Decision Analysis

BU.520.
601
Decision Models
Decision Analysis
DecisionAnalysis
Summer 2013 1
BU.520.601
 Let us flip a fair coin once (there is a fee).
If you win I give you $102. If I win, you give me $100.
How much fee will you pay me for playing the game: $5, $2,
$1, $0? You can select any other amount.
 Let us flip a fair coin 1000 (there is a fee).
If you win a toss, I give you $102. If I win, you give me $100.
How much fee will you pay for the playing the entire game?
Suppose you are getting ready to go the office in a crowded metro.

Carrying an umbrella is a hassle; you will carry it only when you feel
necessary. Forecast for today is 70% chance of rain and the sky is
overcast. Should you carry an umbrella - Yes or no?
My decision would be “Yes” and it is a good decision.

However, there are two possible outcomes - it will rain or not.
If it does not rain, it does not mean I have made a bad decision.
DecisionAnalysis BU.520.601 2
Decision Analysis (DA)
• DA is a methodology applicable to analyze a wide variety of
problems.
• Although DA was used in the 1950s (at Du Pont) and early
1960s (at Pillsbury), major DA development took place in mid
sixties. One of the earliest application (at GE) was to analyze
whether a super heater should be added to the current power
reactor.
• DA has been considered as a technology to assist
(individuals and) organizations in decision making by
quantifying the considerations (even though they may be
subjective) to deduce logical actions.
Decision Analysis (DA)
One can discuss many topics listed below; we will look at a few.
• Problem Formulation.
• Decision Making with / without Probabilities.
• Risk Analysis and Sensitivity Analysis.
• Decision Analysis with Sample / Perfect Information.
• Multistage decision making.
Tools and terminology • Bayes’ rule

• Basic statistics and probability • Decision vs. outcome
• Influence diagram / payoff table / • Risk management
decision tree • Minimax / maximin /
• EMV: Expected Monetary Value • Utility theory
• EVSI / EVPI : Expected Value of
Sample / Perfect Information
Decision analysis without probabilities
Concepts covered: Payoff table.
Different approaches: Maximax, maximin, minimax regret
Example: There are four projects; I can select only one. The
payoff table shows potential “payoff” depending upon likely
economic conditions.
Alternatives Economic Condition Since the payoff in

Recession Normal Boom project C is higher than
the payoff for D for
Project A 4075 5000 6100 every economic
Project B 0 5250 12080 condition, we say that
Project C project C is dominant.
2500 7000 10375
We can eliminate
Project D 1500 6000 9500 project D from
consideration.
Maximax
If you are an optimist, you will decide on the basis of Maximax.
Alternatives Economic Condition Step 1: Pick the max value
Recession Normal Boom for each alternative.
Project A 6100
4075 5000 6100
Project B 12080
0 5250 12080
Project C 10375
2500 7000 10375
Step 2:Then pick the

alternative with max payoff.
Maximin
If you are a conservative you will use Maximin.
Alternatives Economic Condition 1: Pick the min value

Project A 4075 5000 6100 4075
Project B 0 5250 12080 0
Project C 2500 7000 10375 2500
2: Then pick the alternative

with max payoff.
Minimax Regret You are neither optimist nor conservative.
Alternatives Economic Condition Step 1: Calculate

the maximum for
Recession Normal Boom each outcome.
Project A 4075 5000 6100
Project B 0 5250 12080
Project C 2500 7000 10375
4075| 7000| 12080
Alternatives Regret Table Stet 2: Prepare

“Regret Table” by
Recession Normal Boom subtracting each
Project A 0 2000 5980 outcome cell
Project B value from its
4075 1750 0
maximum.
Project C 1575 0 1705
At least one number for each regret table outcome is zero and there
are no negative numbers. Why?
Minimax Regret..
Alternatives Economic Condition

Recession Normal Boom
Project A 4075 5000 6100
Project B 0 5250 12080
Project C 2500 7000 10375
4075| 7000| 12080
Alternatives Regret Table Step 3: Pick the max value
Project A 0 2000 5980 5980
Project B 4075 1750 0 4075
Project C 1575 0 1705 1705
Step 4: Pick the alternative

with minimum regret.
General comments Payoff table
Alternatives Economic Condition
Recession Normal Boom
Table columns show
Project A 4075 5000 6100
outcomes (also called
state of nature). Project B 0 5250 12080
Project C 2500 7000 10375
• The maximax payoff criterion seeks the largest of the
maximum payoffs among the actions.
• The maximin payoff criterion seeks the largest of the minimum
payoffs among the actions.
• The minimax regret criterion seeks the smallest of the
maximum regrets among the actions.
The above three approaches we used involved Decision

Making without Probabilities.
Decision analysis with probabilities
Typically, we use a tree diagram for the decision analysis.
1. A decision point is shown by a rectangle
2. Alternatives available at a decision point
DB are shown as decision branches (DB).
3. At the end of each DB, there
CB can be two or more chance
20%
55% events shown by a node and
Decision chance branches (CB).
point 25% Chance events must be mutually
exclusive and exhaustive (total
probability = 1).
4. At the end of each branch is an endpoint shown as a triangle
where a payoff will be identified.
Decision analysis with probabilities
Decision point: Chance event : End point:
DB: Decision Branch CB: Chance Branch
At the chance node, we calculate the average
(i.e. expected) payoff. The terminology used is
DB Expected Monetary Value (EMV)
If there is no chance event for a
CB particular decision branch, it’s
20%
55% EMV is equal to the payoff.
25% We select the decision with the

highest EMV .
What if we are dealing with costs?
A larger tree diagram
Example 1 You bought 500 units of X @$10 each.
A dealer has offered to buy these from you @$14 each ( you can
make $4/unit profit).
You can sell these yourself for $16

each ($6/unit profit) but the Demand: X 300 400 500 600
demand is uncertain. The demand Pr(X) 0.30 0.45 0.20 0.05
distribution is shown in the table.
Obviously, if demand exceeds 500, you will sell all 500. On the
other hand, if demand is under 500, you will have leftover units.
These leftover items can disposed off for $7 each ($3 loss, the
dealer will no longer buy these leftover units from you).
What’s your decision?
Example 1 .. Suppose you have 500 units of X in
Demand: X 300 400 500 600 stock, purchased for $10 each. Dealer
Pr(X) 0.30 0.45 0.20 0.05 sales price:$14, self sale price:$16
with salvage value:$7.
Start with the tree having 2 branches (DB) at the decision point.
There are no chance events in the dealer sale branch,
Dealer For the self sale, there are 4
Sale mutually exclusive possibilities.
Self sale
500, 20%
Example 1 ... Suppose you have 500 units of X in
Demand: X 300 400 500 600 stock, purchased for $10 each. Dealer
Pr(X) 0.30 0.45 0.20 0.05 sales price:$14, self sale price:$16
with salvage value:$7.
EMV = 2000
Payoff = 500*4 = 2000
Dealer
Sale Payoff = 300*6 – 200*3 = 1200
Payoff = 400*6 – 100*3 = 2100

Self sale
500, 20% Payoff = 500*6 = 3000
Payoff = 500*6 = 3000

EMV = 0.3*1200 +
0.45*2100 + 0.2* 3000 Your decision?
+ 0.05*3000 = 2055
Risk Profile Risk profile is the probability distribution for
the payoff associated with a particular action.
30% 300 Payoff = 1200

Self Sale
400
45% Payoff = 2100
20%
500 Payoff = 3000
5%
600 Payoff = 3000
The risk profile shows all the possible economic outcomes and
provides the probability of each: it is a probability distribution for
the principal output of the model.
Example 3
We have received RFP (Request For Proposal).
• We may not want to bid at all (our cost: 0)
• If we bid, we will have to spend $5k for proposal preparation.
Based on the information provided in the RFP, a quick decision
is to bid either $115k or $120k or $125k.
We must select among 4 alternatives (including no bid).
• A quick estimate of the cost of the project (in addition to the

preparation cost) is $95k.
• Looks like we may have a competitor.
• If we bid the same amount as the competitor, we will get the
project because of our reputation with the client.
• We have gathered some probabilities based on past
experience.
Example 3.. All numbers in thousand dollars
Our bid (OB) must be 0 (no bid), 115, 120 or 125.
Competitor’s bid (CB): 0, under 115, 115 to under 120, 120 to under
125, 125 and over.
Assumption: If bids are equal, we get the contract.
Information : Preparation cost: $5 + Cost of work : $95 = $100 total
Profit for our bid

Use mini-max,
 Competitor’s bid 0 115 120 125 maxi-max, etc?
1. No bid 0 15 20 25 There are
2a. Under $115 0 -5 -5 -5 probabilities
2b. $115 to under $120 involved.
0 15 -5 -5
2c. $120 to under $125 0 15 20 -5
2d. Over $125 0 15 20 25
Example 3…
1. There is a 30% probability that the competitor will not bid.
2. If the competitor does bid, there is
(a) 20% probability of bid under $115.
(b) 40% probability of bid $115 to under $120.
(c) 30% probability of bid under $120 to under $125.
(d) 10% probability of bid over $125.
Actual Profit for our bid

Prob. Prob. Prob.  Competitor’s bid 0 115 120 125
30% 30% - 1. No bid 0 15 20 25
14% 20% 2a. Under $115 0 -5 -5 -5
28% 40% 2b. $115 to under $120 0 15 -5 -5
70%
21% 30% 2c. $120 to under $125 0 15 20 -5
7% 10% 2d. Over $125 0 15 20 25
Example 3: Actual Profit for our bid
Prob.  Competitor
0 115 120 125
30% 1. No bid 0 15 20 25
14% 2a. < $115 0 -5 -5 -5
28% 2b. $115 to < $120 0 15 -5 -5
21% 2c. $120 to < $125 0 15 20 -5
7% 2d. > $125 0 15 20 25
$0 Lose Payoff = (-5), Probability 14%
No Payoff = 15, Probability 86%

$115 Win
bid
bid
(-5)*(0.14) + 15 * (0.86) = $12.2
Example 3: Actual Profit for our bid
Prob.  Competitor
0 115 120 125
30% 1. No bid 0 15 20 25
14% 2a. < $115 0 -5 -5 -5
28% 2b. $115 to < $120 0 15 -5 -5
21% 2c. $120 to < $125 0 15 20 -5
7% 2d. > $125 0 15 20 25
$0 $12.2 L -5, 14% Our decision?

No Bid W 15, 86%
bid $115 $9.5
L -5, 42%
Bid We will now use
$120 W 20, 58% Excel to solve the
Bid=
$125 $6.1
L -5, 63% problem.
W
25, 37%
Ex. 3: Excel =SUMPRODUCT(Profit_bid_115,Probabilities)
=MAX(D9:G9)
INDEX+MATCH
HLOOKUP ?
Value we are looking (12.2) is not in the ascending order in the table.
Example 3: Sensitivity analysis
What if 30% probability of no bid from competitor is incorrect?
We can build a one variable data table.

Variable: Competitor’s no bid probability.
We select two outputs: bid and

(corresponding maximum) profit.
Ex. 3: DA and value of information
Our decision was to bid $115 and EMV was $12.2. Suppose we
get competitor’s bid information. Can we improve our profit?
Profit for our bid
 Competitor’s bid 0 115 120 125 What is the probability?
1. No bid 0 15 20 25 0.30
2a. Under $115 0 -5 -5 -5 0.7 * 0.2 = 0.14
2b. $115 to under $120 0 15 -5 -5 0.7 * 0.4 = 0.28
2c. $120 to under $125 0 15 20 -5 0.7 * 0.3 = 0.21
2d. Over $125 0 15 20 25 0.7 * 0.1 = 0.07
EMV = 0.3*25+0.14*0+0.28*15+0.21*20+0.07*25 = 17.65

Earned Value of Perfect Information (EVPI) = $17.65 – $12.2 = $5.45
Sometimes we may have partial information.
Example 3: Alternate method
CB=0
<115 -$5
15(.3)+11(.7) = $12.2 30% $15 20% 115 to <120 $15
40%
$0 70%
CB 30% 120 to < 125
OB= 10%
$15
No $115 >125 $15
bid
$20
30%
OB=
bid $120 70%
$5
Our $12.2 $9.5
-5(.2)+15(.4+.3+.1) = $11
decision OB=
$125
30% $25
70% -$2
$6.1 EMV Payoff
Example 3…..
Values 12.2, 9.5 and 6.1

$12.2 represent Expected Monetary
Values (EMV).
$0
OB=
No $115 This line indicates the decision
bid made.
$9.5
OB= This is called folding back the
bid $120 decision tree.
$12.2
OB=
$125
$6.1
•
Utility theory Different people will pay different
amounts to play the first game
Consider the gambling Expected payoff in the first game is $1
problems again. but most people do not want to play the
– Let us flip a fair coin once. game at all.
– If you win I give you $102 Why? Losing $100 is a bigger event
than winning $102
– If I win, you give me $100
• Most people will play the second game.
– How much will you pay me
to play this game: $5, $2, Still differ in how much they will pay.
$1, $0 ? • For most people a gain that is twice as
Consider another gamble big is not twice as good.
– Let us flip the same coin • A loss of twice as much is more than
(500 times) with the same twice as bad.
payoffs • People’s attitude towards risk can be
– How much will you pay me categorized as: risk averse, risk seeker
to play this game? and risk neutral.
• A common way to express it is through
the decision-maker’s utility function.
Utility is a measure of relative satisfaction. We can plot a graph of amount
of money spent vs. “utility” on a 0 to 100 scale. Typical shapes for different
types of risk takers generally follow the patterns shown below.
U(100) U(100) U(100)
U(0) U(0) U(0)

0 100 0 100 0 100
Risk seeker Risk averse Risk neutral
U(100) U(100) U(100)
U(0) U(0) U(0)

0 100 0 100 0 100
Graphs above show that to achieve 50% utility, risk seekers will pay maximum,
risk averse will pay minimum and risk neutral will pay an average amount.

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BU.520.

Suppose you are getting ready to go the office in a crowded metro.

My decision would be “Yes” and it is a good decision.

Tools and terminology • Bayes’ rule

Alternatives Economic Condition Since the payoff in

Step 2:Then pick the

Alternatives Economic Condition 1: Pick the min value

2: Then pick the alternative

Alternatives Economic Condition Step 1: Calculate

Alternatives Regret Table Stet 2: Prepare

Alternatives Economic Condition

Step 4: Pick the alternative

The above three approaches we used involved Decision

25% We select the decision with the

What if we are dealing with costs?

You can sell these yourself for $16

What’s your decision?

Payoff = 400*6 – 100*3 = 2100

Payoff = 500*6 = 3000

30% 300 Payoff = 1200

600 Payoff = 3000

• A quick estimate of the cost of the project (in addition to the

Profit for our bid

Actual Profit for our bid

$0 Lose Payoff = (-5), Probability 14%

No Payoff = 15, Probability 86%

$0 $12.2 L -5, 14% Our decision?

We can build a one variable data table.

We select two outputs: bid and

EMV = 0.3*25+0.14*0+0.28*15+0.21*20+0.07*25 = 17.65

Values 12.2, 9.5 and 6.1

U(100) U(100) U(100)

U(0) U(0) U(0)

U(100) U(100) U(100)

U(0) U(0) U(0)

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Payoff = 4006 – 1003 = 2100

EMV = 0.325+0.140+0.2815+0.2120+0.07*25 = 17.65