Overview of Chapter 4

In this lecture, we will cover:

• Decision trees and expected monetary value
• Double risk dilemma
• Influence diagrams
– Asymmetric and symmetric influence diagrams
• Risk profiles
– Cumulative risk profiles
• Dominance
 Preliminary Considerations
• Simplification
– A necessary aspect of analysis
• Not just pedagogical
• Cannot include all the details
• Ensure include relevant information and aspects of
decision
• Probabilities
– Quantify chances of each outcome
– Allows factoring in ‘beliefs’
 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
 Decision Trees and EMV
• “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, or
2. Choose the branch with the highest value or
expected value when a decision node is
1

encountered.
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?
Decision Tree Example
 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.
 Risk Profiles
• Probability values
– The chance an event will happen, often presented
as a %
– The probabilities for a given alternative or a
strategy must always sum to one.
 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
 Risk Profiles
• Constructing a risk profile
– Collapse a decision tree by multiplying out the
probabilities on sequential chance branches
• Similar to the folding-back procedure we
learned earlier
– Except that in a risk profile we keep track of the
possible outcomes and their probabilities
 Risk Profiles
• Risk profiles can be used as an alternative to EMV.
– Allows you to check every possible strategy.
– For complex decisions it can be tedious to analyze
numerous risk profiles.
• A common compromise:
– First, analyze risk profiles for only the first one or two
decisions
– Second, make future decisions using a decision rule
such as maximizing EMV
– This is the approached used in PrecisionTree
 Cumulative Risk Profiles
• Cumulative format:
– On the vertical axis, show the aggregate chance
that the payoff is less than or equal to the
corresponding value on the horizontal axis.
– This is done by translating the information
contained in the risk profile.
– Add up, or accumulate, the chances of the
individual payoffs.
Constructing a Risk Profile – Step 1
 Constructing a Risk Profile – 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.
Constructing a Risk Profile – Step 3
The seven branches from the chance node in Step 2 have
been combined into three branches.
Constructing a Risk Profile – Step 4
The risk profile shown on x and y axes.

Probabilities for Decision Tree 'Texaco vs. Pennzoil'

Choice Comparison for Node 'Accept $2 Billion?'
100%

80%

60%

Accept $2 Billion
Probability

Counteroffer $5 Billion
40%

20%

0%
$0.00

$4.00

$8.00

$10.00
-$2.00

$2.00

$6.00

$12.00
Constructing a Risk Profile – Step 5
The cumulative risk profile, also shown
on x and y axes.
 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 one strategy’s profile is always to the right of
an alternative’s, then the first is said to
dominate, and is definitely the best strategy.
Dominance
Dominance
Dominance
Dominance
 Dominance
Strategy A
(dotted line)
dominates
Strategy B
(solid line)
because
Strategy A is
always right
of Strategy
B.
 Dominance
• Varying degree 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
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.
 “The Summer Job” Example
• Summer job decision involves two objectives
– Money
– Fun
• Money already has a scale – monetary value
• Need to create a scale for fun since doesn’t
have a natural scale
 “The Summer Job” Example
Start by
representing the
situation as an
influence
diagram – the Big
Picture.
Also, shows areas
of uncertainty.
 “The Summer Job” Example
Next, create a
decision tree –
shows Sam’s
beliefs (scale)
about fun and
translates
uncertainties
into
probabilities.
 “The Summer Job” Example
Calculate EMVs and create risk profiles for the two alternative jobs, one objective at a time.
 “The Summer Job” Example
• 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.
• Must also assign probabilities to various options
 “The Summer Job” Example
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.
 “The Summer Job” Example
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.
 “The Summer Job” Example
Now fold back the tree and calculate expected
values using probabilities and overall scores. Show
as risk profiles for the summer job.
 “The Summer Job” Example
Create cumulative risk profiles and check for dominance.
The forest job is stochastically dominant.
 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