1

CHAPTER
C OMPARING D ECISIONS U NDER
U NCERTAINTY AND R ISK

1.1 Introduction
In this chapter we try to compare different decisions when the outcomes of
the decisions are not completely under the decision maker’s control. In partic-
ular, we consider situations in which the environment of the decision maker
is indifferent to the decision taken by the decision maker. So, the material that
we consider in this chapter does not naturally hold when the decision maker’s
decision is being scrutinized by a competitor, who will take a decision which
will maximize the competitor’s benefit, possibly to the detriment of the origi-
nal decision maker.
Consider for example, a furniture manufacturer who manufactures wood-
en tables and chairs, and whose objective is to maximize the contribution to
profits from these two products. Tables require 3 m2 of wood and 3 labor-
hours to produce and earn a contribution of Rs.1000 per unit. Chairs on the
other hand require 2m2 of wood and 1 labor-hour to produce and earn a con-
tribution of Rs.600 per unit. The manufacturer has a supplier of wood, who
promises to supplies her up to 2000 m2 of wood per month on demand at a
cost of Rs.150 per m2 . In addition to wood, she requires other material, such
as paint, varnish, and fabric to create the tables and chairs. These are abun-
dantly available as long as she orders an adequate quantity well in advance.
She has 10 people working for her on fixed salary, each of whom puts in eight

1
2 CHAPTER 1. COMPARING DECISIONS

hours of labor each working day. She assumes a total of 20 working days in a
month.
If the supplier does indeed supply her with 2000 m2 of wood each month,
and the people turn up for work each day, then she can use a linear program-
ming model to optimize her product mix. This mix is to produce 400 tables
and 400 chairs each month and earns a contribution of Rs.6,30,000. If anyone
suggests an alternate product mix, of say 500 tables and 100 chairs, she can
convince herself that her product mix is better simply by computing the con-
tribution from the other product mix and observing that it is lower than that
for her product mix.
In a realistic scenario, the manufacturer must face uncertainties that are
not resolved at the time of planning. For example, the supplier of wood may
not be able to supply the required amount of wood for her manufacturing
process. She may face absenteeism among her employees. As a simplified
situation, assume that her supplier supplies her with either 2000 m2 of wood
a month, or if the supplier’s stocks are low, only 1500 m2 of wood. In some
months her employees put in 1600 labor-hours per month, and in others when
absenteeism is high they put in 1200 labor hours. Table 1.1 shows the optimal
product mixes for the manufacturer if she knew the conditions that she would
face the following month accurately when determining her product mix.

Table 1.1: Optimal mix under different scenarios

Wood Labor Optimal

Scenario Availability Availability Tables Chairs Revenue
I 2000 m2 1600 labor-days 400 400 Rs.340000
II 2000 m2 1200 labor-days 133 800 Rs.313333
III 1500 m2 1600 labor-days 500 0 Rs.275000
IV 1500 m2 1200 labor-days 300 300 Rs.255000

The manufacturer’s problem of finding an optimal production strategy

now becomes more complicated. For the time being, we will assume that she
chooses to adopt a product mix which is optimal in at least one of the four
scenarios. Since some of the product mixes are infeasible for some of the sce-
narios and since she does not know which scenario she is in at the time of her
decision, she also needs to decide whether to manufacture the tables first or
the chairs first. She thus has seven decision alternatives to choose from (since
in one situation she does not manufacture chairs at all). Once she decides
on the product mix that she aims for, she orders enough of the other mate-
rial (paint, varnish, and fabric) that she needs for her product mix. Table 1.2
shows the contributions to profits for different product mixes under different
1.1. INTRODUCTION 3

scenarios. Such a table in which the payoffs for each strategy-scenario pair What is a payoff
are listed is called a payoff table. table?

Table 1.2: The manufacturer’s payoffs under different scenarios

Scenarios
Strategy Prod. Mix Order I II III IV
A (400,400) Tables first Rs.340000 Rs.220000 Rs.265000 Rs.220000
B (400,400) Chairs first Rs.340000 Rs.266667 Rs.248333 Rs.248333
C (133,800) Tables first Rs.313333 Rs.313333 Rs.238333 Rs.238333
D (133,800) Chairs first Rs.313333 Rs.313333 Rs.225000 Rs.225000
E (500, 0) Rs.275000 Rs.220000 Rs.275000 Rs.220000
F (300,300) Tables first Rs.255000 Rs.255000 Rs.255000 Rs.255000
G (300,300) Chairs first Rs.255000 Rs.255000 Rs.255000 Rs.255000

Notice from the payoff table that each strategy is evaluated in terms of not
one but four payoffs, corresponding to the four scenarios that may arise. So
comparing two strategies is not in terms of comparing two numbers, but in
terms of comparing two vectors of numbers. This is not easy; for example,
Strategy A is better off than Strategy B in Scenario 3, but is worse off in Scenar-
ios 2 and 4. So the task of comparing strategies is the task of combining the
entries of the vectors of numbers corresponding to the strategies into single
numbers which can then be compared. While doing this, an idea about the
relative likelihood of the different scenarios is helpful. However, such an idea
may or may not be available. In this context, it is useful to realize that uncer-
tain decision making situations arise in a spectrum. On one end of the spec- Levels of uncer-
trum are those situations in which decision scenarios either occur completely tainty.
at random, or due to processes which have so many contributing factors that
it is not realistic to assume that we will have enough information to ascer-
tain the likelihood of different scenarios. Such decision making situations
are called situations of (deep) uncertainty. Such situations arise for example,
when one wants to predict the weather, say seven days in advance. On the
other end of the spectrum, there are situations in which the random process
giving rise to the scenarios are understood perfectly, and simple probabilistic
methods are useful to determine the likelihood of scenarios. Such situations
occur, for example, when one is betting on the throw of fair dice. These sit-
uations are called situations of stochastic uncertainty or risk. Most business
scenarios fall somewhere in between; some but not all the important deter-
minants of a phenomenon are known, and collecting enough data about the
determinants will allow the decision maker to have a rough idea about the
likelihood of particular scenarios. These are situations in which management
4 CHAPTER 1. COMPARING DECISIONS

tools such as market research become useful. In any scientific endeavor, the
idea is to start from the deep uncertainty end of the spectrum and move the
situation to the risk end of the spectrum through a better understanding of
the scenario and/or data collection.
The techniques used to make decisions about situations in different parts
of the spectrum are different, and are in general a mixture of techniques used
for deep uncertainty and risk. In the remainder of the chapter we explain
some of the techniques used for situations in the two ends of the spectrum.

1.2 Decision Making Under Deep Uncertainty

As mentioned earlier, when a decision maker makes decisions under uncer-
tainty, they do not know the probabilities with which each of the scenarios oc-
cur. Hence they cannot have recourse to probabilities while making decisions.
There are three main techniques for making decisions under uncertainty, of
which the first two make rather extreme risk profile assumptions.

The maximax approach

In this approach, the decision maker evaluates a decision strategy by the high-
est payoff that it can yield and ignores payoff values from all other scenarios.
For instance, in the example above, a decision maker following a maximax ap-
proach will assign a payoff of Rs.340000 to Strategy A, although in scenarios II
through IV, the payoffs from the strategy are lower. Hence a decision maker
who follows a maximax strategy is an extreme optimist. In the example in the
introductory section, the payoffs that the decision maker assigns to each of
the strategies is given in Table 1.3.

Table 1.3: Payoffs according to a maximax (or optimistic) approach

Scenarios Payoff
Strategy I II III IV assigned
A Rs.340000 Rs.220000 Rs.265000 Rs.220000 Rs.340000
B Rs.340000 Rs.266667 Rs.248333 Rs.248333 Rs.340000
C Rs.313333 Rs.313333 Rs.238333 Rs.238333 Rs.313333
D Rs.313333 Rs.313333 Rs.225000 Rs.225000 Rs.313333
E Rs.275000 Rs.220000 Rs.275000 Rs.220000 Rs.275000
F Rs.255000 Rs.255000 Rs.255000 Rs.255000 Rs.255000
G Rs.255000 Rs.255000 Rs.255000 Rs.255000 Rs.255000
1.2. DECISION MAKING UNDER DEEP UNCERTAINTY 5

The decision maker then proceeds to choose that strategy for which the
payoff that they have assigned is the highest. In this example, they will be
indifferent between choosing either Strategy A or Strategy B.
Over time, decision makers who choose to follow the maximax strategy
can make large payoffs if observed scenarios are favorable in the long run.
However, if they are not, then such decision makers are liable to lose large
payoffs, and unless they have enough money in reserve, can be wiped out of
the market.

The maximin approach

This approach is diametrically opposite to the previous approach. If a deci-
sion maker follows this approach, then they evaluate a decision strategy by
the minimum payoff that it can yield, ignoring the other payoff values from
the strategy in other scenarios. In the example above for instance, such a deci-
sion maker will assign a payoff of Rs.220000 to Strategy A, although in Scenar-
ios I and III the payoffs from this strategy are higher. Hence a decision maker
adopting a maximin decision making approach is an extreme pessimist. In the
example, the payoffs that the decision maker assigns to each decision strategy
is given in Table 1.4. The decision maker then proceeds to choose that strategy

Table 1.4: Payoffs according to a maximin (or pessimistic) approach

Scenarios Payoff
Strategy I II III IV assigned
A Rs.340000 Rs.220000 Rs.265000 Rs.220000 Rs.220000
B Rs.340000 Rs.266667 Rs.248333 Rs.248333 Rs.248333
C Rs.313333 Rs.313333 Rs.238333 Rs.238333 Rs.238333
D Rs.313333 Rs.313333 Rs.225000 Rs.225000 Rs.225000
E Rs.275000 Rs.220000 Rs.275000 Rs.220000 Rs.220000
F Rs.255000 Rs.255000 Rs.255000 Rs.255000 Rs.255000
G Rs.255000 Rs.255000 Rs.255000 Rs.255000 Rs.255000

for which the payoff that they have assigned is the highest. In this example,
they will be indifferent between choosing either Strategy F or Strategy G.
Over time, decision makers who choose to follow the maximin strategy will
make small payoffs in each period. They will tend to avoid any strategy that
yields a negative payoff in the worst case.
 6 CHAPTER 1. COMPARING DECISIONS

The min-max regret approach

The two decision strategies described above suffer from the drawback that
they deal with decision makers who are either extremely risk prone or ex-
tremely risk averse. Decision makers do not typically show such extreme be-
havior. The approach that we discuss now addresses this drawback.
A decision maker takes their decision before they know which scenario will
unfold. In case their decision is optimal in the scenario that unfolds, the de-
cision maker would have taken the best decision that could have been taken.
If that was not the case, then the payoffs from the decision maker’s decision
is suboptimal, and they could have obtained a higher payoff than what they
What is regret? has obtained through their decision. The difference between the payoff that
the decision maker could have achieved had they known the scenario that
would unfold and the payoff that they made through their decision is the de-
cision maker’s regret given a particular decision and a scenario. For example,
suppose that a decision maker decides to adopt Strategy A, and the scenario
that unfolds is Scenario III. The best strategy for Scenario II is Strategy C or D,
which would yield a payoff of Rs.313333. The payoff that the decision maker
obtains through Strategy A is Rs.22000. So the regret associated with Strategy
A when the realized scenario is Scenario II is Rs.(313333 − 220000) = Rs.93333.
The regrets corresponding to each strategy-scenario pair is given in Table 1.5.

Table 1.5: Regrets for different strategy-scenario pairs

Scenarios Maximum
Strategy I II III IV Regret
A Rs.0 Rs.93333 Rs.10000 Rs.35000 Rs.93333
B Rs.0 Rs.46666 Rs.26667 Rs.6667 Rs.46666
C Rs.26667 Rs.0 Rs.36667 Rs.16667 Rs.36667
D Rs.26667 Rs.0 Rs.50000 Rs.30000 Rs.50000
E Rs.65000 Rs.93333 Rs.0 Rs.35000 Rs.93333
F Rs.85000 Rs.58333 Rs.20000 Rs.0 Rs.85000
G Rs.85000 Rs.58333 Rs.20000 Rs.0 Rs.85000

For each decision strategy therefore, there are four regret values, one cor-
responding to each scenario. Since the decision maker does not have any
information about the likelihood of any of the scenarios being realized, the
decision maker chooses the largest of these regrets to represent the regret cor-
responding to a particular strategy. This value is shown in the last column
of Table 1.5 and gives the maximum amount by which the payoff from a par-
ticular strategy will be off from the optimal payoff if that strategy is adopted.
1.3. DECISION MAKING UNDER RISK 7

Obviously, the decision maker would like to minimize the maximum regret,
and chooses that strategy for which the value of the maximum regret is the
minimum. In this example therefore, the decision maker will choose Strategy
C if they adopt the min-max regret approach.
If one adopts a decision making approach using the min-max regret strat-
egy then one can incorporate a reason for sub-optimality of a decision which
is not accounted for in the other two approaches. Consider for example the re-
gret associated with Strategy F in Scenario I. In Strategy F the decision maker
decides to produce 300 tables and 300 chairs. In Scenario I, the amounts of
wood and labor available are 2000 m2 and 1600 labor-hours respectively, so
that even after producing the 600 articles, she has 500 m2 of wood and 400
labor-hours remaining unutilized. Her regret in this case is therefore due to
a loss in opportunity to create more tables and chairs. (She cannot produce
more of tables and chairs, since the other material that she needs for further
production, like paint, varnish, and fabric are not available with her.) This op-
portunity loss factor is not incorporated in either the maximax approach or
the maximin approach.

1.3 Decision Making Under Risk

When a decision maker is taking decisions under risk (as opposed to uncer-
tainty) they have a fair idea about the chances of each of the scenarios being
realized. In other words, they know the probabilities of occurrence of vari-
ous scenarios. Under this condition, it is easier to combine the vector of pay-
offs under different scenarios that each decision strategy entails into a single
number which can represent the effectiveness of a decision strategy.

Expected value approach

Consider a decision strategy for a decision maker which gives rise to a series
of payoffs corresponding to different scenarios that can unfold. If the deci-
sion maker knows the probability of the different scenarios, then the decision
maker can obtain a weighted sum of the payoffs from different scenarios in
which each payoff is weighted by the probability of the corresponding sce-
nario. This weighted sum is called the expected value of the distribution of
payoffs. For example, if Scenarios I through IV occurred with probabilities 0.4,
0.3, 0.1, and 0.2 respectively, then the expected payoff associated with Strategy
A is

0.4×Rs.340000+0.3×Rs.220000+0.1×Rs.265000+0.2×Rs.220000 = Rs.272500.
8 CHAPTER 1. COMPARING DECISIONS

Similar calculations show that the expected payoffs of the other six strategies
are Rs.290500, Rs.290833, Rs.286833, Rs.247500, Rs.255000, and Rs.255000 re-
spectively. The decision maker chooses the scenario that maximizes expected
payoff, i.e., chooses Strategy C whose expected payoff is Rs.290833.
When taking decision under risk, the most common strategy used is that
of maximizing expected payoffs (or minimizing expected costs for cost mini-
mization problems). A part of the reason for doing so is that expected values
is one of the best known measures for handling uncertain situations, and is
thus well-understood by all parties involved in decision making.

Why not expected regret?

Using expected regret values would appear to be a natural method of choosing
an appropriate strategy. However, this is not used in practice, as the prescrip-
tion of this strategy matches that of expected payoff maximization.
To see why this is the case, let us consider comparing two strategies A and
B. Suppose that there are k scenarios, with the probability of Scenario j occur-
ring as p j . Let the payoffs for the two strategies in each of the k scenarios be
a 1 , a 2 , . . . , a k and b 1 , b 2 , . . . , b k respectively. Further let the maximum payoffs
possible in each of the scenarios be m 1 , m 2 , . . . , m k . Note that these values are
independent of the strategy chosen by a decision maker.
Now suppose we prefer Strategy A over Strategy B using the expected pay-
off maximization approach. Denoting the expected payoffs of Strategies A and
B with E P (A) and E P (B ) respectively, we have
k
X k
X
E P (A) > E P (B ), i.e., aj pj > bj pj.
j =1 j =1

Now the regret for Strategy A under the j -th scenario is (m j −a j ) while that
for Strategy B is (m j − b j ). So the expected regret E R(A) for Strategy A is

k
X k
X
E R(A) = (m j − a j )p j = m j p j − E P (A)
j =1 j =1

and that for Strategy B is

k
X
E R(B ) = m j p j − E P (B ).
j =1

Since E P (A) > E P (B ), it follows that E R(A) < E R(B ) which implies that if the
decision maker’s objective was to minimize expected regret, they would have
chosen Strategy A over Strategy B.
1.4. PROBLEMS 9

So we see that the strategy which has the highest expected value has the
lowest expected regret, and hence decisions using the expected value criterion
match those using the expected regret criterion. Since expected values are
easier to understand and explain than expected regrets, the expected regret
criterion is not used in practice.

1.4 Problems
Problem 1.1: A wholesale shop sells crates of fresh (unprocessed) milk. Each
crate consists of 20 bottles. The shop procures crates at Rs.100 per crate, and
sells it at Rs.180 per crate. From past experience, the shop assesses the prob-
abilities of the daily demand for milk as follows:

Demand
(crates) Probability
1 0.1
2 0.1
3 0.3
4 0.3
5 0.2

Unprocessed milk is perishable, and milk procured on one day is considered

to be spoilt the next day. Spoilt milk has no value.

a. Draw the payoff table for the shop.

b. If the shop uses the maximax criterion to make decisions, how many crates
of milk should they stock each day? How many crates should they stock if
they use the maximin criterion?

c. If the shop uses the maximum regret criterion to make decisions, how
many crates of milk should they stock each day? What would be the value
of the maximum regret for the decision that the shop takes?

d. If the shop uses the expected value criterion to make decisions, how many
crates of milk should they stock each day? What would be the expected
profit for the decision that the shop takes?

Problem 1.2: The SciTool Company specializes in scientific instruments, and

has been invited to make a bid on a government contract. The contract calls
10 CHAPTER 1. COMPARING DECISIONS

for a certain number of these instruments to be delivered during the coming

year. The bids must be sealed, so that no company knows what the others
are bidding. SciTool estimates that it will cost Rs.5000 to prepare a bid, and
Rs.95000 to supply the instruments if it wins the contract. Therefore, it has to
decide whether to submit a bid at all, and if it decides to submit a bid, then
whether to submit a bid for Rs.115000, or Rs.120000, or Rs.125000. On the ba-
sis of past contracts of this type, SciTool believe that there is a 30% chance that
there will be no competing bids. In case there are competing bids, then it esti-
mates that the probabilities of the lowest bid being less than Rs.115000 is 0.2,
between Rs.115000 and Rs.120000 is 0.4, between Rs.120000 and Rs.125000 is
0.3, and above Rs.125000 is 0.1. It also estimates that the chance of another
bid being exactly Rs.115000, or Rs.120000, or Rs.125000 is negligible.

a. Write down the entries in the payoff table for SciTool.

b. If SciTool uses the maximin approach to make a decision, what decision

should it take?

c. What is the maximum regret associated with the decision to submit a bid
for Rs.125000?

d. If SciTool wants to minimize maximum regret, what decision should it

take? What will be the value of the maximum regret for their decision?

e. If SciTool wants to use the most likely scenario approach, what decision
should it take?

f. How much payoff should SciTool expect if they decide to submit a bid for
Rs.120000?

g. If SciTool wants to minimize the expected regret associated with their de-
cision, what decision should it take? What will be the value of the expected
regret for their decision?

Problem 1.3: The Morton Company is considering the introduction of a new

product that is believed to have a p = 70% chance of being successful (and a
30% chance of being unsuccessful). If the product is ultimately successful, the
net profit to the company will be $15 million; if unsuccessful, the net loss will
be $25 million.

a. Assuming that the company follows a maximax decision criterion, what

decision should it take?
1.4. PROBLEMS 11

b. Assuming that the company follows a decision criterion of minimizing the

maximum opportunity loss (regret), what decision should it take?

c. Assuming that the company follows a decision criterion of maximizing ex-

pected net profits, what decision should it take?

d. Assume that the company follows a decision criterion of maximizing ex-

pected net profits. Within what range of p values would the company’s
decision as computed in part (c) remain unchanged?

e. Assume that the company follows a decision criterion of maximizing ex-

pected net profits. Within what range can the value of net profits from a
successful introduction vary before the company’s decision as computed
in part (c) changes? Assume for this question, that the net loss if the prod-
uct is unsuccessful remains the same.

Problem 1.4: A manufacturer must produce and deliver 1000 batches of a

particular chemical to a customer. The contribution to profits from each batch
is Rs.30. The manufacturing process of a certain chemical is not perfectly un-
der control. There is a 80% chance that 100 of the 1000 batches are substan-
dard, and a 20% chance that 300 of the 1000 batches are substandard. If the
manufacturer sends a substandard batch to the customer then the customer
demands a replacement for the substandard batch. The cost of replacing a
substandard batch with a perfect batch is Rs.400. The manufacturer has three
options for corrective action available to him.

Option 1: He can distill all the batches of the chemical at a cost of Rs.100 per
batch, and thus have no substandard batches sent to the customer.

Option 2: He can use a chemical reagent to test the quality of each batch at
a cost of Rs.20 per batch, and distill only those batches that are classi-
fied by the test as substandard at the cost of Rs.100 per batch. However
this test is inaccurate. While “good” batches never get classified as sub-
standard by the test, 5% of substandard batches get classified as “good”
and are not distilled. These batches when sent to a customer have to be
replaced at a cost of Rs.400 per batch replaced.

Option 3: He can use a specific gravity test which costs Rs.10 per batch, and
distill only those batches that are classified by the test as substandard at
the cost of Rs.100 per batch. This test is also not accurate. 10% of the
substandard batches get classified as “good” and have to be replaced
12 CHAPTER 1. COMPARING DECISIONS

later (at a cost of Rs.400 per batch). The test also classifies 10% of the
good batches as “substandard”.

a. Draw the payoff table for the manufacturer.

b. If the manufacturer made decisions using the expected value criterion,

which of the options should he choose? What is the expected contribu-
tion to profits for this decision?

c. What is the expected regret if the manufacturer chose Option 3?

Problem 1.5: Tara owns a company that manufactures a fruit product called
CrunchyBites. A packet of this product contains 400gms of dry fruits and
100gms of sugar syrup, and is very popular among young children. It sells
for Rs.11 per packet in the market.
It is the end of the month and Tara has to decide on her purchasing and
manufacturing strategy for the next month. Her supplier for dry fruits is not
reliable; there is a 60% chance that he will supply 4000kg of dry fruits for a
month and a 40% chance that he will supply 6000kg. He supplies dry fruits at
Rs.10 per kilo. As per contract, Tara has to buy the full quantity of dry fruits
that the supplier supplies. She can buy any quantity of dry fruits from the
open market as she likes, but at Rs.15 per kilo.
Tara’s syrup supplier can supply any quantity of syrup that she wants. If
she orders syrup now, before the dry fruits supplier has supplied the dry fruits,
the syrup supplier charges Rs.5 per kilo of syrup. However, if she delays her
order till after her dry fruit supplier supplies dry fruits, the charge goes up to
Rs.7 per kilo of syrup.
Tara’s packing and related overheads come to Rs.2 per pack. She can man-
ufacture a maximum of 15000 packets of CrunchyBites in a month.
The monthly market demand for CrunchyBites is the following:

Demand 10000 packets 15000 packets

Chance 40% 60%

Unsold CrunchyBites packets are sent to a discount store to be sold at Rs.8

per packet. Excess dry fruits can also be sold at the same store at Rs.12 per
kilo. The discount store can sell as many CrunchyBites packets and as much
dry fruits as Tara sends them. Any excess syrup has to be thrown away.
Tara is considering the following four strategies:
1.4. PROBLEMS 13

Strategy 1: Buy 1500 kilos of syrup before the dry fruits supplier supplies fruits.
If the dry fruits supplier supplies 4000kg of fruits, then make and
sell 10000 packets of CrunchyBites; and if he supplies 6000kg, then
make and sell 15000 packets of CrunchyBites.

Strategy 2: Buy 1000 kilos of syrup before the dry fruits supplier supplies fruits.
If the dry fruits supplier supplies 4000kg of fruits, then make and
sell 10000 packets of CrunchyBites; and if he supplies 6000kg, then
make and sell 15000 packets of CrunchyBites buying 500 kilos of
syrup at the higher price.

Strategy 3: Buy 1500 kilos of syrup before the dry fruits supplier supplies fruits.
Make and sell 15000 packets of CrunchyBites, buying 2000kg of
dry fruits from the open market in case the dry fruits supplier sup-
plies 4000kg of fruits.

Strategy 4: Buy 1000 kilos of syrup before the dry fruits supplier supplies fruits.
Regardless of the amount of fruits that the dry fruits supplier sup-
plies, make and sell 10000 packets of CrunchyBites.

a. What is the payoff from each of the strategies if the dry fruits supplier
supplies 4000kgs of dry fruits and the market demand for CrunchyBites
is 15000 packets?

b. What is the expected payoff from each of Tara’s strategies?

c. If Tara’s objective is to maximize her expected payoff, which of the four

strategies should she adopt?

d. Given Tara’s strategies, what is the maximum regret (or opportunity loss)
if Tara decides to follow Strategy 1?

e. Given Tara’s strategies, what is the expected regret (or opportunity loss) if
Tara decides to follow Strategy 1?

f. What is the minimum chance of the demand being 15000 packets for which
your answer for part (c) remains unchanged?

g. Tara decides to insist that her dry fruit supplier supply her with 6000 kilos
of dry fruits every month. For this, the dry fruit supplier can increase his
price of dry fruits. What would be the maximum rate (Rs. per kilo of dry
fruits) that she should be prepared to pay?
 2
CHAPTER
M ULTISTAGE D ECISION M AKING
U NDER R ISK

2.1 Introduction
Consider the example provided in Section 1.1. In the example, the decision
maker has to make her decision in one time point; the product mix that she
needs to aim for, and whether to produce tables first, or whether to produce
chairs first. In the majority of decision making scenarios, the decision mak-
ing is more complex. It involves making multiple decisions at different points
in time, and decisions made earlier have an effect on the payoffs of decisions
made later. In this chapter we study such multi-stage decision making situa-
tions.
We make two assumptions in this chapter. The first is that these situations Assumptions.
are of stochastic uncertainty, and each uncertain event is associated with a
probability of encountering it. The second assumption is that we evaluate dif-
ferent strategies of the decision maker in terms of the expected value criterion
described in Section 1.3. Although these assumptions are generally accepted
in practice, it is possible to consider situations in which they are not appro-
priate. The methods for dealing with such violations are not covered in this
chapter.
In order to understand multi-stage decision making processes, consider
the following decision problem faced by the production manager of a com-
pany X. The company produces a product which is seeing large increases in

1
2 CHAPTER 2. DECISION TREES

market demand. The company’s current production facility is not enough to

meet the demand for the product. In addition to the option of asking the pro-
duction staff to work overtime, the production manager has two more options
to consider. The first option is to subcontract the manufacturing of additional
units of the product to another company, Y. The manager feels that there is an
80% chance that Y will be able to fill the additional demand reliably. In that
case, X will make a profit of Rs.12 lakhs over what it is currently making over
the life-cycle of the product. If Y cannot fill the demand reliably (i.e., their per-
formance is erratic), then X loses Rs.4 lakhs due to various contractual obliga-
tions. The second option is for the production manager to approach the com-
pany’s board asking for permission to augment the production facility. The
manager feels that the chance of approval is 70%. If the board approves the
request, the manager expects an additional profit of Rs.14 lakhs over the life-
cycle of the product. If the board rejects the request, the production manager
can either continue with his current facility and pay overtime to his staff, or
subcontract the production to company Y. In case he goes for overtime pay-
ment, he expects to earn an additional profit of Rs.5 lakhs over the life-cycle
of the product. If he subcontracts production to Y at this stage, he expects
the additional profit to be Rs.10 lakhs if Y fills the product reliably, and the
expected loss to be Rs.5 lakhs if they do not. The decision making problem is
one of figuring out what the production manager should do.
A solution to a decision problem must specify a course of action in all sce-
narios, and so even though the immediate decision that the production man-
ager needs to take is to choose between going for overtime, or for subcontract-
ing, or for approaching the board with a proposal for capacity augmentation,
solution alternatives for the manager are the following.

Strategy A: Proceed with same capacity and overtime payment.

Strategy B: Subcontract to company Y.

Strategy C: Approach the board with a proposal to augment capacity, and if

they reject the proposal go for paying overtime.

Strategy D: Approach the board with a proposal to augment capacity, and if

they reject the proposal, subcontract to company Y.

At the end of the life-cycle of the product, the production manager will
find himself in one of the following scenarios.

Scenario I: No proposal was made, and the production staff worked over-
time. (Additional profit was Rs.5 lakhs.)
2.2. REPRESENTING MULTI-STAGE DECISION PROBLEMS 3

Scenario II: No proposal was made, company Y’s service was used, and com-
pany Y delivered reliably. (Additional profit was Rs.12 lakhs.)

Scenario III: No proposal was made, company Y’s service was used, and com-
pany Y delivered erratically. (Loss of profit was Rs.4 lakhs.)

Scenario IV: A proposal was made and accepted, so that the production fa-
cility was augmented. (Additional profit was Rs.14 lakhs.)

Scenario V: A proposal was made and rejected, and the production staff work-
ed overtime. (Additional profit was Rs.5 lakhs.)

Scenario VI: A proposal was made and rejected, company Y’s service was used,
and company Y delivered reliably. (Additional profit was Rs.10 lakhs.)

Scenario VII: A proposal was made and rejected, company Y’s service was
used, and company Y delivered erratically. (Loss of profit was Rs.5 lakhs.)

Note that every decision scenario will not be observed for each of the de-
cision strategies. For example, if the production manager decides to adopt
strategy B, he will only see one of Scenarios B and C. If we construct a payoff
table for this problem, the table will be

Scenario
Strategy I II III IV V VI VII
A 5
B 12 −4
C 14 5
D 14 10 −5

In addition, the probability of occurrence of each of the scenarios will be dif-

ferent for each of the decision strategies.
Hence there is a need for a more elegant way of representing and solving
multi-stage decision problems. We will see that method in the next section.

2.2 Representing multi-stage decision problems

Since the payoff table is a cumbersome way of representing multi-stage prob-
lems, one uses a more elegant “graphical” method to represent such prob-
lems. The representation is over time; the left hand side of the diagram rep-
resenting the present while the right hand side representing the future. Each
4 CHAPTER 2. DECISION TREES

sequence of decisions and events that make up the realization of the effects of
a decision strategy is represented as a path in the diagram from the present to
the future.
A diagram that shows all possible realizations in a decision problem is one
which starts at a single point on the left corresponding to the present situation
(before the decision making process starts) and then fans out to the right, with
paths representing different possible realizations. For the decision problem
that we consider, this diagram is shown in Figure 2.1. Each scenario represents

Pay
overtime Payoff:
Rs.5 lakhs

Company Y is
reliable Payoff:
Rs.12 lakhs

a b
Approach
Company Y
Payoff:
Company Y is – Rs.4 lakhs
erratic
Proposal is
approved Payoff:
Rs.14 lakhs
Pay
overtime Payoff:
c
Send proposal Rs.5 lakhs
to the board
Company Y is
d reliable Payoff:
Proposal is
rejected Rs.10 lakhs

e
Approach
Company Y
Payoff:
Company Y is – Rs.5 lakhs
erratic

Figure 2.1: A diagram showing all realizations for the problem

a state at the end of the problem reached by a path (i.e., a realization) from the
left to the right. The payoff to be achieved in the scenario is also marked in the
diagram.
At every junction in the tree (represented by letters from ‘a’ through ‘e’)
there is a possibility of choosing one of multiple realizations. There is how-
ever a difference in the way paths are followed at each junction. In junctions
‘a’ and ‘d’ it is up to the decision maker, the production manager in this case,
2.2. REPRESENTING MULTI-STAGE DECISION PROBLEMS 5

to choose which of the paths he wishes to take. In the other three junctions,
the choice of paths is through a random process, and the decision maker can-
not guide the choice. In the problem situations that we consider, the choice
of paths happen with pre-specified probabilities. If we add these bits of infor-
mation, i.e., the distinction between junctions where the decision maker can
choose paths and where he cannot, and the probabilities with which paths
are chosen at junctions where the decision maker cannot choose the paths,
we obtain an enhanced version of the diagram in Figure 2.1 called a decision
tree. By convention, we represent junctions in which the decision maker can What is a deci-
choose paths with squares and call them decision nodes, while the other junc- sion tree?
tions are represented by circles and are called chance nodes or event nodes.
The probabilities of paths being chosen at each chance node is also added to
the diagram to form the decision tree. Figure 2.2 shows the decision tree for
the production manager’s problem.

Pay
overtime Payoff:
Rs.5 lakhs

Company Y is
reliable Payoff:
p = 0.8 Rs.12 lakhs

a b
Approach
Company Y
p = 0.2 Payoff:
Company Y is – Rs.4 lakhs
erratic
Proposal is
approved Payoff:
p = 0.7 Rs.14 lakhs
Pay
overtime Payoff:
c
Send proposal Rs.5 lakhs
to the board
p = 0.3 Company Y is
d reliable Payoff:
Proposal is
rejected p = 0.8 Rs.10 lakhs

e
Approach
Company Y
p = 0.2 Payoff:
Company Y is – Rs.5 lakhs
erratic

Figure 2.2: The decision tree for the problem

Note that a decision tree is merely a graphical representation of a multi-

6 CHAPTER 2. DECISION TREES

stage decision problem with all data for the problem represented conveniently.
In the next section we will see how to analyze decision trees and choose an op-
timal decision strategy.

2.3 Solving multi-stage decision problems

Given the decision tree representation of the production manager’s problem,
we now solve the problem and arrive at the optimal decision for the manager.
Recall that by our assumption, the production manager uses the expected
value criterion for comparing decision alternatives and choose a decision that
maximizes the expected payoff.
Any decision strategy for this problem answers at least one of two ques-
tions; (1) the immediate question of whether to pay overtime, subcontract, or
make a proposal to the board (as depicted by decision node ‘a’ in the decision
tree of Figure 2.2, and (2) the question of what to do if a proposal is made and
rejected by the board (as depicted by decision node ‘d’. Of course for some de-
cision strategies (such as strategy A and strategy B) the second question does
not arise, but since we do not know beforehand whether one among strate-
gies A and B would be optimal, we need to answer both the questions. In
other words, a solution to a decision tree prescribes an optimal choice at each
decision node, whether it is reached or not.
Now consider the optimal choice at decision node ‘a’. Since the produc-
tion manager is an expected value maximizer, the choice that he will make at
node ‘a’ is the one among the three alternatives that will earn him the maxi-
mum expected payoff. However, we do not know the expected payoff in two of
the three choices (they lead to chance nodes ‘b’ and ‘c’), and so to arrive at this
decision, we need to compute the expected payoffs at ‘b’ and ‘c’. It is obvious
therefore that our analysis of the decision tree should start at the right hand
side of the tree and roll back towards the left, making appropriate decisions
whenever possible. Consider node ‘e’ for example. This is a chance node, and
hence the expected payoff at ‘e’ is Rs.(10 × 0.8 − 5 × 0.2) lakhs i.e., Rs.7 lakhs.
Similarly, the expected payoff at chance node ‘b’ is Rs.(12×0.8−4×0.2) lakhs or
Rs.8.8 lakhs. Once we calculate the expected payoff at ‘e’, we are in a position
to determine the decision at node ‘d’. At node ‘d’ the choice is between paying
overtime and earning a payoff of Rs.5 lakhs and of approaching company Y
and earning an expected payoff of Rs.7 lakhs. For an expected payoff maxi-
mizer, the choice of course is the latter, and hence if the production manager
makes a proposal to the board and the board rejects it, it is optimal for the
production manager to approach company Y. Having made this decision, we
know that should the decision maker reach node ‘d’ then his expected payoff
2.4. SENSITIVITY ANALYSIS 7

is Rs.7 lakhs (the maximum of Rs.5 lakhs and Rs.7 lakhs). This allows us to
compute the expected payoff at chance node ‘c’ as Rs.(14 × 0.7 + 7 × 0.3) lakhs
or Rs.11.9 lakhs. Having computed the expected payoff at node ‘c’, we can
combine this information with the expected payoff at node ‘b’ and the given
payoff at the other node to ascertain that at node ‘a’, the optimal strategy is
to send the proposal of capacity augmentation to the board. And combining
the optimal decisions at decision nodes ‘a’ and ‘c’, we come to the conclusion
that the optimal strategy for the production manager is strategy C, i.e., to send
in a proposal for capacity augmentation to the board, and in case the board
rejects the proposal, to approach company Y with a subcontracting offer. The
expected payoff for this strategy is Rs.11.9 lakhs.
At this point we should be clear about out interpretation of the expected
payoff value of Rs.11.9 lakhs. This figure is an expected value. So this means
that if the production manager faced the same decision problem a large num-
ber (tending to an infinite number) of times, applied strategy C every time,
and computed the average of all the payoffs he received, the average payoff
would be Rs.111.9 lakhs. Every time he takes the decision, he stands to earn
Rs.14 lakhs with probability 0.7, Rs.10 lakhs with probability 0.3 × 0.8 = 0.24,
and lose Rs.5 lakhs with probability 0.3 × 0.2 = 0.06.

2.4 Sensitivity analysis

While computing an optimal decision strategy for the production manager,
we have chosen a 0.7 probability value for a proposal made to the board be-
ing accepted, and a 0.8 probability value of company Y delivering the product
reliably. In any practical scenario, it is almost certain that these probabilities
do not have these exact values, although we expect them to be close to the
chosen values. An important part of analyzing decision trees is to find out
how robust the optimal decision is to changes in these parameters, or in other
words, for what ranges of these probability values does the optimal decision
strategy remain optimal. Notice that we do not make any claim about the ex-
pected payoff from the optimal strategy, but merely ask for the strategy not to
be worse than any other strategy in expected value terms. Such an analysis,
when we allow the value of exactly one of the parameters to change, is called
sensitivity analysis. In the remainder of this section, we demonstrate how to
perform sensitivity analysis on decision trees.
Consider any probability value associated with the production manager’s
decision problem. This could either be the probability that a proposal of ca-
pacity expansion made to the board is accepted, or the probability that com-
pany Y delivers reliably. Let us denote the chosen probability value by p. Now,
8 CHAPTER 2. DECISION TREES

since there are two decision nodes ‘a’ and ‘d’ in the decision tree in Figure 2.2,
any change in the optimal strategy will be reflected as a change in the opti-
mal decision at one or both of these decision nodes. Now let us suppose that
submitting a proposal of capacity
£ a expansion to the board remains the opti-
a
¤
mal decision at node ‘a’ if p ∈ p l , p h , and approaching company Y remains
the optimal decision at node ‘d’ if p ∈ p ld , p hd . Then the range of p for which
£ ¤

strategy C remains optimal is

range = max p la , p ld , min p ha , p hd .

£ © ª © ª¤

Consider the probability value p = 0.7 for a proposal on capacity expan-

sion made to the board being accepted. When we find the allowable range of
p, we consider the other probability (that of company Y delivering reliably)
to remain unchanged. In that case, there is no change in the expected payoff
at node ‘e’ and the decision at node ‘d’ remains unchanged whatever be the
value of p. Hence we can conclude that the optimal decision at node ‘d’ for
Strategy C remains unchanged if p ∈ [0, 1]. The expected payoff at node ‘b’ is
not affected by changes in p and remains unchanged at Rs.8.8 lakhs. The ex-
pected payoff at node ‘c’, calculated as Rs.14p +7(1− p) lakhs = Rs.7p +7 lakhs
obviously changes with the value of p. The decision at node ‘a’ will remain
unchanged when this payoff does not fall below max{Rs.5 lakhs, Rs.8.8 lakhs}
= Rs.8.8 lakhs. So the decision remains unchanged when 7p + 7 ≥ 8.8 or p ≥
0.257. Therefore the optimal decision at node ‘a’ for Strategy C remains un-
changed if p ∈ [0.257, 1]. Combining these values we see that Strategy C re-
mains unchanged when the probability for a proposal made to the board be-
ing accepted is in the range [0.257,1].
Next consider the probability value r = 0.8 of company Y delivering reli-
ably. Similar to the earlier case, when we consider changes in this value, we
assume that the probability that the board accepts a proposal for capacity ex-
pansion remains fixed at 0.7. When the value of r changes, the expected pay-
offs at nodes ‘b’ and ‘e’ obviously change. In terms of r , the expected payoff
at node ‘b’ is Rs.12r − 4(1 − r ) lakhs = Rs.16r − 4 lakhs and that at node ‘e’ is
Rs.15r − 5 lakhs. In the optimal strategy before the change, i.e., in Strategy C,
the decision at node ‘d’ is to approach company Y. So as the value of r changes,
the expected payoff at node ‘d’ also changes to Rs.15r − 5 lakhs. The expected
payoff at node ‘c’ changes since the expected payoff at node ‘d’ changes, and
becomes Rs.11.2+0.3(15r −5) lakhs = Rs.4.5r +9.7 lakhs. The optimal decision
at at node ‘d’ before the value of r changes remains optimal as long as the ex-
pected payoff at node ‘e’ does not fall below Rs.5 lakhs, i.e., 15r − 5 ≥ 5, i.e.,
r ∈ [0.667, 1]. Similarly, the optimal decision at node ‘a’ before the value of r
changes remains optimal as long as 4.5r + 9.7 ≥ max{5, 16r − 4}. As this always
2.5. VALUE OF INFORMATION 9

happens, the optimal decision at node ‘a’ remains optimal when r ∈ [0, 1].
Therefore, strategy C remains unchanged when the probability of company
Y acting reliably is in the range [0.667,1].
It is important to reiterate a few points at this stage. First, when perform-
ing sensitivity analysis, the objective is to find the range of probability values
for which a complete decision strategy remains optimal. Hence it is not suf-
ficient to account only for changes at any one decision node. Note that the
decision at a decision node can change only when the payoffs for at least one
of the alternatives at that node changes. So if a probability value changes, then
decisions “downstream” to the position where that probability value occurs in
the decision tree do not change. Also, any decision “upstream” to that posi-
tion can change only if there are no intermediate decision nodes that filter out
the effect of the change (by choosing a decision alternative which does not lie
on the same path.)

2.5 Value of information

Recall that the decision maker’s criterion for evaluating alternatives is one of
maximizing expected payoffs, which means that implicitly they averaging re-
turns from a large number of identical situations. However, since the present
decision situation is not likely to be repeated identically several times, the de-
cision maker can benefit with any expert advice that pertains to the situation
at hand. For example, in the decision problem that we consider in this chap-
ter, the decision maker is more concerned about the board’s response to this
particular capacity expansion proposal rather than to the board’s response for
capacity expansion proposals in general. Also, he is more concerned about
the ability of company Y to deliver this particular product reliably rather than
that of company Y’s general ability to deliver products reliably. Therefore,
the decision maker (the production manager in our case) will assign a value
to expert advice about their current situation. In this section, we describe a
method to compute the worth of such advice. We first consider the utopian
case of an expert who is perfect, i.e., never makes mistakes, and then consider
more practical fallible experts. In both cases, we compute the worth of the ad-
vice as the increase in expected payoffs that the decision maker achieves with
the expert’s help.

Expected value of perfect information

Consider a perfect expert. In our example, suppose that this expert is infallible
at predicting whether or not company Y will deliver the product reliably. How
 10 CHAPTER 2. DECISION TREES

much is the advise of such an expert worth to the production manager?

Note that the advise of the expert is worth something to the production
manager before he takes the decision of whether or not to approach company
Y. After the decision has been taken the expert’s advice is of no practical use
since the production manager cannot take advantage of the advice to make
better decisions. Also note that since the expert is always right, and company
Y delivers reliably 80% of the time, the expert will say that company Y will de-
liver reliably with a probability of 0.8. However, in a given situation they will
respond with a definite YES or a definite NO, and not make probabilistic state-
This is an im- ments. Also note that since the expert is always right, the decision maker will
portant point to not second-guess the expert, and will take the expert’s decision as the truth
keep in mind. while taking decisions. (This point seems trivial in the present case, but will
be more consequential when we consider fallible experts.)

We know that without the expert’s advice, the optimal strategy for the pro-
duction manager is strategy C which yields an expected payoff of Rs.11.9 lakhs
(see Section 2.3). We also know that in case the expert says that company Y will
deliver reliably, the manager does not need to consider the option of paying
overtime, since the payoff from approaching company Y will be more than
that from paying overtime. Additionally we know that if the expert says that
company Y will not deliver reliably, then the manager does not need to con-
sider the option of approaching them, since the payoff from paying overtime
is higher. So when there is an option of asking the expert, the decision tree for
the decision process is the one shown in Figure 2.3.

Solving the decision tree we find that the expected payoff if the decision
maker decides to consult the expert is Rs.12.5 lakhs. In this diagram, the op-
timal strategy is to consult the expert (at decision node ’a’) and to approach
the board with a proposal no matter what the expert says (at decision nodes
‘c’ and ‘d’). If the board rejects the proposal, they should approach company Y
if the expert says that they will be reliable in their deliveries, and pay overtime
otherwise. The reason that the expert’s advice earns the production manager
a higher expected payoff is that the expert prevents the production manager
from ending up in scenarios in which he would lose money.

Since the expected payoff with access to the expert is Rs.12.5 lakhs while
that without access to the expert is Rs.11.9 lakhs, the worth of the expert’s
opinion is calculated to be Rs.12.5 lakhs - Rs.11.9 lakhs = Rs.0.6 lakhs. This
figure is an expected payoff figure obtained by assuming perfect information
What is EVPI? from the expert. So this figure is called the Expected Value of Perfect Informa-
tion (EVPI).
2.5. VALUE OF INFORMATION 11

Do not ask the

expert Expected Payoff:
Rs.11.9 lakhs

Approach
Company Y Payoff:
Rs.12 lakhs
a Expert says that
Y is reliable Proposal is
c approved Payoff:
p = 0.8 Rs.14 lakhs
p = 0.7

e
Approach board
with proposal
p = 0.3 Payoff:
Proposal is rejected Rs.10 lakhs
b (approach Y)
Ask the expert
Pay
overtime Payoff:
Rs.5 lakhs

p = 0.2 Proposal is
d approved Payoff:
Expert says that
Y is erratic p = 0.7 Rs.14 lakhs

f
Approach board
with proposal
p = 0.3 Payoff:
Proposal is rejected Rs.5 lakhs
(pay overtime)

Figure 2.3: The decision tree with access to perfect information

Expected value of sample information

Next consider an imperfect expert. The imperfection of the expert can lead
the decision maker to two types of mistakes. The first type of mistake is when
an expert states in error that company Y will deliver reliably when it actually
delivers erratically. In such situations, if the production manager follows the
expert, then he makes a monetary loss. The second type of mistake is when
the expert erroneously states that company Y will be erratic in their delivery
when they actually deliver reliably. In this situation, if the production man-
ager follows the expert’s advice, then he will prefer paying overtime to ap-
proaching company Y and will settle for a lower payoff, thus incurring op-
portunity losses. Both these errors clearly do not occur for a perfect expert,
simply because such experts are infallible. These errors are also the reason
why an imperfect expert’s advice cannot be worth more than that of a perfect
expert.
 12 CHAPTER 2. DECISION TREES

Why should one take advice from an imperfect expert when we know that
an imperfect expert makes mistakes and can advise a decision maker into sit-
uations in which the decision maker suffers monetary or opportunity losses?
One takes such advice because when the imperfect expert is correct in their
decision, they can prevent a decision maker from taking decisions that lead to
losses. One expects the latter type of situations to be more frequent than situ-
ations in which the expert makes mistakes, and in the expected value sense, a
decision maker is better off with an imperfect expert’s advice than without it.
It is also this reason that suggests that the decision maker follows the expert’s
advice even though there is a chance that the expert had made a mistake in
judgement. The decision tree with the option of asking an imperfect expert is
shown in Figure 2.4. Note that we have not determined the probability with
which such an expert will say that company Y will deliver reliably.
In order to compute the worth of an imperfect expert’s advice, we need to
find out the probability p with which the expert will say that company Y will
deliver reliably. Data on the expert’s past decisions can help us find the value
of p using Bayes’ rule. Consider for instance in our example, we have an expert
who when she says that company Y will deliver reliably is correct 90% of the
time, and when she says that they will deliver erratically is correct 80% of the
time. The joint probability of company Y delivering reliably and the expert
saying that they will is 0.9p and the joint probability of company Y delivering
reliably and the expert saying that they will not is (1 − 0.8)(1 − p). So in terms
of p, the probability that company Y will deliver reliably is 0.9p + 0.2(1 − p) =
0.7p +0.2. We know this value is actually 0.8, so that 0.7p −0.2 = 0.8 or p = 6/7.
This means that such an expert will say that company Y will deliver reliably
6/7-th of the time.
Solving the decision tree we find that the expected payoff if the decision
maker decides to consult the expert is Rs.12.2 lakhs. The optimal strategy for
the production manager in this situation is to ask the expert at node ‘a’ and
submit a proposal to the board at nodes ‘e’, ‘f’, ‘g’, and ‘h’. If the board rejects
the proposal, the production manager should approach company Y if the ex-
pert says that they are reliable, and pay overtime otherwise. In the diagram,
the expert’s erroneous advice causes the production manager to face a possi-
ble monetary loss at chance node ‘k’, and an opportunity loss at chance nodes
‘l’ and ‘m’.
Since the expected payoff with access to the imperfect expert is Rs.12.2
lakhs while that without access to the expert is Rs.11.9 lakhs, the worth of
the expert’s opinion is calculated to be Rs.12.2 lakhs - Rs.11.9 lakhs = Rs.0.3
What is EVSI? lakhs. As with EVPI, this figure is an expected payoff figure. In practice, since
imperfect information is most often obtained through sampling studies, this
expected value is called Expected Value of Sample Information (EVSI).
2.6. PROBLEMS 13

Expert is right
Payoff Rs. 12 Lakhs
Do not ask the Expected Payoff Probability
expert Rs. 11.9 Lakhs 0.9

Approach Y
d

Expert is wrong
Expert says Y is Payoff Rs. -4 Lakhs
reliable Probability 0.1

a Probability p c
Proposal is
approved
Payoff Rs. 14 Lakhs
Probability 0.7

Approach board
with proposal e
Expert is right
Payoff Rs. 10 Lakhs
Proposal is Probability
rejected, 0.9
b approach Y
Ask the expert f
Probability 0.3

Expert is wrong
Pay overtime Payoff Rs. -5 Lakhs
Payoff Rs. 5
Probability 0.1
Lakhs

Expert says Y is
Proposal is
erratic
g approved
Payoff Rs. 14 Lakhs
Probability 1-p
Probability 0.7

h
Approach board
with proposal Proposal is
rejected, pay
overtime
Payoff Rs. 5 Lakhs
Probability 0.3

Figure 2.4: The decision tree with access to imperfect information

14 CHAPTER 2. DECISION TREES

2.6 Problems
Problem 2.1: A complex airborne navigating system incorporates a sub-ass-
embly which unrolls a map of the flight plan synchronously with the move-
ment of the aeroplane. This sub-assembly is bought on very good terms from
a subcontractor, but is not always in perfect adjustment on delivery. The sub-
assemblies can be readjusted on delivery to guarantee accuracy at a cost of
$220 per sub-assembly. It is not however, possible to distinguish visually those
assemblies that need adjustment.
Alternatively, the sub-assemblies can each be tested electronically to see
if they need adjustment at a cost of $48 per sub-assembly tested. Past experi-
ence shows that about 40 percent of those supplied are defective; the proba-
bility of the test indicating a bad adjustment when the sub-assembly is faulty
is 0.8, while the probability that the test indicates a good adjustment when the
sub-assembly is properly adjusted is 0.9. If the adjustment is not made and
the sub-assembly is found to be faulty when the system has its final check,
the cost of subsequent rectification will be $600.
Draw up a decision tree to show the alternatives open to the purchaser and
use it to determine his appropriate course of action.

Problem 2.2: A company prospecting for minerals divides its exploration area
into ten plots, intending to drill to a depth of 300 feet near the center of each
plot. Geological data suggest that the ten plots are either wholly within a large
mineral field discovered in a neighbouring area or wholly outside the field,
and that there is a 50:50 chance of either. Drilling to 300 feet within the field
would give a 50% chance of a strike, whereas outside the field there would be
virtually no chance of a strike.
On striking minerals the total operating profit can be expected to be $50
million, excluding the cost of exploratory drilling, the cost of which is $100,000
per hole.
After each hole has been drilled a decision is made whether or not to con-
tinue drilling with the next hole. The criterion used for this decision is whether
the expected drilling cost, not including the holes already drilled, exceeds the
expected operating profit.

1. What is the probability that the plots lie within the field, given that no
successful holes have been drilled?

2. How many unsuccessful holes will the company drill before abandoning
the search, and what is the expected drilling cost before the operation
starts?
2.6. PROBLEMS 15

Problem 2.3: There is 60% chance that there are oil-bearing rocks under a
piece of land. With current technology, if a region contains oil-bearing rocks,
there is 80% chance that if an oil and gas company drills a well in that region,
they will hit oil. It requires 1 million dollars to drill a well, and the revenue
earned from the oil extracted is 3 million dollars. The oil and gas company
wants to maximize profits, and follows the expected value criterion to decide
whether to drill a well in that piece of land.

a. Will the company drill a well in that piece of land? What is the expected
value of their best decision?

b. What is the expected value of perfect information in this case?

The company has the option of drilling zero, one, or two wells in that piece of
land. If they decide to drill wells, their decision to drill a second well depends
on the outcome of their drilling the first well.

c. Assume that the company drills a well and the well that they drill hits oil.
How does this fact revise the chance of the presence of oil-bearing rocks
under that piece of land? How does it affect the chance of the company
hitting oil under that piece of land?

d. Assume that the company drills a well and the well that they drill DOES
NOT hit oil. How does this fact revise the chance of the presence of oil-
bearing rocks under that piece of land? How does it affect the chance of
the company hitting oil under that piece of land?

e. Under this policy of deciding on drilling the second well depending on the
result of drilling the first well, what is their expected profit?

Problem 2.4: ABC Company is in the business of manufacturing widgets. The

market size of widgets is 1000 widgets. The market share of a company is as-
sessed by a probability distribution given below:

Market Share 10% 20% 40%

Probability 0.3 0.3 0.4

The company can make widgets by one of the two processes A and B. Pro-
cess A involves a fixed cost of Rs.10,000 and a variable cost of Rs.40 per widget
16 CHAPTER 2. DECISION TREES

produced. Process B involves a fixed cost of Rs.16,000 and a variable cost of

Rs.20 per widget produced.

a. Which of the two processes is the better choice for the company if it wants
to minimize expected manufacturing cost?

b. Within what ranges of probabilities will the choice that you suggest in part
(a) remain the better choice?

Problem 2.5: The Alpha-Omega Company is unsure about its market share
for a particular product. The market share could be 10%, 15%, or 35%. The
company’s initial guess about the chances of the market share being these
values are 0.20, 0.35, and 0.45 respectively. The size of the market is 200. If the
company decides to manufacture the product using process A, then it incurs
a fixed cost of Rs.25,000 and a variable cost of Rs.1200 per unit. If it manufac-
tures the product using process B, then it incurs a fixed cost of Rs.50,000 and
a variable cost of Rs.400 per unit.

a. Write down costs of the two processes under different market share situa-
tions.

b. Which of these two processes should the company use under the expected
value criterion? What would be the expected value of cost incurred?

c. The company is quite sure about the 0.20 probability of their market share
being 10% but are unsure of the other two probability values. Within what
range of probability values for the market share being 15% would their de-
cision in Part (b) remain optimal?

Problem 2.6: Consider the ABC Company of Problem 2.4. The company de-
cides to hire the services of a market research firm to have a better idea of its
actual market share. The market research firm charges a flat fee of Rs.100 re-
gardless of the sample size and an additional charge of Rs.10 per respondent
sampled.

a. What is the expected value of perfect information for ABC Company?

b. What is the maximum number of respondents that ABC Company can ask
the market research firm to sample?
2.6. PROBLEMS 17

c. If the market research firm samples 5 respondents and 2 out of the 5 sam-
pled say that they would buy the widgets manufactured by ABC Company,
which of the two processes should ABC Company use to manufacture wid-
gets if they desire to minimize the expected cost of manufacturing wid-
gets? What is their expected manufacturing cost using this process?

d. What is the expected value of sample information for a sample size of 5

respondents?

Problem 2.7: Consider the Alpha-Omega Company in Problem 2.5. In order

to better ascertain its market share, the company decides to contact a mar-
ket research agency to ask customers of the product whether they use Alpha-
Omega’s product. The market research agency charges a fixed cost of Rs.200
and a variable cost of Rs.50 per customer contacted. Assume that Alpha-
Omega asks the agency to contact 18 customers.

a. What is the expected value of perfect information in this situation?

b. If 2 out of the 18 say that they use Alpha-Omega’s product, which of these
two processes should the company use?

c. If 3 out of the 18 say that they use Alpha-Omega’s product, which of these
two processes should the company use?

d. Compute the EVSI if the company asks the market research agency to con-
tact 18 customers. What is the expected value of the company’s net gain
from this sampling survey?