Decision Analysis

Basic Terms

• Decision Alternatives (eg. Production quantities)

• States of Nature (eg. Condition of economy)
• Payoffs ($ outcome of a choice assuming a state of nature)
• Criteria (eg. Expected Value)
What kinds of problems?

• Alternatives known
• States of Nature and their probabilities are known.
• Payoffs computable under different possible scenarios
Decision Environments

Ignorance – Probabilities of the states of nature are

unknown, hence assumed equal
Risk / Uncertainty – Probabilities of states of nature are
known
Certainty – It is known with certainty which state of nature
will occur. Trivial problem.
Example – Decisions under Ignorance

Assume the following payoffs in $ thousand for 3 alternatives –

building 100, 200, or 400 condos. The payoffs ($ million) depend
on how many are sold, which depends on the economy. Three
scenarios are considered - a Poor, Average, or Good economy at
the time the condos are completed.

Payoff Table
S1 S2 S3
(Poor) (Avg) (Good)
A1 (100 units) 3 3.5 4
A2 (200 units) -1 6 7
A3 (400 units) -10 -2 12
Maximax - Risk Seeking Behavior

What would a risk seeker decide to do? Maximize payoff without

regard for risk. In other words, use the MAXIMAX criterion. Find
maximum payoff for each alternative, then the maximum of those.

S1 S2 S3 MAXIMAX
A1 3 3.5 4 4
A2 -1 6 7 7
A3 -10 -2 12 12

The best alternative under this criterion is A3, with a potential

payoff of 12.
Maximin – Risk Averse Behavior
What would a risk averse person decide to do? Make the best of the
worst case scenarios. In other words, use the MAXIMIN criterion.
Find minimum payoff for each alternative, then the maximum of those.

S1 S2 S3 MAXIMIN
A1 3 3.5 4 3
A2 -1 6 7 -1
A3 -10 -2 12 -10

The best alternative under this criterion is A1, with a worst case
scenario of 3, which is better than other worst cases.
LaPlace – the Average
What would a person somewhere in the middle of the two extremes
choose to do? Take an average of the possible payoffs. In other words,
use the LaPlace criterion (named after mathematician Pierre LaPlace).
Find the average payoff for each alternative, then the maximum of
those.
S1 S2 S3 LaPlace
A1 3 3.5 4 3.5
A2 -1 6 7 4
A3 -10 -2 12 0

The best alternative under this criterion is A2, with an average

payoff of 4, which is better than the other two averages.
Minimax Regret – Lost Opportunity
What would a person choose who wanted to minimize the worst
mistake possible? For each state of nature, find the maximum payoff,
and subtract each of the payoffs from it to compute the lost
opportunities (regrets). Then find maximum values for each
alternative, and the minimum of those.
Opportunity Loss (Regret) Table
S1 S2 S3 Minimax
A1 0 2.5 8 8
A2 4 0 5 5
A3 13 8 0 13
The best alternative under this criterion is A2, with a maximum
regret of 5, which is better than the other two maximum regrets.
Example – Decisions under Risk

Assume now that the probabilities of the states of nature are

known, as shown below.

S1 S2 S3
(Poor) (Avg) (Good)
A1 (100 units) 3 3.5 4
A2 (200 units) -1 6 7
A3 (400 units) -10 -2 12
Probabilities 0.30 0.60 0.10
Expected Values
When probabilities are known, compute a weighed average of payoffs,
called the Expected Value, for each alternative and choose the
maximum value.
Payoff Table
S1 S2 S3 EV
A1 3 3.5 4 3.40
A2 -1 6 7 4.00
A3 -10 -2 12 -3.00
Probabilities 0.30 0.60 0.10

The best alternative under this criterion is A2, with a maximum EV

of 4.00, which is better than the other two EVs.
Expected Opportunity Loss (EOL)
Compute the weighted average of the opportunity losses for each
alternative to yield the EOL.
Opportunity Loss (Regret) Table
S1 S2 S3 EOL
A1 0 2.5 8 2.30
A2 4 0 5 1.70
A3 13 8 0 8.70
Probabilities 0.30 0.60 0.10

The best alternative under this criterion is A2, with a minimum

EOL of 1.70, which is better than the other two EOLs.

Note that EV + EOL is constant for each alternative! Why?

EVUPI: EV with Perfect Information

If you knew everytime with certainty which state of nature was

going to occur, you would choose the best alternative for each
state of nature every time. Thus the EV would be the weighted
average of the best value for each state. Take the best times the
probability, and add them all.

S1 S2 S3 3*0.3 = 0.90
(Poor) (Avg) (Good) 6*0.6 = 3.60
A1 (100 units) 3 3.5 4 12*0.1 = 1.20
A2 (200 units) -1 6 7 _____________
Sum = 5.70
A3 (400 units) -10 -2 12
Probabilities 0.30 0.60 0.10 Thus EVUPI = 5.70
EVPI: Value of Perfect Information

If someone offered you perfect information about which state of

nature was going to occur, how much is that information worth to
you in this decision context?

Since EVUPI is 5.70, and you could have made 4.00 in the long
run (best EV without perfect information), the value of this
additional information is 5.70 – 4.00 = 1.70.

Thus, EVPI = EVUPI – Evmax

= EOLmin
 Decision Tree

0.3 3.00
3.40 0.6 3.50
0.1
A1 4.00
0.3 -1.00
A2 0.6 6.00
A2 4.00 0.1 7.00
4.00
A3 0.3 -10.00
0.6
-3.00 -2.00
0.1 12.00
Sequential Decisions

• Would you hire a consultant (or a psychic) to get more info

about states of nature?
• How would additional info cause you to revise your
probabilities of states of nature occuring?
• Draw a new tree depicting the complete problem.
Consultant’s Track Record

S1 S2 S3

Past Fav. 20 60 70

Forecast Unfav. 80 40 30

100 100 100

Probabilities

• P(F/S1) = 0.2 P(U/S1) = 0.8

• P(F/S2) = 0.6 P(U/S2) = 0.4
• P(F/S3) = 0.7 P(U/S3) = 0.3

• F= Favorable U=Unfavorable
Joint Probabilities

S1 S2 S3 Total

Fav. 0.06 0.36 0.07 .49

Unfav. 0.24 0.24 0.03 .51

Prior 0.3 0.6 0.1 1.00

Probs
Posterior Probabilities

• P(S1/F) = 0.06/0.49 = 0.122

• P(S2/F) = 0.36/0.49 = 0.735
• P(S3/F) = 0.07/0.49 = 0.143

• P(S1/U) = 0.24/0.51 = 0.47

• P(S2/U) = 0.24/0.51 = 0.47
• P(S3/U) = 0.03/0.51 = 0.06
Solution

• Solve the decision tree using the posterior probabilities just

computed.