3

Decision
Analysis

To accompany
Quantitative Analysis for Management, Twelfth Edition,
by Render, Stair, Hanna and Hale
Power Point slides created by Jeff Heyl Copyright ©2015 Pearson Education, 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.
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.

Copyright ©2015 Pearson Education, Inc. 3–2

 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 A Minimization Example
3.7 Using Software for Payoff Table Problems
3.8 Decision Trees
3.9 How Probability Values Are Estimated by Bayesian
Analysis
3.10 Utility Theory
Copyright ©2015 Pearson Education, Inc. 3–3
 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 applies a quantitative
approach

Copyright ©2015 Pearson Education, Inc. 3–4

 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 (typically 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

Copyright ©2015 Pearson Education, Inc. 3–5

 Thompson Lumber Company
Step 1 – Define the problem
• Consider expanding by manufacturing
and marketing a new product – backyard
storage sheds
Step 2 – List alternatives
• Construct a large new plant
• Construct a small new plant
• Do not develop the new product line
Step 3 – Identify possible outcomes, states of
nature
• The market could be favorable or
unfavorable

Copyright ©2015 Pearson Education, Inc. 3–6

 Thompson Lumber Company

Step 4 – List the payoffs

• Identify conditional values for the profits
for large plant, small plant, and no
development 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

Copyright ©2015 Pearson Education, Inc. 3–7

 Thompson Lumber Company

TABLE 3.1 – Conditional Values

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

Copyright ©2015 Pearson Education, Inc. 3–8

 Types of Decision-Making
Environments
• Decision making under certainty
– The decision maker knows with certainty the
consequences of every alternative or decision
choice
• Decision making under uncertainty
– The decision maker does not know the
probabilities of the various outcomes
• Decision making under risk
– The decision maker knows the probabilities of the
various outcomes

Copyright ©2015 Pearson Education, Inc. 3–9

 Decision Making Under
Uncertainty
• Criteria for making decisions under
uncertainty

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

Copyright ©2015 Pearson Education, Inc. 3 – 10

 Optimistic
• Used to find the alternative that maximizes
the maximum payoff – maximax criterion
– Locate the maximum payoff for each alternative
– Select the alternative with the maximum number

TABLE 3.2 – Thompson’s Maximax Decision

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large plant 200,000 –180,000 200,000
Construct a small plant 100,000 –20,000 100,000
Maximax
Do nothing 0 0 0

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 Pessimistic
• Used to find the alternative that maximizes
the minimum payoff – maximin criterion
– Locate the minimum payoff for each alternative
– Select the alternative with the maximum number
TABLE 3.3 – Thompson’s Maximin Decision

STATE OF NATURE

FAVORABLE UNFAVORABLE MINIMUM IN

ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large plant 200,000 –180,000 –180,000
Construct a small plant 100,000 –20,000 –20,000
Do nothing 0 0 0
Maximin
Copyright ©2015 Pearson Education, Inc. 3 – 12
Criterion of Realism (Hurwicz)
• Often called weighted average
– Compromise between optimism and pessimism
– Select a coefficient of realism , with 0 ≤ a ≤ 1
a = 1 is perfectly optimistic
a = 0 is perfectly pessimistic
– Compute the weighted averages for each
alternative
– Select the alternative with the highest value

Weighted average = (best in row)

+ (1 – )(worst in row)

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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
TABLE 3.4 – Thompson’s Criterion of Realism Decision
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8) $
Construct a large plant 200,000 –180,000 124,000
Realism
Construct a small plant 100,000 –20,000 76,000

Do nothing 0 0 0

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 Equally Likely (Laplace)
• Considers all the payoffs for each alternative
– Find the average payoff for each alternative
– Select the alternative with the highest average

TABLE 3.5 – Thompson’s Equally Likely Decision

STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large plant 200,000 –180,000 10,000

Construct a small plant 100,000 –20,000 40,000

Equally likely
Do nothing 0 0 0

Copyright ©2015 Pearson Education, Inc. 3 – 15

 Minimax Regret
• Based on opportunity loss or regret
– The difference between the optimal profit and
actual payoff for a decision
1. Create an opportunity loss table by determining
the opportunity loss from not choosing the best
alternative
2. Calculate opportunity loss by subtracting each
payoff in the column from the best payoff in the
column
3. Find the maximum opportunity loss for each
alternative and pick the alternative with the
minimum number

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 Minimax Regret
TABLE 3.6 – Determining Opportunity Losses for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET
($) ($)

200,000 – 200,000 0 – (–180,000)

200,000 – 100,000 0 – (–20,000)

200,000 – 0 0–0

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 Minimax Regret
TABLE 3.7 – Opportunity Loss Table for Thompson Lumber

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

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 Minimax Regret

TABLE 3.8 – Thompson’s Minimax Decision Using Opportunity Loss

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large 0 180,000 180,000
plant
Construct a small
plant 100,000 20,000 100,000
Minimax
Do nothing 200,000 0 200,000

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 Decision Making Under Risk
• When there are several possible states of
nature and the probabilities associated with
each possible state are known
– Most popular method – choose the alternative with
the highest expected monetary value (EMV)

where
Xi = payoff for the alternative in state of nature i
P(Xi) = probability of achieving payoff Xi (i.e., probability of state of nature i)
∑ = summation symbol

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 Decision Making Under Risk
• Expanding the equation

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)

Copyright ©2015 Pearson Education, Inc. 3 – 21

 EMV for Thompson Lumber
• Each market outcome has a probability of
occurrence of 0.50
• Which alternative would give the highest
EMV?
plant) = ($200,000)(0.5) + (–$180,000)(0.5)
= $10,000
plant) = ($100,000)(0.5) + (–$20,000)(0.5)
= $40,000
othing) = ($0)(0.5) + ($0)(0.5)
= $0
Copyright ©2015 Pearson Education, Inc. 3 – 22
 EMV for Thompson Lumber
TABLE 3.9 – Decision Table with Probabilities and EMVs
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large plant 200,000 –180,000 10,000

Construct a small plant 100,000 –20,000 40,000

Do nothing 0 0 0

Probabilities 0.50 0.50 Best EMV

Copyright ©2015 Pearson Education, Inc. 3 – 23

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

EVwPI = ∑(best payoff in state of nature i)

(probability of state of nature i)

Copyright ©2015 Pearson Education, Inc. 3 – 24

 Expected Value of Perfect
Information (EVPI)
• Expanded EVwPI becomes
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)
• And
EVPI = EVwPI – Best EMV

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 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
• Should Thompson Lumber purchase the
information?

Copyright ©2015 Pearson Education, Inc. 3 – 26

 Expected Value of Perfect
Information (EVPI)
TABLE 3.10 – Decision Table with Perfect Information

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)

Construct a large plant 200,000 -180,000 10,000

Construct a small plant 100,000 -20,000 40,000

Do nothing 0 0 0
With perfect 200,000 0 100,000
information
EVwPI
Probabilities 0.5 0.5

Copyright ©2015 Pearson Education, Inc. 3 – 27

 Expected Value of Perfect
Information (EVPI)
• The maximum EMV without additional
information is $40,000
– Therefore

EVPI = EVwPI – Maximum EMV

= $100,000 - $40,000
= $60,000

So the maximum Thompson should pay

for the additional information is $60,000

Copyright ©2015 Pearson Education, Inc. 3 – 28

 Expected Value of Perfect
Information (EVPI)
• The maximum EMV without additional
information is $40,000
Thompson should not pay
– Therefore $65,000 for this information

EVPI = EVwPI – Maximum EMV

= $100,000 - $40,000
= $60,000

So the maximum Thompson should pay

for the additional information is $60,000

Copyright ©2015 Pearson Education, Inc. 3 – 29

 Expected Opportunity Loss
• Expected opportunity loss (EOL) is the cost of
not picking the best solution
– 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

Copyright ©2015 Pearson Education, Inc. 3 – 30

 Expected Opportunity Loss
EOL (large plant) = (0.50)($0) + (0.50)($180,000) = $90,000
EOL (small plant) = (0.50)($100,000) + (0.50)($20,000) = $60,000
EOL (do nothing) = (0.50)($200,000) + (0.50)($0) = $100,000

TABLE 3.11 – EOL Table for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small plant 100,000 20,000 60,000
Do nothing 200,000 0 100,000
Probabilities 0.5 0.5
Best EOL

Copyright ©2015 Pearson Education, Inc. 3 – 31

 Decision Trees
• Any problem that can be presented in a
decision table can be graphically represented
in a decision tree
– Most beneficial when a sequence of decisions
must be made
– All decision trees contain decision points/nodes
and state-of-nature points/nodes
– At decision nodes one of several alternatives may
be chosen
– At state-of-nature nodes one state of nature will
occur

Copyright ©2015 Pearson Education, Inc. 3 – 32

 Five Steps of
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

Copyright ©2015 Pearson Education, Inc. 3 – 33

 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

Copyright ©2015 Pearson Education, Inc. 3 – 34

 Thompson’s Decision Tree
FIGURE 3.2
A State-of-Nature Node

Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
s tr la
on eP
C rg
La Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
ing

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 Thompson’s Decision Tree
FIGURE 3.3
EMV for Node 1 = (0.5)($200,000) + (0.5)(–$180,000)
= $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
u
tr l a
s
n eP
o
C arg
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node 2 = (0.5)($100,000)
ing + (0.5)(–$20,000)
= $40,000

$0
Copyright ©2015 Pearson Education, Inc. 3 – 36
 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

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 Utility Theory
FIGURE 3.6 – 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

Copyright ©2015 Pearson Education, Inc. 3 – 38

 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

Copyright ©2015 Pearson Education, Inc. 3 – 39

 Utility Theory
FIGURE 3.7 – Standard Gamble for Utility Assessment

(p)
Best Outcome
Utility = 1

1 (1 – p) Worst Outcome
tive Utility = 0
erna
Alt

Alt
e rna
tive
2
Other Outcome
Utility = ?

Copyright ©2015 Pearson Education, Inc. 3 – 40

 Utility Theory
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

Copyright ©2015 Pearson Education, Inc. 3 – 41

 Investment Example
• Construct a utility curve revealing 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, prefer to have her money
in the bank
– If p = 0.80, Jane is indifferent between the bank or
the real estate investment

Copyright ©2015 Pearson Education, Inc. 3 – 42

 Investment Example
Figure 3.8 – Utility of $5,000
p = 0.80 $10,000
U($10,000) = 1.0

(1 – p) = 0.20 $0
s t in e U($0.00) = 0.0
e t
Inv Esta
e al
R

Inv
es
t in
Ba
nk
$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
Copyright ©2015 Pearson Education, Inc. 3 – 43
 Investment Example
• Assess other utility values
Utility for $7,000 = 0.90
Utility for $3,000 = 0.50

• Use the three different dollar amounts and

assess utilities

Copyright ©2015 Pearson Education, Inc. 3 – 44

 Utility Curve
FIGURE 3.9 – Utility Curve

U ($10,000) = 1.0
1.0 –
U ($7,000) = 0.90
0.9 –
U ($5,000) = 0.80
0.8 –

0.7 –

0.6 –
U ($3,000) = 0.50
Utility

0.5 –

0.4 –

0.3 –

0.2 –

0.1 – U ($0) = 0
| | | | | | | | | | |
$0 $1,000 $3,000 $5,000 $7,000 $10,000
Monetary Value
Copyright ©2015 Pearson Education, Inc. 3 – 45
 Utility Curve
• Typical of a risk avoider
– Less utility from greater risk
– Avoids situations where high losses might occur
– As monetary value increases, 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
• Risk indifferent gives a linear utility curve

Copyright ©2015 Pearson Education, Inc. 3 – 46

 Preferences for Risk
FIGURE 3.10

Risk
Avoider

ce n
re
Utility

ffe
di
In
k
is
R

Risk
Seeker

Monetary Outcome
Copyright ©2015 Pearson Education, Inc. 3 – 47
 Copyright

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2-48