Decision Analysis

Alternatives and States of

Nature
Good Decisions vs. Good
Outcomes
Payoff Matrix
Decision Trees
Utility Functions
Decisions under Uncertainty
Decisions under Risk

-1-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Case Problem - (A) p. 38
As director of a home health agency, you are in the process of evaluating the possible
addition of physical therapy services for your clients. Three options are under consideration:
Option A: The home health agency would contract with an independent practitioner to provide
PT services on a fee-for-service basis.
Costs:

The PT will be paid $60 per home visit.

Option B: The home health agency would hire a staff physical therapist, provide the therapist with
an automobile, and cover medical supplies and gasoline.
Costs:

Monthly PT salary of $4000

Monthly automobile lease payment of $400
Medical supplies and gasoline allowance of $7 per visit

Option C: The home health agency would utilize an independent contractor to provide PT
services, provide the contractor with an automobile and fringe benefits, and pay a
medical supply and gasoline allowance.
Costs:

PT services of $35 per visit

Monthly automobile lease payment of $400
Fringe benefits (including insurance) of $200 per month
Medical supplies and gasoline allowance of $7 per visit

Under all three alternatives the average payment for a PT home visit is $75 per visit.
The home health agency is trying to decide for which of these three options the maximum
profit would be realized. In searching for the best option, the agency realizes that the demand for
services influences the optimum choice. The agency would like to better understand the
relationship between demand and optimum choice. Specific questions that the agency has posed
include the following:
1. With no knowledge of demand for PT services, which option should be chosen?
2. For a given probability distribution of demand for PT services, which option provides maximum
profit?
3. How sensitive is the choice of best option to the probability distribution of demand?
4. How much value should be placed on a system that can forecast future demand for PT
services?
Assume that, using a combination of marketing analysis, analysis of competitors' volume
data, and some careful assumptions, it has been determined that there are only four possible values
of monthly demand for PT services: 30, 90, 140, or 150 visits. Assume further that the relative
frequency with which each of these demands occurs is also available from health facilities utilization
data compiled in a recent statewide study. These relative frequencies provide reasonable estimates
of the probabilities associated with each value of monthly demand, which for the case problem are
assumed to equal 0.1, 0.4, 0.2, and 0.3, respectively.

-2-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

-3-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

-4-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Decisions under Uncertainty

-5-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Decisions under Uncertainty

-6-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Decisions under Uncertainty

-7-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Decisions under Risk

-8-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Decisions under Risk

-9-

HMP654/EXECMAS

Decision Analysis - Payoff Tables

Decisions under Risk

-10-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Utility theory provides a way to
incorporate the decision
makers attitudes and
preferences toward risk and
return in the decision analysis
process so that the most
desirable decision alternative is
identified.
A utility function translates each
of the possible payoffs in a
decision problem into a nonmonetary measure known as a
utility.
-11-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Utility

risk averse

1.00
risk neutral
0.75

risk seeking

0.50

0.2
5
0
Payoff

-12-

HMP654/EXECMAS

Decision Analysis - Utility Theory

The utility of a payoff
represents the total worth,
value, or desirability of the
outcome of a decision
alternative to the decision
maker.
A risk averse decision maker
assigns the largest relative
utility to any payoff but has a
diminishing marginal utility for
increased payoffs.

-13-

HMP654/EXECMAS

Decision Analysis - Utility Theory

A risk seeking decision maker
assigns the smallest utility to
any payoff but has an increasing
marginal utility for increased
payoffs.
A risk neutral decision maker
falls in between these two
extremes and has a constant
marginal utility for increased
payoffs.

-14-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Constructing Utility Functions
Step 1 - Assign a utility value of 0 to
the worst outcome (W) in a decision
problem and a utility value of 1 to
the best outcome (B).

-15-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Constructing Utility Functions
Step 2 - For any other outcome x, find the
probability p at which the decision maker
is indifferent between the following two
alternatives:
Receive x with certainty or
Receive B with probability p or W with
probability 1-p

The value of p is the utility that the

decision maker assigns to the outcome x.

-16-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Constructing Utility Functions
For example, lets compute the utility for
the $450 entry that corresponds to alternative
A and state of nature N=30. The problem
consists on finding the value of p that makes
the following two options equally attractive
for the decision maker:
Receive $450 with certainty
Play a game in which the decision
maker can make $5,800 with
probability p or lose $2,360 with
probability 1-p
Lets assume that the value of p that makes
these two choices equally attractive to the
decision maker is 0.7. Then the utility that
the decision maker assigns to the $450 is
0.7.
-17-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Constructing Utility Functions

-18-

HMP654/EXECMAS

Decision Analysis - Utility Theory

Constructing Utility Functions

-19-

HMP654/EXECMAS

Decision Analysis - Utility Theory

The Exponential Utility Function

A sensible value for R is the

maximum value of Y for which the
decision maker is willing to
participate in a game of chance with
the following possible outcomes:
Win $Y with probability 0.5
Lose $Y/2 with probability 0.5
-20-

HMP654/EXECMAS

Decision Analysis - Utility Theory

The Exponential Utility Function

-21-

HMP654/EXECMAS