Chapter 09

Chapter 9
DECISION ANALYSIS
UEH – School of International Business & Marketing © The McGraw-Hill Companies, Inc., 2013
Table of Contents
1. Decision Analysis Examples

2. A Case Study: The Goferbroke Company Problem (Section 9.1)
3. Decision Criteria (Section 9.2)

4. Decision Trees (Section 9.3)
5. Sensitivity Analysis with Decision Trees (Section 9.4)
6. Checking Whether to Obtain More Information (Section 9.5)
7. Using New Information to Update the Probabilities (Section 9.6)
8. Decision Tree to Analyze a Sequence of Decisions (Section 9.7)
9. Sensitivity Analysis with a Sequence of Decisions (Section

UEH – School of International Business & Marketing
9.8)
© The McGraw-Hill Companies, Inc., 2013
Learning Objectives
 After completing this chapter, you should be able to
 1. Identify the kind of decision-making environment for which decision

analysis is needed.
 2. Describe the logical way in which decision analysis organizes a problem.
 3. Formulate a payoff table from a description of the problem.
 4. Describe and evaluate several alternative criteria for making a decision

based on a payoff table.
Learning Objectives
 5. Apply Bayes’ decision rule to solve a decision analysis problem.
 6. Formulate and solve a decision tree for dealing with a sequence of

decisions.
 7. Use QM for windows to construct and solve a decision tree.
 8. Determine whether it is worthwhile to obtain more information before

making a decision.
 9. Use new information to update the probabilities of the states of nature.
1. 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?

 Some Examples
 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?

 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?

 Some Examples
 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?

 Some Examples
 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?
2. 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.
2.1. 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
2.2. 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.
2.2. Decision Analysis Terminology
 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.
2.3. 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
2.4. 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
3. Decision Criteria
Maximax Maximin
Criterion Criterion
Maximum Bayes’
Likelihood Decision
Criterion Rule
3.1. 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
3.2. 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
3.3. 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
3.4. 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
 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.
4. 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.
4. Decision Tree for Goferbroke
Payoff
700
Oil (0.25)
Drill
Dry (0.75)
-100
A
Sell
90
4. 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.
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
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.
4. 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.
4. RSPE 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
4. Consolidate the Data and Results
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
5. Sensitivity Analysis: Prior Probability of Oil = 0.15
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
21 Revenue if Dry 0
23
24 Action Sell
25
5. Sensitivity Analysis: Prior Probability of Oil = 0.35
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
21 Revenue if Dry 0
23
24 Action Sell
25
5. 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%
5. 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
6. 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).
6. Expected Payoff with Perfect Information
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
7. 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.
7.1. 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.
7.1. Seismic Survey for Goferbroke
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
7.2. 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.
7.3. 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.
7.4. 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.
7.5. 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
7.6. 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
7.7. Template for Posterior Probabilities
Data: P(Finding | State)

State of Prior Finding
Nature Probability FSS USS
Oil 0.25 0.6 0.4
Dry 0.75 0.2 0.8
Posterior P(State | Finding)

Probabilities: State of Nature
Finding P(Finding) Oil Dry
FSS 0.3 0.5 0.5
USS 0.7 0.1429 0.8571
7.7. Template for Posterior Probabilities
Data: P(Finding | State)

State of Prior Finding
Oil 0.2 0.5 0.5
Dry 0.8 0.3 0.7
Posterior P(State | Finding)

Probabilities: State of Nature
Finding P(Finding) Oil Dry
FSS 0.34 0.294118 0.705882
USS 0.66 0.1515 0.8485
8. 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
8.1. 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
8.2. 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
8.3. 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
9. 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
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
HƯỚNG DẪN
1. NHẬP DATA
2. KHAI BÁO DATA TRÊN TEMPLATE
3. KHAI BÁO DATA TRÊN CÂY TỪ DATA
TABLE VÀ TEMPLATE
4. LẬP BẢNG PRIOR % VÀ KHAI CÁC
QUYẾT ĐỊNH THEO CÂY
5.CHỌN BẢNG VÀ VÀO DATA TABLE
TRÊN MENU WHAT-IF ANALYSIS TRÊN
DATA, CHỌN THAY ĐỔI COLUMN...BẤM
OK
9. 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
15 1 No Drill Drill Drill 700
9. 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).
10. 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.
10. Using Utilities to Better Reflect the Values of
Payoffs
 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).
10.1. A Typical Utility Function for Money
U(M)
0.75
0.5
0.25
0
$10,000 $30,000 $60,000 $100,000 M
10.2. Shape of Utility Functions
U(M) U(M) U(M)
M M M
(a) Risk averse (b) Risk seeker (c) Risk neutral
10.3. 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.
10.4. 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
10.5. 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.
10.5. The Equivalent Lottery Method
3. To determine the utility of another potential payoff

M, consider the two alternatives:
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.
10.6. 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.
10.6. Generating the Utility Function for Max
Flyer
 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.
10.7. Max’s Utility Function for Money
10.8. 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
10.9. 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
10.10. 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.
10.10. Exponential Utility Function
 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.
10.11. Setting up RSPE to use the Exponential
Utility Function
10.11. 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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Chapter 09

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Chapter 9

1. Decision Analysis Examples

3. Decision Criteria (Section 9.2)

8. Decision Tree to Analyze a Sequence of Decisions (Section 9.7)

9. Sensitivity Analysis with a Sequence of Decisions (Section

 1. Identify the kind of decision-making environment for which decision

 2. Describe the logical way in which decision analysis organizes a problem.

 3. Formulate a payoff table from a description of the problem.

 4. Describe and evaluate several alternative criteria for making a decision

 6. Formulate and solve a decision tree for dealing with a sequence of

 7. Use QM for windows to construct and solve a decision tree.

 8. Determine whether it is worthwhile to obtain more information before

 9. Use new information to update the probabilities of the states of nature.

 Managers often must make decisions in

 Managers often must make decisions in

 Managers often must make decisions in

 Managers often must make decisions in

 Managers often must make decisions in

Status of Land Oil Dry

Drill for oil $700,000 –$100,000

Sell the land 90,000 90,000

 The decision maker is the individual or group

 The decision maker generally will have some

State of Nature Prior Probability

The tract of land contains oil 0.25

The tract of land is dry (no oil) 0.75

Alternative Oil Dry

Drill for oil 700 –100

Sell the land 90 90

Prior probability 0.25 0.75

 The maximum likelihood criterion focuses on the

 Bayes’ decision rule directly uses the prior

 Features of Bayes’ Decision Rule:

 Criticisms of Bayes’ Decision Rule:

 A decision tree can apply Bayes’ decision rule

RSPE can be used to construct

4. Select the node at the end of

 The prior probabilities of the possible states of

 Goferbroke can obtain improved estimates of the

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

 Given the joint probabilities of both a particular

 The posterior probabilities give the probability of

0.8 0.6 = 0.86

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

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

Data: P(Finding | State)

Posterior P(State | Finding)

Data: P(Finding | State)

Posterior P(State | Finding)

Oil (0.25) 700

-100 -15.71428571 86%

-100 270 50%

-100 100 75%

-100 270 50%

-100 100 75%

Let p = Prior probability of oil

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

• 25% chance of $100,000

Both have E(Utility) =0.25.