Quantitative Analysis for Management

Fourteenth Edition

Chapter 3
Decision Analysis

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Learning Objectives (1 of 2)
After completing this chapter, students will be able to:
3.1 List the steps of the decision-making process.
3.2 Describe the types of decision-making environments.
3.3 Make decisions under uncertainty.
3.4 Use probability values to make decisions under risk.
3.5 Use computers to solve basic decision-making
problems.
3.6 Develop accurate and useful decision trees.

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Learning Objectives (2 of 2)
3.7 Revise probability estimates using Bayesian analysis.
3.8 Understand the importance and use of utility theory in
decision making.

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Introduction
Decision theory is an analytic and systematic approach
to the study of decision making
What is involved in making a good decision?
A good decision is one that is based on logic, considers all
available data and possible alternatives, and applies a
quantitative approach

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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 (typically 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

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Thompson Lumber Company (1 of 2)
• Step 1 – Define the problem
– Consider manufacturing and marketing new product

• Step 2 – List alternatives

– Large plant, small plant, do nothing

• Step 3 – Identify possible outcomes, states of nature

– Market is favorable or unfavorable

• Step 4 – List the payoffs

– Identify conditional values for each alternative

• Step 5 – Select the decision model

– Depends on environment & risk uncertainty

• Step 6 – Apply the model to the data

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Thompson Lumber Company (2 of 2)
Table 3.1 Decision Table with Conditional Values for
Thompson Lumber
State of Nature State of Nature
Alternative Favorable Market ($) Unfavorable Market ($)
Construct a large plant 200,000  180, 000
negative 180,000

Construct a small plant 100,000  20, 000

negative 20,000

Do nothing 0 0

Note: It is important to include all alternatives, including “do nothing.”

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Types of Decision-Making Environments
• Decision making under certainty
– The decision maker knows with certainty the
consequences of every alternative or decision choice
• Decision making under uncertainty
– The decision maker does not know the probabilities of
the various outcomes
• Decision making under risk
– The decision maker knows the probabilities of the
various outcomes

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Decision Making Under Uncertainty
• Criteria for making decisions under uncertainty
1. Maximax (optimistic)
2. Maximin (pessimistic)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret

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Optimistic = Maximax
• Used to find the alternative that maximizes the maximum
payoff—maximax criterion
1. Locate the maximum payoff for each alternative
2. Select the alternative with the maximum number

Table 3.2 Thompson’s Maximax Decision

State of Nature
State of Nature Unfavorable Market Maximum in a Row
Alternative Favorable Market ($) ($) ($)
Construct a large plant 200,000  180, 000
negative 180,000 A text, Maximax points to 200,000 inside a circle.

 20, 000
Construct a small plant 100,000 negative 20,000
100,000

Do nothing 0 0 0

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Pessimistic = Maximin
• Used to find the alternative that maximizes the minimum
payoff—maximin criterion
1. Locate the minimum payoff for each alternative
2. Select the alternative with the maximum number
Table 3.3 Thompson’s Maximin Decision
State of Nature State of Nature
Alternative Favorable Market ($) Unfavorable Market ($) Maximum in a Row ($)
Construct a large plant 200,000  180, 000
negative 180,000

 180, 000
negative 180,000

Construct a small plant 100,000  20, 000

negative 20,000

 20, 000
negative 20,000

Do nothing 0 0
A text, Maximax points to 0 inside a circle.

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Criterion of Realism (Hurwicz Criterion) (1 of 2)
• Often called weighted average
– Compromise between optimism and pessimism
– Select a coefficient of  , with 0  1
realism
1 is perfectly optimistic
 0 is perfectly pessimistic
– Compute the weighted averages for each alternative
– Select the alternative with the highest value

Weighted average  (best payoff )  (1   )(worst payoff )

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Criterion of Realism (Hurwicz Criterion) (2 of 2)
For the large plant alternative using   0.8
0.8 200,000   (1  0.8 )(  180,000)  124,000

For the small plant alternative using   0.8

0.8 100,000   (1  0.8 )(  20,000 ) 76,000

Table 3.4 Thompson’s Criterion of Realism Decision

Criterion of Realism
or Weighted Average
State of Nature State of Nature left parenthesis alpha equals 0.8 right parenthesis left parenthesis dollars right parenthesis

( 0.8) ($)
Alternative Favorable Market ($) Unfavorable Market ($)
Construct a large plant 200,000
 180, 000
negative 180,000 A text, realism, points to 124,000 inside a circle.

Construct a small plant 100,000  20, 000

negative 20,000

76,000
Do nothing 0 0 0

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Equally Likely (Laplace Criterion)
• Considers all the payoffs for each alternative
– Find the average payoff for each alternative
– Select the alternative with the highest average
Table 3.5 Thompson’s Equally Likely Decision
State of Nature
State of Nature Unfavorable Market
Alternative Favorable Market ($) ($) Row Average ($)
Construct a large plant 200,000  180, 000
negative 180,000
10,000

Construct a small plant 100,000

 20, 000
negative 20,000 A text, equally likely, points to 40,000 inside a circle.

Do nothing 0 0 0

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Minimax Regret (1 of 3)
• Based on opportunity loss or regret
– The difference between the optimal profit and actual payoff
for a decision
Step 1—Create an opportunity loss table by determining
the opportunity loss from not choosing the best alternative
Step 2—Calculate opportunity loss by subtracting each
payoff in the column from the best payoff in the column
Step 3—Find the maximum opportunity loss for each
alternative, and pick the alternative with the minimum
number

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Minimax Regret (2 of 3)
Table 3.6 Determining Opportunity Losses for Thompson Lumber
State of Nature State of Nature
Favorable Market ($) Unfavorable Market ($)

200,000  200,000
200,000 minus 200,000

0  (  180,000)
0 minus left parenthesis negative 180,000 right parenthesis

200,000  100,000
200,000 minus 100,000

0  (  20,000)
0 minus left parenthesis negative 20,000 right parenthesis

200,000  0
200,000 minus 0

0 0
0 minus 0

Table 3.7 Opportunity Loss Table for Thompson Lumber

State of Nature State of Nature
Alternative Favorable Market ($) Unfavorable Market ($)
Construct a large plant 0 180,000

Construct a small plant 100,000 20,000

Do nothing 200,000 0

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Minimax Regret (3 of 3)
Table 3.8 Thompson’s Minimax Decision Using Opportunity Loss

State of Nature State of Nature

Alternative Favorable Market ($) Unfavorable Market ($) Maximum in a Row ($)
Construct a large plant 0 180,000 180,000

Construct a small plant 100,000 20,000

A text, minimax, points to 100,000 inside a circle.

Do nothing 200,000 0 200,000

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Decision Making Under Risk (1 of 2)
• When there are several possible states of nature and the
probabilities associated with each possible state are known
– Most popular method—choose the alternative with the highest
expected monetary value (EMV)

EMV(alternative)  Xi P( X i )
where

Xi  payoff for the alternative in state of nature i

P ( Xi )  probability of achieving payoff X i (i.e., probability of
state of nature i)

  summation symbol

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Decision Making Under Risk (2 of 2)
• Expanding the equation

EMV (alternative i) payoff of first state of nature 

probability of first state of nature 
 payoff of second state of nature 
probability of second state of nature 
 …  payoff of last state of nature 
(probability of last state of nature)

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EMV for Thompson Lumber
Each market outcome has a probability of occurrence of
0.50 Which alternative would give the highest EMV?
Table 3.9 Decision Table with Probabilities and EMVs for
Thompson Lumber
State of Nature State of Nature
Alternative Favorable Market ($) Unfavorable Market ($) EMV ($)
Construct a large plant 200,000 10,000
 180, 000
negative 180,000

Construct a small plant 100,000

 20, 000
negative 20,000 A text, best E M V, points to 40,000 inside a circle.

Do nothing 0 0 0
Blank

Probabilities 0.50 0.50

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Expected Value of Perfect Information
(EVPI) (1 of 6)
• EVPI places an upper bound on what you should pay for
additional information
• EVwPI is the long-run average return if we have perfect
information before a decision is made

EVwPI (best payoff in state of nature i )

(probability of state of nature i )

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Expected Value of Perfect Information (E
VPI) (2 of 6)
• Expanded EVwPI becomes

EVwPI best payoff for first state of nature 

probability of first state of nature 
 best payoff for second state of nature 
probability of second state of nature 
 …  best payoff for last state of nature 
probability of last state of nature 

And
EVPI EVwPI  Best EMV
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Expected Value of Perfect Information
(EVPI) (3 of 6)
• Scientific Marketing, Inc. offers analysis that will provide
certainty about market conditions (favorable)
• Additional information will cost $65,000
• Should Thompson Lumber purchase the information?

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Expected Value of Perfect Information
(EVPI) (4 of 6)
Table 3.10 Decision Table with Perfect Information

State of Nature State of Nature

Alternative Favorable Market ($) Unfavorable Market ($) EMV ($)
Construct a large plant 200,000 10,000
 180, 000
negative 180,000

Construct a small plant 100,000  20, 000

negative 20,000 40,000

Do nothing 0 0 0
With perfect 200,000 0
information A text E V w P I, points to 100,000 inside a circle.

Blank

Probabilities 0.50 0.50

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Expected Value of Perfect Information
(EVPI) (5 of 6)
• The maximum EMV without additional information is
$40,000
– Therefore

EVPI EVwPI  Maximum EMV

$100,000  $40,000
$60,000

So, the maximum Thompson should pay for the additional

information is $60,000

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Expected Value of Perfect Information
(EVPI) (6 of 6)
• The maximum EMV without additional information is
$40,000
– Therefore
Thompson should not pay $65,000 for this information

EVPI EVwPI  Maximum EMV

$100,000  $40,000
$60,000

So the maximum Thompson should pay for the additional

information is $60,000

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Expected Opportunity Loss (1 of 2)
• Expected opportunity loss (EOL) is the cost of not picking
the best solution
– 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

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Expected Opportunity Loss (2 of 2)
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

Table 3.11 EOL Table for Thompson Lumber

State of Nature State of Nature

Alternative Favorable Market ($) Unfavorable Market ($) EOL ($)
Construct a large plant 0 180,000 90,000

Construct a small plant 100,000 20,000

A text, best E O L, points to 60,000 inside a circle.

Do nothing 200,000 0 100,0

0
Blank

Probabilities 0.50 0.50

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Sensitivity Analysis (1 of 3)
Define P = probability of a favorable market
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

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Sensitivity Analysis (2 of 3)
Figure 3.1 Sensitivity Analysis

Best Alternative Range of P Values

Do nothing Less than 0.167
Construct a small plant 0.167–0.615
Construct a large plant Greater than 0.615

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Sensitivity Analysis (3 of 3)
Point 1: EMV(do nothing) EMV(small plant)
20,000
0 $120,000P  $20,000 P 0.167
120,000

Point 2: EMV(small plant) EMV(large plant)

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

160,000
P 0.615
260,000

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A Minimization Example (1 of 4)
Three-year lease for a copy machine—which cost is lowest?
Table 3.12 Payoff Table with Monthly Copy Costs for Business Analytics
Department
Blank

10,000 Copies per Month 20,000 Copies per Month 30,000 Copies per Month
($) ($) ($)
Machine A 950 1,050 1,150
Machine B 850 1,100 1,350
Machine C 700 1,000 1,300

Table 3.13 Best and Worst Payoffs (Costs) for Business Analytics Department
Blank

10,000 20,000 Copies 30,000 Best Payoff Worst Payoff

Copies per per Month ($) Copies per (Minimum) ($) (Maximum) ($)
Month ($) Month ($)
Machine A 950 1,050 1,150 950 1,150
Machine B 850 1,100 1,350 850 1,350
Machine C 700 1,000 1,300 700 1,300
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A Minimization Example (2 of 4)
1. Determine the best alternative using Hurwicz criteria
with 70% coefficient.
2. Determine the best alternative using the equally likely
criteria.
3. Determine the best alternative using the EMV criterion
using P(10,000) 0.4, P(20,000) 0.3, P(30,000) 0.3

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A Minimization Example (3 of 4)
Table 3.14 Expected Monetary Values and Expected Values with
Perfect Information for Business Analytics Department
Blank

10,000 Copies per 20,000 Copies per 30,000 Copies per EMV ($)
Month ($) Month ($) Month ($)

Machine A 950 1,050 1,150 1,040

Machine B 850 1,100 1,350 1,075
Machine C 700 1,000 1,300 970
With perfect 700 1,000 1,150 925
information
Blank

Probability 0.4 0.3 0.3

EVwPI $925
Best EMV without perfect information $970
EVPI 970  925 $45

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A Minimization Example (4 of 4)
Table 3.15 Opportunity Loss Table for Business Analytics
Department
Blank

10,000 20,000 30,000 Maximum ($) EOL ($)

Copies per Copies per Copies per
Month ($) Month ($) Month ($)
Machine A 250 50 0 250 115

Machine B 150 100 200 200 150

Machine C 0 0 150 150 45

Blank Blank

Probability 0.4 0.3 0.3

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Using Software (1 of 2)
Program 3.1A QM for Windows Input for Thompson
Lumber Example

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Using Software (2 of 2)
Program 3.1B QM for Windows Output Screen for Thompson Lumber
Example

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Using Excel (1 of 4)
Program 3.2A Excel QM Results for Thompson Lumber Example

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Using Excel (2 of 4)
Program 3.2B Key Formulas in Excel QM for Thompson Lumber
Example

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Decision Trees
Any problem presented in a decision table can be graphically represented in a
decision tree

• Most beneficial with a sequence of decisions

• All decision trees contain decision points/nodes and state-of-nature

points/nodes
• At decision nodes (the squares), one of several alternatives may be chosen

• At state-of-nature nodes (the circles), one state of nature will occur

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Five Steps of 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

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Thompson’s Decision Tree (1 of 2)
Figure 3.2 Thompson Lumber Decision Tree

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Thompson’s Decision Tree (2 of 2)
Figure 3.3 Completed and Solved Decision Tree for
Thompson Lumber

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Thompson’s Complex Decision Tree (1 of 5)
Figure 3.4
Larger Decision
Tree with
Payoffs and
Probabilities for
Thompson
Lumber

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Thompson’s Complex Decision Tree (2 of 5)
1. 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

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Thompson’s Complex Decision Tree (3 of 5)
2. 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

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Thompson’s Complex Decision Tree (4 of 5)
The best choice is to seek marketing information
3. 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. Expected value no market survey
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
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Thompson’s Complex Decision Tree (5 of 5)
Figure 3.5
Thompson’s
Decision Tree
with EMVs
Shown
What is the
value of doing
the survey?

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Efficiency of Sample Information
Market survey is only 32% as efficient as perfect information
• Possibly many types of sample information available
• Different sources can be evaluated

EVSI
Efficiency of sample information  100%
EVPI

• For Thompson

19,200
Efficiency of sample information  100%  32%
60,000

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Sensitivity Analysis (1 of 2)
• How sensitive are the decisions to changes in the
probabilities?
• How sensitive is our decision to the probability of a
favorable survey result?
• If the probability of a favorable result (p = .45) were to
change, would we make the same decision?
• How much could it change before we would make a
different decision?

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Sensitivity Analysis (2 of 2)
If p < 0.36, do not conduct the survey
If p > 0.36, conduct the survey

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 )

 $104,000 p  $2,400

We are indifferent when the EMV of node 1 is the same as the EMV of not
conducting the survey

$104,000 p  $2,400  $40,000

$104,000 p  $37,600
p  $37,600 $104,000 0.36
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Bayesian Analysis
• Many ways of getting probability data
– 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

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Calculating Revised Probabilities (1 of 5)

• Four conditional probabilities for Thompson Lumber

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

• Prior probabilities

P FM  0.50
P UM  0.50

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Calculating Revised Probabilities (2 of 5)

Table 3.16 Market Survey Reliability in Predicting States of

Nature
State of Nature State of Nature
Result of Survey Favorable Market (FM) Unfavorable Market (UM)
Positive (predicts P (survey positive | FM) 0.70
P left parenthesis survey positive pipe F M right parenthesis equals 0.70

P (survey positive | UM) 0.20

P left parenthesis survey positive pipe U M right parenthesis equals 0.20

favorable market
for product)
Negative (predicts P left parenthesis survey negative pipe F M right parenthesis equals 0.30 P left parenthesis survey negative pipe U M right parenthesis equals 0.80

P (survey negative | FM) 0.30 P (survey negative | UM) 0.80

unfavorable
market for
product)

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Calculating Revised Probabilities (3 of 5)

• Calculating posterior probabilities

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
A = favorable market
B = positive survey

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Calculating Revised Probabilities (4 of 5)

Table 3.17 Probability Revisions Given a Positive Survey

State Conditional Probability Prior Probability Posterior Posterior Probability
P (State of Nature |
P left parenthesis Survey positive pipe State of Nature right parenthesis
P left parenthesis State of Nature pipe Survey positive right parenthesis

of P (Survey Positive | Probability

Nature State of Nature) Joint Survey Positive)
Probability
FM 0.70 = 0.35
0.50 0.35/0.45 0.78
Times 0.50 Start fraction 0.35 over 0.45 end fraction equals 0.78

UM 0.20 = 0.10 0.10/0.45 0.22

0.50
Times 0.50 Start fraction 0.10 over 0.45 end fraction equals 0.22

Blank Blank

P (survey results positive)

P left parenthesis survey results positive right parenthesis
= 0.45 1.00

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Calculating Revised Probabilities (5 of 5)

Table 3.18 Probability Revisions Given a Negative Survey

State Conditional Prior Probability Posterior Posterior Probability
P left parenthesis State of Nature pipe Survey negative right parenthesis

of Probability
P (Survey Negative |
P left parenthesis Survey negative pipe State of Nature right parenthesis
Probability P (State of Nature |
Nature State of Nature) Joint Survey Negative)
Probability
FM 0.30 = 0.15
0.50 0.15/0.55 0.27
Times 0.50 Start fraction 0.15 over 0.55 end fraction equals 0.27

UM 0.80 = 0.40
0.50 0.40/0.55 0.73
Times 0.50 Start fraction 0.40 over 0.55 end fraction equals 0.73

Blank Blank

P (survey results negative)

P left parenthesis survey results negative right parenthesis
= 0.55 1.00

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Using Excel (3 of 4)
Program 3.3A Results of Bayes’ Calculations in Excel 2016

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Using Excel (4 of 4)
Program 3.3B Formulas Used for Bayes’ Calculations

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Potential Problems Using Survey Results
• We can not always get the necessary data for analysis
• Survey results may be based on cases where an action
was taken
• Conditional probability information may not be as
accurate as we would like

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Utility Theory (1 of 3)
• Monetary value is not always a true indicator of the
overall value of the result of a decision
• The overall value of a decision is called utility
• Economists assume that rational people make decisions
to maximize their utility
• Utility assessment assigns the worst outcome a utility of
0 and the best outcome a utility of 1
• A standard gamble is used to determine utility values
• When you are indifferent, your utility values are equal

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Utility Theory (2 of 3)
Figure 3.6 Your Decision Tree for the Lottery Ticket

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Utility Theory (3 of 3)
Figure 3.7 Standard Gamble for a Utility Assessment

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Investment Example (1 of 2)
• Construct a utility curve revealing preference for money
between $0 and $10,000
• A utility curve plots the utility value versus the monetary value
– An investment in a bank will result in $5,000
– An investment in real estate will result in $0 or $10,000
– Unless there is an 80% chance of getting $10,000 from the
real estate deal, prefer to have her money in the bank
– If p = 0.80, Jane is indifferent between the bank or the real
estate investment

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Investment Example (2 of 2)
Figure 3.8 Utility of $5,000

What are the utility values for $3,000 and for $7,000?
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Utility Curve
Figure 3.9 Utility Curve for Jane Dickson

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Preferences for Risk
Figure 3.10 Preferences for Risk Risk Avoider
• Avoids high losses
• Less utility from greater risk
Risk Seeker
• Utility curve increases faster
than payoff
• More utility from greater risk
Risk Indifferent
• Linear utility

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Utility as a Decision-Making Criteria (1 of 3)
Mark Simkin’s thumbtack game

Lands Point Up Lands Point Down

Mark wins $10,000 Mark loses $10,000

Figure 3.11 Decision Facing Mark Simkin

Should Mark play the game is P(point up) 0.45?

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Utility as a Decision-Making Criteria (2 of 3)
Step 1 – Define Mark’s utilities
U (  $10,000) 0.05
U ($0) 0.15
U ($10,000) 0.30

Figure 3.12 Utility Curve

for Mark Simkin

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Utility as a Decision-Making Criteria (3 of 3)
Step 2 – Replace monetary values with utility values
E (alternative 1: play the game) 0.45 0.30   (0.55) 0.05 
0.135  0.027 0.162
E (alternative 2 : don’t play the game) 0. 15
Figure 3.13 Using Expected Utilities in Decision Making

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