D ECISION A NALYSIS

Z HAN PANG , P H .D.

L ANCASTER U NIVERSITY M ANAGEMENT S CHOOL
O FFICE : R OOM A59 IN M ANAGEMENT S CHOOL
O FFICE H OUR : M ONDAY 2-4PM
Z . PANG @ LANCASTER . AC. UK

November 2013

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

1 / 19

Decision Making in Deterministic Worlds

Deterministic Mathematical Programming focuses primarily on decision

making when the consequences of alternative decisions are known with
certain degree of certainty.
This decision-making environment enables formulating deterministic
mathematical models (linear programming, integer programming and
nonlinear programming, etc.) with objective functions that specify the
estimated consequences under alternative decisions.
Can you give me some examples?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

2 / 19

Decision Making in Deterministic Worlds

Deterministic Mathematical Programming focuses primarily on decision

making when the consequences of alternative decisions are known with
certain degree of certainty.
This decision-making environment enables formulating deterministic
mathematical models (linear programming, integer programming and
nonlinear programming, etc.) with objective functions that specify the
estimated consequences under alternative decisions.
Can you give me some examples?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

2 / 19

Decision Making in Deterministic Worlds

Deterministic Mathematical Programming focuses primarily on decision

making when the consequences of alternative decisions are known with
certain degree of certainty.
This decision-making environment enables formulating deterministic
mathematical models (linear programming, integer programming and
nonlinear programming, etc.) with objective functions that specify the
estimated consequences under alternative decisions.
Can you give me some examples?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

2 / 19

Decision Making under Uncertainty

Real-world decisions are often made under in environments in face of great
uncertainty. Decision Analysis is primarily designed to address these
decision-making problems under uncertainty.
Here are a few examples.
A firm introducing a new product into the marketplace. What will be the
reaction of potential customers (and competitors)? How much should be
produced? How much the product is priced?
Lancaster University has installed one wind turbine. Should it install the
second one? How much wind is there? What is the capacity of the wind
power generator?
An oil company deciding whether to drill for oil in a chosen location. How
likely is oil there? How much? How deep should they drill? should
geologists investigate the site further before drilling?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

3 / 19

Decision Making under Uncertainty

Real-world decisions are often made under in environments in face of great
uncertainty. Decision Analysis is primarily designed to address these
decision-making problems under uncertainty.
Here are a few examples.
A firm introducing a new product into the marketplace. What will be the
reaction of potential customers (and competitors)? How much should be
produced? How much the product is priced?
Lancaster University has installed one wind turbine. Should it install the
second one? How much wind is there? What is the capacity of the wind
power generator?
An oil company deciding whether to drill for oil in a chosen location. How
likely is oil there? How much? How deep should they drill? should
geologists investigate the site further before drilling?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

3 / 19

Decision Making under Uncertainty

Real-world decisions are often made under in environments in face of great
uncertainty. Decision Analysis is primarily designed to address these
decision-making problems under uncertainty.
Here are a few examples.
A firm introducing a new product into the marketplace. What will be the
reaction of potential customers (and competitors)? How much should be
produced? How much the product is priced?
Lancaster University has installed one wind turbine. Should it install the
second one? How much wind is there? What is the capacity of the wind
power generator?
An oil company deciding whether to drill for oil in a chosen location. How
likely is oil there? How much? How deep should they drill? should
geologists investigate the site further before drilling?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

3 / 19

A Prototype Example: Goferbroke Problem

The Goferbroke Company owns a tract of land that may contain oil. A
consulting geologist has reported to management that she believes there is
one chance in four of oil. Because of this prospect, another oil company has
offered to purchase the land for $90,000.
However, Goferbroke is considering holding the land in order to drill for oil for
itself, which costs about $100, 000. If oil is found, the resulting expected
revenue will be $800,000, yielding expected profit of $700,000. A loss of
$100,000 will be incurred if the land is dry (no oil).

What should Goferbroke do? To drill or to sell?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

4 / 19

A Prototype Example: Goferbroke Problem

The Goferbroke Company owns a tract of land that may contain oil. A
consulting geologist has reported to management that she believes there is
one chance in four of oil. Because of this prospect, another oil company has
offered to purchase the land for $90,000.
However, Goferbroke is considering holding the land in order to drill for oil for
itself, which costs about $100, 000. If oil is found, the resulting expected
revenue will be $800,000, yielding expected profit of $700,000. A loss of
$100,000 will be incurred if the land is dry (no oil).

What should Goferbroke do? To drill or to sell?

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

4 / 19

Prospective Profits for Goferbroke

Table: Payoff Table of Goferbroke Problem

Alternative
Drill for oil
Sell the land
Chance of status

Z HAN PANG , P H .D. (LANCS)

State of Nature
Oil
Dry
$700,000 -$100,000
$90,000
$90,000
25%
75%

D ECISION A NALYSIS

Expected Payoff
$100
$90
Optimal Decision= Drill

November 2013

5 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

Conceptual Modeling Framework of Decision Analysis

There are several key elements in decision analysis.
State of nature describes the uncertainty associated with the underlying
state variable. The state of the variable is chosen by nature in
probabilistic sense. The set of all state of nature is called state space.
Alternative is the feasible decision or action that is available to choose by
decision maker. The set of all feasible alternatives is called action space.
Payoff is a quantitative measure of the value to the decision maker of the
consequences of the outcome of the combination of the state of nature
and chosen alternative.
Decision criterion specifies of the objective of decision maker.
Expected Profit Maximization: Choose the decision alternative that
maximizes the expected payoff. (What is Goferbrokes decision under this
criterion?)
Maximum Likelihood Criterion: Identify the most likely state of nature and
choose the decision alternative with the maximum payoff at this state. (What
is Goferbrokes decision under this criterion?)
Maxmin Payoff Criterion: For each decision alternative, find the minimum
payoff over all possible states of nature; then choose the alternative that
leads to the largest minimum payoff over the corresponding states of nature?
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

6 / 19

A Gaming Perspective

A game between decision maker and nature:

1

The decision maker chooses one of the decision alternatives.

Nature chooses one of the possible states of nature.

The combination of the chosen alternative and state of nature leads to a

payoff.

A rational decision maker as the first mover should choose the alternative
that yields the best payoff.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

7 / 19

A Gaming Perspective

A game between decision maker and nature:

1

The decision maker chooses one of the decision alternatives.

Nature chooses one of the possible states of nature.

The combination of the chosen alternative and state of nature leads to a

payoff.

A rational decision maker as the first mover should choose the alternative
that yields the best payoff.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

7 / 19

A Gaming Perspective

A game between decision maker and nature:

1

The decision maker chooses one of the decision alternatives.

Nature chooses one of the possible states of nature.

The combination of the chosen alternative and state of nature leads to a

payoff.

A rational decision maker as the first mover should choose the alternative
that yields the best payoff.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

7 / 19

A Gaming Perspective

A game between decision maker and nature:

1

The decision maker chooses one of the decision alternatives.

Nature chooses one of the possible states of nature.

The combination of the chosen alternative and state of nature leads to a

payoff.

A rational decision maker as the first mover should choose the alternative
that yields the best payoff.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

7 / 19

Decision Analysis with Experimentation

In the presence of uncertainty, firms may invest in acquiring more information
to improve their prediction of the prior probabilities of the states of nature.
Suppose that Goferbroke has an option to conduct a detailed seismic survey
of the land to obtain a better estimate of the probability of oil with a cost of
$30,000. Such a survey obtains seismic soundings that indicate whether the
geological structure is favourable to the presence of oil. There are two
possible findings:
USS: Unfavourable seismic soundings; oil is fairly unlikely.
FSS: Favourable seismic soundings; oil is fairly likely.
Based on past experience and data, if there is oil, then the probability of
unfavorable seismic soundings is
P(USS|State = Oil) = 1 P(FSS|State = Oil) = 0.4;
if there is no oil (dry), then the probability of unfavourable seismic soundings
is P(USS|State = Dry) = 1 P(FSS|State = Dry ) = 0.8.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

8 / 19

Decision Analysis with Experimentation

In the presence of uncertainty, firms may invest in acquiring more information
to improve their prediction of the prior probabilities of the states of nature.
Suppose that Goferbroke has an option to conduct a detailed seismic survey
of the land to obtain a better estimate of the probability of oil with a cost of
$30,000. Such a survey obtains seismic soundings that indicate whether the
geological structure is favourable to the presence of oil. There are two
possible findings:
USS: Unfavourable seismic soundings; oil is fairly unlikely.
FSS: Favourable seismic soundings; oil is fairly likely.
Based on past experience and data, if there is oil, then the probability of
unfavorable seismic soundings is
P(USS|State = Oil) = 1 P(FSS|State = Oil) = 0.4;
if there is no oil (dry), then the probability of unfavourable seismic soundings
is P(USS|State = Dry) = 1 P(FSS|State = Dry ) = 0.8.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

8 / 19

Decision Analysis with Experimentation

In the presence of uncertainty, firms may invest in acquiring more information
to improve their prediction of the prior probabilities of the states of nature.
Suppose that Goferbroke has an option to conduct a detailed seismic survey
of the land to obtain a better estimate of the probability of oil with a cost of
$30,000. Such a survey obtains seismic soundings that indicate whether the
geological structure is favourable to the presence of oil. There are two
possible findings:
USS: Unfavourable seismic soundings; oil is fairly unlikely.
FSS: Favourable seismic soundings; oil is fairly likely.
Based on past experience and data, if there is oil, then the probability of
unfavorable seismic soundings is
P(USS|State = Oil) = 1 P(FSS|State = Oil) = 0.4;
if there is no oil (dry), then the probability of unfavourable seismic soundings
is P(USS|State = Dry) = 1 P(FSS|State = Dry ) = 0.8.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

8 / 19

Bayes Rule: Learning under Uncertainty

By Bayes Rule, the posterior probabilities are

P(State = Oil|Finding = USS)
=

P(Finding = USS|State = Oil)P(State = Oil)

P(Finding = USS|State = Oil)P(State = Oil) + P(Finding = USS|State = Dry )P(State = Dry )

0.4(0.25)
1
=
0.4(0.25) + 0.8(0.75)
7
6
1
=
7
7
0.6(0.25)
1
P(State = Oil|Finding = FSS) =
=
0.6(0.25) + 0.2(0.75)
2

P(State = Dry|Finding = USS) = 1

P(State = Dry|Finding = FSS) = 1

Z HAN PANG , P H .D. (LANCS)

1
1
= .
2
2

D ECISION A NALYSIS

November 2013

9 / 19

Decision Analysis with Information Updates

Table: Payoff Table with New Information

Alternative
Finding=USS

Drill for oil

Sell the land
Alternative

Finding=FSS

Drill for oil

Sell the land

Z HAN PANG , P H .D. (LANCS)

State of Nature
Oil (1/7)
Dry (6/7)
$700,000
-$100,000
$90,000
$90,000
State of Nature
Oil (1/2)
Dry (1/2)
$700,000
-$100,000
$90,000
$90,000

D ECISION A NALYSIS

Expected Payoff
$14,300
$90,000
Expected Payoff
$300,000
$90,000

Optimal Decision
Sell
Optimal Decision
Drill

November 2013

10 / 19

The Value of Information

If Goferbroke conducts the survey, then the probability to have the survey
finding of USS is
P(Finding = USS) = 0.25(0.4) + 0.75(0.8) = 0.7;
the probability to have the survey finding of FSS is
P(Finding = FSS) = 0.25(0.6) + 0.75(0.2) = 0.3.
We know that conditioned on Findings=USS, Goferbroke chooses to sell the
land to receive a fixed payoff of $90,000; on Finding=FSS, Goferbroke
chooses to drill for oil with an expected payoff of $300,000. The expected
payoff with the survey information is
0.7($90, 000) + 0.3($300, 000) = $153, 000.
Should Goferbroke conduct the survey? What is the value of the acquired
information?
Value of Information = $153, 000 $100, 000 = $53, 000 > $30, 000.
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

11 / 19

The Value of Information

If Goferbroke conducts the survey, then the probability to have the survey
finding of USS is
P(Finding = USS) = 0.25(0.4) + 0.75(0.8) = 0.7;
the probability to have the survey finding of FSS is
P(Finding = FSS) = 0.25(0.6) + 0.75(0.2) = 0.3.
We know that conditioned on Findings=USS, Goferbroke chooses to sell the
land to receive a fixed payoff of $90,000; on Finding=FSS, Goferbroke
chooses to drill for oil with an expected payoff of $300,000. The expected
payoff with the survey information is
0.7($90, 000) + 0.3($300, 000) = $153, 000.
Should Goferbroke conduct the survey? What is the value of the acquired
information?
Value of Information = $153, 000 $100, 000 = $53, 000 > $30, 000.
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

11 / 19

The Value of Information

If Goferbroke conducts the survey, then the probability to have the survey
finding of USS is
P(Finding = USS) = 0.25(0.4) + 0.75(0.8) = 0.7;
the probability to have the survey finding of FSS is
P(Finding = FSS) = 0.25(0.6) + 0.75(0.2) = 0.3.
We know that conditioned on Findings=USS, Goferbroke chooses to sell the
land to receive a fixed payoff of $90,000; on Finding=FSS, Goferbroke
chooses to drill for oil with an expected payoff of $300,000. The expected
payoff with the survey information is
0.7($90, 000) + 0.3($300, 000) = $153, 000.
Should Goferbroke conduct the survey? What is the value of the acquired
information?
Value of Information = $153, 000 $100, 000 = $53, 000 > $30, 000.
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

11 / 19

The Value of Information

If Goferbroke conducts the survey, then the probability to have the survey
finding of USS is
P(Finding = USS) = 0.25(0.4) + 0.75(0.8) = 0.7;
the probability to have the survey finding of FSS is
P(Finding = FSS) = 0.25(0.6) + 0.75(0.2) = 0.3.
We know that conditioned on Findings=USS, Goferbroke chooses to sell the
land to receive a fixed payoff of $90,000; on Finding=FSS, Goferbroke
chooses to drill for oil with an expected payoff of $300,000. The expected
payoff with the survey information is
0.7($90, 000) + 0.3($300, 000) = $153, 000.
Should Goferbroke conduct the survey? What is the value of the acquired
information?
Value of Information = $153, 000 $100, 000 = $53, 000 > $30, 000.
Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

11 / 19

Decision Tree
Using circles to indicate event (chance) nodes, squares to indicate decision
modes and lines to indicate corresponding branches, we can draw a decision
tree for Goferbroke.

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

12 / 19

Decision Analysis with Decision Tree

Z HAN PANG , P H .D. (LANCS)

D ECISION A NALYSIS

November 2013

13 / 19

Dynamic Decision Analysis

Decision makers often have to adjust their decisions overtime contingent on
the changes of decision environments. Please consider the following problem.

Advance Selling
Consider a firm selling a seasonal product to a consumer market of a fixed
size N over two periods. The first period is an advance selling period and the
second period is the selling season. Consumers willingness-to-pay in the
second period depends on weather conditions. When the whether is good,
the maximum price consumers would like to pay is H. When the weather is
bad, the maximum price consumers would like to pay is L. The firm knows the
probability that the weather is good is q and the probability that the weather is
bad is 1 q. In the first period, the firm has an option to advance sell the
product with a price p1 . The firm can decide whether to advance sell or wait
until the weather conditions are observed. Consumers decide whether to
purchase in the first period or wait until the second period. The production
cost of the product is c per unit. How to model such a dynamic decision
problem? How much should the firm charge in the first period to induce
consumers to advance buy? Should the firm offer advance selling at all?
Z HAN PANG , P H .D. (LANCS)

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Advance Selling - A Sequential Game

First, consider the situation in which all consumers wait until the second period
to make purchases. Then it is straightforward that when the weather condition
is good the firm would like to set the price H; otherwise, the price is L.
Second, suppose that the firm advance sells in the first period at price p1 . If
consumers advance buy, their net surpluses are qH + (1 q)L p1 . If they
wait, their net surpluses are 0. Hence, to induce consumers advance buy, the
firm needs to ensure that qH + (1 q)L p1 0, or, equivalently,
p1 qH + (1 q)L. Clearly, the firm will charge p1 = qH + (1 q)L.
Now we know that if the firm offers the advance selling its expected profit is
(qH + (1 q)L c)N.
If the firm does not offer the advance selling, its expected profit is
(q(H c) + (1 q)(L c))N.
Thus, the firms profit is indifferent between advance selling and spot selling.
Further question: If 50% of customers always wait until the second period to
make the purchase, what will be the firms decisions?
Z HAN PANG , P H .D. (LANCS)

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Exercise 1
Investment Strategy
Consider three possible scenarios of investment economy: (1) an improving economy, (2) a stable economy,
and (3) a worsening economy. The prior probabilities of the three economies are 0.1, 0.5 and 0.4, respectively.
There are three types of investment strategy: conservative investment that would perform well in an improving
economy and only suffer a small loss in a worsening economy; speculative investment that would perform
extremely well in an improving economy but would do very badly in a worsening economy; and countercyclical
investment that would lose some money in an improving economy but would perform well in a worsening
economy.

Conservative
Speculative
Countercyclical
Prior probability

Improving Economy
$30 million
$40 million
-$10 million
0.1

Stable Economy
$ 5 million
$ 10 million
$ 0 million
0.5

Worsening Economy
-$10 million
-$30 million
$15 million
0.4

What are the optimal investment strategies under the following criteria?
(a) Maxmin payoff criterion
(b) Maximum likelihood criterion
(c) Expected payoff maximization criterion
If the prior probabilities are (0.1, 0.3, 0.6), what are the optimal investment strategies?

Z HAN PANG , P H .D. (LANCS)

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Exercise 2

Inventory Control
Consider a newspaper retailer selling a daily newspaper. Suppose that the demand per day follows a Poisson
distribution with mean 100. The cost per copy is $0.5 and the retail price is $1. Unmet demand is lost and
unsold copies have zero salvage value. How many copies should the retailer order per day to maximize the
expected profit per day? [You can use Excel Spreadsheet to find the optimal solution]

Z HAN PANG , P H .D. (LANCS)

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Reference
Hillier F. S., G. J. Liberman. 2009. Chapter 15 Decision Analysis, Introduction to Operations Research,
9th edition, McGraw Hill press.

Z HAN PANG , P H .D. (LANCS)

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Appendix: Bayes Theorem

P(A|B) =

Z HAN PANG , P H .D. (LANCS)

P(B|A)P(A)
P(B|A)P(A)
=

P(B)
P(B|A)P(A) + P(B|A)P(
A)

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