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# DECISION ANALYSIS Decision analysis addresses the issue of making the right decision in the face of great uncertainty

. It provides a framework and methodology for rational decision making when the outcomes are uncertain. CASES 1. A manufacturer introducing a new product into the market place. Questions are: How much should be produced? Should the product be test marketed? How much advertising?

2. A financial firm investing in securities: What are the market sectors and individual securities with the best prospects? Where is the economy heading? How will interest rates behave? How should these factors affect the investment decisions? 3. A government contractor bidding on a new contract: What other companies are bidding? What are there likely bids? What will be cost of the project?

4. An agricultural company selecting the mix of crops: What will be the weather conditions? Where are prices headed? What will costs be? 5. An oil company deciding to drill for oil at a particular location: How likely is oil there? How much? How deep to drill? Should Geologists do further investigation before drilling? In all these cases the decision maker has to answer his questions and arrive at the right decision when the environment has uncertainty. Decision analysis is used to answer questions in these types of scenarios.

. In the second case decisionmaking is done after some testing is done to reduce the level of uncertainty. Decision making without experimentation 2. Decision making with experimentation In the first case decisionmaking is done immediately.Decision analysis is divided into two types: 1.

Different situations would be there when the action is undertaken. 2. These are known as payoffs. The decision maker must choose an action from a set of possible actions. 4. A payoff table is used to provide the payoff for each combination. The decision maker will also have some information about the likelihood of a state of nature occurring.Framework for decision analysis 1. Each of these situations is called a state of nature. These are known as prior probabilities. Each combination of action and state of nature would give rise to some monetary gain. 3. . 5.

000.Example An oil company µA¶ owns a tract of land that may contain oil.000 will be incurred if the land contains no oil.000. The cost of drilling is $100. Company µA¶ is considering drilling for oil itself.000. Expected revenue is $800. A loss of $100. Another oil company has offered to purchase the land for $90. A Geologist has told management that there is 1 chance in 4 that it contain oil. . Expected profit is $700.000.

25 DRY -100 90 0.75 .000 $90.000 $90.000 75% Payoff Table STATE OF NATURE ALTERNATIVE Drill for Oil Sell the Land Prior Probability OIL 700 90 0.000 25% DRY -$100.Profit Table PAYOFF ALTERNATIVE Drill for Oil Sell the Land Chance OIL $700.

. Bays decision rule 1. Choose the action whose minimum payoff gives this maximum. The maxmin payoff criterion 2. find the minimum payoff over all possible states of nature. The maximum likelihood criterion 3. Find the maximum of these minimums.Decision Analysis without experimentation has three criterions by which to select the action to be undertaken: 1. State of Nature ALTERNATIVE Drill Sell OIL 700 90 DRY -100 90 MINIMUM -100 90 maximum Under this criterion for the example the action to be taken is to sell the land. The Maximin Pay Off Criterion For each possible action.

2. find the action with the maximum payoff. Maximum Likelihood Criterion Identify the most likely state of nature (the one with the largest prior probability).25 DRY -100 90 0. Choose this action: State of Nature ALTERNATIVE Drill Sell OIL 700 90 0.75 Maximum MAXIMUM . For this state of nature.

75 (90) = 90 State Of Nature ALTERNATIVE Drill Sell Prior Probability OIL 700 90 0.25 DRY -100 90 0.3. Bayes Decision Rule Using the prior probability calculate the expected value of the payoff for each of the possible actions. E [Payoff (Drill)] = 0.75 EXPECTED PAYOFF 100 Maximum 90 . Choose the action with the maximum expected payoff.75 (-100) = 100 E [Payoff (Sell)] = 0.25 (90) + 0.25 (700) + 0.

Bayes Decision Rule .1 $10M 0 0. Maximum Payoff Criteria 2.5 -$30M $15M 0. Maximum Likelihood 3.CLASS WORK There are 3 courses of action with 3 state of nature. as follows: State Of Nature Alternative Improving Economy $30M Stable Economy $5M Worsening Economy &10M Conservative Investment Speculative Investment Counter Cyclical &40M -$10M1 0.4 Which action should betaken under: 1.

The manager now needs to decide how many cases to purchase. Her regular supplier can provide as many cases as she wants. However. The manager estimates that she will be able to sell 10. The prior probabilities are 0.0.3 and 0.1 of being able to sell 10.4. 11. She can purchase the apples for $3 per cases and sell them for $8 per case. 0.CLASS WORK 1. 11. . 12 and 13 cases. she will need to sell them tomorrow and discard any that remain unsold. A manager of a Grocery store needs to replenish her supply of apples.2. 12 or 13 cases tomorrow. because these apples already are very ripe.

Develop a decision formulation of this problem analysis b.4 S2 25 50 40 0.6 . How many cases should be purchased according to the maximum likelihood criterion? d. How many cases of apples should be purchased under the maximin payoff criterion? c.a. How many cases should be purchased according to bayes decision rule? 2. Consider a decision analysis problem whose payoffs are: ALTERNATIVE STATE OF NATURE S1 A1 A2 A3 Prior Probabilities 80 30 60 0.

1 .3 S3 110 150 0. Which alternative should be chosen under maximum likelihood criterion c. The following is a payoff table for a decision analysis problem: ALTERNATIVE S1 A1 A2 Prior Probabilities 220 200 0.a.6 STATE OF NATURE S2 170 180 0. Which alternative should be chosen under bayes decision rule 3. Which alternative should be chosen under the maximum payoff criterion b.

the manager has obtained the following estimates of crop yields and net incomes per bushel under various weather conditions. For each of these crops.a. . Which alternative should be chosen under the maxmin payoff criterion? b. Which alternative should be chosen under the maximum likelihood criterion? c. Which alternative should be chosen under bayes decision rule? 4. He now needs to make a decision on which one of four crops to grow. For greater efficiency. the manager always devotes the farm to growing one crop at a time. There is a manager of a large farm with 1000 acres of arable land.

00 40 40 40 $0.5. damp weather a.3. Develop a decision analysis formulation of this problem. moderate.2 for dry. b.50 30 25 25 $1. 0.00 15 20 30 $1. Determine which crop to grow using Bayes Decision Rule . 0.Weather Dry Moderate Damp Net income per bushel Crop 1 Crop 2 Crop 3 Crop 4 20 35 40 $1.50 The prior probabilities are 0.

To obtain posterior probabilities we are given.Decision analysis with experimentation Many times additional testing can be done to improve the prior probabilities of the states of nature. state of nature is i.3 «. Finding = Finding from experimentation or testing Finding j = One value of finding P [State = State i | Finding = Finding j] = posterior probability that.. . 2. P (State = State i) and P (Finding = Finding j| State = State i) . given that finding = finding j. These improved estimates are called posterior probabilities. Notations n = Number of possible states of nature P (State = State i) = Prior probability for state of nature i i = 1. n.

This will enable the company to obtain an improved estimate of oil. 3. The findings from the survey can be divided into two categories: USS: Unfavorable Seismic Soundings.For each I = 1. . oil is likely. 000. oil is unlikely FSS: Favorable Seismic Sounding. 2. The cost of doing the survey is $30. ««««n the formula for the posterior probability is P(STATE = STATE i FINDING = FINDING j) ! P ( FINDING ! FINDINGj ! FINDINGj STATE ! STATEi ) P ( STATE ! STATEi ) STATE ! STATEk ) P ( STATE ! STATEk ) § P ( FINDING k !1 n Example: For Oil Company µA¶ there is an option of carrying out extra testing or a detailed seismic survey of the land.

75 ) P (STATE = DRY FINDING = FSS) = 0 . 25 ) ! 0 . 75 ) P (STATE = OIL FINDING = FSS) = 0 .5 0 .8 P (FSS I STATE = DRY = 0. 8 ( 0 . 86 0 .4 P (FSS STATE = OIL) = 0.Based on past experience P (USSSTATE = OIL) = 0. 2 ( 0 . 6 ( 0 . 6 ( 0 . 4 ( 0 . 25 ) ! 0 . 4 ( 0 .25. 75 ) . 8 ( 0 . 25 ) 0 . 75 ) ! 0 . 2 ( 0 . 25 ) 0 . 25 ) 0 . 8 ( 0 . 25 ) 0 .6 P (USS STATE = DRY) = 0.2 PRIOR PROBABILITIES P (STATE=OIL) = 0. 2 ( 0 . 6 ( 0 . 75 ) ! 0 .5 0 .75 P (STATE = OIL FINDING = USS) ! 0 . 4 ( 0 . P (STATE =DRY) = 0. 14 P (STATE = DRY FINDING = USS) = 0 . 25 ) 0 .

GIVEN USS Posterior Probabilities P(STATEFINDING) Joint Probabilities P (STATE AND FINDING) After the calculations are done.2) = 0.6/0.7 = 0.3 = 0. Bayes Decision Rule can be applied with the posterior probabilities replacing the prior probabilities .25(0.7 = 0.6) = 0. GIVEN FSS 0.15/0.7 STATE OIL DRY 0.25(0.86 DRY. GIVEN FSS 0.1/0.75(0.15/0.75(0.3 0.4) = 0.5 0.1 OIL & USS 0.8) = 0.We next apply Bayes Decision Rule to obtain the expected payoffs PROBABILITIES FINDING P (FINDING) FSS USS 0.5 0.14 0. GIVEN USS 0.5 OIL.18 DRY & FSS 0.15 OIL & FSS 0.6 DRY & USS Prior Probabilities Conditional Probabilities P (FINDINGSTATE) 0.14 OIL.5 DRY.86 All these calculations can be organized in a Probability Tree Diagram 0.3 = 0.

86(.100 90 0.86(90) ± 30 = 60 If finding is favourable: E [Payoff (Drill)Finding = FSS] = 0.86 0.5(700) + 0.5 1. Drill 700 2.5(-100) ± 30 = 270 E [Payoff (Sell)Finding = FSS] = 0.14(90) + 0.18 E [Payoff (Sell)Finding = USS] = 0. Sell 90 USS 0.14(700) + 0.100) ± 30 = .5(90) ± 30 = 60 .14 FSS 0.Payoff Table: Alternative Oil Dry .5 If finding is unfavourable: E [Payoff (Drill)Finding = USS] = 0.5(90) + 0.

favorable seismic soundings are obtained 80% of the time.Finding USS FSS Class Work Action Sell Drill Expected Payoff 60 270 For the oil company example a consulting geologist has given more precise estimates on the likelihood of obtaining favorable seismic soundings. 1. favourable seismic soundings are obtained 40% of the time. show in a probability tree diagram? . Specifically when the land contains oil. What are the posterior probabilities. When the land is dry.

GIVEN USS 0.9 DRY.6 .05 OIL & USS 0.05/0. Class Work ± 2 2. GIVEN FSS 02/05 0.45 DRY & USS 0.45/0.Solution = (0.4 OIL.6 DRY. 0. GIVEN USS 0.5 The optimal policy is to do a seismic survey and sell if it is unfavourable and drill if it is favourable. GIVEN FSS 0.3/0.1 OIL.5 0.2 OIL & FSS 0.5 0.4 -100 100 0.25)(0. The following Payoff Table is given Alternative A1 A2 Price Prob.3 DRY & FSS 0. State of nature S1 S2 400 0 0.8) 1.

8 = 0.4 x 0.Can pay $100 to have research done to better predict which state of nature will occur.16 + 0.5 x 0.64 .36 P(S2) = 0. the research will accurately predict S2. the research will accurately predict S1.16 P(S2 and S1) = 0.6 x 0.48 P(S1) = 0. 1.12 P(S2 and S2) = 0. P(S1 and S1) = 0. (but will inaccurately predict S2. When the true state of nature is S1. 60% of the time. When the true state of nature is S2.4 x 0. 80% of the time (but will inaccurately predict S1 20% of the time Given that research is done.6 = 0.2 = 0.48 = 0.12 = 0. determine the posterior probabilities of the states of nature for each of the two cases.24 P(S1 and S2) = 0. 40% of the time).24 + 0.4 = 0.

000 and $20.26 = 0.12/0.000 credit to a new customer. Experience indicates that 20% of companies similar to this dress manufacturer are poor risks.12 S2 & S1 0.64 0. He is currently faced with the question of whether to extend $100. good risk. .64 0.$15. S2 0. 50% are average risks and 30% are good risks.S1S1 0.48 S2 and S2 S2 S2.2 0. He has three categories for the credit-worthiness of a company.S1 0.000 for good risks. He does not know which category this new customer fits.8 Example There is a manager of a fabric mill.16 S1 and S2 0. average risk.16/0.36 0.24/0.24 S1 & S1 0. If credit is extended the expected profit for poor risks is . poor risk.333 0.677 P(S1 S1) 0.000 for average risk $10.4 S1 S2.75 P(S2 S1) P(S2 S2) 0.48/0.25 P(S1 S2) 0.6 0.

each of the three possible credit evaluations by the credit rating organization.The manager is able to consult a consult a credit rating organization for a fee of $5000 per company evaluated. For companies whose actual credit record with the mill turns out to fall into each of the three categories. Actual Credit Record State Credit Evaluation Poor Finding Average Good Poor 50% 40% 10% Average Good 40% 50% 10% 20% 40% 40% . the following table shows the percentages that were given.

For each of the three possible credit evaluations of this potential customer. Use Bayes Decision Rule to determine which decision alternative should be chosen. Assume the credit rating organization is not used. Develop a probability Tree Diagram to find the Posterior Probabilities of the respective states of nature. Develop a decision analysis formation of this programme b. . Assume now that the credit rating organization is used. c.a.

Alternative Poor Average Good 10000 0 20000 0 8000 Maxi mum 0 Extend credit -15000 Do not extend credit 0 Prior 0. State Alternative Extend credit Do not extend credit Prior probabilities Poor -15000 0 0.2 Average 10000 0 0.3 .2 probabilities Extend credit (Expected payoff is $8000 0.5 0.Solution a.5 Good 20000 0 0.3 b.

2 0. PS GF.02 PS & GF 0.5 AS 0. PF = Poor Finding PE = Poor State 0.12 GS & AF 0.1 PS & PF 0.3 . AS 0.1 GF.4 0. PS 0.5 0.5556 AS AF 0. GF GF = Good Finding GS = Good State 0.06 GS & PF 0.1778 PS AF 0.5 AF.6316 GS GF 0. GS 0.3.25 AS & AF 0.08 PS & AF 0.1 PS PF.1657 GS PF 0. GS 0.4 PF.12 GS.05 AS & GF 0. AS GS PF.1053 PS GF 0.02 AS & PF 0.4 AF. AS 0. GS GF. 2 0.5556 AS PF 0.2667 GS AF 0. PS AF = Average Finding AS = Average State 0.2632 AS GF 0.4 AF.28 PS PF 0.

DECISION TREES Decision trees provide away of visually displaying the decision analysis problem Example For the oil company µA¶ problem the decision tree is Oil Drill Unfavor b Drill Favor a Drill e Sell Sell Sell h Oil Dry d c Sell g Oil Dry f Dry Seismic No Seismic Survey The nodes of the Decision Tree are referred to as forks and the arcs are called branches. .

100 .3 d Sell 90 Drill . adding 90 both .100 Dry (0.7) b Favor 0. indicates that a random event occurs at that point.5) Seismic .100 Dry (0.130 90 Sell 60 Oil (0. indicates a decision needs to be made at that point in process 2.100 c 800 f Drill 0 .Forks are of two types 1.5) 670 800 g 0 . Oil (0.143) 670 Unfavor (0. Chance Fork ± Represented by a circle.75) e 90 Decision Tree after probabilities and pay offs.25) 700 800 h Drill 0 .130 Dry (0. Path required to reach a terminal branch is determined both by the decision made and by random events.30 a No Seismic 60 Oil (0.857) . Decision Fork ± Represented by a square.

. For each Chance Fork. cut out each rejected branch by inserting a double dash. calculate the expected payoff of each branch by the probability of that branch and summing these products. 2.Analysis 1. Record this payoff next to the relevant Fork 3. For each column do either step 2 or step 3 depending upon whether the Fork is a Chance Fork or a Decision Fork. For each Decision Fork. compare the expected payoffs of its branches and choose the alternative whose branch has the largest expected payoff. Start at the last column of the tree and move left one column at a time.

7 Sell Alternative has EP = 60 60 > -15. For Fork f EP = 0.857(-130) = -15.Example Consider oil company example Chance Fork f.7 For Fork g EP = 0.5(670) + 0.143(670) + 0. g.d and e.15.7 so choose Sell Alternative with .5(-130) = 270 For Fork h EP = 0. h. For Fork c Drill Alternative has EP = .75(-100) = 100 Moving one step to the left brings us to Decision Forks c. Apply step 2.25(700) + 0.

.7(60) + 0. so choose Do Seismic Survey.Fork d Drill Alternative has EP = 270 Sell Alternative has EP = 60 2. so choose Drill Alternative Fork e Drill Alternative has EP = 100 Sell Alternative has EP = 90 100 > 90.70 > 60. so choose Drill Alternative We move one more column to the left For Fork b EP = 0.3(270) = 123 Moving one column to the left Fork a Do Seismic Survey has EP = 123 No Seismic Survey has EP = 100 123 > 100.

2 b c 0.4 d 0.100 Dry (0. Do the analysis to obtain the final tree .130 d 270 90 60 Sell 100 Oil (0.130 c 90 Sell 60 Oil (0.75) e 90 Sell 90 Class Work 0.3 Oil (0.100 Dry (0.5) .5) 670 270 g 800 Drill 0 100 .7) 123 Seismic .6 2500 .700 900 a 800 750 1.30 a 0 No Seismic Survey b Favor 0.8 0.Final Tree Unfavor (0.7 670 f Drill 0 60 .857) .100 Dry (0.143) .15.100 100 .25) 700 800 h Drill 0 .

700 Class Work d 0.5 0.2 b a 820 750 820 900 0.5 f 0.4 25005 06 d 580 c 0.8 900 800 0.4 -10 0.6 0.5 b 0.6 .5 10 0 30 -10 a e 0.3 40 -5 1. Do the analysis 10 .Solution 0.4 c g 0.

3 and 0.$11 per share with respective probabilities 0.3 5 40 8 5 0.4 on Wednesday.5 0.5 10 15 0 15 2. 0. unchanged or 10% higher than Tuesday¶s close with the following probabilities .5 30 . on Tuesday you expect the stock to close at $9.7 . you expect the stock to close 10% lower.10 -5 8 0.Solution 0.10 10 Class work On Monday a certain stock closed at $10 per share.5 0. $10.5 0.3.

. so your options are to buy at the end of Tuesday or at the end of Wednesday. You wish to determine the optimal strategy for whether to buy on Tuesday or defer the purchase until Wednesday to minimize the expected purchase price.7 0.3 0.2 On Tuesday. All purchases are made at the end of the day. 1.4 0.Tuesday¶s Close $9 $ 10 $ 11 10% lower 0.3 0. you are directed to buy 100 shares of the stock before Thursday. Develop and analyze a decision free for determining the optimal strategy. at the known closing price of the day.2 0.6 0.2 0.1 Unchanged 10% higher 0.

4 10% lower .2 Unchanged 0.1100 Buy 0.6 10% Higher 0.1000 Wait .810 .3 Close at $ 10 .900 .3 10% Higher .900 0.3 Unchanged . If the price is $10 or $ 11 on Tuesday than buy on Tuesday .1168 0.2 10% lower Wait 0.891 Cl os e at $ 9 Buy 0.7 10% Higher .1100 0.900 .2 Unchanged .990 Wait .3 0 .1000 .891 0.1210 The optimal policy is to wait until Wednesday If the price is $ 9 on Tuesday.1000 .4 0.1000 .Solution 0.1 10% lower .990 .1100 .1040 Cl os e at $ 11 0.