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Unit 2

This document provides an overview of decision analysis techniques. It discusses problem formulation, decision trees, expected value analysis, value of information, risk analysis, sensitivity analysis, and Bayesian updating of probabilities. The key points are: - Decision analysis helps choose optimal strategies when facing uncertain future events and decision alternatives. - Problem formulation involves defining decisions, potential outcomes, and resulting payoffs. - Decision trees visually represent the relationships between decisions and outcomes. - Expected value analysis and value of information techniques incorporate probability estimates. - Risk, sensitivity, and Bayesian analyses further inform the decision making process.

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Soonyoung Kwon
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0% found this document useful (0 votes)
24 views6 pages

Unit 2

This document provides an overview of decision analysis techniques. It discusses problem formulation, decision trees, expected value analysis, value of information, risk analysis, sensitivity analysis, and Bayesian updating of probabilities. The key points are: - Decision analysis helps choose optimal strategies when facing uncertain future events and decision alternatives. - Problem formulation involves defining decisions, potential outcomes, and resulting payoffs. - Decision trees visually represent the relationships between decisions and outcomes. - Expected value analysis and value of information techniques incorporate probability estimates. - Risk, sensitivity, and Bayesian analyses further inform the decision making process.

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Soonyoung Kwon
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We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 13: Decision Analysis

Decision Analysis
Decision analysis can be used to develop an optimal strategy when a decision maker is faced with several decision
alternatives and an uncertain or risk-filled pattern of future events.
• Even when a careful decision analysis has been conducted, the uncertain future events make the final consequence
uncertain.
• The risk associated with any decision alternative is a direct result of the uncertainty associated with the final
consequence.
• Good decision analysis includes risk analysis that provides probability information about the favorable as well as the
unfavorable consequences that may occur.
Problem Formulation
• A decision problem is characterized by decision alternatives, states of nature, and resulting payoffs.
• The decision alternatives are the different possible strategies the decision maker can employ.
• The states of nature refer to future events, not under the control of the decision maker, which may occur. States of
nature should be defined so that they are mutually exclusive and collectively exhaustive.
Example: Pittsburgh Development Corp.
Pittsburgh Development Corporation (PDC) purchased land that will be the site of a new luxury condominium complex.
PDC commissioned preliminary architectural drawings for three different projects: one with 30, one with 60, and one with
90 condominiums.
The financial success of the project depends upon the size of the condominium complex and the chance event concerning
the demand for the condominiums. The statement of the PDC decision problem is to select the size of the new complex
that will lead to the largest profit given the uncertainty concerning the demand for the condominiums.
Influence Diagrams
• An influence diagram is a graphical device showing the relationships among the decisions, the chance events, and the
consequences.
• Squares or rectangles depict decision nodes.
• Circles or ovals depict chance nodes.
• Diamonds depict consequence nodes.
• Lines or arcs connecting the nodes show the direction of influence.

Payoff Tables
• The consequence resulting from a specific combination of a decision alternative and a state of nature is a payoff.
• A table showing payoffs for all combinations of decision alternatives and states of nature is a payoff table.
• Payoffs can be expressed in terms of profit, cost, time, distance or any other appropriate measure.
Decision Making without Probabilities
Three commonly used criteria for decision making when probability information regarding the likelihood of the states of
nature is unavailable are:
• the optimistic approach – the decision with the largest payoff or lowest cost is chosen.
• the conservative approach - for each decision the minimum payoff is listed and the decision corresponding to the
maximum of these payoffs is selected. Or the maximum costs are determined and the minimum of those is selected.
• the minimax regret approach.

Minimax Regret Approach


• The minimax regret approach requires the construction of a regret table or an opportunity loss table.
• This is done by calculating for each state of nature the difference between each payoff and the largest payoff for
that state of nature.
• Then, using this regret table, the maximum regret for each possible decision is listed.
• The decision chosen is the one corresponding to the minimum of the maximum regrets.

Decision Making with Probabilities


Expected Value Approach
• If probabilistic information regarding the states of nature is available, one may use the expected value (EV) approach
• Here the expected return for each decision is calculated by summing the products of the payoff under each state of
nature and the probability of the respective state of nature occurring.
• The decision yielding the best expected return is chosen.
Decision Tree
• A decision tree is a chronological representation of the
decision problem.
• Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond
to the decision alternatives.
• The branches leaving each round node represent the
different states of nature while the branches leaving each square node represent the different decision alternatives.
• At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.

Expected Value of Perfect Information


Frequently information is available which can improve the probability estimates for the states of nature.
• The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew
with certainty which state of nature would occur.
• The EVPI provides an upper bound on the expected value of any sample of survey information.
EVPI = |EVwPI– EVwoPI|
Expected Value with Perfect Information (EVWPI) EVwPI = 0.8(20 mil) + 0.2(7 mil) = $17.4 mil
Expected Value without Perfect Information (EVwoPI) EVwoPI = 0.8(20 mil) + 0.2(-9 mil) = $14.2 mil
Expected Value of Perfect Information (EVPI) EVPI = |EVWPI – EVwoPI| = |17.4 – 14.2| = $3.2 mil
Risk Analysis
• Risk analysis helps the decision maker recognize the difference between:
• the expected value of a decision alternative, and • the payoff that might actually occur

• The risk profile for a decision alternative shows the possible payoffs for the decision alternative along with their
associated probabilities.
Sensitivity Analysis
Sensitivity analysis can be used to determine how changes to the following inputs affect the recommended decision
alternative:
• probabilities for the states of nature
• values of the payoffs
• If a small change in the value of one of the inputs causes a change in the recommended decision alternative, extra effort
and care should be taken in estimating the input value.
Decision Analysis with Sample Information
Frequently, decision makers have preliminary or prior probability assessments for the states of nature that are the best
probability values available at that time.
• To make the best possible decision, the decision maker may want to seek additional information about the states of
nature.
This new information, often obtained through sampling, can be used to revise the prior probabilities so that the final
decision is based on more accurate probabilities for the states of nature.
• These revised probabilities are called posterior probabilities
Example: Pittsburgh Development Corp.
• Let us return to the PDC problem and assume that management is considering a 6-month market research study designed
to learn more about potential market acceptance of the PDC condominium project. Management anticipates that the
market research study will provide one of the following two results:
1. Favorable report: A significant number of the individuals contacted express interest in purchasing a PDC condominium.
2. Unfavorable report: Very few of the individuals contacted express interest in purchasing a PDC condominium.
Decision Strategy
• A decision strategy is a sequence of decisions and chance outcomes where the decisions chosen depend on the yet-to-be-
determined outcomes of chance events.
• The approach used to determine the optimal decision strategy is based on a backward pass through the decision tree
using the following steps:
• At chance nodes, compute the expected value by multiplying the payoff at the end of each branch by the corresponding
branch probabilities.
• At decision nodes, select the decision branch that leads to the best expected value. This expected value becomes the
expected value at the decision node.
PDC's Decision Strategy
PDC's optimal decision strategy is:
• Conduct the market research study.
• If the market research report is favorable, construct the large condominium complex.
• If the market research report is unfavorable, construct the medium condominium complex.

Expected Value of Sample Information


• The expected value of sample information (EVSI) is the additional expected profit possible through knowledge of the
sample or survey information.
• The expected value associated with the market research study is $15.93.
• The best expected value if the market research study is not undertaken is $14.20. 1
• We can conclude that the difference, $15.93 $14.20% = $1.73, is the expected value of sample information.
• Conducting the market research study adds $1.73 million to the PDC expected value.
Efficiency of Sample Information
• Efficiency of sample information is the ratio of EVSI to EVPI.
• As the EVPI provides an upper bound for the EVSI, efficiency is always a number between 0 and 1. The efficiency of
the survey:
E = (EVSI/EVPI) X 100
= [($1.73 mil) / ($3.20 mil)] X 100
= 54.1%
The information from the market research study is 54.1% as efficient as perfect information.

Computing Branch Probabilities


Branch (Posterior) Probabilities Calculation
Step 1:
For each state of nature, multiply the prior probability by its conditional probability for the indicator - this gives the joint
probabilities for the states and indicator.
• Step 2:
Sum these joint probabilities over all states -- this gives the marginal probability for the indicator.
• Step 3:
For each state, divide its joint probability by the marginal probability for the indicator -- this gives the
posterior probability distribution.

• Knowledge of sample (survey) information can be used to revise the probability estimates for the states of nature.
• Prior to obtaining this information, the probability estimates for the states of nature are called prior probabilities.
• With knowledge of conditional probabilities for the outcomes or indicators of the sample or survey information, these
prior probabilities can be revised by employing Bayes' Theorem.
• The outcomes of this analysis are called posterior probabilities or branch probabilities for decision trees.

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