Anderson

Anderson Sweeney
Sweeney Williams
Williams

QUANTITATIVE
METHODS FOR
BUSINESS 8e

Slides Prepared by JOHN LOUCKS

© 2001 South-Western College Publishing/Thomson Learning Slide

1
 Chapter 4
Decision Analysis, Part B
 Expected Value of Perfect Information
 Decision Analysis with Sample Information
 Developing a Decision Strategy
 Expected Value of Sample Information

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 Example: Burger Prince

Burger Prince Restaurant is contemplating opening a new

restaurant on Main Street. It has three different models, each
with a different seating capacity. Burger Prince estimates
that the average number of customers per hour will be 80,
100, or 120. The payoff table for the three models is as
follows:

Average Number of Customers Per Hour

s1 = 80 s2 = 100 s3 = 120

Model A $10,000 $15,000 $14,000

Model B $ 8,000 $18,000 $12,000
Model C $ 6,000 $16,000 $21,000

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 Example: Burger Prince

 Expected Value Approach

Calculate the expected value for each decision. The
decision tree on the next slide can assist in this
calculation. Here d1, d2, d3 represent the decision
alternatives of models A, B, C, and s1, s2, s3 represent the
states of nature of 80, 100, and 120.

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 Example: Burger Prince

 Decision Tree Payoffs

s1 .4 10,000
s2 .2
22 15,000
s3 .4
d1
14,000
s1 .4
d2 8,000
1 s2 .2
33 18,000
d3 s3
.4
12,000
s1 .4
6,000
s2 .2
44 16,000
s3
.4
21,000

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 Example: Burger Prince

 Expected Value For Each Decision

EMV = .4(10,000) + .2(15,000) + .4(14,000)
d1 2 = $12,600

Model A

Model B d2 EMV = .4(8,000) + .2(18,000) + .4(12,000)

1 33 = $11,600

d3
Model C
EMV = .4(6,000) + .2(16,000) + .4(21,000)
4 = $14,000

Choose the model with largest EV, Model C.

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 Expected Value of Perfect Information

 Frequently information is available which can

improve the probability estimates for the states of
nature.
 The expected value of perfect information (EVPI) is
the increase in the expected profit that would result if
one knew with certainty which state of nature would
occur.
 The EVPI provides an upper bound on the expected
value of any sample or survey information.

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 Expected Value of Perfect Information

 EVPI Calculation
• Step 1:
Determine the optimal return corresponding to
each state of nature.
• Step 2:
Compute the expected value of these optimal
returns.
• Step 3:
Subtract the EV of the optimal decision from the
amount determined in step (2).

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 Example: Burger Prince

 Expected Value of Perfect Information

Calculate the expected value for the optimum
payoff for each state of nature and subtract the EV of
the optimal decision.

EVPI= .4(10,000) + .2(18,000) + .4(21,000) - 14,000 = $2,000

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 Example: Burger Prince

 Spreadsheet for Expected Value of Perfect Information

A B C D E F
1 PAYOFF TABLE
2
3 Decision State of Nature Expected Recommended
4 Alternative s1 = 80 s2 = 100 s3 = 120 Value Decision
5 d1 = Model A 10,000 15,000 14,000 12600
6 d2 = Model B 8,000 18,000 12,000 11600
7 d3 = Model C 6,000 16,000 21,000 14000 d3 = Model C
8 Probability 0.4 0.2 0.4
9 Maximum Expected Value 14000
10
11 Maximum Payoff EVwPI EVPI
12 10,000 18,000 21,000 16000 2000

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 Risk Analysis

 Risk analysis helps the decision maker recognize the

difference between:
• the expected value of a decision alternative
and
• the payoff that might actually occur
 The risk profile for a decision alternative shows the
possible payoffs for the decision alternative along with
their associated probabilities.

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 Example: Burger Prince

 Risk Profile for the Model C Decision Alternative

.50

.40
Probability

.30

.20

.10

5 10 15 20 25
Profit ($thousands)

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 Sensitivity Analysis

 Sensitivity analysis can be used to determine how

changes to the following inputs affect the recommended
decision alternative:
• probabilities for the states of nature
• values of the payoffs
 If a small change in the value of one of the inputs causes
a change in the recommended decision alternative,
extra effort and care should be taken in estimating the
input value.

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 Bayes’ Theorem and Posterior Probabilities

 Knowledge of sample or survey information can be

used to revise the probability estimates for the states of
nature.
 Prior to obtaining this information, the probability
estimates for the states of nature are called prior
probabilities.
 With knowledge of conditional probabilities for the
outcomes or indicators of the sample or survey
information, these prior probabilities can be revised by
employing Bayes' Theorem.
 The outcomes of this analysis are called posterior
probabilities or branch probabilities for decision trees.

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 Computing Branch Probabilities

 Branch (Posterior) Probabilities Calculation

• Step 1:
For each state of nature, multiply the prior probability
by its conditional probability for the indicator -- this
gives the joint probabilities for the states and indicator.
• Step 2:
Sum these joint probabilities over all states -- this
gives the marginal probability for the indicator.
• Step 3:
For each state, divide its joint probability by the
marginal probability for the indicator -- this gives the
posterior probability distribution.

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 Expected Value of Sample Information

 The expected value of sample information (EVSI) is

the additional expected profit possible through
knowledge of the sample or survey information.

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 Expected Value of Sample Information

 EVSI Calculation
• Step 1:
Determine the optimal decision and its expected
return for the possible outcomes of the sample or survey
using the posterior probabilities for the states of nature.
Step 2:
Compute the expected value of these optimal
returns.
• Step 3:
Subtract the EV of the optimal decision obtained
without using the sample information from the amount
determined in step (2).

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 Efficiency of Sample Information

 Efficiency of sample information is the ratio of EVSI to

EVPI.
 As the EVPI provides an upper bound for the EVSI,
efficiency is always a number between 0 and 1.

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 Example: Burger Prince

 Sample Information
Burger Prince must decide whether or not to
purchase a marketing survey from Stanton Marketing
for $1,000. The results of the survey are "favorable" or
"unfavorable". The conditional probabilities are:
P(favorable | 80 customers per hour) = .2
P(favorable | 100 customers per hour) = .5
P(favorable | 120 customers per hour) = .9

Should Burger Prince have the survey performed

by Stanton Marketing?

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 Example: Burger Prince

 Influence Diagram

Legend:
Market Avg. Number
Decision
Survey of Customers
Chance
Results Per Hour
Consequence

Market Restaurant
Profit
Survey Size

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 Example: Burger Prince

 Posterior Probabilities

Favorable

State Prior Conditional Joint Posterior

80 .4 .2 .08 .148
100 .2 .5 .10 .185
120 .4 .9 .36 .667
Total .54 1.000

P(favorable) = .54

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 Example: Burger Prince

 Posterior Probabilities

Unfavorable

State Prior Conditional Joint Posterior

80 .4 .8 .32 .696
100 .2 .5 .10 .217
120 .4 .1 .04 .087
Total .46 1.000

P(unfavorable) = .46

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 Example: Burger Prince

 Formula Spreadsheet for Posterior Probabilities

A B C D E
1 Market Research Favorable
2 Prior Conditional Joint Posterior
3 State of Nature Probabilities Probabilities Probabilities Probabilities
4 s1 = 80 0.4 0.2 =B4*C4 =D4/$D$7
5 s2 = 100 0.2 0.5 =B5*C5 =D5/$D$7
6 s3 = 120 0.4 0.9 =B6*C6 =D6/$D$7
7 P(Favorable) = =SUM(D4:D6)
8
9 Market Research Unfavorable
10 Prior Conditional Joint Posterior
11 State of Nature Probabilities Probabilities Probabilities Probabilities
12 s1 = 80 0.4 0.8 =B12*C12 =D12/$D$15
13 s2 = 100 0.2 0.5 =B13*C13 =D13/$D$15
14 s3 = 120 0.4 0.1 =B14*C14 =D14/$D$15
15 P(Unfavorable) = =SUM(D12:D14)

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 Example: Burger Prince

 Solution Spreadsheet for Posterior Probabilities

A B C D E
1 Market Research Favorable
2 Prior Conditional Joint Posterior
3 State of Nature ProbabilitiesProbabilities Probabilities Probabilities
4 s1 = 80 0.4 0.2 0.08 0.148
5 s2 = 100 0.2 0.5 0.10 0.185
6 s3 = 120 0.4 0.9 0.36 0.667
7 P(Favorable) = 0.54
8
9 Market Research Unfavorable
10 Prior Conditional Joint Posterior
11 State of Nature Probabilities Probabilities Probabilities Probabilities
12 s1 = 80 0.4 0.8 0.32 0.696
13 s2 = 100 0.2 0.5 0.10 0.217
14 s3 = 120 0.4 0.1 0.04 0.087
15 P(Favorable) = 0.46

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 Example: Burger Prince

 Decision Tree (top half)

s1 (.148)
$10,000
s2 (.185)
4 $15,000
d1 s3 (.667)
$14,000
s1 (.148)
$8,000
d2
5 s2 (.185)
22 $18,000
s3 (.667)
I1 d3 $12,000
s1 (.148)
(.54) $6,000
6 s2 (.185)
$16,000
s3 (.667)
1 $21,000

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 Example: Burger Prince

 Decision Tree (bottom half)

1 s1 (.696) $10,000
s2 (.217)
I2 77 $15,000
d1 s3 (.087)
(.46)
$14,000
s1 (.696)
d2 $8,000
s2 (.217)
3 88 $18,000
s3 (.087)
d3 $12,000
s1 (.696) $6,000
s2 (.217)
99 $16,000
s3 (.087)
$21,000

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 Example: Burger Prince

EMV = .148(10,000) + .185(15,000)

d1 44
+ .667(14,000) = $13,593
$17,855
d2
22 55 EMV = .148 (8,000) + .185(18,000)
d3 + .667(12,000) = $12,518
I1
(.54)
66 EMV = .148(6,000) + .185(16,000)
+.667(21,000) = $17,855
1
77 EMV = .696(10,000) + .217(15,000)
I2 d1 +.087(14,000)= $11,433
(.46)
d2
33 88 EMV = .696(8,000) + .217(18,000)
d3 + .087(12,000) = $10,554
$11,433
99 EMV = .696(6,000) + .217(16,000)
+.087(21,000) = $9,475
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 Example: Burger Prince

 Expected Value of Sample Information

If the outcome of the survey is "favorable" choose
Model C. If it is unfavorable, choose model A.

EVSI = .54($17,855) + .46($11,433) - $14,000 = $900.88

Since this is less than the cost of the survey, the

survey should not be purchased.

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 Example: Burger Prince

 Efficiency of Sample Information

The efficiency of the survey:

EVSI/EVPI = ($900.88)/($2000) = .4504

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The End of Chapter 4, Part B

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