Decision Analysis

Hassan Rana

HSR 1
Learning Objectives Students will be able to:
• List the steps of the decision-making
process
• Describe the types of decision-making
environments
• Use probability values to make decisions
under risk
• Make decisions under uncertainty where
there is risk but probability values are not
known
• Use computers to solve basic decision-
making problems
HSR 2
 Introduction

HSR 3
Introduction Decision
• The act or process of deciding
• A conclusion or resolution reached after
consideration
• It is a selection of a belief or a course of action
among several alternative possibilities
• A good decision is based on logic

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Introduction Decision analysis (DA)
• It is the discipline comprising the philosophy,
theory, methodology, and professional
practice necessary to address important
decisions in a formal manner
• It is an analytical and systematic way to tackle
problems
• For evaluating and choosing among
alternatives

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Steps in Decision Theory • Clearly define the problem at hand
• List the possible alternatives
• Identify the possible outcomes – State of
Nature
• List the payoff or profit of each combination of
alternatives and outcomes – Condition Values
• Select one of the mathematical decision
theory models
• Apply the model and make your decision

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 Types of Decision Making

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Decision-Making Environments Type 1: Decision-making under Certainty
• The decision-maker knows with certainty the
consequences of every alternative or decision
choice
Type 2: Decision-making under Uncertainty
• The decision-maker does not know the
probabilities of the various outcomes
Type 3: Decision-making under Risk
• The decision-maker does know the
probabilities of the various outcomes

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DM with Uncertainty Decision-making under Uncertainty
• Optimistic - Maximax
Find the alternative that maximizes the
maximum outcome for every alternative
• Pessimistic - Maximin
Find the alternative that maximizes the
minimum outcomes for every alternative
• Criterion of realism - Hurwicz
Find the alternative that is a compromise
between an optimistic and a pessimistic
decision
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DM with Uncertainty Decision-making under Uncertainty
• Equally likely - Laplace
Find the alternative that maximizes the
average outcome for every alternative
• Minimax Regret
Find the alternative that minimizes the
maximum opportunity loss for every
alternative

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 Example

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Example • John Thompson is the founder and president of
Thompson Lumber Company, a profitable firm
located in Portland, Oregon.
• The problem that John Thompson identifies is
whether to expand his product line by
manufacturing and marketing a new product,
backyard storage sheds.
• John decides that his alternatives are to construct
• A large new plant to manufacture the storage
sheds,
• A small plant, or
• No plant at all (i.e., he has the option of not
developing the new product line)
HSR 12
Example • Thompson determines that there are only two
possible outcomes:
• The market for the storage sheds could be
favorable, meaning that there is a high demand
for the product, or
• It could be unfavorable, meaning that there is a
low demand for the sheds.
• John Thompson has already evaluated the
potential profits associated with the various
outcomes.

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Example • Potential Profits (conditional value) are:
• With a favorable market, he thinks a large
facility would result in a net profit of $200,000
to his firm, however, if the market is
unfavorable would be a $180,000 net loss.
• A small plant would result in a net profit of
$100,000 in a favorable market, but a net loss
of $20,000 would occur if the market was
unfavorable.
• Doing nothing would result in $0 profit in either
market.

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Decision Table
State of Nature
Alternatives
Fav Market Unfav Market

Large Plant

Small Plant

Nothing

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Decision Table
State of Nature
Alternatives
Fav Market Unfav Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

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Maximax
State of Nature
Alternatives Max in Row
Fav Unfav
Market Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

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Maximax
State of Nature
Alternatives Max in Row
Fav Unfav
Market Market

Large Plant 200,000 -180,000 200,000

Small Plant 100,000 -20,000 100,000

Nothing 0 0 0

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Maximin
State of Nature
Alternatives Min in Row
Fav Unfav
Market Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

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Maximin
State of Nature
Alternatives Min in Row
Fav Unfav
Market Market

Large Plant 200,000 -180,000 -180,000

Small Plant 100,000 -20,000 -20,000

Nothing 0 0 0

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Hurwicz Criterion
State of Nature Criterion of
Alternatives Realism
Fav Unfav α= .
Market Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

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Hurwicz Criterion
State of Nature Criterion of
Alternatives Realism
Fav Unfav α=0.8
Market Market

Large Plant 200,000 -180,000 124,000

Small Plant 100,000 -20,000 76,000

Nothing 0 0 0

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Laplace
State of Nature
Row
Alternatives
Fav Unfav Average
Market Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

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Laplace
State of Nature
Row
Alternatives
Fav Unfav Average
Market Market

Large Plant 200,000 -180,000 10,000

Small Plant 100,000 -20,000 40,000

Nothing 0 0 0

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Decision Table
State of Nature
Alternatives
Fav Market Unfav Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

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Minimax Regret
State of Nature
Alternatives Max
Fav Unfav
Market Market

Large Plant 0 180,000

Small Plant 100,000 20,000

Nothing 200,000 0

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Minimax Regret
State of Nature
Alternatives Max
Fav Unfav
Market Market

Large Plant 0 180,000 180,000

Small Plant 100,000 20,000 100,000

Nothing 200,000 0 200,000

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 Example

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Decision Table
State of Nature
Alternatives
Good Average Poor
Market Market Market

Large Plant 75,000 25,000 -40,000

Small Plant 100,000 35,000 -60,000

Nothing 0 0 0

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DM with Risk Expected Monetary Value

𝐄𝐌𝐕 𝐀𝐥𝐭𝐞𝐫𝐧𝐚𝐭𝐢𝐯𝐞 = ෍ 𝑿𝒊 𝑷 𝑿𝒊

𝑿𝒊 = 𝑷𝒂𝒚𝒐𝒇𝒇 𝒇𝒐𝒓 𝒕𝒉𝒆 𝒂𝒍𝒕𝒆𝒓𝒏𝒂𝒕𝒊𝒗𝒆 𝒊𝒏 𝒔𝒕𝒂𝒕𝒆 𝒐𝒇 𝒏𝒂𝒕𝒖𝒓𝒆 𝒊

𝑷(𝑿𝒊 ) = 𝑷𝒓𝒐𝒃𝒂𝒍𝒊𝒕𝒚 𝒐𝒇 𝒂𝒄𝒉𝒊𝒆𝒗𝒊𝒏𝒈 𝒑𝒂𝒚𝒐𝒇𝒇 𝑿𝒊

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EMV
State of Nature
Alternatives EMV
Fav Unfav
Market Market

Large Plant 200,000 -180,000

Small Plant 100,000 -20,000

Nothing 0 0

P 0.50 0.50

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EMV
State of Nature
Alternatives EMV
Fav Unfav
Market Market

Large Plant 200,000 -180,000 10,000

Small Plant 100,000 -20,000 40,000

Nothing 0 0 0

P 0.50 0.50

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DM with Risk Expected Value of Perfect Information (EVPI)
• EVPI = EVwPI – Best EMV
𝒃𝒆𝒔𝒕 𝒑𝒂𝒚𝒐𝒇𝒇 𝒊𝒏 𝒔𝒕𝒂𝒕𝒆 𝒐𝒇 𝒏𝒂𝒕𝒖𝒓𝒆 𝒊 ×
𝑬𝑽𝒘𝑷𝑰 = ෍
(𝒑𝒓𝒐𝒃𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒔𝒕𝒂𝒕𝒆 𝒐𝒇 𝒏𝒂𝒕𝒖𝒓𝒆 𝒊)

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EVPI
State of Nature
Alternatives EMV
Fav Unfav
Market Market

Large Plant 200,000 -180,000 10,000

Small Plant 100,000 -20,000 40,000

Nothing 0 0 0

With perfect
information

P 0.50 0.50

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EVPI
State of Nature
Alternatives EMV
Fav Unfav
Market Market

Large Plant 200,000 -180,000 10,000

Small Plant 100,000 -20,000 40,000

Nothing 0 0 0

With perfect
200,000 0 100,000
information

P 0.50 0.50

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DM with Risk Expected Value of Perfect Information (EVPI)
• EVPI = EVwPI – Best EMV
𝒃𝒆𝒔𝒕 𝒑𝒂𝒚𝒐𝒇𝒇 𝒊𝒏 𝒔𝒕𝒂𝒕𝒆 𝒐𝒇 𝒏𝒂𝒕𝒖𝒓𝒆 𝒊 ×
𝑬𝑽𝒘𝑷𝑰 = ෍
(𝒑𝒓𝒐𝒃𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒔𝒕𝒂𝒕𝒆 𝒐𝒇 𝒏𝒂𝒕𝒖𝒓𝒆 𝒊)

• EVPI = 100,000 – 40,000

• = 60,000

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 Decision Trees

HSR 39
Decision Trees • Any problem that can be presented in a decision
table can also be graphically represented in a
decision tree.
• Decision trees are most beneficial when a
sequence of decisions must be made.
• All decision trees contain decision points or
nodes, from which one of several alternatives may
be chosen.
• All decision trees contain state-of-nature points or
nodes, out of which one state of nature will occur.

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5 Steps - Decision Tree Analysis 1. Define the problem.
2. Structure or draw the decision tree.
3. Assign probabilities to the states of nature.
4. Estimate payoffs for each possible combination
of alternatives and states of nature.
5. Solve the problem by computing expected
monetary values (EMVs) for each state of
nature node.

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Structure of Decision Trees • Trees start from left to right.
• Trees represent decisions and outcomes in
sequential order.
• Squares represent decision nodes.
• Circles represent states of nature nodes.
• Lines or branches connect the decisions nodes
and the states of nature.

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Example • John Thompson is the founder and president of
Thompson Lumber Company, a profitable firm
located in Portland, Oregon.
• The problem that John Thompson identifies is
whether to expand his product line by
manufacturing and marketing a new product,
backyard storage sheds.
• John decides that his alternatives are to construct
• A large new plant to manufacture the storage
sheds,
• A small plant, or
• No plant at all (i.e., he has the option of not
developing the new product line)
HSR 43
Example • Thompson determines that there are only two
possible outcomes:
• The market for the storage sheds could be
favorable, meaning that there is a high demand
for the product, or
• It could be unfavorable, meaning that there is a
low demand for the sheds.
• John Thompson has already evaluated the
potential profits associated with the various
outcomes.

HSR 44
Example • Potential Profits (conditional value) are:
• With a favorable market, he thinks a large
facility would result in a net profit of $200,000
to his firm, however, if the market is
unfavorable would be a $180,000 net loss.
• A small plant would result in a net profit of
$100,000 in a favorable market, but a net loss
of $20,000 would occur if the market was
unfavorable.
• Doing nothing would result in $0 profit in either
market.

HSR 45
Example • John Thompson has two decisions to make,
with the second decision dependent on the
outcome of the first. Before deciding about
building a new plant, John has the option of
conducting his own marketing research
survey, at a cost of $10,000.
• The information from his survey could help
him decide whether to construct a large plant,
a small plant, or not to build at all. John
recognizes that such a market survey will not
provide him with perfect information, but it
may help quite a bit nevertheless

HSR 46
Thompson’s Decision Tree
A State-of-Nature Node

Favorable Market
A Decision Node
1
Unfavorable Market

Favorable Market
Construct
Small Plant
2
Unfavorable Market

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Thompson’s Decision Tree
EMV for Node = (0.5)($200,000) + (0.5)(–$180,000)
1 = $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
–$180,000

Favorable Market (0.5)

$100,000
Construct
Small Plant
2
Unfavorable Market (0.5)
–$20,000

EMV for Node = (0.5)($100,000)

2 = $40,000 + (0.5)(–$20,000)

$0

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Example • If survey is conducted, there is a 45% chance that
the survey results will indicate a favorable market
for storage sheds. We also note that the
probability is 0.55 that the survey results will be
negative.

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Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
2 Unfavorable Market (0.22)
–$190,000
Favorable Market (0.78)
Small $90,000
3 Unfavorable Market (0.22)
Plant –$30,000
No Plant
–$10,000
1 Favorable Market (0.27)
$190,000
4 Unfavorable Market (0.73)
–$190,000
Favorable Market (0.27)
Small $90,000
Plant
5 Unfavorable Market (0.73)
–$30,000
No Plant
–$10,000

Favorable Market (0.50)

$200,000
6 Unfavorable Market (0.50)
–$180,000
Favorable Market (0.50)
Small $100,000
7 Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0

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Example • If survey is conducted, there is a 45% chance that
the survey results will indicate a favorable market
for storage sheds. We also note that the
probability is 0.55 that the survey results will be
negative.
• There is a 78% probability of a favorable market
for the sheds given a favorable result from the
market survey. In this case, there is a 22% chance
that the market for sheds will be unfavorable
given that the survey results are positive.
• There is a 27% chance that the market for sheds
will be favorable given that John’s survey results
are negative. The probability is much higher, 0.73,
that the market will actually be unfavorable given
that the survey was negative.
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Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
2 Unfavorable Market (0.22)
–$190,000
Favorable Market (0.78)
Small $90,000
3 Unfavorable Market (0.22)
Plant –$30,000
No Plant
–$10,000
1 Favorable Market (0.27)
$190,000
4 Unfavorable Market (0.73)
–$190,000
Favorable Market (0.27)
Small $90,000
Plant
5 Unfavorable Market (0.73)
–$30,000
No Plant
–$10,000

Favorable Market (0.50)

$200,000
6 Unfavorable Market (0.50)
–$180,000
Favorable Market (0.50)
Small $100,000
7 Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0

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Thompson’s Complex Decision Tree
1. Given favorable survey results,
EMV(node 2) = EMV(large plant | positive survey)
= (0.78)($190,000) + (0.22)(–$190,000) = $106,400
EMV(node 3) = EMV(small plant | positive survey)
= (0.78)($90,000) + (0.22)(–$30,000) = $63,600
EMV for no plant = –$10,000

2. Given negative survey results,

EMV(node 4) = EMV(large plant | negative survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –$87,400
EMV(node 5) = EMV(small plant | negative survey)
= (0.27)($90,000) + (0.73)(–$30,000) = $2,400
EMV for no plant = –$10,000

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Thompson’s Complex Decision Tree 3. Compute the expected value of the market survey,
EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200

4. If the market survey is not conducted,

EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EMV for no plant = $0

5. The best choice is to seek marketing information.

HSR 54
Thompson’s Complex Decision Tree First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
Unfavorable Market (0.22)
–$190,000

$106,400
$63,600 Favorable Market (0.78)
Small $90,000
Unfavorable Market (0.22)
Plant –$30,000
No Plant
–$10,000
–$87,400 Favorable Market (0.27)
$190,000
Unfavorable Market (0.73)
–$190,000

$2,400
$2,400 Favorable Market (0.27)
Small $90,000
Unfavorable Market (0.73)
Plant –$30,000
No Plant
–$10,000
$49,200

$10,000 Favorable Market (0.50)

$200,000
Unfavorable Market (0.50)
–$180,000
$40,000

$40,000 Favorable Market (0.50)

Small $100,000
Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0

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EV of Sample Information • Suppose Thompson wants to know the
actual value of doing the survey.
Expected value Expected value
with sample of best decision
EVSI = information, assuming – without sample
no cost to gather it information

= (EV with sample information + cost)

– (EV without sample information)

EVSI = ($49,200 + $10,000) – $40,000 = $19,200

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 Utility Theory

HSR 57
Utility Theory • Monetary value is not always a true indicator
of the overall value of the result of a decision.
• The overall value of a decision is called utility.
• Economists assume that rational people make
decisions to maximize their utility.

HSR 58
Utility Theory
Your Decision Tree for the Lottery Ticket
$2,000,000
Accept
Offer
$0
Heads
Reject (0.5)
Offer

Tails
(0.5)

EMV = $2,500,000
$5,000,000

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Utility Theory • Utility assessment assigns the worst outcome a utility
of 0, and the best outcome, a utility of 1.
• A standard gamble is used to determine utility values.
• When you are indifferent, your utility values are equal.

Expected utility of alternative 2 = Expected utility of alternative 1

Utility of other outcome = (p)(utility of best outcome, which is 1)
+ (1 – p)(utility of the worst outcome,
which is 0)
Utility of other outcome = (p)(1) + (1 – p)(0) = p

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Standard Gamble for Utility Assessment
(p)
Best Outcome
Utility = 1
(1 – p) Worst Outcome
Utility = 0

Other Outcome
Utility = ?

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Investment Example • Jane Dickson wants to construct a utility curve
revealing her preference for money between $0 and
$10,000.
• A utility curve plots the utility value versus the
monetary value.
• An investment in a bank will result in $5,000.
• An investment in real estate will result in $0 or
$10,000.
• Unless there is an 80% chance of getting $10,000
from the real estate deal, Jane would prefer to have
her money in the bank.
• So if p = 0.80, Jane is indifferent between the bank or
the real estate investment.

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Investment Example p = 0.80 $10,000
U($10,000) = 1.0

(1 – p) = 0.20 $0
U($0.00) = 0.0

$5,000
U($5,000) = p = 0.80

Utility for $5,000 = U($5,000) = pU($10,000) + (1 – p)U($0)

= (0.8)(1) + (0.2)(0) = 0.8

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Investment Example  We can assess other utility values in the same way.
 For Jane these are:

Utility for $7,000 = 0.90

Utility for $3,000 = 0.50

 Using the three utilities for different dollar amounts,

she can construct a utility curve.

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Utility Curve 1.0 –
U ($10,000) = 1.0

0.9 –
U ($7,000) = 0.90

0.8 –
U ($5,000) = 0.80

0.7 –

0.6 –
Utility

0.5 –
U ($3,000) = 0.50

0.4 –

0.3 –

0.2 –

0.1 –
U ($0) = 0
| | | | | | | | | | |
$0 $1,000 $3,000 $5,000 $7,000 $10,000

Monetary Value

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Utility Curve  Jane’s utility curve is typical of a risk avoider.
 She gets less utility from greater risk.
 She avoids situations where high losses might occur.
 As monetary value increases, her utility curve increases
at a slower rate.

 A risk seeker gets more utility from greater risk

 As monetary value increases, the utility curve increases
at a faster rate.

 Someone with risk indifference will have a linear

utility curve.

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Preferences for Risk
Risk
Avoider

Utility

Risk
Seeker

Monetary Outcome

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Utility as a Decision-Making Criteria  Once a utility curve has been developed
it can be used in making decisions.
 This replaces monetary outcomes with
utility values.
 The expected utility is computed instead
of the EMV.

HSR 68
Utility as a Decision-Making Criteria  Mark Simkin loves to gamble.
 He plays a game tossing thumbtacks in
the air.
 If the thumbtack lands point up, Mark wins
$10,000.
 If the thumbtack lands point down, Mark
loses $10,000.
 Mark believes that there is a 45% chance
the thumbtack will land point up.
 Should Mark play the game (alternative 1)?

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Utility as a Decision-Making Criteria Decision Facing Mark Simkin
Tack Lands
Point Up (0.45)
$10,000

Tack Lands
Point Down (0.55)
–$10,000

Mark Does Not Play the Game

$0

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Utility as a Decision-Making Criteria  Step 1– Define Mark’s utilities.
U (–$10,000) = 0.05
U ($0) = 0.15
U ($10,000) = 0.30

 Step 2 – Replace monetary values with

utility values.
E(alternative 1: play the game) = (0.45)(0.30) + (0.55)(0.05)
= 0.135 + 0.027 = 0.162
E(alternative 2: don’t play the game) = 0.15

HSR 71
Utility Curve for Mark Simkin
1.00 –

0.75 –

Utility

0.50 –

0.30 –
0.25 –

0.15 –

0.05 –
0 |– | | | |
–$20,000 –$10,000 $0 $10,000 $20,000

Monetary Outcome

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Utility as a Decision-Making Criteria Using Expected Utilities in Decision Making

E = 0.162 Tack Lands Utility

Point Up (0.45)
0.30

Tack Lands
Point Down (0.55)
0.05

Don’t Play
0.15

HSR 73
 Questions

HSR 74
HSR 75