Learning Objectives

In this topic, you learn:

Decision Analysis

To use payoff tables and decision trees to evaluate alternative courses of action To select an action based on a chosen decision criterion

Steps in Decision Making

List Alternative Courses of Action
actions

Decsion Problem in the Form of a Payoff Table

Profit in $1,000s Investment Choice (Actions)
States of Nature Large Factory Strong Economy Stable Economy Weak Economy 200 50 -120 Average Factory 90 120 -30 Small Factory 40 30 20

List Possible Outcomes

states of nature

Determine Payoffs
associate a payoff for each action/state-of-nature combination

Choose a Decision Criterion

select an action based on the decision criterion

Decision Criteria
Maximax
An optimistic decision criterion

Maximax Solution
States of Nature (Events)

Maximin
A pessimistic decision criterion

Profit in $1,000s Investment Choice (Action) Large Average Small Factory Factory Factory
200 50 -120 90 120 -30 40 30 20

Expected Monetary Value (EMV(j))

The expected payoff for taking action j

Strong Economy Stable Economy Weak Economy

Maximum payoff for Large Factory is 200 Maximum payoff for Average Factory is 120 Maximum payoff for Small Factory is 40 Decision: Build the Large Factory because 200 is the maximum profit

Maximin Solution
States of Nature

Expected Monetary Value Solution

The EMV is the weighted average payoff, given specified probabilities for each s-n

Profit in $1,000s Actions Large Average Small Factory Factory Factory

200 50 -120 90 120 -30 40 30 20

Strong Economy Stable Economy Weak Economy

EMV( j) = x ijPi
i=1

Minimum payoff for Large Factory is -120 Minimum payoff for Average Factory is -30 Minimum payoff for Small Factory is 20 Decision: Build the Small Factory because 20 is the maximum profit

where EMV(j) = expected monetary value of action j xij = payoff for action j when s-n i occurs Pi = probability of s-n i

Expected Monetary Value Solution

(continued)

Expected Monetary Value Solution

Goal: Maximize expected value Payoff Table:
Profit in $1,000s Investment Choice (Action) States of Nature (Events) Large Factory 200 50 -120 Average Factory 90 120 -30 Small Factory 40 30 20

(continued)

The expected value is the weighted average payoff, given specified probabilities for each s-n
Profit in $1,000s Actions States of Nature Large Factory 200 50 -120 Average Factory 90 120 -30 Small Factory 40 30 20

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

Expected Value (EMV)

61

81

31

Suppose these probabilities have been assessed for these three events

Maximize expected value by choosing Average factory

Example: EMV (Average factory) = (90)(.3) + (120)(.5) + (-30)(.2) = 81

Another Way to Display & Analyze the Same Information Decision tree

Decision Problem in the Form of a Decision Tree

Strong Economy (.3) 200 50 -120 90 120 -30 40 30 20

Large factory

Stable Economy (.5) Weak Economy (.2)

action node state-of-nature node branch

Action Node Small factory State of Nature Node
Chap 19-11

Strong Economy (.3)

Average factory

Stable Economy (.5) Weak Economy (.2)

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

Probabilities Payoffs

Fold Back the Tree

EMV=200(.3)+50(.5)+(-120)(.2)=61

Make the Decision

EV=61

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

200 50 -120 90 120 -30 40 30 20

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

200 50 -120 90
Maximum

Large factory

Large factory

EMV=90(.3)+120(.5)+(-30)(.2)=81

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

EV=81

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

Average factory

Average factory

120 -30 40 30 20

EMV=81

EMV=40(.3)+30(.5)+20(.2)=31

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

EV=31

Strong Economy (.3) Stable Economy (.5) Weak Economy (.2)

Small factory

Small factory

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 19-13

Copyright 2012 Pearson Education, Inc. publishing as Prentice Hall

Chap 19-14

Application to Investment
Consider the choice of Stock A vs Stock B
Percent Return Actions States of Nature Stock A
Strong Economy (.7) Weak Economy (.3)

Application to Investment
(continued)

Calculate the standard deviation for both stocks

Percent Return Action States of Nature Stock A
Strong Economy (.7) Weak Economy (.3)

Stock B 14 8

Example
2 = ( X i ) 2 P ( X i ) = A
i =1 N

30 -10

Stock B 14 8

30 -10

(30 18) 2 (.7) + (10 18) 2 (.3) = 336.0

Expected Return: 18.0

12.2

Stock A has a higher EMV, but what about risk ?

Expected Return: Standard Deviation

18.00 18.33

12.20 2.75

Application to Investment
(continued)

Calculate the coefficient of variation (CV) for each stock

CVA =

A 18.33 = = 1.0183 EMVA 18.0 B 2.75 = = 0.225 EMVB 12.2

Stock A is more risky

CVB =