Chapter 19 Decision Analysis

Statistics for Business and Economics (13e)
Statistics for
Business and Economics (13e)
Anderson, Sweeney, Williams, Camm, Cochran
© 2017 Cengage Learning
Slides by John Loucks

St. Edwards University
© 2017 Cengage Learning. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
otherwise on a password-protected website or school-approved learning management system for classroom use.
1
Chapter 21
Decision Analysis
• Problem Formulation
• Decision Making with Probabilities
• Decision Analysis with Sample Information
• Computing Branch Probabilities using Bayes’ Theorem
2
Problem Formulation
• The first step in the decision analysis process is problem formulation.
• We begin with a verbal statement of the problem.
• Then we identify:
• the decision alternatives
• the states of nature (uncertain future events)
• the payoffs (consequences) associated with each specific combination of:
• decision alternative
• state of nature
3
Problem Formulation
• A decision problem is characterized by decision alternatives, states of
nature, and resulting payoffs.
• The decision alternatives are the different possible strategies the decision
maker can employ.
• The states of nature refer to future events, not under the control of the
decision maker, which may occur.
• States of nature should be defined so that they are mutually exclusive and
collectively exhaustive.
4
Payoff Tables
• The consequence resulting from a specific combination of a decision
alternative and a state of nature is a payoff.
• A table showing payoffs for all combinations of decision alternatives and states
of nature is a payoff table.
• Payoffs can be expressed in terms of profit, cost, time, distance or any other
appropriate measure.
5
Decision Trees
• A decision tree provides a graphical representation showing the sequential
nature of the decision-making process.
• Each decision tree has two types of nodes:
• round nodes correspond to the states of nature
• square nodes correspond to the decision alternatives
6
Decision Trees
• The branches leaving each round node represent the different states of nature
while the branches leaving each square node represent the 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.
7
Decision Making with Probabilities

• Once we have defined the decision alternatives and states of nature for the
chance events, we focus on determining probabilities for the states of nature.
• The classical method, relative frequency method, or subjective method of
assigning probabilities may be used.
• Because one and only one of the N states of nature can occur, the probabilities
must satisfy two conditions:
P(sj) > 0 for all states of nature

𝑁
∑ 𝑃 ( 𝑠 𝑗 ) =𝑃 ( 𝑠1 ) +𝑃 ( 𝑠2 ) +…+𝑃 ( 𝑠 𝑁 ) =1
𝑗=1
8
Decision Making with Probabilities

• Then we use the expected value approach to identify the best or
recommended decision alternative.
• The expected value of each decision alternative is calculated (explained on the
next slide).
• The decision alternative yielding the best expected value is chosen.
Expected Value Approach

• The expected value of a decision alternative is the sum of weighted payoffs for
the decision alternative.
• The expected value (EV) of decision alternative di is defined as
𝑁
𝐸𝑉 ( 𝑑𝑖 )=∑ 𝑃 (𝑠 𝑗 )𝑉 𝑖𝑗
𝑗=1
where: N = the number of states of nature

P(sj ) = the probability of state of nature sj
Vij = the payoff corresponding to decision alternative di
and state of nature sj
10

• Example: Burger Prince
Burger Prince Restaurant is considering opening a new restaurant on Main
Street. It has three different restaurant layout models (A, B, and C), each with
a different seating capacity.
Burger Prince estimates that the average number of customers served
per hour will be 80, 100, or 120. The payoff table for the three models is on
the next slide.
11

• Payoff Table
Average Number of
Customers Per Hour
s1 = 80 s2 = 100 s3 = 120
Model A $10,000 $15,000 $14,000

Model B $ 8,000 $18,000 $12,000
Model C $ 6,000 $16,000 $21,000
12

• Calculate the expected value for each decision.
• The decision tree on the next slide can assist in this calculation.
• Here d1, d2, d3 represent the decision alternatives of models A, B, and C.
• And s1, s2, s3 represent the states of nature of 80, 100, and 120 customers
per hour.
13

• Decision Tree Payoffs
s1 .4 10,000
s2 .2
2 s3 15,000
.4
d1
14,000
s1 .4
d2 8,000
s2 .2
1 3 18,000
s3 .4
d3 12,000
s1 .4
6,000
4 s2 .2
s3 16,000
.4
21,000
14

• Decision Tree
EMV = .4(10,000) + .2(15,000)
d1 2 + .4(14,000) = $12,600
Model A
EMV = .4(8,000) + .2(18,000)
Model B d2 + .4(12,000) = $11,600
1 3
d3 EMV = .4(6,000) + .2(16,000)

Model C
4 + .4(21,000) = $14,000
Choose the model with largest EV, Model C
15
Expected Value of Perfect Information

• Frequently, information is available that can improve the probability estimates
for the states of nature.
• The expected value of perfect information (EVPI) is the increase in the
expected profit that would result if one knew with certainty which state of
nature would occur.
• The EVPI provides an upper bound on the expected value of any sample or
survey information.
16

• The expected value of perfect information is defined as
EVPI = |EVwPI – EVwoPI|
where:
EVPI = expected value of perfect information
EVwPI = expected value with perfect information
about the states of nature
EVwoPI = expected value without perfect information
17

• EVPI Calculation
• Step 1: Determine the optimal return corresponding to each state of nature.
•Step 2: Compute the expected value of these optimal returns.
• Step 3: Subtract the EV of the optimal decision from the amount determined
in step (2).
18

• Calculate the expected value for the optimum payoff for each state of nature
and subtract the EV of the optimal decision.
EVPI = .4(10,000) + .2(18,000) + .4(21,000) - 14,000 = $2,000
19
Decision Analysis With Sample Information

• Knowledge of sample (survey) information can be used to revise the
probability estimates for the states of nature.
• Prior to obtaining this information, the probability estimates for the states of
nature are called prior probabilities.
• With knowledge of conditional probabilities for the outcomes or indicators of
the sample or survey information, these prior probabilities can be revised by
employing Bayes' Theorem.
• The outcomes of this analysis are called posterior probabilities or branch
probabilities for decision trees.
20

• Decision Strategy
• A decision strategy is a sequence of decisions and chance outcomes.
• The decisions chosen depend on the yet to be determined outcomes of
chance events.
• The approach used to determine the optimal decision strategy is based on a
backward pass through the decision tree.
21

• Backward Pass Through the Decision Tree
• At Chance Nodes:
Compute the expected value by multiplying the payoff at the end of each
branch by the corresponding branch probability.
• At Decision Nodes:
Select the decision branch that leads to the best expected value. This
expected value becomes the expected value at the decision node.
22

Burger Prince must decide whether to purchase a marketing survey from
Stanton Marketing for $1,000. The results of the survey are "favorable" or
"unfavorable". The conditional probabilities are:
P(favorable | 80 customers per hour) = .2
23

• Decision Tree (top half)
s1 (.148)
$10,000
s2 (.185)
d1 4 $15,000
s3 (.667)
$14,000
s1 (.148) $8,000
d2 s2 (.185)
2 5 $18,000
s3 (.667)
I1 d3 $12,000
s1 (.148)
(.54) $6,000
s2 (.185)
6 $16,000
s3 (.667)
1
$21,000
24

• Decision Tree (bottom half)
s1 (.696)
1 $10,000
I2 s2 (.217)
(.46) d1 7 $15,000
s3 (.087)
$14,000
s1 (.696) $8,000
d2 s2 (.217)
3 8 $18,000
s3 (.087)
d3 $12,000
s1 (.696)
$6,000
s2 (.217)
9 $16,000
s3 (.087)
$21,000
25

d1 4 EMV = .148(10,000) + .185(15,000)
$17,855 + .667(14,000) = $13,593
d2
2 5 EMV = .148 (8,000) + .185(18,000)
I1 d3 + .667(12,000) = $12,518
(.54)
6 EMV = .148(6,000) + .185(16,000)
+.667(21,000) = $17,855
1
d1 7 EMV = .696(10,000) + .217(15,000)
I2 +.087(14,000)= $11,433
(.46) d2
3 8 EMV = .696(8,000) + .217(18,000)
d3 + .087(12,000) = $10,554
$11,433
9 EMV = .696(6,000) + .217(16,000)
+.087(21,000) = $9,475
26
Expected Value of Sample Information

• The expected value of sample information (EVSI) is the additional expected
profit possible through knowledge of the sample or survey information.
EVSI = |EVwSI – EVwoSI|
where:
EVSI = expected value of sample information
EVwSI = expected value with sample information
EVwoSI = expected value without sample information
27

• EVwSI Calculation
• Step 1: Determine the optimal decision and its expected return for the
possible outcomes of the sample using the posterior probabilities for the
states of nature.
• Step 2: Compute the expected value of these optimal returns.
28

d1 4 $13,593
$17,855
d2
2 5 $12,518
I1 d3
(.54)
6 $17,855
EVwSI = .54(17,855)
+ .46(11,433) 1
= $14,900.88 d1 7 $11,433
I2
(.46) d2
3 8 $10,554
d3
$11,433
9 $ 9,475
29

• If the outcome of the survey is "favorable”, choose Model C.
• If the outcome of the survey is “unfavorable”, choose Model A.
EVwSI = .54($17,855) + .46($11,433) = $14,900.88
30

• EVSI Calculation
Subtract the EVwoSI (the value of the optimal decision obtained without using
the sample information) from the EVwSI.
EVSI = .54($17,855) + .46($11,433) - $14,000 = $900.88
• Conclusion
Because the EVSI is less than the cost of the survey, the survey should not be
purchased.
31
Computing Branch Probabilities Using Bayes’ Theorem

• Bayes’ Theorem can be used to compute branch probabilities for
decision trees.
• For the computations we need to know:
• the initial (prior) probabilities for the states of nature,
• the conditional probabilities for the outcomes or indicators of the sample
information given each state of nature.
• A tabular approach is a convenient method for carrying out the computations.
32
Computing Branch Probabilities Using Bayes’ Theorem

• Step 1
For each state of nature, multiply the prior probability by its conditional
probability for the indicator. This gives the joint probabilities for the states
and indicator.
• Step 2
Sum these joint probabilities over all states. This gives the marginal
probability for the indicator.
• Step 3
For each state, divide its joint probability by the marginal probability for
the indicator. This gives the posterior probability distribution.
33

Recall that Burger Prince is considering purchasing a marketing survey from
Stanton Marketing. The results of the survey are "favorable“ or "unfavorable".
The conditional probabilities are:

Compute the branch (posterior) probability distribution.
34
Posterior Probabilities
Favorable
State Prior Conditional Joint Posterior

80 .4 .2 .08 .148 = .08/.54
100 .2 .5 .10 .185
120 .4 .9 .36 .667
Total .54 1.000
P(Favorable) = .54
35
Posterior Probabilities
Unfavorable
State Prior Conditional Joint Posterior

80 .4 .8 .32 .696 = .32/.46
100 .2 .5 .10 .217
120 .4 .1 .04 .087
Total .46 1.000
P(Unfavorable) = .46
36
End of Chapter 21
37

Chapter 19 Decision Analysis

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Chapter 19 Decision Analysis

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Statistics for Business and Economics (13e)

Slides by John Loucks

Decision Making with Probabilities

P(sj) > 0 for all states of nature

Decision Making with Probabilities

Expected Value Approach

where: N = the number of states of nature

Expected Value Approach

Expected Value Approach

Model A $10,000 $15,000 $14,000

Expected Value Approach

Expected Value Approach

Expected Value Approach

d3 EMV = .4(6,000) + .2(16,000)

Choose the model with largest EV, Model C

Expected Value of Perfect Information

Expected Value of Perfect Information

EVPI = |EVwPI – EVwoPI|

Expected Value of Perfect Information

Expected Value of Perfect Information

Decision Analysis With Sample Information

Decision Analysis With Sample Information

Decision Analysis With Sample Information

Decision Analysis With Sample Information

Decision Analysis With Sample Information

Decision Analysis With Sample Information

Decision Analysis With Sample Information

Expected Value of Sample Information

Expected Value of Sample Information

Decision Analysis With Sample Information

Expected Value of Sample Information

EVwSI = .54($17,855) + .46($11,433) = $14,900.88

Expected Value of Sample Information

Computing Branch Probabilities Using Bayes’ Theorem

Computing Branch Probabilities Using Bayes’ Theorem

Decision Analysis With Sample Information

P(favorable | 80 customers per hour) = .2

State Prior Conditional Joint Posterior

State Prior Conditional Joint Posterior

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