Probability and Decision

Analysis

Structuring Decisions

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This chapter will cover
• Clarity Test
• Expected Monetary Value
• Risk Profiles
• Dominance

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Clarity test
• The decision problem should be specified clearly
enough so that the various people involved in the
decision are thinking about the decision elements
in exactly the same way.
• There should be no misunderstandings regarding
the definitions of the basic decision elements:
– Decisions
– Uncertain events and their consequences
– Objectives
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Example
• The exposure rate to a toxin is “high”.
– The above example does not pass the clarity test because
“high” is ambiguous.

• The exposure rate to a toxin is high, that is when the

average skin contact per person-day of use exceeds an
average 10 mg of material per second over 10
consecutive minutes.
– This definition removes ambiguity.
– A clairvoyant who can measure the above aspects can
definitely determine if the exposure rate is high or not.

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Probabilistic methods
• At times, states of nature can be assigned probabilities
that represent their likelihood of occurrence.
• For decision problems that occur more than once, we can
often estimate these probabilities from historical data.
• Other decision problems represent one-time decisions
where historical data for estimating probabilities don’t
exist.
– In these cases, subjective probabilities are often assigned based
on interviews with one or more domain experts.
– Interviewing techniques exist for soliciting probability estimates
that are reasonably accurate and free of the unconscious biases
that may impact an expert’s opinions.

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Expected Monetary Value
• Selects alternative with the largest expected
monetary value (EMV)

EMVi   rij p j
j
𝑟𝑖𝑗 : payoff for alternative 𝑖 under the 𝑗th state of nature
𝑝𝑗 : probability of the 𝑗th state of nature

• EMVi is the average payoff we would receive if we

faced the same decision problem numerous times
and always selected alternative i.
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Example

Airport is Built at
Land Purchased Location
at Location(s) A B EMV
A $13 ($12) ($2.0)
B wins B ($8) $11 $3.4
A&B $5 ($1) $1.4
None $0 $0 $0.0

Probability 0.4 0.6

Check EMV.xlsx 7
Decision trees and EMV
• Decision trees: diagram representing
alternatives as branches (lines) connected by
– Chance nodes
– Decision nodes
• Expected monetary value (EMV)
– Include monetary outcomes of alternatives
– Include probability of each outcome

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Folding back the tree
• “Folding back the tree” – method for finding
EMVs using decision trees
– Start at the endpoints of the branches on the far
right-hand side and move to the left:
1. Calculate expected values when a chance node is
encountered.
2. Choose the branch with the highest value or
expected value when a decision node is
encountered.
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A decision tree for Magnolia Inns
Land Purchase Decision Airport Location Payoff

A 31 13
Buy A
1
-18 B 6 -12
A 4 -8
Buy B
2
-12 B 23 11
0
A 35 5
Buy A&B
3
-30
B 29 -1
A 0 0
Buy nothing
4
0 B 0 0 10
 Folding back the decision tree
Land Purchase Decision Airport Location Payoff
0.4
A 31 13
Buy A
EMV=-2
1
-18 6
B 0.6 -12
0.4
A 4 -8
Buy B
2
-12 EMV=3.4 23
B 0.6 11
0 0.4
A 35 5
EMV=3.4 Buy A&B
EMV=1.4
3
-30
B 29
0.6 -1
0.4
A 0 0
Buy nothing
EMV= 0
4
0 B 0
0.6 0 11
Multi-stage decision problems
• Many problems involve a series of decisions.
• Example:
– Should you go out to dinner tonight?
– If so,
• Who will you go with?
• Where will you go?
• How much will you spend?
• How will you get there?
• Multistage decisions can be analyzed using
decision trees.
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Example – COM-TECH
• COM-TECH is considering whether to apply for a $85,000 research
grant for using wireless comms technology to enhance safety in the
coal industry.
• COM-TECH would spend approximately $5,000 preparing the grant
proposal and estimates a 50-50 chance of receiving the grant.
• If awarded the grant, COM-TECH would need to decide which of
three communications technologies to use.
• COM-TECH would need to acquire some new equipment depending
on which technology is used:

Technology Equipment Cost

Microwave $4,000
Cellular $5,000
Infrared $4,000
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Example – COM-TECH (continued)
• COM-TECH knows it will also spend money in R&D, but it doesn’t
know exactly what the R&D costs will be. COM-TECH estimates the
following best case and worst-case R&D costs and probabilities,
based on its expertise in each area.
Best Case Worst Case
Cost Prob. Cost Prob.
Microwave $30,000 0.4 $60,000 0.6
Cellular $40,000 0.8 $70,000 0.2
Infrared $40,000 0.9 $80,000 0.1
• COM-TECH needs to synthesize all the factors in this problem to
decide whether or not to submit a grant proposal.

Check forward_pass.xlsx and backward_pass.xlsx 14

EMV caution
• The EMV rule should be used with caution in
one-time decision problems.
• It ignores risk!

State of Nature
Decision 1 2 EMV
A 15,000 -5,000 5,000 ←maximum
B 5,000 4,000 4,500
Probability 0.5 0.5

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Risk profiles
• EMV does not tell the whole story.
– Amount of variation in the consequences
– Set of possible consequences for each alternative
– Probabilities of possible outcomes
• Risk profiles help fill these gaps.
• Risk profiles are an alternative to EMV.

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Example – Texaco vs. Pennzoil
• In 1984 Pennzoil and Getty Oil entered into a merger agreement whereby
Pennzoil would acquire Getty. Pennzoil and Getty signed a Memorandum
of Agreement subject to the approval of each board and issued a press
release.
• Texaco made an alternative offer to Getty’s board. Getty repudiated its
agreement with Pennzoil and accepted Texaco’s offer.
• Pennzoil immediately sued Texaco, alleging Texaco had illegally interfered
in the negotiations. Pennzoil won the case in 1985 and was awarded $11.1
billion, the largest judgment ever in the U.S. at the time(reduced to 10.3).
• Texaco said they would appeal the case to the Supreme Court, and would
file for bankruptcy if forced to pay.
• In April 1987, just before Pennzoil began to file liens against Texaco's
assets, Texaco offered to pay Pennzoil $2 billion to settle the entire case.
Pennzoil wanted between $3 and $5 billion. What should Pennzoil do?
Take the $2 billion and run? Or try for $5 billion? 17
Influence diagram

Accept or
Counteroffer

Respond to
Texaco’s response

Check Pennzoil_ID.xlsx
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Decision tree Check Pennzoil_DT.xlsx

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Risk profiles
• An alternative’s or strategy’s risk profile:
– EMV summarizes each alternative into a single
number.
– Risk profiles graphically display the range of possible
results.
• Convey more of the complexity of the alternative
– Consequence values together with their associated
probabilities give a complete picture of what could
happen when we choose an alternative or strategy.
– The graph of the consequence values along the x axis
and their associated probabilities along the y axis
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Constructing a risk profile
1. Eliminate intermediate decision nodes by
keeping only the best decision path for each.
2. Collapse out a decision tree by multiplying
out the probabilities on sequential chance
branches.
3. Keep track of the different outcomes and
probabilities while adopting an approach
similar to folding back the tree.

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Example – Step 1

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 Example – Step 2
The three chance nodes have been collapsed into one chance node. The probabilities on
the branches are the product of the probabilities from sequential branches in Step 1.

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Example – Step 3
The seven branches from the chance node in Step 2 have
been combined into three branches.

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The resulting risk profiles

Probabilities for Decision Tree 'Penzoil Decision Tree'

Choice Comparison for Node 'Accept or Counteroffer'
100%

80%

60%
Probability

Accept $2 Billion
40%
Counteroffer $5 Billion

20%

0%
-2

10

12
8
0

Payoff ($B)
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The resulting risk profiles (cumulative)
Cumulative Probabilities for Decision Tree 'Penzoil Decision Tree'
Choice Comparison for Node 'Accept or Counteroffer'
100%

80%
Cumulative Probability

60%

Accept $2 Billion
40%
Counteroffer $5 Billion

20%

0%
-2

10

12
0

Payoff ($B)

Cumulative probability represents the probability of the payoff being less than
or equal to x.
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Dominance
• A way to determine if one strategy is head-and-
shoulders better than other strategies.
• Construct cumulative risk profiles for the
competing strategies.
– Best done with continuous risk profiles (more in Ch. 8)
• If the cumulative risk profile of strategy A is “to
the right” of that of strategy B (assuming higher
desired payoff), then A is said to dominate B.

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Example

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Example

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Example

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Example

A
Strategy A
dominates
Strategy B

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Example

No
dominance

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Varying degrees of dominance
• Stochastic or probability dominance: when
considering all the possible events and the
probability of their occurrence, one alternative is
always at least as good and at times it is better.

• Deterministic dominance: occurs when the

maximum payout of one alternative is less than
the minimum payout of another alternative.
– Stronger than stochastic dominance
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Decisions with multiple objectives:
example
The Summer Job
• Sam Chu was in a quandary. With two job offers in hand, the choice he should
make was far from obvious. The first alternative was a job as an assistant at a local
small business; the job would pay a bit above minimum wage ($9.25 per hour), it
would require 30 to 40 hours per week, and the hours would be primarily during
the week, leaving the weekends free. The job would last for three months (13
weeks), but the exact amount of work, and hence the amount Sam could earn,
was uncertain. However, the free weekends could be spent with friends.
• The second alternative was to work as a member of a trail-maintenance crew for a
conservation organization. This job would require 10 weeks of hard work, 40
hours per week at $11.45 per hour, in a national forest in a neighboring state. The
job would involve extensive camping and backpacking. Members of the
maintenance crew would come from a large geographic area and spend the entire
10 weeks together, including weekends. Although Sam had no doubt about the
earnings this job would provide, the real uncertainty was what the staff and other
members of the crew would be like. Would new friendships develop? The nature
of the crew and the leaders could make for 10 weeks of a wonderful time, 10
weeks of misery, or anything in between.

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What are the objectives that Sam
cares about?
• Money
– Has a natural scale.
• Fun
– Does not have a natural scale.
– We need to create a scale for it.

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Let’s represent the relationships using
an influence diagram.

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 Let’s then draw the decision tree.

This tree shows

Sam’s beliefs (scale)
about fun and
translates
uncertainties into
probabilities.

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Let’s check the EMV/risk profiles for
each objective at a time.

EMV: $4,580 EMV: $4,269

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Quantifying “fun”
• To continue, we must create subjective but
quantitative ratings for Sam’s beliefs
concerning fun.
– Need to convert earlier scale of fun levels into
meaningful numerical measurements
– Purely subjective – will vary by individual
– Best scale for ratings is 0 – 100
– Once put on the new numeric scale, it is possible
to compare “how much” fun there is in the two
jobs.
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Understanding tradeoffs

Put money on same

scale as fun (0 -100) and
assign decision weights
to show relative
importance of money
and fun. Create a
decision tree with the
ratings to show trade-
offs involved.

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 Calculating a single overall score

Subjectively determine
weights of fun compared to
salary. Use these to calculate
to calculate overall utility
scores for the various options
and show as decision tree.

Sam gives a weight of 60% to

Salary and a weight to 40% to
Fun then computes the
overall score.

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Calculating the risk profiles/EMV for
the overall score

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Calculating the risk profiles/EMV for
the overall score (cumulative)

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 Checking for dominance

Forest Job stochastically

dominates the In-Town Job

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Summary
In this chapter, you have learned how to analyze
a structured problem to find the preferred
alternative. For analysis, you used:
• Decision trees
• Expected monetary value (EMV)
• Influence diagrams
• Risk profiles and cumulative risk profiles
• Dominance
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