Risk Analysis

Decision Making Under

Risk and Uncertainty
Decision Making Under Risk and Uncertainty

Examples???

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 Examples
◼ Manufacturer introducing a new product in the marketplace.
◼ Financial firm investing in stocks.
◼ Contractor bidding on a new contract.
◼ Oil company deciding to drill for oil in a particular location.

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 Examples
Pittsburgh Development Corporation (PDC) purchased land that will be the site of a new
luxury condominium complex. The location provides a spectacular view of downtown
Pittsburgh and the Golden Triangle where the Allegheny and Monongahela Rivers meet to
form the Ohio River. PDC plans to price the individual condominium units between
$300,000 and $1,400,000.

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 Examples
PDC commissioned preliminary architectural drawings for three different projects: one
with 30 condominiums, one with 60 condominiums, and one with 90 condominiums. The
financial success of the project depends upon the size of the condominium complex and the
chance event concerning the demand for the condominiums.
The statement of the PDC decision problem is to select the size of the new luxury
condominium project that will lead to the largest profit given the uncertainty concerning
the demand for the condominiums

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 Influence Diagram

Demand
Decision
Chance i) Strong (s1)
Consequence ii) Weak (s2)

Complex Size

i) Small (d1) Profit

ii) Medium (d2)
iii) Large (d3)

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 Payoff Table

States of Nature
Strong Demand Weak Demand

Small Complex 8 7
Decision Medium Complex 14 5
Alternatives Large Complex 20 -9

*Payoff in $ Million

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 Problem Formulation
◼ A decision problem is characterized by decision alternatives, states of nature, and
resulting payoffs.
◼ The decision alternatives are the different possible strategies the decision maker can
employ.
◼ The states of nature refer to future events, not under the control of the decision maker,
which may occur. States of nature should be defined so that they are mutually exclusive
and collectively exhaustive.

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 Example

Three decision alternatives, two states of nature

States of Nature
Strong Demand Weak Demand

Small Complex 8 7
Decision Medium Complex 14 5
Alternatives Large Complex 20 -9

*Payoff in $ Million

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 Payoff Tables
◼ The consequence resulting from a specific combination of a decision alternative and a
state of nature is a payoff.
◼ A table showing payoffs for all combinations of decision alternatives and states of nature
is a payoff table.
◼ Payoffs can be expressed in terms of profit, cost, time, distance or any other appropriate
measure.

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 Example

Payoff table representing profits (in $Million)

States of Nature
Strong Demand Weak Demand

Small Complex 8 7
Decision Medium Complex 14 5
Alternatives Large Complex 20 -9

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 Example

Payoff table representing profits (in $Million)

States of Nature
Strong Demand Weak Demand

Small Complex 8 7
Decision Medium Complex 14 5
Alternatives Large Complex 20 -9

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 Example

Payoff table representing profits (in $Million)

States of Nature
Strong Demand Weak Demand

Small Complex 8 7
Decision Medium Complex 14 5
Alternatives Large Complex 20 -9

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Decision Making Environment

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 Decision-Making Environments
 Decision making under uncertainty
 Complete uncertainty as to which state of nature may occur
 Decision making under risk
 Several states of nature may occur
 Each has a probability of occurring
 Decision making under certainty
 State of nature is known

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Decision Making under
Uncertainty

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 Decision Making under Uncertainty
◼ Three commonly used criteria for decision making when probability information
regarding the likelihood of the states of nature is unavailable are:
 the optimistic approach
 the conservative approach
 the minimax regret approach.

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 Optimistic Approach
◼ The optimistic approach would be used by an optimistic decision maker.
◼ The decision with the largest possible payoff is chosen.
◼ If the payoff table was in terms of costs, the decision with the lowest cost would be
chosen.

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 Example: Optimistic Approach
An optimistic decision maker would use the optimistic (maximax) approach. We choose
the decision that has the largest single value in the payoff table.

Maximum
Decision Payoff
Maximax Small (d1) 8 Maximax
decision Medium (d2) 14 payoff
Large (d3 ) 20

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 Conservative Approach
◼ The conservative approach would be used by a conservative decision maker.
◼ For each decision the minimum payoff is listed and then the decision corresponding to
the maximum of these minimum payoffs is selected. (Hence, the minimum possible
payoff is maximized.)
◼ If the payoff was in terms of costs, the maximum costs would be determined for each
decision and then the decision corresponding to the minimum of these maximum costs
is selected. (Hence, the maximum possible cost is minimized.)

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 Example: Conservative Approach
A conservative decision maker would use the conservative (maximin) approach. List the minimum
payoff for each decision. Choose the decision with the maximum of these minimum payoffs.

Minimum Maximin
Decision Payoff payoff
Maximin Small (d1) 7
decision Medium (d2) 5
Large (d3) -9

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 Minimax Regret Approach
◼ The minimax regret approach requires the construction of a regret table or an
opportunity loss table.
◼ This is done by calculating for each state of nature the difference between each payoff
and the largest payoff for that state of nature.
◼ Then, using this regret table, the maximum regret for each possible decision is listed.
◼ The decision chosen is the one corresponding to the minimum of the maximum regrets.

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 Example

Payoff table representing profits (in $Million)

States of Nature
Strong Demand Weak Demand

Small Complex 8 7
Decision Medium Complex 14 5
Alternatives Large Complex 20 -9

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 Example: Minimax Regret Approach
For the minimax regret approach, first compute a regret table by subtracting each payoff
in a column from the largest payoff in that column. In this example, in the first column
subtract 8, 14, and 20 from 20; etc.

The resulting regret table is:

s1 s2 s3 States of Nature
Strong Demand Weak Demand
d1 0 1 1
d2 4 Small
2 Complex
0 12 0
Decision
d3 Medium
3 0 Complex
2 6 2
Large Complex 0 16

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 Example: Minimax Regret Approach
For each decision list the maximum regret.
Choose the decision with the minimum of these values.

Maximum
Decision Regret
Small (d1) 12
Medium (d2) 6
Minimax Large (d3) 16 Minimax
decision regret

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 Summary

Approach Decision
Optimistic Large Complex (d1)
Conservative Small Complex (d2)
Minimax Regret Medium Complex (d3)

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Decision Making under Risk

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 Decision Making with Probabilities
◼ Expected Value Approach
 Ifprobabilistic information regarding the states of nature is available, one may use the
expected value (EV) approach.
 Here the expected return for each decision is calculated by summing the products of
the payoff under each state of nature and the probability of the respective state of
nature occurring.
 The decision yielding the best expected return is chosen.

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 Payoffs (in $M)
8

2
7

14
Medium (d2)
1 3
5

20
4
-9

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 Expected Value for Each Decision

EV = .8(8) + .2(7)
2 = $7.8

Medium (d2)
1 3 EV = .8(14) + .2(5)
= $12.2

4 EV = .8(20) + .2(-9)
= $14.2

Choose the alternative with largest EV, Large Complex

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 Payoffs (in $M)
8

2
7

14
Medium (d2)
1 3
5

20
4
-9

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 Expected Value for Each Decision

EV = .2(8) + .8(7)
2 = $7.2

Medium (d2)
1 3 EV = .2(14) + .8(5)
= $6.8

4 EV = .2(20) + .8(-9)
= - $3.2

Choose the alternative with largest EV, Small Complex

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 Expected Value of a Decision Alternative
◼ The expected value of a decision alternative is the sum of weighted payoffs for the
decision alternative.
◼ The expected value (EV) of decision alternative di is defined as:

N
EV( d i ) =  P( s j )Vij
j =1

where: N = the number of states of nature

P(sj ) = the probability of state of nature sj
Vij = the payoff corresponding to decision alternative di and state of nature sj

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Expected Value of Sample Information

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 Prior Probabilities
Status of Nature Prior Probabilities
Sj P(Sj)
Strong Demand (S1) 0.8
Weak Demand (S2) 0.2

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 Sample Information
Status of Nature Market Research
Sj
Favourable (F) Unfavourable (U)
Strong Demand (S1) P(F|S1)=0.90 P(U|S1)=0.10
Weak Demand (S2) P(F|S2)=0.25 P(U|S2)=0.75

PDC must decide whether or not to purchase a marketing survey from Stanton Marketing for $0.25M.

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 Computing Posterior Probabilities
Status of Nature Prior Conditional Joint Posterior
Sj Probabilities Probabilities Probabilities Probabilities
P(Sj) P(F|Sj) P(F∩Sj) P(Sj|F)
Strong Demand (S1) 0.8 0.90 0.72 0.94
Weak Demand (S2) 0.2 0.25 0.05 0.06
1.0 P(F)=0.77 1.00

Note: Using Baye’s theorem

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 Computing Posterior Probabilities
Status of Nature Prior Conditional Joint Posterior
Sj Probabilities Probabilities Probabilities Probabilities
P(Sj) P(U|Sj) P(U∩Sj) P(Sj|U)
Strong Demand (S1) 0.8 0.10 0.08 0.35
Weak Demand (S2) 0.2 0.75 0.15 0.65
1.0 P(U)=0.23 1.00

Note: Using Baye’s theorem

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 Sample Information
PDC must decide whether or not to purchase a marketing survey from Stanton Marketing for
$0.25M. The results of the survey are "favorable" or "unfavorable". The conditional probabilities
are:

P(Favorable Report) = 0.77

P(Unfavorable Report) = 0.23
P(Strong Demand | Favorable Report) = 0.94
P(Weak Demand | Favorable Report) = 0.06
P(Strong Demand | Unfavorable Report) = 0.35
P(Weak Demand | Unfavorable Report) = 0.65

Should PDC have the survey performed by Stanton Marketing?

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 Influence Diagram

Demand
Decision
Chance i) Strong (S1)
Consequence ii) Weak (S2)

Complex Size

i) Small (d1) Profit

ii) Medium (d2)
iii) Large (d3)

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 Influence Diagram

Market Survey Demand

Decision Results
Chance i) Favorable (f1) i) Strong (S1)
ii) Unfavorable (f2) ii) Weak (S2)
Consequence

Complex Size
Market Survey
i) Small (d1) Profit
i) Yes ii) Medium (d2)
ii) No iii) Large (d3)

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 Payoffs (in $M)
8

2
7

14
Medium (d2)
1 3
5

20
4
-9

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 s1
d1 6 s2
d2 s1
7
3 s2
d3
s1
8
s2
s1
2 9
d1 s2
s1
d2 10
4 s2
d3 s1
11
1 s2
s1
d1 12 s2
d2 s1
13
5 s2
d3
s1
14
s2
 s1 (.94) $8M
d1 6 s2 (.06) $7M
d2 s1 (.94) $14M
7
3 s2 (.06) $5M
d3
s1 (.94) $20M
8
s2 (.06) $-9M
s1 (.35) $8M
2 9
d1 s2 (.65) $7M
s1 (.35) $14M
d2 10 $5M
4 s2 (.65)
d3 s1 (.35) $20M
11 $-9M
1 s2 (.65)
s1 (.80) $8M
d1 12 s2 (.20) $7M
d2 s1 (.80) $14M
13
5 s2 (.20) $5M
d3
s1 (.80) $20M
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s2 (.20) $-9M
 EV = 0.94(8) + 0.06(7)
d1 6 = $7.94M
d2 7
EV = 0.94(14) + 0.06(5)
3 = $13.46M
d3
EV = 0.94(20) + 0.06(-9)
8
= $18.26M

2 9
EV = 0.35(8) + 0.65(7)
d1 = $7.35M
d2 10 EV = 0.35(14) + 0.65(5)
4 = $8.15M
d3
11 EV = 0.35(20) + 0.65(-9)
1 = $1.15M

12 EV = 0.80(8) + 0.20(7)
d1 = $7.80M
d2 13 EV = 0.80(14) + 0.20(5)
5
d3 = $12.20M
14 EV = 0.80(20) + 0.20(-9)
= $14.20M
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 3 EV = $18.26M

4 EV = $8.15M

5 EV = $14.20M

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 EV = 0.77(18.26) + 0.23(8.15)
2 = $15.93M

5 EV = $14.20M

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 Answer

Hence, going for market survey is recommended as the expected payoff increases by
(15.93 – 14.20) = $1.73M > $0.25M

$1.73M is the expected value of sample information (EVSI).

The expected value of sample information (EVSI) is the additional expected profit
possible through knowledge of the sample or survey information.
 Expected Value of Sample Information
◼ EVSI Calculation
 Step 1:
Determine the optimal decision and its expected return for the possible outcomes
of the sample using the posterior probabilities for the states of nature.
 Step 2:
Compute the expected value of these optimal returns.
 Step 3:
Subtract the EV of the optimal decision obtained without using the sample
information from the amount determined in step (2).

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 Decision Tree
◼ A decision tree is a chronological representation of the decision problem.
◼ Each decision tree has two types of nodes; round nodes correspond to the states of
nature while square nodes correspond to the decision alternatives.
◼ The branches leaving each round node represent the different states of nature while the
branches leaving each square node represent the different decision alternatives.
◼ At the end of each limb of a tree are the payoffs attained from the series of branches
making up that limb.

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