Decision Analysis - Part 3

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  Any problem that can be presented in a decision table can also be
graphically illustrated in a decision tree

 A decision tree consists of:

 nodes (or points)
 arcs (or lines)
 network

FIGURE 1. Decision Tree for Thompson Lumber

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  A decision tree presents the decision alternatives and outcomes in
a sequential manner. All decision trees are similar in that they
contain decision nodes and outcome nodes.
 These nodes are represented using the following symbols:
 = A decision node. Arcs (lines) originating from a decision node
denote all decision alternatives available to the decision maker
at that node. Of these, the decision maker must select only one
alternative.
 = An outcome node. Arcs (lines) originating from an outcome
node denote all outcomes that could occur at that node. Of
these, only one outcome will actually occur.
 Thompson Lumber’s case - John has to decide among his three
alternatives (size of the plant). Once John makes this decision, one of
three possible outcomes (high, moderate, low)

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  Using money to measure the value of a decision could
sometimes lead to bad decisions. The reason for this is that
different people value money differently at different times.
 For example, having $100 in your pocket may mean a lot to you
today, when you are a student, but may be relatively unimportant in
a few years, when you are a wealthy businessperson
 Assume that you are the holder of a lottery ticket. In a few
moments, a fair coin will be flipped. If it comes up tails, you win
$100,000.If it comes up heads, you win nothing. Now suppose a
wealthy person offers you $35,000 for your ticket before the coin is
flipped. What should you do?
 Of course, just how low a specific individual would go is a matter of
personal preference because, as noted earlier, different people
value money differently. This example, however, illustrates how
basing a decision on EMV may not be appropriate
 One way to get around this problem and incorporate a person’s
attitude toward risk in the model is through utility theory
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 FIGURE 6. Decision Tree for a Lottery Ticket

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  Using a utility function is a way of converting a person’s value for
money and attitudes toward risk into a dimensionless number
between 0 and 1. There are three important issues to note at this
stage, as follows:
 Each person has his or her own utility function. It is therefore
critical in any problem to determine the utility function for the
decision maker in that problem.
 A person’s utility function could change over time as his or her
economic and other conditions change. A person’s utility function
should therefore be updated periodically.
 A person may have different utility functions for different
magnitudes of money. For example, most people tend to be
very willing to take risks when the monetary amounts involved are
small. (lottery ticket). However, the same people tend to be
unwilling to take risks with larger monetary amounts. This implies
that we should consider a person’s utility function only over the
relevant range of monetary values involved in the problem.
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  Jane Dickson would like to construct a utility function to reveal
her preference for monetary amounts between $0 and $50,000.
We start assessing Jane’s utility function by assigning a utility
value of 0 to the worst payoff and a utility value of 1 to the best
payoff. That is, U($0) = 0 and U($50,000) = 1. Monetary values
between these two payoffs will have utility values between 0 and 1.
 What is the minimum guaranteed amount that you will accept
in order to walk away from this gamble

FIGURE 7. Gamble Posed to Jane for Utility Assessment

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  The answer to this question may vary from person to person, and it
is called the certainty equivalent between the two payoff values
($0 and $50,000, in this case). Let’s suppose Jane is willing to
settle for $15,000. (Some of you may have settled for less, while
others may have wanted more)

 Jane would rather have the certainty of getting $15,000 rather the
possibility of getting $50,000

Utility calculation:
U($15,000) = U($0) x 0.5 + U($50,000) x 0.5
Where, U($0) = U(worst payoff) = 0
U($50,000) = U(best payoff) = 1
U($15,000) = 0 x 0.5 + 1 x 0.5 = 0.5 (for Jane)

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  We repeat the gamble in Figure 7, except that the two monetary
amounts presented to Jane in the gamble are $15,000 and
$50,000. The EMV is $32,500. Let’s suppose Jane is willing to
settle for a certainty equivalent of $27,000. This implies:

U($27,000) = U($15,000) × 0.5 + U($50,000) × 0.5 = 0.5 × 0.5 + 1 × 0.5

= 0.75 (Jane)

 We repeat the gamble in Figure 7 again, this time with monetary

amounts of $0 and $15,000. The EMV is $7,500. Let’s suppose
Jane is willing to settle for a certainty equivalent of $6,000. This
implies:

U($6,000) = U($0) × 0.5 + U($15,000) × 0.5 = 0 × 0.5 + 0.5 × 0.5 = 0.25

(Jane)

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  At this stage, we know the monetary values associated with utilities
of 0, 0.25, 0.5, 0.75, and 1 for Jane. If necessary, we can continue
this process several more times to find additional utility points
 The five assessments are usually enough to get an idea of
Jane’s feelings toward risk. Perhaps the easiest way to view Jane’s
utility function is to construct a utility curve that plots utility values
(Y-axis) versus monetary values (X-axis)

FIGURE 8. Utility Curve for Jane Dickson

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  Jane’s utility curve is typical of a risk avoider. A risk avoider is a
decision maker who gets less utility or pleasure from a greater
risk and tends to avoid situations in which high losses might occur.
As monetary value increases on her utility curve, the utility
increases at a slower rate. Another way to characterize a person’s
attitude toward risk is to compute the risk premium:

 The risk premium represents the monetary amount that a

decision maker is willing to give up in order to avoid the risk
associated with a gamble. For example, Jane’s risk premium in
the first gamble between $0 and $50,000 is computed as
$25,000 - $15,000 = $10,000. That is, Jane is willing to give up
$10,000 to avoid the uncertainty associated with a gamble.
 Likewise, she is willing to give up $5,500 (= $32,500 - $27,000) to
avoid the risk of gambling between $15,000 and $50,000.
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  Clearly, a person who is more averse to risk will be willing to
give up an even larger amount to avoid the uncertainty. In
contrast, a person who is a risk seeker will insist on getting a
certainty equivalent that is greater than the EMV in order to
walk away from a gamble. Such a person will therefore have a
negative risk premium.
 A person who is risk neutral will always specify a certainty
equivalent that is exactly equal to the EMV. Based on the
preceding discussion, we can now define the following three
preferences for risk:

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  The shape of a person’s utility curve depends on the specific
decision being considered, the person’s psychological frame of
mind, and how the person feels about the future.
 It may well be that a person has one utility curve for some
situations and a completely different curve for others. In
practice, most people are likely to be risk seekers when the
monetary amounts involved are small (lottery ticket) but tend to
become risk avoiders as the monetary amounts increase.
 The exact monetary amount at which a specific individual switches
from being a risk seeker to a risk avoider is, of course, a matter of
personal preference

FIGURE 9. Utility Curves for

Different Risk Preferences

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  Once we have determined a decision maker’s utility curve, how do
we use it in making decisions? We construct the decision tree
and make all prior and revised probability estimates and
computations as before. However, instead of using monetary
values as payoffs, we now replace all monetary payoffs with
the appropriate utility values. We then fold back the decision tree,
using the criterion of maximizing expected utility values

 EXAMPLE. Mark Simkin has an opportunity to invest in a new

business venture. If the venture is a big success, Mark will make a
profit of $40,000. If the venture is a moderate success, Mark will
make a profit $10,000. If the venture fails, Mark will lose his
investment of $30,000. Mark estimates the venture’s chances as
20% for big success, 30% for moderate success, and 50% for
failure. Should Mark invest in the venture?

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 FIGURE 10. Decision Tree Using EMV for Mark Simkin

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  Now let’s view the same problem from a utility perspective. Mark is
able to construct a utility curve showing his preference for monetary
amounts between $40,000 and –$30,000 (the best and worst
payoffs in his problem). This curve, shown in Figure 11, indicates
that within this monetary range Mark is a risk seeker From Figure
11, we note the following utility values for Mark: U(-$30,000) = 0,
U($0) = 0.15, U($10,000) = 0.30, and U($40,000) = 1
 Substituting these values in the decision tree in Figure 10 in
place of the monetary values, we fold back the tree to maximize
Mark’s expected utility. Using utility values, the expected utility at
node 1 is 0.29, which is greater than the utility of 0.15 at node 2.
 Mark should invest his money in the venture, opposite of the
decision suggested if EMV had been used, and it clearly illustrates
how using utilities instead of monetary values may lead to different
decisions in the same problem. In Mark’s case, the utility curve
indicates that he is a risk seeker, and the choice of investing in the
venture certainly reflects his preference for risk
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 FIGURE 11. Utility Curve for Mark Simkin
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 FIGURE 12. Decision Tree Using Utility Values for Mark Simkin

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