Decision Analysis

Chapter 15

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Introduction
• Business analytics is about making better decisions
• Decision analysis can be used to develop an optimal strategy:
• When a decision maker is faced with several decision alternatives and an
uncertain or risk-filled pattern of future events
• For example: The State of North Carolina used decision analysis in evaluating
whether to implement a medical screening test to detect metabolic disorders
in newborns
• A good decision analysis includes careful consideration of risk

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Introduction
• Risk analysis helps to provide the probability information about the
favorable as well as the unfavorable outcomes that may occur
• Decision analysis considers problems that involve reasonably few
decision alternatives and reasonably few possible future events
• Topics to be discussed under decision analysis:
• Payoff tables and decision trees
• Sensitivity analysis
• Use of Bayes’ theorem

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Problem Formulation
Payoff Tables
Decision Trees

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Problem Formulation
• The first step in the decision analysis process is problem formulation:
• Create verbal statement of the problem
• Identify the decision alternatives:
• The uncertain future events, referred to as chance events
• The outcomes associated with each combination of decision alternative and chance
event outcome

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Problem Formulation
Example: Construction project of Pittsburgh Development Corporation
• PDC commissioned preliminary architectural drawings for three
different projects:
• One with 30 condominiums
• One with 60 condominiums
• One with 90 condominiums
• The financial success of the project depends on:
• The size of the condominium complex
• The chance event concerning the demand for the condominiums

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Problem Formulation
• The statement of the PDC decision problem is to select the size of the
new luxury condominium project that will lead to the largest profit
given the uncertainty concerning the demand for the condominiums
• Given the statement of the problem, it is clear that the decision is to
select the best size for the condominium complex
• PDC has the following three decision alternatives:
• d1 = a small complex with 30 condominiums
• d2 = a medium complex with 60 condominiums
• d3 = a large complex with 90 condominiums

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Problem Formulation
• In decision analysis, the possible outcomes for a chance event are the
states of nature
• The states of nature are mutually exclusive (no more than one can
occur) and collectively exhaustive (at least one must occur)
• Thus one and only one of the possible states of nature will occur
• For PDC example: The chance event concerning the demand for the
condominiums has two states of nature:
• s1 = strong demand for the condominiums
• s2 = weak demand for the condominiums

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Problem Formulation
Payoff Tables Table 15.1: Payoff Table for the PDC
Condominium Project ($ Millions)
• Payoff is the outcome
resulting from a specific
combination of a decision
alternative and a state of
nature
• Payoff table is a table
showing payoffs for all
combinations of decision
alternatives and states of
nature
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Problem Formulation
• We will use the notation Vij to denote the payoff associated with
decision alternative i and state of nature j
• Using Table 15.1, V31 = 20 indicates that a payoff of $20 million occurs
if the decision is to build a large complex (d3) and the strong demand
state of nature (s1) occurs

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Problem Formulation
Decision Tree
• A decision tree provides a graphical representation of the decision-
making process
• Shows the natural or logical progression that will occur over time
• Example: The topmost payoff of 8 indicates that an $8 million profit is
anticipated if PDC constructs a small condominium complex (d1) and
demand turns out to be strong (s1)

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Figure 15.1: Decision Tree For The PDC Condominium
Project ($ Millions)

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Problem Formulation
• The decision tree in Figure 15.1 shows:
• Four nodes, numbered 1–4
• Nodes are used to represent decisions and chance events
• Squares are used to depict decision nodes, circles are used to depict
chance nodes
• Node 1 is a decision node, and nodes 2, 3, and 4 are chance nodes

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Problem Formulation
• The branches connect the nodes; those leaving the decision node
correspond to the decision alternatives
• The branches leaving each chance node correspond to the states of
nature
• The outcomes (payoffs) are shown at the end of the states-of-nature
branches

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Decision Analysis Without
Probabilities
Optimistic Approach
Conservative Approach
Minimax Regret Approach

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Decision Analysis Without Probabilities
• Decision analysis without probabilities is appropriate in situations:
• In which a simple best-case and worst-case analysis is sufficient
• Where the decision maker has little confidence in his or her ability to
assess the probabilities

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Decision Analysis Without Probabilities
Optimistic Approach
• The optimistic approach evaluates each decision alternative in terms of the
best payoff that can occur
• The decision alternative that is recommended is the one that provides the
best possible payoff
• For minimization problems, this approach leads to choosing the alternative
with the smallest payoff

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Decision Analysis Without Probabilities
Table 15.2: Maximum Payoff For Each PDC
Decision Alternative
In the PDC problem, the
optimistic approach would
lead the decision maker to
choose the alternative
corresponding to the
largest profit

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Decision Analysis Without Probabilities
Conservative Approach
• The conservative approach evaluates each decision alternative in terms of
the worst payoff that can occur
• The decision alternative recommended is the one that provides the best of
the worst possible payoffs
• For problems involving minimization (for example, when the output
measure is cost), this approach identifies the alternative that will minimize
the maximum payoff

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Decision Analysis Without Probabilities
Table 15.3: Minimum Payoff For Each
PDC Decision Alternative

In the PDC problem, the

conservative approach
would lead the decision
maker to choose the
alternative that maximizes
the minimum possible profit
that could be obtained

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Decision Analysis Without Probabilities
Minimax Regret Approach
• Regret is the difference between the payoff associated with a
particular decision alternative and the payoff associated with the
decision that would yield the most desirable payoff for a given state
of nature
• Regret is often referred to as opportunity loss
• Under the minimax regret approach, one would choose the decision
alternative that minimizes the maximum state of regret that could
occur over all possible states of nature

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Decision Analysis Without Probabilities
• Using equation (15.1) and the payoffs in Table 15.1, the regret
associated with each combination of decision alternative di and state
of nature sj is computed
• To compute the regret, subtract each entry in a column from the
largest entry in the column

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Decision Analysis Without Probabilities
Table 15.4: Opportunity Loss, or Regret, Table for the PDC Condominium Project
($ Millions)

Table 15.5: Maximum Regret for Each PDC Decision Alternative

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Decision Analysis Without Probabilities
• The next step in applying the minimax regret approach is to list the
maximum regret for each decision alternative
• For the PDC problem, the alternative to construct the medium
condominium complex, with a corresponding maximum regret of $6
million, is the recommended minimax regret decision

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Decision Analysis with
Probabilities
Expected Value Approach
Risk Analysis
Sensitivity Analysis

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Decision Analysis With Probabilities
Expected Value Approach
• The expected value (EV) of a decision alternative is the sum of weighted
payoffs for the decision alternative
• The weight for a payoff is the probability of the associated state of nature
and therefore the probability that the payoff will occur

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Figure 15.2: PDC Decision Tree with State-of-Nature
Branch Probabilities

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Figure 15.3: Applying the Expected Value Approach
Using a Decision Tree for the PDC Condominium Project

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Decision Analysis With Probabilities
• Select the decision branch leading to the chance node with the best
expected value
• The decision alternative associated with this branch is the
recommended decision
• In practice, obtaining precise estimates of the probabilities for each
state of nature is often impossible, so historical data is preferred to
use for estimating the probabilities for the different states of nature

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Decision Analysis With Probabilities
Risk Analysis
• Risk analysis helps the decision maker recognize the difference
between the expected value of a decision alternative and the payoff
that may actually occur
• Decision alternative and a state of nature combine to generate the
payoff associated with a decision
• Risk profile for a decision alternative shows the possible payoffs
along with their associated probabilities

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Figure 15.4: Risk Profile for the Large Complex Decision
Alternative for the PDC Condominium Project

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Decision Analysis With Probabilities
Sensitivity Analysis
• Sensitivity analysis determines how changes in the probabilities for the
states of nature or changes in the payoffs affect the recommended decision
alternative
• In many cases, the probabilities for the states of nature and the payoffs are
based on subjective assessments
• Sensitivity analysis helps the decision maker understand which of these
inputs are critical to the choice of the best decision alternative
• If a small change in the value of one of the inputs causes a change in the
recommended decision alternative, the solution to the decision analysis
problem is sensitive to that particular input

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Decision Analysis With Probabilities
• Example: Suppose that, in the PDC problem, the probability for a strong
demand is revised to 0.2 and the probability for a weak demand is revised
to 0.8
• EV(d1 ) = 0.2 (8) + 0.8 (7) = 7.2
• EV(d2 ) = 0.2 (14) + 0.8 (5) = 6.8
• EV(d3 ) = 0.2 (20) + 0.8 (29) = 23.2
• With these probability assessments, the recommended decision alternative
alternative is to construct a small condominium complex (d1), with an
expected value of $7.2 million
• When the probability of strong demand is large, PDC should build the large
complex; when the probability of strong demand is small, PDC should build
the small complex
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