MHD Ch04 3e

CHAPTER 4
Making Choices
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or
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Overview of Chapter 4
In this lecture, we will cover:

Decision trees and expected monetary value
Double risk dilemma
Influence diagrams
• Asymmetric and symmetric influence diagrams
Risk profiles
• Cumulative risk profiles
Dominance
© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
Preliminary Considerations
 Simplification
• A necessary aspect of analysis
• Not just pedagogical
• Cannot include all the details
• Ensure include relevant information and aspects of decision
 Probabilities
• Quantify chances of each outcome
• Allows factoring in ‘beliefs’
Decision Trees and EMV
 Decision trees: diagram representing alternatives

as branches (lines) connected by
• Chance nodes
• Decision nodes
 Expected monetary value (EMV)
• Include monetary outcomes of alternatives
• Include probability of each outcome
Decision Trees and EMV
 “Folding back the tree” – method for finding EMVs

using decision trees
• Start at the endpoints of the branches on the far right-
hand side and move to the left
1. Calculate expected values when a chance node is
encountered, or
2. Choose the branch with the highest value or expected
value when a decision node is encountered.
1
Decision Tree Example (Figure 4.2)
Double Risk Dilemma Example
 Double-risk dilemma - choosing between two risky

alternatives.
 Example: You have a ticket that will let you participate in a lottery that
will pay off $10 with a 45% chance, and nothing with a 55% chance.
Your friend has a ticket to a different lottery that has a 20% chance of
paying $25 and an 80% chance of paying nothing. Your friend has
offered to let you have his ticket if you will give him your ticket plus
one dollar. Should you agree to the trade and play to win $25, or
should you keep your ticket and have a better chance of winning
$10?
 Notice, you could win as much as $24 or possibly

lose $1
 Calculations for analysis
EMV (Keep Ticket) = (0.45 * $10) + (0.55 * $0)
= $4.50
EMV (Trade Ticket) = (0.20 * $24) + (0.80 * $-1)
= $4.00
Influence Diagrams
 Decision trees and EMV are primarily for simple

situations and small trees.
 Influence diagrams are preferred for more
complicated situations
• Influence diagrams ‘think’ about a decision in terms of
symmetric expansion of the decision tree from one node
to the next.
• Computer programs (like PrecisionTree) make this
approach easier
Influence Diagram Example
Example: Should I take my umbrella today?

If I don’t take the umbrella, and it rains, my good clothes are
ruined, and I get is zero units of satisfaction.
If I don’t take the umbrella and the sun shines, this is the best
of all possible consequences. I get a 100 units of satisfaction.
If I decide to take my umbrella, my clothes will not get spoiled.
However, it is a bit of a nuisance to carry the umbrella around
all day. So my consequence is 80, between the other two
values.
Influence Diagram Example
Umbrella Problem as an Asymmetric Decision Tree
Umbrella Problem as a Symmetric Influence Diagram
Risk Profiles
 EMV does not tell the whole story.

• Amount of variation in the consequences
• Set of possible consequences for each alternative
• Probabilities of possible outcomes
 Risk profiles help fill these gaps.
 Risk profiles are an alternative to EMV.
Risk Profiles
 Probability values
• The chance an event will happen, often presented as a
%
• The probabilities for a given alternative or a strategy
must always sum to one.
Risk Profiles
 An alternative’s or strategy’s risk profile:
• EMV summarizes each alternative into a single number.
• Risk profiles graphically display the range of possible
results.
• Convey more of the complexity of the alternative
• Consequence values together with their associated
probabilities give a complete picture of what could happen
when we choose an alternative or strategy.
• The graph of the consequence values along the x axis and
their associated probabilities along the y axis
Risk Profiles
 Constructing a risk profile

• Collapse a decision tree by multiplying out the
probabilities on sequential chance branches
 Similar to the folding-back procedure we learned
earlier
• Except that in a risk profile we keep track of the possible
outcomes and their probabilities
Cumulative Risk Profiles
 Cumulative format:
• On the vertical axis, show the aggregate chance that the
payoff is less than or equal to the corresponding value
on the horizontal axis.
• This is done by translating the information contained in
the risk profile.
• Add up, or accumulate, the chances of the individual
payoffs.
Constructing a Risk Profile – Step 1
The three chance nodes have been collapsed into one chance node. The
probabilities on the branches are the product of the probabilities from sequential
branches in Step 1.
The seven branches from the chance node in Step 2 have
been combined into three branches.
The risk profile shown on x and y axes.
The cumulative risk profile, also shown
on x and y axes.
Risk Profiles
 Risk profiles can be used as an alternative to EMV.
• Allows you to check every possible strategy.
• For complex decisions it can be tedious to analyze
numerous risk profiles.
 A common compromise:
• First, analyze risk profiles for only the first one or two
decisions
• Second, make future decisions using a decision rule such
as maximizing EMV
• This is the approached used in PrecisionTree
Dominance
 A way to determine if one strategy is head-and-

shoulders better than other strategies
 Construct cumulative risk profiles for the competing
strategies
• Best done with continuous risk profiles (more in Ch. 8)
 If one strategy’s profile is always to the right of an
alternative’s, then the first is said to dominate, and
is definitely the best strategy.
Dominance
Strategy A
(dotted line)
dominates
Strategy B
(solid line)
because
Strategy A is
always right
of Strategy
B.
Dominance
 Varying degree of dominance

• Stochastic or probability dominance: when considering
all the possible events and the probability of their
occurrence, one alternative is always at least as good
and at times it is better.
• Deterministic dominance: occurs when the maximum
payout of one alternative is less than the minimum
payout of another alternative
• Stronger than stochastic dominance
Decisions with Multiple Objectives: Example
The Summer Job
Sam Chu was in a quandary. With two job offers in hand, the choice he should make was far
from obvious. The first alternative was a job as an assistant at a local small business; the job
would pay a bit above minimum wage ($9.25 per hour), it would require 30 to 40 hours per week,
and the hours would be primarily during the week, leaving the weekends free. The job would last
for three months (13 weeks), but the exact amount of work, and hence the amount Sam could
earn, was uncertain. However, the free weekends could be spent with friends.
The second alternative was to work as a member of a trail-maintenance crew for a conservation
organization. This job would require 10 weeks of hard work, 40 hours per week at $11.45 per
hour, in a national forest in a neighboring state. The job would involve extensive camping and
backpacking. Members of the maintenance crew would come from a large geographic area and
spend the entire 10 weeks together, including weekends. Although Sam had no doubt about the
earnings this job would provide, the real uncertainty was what the staff and other members of the
crew would be like. Would new friendships develop? The nature of the crew and the leaders
could make for 10 weeks of a wonderful time, 10 weeks of misery, or anything in between.
“The Summer Job” Example
 Summer job decision involves two objectives

• Money
• Fun
 Money already has a scale – monetary value
 Need to create a scale for fun since doesn’t have a
natural scale
Start by
representing the
situation as an
influence diagram –
the Big Picture.
Also, shows areas
of uncertainty.
Next, create a
decision tree –
shows Sam’s
beliefs (scale)
about fun and
translates
uncertainties into
probabilities.
Calculate EMVs and create risk profiles for the two alternative jobs, one objective at a time.
 To continue, we must create subjective but

quantitative ratings for Sam’s beliefs concerning fun.
• Need to convert earlier scale of fun levels into meaningful
numerical measurements
• Purely subjective – will vary by individual
• Best scale for ratings is 0 – 100
• Once put on the new numeric scale, it is possible to
compare “how much” fun there is in the two jobs.
 Must also assign probabilities to various options
Put money on same
scale as fun (0 -100)
and assign decision
weights to show
relative importance of
money and fun.
Create a decision tree
with the ratings to
show trade-offs
involved.
Subjectively determine
weights of fun
compared to salary.
Use these to calculate
to calculate overall
utility scores for the
various options and
show as decision tree.
Now fold back the tree and calculate expected values
using probabilities and overall scores. Show as risk
profiles for the summer job.
Create cumulative risk profiles and check for
dominance. The forest job is stochastically dominant.
Summary
In this chapter, you have learned how to analyze a

structured problem to find the preferred alternative.
For analysis, you used:
Decision trees
Expected monetary value (EMV)
Influence diagrams
Risk profiles and cumulative risk profiles
Dominance

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CHAPTER 4

In this lecture, we will cover:

 Decision trees: diagram representing alternatives

 “Folding back the tree” – method for finding EMVs

 Double-risk dilemma - choosing between two risky

 Notice, you could win as much as $24 or possibly

 Decision trees and EMV are primarily for simple

Example: Should I take my umbrella today?

 EMV does not tell the whole story.

 Constructing a risk profile

 A way to determine if one strategy is head-and-

 Varying degree of dominance

 Summer job decision involves two objectives

 To continue, we must create subjective but

In this chapter, you have learned how to analyze a

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