IIMT 2641 Introduction to Business Analytics

Module 1: Probability and Decision Analysis

Topic 2: Developing a New Product, Summer Job
Decision

1
Decision Tree
Do not produce $15.6 Million
0 P(S) Strong

Strong 0.3 E
⑰
! =? P(S/positive)
#
$18 Million
A No Survey, Produce B
Weak 0.7
O
Weak
! =? $
-$8 Million -$10.4 Million
Produce

0
Conduct Market
Survey Test Positive survey results
C D -$2.4 Million
O
! =?
-
-
!
P =
Do not produce
P(Positive)
$15.6 Million

C !" =?
Strong
&
! =?
%
PCS/Negoei)
Negative survey results G
Produce
&-$10.4
P(w/regatives
!& =?
=

Weak
Million
F

Do not produce
33 -$2.4 Million
Decision contingent on the survey results
§ After she receives the market survey results, Caroline will need to decide
whether or not to produce Suds-Away: node D and node F (decision node
and branches)
§ The accuracy of the survey and the potential revenue implications of the
state of the market for Suds-Away makes this seemingly obvious decision
non-trivial

§ Suppose that the market survey test outcome is positive and that Caroline
decides to produce Suds-Away
§ Even though the market survey test is positive in this case, there is still the
possibility that the test will misread the market and that the market for
Suds-Away might be weak rather than strong
§ Hence, we must place an event node (chances branch), node E, after
Caroline's decision to produce Suds-Away

34
Assigning probabilities
§ For node B, without taking the market survey, Caroline knows from her
experience that there is a 30% chance that the market for Suds-Away will
be strong and a 70% chance that the market will be weak

§ However, it is a bit of difficult to determine the probabilities for the other

branches
– E.g., What values are !! and !" for the branches emanating from node C?

§ We will derive the unknown probabilities based on probability theory we

learned

35
 (a) (S)
P(S(a) =

-- _
*
Probability table 4(Q) P(Q)

7
§ S: "the market for Suds-Away is strong” P(Q) P(S1a) FPIW1a)
-
=

W
§ W: "the market for Suds-Away is weak” =

P(G)S) P(S) P(a/w) PIWS

·
=
.

§ Q: "the market survey test results are positive"

§ N: "the market survey test results are negative” -(1-P(N)S)) x0 3 +0 / .
x0
7 .
.

( -0 2) x0 3 07
=

§ The information we have: P(SIN)

.
0 .
+
.

– There is a 30% chance that the market will be strong 0 31

=

– If the market is weak, there is a 10% chance that the test will be positive
– If the market is strong, there is a 20% chance that the test will be negative
! " = 0.3, ! ( ) = 0.1, +,- ! / " = 0.2
-
&
Market is Market is Weak
Total
Strong (S) (W)
Market Test is
? ? ?
Positive
Market Test is ? ?
?
Negative

36 Total 0.3 0.7 1.00

The missing probabilities in the decision tree
§ !! is simply the probability that the
outcome of the market survey is
positive
Y
94 1 4)
=

4
-

!" is simply the probability that the

=

§
outcome of the market survey is
negative
0 .

31

&R 069
&
=

14, =

§ ! is the probability that the market is

#
strong, given that the survey results are
positive

37
Probability table (Continued)
§ ! ( ) = 0.1 implies that ! / ) = 1 − ! ( ) = 0.9
§ ! / " = 0.2 implies that ! ( " = 1 − ! / " = 0.8
§ Apply the multiplication rule:
– ! $ ∩ & = ! $ & ⋅ ! & = 0.1 ⋅ 0.7 = 0.07
– ! , ∩ & = ! , & ⋅ ! & = 0.9 ⋅ 0.7 = 0.63
– ! $ ∩ 0 = ! $ 0 ⋅ ! 0 = 0.8 ⋅ 0.3 = 0.24
– ! , ∩ 0 = ! , 0 ⋅ ! 0 = 0.2 ⋅ 0.3 = 0.06

Market is Market is Weak

Total
Strong (S) (W)
Market Test is
0.24 0.07 ?
Positive
Market Test is 0.06 0.63
?
Negative

Total 0.3 0.7 1.00

38
The missing probabilities in the decision tree
§ !! is simply the probability that the
outcome of the market survey is
positive
– ! ( =! (∩" +! (∩) =
0.24 + 0.07 = 0.31

§ !" is simply the probability that the

outcome of the market survey is
negative
– ! / = 1 − ! ( = 0.69

§ !# is the probability that the market is

strong, given that the survey results are
positive
'()∩+) -."$
– ! 0|$ = '(+)
= -.#!

39
The missing probabilities in the decision tree
Likewise, we can compute !$ . !% , !&

⑦
§
using the third law of probability
!$ = ! & $ =
!(& ∩ $) 0.07
=
0
!($) 0.31
0
0
!(0 ∩ ,) 0.06
!% = ! 0 , = =
!(,) 0.69

!(& ∩ ,) 0.63
!& = ! & , = =
!(,) 0.69

-
Newit

0
1

89
0 .

40
Making decisions
§ Given the probabilities, we can now solve the decision tree using the folding-back
procedure
– Start with the end nodes of the decision tree, and evaluate each event node and
each decision node
q For an event node, compute the EMV of the node by computing the weighted
-

average of the EMV of each branch weighted by its probability

q For a decision node, compute the EMV of the node by choosing that branch
-
emanating from the node with the best EMV value
– The decision tree is solved when all nodes have been evaluated
– The EMV of the optimal decision strategy is the EMV computed for the starting
branch of the tree

41
 2 4

&
7-
.

Decision Tree 10 4)
5,X) .

-
6
-x 15
+

-
$15.6 Million
.

Do not produce
0 Strong
24/31

A No Survey, Produce B
Strong

Weak
0.3

0.7 I$18 Million

-$8 Million
0 E

Weak
7/31
-$10.4 Million
O
⑰ !
Produce
Conduct Market
Survey Test Positive survey results
C D -$2.4 Million
31% Do not produce

$15.6 Million z
6

0
x 15 .

3x40 4)
69% Strong
2/23 - .

Negative survey results G

Produce 21/23

⑳
Weak
-$10.4 Million
F

Do not produce
42 -$2.4 Million
Caroline’s optimal decision strategy

§ Caroline should conduct the market survey test?

§ If the survey results are positive, she should decide to produce the new
product

§ If the survey results are negative, she should decide not to produce the new
product

§ The EMV of the optimal strategy is ?

43
Decision Tree
Do not produce $15.6 Million
0 Strong
$9.73 Million

⑧
24/31

8-$0.2 Million Strong 0.3 E

$18 Million
A No Survey, Produce B 7/31
Weak 0.7 Weak
-$8 Million -$10.4 Million

0
Produce
Conduct Market

O
Survey Test Positive survey results
0 D -$2.4 Million
C
31%
i
Do not produce
e
$1.36 Million
C$9.73 Million

$15.6 Million

0 69% Strong
-$8.14 Million 2/23
Negative survey results G
Produce 21/23
Weak

-
-$10.4 Million

C -$2.4 Million F

Do not produce
44 -$2.4 Million
Caroline’s optimal decision strategy
-

§ Caroline should conduct the market survey test?

-

§ If the survey results are positive, she should decide to produce the new
product
– The EMV of the this decision is $9.73 million

§ If the survey results are negative, she should decide not to produce the new
product
– The EMV of this decision is -$2.4 million

§ The EMV of the above strategy is $1.36 million

45
Decision Tree
assume risk-neutral
risk overse ? $15.6 Million
Do not produce
0 Strong
77.4%
Strong 0.3 E
$18 Million
A No Survey, Produce B 22.6%
Weak 0.7 Weak
-$8 Million -$10.4 Million
Produce
Conduct Market
Survey Test Positive survey results
C D -$2.4 Million
31% Do not produce

$15.6 Million
69% Strong
8.7%
Negative survey results G
Produce 91.3%
Weak
-$10.4 Million
F

Do not produce
46 -$2.4 Million
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision

Summer Job - decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from Vanessa $21600
25% 5%
$16800 $0
40%
40%
D $12000
$11580 25%
$6000
5% $0

48
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

49
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

3. The distribution of summer salaries that Bill could expect to receive was assumed to
be the same as the MBA students last year
How might changes in this distribution of salaries affect the optimal decision strategy?

50
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

3. The distribution of summer salaries that Bill could expect to receive was assumed to
be the same as the MBA students last year
How might changes in this distribution of salaries affect the optimal decision strategy?

The process of testing and evaluating how the solution to a decision tree behaves in the
presence of changes in the data is referred to as sensitivity analysis

51
Using Excel spreadsheet for sensitivity analysis

§ In order to evaluate how the optimal decision strategy behaves as a function

of changes in the data assumptions, we will have to solve and re-solve the
decision tree model many times, each time with slightly different values of
certain data
§ This approach is tedious and can be expedited with the help of Excel

§ The data for the decision tree is given in the upper part of the spreadsheet
§ The "solution" is computed in the lower part in the "EMV of Nodes" table
– The computation of the EMV of each node is performed automatically as a
function of the data

52
 Data

Using Excel spreadsheet for sensitivity analysis

Data

§ EMV of node D (and node E) can be computed using Excel function SUMPRODUCT
§ EMV of node C = MAX(EMV of node E, 14000)
§ EMV of node B = 0.6 × (EMV of node C) + (1 - 0.6) × (EMV of node D)
§ EMV of node A = MAX(EMV of node B, 12000)

53
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

54
Summer Job - decision tree

O
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from Vanessa p $21600
25% 5%
$16800 $0
40%

0
40%
D $12000
$11580 25%
$6000
5%
14000xp
*
$0
11580x(1 A
+

p )
-

+
12000
=

14000x4 +

11580x2
p)
=
12000) prp *
-

55
You will chouse to
reject John's offer CPU .
may change
decision at Al
Sensitivity relative to key data issue 1
Data

§ Denote the probability that Vanessa's firm will offer Bill a summer job by p
§ Vary the value of p to see when the optimal strategy changes

56
Sensitivity relative to key data issue 1
Data

§ EMVs of node A and node B remain equal to each other while we reduce p from 60%
to 18%
§ EMV of node A being equal to EMV of node B means the optimal decision is to reject
John's offer

57
 Aslonges p I PA , you
will not
change
the desisw-

Sensitivity relative to key data issue 1

Data

§ EMV of node A becomes to be greater than EMV of node B for p is 17%

§ This means the optimal decision is to accept John's offer
§
②
Hence, as long as p ≥ 18%, then the optimal decision strategy will still be to reject
John's offer and to accept a summer job with Vanessa's firm if they offer it to him
– This is reassuring, as Bill is very confident that the probability of Vanessa's firm
offering him a summer job is surely greater than 18%
58
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

59
Summer Job - decision tree

C
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800

O
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60% 25% -c
$13032 5% $6000
No Offer from Vanessa $21600
25% 5%
EMVIDSV $16800 $0
# 40%
40%

⑳
EM(B) D $12000
↓ -c
$11580 25%
may affect
decision A $6000

CA 5% $0
you will
change
C no
the decision

⑱6/x1400 +

40
% x(11580 -

c
60
Sensitivity relative to key data issue 2
Data

§ Denote implicit cost to Bill of participating in the school's corporate summer

recruiting program by c
§ Vary the value of c to see when the optimal strategy changes

61
Sensitivity relative to key data issue 2
Data

§ The cost c should now be subtracted from the previous EMV of node D
EMV of node D = 0.05×21600 + 0.25×16800 + 0.4×12000 + 0.25×6000 + 0.05×0 − c
§ EMV of node E is treated in the same way
§ EMVs of node A and node B are equal for c ≤ 2580

62
Sensitivity relative to key data issue 2
Data

§ EMV of node A becomes to be greater than EMV of node B for c ≥ 2581

§ Hence, as long as c ≤ 2580, then the optimal decision strategy will still be to reject
John's offer and to accept a summer job with Vanessa's firm if they offer it to him
– This is reassuring, as the implicit cost to Bill of participating in the school's corporate
summer recruiting program is much less than $2,580

63
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

3. The distribution of summer salaries that Bill could expect to receive was assumed to
be the same as the MBA students last year
How might changes in this distribution of salaries affect the optimal decision strategy?

The process of testing and evaluating how the solution to a decision tree behaves in the
presence of changes in the data is referred to as sensitivity analysis

64
Summer Job - decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60%
5% 25% +S
$13032 $6000
No Offer from Vanessa $21600
25% 5%
$16800 $0
40%
40%
D $12000
+S S>0
$11580 25%
$6000
affect decision (
5%
only
$0

*
14000 =
11580 +

S
-

S-SA decision
, you will not
chage .

65
Sensitivity relative to key data issue 3
Data

§ Suppose we modify all of the possible salary offers by an amount S

§ Vary the value of S to see when the optimal strategy changes

66
Sensitivity relative to key data issue 3
Data

§ Each possible summer salary is added by S

§ Recall that EMV of node C = MAX(EMV of node E, 14000)
§ >
EMV of node C is equal to 14,000 for S ≤ 2420
§ EMV of node C being equal to 14000 means that Bill should accept an offer from
Vanessa's firm if it materialized
67
Sensitivity relative to key data issue 3
Data

§ EMV of node C becomes to be greater than $14,000 for S ≥ 2421

§ This means Bill should reject an offer from Vanessa's firm if it materialized
§ Hence, as long as S ≤ 2420, then the optimal decision strategy will still be to accept an
offer from Vanessa's firm if it materialized
– This is reassuring, as summer salaries from corporate summer recruiting in general would
not increase by $2,421 within a year

68
 -

Summary of sensitivity analysis

§ We have explored three data issues
– The probability p of Vanessa's firm offering Bill a summer job
– The implicit cost c of participating in corporate summer recruiting
– An increase S in all possible salary values from corporate summer recruiting

§ We have found that the optimal decision strategy does not change unless the
three quantities take on unreasonable values

§ Hence, it is safe to proceed with confidence in recommending to Bill that he

adopt the optimal decision strategy found in the solution to the decision tree
model
– He should reject John's job offer, and he should accept a job offer from Vanessa's
firm if such an offer is made

69
Principal steps of decision analysis
1. Structure the decision problem
– List all of the decisions that have to be made
– List all of the uncertain events in the problem and all of their possible outcomes
-

2. Construct
-
the basic decision tree by placing the decision nodes and the event nodes in
their chronological and logically consistent order
3. Determine the probability of each possible outcome of each uncertain event
-

4. Determine the numerical values of each end node of the decision tree
e
5. Solve the decision tree using the folding-back procedure
- – Start with the end nodes of the decision tree, and evaluate each event node and
each decision node
– The decision tree is solved when all nodes have been evaluated
– The EMV of the optimal decision strategy is the EMV computed for the starting
branch of the tree
6. Perform sensitivity analysis on all key data values

- – For each data value for which the decision-maker lacks confidence, test how the
optimal decision strategy will change relative to a change in the data value, one
data value at a time
70
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision

Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision