Table of Contents

Chapter 9 (Decision Analysis)

Decision Analysis Examples 9.2–9.3

A Case Study: The Goferbroke Company Problem (Section 9.1) 9.4–9.8
Decision Criteria (Section 9.2) 9.9–9.13
Decision Trees (Section 9.3) 9.14–9.19
Sensitivity Analysis with Decision Trees (Section 9.4) 9.20–9.24
Checking Whether to Obtain More Information (Section 9.5) 9.25–9.27
Using New Information to Update the Probabilities (Section 9.6) 9.28–9.35
Decision Tree to Analyze a Sequence of Decisions (Section 9.7) 9.36–9.39
Sensitivity Analysis with a Sequence of Decisions (Section 9.8) 9.40–9.46
Using Utilities to Better Reflect the Values of Payoffs (Section 9.9) 9.47–9.59

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 Decision Analysis

• Managers often must make decisions in environments that are fraught with
uncertainty.

• Some Examples
– A manufacturer introducing a new product into the marketplace
• What will be the reaction of potential customers?
• How much should be produced?
• Should the product be test-marketed?
• How much advertising is needed?
– A financial firm investing in securities
• Which are the market sectors and individual securities with the best prospects?
• Where is the economy headed?
• How about interest rates?
• How should these factors affect the investment decisions?

9-2
 Decision Analysis

• Managers often must make decisions in environments that are fraught with
uncertainty.

• Some Examples
– A government contractor bidding on a new contract.
• What will be the actual costs of the project?
• Which other companies might be bidding?
• What are their likely bids?
– An agricultural firm selecting the mix of crops and livestock for the season.
• What will be the weather conditions?
• Where are prices headed?
• What will costs be?
– An oil company deciding whether to drill for oil in a particular location.
• How likely is there to be oil in that location?
• How much?
• How deep will they need to drill?
• Should geologists investigate the site further before drilling?

9-3
 The Goferbroke Company Problem

• The Goferbroke Company develops oil wells in unproven territory.

• A consulting geologist has reported that there is a one-in-four chance of oil on

a particular tract of land.

• Drilling for oil on this tract would require an investment of about $100,000.

• If the tract contains oil, it is estimated that the net revenue generated would be
approximately $800,000.

• Another oil company has offered to purchase the tract of land for $90,000.

Question: Should Goferbroke drill for oil or sell the tract?

9-4
 Prospective Profits

Profit
Status of Land Oil Dry
Alternative
Drill for oil $700,000 –$100,000

Sell the land 90,000 90,000

Chance of status 1 in 4 3 in 4

9-5
 Decision Analysis Terminology

• The decision maker is the individual or group responsible for making the
decision.

• The alternatives are the options for the decision to be made.

• The outcome is affected by random factors outside the control of the decision
maker. These random factors determine the situation that will be found when
the decision is executed. Each of these possible situations is referred to as a
possible state of nature.

• The decision maker generally will have some information about the relative
likelihood of the possible states of nature. These are referred to as the prior
probabilities.

• Each combination of a decision alternative and a state of nature results in

some outcome. The payoff is a quantitative measure of the value to the
decision maker of the outcome. It is often the monetary value.

9-6
 Prior Probabilities

State of Nature Prior Probability

The tract of land contains oil 0.25

The tract of land is dry (no oil) 0.75

9-7
Payoff Table (Profit in $Thousands)

State of Nature
Alternative Oil Dry

Drill for oil 700 –100

Sell the land 90 90

Prior probability 0.25 0.75

9-8
 The Maximax Criterion

• The maximax criterion is the decision criterion for the eternal optimist.

• It focuses only on the best that can happen.

• Procedure:
– Identify the maximum payoff from any state of nature for each alternative.
– Find the maximum of these maximum payoffs and choose this alternative.

State of Nature
Alternative Oil Dry Maximum in Row
Drill for oil 700 –100 700  Maximax
Sell the land 90 90 90

9-9
 The Maximin Criterion

• The maximin criterion is the decision criterion for the total pessimist.

• It focuses only on the worst that can happen.

• Procedure:
– Identify the minimum payoff from any state of nature for each alternative.
– Find the maximum of these minimum payoffs and choose this alternative.

State of Nature
Alternative Oil Dry Minimum in Row
Drill for oil 700 –100 –100
Sell the land 90 90 90  Maximin

9-10
 The Maximum Likelihood Criterion

• The maximum likelihood criterion focuses on the most likely state of nature.

• Procedure:
– Identify the state of nature with the largest prior probability
– Choose the decision alternative that has the largest payoff for this state of nature.

State of Nature
Alternative Oil Dry
Drill for oil 700 –100 –100
Sell the land 90 90 90  Step 2: Maximum
Prior probability 0.25 0.75

Step 1: Maximum

9-11
 Bayes’ Decision Rule

• Bayes’ decision rule directly uses the prior probabilities.

• Procedure:
– For each decision alternative, calculate the weighted average of its payoff by
multiplying each payoff by the prior probability and summing these products. This
is the expected payoff (EP).
– Choose the decision alternative that has the largest expected payoff.

A B C D E F
1 Bayes' Decision Rule for the Goferbroke Co.
2
3 Payoff Table State of Nature Expected
4 Alternative Oil Dry Payoff
5 Drill 700 -100 100
6 Sell 90 90 90
7
8 Prior Probability 0.25 0.75

9-12
 Bayes’ Decision Rule

• Features of Bayes’ Decision Rule

– It accounts for all the states of nature and their probabilities.
– The expected payoff can be interpreted as what the average payoff would become if
the same situation were repeated many times. Therefore, on average, repeatedly
applying Bayes’ decision rule to make decisions will lead to larger payoffs in the
long run than any other criterion.

• Criticisms of Bayes’ Decision Rule

– There usually is considerable uncertainty involved in assigning values to the prior
probabilities.
– Prior probabilities inherently are at least largely subjective in nature, whereas sound
decision making should be based on objective data and procedures.
– It ignores typical aversion to risk. By focusing on average outcomes, expected
(monetary) payoffs ignore the effect that the amount of variability in the possible
outcomes should have on decision making.

9-13
 Decision Trees

• A decision tree can apply Bayes’ decision rule while displaying and analyzing
the problem graphically.

• A decision tree consists of nodes and branches.

– A decision node, represented by a square, indicates a decision to be made. The
branches represent the possible decisions.
– An event node, represented by a circle, indicates a random event. The branches
represent the possible outcomes of the random event.

9-14
 Decision Tree for Goferbroke
  Payoff

700
Oil (0.25)

Drill
Dry (0.75)
­100
A

Sell

90

9-15
 Using TreePlan

TreePlan, an Excel add-in developed by Professor Michael Middleton, can be used to

construct and analyze decision trees on a spreadsheet.
1. Choose Decision Tree on the Add-Ins tab (Excel 2007 or 2010) or the Tools menu (for
other versions).
2. Click on New Tree, and it will draw a default tree with a single decision node and two
branches, as shown below.
3. The labels in D2 and D7 (originally Decision 1 and Decision 2) can be replaced by more
descriptive names (e.g., Drill and Sell).

9-16
 Using TreePlan

4. To replace a node (such as the terminal node of the drill branch in F3) by a different
type of node (e.g., an event node), click on the cell containing the node, choose
Decision Tree again from the Add-Ins tab (Excel 2007 or 2010) or Tools menu
(other versions of Excel), and select “Change to event node”.

9-17
 Using TreePlan

5. Enter the correct probabilities in H1 and H6.

6. Enter the partial payoffs for each decision and event in D6, D14, H4, and H9.

9-18
 TreePlan Results

• The numbers inside each decision node indicate which branch should be
chosen (assuming the branches are numbered consecutively from top to
bottom).
• The numbers to the right of each terminal node is the payoff if that node is
reached.
• The number 100 in cells A10 and E6 is the expected payoff at those stages in
the process.

9-19
 Consolidate the Data and Results
A B C D E F G H I J K
1 0.25
2 Oil
3 700
4 Drill 800 700
5
6 -100 100 0.75
7 Dry
8 -100
9 1 0 -100
10 100
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability Of Oil 0.25
23
24 Action Drill
25
26 Expected Payoff 100

9-20
Sensitivity Analysis: Prior Probability of Oil = 0.15

A B C D E F G H I J K
1 0.15
2 Oil
3 700
4 Drill 800 700
5
6 -100 20 0.85
7 Dry
8 -100
9 2 0 -100
10 90
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability Of Oil 0.15
23
24 Action Sell
25
26 Expected Payoff 90

9-21
Sensitivity Analysis: Prior Probability of Oil = 0.35

A B C D E F G H I J K
1 0.35
2 Oil
3 700
4 Drill 800 700
5
6 -100 180 0.65
7 Dry
8 -100
9 1 0 -100
10 180
11
12 Sell
13 90
14 90 90
15
16
17 Data
18 Cost of Drilling 100
19 Revenue if Oil 800
20 Revenue if Sell 90
21 Revenue if Dry 0
22 Probability Of Oil 0.35
23
24 Action Drill
25
26 Expected Payoff 180

9-22
 Using Data Tables to Do Sensitivity Analysis

A B C D E F G H I J K L M
1 0.25
2 Oil
3 700
4 Drill 800 700
5
6 -100 100 0.75
7 Dry
8 -100
9 1 0 -100
10 100
11
12 Sell
13 90
14 90 90
15
16 Probability Expected
17 Data of Oil Action Payoff
18 Cost of Drilling 100 Drill 100
19 Revenue if Oil 800 0.15 Select these
20 Revenue if Sell 90 0.17 cells (I18:K29),
21 Revenue if Dry 0 0.19 before
22 Probability Of Oil 0.25 0.21 choosing Table
23 0.23 from the Data
24 Action Drill 0.25 menu.
25 0.27
26 Expected Payoff 100 0.29
27 0.31
28 0.33
29 0.35

9-23
 Data Table Results
The Effect of Changing the Prior Probability of Oil

I J K
16 Probability Expected
17 of Oil Action Payoff
18 Drill 100
19 0.15 Sell 90
20 0.17 Sell 90
21 0.19 Sell 90
22 0.21 Sell 90
23 0.23 Sell 90
24 0.25 Drill 100
25 0.27 Drill 116
26 0.29 Drill 132
27 0.31 Drill 148
28 0.33 Drill 164
29 0.35 Drill 180

9-24
 Checking Whether to Obtain More Information

• Might it be worthwhile to spend money for more information to obtain better

estimates?

• A quick way to check is to pretend that it is possible to actually determine the true
state of nature (“perfect information”).

• EP (with perfect information) = Expected payoff if the decision could be made

after learning the true state of nature.

• EP (without perfect information) = Expected payoff from applying Bayes’

decision rule with the original prior probabilities.

• The expected value of perfect information is then

EVPI = EP (with perfect information) – EP (without perfect information).

9-25
Expected Payoff with Perfect Information

B C D
3 Payoff Table State of Nature
4 Alternative Oil Dry
5 Drill 700 -100
6 Sell 90 90
7 Maximum Payoff 700 90
8
9 Prior Probability 0.25 0.75
10
11 EP (with perfect info) 242.5

9-26
 Expected Payoff with Perfect Information

A B C D E F G H I J K
1
2 Drill
3 0.25 700
4 Oil 700 700
5 1
6 0 700
7 Sell
8 90
9 90 90
10
11 242.5
12 Drill
13 0.75 -100
14 Dry -100 -100
15 2
16 0 90
17 Sell
18 90
19 90 90

9-27
 Using New Information to Update the Probabilities

• The prior probabilities of the possible states of nature often are quite
subjective in nature. They may only be rough estimates.

• It is frequently possible to do additional testing or surveying (at some expense)

to improve these estimates. The improved estimates are called posterior
probabilities.

9-28
 Seismic Survey for Goferbroke

• Goferbroke can obtain improved estimates of the chance of oil by conducting

a detailed seismic survey of the land, at a cost of $30,000.

• Possible findings from a seismic survey:

– FSS: Favorable seismic soundings; oil is fairly likely.
– USS: Unfavorable seismic soundings; oil is quite unlikely.

• P(finding | state) = Probability that the indicated finding will occur,

given that the state of nature is the indicated one.

P(finding | state)
State of Nature Favorable (FSS) Unfavorable (USS)
Oil P(FSS | Oil) = 0.6 P(USS | Oil) = 0.4
Dry P(FSS | Dry) = 0.2 P(USS | Dry) = 0.8

9-29
 Calculating Joint Probabilities

• Each combination of a state of nature and a finding will have a joint

probability determined by the following formula:

P(state and finding) = P(state) P(finding | state)

• P(Oil and FSS) = P(Oil) P(FSS | Oil) = (0.25)(0.6) = 0.15.

• P(Oil and USS) = P(Oil) P(USS | Oil) = (0.25)(0.4) = 0.1.

• P(Dry and FSS) = P(Dry) P(FSS | Dry) = (0.75)(0.2) = 0.15.

• P(Dry and USS) = P(Dry) P(USS | Dry) = (0.75)(0.8) = 0.6.

9-30
 Probabilities of Each Finding

• Given the joint probabilities of both a particular state of nature and a particular
finding, the next step is to use these probabilities to find each probability of
just a particular finding, without specifying the state of nature.

P(finding) = P(Oil and finding) + P(Dry and finding)

• P(FSS) = 0.15 + 0.15 = 0.3.

• P(USS) = 0.1 + 0.6 = 0.7.

9-31
 Calculating the Posterior Probabilities

• The posterior probabilities give the probability of a particular state of nature,

given a particular finding from the seismic survey.

P(state | finding) = P(state and finding) / P(finding)

• P(Oil | FSS) = 0.15 / 0.3 = 0.5.

• P(Oil | USS) = 0.1 / 0.7 = 0.14.

• P(Dry | FSS) = 0.15 / 0.3 = 0.5.

• P(Dry | USS) = 0.6 / 0.7 = 0.86.

9-32
 Probability Tree Diagram
  Prior Joint 
Conditional  Posterior 
Probabilities  Probabilities  Probabilities  Probabilities 
P(state) P(finding | state) P(state and finding) P(state | finding)

0.15  = 0.5
0.25(0.6) = 0.15  0.3
0.6  Oil and FSS Oil, given FSS
FSS, given Oil

0.4 
0.25  USS, given Oil 0.1  = 0.14
0.25(0.4) = 0.1 0.7
Oil
Oil and USS Oil, given USS

0.15  = 0.5
0.2  0.75(0.2) = 0.15  0.3
0.75 
Dry FSS, given Dry Dry and FSS Dry, given FSS

0.8  0.6  = 0.86

USS, given Dry 0.75(0.8) = 0.6 0.7
Dry and USS Dry,  given USS

Unconditional probabilities: P(FSS) = 0.15 + 0.15 = 0.3 
P(finding) P(USS) = 0.1  +  0.6  =  0.7

9-33
 Posterior Probabilities

P(state | finding)

Finding Oil Dry

Favorable (FSS) P(Oil | FSS) = 1/2 P(Dry | FSS) = 1/2

Unfavorable (USS) P(Oil | USS) = 1/7 P(Dry | USS) = 6/7

9-34
 Template for Posterior Probabilities

B C D E F G H
3 Data: P(Finding | State)
4 State of Prior Finding
5 Nature Probability FSS USS
6 Oil 0.25 0.6 0.4
7 Dry 0.75 0.2 0.8
8
9
10
11
12 Posterior P(State | Finding)
13 Probabilities: State of Nature
14 Finding P(Finding) Oil Dry
15 FSS 0.3 0.5 0.5
16 USS 0.7 0.1429 0.8571
17
18
19

9-35
Decision Tree for the Full Goferbroke Co. Problem
  Oil
f
Drill Dry

c
Unfavorable Sell

Oil
b g
Drill Dry
Do seismic survey
Favorable
d
a Sell

Oil
h
No seismic survey Drill
Dry

e
Sell

9-36
 Decision Tree with Probabilities and Payoffs
  Payoff
Oil (0.143) 670
800
f
Drill 0
­100 Dry(0.857) ­130

c
90
Unfavorable Sell 60
0
Oil (0.5) 670
b 800
g
Do seismic survey 0 Drill 0
Favorable ­100 Dry (0.5) ­130
­30 (0.3)
d
90
a Sell 60

Oil (0.25) 700
800
0 h
Drill 0
No seismic survey ­100 ­100
Dry (0.75)
e
90
Sell 90

9-37
 The Final Decision Tree
 
Payoff
Oil (0.143) 670
­15.7
800
f
0
Drill
­100 Dry (0.857) ­130
60
c
90
Unfavorable Sell 60
0
123 Oil (0.5) 670
270
b g 800

0 Drill ­100 0
Do seismic survey Dry (0.5) ­130
­30 Favorable (0.3) 270
d
123 90
a Sell 60
Oil (0.25) 700
100
0 800
h
No seismic survey Drill 0
­100 Dry (0.75) ­100
100
e
90
Sell 90

9-38
TreePlan for the Full Goferbroke Co. Problem
A B C D E F G H I J K L M N O P Q R S
1 Decision Tree for Goferbroke Co. Problem (With Survey)
2
3 0.143
4 Oil
5 670
6 Drill 800 670
7
8 -100 -15.714 0.857
9 0.7 Dry
10 Unfavorable -130
11 2 0 -130
12 0 60
13
14 Sell
15 60
16 90 60
17 Do Survey
18 0.5
19 -30 123 Oil
20 670
21 Drill 800 670
22
23 -100 270 0.5
24 0.3 Dry
25 Favorable -130
26 1 0 -130
27 0 270
28
29 1 Sell
30 123 60
31 90 60
32
33 0.25
34 Oil
35 700
36 Drill 800 700
37
38 -100 100 0.75
39 Dry
40 No Survey -100
41 1 0 -100
42 0 100
43
44 Sell
45 90
46 90 90

9-39
 Organizing the Spreadsheet for Sensitivity Analysis
A B C D E F G H I J K L M N O P Q R S T U V W X Y Z AA
3 0.143 Data
4 Oil Cost of Survey 30
5 670 Cost of Drilling 100
6 Drill 800 670 Revenue if Oil 800
7 Revenue if Sell 90
8 -100 -15.714 0.857 Revenue if Dry 0
9 0.7 Dry Prior Probability Of Oil 0.25
10 Unfavorable -130 P(FSS|Oil) 0.6
11 2 0 -130 P(USS|Dry) 0.8
12 0 60
13
14 Sell Action
15 60 Do Survey? Yes
16 90 60
17 Do Survey If No If Yes
18 0.5
19 -30 123 Oil Drill Drill If Favorable
20 670 Sell If Unfavorable
21 Drill 800 670
22
23 -100 270 0.5
24 0.3 Dry Expected Payoff
25 Favorable -130 ($thousands)
26 1 0 -130 123
27 0 270
28
29 1 Sell
30 123 60 Data: P(Finding | State)
31 90 60 State of Prior Finding
32 Nature Probability FSS USS
33 0.25 Oil 0.25 0.6 0.4
34 Oil Dry 0.75 0.2 0.8
35 700
36 Drill 800 700
37
38 -100 100 0.75
39 Dry Posterior P(State | Finding)
40 No Survey -100 Probabilities: State of Nature
41 1 0 -100 Finding P(Finding) Oil Dry
42 0 100 FSS 0.3 0.5 0.5
43 USS 0.7 0.143 0.857
44 Sell
45 90
46 90 90

9-40
 The One Input, One Output Option of SensIt
U V W X Y
3 Data
4 Cost of Survey 30
5 Cost of Drilling 100
6 Revenue if Oil 800
7 Revenue if Sell 90
8 Revenue if Dry 0
9 Prior Probability Of Oil 0.25
10 P(FSS|Oil) 0.6
11 P(USS|Dry) 0.8
12
13
14 Action
15 Do Survey? Yes
16
17 If No If Yes
18
19 Drill Drill If Favorable
20 Sell If Unfavorable
21
22
23
24 Expected Payoff
25 ($thousands)
26 123

9-41
 SensIt One Input, One Output

SensIt 1.33 Academic Version

700
Expected Payof

600
500
400
300
200
100
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Prior Probability Of Oil

9-42
 Optimal Policy

Let p = Prior probability of oil

If p ≤ 0.168, then sell the land (no seismic survey).

If 0.169 ≤ p ≤ 0.308, then do the survey; drill if favorable, sell if not.

If p ≥ 0.309, then drill for oil (no seismic survey).

9-43
 The Many Inputs, One Output Option of SensIt

U V W X Y
3 Data
4 Cost of Survey 30
5 Cost of Drilling 100
6 Revenue if Oil 800
7 Revenue if Sell 90
8 Revenue if Dry 0
9 Prior Probability Of Oil 0.25
10 P(FSS|Oil) 0.6
11 P(USS|Dry) 0.8
12
13
14 Action
15 Do Survey? Yes
16
17 If No If Yes
18
19 Drill Drill If Favorable
20 Sell If Unfavorable
21
22
23
24 Expected Payoff
25 ($thousands)
26 123

9-44
 SensIt Spider Graph

SensIt 1.33 Academic Version

160

150

140

130
Revenue if Oil

120 Cost of Drilling

Revenue if Sell
110
Cost of Survey

100

90
70.0% 80.0% 90.0% 100.0% 110.0% 120.0% 130.0% 140.0%

Input Value as % of Base Case

9-45
 SensIt Tornado Diagram

Sensit - Sensitivity Analysis - Tornado

Revenue if Oil 600 1000

Cost of Drilling 140 75

Revenue if Sell 85 95

Cost of Survey 32 28

90 100 110 120 130 140 150 160

Expected Payoff

9-46
Using Utilities to Better Reflect the Values of Payoffs

• Thus far, when applying Bayes’ decision rule, we have assumed that the
expected payoff in monetary terms is the appropriate measure.

• In many situations, this is inappropriate.

• Suppose an individual is offered the following choice:

– Accept a 50-50 chance of winning $100,000.
– Receive $40,000 with certainty.

• Many would pick $40,000, even though the expected payoff on the 50-50
chance of winning $100,000 is $50,000. This is because of risk aversion.

• A utility function for money is a way of transforming monetary values to an

appropriate scale that reflects a decision maker’s preferences (e.g., aversion to
risk).

9-47
 A Typical Utility Function for Money

U(M)

0.75

0.5

0.25

0
$10,000 $30,000 $60,000 $100,000 M

9-48
 Shape of Utility Functions

 
U(M) U(M) U(M)

M M M
(a) Risk averse (b) Risk seeker (c) Risk neutral

9-49
 Utility Functions

• When a utility function for money is incorporated into a decision analysis

approach, it must be constructed to fit the current preferences and values of
the decision maker.

• Fundamental Property: Under the assumptions of utility theory, the decision

maker’s utility function for money has the property that the decision maker is
indifferent between two alternatives if the two alternatives have the same
expected utility.

• When the decision maker’s utility function for money is used, Bayes’ decision
rule replaces monetary payoffs by the corresponding utilities.

• The optimal decision (or series of decisions) is the one that maximizes the
expected utility.

9-50
 Illustration of Fundamental Property

By the fundamental property, a decision maker with the utility function below-
right will be indifferent between each of the three pairs of alternatives below-left.

U(M)

• 25% chance of $100,000

• $10,000 for sure 1
Both have E(Utility) = 0.25.

• 50% chance of $100,000 0.75

• $30,000 for sure
Both have E(Utility) = 0.5. 0.5

• 75% chance of $100,000

• $60,000 for sure 0.25
Both have E(Utility) = 0.75.
0
$10,000 $30,000 $60,000 $100,000 M

9-51
 The Equivalent Lottery Method

1. Determine the largest potential payoff, M=Maximum.

Assign U(Maximum) = 1.

2. Determine the smallest potential payoff, M=Minimum.

Assign U(Minimum) = 0.

3. To determine the utility of another potential payoff M, consider the two

aleternatives:
A1: Obtain a payoff of Maximum with probability p.
Obtain a payoff of Minimum with probability 1–p.
A2: Definitely obtain a payoff of M.

Question to the decision maker: What value of p makes you indifferent?

Then, U(M) = p.

9-52
 Generating the Utility Function for Max Flyer

• The possible monetary payoffs in the Goferbroke Co. problem are –130, –100,
0, 60, 90, 670, and 700 (all in $thousands).

• Set U(Maximum) = U(700) = 1.

• Set U(Minimum) = U(–130) = 0.

• To find U(M), use the equivalent lottery method.

• For example, for M=90, consider the two alternatives:

A1: Obtain a payoff of 700 with probability p
Obtain a payoff of –130 with probability 1–p.
A2: Definitely obtain a payoff of 90

• If Max chooses a point of indifference of p = 1/3, then U(90) = 1/3.

9-53
Max’s Utility Function for Money

9-54
Utilities for the Goferbroke Co. Problem

Monetary Payoff, M Utility, U(M)

–130 0.00
–100 0.05
60 0.30
90 0.33
670 0.97
700 1.00

9-55
 Decision Tree with Utilities
0.143
Oil
0.97
Drill 0.97 0.97

0 0.13871 0.857
0.7 Dry
Unfavorable 0
2 0 0
0 0.3

Sell
0.3
0.3 0.3
Do Survey
0.5
0 0.3555 Oil
0.97
Drill 0.97 0.97

0 0.485 0.5
0.3 Dry
Favorable 0
1 0 0
0 0.485

1 Sell
0.3555 0.3
0.3 0.3

0.25
Oil
1
Drill 1 1

0 0.2875 0.75
Dry
No Survey 0.05
2 0.05 0.05
0 0.333

Sell
0.333
0.333 0.333
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 Exponential Utility Function

• The procedure for constructing U(M) requires making many difficult decisions
about probabilities.

• An alternative approach assumes a certain form for the utility function and
adjusts this form to fit the decision maker as closely as possible.

• A popular form is the exponential utility function

U(M) = R (1 – e–M/R)

where R is the decision maker’s risk tolerance.

• An easy way to estimate R is to pick the value that makes you indifferent
between the following two alternatives:
a) A 50-50 gamble where you gain R dollars with probability 0.5 and lose R/2 dollars
with probability 0.5.
b) Neither gain nor lose anything.

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Using TreePlan with an Exponential Utility Function

• Specify the value of R in a cell on the spreadsheet.

• Give the cell a range name of RT (TreePlan refers to this term as the risk
tolerance).

• Click on the Option button in the TreePlan dialogue box and select the “Use
Exponential Utility Function” option.

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Decision Tree with an Exponential Utility Function
A B C D E F G H I J K L M N O P Q R S
3 0.143
4 Oil
5 670
6 Drill 800 670
7 0.602
8 -100 -57.052 0.857
9 0.7 -0.0815 Dry
10 Unfavorable -130
11 2 0 -130
12 0 60 -0.196
13 0.0791
14 Sell
15 60
16 90 60
17 Do Survey 0.0791
18 0.5
19 -30 90.0036 Oil
20 0.1163 670
21 Drill 800 670
22 0.602
23 -100 165.23116 0.5
24 0.3 0.203 Dry
25 Favorable -130
26 1 0 -130
27 0 165.231 -0.196
28 0.203
29 1 Sell
30 90 60
31 0.1163 90 60
32 0.0791
33 0.25
34 Oil
35 700
36 Drill 800 700
37 0.618
38 -100 32.7511 0.75
39 0.0440 Dry
40 No Survey -100
41 2 0 -100
42 0 90 -0.147
43 0.11629
44 Sell
45 90
46 90 90
47 0.1163
48 Risk Tolerance (RT) 728

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