DECISION ANALYSIS

Fourah Bay College

Department of Mathematics and Statistics
Year III
Introduction to Decision Analysis
•  We make decisions daily by the minutes or hours.
•  To make these decisions we need data or
information.
•  Many people make decision without analysing the
situation, all the options available.
•  Decision making can be subjective or systematic.
•  The object of studying decision analysis is to
develop techniques to aid the process of
systematic decision making, not to replace the
decision.
Definition of Decision Analysis
•  It’s the process and methodology of identifying,
modeling, assessing and determining an
appropriate course of action for a given decision
problem.
•  This process often involves a wide array of tools
and the basic approach is to break the problem
down into manageable and understandable parts
that the decision maker can comprehend and
handle.
 4

Three types of Decision Makers

•  Risk Averse -Prefers a certain outcome to a
chance outcome having the same expected
value.

•  Risk Taking - Prefers a chance outcome to a

certain outcome having the same expected value.

•  Risk Neutral - Is indifferent between a chance

outcome and a certain outcome having the same
expected value.
Components of Decision Making
•  A decision-making situation includes several
components:
•  The Decisions themselves,
•  The Decision Maker responsible for making the
decision and has control over the decision.
•  Alternatives: these are other possible courses of
action under the decision maker’s control. A possible
alternative by the way is to do nothing.
•  Outcomes: are payoffs or net benefit expressed as
profit, revenue or cost. It is given in a payoff matrix/
table
•  Payoffs are typically expressed in terms of profit
revenues, or cost (although they can be expressed in
terms of a variety of values).
Components of Decision Making – Cont.
•  States of nature: the actual events that may occur
in the future. The decision maker is uncertain of the
states of nature and has no control over them. Only
one state of nature will occur. They are mutually
exclusive events.
•  The states of nature are good economic conditions
and bad economic conditions.
•  For example, consider a coffee vendor who must
decide whether to stock coffee for a football game
in November. If the weather is cold, most of the
coffee will be sold, but if the weather is warm, very
little coffee will be sold.
•  The decision is to order or not to order coffee, and
the states of nature are warm and cold weather.
Payoff matrix/tables
•  A payoff table is a means of organizing and illustrating a
decision situation, including the payoffs from the different
decisions, given the various states of nature in a decision
problem.

Each decision, 1 or 2, in Table 12.1 will result in an outcome, or payoff,

for the particular state of nature that will occur in the future.
Five Steps in Decision Making
1.  Clearly define the problem
2.  List all possible alternatives
3.  Identify all possible outcomes for each
alternative
4.  Identify the payoff for each alternative &
outcome combination
5.  Use a decision modeling technique to
choose an alternative
 Categories of Decision Making
•  Decision making under certainty: In this case data
is known deterministically. The future state-of-nature
is assumed to be known. These problems can be
solved using the following techniques, linear
programming, nonlinear programming, etc.
•  Decision making under risk.
•  There is some knowledge of the probability of the
states of nature occurring.
•  Decision making under uncertainty.
•  There is no knowledge about the probability of the
states of nature occurring.
•  In actual practice, however, many decision-making
situations occur under conditions of uncertainty.
Decision Making Without Probabilities
•  This is the decision situation in which probabilities cannot
be assigned to future occurrences.
•  Often times it is possible to assign probabilities to the
states of nature to aid the decision maker, however, in
some cases the decision maker is not able to assign
probabilities.
•  This is the type of decision-making situation that will be
first addressed in this section.
Decision Making Under Uncertainty
•  The decision criteria are based on the decision
maker’s attitude toward life.
•  The criteria include the:
•  Maximin Criterion - pessimistic or conservative
approach.
•  Maximax Criterion - optimistic or aggressive
approach.
•  Minimax Regret Criterion - pessimistic or
conservative approach.
•  Hurwicz:
•  Equal likelihood : The Principle of Insufficient
Reason
Decision-Making Criteria
•  Once the decision situation has been organized
into a payoff table, several criteria are available
for making the actual decision.
•  These decision criteria are:
1.  Maximax
2.  Maximin
3.  Minimax regret
Maximax or Optimistic criterion
•  Maximax: With the maximax criterion, the decision
maker selects the decision that will result in the maximum
of the maximum payoffs (the best of the best). The
maximax criterion is very optimistic. The decision maker
assumes that the most favorable state of nature for each
decision alternative will occur.
•  In solving a maximax problem, we either maximise or
minimise the outcome.
Maximax or Optimistic criteria – Example
•  An investor is to purchase one of three types of real
estate. The investor must decide among an apartment
building, an office building, and a warehouse. The future
states of nature that will determine how much profit the
investor will make are good economic conditions and poor
economic conditions.
•  The profits that will result from each decision in the event
of each state of nature are shown in the table below.
 Solution
•  Identify the highest payoffs (profit) for each decision:

•  Therefore: The investor’s decision is to invest on office building with a

profit of $100,000

Note:
•  Although the decision to purchase an office building will result in the
largest payoff ($100,000), such a decision completely ignores the
possibility of a potential loss of $40,000.
•  It should be pointed out that the maximax decision rule as presented
here deals with profit (a maximisation situation).
•  However, if the payoff table consisted of costs (a minimisation
problem), the opposite selection would be indicated: the minimum of
the minimum costs, or a minimin criterion.
Maximin/ Pessimist/Conservative criterion
In contrast with the maximax criterion, which is very
optimistic, the maximin criterion is pessimistic. With the
maximin criterion, the decision maker selects the decision
that will reflect the maximum of the minimum payoffs.
 Maximin/ Pessimist/Conservative criterion
•  Using the earlier payoff table and the Maximin criterion:
•  Identify the lowest payoffs (profit) for each decision:

•  The minimum payoffs for our example are +30,000, - +40,000, and
$10,000.
•  The maximum of these three payoffs is $30,000; thus, the decision
arrived at by using the maximin criterion would be to purchase the
apartment building.
•  Had the payoffs been costs instead of profits, the conservative
approach would be to select the maximum cost for each decision.
Then the decision that resulted in the minimum, the minimax, of these
costs would be selected.
The Minimax Regret Criterion
•  Regret is the difference between the payoff from the best
decision and all other decision payoffs.
•  With this decision criterion, the decision maker attempts to
avoid regret by selecting the decision alternative that
minimizes the maximum regret.
•  The minimax regret criterion minimizes the maximum
regret.
•  To use the minimax regret criterion, a decision maker first
selects the maximum payoff under each state of nature.
•  For our example, the maximum payoff under good
economic conditions is $100,000, and the maximum
payoff under poor economic conditions is $30,000.
•  All other payoffs under the respective states of nature are
subtracted from these amounts, as follows:
The Minimax Regret Criterion

The values are summarized below in a modified version of the

payoff table known as a regret table or an opportunity loss table

To make the decision according to the minimax regret

criterion, the maximum regret for each decision must be
determined.
The Minimax Regret Criterion
•  Maximum regret for each decision are as follows:
•  Apartment building $50,000
•  Office building $70,000
•  Warehouse $70,000
•  According to the minimax regret criterion, the decision
should be to purchase the apartment building rather than
the office building or the warehouse.
•  This particular decision is based on the philosophy that
the investor will experience the least amount of regret by
purchasing the apartment building.
The Hurwicz Criterion
•  The Hurwicz criterion strikes a compromise between the
maximax and maximin criteria.
•  The principle underlying this decision criterion is that the
decision maker is neither totally optimistic (as the maximax
criterion assumes) nor totally pessimistic (as the maximin
criterion assumes).
•  With the Hurwicz criterion, the decision payoffs are weighted by
a coefficient of optimism.
•  The coefficient of optimism, α, is a measure of the decision
maker’s optimism.
•  The coefficient of optimism, α, is between zero and one (i.e.,
0 ... α ... 1.0). If α = 1.0, then the decision maker is said to be
completely optimistic; if α = 0, then the decision maker is
completely pessimistic.
•  Given this definition, if α is the coefficient of optimism, 1 - α is
the coefficient of pessimism.
The Hurwicz Criterion
•  The Hurwicz criterion requires that for each decision
alternative, the maximum payoff be multiplied by α and
the minimum payoff be multiplied by 1 – α, and the
maximum weighted value is selected.
•  For our investment example, if α equals .4 (i.e., the
investor is slightly pessimistic), 1 - α = .6, and the
following values will result:

Using the Hurwicz criterion, the maximum weighted value is

$38,000. Thus, the decision would be to purchase the
apartment building.
The Hurwicz Criterion
•  It should be pointed out that when α = 0, the Hurwicz
criterion is actually the maximin criterion; when α = 1.0, it
is the maximax criterion.
•  A limitation of the Hurwicz criterion is the fact that α must
be determined by the decision maker. It can be quite
difficult for a decision maker to accurately determine his or
her degree of optimism.
•  Regardless of how the decision maker determines α, it is
still a completely subjective measure of the decision
maker’s degree of optimism.
•  Therefore, the Hurwicz criterion is a completely
subjective decision-making criterion.
The Equal Likelihood Criterion
•  When the maximax criterion is applied to a decision
situation, the decision maker implicitly assumes that the
most favorable state of nature for each decision will occur.
•  Alternatively, when the maximin criterion is applied, the
least favorable states of nature are assumed.
•  The equal likelihood, or LaPlace criterion weights each
state of nature equally, thus assuming that the states of
nature are equally likely to occur.
•  Using our previous example and given that there are two
states of nature in our example, we assign a weight of .50
to each one.
•  Next, we multiply these weights by each payoff for each
decision:
The Equal Likelihood Criterion

The decision criteria is, we select the decision that has the
maximum of these weighted values.

Because $40,000 is the highest weighted value, the

investor’s decision would be to purchase the apartment
building.
 Select the best decision, using the following decision criteria.
a. Maximax
Exercises b. Maximin
3. Stevie Stone, a bellhop at the Royal Sundown Hotel in Atlanta
•  Stevie Stone, a bellhop
ment at the
position. Royal Sundown
Although accepting Hotel in Atlanta,
the offer has him a
would assure
been offeredifagood
management
economicposition. Although
conditions accepting
prevailed, the offer
he would actually ma
would assure himasa ajob
than if there(because
bellhop was a recession, if good
of the large economic
tips he gets as a bellhop
conditions prevailed, he would actually make less money as a
manager than 5 years for each(because
as a bellhop job, givenofeach futuretips
the large economic
he gets condition,
as a is s
bellhop). Histable:
salary during the next 5 years for each job, given each
future economic condition, is shown in the following payoff table:
Economic Conditions

Decision Good Recession

Bellhop $120,000 $60,000

Manager 85,000 85,000
•  Select the best decision, using the following decision criteria.
•  a. Minimax regret
Select the best decision, using the following decision criteria.
•  b. Hurwicz (aa. =Minimax
.4) regret
•  c. Equal likelihood
b. Hurwicz (a = .4)
c. Equal likelihood
12 Exercise
DECISION ANALYSIS

•  A farmer in Georgia must decide which crop to plant next year on his
land: passes the Senate.
corn, peanuts, or soybeans.The Theprofit
return the
from farmer
each cropwill realize fro
will be
determined
sults by
onwhether a newbill,
the trade tradeisbillshown
with Russia passes
in the the Senate.
following payoff t
The profit the farmer will realize from each crop, given the two possible
results on the trade bill, is shown in the following payoff table:
Trade Bill

Crop Pass Fail

Corn $35,000 $ 8,000

Peanuts 18,000 12,000
Soybeans 22,000 20,000
•  Determine the best crop to plant, using the following decision criteria.
•  a. Maximax
Determine the best crop to plant, using the following de
•  b. Maximin
a. Maximax
•  c. Minimax regret
b. Maximin
•  d. Hurwicz (a = .3)
• 
c. likelihood
e. Equal Minimax regret
d. Hurwicz (a = .3)
Exercise
•  A local real estate investor in Orlando is considering three alternative
PROBLEMS 575
investments: a motel, a restaurant, or a theater. Profits from the motel or
8.restaurant
A local real will
estatebe affected
investor by the
in Orlando availability
is considering threeofalternative
gasoline and the anumber
investments: motel, a restau-
ofrant,
tourists; profits
or a theater. from
Profits fromthe
thetheater will be relatively
motel or restaurant stable
will be affected under
by the any of gasoline
availability
conditions.
and the numberTheoffollowing payoff
tourists; profits fromtable shows
the theater will the profit or
be relatively loss
stable thatany
under could
conditions.
result from each
The following payoffinvestment:
table shows the profit or loss that could result from each investment:

Gasoline Availability

Investment Shortage Stable Supply Surplus

Motel $-8,000 $15,000 $20,000

Restaurant 2,000 8,000 6,000
Theater 6,000 6,000 5,000

•  Determine thebest
Determine the best investment,
investment, using
using the the decision
following following decision criteria.
criteria.
•  a.a.Maximax
Maximax
•  b.b.Maximin
Maximin
•  c. c.Minimax
Minimaxregret
regret
d. Hurwicz (a = .4)
•  d.e.Hurwicz (a = .4)
Equal likelihood
•  e. Equal likelihood
9. A television network is attempting to decide during the summer which of the following three football
games to televise on the Saturday following Thanksgiving Day: Alabama versus Auburn, Georgia
Decision Making With Probabilities
•  This is the decision situation in which probabilities can be
assigned to future occurrences.
•  It is often possible to assign probabilities to the states of
nature to aid the decision maker in selecting the decision
that has the best outcome.
•  This is the type of decision-making situation that is
addressed in this section.
 30

Decision Making Under Risk

•  The probability estimate for the occurrence
of each state of nature (if available) can be
incorporated in the search for the optimal
decision.
•  For each decision calculate its expected
payoff.
The Expected Value Criterion – Without
Perfect Information
•  To apply the concept of expected value as a
decision-making criterion, the decision maker must
first estimate the probability of occurrence of each
state of nature.
•  Expected value is computed by multiplying each
decision out- come under each state of nature by the
probability of its occurrence
•  For each decision calculate the expected payoff as
follows:
Expected Payoff = Σ(Probability)(Payoff)
•  The summation is calculated across all the states of
nature)
•  Select the decision with the best expected payoff
 32

The Expected Value Criterion - Example

Given the payoff table with probability of the state of nature
below:

The expected value (EV) for each decision is computed as follows:

EV(apartment) = +50,000(.60) + 30,000(.40) = +42,000
EV(office) = +100,000(.60) – 40,000(.40) = +44,000
EV(warehouse) = +30,000(.60) + 10,000(.40) = +22,000
The best decision is the one with the greatest expected value.
The Optimal decision is to invest in Office
 33

When to use the expected value approach

• The expected value criterion is useful
generally in two cases:
•  Long run planning is appropriate, and
decision situations repeat themselves.
•  The decision maker is risk neutral.
Expected Opportunity Loss
•  A decision criterion closely related to expected value is
expected opportunity loss. To use this criterion, we
multiply the probabilities by the regret (i.e., opportunity
loss) for each decision outcome
•  Expected opportunity loss is the expected value of the
regret for each decision.
Expected Opportunity Loss
•  The expected opportunity loss (EOL) for each decision is
computed as follows:
•  EOL(apartment) = +50,000(.60) + 0(.40) = +30,000
EOL(office) = +0(.60) + 70,000(.40) = +28,000
•  EOL(warehouse) = +70,000(.60) + 20,000(.40) = +50,000

•  As with the minimax regret criterion, the best decision

results from minimizing the expected regret or opportunity
loss.

Because $28,000 is the minimum expected regret,

the decision is to purchase the office building.
Perfect Information
•  Perfect Information would tell us with certainty
which outcome is going to occur
•  Having perfect information before making a
decision would allow choosing the best payoff for
the outcome
Expected Value of Perfect Information
•  It is often possible to purchase additional information regarding
future events and thus make a better decision.
•  For example, a real estate investor could hire an economic
forecaster to per- form an analysis of the economy to more
accurately determine which economic condition will occur in the
future.
•  The investor (or any decision maker) would be foolish to pay
more for this information than he or she stands to gain in extra
profit from having the information.
•  The expected value of perfect information (EVPI) is the
maximum amount a decision maker would pay for additional in-
formation.

EVPI equals the expected value, given perfect

information, minus the expected value without
perfect information
Expected Value With Perfect Information
•  The expected payoff of having perfect information before
making a decision
EVwPI = ∑ (probability of outcome) x ( best payoff of outcome)
Payoffs in blue would be chosen based on perfect
information (knowing demand level)
Demand
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
Probability 0.3 0.5 0.2

EVwPI = $110,000
Expected Value Without Perfect Information
Demand
Alternatives High Moderate Low
Large plant (LP) 200,000 100,000 -120,000
Small plant (SP) 90,000 50,000 -20,000
No plant (NP) 0 0 0
Probability 0.3 0.5 0.2

•  The expected value (EV) for each decision is computed

as follows:
•  EV(LP) = 200,000(.30) + 100,000(.50) - 120,000)(.20)= 86,000
•  EV(SP) = 90,000(.60) + 50,000(.40) - 120,000(.20)= 48,000
•  EV(NP) = 0(.30) + 0(.50) + 0(.2) = 0

EVwoPI = $86,000
Expected Value of Perfect Information
EVPI = EVwPI – EMV
= $110,000 - $86,000
= $24,000
•  The “perfect information” increases the expected value
by $24,000
•  Would it be worth $30,000 to obtain this perfect
information for demand?
Exercise
•  The Miramar Company is going to introduce one of three new products: a
widget, a hummer, or a nimnot. The market conditions (favorable, stable,
or unfavorable) will determine the profit or loss the company realizes,
PROBLEMS
as 579
shown in the following payoff table:

Market Conditions

Favorable Stable Unfavorable

Product .2 .7 .1

Widget $120,000 $70,000 $ -30,000

Hummer 60,000 40,000 20,000
Nimnot 35,000 30,000 30,000

•  Compute the expected value for each decision and select the best one.
a. Compute the expected value for each decision and select the best one.
•  b. Develop the opportunity loss table and compute the expected
b. Develop the opportunity loss table and compute the expected opportunity loss for each product.
opportunity loss for each product.
c. Determine how much the firm would be willing to pay to a market research firm to gain bet-
•  c. Determine how much the firm would be willing to pay to a market
ter information about future market conditions.
research firm to gain better information about future market conditions.
19. The financial success of the Downhill Ski Resort in the Blue Ridge Mountains is dependent on
the amount of snowfall during the winter months. If the snowfall averages more than 40 inches,
 termined that there is a .50 probability that interest rates will decline, a .40 pr
will remain stable, and a .10 probability that rates will increase.
a. Using expected value, determine the best project.
Exercises
b. Determine the expected value of perfect information.
25. Fenton and Farrah Friendly, husband-and-wife car dealers, are soon going t
Fenton They
• ership. and Farrah
have Friendly, husband-and-wife
three offers: from a foreign carcompact
dealers, are
carsoon
company, from
going
of to opencars,
full-sized a newand
dealership.
from a They
truckhave three offers:
company. from a foreign
The success of each type
compacton
depend car company,
how from a U.S.-producer
much gasoline is going to ofbefull-sized
available cars, and the
during fromnext
a few
truck company. The success of each type of dealership will depend on
from each type
how much of dealership,
gasoline given
is going to be the availability
available of gas,
during the next is shown in the
few years.
The profit from each type of dealership, given the availability of gas, is
table:
shown in the following payoff table:

Gasoline Availability

Shortage Surplus
Dealership .6 .4

Compact cars $ 300,000 $150,000

Full-sized cars -100,000 600,000
Trucks 120,000 170,000
•  Determine which type of dealership the couple should purchase.
Construct awhich
• Determine decision tree
type of for the decision
dealership situation
the couple described
should above and
purchase.
indicate the best decision.
26. The Steak and Chop Butcher Shop purchases steak from a local meatpackin
Exercise
•  The director of career advising at Orange Community College wants to use
decision analysis to provide information to help students decide which 2-year
degree program they should pursue. The director has set up the following payoff
table for six of the most popular and successful degree programs at OCC that
shows the estimated 5-year gross income ($) from each degree for four future
economic conditions:

•  Determine the best degree program in terms of projected income, using the
following decision criteria:
•  a. Maximax
•  b. Maximin
•  c. Equal likelihood
•  d. Hurwicz (a = .50)
Exercise
•  From the exercise above, the director of career advising
at Orange Community College has paid a small fee to a
local investment firm to indicate a probability for each
future economic condition over the next 5 years. The firm
estimates that there is a .20 probability of a recession, a .
40 probability that the economy will be average, a .30
probability that the economy will be good, and a .10
probability that it will be robust.
•  Using expected value determine the best degree program
in terms of projected income.
•  If you were the director of career advising, which degree
program would you recommend?
 Decision Trees
•  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 - square
nodes correspond to the decision alternatives.
•  The branches leaving round nodes represent the
different states of nature while the branches
leaving square nodes represent 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.
Decision Trees
•  Decision-tree models offer a visual tool that can
represent the key elements in a model for
decision making under uncertainty and help
organize those elements by distinguishing
between decisions (controllable variables) and
random events (uncontrollable variables).
•  In a decision tree, we describe the choices and
uncertainties facing a single decision-making
agent.
•  This usually means a single decision maker, but it
could also mean a decision-making group or a
company.
 47

Characteristics of a decision tree

•  A Decision Tree is a chronological representation
of the decision process.
•  The tree is composed of nodes and branches.

A branch emanating from a

decision node corresponds
Chance to a decision alternative. It
node includes a cost or benefit
Decision P(S2) value.
node
A branch emanating from a
state of nature (chance)
node corresponds to a
P(S2) particular state of nature, and
includes the probability of this
state of nature.
Using Trees to Model Decisions
•  A probability tree depicts one or more random
factors

•  The node from which the branches emanate is called

a chance node, and each branch represents one of
the possible states that could occur.

•  Each state, therefore, is a possible resolution of the

uncertainty represented by the chance node.

•  Eventually, we’ll specify probabilities for each of the

states and create a probability distribution to describe
uncertainty at the chance node.
Representing Decisions
•  In a decision tree, we represent decisions as
square nodes (boxes), and for each decision,
the alternative choices are represented as
branches emanating from the decision node.

•  These are potential actions that are available to

the decision maker.

•  In addition, for each uncertain event, the possible

alternative states are represented as branches
emanating from a chance node, labeled with their
respective probabilities.
Analyzing the Decision Tree
•  Whereas we build the tree left to right, to reflect
the temporal sequence in which a decision is
followed by a chance event, we evaluate the tree
in the reverse direction.
•  At each chance node, we can calculate the
expected payoff represented by the probability
distribution at the node.
•  This value becomes associated with the
corresponding action branch of the decision node.
•  Then, at the decision node, we calculate the
largest expected payoff to determine the best
action.
•  This process of making the calculations is usually
referred to as rolling back the tree.
Decision Trees: Risk Profiles
•  The distribution associated with a particular action
is called its risk profile.
•  The risk profile shows all the possible economic
outcomes and provides the probability of each: It
is a probability distribution for the principal output
of the model.
•  This form reinforces the notion that, when some
of the input parameters are described in
probabilistic terms, we should examine the
outputs in probabilistic terms.
•  After we determine the optimal decision, we can
use a probability model to describe the profit
outcome.
 Decision Trees for a Series of Decisions
•  Decision trees are especially useful in situations where there
are multiple sources of uncertainty and a sequence of
decisions to make.
•  For example, suppose that we are introducing a new product
and that the first decision determines which channel to use
during test-marketing.
•  When this decision is implemented, and we make an initial
commitment to a marketing channel, we can begin to
develop estimates of demand based on our test.
•  At the end of the test period, we might reconsider our
channel choice, and we may decide to switch to another
channel.
•  Then, in the full-scale introduction, we attain a level of profit
that depends, at least in part, on the channel we chose
initially.
 Principles for Building and Analyzing
Decision Trees
1.  Determine the essential decisions and uncertainties.
2.  Place the decisions and uncertainties in the appropriate
temporal sequence.
3.  Start the tree with a decision node representing the first
decision.
4.  Select a representative (but not necessarily exhaustive)
number of possible choices for the decision node.
5.  For each choice, draw a chance node representing the
first uncertain event that follows the initial decision.
6.  Select a representative (but not necessarily exhaustive)
number of possible states for the chance node.
7.  Continue to expand the tree with additional decision
nodes and chance nodes until the overall outcome can
be evaluated.
Decision Tree Example
•  Using the table below construct a decision tree.
Solution
Solution
•  EV(node 2) = .60(+50,000) + .40(+30,000) = +42,000
EV(node 3) = .60(+100,000) + .40(-+40,000) = +44,000
EV(node 4) = .60(+30,000) + .40(+10,000) = +22,000
Solution continue
Sequential Decision Trees
•  A sequential decision tree illustrates a situation requiring a series of decisions.
•  If a decision situation requires a series of decisions, then a payoff table cannot be created,
and a decision tree becomes the best method for decision analysis.
•  Example:
•  An investor is faced with a decision of whether to purchase an apartment building or land. If
the apartment building is purchased, the town may exhibit population growth, with a
probability of .60, or there may be no population growth or a decline, with a probability of .40.
On the other hand, if the investor chooses to purchase land, 3 years in the future another
decision will have to be made regarding the development of the land. The cost of each
venture $800,000 and $200,000, respectively. If the population grows, the investor will
achieve a payoff of $2,000,000 over a 10-year period. However, if no population growth
occurs, a payoff of only $225,000 will result. Either apartments will be built, at a cost of
$800,000, or the land will be sold, with a payoff of $450,000. The land can be developed
commercially at a cost of $600,000, or the land can be sold for $210,000. The population
may grow, with a conditional probability of .80, or there may be no population growth, with a
conditional probability of .20. The probability of population growth is higher (and the
probability of no growth is lower) than before because there has already been population
growth for the first 3 years. The payoffs for these two states of nature at the end of the 10-
year period are $3,000,000 and $700,000, respectively. If the investor decides to develop the
land commercially at node 5, then two states of nature can occur: Population growth can
occur, with a probability of .30 and an eventual payoff of $2,300,000, or no population growth
can occur, with a probability of .70 and a payoff of $1,000,000. The probability of population
growth is low (i.e., .30) because there has already been no population growth.
 Solution
First, we must compute the expected values at nodes 6 and 7:
•  EV(node 6) = .80(+3,000,000) + .20(+700,000) = +2,540,000
•  EV(node 7) = .30(+2,300,000) + .70(+1,000,000) = +1,390,000
At decision nodes 4 and 5, we must make a decision.
Node 4 = $2,540,000 - $800,000 = $1,740,000 or $450,000
Node 5 = $1,390,000 - $600,000 = $790,000 or $210,000
The decision is to build the apartment building, and the value at node 4 is
$1,740,000
Next, we must compute the expected values at nodes 2 and 3:
•  EV(node 2) = .60(+2,000,000) + .40(+225,000) = +1,290,000
•  EV(node 3) = .60(+1,740,000) + .40(+790,000) = +1,360,000
Now we must make the final decision for node 1. As before, we select the
decision with the greatest expected value after the cost of each decision is
subtracted out:
•  apartment building: $1,290,000 - $800,000 = $490,000
•  land: $1,360,000 - $200,000 = $1,160,000
Because the highest net expected value is $1,160,000, the decision is
to purchase land, and the payoff of the decision is $1,160,000.
Solution
Exercises
•  TheMiramarCompanyisgoingtointroduceoneofthreenewproducts:awid
get,ahummer,or a nimnot. The market conditions (favorable, stable, or
unfavorable) will determine the profit or loss the company realizes, as
shown in the following payoff table:

a.  Compute the expected value for each decision and select the best
one.
b.  Develop the opportunity loss table and compute the expected
opportunity loss for each product.
c.  Determine how much the firm would be willing to pay to a market
research firm to gain better information about future market
conditions.
Exercise
•  Fenton and Farrah Friendly, husband-and-wife car dealers, are soon
going to open a new dealership. They have three offers: from a
foreign compact car company, from a U.S.-producer of full-sized cars,
and from a truck company. The success of each type of dealership
will depend on how much gasoline is going to be available during the
next few years. The profit from each type of dealership, given the
availability of gas, is shown in the following payoff table:
Exercise
•  Given the following sequential decision tree, determine
which is the optimal investment, A or B:

Hint: A, EV(A) = $23,300

Exercises
•  Allen Abbott has a wide-curving, uphill driveway leading to his
garage. When there is a heavy snow, Allen hires a local
carpenter, who shovels snow on the side in the winter, to
shovel his driveway. The snow shoveler charges $30 to shovel
the driveway. Following is a probability distribution of the
number of heavy snows each winter:

•  Allen is considering purchasing a new self-propelled snow

blower for $625 that would allow him, his wife, or his children to
clear the driveway after a snow. Discuss what you think Allen’s
decision should be and why.
Hint: EV (shoveler) = $99.6
Exercise
•  The financial success of the Downhill Ski Resort in the Blue Ridge
Mountains is dependent on the amount of snowfall during the winter
months. If the snowfall averages more than 40 inches, the resort will
be successful; if the snowfall is between 20 and 40 inches, the resort
will receive a moderate financial return; and if snowfall averages less
than 20 inches, the resort will suffer a financial loss. The financial
return and probability, given each level of snowfall, follow:

•  A large hotel chain has offered to lease the resort for the winter for
$40,000. Compute the expected value to determine whether the
resort should operate or lease. Explain your answer.
Hint: EV (operate) same as leasing; conservative decision is to
lease
 22 .30
23 .30
24 .10
1.00

Exercise The shop must decide how much steak to order in a week. Constr
sion situation and determine the amount of steak that should be o
•  The Loebuck Grocery must decide how many cases of milk to stock each
27. The Loebuck Grocery must decide how many cases of milk to sto
week toThe
meet demand. The probability distribution of demand during a
probability distribution of demand during a week is shown in
week is shown in the following table:
Demand (cases) Probability

15 .20
16 .25
17 .40
18 .15
1.00

•  Each case
Eachcosts
casethecosts
grocer $10
the and sells
grocer $10for $12.
and Unsold
sells casesUnsold
for $12. are soldcases a
to a local farmer
mixes the(who mixes
milk withthe milkfor
feed with feed for livestock)
livestock) forcase.
for $2 per $2 perIf there is
case. Ifers
there
theis cost
a shortage, the grocer
of customer considers
ill will the cost
and lost of customer
profit to be $4 ill
per case
will andmany
lost profit to be
cases $4 pertocase.
of milk order The grocer
each must decide how many
week.
cases ofb.milk to order each week.
a. Construct the payoff table for this decision situation.
Compute the expected value of each alternative amount of mi
•  a. Construct thethe
lect payoff
besttable for this decision situation.
decision.
•  b. Compute the expected value of each alternative amount of milk that
c. Construct the opportunity loss table and determine the best de
d. Compute the expected value of perfect information.
could be stocked and select the best decision.
28. The manager of the greeting card section of Mazey’s departme
•  c. Construct the opportunity loss table and determine the best decision.
der for a particular line of Christmas cards. The cost of each bo
•  d. Compute the expected
be sold value of
for $5 during perfect
the information.
Christmas season. After Christmas, t
Hint: (b) box.
Stock 16 cases; (c) stock 16 cases; (d) $5.80
The card section manager believes that all leftover cards ca
timated demand during the Christmas season for the line of Ch
probabilities, is as follows:
 Exercise
•  The Palm Garden Greenhouse specializes in raising carnations that are
TER 12 DECISION ANALYSIS
sold to florists. Carnations are sold for $3.00 per dozen; the cost of
growing the carnations
29. The Palm Garden andGreenhouse
distributing specializes
them to theinflorists is carnations
raising $2.00 per that are
dozen. Any
tions carnations left$3.00
are sold for at theper
enddozen;
of the the
daycost
are sold to localthe carnations a
of growing
restaurants and hotels
the florists for $0.75
is $2.00 per dozen.
per dozen. The estimated
Any carnations cost
left at theof
end of the day
customer ill will if demand is not met is $1.00 per dozen. The expected
rants and hotels for $0.75 per dozen. The estimated cost of customer ill w
is $1.00 per dozen. The expected daily demand (in dozens) for the carnat
daily demand (in dozens) for the carnations is as follows:
Daily Demand Probability

20 .05
22 .10
24 .25
26 .30
28 .20
30 .10
1.00

•  a. Develop the payoff

a. Develop thetable for table
payoff this decision situation.situation.
for this decision
•  b. Compute the expected
b. Compute value of value
the expected each alternative number number
of each alternative of (dozens of)
of (dozens o
carnations that could be stocked and select the best decision.
be stocked and select the best decision.
c. Construct the opportunity loss table and determine the best decision.
•  c. Construct the opportunity
d. Compute loss table
the expected valueand determine
of perfect the best decision.
information.
•  d. Compute the expected value of perfect information.
30. Assume that the probabilities of demand in Problem 28 are no longer v
Hint: (b) tion
Stock 26 dozen;
is now (c) stock
one without 26 dozen; Determine
probabilities. (d) $3.10 the best number of b
using the following decision criteria.
a. Maximin
Exercise
•  Assume that the probabilities of demand in Palm Garden
Greenhouse & Loebuck Grocery are no longer valid; the
decision situation is now one without probabilities.
Determine the best number of boxes of cards to stock,
using the following decision criteria.
•  a. Maximin
•  b. Maximax
•  c. Hurwicz (a = .4)
•  d. Minimax regret