DECISIONANALYSIS

(Hillier&LiebermanIntroductiontoOperationsResearch,8th edition)

Introduction
Decisionoftenmustbemadeinuncertainenvironments

f
b
d
Examples:
Manufacturerintroducinganewproductinthemarketplace.
Governmentcontractorbiddingonanewcontract.
Oilcompanydecidingtodrillforoilinaparticularlocation.

Decisionanalysis:decisionmakinginfaceofgreat
uncertainty;rationaldecisionwhentheoutcomesare
uncertain.
Makingdecisionswith orwithoutexperimentation.
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Prototypeexample
yp
p
Goferbroke Companyownsatractoflandthatcan
containoil.
Contractedgeologistreportsthatchanceofoilis1in4
Contractedgeologistreportsthatchanceofoilis1in4.
Anotheroilcompanyoffers90.000 fortheland.
Costofdrillingis100.000.Ifoilisfound,expectedrevenue
Costofdrillingis100 000 Ifoilisfound expectedrevenue
is800.000 (expectedprofitis700.000).
Statusofland

Payoff

Alternative

Oil

Dry

D illf il
Drillforoil

700.000

100.000

Selltheland

90.000

90.000

1in4

3in4

Chanceofstatus
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Decisionmakingwithoutexperimentation
g
p

Analogy
l
togametheory:
h
Players:decisionmaker(player1)andnature(player2).
Availablestrategiesfor2players:alternativeactionsand
possiblestatesofnature,respectively.
Combinationofstrategiesresultsinsomepayofftoplayer1
f
ff
(decisionmaker).
But,arebothplayersstillrational?

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Decision analysis
y framework
1. Decisionmakerneedstochooseoneofalternative
actions.
p
f
2. Nature thenchoosesoneofpossiblestatesofnature.
3. Eachcombinationofanactionandstateofnature
resultsinapayoff oneoftheentriesinapayoff
resultsinapayoff,oneoftheentriesinapayoff
table.
4 Probabilitiesforstatesofnatureprovidedbyprior
4.
distributionarepriorprobabilities.
5. Payofftableshouldbeusedtofindanoptimalaction
P
fft bl h ldb dt fi d ti l ti
forthedecisionmakeraccordingtoan appropriate
criterion.
it i
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PayofftableforGoferbrokeCo.problem
y
p

Stateofnature
Alternative

Oil

Dry

1 Drillforoil
1.Drillforoil

700

100
100

2.Selltheland

90

90

0.25

0.75

Priorprobability

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Maximinpayoffcriterion
p y
Maximin payoffcriterion: foreachpossibleaction,
findtheminimumpayoff overallstatesofnature.
Next,findthemaximum oftheseminimumpayoffs.
Choosetheactionwhoseminimumpayoffgivesthis
maximum.
Bestguarantee ofpayoff:pessimisticviewpoint.
St t f t
Stateofnature
Alternative

Oil

Dry

Minimum

1 Drillforoil
1.Drillforoil

700

100

100

2.Selltheland

90

90

0.25

0.75

Priorprobability
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90

Maximinvalue

535

Maximumlikelihoodcriterion
Maximumlikelihood criterion: Identifymostlikely
stateofnature(withlargestpriorprobability).For
thisstateofnature,findtheactionwithmaximum
payoff.Choosethisaction.
g
p
Mostlikelyy state:ignoresimportantinformationand
lowprobabilitybigpayoff.
Stateofnature
Alternative

Oil

Dry

1.Drillforoil

700

100

2.Selltheland

90

90

0.25

0.75

Priorprobability
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Mostlikely

Maximuminthiscolumn

536

Bayesdecisionrule
y
Bayes decisionrule: Usingpriorprobabilities,
Bayesdecisionrule:
calculatetheexpectedvalueofpayoffforeach
possibledecisionalternative.Choosethedecision
alternativewiththemaximumexpectedpayoff.
Fortheprototypeexample:
E[Payoff(drill)]=0.25(700)+0.75(100)=100.
E[Payoff(sell)]=0.25(90)+0.75(90)=90.
E[Payoff(sell)] 0 25(90)+0 75(90) 90

Incorporatesallavailableinformation(payoffsand
priorprobabilities).
i b biliti )
Whatifprobabilitiesarewrong?
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SensitivityanalysiswithBayesrules
y
y
y
Priorprobabilitiescanbequestionable
Priorprobabilitiescanbequestionable.
Trueprobabilitiesofhavingoilare0.15to0.35(so,
probabilitiesfordrylandarefrom0 85to0 65)
probabilitiesfordrylandarefrom0.85to0.65).
p=priorprobabilityofoil.
Example:expectedpayofffromdrillingforanyp:
E[Payoff(drill)]=700p 100(1 p)=800p 100.

Infigure,thecrossoverpoint iswherethedecision
changesfromonealternativetoanother:
g
E[Payoff(drill)]=E[Payoff(sell)]
100=90
90 p =0.2375
0.2375
800p 100
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Expectedpayoffforalternativechanges
p
p y
g

Andformore
than2variables?
UseExcelSensIt.
Thedecisionis
verysensitive
top!

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Decisionmakingwithexperimentation
g
p
Improvedestimatesarecalledposterior
probabilities.
Example:adetailedseismicsurveycosts30.000.
USS:unfavorableseismicsoundings:oilisfairlyunlikely.
g
y
y
FSS:favorableseismicsoundings:oilisfairlylikely.

Basedonpastexperience,thefollowingprobabilities
aregiven:
P(USS|State=Oil)=0.4;P(FSS|State=Oil)=1
P(USS|State=Oil)=0 4;P(FSS|State=Oil)=1 0.4=0.6.
0 4=0 6
P(USS|State=Dry)=0.8;P(FSS|State=Dry)=1 0.8=0.2.
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Posteriorprobabilities
p
n =numberofpossiblestatesofnature.
u be o poss b e states o atu e
P(State=statei)=priorprobabilitythattruestateof
natureisstatei fori=1 2 n
natureisstatei,fori=1,2,,n.
Finding=findingfromexperimentation(randomvar.)
d
Findingj
=onepossiblevalueoffinding.
bl
l
ff d
P(State=statei |Finding =finding j)=posterior
probability thattruestateofnatureisstatei,given
Finding =finding j ,fori=1,2,,n.
GivenP(State=statei) andP(Finding=findingj|State=statei)
fori=1,2,,n,
, , , , whatisP(State=statei
(
||Finding=finding
g
g j)?
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Posteriorprobabilities
p
Fromprobabilitytheory,theBayestheorem canbe
obtained:
P(State=statei ||Finding=finding
g
g j) =
=

P((Finding=finding
g
g j ||State=statei )P((State=statei )
n

P(Finding=findingj |State=statek )P(State=statek )

k =1

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Bayestheoreminprototypeexample
y
p
yp
p
Ifseismicsurveyinunfavorable(USS j=1):
Ifseismicsurveyinunfavorable(USS,j=1):
0.4(0.25)
1
P(State=Oil|Finding=USS) =
= ,
0 4(0 25) + 0.8(0.75)
0.4(0.25)
0 8(0 75) 7
1 6
P(State=Dry|Finding=USS)
y|
g
=1 = .
7 7

Ifseismicsurveyinfavorable(FSS,j=2):
P(State=Oil|Finding=FSS) =

0.6(0.25)
1
= ,
0.6(0.25) + 0.2(0.75) 2

1 1
P(State=Dry|Finding=FSS) = 1 = .
2 2
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Probabilitytreediagram
y
g

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Expectedpayoffs
p
p y
ExpectedpayoffscanbefoundagainusingBayes
decisionrulefortheprototypeexample,with
posteriorprobabilitiesreplacing priorprobabilities:
ExpectedpayoffsiffindingisUSS:

1
6
y (
|
g
) = (700)
(7 ) + (100)) 30 = 155.77
E[[Payoff(drill|Finding=USS)
7
7
1
6
E[Payoff(sell|Finding=USS) = (90) + (90) 30 = 60
7
7

ExpectedpayoffsiffindingisFSS:

1
1
[Payoff(drill|Finding FSS) = (700) + (100) 30 = 270
E[Payoff(drill|Finding=FSS)
2
2
1
1
E
[Payoff(sell|Finding=FSS)
[
y
(
|
g
)
=
(9
(90)
)
+
(9
(90)) 330 = 60

2
2

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Optimalpolicy
p
p y
UsingBayesdecisionrule,theoptimalpolicyof
optimizingpayoffisgivenby:
Findingfrom
seismicsurvey

Optimal
alternative

Expectedpayoff
excludingcostof
survey

Expectedpayoff
includingcostof
survey

USS

Selltheland
Se
t e a d

90

60

FSS

Drillforoil

300

270

Isitworthspending30.000 toconduct
p
theexperimentation?
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Valueofexperimentation
p
Beforeperforminganexperimentation,determineits
potentialvalue.
Twocomplementarymethods:
1. Expectedvalueofperfectinformation itis
assumedthatexperimentwillremovealluncertainty.
Providesanupperbound
o des a uppe bou d o
onpotentialvalueof
pote t a a ue o
experiment.
2 Expectedvalueofinformation istheactual
2.
improvementinexpectedpayoff.
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Expectedvalueofperfectinformation
p
p
Stateofnature
Alternative

Oil

Dry

1.Drillforoil

700

100

2.Selltheland

90

90

Maximumpayoff

700

90

P i b bili
Priorprobability

0.25

0.75

Expectedpayoffwithperfectinformation=0.25(700)+0.75(90)=242.5

Expectedvalueofperfectinformation(EVPI) is:
EVPI=expectedpayoffwithperfectinformation expectedpayoffwithout
experimentation

Example:EVPI=242.5 100=142.5.Thisvalueis>30.
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Expectedvalueofinformation
p
Requiresexpectedpayoffwithexperimentation:
Requiresexpectedpayoffwithexperimentation
Expectedpayoffwithexperimentation =
P(Finding=findingj )E[payoff|Finding=findingj ]
j

Example:seeprobabilitytreediagram,where:
P(USS)=0.7, P(FSS)=0.3.
Expectedpayoff(excludingcostofsurvey)was
obtainedinoptimalpolicy:
p
p y
E(Payoff|Finding=USS)=90,
E(Payoff|Finding=FSS)=300.
E(Payoff|Finding FSS) 300.
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Expectedvalueofinformation
p
So,expectedpayoffwithexperimentation is
Expectedpayoffwithexperim.=0.7(90)+0.3(300)=153.

Expectedvalueofexperimentation(EVE) is:
EVE=expectedpayoffwithexperimentation expected
payoffwithoutexperimentation
Example: EVE=153 100=53.
As53exceeds30,theseismicsurveyshouldbedone.

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Decisiontrees
P
Prototypeexamplehasasequenceoftwodecisions:

l h
f
d i i
Shouldaseismicsurveybeconductedbeforeanactionis
chosen?
h
?
Whichaction(drillforoilorselltheland)shouldbechosen?
h
Thesequestionshaveacorrespondingdecisiontree.
h
d d

Junctionpointsarenodes,andlinesarebranches.
Adecisionnode,representedbyasquare,indicates
thatadecision needstobemadeatthatpoint.
p
Aneventnode,representedbyacircle,indicatesthat
arandomevent occursatthatpoint.
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Decisiontreeforprototypeexample
p
yp
p

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Decisiontreewithprobabilities
p

probability

cash flow

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Performingtheanalysis
g
y
1. Startatrightsideofdecisiontreeandmoveleftone
column atatime.Foreachcolumn,performstep2or
step3dependingifnodesareevent ordecision nodes.
2. Foreacheventnode,calculateitsexpectedpayoff by
multiplyingexpectedpayoffofeachbranchby
probabilityofthatbranchandsummingthese
products Recordvaluenexttoeachnodeinbold
products.Recordvaluenexttoeachnodeinbold.
3. Foreachdecisionnode,comparetheexpectedpayoffs
ofitsbranches,andchoosealternativewithlargest
fit b
h d h
lt
ti ithl
t
expectedpayoff.Recordthechoicebyinsertinga
d bl d hi h j t db
doubledashineachrejectedbranch.
h
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Decisiontreewithanalysis
y

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Optimalpolicyforprototypeexample
p
p y
p
yp
p
Thedecisiontreeresultsinthefollowingdecisions:
1. Dotheseismicsurvey.
2. Iftheresultisunfavorable,selltheland.
If h
l i f
bl ll h l d
3. Iftheresultisfavorable,drillforoil.
4. Theexpectedpayoff(includingthecostofthe
seismicsurvey)is123(123000).
y)
3( 3
)
Sameresultasobtainedwithexperimentation
Foranydecisiontree,thebackwardinduction
procedure alwaysleadstooptimalpolicy.
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Utilitytheory
y
y
Youareofferedthechoiceof:
1. Acceptinga50:50chanceofwinning$100.000
ornothing;
2. Receiving$40.000withcertainty.
Whatdoyouchoose?

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Utilityfunctionformoney
y
y
Utilityfunctions(u(M))formoney(M):usuallythereisa
d
decreasingmarginalutilityformoney
i
i l ili f
(i di id li i k
(individualisrisk
averse).

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Utility
y function formoney
y
Italsoispossibletoexhibitamixtureofthesekindsof
p
behavior(riskaverse,riskseeker,riskneutral)
Anindividual sattitudetowardriskmaybedifferent
Anindividualsattitudetowardriskmaybedifferent
whendealingwithonespersonalfinancesthanwhen
makingdecisionsonbehalfofanorganization.
Whenautilityfunctionformoneyisincorporatedinto
adecisionanalysisapproachtoaproblem thisutility
adecisionanalysisapproachtoaproblem,thisutility
functionmustbeconstructedtofitthepreferences
andvaluesofthedecisionmakerinvolved (The
andvaluesofthedecisionmakerinvolved.(The
decisionmakercanbeeitherasingleindividualora
groupofpeople )
groupofpeople.)
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Utilitytheory
y
y
Fundamentalproperty:thedecisionmakersutility
Fundamentalproperty:thedecisionmaker
sutility
functionformoney hasthepropertythatthedecision
makerisindifferent
ff
betweentwoalternativecourses
ofactioniftheyhavethesameexpectedutility.
p Offer: anopportunitytoobtaineither
pp
y
Example.
$100.000(utility=4)withprobabilityp ornothing
(utility=0)withprobability1 p.Thus,E(utility)=4p.
Decisionmakerisindifferentfore.g.:
Offerwithp =0.25(E(utility)=1)ordefinitelyobtaining
$ 0 000( tilit )
$10.000(utility=1).
Offerwithp =0.75(E(utility)=3)ordefinitelyobtaining
$60.000(utility 3).
$60.000(utility=3).
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Roleofutilitytheory
y
y
Whendecisionmakersutilityfunctionformoneyis
usedtomeasurerelativeworthofvariouspossible
monetaryoutcomes,Bayesdecisionrulereplaces
monetarypayoffsbycorrespondingutilities.
Thus,optimalaction istheonethatmaximizesthe
expectedutility.
Notethatutilityfunctionsmaynotbemonetary.
Example:doctorsdecisionoftreatingornotapatient
involvesfuturehealthofthepatient.
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Applyingutilitytheorytoexample
pp y g
y
y
p
TheGoferbroke Co.doesnothavemuchcapital,soalossof
100.000 wouldbequiteserious.
ldb i i
Scaleofutilityfunctionisirrelevant.Onlytherelativevaluesof
the tilitiesmatter
theutilitiesmatter.
Thecompleteutilityfunctioncanbefoundusingthefollowing
values:
Monetarypayoff

Utility

130
130

150
150

100

105

60

60

90

90

670

580

700

6
600

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UtilityfunctionforGoferborkeCo.
y

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Estimatingu(M)
g ( )
Apopularformistheexponentialutilityfunction:
M

u(M ) = R 1 e R

R =decisionmaker
=decisionmakersrisktolerance
srisktolerance.
Designedtofitariskaverseindividual.
Forprototypeexample,R
F

l R =2250foru(670)=580and

f (6 ) 8 d
u(700)=600,andR =465foru(130)=150.

However,itisnotpossibletohavedifferentvaluesof
H
iti t
ibl t h diff
t l f
R forthesameutilityfunction.
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Decisiontreewithutilityfunction
y
Thesolutionisexactlythesameasbefore,except for
substitutingutilities formonetarypayoffs.
Thus,thevalueobtainedtoevaluateeachforkofthe
treeisnowtheexpectedutilityy ratherthanthe
expectedmonetarypayoff.
Opt a dec s o s se ected by ayes dec s o u e
OptimaldecisionsselectedbyBayesdecisionrule
maximizetheexpectedutilityfortheoverallproblem.

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Decisiontreeusingutilityfunction
g
y
Different decision tree
but same optimal
policy.

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