Table of Contents

Chapter 9 (Decision Analysis)

Decision Analysis Examples 9.2–9.3

A Case Study: The Goferbroke Company Problem (Section 9.1) 9.4–9.8
Decision Criteria (Section 9.2) 9.9–9.13
Decision Trees (Section 9.3) 9.14–9.19
Sensitivity Analysis with Decision Trees (Section 9.4) 9.20–9.24
Checking Whether to Obtain More Information (Section 9.5) 9.25–9.26
Using New Information to Update the Probabilities (Section 9.6) 9.27–9.34
Decision Tree to Analyze a Sequence of Decisions (Section 9.7) 9.35–9.38
Sensitivity Analysis with a Sequence of Decisions (Section 9.8) 9.39–9.41
Using Utilities to Better Reflect the Values of Payoffs (Section 9.9) 9.42–9.54

McGraw-Hill/Irwin 9.1 © The McGraw-Hill Companies, Inc., 2013

 Decision Analysis

• Managers often must make decisions in environments that are fraught with
uncertainty.

• Some Examples
– A manufacturer introducing a new product into the marketplace
• What will be the reaction of potential customers?
• How much should be produced?
• Should the product be test-marketed?
• How much advertising is needed?
– A financial firm investing in securities
• Which are the market sectors and individual securities with the best prospects?
• Where is the economy headed?
• How about interest rates?
• How should these factors affect the investment decisions?

McGraw-Hill/Irwin 9.2 © The McGraw-Hill Companies, Inc., 2013

 Decision Analysis

• Managers often must make decisions in environments that are fraught with
uncertainty.

• Some Examples
– A government contractor bidding on a new contract.
• What will be the actual costs of the project?
• Which other companies might be bidding?
• What are their likely bids?
– An agricultural firm selecting the mix of crops and livestock for the season.
• What will be the weather conditions?
• Where are prices headed?
• What will costs be?
– An oil company deciding whether to drill for oil in a particular location.
• How likely is there to be oil in that location?
• How much?
• How deep will they need to drill?
• Should geologists investigate the site further before drilling?

McGraw-Hill/Irwin 9.3 © The McGraw-Hill Companies, Inc., 2013

 The Goferbroke Company Problem

• The Goferbroke Company develops oil wells in unproven territory.

• A consulting geologist has reported that there is a one-in-four chance of oil on

a particular tract of land.

• Drilling for oil on this tract would require an investment of about $100,000.

• If the tract contains oil, it is estimated that the net revenue generated would be
approximately $800,000.

• Another oil company has offered to purchase the tract of land for $90,000.

Question: Should Goferbroke drill for oil or sell the tract?

McGraw-Hill/Irwin 9.4 © The McGraw-Hill Companies, Inc., 2013

 Prospective Profits

Profit
Status of Land Oil Dry
Alternative
Drill for oil $700,000 –$100,000

Sell the land 90,000 90,000

Chance of status 1 in 4 3 in 4

McGraw-Hill/Irwin 9.5 © The McGraw-Hill Companies, Inc., 2013

 Decision Analysis Terminology

• The decision maker is the individual or group responsible for making the
decision.

• The alternatives are the options for the decision to be made.

• The outcome is affected by random factors outside the control of the decision
maker. These random factors determine the situation that will be found when
the decision is executed. Each of these possible situations is referred to as a
possible state of nature.

• The decision maker generally will have some information about the relative
likelihood of the possible states of nature. These are referred to as the prior
probabilities.

• Each combination of a decision alternative and a state of nature results in

some outcome. The payoff is a quantitative measure of the value to the
decision maker of the outcome. It is often the monetary value.

McGraw-Hill/Irwin 9.6 © The McGraw-Hill Companies, Inc., 2013

 Prior Probabilities

State of Nature Prior Probability

The tract of land contains oil 0.25

The tract of land is dry (no oil) 0.75

McGraw-Hill/Irwin 9.7 © The McGraw-Hill Companies, Inc., 2013

 Payoff Table (Profit in $Thousands)

State of Nature
Alternative Oil Dry

Drill for oil 700 –100

Sell the land 90 90

Prior probability 0.25 0.75

McGraw-Hill/Irwin 9.8 © The McGraw-Hill Companies, Inc., 2013

 The Maximax Criterion

• The maximax criterion is the decision criterion for the eternal optimist.

• It focuses only on the best that can happen.

• Procedure:
– Identify the maximum payoff from any state of nature for each alternative.
– Find the maximum of these maximum payoffs and choose this alternative.

State of Nature
Alternative Oil Dry Maximum in Row
Drill for oil 700 –100 700  Maximax
Sell the land 90 90 90

McGraw-Hill/Irwin 9.9 © The McGraw-Hill Companies, Inc., 2013

 The Maximin Criterion

• The maximin criterion is the decision criterion for the total pessimist.

• It focuses only on the worst that can happen.

• Procedure:
– Identify the minimum payoff from any state of nature for each alternative.
– Find the maximum of these minimum payoffs and choose this alternative.

State of Nature
Alternative Oil Dry Minimum in Row
Drill for oil 700 –100 –100
Sell the land 90 90 90  Maximin

McGraw-Hill/Irwin 9.10 © The McGraw-Hill Companies, Inc., 2013

 The Maximum Likelihood Criterion

• The maximum likelihood criterion focuses on the most likely state of nature.

• Procedure:
– Identify the state of nature with the largest prior probability
– Choose the decision alternative that has the largest payoff for this state of nature.

State of Nature
Alternative Oil Dry
Drill for oil 700 –100 –100
Sell the land 90 90 90  Step 2: Maximum
Prior probability 0.25 0.75

Step 1: Maximum

McGraw-Hill/Irwin 9.11 © The McGraw-Hill Companies, Inc., 2013

 Bayes’ Decision Rule

• Bayes’ decision rule directly uses the prior probabilities.

• Procedure:
– For each decision alternative, calculate the weighted average of its payoff by
multiplying each payoff by the prior probability and summing these products. This
is the expected payoff (EP).
– Choose the decision alternative that has the largest expected payoff.

A B C D E F
1 Bayes' Decision Rule for the Goferbroke Co.
2
3 Payoff Table State of Nature Expected
4 Alternative Oil Dry Payoff
5 Drill 700 -100 100
6 Sell 90 90 90
7
8 Prior Probability 0.25 0.75

McGraw-Hill/Irwin 9.12 © The McGraw-Hill Companies, Inc., 2013

 Bayes’ Decision Rule

• Features of Bayes’ Decision Rule

– It accounts for all the states of nature and their probabilities.
– The expected payoff can be interpreted as what the average payoff would become if
the same situation were repeated many times. Therefore, on average, repeatedly
applying Bayes’ decision rule to make decisions will lead to larger payoffs in the
long run than any other criterion.

• Criticisms of Bayes’ Decision Rule

– There usually is considerable uncertainty involved in assigning values to the prior
probabilities.
– Prior probabilities inherently are at least largely subjective in nature, whereas sound
decision making should be based on objective data and procedures.
– It ignores typical aversion to risk. By focusing on average outcomes, expected
(monetary) payoffs ignore the effect that the amount of variability in the possible
outcomes should have on decision making.

McGraw-Hill/Irwin 9.13 © The McGraw-Hill Companies, Inc., 2013

 Decision Trees

• A decision tree can apply Bayes’ decision rule while displaying and analyzing
the problem graphically.

• A decision tree consists of nodes and branches.

– A decision node, represented by a square, indicates a decision to be made. The
branches represent the possible decisions.
– An event node, represented by a circle, indicates a random event. The branches
represent the possible outcomes of the random event.

McGraw-Hill/Irwin 9.14 © The McGraw-Hill Companies, Inc., 2013

 Decision Tree for Goferbroke

Payoff

700
Oil (0.25)

Drill
Dry (0.75)
-100
A

Sell

90

McGraw-Hill/Irwin 9.15 © The McGraw-Hill Companies, Inc., 2013

 Using RSPE to Construct Decision Trees
RSPE can be used to construct and analyze decision trees on a spreadsheet.
1. Choose Node>Add Node from the Decision Tree menu on the RSPE ribbon.
2. Specify the type of node (Decision or Event).
3. Label the branches and specify the value for each branch.

McGraw-Hill/Irwin 9.16 © The McGraw-Hill Companies, Inc., 2013

 Using RSPE to Construct Decision Trees

A B C D E F G
1
2 Sell
3 90
4 90 90
5 1
6 90
7 Decision 2
8 0
9 0 0

McGraw-Hill/Irwin 9.17 © The McGraw-Hill Companies, Inc., 2013

 Using RSPE to Construct Decision Trees

4. Select the node at the end of the Drill branch and choose Decision Tree > Change Node
5. Choose Event node type and enter the name and partial payoffs for each branch.

McGraw-Hill/Irwin 9.18 © The McGraw-Hill Companies, Inc., 2013

 RSPE Results
• The numbers inside each decision node indicate which branch should be
chosen (assuming the branches are numbered consecutively from top to
bottom).
• The numbers to the right of each terminal node is the payoff if that node is
reached.
• The number 100 in cells A10 and E6 is the expected payoff at those stages in
the process.
A B C D E F G H I J K
1 25%
2 Oil
3 700
4 Drill 800 700
5
6 -100 100 75%
7 Dry
8 -100
9 1 0 -100
10 100
11
12 Sell
13 90
14 90 90

McGraw-Hill/Irwin 9.19 © The McGraw-Hill Companies, Inc., 2013

 Consolidate the Data and Results
A B C D E F G H I J K
1 25%
2 Oil
3 700
4 Drill 800 700
5
6 -100 100 75%
7 Dry
8 -100
9 1 0 -100
10 100
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability of Oil 25%
23
24 Action Drill
25
26 Expected Payoff 100

McGraw-Hill/Irwin 9.20 © The McGraw-Hill Companies, Inc., 2013

 Sensitivity Analysis: Prior Probability of Oil = 0.15
A B C D E F G H I J K
1 15%
2 Oil
3 700
4 Drill 800 700
5
6 -100 20 85%
7 Dry
8 -100
9 2 0 -100
10 90
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability of Oil 15%
23
24 Action Sell
25
26 Expected Payoff 90

McGraw-Hill/Irwin 9.21 © The McGraw-Hill Companies, Inc., 2013

 Sensitivity Analysis: Prior Probability of Oil = 0.35
A B C D E F G H I J K
1 15%
2 Oil
3 700
4 Drill 800 700
5
6 -100 20 85%
7 Dry
8 -100
9 2 0 -100
10 90
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability of Oil 15%
23
24 Action Sell
25
26 Expected Payoff 90

McGraw-Hill/Irwin 9.22 © The McGraw-Hill Companies, Inc., 2013

 Using Data Tables to Do Sensitivity Analysis
A B C D E F G H I J K L M
1 15%
2 Oil
3 700
4 Drill 800 700
5
6 -100 20 85%
7 Dry
8 -100
9 2 0 -100
10 90
11
12 Sell
13 90
14 90 90
15
16 Probability Expected
17 Data of Oil Action Payoff
Select these cells before
18 Cost of Drilling 100 Sell 90
choosing Data Table
19 Revenue if Oil 800 15%
from the What-If
20 Revenue if Sell 90 17% Analysis menu on the
21 Revenue if Dry 0 19% Data tab.
22 Probability of Oil 15% 21%
23 23%
24 Action Sell 25%
25 27%
26 Expected Payoff 90 29%
27 31%
28 33%
29 35%

McGraw-Hill/Irwin 9.23 © The McGraw-Hill Companies, Inc., 2013

 Data Table Results
The Effect of Changing the Prior Probability of Oil

I J K
16 Probability Expected
17 of Oil Action Payoff
18 Drill 100
19 0.15 Sell 90
20 0.17 Sell 90
21 0.19 Sell 90
22 0.21 Sell 90
23 0.23 Sell 90
24 0.25 Drill 100
25 0.27 Drill 116
26 0.29 Drill 132
27 0.31 Drill 148
28 0.33 Drill 164
29 0.35 Drill 180

McGraw-Hill/Irwin 9.24 © The McGraw-Hill Companies, Inc., 2013

 Checking Whether to Obtain More Information

• Might it be worthwhile to spend money for more information to obtain better

estimates?

• A quick way to check is to pretend that it is possible to actually determine the true
state of nature (“perfect information”).

• EP (with perfect information) = Expected payoff if the decision could be made

after learning the true state of nature.

• EP (without perfect information) = Expected payoff from applying Bayes’

decision rule with the original prior probabilities.

• The expected value of perfect information is then

EVPI = EP (with perfect information) – EP (without perfect
information).

McGraw-Hill/Irwin 9.25 © The McGraw-Hill Companies, Inc., 2013

 Expected Payoff with Perfect Information
A B C D E F G H I J K
1
2 Drill
3 25% 700
4 Oil 700 700
5 1
6 0% 700
7 Sell
8 90
9 90 90
10
11 242.5
12 Drill
13 75% -100
14 Dry -100 -100
15 2
16 0 90
17 Sell
18 90
19 90 90

McGraw-Hill/Irwin 9.26 © The McGraw-Hill Companies, Inc., 2013

 Using New Information to Update the Probabilities

• The prior probabilities of the possible states of nature often are quite
subjective in nature. They may only be rough estimates.

• It is frequently possible to do additional testing or surveying (at some

expense) to improve these estimates. The improved estimates are called
posterior probabilities.

McGraw-Hill/Irwin 9.27 © The McGraw-Hill Companies, Inc., 2013

 Seismic Survey for Goferbroke

• Goferbroke can obtain improved estimates of the chance of oil by conducting

a detailed seismic survey of the land, at a cost of $30,000.

• Possible findings from a seismic survey:

– FSS: Favorable seismic soundings; oil is fairly likely.
– USS: Unfavorable seismic soundings; oil is quite unlikely.

• P(finding | state) = Probability that the indicated finding will occur,

given that the state of nature is the indicated one.

P(finding | state)
State of Nature Favorable (FSS) Unfavorable (USS)
Oil P(FSS | Oil) = 0.6 P(USS | Oil) = 0.4
Dry P(FSS | Dry) = 0.2 P(USS | Dry) = 0.8

McGraw-Hill/Irwin 9.28 © The McGraw-Hill Companies, Inc., 2013

 Calculating Joint Probabilities

• Each combination of a state of nature and a finding will have a joint

probability determined by the following formula:

P(state and finding) = P(state) P(finding | state)

• P(Oil and FSS) = P(Oil) P(FSS | Oil) = (0.25)(0.6) = 0.15.

• P(Oil and USS) = P(Oil) P(USS | Oil) = (0.25)(0.4) = 0.1.

• P(Dry and FSS) = P(Dry) P(FSS | Dry) = (0.75)(0.2) = 0.15.

• P(Dry and USS) = P(Dry) P(USS | Dry) = (0.75)(0.8) = 0.6.

McGraw-Hill/Irwin 9.29 © The McGraw-Hill Companies, Inc., 2013

 Probabilities of Each Finding

• Given the joint probabilities of both a particular state of nature and a particular
finding, the next step is to use these probabilities to find each probability of
just a particular finding, without specifying the state of nature.

P(finding) = P(Oil and finding) + P(Dry and finding)

• P(FSS) = 0.15 + 0.15 = 0.3.

• P(USS) = 0.1 + 0.6 = 0.7.

McGraw-Hill/Irwin 9.30 © The McGraw-Hill Companies, Inc., 2013

 Calculating the Posterior Probabilities

• The posterior probabilities give the probability of a particular state of nature,

given a particular finding from the seismic survey.

P(state | finding) = P(state and finding) / P(finding)

• P(Oil | FSS) = 0.15 / 0.3 = 0.5.

• P(Oil | USS) = 0.1 / 0.7 = 0.14.

• P(Dry | FSS) = 0.15 / 0.3 = 0.5.

• P(Dry | USS) = 0.6 / 0.7 = 0.86.

McGraw-Hill/Irwin 9.31 © The McGraw-Hill Companies, Inc., 2013

 Probability Tree Diagram
Prior Conditional Joint Posterior
Probabilities Probabilities Probabilities Probabilities
P(state) P(finding | state) P(state and finding) P(state | finding)

0.15 = 0.5
0.25(0.6) = 0.15 0.3
0.6 Oil and FSS Oil, given FSS
FSS, given Oil

0.4
0.25 USS, given Oil 0.1 = 0.14
0.25(0.4) = 0.1 0.7
Oil
Oil and USS Oil, given USS

0.15 = 0.5
0.2 0.75(0.2) = 0.15 0.3
0.75 Dry, given FSS
Dry FSS, given Dry Dry and FSS

0.8 0.6 = 0.86

USS, given Dry 0.75(0.8) = 0.6 0.7
Dry and USS Dry, given USS

Unconditional probabilities: P(FSS) = 0.15 + 0.15 = 0.3

P(finding) P(USS) = 0.1 + 0.6 = 0.7

McGraw-Hill/Irwin 9.32 © The McGraw-Hill Companies, Inc., 2013

 Posterior Probabilities

P(state | finding)

Finding Oil Dry

Favorable (FSS) P(Oil | FSS) = 1/2 P(Dry | FSS) = 1/2

Unfavorable (USS) P(Oil | USS) = 1/7 P(Dry | USS) = 6/7

McGraw-Hill/Irwin 9.33 © The McGraw-Hill Companies, Inc., 2013

 Template for Posterior Probabilities

B C D E F G H
3 Data: P(Finding | State)
4 State of Prior Finding
5 Nature Probability FSS USS
6 Oil 0.25 0.6 0.4
7 Dry 0.75 0.2 0.8
8
9
10
11
12 Posterior P(State | Finding)
13 Probabilities: State of Nature
14 Finding P(Finding) Oil Dry
15 FSS 0.3 0.5 0.5
16 USS 0.7 0.1429 0.8571
17
18
19

McGraw-Hill/Irwin 9.34 © The McGraw-Hill Companies, Inc., 2013

 Decision Tree for the Full Goferbroke Co. Problem
Oil
f
Drill
Dry

c
Unfavorable Sell

Oil
b g
Drill Dry
Do seismic survey
Favorable
d
a Sell

Oil
h
No seismic survey Drill
Dry

e
Sell

McGraw-Hill/Irwin 9.35 © The McGraw-Hill Companies, Inc., 2013

 Decision Tree with Probabilities and Payoffs
Payoff
Oil (0.143) 670
800
f
Drill 0
-100 Dry(0.857) -130

c
90
Unfavorable Sell 60
0
Oil (0.5) 670
b 800
g
Do seismic survey 0 Drill 0
Favorable -100 Dry (0.5) -130
-30 (0.3)
d
90
a Sell 60

Oil (0.25) 700

800
0 h
Drill 0
No seismic survey -100 -100
Dry (0.75)
e
90
Sell 90

McGraw-Hill/Irwin 9.36 © The McGraw-Hill Companies, Inc., 2013

 The Final Decision Tree
Payoff
Oil (0.143) 670
-15.7
800
f
0
Drill
-100 Dry (0.857) -130
60
c
90
Unfavorable Sell 60
0
123 Oil (0.5) 670
270
b g 800

0 Drill 0
Do seismic survey -100 Dry (0.5) -130
-30 Favorable (0.3) 270
d
123 90
a Sell 60
Oil (0.25) 700
100
0 800
h
No seismic survey Drill 0
-100 Dry (0.75) -100
100
e
90
Sell 90

McGraw-Hill/Irwin 9.37 © The McGraw-Hill Companies, Inc., 2013

 RSPE for the Full Goferbroke Co. Problem
14%
Oil
670
Drill 800 670

-100 -15.71428571 86%

70% Dry
Unfavorable -130
2 0 -130
0 60

Sell
60
90 60
Do Survey
50%
-30 123 Oil
670
Drill 800 670

-100 270 50%

30% Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

25%
Oil
700
Drill 800 700

-100 100 75%

Dry
No Survey -100
1 0 -100
0 100

Sell
90
90 90

McGraw-Hill/Irwin 9.38 © The McGraw-Hill Companies, Inc., 2013

 Organizing the Spreadsheet for Sensitivity Analysis
Decision Tree for Goferbroke (with Survey) Prior
Probability Do If Survey
14% Data of Oil Survey? Favorable
Oil Cost of Survey 30 Yes Drill
670 Cost of Drilling 100 0 No Sell
Drill 800 670 Revenue if Oil 800 0.1 No Drill
Revenue if Sell 90 0.2 Yes Drill
-100 -15.71428571 86% Revenue if Dry 0 0.3 Yes Drill
70% Dry Probability of Oil 0.25 0.4 No Drill
Unfavorable -130 P(FSS | Oil) 0.6 0.5 No Drill
2 0 -130 P(USS | Dry) 0.8 0.6 No Drill
0 60 0.7 No Drill
0.8 No Drill
Sell Action 0.9 No Drill
60 Do Survey? Yes 1 No Drill
90 60
Do Survey If No If Yes
50%
-30 123 Oil Drill Drill If Favorable
670 Sell if Unfavorable
Drill 800 670

-100 270 50%

30% Dry Expected Payoff
Favorable -130 ($thousands)
1 0 -130 123
0 270

1 Sell
123 60 Data: P(Finding | State)
90 60 State of Prior Finding
Nature Probability FSS USS
25% Oil 0.25 0.6 0.4
Oil Dry 0.75 0.2 0.8
700
Drill 800 700

-100 100 75%

Dry Posterior P(State | Finding)
No Survey -100 Probabilities: State of Nature
1 0 -100 Finding P(Finding) Oil Dry
0 100 FSS 0.3 0.5 0.5
USS 0.7 0.142857 0.857143
Sell
90
90 90

McGraw-Hill/Irwin 9.39 © The McGraw-Hill Companies, Inc., 2013

Data Table: Optimal Policy vs. Prior Probability of Oil
Y Z AA AB AC AD
1 Prior Expected
2 Probability Do If Survey If Survey If No Payoff
3 of Oil Survey? Favorable Unfavorable Survey ($thousands)
4 Yes Drill Sell Drill 123
5 0 No Sell Sell Sell 90
6 0.1 No Drill Sell Sell 90
7 0.2 Yes Drill Sell Sell 102.8
8 0.3 Yes Drill Sell Drill 143.2
9 0.4 No Drill Drill Drill 220
10 0.5 No Drill Drill Drill 300
11 0.6 No Drill Drill Drill 380
12 0.7 No Drill Drill Drill 460
13 0.8 No Drill Drill Drill 540
14 0.9 No Drill Drill Drill 620
15 1 No Drill Drill Drill 700

McGraw-Hill/Irwin 9.40 © The McGraw-Hill Companies, Inc., 2013

 Optimal Policy

Let p = Prior probability of oil

If p ≤ 0.168, then sell the land (no seismic survey).

If 0.169 ≤ p ≤ 0.308, then do the survey; drill if favorable, sell if not.

If p ≥ 0.309, then drill for oil (no seismic survey).

McGraw-Hill/Irwin 9.41 © The McGraw-Hill Companies, Inc., 2013

Using Utilities to Better Reflect the Values of Payoffs

• Thus far, when applying Bayes’ decision rule, we have assumed that the
expected payoff in monetary terms is the appropriate measure.

• In many situations, this is inappropriate.

• Suppose an individual is offered the following choice:

– Accept a 50-50 chance of winning $100,000.
– Receive $40,000 with certainty.

• Many would pick $40,000, even though the expected payoff on the 50-50
chance of winning $100,000 is $50,000. This is because of risk aversion.

• A utility function for money is a way of transforming monetary values to an

appropriate scale that reflects a decision maker’s preferences (e.g., aversion to
risk).

McGraw-Hill/Irwin 9.42 © The McGraw-Hill Companies, Inc., 2013

 A Typical Utility Function for Money

U(M)

0.75

0.5

0.25

0
$10,000 $30,000 $60,000 $100,000 M

McGraw-Hill/Irwin 9.43 © The McGraw-Hill Companies, Inc., 2013

 Shape of Utility Functions

U(M) U(M) U(M)

M M M
(a) Risk averse (b) Risk seeker (c) Risk neutral

McGraw-Hill/Irwin 9.44 © The McGraw-Hill Companies, Inc., 2013

 Utility Functions

• When a utility function for money is incorporated into a decision analysis

approach, it must be constructed to fit the current preferences and values of
the decision maker.

• Fundamental Property: Under the assumptions of utility theory, the decision

maker’s utility function for money has the property that the decision maker is
indifferent between two alternatives if the two alternatives have the same
expected utility.

• When the decision maker’s utility function for money is used, Bayes’ decision
rule replaces monetary payoffs by the corresponding utilities.

• The optimal decision (or series of decisions) is the one that maximizes the
expected utility.

McGraw-Hill/Irwin 9.45 © The McGraw-Hill Companies, Inc., 2013

 Illustration of Fundamental Property

By the fundamental property, a decision maker with the utility function below-
right will be indifferent between each of the three pairs of alternatives below-left.

U(M)
• 25% chance of $100,000
• $10,000 for sure 1
Both have E(Utility) = 0.25.

• 50% chance of $100,000 0.75

• $30,000 for sure
Both have E(Utility) = 0.5. 0.5

• 75% chance of $100,000

• $60,000 for sure 0.25
Both have E(Utility) = 0.75.
0
$10,000 $30,000 $60,000 $100,000 M

McGraw-Hill/Irwin 9.46 © The McGraw-Hill Companies, Inc., 2013

 The Equivalent Lottery Method

1. Determine the largest potential payoff, M=Maximum.

Assign U(Maximum) = 1.

2. Determine the smallest potential payoff, M=Minimum.

Assign U(Minimum) = 0.

3. To determine the utility of another potential payoff M, consider the two

aleternatives:
A1: Obtain a payoff of Maximum with probability p.
Obtain a payoff of Minimum with probability 1–p.
A2: Definitely obtain a payoff of M.

Question to the decision maker: What value of p makes you indifferent?

Then, U(M) = p.

McGraw-Hill/Irwin 9.47 © The McGraw-Hill Companies, Inc., 2013

 Generating the Utility Function for Max Flyer

• The possible monetary payoffs in the Goferbroke Co. problem are –130, –100,
0, 60, 90, 670, and 700 (all in $thousands).

• Set U(Maximum) = U(700) = 1.

• Set U(Minimum) = U(–130) = 0.

• To find U(M), use the equivalent lottery method.

• For example, for M=90, consider the two alternatives:

A1: Obtain a payoff of 700 with probability p
Obtain a payoff of –130 with probability 1–p.
A2: Definitely obtain a payoff of 90

• If Max chooses a point of indifference of p = 1/3, then U(90) = 1/3.

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 Max’s Utility Function for Money

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 Utilities for the Goferbroke Co. Problem

Monetary Payoff, M Utility, U(M)

–130 0.00
–100 0.05
60 0.30
90 0.33
670 0.97
700 1.00

McGraw-Hill/Irwin 9.50 © The McGraw-Hill Companies, Inc., 2013

 Decision Tree with Utilities 14%
Oil
0.97
Drill 0.97 0.97

0 0.138571429 86%
70% Dry
Unfavorable 0
2 0 0
0 0.3

Sell
0.3
0.3 0.3
Do Survey
50%
0 0.3555 Oil
0.97
Drill 0.97 0.97

0 0.485 50%
30% Dry
Favorable 0
1 0 0
0 0.485

1 Sell
0.3555 0.3
0.3 0.3

25%
Oil
1
Drill 1 1

0 0.2875 75%
Dry
No Survey 0.05
2 0.05 0.05
0 0.333

Sell
0.333
0.333 0.333

McGraw-Hill/Irwin 9.51 © The McGraw-Hill Companies, Inc., 2013

 Exponential Utility Function

• The procedure for constructing U(M) requires making many difficult decisions
about probabilities.

• An alternative approach assumes a certain form for the utility function and
adjusts this form to fit the decision maker as closely as possible.

• A popular form is the exponential utility function

U(M) = 1 – e–M/R

where R is the decision maker’s risk tolerance.

• An easy way to estimate R is to pick the value that makes you indifferent
between the following two alternatives:
a) A 50-50 gamble where you gain R dollars with probability 0.5 and lose R/2 dollars
with probability 0.5.
b) Neither gain nor lose anything.

McGraw-Hill/Irwin 9.52 © The McGraw-Hill Companies, Inc., 2013

Setting up RSPE to use the Exponential Utility Function

McGraw-Hill/Irwin 9.53 © The McGraw-Hill Companies, Inc., 2013

 Decision Tree with an Exponential Utility Function
14%
Oil
670
Drill 800 670
0.488291422
-100 -48.06593977 86%
70% -0.04923984 Dry
Unfavorable -130
2 0 -130
0 60 -0.138828383
0.058235466
Sell
60
90 60
Do Survey 0.058235466
50%
-30 97.81602738 Oil
0.093184282 670
Drill 800 670
0.488291422
-100 192.0465146 50%
30% 0.174731519 Dry
Favorable -130
1 0 -130
0 192.0465146 -0.138828383
0.174731519
1 Sell
97.81603 60
0.093184 90 60
0.058235466
25%
Oil
700
Drill 800 700
0.503414696
-100 48.11465215 75%
0.046975485 Dry
No Survey -100
2 0 -100
0 90 -0.105170918
0.086068815
Sell
90
90 90
0.086068815
Risk Tolerance 1000

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