Chapter 8

Decision Analysis

Slides 8a: Introduction

Decision Analysis

A set of alternative actions

We

may chose whichever we please

A set of possible states of nature

Only

one will be correct, but we dont know in

advance

A set of outcomes and a value for each

Each

is a combination of an alternative action and a

state of nature
Value can be monetary or otherwise

Decision Analysis

Certainty
Decision

Maker knows with certainty what the state of

nature will be - only one possible state of nature

Ignorance
Decision

Maker knows all possible states of nature,

but does not know probability of occurrence

Risk
Decision

Maker knows all possible states of nature,

and can assign probability of occurrence for each state

Decision Making Under Certainty

Decision Variable
Units to build
Parameter Estimates
Cost to build (/unit)
Revenue (/unit)
Demand (units)

150

$
$

6,000
14,000
250

Consequence Variables
Total Revenue
Total Cost

$ 2,100,000
$ 900,000

Performance Measure
Net Revenue

$ 1,200,000

Decision Making Under Ignorance

Payoff Table
Kelly Construction Payoff Table (Prob. 8-17)
State of Nature
Demand
Alternative
Actions Low (50 units) Medium (100 units) High (150 units)
Build 50

400,000

400,000

400,000

Build 100

100,000

800,000

800,000

Build 150

(200,000)

500,000

1,200,000

Decision Making Under Ignorance

Maximax
Select the strategy with the highest possible
return
Maximin
Select the strategy with the smallest possible
loss
LaPlace-Bayes
All states of nature are equally likely to occur.
Select alternative with best average payoff

Maximax:
The Optimistic Point of View

Select the best of the best strategy

Evaluates

each decision by the maximum possible

return associated with that decision (Note: if cost data
is used, the minimum return is best)
The decision that yields the maximum of these
maximum returns (maximax) is then selected

For risk takers

Doesnt

consider the down side risk

Ignores the possible losses from the selected
alternative

Maximax Example
Kelly Construction
State of Nature
Alternative
Actions

Demand

Maximax
Criterion

Low (50 units) Medium (100 units) High (150 units)

Max

Build 50

400,000

400,000

400,000

400,000

Build 100

100,000

800,000

800,000

800,000

Build 150

(200,000)

500,000

1,200,000

1,200,000

Maximin:
The Pessimistic Point of View

Select the best of the worst strategy

Evaluates

each decision by the minimum

possible return associated with the decision
The decision that yields the maximum value
of the minimum returns (maximin) is selected

For risk averse decision makers

A protect

strategy
Worst case scenario the focus

Maximin
Kelly Construction
State of Nature
Alternative
Actions

Demand

Maximin
Criterion

Low (50 units) Medium (100 units) High (150 units)

Min

Build 50

400,000

400,000

400,000

400,000

Build 100

100,000

800,000

800,000

100,000

Build 150

(200,000)

500,000

1,200,000

(200,000)

Decision Making Under Risk

Expected Return (ER)*

Select

the alternative with the highest (long term)

expected return

A weighted

average of the possible returns for each

alternative, with the probabilities used as weights

* Also referred to as Expected Value (EV) or Expected

Monetary Value (EMV)

**Note that this amount will not be obtained in the short
term, or if the decision is a one-time event!

Expected Return
State of Nature
Alternative
Actions

Demand

Expected
Return

Low (50 units) Medium (100 units) High (150 units)

ER

Build 50

400,000

400,000

400,000

400,000

Build 100

100,000

800,000

800,000

660,000

Build 150

(200,000)

500,000

1,200,000

570,000

0.5

0.3

1.0

Probability

0.2

Expected Value of Perfect Information

EVPI measures how much better you could do on this decision if you
could always know when each state of nature would occur, where:
EVUPI

= Expected Value Under Perfect Information (also called EVwPI,

the EV with perfect information, or EVC, the EV under certainty)

EVUII

= Expected Value of the best action with imperfect information

(also called EVBest )

EVPI

= EVUPI EVUII

EVPI tells you how much you are willing to pay for perfect
information (or is the upper limit for what you would pay for
additional imperfect information!)

Expected Value of Perfect

Information
State of Nature
Alternative
Actions

Demand

Expected
Return

Low (50 units) Medium (100 units) High (150 units)

ER

Build 50

400,000

400,000

400,000

400,000

Build 100

100,000

800,000

800,000

660,000

Build 150

(200,000)

500,000

1,200,000

570,000

0.2

0.5

0.3

1.0

400,000

800,000

1,200,000

840,000

EVPI

180,000

Probability
Best Decision

Using Excel to Calculate EVPI:

Formulas View
Kelly Construction
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14

Payoffs
Alternatives
Build 50
Build 100
Build 150
Probability
Best Decision

States of Nature
Low (50 units) Medium (100 units)
400000
400000
100000
800000
-200000
500000
0.2
0.5
=MAX(B5:B7)
=MAX(C5:C7)

Expected Return
High (150 units)
ER
400000
=SUMPRODUCT(B5:D5,B$8:D$8)
800000
=SUMPRODUCT(B6:D6,B$8:D$8)
1200000
=SUMPRODUCT(B7:D7,B$8:D$8)
0.3
=MAX(D5:D7)
EVwPI = =SUMPRODUCT(B9:D9,B8:D8)
EVBest = =MAX(E5:E7)
EVPI = =E11-E12

The Newsvendor Model

A newsvendor can buy the Wall Street Journal
newspapers for 40 cents each and sell them for
75 cents.
However, he must buy the papers before he
knows how many he can actually sell. If he
buys more papers than he can sell, he disposes
of the excess at no additional cost. If he does
not buy enough papers, he loses potential
sales now and possibly in the future.
Suppose that the loss of future sales is
captured by a loss of goodwill cost of 50 cents
per unsatisfied customer.

The demand distribution is as follows:

P0 = Prob{demand = 0} = 0.1
P1 = Prob{demand = 1} = 0.3
P2 = Prob{demand = 2} = 0.4
P3 = Prob{demand = 3} = 0.2
Each of these four values represent the states of
nature. The number of papers ordered is the
decision. The returns or payoffs are as follows:

Decision
0
-150
1
-65
2
20
3
105

State of Nature (Demand)

0
1
2
3
0
-50
-100
-40

35

-15

-80

-5

70

-45

30

-120

Payoff = 75(# papers sold)

40(# papers ordered) 50(unmet demand)
Where 75 = selling price
40 = cost of buying a paper
50 = cost of loss of goodwill

Now, the ER is calculated for each decision:

ER0 = 0(0.1) 50(0.3) 100(0.4) 150(0.2) = -85
ER1 = -40(0.1) + 35(0.3) 15(0.4) 65(0.2) = -12.5
ER2 = -80(0.1) 5(0.3) + 70(0.4) + 20(0.2) = 22.5
ER3 = -120(0.1) 45(0.3) + 30(0.4) 105(0.2) = 7.5
State of Nature (Demand)
Decision
0
1
2
3
0 Of these
0
-50
four
ERs, -100
-85
1
-40
35
-15
choose the
-12.5
maximum,
2
-80
-5
70
and
order
2
papers
22.5
3
-120
-45
30
7.5
Prob.
0.1
0.3
0.4

ER
-150
-65
20
105

Decision
0
-150
1
-65
2
20
3
105
Prob.
0.2

State of Nature
1
2

0
0

-50

-100

-40

35

-15

-80

-5

70

-45

30

-120
0.1

0.3

0.4

ER(new) = 0(0.1) + 35(0.3) + 70(0.4) +

105(0.2)= 59.5
ER(current) = 22.5
EVPI = 59.5 22.5 = 37.0 cents

Maximax Criterion: The Maximax criterion is an

optimistic decision making criterion.

This method evaluates each decision by the

maximum possible return associated with that
decision.
The decision that yields the maximum
of these
max
maximum
returns (maximax) is then selected.
max

Maximin Criterion: The Maximin criterion is an

extremely conservative, or pessimistic, approach to

making decisions.
Maximin evaluates each decision by the minimum
possible return associated with the decision.
Then, the decision that yields the maximum
value
max
of the minimum
returns (maximin) is selected.
min

So, using the 3 criteria, we made the following

decisions regarding the newsvendor data:

Criteria
Maximin Cash Flow
Expected Return
Maximax Cash Flow

Decision
Order 1 paper
Order 2 papers
Order 3 papers

THE RATIONALE FOR

UTILITY
Most people are risk-averse,
risk-averse which means
they would feel that the loss of a certain
amount of money would be more painful than
the gain of
the same amount of money.
Utility functions in decision analysis measure
the attractiveness of money.
Utility can be thought of as a measure of
satisfaction.

Typical risk-averse utility function:

A gain
in
utility
of
0.06

Utility
1.0
0.910
0.850
0.775
0.680
0.524

100

200

300

400

500

Go from $400
to $500 results

600 Do

To illustrate, first suppose you have $100 and

someone gives you an additional $100. Note that
your utility increases by

U(200) U(100) = 0.680 0.524 = 0.156

Now suppose you start with $400 and someone
gives you an additional $100. Now your utility
increases by

U(500) U(400) = 0.910 0.850 = 0.060

This illustrates that an additional $100 is less
attractive if you have $400 on hand than it is if
you start with $100.

Utilities and Decisions under

Risk
Summary:

Utility is a way to incorporate risk aversion

into the expected return calculation.
Calculating a utility function is out of the scope
of this course, but it can be calculated by a
series of lottery questions (e.g., Would you
prefer one million dollars or a 50% chance of
earning five million?).