Basic Business Statistics

11th Edition

Chapter 17

Decision Making

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc. Chap 17-1

 Learning Objectives

In this chapter, you learn:

 To use payoff tables and decision trees to
evaluate alternative courses of action
 To use several criteria to select an alternative
course of action
 To use Bayes’ theorem to revise probabilities in
light of sample information
 About the concept of utility
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-2
 Steps in Decision Making

 List Alternative Courses of Action

 Choices or actions
 List Uncertain Events
 Possible events or outcomes
 Determine ‘Payoffs’
 Associate a Payoff with Each Choice/Event
combination
 Adopt Decision Criteria
 Evaluate Criteria for Selecting the Best Course of
Action

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-3

 List Possible Actions or Events

Two
Methods of
Listing

Payoff Table Decision Tree

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-4

 A Payoff Table
A payoff table shows alternatives,
states of nature, and payoffs

Profit in $1,000’s
States of Nature Investment Choice (Action)
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40

Stable Economy 50 120 30
Weak Economy -120 -30 20

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-5

 Sample Decision Tree
Strong Economy 200
Large factory Stable Economy 50
Weak Economy -120

Strong Economy 90
Average factory Stable Economy 120
Weak Economy -30

Strong Economy 40
Small factory Stable Economy 30
Weak Economy 20

Payoffs
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-6
 Opportunity Loss
Opportunity loss is the difference between an actual
payoff for an action and the highest possible payoff,
given a particular event
Profit in $1,000’s Payoff
State Of Nature (Action) Table
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40

Stable Economy 50 120 30
Weak Economy -120 -30 20
The action “Average factory” has payoff 90 for “Strong Economy”. Given
“Strong Economy”, the choice of “Large factory” would have given a
payoff of 200, or 110 higher. Opportunity loss = 110 for this cell.

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-7

 Opportunity Loss
(continued)
Profit in $1,000’s Payoff
States of Nature Investment Choice (Action) Table
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40 Opportunity

Stable Economy 50 120 30
Weak Economy -120 -30 20
Loss Table
Opportunity Loss in $1,000’s
States of Nature Investment Choice (Action)
(Events) Large Average Small
Factory Factory Factory

Strong Economy 0 110 160

Stable Economy 70 0 90
Weak Economy 140 50 0
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-8
 Decision Criteria
 Maximax
 An optimistic decision criteria
 Maximin
 A pessimistic decision criteria
 Expected Monetary Value (EMV(j))
 The expected profit for taking action j
 Expected Opportunity Loss (EOL(j))
 The expected opportunity loss for taking action j
 Expected Value of Perfect Information (EVPI)
 The expected opportunity loss from the best decision
 Return to Risk Ratio
 Takes into account the variability in payoffs

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-9

 Maximax Solution
Profit in $1,000’s
States of Nature Investment Choice (Action)
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40

Stable Economy 50 120 30
Weak Economy -120 -30 20
Maximum payoff for Large Factory is 200
Maximum payoff for Average Factory is 120
Maximum payoff for Small Factory is 40

Maximax Decision: Build the Large Factory because 200 is the maximum
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-10
 Maximin Solution
Profit in $1,000’s
States of Nature Investment Choice (Action)
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40

Stable Economy 50 120 30
Weak Economy -120 -30 20
Minimum payoff for Large Factory is -120
Minimum payoff for Average Factory is -30
Minimum payoff for Small Factory is 20

Maximin Decision: Build the Small Factory because 20 is the maximum

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-11
 Expected Monetary Value
Solution
Goal: Maximize expected value
 The expected monetary value is the weighted
average payoff, given specified probabilities for
each event
N
EMV( j)   x ijPi
i1

Where EMV(j) = expected monetary value of action j

xij = payoff for action j when event i occurs
Pi = probability of event i
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-12
 Expected Monetary Value
Solution
(continued)

 The expected value is the weighted average

payoff, given specified probabilities for each
event Profit in $1,000’s
Investment Choice (Action)
States of Nature Large Average Small
(Events) Factory Factory Factory

Strong Economy (.3) 200 90 40

Stable Economy (.5) 50 120 30
Weak Economy (.2) -120 -30 20

Suppose these probabilities have been

assessed for these three events
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-13
 Expected Monetary Value
Solution
(continued)
Goal: Maximize expected value
Payoff Table:
Profit in $1,000’s
Investment Choice (Action)
States of Nature Large Average Small
(Events) Factory Factory Factory

Strong Economy (.3) 200 90 40

Stable Economy (.5) 50 120 30
Weak Economy (.2) -120 -30 20
Expected Value (EMV) 61 81 31 Example:
EMV (Average factory) =
(90)(.3) +
Maximize expected value by
(120)(.5) +
choosing Average factory
(-30)(.2) = 81
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-14
 Decision Trees Are Another Way To
Display & Analyze The Same Information

 A Decision tree shows a decision problem,

beginning with the initial decision and ending
will all possible outcomes and payoffs.

Use a square to denote decision nodes

Use a circle to denote uncertain events

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-15

 Add Probabilities and Payoffs
(continued)
Strong Economy (.3) 200
Large factory Stable Economy (.5) 50
Weak Economy (.2) -120

Strong Economy (.3) 90

Average factory Stable Economy (.5) 120
Weak Economy (.2)
-30

Decision Strong Economy (.3) 40

Small factory Stable Economy (.5) 30
Weak Economy (.2)
20
Uncertain
Events
Probabilities Payoffs
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-16
 Fold Back the Tree
EMV=200(.3)+50(.5)+(-120)(.2)=61
Strong Economy (.3) 200
Large factory Stable Economy (.5) 50
Weak Economy (.2) -120

EMV=90(.3)+120(.5)+(-30)(.2)=81
Strong Economy (.3) 90
Average factory Stable Economy (.5) 120
Weak Economy (.2)
-30

EMV=40(.3)+30(.5)+20(.2)=31
Strong Economy (.3) 40
Small factory Stable Economy (.5) 30
Weak Economy (.2)
20

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-17

 Make the Decision
EV=61
Strong Economy (.3) 200
Large factory Stable Economy (.5) 50
Weak Economy (.2) -120

EV=81
Strong Economy (.3) 90
Maximum
Average factory Stable Economy (.5) 120
EMV=81
Weak Economy (.2)
-30

EV=31
Strong Economy (.3) 40
Small factory Stable Economy (.5) 30
Weak Economy (.2)
20

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-18

 Expected Opportunity Loss
Solution
Goal: Minimize expected opportunity loss

 The expected opportunity loss is the weighted

average loss, given specified probabilities for
each event
N
EOL( j)   L ijPi
i1

Where: EOL(j) = expected opportunity loss of action j

Lij = opportunity loss for action j when event i occurs
Pi = probability of event i
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-19
 Expected Opportunity Loss
Solution
Goal: Minimize expected opportunity loss
Opportunity Loss Table
Opportunity Loss in $1,000’s
Investment Choice (Action)
States of Nature Large Average Small
(Events) Factory Factory Factory

Strong Economy (.3) 0 110 160

Stable Economy (.5) 70 0 90
Weak Economy (.2) 140 50 0 Example:
Expected Op. Loss (EOL) 63 43 93 EOL (Large factory) =
0(.3) +
Minimize expected op. loss by 70(.5) +
choosing Average factory (140)(.2) = 63
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-20
 Expected Opportunity Loss
vs. Expected Monetary Value

 The Expected Monetary Value (EMV) and the

Expected Opportunity Loss (EOL) criteria are
equivalent.

 Note that in this example the expected monetary

value solution and the expected opportunity loss
solution both led to the choice of the average size
factory.

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-21

 Value of Information

 Expected Value of Perfect Information, EVPI

Expected Value of Perfect Information
EVPI = Expected profit under certainty
– expected monetary value of the best alternative

(EVPI is equal to the expected opportunity loss

from the best decision)

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-22

 Expected Profit Under Certainty
 Expected profit under certainty
= expected value of the best decision, given perfect information

Profit in $1,000’s
Investment Choice (Action)
States of Nature Large Average Small
(Events) Factory Factory Factory Value of best
decision for each
event:
200
Strong Economy (.3) 200 90 40
Stable Economy (.5) 50 120 30
Weak Economy (.2) -120 -30 20
120
Example: Best
decision given
“Strong Economy”
is “Large factory”
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc..
20 Chap 17-23
 Expected Profit Under Certainty
(continued)
Profit in $1,000’s
Investment Choice (Action)
States of Nature Large Average Small
(Events) Factory Factory Factory

200
Strong Economy (.3) 200 90 40
Stable Economy (.5) 50 120 30
120
Weak Economy (.2) -120 -30 20
Now weight these 200(.3)+120(.5)+20(.2) = 124 20
outcomes with
their probabilities
to find the
expected value. Expected
profit under
certainty
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-24
 Value of Information Solution
Expected Value of Perfect Information (EVPI)
EVPI = Expected profit under certainty
– Expected monetary value of the best decision

Recall: Expected profit under certainty = 124

EMV is maximized by choosing “Average factory”,

where EMV = 81

so: EVPI = 124 – 81

= 43
(EVPI is the maximum you would be willing to spend to obtain
perfect information)
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-25
 Accounting for Variability
Consider the choice of Stock A vs. Stock B
Percent Return
Stock Choice (Action)
States of Nature Stock A Stock B
(Events)

Strong Economy (.7) 30 14

Weak Economy (.3) -10 8
Expected Return: 18.0 12.2

Stock A has a higher

EMV, but what about
risk?
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-26
 Accounting for Variability
(continued)
Calculate the variance and standard deviation for
Stock A and Stock B:
Percent Return
Stock Choice
(Action) Example
States of Nature
N
(Events) Stock A Stock B
σ   ( X i  μ) 2 P ( X i ) 
2
A
i 1

(30  18) 2 (.7)  (10  18) 2 (.3)  336.0

Strong Economy (.7) 30 14

Weak Economy
Expected (.3)
Return: -10
18.0 8
12.2
Variance: 336.0 7.56
Standard Deviation 18.33 2.75

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-27

 Accounting for Variability
(continued)

Calculate the coefficient of variation for each stock:

CVA 
σA
 100% 
18.33
 100%  101.83%
Stock A has
EMVA 18.0 much more
relative
variability
σB 2.75
CVB   100%   100%  22.54%
EMVB 12.2

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-28

 Return-to-Risk Ratio

Return-to-Risk Ratio (RTRR):

EMV(j)
RTRR(j) 
σj

Expresses the relationship between the return

(expected payoff) and the risk (standard deviation)

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-29

 Return-to-Risk Ratio
EMV(j)
RTRR(j) 
σj

EMV(A) 18.0
RTRR(A)    0.982
σA 18.33

EMV(B) 12.2
RTRR(B)    4.436
σB 2.75

You might want to consider Stock B if you don’t

like risk. Although Stock A has a higher Expected
Return, Stock B has a much larger return to risk
ratio and a much smaller CV
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-30
 Decision Making
with Sample Information

Prior
Probability
 Permits revising old
New
probabilities based on new
Information
information
Revised
Probability

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-31

 Revised Probabilities
Example
Additional Information: Economic forecast is strong economy
 When the economy was strong, the forecaster was correct
90% of the time.
 When the economy was weak, the forecaster was correct 70%
of the time.
F1 = strong forecast
F2 = weak forecast Prior probabilities
from stock choice
E1 = strong economy = 0.70 example
E2 = weak economy = 0.30
P(F1 | E1) = 0.90 P(F1 | E2) = 0.30
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-32
 Revised Probabilities
Example
(continued)

P(F1 | E1 )  .9 , P(F1 | E 2 )  .3

P(E1 )  .7 , P(E 2 )  .3
 Revised Probabilities (Bayes’ Theorem)
P(E1 )P(F1 | E1 ) (.7)(.9)
P(E1 | F1 )    .875
P(F1 ) (.7)(.9)  (.3)(.3)
P(E 2 )P(F1 | E 2 )
P(E2 | F1 )   .125
P(F1 )
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-33
 EMV with
Revised Probabilities
Pi Event Stock A xijPi Stock B xijPi
.875 strong 30 26.25 14 12.25
.125 weak -10 -1.25 8 1.00

Σ = 25.0 Σ = 13.25
Revised
probabilities
EMV Stock B = 13.25

EMV Stock A = 25.0

Maximum
EMV
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-34
 EOL Table with
Revised Probabilities
Pi Event Stock A xijPi Stock B xijPi
.875 strong 0 0 16 14.00
.125 weak 18 2.25 0 0

Σ = 2.25 Σ = 14.00
Revised
probabilities
EOL Stock B = 14.00

EOL Stock A = 2.25

Minimum
EOL
Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-35
 Accounting for Variability with
Revised Probabilities
Calculate the variance and standard deviation for
Stock A and Stock B:
Percent Return
Stock Choice (Action)
States of Nature Stock A Stock B
(Events) N
σ   (X i  μ) 2 P(X i ) 
2
A
i 1

(30  25) 2 (.875)  (10  25) 2 (.125)  175.0

Strong Economy (.875) 30 14
Weak Economy (.125) -10 8
Expected Return: 25.00 13.25
Variance: 175.00 3.94
Standard Deviation: 13.23 1.98

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-36

 Accounting for Variability with
Revised Probabilities
(continued)

The coefficient of variation for each stock using the

results from the revised probabilities:

σA 13.229
CVA   100%   100%  52.92%
EMVA 25.0

σB 1.984
CVB   100%   100%  14.97%
EMVB 13.25

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-37

 Return-to-Risk Ratio with
Revised Probabilities

EMV(A) 25.0
RTRR(A)    1.890
σA 13.229

EMV(B) 13.25
RTRR(B)    6.677
σB 1.984

With the revised probabilities, both stocks have

higher expected returns, lower CV’s, and larger
return to risk ratios

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-38

 Utility

 Utility is the pleasure or satisfaction

obtained from an action.

 The utility of an outcome may not be the same

for each individual.

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-39

 Utility

 Example: each incremental $1 of profit does not

have the same value to every individual:

 A risk averse person, once reaching a goal,

assigns less utility to each incremental $1.
 A risk seeker assigns more utility to each
incremental $1.
 A risk neutral person assigns the same utility to
each extra $1.

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-40

 Three Types of Utility Curves
Utility

Utility

Utility
$ $ $

Risk Averter Risk Seeker Risk-Neutral

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-41

 Maximizing Expected
Utility

 Making decisions in terms of utility, not $

 Translate $ outcomes into utility outcomes

 Calculate expected utilities for each action
 Choose the action to maximize expected utility

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-42

 Chapter Summary
 Described the payoff table and decision trees
 Opportunity loss
 Provided criteria for decision making
 Maximax and Maximin
 Expected monetary value
 Expected opportunity loss
 Return to risk ratio
 Introduced expected profit under certainty and the value of
perfect information
 Discussed decision making with sample information
 Addressed the concept of utility

Basic Business Statistics, 11e © 2009 Prentice-Hall, Inc.. Chap 17-43