Chapter 19: Decision Analysis

91

Chapter 19
Decision Analysis
LEARNING OBJECTIVES
Chapter 19 describes how to use decision analysis to improve management decisions, thereby enabling
you to:
1.
2.
3.
4.
5.

Learn about decision making under certainty, under uncertainty, and under risk.
Learn several strategies for decision-making under uncertainty, including expected payoff,
expected opportunity loss, maximin, maximax, and minimax regret.
Learn how to construct and analyze decision trees.
Understand aspects of utility theory.
Learn how to revise probabilities with sample information.
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

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STUDY QUESTIONS
1. In decision analysis, decision-making scenarios are divided into three categories: decision-making
under ______________, decision-making under _______________, and decision-making under
______________.
2. Many decision analysis problems can be viewed as having three variables:
1. _____________________, 2. ____________________, and 3. ______________________.
3. Occurrences of nature that can happen after a decision has been made that can affect the outcome of
the decision and over which the decision-maker has little or no control are called
_________________________________. The benefits or rewards that result from selecting a
particular decision alternative are called _______________. The various choices or options available
to the decision-maker in any given problem situation are called
__________________________________.
4. Examine the decision table shown below:

Decision
Alternative

1
2
3

State of Nature
1
2
50
25
10
15
20
5

3
75
20
10

4
125
25
20

The selected decision alternative using a Maximax criterion is __________________ and the optimal
payoff is ___________.
5. Use the decision table from question 4. The selected decision alternative using a Maximin criterion is
_____________ and the payoff for this is ____________. Suppose Hurwicz criterion is used to select
a decision alternative and is .3. The selected decision alternative is ____________________ and the
payoff is ____________________. However, if is .8, the selected decision alternative is
____________________ and the payoff is ____________________.
6. Use the decision table from question 4 to construct an Opportunity Loss table. Using this table and a
Minimax Regret criterion, the selected decision alternative is _____________________ and the
minimum regret is _____________.
7. With decision trees, the decision alternatives are depicted by a ______________ node and the states
of nature are represented by a ________________ node.
8. The decision table presented in question 4 has been reproduced below with probabilities assigned to
the states of nature:

Decision
Alternative

1
2
3

State of Nature
1(.20) 2(.35) 3(.40) 4(.05)
50
25
75
125
10
15
20
25
20
5
10
20

The expected monetary value of selecting decision alternative 1 is _______________. The expected
monetary value of selecting decision alternative 2 is _______________. The expected monetary value
of selecting decision alternative 3 is _______________.

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9. An EMV'er would choose decision alternative __________ based on the results of question 8.
10. The expected value of perfect information for the decision scenario presented in question 8 is
___________________.
11. The degree of pleasure of displeasure a decision-maker has in being involved in the outcome
selection process given the risks and opportunities available is __________________.
12. If it takes more than the expected monetary value to get a player to withdraw from a game, then that
person is said to be a ________________.
13. Consider the decision table shown below:

Decision

1
2

State of Nature
X(.40) Y(.60)
200
500
50
800

The expected monetary value of this decision scenario is ___________________.

Suppose the decision maker has an opportunity to buy a forecast to assist him/her in making the
decision. When the state of nature is X, the forecaster will predict X 85% of the time and Y 15% of
the time. When the state of nature is Y, the forecaster will predict Y 95% of the time and will predict
X 5% of the time. If the forecast is purchased and the forecaster predicts that X will occur, then
revised probability of X occurring is ________________ and of Y occurring is _____________. If the
forecaster predicts that Y will occur, then the revised probability of X occurring is _____________
and of Y occurring is __________________. The probability that the forecaster will predict X is
_______________. The probability that the forecaster will predict Y is ______________. The
expected monetary value with information is _________________. The expected value of sample
information is _________________.

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ANSWERS TO STUDY QUESTIONS

1.

Certainty, Uncertainty, Risk

7.

2.

Decision Alternatives, States of

Nature, Payoffs

8.

17.5, 16.5, 0.75

9.

3.

States of Nature, Payoffs, Decision

Alternatives

10.

26

4.

1, 125

11.

Utility

5.

2, 10, 2, 14.5, 1, 90

12.

Risk-taker

6.

1, 60

13.

500, .9189, .0811, .0952, .9048, .37,

.63, .542.02, 42.02

SOLUTIONS TO ODD-NUMBERED PROBLEMS IN CHAPTER 19

19.1

s1
d1 250
d2 110
d3 390

s2
175
100
140

s3
Max Min
25
250 25
70
110
70
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.

Chapter 19: Decision Analysis

d.) The opportunity loss table is:

s1
d1 140
d2 280
d3
0

s2
0
75
35

s3
95
0
150

Max
140
280
150

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

Decision: Select d1 to minimize the regret.
19.3

R
A 60
B 10
C 10
D 20

D
15
25
40
25

I
25
30
15
5

Max
60
30
40
25

Min
25
10
10
5

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

Decision: Select A
Maximin = Max {25, 10, 10, 5} = 10
Decision: Select B
19.5, 19.6

95

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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

19.9

Down(.30)
150
175

Lock-In
No

Up(.65)
200
250

No Change(.05)
0
0

EMV
85
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
19.11 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.
19.13
S
M
L

Dec(.60)
225
125
350

Inc(.40)
425
150
400

EMV
35
15
50

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

For Forecast (Decrease):
Prior
Decrease .60
Increase .40

Cond. Joint
.75
.45
.15
.06
F(Dec) = .51

Revised
.8824
.1176

For Forecast (Increase):

Prior
Decrease .60
Increase .40

Cond. Joint
.25
.15
.85
.34
F(Inc) = .49

Revised
.3061
.6939

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The expected value with sampling is 244.275

EVSI = EVWS EMV = 244.275 50 = 194.275
19.15
Drill
Don't Drill

Oil(.11)
1,000,000
0

No Oil(.89)
100,000
0

EMV
21,000
0

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

The decision is to Drill.

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Oil

Actual
Oil
No Oil
.20
.10

No Oil

.80

Forecast
.90

Forecast Oil:
State
Oil
No Oil

Prior
.11
.89

Cond. Joint
.20
.022
.10
.089
P(FOil) = .111

Revised
.1982
.8018

Forecast No Oil:
State
Oil
No Oil

Prior
.11
.89

Cond.
Joint
.80
.088
.90
.801
P(FNo Oil) = .889

Revised
.0990
.9010

The Expected Value With Sampling Information is 21,012.32

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

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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
19.19
Small
Modest
Large

Small
200
100
300

Moderate
250
300
400

Large
300
600
2000

a.) Maximax: Max {300, 600, 2000} = 2000

Decision: Large Number
Minimax: Max {200, 100, 300} = 200
Decision: Small Number

Min
200
100
300

Max
300
600
2000

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b.) Opportunity Loss:

Small
Modest
Large

Small
0
100
500

Moderate
150
100
0

Large
1700
1400
0

Max
1700
1400
500

Min {1700, 1400, 500} = 500

Decision: Large Number
c.) Minimax regret criteria leads to the same decision as Maximax.
19.21
Reg.
Weekend
Not Open

Mild(.75)
2000
1200
300

Severe(.25)
2500
200
100

EMV
875
850
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

Chapter 19: Decision Analysis

19.23
Automate
Do Not

Red.(.15)
40,000
5,000

Con.(.35)
15,000
10,000

Inc.(.50)
60,000
30,000

Decision: Based on Max EMV =

Max {18750, 10750} = 18,750, Select Automate
Forecast Reduction:
State
R
C
I

Prior
.15
.35
.50

Cond. Joint
.60
.09
.10
.035
.05
.025
P(FRed) = .150

Revised
.60
.2333
.1667

Forecast Constant:
State
R
C
I

Prior
.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

101

EMV
18,750
10,750

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Expected Value With Sample Information = 21,425.55

EVSI = EVWSI EMV = 21,425.55 18,750 = 2,675.55

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