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)

EMV (alternative 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)
Example:
Suppose that John Thompson now believes that the probability of
a favorable market is exactly the same as the probability of an
unfavorable market; that is, each state of nature has a 0.50
probability. Which alternative would give the greatest expected
monetary value?
  Each market has a probability of 0.50
 Which alternative would give the highest EMV?
 The calculations are

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

= $10,000
EMV (small plant) = (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
EMV (do nothing) = (0.50)($0) + (0.50)($0)
= $0
EMV

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

Largest EMV
 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 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
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
 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
So the maximum payment for
Best alternative
thefor unfavorable
additional state of is
information nature is
to do nothing$60,000
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
Expected Opportunity Loss

• Expected opportunity loss (EOL) is the cost of not

picking the best solution
• First construct an opportunity loss table
• For each alternative, multiply the opportunity loss
by the probability of that loss for each possible
outcome and add these together
• Minimum EOL will always result in the same
decision as maximum EMV
• 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
Minimum EOL
EOL (large plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
EOL (small plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
EOL (do nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
Sensitivity Analysis
 Sensitivity analysis examines how our decision
might change with different input data
 For the example

P = probability of a favorable market

(1 – P) = probability of an unfavorable market
Sensitivity Analysis
EMV(Large Plant) = $200,000P – $180,000)(1 – P)
= $200,000P – $180,000 + $180,000P
= $380,000P – $180,000
EMV(Small Plant) = $100,000P – $20,000)(1 – P)
= $100,000P – $20,000 + $20,000P
= $120,000P – $20,000
EMV(Do Nothing) = $0P + 0(1 – P)
= $0
Sensitivity Analysis
EMV Values

$300,000

$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P

–$200,000
Figure 3.1
Sensitivity Analysis
Point 1:
EMV(do nothing) = EMV(small plant)
20,000
0  $120,000 P  $20,000 P  0.167
120,000
Point 2:
EMV(small plant) = EMV(large plant)

$120,000 P  $20,000  $380,000 P  $180,000

160,000
P  0.615
260,000
 Sensitivity Analysis
BEST RANGE OF P
ALTERNATIVE VALUES
Do nothing Less than 0.167
EMV Values Construct a small plant 0.167 – 0.615
$300,000 Construct a large plant Greater than 0.615

$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P

–$200,000
 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 and
state-of-nature points
• 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
Example of Decision Tree
A State-of-Nature Node
Favorable Market
A Decision Node
1
Unfavorable Market
uct nt
r
n st Pla
e
Co arg
L Favorable Market
Construct
2
Small Plant Unfavorable Market
Do
No
th
in
g
 EMV for Node = (0.5)($200,000) + (0.5)(–$180,000)
1 = $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
ct nt –$180,000
r u
n st Pla
e
Co arg
L Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
No
th EMV for Node = (0.5)($100,000)
in
g 2 = $40,000 + (0.5)(–$20,000)

$0
Complex Decision Tree
Before deciding about building a new plant, John has the option of conducting his own
marketing research survey, at a cost of $10,000
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)
ur Ne su 0.5 ePla –$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
t
uc

No Plant
–$10,000
nd
Co

Do Favorable Market (0.50)

N ot C $200,000
t 6 Unfavorable Market (0.50)
ond
uct P la n –$180,000
ge
Sur
ve Lar Favorable Market (0.50)
$100,000
y Small
Plant
7 Unfavorable Market (0.50)
–$20,000
No Plant
$0
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
3. 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
4. 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
5. Best choice is to seek marketing information
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
la nt Unfavorable Market (0.22)
P –$190,000

$106,400
a rge $63,600 Favorable Market (0.78)
L $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 (
e
ant Unfavorable Market (0.73)
rv Ne su 0.5 Pl –$190,000
Su
ga lts 5) rge $2,400

$2,400
La Favorable Market (0.27)
t

tiv Small $90,000

ke

e Unfavorable Market (0.73)

ar

Plant –$30,000
tM
c

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 lan –$180,000
ge
$40,000
t Su Lar $40,000 Favorable Market (0.50)
r ve Small $100,000
y Unfavorable Market (0.50)
Plant –$20,000
No Plant
$0
Expected Value of Sample Information

• To know the actual value of doing the survey

Expected value Expected value

with sample of best decision
EVSI = information – without sample
information

= (EV with sample information + cost)

– (EV without sample information)

EVSI = ($49,200 + $10,000) – $40,000 = $19,200

 Efficiency Sample Information
• none of the sources of information are perfect, they can be evaluated by
comparing the EVSI with the EVPI. If the sample information was perfect,
then the efficiency would be 100%.
• The efficiency of sample information is
 Sensitivity Analysis

 How sensitive are the decisions to

changes in the probabilities?
 How sensitive is our decision to the
probability of a favorable survey result?
 That is, if the probability of a favorable
result (p = .45) where to change, would we
make the same decision?
 How much could it change before we would
make a different decision?
 Sensitivity Analysis
p =probability of a favorable survey result
(1 – p) =probability of a negative survey
result
EMV(node 1) = ($106,400)p +($2,400)(1 – p)
= $104,000p + $2,400
We are indifferent when the EMV of node 1 is the
same as the EMV of not conducting the survey,
$40,000

$104,000p + $2,400 = $40,000

$104,000p= $37,600
p= $37,600/$104,000 = 0.36
 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
 Through discussions with experts Thompson has
learned the following
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
unfavorable P (survey negative | FM) P (survey negative | UM)
market for = 0.30 = 0.80
product)

 He can use this information and Bayes’ theorem

to calculate posterior probabilities
Calculating Revised Probabilities

 Recall Bayes’ theorem is

P ( B | A )  P ( A)
P( A | B) 
P ( B | A)  P ( A)  P ( B | A )  P ( A )

where
A, B  any two events
A  complement of A

For this example, A will represent a favorable

market and B will represent a positive survey
  P (FM | survey positive)
P ( survey positive | FM )  P ( FM )

P(survey positive |FM)  P(FM)  P(survey positive |UM)  P(UM)

(0.70)(0.50) 0.35
   0.78
(0.70 )(0.50 )  (0.20 )(0.50) 0.45

 P (UM | survey positive)

P ( survey positive | UM )  P (UM )

P(survey positive |UM)  P(UM)  P(survey positive |FM)  P(FM)

(0.20)(0.50) 0.10
   0.22
(0.20)(0.50)  (0.70 )(0.50 ) 0.45
 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
  P (FM | survey negative)
P ( survey negative | FM )  P ( FM )

P(survey negative |FM)  P(FM)  P(survey negative |UM)  P(UM)

(0.30)(0.50) 0.15
   0.27
(0.30 )(0.50 )  (0.80 )(0.50) 0.55

 P (UM | survey negative)

P ( survey negative | UM )  P (UM )

P(survey negative |UM)  P(UM)  P(survey negative |FM)  P(FM)

(0.80)(0.50) 0.40
   0.73
(0.80)(0.50)  (0.30 )(0.50 ) 0.55
 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