Statistics for Managers

Using Microsoft Excel

Chapter 5
Decision Making

© 1999 Prentice-Hall, Inc. Chap. 5 - 1

 Chapter Topics
•The Payoff Table and Decision Trees
•Opportunity Loss
•Criteria for Decision Making
•Expected Monetary Value
•Expected Profit Under Certainty
•Return to Risk Ratio
•Decision Making with Sample Information
•Utility
© 1999 Prentice-Hall, Inc. Chap. 5 - 2
 Features of
Decision Making
•List Alternative Courses of Action
(Possible Events or Outcomes)
•Determine ‘Payoffs’
(Associate a Payoff with Each Event or Outcome)

•Adopt Decision Criteria

(Evaluate Criteria for Selecting the Best Course of
Action)

© 1999 Prentice-Hall, Inc. Chap. 5 - 3

 List Possible
Actions or Events

Two Methods
of Listing

Payoff Table Decision Tree

© 1999 Prentice-Hall, Inc. Chap. 5 - 4

 Payoff Table

Consider a food vendor determining

whether to sell soft drinks or hot dogs.

Course of Action (Aj)

Event (Ei) Sell Soft Drinks (A1) Sell Hot Dogs (A2)

Cool Weather (E1) x11 =$50 x12 = $100

Warm Weather (E2) x21 = 200 x22 = 125

xij = payoff (profit) for event i and action j

© 1999 Prentice-Hall, Inc. Chap. 5 - 5

 Decision Tree:Example

Food Vendor Profit Tree Diagram

a t her x11 = $50
We
Cool
ks Warm W
i n eather
Sof t Dr x21 = 200

Hot x12 = 100

D ogs ea t her
Cool W
Warm W
eath er
x22 =125
© 1999 Prentice-Hall, Inc. Chap. 5 - 6
 Opportunity Loss:
Example
Highest possible profit for an event Ei
- Actual profit obtained for an action Aj
Opportunity Loss (lij )
Event: Cool Weather
Action: Soft Drinks Profit: $50
Alternative Action: Hot Dogs Profit: $100
Opportunity Loss = $100 - $50 = $50

© 1999 Prentice-Hall, Inc. Chap. 5 - 7

 Opportunity Loss: Table

Alternative Course of Action

Event Optimal Profit of Sell Soft Drinks Sell Hot Dogs
Action Optimal
Action
Cool Hot 100 100 - 50 = 50 100 - 100 = 0
Weather Dogs

Warm Soft 200 200 - 200 = 0 200 - 125 = 75

Weather Drinks

© 1999 Prentice-Hall, Inc. Chap. 5 - 8

 Decision Criteria

Expected Monetary Value (EMV)

 The expected profit for taking an action Aj

Expected Opportunity Loss (EOL)

 The expected loss for not taking action Aj

Expected Value of Perfect Information (EVPI)

 The expected opportunity loss from the best decision

© 1999 Prentice-Hall, Inc. Chap. 5 - 9

 Decision Criteria -- EMV
Expected Monetary Value (EMV)
Sum (monetary payoffs of events)  (probabilities of the events)

N
Vj  X ij Pi
i=1

EMVj = expected monetary value of action j

xi,j = payoff for action j and event i
Pi = probability of event i occurring

© 1999 Prentice-Hall, Inc. Chap. 5 - 10

 Decision Criteria -- EMV Table
Example: Food Vendor
Pi Event Soft xijPi Hot xijPi
Drinks Dogs
.50 Cool $50 $50 .5 = $25 $100 $100.50 = $50

.50 Warm $200 $200 .5 = 100 $125 $25.50 = 62.50

EMV Soft Drink = $125 EMV Hot Dog = $112.50

Better alternative
© 1999 Prentice-Hall, Inc. Chap. 5 - 11
 Decision Criteria -- EOL
Expected Opportunity Loss (EOL)
Sum (opportunity losses of events)  (probabilities of events)

N
Lj  l ij Pi
i =1

EOLj = expected monetary value of action j

li,j = payoff for action j and event i
Pi = probability of event i occurring
© 1999 Prentice-Hall, Inc. Chap. 5 - 12
 Decision Criteria -- EOL Table
Example: Food Vendor
Pi Event Op Loss lijPi OP Loss lijPi
Soft Drinks Hot Dogs
.50 Cool $50 $50.50 = $25 $0 $0.50 = $0

.50 Warm 0 $0 .50 = $0 $75 $75 .50 = $37.50

EOL Soft Drinks = $25 EOL Hot Dogs = $37.50

Better Choice
© 1999 Prentice-Hall, Inc. Chap. 5 - 13
 Decision Criteria -- EVPI

Expected Value of Perfect Information (EVPI)

 The expected opportunity loss from the best decision

Expected Profit Under Certainty

- Expected Monetary Value of the Best Alternative
EVPI (should be a positive number)

 Represents the maximum amount you are willing

to pay to obtain perfect information
© 1999 Prentice-Hall, Inc. Chap. 5 - 14
 EVPI Computation
Expected Profit Under Certainty
= .50($100) + .50($200)
= $150

Expected Monetary Value of the Best Alternative

= $125
EPVI = $25 The maximum you would be willing to
spend to obtain perfect information.

© 1999 Prentice-Hall, Inc. Chap. 5 - 15

 Taking Account of
Variability: FoodVendor
2 for Soft Drink
= (50 -125)2 .5 + (200 -125)2 .5 = 5625
 for Soft Drink = 75
CVfor Soft Drinks = (75/125)  100% = 60%
2 for Hot Dogs = 156.25  for Hot dogs = 12.5
CVfor Hot dogs = 11.11%
© 1999 Prentice-Hall, Inc. Chap. 5 - 16
 Return to Risk Ratio
Expresses the relationship between the return
(payoff) and the risk (standard deviation).
EMV j
RRR = Return to Risk Ratio = j
RRRSoft Drinks = 125/75 = 1.67 RRRHot Dogs = 9
You might wish to choose Hot Dogs. Although Soft
Drinks have the higher Expected Monetary Value,
Hot Dogs have a much larger return to risk ratio and a
much smaller CV.
© 1999 Prentice-Hall, Inc. Chap. 5 - 17
 Decision Making with
Sample Information
Prior
Probability
•Permits Revising Old
Probabilities Based on New New
Information Information

Revised
Probability

© 1999 Prentice-Hall, Inc. Chap. 5 - 18

 Revised Probabilities
Example: Food Vendor
Additional Information: Weather forecast is COOL.
When the weather is cool, the forecaster was correct 80% of the time.
When it has been warm, the forecaster was correct 70% of the time.

F1 = Cool forecast
F2 = Warm forecast
E1 = Cool Weather = 0.50 Prior
Probability
E2 = Warm Weather = 0.50
P(F1 | E1) = 0.80 P(F1 | E2) = 0.30

© 1999 Prentice-Hall, Inc. Chap. 5 - 19

 Revising Probabilities
Example:Food Vendor
Revised Probability
P(F1 | E1) = 0.80 P(F1 | E2) = 0.30 E1 = 0.50 E2 = 0.50

P(cool)  P(cool forecast | cool)

P(E1 | F1) =
P(cool forecast)
(.50) (.80)
= = .73
(.80)(.50) + (.30)(.50)

P(warm)  P(cool forecast | warm)

P(E2 | F1) = = .27
P(cool forecast)
© 1999 Prentice-Hall, Inc. Chap. 5 - 20
 Revised EMV Table
Example: Food Vendor
Pi Event Soft xijPi Hot xijPi
Drinks Dogs
.73 Cool $50 $36.50 $100 $73

.27 Warm $200 54 125 33.73

EMV Soft Drink = $90.50 EMV Hot Dog = $106.75

Better alternative
© 1999 Prentice-Hall, Inc. Chap. 5 - 21
 Revised EOL Table
Example: Food Vendor
Pi Event Op Loss lijPi OP Loss lijPi
Soft Drink Hot Dogs

.73 Cool $50 $36.50 $0 0

.27 Warm 0 $0 75 20.25

EOL Soft Drinks = 36.50 EOL Hot Dogs = $20.25

Better Choice
© 1999 Prentice-Hall, Inc. Chap. 5 - 22
 Revised EVPI Computation
Expected Profit Under Certainty
= .73($100) + .27($200)
= $127

Expected Monetary Value of the Best Alternative

= $106.75
EPVI = $20.25 The maximum you would be willing to
spend to obtain perfect information.

© 1999 Prentice-Hall, Inc. Chap. 5 - 23

 Taking Account of Variability:
Revised Computation
2 for Soft Drinks
= (50 -90.5)2 .73 + (200 -90.5)2 .27 = 4434.75
 for Soft Drinks = 66.59

CVfor Soft Drinks = (66.59/90.5)  100% = 73.6%

2 for Hot Dogs = 123.1875
 for Hot dogs = 11.10
CVfor Hot dogs = (11.10/106.75)  100% = 10.4%
© 1999 Prentice-Hall, Inc. Chap. 5 - 24
 Revised Return to Risk Ratio
Expresses the relationship between the return
(payoff) and the risk (standard deviation).
EMV j
RRR = Return to Risk Ratio = j

RRRSoft Drinks = 90.50/66.59 = 1.36 RRRHot Dogs = 9.62

You might wish to choose Hot Dogs. Hot Dogs have a

much larger return to risk ratio.

© 1999 Prentice-Hall, Inc. Chap. 5 - 25

 Utility
Utility is the idea that each incremental $1 of
profit does not have the same value to every
individual:
• A risk averse person, once reaching a goal,
assigns less value to each incremental $1.
• A risk seeker assigns more value to each
incremental $1.
• A risk neutral person assigns the same value
to each $1.
© 1999 Prentice-Hall, Inc. Chap. 5 - 26
 Chapter Summary
•Described The Payoff Table and Decision Trees
•Opportunity Loss
•Provided Criteria for Decision Making
•Expected Monetary Value
•Expected Profit Under Certainty
•Return to Risk Ratio
•Discussed Decision Making with Sample
Information
•Addressed the Concept of Utility
© 1999 Prentice-Hall, Inc. Chap. 5 - 27