Decision Analysis

The Office of the Product Manager

of an FMCG Company

There is an idea of a New Product.

Should it be developed and introduced in the
market?

A decision has to be taken!

How to go about it?

Possible Decision Alternatives

Develop and introduce the product
Do not develop the product

Market Information, Uncertainty

and Consequences?
Market Information
Similar products exist in the market

Uncertainty?
What will be the market potential
(penetration) of the New Product?

Consequences?
What are the consequences of the various
decision alternatives under different market
potentials as estimated or judged by the
decision maker?

PRIOR ANALYSIS
Estimation of Potential Market Penetration
Judgment of the Product Manager
In actual practice, penetration would be a continuous
random variable
The product would achieve no less than 2.5 percent and
no more than 17.5 percent of the market
Three specified levels of penetration would be adequate
to deal with uncertainty regarding penetration
Estimates of Potential Market Penetration
States
of
Nature

Not in
the control
of the
Decision Maker

Range of Potential
Penetration

Mid-points
(p)

0.025 but less than 0.075

0.075 but less than 0.125
0.125 but less than 0.175

0.05
0.10
0.15

()
1
2
3

PRIOR ANALYSIS
Estimation of Payoffs for New Product
After an extensive discussion with the Production
Manager and the Finance Director of the
Company, the Product Manager arrives at
the following Payoff Table
Payoffs (in million Rs.) for New Product
States of Nature

Decisions

1: p = 0.05
D1: Introduce
D2: Do not introduce

2: p = 0.10

3: p = 0.15

-2

Payoff = present value of the estimated profit

PRIOR ANALYSIS
Decision Rules under Risk wherein prior probabilities can be determined

The Expected Value Decision Rule

Penetration within each of the first two class intervals are
JUDGED to occur with twice the likelihood than that in the
last class
Expected Payoffs for the New Product Model
Decision
(D)

Payoffs
P(D, )

Prior
Probability
f()

Expected
Payoff
E[P(D, )]

D1

-2
1
5

0.4
0.4
0.2

0.6

D2

0
0
0

0.4
0.4
0.2

0.0

Decision:
Introduce

POSTERIOR ANALYSIS - seeking

additional information about the states of nature
What is the expected upper limit for the value
of additional information?
PERFECT INFORMATION
Best
about
Decision
State of nature
1
2
3

D2
D1
D1

Payoff for
BEST
DECISION

0
1
5

Expected Value with Perfect Information = 0*0.4+1*0.4+5*0.2 = 1.4

Expected Value Under Risk = 0.6 (obtained earlier)
Therefore, the Product Manager will be willing to pay 0.8 million
rupees for perfect information.
Expected Value of Perfect Information (EVPI) = Rs. 800,000

POSTERIOR ANALYSIS - Revision

of Prior Probabilities
Suppose that a market survey based on a consumer panel
of 100 customers yields the additional information that
only 3 customers would buy the new product
Calculation of Posterior Probabilities

1
2
3

f() f(3|) f() * f(3|) f(|3)= [f() * f(3|)]/f(3)

0.4 0.1396 0.05584
0.95912
0.4 0.0059 0.00236
0.04054
0.2 0.0001 0.00002
0.00034
1.0
f(3) = 0.05822
1.0000

POSTERIOR ANALYSIS - Decision

based on Revised Probabilities
Expected Posterior Payoffs for the New Product Model
Decision
(D)

D1
D2

Payoffs
P(D, )

-2
1
5
0
0
0

Posterior
Probability
f(|x)

Expected
Payoff
E[P(D, )|x]

0.95912
0.04054
0.00034

- 1.876

0.95912
0.04054
0.00034

0.0

Decision: Do not introduce

PREPOSTERIOR ANALYSIS
Calculation of ALL Posterior Probabilities
for a Consumer Panel of 5 customers
f(x| )

f()

0
1
2
3
4
5
0.773781 0.203627 0.021434 0.001128 2.97E-05 3.13E-07
0.59049 0.32805
0.0729
0.0081 0.00045 0.00001
0.443705 0.391505 0.138178 0.024384 0.002152 7.59E-05
f() * f(x|)

f(x)

0.4 0.309512 0.081451 0.008574 0.000451 1.19E-05 1.25E-07

0.4 0.236196 0.13122 0.02916 0.00324 0.00018
4E-06
0.2 0.088741 0.078301 0.027636 0.004877 0.00043 1.52E-05
0.634449 0.290972 0.065369 0.008568 0.000622 1.93E-05

1
2
3

1
2
3

f(|x)= [f() * f(x|)]/f(x)

0.487844 0.279926 0.131159 0.052666 0.019086 0.006472
0.372285 0.450972 0.44608 0.378146 0.289302 0.20712
0.139871 0.269102 0.422761 0.569188 0.691612 0.786408

PREPOSTERIOR ANALYSIS
Calculation of Expected Payoffs for ALL possible
outcomes and all Decisions for a Consumer Panel
of 5 customers
No. of customers favouring the product
Decision/Payoff
-2

D1

1
5
0

D2

0
0

0
0.487844037
0.372284986
0.139870977
0.487844037
0.372284986
0.139870977

1
0.279926
0.450972
0.269102
0.279926
0.450972
0.269102

2
0.131159
0.44608
0.422761
0.131159
0.44608
0.422761

0.052666
0.378146
0.569188
0.052666
0.378146
0.569188

0.019085886
0.289301858
0.691612255
0.019085886
0.289301858
0.691612255

5
0.006472492
0.207119741
0.786407767
0.006472492
0.207119741
0.786407767

Posterior Probabilities for various outcomes

PREPOSTERIOR ANALYSIS
Expected Value of Experimentation - for a
Consumer Panel of 5 customers
Outcome of the
experiment (x)
0
1
2
3
4
5

f(x)

Expected
payoff

0.634449438
0.290971563
0.065369375
0.008568125
0.000622188
1.93125E-05

Bayes
Decision

0.095951795
1.236627505
2.297568624
3.118754103
3.709191361
4.126213592

D1
D1
D1
D1
D1

Expected Payoff with Experimentation = 0.6

Expected Value of Sample Information = 0.6 - 0.6 = 0.0

PREPOSTERIOR ANALYSIS
Expected Value of Experimentation - for a
Consumer Panel of 10 customers
Outcome of the
experiment (x)
0
1
2
3
4
5
6
7
8
9
10

f(x)

0.418341033
0.350503161
0.162517349
0.053115019
0.012869169
0.002317759
0.000305912
2.87143E-05
1.81295E-06
6.89611E-08
1.19334E-09
Expected Payoff with Experimentation =

Expected Bayes
payoff Decision
0
0.714099
1.807025
2.718853
3.402548
3.899163
4.254908
4.504712
4.675865
4.790433
4.865693

D2
D1
D1
D1
D1
D1
D1
D1
D1
D1
D1

0.742644

Expected Value of Sample Information = 0.743 - 0.6 = 0.143

DECISION TREE
Basic Tree Structure
Incorporating Probabilities

Backward Induction

P( i) P(X1 | i) P(X2 | i) P(X3 | i)

1
2
3

0.3
0.5
0.2

0.7
0.3
0.1

0.2
0.5
0.1

0.1
0.2
0.8

0.5526

D1

20

0.3947

12.499

0.0527

12.499

D2

5
-10

0.5526
0.3947

0
0

0.0527

X1

LEGENDS

0.38
6.818

0.7576 5
0.0606

6.818

X2

20

0.1818

D1

Market Test
6.9996

-10

0.1818

0.33
D2

0.29
Decisions
X3
D1: Introduce
D2: Do not introduce
-1.725
D1
States of Nature
1: 15% Market Share
0
2: 5% Market Share
0
D2
3: 1% Market Share
Outcomes of Market Test
Estimated Payoffs
X1: Market Share10%
X2: 3%<Market Share<10%
in million Rs.
X3: Market Share 3%

0.7576
0
0.0606

0
0.1034

20

0.3449 5
0.5517
0.1034

-10
0

0.3449 0
0.5517

1
2
3
1
2
3
1
2
3
1
2
3
1
2
3
1
2
3