DECISIONANALYSIS

(Hillier&LiebermanIntroductiontoOperationsResearch,8th edition)
 Introduction

Decisionoftenmustbemadeinuncertainenvironments
f b d
Examples:
Manufacturerintroducinganewproductinthemarketplace.
Governmentcontractorbiddingonanewcontract.
Oilcompanydecidingtodrillforoilinaparticularlocation.
Decisionanalysis:decisionmakinginfaceofgreat
uncertainty;rationaldecisionwhentheoutcomesare
uncertain.
Makingdecisionswith orwithoutexperimentation.

Optimization and Decision 2009 530

 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
Chanceofstatus 1in4 3in4

Optimization and Decision 2009 531

 Decisionmakingwithoutexperimentation
g p

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

But,arebothplayersstillrational?

Optimization and Decision 2009 532

 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
Optimization and Decision 2009 533
 PayofftableforGoferbrokeCo.problem
y p

Stateofnature
Alternative Oil Dry
1 Drillforoil
1.Drillforoil 700 100
100
2.Selltheland 90 90
Priorprobability 0.25 0.75

Optimization and Decision 2009 534

 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 90 Maximinvalue
Priorprobability 0.25 0.75

Optimization and Decision 2009 535

 Maximumlikelihoodcriterion
Maximumlikelihood criterion: Identifymostlikely
stateofnature(withlargestpriorprobability).For
thisstateofnature,findtheactionwithmaximum
payoff.Choosethisaction.
Mostlikelyy state:ignoresimportantinformationand
g p
lowprobabilitybigpayoff.
Stateofnature
Alternative Oil Dry
1.Drillforoil 700 100
2.Selltheland 90 90 Maximuminthiscolumn
Priorprobability 0.25 0.75

Optimization and Decision 2009 Mostlikely 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?
OptimizationandDecision2009 537
 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)]
800p 100
100=90
90 p =0.2375
0.2375
Optimization and Decision 2009 538
 Expectedpayoffforalternativechanges
p p y g

Andformore
than2variables?
UseExcelSensIt.

Thedecisionis
verysensitive
top!

Optimization and Decision 2009 539

 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.

Optimization and Decision 2009 540

 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)
, , , , whatisP(State=statei
fori=1,2,,n, ( g j)?
||Finding=finding
g
Optimization and Decision 2009 541
 Posteriorprobabilities
p

Fromprobabilitytheory,theBayestheorem canbe
obtained:

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

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

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

k =1

Optimization and Decision 2009 542

 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):
0.6(0.25) 1
P(State=Oil|Finding=FSS) = = ,
0.6(0.25) + 0.2(0.75) 2
1 1
P(State=Dry|Finding=FSS) = 1 = .
2 2
Optimization and Decision 2009 543
 Probabilitytreediagram
y g

Optimization and Decision 2009 544

 Expectedpayoffs
p p y
ExpectedpayoffscanbefoundagainusingBayes
decisionrulefortheprototypeexample,with
posteriorprobabilitiesreplacing priorprobabilities:
ExpectedpayoffsiffindingisUSS:
1 6
y ( | g ) = (700)
E[[Payoff(drill|Finding=USS) (7 ) + (100)) 30 = 155.77
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)
) + (90)) 330 = 60
(9
2 2
Optimization and Decision 2009 545
 Optimalpolicy
p p y

UsingBayesdecisionrule,theoptimalpolicyof
optimizingpayoffisgivenby:

Expectedpayoff Expectedpayoff
Findingfrom Optimal
excludingcostof includingcostof
seismicsurvey alternative
survey survey
USS Selltheland
Se t e a d 90 60
FSS Drillforoil 300 270

Isitworthspending30.000 toconduct
p
theexperimentation?
Optimization and Decision 2009 546
 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.

Optimization and Decision 2009 547

 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.

Optimization and Decision 2009 548

 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.
Optimization and Decision 2009 549
 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.

Optimization and Decision 2009 550

 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.
Optimization and Decision 2009 551
 Decisiontreeforprototypeexample
p yp p

Optimization and Decision 2009 552

 Decisiontreewithprobabilities
p

probability

cash flow

Optimization and Decision 2009 553

 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
Optimization and Decision 2009 554
 Decisiontreewithanalysis
y

Optimization and Decision 2009 555

 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.
Optimization and Decision 2009 556
 Utilitytheory
y y

Youareofferedthechoiceof:

1. Acceptinga50:50chanceofwinning$100.000
ornothing;
2. Receiving$40.000withcertainty.

Whatdoyouchoose?

Optimization and Decision 2009 557

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

Optimization and Decision 2009 558

 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.)
OptimizationandDecision2009 559
 Utilitytheory
y y

Fundamentalproperty:thedecisionmakersutility
Fundamentalproperty:thedecisionmaker sutility
functionformoney hasthepropertythatthedecision
makerisindifferent
ff betweentwoalternativecourses
ofactioniftheyhavethesameexpectedutility.
Example.p Offer: anopportunitytoobtaineither
pp y
$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).
Optimization and Decision 2009 560
 Roleofutilitytheory
y y

Whendecisionmakersutilityfunctionformoneyis
usedtomeasurerelativeworthofvariouspossible
monetaryoutcomes,Bayesdecisionrulereplaces
monetarypayoffsbycorrespondingutilities.
Thus,optimalaction istheonethatmaximizesthe
expectedutility.

Notethatutilityfunctionsmaynotbemonetary.
Example:doctorsdecisionoftreatingornotapatient
involvesfuturehealthofthepatient.

Optimization and Decision 2009 561

 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
Optimization and Decision 2009 562
 UtilityfunctionforGoferborkeCo.
y

Optimization and Decision 2009 563

 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.

Optimization and Decision 2009 564

 Decisiontreewithutilityfunction
y

Thesolutionisexactlythesameasbefore,except for
substitutingutilities formonetarypayoffs.
Thus,thevalueobtainedtoevaluateeachforkofthe
treeisnowtheexpectedutilityy ratherthanthe
expectedmonetarypayoff.
OptimaldecisionsselectedbyBayesdecisionrule
Opt a dec s o s se ected by ayes dec s o u e
maximizetheexpectedutilityfortheoverallproblem.

Optimization and Decision 2009 565

 Decisiontreeusingutilityfunction
g y

Different decision tree

but same optimal
policy.

Optimization and Decision 2009 566