CHAPTER 5

DECISION ANALYSIS

Decision theory provides a framework and methodology for rational decision making. It
treats decisions against nature, where the result (return) from a decision depends on
action of another player (nature). For example, if the decision is to carry an umbrella or
not, the return (get wet or not) depends on what action nature takes. It is important to note
that, in this model, the returns accrue only to the decision maker. Nature does not care
what the outcome is. This condition distinguishes decision theory from game theory. In
game theory, both players have an interest in the outcome.

In many cases, solving your problem involves choosing among alternatives. Your
objective is to choose the alternative that is best, where best depends on what your
goals are. Indeed, the first rule of decision making is to know what your goals are. For
example, if your decision problem is which movie to see, then best means most
entertaining (assuming being entertained is your goal).

Having identified your goals, you next have to identify your alternatives. For some
decision-making problems, your alternatives are obvious. For instance, if you are
deciding which movie to see, then your alternatives are the movies playing plus, possibly,
not seeing any movie at all. For other problems, however, identifying your alternatives is
more difficult. For instance, if you are deciding which personal computer to buy, then it
can be quite difficult to identify all your alternatives (e.g., you may not know all the
companies that make computers or all the optional configurations available).

Your choice of alternative will lead to some consequence. Depending on the decisionmaking problem you face, the consequence of choosing a given alternative will be either
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known or uncertain. If you are driving in your neighborhood, then you know where you
will end up if you turn left at a given intersection. If you are investing in the stock
market, then you are uncertain about what returns you will earn. Typically, we will
suppose that even if you are uncertain about which particular consequence will occur,
you know the set of possible consequences. For instance, although you dont know what
your stock price will be a year from now; you do know that it will be some non-negative
number. Moreover, you likely know something about which stock prices are more or less
likely. For example, you may believe that it is more likely that your stocks price will
change by 20% or less than it will change by 21% or more.

5.1 Prototype Example

The X Company owns a land that may contain oil. A geologist has reported to
management that he/she believes there is a chance of of oil. Because of this an oil
company has offered to purchase the land for LE90,000. However, X is considering
holding the land in order to drill for oil itself. If oil is found, the companys expected
profit will be approximately LE700,000. A loss of LE100,000 will be incurred if the land
is dry (no oil).

In this example, the decision maker must choose an action d from a set of possible
actions. The set contains all the feasible alternatives under consideration for how to
proceed. Table 5.1 summarizes the example data.

Table 5.1 Prospective profit for the X Company

State of nature

decision
Oil

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Drill for oil

Sell the land

LE700,000
LE90,000

Chance of state

129

Dry
-LE100,000
LE90,000

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This choice of an action must be made in the face of uncertainty, because the outcome
will be affected by random factors that are outside the control of the decision maker.
Each of these possible situations is referred to as a state of nature. For each combination
of a decision di and a state of nature j, the decision maker knows what the resulting
payoff would be. The payoff is a quantitative measure of the value to the decision maker
of the consequences of the outcome. Frequently, payoff is represented by the monetary
gain (profit)

5.2 General Representation

In general, the decision analysis problem can be represented as given in Table 5.2. This
table shows that the fundamental piece of data for decision theory problems is the payoff.
This table is also called the payoff table. Table 5.2 provides the payoff for each
combination of a decision d and state of nature j.

Table 5.2 Payoff table for the decision analysis

1

State of nature
2
.
m

r11
r21
.....
rn1

r12
r22
.....
rn2

decision
d1
d2
.
dn

.
.
....
.

r1m
r2m
....
rnm

The entries rij are the payoffs for each possible combination of decision and state of
nature. The decision process can be summarized as follow:
- The decision maker selects one of the possible actions d1, d2, , dn. Say di.
- After this decision is made, a state of nature occurs. Say state j.
- The return received by the decision maker is rij.
- The payoff table then should be used to find an optimal decision according to the
appropriate criterion.

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The question faced by the decision maker is: which decision to select? The decision will
depend on the decision maker's belief concerning what nature will do, that is, which state
of nature will occur. If we believe state j will occur, we select the decision di associated
with the largest number rij in column j of the payoff table. Different assumptions about
nature's behavior lead to different procedures for selecting the best" decision.

If we know which state of nature will occur, we simply select the decision that yields the
largest return for the known state of nature. In practice, there may be infinitely many
possible decisions. If these possible decisions are represented by a vector d and the return
by the real-valued function r(d), the decision problem can then be formulated as:
max r(d) subject to feasibility constraints on d
As indicated in Table 5.1, the X Company has two possible actions (decisions; d1 and d2):
drill for oil or sell the land. With each decision, there is two possible states of natures: the
land contains oil or not. The prior probabilities of the two states of nature are 0.25 and
0.75 respectively.

5.3 Decisions Under Uncertainty

Choosing a specific decision depends upon the decision maker either if he/she is a risk
averse or a risk taker. Thus, the following three methods will be considered: Maximin
payoff criterion; the maximum likelihood criterion, and the expected value.

5.3.1

The Max-min Payoff Criterion

In this method, for each possible decision, the minimum payoff over all states of nature is
determined. Then, select the maximum of these minimum payoffs. Finally, choose the
decision whose minimum payoff gives this maximum. Going back to the prototype
example of section 5.1, the minimum payoff for the first decision "Drill for oil" is LE100,000 and that for the second decision "Sell the land" is LE90,000. Then the
selected decision is "Sell the land" as it has the maximum of the minimum payoffs.

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Such method provides the best guarantee of the payoff that will be obtained. This
criterion is not often used in decision analysis as it is extremely conservative criterion.
This criterion normally is of interest only to a very cautions decision maker.

5.3.2

The Maximum Likelihood Criterion

This method focuses on the most likely state of nature (i.e., the state of nature with
highest probability of occurrence). Using this method, one should identify the most likely
state of nature and then select the decision with the highest payoff in this state of nature.
In the prototype example of section 5.1, the "Dry" state of nature has the maximum
probability of occurrence "0.75". At this state of nature, the highest payoff is LE90,000
corresponding to second decision. Thus, the selected decision is "Sell the land".

This method assumes that the most important state of nature is the most likely one, and
the chosen decision is the best one for the most important state of nature. However, this
method does not rely on the probabilities of the other states of nature. This represents the
major drawback of this method as it ignores all other information.

5.3.3

The Expected Return

This method is the most commonly one. It uses the best available estimates of the
probabilities of the respective states of nature. Then, it calculates the expected value of
the payoff for each of the possible decisions, and then chooses the action with maximum
expected payoff. Expected value is a criterion for making a decision that takes into
account both the possible outcomes for each decision alternative and the probability that
each outcome will occur.

Illustrative Example
Consider that two persons (a and b) are playing with rolling a die. Player "a" will
pay to the other LE9, and then a fair die will be rolled. If the die comes up a 3, 4, 5,

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or 6, then player "b" will pay "a" LE15. If the die comes up 1 or 2, player "a" looses
the LE9. Furthermore, player "b" agrees to repeat this game as many times as
player "a" wishes to play. Should player "a" agree to play this game?

If a six-sided die is fair, there is a 1/6 probability that any specified side will come
up on a roll. Therefore there is a 4/6 (2/3) probability that a 3, 4, 5, or 6 will come
up and you will win. At first glance, this may not look like a good bet since "a"
may lose LE9, while he/she can only win LE6. However, the probability of winning
the LE6 is 2/3, while the probability of losing the LE9 is only 1/3. Perhaps this isn't
such a bad bet after all since the probability of winning is greater than the
probability of losing. The payoff table is shown below.

Table 5.2: Payoff Table of the Illustrative Example

decision

State of nature
Win
Loose

Play
Do not play

LE6
LE0

-LE9
LE0

Chance of state

2/3

1/3

The key to analyze this decision is that "b" allows "a" plays this game as many
times as he/she wants. For example, how often would you expect to win if you play
the game 1,500 times? Based on probability theory, you know that the proportion of
games in which you will win over the long run is approximately equal to the
probability of winning a single game. Thus, out of the 1,500 games, you would
expect to win approximately (2/3) x 1500 = 1000 times. Therefore, over the 1,500
games, you would expect to win a total of approximately 1000 x LE6 + 500 x (LE9) = LE1500.

Based on this logic, what is each play of the game worth? If 1500 plays of the game
are worth LE1500, then one play of the game should be worth LE1500 / 1500 =
LE1. Accordingly, you will make an average of LE1 each time you play the game.
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A little thought about the logic of these calculations shows that you can directly
determine the average payoff from one play of the game by multiplying each
possible payoff from the game by the probability of that payoff, and then adding up
the results. For the die tossing game, this calculation is (2/3) x LE6 + (1/3) x LE(-9)
= LE1.

The quantity calculated is called the expected value for an alternative; this value is
a good measure of the value of an alternative since over the long run this is the
average amount that you expect to make from selecting the alternative. Expected
Value for an uncertain alternative is calculated by multiplying each possible
outcome of the uncertain alternative by its probability, and summing the results.
The expected value decision criterion selects the alternative that has the best
expected value. In situations involving profits where "more is better," the
alternative with the highest expected value is best, and in situations involving costs,
where "less is better," the alternative with the lowest expected value is best.

In calculating the expected return, we make the assumption that there is more than
one state of nature and that the decision maker knows the probability with which
each state of nature will occur. Let pj be the probability that state j will occur. If the
decision maker makes decision di, then the expected return ERi is:
ERi = ri1p1 + ri2p2 + .. + rimpm.
The decision di* that maximizes ERi will be chosen namely
ERi* = maximum over all i of ERi.
Example 5.1
Let us consider the example of the newsboy problem: a newsboy buys papers from the
delivery truck at the beginning of the day. During the day, he sells papers. Leftover
papers at the end of the day are worthless. Assume that each paper costs 15 cents and
sells for 50 cents and that the following probability distribution is known.
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p0 = Prob { demand = 0 } = 2/10

p1 = Prob { demand = 1 } = 4/10
p2 = Prob { demand = 2 } = 3/10
p3 = Prob { demand = 3 } = 1/10
How many papers should the newsboy buy from the delivery truck?

To solve this exercise, we first construct the payoff table. Here rij is the reward achieved
when i papers are bought and a demand j occurs.

Decision
0
1
2
3

0
0
-15
-30
-45

State of nature
1
2
0
0
35
35
20
70
5
50

3
0
35
70
105

Next, we compute the expected returns for each possible decision.

ER0 = 0(2/10)

+ 0(4/10)

+ 0(3/10)

+ 0(1/10)

=0

ER1 = -15(2/10)

+ 35(4/10)

+ 35(3/10)

+ 35(1/10)

= 25

ER2 = -40(2/10)

+ 10(4/10)

+ 60(3/10)

+ 60(1/10)

= 30

ER3 = -45(2/10)

+ 5(4/10)

+ 50(3/10)

+ 105(1/10)

= 18.50

The maximum occurs when the newsboy buys 2 papers from the delivery truck. His
expected return is then 30 cents. The fact that the newsboy must make his buying
decision before demand is realized has a considerable impact on his revenues. If he could
first see the demand being realized each day and then buy the corresponding number of
newspapers for that day, his expected return would increase by an amount known as the
expected value of perfect information. Millions of dollars are spent every year on market
research projects; geological tests etc, to determine what state of nature will occur in a
wide variety of applications.
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It should be pointed out that the criterion of maximizing expected return can sometimes
produce unacceptable results. This is because it ignores downside risk. Most people are
risk averse, which means they would feel that the loss of x dollars is more painful than
the benefit obtained from the gain of the same amount. Decision theory deals with this
problem by introducing a function that measures the attractiveness" of money. This
function is called the utility function. Instead of working with a payoff table containing
the dollar amounts rij, one would instead work with a payoff table containing the utilities,
say uij. The optimal decision di* is that which maximizes the expected utility:
EUi = ui1p1 + ui2p2 + + uimpm

over all i

5.4 Decision Trees

Decision trees provide a useful way of visually displaying the problem and then
organizing the computational work. These trees are especially helpful when a sequence of
decisions must be made.

Example 5.2
Company ABC has developed a new line of products. Top management is attempting to
decide on the appropriate marketing and production strategy. Three strategies are being
considered, which we will simply refer to as A (aggressive), B (basic) and C (cautious).
The market conditions under study are denoted by S (strong) or W (weak). Management's
best estimate of the net profits (in millions of dollars) in each case is given in the
following payoff table. Management's best estimates of the probabilities of a strong or a
weak market are 0.45 and 0.55 respectively. Which strategy should be chosen?

State of nature

decision
A
B
C

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30
20
5

-8
7
15

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Using the approach introduced earlier, we can compute the expected return for each
decision and select the best one, just as we did for the newsboy problem.

ERA = 30(0.45) - 8(0.55)

= 9.15

ERB = 20(0.45) + 7(0.55)

= 12.85

ERC = 5(0.45) + 15(0.55)

= 10.50

The optimal decision is to select B.

A convenient way to represent this problem is through the use of decision trees, as in
Figure 5.1. A square node represents a point at which a decision must be made, and
each line leading from a square will represent a possible decision. A circular node
represents situations where the outcome is uncertain, and each line leading from a circle
will represent a possible outcome.

Figure 5.1: Decision tree for Example 2

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Using a decision tree to find the optimal decision is called solving the tree. To solve a
decision tree, one works backwards. This is called folding back the tree. First, the
terminal branches are folded back by calculating an expected value for each terminal
node. See Figure 5.2. Management now faces the simple problem of choosing the
alternative that yields the highest expected terminal value. So, a decision tree provides
another, more graphic, way of viewing the same problem. Exactly the same information
is utilized, and the same calculations are made.

Figure 5.2: Reduced decision tree for Example 2

Solving trees for expected-value

1. For each of the rightmost nodes proceed as follows:

(a) If the node is a decision node, determine the best alternative to take. The
payoff from this alternative is the value of this decision node. Arrow the best
alternative.
(b) If the node is a chance node, calculate the expected value. This expected
value is the value of this chance node.
2. For the nodes one to the left proceed as follows:

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(a) If the node is a decision node, determine the best alternative to take, using as
needed, and the values of future nodes (nodes to the right) as payoffs. The
payoff from this alternative is the value of this decision node. Arrow the best
alternative.
(b) If the node is a chance node, calculate the expected value, using, as needed,
the values of future nodes (nodes to the right) as payoffs. The expected value
is the value of this chance node.
3. Repeat Step 2 as needed, until the leftmost node is reached. Following the arrows
from left to right gives the sequence of appropriate decisions to take.

5.5 Sensitivity Analysis

The expected return of strategy A is:
ERA = 30 P(S) 8 P(W)
or, equivalently,
ERA = 30 P(S) - 8(1 - P(S)) = - 8 + 38 P(S)
Thus, this expected return is a linear function of the probability that market conditions
will be strong. Similarly
ERB = 20 P(S) + 7(1 P(S)) = 7 + 13 P(S)
ERC = 5 P(S) + 15(1 - P(S)) = 15 10 P(S)
We can plot these three linear functions on the same set of axes (see Figure 5.3). This
diagram shows that Company ABC should select the basic strategy (strategy B) as long
as the probability of a strong market demand is between P(S) = 0.348 and P(S) = 0.6.
This is reassuring, since the optimal decision in this case is not very sensitive to an
accurate estimation of P(S). However, if P(S) falls below 0.348, it becomes optimal to

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choose the cautious strategy C, whereas if P(S) is above 0.6, the aggressive strategy A
becomes optimal.

Figure 5.3: Expected return as a function of P(S)

5.6 Sequential Decisions

5.6.1

Conditional Probability

Example 5.3
An experiment consists of rolling a die once. Let X be the outcome. Let F be the event
that X = 6, and let E be the event that X > 4. We assign the distribution function m() =
1/6 for = 1, 2, ., 6. Thus, P(F) = 1/6. Now, suppose that the die is rolled and we
are told that the event E has occurred. This leaves only two possible outcomes: 5 and 6.
In the absence of any other information, we would still regard these outcomes to be
equally likely, so the probability of F becomes 1/2, making P(F/E) = 1/2.

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Example 5.4
In the Life Table, one finds that in a population of 100,000 females, 89.835% can expect
to live to age 60, while 57.062% can expect to live to age 80. Given that a woman is 60,
what is the probability that she lives to age 80?

This is an example of a conditional probability. In this case, the original sample space can
be thought of as a set of 100,000 females. The events E and F are the subsets of the
sample space consisting of all women who live at least 60 years, and at least 80 years,
respectively. We consider E to be the new sample space, and note that F is a subset of E.
Thus, the size of E is 89,835, and the size of F is 57,062. So, the probability in question
equals 57,062/89,835 = 0.6352. Thus, a woman who is 60 has a 63.52% chance of living
to age 80.

5.6.2

Decisions Under Conditional Probability

Frequently, additional testing can be done to improve the preliminary estimates of the
probabilities of the respective state of nature provided by the prior probabilities.

Going back to the prototype example of section 5.1, an available option before making a
decision of drill for oil or sell the land is to conduct a seismic survey of the land to obtain
a better estimate of the probability of oil. The cost of this seismic study is LE30,000. This
seismic survey indicates whether the geological structure is favorable to the presence of
oil.

The seismic survey has two states of nature: S = 1 (oil is fairly likely); S = 0 (oil is fairly
unlikely). From past experience, if there is oil such seismic study were encouraging
(favorable) 60% of the time and they were discouraging (unfavorable) 40% of the time. If
there is no oil such seismic study were encouraging (favorable) 20% of the time and they
were discouraging (unfavorable) 80% of the time. This can be represented using the
decision tree as follows (Figure 5.4)

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670
Oil
Drill

f
Dry

-130

c
Sell

60

Unfavorable
S=0

670
Oil
b

g
Favorable
S=1

Do seismic
survey

Dry

Drill
d

-130

Sell

60

700
Oil

a
h

No seismic
survey

Dry

-100

Drill
e

90

Sell

Figure 5.4: Decision tree of the prototype example

Example 5.5
As stated in Example 2, although the basic strategy B is appealing for Company ABC,
ABC's management has the option of asking the marketing research group to perform a
market research study. Within a month, this group can report on whether the study was
encouraging (E) or discouraging (D). In the past, such studies have tended to be in the
right direction: When market ended up being strong, such studies were encouraging 60%
of the time and they were discouraging 40% of the time. Whereas, when market ended up
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being weak, these studies were discouraging 70% of the time and encouraging 30% of the
time. Such a study would cost $500,000. Should management request the market research
study or not?

Figure 5.5: Test versus no-test decision tree

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Let us construct the decision tree for this sequential decision problem. See Figure 5.5. It
is important to note that the tree is created in the chronological order in which
information becomes available. Here, the sequence of events is:
- Test decision
- Test result (if any)
- Make decision
- Market condition
The leftmost node corresponds to the decision to test or not to test. Moving along the
"Test" branch, the next node to the right is circular, since it corresponds to an uncertain
event. There are two possible results. Either the test is encouraging (E), or it is
discouraging (D). The probabilities of these two outcomes are P(E) and P(D)
respectively. How does one compute these probabilities?

The information we are given is conditional. Given S, the probability of E is 60% and the
probability of D is 40%. Similarly, we are told that, given W, the probability of E is 30%
and the probability of D is 70%. We denote these conditional probabilities as follows:
P(E|S) = 0.6

P(E|W) = 0.3

P(D|S) = 0.4

P(D|W) = 0.7

In addition, we know P(S) = 0.45 and P(W) = 0.55. This is all the information we need to
compute P(E) and P(D). Indeed, for events S1; S2; .., Sn that partition the space of
possible outcomes and an event T, one has:
P(T) = P(T|S1) P(S1) + P(T|S2) P(S2) + .. + P(T|Sn) P(Sn)
Here, this gives:
P(E)

= P(E|S) P(S) + P(E|W) P(W)

= (0.6) (0.45) + (0.3) (0.55) = 0.435

and

P(D)

= P(D|S) P(S) + P(D|W) P(W)

= (0.4) (0.45) + (0.7) (0.55) = 0.565

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As we continue to move to the right of the decision tree, the next nodes are square,
corresponding to the three marketing and production strategies. Still further to the right
are circular nodes corresponding to the uncertain market conditions: either weak or
strong. The probability of these two events is now conditional on the outcome of earlier
uncertain events, namely the result of the market research study, when such a study was
performed. This means that we need to compute the following conditional probabilities:
P(S|E); P(W|E); P(S|D) and P(W|D). These quantities are computed using the formula:
P(R|T) = P(T|R) P(R) / P(T)
This is valid for any two events R and T. Here, we get
P(S|E) = P(E|S) P(S) / P(E) = (0.6) (0.45) / 0.435 = 0.621
Similarly,

P(W|E) = 0.379
P(S|D) = 0.318

P(W|D) = 0.682

Now, we are ready to solve the decision tree. As earlier, this is done by folding back. See
Figures 5.6, 5.7 and 5.8. You fold back a circular node by calculating the expected
returns. You fold back a square node by selecting the decision that yields the highest
expected return. The expected return when the market research study is performed is
12.96 million dollars, which is greater than the expected return when no study is
performed. So the study should be undertaken.

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Figure 5.6: Solving the tree

Figure 5.7: Solving the tree

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Figure 5.8: Solving the tree

5.7 Solved Examples
5.7.1

Example 1

An art dealer has a client who will buy the masterpiece Rain Delay for $50,000. The
dealer can buy the painting now for $40,000 (making a profit of $10,000). Alternatively,
he can wait one day, when the price will go down to $30,000. The dealer can also wait
another day when the price will be $25,000. If the dealer does not buy by that day, then
the painting will no longer be available. On each day, there is a 2/3 chance that the
painting will be sold elsewhere and will no longer be available.
(a) Draw a decision tree representing the dealers decision making process.
(b) Solve the tree. What is the expected profit? When should he buy the painting?

Solution
a.

Figure 5.9: Decision tree for Example 5.6

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b. Folding back the tree, the value is 10, for an expected profit of $10,000. He should buy
the painting immediately.

5.7.2

Example 2

The Scrub Professional Cleaning Service receives preliminary sales contracts from two
sources: its own agent and building managers. Historically, 3/8 of the contracts have
come from the Scrub agent and 5/8 from building managers. Unfortunately, not all
preliminary contracts result in actual sales contracts. Actually, only 1/2 of those
preliminary contracts received from building managers result in a sale, whereas 3/4 of
those received from the Scrub agent result in a sale. The net return to Scrub from a sale is
$6400. The cost of processing and following up on a preliminary contract that does not
result in a sale is $320. What is the expected return associated with a preliminary sales
contract?

Solution
The decision tree for scrub professional cleaning service:

Reduced decision tree:

Therefore, the expected return is = 3/8 * 4720 + 5/8 * 3440 = 3920

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5.7.3

Example 3

Walter's Dog and Pony show is scheduled to appear in Cedar Rapids on July 4. The
profits obtained are heavily dependent on the weather. In particular, if the weather is
rainy, the show loses $28,000 and if sunny, the show makes a profit of $12,000. (We
assume that all days are either rainy or sunny.) Walter can decide to cancel the show, but
if he does, he forfeits a $1,000 deposit he put down when he accepted the date. The
historical record shows that on July 4, it has rained 1/4 of the time for the last 100 years.

(a) What decision should Walter make to maximize his expected net dollar return?

Walter has the option to purchase a forecast from Victor's Weather Wonder. Victor's
accuracy varies. On those occasions when it has rained, Victor has been correct (i.e.
predicted rain) 90% of the time. On the other hand, when it has been sunny, he has been
right (i.e. predicted sun) only 80% of the time.

(b) If Walter had the forecast, what strategy should he follow to maximize his
expected net dollar return?

Solution
a) According to the decision tree given below Walter should show.

Decision tree for Walter:

Expected net dollar return = 2000

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b) If Walter had the forecast.

Prob (predicted sun) = Prob (predicted sun|sun) * Prob (sun) + Prob (predicted
sun|rain) * Prob (rain)

Prob (sun|predicted sun) = [Prob (predicted sun|sun) * Prob (sun)] / Prob (predicted sun)
= (0.8 * ) / (0.8 * + 0.1 * ) =

= 0.96

Prob (rain|predicted sun) = 1 0.96 = 0.04

Prob (rain|predicted rain) = (0.9 * 1/4) / (0.9 * 1/4 + 0.2 * 3/4) = 0.6
Prob (sun|predicted rain) = 1 0.6 = 0.4

If predicted sun:
show: expected value = 0.96 * 12000 0.04 * 28000 = 10400
cancel: expected value = - 1000
If predicted rain:
show: expected value = 0.4 * 12000 0.6 * 28000 = - 12000
cancel: expected value = - 1000

The strategy should be followed is: If predicted sun, then show. If predicted rain, then
cancel.
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5.7.4

Example 4

A firm can delay its launch of a new product or not delay. The success of the product
depends on the growth rate of the economy. If the economy enjoys a high rate of growth,
then the firm stands to earn $20 million. If the rate of growth is moderate, then the firm
makes $5 million. Finally if there is low or no growth, then firm will lose $5 million. If
the firm delayed its launch of the new product, this will allow the firm to learn the state
of the economy before making its launch decision. Delay is not without cost. IF the firm
delayed its launch of the new product, this will cost the firm $D million. The probabilities
that the economy rate growth being high, moderate, or low are 02, 0.4, and 0.4,
respectively.
a. Draw the decision tree for this example showing the payoffs and the
probabilities of each state on the tree.
b. What is the maximum value of D if the company decided to delay the launch of
its product?
Solution

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b. From the above decision tree, we see the firm should delay if $6 million 3/5D
$4 million. Or, solving for D, if D $10/3 million.

5.8 Exercises
1.

As winter approaches, you are concerned that your dewatering system will not be
able to keep the site dry and will delay progress. You know that any significant
amount of rain will flood the site. Additional pumps will cut into a slim profit
margin, if not generate losses. Also, delays combined with liquated damages will
reduce profit. Which of these two options (do nothing or install additional pumps)
is the desired option? Considering that, the probability that the rain will be less
than 6 inch in 12-hour period is 0.5 (S1), the probability that the rain will reach 6
inch one time in 12-hour period is 0.3 (S2), and the probability that the rain will
reach 6 inch many times in 12-hour period is 0.2 (S3). The pound values
representing costs are shown in the following table.

Alternative

S1

S2

S3

Install pumps

15,000

15,000

65,000

Do noting

20,000

100,000

a. Identify the actions, state of nature, and payoff table and draw the decision
tree.
b. Determine the better decision.

2.

A university must decide between two plans for starting a graduate program in a
new academic year. The goal is to maximize the increase in student population,
but it is unclear whether the interest in this new area will be high, medium, or low.
Projected increases in student populations and their probabilities are shown below
for each plan.

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Increase
Interest

Probability
Plan 1

Plan 2

High

0.6

220

200

Medium

0.3

170

180

Low

0.1

110

150

a. Develop a decision analysis formulation for this problem by identifying the

actions, state of nature, and payoff table and draw the decision tree.
b. What is the optimal action?
3.

You, as a primary contractor, are suing a subcontractor over failure to complete a

portion of a construction project. The subcontractors bonding company has
offered to settle out of court for LE410,000. You are considering making a
counteroffer of LE500,000. The bonding company may accept the offer, refuse
the offer ad go to trial, or make a counteroffer. Your lawyer has dealt with the
bonding company on similar suits. He/she says there is a 20% chance the
company will counter your counteroffer with LE450,000 and 40% chance it will
go to the court. If the bonding company counters your counteroffer, you can
accept or decline and go to court. If the case goes to court, there is a 10% chance
you will be awarded LE1,000,000 a 35% chance of a LE500,000 award, and a
55% chance of the suits being dismissed as trivial. What course of action should
you pursue?

4.

Two pumping systems A and B are suggested for supplying water. The
construction cost for systems A and B is LE250,000 and LE750,000, respectively.
If partial failure occurs, it is expected that damage cost for systems A and B is
LE800,000 and LE150,000, respectively. If complete failure occurs, it is expected
that damage cost for systems A and B is LE1,500,000 and LE600,000,
respectively. The probabilities of partial and complete failures are 5% and 1 %,
respectively.

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a. Identify the actions, state of nature, and payoff table and draw the decision tree.
b. Determine the better system to minimize losses.

5.

Consider a project that needs 20-Mgal/day of water. Two alternatives are under
study. Alternative A is to use a primary pump of 20-Mgal/day and a backup ump
with the same capacity. Alternative B is to use two primary pups of 10-Mgal/day
each and a backup pump f 10-Mgal/day. The probabilities of failure for both
systems are shown in the table below.
Probability
Alternative
Q=0

Q = 10

Q = 20

0.0025

0.0

0.9975

0.001

0.006

0.993

The capital cost for construction of a pumping station, in millions of dollars, s a

function of flow q in million gallons/day (Mgal/day) is C = 0.035q1.25. Failure to
deliver 20 Mgal/day of water is assumed to cause inconvenience and economic
loss. The annual losses are estimated to be as given in the table below.
q (Mgal/day)

10

20

Annual loss

$250M

$25M

Draw a decision tree and determine the better pump system.

6.

Wildcat Oil is considering spending $100,000 to drill at a particular spot. The

result of such a drilling is either a DryWell" (of no value), a Wet Well"
(providing $150,000 in revenues) or a Gusher" (providing $250,000 in revenues).
The probabilities for these three possibilities are 0.5, 0.3 and 0.2 respectively.

(a) Draw a decision tree for the problem of deciding whether to drill or not.

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(b) Solve the decision tree assuming the goal is to maximize the expected net
revenue. Should the company drill?
(c) Close-enough Consultants offer to use their specialized seismic hammer. This
hammer returns either encouraging or discouraging results. In the past, when
applied to a Gusher, the hammer always returned encouraging results. When
applied to a Wet Well, it was encouraging 75% of the time and discouraging
25% of the time. When applied to a Dry Well, it was encouraging one-third of
the time and discouraging two-thirds of the time. What strategy should be
followed to maximize the expected net return?

7.

Omar has been employed at Gold Real Estate Company at a salary of LE 2000 per
month during the last year. Because Omar is considered to be a top salesman, the
manager of the company is offering him one of three salary plans for the next
year: 1) a 25% increase to LE 2500 per month; 2) a base salary of LE 1000 per
month plus LE 600 per house sold; or, 3) a straight commission of LE 1000 per
sold house. Suppose that during the past year the following is Omars distribution
of home sales.
Number of months

Home sales

(a) Calculate the monthly salary payoff table for Omar; showing the possible
decisions, their state of natures, and probability of occurrence.
(b) Find Omars optimal decision using: the conservative approach; and the
optimistic approach.
(c) Assuming that the above table is a typical distribution for Omars monthly
sales, using the expected value, what salary plan should Omar select?

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REFERENCES
Anderson, D.R., Sweeney, D.J., and Williams, T.A. (2005). An Introduction to
Management Science: Quantitative Approaches to Decision Making, 11th Edition,
Thompson South-Western College Publishing

Cornuejols, G., and Trick, M. (2002). Quantitative Methods for the Management
Sciences, Course Notes, Graduate School of Industrial Administration, Carnegie Mellon
University, Pittsburgh, PA, USA
Griffis, F.H., Farr, J.V., and Morris, M.D. (2000). Construction Planning for Engineers,
McGraw-Hill, Inc., New York.
Hillier, F.S., and Liberman, G.J. (1990). Introduction to Mathematical Programming,
McGraw-Hill, Inc., New York.

Hillier, F.S., and Liberman, G.J. (1995). Introduction to Operations Research, McGrawHill, Inc., New York.

Revelle. C.S., Whitlatch. E.E., and Wright, J.R. (2004). Civil and Environmental Systems
Engineering, Prentice Hall, Inc., upper Saddle River, New Jersey.

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