Probability and Decision Analysis

Structuring Decisions and Making Choices

ENGM 603
 Agenda
› One-time problems under certainty
› One-time problems under risk
› Multi-stage problems
› Incorporating risk

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An Example: Magnolia Inns
 Hartsfield International Airport in Atlanta, Georgia, is one of the busiest
airports in the world.
 It has expanded many times to handle increasing air traffic.
 Commercial development around the airport prevents it from building
more runways to handle future air traffic.
 Plans are being made to build another airport outside the city limits.
 Two possible locations for the new airport have been identified, but a
final decision will not be made for a year.
 The Magnolia Inns hotel chain intends to build a new facility near the new
airport once its site is determined.
 Land values around both possible sites for the new airport are increasing
as investors speculate that property values will increase greatly in the
vicinity of the new airport.

 This is a single-stage, one-time decision problem.

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 The Decision Alternatives

1. Buy the parcel of land at location A.

2. Buy the parcel of land at location B.

3. Buy both parcels.

4. Buy nothing.
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Example

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 The Possible States of Nature

1. The new airport is built at location A.

2. The new airport is built at location B.

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Constructing a Payoff Matrix
Outcome 1 Outcome 2 Outcome m
….

Decision 1

Decision 2

. . . . .
. . . . .
. . . . .

Decision n

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Constructing a Payoff Matrix
Outcome 1 Outcome 2 Outcome m
….

Decision 1

Pay off if Outcome 1 occurs

Decision 2
and Decision 2 was made.
. . . . .
. . . . .
. . . . .

Decision n

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 Payoff Matrix

Land Purchased Airport is Built at Location

at Location(s) A B
A $?? $??
B $?? $??

A&B $?? $??

None $?? $??

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Land Purchased Airport is Built at Location
at Location(s) A B
A =31-18=13 $??
B $?? $??

A&B $?? $??

None $?? $??
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Land Purchased Airport is Built at Location
at Location(s) A B
A =$31-$18=$13 $??
B =$4-$12=-$8 $??

A&B $?? $??

None $?? $??
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Land Purchased Airport is Built at Location
at Location(s) A B
A =$31-$18=$13 $??
B =$4-$12= - $8 $??

A&B =$31+$4-($18+$12)=$5 $??

None $0 $??
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 Payoff Matrix

Land Purchased Airport is Built at Location

at Location(s) A B
A $13 ($12)
B ($8) $11

A&B $5 ($1)
None $0 $0

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 Decision Rules
› If the future state of nature (airport location) were
known, it would be easy to make a decision.
› Failing this, a variety of non-probabilistic
(deterministic) decision rules can be applied to this
problem:
› Maximax
› Maximin
› Minimax regret
› No decision rule is always best and each has its own
weaknesses.

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 Payoff Matrix
MaxiMax

Airport is Built at
Land Purchased Location
at Location(s) A B Max
A $13 ($12) $13
B ($8) $11 $11
A&B $5 ($1) $5
None $0 $0 $0

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 The Maximax Decision Rule
› Identify the maximum payoff for each alternative.
› Choose the alternative with the largest maximum payoff.

 Weakness
– Consider the following payoff matrix
State of Nature
Decision 1 2 MAX
A 30 -10000 30 ←maximum
B 29 29 29

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 Payoff Matrix
MaxiMin

Airport is Built at
Land Purchased Location
at Location(s) A B Min
A $13 ($12) $(12)
B ($8) $11 $(8)
A&B $5 ($1) $(1)
None $0 $0 $0

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 The Maximin Decision Rule
› Identify the minimum payoff for each alternative.
› Choose the alternative with the largest minimum payoff.

 Weakness
– Consider the following payoff matrix
State of Nature
Decision 1 2 MIN
A 1000 28 28
B 29 29 29 ←maximum

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 The Payoff Matrix and Regret
If state of nature A occurs, then If state of nature B occurs, then
the highest payoff is $13 the highest payoff is $11

Land Purchased Airport is Built at Location

at Location(s) A B
A $13 ($12)
B ($8) $11

A&B $5 ($1)
None $0 $0

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 Regret Matrix
Abolute values calculated by
Absolue values calculated by
subtracting $11 from the
subtracting $13 from the
corresponding entries of the
corresponding entries of the
Payoff Matrix
Payoff Matrix
Airport is Built at
Land Purchased Location
at Location(s) A B
A $0 $23
B $21 $0
A&B $8 $12
None $13 $11

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 Regret Matrix
the MinMax regret policy

Airport is Built at
Land Purchased Location
at Location(s) A B Max
A $0 $23 $23
B $21 $0 $21
A&B $8 $12 $12
None $13 $11 $13

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 Anomalies with the Minimax Regret Rule
 Consider the following payoff matrix
State of Nature
Decision 1 2
A 9 2
B 4 6

 The regret matrix is:

State of Nature
Decision 1 2 MAX
A 0 4 4 ←minimum
B 5 0 5
 Note that we prefer A to B.

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 Adding an Alternative
 Consider the following payoff matrix
State of Nature
Decision 1 2
A 9 2
B 4 6
C 3 9

 The regret matrix is:

State of Nature
Decision 1 2 MAX
A 0 7 7
B 5 3 5 ←minimum
C 6 0 6

 Now we prefer B to A?
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 Agenda
› One-time problems under certainty
› One-time problems under risk
› Multi-stage problems
› Incorporating risk

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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 (such as the Magnolia Inns problem)
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.
› We will focus on techniques that can be used once appropriate
probability estimates have been obtained.

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 Expected Monetary Value
 Selects alternative with the largest expected monetary
value (EMV)
EMVi   rij p j
j
rij  payoff for alternativ e i under the jth state of nature
p j  the probabilit y 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.
 See file payoff.xls

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

Probability 0.4 0.6

(13)(0.4) + (-12)(0.6) = - 2

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 EMV Caution
› The EMV rule should be used with caution in one-time
decision problems.
 Weakness (ignores risk)
– – Consider the following payoff matrix
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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 Looking Forward to Future Lectures. The Expected Value
of Perfect Information

› Suppose we could hire a consultant who could predict the future with
100% accuracy.
› With such perfect information, Magnolia Inns’ average payoff would be:
› EV with PI = 0.4*$13 + 0.6*$11 = $11.8 (in millions)
› Without perfect information, the EMV was $3.4 million.
› The expected value of perfect information is therefore:
› EV of PI = $11.8 - $3.4 = $8.4 (in millions)
› In general:
› EV of PI = EV with PI - maximum EMV
› It will always be the case that:

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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
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 Rolling Back A 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
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 Alternate 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 -1
0.6

Buy nothing
0
0
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 Agenda
› One-time problems under certainty
› One-time problems under risk
› Multi-stage problems
› Incorporating risk

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 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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 Multi-Stage Decision 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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 COM-TECH (continued)
 COM-TECH knows she will also spend money in R&D, but she 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 her 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.
 See file forward_pass.xls, backward_pass.xls

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 High R&D Costs
16000
Microwave -60000 16000

-4000 28000 0.4

Low R&D Costs
46000
-30000 46000

0.2
High R&D Costs
0.5 5000
Receive Grant Cellular -70000 5000
3
85000 32000 -5000 29000 0.8
Low R&D Costs
35000
-40000 35000

0.1
High R&D Costs
Submit Proposal -4000
Infrared -80000 -4000
-5000 13500
-4000 32000 0.9
Low R&D Costs
36000
-40000 36000

1 0.5
13500 Don't Receive Grant
-5000
0 -5000

Don't Submit Proposal

0
0 0
 Probability Payoff
0.45 36000
0.05 -4000
0.5 -5000

How do you calculate the Mean? Variance? Standard Deviation?

How would you plot the probability distribution? The
Cumulative Distribution?
Probability Distribution (or risk profile) of the Decision to
1. Apply for the Grant
2. Go with the Infrared Technology

Probability Payoff
0.45 36000
0.05 -4000
0.5 -5000

How do you calculate the Mean? Variance? Standard Deviation?

How would you plot the probability distribution? The
Cumulative Distribution?
 Risk Profiles
› A risk profile summarizes the make-up of an EMV.
› The $13,500 EMV for COM-TECH was created by:

Event Probability Payoff

Receive grant, Low R&D costs 0.5*0.9=0.45 $36,000
Receive grant, High R&D costs 0.5*0.1=0.05 -$4,000
Don’t receive grant 0.5 -$5,000
EMV $13,500

 This can also be summarized in a decision tree

risk_profile.xls.

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 Influence Diagrams
› Provide simple graphical representations of decision situations
using four basic shapes
› Decision node
› Chance node
› Payoff node
› Consequence or calculation node
› Connectors
› Beginning node of an arc is called a predecessor.
› The node at the end of an arc is a successor.
Influence Diagram – Example
 Influence Diagrams & the Fundamental-
Objectives Hierarchy - Example
Venture capitalist’s
decision with two
objectives
 Influence Diagrams & the Fundamental-
Objectives Hierarchy - Example
Multiple
objectives in
selecting a bomb
detection system
 Using Arcs in Influence Diagrams

Arcs are used to

represent
relationships among
the nodes, and
represent either
relevance or
sequence.
 Some Basic Influence Diagrams
› Basic risky decision: there is one decision to make and one
uncertain event.
 Some Basic Influence Diagrams
› Imperfect information: The eventual payoff is affected by
some type of imperfect information about an uncertain event ,
e.g., weather forecast, expert diagnosis, and computer
estimate.
 Some Basic Influence Diagrams
› Imperfect information: The eventual payoff is affected by
some type of imperfect information about an uncertain event ,
e.g., weather forecast, expert diagnosis, and computer
estimate.
 Some Basic Influence Diagrams
› Sequential decisions: a series of interdependent decisions
linked together by sequence arcs
› Order of events and related decisions are shown by the
arcs.
 Some Basic Influence Diagrams
› Sequential decisions: a series of interdependent decisions
linked together by sequence arcs
› Order of events and related decisions are shown by the
arcs.
 Some Basic Influence Diagrams
› Intermediate calculation: a node that aggregates results from
certain predecessor nodes
› A convenient summary of multiple predecessor nodes
 Some Basic Influence Diagrams
› Intermediate calculation: a node that aggregates results from
certain predecessor nodes
› A convenient summary of multiple predecessor nodes
 Influence Diagrams – Common Mistakes
› Interpreting influence diagrams as flowcharts
› A flowcharts depicts the sequential nature of a particular
process where each node represents an event or activity,
whereas an influence diagrams is a snapshot of the decision
situation at a particular point in time.

› Including cycles, i.e., circular paths among the nodes

 Decision Trees
› Can display more details than influence diagrams

Branches from circle =

possible outcomes of a
chance event
Phrases at end of the
branches =
Square = consequences
decision to
be made

Branches from square

= choices available to
decision maker
 Interpreting Decision Trees

1. Options shown by branches from a decision node indicate

that the decision maker can choose only one option
2. Branches from each chance node form a set that is:
› Mutually exclusive – only one outcome can happen
› And collectively exhaustive – no other possible outcomes
exist.
 Interpreting Decision Trees
3. The decision tree shows all of the possible paths that the
decision maker might follow.
› All possible decision alternatives
› All possible chance outcomes
4. Often helpful to view the nodes as occurring chronologically
› Beginning on the left side of the tree: this is the first thing
to happen, usually a decision
› Moving to the right: consequent decisions or chance
events happen
 Some Basic Decision Trees

Range-of-risk dilemma: outcome of a chance event can take on

a value within a range of possible values