Statistics for Managers

Using Microsoft® Excel

5th Edition

Chapter 17
Decision Making

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-1
 Learning Objectives

In this chapter, you learn:

 To use payoff tables and decision trees to
evaluate alternative courses of action
 To use several criteria to select an alternative
course of action
 To use Bayes’ theorem to revise probabilities
in light of sample information
 About the concept of utility

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-2
 Steps in Decision Making

 List Alternative Courses of Action

 Choices or actions
 List Uncertain Events
 Possible events or outcomes
 Determine ‘Payoffs’
 Associate a Payoff with Each Event/Outcome
combination
 Adopt Decision Criteria
 Evaluate Criteria for Selecting the Best Course
of Action

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-3
 Payoff Table
A payoff table shows alternatives,
states of nature, and payoffs

Investment Choice
Profit in $1,000’s (Action)
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40

Stable Economy 50 120 30
Weak Economy -120 -30 20
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-4
 Decision Tree
Strong Economy 200
Large factory Stable Economy 50
Weak Economy -120

Strong Economy 90
Average factory Stable Economy 120
Weak Economy -30

Strong Economy 40
Small factory Stable Economy 30
Weak Economy 20

Payoffs
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-5
 Opportunity Loss
Opportunity loss is the difference between an actual payoff
for an action and the optimal payoff, given a particular event
Investment Choice Payoff
Profit in $1,000’s (Action)
Table
(Events) Large Average Small
Factory Factory Factory

Strong Economy 200 90 40

Stable Economy 50 120 30
The
Weakaction “Average factory”
Economy -120has payoff 90
-30for “Strong Economy”.
20 Given “Strong
Economy”, the choice of “Large factory” would have given a payoff of 200, or
110 higher. Opportunity loss = 110 for this cell.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-6
 Opportunity Loss
Investment Choice (Action)
Profit in Large Average Small
Payoff
$1,000’s Factory Factory Factory Table
(Events)

Strong Economy 200 90 40 Opportunity

Stable Economy 50 120 30 Loss Table
Weak Economy -120 -30 20
Investment Choice (Action)
Opportunity Loss in Large Average Small
$1,000’s Factory
Factory Factory
(Events)

Strong Economy 0 110 160

Stable Economy 70 0 90
Weak Economy 140 50 0
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-7
 Decision Criteria

 Expected Monetary Value (EMV)

 The expected profit for taking action Aj
 Expected Opportunity Loss (EOL)
 The expected opportunity loss for taking action Aj
 Expected Value of Perfect Information (EVPI)
 The expected opportunity loss from the best
decision

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-8
 Expected Monetary Value

Goal: Maximize expected value

 The expected monetary value is the weighted
average payoff, given specified probabilities for
each event N
EMV ( j )   X ij Pi
i 1

Where EMV(j) = expected monetary value of action j

Xij = payoff for action j when event i occurs
Pi = probability of event i
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-9
 Expected Monetary Value

 The expected value is the weighted average

payoff, given specified probabilities for
each event

Investment Choice
Profit in $1,000’s (Action) Suppose these
(Events) probabilities
Large Average Small Factory
Factory Factory have been
assessed for
Strong Economy (0.3) 200 90 40 these three
Stable Economy (0.5) 50 120 30 events
Weak Economy (0.2) -120 -30 20

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-10
 Expected Monetary Value
Payoff Table:
Investment Choice
Profit in $1,000’s (Action)
(Events) Large Average Small
Factory Factory Factory

Strong Economy (0.3) 200 90 40

Stable Economy (0.5) 50 120 30
Weak Economy (0.2) -120 -30 20
EMV (Expected Values) 61 81 31

 Example: EMV (Average factory) = 90(.3) + 120(.5)

+ (-30)(.2) = 81
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-11
 Expected Opportunity Loss
Goal: Minimize expected opportunity loss

 The expected opportunity loss is the weighted

average loss, given specified probabilities for each
event
N
EOL(j)   L ijPi
i 1

Where EOL(j) = expected monetary value of action j

Lij = opportunity loss for action j when event i occurs
Pi = probability of event i
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-12
 Expected Opportunity Loss
Opportunity Loss Table
Investment Choice (Action)
Opportunity Loss in Large Average Small
$1,000’s Factory
Factory Factory
(Events)

Strong Economy (0.3) 0 110 160

Stable Economy (0.5) 70 0 90
Weak Economy (0.2) 140 50 0
Expected Opportunity 63 43 93
Loss (EOL)
 Example: EOL (Large factory) = 0(.3) + 70(.5) +
(140)(.2) = 63
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-13
 Value of Information
Expected Value of Perfect Information, EVPI

 Expected Value of Perfect Information

EVPI = Expected profit under certainty
– expected monetary value of the best
alternative
 EVPI is equal to the expected opportunity loss
from the best decision

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-14
 Expected Profit Under Certainty
 Expected Investment Choice
Profit in $1,000’s (Action)
profit under (Events)
certainty Large Average Small Factory
Factory Factory
= expected
value of the Strong Economy (0.3) 200 90 40
best decision, Stable Economy (0.5) 50 120 30
given perfect Weak Economy (0.2) -120 -30 20
information Value of best decision
for each event: 200 120 20

Example: Best decision given “Strong

Economy” is “Large factory”

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-15
 Expected Profit Under Certainty
Investment Choice
Profit in $1,000’s (Action)
(Events)
Large Average Small Factory
Factory Factory

Strong Economy (0.3) 200 90 40

 Now weight Stable Economy (0.5) 50 120 30
Weak Economy (0.2) -120 -30 20
these outcomes
with their
probabilities to 200 120 20
find the
expected profit 200(.3)+120(.5)+20(.2)
under certainty:
= 124
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-16
 Value of Information Solution
 Expected Value of Perfect Information (EVPI)
EVPI = Expected profit under certainty
– Expected monetary value of the best decision

Recall: Expected profit under certainty = 124

EMV is maximized by choosing “Average factory,”

where EMV = 81

so: EVPI = 124 – 81

= 43
(EVPI is the maximum you would be willing to spend to obtain perfect information)
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-17
 Accounting for Variability

Consider the choice of Stock A vs. Stock B

Stock Choice
(Action)
Percent Return Stock A Stock B
(Events)

Stock A has a higher

EMV, but what about
Strong Economy 30 14
risk?
(.7)
Weak Economy -10 8
(.3)
Expected Return 18.0 12.2
(EMV)
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-18
 Accounting for Variability
Calculate the variance and standard deviation
Stock Choice
(Action)
Percent Return Stock A Stock B
(Events)

Strong Economy (.7) 30 14

Weak Economy (.3) -10 8
Expected Return (EMV) 18.0 12.2
Variance 336.0 7.56
N
Example:
StandardσDeviation
A 
2
( Xi  μ)2 P( X
18.33 2.75
i )  (30  18 ) (.7 )  ( 10  18 ) (.3 )  336 .0
i1
2 2

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-19
 Accounting for Variability

Calculate the coefficient of variation for each stock:

σA 18.33 Stock A has

CVA   100%   100%  101.83%
EMVA 18.0 much more
relative
variability
σB 2.75
CVB   100%   100%  22.54%
EMVB 12.2

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-20
 Return-to-Risk Ratio
Return-to-Risk Ratio (RTRR):

EMV(j)
RTRR(j) 
σj

Expresses the relationship between the return (expected

payoff) and the risk (standard deviation)

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-21
 Return-to-Risk Ratio
EMV(j)
RTRR(j) 
σj

EMV(A) 18.0
RTRR(A)    0.982
σA 18.33

EMV(B) 12.2
RTRR(B)    4.436
σB 2.75

You might want to consider Stock B if you don’t like risk.

Although Stock A has a higher Expected Return, Stock B has
a much larger return to risk ratio and a much smaller CV.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-22
 Decision Making
with Sample Information
Prior
Probability
 Permits revising old
probabilities based on new New
information Information

Revised
Probability

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-23
 Revised Probabilities
Example
Additional Information: Economic forecast is strong economy
 When the economy was strong, the forecaster was correct 90% of the time.
 When the economy was weak, the forecaster was correct 70% of the time.

F1 = strong forecast
F2 = weak forecast Prior probabilities
from stock choice
E1 = strong economy = 0.70 example
E2 = weak economy = 0.30
P(F1 | E1) = 0.90 P(F1 | E2) = 0.30
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-24
 Revised Probabilities
Example
P(F1 | E1 )  .9 , P(F1 | E 2 )  .3

P(E1 )  .7 , P(E 2 )  .3
Revised Probabilities (Bayes’ Theorem)
P( F1 | E1 ) P( E1 ) (.9)(.7)
P( E1 | F1 )    .875
P( F1 ) (.9)(.7)  (.3)(.3)
P( F1 | E2 ) P( E2 )
P( E2 | F1 )   .125
P( F1 )
Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-25
 EMV with
Revised Probabilities
Pi Event Stock A XijPi Stock B XijPi
.875 strong 30 26.25 14 12.25
.125 weak -10 -1.25 8 1.00
Σ = 25.0 Σ = 13.25
Revised
probabilities EMV Stock B = 13.25

EMV Stock A = 25.0 Maximum

EMV

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-26
 EOL Table with
Revised Probabilities
Pi Event Stock A XijPi Stock B XijPi

.875 strong 0 0 16 14.00

.125 weak 18 2.25 0 0
Σ = 2.25 Σ = 14.00
Revised
probabilities EOL Stock B = 14.00

EOL Stock A = 2.25 Minimum

EOL

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-27
 Accounting for Variability with
Revised Probabilities
Calculate the variance and standard deviation
Stock Choice
(Action)
Percent Return Stock A Stock B
(Events)

Strong Economy (.875) 30 14

Weak Economy (.125) -10 8
Expected Return (EMV) 25.0 13.25
Variance 175.0 3.94
N
Example:Standard  ( X i  μ)2 P( X i ) 13.229
σ 2A Deviation
i 1
(30  25) 2 (.875)  (1.984
10  25) 2 (.125)  175.0

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-28
 Accounting for Variability with
Revised Probabilities
The coefficient of variation for each stock using the
results from the revised probabilities:

σA 13.229
CVA   100%   100%  52.92%
EMVA 25.0

σB 1.984
CVB   100%   100%  14.97%
EMVB 13.25

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-29
 Return-to-Risk Ratio with
Revised Probabilities
EMV(A) 25.0
RTRR(A)    1.890
σA 13.229

EMV(B) 13.25
RTRR(B)    6.678
σB 1.984

With the revised probabilities, both stocks have higher

expected returns, lower CV’s, and larger return to risk
ratios

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-30
 Utility

 Utility is the pleasure or satisfaction obtained

from an action.

 The utility of an outcome may not be the

same for each individual.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-31
 Utility Example

Each incremental $1 of profit does not have the

same value to every individual:

A risk averse person, once reaching a goal,

assigns less utility to each incremental $1.
A risk seeker assigns more utility to each
incremental $1.
A risk neutral person assigns the same utility
to each extra $1.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-32
 Three Types of Utility Curves

Utility
Utility

Utility

$ $ $

Risk Averter Risk Seeker Risk-Neutral

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-33
 Maximizing Expected Utility

 Making decisions in terms of utility, not $

 Translate $ outcomes into utility outcomes

 Calculate expected utilities for each action
 Choose the action to maximize expected utility

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-34
 Chapter Summary
In this chapter, we have
 Described the payoff table and decision trees
 Opportunity loss
 Provided criteria for decision making
 Expected monetary value
 Expected opportunity loss
 Return to risk ratio
 Introduced expected profit under certainty and the
value of perfect information
 Discussed decision making with sample information
 Addressed the concept of utility

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-35