Engineering Risk Benefit Analysis

1.155, 2.943, 3.577, 6.938, 10.816, 13.621, 16.862, 22.82,

ESD.72, ESD.721

DA 1. The Multistage Decision Model

George E. Apostolakis
Massachusetts Institute of Technology

Spring 2007

DA 1. The Multistage Decision Model 1

 Why decision analysis?

A structured way for ranking decision options by:

1. Enumerating the immediate and later choices

available to the DM
2. Characterizing the relevant uncertainties
3. Quantifying the relative desirability of outcomes
4. Providing rules for ranking the decision options,
thus helping the DM to select the “best” one.

DA 1. The Multistage Decision Model 2

 Value of formal analysis

• Provides a systematic way to process large amounts

of information

• Decision making process is explicit and enhances

communication

• Provides formal rules for quantifying preferences

DA 1. The Multistage Decision Model 3

 Limitations of DA

• The theory is for an individual decision maker.

This reduces considerably its applicability in
practice. (But, great normative tool.) In most cases
there is no satisfactory way to combine the utility
function of several people
• As with all formal analysis, the results are no better
than the quality of the model and its supporting
assessments
• The required inputs may not be easily obtainable

DA 1. The Multistage Decision Model 4

 Manufacturing Example

• Decision: To continue producing old product (O)

or convert to a new product (N).

The payoffs depend on the market conditions:

s: strong market for the new product

m: mild market for the new product
w: weak market for the new product

DA 1. The Multistage Decision Model 5

 Manufacturing Example Payoffs

• Earnings (payoffs):

L1: $150,000, old product, P[L1/O] = 1.0

L2: $300,000, new product and the market is
strong, P[s] = P[L2/N] = 0.3
L3: $100,000, new product and the market is mild,
P[m] = P[L3/N] = 0.5
L4: -$100,000, new product and the market is weak,
P[w] = P[L4/N] = 0.2

DA 1. The Multistage Decision Model 6

 Building the decision tree

Decision Payoffs
Options
L2 $300K
Payoff
depends on L3 $100K
N market

L4 -$100K

O
L1 $150K
DA 1. The Multistage Decision Model 7
 Decision Tree

Decision States of Nature Payoffs

Options
P[s]= 0.3 L2 $300K
P[m]= 0.5
L3 $100K
N
P[w]=0.2
L4 -$100K

O P[s ∪ m ∪ w ] = 1
L1 $150K

DA 1. The Multistage Decision Model 8

 Non-Probabilistic Decision Rules

• Maximin Rule: Choose option with the largest smallest

payoff (risk averse DM).

N: -$100 O: $150
Choose O

• Maximax Rule: Choose option with the largest payoff

(risk taker).

N: $300 O: $150
Choose N

DA 1. The Multistage Decision Model 9

 Probabilistic Decision Rule

• The maximin and maximax rules are incomplete

because they ignore uncertainties.
• We include probabilities by taking expected values
of the payoffs (slide 31, RPRA 2).
• Decision Rule: Maximize the expected monetary
value (EMV) of the earnings (payoffs).
• In the decision tree, work from right to left and
compute expectations.

DA 1. The Multistage Decision Model 10

 Calculation of the EMV

EMV[N] = 0.3x300 + 0.5x100 + 0.2x(-100) = $120K

EMV[O] = 1.0x150 = $150K

Option O has the largest EMV, therefore it should

be chosen.

DA 1. The Multistage Decision Model 11

 Calculation of the EMV (cont’d)

L2 $300
s, $90
m, $50
L3 $100
EMV[N]=$120
w, -$20
L4 -$100

EMV[O]=$150
$150
L1 $150

Best Decision: O
DA 1. The Multistage Decision Model 12
 A New Decision
• The DM considers the possibility of commissioning
a survey to be able to better judge the future
market.

• The survey costs $20,000.

• There are now two decisions (multistage model):

¾ The initial decision of whether to buy the survey
¾ The terminal decision of whether to market the new
product.

DA 1. The Multistage Decision Model 13

 The survey results can be:
Strong
P(s/L2) = 0.8 P(s/L3) = 0.2 P(s/L4) = 0.0

Mild
P(m/L2) = 0.2 P(m/L3) = 0.6 P(m/L4) = 0.3

Weak
P(w/L2) = 0.0 P(w/L3) = 0.2 P(w/L4) = 0.7
1.0 1.0 1.0

DA 1. The Multistage Decision Model 14

 The new decision tree
*Entries in earnings column Product earns*
do not yet take account Make old C 150,000
Survey product
of the cost of the survey. response 300,000
D
"strong"
Make new C 100,000
product
-100,000

Make old C 150,000

Survey product
Purchase
survey C response D 300,000
"mild" Make new
product C 100,000

-100,000

Make old C 150,000

D product
Survey
response D 300,000
"weak"
Make new 100,000
product C
-100,000
Make old C 150,000
Do not No new product
purchase C information D 300,000
survey is obtained
Make new
product C 100,000

-100,000

Figure by MIT OCW.

DA 1. The Multistage Decision Model 15
 New inputs

• The earnings must be reduced by the survey cost of

$20K: L1 = $130K, L2 = $280K, L3 = $80K,
L4 = -$120K

• The probabilities of the states of nature (the

probabilities of earnings) must also be updated to
reflect the survey findings.
DA 1. The Multistage Decision Model 16
 Bayes’ Theorem (Slide 16, RPRA 2)
• The mutually exclusive and exhaustive states are:
L2, L3, and L4

• Evidence: “Survey result is strong”

P (s / L j )P ( L j )
P( L j / s ) = 4
∑ P(s / L j )P( L j )
2

j = 2, 3,4
DA 1. The Multistage Decision Model 17
 Calculations for “survey result is s”

Payoff Prior Likelihood Product Posterior

Prob. Probability

L2 0.3 P(s/ L2)=0.8 0.24 P(L2/s)=0.706

L3 0.5 P(s/ L3)=0.2 0.10 P(L3/s)=0.294
L4 0.2 P(s/ L4)=0.0 0.00 P(L4/s)=0.000
1.0 0.34 1.000

DA 1. The Multistage Decision Model 18

 Results for m and w

P(L2/m) = 0.143 P(L2/w) = 0.000

P(L3/m) = 0.714 P(L3/w) = 0.417

P(L4/m) = 0.143 P(L4/w) = 0.583

1.000 1.000

DA 1. The Multistage Decision Model 19

 The updated decision tree
O C 1 L1 130,000
s D
.706 L2 280,000
N C .294 L3 80,000
0 L4 -120,000
.34

O C 1 L1 130,000
S C .42 m D
.143 L2 280,000
N C .714 L3 80,000
.143 L4 -120,000
.24

D
O C 1 L1 130,000
w D
0 L2 280,000
N C .417 L3 80,000
.583 L4 -120,000

O C 1 L1 150,000
S C 1 D
.3 L2 300,000
N C .5 L3 100,000
.2 L4 -100,000

Figure by MIT OCW.

DA 1. The Multistage Decision Model 20

 Optimal terminal decisions

1. Solve “backwards in time.”

2. Determine the best solution at every terminal

node, conditional on the DM’s being there.

3. Find the EMV for each terminal node and the

decision option that maximizes the EMV.

4. An arrow indicates the best decision for each

terminal node.

DA 1. The Multistage Decision Model 21

 Decision tree solution
130,000
221,300 O C 1 L1 130,000
s D 221,300 .706 L2 280,000
N C .294 L3 80,000
0 L4 -120,000
.34
130,000
161,008 130,000 O C 1 L1 130,000
S C . 42 m D 80,000 .143 L2 280,000
N C .714 L3 80,000
.143 L4 -120,000
. 24 130,000

D
130,000 O C 1 L1 130,000
w D -36,600 0 L2 280,000
N C .417 L3 80,000
.583 L4 -120,000
150,000 150,000
150,000 O C 1 L1 150,000
S C 1 D 120,000 .3 L2 300,000
N C .5 L3 100,000
.2 L4 -100,000

Figure by MIT OCW.

DA 1. The Multistage Decision Model 22

 Best decision

1. Assume that the DM makes the best decision at

each terminal node, if it is reached.
2. Find the EMV for the initial node.
3. Buy survey: EMV = $161,008
Do not buy survey: EMV = $150,000
4. Best initial decision: Buy survey

DA 1. The Multistage Decision Model 23

 Best terminal decision

If survey result is “strong” ⇒ Market new product

(EMV = $221,200)

If survey result is “mild” ⇒ Market old product

(EMV = $130,000)

If survey result is “weak” ⇒ Market old product

(EMV = $130,000)

DA 1. The Multistage Decision Model 24

General form of a decision tree

H1
G1 P(H1 |C1 )
C1
P(C 1 ) G2
C2
D1
P(C 2 ) Gk
P(C n )
D2 Cn

D3

Dm

GENERAL FORM OF A DECISION TREE

DA 1. The Multistage Decision Model 25
 The multistage decision model
1. Each stage consists of a decision node followed by a
chance node for each of the decision options available in
this stage.

2. The DM must select one of the initial acts Aj.

3. The Aj may be viewed as “learning experiments”

providing, at specified costs, opportunities for obtaining
partial or complete information about present
uncertainties.

4. Following the probabilistic results a1, a2, …, of the initial

decision, the DM must select the next decision B1, B2, …
DA 1. The Multistage Decision Model 26
 The multistage decision model (cont’d)

5. Finally, a terminal chance node, b1, b2,…, occurs.

6. As a result of the initial decision Aw, its chance outcome

ax, the terminal decision By, and its chance outcome bz, the
total consequence C(Aw, ax, By, bz) is obtained.

7. The solution proceeds sequentially backwards in time, i.e.,

we first identify the best decision at each terminal node,
then the best decision one stage earlier assuming that,
whatever chance event results from this stage, it will be
followed by the best of the available terminal decisions.

DA 1. The Multistage Decision Model 27