature
Alternative

Construct a large
plant

Favorable Market
($)

Unfavorable
Market ($)

Maximum in
Row
Minimax
180,000 Regret
(Opportunity
Loss)

180,000

Construct a
small plant

100,000

20,000

100,000

Do nothing

200,000

200,000

Decision Making under Risk

Expected Monetary Value (EMV)
The probabilities of the states of nature P(S) are known.
EMV(Alternative) = Payoffs1*P(S1) + Payoffs2*P(S2) ++ Payoffsn*P(Sn)

Example: Thompson Lumber Company Case

State of Nature
Alternative
Construct a
large plant

Favorable
Market ($)
200,000

Unfavorable
Market ($)

Expected Monetary Value

(EMV)

180,000

(200,000)(0.5) +
(180,000)(0.5) = 10,000
(100,000)(0.5) +
(20,000)(0.5) =

Construct a
small plant

100,000

20,000

Do nothing

Probabilities

0.50

0.50

40,000

(0)(0.5) + (0)(0.5) = 0

Decision Making under Risk

Expected Value with Perfect Information (EVwPI)
EVwPI = best Payoffs1*P(S1) + best Payoffs2*P(S2) ++ best Payoffsn*P(Sn)

Example: Thompson Lumber Company Case

State of Nature
Alternative

Expected Monetary Value

(EMV)

Favorable
Market, S1 ($)

Unfavorable
Market, S2 ($)

Construct a large plant

200,000

-180,000

10,000

Construct a small plant

100,000

-20,000

40,000

0.50

0.50

Do nothing
Probabilities

With Perfect
Information

Best payoff
in S1
200,000

Best payoff in
EVwPI = (200,000)(0.5)
S2
+ (0)(0.5) = 100,000
0

Decision Making under Risk

Expected Value of Perfect Information (EVPI)
EVPI places an upper bound on what one would pay for
additional information.

EVPI = EVwPI Best EMV

where:
EVwPI is Expected Value with Perfect Information.
Best EMV is expected value without perfect information.

Decision Making under Risk

Expected Value of Perfect Information (EVPI)

Hence, the EVPI = EVwPI best EMV

= 100,000 40,000 = $60,000

Expected Opportunity Loss (EOL)

EOL is the cost of not picking the best solution.
EOL = Expected Regret

Thompson Lumber:
Payoff Table
State of Nature
Alternative

Favorable Market
($)

Unfavorable
Market ($)

Construct a large
plant

200,000

-180,000

Construct a small
plant

100,000

-20,000

Do nothing

Probabilities

0.50

0.50

Thompson Lumber: EOL

The Opportunity Loss Table
State of Nature
Alternative
Favorable Market ($)

Unfavorable Market
($)

Construct a large plant

200,000 200,000

0- (-180,000)

Construct a small
plant

200,000 - 100,000

0 (-20,000)

Do nothing

200,000 - 0

0-0

Probabilities

0.50

0.50

Thompson Lumber:
Opportunity Loss Table
State of Nature
Alternative

Favorable Market
($)

Unfavorable
Market ($)

Construct a large
plant

180,000

Construct a small
plant

100,000

20,000

Do nothing

200,000

Probabilities

0.50

0.50

Thompson Lumber: EOL Solution

Alternative
Large Plant
Small Plant
Do Nothing

EOL
(0.50)*$0 +
$90,000
(0.50)*($180,000)
(0.50)*($100,000) $60,000
+ (0.50)(*$20,000)
(0.50)*($200,000) $100,000
+ (0.50)*($0)

Note:
1. The minimum EOL and maximum EMV will suggest the same decision.
2. The value of EVPI will always equal to the minimum EOL value.

Thompson Lumber:
Sensitivity Analysis
Let P = probability of favorable market
EMV(Large Plant):
= $200,000P + (-$180,000)(1-P) = 380,000P - 180,000
EMV(Small Plant):
= $100,000P + (-$20,000)(1-P) = 120,000P - 20,000
EMV(Do Nothing):
= $0P + 0(1-P) = 0

Thompson Lumber:
Sensitivity Analysis (continued)

Decision Making with Uncertainty:

Using the Decision Trees
Decision trees are most beneficial when a
sequence of decisions must be made.
All information included in a payoff table is
also included in a decision tree.

Five Steps to
Decision Tree Analysis
1.
2.
3.
4.

Define the problem.

Structure or draw the decision tree.
Assign probabilities to the states of nature.
Estimate payoffs for each possible combination
of alternatives and states of nature.
5. Solve the problem by computing expected
monetary values (EMVs) at each state of nature
node.

Structure of Decision Trees

Trees start from left to right and represent decisions and
outcomes in sequential order.
A decision node (indicated by a square
) from which
one of several alternatives may be chosen.
A state-of-nature node (indicated by a circle
) out of
which one state of nature will occur.
Lines or branches connect the decisions nodes and the
states of nature.

Thompsons Decision Tree

Step 1: Define the problem
Lets re-look at John Thompsons decision regarding storage sheds.
This simple problem can be depicted using a decision tree.

Step 2: Draw the tree

A State of
Nature Node

Favorable Market

Unfavorable Market
A Decision
Node

Construct
Small Plant

Favorable Market
2
Unfavorable Market

Thompsons Decision Tree

Step 3: Assign probabilities to the states of nature.
Step 4: Estimate payoffs.
A State of
Nature Node
Alternatives

A Decision
Node

Construct
Small Plant

Outcomes

Payoffs

Favorable (0.5)
Market

$200,000

Unfavorable (0.5)
Market

-$180,000

Favorable (0.5)
Market

$100,000

Unfavorable (0.5)
Market

-$20,000

Thompsons Decision Tree

Step 5: Compute EMVs and make decision.
A State of
Favorable (0.5)
Nature Node Market

A Decision
Node

1
EMV
=$10,000
Construct
Small Plant

2
EMV
=$40,000

$200,000

Unfavorable (0.5)
Market
-$180,000
Favorable (0.5)
Market
Unfavorable (0.5)
Market

$100,000

-$20,000
0

Thompsons Decision:
A More Complex Problem
John Thompson has the opportunity of obtaining a market survey
that will give additional information on the probable state of
nature. Results of the market survey will likely indicate there is a
percent change of a favorable market. Historical data show market
surveys accurately predict favorable markets 78 % of the time.
P(Fav. Mkt | Results Favourable) = 0.78
Likewise, if the market survey predicts an unfavorable market,
there is a 73 % chance of its occurring.
P(Unfav. Mkt | Results Negative) = 0.73
Assumed the cost of conduct market survey is $10,000, and is
deducted from each payoff under Conduct Market Survey.

Thompsons Decision Tree

Now that we have redefined the problem (Step 1), lets use this
additional data and redraw Thompsons decision tree (Step 2).

Thompsons Decision Tree

Step 3: Assign the new probabilities to the states of nature.
Step 4: Estimate the payoffs.
Step 5: Compute the EMVs and make decision.

John Thompson Dilemma

John Thompson is not sure how much value to place on
market survey. He wants to determine the monetary
worth of the survey. John Thompson is also interested in
how sensitive his decision is to changes in the market
survey results. What should he do?

Expected Value of Sample Information

Sensitivity Analysis

Expected Value of Sample

Information
o The survey cost $10,000.
o The expected value of $49,200 (when the survey is used) is
based on payoffs after the $10,000 cost was subtracted.
o The expected value with sample information (EV with SI) is
the expected value of using the survey assuming no cost to
gather it. Thus, in this example:
EV with SI = $49,200 + $10,000 (cost) = $59,200.
o Without the sample information, the best expected value is
$40,000. Thus, the expected value would increase by
$19,200 if the survey was available free.

Expected Value of Sample

Information (EVSI)

EVSI ==

Expected value with

sample information
+ study cost

Expected value of best

decision without
sample information

EVSI for Thompson Lumber = $59,200 - $40,000

= $19,200

Thompson could pay up to $19,200 for a market study.

Since it costs only $10,000, the survey is indeed worthwhile.

Sensitivity Analysis
How sensitive are the decisions to changes in the
probabilities?
e.g. If the probability of a favorable survey were
less than the current value (0.45), would the survey
still be selected? How low would this have to be to
cause a change in the decision?

Let p = probability of favorable market

Calculations for Thompson Lumber

Sensitivity Analysis
EMV(node 1) = ($106,400) p + ( 1 - p ) ($2,400)
= $104,000 p + 2,400
Equating the EMV with the survey to the EMV without the
survey, we have

$104,000 p + $2,400 = $40,000

$104,000 p = $37,600
or

p =

$37,600
$104,000

= 0.36

Hence, our decision will stay the same as long as the

probability of favorable survey results, p, is greater than 0.36.

Estimating Probability Values with Bayes

Theorem

Management experience or intuition

History
Existing data
Need to be able to revise probabilities based
upon new data
Information about accuracy
of sample information.

Prior
probabilities

Bayes Theorem

Posterior
probabilities

Bayesian Analysis
The probabilities of a favorable / unfavorable state of nature can be
obtained by analyzing the Market Survey Reliability in Predicting
Actual States of Nature.
STATE OF NATURE
RESULT OF
SURVEY

FAVORABLE MARKET
(FM)

UNFAVORABLE MARKET
(UM)

Positive (predicts
favorable market
for product)

P (survey positive | FM)

= 0.70

P (survey positive | UM)

= 0.20

Negative (predicts
unfavorable
market for
product)

P (survey negative | FM)

= 0.30

P (survey negative | UM)

= 0.80

Bayesian Analysis (continued):

Favorable Survey
POSTERIOR PROBABILITY

CONDITIONAL
PROBABILITY
P(SURVEY
POSITIVE | STATE
OF NATURE)

PRIOR
PROBABILITY

FM

0.70

X 0.50

0.35

0.35/0.45 = 0.78

UM

0.20

X 0.50

0.10

0.10/0.45 = 0.22

P(survey results positive) =

0.45

1.00

STATE OF
NATURE

JOINT
PROBABILITY

P(STATE OF
NATURE |
SURVEY
POSITIVE)

Bayesian Analysis (continued):

Unfavorable Survey
POSTERIOR PROBABILITY

CONDITIONAL
PROBABILITY
P(SURVEY
NEGATIVE | STATE
OF NATURE)

PRIOR
PROBABILITY

FM

0.30

X 0.50

0.15

0.15/0.55 =

0.27

UM

0.80

X 0.50

0.40

0.40/0.55 =

0.73

P(survey results positive) =

0.55

STATE OF
NATURE

JOINT
PROBABILITY

P(STATE OF
NATURE |
SURVEY
NEGATIVE)

1.00

Decision Making Using Utility Theory

There are many occasions in which people make decisions
that would appear to be inconsistent with the EMV
criterion.
E.g.: 1. When people buy insurance, the amount of the
premium is greater than the expected payout. 2. A person
involved in a law suit may choose to settle out of court
rather than go trial even if the expected value of going to
trial is greater hat the proposed settlement.
This is because monetary value is not always a true indicator
of the overall value of the result of a decision.

The overall worth of a particular decision is called utility.

Rational people make decisions that maximize the expected
utility.

Decision Making Using Utility Theory

Utility assessment assigns the worst outcome a utility of 0,
and the best outcome, a utility of 1.

A standard gamble is used to determine utility values.

When you are indifferent, your utility values are equal.
Expected utility of alternative 2 = Expected utility of alternative 1
Utility of other outcome = (p)(utility of best outcome, which is
1) + (1p)(utility of the worst
outcome, which is 0)

Utility of other outcome = (p)(1) + (1p)(0) = p

Where p is the probability of obtaining the best outcome, and (1p) is the
probability of obtaining the worst
outcome.

Standard Gamble for Utility Assessment

p

1p

Best outcome
Utility = 1

Worst outcome
Utility = 0
Other outcome
Utility = ??

Real Estate Example:

Utility Theory
Jane Dickson wants to construct a utility curve revealing her
preference for money between $0 and $10,000.
A utility curve plots the utility value versus the monetary
value.
An investment in a bank will result in $5,000.
An investment in real estate will result in $0 or $10,000.
Unless there is an 80% chance of getting $10,000 from the
real estate deal, Jane would prefer to have her money in the
bank.
So if p = 0.80, Jane is indifferent between the bank or the
real estate investment.

Real Estate Example: Solution

p= 0.80

(1 p)= 0.20

$10,000
U($10,000) = 1.0

0
U(0) = 0

$5,000
U($5,000) = p = 0.80
Hence, Janes Utility for $5,000 = U($5,000) = p
= p*U($10,000) + (1 p)*U($0)
= (0.8)(1) + (0.2)(0) = 0.8

Real Estate Example: Solution

Note: In setting the value of probability p, one
should be aware that utility assessment is
completely subjective. It is a value set by the
decision maker that cannot be measured on an
objective scale.
We can assess other utility values in the same way.
For Jane, let say these are:

Utility for $7,000 = 0.90

Utility for $3,000 = 0.50
Using the three utilities for different dollar amounts,

she can construct a utility curve.

Real Estate Example: Utility Curve

1.0
0.9
0.8

U ($10,000) = 1.0
U ($7,000) = 0.90
U ($5,000) = 0.80

0.7

Utility

0.6
0.5

U ($3,000) = 0.50

0.4
0.3
0.2

0.1

U ($0) = 0

$0

$1,000

$3,000

$5,000

Monetary Value

$7,000

$10,000