Chapter 3

Decision Analysis

To accompany
Quantitative Analysis for Management, Tenth Edition,
by Render, Stair, and Hanna © 2008 Prentice-Hall, Inc.
Power Point slides created by Jeff Heyl © 2009 Prentice-Hall, Inc.
 Learning Objectives
After completing this chapter, students will be able to:

1. List the steps of the decision-making

process
2. Describe the types of decision-making
environments
3. Make decisions under uncertainty
4. Use probability values to make decisions
under risk

© 2009 Prentice-Hall, Inc. 3–2

 Learning Objectives
After completing this chapter, students will be able to:

5. Develop accurate and useful decision

trees
6. Revise probabilities using Bayesian
analysis
7. Use computers to solve basic decision-
making problems
8. Understand the importance and use of
utility theory in decision making

© 2009 Prentice-Hall, Inc. 3–3

 Chapter Outline
3.1 Introduction
3.2 The Six Steps in Decision Making
3.3 Types of Decision-Making
Environments
3.4 Decision Making under Uncertainty
3.5 Decision Making under Risk
3.6 Decision Trees
3.7 How Probability Values Are
Estimated by Bayesian Analysis
3.8 Utility Theory
© 2009 Prentice-Hall, Inc. 3–4
 Introduction

 What is involved in making a good

decision?
 Decision theory is an analytic and
systematic approach to the study of
decision making
 A good decision is one that is based
on logic, considers all available data
and possible alternatives, and the
quantitative approach described here

© 2009 Prentice-Hall, Inc. 3–5

 The Six Steps in Decision Making

1. Clearly define the problem at hand

2. List the possible alternatives
3. Identify the possible outcomes or states
of nature
4. List the payoff or profit of each
combination of alternatives and
outcomes
5. Select one of the mathematical decision
theory models
6. Apply the model and make your decision
© 2009 Prentice-Hall, Inc. 3–6
Thompson Lumber Company

Step 1 – Define the problem

 Expand by manufacturing and
marketing a new product, backyard
storage sheds
Step 2 – List alternatives
 Construct a large new plant
 A small plant
 No plant at all
Step 3 – Identify possible outcomes
 The market could be favorable or
unfavorable

© 2009 Prentice-Hall, Inc. 3–7

Thompson Lumber Company

Step 4 – List the payoffs

 Identify conditional values for the
profits for large, small, and no plants
for the two possible market
conditions
Step 5 – Select the decision model
 Depends on the environment and
amount of risk and uncertainty
Step 6 – Apply the model to the data
 Solution and analysis used to help the
decision making

© 2009 Prentice-Hall, Inc. 3–8

 Thompson Lumber Company

STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0

Table 3.1

© 2009 Prentice-Hall, Inc. 3–9

 Types of Decision-Making
Environments

Type 1: Decision making under certainty

 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 knows the
probabilities of the various outcomes

© 2009 Prentice-Hall, Inc. 3 – 10

 Decision Making Under
Uncertainty
There are several criteria for making decisions
under uncertainty

1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

© 2009 Prentice-Hall, Inc. 3 – 11

 Maximax
Used to find the alternative that maximizes
the maximum payoff
 Locate the maximum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0

Table 3.2
© 2009 Prentice-Hall, Inc. 3 – 12
 Maximin
Used to find the alternative that maximizes
the minimum payoff
 Locate the minimum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0

Table 3.3
Maximin
© 2009 Prentice-Hall, Inc. 3 – 13
 Criterion of Realism (Hurwicz)
A weighted average compromise between
optimistic and pessimistic
 Select a coefficient of realism 
 Coefficient is between 0 and 1
 A value of 1 is 100% optimistic
 Compute the weighted averages for each
alternative
 Select the alternative with the highest value

Weighted average = (maximum in row)

+ (1 – )(minimum in row)

© 2009 Prentice-Hall, Inc. 3 – 14

 Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
 For the small plant alternative using  = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000

STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large 200,000 –180,000 124,000
plant
Realism
Construct a small 100,000 –20,000 76,000
plant
Do nothing 0 0 0
Table 3.4
© 2009 Prentice-Hall, Inc. 3 – 15
 Equally Likely (Laplace)
Considers all the payoffs for each alternative
 Find the average payoff for each alternative
 Select the alternative with the highest average

STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0
Table 3.5

© 2009 Prentice-Hall, Inc. 3 – 16

 Minimax Regret
Based on opportunity loss or regret,
regret the
difference between the optimal profit and
actual payoff for a decision
 Create an opportunity loss table by determining
the opportunity loss for not choosing the best
alternative
 Opportunity loss is calculated by subtracting
each payoff in the column from the best payoff
in the column
 Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number

© 2009 Prentice-Hall, Inc. 3 – 17

 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE
 Opportunity MARKET ($) MARKET ($)
Loss Tables 200,000 – 200,000 0 – (–180,000)
200,000 – 100,000 0 – (–20,000)
200,000 – 0 0–0
Table 3.6

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Table 3.7
© 2009 Prentice-Hall, Inc. 3 – 18
 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000

Table 3.8

© 2009 Prentice-Hall, Inc. 3 – 19

 Decision Making Under Risk
 Decision making when there are several possible
states of nature and we know the probabilities
associated with each possible state
 Most popular method is to choose the alternative
with the highest expected monetary value (EMV)

native i) = (payoff of first state of nature)

x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ … + (payoff of last state of nature)
x (probability of last state of nature)

© 2009 Prentice-Hall, Inc. 3 – 20

 EMV for Thompson Lumber
 Each market has a probability of 0.50
 Which alternative would give the highest EMV?
 The calculations are

rge plant) = (0.50)($200,000) + (0.50)(–$180,000)

= $10,000
mall plant) = (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
o nothing) = (0.50)($0) + (0.50)($0)
= $0

© 2009 Prentice-Hall, Inc. 3 – 21

 EMV for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50

Table 3.9 Largest EMV

© 2009 Prentice-Hall, Inc. 3 – 22

 Expected Value of Perfect
Information (EVPI)
 EVPI places an upper bound on what you should
pay for additional information
EVPI = EVwPI – Maximum EMV
 EVwPI is the long run average return if we have
perfect information before a decision is made

EVwPI = (best payoff for first state of nature)

x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ … + (best payoff for last state of nature)
x (probability of last state of nature)

© 2009 Prentice-Hall, Inc. 3 – 23

 Expected Value of Perfect
Information (EVPI)
 Scientific Marketing, Inc. offers analysis
that will provide certainty about market
conditions (favorable)
 Additional information will cost $65,000
 Is it worth purchasing the information?

© 2009 Prentice-Hall, Inc. 3 – 24

 Expected Value of Perfect
Information (EVPI)
1. Best alternative for favorable state of nature is
build a large plant with a payoff of $200,000
Best alternative for unfavorable state of nature is
to do nothing with a payoff of $0
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

© 2009 Prentice-Hall, Inc. 3 – 25

 Expected Value of Perfect
Information (EVPI)
1. Best alternative for favorable state of nature is
build a large plant with a payoff of $200,000
So the maximum Thompson
Best alternative for unfavorable
should pay for the state of nature is
additional
to do nothinginformation
with a payoff
is of $0
$60,000
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional
information is $40,000
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

© 2009 Prentice-Hall, Inc. 3 – 26

 Expected Opportunity Loss
 Expected opportunity loss (EOL) is the
cost of not picking the best solution
 First construct an opportunity loss table
 For each alternative, multiply the
opportunity loss by the probability of that
loss for each possible outcome and add
these together
 Minimum EOL will always result in the
same decision as maximum EMV
 Minimum EOL will always equal EVPI

© 2009 Prentice-Hall, Inc. 3 – 27

 Expected Opportunity Loss
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small 100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000
Probabilities 0.50 0.50
Table 3.10 Minimum EOL
arge plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
mall plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
o nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
© 2009 Prentice-Hall, Inc. 3 – 28
 Sensitivity Analysis
 Sensitivity analysis examines how our decision
might change with different input data
 For the Thompson Lumber example

P = probability of a favorable market

(1 – P) = probability of an unfavorable market

© 2009 Prentice-Hall, Inc. 3 – 29

 Sensitivity Analysis
EMV(Large Plant) = $200,000P – $180,000)(1 – P)
= $200,000P – $180,000 + $180,000P
= $380,000P – $180,000
EMV(Small Plant) = $100,000P – $20,000)(1 – P)
= $100,000P – $20,000 + $20,000P
= $120,000P – $20,000
EMV(Do Nothing) = $0P + 0(1 – P)
= $0

© 2009 Prentice-Hall, Inc. 3 – 30

 Sensitivity Analysis
EMV Values

$300,000

$200,000
Point 2 EMV (large plant)
$100,000
Point 1 EMV (small plant)
0
EMV (do nothing)
–$100,000
.167 .615 1
–$200,000 Values of P

Figure 3.1

© 2009 Prentice-Hall, Inc. 3 – 31

 Sensitivity Analysis
Point 1:
EMV(do nothing) = EMV(small plant)
20,000
0 $120,000 P  $20,000 P 0.167
120,000

Point 2:
EMV(small plant) = EMV(large plant)
$120,000 P  $20,000 $380,000 P  $180,000
160,000
P 0.615
260,000

© 2009 Prentice-Hall, Inc. 3 – 32

 Sensitivity Analysis
BEST RANGE OF P
ALTERNATIVE VALUES
Do nothing Less than 0.167
EMV Values Construct a small plant 0.167 – 0.615
$300,000 Construct a large plant Greater than 0.615
$200,000
Point 2 EMV (large plant)
$100,000
Point 1 EMV (small plant)
0
EMV (do nothing)
–$100,000
.167 .615 1
–$200,000 Values of P

Figure 3.1
© 2009 Prentice-Hall, Inc. 3 – 33
 Using Excel QM to Solve
Decision Theory Problems

Program 3.1A
© 2009 Prentice-Hall, Inc. 3 – 34
 Using Excel QM to Solve
Decision Theory Problems

Program 3.1B
© 2009 Prentice-Hall, Inc. 3 – 35
 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 and state-of-nature points or
nodes
 A decision node from which one of several
alternatives may be chosen
 A state-of-nature node out of which one state
of nature will occur
© 2009 Prentice-Hall, Inc. 3 – 36
 Five Steps to
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

© 2009 Prentice-Hall, Inc. 3 – 37

 Structure of Decision Trees
 Trees start from left to right
 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

© 2009 Prentice-Hall, Inc. 3 – 38

 Thompson’s Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st Pla
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
Figure 3.2

© 2009 Prentice-Hall, Inc. 3 – 39

 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)
ct nt –$180,000
r u
n st Pla
e
Co arg
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
© 2009 Prentice-Hall, Inc. 3 – 40
 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
nt 2 Unfavorable Market (0.22)
P la –$190,000
ge
Lar Favorable Market (0.78)
$90,000
Small
5) 3 Unfavorable Market (0.22)
0.4 Plant –$30,000
(
e y ts le
rv ul ab No Plant
Su Res vor –$10,000
a
1 Surv F Favorable Market (0.27)
$190,000
y

e
Re y (
e

nt 4 Unfavorable Market (0.73)

rv

Ne su 0.5 P la –$190,000
Su

ga lts 5) ge
Lar Favorable Market (0.27)
t

tiv Small $90,000

ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
M
t
uc

No Plant
–$10,000
nd
Co

Do Favorable Market (0.50)

Not $200,000
Con t 6 Unfavorable Market (0.50)
duc la n
P –$180,000
t Su ge
rve Lar Favorable Market (0.50)
$100,000
y Small
Plant
7 Unfavorable Market (0.50)
–$20,000
No Plant
$0
Figure 3.4
© 2009 Prentice-Hall, Inc. 3 – 41
 Thompson’s Complex Decision Tree

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
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

© 2009 Prentice-Hall, Inc. 3 – 42

 Thompson’s Complex Decision Tree

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
f 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
Best choice is to seek marketing information

© 2009 Prentice-Hall, Inc. 3 – 43

 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
l a nt Unfavorable Market (0.22)

$106,400
P –$190,000
a rge $63,600 Favorable Market (0.78)
L $90,000
Small
5) Unfavorable Market (0.22)
0.4 Plant –$30,000
(
e y ts le
rv ul ab No Plant
Su Res vor –$10,000
Su Fa –$87,400 Favorable Market (0.27)
rv $190,000
y

e
Re y (
e

ant Unfavorable Market (0.73)

rv

Ne su 0.5 Pl –$190,000
Su

ga lts 5) rge $2,400

$2,400
La Favorable Market (0.27)
t

tiv Small $90,000

ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
Mt
uc

No Plant
–$10,000
d
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
duc P la n –$180,000
ge
$40,000

t Su Lar $40,000 Favorable Market (0.50)

rve Small $100,000
y Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0
Figure 3.4
© 2009 Prentice-Hall, Inc. 3 – 44
Expected Value of Sample Information

 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

© 2009 Prentice-Hall, Inc. 3 – 45

 Sensitivity Analysis

 How sensitive are the decisions to

changes in the probabilities?
 How sensitive is our decision to the
probability of a favorable survey result?
 That is, if the probability of a favorable
result (p = .45) where to change, would we
make the same decision?
 How much could it change before we would
make a different decision?

© 2009 Prentice-Hall, Inc. 3 – 46

 Sensitivity Analysis
p = probability of a favorable survey
result
(1 – p) = probability of a negative survey
result 1) = ($106,400)p +($2,400)(1 – p)
EMV(node
= $104,000p + $2,400
We are indifferent when the EMV of node 1 is the
same as the EMV of not conducting the survey,
$40,000

$104,000p + $2,400= $40,000

$104,000p = $37,600
p = $37,600/$104,000 = 0.36
© 2009 Prentice-Hall, Inc. 3 – 47
 Bayesian Analysis
 Many ways of getting probability data
 It can be based on
 Management’s experience and intuition
 Historical data
 Computed from other data using Bayes’
theorem
 Bayes’ theorem incorporates initial
estimates and information about the
accuracy of the sources
 Allows the revision of initial estimates
based on new information
© 2009 Prentice-Hall, Inc. 3 – 48
 Calculating Revised Probabilities

 In the Thompson Lumber case we used these four

conditional probabilities
P (favorable market(FM) | survey results positive) = 0.78
P (unfavorable market(UM) | survey results positive) = 0.22
P (favorable market(FM) | survey results negative) = 0.27
P (unfavorable market(UM) | survey results negative) = 0.73

 The prior probabilities of these markets are

P (FM) = 0.50
P (UM) = 0.50

© 2009 Prentice-Hall, Inc. 3 – 49

 Calculating Revised Probabilities
 Through discussions with experts Thompson has
learned the following
 He can use this information and Bayes’ theorem
to calculate posterior probabilities
STATE OF NATURE
RESULT OF FAVORABLE MARKET UNFAVORABLE MARKET
SURVEY (FM) (UM)

Positive (predicts P (survey positive | FM) P (survey positive | UM)

favorable market
for product) = 0.70 = 0.20

Negative (predicts
unfavorable P (survey negative | FM) P (survey negative | UM)
market for = 0.30 = 0.80
product)

Table 3.11
© 2009 Prentice-Hall, Inc. 3 – 50
 Calculating Revised Probabilities
 Recall Bayes’ theorem is

P ( B | A) P ( A)
P( A | B) 
P ( B | A) P ( A)  P ( B | A) P ( A)

where
A, B any two events
A complement of A

For this example, A will represent a favorable

market and B will represent a positive survey

© 2009 Prentice-Hall, Inc. 3 – 51

 Calculating Revised Probabilities
 P (FM | survey positive)
P ( survey positive | FM ) P ( FM )

P(survey positive |FM) P(FM)  P(survey positive |UM) P(UM)

(0.70)(0.50 ) 0.35
  0.78
(0.70 )(0.50)  (0.20 )(0.50) 0.45

 P (UM | survey positive)

P ( survey positive | UM ) P (UM )


P(survey positive |UM) P(UM)  P(survey positive |FM) P(FM)

(0.20)(0.50) 0.10
  0.22
(0.20 )(0.50)  (0.70 )(0.50 ) 0.45

© 2009 Prentice-Hall, Inc. 3 – 52

 Calculating Revised Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF POSITIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY POSITIVE)
FM 0.70 X 0.50 = 0.35 0.35/0.45 = 0.78
UM 0.20 X 0.50 = 0.10 0.10/0.45 = 0.22
P(survey results positive) = 0.45 1.00

Table 3.12

© 2009 Prentice-Hall, Inc. 3 – 53

 Calculating Revised Probabilities
 P (FM | survey negative)
P ( survey negative | FM ) P ( FM )

P(survey negative |FM) P(FM)  P(survey negative |UM) P(UM)

(0.30)(0.50 ) 0.15
  0.27
(0.30 )(0.50)  (0.80 )(0.50) 0.55

 P (UM | survey negative)

P ( survey negative | UM ) P (UM )


P(survey negative |UM) P(UM)  P(survey negative |FM) P(FM)

(0.80)(0.50) 0.40
  0.73
(0.80 )(0.50)  (0.30 )(0.50 ) 0.55

© 2009 Prentice-Hall, Inc. 3 – 54

 Calculating Revised Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF NEGATIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY NEGATIVE)
FM 0.30 X 0.50 = 0.15 0.15/0.55 = 0.27
UM 0.80 X 0.50 = 0.40 0.40/0.55 = 0.73
P(survey results positive) = 0.55 1.00

Table 3.13

© 2009 Prentice-Hall, Inc. 3 – 55

 Potential Problems Using
Survey Results

 We can not always get the necessary

data for analysis
 Survey results may be based on cases
where an action was taken
 Conditional probability information
may not be as accurate as we would
like

© 2009 Prentice-Hall, Inc. 3 – 56

 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
 Rational people make decisions to
maximize their utility

© 2009 Prentice-Hall, Inc. 3 – 57

 Utility Theory
$2,000,000
Accept
Offer
$0
Heads
(0.5)
Reject
Offer

Tails
(0.5)

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

Figure 3.6

© 2009 Prentice-Hall, Inc. 3 – 58

 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, the 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 © 2009 Prentice-Hall, Inc. 3 – 59
 Standard Gamble

(p)
Best Outcome
Utility = 1

1 (1 – p) Worst Outcome
ve
ti Utility = 0
er na
Alt

Al
te r
na
tiv
e2

Other Outcome
Utility = ?
Figure 3.7

© 2009 Prentice-Hall, Inc. 3 – 60

 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
© 2009 Prentice-Hall, Inc. 3 – 61
 Investment Example
p = 0.80 $10,000
U($10,000) = 1.0

(1 – p) = 0.20 $0
s t in te U($0.00) = 0.0
e
Inv Esta
e al
R
Inv
es
t in
Ba
nk
$5,000
Figure 3.8
U($5,000) = p = 1.0

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

= (0.8)(1) + (0.2)(0) = 0.8
© 2009 Prentice-Hall, Inc. 3 – 62
 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

© 2009 Prentice-Hall, Inc. 3 – 63

 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 –

0.5 –
U ($3,000) = 0.50
Utility

0.4 –

0.3 –

0.2 –

0.1 –

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

Monetary Value
Figure 3.9

© 2009 Prentice-Hall, Inc. 3 – 64

 Utility Curve
 Jane’s utility curve is typical of a risk
avoider
 A risk avoider gets less utility from greater risk
 Avoids situations where high losses might
occur
 As monetary value increases, the 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 who is indifferent will have a linear
utility curve

© 2009 Prentice-Hall, Inc. 3 – 65

 Utility Curve

Risk
Avoider

e
nc
re
Utility

ffe
di
In
k
is
R

Risk
Seeker

Monetary Outcome
Figure 3.10

© 2009 Prentice-Hall, Inc. 3 – 66

 Utility as a
Decision-Making Criteria

 Once a utility curve has been developed

it can be used in making decisions
 Replace monetary outcomes with utility
values
 The expected utility is computed instead
of the EMV

© 2009 Prentice-Hall, Inc. 3 – 67

 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
 Should Mark play the game (alternative 1)?

© 2009 Prentice-Hall, Inc. 3 – 68

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

Tack Lands
1 ame Point Down (0.55)
t i ve the G –$10,000
erna ys
a
Alt rk Pl
Ma
Al
ter
na
tiv
e2

Mark Does Not Play the Game

$0
Figure 3.11

© 2009 Prentice-Hall, Inc. 3 – 69

 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

© 2009 Prentice-Hall, Inc. 3 – 70

 Utility as a
Decision-Making Criteria
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 Figure 3.12

© 2009 Prentice-Hall, Inc. 3 – 71

 Utility as a
Decision-Making Criteria
Tack Lands Utility
E = 0.162 Point Up (0.45)
0.30

Tack Lands
1 ame Point Down (0.55)
t i ve the G 0.05
erna ys
a
Alt rk Pl
Ma
Al
ter
na
tiv
e2

Don’t Play
0.15
Figure 3.13

© 2009 Prentice-Hall, Inc. 3 – 72