Business Statistics, 5 ed.

th

by Ken Black

Discrete Distributions

Chapter 19 Decision Analysis

PowerPoint presentations prepared by Lloyd Jaisingh, Morehead State University

Learning Objectives
Learn about decision making under certainty, under uncertainty, and under risk. Learn several strategies for decision-making under uncertainty, including expected payoff, expected opportunity loss, maximin, maximax, and minimax regret. Learn how to construct and analyze decision trees. Understand aspects of utility theory. Learn how to revise probabilities with sample information.

Decision-Making Scenarios
Decision-making under certainty Decision-making under uncertainty Decision-making under risk

Three Variables in Decision Analysis Problems

Decision Alternatives are the various choices or options available to the decision maker in any given problem situation States of Nature are the occurrences of nature that can effect the outcome of the decision. They are beyond the decision makers control Payoffs are the benefits or rewards that result from selecting a particular decision alternative. They are often expressed in dollars, but may be stated in other units, such as market share

Decision Table
States of Nature s1 s2 s3 P1,1 P1,2 P1,3 P2,1 P2,2 P2,3 P3,1 P3,2 P3,3 Pm,1 Pm,2 Pm,3

Decision Alternatives

d d d d

1 2 3

s P P P P

1, n 2, n 3, n

m, n

where: sj = state of nature dj = decision alternative Pi,j = payoff for decision i under state j

Example: Decision Table for an Investor

Stagnant Stocks $ (500) Bonds $ (100) CDs $ 300 Mixture $ (200) Slow Growth $ 700 $ 600 $ 500 $ 650 Rapid Growth $ 2,200 $ 900 $ 750 $ 1,300

Annual payoffs for an investment of $10,000

Decision-Making Under Certainty

The states of nature are known.

Slow Rapid Stagnant Growth Growth Stocks $ (500) $ 700 $ 2,200 Bonds $ (100) $ 600 $ 900 CDs $ 300 $ 500 $ 750 Mixture $ (200) $ 650 $ 1,300
Annual payoffs for an investment of $10,000

The economy The economy will grow will grow rapidly. rapidly. Invest in stocks. Invest in stocks.

Criteria for Decision Making Under Uncertainty

Maximax payoff: Choose the best of the best Maximin payoff: Choose the best of the worst Hurwicz payoff: Use a weighted average of the extremes Minimax regret: Minimize the maximum opportunity loss

Maximax Criterion
1. Identify the maximum payoff for each alternative. 2. Choose the alternative with the largest maximum.

Stocks Bonds CDs Mixture

Stagnant $ (500) $ (100) $ 300 $ (200)

Slow Growth $ 700 $ 600 $ 500 $ 650

Rapid Growth $ 2,200 $ 900 $ 750 $ 1,300

Maximum $ 2,200 $ 900 $ 750 $ 1,300

Maximin Criterion
1. Identify the minimum payoff for each alternative. 2. Choose the alternative with the largest minimum.

Stocks Bonds CDs Mixture

Stagnant $ (500) $ (100) $ 300 $ (200)

Slow Rapid Growth Growth Minimum $ 700 $ 2,200 $ (500) $ 600 $ 900 $ (100) $ 500 $ 750 $ 300 $ 650 $ 1,300 $ (200)

Hurwicz Criterion
1. Identify the maximum payoff for each alternative. 2. Identify the minimum payoff for each alternative. 3. Calculate a weighted average of the maximum and the minimum using and (1 - ) for weights. 4. Choose the alternative with the largest weighted average. =.7 1 =.3 Slow Rapid Growth Growth Maximum Minimum $ 700 $ 2,200 $ 2,200 $ (500) $ 600 $ 900 $ 900 $ (100) $ 500 $ 750 $ 750 $ 300 $ 650 $ 1,300 $ 1,300 $ (200)

Stagnant Stocks $ (500) Bonds $ (100) CDs $ 300 Mixture $ (200)

Weighted Average $ 1,390 $ 600 $ 615 $ 850

Decision Alternatives for Various Values of

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1- 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 Stocks Max Min 2,200 -500 -500 -230 40 310 580 850 1120 1390 1660 1930 2200 Bonds Max Min 900 -100 -100 0 100 200 300 400 500 600 700 800 900 CDs Max Min 750 300 300 345 390 435 480 525 570 615 660 705 750 Mixture Max Min 1,300 -200 -200 -50 100 250 400 550 700 850 1000 1150 1300

Graph of Hurwicz Criterion Selections for Various Values of

2500 2000 1500 1000 500 0 -500 0.0 0.2 0.4 0.6 0.8 1.0
Stocks

Mixture Bonds CDs

Investment Example: Selected Regrets

Stagnant Stocks $ (500) Bonds $ (100) CDs $ 300 Mixture $ (200) Slow Rapid Growth Growth $ 700 $ 2,200 $ 600 $ 900 $ 500 $ 750 $ 650 $ 1,300
I invested in stocks, and the economy grew slowly. I have no regrets.

I invested in CDs. Then the economy grew rapidly. I am out $1,450.

I invested in stocks. Then the economy stagnated. I regret not investing in CDs. I am $800 down from where I could have been.

Investment Example: Opportunity Loss Table

Stagnant 800 400 0 500 Slow Rapid Growth Growth 0 0 100 1,300 200 1,450 50 900

Stocks Bonds CDs Mixture

Investment Example: Calculating Opportunity Loss

Payoff Table Opportunity Loss Table

Stagnant Stocks $ (500) Bonds $ (100) CDs $ 300 Mixture $ (200)

Slow Rapid Growth Growth $ 700 $ 2,200 $ 600 $ 900 $ 500 $ 750 $ 650 $ 1,300

Stocks Bonds CDs Mixture

Slow Rapid Stagnant Growth Growth 800 0 0 400 100 1,300 0 200 1,450 500 50 900

OLi,j = Max(column j) - Pi,j

Minimax Regret
1. Identify the maximum regret for each alternative. 2. Choose the alternative with the least maximum regret.

Stocks Bonds CDs Mixture

Stagnant 800 400 0 500

Slow Rapid Growth Growth Maximum 0 0 800 100 1,300 1,300 200 1,450 1,450 50 900 900

Decision Making under Risk

Probabilities of the states of nature have been determined
Decision-Making under uncertainty: probabilities of the states of nature are unknown Decision-Making under risk: probabilities of the states of nature are known (have been estimated)

Decision Trees Expected Monetary Value of Alternatives

Decision Table with States of Nature Probabilities for Investment Example

Stagnant .25 $ (500) $ (100) $ 300 $ (200) Slow Growth .45 $ 700 $ 600 $ 500 $ 650 Rapid Growth .30 $ 2,200 $ 900 $ 750 $ 1,300

Probabilities

Stocks Bonds CDs Mixture

Decision Tree for the Investment Example

Stagnant (.25) Chance Node Decision Node Stocks -$500 Slow growth (.45) $700 Rapid Growth (.30) $2,200 Stagnant (.25) -$100 Slow growth (.45) Rapid Growth (.30) $600 $900 Stagnant (.25) $300 Slow growth (.45) $500 Rapid Growth (.30) $750 Stagnant (.25) -$200 Slow growth (.45) $650 Rapid Growth (.30) $1,300

Bonds

CDs Mixture

Expected Monetary Value Criterion

EMV where:

[d ] = X P
n i j =1 i, j i j

d P X

= decision alternative i = the probability of state j = the payoff for decision i in state j

i, j

EMV Calculations for the Investment Example

] EMV[ stocks = ( .25) ( 500) + ( .45) ( 700) + ( .3) ( 2200) = 850 ] EMV[ bonds = ( .25) ( 100) + ( .45) ( 600) + ( .30) ( 900) = 515
EMV[ CDs] = ( .25) ( 300) + ( .45) ( 500) + ( .30) ( 750) = 525

] EMV[ mixture = ( .25) ( 200) + ( .45) ( 650) + ( .30) ( 1300) = 63250 .

Decision Tree with Expected Monetary Values for the Investment Example
$850 Stagnant (.25) -$500 Slow growth (.45) $700 Rapid Growth (.30) $2,200 Stagnant (.25) -$100 Slow growth (.45) Rapid Growth (.30) $600 $900 Stagnant (.25) $300 Slow growth (.45) $500 Rapid Growth (.30) $750 $623.50 Stagnant (.25) -$200 Slow growth (.45) $650 Rapid Growth (.30) $1,300

Stocks Bonds

$515

CDs Mixture

$525

EMV Criterion for the Investment Example

1. Calculate the expected monetary value of each alternative. 2. Choose the alternative with the largest EMV.

Stocks Bonds CDs Mixture

Slow Rapid Stagnant Growth Growth 0.25 0.45 0.30 $ (500) $ 700 $ 2,200 $ (100) $ 600 $ 900 $ 300 $ 500 $ 750 $ (200) $ 650 $ 1,300

Expected Monetary Value $ $ $ $ 850.00 515.00 525.00 632.50

Expected Monetary Payoff with Perfect Information for the Investment Example
Expected Monetary Payoff with Perfect Information = ($300)(.25) + ($700)(.45) + ($2200)(.30) = $1050

Stocks Bonds CDs Mixture

Stagnant .25 $ (500) $ (100) $ 300 $ (200)

Slow Growth .45 $ 700 $ 600 $ 500 $ 650

Rapid Growth .30 $ 2,200 $ 900 $ 750 $ 1,300

Expected Value of Perfect Information for the Investment Example

Expected Value of Perfect Information = Expected Monetary Payoff with Perfect Information - Max(EMV[di]) = $1050 - $850 = $200

Utility
The degree of pleasure or displeasure a decision-maker has in being involved in the outcome selection process given the risks and opportunities available Risk-Avoider Risk-Neutral Risk-Taker

Risk Neutral: Indifferent to Owning a or b

.5 a .5 b -$0 $50,000 00 $100,000

Risk Avoider: Indifferent to Owning a or b

.5 a .5 b -$0 $20,000 00 $100,000

Risk Taker: Indifferent to Owning a or b

.5 a .5 b -$0 $70,000 00 $100,000

Utility Curves for Game Players

Risk-Avoider Chance of Winning the Contest

Risk Neutral

Risk-Taker

Monetary Payoff

Revising Probabilities in Light of Sample Information

Bayes Rule Expected Value of Sample Information

Decision Table for Investment Problem

No Rapid Growth Growth (.65) (.35) $ 500 $ 100 $ (200) $ 1,100

Bonds Stocks

Expected Monetary Value Criterion for the Investment Example

Expected Monetary Value $ 360.00 $ 255.00

Bonds Stocks

No Rapid Growth Growth 0.65 0.35 $ 500 $ 100 $ (200) $ 1,100

Decision Tree for the Investment Example

No Growth (.65) EMV=$360 Bonds $360 No Growth (.65) Stocks EMV=$255 Rapid Growth (.35) $1,100 Rapid Growth (.35) $100 $500

-$200

Historical Performance of Economic Forecaster

Actual State of Economy No Growth (s1) Forecaster Predicts No Growth (F 1) Forecaster Predicts Rapid Growth (F 2) .80 .20 P(Fi|sj) Rapid Growth (s2) .30 .70

Bayes Rule

P ( Xi | Y ) =

P ( Y | Xi ) P ( X i ) P(Y | X 1) P( X 1) + P(Y | X 2 ) P( X 2 ) + P(Y | Xn ) P( Xn )

Revision Based on a Forecast of No Growth (F1)

State of Economy No Growth (s 1) Rapid Growth (s 2) Prior Probabilities Conditional Probabilities Joint Probabilities Revised Probabilities P(sj|F1)

P(s 1) = .65 P(s 2) =.35

P(F 1| s 1) = .80 P(F 1 s 1) = .520 .520/.625 = .832 P(F 1| s 2) = .30 P(F 1 s 2) = .105 .105/.625 = .168 P(F1) = .625

Revision Based on a Forecast of Rapid Growth (F2)

State of Economy No Growth (s 1) Rapid Growth (s 2) Prior Probabilities Conditional Probabilities Joint Probabilities Revised Probabilities P(sj|F2)

P(s 1) = .65 P(s 2) =.35

P(F 2| s 1) = .20 P(F 2 s 1) = .130 .130/.375 = .347 P(F 2| s 2) = .70 P(F 2 s 2) = .245 .245/.375 = .653 P(F1) = .375

Decision Tree for the Investment Example After Revision of Probabilities

$432.80 Bonds $432.80 Forecast No Growth (.625) No Growth (.832) $500 Rapid Growth (.168) $100 No Growth (.832) -$200 Stocks $18.40 Rapid Growth (.168) $1,100 No Growth (.347) $500 Rapid Growth (.653) $100 No Growth (.347) -$200 Stocks $648.90 Rapid Growth (.653) $1,100

Buy Forecast

$513.84

$238.80 Forecast Rapid Growth (.375) Bonds $648.90

Expected Value of Sample Information for the Investment Example

Expected value of sample information = expected monetary value with information - expected monetary value without information = $513.84 - $360 = $153.84

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