48 FOUNDATIONS 2.2.

his decision problem as if this adjusted value were the true value of his monetary
criterion and the difference in nonmonetary assets did not exist.
Generalizing from what we have said thus far, we conclude that the
decision maker can reduce the detailed description of his assets at any end posi-
tion to a single monetary value by the following procedure:
1 After the decision maker has determined the value of his monetary
criterion at a given end position, he selects some one difference between
the nonmonetary assets he will have at the given end position and the
base nonmonetary assets he will have at his base end position, and he
decides for how much cash he would be just willing to agree now to buy
or sell that difference if and when he arrives at the given end position.
This purchase or sale is of course to be thought of as being made in such a way
that it will have no effect on the price at which the decision maker will be able
to buy or sell other assets on or after his evaluation date.
2 The decision maker then «adjusts» the value of his monetary criterion
at the given end position by either subtracting from it the cash price
. -.. . ......... .., ..- ~. .. ... . .
that he_WQ!!t~ _be Just willing to agree now to pay for the d1fference m
nonmone~ry a·s;~ts oi- adding to it the cash price for which he would
be just willing to agree now to sell the difference in nonmonetary assets.
3 The decision maker then selects another difference in nonmonetary
assets between the given end position and the base end position and
repeats steps l and 2; and he continues in this way until the value of
his criterion at the given end position has been adjusted to reflect all
differences in nonmonetary assets between that position and the base
end position.
After this procedure has been carried out at every end position in a • 1

decision problem,
4 The decision maker can proceed to analyze his decision problem as if
(a) his monetary assets at each end position would in fact be equal to
the adjusted value of his criterion at that end position, and (b) his non-
monetary assets at every end position would ·in fact be identical to the
base nonmonetary assets that he will actually have at his base end
position.

What this really means is that, instead of analyzing his real decision problem, the
decision maker may solve that problem by analyzing a substitute decision problem
in which (J) the actual value of his monetary criterion at each end position is
equal to the "adjusted" value of the criterion at the corresponding end position
in the real decision problem, and (2) his actual nonmonetary assets are the same
at every end ,position as they are at the base end position in the real decision
problem. Because the total assets at each end position in the substitute problem
2.1 .7 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 49

are exactly as attractive to the decision maker as the total assets at the corre-
sponding end position in the real problem, the two problems are «equivalent»
in the sense that the decision maker should prefer the same acts in his real prob-
lem that analysis leads him to prefer in the substitute problem.

2.2.7
Salvage Value and Replacement Cost
In some situations, the cash price for which the decision maker would be just
willing to agree now to buy or sell a nonmonetary asset if and when he arrives
at a given end position on his evaluation date will be simply the price at which
he wil\ in fact buy or sell that asset or a similar asset shortly after his evaluation
date. When the value of an a~set at an end position is determined by the price
for which_that ~se! or a similar asset will actually be sold, we shall say that the
value_o( the asset_is ~u_al t; its «salvage value». When the value is determined
by the price at which the asset or a similar asset will actually be bought, we shall
say that the value of the asset is equal to its «replacement cost».

Salvage Value As an example of a situation where the value of an asset at an end

position is determined by its salvage value, suppose that any special tooling ac-
quired by A. H. Mallon to fill a quantity order from XYZ will be scrapped as
soon as the order has been filled. If Mallon believes that the scrap value of tool-
ing for production with all machined parts will be $2,000 net of removal costs,
then $2,000 must be the net price for which Mallon would be just willing to agree
to sell that tooling on his evaluation date. Because he can actually get $2,000
for the tooling a little after his evaluation date, he would be unwilling to agree to
sell it on his evaluation date for appreciably less than $2,000; because $2,000 is -
all he can actually get for the tooling, he would be happy rather than "just will-
ing" to agree to sell it for more than $2,000; his indifference point is .therefore
exactly $2,000.

Replacement Cost As an example of a situation in which the value of an asset

at an end position is determined by its replacement cost, suppose that a retailer
regularly stocks a nonperishable item which he buys from a wholesaler foi:.._$2
per unit and sells to his customers for ~ r unit; suppose that the retailer places
an order with the wholesaler at the close of each business week and receives
delivery before the beginning of the next business week; suppose that the moment
has now arrived when the retailer must decide how many units he should order
to meet the corning week's uncertain customer demand ; suppose that in analyzing
this decision problem he takes as his evaluation date the moment at which he
will place his next weekly order and chooses as his base end position the end
position following the act-event sequence "b~Q__'!!l!~.from ~ hol~l~r. sell 0
units to customers" ; and consider the end position following the sequence "buy
~-
15 units from wholesaler, sell 14 units to customers".
50 FOUNDATIONS 2.2.7

At this end position the retailer will have one more leftover unit than
he will have at his base end position, and since the unit is not perishable, we may
assume that it will in fact ultimately be sold for $5 to some real customer in the
regular course of the retailer's business. It would nevertheless be incorrect to
conclude that $5 is the value of this leftover unit to the retailer on his evaluation
date, since if the unit were suddenly_to disappear on that date he could replace
it at a cost of only $2 by simply adding one more unit to the next order that he
- ·-
places with the wholesaler. Because the retailer is thus exactly $2 better off on
his evaluation date with the leftover unit than he would be without it, $2 is the
proper value to assign to the leftover unit in valuing the retailer's total assets at
the end position at which the leftover unit appears.
Observe that $2 is the value that the retailer will assign to the unit if he
decides for how much cash he would be just willing to agree to sell the leftover
unit on his evaluation date on the assumption that the sale will have no effect
on the price at which he will be able to sell other assets after his evaluation date.
Because the retailer could and would replace the leftover unit for $2 if he did sell
it on his evaluation date, and because selling it on his evaluation date would not
affect his ability to sell other units for a profit in the regular course of business,
$2 is the price at which he would be just willing to agree now to sell the leftover
unit on his evaluation date.

2.2.8
Dependence of Asset Value
on Other Assets
Although it very frequently happens that the value of an asset at an end position
is equal either to its salvage value or to its replacement cost, it must not be
assumed that asset value will always be equal to one or the other of these two
market values. All th!ltcan be said in general is that salvage value establishes a
floor under asset value and replacement cost establishes a ceiling. The actual
-eruf:.positfon value of an asset must in general be established judgmentally, and in
general the value ofan asset at any given end position may depend very substantially
on the decision maker's other assets at that end position.
Consider, for example, the leftover special tooling that Mallon will have
at the end position following "stampings do not work", and suppose that al-
though this tooling would cost $16,000 to replace, its .net scrap value is only
$2,500. Although these two market prices establish a ceiling over and a floor
under the price for which Mallon would be just willing to agree now to sell the
tooling if and when he actually arrives at the end position in question, they do
not tell him where he should set his indifference price between these two limits.
If he will be desperately short of cash at the end position following "stampings
do not work", he may decide that he would in fact sell all of the tooling for scrap
as soon as the XYZ order had been filled, in which case the price for which he
would be just willing to agree now to sell it on his evaluation date would be
2.2.9 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 51

exactly equal to its $2,500 value as scrap. lf on the contrary he will have a large
amount of idle cash in the bank at the end position following "stampings do not
work", he may decide that he would retain the tooling for future use in his busi-
ness rather than sell it for a mere $2,500 cash, in which case the price for which
he would be just willing to agree to sell it might be, say, $7,500. If, as we assumed
in Chapter I, his cash position at the end position following "stampings do not
work" will be neither desperate nor really comfortable, he may decide that al-
though he would keep the tooling rather than sell it for $2,500, he would be
ready to agree to sell it for as little as $5,000.
Besides depending on the amount of cash that he will have on his evalua-
tion date, the value that Mallon assigns to leftover tooling at any end position
will depend on what he will be able to do with the tooling and thus on the whole
complex of tangible and intangible nonmonetary assets which he will have at
that end position. We conclude that:
■ In assigning monetary values to differences between his nonmonetary
assets at any given end position and his nonmonetary assets at his base
end position, the decision maker should imagine that he is already at
the given end position and is really in the process of buying and selling
asset differences for cash; and as he decides on his buying or selling price
for each successive difference he must be careful to keep in mind both
(l) the value of his monetary criterion as adjusted to reflect any "pur-
chases" or "sales" already made, and (2) his total nonmonetary assets,
again as adjusted to reflect any "purchases" or "sales" that have already
been made.
2.2.9
/Share of Market and Reported Income2
Our recommendation that the decision maker should value the end positions of
his decision diagram by first describing and then assigning monetary values to
the "assets" that he will have at these positions may seem at first glance to over-
look the fact that in many decision problems a businessman will feel that one of
the most important aspects of the consequence of any act-event sequence is its
effect o.n the share of ma.rket that he will have on his evaluation date and/ or the
net income that he will report for some particular accounting period. 3 But while
it is true that share of market and net income are not assets in the accounting
sense, they are very definitely assets in the sense in which we have used the wo~d
throughout our previous discussion. As we said at the outset, anything to which
the decision maker attaches value is to be counted as an asset in describing and
valuing end positions.
2 This section should be omitted on a first reading.
> We assume that the reader is familiar with at least some of the many reasons why the
amount by which an act-event sequence affects net income may oe quite di fferent from
the amount of the net cash flow to which the sequence gives rise.
 52 FOUN DA TIONS 2.2.9

What is more, no special problems arise when a decision maker sets out
to take account of "assets" like share of market or reported income by the
procedure we huvc described in previous sections. If, for exam ple, a company's
reported income at a given end position will be less thun it is at the base end
position. the decision maker can value this differcnce by deciding how much
cash he would be just willing to agree now to pay for the advantage to be gained
from reporting the same income at the given end position that he would report
at the base end position. In so doing he must, however, remember that what
he is buying for this price is only the advantage that he would gain from the
report, since the difference between the actual cash flows that result from going
to the two end positions is already reflected in the diffcrence between the un-
adjusted values of his monetary criterion at the two positions.

2.2.10
/ Nonmonetary Criteria 4
We have for some time now been occupied with various problems that can arise
when a decision maker tries to value the end positions of a decision diagram by
first calculating the actual value of some monetary criterion at each end position
of his diagram and then "adjusting" these values to take account of nonmonetary
consequences. We must remember, however, that there is no reason why the
values assigned to the end positions of a decision diagram must be monetary.
All that is really required is to find some way of replacing detailed descriptions
of consequences by meaningful numerical values, and in some problems the most
suitable values may well be nonmonetary.
Valuation of end positions by use of a monetary criterion will usually
work well when the f!!Onetary aspect is the most important aspect of most if not
all of the possible consequences in the decision problem at hand, and this will
be true of most of the problems that we shall encounter in the course of our study.
In some problems, b.o.we.Y..er, the decision maker may f~eL!.~at the most important
aspect of the consequence of each act-event sequence is some _!l_~nJl}onetary
asp~t---e.g., t ~~:_~ _o_f ?arrels of proved oil reserves that he will own as a
result of the sequence; and when this is true, he may fil}si it_extr.emely hard to
-deci~or how much cash h~ would_be just willing to agree now to buy or sell
very larg~-differencesb;tween his nonmonetary assets-at 'various end positions.
In such problems, the decision maker will usually do much better to
base his entire valuation procedure on the use of a nonmonetary criterion. In
the example just mentioned, the decision maker could select as his criterion the
total number of barrels of proved oil reserves that he owns. The first step in
the valuation procedure will then be to calculate the actual value of this non-
monetary criterion at each end position of the decision diagram; the second step
will be to adjust the value of the criterion for all differences in other assets, in-

4 This section should be omitted on a first reading.

2.3.1 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 53

eluding monetary assets, between the base end position and each other end
position of the decision diagram.

2.3
CERTAlNTY EQUIV ALENTS

Assume now that a decision maker has chosen a monetary criterion for valua-
tion of the end positions of his decision diagram, and assume that after calcu-
lating the actual terminal value of this criterion at each end position of the
diagram he has chosen a base end position and adjusted the terminal value of his
criterion at each other end position to allow for all differences between the non-
monetary assets he will have at that end position and the "base" nonmonetary
assets he will have at his base end position. As we said in Section 2.2.6, he is
now ready to solve his real decision problem by actually analyzing an equivalent
substitute decision problem in which (l) his monetary assets at each end position
are in fact equal to the "adjusted" value of his criterion at the corresponding
end position of his real problem, and (2) his nonmonetary assets at each end
position are in fact equal to the base nonmonetary assets that he will actually
have at the base end position of his real problem.
We have already suggested via the example of Chapter 1 how the deci-
sion maker can decompose this equivalent substitute problem and analyze it
systematically by assessing certainty equivalents for uncertain terminal values.
We shall now examine the concept of a certainty equivalent more closely, calling
attention to certain misunderstandings that frequently arise.

2.3.1
Definition of Certainty Equivalent
In order to define the expression "certainty equivalent" carefully, let us first
agree to use the expression «terminal fork» to denote a fork all of whose
branches lead directly to end positions of a decision diagram, and let us recall
once more that although a different terminal value of the decision maker's
criterion may be attached to each different end position of a terminal fork, his
nonmonetary assets at every end position of a diagram that is ready for analysis
will be exactly the same base nonmonetary assets that appear at the base end
position. We can then say that:
■ A.J,le_cision"fflakers «---certainty equivalent» for the uncertain terminal
value that ~gt,1~sl_!lt_ from t~e ga-; blt represe~ied "by a particular
temiinaijy_en_t_fo.r.k..is the guaranteed·_terminal value that he would be
jusFwilling to agree ~~".Y Jo accept in lie_°' of the .uncertain value if and
when·he actually_ar~ives at the b~se.~f t~e fork in question, it being un-
derstood that ·this guaranteed terminal value of his monetary criterion
will be acccrmpanied by exactly the same base nonmonetary assets that ac-
company the terminal criterion value associated to every end position
of the decision -diagram .
.• -----.... ·= 1 .- - ~...... "Cl'- 1',• ;:.~ . . , __ _
54 FOUNDATIONS 2.3.2

2.3.2
Certainty Equivalents and Nonmonetary Assets
In assessin~~-t~ioty equivalent for the uncertain terminal monetary value
that will result from a ga~ble, it js absolµ_tely essential to keep in mind the base
nofimonet!fry-assets that accompany all the monetary values being compared-
lhe-guarnnteechalue which is the certainty equivalent as well as the various
possible monetary values that may result from the gamble. It may seem at first
glance that because the nonmonetary assets that accompany any one of the
monetary values are exactly the same as those that accompany any other, these
nonmonetary assets could perfectly well be completely forgotten, but a-simple
example will suffice to show that this is by no means true.
Consider a decision maker named DJ.p.ont, whose decision diagram con-
tains a terminal event fork with two branches, one leading to terminal net liquid
assets of+ $100,000 while the other leads to terminal net liquid assets of+ $300,-
000; assume that Dupont feels that the two events represented by these branches
are equally likely; and consider two different suppositions concerning the base
nonmonetary assets that will accompany either the net liquid assets that result
from the gamble or the guaranteed net liquid assets that Dupont might agree to
accept as a certainty equivalent for the gamble.
1. If Dupont's nonmonetary assets are thoroughly adequate for the con- -
tinuing conduct of his business, he may well argue that he would not be in a very
difficult position even if he emerged from the gamble with net liquid assets of
only +$100,000 rather than +$300,000; and accordingly he may well decide
that he would insist on net liquid assets of at least $199,000 in exchange for the
gamble.
2. If on the contrary Dupont's uninsured plant has just burned down
and Dupont is desperately in need of $150,000 to rebuild it, he may well decide
that be would be ready to accept guaranteed net liquid assets of $150,000 or
possibly even a little less rather than run the risk of ending up with too little
cash to rebuild his plant. 1

_,,. .· , - 2.3.31 . . i (, ·
.,/ -~el'tii~ty Eqlrlvale,nts ;s!. Market Values . '.
----· !) \ t =- .,. L· .· :,
In some decision problems, it is possible actually to obtain soni.e definite terminal
value in lieu of the uncertain terminal value that will result from a gamble, and
at first glance it might seem that this ''market value" for the gamble should affect
the decision maker's certainty· equivalent. Actually, however, this notion rep-
resents a complete misunderst~nding of the meaning of a certainty equivalent,
as can be shown by another very simple example.
Consider a Mr, Durand: whose only possession is a lottery ticket which
will leave him with net liquid assets of+ $20 if a coin comes up heads when it is
tossed tomorrow, otherwise $0; and suppose that if he makes up his mind to
 -- - - .- - - --

55
SYSTEM ATIC ANALYSIS : BASIC PRINCIPLES
2.3.3 --
I
/ Gli)
G__®
1. '

,,-··/
CID
/, Terminol
'i-
Act \ L
Event volue

' FIGURE 1.6

·\ \ Mr. Durand's Decision Problem
( .

do ~o within th'e next hour, Durand can sell this ticket for a price which will
leave him with net liquid assets of +$9, so that he faces the decision problem
diagrammed in Figure 2.6. It is perfectly true that in his present position, at t~e
origin of Figure 2.6, Durand would be unwilling to sell his ticket for any pnce
that would leave him with less than the + $9 of net liquid assets that he can have
by accepting the offer for the ticket that he has actually received; but this by no
means implies that his certainty equivalent for the uncertain terminal value that.
will result from the gamble at position A in Figure 2.6 cannot be less than + $9.
This certainty equivalent is by definition the guaranteed terminal value he would
be just willing to agree now to accept if and when he actually arrives at position A,
where the existing offer is no longer available; and it is quite conceivable that
Durand would be quite willing to accept only +ss, say, in lieu of the gamble,
if by inadvertence he should allow the existing offer to expire and thus did in
fact arrive at position A.
In other words, whether or not Durand actually wants to choose the
act "hold ticket" and go to position A as a result is not a factor to be considered
when he assesses his certainty equivalent for the uncertain terminal value that
he will face i/he goes to position A. On the contrary, his choice of act is a con-
sequence of his assessment in the sense that he will actually go to position A
onl)' if his assessed certainty equivalent for the uncertain terminal value that
he will face there is at least as great a~ the definite terminal value he will obtain
by choosing the act "sell ticket".

X Assessment of Certainty F,quivalents vs. Valuation of Assets at End Positions The

· fact that a decision maker's certainty equivalent for the uncertain terminal value
represented by an event fork should not be affected by any definite terminal
value he can actually obtain in place of the uncertain value may seem inconsistent
with the assertion in Section 2.2.7 that the value a decision maker should assign
I
to an asset at an end position will often depend on the price for which he can
actually buy or sell that asset. In fact, however, these two assessment problems
are quite different, and no inconsistency exists.

\
56 FOUNDATIONS 2.3.3

Real opportunities for purchase or sale of an asset at an end position

must be considered in valuing such an asset because these opportunities will
actually be available to the decision maker when he reaches the end position in
question. Real opportunities to obtain a definite terminal value in lieu of the
uncertain terminal value represented by an event fork must be explicitly repre-
resented by an act fork on the decision diagram and therefore must not be con-
sidered in assessing a certainty equivalent for the event fork because they will no
longer be available when the decision maker reaches the base of the event fork .

2.3.4
Likings- for Consequences
and Judgments about Chances
We have already pointed out in Chapter l that there are two quite different kinds
of consideration to which a decision maker should pay attention in assessing
his certainty equivalent for the uncertain terminal value represented by any
given terminal event fork. They are:
-----...
t His relative degree o f ~ for each of the possible co~1gs de-
~

scribed by the various terminal values associated to the various oranches

of the fork.
2 The qg,'!._c! (as he sees it) of~ -QLth~ P?._~sib~~ e~:,'!.!,~_represented by
the various branches of the fork, some one of which will determine the
consequence that the decision maker actually enjoys.

In a later chapter we shall see how a decision maker can decompose a

problem of assessing a certainty equivalent and take account of each of these
two kinds of considerations separately. For the time being, however, we argue
only that even a decision maker who does not know how to decompose such an
assessme~t problem can reach a decision on a certainty equivalent that takes
account of both kinds of consideration simultaneously. Because he can decide
whether or not he prefers the uncertain termin_al value represented by any par-
ticular terminal event fork to any given guaranteed terminal value, he can decide
what is the smallest guaranteed terminal value that he would be willing to agree
now to accept if and when he actually faces the uncertain terminal value in
question.

2.3.S
"Estimates" vs. Decisions
Although a decision maker can always decide on some one, definite value as his
certainty equivalent for the uncertain terminal value represented by a given
terminal event fork, he will often fin.d it difficult to do so. Often he will feel that
he might just as well select any on~ value in some fairly wide range as any other;
 -- . . -- - -

2.4.l SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 57

and for this reason the reader may be tempted to think of the certainty equivalent
actually assessed by the decision maker as being a kind of "estimate" of his
"true" certainty equivalent and as being therefore subject to some kind of " range
of error".
Notions of this sort amount, however, to a complete misunderstanding
of the meaning of a certainty equivalent.
■ There exists no such thing as a "true though unknown" certainty equiv-
alent, and therefore there exists no such thing as an "estimate" of a
true certainty equivalent. A certainty equivalent is purely and simply
a decision ; and it follows that no matter how hard it may be for a deci-
sion m~ker to decide on one particular value among all possible values
for a given certainty equivalent, the value he decides on is to be thought
of as exact and accurate to an infinite number of decimal places.

A decision maker who must assess a certainty equivalent is really in

exactly the same kind of situation as a purchasing agent who must place an order
for a certain number of units of part XB-411 even though he does not know
exactly how many units he "should" order at this time. The purchasing agent
cannot conveniently get out of his difficulties by placing an order for "somewhere
between 200 and 300" units. If he does not decide that he will order exactly 250
units, say, he will have to. decide that he will order exactly some other number of
units ; and whatever number of units he decides to order, however unhappily,
that is the number his company will have to pay for and will have available for
use.

2.4
ANALYSIS BY EVALUATION
OF INDIVIDUAL ACTS ·

Now that we have carefully examined the concept of a certainty equivalent for
an uncertain terminal value, which lies at the heart of any method of decomposi-
tion and systematic analysis of a problem of decision under uncertainty, we are
ready to state the general rules for the method of analysis by «evaluation of
individual acts» that we applied to an example in Chapter 1.

2.4.1
Reduction of Terminal Event Forks
The definition in Section 2.3. I of a certainty equivalent for the uncertain terminal
.value represented by a terminal event fork implies that the position at the base
of any t.erminal event fork is exactly as attractive to the decision maker as it
would be if upon arriving at this position he would in fact obtain a definite
terminal value equal to his certainty equivalent for the uncertain terminal value
represented by the fork. Accordingly :
 58 FOUNDATIONS 2.4./

■ After the decision maker has assessed his certainty equivalent for the
uncertain terminal value represented by a terminal event fork, he may
analyze his decision problem as if the position at the hase of the fork
were an end position with a definite terminal value equal to his assessed
certainty equivalent and with the ~me base nonmonetary assets that
appear at all the other end positions of his diagram.

\\'hat this really means is that instead of analyzing his real decision
problem. the decision maker may sol\'e that problem by analyzing a substitutl'
decision problem in which the terminal event fork of the real prohlem is replaced
by an end position with definite, well defined total assets. Because these definite
total assets arc exactly as attractive to the decision maker as the gamble rep-
resented by the original terminal C\'Cnt fork. the two problems nrl' equivalent
in the sense that the decision maker should prefer the same acts in his real prob-
lem that analysis leads him to prefer in the substitute problem.
What we have hitherto described at length as " the decision maker's cer-
tai nty equivalent for the uncertain terminal value represented hy a terminal c,·ent
fork " can therefore be referred to nwrc si mply as the (definite) terminal \'alue that
the decision maker "assigns" to the position at the hase of the f0rk . Although we
shall sometimes refer to such a terminal value as a "certninty-cquivnlcnt terminal
value", we slrnll do so merely in order to remind the reader of the process hy
which the decision maker dl-cided on the value.' After the value has once been
decided 011, the decision maker should think of it as a perfectly ordinary terminal
value at a perfectly ordinary end position in a substitute decision prohlcm.

2.4.2
Reduction of Terminal Act Forks
When the decision maker has replaced all the terminal event forks on the original
diagram of his real decision problem by definite terminal values, he will find that
the resulting « reduced diagram» of an equivalent substitute decision problem
contains terminal act forks with definite terminal values attached to the ends of
their branches. .In the analysis of A. H. Mallon's XYZ decision problem, such
a n act fork first appeared at position X in Figure 1.6 (page IS).
If the decision maker ever actually-arrives at the base of any given act
fork in his decision diagram, he will of course select the act on that fork to which
he assigned the greatest terminal value in the course of his analysis. Accordingly:

■ The decision maker may analyze his decision problem as if the position
at the base of any terminal act fork were actually an end position with a
definite terminal value equal to the greatest of thl' terminal \'altll·s a~-
signed to the various branches of the for k and with the same hase n\,n-
monetary assets that appear ;1t all the other end positions 01' his dia-
gram.
 2.5 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 59

ln other words, the decision maker can solve the decision problem in
which the terminal act fork appears by analyzing a simpler equivalent problem
in which the act fork is replaced by an end position with definite, well defined
total assets.

2.4.3

I An'alysis by Evaluation
of Individual Acts
I From what we have said in Sections 2.4. l and 2.4.2, it follows that a decision
maker can analyze a problem by working backward on the decision diagram in
the way illustrated in Figure 1.9 on page 20.
1. The decision maker first selects some one terminal event fork on the
diagram, assigns a definite terminal value to the position at its base by assessing
his certainty equivalent for the uncertain terminal value represented by the fork ,
eliminates the fork from the diagram, and then repeats this procedure for other
terminal event forks until there are no terminal event forks left on the diagram.
2. If step l does not yield a definite terminal value for every immediate
act, the decision maker next selects some one of the terminal act forks that now
appear on his diagram, assigns to the position at its base the greatest terminal
value that appears at the end of any of its branches, eliminates the fork from
the diagram, and then repeats the procedure for other terminal act forks until
there are no terminal act forks left on the diagram.
3. The decision· maker then returns to step 1 and repeats the entire
procedure until it has resulted in assigning a definite terminal value to every
immediate act, after which he has only to select the immediate act with the
greatest terminal value.
As we said in Chapter 1, this method of analysis is called analysis by
"evaluation of individual acts" because it leads to assignment of a defirite value
to every act on every act fork in the decision diagram.

2.5
ANALYSIS BY EVALUATION,
OF COMPLETE STRATEGIES

When Mr. A. H. Mallon analyzed his problem of deciding whether or not to

build a prototype for XYZ, the conclusion that the immediate act "build proto-
type" was preferable to the immediate act "do not build" was not the only con-
clusion to which his analysis led. His analysis led also to th~ conclusion that if
his chosen immediate act were to be followed by the event ''XYZ orders" , then
the act "tool to stamp" should be chosen in preference to the act "tool to ma-
chine". In other words, Mallon's analysis led, not merely to choice of an im-
mediate act,but to choice ia complete cou, se ofaction or "strategy" for dealing
with the complete decision problem at hand.

L_
60 FOUNDATIONS 2.5

We shall now show how a decision problem can be analyzed, not by

systematically assigning values to individual acts on individual act forks, but by
first describing all the complete strategies that the decision maker wishes to
consider and then systematically assigning a value to each such strategy. We
do so, not because this new form of analysis is actually more convenient in cer-
tain special circumstances, as we shall see much later on, but because a decision
maker can often gain a clearer understanding of certain aspects of a problem
of decision under uncertainty by thinking in terms of strategies even though he
will actually analyze his problem by evaluation of individual acts.

2.5.1
Definition of Strategy
As we suggested above, a complete course of action for dealing with a problem
of decision under uncertainty is called a strategy. More specifically:
■ A « strategy» is a rule which prescribes exactly what act shall be chosen
meverysi'tuat1on-in wli1cb a choice may have to t>ct mad~.before the
evaluation date is reached.
The strategy that A. H. Mallon decided to adopt as a result of the analysis de-
scribed in Chapter l is defined by the rule:
■ Choose the act "build prototype", then if the event "XYZ orders"
occurs, choose the act "tool to stamp".

In more complex decision problems, a rule defining a strategy might consist of a

very long list of instructions specifying the act to be chosen if and when each
possible successive event becomes known to the decision maker.

2.5.2
Strategies Implicit
in a Decision Diagram
After a decision maker has constructed a diagram of his decision problem and
evaluated the consequence at each end position of his diagram, he can system-
atically extract from his diagram descriptions of all the possible strategies ·im-
plicit therein. The procedure by which he can do so can best be suggested by
showing how we could have described all the strategies implicit in the decision
diagram in Figure 1.5 (page 13) of Mr. A. tt:
Mallon's XYZ decision problem.
Starting with the act fork at the origin of Figure 1.5, we see that any
strategy must start by telling Mallon whether to choose the act "build prototype"
or the act "do not build". If the strategy prescribes _the latter act, it carries
Mallon down a path which leads to an end position of the diagram without re-
quiring any further choice of act, and therefore we have already defined one
complete strategy, namely :
STRATEGY I : Do not build prototype.
2.5.3 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 61

If, on the contrary, a strategy tells Mallon to start by choosing the act
"build prototype" on the initial act fork in Figure 1.5, then the event "XYZ
orders" may occur and carry him to a position where he must make a second
choice, between stampings and machinings; and therefore "build prototype"
does not by itself describe a well defined strategy or complete course of action.
There are in fact two different strategies both of which begin with this same act,
namely :
STRATEGY 11 : Build prototype and then :
if XYZ orders, tool to machine;
if XYZ does not order, stop.
STRATEGY Ill : Build prototype and then :
if XYZ orders, tool to stamp;
if XYZ does not order, stop.

Each of these two rules does define a complete strategy, because each of them
does prescribe all the choices that Mallon may have to make before reaching an
end position of Figure 1.5.
Generalizing from this example, we see that one of the strategies implicit
in any decision diagram can be defined by selecting one branch on the initial or
"first-level" act fork at the origin of the diagram, then selecting a branch on each
"second-level" act fork that can be reached from the selected branch on the
first-level fork, and continuing in this way until the decision maker can have no
further choices to make before reaching an end position of the diagram. All the
strategies that are implicit in the diagram can be defined by making all possible
sequences of choices on the act forks in the diagram.

Diagrams of Individual Strategies . At the same time that the strategies implicit
in the decision diagram are being identified, a separate diagram of each in-
dividual strategy can be cons~ructed. Separate diagrams of the three strategies
implicit in Figure 1.5 are shown in Figure 2.7 A; the reader should observe that:
■ Althou~h' the diagram of an individual strategy must contain event forks
showing· all the events that may occur if the strategy in question is fol-
lowed, it must not contain any act forks- instead, it must contain single
act branches showing what particular act is prescribed by the strategy
initially and as each successive event occurs.

2.5.3
Analysis by Evaluation of Complete Strategies
Once a ~trategy has been diagrammed, the decision maker can evaluate it by a
form of backward induction which is identical to the backward induction used
to analyze a complete decision diagram except that no choices of acts have to be
made.
62 FOUNDATIONS 2.5.3

A. Strotegies Implicit in Figure 1.5

Do not build
0 prototype
( + $ 6,000)

Tool to
( +$16,000)
mochine
Build
@ prototype 0 Stop
(+ $ 1,000 )

t'.. (+ $25,000)
Tool to stomp

Build
0 (+ $10,000)
prototype
Stop
(+ $ 1,000)
Terminal net
Act Event Act Event liquid assets

B. First Reduction of Strategy m

Tool to stomp
~------'-----(+$20,000)
Build
@
m ---'----'--<
prototype 0
____ :.;..:.::._ _ _ _ _ ( +$ 1,000)
S~p

C. Second Reduction of Strategy m

Build
--p-ro-to-ty_pe_-+---------------(+$ 9,000 )

FIGURE 2.7
Strategies in A.H. Manon's Decision Problem

Taking strategy III in Figure 2.7A as our first example, we start with
the terminal event fork at position Y in its diagram and ask Mallon to assess
his certainty equivalent for the uncertain terminal value represented by that
fork. Assuming as we did in Section l.2.2 that Mallon's certainty equivalent
is +$20,000, we can reduce the diagram of strategy III in Figure 2.7A to the
simpler form in Figure 2.7B, which shows that Mallon's assessment means that
strategy III is exactly as attractive to him as it would be if the act "tool to stamp"
were sure to lead to a terminal value of+ $20,000.
Next, we go to the !erminal event fork at _position Z in this simplified
diagram and ask Mallon to assess his certainty equivalent for the uncerfain
terminal value represented by this fork. Assuming as we did in Section 1.2.4
that Mallon's certainty equivalent is + $9,000, we can reduce Figure 2.78 t_o
 2.5.4 SYSTEM A TIC ANALYSIS : BASIC PRINCIPLES 63

Figure 2.7C; and we see that Mallon's two assessments have implied that
strategy III is exactly as attractive to him as it would be if it were sure to lead
to a +$9,000 terminal value. We can say that Mallon's certainty-equivalent
terminal value for strategy III is + $9,000.
Having obtained Mallon's certainty equivalent for the uncertain termi-
nal value that will result from strategy III in Figure 2.7, we next take strategy II
and ask Mallon to assess his certainty equivalent for the uncertain terminal value
represented by the terminal event fork at position Z in the diagram of that
strategy. This terminal event fork was not evaluated by Mallon in his earlier
analysis; we shall assume by way of example that Mallon now assigns it acer-
tainty-equivalent value of +$7,000.
The remainder of the analysis of Mallon's problem by «evaluation of
complete strategies» is purely mechanical. By Figure 2.7, strategy I is sure to
yield a terminal value of +$6,000; Mallon's assessments imply that strategies II
and III are exactly as attractive to him as they would be if they were sure to yield
terminal values of +$7,000 and +$9,000 respectively; and therefore strategy III
is the strategy that he should choose.

2,5.4
Equivalence of the Two Methods of Analysis
Most of the results of the analysis by evaluation of complete strategies that
we have just described agree exactly with the results of Mallon's earlier analysis

I
by evaluation of individual acts, which is summarized in Figure 1.9 on page 20.
Specifically, both analyses assigned the same + $6,000 value to strategy I, "do
not build prototype", and both analyses assigned the same + $9,000 value to
strategy III, "build prototype and then tool to stamp if XYZ orders". (Formally,
this latter value was assigned to the individual act "built prototype" in the
earlier analysis, but because it was not assigned until after Mallon h~d decided
that he would tool to stamp if XYZ ordered, we can equally well think of it as
the value assigned -by that analysis to the complete strategy "build prototype
and then tool to stamp if XYZ orders".)
Nor is this agreement between the results of the two analyses a mere
coincidence or a consequence of arbitrary assumptions. The values assigned
by the two analyses to strategies I and III had to agree because they were derived
in both cases from Mallon's evaluations of exactly the same end positions and
Mallon's certainty equivalents for exactly the same uncertain terminal values,
namely (1) the uncertain terminal value that he will face at position Yin Figure
1.9A and Figure 2.7A, and (2) the uncertain terminal value that he will face at
position Zin Figure l.9C and Figure 2.7B.
The one and only difference between the results of the two analyses re-
gards strategy II, which was assigned a value of +$7,000 when Mallon analyzed
his problem by evaluation of complete strategies but which was not evaluated at
all when he analyzed his problem by evaluation of individual acts.
 64 FOUND ATIO NS 2.5.4

This does not mean, however, that when Mallon analyzed his problem
by evaluation of complete strategies he was free to assign a higher value to
strategy II than he assigned to strategy III and thus to reach a different conclu-
sion by evaluation of complete strategies than he had reached by evaluation of
individual acts. If we compare the gamble involved in strategy II in Figure 2.7A
with the gamble involved in strategy Ill in Figure 2.7B, we see that whereas both
gambles will yield the same terminal value if XYZ does not order, the gamble in
strategy Ill will yield a higher terminal value if XYZ does order. It follows that
Mallon's assessments would have been logically inconsistent if in analyzing his
problem by evaluation of complete strategies he had assigned a greater terminal
value to strategy II than he assigned to strategy III.
Returning now to Figure 1.9, let us observe why it was that strategy II
was never assigned a definite terminal value when Mallon analyzed his problem
by evaluation of individual acts. The reason was simply that this complete •
strategy, which calls for "tool to machine" if XYZ orders, was eliminated from
the decision diagram as soon as Mallon assigned a higher value to the individual
act "tool to stamp" than he had assigned to the act "tool to machine". As a
result of this same valuation, however, Mallon became logically obliged to assign
a lower value to strategy II than he assigned to strategy III when he analyzed
his problem by evaluation of complete strategies, and what is true in this example
is true in general.
■ If all the certainty equivalents assessed by a decision maker in an analysis
by evaluation of complete strategies are logically consistent with the cer-
tainty equivalents he would assess in an analysis by evaluation of in-
dividual acts, the two methods of analysis will necessarily lead to choice
of exactly the same strategy and hence to choice of exactly the same
immediate act.
In a later chapter we shall describe indirect methods for assessing cer-
tainty equivalents which ensure that all of a decision maker's certainty equiva-
lents will in fact be logically consistent and at the same time greatly reduce th~
time and effort required to assess them. When certainty equivalents are assessed
by these indir-ect methods, analysis by evaluation of complete strategies and
analysis by evaluation of individual acts are not only logically equivalent in
principle but certain in fact to yiefd exactly the same results in any decision
problem. Which method should be used in any particular decision problem
then becomes a purely technical question of computational convenience that
the decision maker can delegate to a technical assistant.

2.5.5
Completeness of a Decision Diagram
When we stated the general rules for diagramming decision problems in Section
2.1.5, we said that a decision diagram must show, not only all the immediate acts
 2.6.2 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 65

among which the decision maker actually wishes to choose now, but also all un-
certain events and future acts that he wishes to consider because they may
directly or indirectly affect the consequences of his immediate act. Using the
concept of strategies, we can reexpress this "completeness" requirement some-
what more clearly.
t The decisioR diagram must show all strategies which the decision maker
wishes to consider. If it fails to do so, it may be said to be «structurally
incomplete».
2 The decision diagram must show all events which could materially affect
the value of the decision maker's criterion on his evaluation date. If it
fails to do so, it may be said to be « valuationally incomplete».

2.6
SUMMARY

2.6.1
Delimitation of a Decision Problem
When a decision maker must choose one among a number of possible immediate
acts, the ultimate consequences of some if not all of these acts will in general
depend on uncertain events and future acts extending indefinitely far into the
future. In principle, the decision maker would like to take systematic account
of the etfects of all these uncertain events and possible future acts, but since this
is impossible,
■ The decision maker must delimit his decision problem by selecting some
definite «evaluation date» beyond which it is not worthwhile in his
judgment to try to take account of the effects of specific acts and events.
He will describe his problem in terms of only those acts and events that
may be chosen by or become known to him before he reaches his evalua-
tion date, and he will evaluate the consequences of these acts and events
as they will appear to him directly upon reaching his evaluation date.

2.6.2
Decision Diagrams
After a decision problem has been delimited by a definite evaluation date, it can
be described by a «decision diagram».

1 A decision diagram consists of interconnected branches each of which

represents either an act which the decision maker may choose or an
. ~

event of which the decision maker may learn .

2 A choice among acts is represented by an act fork ; an uncertainty about

events is represented by an event fork. The events or acts on any one
 66 FOUNDATIONS
2.6.2

fork must be (I) mutually exclusive in the sense that no more than 0
?f them can possibly occur or be chosen, and (2) collectively exhausti~:
m the sense that some one of them must occur or be chosen.

3 The order in which act and event forks appear in a decision diagram
must be such that the path from the origin of the diagram to the base
of any act fork gives a correct representation of the information that
will and will not be available to the decision maker when he actually
has to make the choice represented by the act fork in question.
4 To be complete, a decision diagram must show (I) all the immediate
acts among which the decision maker wishes to choose, (2) all future
acts and uncertain events he wishes to consider because they may di-
rectly affect the consequences of the immediate acts, and (3) all uncer-
tain events that he wishes to consider because they may affect his future
choices among acts and thus indirectly affect the consequences of the
immediate acts.

For an alternative definition of completeness in terms of strategies, see paragraph

3 in Sec!ion 2.6.6 below.

2.6.3
Valuation of Consequences
After a decision diagram has been constructed, the decision maker must describe
the consequence of every act-event sequence in the diagram, but before proceed-
ing to the actual analysis of his problem he will usually do well to replace each
such description by a numerical value. In this book, the discussion of assigning
such values will be restricted to «short-term» decision problems where dates
are relevant only insofar as they affect the amount of interest actually paid or
received.
When consequences are wholly or primarily of a financial or monetary
nature, a decision maker can frequently assign values to them by proceeding as
follows :
1 The decision maker first selects that single measure of monetary assets
whose value best describes his general business position. This quantity
will be called his «criterion» for Vc!luation of consequences and its
value on his evaluation date will be called.its «terminal value».
Very frequently, a good choice for the criterion will_be «net liquid assets», de-
fined as cash on hand, plus all claims to receive cash-which will or could be real-
ized in the near future, minus all obligations to pay cash whi~h will or could be
enforced in the near future. ··
2 The decision maker next calculates the actual terminal v~lue o'. _his
criterion that will result from each act-event sequence on ht~ _dec1S1on
diagram and records this value at the corresponding end pos1t1on.
2.6.4 SYSTEMATIC ANALYSIS : BASIC PRINCIPLES 67

These terminal values will depend, not only on the cash flows associated with
acts and events that are directly connected with the decision problem at hand,
but also on the net «contextual» cash flow resulting from the decision maker's
..other business". Consequently any uncertainty that the decision maker may
have concerning the contextual flow must be explicitly represented in the decision
diagram.
3 After selecting a «base end position», the decision maker next writes
down opposite each other end position all differences between his non-
monetary assets at that position and the «base nonmonetary assets»
that he will have at the base end position.
4 Finally, the decision maker «adjusts» the value of his criterion at each
end position to reflect the value of these differences in nonmonetary
assets by deciding for how much cash he would be just willing to agree
now to buy or sell the differences if and when he arrives at the end posi-
tion in question.
s The decision maker can now solve his real decision problem by analyzing
an equivalent substitute decision problem in which (1) the actual value
of his criterion at each end position is equal to its adjusted value at the
corresponding end position of his real problem, and (2) his nonmonetary
assets are identical at every end position to those he will actually have at
the base end position of his real problem.
When consequences are wholly or primarily of a nonmonetary nature,
it may be better to use a measure of some nonmonetary asset as a criterion. See .
Section 2.2. IO.

2.6.4
Certainty Equivalents
and Equivalent Decision Problems
If the term «terminal fork» is used to denote any fork all of whose branches
terminate in end positions, then:
1 A decision maker's «certainty equivalent» for the uncertain terminal
value represented by a particular terminal event fork is the guaranteed
terminal value that he would be just willing to agree now to accept in
lieu of the uncertain terminal value if and when he arrives at the base
of the fork in question, it being understood that this guaranteed value
of the decision maker's criterion asset will be accompanied by exactly
the same base nonmonetary assets that are present at all end positions
of his decision diagram.
2 Because the position at the base of a terminal event fork is exactly as
attractive to the decision maker as it would be if it would actually yield
a definite terminal value equal to his assessed certainty equivalent, he
68 FOUNDATIONS 2.6.4

can solve the decision problem in which the fork appears by analyzing
a simpler substitute decision problem in which the position at the base
of the fork is treated as an end position with a definite terminal value
equal to his certainty equivalent.
Because every consequence in the substitute problem is exactly as attractive to
the decision maker as the corresponding consequence in the original problem,
the two problems are equivalent in the sense that the decision maker should
prefer the same acts in the original problem that analysis leads him to prefer in
the substitute problem.
3 Because on a terminal act fork the decision maker will choose the act
with the greatest terminal value, he can solve the decision problem in
which the fork appears by analyzing a simpler substitute decision prob-
lem in which the position at the base of the fork is treated as an end
position with a definite terminal value equal to the greatest terminal
value associated to any branch of the original fork.

Again, the original and the substitute problems are equivalent in the sense that
the decision maker should prefer the same acts in the original problem. that
analysis leads him to prefer in the substitute problem.

2.6.5
Analysis by Evaluation of Individual Acts
■ To analyze a decision problem by «evaluation of individual acts», the
decision maker works backward on the diagram of his decision problem,
alternately replacing terminal event forks and terminal act forks by
definite terminal values until all event forks have been eliminated and
he has assigned a definite terminal value to every act on the act fork
at the origin of the diagram.

2.6.6
Analysis by Evaluation
of Complete Strategies
1 A «strategy>> is a rule which prescribes exactly what act shall be
chosen in every situation in which a choice may have to be made before
the evaluation date is reached.
2 One of the strategies implicit in a decision diagram may be defined by
selecting a branch on the initial or first-level act fork at the origin of a
decision diagram, then selecting a branch on each second-level act fork
that can be reached from the selected branch on the first-level act fork,
and continuing in this way until the decision maker can have no further
choices to make before reaching an end position of the diagram. All
the strategies that are implicit in a decision diagram can be defined by
 2.E.1 SYSTEM ATIC ANALYSIS : BASIC PRINCIPLES 69

making all possible sequences of choices on the act forks in the complete
decision diagram.

3 To be complete, a decision diagram must show (1) all the strategies the
decision maker wishes to consider, and (2) all the events the decision
maker wishes to consider because they may affect the terminal value of
his criterion.

4 An individual strategy can be described by a diagram which resembles a

complete decision diagram except for the fact that it contains no act
forks. Instead, it contains single act branches representing the acts
prescri~ by the strategy.
5 To analyze a decision problem by «evaluation of complete strategies»,
the decision maker first constructs a separate diagram of each strategy.
He then evaluates each strategy by working backward on its diagram,
replacing terminal event forks by definite certainty-equivalent terminal
values until all forks have been eliminated and he has assigned a definite
terminal value to the strategy as a whole.
6 Provided that all the decision maker's certainty equivalents are logically
consistent, analysis by evaluation of complete strategies must lead to
choice of exactly the same strategy and hence the same immediate act
that would be chosen as a result of analysis by evaluation of individual
acts.

EXERCISFS

A. DECISION PROBLEMS AND DECISION DIAGRAMS

, / 2.1 In analyzing an investment opportunity he has recently been offered, Mr.

Robert Kent takes July 17, 1969, as his evaluation date and selects as his
criterion the sum of his cash and the market value of his ~r~[~,Y~~-
One
of the terminal event forks in his decision diagram is reproduced as Figure
2.8, which shows that if Kent reaches position A and event X then occurs,
the terminal value of his criterion will be + $100,000, whereas if event Y
occurs, the terminal value of his criterion will be only +$10,000.
As Kent tries to assess his certainty equivalent for the uncertain
terminal value at position A in Figure 2.8, he is unsure how to take account

/\~(+$100,000)

. v - ~ ( + $ 10,000 )

Terminal
Event value

FIGURE 2.8
Robert Kent's Decision Problem