Lecture 5

Risk & Sensitivity

Analysis
Chapter 13 in the textbook: INTRODUCTION TO MANAGEMENT SCIENCE

DR. NOR KHAIRUSSHIMA

 Risk Analysis
 helps the decision
maker recognize the
difference between the
expected value of a
decision alternative and
the payoff that may
actually occur.
DR. NOR KHAIRUSSHIMA
Sensitivity Analysis
 helps the decision
maker by describing
how changes in the
state-of-nature
probabilities and/or
changes in the payoffs
affect the recommended
decision alternative.
2
 RISK ANALYSIS

The risk profile for a decision alternative shows the

possible payoffs for the decision alternative along
with their associated probabilities.

DR. NOR KHAIRUSSHIMA 3

CASE STUDY 1: RISK PROFILE
 Large Complex Decision Alternative (d3)

In the previous example

for Case Study 1.
Using EV approach,
we identify that d3
(large condo)
is the best
decision alternative

DR. NOR KHAIRUSSHIMA 4

 State of Nature
Strong Demand Weak Demand
Decision
s1 s2
Alternatives
0.8 0.2
Large complex d3
20 -9

DR. NOR KHAIRUSSHIMA 5

 Case Study 1: Risk Profile
 Large Complex Decision Alternative (d3)

In 1.0
the previous example
0.8for Case Study 1.
Probability

Using
0.6 EV approach,
we identify that d3
0.4
(large condo)
0.2
is the best
decision alternative
-20 -10 0 10 20
Profit ($thousands)
6
DR. NOR KHAIRUSSHIMA
 Sometimes a review of the
risk profile associated with
an optimal decision
alternative may cause the
decision maker to choose
another decision
alternative even though the
expected value of the other
decision alternative is not
as good

DR. NOR KHAIRUSSHIMA 7

 State of Nature
Strong Weak
Decision Demand Demand
EV
Alternatives s1 s2
0.8 0.2
Small complex
8 7 7.8
d1
Medium
complex 14 5 12.2
d2
Large complex
20 -9 14.2
d3
Because no probability of a loss is associated with this decision
alternative,
the medium complex decision alternative would be judged less risky
DR. NOR KHAIRUSSHIMA 8
than the large complex decision alternative
 SENSITIVITY ANALYSIS

Used to determine how changes to the following inputs affect

the recommended decision alternative:

• a) probabilities for the states of nature

• b) values of the payoffs

DR. NOR KHAIRUSSHIMA 9

 SENSITIVITY ANALYSIS

If a change in the value

• the solution is SENSITIVE to
of one of the inputs
causes a change in the that particular input. Extra effort
recommended decision and care should be taken in
alternative, estimating the input value.

If change in the value

• the solution is NOT
of one of the inputs does
not cause a change in SENSITIVE to that particular
the recommended input. No extra time or effort
decision alternative would be needed to refine the
estimated input value 10
DR. NOR KHAIRUSSHIMA
SENSITIVITY ANALYSIS

INPUT:
Probabilities

DR. NOR KHAIRUSSHIMA 11

 CASE STUDY 1: SENSITIVITY
ANALYSIS
Supposed:
Pstrong(s1)=0.2; Pweak(s2)=0.8

 The new EV:Thus, when probability of

strong demand is HIGH (Ps1=0.8),
EV(d1)= 0.2(8)+0.8(7)=
PDC should 7.2
build large complex.
EV(d2)= 0.2(14) +0.8(5)= 6.8
EV(d3) When probability of
= 0.2(20)+0.8(-9)=-3.2
strong demand is LOW (Ps1=0.2),
PDC should build smaller complex
12
DR. NOR KHAIRUSSHIMA
 We could continue to
modify the probabilities and
learn even more about how
changes, it affects the
recommended decision
alternative.

The drawback is the

numerous calculations
required to evaluate the
effect of several possible
changes in the state-of-
nature probabilities
DR. NOR KHAIRUSSHIMA 13
 GRAPHICAL SENSITIVITY
ANALYSIS:
STATES OF NATURE
PROBABILITIES
 For special case of 2 states of nature, a graphical representation
can be used to determine how changes for the probabilities of
states of nature affect the recommended decision alternatives.

DR. NOR KHAIRUSSHIMA 14

 CASE STUDY 1: SENSITIVITY
ANALYSIS PROBABILITIES
Let p denote the probability of states of nature s1 so
P(s1)=p and P(s2)=1-P(s1)=1-p

The expected value is

EV(d1) = P (s1)(8) + P(s2)(7)
= p(8) + (1-p)(7)
= p+7

EV(d2) = 9p+5 EV(d3) = 29p-9

DR. NOR KHAIRUSSHIMA 15
 d3

d2
d1

EV(d1)=EV(d2) EV(d2)=EV(d3)

P=0.25 P=0.7
p≤0.25 0.25≤ p≤0.7 P≥0.7

See how the change in state of nature probabilities

affect the recommended decision alternatives 16
DR. NOR KHAIRUSSHIMA
 TYPE 4: DECISION ANALYSIS
WITH SAMPLE INFORMATION

Knowledge of sample (survey) information can

be used to revise the probability estimates for the
states of nature.

DR. NOR KHAIRUSSHIMA 17

 EVPI:
EVPIprofit
is the increase in the expected vs EVSI
that would
result if one knew with certainty which state of
nature would occur.

EVSI:
is the additional expected profit possible through
knowledge of the sample or survey
information

DR. NOR KHAIRUSSHIMA 18

 BAYES' THEOREM

Branch/
Prior Conditional Posterior/
Probabilities Probabilities Revised
Probabilities

Market study, sampling, testing, experiments

results

DR. NOR KHAIRUSSHIMA 19

 CASE STUDY 1
Assuming the PDC Sdn. Bhd. management is considering 6
month market research study designed to learn more about
potential market acceptance of the condo project
The management anticipates that the market research study will
provide one of the following results:
1. Favorable report: A significant number of individual
contacted express interest in purchasing PDC Sdn.
Bhd. condo
2. Unfavorable report: Very few individual contacted
express interest in purchasing PDC Sdn. Bhd. condo

DR. NOR KHAIRUSSHIMA 20

 Case Study : Influence Diagram
cont.
 Influence Diagram with Sample Information

Research States of nature:

Study Demand
Result
Strong (s1)
Weak (s2)

Research
Research Consequence:
Complex Size Profit
Study
Study
Cost $
Profit
Decision Alternatives
Small complex (d1)
Medium complex (d2)
21
Large complex (d3) DR. NOR KHAIRUSSHIMA
CASE STUDY: DECISION
TREE(SLIDE 4)
Small (d1)
Strong (s1)
8
2
Weak (s1)
7

Medium (d2)
Strong (s1)
14
1 3
Weak (s1)
5

Large (d3)
Strong (s1)
20
4
Weak (s1)
-9
DR. NOR KHAIRUSSHIMA 22
CASE STUDY: DECISION TREE CONT.
Small (d1) Strong (s1) 8
6
Favorable
Weak (s2)
7
Report Medium (d2) Strong (s1) 14
3 7
Market
Weak (s2)
5
Research Large (d3) Strong (s1) 20
Study
8 Weak (s2)
-9
2

Small (d1) Strong (s1) 8

9
Unfavorable Weak (s2)
7
1 Report Medium (d2) Strong (s1) 14
4 10 Weak (s2)
5
Large (d3) Strong (s1) 20
11 Weak (s2)
-9

Small (d1) Strong (s1) 8

12
No Market Research
Weak (s2)
7
Study Medium (d2) Strong (s1) 14
5 13 Weak (s2)
5
Large (d3) Strong (s1) 20
14 Weak (s2)
23
DR. NOR KHAIRUSSHIMA -9
 FINDING
BRANCH PROBABILITIES
(IF NOT GIVEN)

DR. NOR KHAIRUSSHIMA 24

 CASE STUDY :
CONDITIONAL PROBABILITIES
Conditional probability of the market is the research
outcomes (the sample information) given each state of
nature

Market Research
States of Nature Favorable, F Unfavorable, U
Strong demand, s1 P(F|s1)=0.90 P(U|s1)=0.10
Weak demand, s2 P(F|s2)=0.25 P(U|s2)=0.75

DR. NOR KHAIRUSSHIMA 25

Steps in calculating branch probabilities
1. In column 1 enter the states of nature. In column 2 enter the
prior probabilities for states of nature. In column 3 enter the
conditional probabilities of a favorable (F) or unfavourable (U)
market report given each sates of nature
2. In column 4 compute the joint probabilities by multiplying the
prior probability values in column 2 by the corresponding
probability values in column 3.
3. Sum of joint probabilities in column 4 to obtain the
probability of a favorable or unfavorable market research
report, P(F) or P(U)

4. Divide each joint probability in column 4 by P(F)=0.77 or

P(U)=0.23 to obtain the revised or posterior probabilities,
P(s1|F) and P(s2|F) or P(s1|U) and P(s2|U)
26
DR. NOR KHAIRUSSHIMA
 Favourable Market
StatesStates
of Nature
of Prior
Prior Prob
Prob Conditional
Conditional JointProb
Joint Prob Revised/
Revised/
Nature Prob
Prob Posterior
Posterior Prob
Prob
sjsj P(sj)=
P(sj)= A
A P(F|sj)=B
P(F|sj)=B AAxxBB=C
=C P(si|F)=
P(si|F)=
C/∑
C/∑ CC
s1 0.8 0.90 0.72 0.94
s1 0.8 0.90

s2s2 0.2
0.2 0.25
0.25 0.05 0.06
=1.00
=1.00 =P(F)=0.77 =1.00

Unfavourable Market
States of Nature
States of Prior
PriorProb
Prob Conditional Prob
Conditional Joint
JointProb
Prob Revised/
Revised/
Posterior Prob
Nature Prob Posterior Prob
sj P(sj)= A P(U|sj)=B A x B =C P(si|U)=
sj P(sj)= A P(U|sj)=B A x B =C P(si|U)=
C/∑ C
C/∑ C
s1 0.8 0.1 0.08 0.35
s1 0.8 0.1
s2 0.2 0.75 0.15 0.65
s2 0.2 0.75
=1.00 =P(U)=0.23 =1.00
=1.00 27
DR. NOR KHAIRUSSHIMA
 CASE STUDY: BRANCH OR
REVISED OR POSTERIOR
PROBABILITIES
If market study is undertaken:
P(Favorable report) =P(F)= 0.77
P(Unfavorable report) =P(U)= 0.23

If market report is Favorable:

P(Strong demand given favorable report) =P(s1|F)=0.94
P(Weak demand given favorable report) =P(s2|F)= 0.06

If market report is Unfavorable:

P(Strong demand given unfavorable report)=P(s1|U)=0.35
P(Weak demand given unfavorable report)= P(s2|U)=0.65 28
DR. NOR KHAIRUSSHIMA
 Small (d1) 8
Strong (s1) 0.94
6 Weak (s2) 0.06
Favorable Report 7
Medium (d2) Strong (s1) 0.94 14
3 7 Weak (s2) 0.06
0.77 5
Large (d3) Strong (s1) 0.94 20
Market Research 8 Weak (s2) 0.06
Study -9
2

Small (d1) 8
Strong (s1) 0.35
9 Weak (s2) 0.65
Unfavorable 7
1 Report Medium (d2) Strong (s1) 0.35 14
4 10 Weak (s2) 0.65
0.23 5
Large (d3) Strong (s1) 0.35 20
11 Weak (s2) 0.65
-9

Small (d1) 8
Strong (s1) 0.8
12
No Market Research
Weak (s2) 0.2
7
Study Medium (d2) Strong (s1) 0.8 14
5 13 Weak (s2) 0.2
5
Large (d3) Strong (s1) 0.8 20
14 Weak (s2) 0.2
-9 29
DR. NOR KHAIRUSSHIMA
 DECISION STRATEGY

A sequence of decision and change outcomes

where the decision is chosen depend on the
yet to be determined outcomes of chance
event

DR. NOR KHAIRUSSHIMA 30

Steps of determining the optimal decision is using strategy
“backward pass” through decision tree:

1. At chance nodes, compute EV (payoff value x branch

probabilities)

2. At decision nodes, select decision branch that leads to the

best EV.
31
DR. NOR KHAIRUSSHIMA
 CASE STUDY 1
6 EV=7.94
Small (d1)

DECISION TREE WITH

7 EV=13.46EV AT
Favorable Report
Medium (d2)
3

CHANCE NODES 6-14

8 EV=18.26
Market Research
Large (d3)

Study
2

Small (d1)
9 EV=7.35
Unfavorable
1 Report Medium (d2)
4 10 EV=8.15

Large (d3)
11 EV=1.15

Small (d1) EV=7.80

12
No Market Research
Study Medium (d2)
5 13 EV=12.20

Large (d3)
14 EV=14.20
32
DR. NOR KHAIRUSSHIMA
 Favorable Report

3 EV (d3)=18.26
0.77

Market Research
Study
EV(node2) =0.77EV(node3)+0.23EV(node4)
2 =0.77(18.26)+0.23(8.15)
= 15.93

1 Unfavorable
Report
4 EV(d2)=8.15
0.23

No Market Research
Study
5 EV (d3)=14.20

DR. NOR KHAIRUSSHIMA 33

 Market Research
Study
2 EV=15.93

1 The optimal decision for PDC Sdn. Bhd.

is to conduct the market research

No Market Research
Study
5 EV=14.20

DR. NOR KHAIRUSSHIMA 34

 Favorable Report

3 EV (d3)=18.26
0.77

Market Research
Study
2

1 Unfavorable
Report
4 EV(d2)=8.15
0.23

And then carry out the following decision strategy:

1. If the market research is favorable

– construct large condominium
2. If the market research is unfavorable
– construct medium condominium 35
DR. NOR KHAIRUSSHIMA
CASE STUDY: EXPECTED VALUE
OF SAMPLE INFORMATION
PDC wants to know the actual value of doing the survey

Expected value Expected value

EVSI = with sample – of best decision
information without sample
information

= (EV with sample information)

– (EV without sample information)

DR. NOR KHAIRUSSHIMA 36

 Market Research Study
2 EV=15.93
EVwSI

No Market
Research Study
5 EV=14.20
DR. NOR KHAIRUSSHIMA
EVwoSI 37
 CASE STUDY
EXPECTED VALUE OF SAMPLE
INFORMATION
EVSI= |$15.93 - $14.20|
= $1.73

$1.73 million is the expected value

SURVEY $
of sample information (EVSI)

This suggests PDC should be willing to pay up to

$1.73 million to conduct the market research study.

DR. NOR KHAIRUSSHIMA 38

 CASE STUDY 1:
EFFICIENCY OF SAMPLE
INFORMATION
E= EVSI/EVPI x 100
EVPI (Lecture 4)= $3.2 million
EVSI= $1.73 million

Efficiency = 1.73/3.2 x 100 = 54.1%

The information from market research is 54.1% as efficient as
perfect information

DR. NOR KHAIRUSSHIMA 39

THE END OF RISK AND
SENSITIVITY ANALYSIS

DR. NOR KHAIRUSSHIMA 40