Chapter --2

Decision Analysis

1
 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.

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.
3-3
 Introduction

• Decision theory is an analytic and

systematic approach to the study of decision
making.

3-4
 Decision ….

Good decisions:
based on reasoning
consider all available data and possible alternatives
employ a quantitative approach
Bad decisions:
not based on reasoning
do not consider all available data and possible
alternatives
do not employ a quantitative approach
5
 Decision …!!

A good decision may occasionally result in an

unexpected outcome; it is still a good decision if
made properly

A bad decision may occasionally result in a

good outcome if you are lucky; it is still a bad
decision

6
 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.
3-7
 I will use The fallowing Example to show you the

application of the above mentioned steps

Example

The Thompson Lumber Company

Problem.
The Thompson Lumber Co. must decide whether or
not to expand its product line by manufacturing and
marketing a new product, backyard storage sheds
8
 Cont’d…..
Step 1 – Define the problem.
 The company is considering expanding by manufacturing and

marketing a new product – backyard storage sheds.

Step 2 – List alternatives.
alternative: “a course of action or strategy that may be chosen by
the decision maker
 Construct a large new plant.

 Construct a small new plant.

 Do not develop the new product line at all.

Step 3 – Identify possible outcomes.

 The market could be favorable or unfavorable .
3-9
 Cont’d…

Step 3 – Identify the states of nature

1) The market for storage sheds could be favorable
high demand
2) The market for storage sheds could be unfavorable
low demand

state of nature: “an outcome over which the decision

maker has little or no control”
e.g., lottery, coin-toss, whether it will rain today

3-10
 Cont’d…

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.

Conditional values: “reward depends upon the

alternative and the state of nature

3-11
 Cont’d…

with a favorable market:

a large plant produces a net profit of $200,000
a small plant produces a net profit of $100,000
no plant produces a net profit of $0
with an unfavorable market:
a large plant produces a net loss of $180,000
a small plant produces a net loss of $20,000
no plant produces a net profit of $0
3-12
 Cont’d…..

Step 5 – Select an appropriate model and apply it

1. Model selection depends on the operating
environment and degree of uncertainty
Step 6 – Apply the model to the data.

Solution and analysis are then used to aid in

decision-making.

3-13
 Cont’d…..
Decision Table with Conditional Values for Thompson Lumber

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 3-14

 Types of Decision-Making Environments

Type 1: Decision making under certainty

– The decision maker knows with certainty
the consequences of every alternative or
decision choice.
– Always choose the alternative that results
in the best possible outcome

3-15
 Cont’d…

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.

16
 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
3-17
 Maximax Criterion (“Go for the Gold”)

Select the decision that results in the maximum

of the maximum rewards
A very optimistic decision criterion
• Decision maker assumes that the most favorable
state of nature for each action will occur

18
 Maximax Criterion (“Go for the Gold”)
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 A

ALTERNATIVE MARKET ($) MARKET ($) ROW ($)

Construct a large plant –180,000

200,000 200,000
Maximax

Construct a small plant –20,000

100,000 100,000

Do nothing 0 0 0
3-19
 Maximax Criterion (“Go for the Gold”)

• Thompson Lumber Co. assumes that the most

favorable state of nature occurs for each decision
alternative
• Select the maximum reward for each decision
All three maximums occur if a favorable
economy prevails (a tie in case of no plant)

20
Select the maximum of the maximums

 Maximum is $200,000; corresponding decision

is to build the large plant

 Potential loss of $180,000 is completely

ignored

21
 Maximin Criterion “Best of the Worst”

 Select the decision that results in the maximum of the

minimum rewards
 A very pessimistic decision criterion

Decision maker assumes that the minimum reward

occurs for each decision alternative
Select the maximum of these minimum rewards

22
 Maximin Criterion “Best of the Worst”
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 A

ALTERNATIVE MARKET ($) MARKET ($) ROW ($)

–
Construct a large plant –180,000
200,000 180,000

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

Do nothing 0 0 0

Table 3.3 Maximin 3-23

 Maximin Criterion “Best of the Worst”
 Thompson Lumber Co. assumes that the least favorable state of
nature occurs for each decision alternative
 Select the minimum reward for each decision
 All three minimums occur if an unfavorable economy prevails
(a tie in case of no plant)

 Select the maximum of the minimums

 Maximum is $0; corresponding decision is to do nothing

 A conservative decision; largest possible gain, $0, is much less

than maximax
24
 Criterion of Realism

Also known as the weighted average or Hurwicz criterion

A compromise between an optimistic and pessimistic

decision

• A coefficient of realism, α , is selected by the decision

maker to indicate optimism or pessimism about the future.

0≤α≤1.

25
Criterion of Realism
When α is close to 1, the decision maker is
optimistic.
When α is close to 0, the decision maker is
pessimistic.
 Compute the weighted averages for each
alternative.
 Select the alternative with the Highest Value.

26
 Criterion of Realism
Criterion of realism = (maximum in row) +
(1 – )(minimum in row)

A weighted average where maximum and minimum

rewards are weighted by  and (1 - ) respectively

3-27
 Criterion of Realism
Assume a coefficient of realism equal to 0.8:
STATE OF NATURE

CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8) $

Construct a large plant –180,000

200,000 124,000
Realism

Construct a small plant –20,000 76,000

100,000

Do nothing 0 0 0

3-28
Table 3.4
 Criterion of Realism

Weighted Averages
 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

Select the decision with the highest weighted value

29
 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
–180,000
plant 200,000 10,000
Construct a small
–20,000
plant 100,000 40,000
Equally likely
Do nothing 0 0 0

Table 3.5
 Equally Likely

Select the decision with the highest weighted value

Maximum is $40,000; corresponding decision is to

build the small plant

31
 Minimax Regret

Based on opportunity loss or regret, this is the

difference between the optimal profit and actual
payoff for a decision.
– Create an opportunity loss table by determining
the opportunity loss from not choosing the best
alternative.

3-32
 Minimax Regret

– 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.
• If I knew the future, how much I’d regret my
decision…
33
 Minimax Regret

Determining Opportunity Losses for Thompson Lumber

STATE OF NATURE

FAVORABLE MARKET ($) UNFAVORABLE MARKET ($)

200,000 – 200,000 0 – (–180,000)

200,000 – 100,000 0 – (–20,000)

200,000 – 0 0–0

Table 3.6 3-34

 Minimax Regret

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

3-35
Table 3.7
 Minimax Regret

Thompson’s Minimax Decision Using Opportunity Loss

STATE OF NATURE

FAVORABLE UNFAVORABLE MAXIMUM IN A

ALTERNATIVE MARKET ($) MARKET ($) ROW ($)

Construct a large plant 0 180,000

180,000

Construct a small
20,000
plant 100,000 100,000
Minimax

Do nothing 0
200,000 200,000

Table 3.8 3-36

 Minimax Regret
Select the alternative with the lowest
maximum regret

37
Summary of Results

38
 Decision Making Under Risk

• This is decision making when there are several possible

states of nature, and the probabilities associated with each
possible state are known.
• The most popular method is to choose the alternative with
the highest expected monetary value (EMV).
– This is very similar to the expected value calculated in
the last chapter.

3-39
40
 EMV for Thompson Lumber
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

Probabilities 0.50 0.50

3-41
Table 3.9
 EMV for Thompson Lumber

 Suppose each market outcome has a probability of

occurrence of 0.50.
 Which alternative would give the highest EMV?

 The calculations are:

EMV (large plant)= ($200,000)(0.5) + (–$180,000)(0.5)

= $10,000
EMV (small plant) = ($100,000)(0.5) + (–$20,000)(0.5)
= $40,000
EMV (do nothing) = ($0)(0.5) + ($0)(0.5)
= $0
3-42
 EMV for Thompson Lumber
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)

Construct a large plant –180,000 10,000

200,000

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

Do nothing 0 0 0

Largest EMV
Probabilities 0.50 0.50

3-43
Table 3.9
 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)

3-44
 Expected Value of Perfect Information (EVPI)

• Suppose 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?

3-45
 Expected Value of Perfect Information (EVPI)

Decision Table with Perfect Information

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

With perfect
200,000 0 100,000
information
EVwPI
Probabilities 0.5 0.5
Table 3.10 3-46
 Expected Value of Perfect Information (EVPI)
The maximum EMV without additional information is $40,000.
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000

So the maximum Thompson should pay for the additional

information is $60,000.

Therefore, Thompson should not pay $65,000 for this

information.
 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. 3-48
 Expected Opportunity Loss
STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL

Construct a large plant 0 180,000

90,000

Construct a small plant 20,000

100,000 60,000

Do nothing 0
200,000 100,000
Table 3.11
Probabilities 0.50 0.50 Minimum EOL
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 3-49
 Sensitivity Analysis
 Sensitivity analysis examines how the 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

3-50
 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

3-51
 Sensitivity Analysis

EMV Values

$300,000

$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P

–$200,000

Figure 3.1
3-52
 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

3-53
 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)

.167 .615 1
–$100,000 Values of P

–$200,000
Figure 3.1
3-54
 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.
3-55
 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.

3-56
 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.

3-57
 Thompson’s Decision Tree
A State-of-Nature Node

Favorable Market
A Decision Node
1
Unfavorable Market
u ct t
r
st Plan
n
Co rge
La Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
N ot
h ing

Figure 3.2

3-58
 Thompson’s Decision Tree

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)
–$180,000
u ct t
r
st Plan
n
Co rge
La Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
N ot
h EMV for Node 2 = (0.5)($100,000)
ing
= $40,000 + (0.5)(–$20,000)
Figure 3.3
$0
3-59
 Thompson’s Complex Decision Tree

First Decision Second Decision Payoffs

Point Point
Favorable Market (0.78)
$190,000
t 2 Unfavorable Market (0.22)
ePlan –$190,000
Larg Favorable Market (0.78)
Small $90,000
. 4 5) Plant
3 Unfavorable Market (0.22)
–$30,000
0
e y( s
rv lt le No Plant
Su esu orab –$10,000
R av
1 Su r F Favorable Market (0.27)
ve $190,000
Re y (0 4
y

t Unfavorable Market (0.73)

Plan
ve

Ne sul .55 e –$190,000

ur

ga ts ) Larg Favorable Market (0.27)

tS

tiv Small $90,000

ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct
du

No Plant
–$10,000
n
Co

Do Favorable Market (0.50)

Not $200,000
Con t 6 Unfavorable Market (0.50)
d uct ePlan –$180,000
Su r v Larg Favorable Market (0.50)
ey Small $100,000
Plant
7 Unfavorable Market (0.50)
Figure 3.4 –$20,000
No Plant
$0
3-60
 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

3-61
 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
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
The best choice is to seek marketing information.

3-62
 Thompson’s Complex Decision Tree

First Decision Point Second Decision Point Payoffs

$106,400 Favorable Market (0.78)

$190,000
t Unfavorable Market (0.22)
Plan –$190,000

$106,400
e
Larg $63,600 Favorable Market (0.78)
Small $90,000
) Unfavorable Market (0.22)
. 45 Plant –$30,000
0
ey( s e
rv lt l No Plant
Su esu orab –$10,000
R v
Su Fa –$87,400 Favorable Market (0.27)
rv $190,000
ey
Re (0 t Unfavorable Market (0.73)
Ne sul .5 5 e Plan –$190,000
Larg
t

ga ts ) $2,400 Favorable Market (0.27)

ke

$2,400
tiv Small $90,000
ar

e
ey t M

Unfavorable Market (0.73)

Plant –$30,000
rv u c
Su ond

No Plant
–$10,000
C
$49,200

$10,000 Favorable Market (0.50)

Do $200,000
No t
C on t Unfavorable Market (0.50)
du c e Plan –$180,000
t Su Larg
$40,000

rvey $40,000 Favorable Market (0.50)

Small $100,000
Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0
3-63
Figure 3.5
 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?

3-64
 Sensitivity Analysis
p= probability of a favorable survey result
(1 – p) = probability of a negative survey
result
EMV(node 1) = ($106,400)p +($2,400)(1 – p)
= $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
If p<0.36, do not conduct the survey. If p>0.36, conduct the survey.
3-65
 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.

3-66
 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 3-67
Standard Gamble for Utility Assessment
(p)
Best Outcome
Utility = 1

(1 – p)
1 Worst Outcome
ve Utility = 0
ati
ltern
A

Alt
ern
ati
ve
2

Other Outcome
Utility = ?

3-68
Figure 3.7
 Investment Example
• Sara 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, Sara would prefer to have her money in the bank.
• So if p = 0.80, Sara is indifferent between the bank or the real
estate investment.
3-69
 Investment Example
p = 0.80 $10,000
U($10,000) = 1.0

(1 – p) = 0.20 $0
t in U($0.00) = 0.0
e s e
Inv Estat
e a l
R

Inv
est
in B
an
k
$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

3-70
Figure 3.8
 Investment Example
 We can assess other utility values in the same way.
 For Sara 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.

3-71
 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
Figure 3.9
3-72
 Utility Curve
 Sara’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.

3-73
 Preferences for Risk

Risk
Avoider

e
nc
re
Utility

ffe
di
In
sk
Ri

Risk
Seeker

Figure 3.10
Monetary Outcome
3-74
 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.

3-75
 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)?

3-76
 Utility as a
Decision-Making Criteria

Decision Facing Mark Simkin

Tack Lands Point
Up (0.45)
$10,000

Tack Lands
e
ve1 eG am Point Down (0.55)
ti –$10,000
erna ys th
Alt k Pla
r
Ma
Alt
ern
ati
ve
2

Figure 3.11 Mark Does Not Play the Game

$0
3-77
 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

3-78
 Utility Curve for Mark Simkin

1.00 –

0.75 –
Utility

0.50 –

0.30 –
0.25 –

0.15 –

0.05 –
Figure 3.12 0 |– | | | |

–$20,000 –$10,000 $0 $10,000 $20,000

Monetary Outcome
3-79
 Utility as a
Decision-Making Criteria

Using Expected Utilities in Decision Making

E = 0.162 Tack Lands Point Utility

Up (0.45)
0.30

Tack Lands
e
ve1 eG am Point Down (0.55)
ti 0.05
terna ays th
Al k Pl
r
Ma
Alt
ern
ati
ve
2
Figure 3.13 Don’t Play
0.15
3-80