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
 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
 Chapter Outline

3.1 Introduction
3.2 The Six Steps in Decision Making
3.3 Types of Decision-Making Environments
3.4 Decision Making under Uncertainty
3.5 Decision Making under Risk
3.6 Decision Trees
3.7 How Probability Values Are Estimated by
Bayesian Analysis
3.8 Utility Theory
 Introduction
• What is involved in making a good decision?
• Decision theory is an analytic and systematic
approach to the study of decision making
• A good decision is one that is based on logic,
considers all available data and possible
alternatives, and the quantitative approach
described here
 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 or 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
 Thompson Lumber Company
Step 1 – Define the problem
 Expand by manufacturing and marketing a new product,
backyard storage sheds
Step 2 – List alternatives
 Construct a large new plant
 A small plant
 No plant at all
Step 3 – Identify possible outcomes
 The market could be favorable or unfavorable
 Thompson Lumber Company
Step 4 – List the payoffs
 Identify conditional values for the profits for large, small,
and no plants for the two possible market conditions
Step 5 – Select the decision model
 Depends on the environment and amount of risk and
uncertainty
Step 6 – Apply the model to the data
 Solution and analysis used to help the decision making
 Thompson Lumber Company
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
 Types of Decision-Making Environments

Type 1: Decision making under certainty

– Decision maker knows with certainty the
consequences of every alternative or decision
choice
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
 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
 Type 2: 1. Maximax
Used to find the alternative that maximizes the
maximum payoff or profit
 Locate the maximum payoff for each alternative
 Select the alternative with the maximum number = Construct a large
plant

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
1. Construct a large 200,000 –180,000 200,000
plant
Maximax
2. Construct a small
plant 100,000 –20,000 100,000

Do nothing 0 0 0

Table 3.2
 2. Maximin
Used to find the alternative that maximizes the
minimum payoff or profit
 Locate the minimum payoff for each alternative
 Select the alternative with the maximum number = Do Nothing

STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large 200,000 –180,000 –180,000
plant
Construct a small
plant 100,000 –20,000 –20,000

Do nothing 0 0 0

Table 3.3
Maximin
 Criterion of Realism (Hurwicz)
A weighted average compromise between optimistic
and pessimistic
 Select a coefficient of realism 
 Coefficient is between 0 and 1
 A value of 1 is 100% optimistic
 Compute the weighted averages for each alternative
 Select the alternative with the highest value

Weighted average =(maximum in row) + (1 – )(minimum in row)

 Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
(160,000) + (0.2)(-180,000) = 160,000 – 36,000 = 124,000
 For the small plant alternative using  = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000
Weighted average =(maximum in row) + (1 – )(minimum in row)
STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large
200,000 –180,000 124,000
plant
Construct a small Realism
100,000 –20,000 76,000
plant
Do nothing 0 0 0

Table 3.4
 Equally Likely (Laplace)
Considers all the payoffs for each alternative
200,000 + (-180,000) = 20,000
 Find the average payoff for each alternative
100,000 + (-20,000) = 80,000/
40,000
 Select the alternative with the highest average

STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large 200,000 –180,000 10,000
plant
Construct a small 100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0

Table 3.5
 Minimax Regret
Based on opportunity loss or regret, the difference
between the optimal profit and actual payoff for a
decision
– Create an opportunity loss table by determining the
opportunity loss for not choosing the best alternative
– 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
 Minimax Regret
STATE OF NATURE
FAVORABLE UNFAVORABLE
 Opportunity Loss MARKET ($) MARKET ($)
Tables
200,000 – 200,000 0 – (–180,000)
200,000 – 100,000 0 – (–20,000)
200,000 – 0 0–0
Table 3.6

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
Table 3.7
 Minimax Regret

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small 100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000

Table 3.8
Maximum Loss
 Decision Making Under Risk
• Decision making when there are several possible states of
nature and we know the probabilities associated with
each possible state
• Most popular method is to choose the alternative with
the highest expected monetary value (EMV)

ernative i) = (payoff of first state of nature)

x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ … + (payoff of last state of nature)
x (probability of last state of nature)
 EMV for Thompson Lumber
 Each market has a probability of 0.50
 Which alternative would give the highest EMV?
 The calculations are

ge plant) = (0.50)($200,000) + (0.50)(–$180,000)

= $10,000
mall plant) = (0.30)($100,000) + (0.30)(–$20,000)
= $40,000
nothing) = (0.20)($0) + (0.20)($0)
= $0
 EMV for Thompson Lumber

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
Probabilities 0.50 0.50

Table 3.9 Largest EMV

Quiz 1 on 24th Sept at 11am
We will stop here to 1pm
 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)
 Expected Value of Perfect Information (EVPI)

• Scientific Marketing, Inc. offers John Thompson

analysis that will provide certainty about market
conditions (favorable)
• Additional information will cost $65,000
• Is it worth purchasing the information?
 Expected Value of Perfect Information (EVPI)

1. Best alternative for favorable state of nature is build a large plant with a
payoff of $200,000
Best alternative for unfavorable state of nature is to do nothing with a payoff
of $0
EVPI = EVwPI – Maximum EMV
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. The maximum EMV without additional information is $40,000
EVPI = EVwPI – Maximum EMV
= $100,000 - $40,000
= $60,000 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)
 Expected Value of Perfect Information (EVPI)

1. Best alternative for favorable state of nature is build a large plant with a
payoff of $200,000
Best alternative for unfavorable state of nature is to do nothing with a payoff
of $0
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $100,000
2. 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
 Expected Opportunity Loss

Expected opportunity loss (EOL) is the cost of not

picking the best solution
1. First construct an opportunity loss table
2. For each alternative, multiply the opportunity
loss by the probability of that loss for each
possible outcome and add these together
3. Minimum EOL will always result in the same
decision as maximum EMV
4. Minimum EOL will always equal EVPI
 Expected Opportunity Loss

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small 100,000 20,000 60,000
plant

Do nothing 200,000 0
100,000
Probabilities 0.50 0.50
Table 3.10 Minimum EOL
arge plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
small plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
do nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
 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
and state-of-nature points or nodes
– A decision node from which one of several alternatives
may be chosen
– A state-of-nature node out of which one state of
nature will occur
 Five Steps to
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
 Structure of Decision Trees
• Trees start from left to right
• 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
 Thompson’s Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct t
r
st Plan
n
Co rge
La Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
N ot
h ing

Figure 3.2
 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
uct 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
 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
Favorable Market (0.78)
$190,000
nt 2 Unfavorable Market (0.22)
P la –$190,000
ge
Lar Favorable Market (0.78)
$90,000
Small
5) 3 Unfavorable Market (0.22)
0.4 Plant –$30,000
(
e y ts le
rv ul ab No Plant
Su Res vor –$10,000
a
1 Surv F Favorable Market (0.27)
e $190,000
y

Re y (
ve

nt 4 Unfavorable Market (0.73)

Ne su 0.5 Pla
ur

e –$190,000
ga lts 5) g
Lar
tS

Favorable Market (0.27)

tiv Small $90,000
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
n
Co

Do Favorable Market (0.50)

Not $200,000
Con t 6 Unfavorable Market (0.50)
duc P la n –$180,000
t Su ge
rve Lar Favorable Market (0.50)
$100,000
y Small
7 Unfavorable Market (0.50)
Plant –$20,000
Figure 3.4
No Plant
$0
Copyright ©2012 Pearson Education, Inc.
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publishing as Prentice Hall
 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

Copyright ©2012 Pearson Education, Inc.

3-34
publishing as Prentice Hall
 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.

Copyright ©2012 Pearson Education, Inc.

3-35
publishing as Prentice Hall
 Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
Pl ant Unfavorable Market (0.22)
–$190,000
ge

$106,400
Lar $63,600 Favorable Market (0.78)
$90,000
Small
5) Unfavorable Market (0.22)
0.4 Plant –$30,000
(
e y ts le
rv ul ab No Plant
Su Res vor –$10,000
Su Fa –$87,400 Favorable Market (0.27)
rv $190,000
e
y

Re y (
ve

a nt Unfavorable Market (0.73)

Ne su 0.5 Pl
ur

–$190,000
ga lts 5) rge
tS

a $2,400 Favorable Market (0.27)

$2,400
L
$2,400
tiv Small $90,000
ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con t Unfavorable Market (0.50)
duc P la n –$180,000
ge
$40,000

t Su Lar $40,000
$40,000

rve Favorable Market (0.50)

y Small $100,000
Unfavorable Market (0.50)
Plant –$20,000
Figure 3.5
No Plant
$0
Copyright ©2012 Pearson Education, Inc.
3-36
publishing as Prentice Hall
 Bayesian Analysis

 Many ways of getting probability data

 It can be based on
 Management’s experience and intuition
 Historical data
 Computed from other data using Bayes’ theorem
 Bayes’ theorem incorporates initial estimates
and information about the accuracy of the
sources
 Allows the revision of initial estimates based
on new information
 Calculating Revised Probabilities

 In the Thompson Lumber case we used these four conditional probabilities

P (favorable market(FM) | survey results positive) = 0.78

P (unfavorable market(UM) | survey results positive) = 0.22
P (favorable market(FM) | survey results negative) = 0.27
P (unfavorable market(UM) | survey results negative) = 0.73

 The prior probabilities of these markets are

P (FM) = 0.50
P (UM) = 0.50
 Calculating Revised Probabilities
 Through discussions with experts Thompson has learned the following
 He can use this information and Bayes’ theorem to calculate posterior
probabilities

STATE OF NATURE
RESULT OF FAVORABLE MARKET UNFAVORABLE MARKET
SURVEY (FM) (UM)

Positive (predicts P (survey positive | FM) P (survey positive | UM)

favorable market
for product) = 0.70 = 0.20

Negative (predicts P (survey negative | P (survey negative |

unfavorable FM) UM)
market for
product) = 0.30 = 0.80

Table 3.11
 Calculating Revised Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF POSITIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY POSITIVE)
FM 0.70 X 0.50 = 0.35 0.35/0.45 = 0.78
UM 0.20 X 0.50 = 0.10 0.10/0.45 = 0.22
P(survey results positive) = 0.45 1.00

Table 3.12
 Calculating Revised Probabilities

POSTERIOR PROBABILITY
CONDITIONAL
PROBABILITY P(STATE OF
P(SURVEY NATURE |
STATE OF NEGATIVE | STATE PRIOR JOINT SURVEY
NATURE OF NATURE) PROBABILITY PROBABILITY NEGATIVE)
FM 0.30 X 0.50 = 0.15 0.15/0.55 = 0.27
UM 0.80 X 0.50 = 0.40 0.40/0.55 = 0.73
P(survey results positive) = 0.55 1.00

Table 3.13