Taylor 11 CHPT 12 3 - Notes

Decision Analysis
Chapter 12
Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall
12-1
Chapter Topics
Components of Decision Making

Decision Making without Probabilities
Decision Making with Probabilities
Decision Analysis with Additional Information
Utility
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Decision Analysis
Overview
Previous chapters used an assumption of certainty with regards to
problem parameters.
This chapter relaxes the certainty assumption
Two categories of decision situations:
Probabilities can be assigned to future occurrences
Probabilities cannot be assigned to future occurrences
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Decision Analysis
Components of Decision Making
A state of nature is an actual event that may occur in the future.
A payoff table is a means of organizing a decision situation,
presenting the payoffs from different decisions given the various
states of nature.
Table 12.1 Payoff table

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Decision Analysis
Decision Making Without Probabilities
Figure 12.1 Decision

situation with real
estate investment
alternatives
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Decision Analysis
Table 12.2 Payoff table for the real estate

investments
Decision-Making Criteria
maximax
maximin
minimax regret
Hurwicz
likelihood
Copyright
2013 Pearson Education, Inc. Publishing as Prentice Hall
minimax
equal
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Maximax Criterion
In the maximax criterion the decision maker selects the
decision that will result in the maximum of maximum payoffs;
an optimistic criterion.
Table 12.3
Payoff table illustrating a maximax decision
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Maximin Criterion
In the maximin criterion the decision maker selects the
decision that will reflect the maximum of the minimum
payoffs; a pessimistic criterion.
Table 12.4 Payoff table illustrating a maximin decision

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Minimax Regret Criterion
Regret is the difference between the payoff from the best
decision and all other decision payoffs.
Example: under the Good Economic Conditions state of
nature, the best payoff is $100,000. The managers regret for
choosing the Warehouse alternative is $100,000$30,000=$70,000
Table 12.5
Regret table
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Minimax Regret Criterion
The manager calculates regrets for all alternatives under each
state of nature. Then the manager identifies the maximum
regret for each alternative.
Finally, the manager attempts to avoid regret by selecting the
decision alternative that minimizes the maximum regret.
Table 12.6 Regret table illustrating the minimax regret

decision
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Hurwicz Criterion
The Hurwicz criterion is a compromise between the maximax
and maximin criteria.
A coefficient of optimism, , is a measure of the decision
makers optimism.
The Hurwicz criterion multiplies the best payoff by and the
worst payoff by 1- , for each decision, and the best result is
selected. Here, = 0.4.
Decision
Apartment building
Values
$50,000(.4) + 30,000(.6) = 38,000
Office building
$100,000(.4) - 40,000(.6) = 16,000
Warehouse
$30,000(.4) + 10,000(.6) = 18,000
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Equal Likelihood Criterion
The equal likelihood ( or Laplace) criterion multiplies the
decision payoff for each state of nature by an equal weight,
thus assuming that the states of nature are equally likely to
occur.
Decision
Apartment building
Values
$50,000(.5) + 30,000(.5) = 40,000
Office building
$100,000(.5) - 40,000(.5) = 30,000
Warehouse
$30,000(.5) + 10,000(.5) = 20,000
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Summary of Criteria Results
A dominant decision is one that has a better payoff than
another decision under each state of nature.
The appropriate criterion is dependent on the risk personality
and philosophy of the decision maker.
Criterion
Decision (Purchase)
Maximax
Office building
Maximin
Apartment building
Minimax regret
Apartment building
Hurwicz
Apartment building
Equal likelihood
Apartment building
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Solution with QM for Windows (1 of 3)
Exhibit 12.1
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Equal likelihood weight
Exhibit 12.2
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Exhibit 12.3
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Solution with Excel
=MIN(C7,D7)
=MAX(E7,E9)
=MAX(F7:F9)
=MAX(C18,D18)
=MAX(C7:C9)-C9
=C7*C25+D7*C26
=C7*0.5+D7*0.5
Exhibit 12.4
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Expected Value
Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence.
Table 12.7 Payoff table with probabilities for states of

nature
EV(Apartment) = $50,000(.6) + 30,000(.4) = $42,000
EV(Office) = $100,000(.6) - 40,000(.4) = $44,000
EV(Warehouse) = $30,000(.6) + 10,000(.4) = $22,000
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Expected Opportunity Loss
The expected opportunity loss is the expected value of the
regret for each decision.
The expected value and expected opportunity loss criterion
result in the same decision.
EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000
EOL(Office) = $0(.6) + 70,000(.4) = 28,000
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
Table 12.8 Regret table with probabilities for states of nature

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Expected Value Problems

Solution with QM for Windows
Expected values
Exhibit 12.5
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Solution with Excel and Excel QM (1 of 2)
Expected value for

apartment building
Exhibit 12.6
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Solution with Excel and Excel QM (2 of 2)
Click on Add-Ins to access
the Excel QM menu
Exhibit 12.7
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Expected Value of Perfect Information
The expected value of perfect information (EVPI) is the
maximum amount a decision maker would pay for additional
information.
EVPI equals the expected value given perfect information
minus the expected value without perfect information.
EVPI equals the expected opportunity loss (EOL) for the best
decision.
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EVPI Example (1 of 2)
Table 12.9
Payoff table with decisions, given perfect information
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EVPI Example (2 of 2)
Decision with perfect information:
$100,000(.60) + 30,000(.40) = $72,000
Decision without perfect information:
EV(office) = $100,000(.60) - 40,000(.40) = $44,000
EVPI = $72,000 - 44,000 = $28,000
EOL(office) = $0(.60) + 70,000(.4) = $28,000
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EVPI with QM for Windows
The expected value, given
perfect information, in Cell F12
=MAX(E7:E9)
=F12-F11
Exhibit 12.8
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Decision Trees (1 of 4)
A decision tree is a diagram consisting of decision nodes
(represented as squares), probability nodes (circles), and
decision alternatives (branches).
Table 12.10 Payoff table for real estate investment example

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Figure 12.2 Decision tree for real estate investment example

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The expected value is computed at each probability node:
EV(node 2) = .60($50,000) + .40(30,000) = $42,000
EV(node 3) = .60($100,000) + .40(-40,000) = $44,000
EV(node 4) = .60($30,000) + .40(10,000) = $22,000
Branches with the greatest expected value are selected.
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Figure 12.3 Decision tree with expected value at probability

nodes
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Decision Trees with QM for Windows
Select node to add from
Number of branches
from node 1
Add branches from node

1 to 2, 3, and 4
Exhibit 12.9
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Decision Trees with Excel and TreePlan (1 of 4)
Exhibit 12.10
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To create another branch, click
B5, then the Decision Tree
menu, and select Add Branch
Invoke TreePlan from

the Add Ins menu
Exhibit 12.11
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Click on cell F3,

then Decision Tree
Select Change to
Event Node and add
two new branches
Exhibit 12.12
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Add numerical dollar and probability
values in these cells in column H
Exhibit 12.13
These cells contain decision tree

formulas; do not type in these
cells in columns E and I
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Sequential Decision Tree Analysis

Solution with QM for Windows
Cell A16 contains

the expected value
of $44,000
Exhibit 12.14
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Sequential Decision Trees (1 of 4)
A sequential decision tree is used to illustrate a situation
requiring a series of decisions.
Used where a payoff table, limited to a single decision, cannot
be used.
The next slide shows the real estate investment example
modified to encompass a ten-year period in which several
decisions must be made.
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Figure 12.4 Sequential decision tree

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Expected value of apartment building is:
$1,290,000-800,000 = $490,000
Expected value if land is purchased is:
$1,360,000-200,000 = $1,160,000
The decision is to purchase land; it has the highest net
expected value of $1,160,000.
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13

Figure 12.5 Sequential decision tree with nodal expected

values
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Solution with Excel QM
Exhibit 12.15
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Solution with TreePlan
Exhibit 12.16
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Bayesian Analysis (1 of 3)
Bayesian analysis uses additional information to alter the
marginal probability of the occurrence of an event.
In the real estate investment example, using the expected
value criterion, the best decision was to purchase the office
building with an expected value of $444,000, and EVPI of
$28,000.
Table 12.11 Payoff table for real estate investment

12-43

A conditional probability is the probability that an event will
occur given that another event has already occurred.
An economic analyst provides additional information for the
real estate investment decision, forming conditional
probabilities:
g = good economic conditions
p = poor economic conditions
P = positive economic report
N = negative economic report
P(Pg) = .80
P(NG) = .20
P(Pp) = .10
P(Np) = .90
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A posterior probability is the altered marginal probability of an
event based on additional information.
Prior probabilities for good or poor economic conditions in
the real estate decision:
P(g) = .60; P(p) = .40
Posterior probabilities by Bayes rule:
(gP) = P(PG)P(g)/[P(Pg)P(g) + P(Pp)P(p)]
= (.80)(.60)/[(.80)(.60) + (.10)(.40)] = .923
Posterior (revised) probabilities for decision:
P(gN) = .250
P(pP) = .077
P(pN) = .750
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Decision Trees with Posterior Probabilities (1 of
4)
Decision trees with posterior probabilities differ from earlier
versions in that:
Two new branches at the beginning of the tree represent
report outcomes.
Probabilities of each state of nature are posterior
probabilities from Bayes rule.
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4)
Figure 12.6 Decision tree with posterior

probabilities
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4)
EV (apartment building) = $50,000(.923) + 30,000(.077)
= $48,460
EV (strategy) = $89,220(.52) + 35,000(.48) = $63,194
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16

4)
Figure 12.7 Decision tree analysis for real estate investment

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Computing Posterior Probabilities with Tables
Table 12.12 Computation of posterior

probabilities
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Computing Posterior Probabilities with Excel
Exhibit 12.17
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Expected Value of Sample Information
The expected value of sample information (EVSI) is the
difference between the expected value with and without
information:
For example problem, EVSI = $63,194 - 44,000 = $19,194
The efficiency of sample information is the ratio of the
expected value of sample information to the expected value of
perfect information:
efficiency = EVSI /EVPI = $19,194/ 28,000 = .68
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Utility (1 of 2)
Table 12.13 Payoff table for auto insurance example
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Utility (2 of 2)
Expected Cost (insurance) = .992($500) + .008(500) = $500
Expected Cost (no insurance) = .992($0) + .008(10,000) = $80
The decision should be do not purchase insurance, but people
almost always do purchase insurance.
Utility is a measure of personal satisfaction derived from
money.
Utiles are units of subjective measures of utility.
Risk averters forgo a high expected value to avoid a lowprobability disaster.
Risk takers take a chance for a bonanza on a very lowprobability event in lieu of a sure thing.
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Decision Analysis
Example Problem Solution (1 of 9)
A corporate raider contemplates the future of a recent acquisition.
Three alternatives are being considered in two states of nature. The
payoff table is below.
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Decision Analysis
a. Determine the best decision without probabilities using the
5 criteria of the chapter.
b. Determine best decision with probabilities assuming .70
probability of good conditions, .30 of poor conditions. Use
expected value and expected opportunity loss criteria.
c. Compute expected value of perfect information.
d. Develop a decision tree with expected value at the nodes.
e. Given the following, P(Pg) = .70, P(Ng) = .30, P(Pp) =
20, P(Np) = .80, determine posterior probabilities using
Bayes rule.
f. Perform a decision tree analysis using the posterior
probability obtained in part e.
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Decision Analysis
Step 1 (part a): Determine decisions without probabilities.
Maximax Decision: Maintain status quo
Decisions
Maximum Payoffs
Expand
Status quo
Sell
$800,000
1,300,000 (maximum)
320,000
Maximin Decision: Expand

Decisions
Minimum Payoffs
Expand
Status quo
Sell
$500,000 (maximum)
-150,000
320,000
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Decision Analysis
Minimax Regret Decision: Expand
Decisions
Maximum Regrets
Expand
$500,000 (minimum)
Status quo
Sell
650,000
980,000
Hurwicz ( = .3) Decision: Expand

Expand
Status quo
$285,000
Sell
$800,000(.3) + 500,000(.7) = $590,000

$1,300,000(.3) - 150,000(.7) =
$320,000(.3) + 320,000(.7) = $320,000
12-58
Decision Analysis
Equal Likelihood Decision: Expand
Expand
Status quo
Sell
$800,000(.5) + 500,000(.5) = $650,000

$1,300,000(.5) - 150,000(.5) = $575,000
$320,000(.5) + 320,000(.5) = $320,000
Step 2 (part b): Determine Decisions with EV and EOL.

Expected value decision: Maintain status quo
Expand
Status quo
Sell
$800,000(.7) + 500,000(.3) = $710,000

$1,300,000(.7) - 150,000(.3) = $865,000
$320,000(.7) + 320,000(.3) = $320,000
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Decision Analysis
Expected opportunity loss decision: Maintain status quo
Expand
Status quo
Sell
$500,000(.7) + 0(.3) = $350,000

0(.7) + 650,000(.3) = $195,000
$980,000(.7) + 180,000(.3) = $740,000
Step 3 (part c): Compute EVPI.

EV given perfect information =
1,300,000(.7) + 500,000(.3) = $1,060,000
EV without perfect information =
$1,300,000(.7) - 150,000(.3) = $865,000
EVPI = $1,060,000 - 865,000 = $195,000
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20
Decision Analysis
Step 4 (part d): Develop a decision tree.
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Decision Analysis
Step 5 (part e): Determine posterior probabilities.
P(gP) = P(Pg)P(g)/[P(Pg)P(g) + P(Pp)P(p)]
= (.70)(.70)/[(.70)(.70) + (.20)(.30)] = .891
P(pP) = .109
P(gN) = P(Ng)P(g)/[P(Ng)P(g) + P(Np)P(p)]
= (.30)(.70)/[(.30)(.70) + (.80)(.30)] = .467
P(pN) = .533
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Decision Analysis
Step 6 (part f): Decision tree analysis.
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Decision Analysis

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Components of Decision Making

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Table 12.1 Payoff table

Figure 12.1 Decision

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Table 12.2 Payoff table for the real estate

Decision Making without Probabilities

Payoff table illustrating a maximax decision

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making without Probabilities

Table 12.4 Payoff table illustrating a maximin decision

Decision Making without Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making without Probabilities

Table 12.6 Regret table illustrating the minimax regret

Decision Making without Probabilities

$100,000(.4) - 40,000(.6) = 16,000

$30,000(.4) + 10,000(.6) = 18,000

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making without Probabilities

$100,000(.5) - 40,000(.5) = 30,000

$30,000(.5) + 10,000(.5) = 20,000

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making without Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making without Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making without Probabilities

Decision Making without Probabilities

Decision Making without Probabilities

Decision Making with Probabilities

Table 12.7 Payoff table with probabilities for states of

Decision Making with Probabilities

Table 12.8 Regret table with probabilities for states of nature

Expected Value Problems

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Expected Value Problems

Expected value for

Expected Value Problems

Decision Making with Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making with Probabilities

Payoff table with decisions, given perfect information

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making with Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making with Probabilities

Decision Making with Probabilities

Table 12.10 Payoff table for real estate investment example

Decision Making with Probabilities

Figure 12.2 Decision tree for real estate investment example

Decision Making with Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making with Probabilities

Figure 12.3 Decision tree with expected value at probability

Decision Making with Probabilities

Add branches from node

Decision Making with Probabilities

Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall

Decision Making with Probabilities