Table of Contents Chapter 12 (Decision Analysis)

Decision Analysis Examples 12.212.3 A Case Study: The Goferbroke Company Problem (Section 12.1) 12.412.8 Decision Criteria (Section 12.2) 12.912.13 Decision Trees (Section 12.3) 12.1412.19 Sensitivity Analysis with Decision Trees (Section 12.4) 12.2012.24 Checking Whether to Obtain More Information (Section 12.5) 12.2512.27 Using New Information to Update the Probabilities (Section 12.6) 12.2812.35 Decision Tree to Analyze a Sequence of Decisions (Section 12.7) 12.3612.39 Sensitivity Analysis with a Sequence of Decisions (Section 12.8) 12.4012.47 Using Utilities to Better Reflect the Values of Payoffs (Section 12.9)12.4812.64

Decision Analysis
Managers often must make decisions in environments that are fraught with uncertainty. Some Examples
A manufacturer introducing a new product into the marketplace What will be the reaction of potential customers? How much should be produced? Should the product be test-marketed? How much advertising is needed? A financial firm investing in securities Which are the market sectors and individual securities with the best prospects? Where is the economy headed? How about interest rates? How should these factors affect the investment decisions?

Decision Analysis
Managers often must make decisions in environments that are fraught with uncertainty. Some Examples
A government contractor bidding on a new contract. What will be the actual costs of the project? Which other companies might be bidding? What are their likely bids? An agricultural firm selecting the mix of crops and livestock for the season. What will be the weather conditions? Where are prices headed? What will costs be? An oil company deciding whether to drill for oil in a particular location. How likely is there to be oil in that location? How much? How deep will they need to drill? Should geologists investigate the site further before drilling?

The Goferbroke Company Problem

The Goferbroke Company develops oil wells in unproven territory. A consulting geologist has reported that there is a one-in-four chance of oil on a particular tract of land. Drilling for oil on this tract would require an investment of about $100,000. 100000

If the tract contains oil, it is estimated that the net revenue generated would be approximately $800,000.800 000
Another oil company has offered to purchase the tract of land for $90,000. 90000

Question: Should Goferbroke drill for oil or sell the tract?

Prospective Profits

Profit
Status of Land Alternative Drill for oil Sell the land Chance of status $700,000 90,000 1 in 4 $100,000 90,000 3 in 4 Oil Dry

Decision Analysis Terminology

The decision maker is the individual or group responsible for making the decision. The alternatives are the options for the decision to be made. The outcome is affected by random factors outside the control of the decision maker. These random factors determine the situation that will be found when the decision is executed. Each of these possible situations is referred to as a possible state of nature. The decision maker generally will have some information about the relative likelihood of the possible states of nature. These are referred to as the prior probabilities. Each combination of a decision alternative and a state of nature results in some outcome. The payoff is a quantitative measure of the value to the decision maker of the outcome. It is often the monetary value.

Prior Probabilities

State of Nature The tract of land contains oil The tract of land is dry (no oil)

Prior Probability 0.25 0.75

Payoff Table (Profit in $Thousands)

State of Nature
Alternative Drill for oil Sell the land Prior probability Oil 700 90 0.25 Dry 100 90 0.75

The Maximax Criterion

The maximax criterion is the decision criterion for the eternal optimist. It focuses only on the best that can happen.

Procedure:
Identify the maximum payoff from any state of nature for each alternative. Find the maximum of these maximum payoffs and choose this alternative.

State of Nature Alternative Drill for oil Sell the land Oil 700 90 Dry 100 90 Maximum in Row 700 Maximax 90

The Maximin Criterion

The maximin criterion is the decision criterion for the total pessimist. It focuses only on the worst that can happen.

Procedure:
Identify the minimum payoff from any state of nature for each alternative. Find the maximum of these minimum payoffs and choose this alternative.

State of Nature Alternative Drill for oil Sell the land Oil 700 90 Dry 100 90 Minimum in Row 100 90 Maximin

The Maximum Likelihood Criterion

The maximum likelihood criterion focuses on the most likely state of nature. Procedure:
Identify the state of nature with the largest prior probability Choose the decision alternative that has the largest payoff for this state of nature.

State of Nature Alternative Drill for oil Sell the land Prior probability Oil 700 90 0.25 Dry 100 90 0.75 Step 1: Maximum 100 90 Step 2: Maximum

Bayes Decision Rule

Bayes decision rule directly uses the prior probabilities. Procedure:
For each decision alternative, calculate the weighted average of its payoff by multiplying each payoff by the prior probability and summing these products. This is the expected payoff (EP). Choose the decision alternative that has the largest expected payoff.
A 1 2 3 4 5 6 7 8 B C D E F

Bayes' Decision Rule for the Goferbroke Co.

Payoff Table Alternative Drill Sell Prior Probability State of Nature Oil Dry 700 -100 90 90 0.25 0.75 Expected Payoff 100 90

Bayes Decision Rule

Features of Bayes Decision Rule
It accounts for all the states of nature and their probabilities. The expected payoff can be interpreted as what the average payoff would become if the same situation were repeated many times. Therefore, on average, repeatedly applying Bayes decision rule to make decisions will lead to larger payoffs in the long run than any other criterion.

Criticisms of Bayes Decision Rule

There usually is considerable uncertainty involved in assigning values to the prior probabilities. Prior probabilities inherently are at least largely subjective in nature, whereas sound decision making should be based on objective data and procedures. It ignores typical aversion to risk. By focusing on average outcomes, expected (monetary) payoffs ignore the effect that the amount of variability in the possible outcomes should have on decision making.

Decision Trees
A decision tree can apply Bayes decision rule while displaying and analyzing the problem graphically. A decision tree consists of nodes and branches.
A decision node, represented by a square, indicates a decision to be made. The branches represent the possible decisions. An event node, represented by a circle, indicates a random event. The branches represent the possible outcomes of the random event.

Decision Tree for Goferbroke

Payoff 700 Oil (0.25)

B Drill Dry (0.75) A -100

Sell 90

Using TreePlan
TreePlan, an Excel add-in developed by Professor Michael Middleton, can be used to construct and analyze decision trees on a spreadsheet.
1. Choose Decision Tree under the Tools menu. 2. Click on New Tree, and it will draw a default tree with a single decision node and two branches, as shown below. 3. The labels in D2 and D7 (originally Decision 1 and Decision 2) can be replaced by more descriptive names (e.g., Drill and Sell).
A 1 2 3 4 5 6 7 8 9 B C Drill 0 0 1 0 Sell 0 0 0 0 D E F G

Using TreePlan
4. To replace a node (such as the terminal node of the drill branch in F3) by a different type of node (e.g., an event node), click on the cell containing the node, choose Decision Tree again from the Tools menu, and select Change to event node.

Using TreePlan
5. Enter the correct probabilities in H1 and H6. 6. Enter the partial payoffs for each decision and event in D6, D14, H4, and H9.
A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 B C D E F G H I J K

0.25 Oil 700 Drill -100 100 Dry -100 1 100 Sell 90 90 90 0 -100 800 0.75 700

TreePlan Results
The numbers inside each decision node indicate which branch should be chosen (assuming the branches are numbered consecutively from top to bottom).

The numbers to the right of each terminal node is the payoff if that node is reached.
The number 100 in cells A10 and E6 is the expected payoff at those stages in the process.
A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 B C D E F G H I J K

0.25 Oil 700 Drill -100 100 Dry -100 1 100 Sell 90 90 90 0 -100 800 0.75 700

Consolidate the Data and Results

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 B C D E F G H I J K

0.25 Oil 700 Drill -100 100 Dry -100 1 100 Sell 90 90 90 0 -100 800 0.75 700

Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Probability Of Oil Action Expected Payoff

Data 100 800 90 0 0.25 Drill 100

Sensitivity Analysis: Prior Probability of Oil = 0.15

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 B C D E F G H I J K

0.15 Oil 700 Drill -100 20 Dry -100 2 90 Sell 90 90 90 0 -100 800 0.85 700

Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Probability Of Oil Action Expected Payoff

Data 100 800 90 0 0.15 Sell 90

Sensitivity Analysis: Prior Probability of Oil = 0.35

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 B C D E F G H I J K

0.35 Oil 700 Drill -100 180 Dry -100 1 180 Sell 90 90 90 0 -100 800 0.65 700

Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Probability Of Oil Action Expected Payoff

Data 100 800 90 0 0.35 Drill 180

Using Data Tables to Do Sensitivity Analysis

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 B C D E F G H I J K L M

0.25 Oil 700 Drill -100 100 Dry -100 1 100 Sell 90 90 90 Probability of Oil 0.15 0.17 0.19 0.21 0.23 0.25 0.27 0.29 0.31 0.33 0.35 Expected Payoff 100 0 -100 800 0.75 700

Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Probability Of Oil Action Expected Payoff

Data 100 800 90 0 0.25 Drill 100

Action Drill

Select these cells (I18:K29), before choosing Table from the Data menu.

Data Table Results The Effect of Changing the Prior Probability of Oil

I 16 17 18 19 20 21 22 23 24 25 26 27 28 29

Probability of Oil 0.15 0.17 0.19 0.21 0.23 0.25 0.27 0.29 0.31 0.33 0.35

Action Drill Sell Sell Sell Sell Sell Drill Drill Drill Drill Drill Drill

Expected Payoff 100 90 90 90 90 90 100 116 132 148 164 180

Checking Whether to Obtain More Information

Might it be worthwhile to spend money for more information to obtain better estimates?

A quick way to check is to pretend that it is possible to actually determine the true state of nature (perfect information).
EP (with perfect information) = Expected payoff if the decision could be made after learning the true state of nature. EP (without perfect information) = Expected payoff from applying Bayes decision rule with the original prior probabilities. The expected value of perfect information is then EVPI = EP (with perfect information) EP (without perfect information).

Expected Payoff with Perfect Information

3 Payoff Table State of Nature 4 Alternative Oil Dry 5 Drill 700 -100 6 Sell 90 90 7 Maximum Payoff 700 90 8 9 Prior Probability 0.25 0.75 10 11 EP (w ith perfect info) 242.5

Expected Payoff with Perfect Information

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 B C D E F G H I J K

Drill 0.25 Oil 1 0 700 Sell 90 90 242.5 Drill 0.75 Dry 2 0 90 Sell 90 90 90 -100 -100 -100 90 700 700 700

Using New Information to Update the Probabilities

The prior probabilities of the possible states of nature often are quite subjective in nature. They may only be rough estimates. It is frequently possible to do additional testing or surveying (at some expense) to improve these estimates. The improved estimates are called posterior probabilities.

Seismic Survey for Goferbroke

Goferbroke can obtain improved estimates of the chance of oil by conducting a detailed seismic survey of the land, at a cost of $30,000. Possible findings from a seismic survey:
FSS: Favorable seismic soundings; oil is fairly likely. USS: Unfavorable seismic soundings; oil is quite unlikely.

P(finding | state) = Probability that the indicated finding will occur, given that the state of nature is the indicated one.

P(finding | state)

State of Nature
Oil Dry

Favorable (FSS)
P(FSS | Oil) = 0.6 P(FSS | Dry) = 0.2

Unfavorable (USS)
P(USS | Oil) = 0.4 P(USS | Dry) = 0.8

Calculating Joint Probabilities

Each combination of a state of nature and a finding will have a joint probability determined by the following formula:

P(state and finding) = P(state) P(finding | state)

P(Oil and FSS) = P(Oil) P(FSS | Oil) = (0.25)(0.6) = 0.15. P(Oil and USS) = P(Oil) P(USS | Oil) = (0.25)(0.4) = 0.1.

P(Dry and FSS) = P(Dry) P(FSS | Dry) = (0.75)(0.2) = 0.15.

P(Dry and USS) = P(Dry) P(USS | Dry) = (0.75)(0.8) = 0.6.

Probabilities of Each Finding

Given the joint probabilities of both a particular state of nature and a particular finding, the next step is to use these probabilities to find each probability of just a particular finding, without specifying the state of nature.

P(finding) = P(Oil and finding) + P(Dry and finding)

P(FSS) = 0.15 + 0.15 = 0.3. P(USS) = 0.1 + 0.6 = 0.7.

Calculating the Posterior Probabilities

The posterior probabilities give the probability of a particular state of nature, given a particular finding from the seismic survey.

P(state | finding) = P(state and finding) / P(finding)

P(Oil | FSS) = 0.15 / 0.3 = 0.5. P(Oil | USS) = 0.1 / 0.7 = 0.14.

P(Dry | FSS) = 0.15 / 0.3 = 0.5.

P(Dry | USS) = 0.6 / 0.7 = 0.86.

Probability Tree Diagram

Prior Probabilities P(state) Conditional Probabilities P(finding | state) Joint Probabilities P(state and finding) Pos terior Probabilities P(state | finding) 0.15 = 0.5 0.3 Oil, given F SS

0.6 FSS, given Oil

0.25(0.6) = 0.15 Oil and FSS

0.25 Oil

0.4 USS, given Oil

0.25(0.4) = 0.1 Oil and USS

0.1 = 0.14 0.7 Oil, given USS

0.75 Dry

0.2 FSS, given Dry

0.75(0.2) = 0.15 Dry and FS S

0.15 = 0.5 0.3 Dry, given FSS

0.8 USS, given Dry

0.75(0.8) = 0.6 Dry and USS

0.6 = 0.86 0.7 Dry, given USS

Unconditional probabilities: P(FSS) = 0.15 + 0.15 = 0.3 P(finding) P(USS) = 0.1 + 0.6 = 0.7

Posterior Probabilities

P(state | finding) Finding Favorable (FSS) Unfavorable (USS) Oil P(Oil | FSS) = 1/2 P(Oil | USS) = 1/7 Dry P(Dry | FSS) = 1/2 P(Dry | USS) = 6/7

Template for Posterior Probabilities

B C D E F G H

3 Data: 4 State of Prior 5 Nature Probability 6 Oil 0.25 7 Dry 0.75 8 9 10 11 12 Posterior 13 Probabilities: 14 Finding P(Finding) 15 FSS 0.3 16 USS 0.7 17 18 19

P(Finding | State) Finding FSS 0.6 0.2 USS 0.4 0.8

P(State | Finding) State of Nature Oil 0.5 0.1429 Dry 0.5 0.8571

Decision Tree for the Full Goferbroke Co. Problem

Oil f Drill c Unfavorable b Do seismic s urvey Drill Favorable d a Sell Oil h No seismic s urvey e Sell Drill Dry Sell Oil g Dry Dry

Decision Tree with Probabilities and Payoffs

Payoff f Drill -100 c Unfavorable 0 b Do seismic s urvey -30 a 0 Favorable (0.3) d Drill -100 90 Sell Oil (0.25) 800 0 Dry (0.75) g Sell 90 Oil (0.5) 800 0 Dry (0.5) Oil (0.143) 800 0 Dry(0.857) 670

-130

60 670

-130 60 700

0 No seismic s urvey e

h Drill -100 90

-100

Sell

90

The Final Decision Tree

Payoff -15.7 f Drill 60 c Unfavorable 123 b Do seismic s urvey -30 123 a 0 No seismic s urvey 100 e Sell 0 270 g 0 Favorable (0.3) 270 d Sell Drill -100 90 Oil (0.25) 800 0 -100 90 Dry (0.75) -100 Sell -100 90 Oil (0.5) Oil (0.143) 800 0 Dry (0.857) 670

-130

60 800 0 -130 60 100 h 700 670

Dry (0.5)

Drill

90

TreePlan for the Full Goferbroke Co. Problem

A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 B C D E F G H I J K L M N O P Q R S

Decision Tree for Goferbroke Co. Problem (With Survey)

0.143 Oil 670 Drill -100 0.7 Unfavorable 2 0 60 Sell 60 90 Do Survey 0.5 -30 123 Drill -100 0.3 Favorable 1 0 1 123 90 0.25 Oil 700 Drill -100 No Survey 1 0 100 Sell 90 90 90 0 -100 100 800 0.75 Dry -100 700 60 270 Sell 60 270 Dry -130 0 -130 Oil 670 800 0.5 670 60 -15.714 800 0.857 Dry -130 0 -130 670

Organizing the Spreadsheet for Sensitivity Analysis

A 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 B C D E F G H I J K L M N O P Q R S T U V W X Y Z AA

0.143 Oil 670 Drill -100 0.7 Unfavorable 2 0 60 Sell 60 90 Do Survey 0.5 -30 123 Drill -100 0.3 Favorable 1 0 1 123 90 0.25 Oil 700 Drill -100 No Survey 1 0 100 Sell 90 90 90 0 -100 100 800 0.75 Dry -100 700 60 270 Sell 60 Data: 270 Dry -130 0 -130 Oil 670 800 0.5 670 60 -15.714 800 0.857 Dry -130 0 -130 670

Cost of Survey Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Prior Probability Of Oil P(FSS|Oil) P(USS|Dry)

Data 30 100 800 90 0 0.25 0.6 0.8

Do Survey? If No Drill

Action Yes If Yes Drill Sell If Favorable If Unfavorable

Expected Payoff ($thousands) 123

State of Nature Oil Dry

Prior Probability 0.25 0.75

FSS 0.6 0.2

P(Finding | State) Finding USS 0.4 0.8

Posterior Probabilities: Finding FSS USS

P(Finding) 0.3 0.7

Oil 0.5 0.143

P(State | Finding) State of Nature Dry 0.5 0.857

The Plot Option of SensIt

U 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 V W X Y

Cost of Survey Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Prior Probability Of Oil P(FSS|Oil) P(USS|Dry)

Data 30 100 800 90 0 0.25 0.6 0.8

Do Survey? If No Drill

Action Yes If Yes Drill Sell If Favorable If Unfavorable

Expected Payoff ($thousands) 123

SensIt Plot
Sensit - Sensitivity Analysis - Plot 700 600

Expected Payoff

500 400 300 200 100 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 Prior Probability Of Oil

Optimal Policy
Let p = Prior probability of oil If p 0.168, then sell the land (no seismic survey).

If
If

0.169 p 0.308, then do the survey; drill if favorable, sell if not.

p 0.309, then drill for oil (no seismic survey).

The Spider Option of SensIt

U 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 V W X Y

Cost of Survey Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Prior Probability Of Oil P(FSS|Oil) P(USS|Dry)

Data 30 100 800 90 0 0.25 0.6 0.8

Do Survey? If No Drill

Action Yes If Yes Drill Sell If Favorable If Unfavorable

Expected Payoff ($thousands) 123

SensIt Spider Graph

Sensit - Sensitivity Analysis - Spider 136 134 132 130

Expected Payoff Value

128 126 124 122 120 118 116 114 112 110 90% 92% 94% 96% 98% 100% 102% 104% 106% 108% 110% Cost of Survey Cost of Drilling Revenue if Oil Revenue if Sell

% Change in Input Value

The Tornado Option of SensIt

U 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 V W X Y

Cost of Survey Cost of Drilling Revenue if Oil Revenue if Sell Revenue if Dry Prior Probability Of Oil P(FSS|Oil) P(USS|Dry)

Data 30 100 800 90 0 0.25 0.6 0.8

Low 28 75 600 85

Base 30 100 800 90

High 32 140 1000 95

Do Survey? If No Drill

Action Yes If Yes Drill Sell If Favorable If Unfavorable

Expected Payoff ($thousands) 123

SensIt Tornado Diagram

Sensit - Sensitivity Analysis - Tornado

Revenue if Oil 600

1000

Cost of Drilling

140

75

Revenue if Sell

85

95

Cost of Survey

32

28

90

100

110

120

130

140

150

160

Expected Payoff

Using Utilities to Better Reflect the Values of Payoffs

Thus far, when applying Bayes decision rule, we have assumed that the expected payoff in monetary terms is the appropriate measure. In many situations, this is inappropriate. Suppose an individual is offered the following choice:
Accept a 50-50 chance of winning $100,000. Receive $40,000 with certainty.

Many would pick $40,000, even though the expected payoff on the 50-50 chance of winning $100,000 is $50,000. This is because of risk aversion.
A utility function for money is a way of transforming monetary values to an appropriate scale that reflects a decision makers preferences (e.g., aversion to risk).

A Typical Utility Function for Money

U(M)

0.75

0.5

0.25

$10,000

$30,000

$60,000

$100,000 M

Shape of Utility Functions

U(M)

U(M)

U(M)

(a) Risk averse

(b) Risk seeker

(c) Risk neutral

Utility Functions
When a utility function for money is incorporated into a decision analysis approach, it must be constructed to fit the current preferences and values of the decision maker. Fundamental Property: Under the assumptions of utility theory, the decision makers utility function for money has the property that the decision maker is indifferent between two alternatives if the two alternatives have the same expected utility. When the decision makers utility function for money is used, Bayes decision rule replaces monetary payoffs by the corresponding utilities. The optimal decision (or series of decisions) is the one that maximizes the expected utility.

Illustration of Fundamental Property

By the fundamental property, a decision maker with the utility function belowright will be indifferent between each of the three pairs of alternatives below-left.
U(M)

25% chance of $100,000 $10,000 for sure Both have E(Utility) = 0.25.

50% chance of $100,000 $30,000 for sure Both have E(Utility) = 0.5.
75% chance of $100,000 $60,000 for sure Both have E(Utility) = 0.75.

0.75

0.5

0.25

$10,000

$30,000

$60,000

$100,000 M

The Lottery Procedure

1. We are given three possible monetary payoffsM1, M2, M3 (M1 < M2 < M3). The utility is known for two of them, and we wish to find the utility for the third.

2. The decision maker is offered the following two alternatives:

a) Obtain a payoff of M3 with probability p. Obtain a payoff of M1 with probability (1p). b) Definitely obtain a payoff of M2.

3. What value of p makes you indifferent between the two alternatives?

4. Using this value of p, write the fundamental property equation, E(utility for a) = E(utility for b) so p U(M3) + (1p) U(M1) = U(M2). 5. Solve this equation for the unknown utility.

Procedure for Constructing a Utility Function

1. List all the possible monetary payoffs for the problem, including 0. 2. Set U(0) = 0 and then arbitrarily choose a utility value for one other payoff.

3. Choose three of the payoffs where the utility is known for two of them.
4. Apply the lottery procedure to find the utility for the third payoff. 5. Repeat steps 3 and 4 for as many other payoffs with unknown utilities as desired. 6. Plot the utilities found on a graph of the utility U(M) versus the payoff M. Draw a smooth curve through these points to obtain the utility function.

Generating the Utility Function for Max Flyer

The possible monetary payoffs in the Goferbroke Co. problem are 130, 100, 0, 60, 90, 670, and 700 (all in $thousands). Set U(0) = 0. Arbitrarily set U(130) = 150.

Finding U(700)
The known utilities are U(130) = 150 and U(0) = 0. The unknown utility is U(700). Consider the following two alternatives:
a) Obtain a payoff of 700 with probability p. Obtain a payoff of 130 with probability (1p). b) Definitely obtain a payoff of 0.

What value of p makes you indifferent between these two alternatives? Max chooses p = 0.2. By the fundamental property of utility functions, the expected utilities of the two alternatives must be equal, so pU(700) + (1p)U(130) = U(0) 0.2U(700) + 0.8(150) = 0 0.2U(700) 120 = 0 0.2U(700) = 120 U(700) = 600

Finding U(100)
The known utilities are U(130) = 150 and U(0) = 0. The unknown utility is U(100). Consider the following two alternatives:
a) Obtain a payoff of 0 with probability p. Obtain a payoff of 130 with probability (1p). b) Definitely obtain a payoff of 100.

What value of p makes you indifferent between these two alternatives? Max chooses p = 0.3. By the fundamental property of utility functions, the expected utilities of the two alternatives must be equal, so pU(0) + (1p)U(130) = U(100) 0.3(0) + 0.7(150) = U(100) U(100) = 105

Finding U(90)
The known utilities are U(700) = 600 and U(0) = 0. The unknown utility is U(90). Consider the following two alternatives:
a) Obtain a payoff of 700 with probability p. Obtain a payoff of 0 with probability (1p). b) Definitely obtain a payoff of 90.

What value of p makes you indifferent between these two alternatives? Max chooses p = 0.15. By the fundamental property of utility functions, the expected utilities of the two alternatives must be equal, so pU(700) + (1p)U(0) = U(90) 0.15(600) + 0.85(0) = U(90) U(90) = 90

Maxs Utility Function for Money

U(M) 700 600 utility function 500 400 300 200 100 0 -200 -100 -100 -200 100 200 300 400 500 600 700 M Thousands of dollars monetary value line

Utilities for the Goferbroke Co. Problem

Monetary Payoff, M
130 100 0 60 90 670 700

Utility, U(M)
150 105 0 60 90 580 600

Decision Tree with Utilities

A 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 B C D E F G H I J K L M N O P Q R S

0.143 Oil 580 Drill 0 0.7 Unfavorable 2 0 60 Sell 60 60 Do Survey 0.5 0 106.5 Drill 0 0.3 Favorable 1 0 1 106.5 60 0.25 Oil 600 Drill 0 No Survey 2 0 90 Sell 90 90 90 -105 -105 71.25 600 0.75 Dry -105 600 60 215 Sell 60 -150 -150 215 Dry -150 Oil 580 580 0.5 580 60 -45.61 580 0.857 Dry -150 -150 -150 580

Exponential Utility Function

The procedure for constructing U(M) requires making many difficult decisions about probabilities. An alternative approach assumes a certain form for the utility function and adjusts this form to fit the decision maker as closely as possible. A popular form is the exponential utility function

U(M) = R (1 eM/R)
where R is the decision makers risk tolerance. An easy way to estimate R is to pick the value that makes you indifferent between the following two alternatives:
a) A 50-50 gamble where you gain R dollars with probability 0.5 and lose R/2 dollars with probability 0.5. b) Neither gain nor lose anything.

Using TreePlan with an Exponential Utility Function

Specify the value of R in a cell on the spreadsheet. Give the cell a range name of RT (TreePlan refers to this term as the risk tolerance). Click on the Option button in the TreePlan dialogue box and select the Use Exponential Utility Function option.

Decision Tree with an Exponential Utility Function

A 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 B C D E F G H I J K L M N O P Q R S

0.143 Oil 670 Drill -100 0.7 Unfavorable 2 0 60 0.0791 Sell 60 90 Do Survey -30 90.0036 0.1163 Drill -100 165.23116 0.203 1 0 1 90 0.1163 165.231 0.203 Sell 60 90 0.25 Oil 700 Drill -100 No Survey 2 0 90 0.11629 Sell 90 90 Risk Tolerance (RT) 728 90 0.1163 0 -100 -0.147 32.7511 0.0440 800 0.75 Dry -100 700 0.618 60 0.0791 60 0.0791 0.5 Oil 670 800 0.5 Dry -130 0 -130 -0.196 670 0.602 -57.052 -0.0815 800 0.857 Dry -130 0 -130 -0.196 670 0.602

0.3 Favorable