.

SLIDES BY
.
.
.
.
.
.
. John Loucks
.
. St. Edward’s Univ.
.
.

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Slide 1
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 Chapter 4
Decision Analysis
 Problem Formulation
 Decision Making without Probabilities
 Decision Making with Probabilities
 Risk Analysis and Sensitivity Analysis
 Decision Analysis with Sample Information
 Computing Branch Probabilities

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 Decision Analysis

 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.
 Even when a careful decision analysis has been
conducted, the uncertain future events make the final
consequence uncertain.
 The risk associated with any decision alternative is a
direct result of the uncertainty associated with the
final consequence.
 Good decision analysis includes risk analysis that provides
probability information about the favorable as well as the
unfavorable consequences that may occur.
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 Problem Formulation

 A decision problem is characterized by decision

alternatives, states of nature, and resulting payoffs.
 The decision alternatives are the different possible
strategies the decision maker can employ.
 The states of nature refer to future events, not
under the control of the decision maker, which may
occur. States of nature should be defined so that
they are mutually exclusive and collectively
exhaustive.

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 Example: Pittsburgh Development Corp.

Pittsburgh Development Corporation (PDC)

purchased land that will be the site of a new luxury
condominium complex. PDC commissioned
preliminary architectural drawings for three different
projects: one with 30, one with 60, and one with 90
condominiums.
The financial success of the project depends upon
the size of the condominium complex and the chance
event concerning the demand for the condominiums.
The statement of the PDC decision problem is to
select the size of the new complex that will lead to the
largest profit given the uncertainty concerning the
demand for the condominiums.

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Slide 5
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Influence Diagrams

 An influence diagram is a graphical device showing

the relationships among the decisions, the chance
events, and the consequences.
 Squares or rectangles depict decision nodes.
 Circles or ovals depict chance nodes.
 Diamonds depict consequence nodes.
 Lines or arcs connecting the nodes show the direction
of influence.

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 Influence Diagrams

Decision
Demand for the
Chance Condominiums
Consequence

Complex
Profit
Size

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Slide 7
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Payoff Tables

 The consequence resulting from a specific

combination of a decision alternative and a state of
nature is a payoff.
 A table showing payoffs for all combinations of
decision alternatives and states of nature is a payoff
table.
 Payoffs can be expressed in terms of profit, cost, time,
distance or any other appropriate measure.

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 Example: Pittsburgh Development Corp.

Consider the following problem with three

decision alternatives and two states of nature with the
following payoff table representing profits:

PAYOFF TABLE States of Nature

Strong Demand Weak Demand
Decision Alternative s1 s2
Small complex, d1 8 7
Medium complex, d2 14 5
Large complex, d3 20 -9

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Slide 9
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Making without Probabilities

 Three commonly used criteria for decision making

when probability information regarding the
likelihood of the states of nature is unavailable are:
• the optimistic approach
• the conservative approach
• the minimax regret approach.

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Slide 10
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 Optimistic Approach

 The optimistic approach would be used by an

optimistic decision maker.
 The decision with the largest possible payoff is
chosen.
 If the payoff table was in terms of costs, the decision
with the lowest cost would be chosen.

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Slide 11
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 Example: Optimistic Approach

An optimistic decision maker would use the

optimistic (maximax) approach. We choose the
decision that has the largest single value in the payoff
table.

Maximum
Decision Payoff
Maximax d1 8 Maximax
decision d2 14 payoff
d3 20

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 Conservative Approach

 The conservative approach would be used by a

conservative decision maker.
 For each decision the minimum payoff is listed and
then the decision corresponding to the maximum
of these minimum payoffs is selected. (Hence, the
minimum possible payoff is maximized.)
 If the payoff was in terms of costs, the maximum
costs would be determined for each decision and
then the decision corresponding to the minimum
of these maximum costs is selected. (Hence, the
maximum possible cost is minimized.)

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 Example: Conservative Approach

A conservative decision maker would use the

conservative (maximin) approach. List the minimum
payoff for each decision. Choose the decision with
the maximum of these minimum payoffs.

Maximin Minimum
decision Decision Payoff Maximin
payoff
d1 7
d2 5
d3 -9

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or duplicated, or posted to a publicly accessible website, in whole or in part.
 Minimax Regret Approach

 The minimax regret approach requires the

construction of a regret table or an opportunity loss
table.
 This is done by calculating for each state of nature
the difference between each payoff and the largest
payoff for that state of nature.
 Then, using this regret table, the maximum regret for
each possible decision is listed.
 The decision chosen is the one corresponding to the
minimum of the maximum regrets.

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 Example: Minimax Regret Approach

For the minimax regret approach, first compute a

regret table by subtracting each payoff in a column from
the largest payoff in that column. In this example, in
the first column subtract 8, 14, and 20 from 20; etc.

States of Nature
REGRET TABLE Strong Demand Weak Demand
Decision Alternative s1 s2

Small complex, d1 12 0
Medium complex, d2 6 2
Large complex, d3 0 16

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 Example: Minimax Regret Approach

For each decision list the maximum regret.

Choose the decision with the minimum of these
values.

Maximum
Decision Regret
d1 12
d2 6
Minimax d3 16 Minimax
decision regret

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Slide 17
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Making with Probabilities

 Expected Value Approach

• If probabilistic information regarding the states of
nature is available, one may use the expected
value (EV) approach.
• Here the expected return for each decision is
calculated by summing the products of the payoff
under each state of nature and the probability of
the respective state of nature occurring.
• The decision yielding the best expected return is
chosen.

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or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value of a Decision Alternative

 The expected value of a decision alternative is the

sum of weighted payoffs for the decision alternative.
 The expected value (EV) of decision alternative di is
defined as:
N
EV( d i )   P( s j )Vij
j 1

where: N = the number of states of nature

P(sj ) = the probability of state of nature sj
Vij = the payoff corresponding to decision
alternative di and state of nature sj

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Slide 19
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value Approach

Calculate the expected value for each decision.

The decision tree on the next slide can assist in this
calculation. Here d1, d2, and d3 represent the decision
alternatives of building a small, medium, and large
complex, while s1 and s2 represent the states of nature
of strong demand and weak demand.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 20
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Trees

 A decision tree is a chronological representation of

the decision problem.
 Each decision tree has two types of nodes; round
nodes correspond to the states of nature while square
nodes correspond to the decision alternatives.
 The branches leaving each round node represent the
different states of nature while the branches leaving
each square node represent the different decision
alternatives.
 At the end of each limb of a tree are the payoffs
attained from the series of branches making up that
limb.

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Slide 21
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Tree

Payoffs
s1 .8
$8 mil
2 s2 .2
d1 $7 mil
s1 .8
d2 $14 mil
1 3 s2 .2
d3 $5 mil
s1 .8
$20 mil
4 s2 .2
-$9 mil

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Slide 22
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value for Each Decision

EMV = .8(8 mil) + .2(7 mil) = $7.8 mil

Small d1 2

EMV = .8(14 mil) + .2(5 mil) = $12.2 mil

Medium d2
1 3

EMV = .8(20 mil) + .2(-9 mil) = $14.2 mil

Large d3 4

Choose the decision alternative with the largest EV.

Build the large complex.

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Slide 23
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value of Perfect Information

 Frequently information is available which can

improve the probability estimates for the states of
nature.
 The expected value of perfect information (EVPI) is
the increase in the expected profit that would result
if one knew with certainty which state of nature
would occur.
 The EVPI provides an upper bound on the expected
value of any sample or survey information.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 24
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value of Perfect Information

 EVPI Calculation
• Step 1:
Determine the optimal return corresponding
to each state of nature.
• Step 2:
Compute the expected value of these optimal
returns.
• Step 3:
Subtract the EV of the optimal decision from
the amount determined in step (2).

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 25
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value of Perfect Information

 Expected Value with Perfect Information (EVwPI)

EVwPI = .8(20 mil) + .2(7 mil) = $17.4 mil

 Expected Value without Perfect Information (EVwoPI)

EVwoPI = .8(20 mil) + .2(-9 mil) = $14.2 mil

 Expected Value of Perfect Information (EVPI)

EVPI = |EVwPI – EVwoPI| = |17.4 – 14.2| = $3.2 mil

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 26
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Risk Analysis

 Risk analysis helps the decision maker recognize the

difference between:
• the expected value of a decision alternative, and
• the payoff that might actually occur
 The risk profile for a decision alternative shows the
possible payoffs for the decision alternative along
with their associated probabilities.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 27
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Risk Profile

 Large Complex Decision Alternative

1.00

.80
Probability

.60

.40

.20

-10 -5 0 5 10 15 20

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Slide 28
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Sensitivity Analysis

 Sensitivity analysis can be used to determine how

changes to the following inputs affect the
recommended decision alternative:
• probabilities for the states of nature
• values of the payoffs
 If a small change in the value of one of the inputs
causes a change in the recommended decision
alternative, extra effort and care should be taken in
estimating the input value.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 29
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Analysis with Sample Information

 Frequently, decision makers have preliminary or prior

probability assessments for the states of nature that
are the best probability values available at that time.
 To make the best possible decision, the decision maker
may want to seek additional information about the
states of nature.
 This new information, often obtained through
sampling, can be used to revise the prior probabilities
so that the final decision is based on more accurate
probabilities for the states of nature.
 These revised probabilities are called posterior
probabilities.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 30
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 Example: Pittsburgh Development Corp.

Let us return to the PDC problem and assume

that management is considering a 6-month market
research study designed to learn more about
potential market acceptance of the PDC
condominium project. Management anticipates that
the market research study will provide one of the
following two results:
1. Favorable report: A significant number of the
individuals contacted express interest in
purchasing a PDC condominium.
2. Unfavorable report: Very few of the individuals
contacted express interest in purchasing a PDC
condominium.

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Slide 31
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Influence Diagram

Decision Market Demand

Chance Survey for the
Consequence Results Condominiums

Market Complex
Profit
Survey Size

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Slide 32
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 Sample Information

PDC has developed the following branch

probabilities.

If the market research study is undertaken:

P(Favorable report) = P(F) = .77

P(Unfavorable report) = P(U) = .23

If the market research report is favorable:

P(Strong demand | favorable report) = P(s1|F) = .94

P(Weak demand | favorable report) = P(s2|F) = .06

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Slide 33
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 Sample Information

If the market research report is unfavorable:

P(Strong demand | unfavorable report) = P(s1|U) = .35

P(Weak demand | unfavorable report) = P(s2|U) = .65

If the market research study is not undertaken, the prior

probabilities are applicable:

P(Favorable report) = P(F) = .80

P(Unfavorable report) = P(U) = .20

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Slide 34
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 Decision Tree
s1 P(s1) = .94 $ 8 mil
d1 6 s2
P(s2) = .06 $ 7 mil
d2 s1
s2 P(s1) = .94 $14 mil
F 3 7
d3 P(s2) = .06 $ 5 mil
(.77) s1
s2 P(s1) = .94 $20 mil
8
Conduct P(s2) = .06 -$ 9 mil
2 s1 P(s1) = .35
Market d1 s2 $ 8 mil
9
Research U P(s2) = .65 $ 7 mil
d2 s1
Study (.23) 10 s2 P(s1) = .35 $14 mil
4
d3 s1 P(s2) = .65 $ 5 mil
1 $20 mil
11 s2 P(s1) = .35
s1 P(s2) = .65 -$ 9 mil
d1 12 s2 P(s1) = .80 $ 8 mil
Do Not Conduct
s1 P(s2) = .20 $ 7 mil
Market Research d2
5 13 s2 P(s1) = .80 $14 mil
Study d3 s1 P(s2) = .20 $ 5 mil
14 s2 P(s1) = .80 $20 mil
P(s2) = .20 -$ 9 mil
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Slide 35
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Strategy

 A decision strategy is a sequence of decisions and

chance outcomes where the decisions chosen depend on
the yet-to-be-determined outcomes of chance events.
 The approach used to determine the optimal decision
strategy is based on a backward pass through the
decision tree using the following steps:
• At chance nodes, compute the expected value by
multiplying the payoff at the end of each branch by
the corresponding branch probabilities.
• At decision nodes, select the decision branch that
leads to the best expected value. This expected value
becomes the expected value at the decision node.

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Slide 36
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Tree
EV = d1 6 EV = .94(8) + .06(7) = $7.94 mil
$18.26 mil
d2
F 3 7 EV = .94(14) + .06(5) = $13.46 mil
d3
(.77)
EV = 8 EV = .94(20) + .06(-9) = $18.26 mil
$15.93 2
mil d1 9 EV = .35(8) + .65(7) = $7.35 mil
U
d2
(.23) 4 10 EV = .35(14) + .65(5) = $8.15 mil
d3
1 EV =
11 EV = .35(20) + .65(-9) = $1.15 mil
EV = $8.15 mil
$15.93 d1 12 EV = .8(8) + .2(7) = $7.80 mil
mil
d2
5 13 EV = .8(14) + .2(5) = $12.20 mil
d3
EV = $14.20 mil
14 EV = .8(20) + .2(-9) = $14.20 mil
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Slide 37
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Decision Strategy

 PDC’s optimal decision strategy is:

• Conduct the market research study.
• If the market research report is favorable, construct
the large condominium complex.
• If the market research report is unfavorable,
construct the medium condominium complex.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 38
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Risk Profile

 PDC’s Risk Profile

1.00

.80 .72
Probability

.60

.40

.20 .15
.05 .08

-10 -5 0 5 10 15 20

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 39
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Expected Value of Sample Information

 The expected value of sample information (EVSI) is

the additional expected profit possible through
knowledge of the sample or survey information.
 The expected value associated with the market
research study is $15.93.
 The best expected value if the market research
study is not undertaken is $14.20.
 We can conclude that the difference, $15.93 
$14.20 = $1.73, is the expected value of sample
information.
 Conducting the market research study adds $1.73
million to the PDC expected value.

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Slide 40
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Efficiency of Sample Information

 Efficiency of sample information is the ratio of EVSI to

EVPI.
 As the EVPI provides an upper bound for the EVSI,
efficiency is always a number between 0 and 1.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 41
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Efficiency of Sample Information

The efficiency of the survey:

E = (EVSI/EVPI) X 100
= [($1.73 mil)/($3.20 mil)] X 100
= 54.1%

The information from the market research study is 54.1% as

efficient as perfect information.

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Slide 42
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Computing Branch Probabilities

 We will need conditional probabilities for all sample

outcomes given all states of nature, that is, P(F | s1),
P(F | s2), P(U | s1), and P(U | s2).

Market Research
State of Nature Favorable, F Unfavorable, U
Strong demand, s1 P(F| s1) = .90 P(U| s1) = .10
Weak demand, s2 P(F| s2) = .25 P(U| s2) = .75

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Slide 43
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 Computing Branch Probabilities

 Branch (Posterior) Probabilities Calculation

• Step 1:
For each state of nature, multiply the prior
probability by its conditional probability for the
indicator -- this gives the joint probabilities for the
states and indicator.

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Slide 44
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 Computing Branch Probabilities

 Branch (Posterior) Probabilities Calculation

• Step 2:
Sum these joint probabilities over all states --
this gives the marginal probability for the indicator.
• Step 3:
For each state, divide its joint probability by the
marginal probability for the indicator -- this gives
the posterior probability distribution.

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Slide 45
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 Bayes’ Theorem and Posterior Probabilities

 Knowledge of sample (survey) information can be

used to revise the probability estimates for the states of
nature.
 Prior to obtaining this information, the probability
estimates for the states of nature are called prior
probabilities.
 With knowledge of conditional probabilities for the
outcomes or indicators of the sample or survey
information, these prior probabilities can be revised by
employing Bayes' Theorem.
 The outcomes of this analysis are called posterior
probabilities or branch probabilities for decision trees.

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Slide 46
or duplicated, or posted to a publicly accessible website, in whole or in part.
 Posterior Probabilities

Favorable
State of Prior Conditional Joint Posterior
Nature Probability Probability Probability Probability
sj P(sj) P(F|sj) P(F I sj) P(sj |F)

s1 0.8 0.90 0.72 0.94

s2 0.2 0.25 0.05 0.06
P(favorable) = P(F) = 0.77 1.00

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Slide 47
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 Posterior Probabilities

Unfavorable
State of Prior Conditional Joint Posterior
Nature Probability Probability Probability Probability
sj P(sj) P(U|sj) P(U I sj) P(sj |U)

s1 0.8 0.10 0.08 0.35

s2 0.2 0.75 0.15 0.65
P(unfavorable) = P(U) = 0.23 1.00

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Slide 48
or duplicated, or posted to a publicly accessible website, in whole or in part.
 End of Chapter 4

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© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
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© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 51
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© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied
Slide 52
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