Decision Analysis: Learning Objectives

Chapter 19: Decision Analysis 1
Chapter 19
Decision Analysis
LEARNING OBJECTIVES
Chapter 18 describes how to use decision analysis to improve management decisions,
thereby enabling you to:
1.
Learn about decision making under certainty, under uncertainty, and under risk.
2.
Learn several strategies for decision-making under uncertainty, including

expected payoff, expected opportunity loss, maximin, maximax, and minimax
regret.
3.
Learn how to construct and analyze decision trees.
4.
Understand aspects of utility theory.
5.
Learn how to revise probabilities with sample information.
CHAPTER TEACHING STRATEGY
The notion of contemporary decision making is built into the title of the text as a
statement of the importance of recognizing that statistical analysis is primarily done as a
decision-making tool. For the vast majority of students, statistics take on importance
only in as much as they aid decision-makers in weighing various alternative pathways
and helping the manager make the best possible determination. It has been an underlying
theme from chapter 1 that the techniques presented should be considered in a decisionmaking context. This chapter focuses on analyzing the decision-making situation and
presents several alternative techniques for analyzing decisions under varying conditions.
Early in the chapter, the concepts of decision alternatives, the states of nature, and
the payoffs are presented. It is important that decision makers spend time brainstorming
about possible decision alternatives that might be available to them. Sometimes the best
alternatives are not obvious and are not immediately considered. The international focus

on foreign companies investing in the U.S. presents a scenario in which there are several
possible alternatives available. By using cases such as the Fletcher-Terry case at the
chapter's end, students can practice enumerating possible decision alternatives.
States of nature are possible environments within which the outcomes will occur
over which we have no control. These include such things as the economy, the weather,
health of the CEO, wildcat strikes, competition, change in consumer demand, etc. While
the text presents problems with only a few states of nature in order to keep the length of
solution reasonable, students should learn to consider as many states of nature as possible
in decision making. Determining payoffs is relatively difficult but essential in the
analysis of decision alternatives.
Decision-making under uncertainty is the situation in which the outcomes are not
known and there are no probabilities given as to the likelihood of them occurring. With
these techniques, the emphasis is whether or not the approach is optimistic, pessimistic,
or weighted somewhere in between.
In making decisions under risk, the probabilities of each state of nature occurring
are known or are estimated. Decision trees are introduced as an alternative mechanism
for displaying the problem. The idea of an expected monetary value is that if this
decision process were to continue with the same parameters for a long time, what would
the long-run average outcome be? Some decisions lend themselves to long-run average
analysis such as gambling outcomes or insurance actuary analysis. Other decisions such
as building a dome stadium downtown or drilling one oil well tend to be more one time
activities and may not lend themselves as nicely to expected value analysis. It is
important that the student understand that expected value outcomes are long-run averages
and probably will not occur in single instance decisions.
Utility is introduced more as a concept than an analytic technique. The
idea here is to aid the decision-maker in determining if he/she tends to be more of a risktaker, an EMV'r, or risk-averse. The answer might be that it depends on the matter over
which the decision is being made. One might be a risk-taker on attempting to employ a
more diverse work force and at the same time be more risk-averse in investing the
company's retirement fund.
CHAPTER OUTLINE
19.1 The Decision Table and Decision Making Under Certainty
Decision Table
Decision-Making Under Certainty
19.2 Decision Making Under Uncertainty
Maximax Criterion
Maximin Criterion
Hurwicz Criterion
Minimax Regret
19.3 Decision Making Under Risk
Decision Trees
Expected Monetary Value (EMV)
Expected Value of Perfect Information
Utility
19.4 Revising Probabilities in Light of Sample Information
Expected Value of Sample Information
KEY TERMS
Decision Alternatives
Decision Analysis
Decision Making Under Certainty
Decision Making Under Risk
Decision Making Under Uncertainty
Decision Table
Decision Trees
EMV'er
Expected Monetary Value (EMV)
Expected Value of Perfect Information
Expected Value of Sample Information
Hurwicz Criterion
Maximax Criterion
Maximin Criterion
Minimax Regret
Opportunity Loss Table
Payoffs
Payoff Table
Risk-Avoider
Risk-Taker
States of Nature
Utility
SOLUTIONS TO PROBLEMS IN CHAPTER 19
19.1
S1
S2
S3
Max
Min
d1 250
175
-25
250
-25
d2 110
100
70
110
70
d3 390
140
-80
390
-80
a.) Max {250, 110, 390} = 390
b.) Max {-25, 70, -80} = 70
decision: Select d3
decision: Select d2
c.) For = .3
d1: .3(250) + .7(-25) = 57.5
d2: .3(110) + .7(70) = 82
d3: .3(390) + .7(-80) = 61
decision: Select d2
For = .8
d1: .8(250) + .2(-25) = 195
d2: .8(110) + .2(70) = 102
d3: .8(390) + .2(-80) = 296
decision: Select d3
Comparing the results for the two different values of alpha, with a more pessimist
point-of-view ( = .3), the decision is to select d2 and the payoff is 82. Selecting
by using a more optimistic point-of-view ( = .8) results in choosing d3 with a
higher payoff of 296.

d.) The opportunity loss table is:
S1
S2
S3
Max
d1 140
95
140
d2 280
75
280
d3
35
150
150
The minimax regret = min {140, 280, 150} = 140

Decision: Select d1 to minimize the regret.
19.2
S1
S2
S3
S4
Max
Min
d1
50
70
120
110
120
50
d2
80
20
75
100
100
20
d3
20
45
30
60
60
20
d4 100
85
-30
-20
100
-30
d5
-10
65
80
80
-10
a.) Maximax = Max {120, 100, 60, 100, 80} = 120

Decision: Select d1
b.) Maximin = Max {50, 20, 20, -30, -10} = 50
Decision: Select d1
c.) = .5
Max {[.5(120)+.5(50)], [.5(100)+.5(20)],
[.5(60)+.5(20)], [.5(100)+.5(-30)], [.5(80)+.5(-10)]}=
Max { 85, 60, 40, 35, 35 } = 85
Decision: Select d1
d.) Opportunity Loss Table:November 8, 1996

S1
S2
S3
S4
Max
d1
50
15
50
d2
20
65
45
10
65
d3
80
40
90
50
90
d4
150
130
150
d5 100
95
55
30
100
Min {50, 65, 90, 150, 100} = 50

Decision: Select d1
19.3
Max Min
A 60
15
-25
60
-25
10
25
30
30
10
C -10
40
15
40
-10
D 20
25
25
Maximax = Max {60, 30, 40, 25} = 60

Decision: Select A
Maximin = Max {-25, 10, -10, 5} = 10
Decision: Select B
19.4
Not
Somewhat
Very
Max
Min
None
-50
-50
-50
-50
-50
Few
-200
300
400
400
-200
Many -600
100
1000
1000
-600
a.) For Hurwicz criterion using = .6:

Max {[.6(-50) + .4(-50)], [.6(400) + .4(-200)],
[.6(1000) + .4(-600)]} = {-50, -160, 360}= 360
Decision: Select "Many"
b.) Opportunity Loss Table:
Not
Somewhat
Very
Max
350
1050
1050
Few
150
600
600
Many
550
200
550
None
Minimax regret = Min {1050, 600, 550} = 550

Decision: Select "Many"
19.5, 19.6

19.7 Expected Payoff with Perfect Information =
5(.15) + 50(.25) + 20(.30) + 8(.10) + 6(.20) = 31.75
Expected Value of Perfect Information = 31.25 - 25.25 = 6.50
19.8 a.) & b.)
c.) Expected Payoff with Perfect Information =

150(40) + 450(.35) + 700(.25) = 392.5
Expected Value of Perfect Information = 392.5 - 370 = 22.50
19.9
Down(.30)
Up(.65)
No Change(.05)
EMV
Lock-In
-150
200
85
No
175
-250
-110
Decision: Based on the highest EMV)(85), "Lock-In"

Expected Payoff with Perfect Information =
175(.30) + 200(.65) + 0(.05) = 182.5
Expected Value of Perfect Information = 182.5 - 85 = 97.5
19.10
EMV
No Layoff
-960
Layoff 1000
-320
Layoff 5000
400
Decision: Based on maximum EMV (400), Layoff 5000

Expected Payoff with Perfect Information =
100(.10) + 300(.40) + 600(.50) = 430
Expected Value of Perfect Information = 430 - 400 = 30
19.11 a.) EMV = 200,000(.5) + (-50,000)(.5) = 75,000

b.) Risk Avoider because the EMV is more than the
investment (75,000 > 50,000)
c.) You would have to offer more than 75,000 which
is the expected value.
19.12 a.)
S1(.30)
S2(.70)
EMV
d1
350
-100
35
d2
-200
325
167.5
Decision: Based on EMV,

maximum {35, 167.5} = 167.5
b. & c.)
For Forecast S1:

Prior
Cond.
Joint
Revised
S1
.30
.90
.27
.6067
S2
.70
.25
.175
F(S1) = .445
.3933
For Forecast S2:

Prior
Cond.
Joint
Revised
S1
.30
.10
.030
.054
S2
.70
.75
.525
F(S2) = .555
.946
EMV with Sample Information = 241.63
d.) Value of Sample Information = 241.63 - 167.5 = 74.13
19.13
Dec(.60)
Inc(.40)
EMV
-225
425
35
125
-150
15
350
-400
50
Decision: Based on EMV = Maximum {35, 15, 50} = 50
For Forecast (Decrease):

Prior
Cond.
Joint
Revised
Decrease
.60
.75
.45
.8824
Increase
.40
.15
.06
F(Dec) = .51
.1176
For Forecast (Increase):

Prior
Cond.
Joint
Revised
Decrease
.60
.25
.15
.3061
Increase
.40
.85
.34
F(Inc) = .49
.6939
The expected value with sampling is 244.275

EVSI = EVWS - EMV = 244.275 - 50 = 194.275
19.14
Decline(.20) Same(.30) Increase(.50)

Don't Plant
20
-40
Small
-90
10
175
Large
-600
-150
800
Decision: Based on Maximum EMV =

Max {-16, 72.5, 235} = 235, plant a large tree farm
For forecast decrease:

Prior
Cond.
Joint
Revised
.20
.70
.140
.8974
.30
.02
.006
.0385
.50
.02
.010
.0641
P(Fdec) = .156
For forecast same:
Prior
Cond.
Joint
Revised
.20
.25
.05
.1333
.30
.95
.285
.7600
.50
.08
.040
.1067
P(Fsame) = .375
For forecast increase:
Prior
Cond.
Joint
Revised
.20
.05
.01
.0213
EMV
-16
72.5
235
.30
.03
.009
.0192
.50
.90
.45
.9595
P(Finc) = .469
The Expected Value with Sampling Information is 360.413

EVSI = EVWSI - EMV = 360.413 - 235 = 125.413
19.15
Oil(.11)
Drill
No Oil(.89)
EMV
1,000,000
-100,000
21,000
Don't Drill
Decision: The EMV for this problem is Max {21,000, 0} = 21,000.

The decision is to Drill.
Actual
Oil
No Oil
Oil
.20
.10
No Oil
.80
.90
Forecast
Forecast Oil:
State
Prior
Cond.
Joint
Revised
Oil
.11
.20
.022
.1982
No Oil
.89
.10
.089
.8018
P(FOil) = .111
Forecast No Oil:
State
Prior
Cond.
Joint
Revised
Oil
.11
.80
.088
.0990
No Oil
.89
.90
.801
.9010
P(FNo Oil) = .889
The Expected Value With Sampling Information is 21,012.32
EVSI = EVWSI - EMV = 21,000 - 21,012.32 = 12.32
19.16
S1
S2
Max.
Min.
d1
50
100
100
50
d2
-75
200
200
-75
d3
25
40
40
25
d4
75
10
75
10
a.) Maximax:
Max {100, 200, 40, 75} = 200
Decision: Select d2
b.) Maximin:
Max {50, -75, 25, 10} = 50
Decision: Select d1
c.) Hurwicz with = .6
d1:
d2:
d3:
d4:
100(.6) + 50(.4) = 80
200(.6) + (-75)(.4) = 90
40(.6) + 25(.4) = 34
75(.6) + 10(.4) = 49
Max {80, 90, 34, 49} = 90

Decision: Select d2
d.) Opportunity Loss Table:
S1
S2
Maximum
d1
25
100
100
d2
150
150
d3
50
160
160
d4
190
190
Min {100, 150, 160, 190} = 100

Decision: Select d1
19.17
b.) d1: 400(.3) + 250(.25) + 300(.2) + 100(.25) = 267.5

d2: 300(.3) + (-100)(.25) + 600(.2) + 200(.25) = 235
Decision: Select d1
c.) Expected Payoff of Perfect Information:
400(.3) + 250(.25) + 600(.2) + 200(.25) = 352.5
Value of Perfect Information = 352.5 - 267.5 = 85
19.18
S1(.40)
S2(.60)
EMV
d1
200
150
170
d2
-75
450
240
d3
175
125
145
Decision: Based on Maximum EMV =

Max {170, 240, 145} = 240
Select d2
Forecast S1:
State
Prior
Cond.
Joint
Revised
S1
.4
.9
.36
.667
S2
.6
.3
.18
.333
P(FS1) = .54
Forecast S2:
State
Prior
Cond.
Joint
Revised
S1
.4
.1
.04
.087
S2
.6
.7
.42
.913
P(FS2) = .46
The Expected Value With Sample Information is 285.00

EVSI = EVWSI - EMV = 285 - 240 = 45
19.19
Small
Small
Moderate
Large
Min
Max
200
250
300
200
300
Modest
100
300
600
100
600
Large
-300
400
2000
-300
2000
a.) Maximax: Max {300, 600, 2000} = 2000

Decision: Large Number
Minimax: Max {200, 100, -300} = 200
Decision: Small Number
b.) Opportunity Loss:
Small
Moderate
Large
Max
150
1700
1700
Modest
100
100
1400
1400
Large
500
500
Small
Min {1700, 1400, 500} = 500

Decision: Large Number
c.) Minimax regret criteria leads to the same decision as Maximax.
19.20
No
Low
Fast
Max
Min
Low
-700
-400
1200
1200
-700
Medium
-300
-100
550
550
-300
High
100
125
150
150
100
a.) = .1:
Low: 1200(.1) + (-700)(.9) = -510
Medium: 550(.1) + (-300)(.9) = -215
High: 150(.1) + 100(.9) = 105
Decision: Price High (105)
b.) = .5:
Low: 1200(.5) + (-700)(.5) = 250
Medium: 550(.5) + (-300)(.5) = 125
High: 150(.5) + 100(.5) = 125
Decision: Price Low (250)
c.) = .8:
Low: 1200(.8) + (-700)(.2) = 820
Medium: 550(.8) + (-300)(.2) = 380
High: 150(.8) + 100(.2) = 140
Decision: Price Low (820)
d.) Two of the three alpha values (.5 and .8) lead to a decision of pricing low.
Alpha of .1 suggests pricing high as a strategy. For optimists (high
alphas), pricing low is a better strategy; but for more pessimistic people,
pricing high may be the best strategy.
19.21
Mild(.75)
Severe(.25)
EMV
Reg.
2000
-2500
875
Weekend
1200
-200
850
Not Open
-300
100
-200
Decision: Based on Max EMV =

Max{875, 850, -200} = 875, open regular hours.
Expected Value with Perfect Information =

2000(.75) + 100(.25) = 1525
Value of Perfect Information = 1525 - 875 = 650
19.22
Weaker(.35) Same(.25) Stronger(.40)
EMV
Don't Produce
-700
-200
150
-235
Produce
1800
400
-1600
90
Decision: Based on Max EMV = Max {-235, 90} = 90, select Produce.
Expected Payoff With Perfect Information =
1800(.35) + 400(.25) + 150(.40) = 790
Value of Perfect Information = 790 - 90 = 700

19.23
Automate
Do Not
Red.(.15)
Con.(.35)
Inc.(.50)
EMV
-40,000
-15,000
60,000
18,750
5,000
10,000
-30,000
-10,750
Decision: Based on Max EMV =

Max {18750, -10750} = 18,750, Select Automate
Forecast Reduction:
State
Prior
R
C
I
.15
.35
.50
Cond.
Joint
.60
.09
.10
.035
.05
.025
P(FRed) = .150
Revised
.60
.2333
.1667
Forecast Constant:
State
Prior
R
C
I
.15
.35
.50
Cond.
Joint
.30
.045
.80
.280
.25
.125
P(FCons) = .450
Revised
.10
.6222
.2778
Forecast Increase:
State
Prior
R
C
I
.15
.35
.50
Cond.
Joint
.10
.015
.10
.035
.70
.350
P(FInc) = .400
Revised
.0375
.0875
.8750
Expected Value With Sample Information = 21,425.55
EVSI = EVWSI - EMV = 21,425.55 - 18,750 = 2,675.55
19.24
Chosen(.20)
Not Chosen(.80)
EMV
Build
12,000
-8,000
-4,000
Don't
-1,000
2,000
1,400
Decision: Based on Max EMV = Max {-4000, 1400} = 1,400,

choose "Don't Build" as a strategy.
Forecast Chosen:
State
Prior
Cond. Joint
Revised
Chosen
.20
.45
.090
.2195
Not Chosen
.80
.40
.320
P(FC) = .410
.7805
Cond. Joint
Revised
Forecast Not Chosen:

State
Prior
Chosen
.20
.55
.110
.1864
Not Chosen
.80
.60
.480
P(FC) = .590
.8136
Expected Value With Sample Information = 1,400.09

EVSI = EVWSI - EMV = 1,400.09 - 1,400 = .09

Decision Analysis: Learning Objectives

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Chapter 19: Decision Analysis 1

Learn several strategies for decision-making under uncertainty, including

Learn how to construct and analyze decision trees.

Understand aspects of utility theory.

Learn how to revise probabilities with sample information.

CHAPTER TEACHING STRATEGY

Chapter 19: Decision Analysis 2

Chapter 19: Decision Analysis 3

Chapter 19: Decision Analysis 4

SOLUTIONS TO PROBLEMS IN CHAPTER 19

a.) Max {250, 110, 390} = 390

b.) Max {-25, 70, -80} = 70

Chapter 19: Decision Analysis 5

The minimax regret = min {140, 280, 150} = 140

a.) Maximax = Max {120, 100, 60, 100, 80} = 120

Chapter 19: Decision Analysis 6

d.) Opportunity Loss Table:November 8, 1996

Min {50, 65, 90, 150, 100} = 50

Maximax = Max {60, 30, 40, 25} = 60

Chapter 19: Decision Analysis 7

a.) For Hurwicz criterion using = .6:

Minimax regret = Min {1050, 600, 550} = 550

Chapter 19: Decision Analysis 8

Chapter 19: Decision Analysis 9

19.8 a.) & b.)

c.) Expected Payoff with Perfect Information =

Chapter 19: Decision Analysis 10

Decision: Based on the highest EMV)(85), "Lock-In"

Decision: Based on maximum EMV (400), Layoff 5000

19.11 a.) EMV = 200,000(.5) + (-50,000)(.5) = 75,000

Chapter 19: Decision Analysis 11

Decision: Based on EMV,

For Forecast S1:

For Forecast S2:

Chapter 19: Decision Analysis 12

EMV with Sample Information = 241.63

d.) Value of Sample Information = 241.63 - 167.5 = 74.13

Chapter 19: Decision Analysis 13

Decision: Based on EMV = Maximum {35, 15, 50} = 50

For Forecast (Decrease):

For Forecast (Increase):

Chapter 19: Decision Analysis 14

The expected value with sampling is 244.275

Chapter 19: Decision Analysis 15

Decline(.20) Same(.30) Increase(.50)

Decision: Based on Maximum EMV =

For forecast decrease:

Chapter 19: Decision Analysis 16

Chapter 19: Decision Analysis 17

The Expected Value with Sampling Information is 360.413

Decision: The EMV for this problem is Max {21,000, 0} = 21,000.

P(FNo Oil) = .889

Chapter 19: Decision Analysis 18

The Expected Value With Sampling Information is 21,012.32

EVSI = EVWSI - EMV = 21,000 - 21,012.32 = 12.32

Chapter 19: Decision Analysis 19

Max {100, 200, 40, 75} = 200

Max {50, -75, 25, 10} = 50

Max {80, 90, 34, 49} = 90

Min {100, 150, 160, 190} = 100

Chapter 19: Decision Analysis 20

b.) d1: 400(.3) + 250(.25) + 300(.2) + 100(.25) = 267.5

Chapter 19: Decision Analysis 21