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Problem Formulation Decision Making without Probabilities Decision Making with Probabilities Risk Analysis and Sensitivity Analysis Decision Analysis with Sample Information Computing Branch Probabilities
Problem Formulation
A decision problem is characterized by decision alternatives, states of nature, and resulting payoffs. The decision alternatives are the different possible strategies the decision maker can employ. The states of nature refer to future events, not under the control of the decision maker, which may occur. States of nature should be defined so that they are mutually exclusive and collectively exhaustive.
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2005 Thomson/South-Western
Influence Diagrams
An influence diagram is a graphical device showing the relationships among the decisions, the chance events, and the consequences. Squares or rectangles depict decision nodes. Circles or ovals depict chance nodes. Diamonds depict consequence nodes. Lines or arcs connecting the nodes show the direction of influence.
2005 Thomson/South-Western
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Payoff Tables
The consequence resulting from a specific combination of a decision alternative and a state of nature is a payoff. A table showing payoffs for all combinations of decision alternatives and states of nature is a payoff table. Payoffs can be expressed in terms of profit, cost, time, distance or any other appropriate measure.
2005 Thomson/South-Western
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Decision Trees
A decision tree is a chronological representation of the decision problem. Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives.
2005 Thomson/South-Western
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The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.
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Three commonly used criteria for decision making when probability information regarding the likelihood of the states of nature is unavailable are: the optimistic approach the conservative approach the minimax regret approach.
2005 Thomson/South-Western
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Optimistic Approach
The optimistic approach would be used by an optimistic decision maker. The decision with the largest possible payoff is chosen. If the payoff table was in terms of costs, the decision with the lowest cost would be chosen.
2005 Thomson/South-Western
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Conservative Approach
The conservative approach would be used by a conservative decision maker. For each decision the minimum payoff is listed and then the decision corresponding to the maximum of these minimum payoffs is selected. (Hence, the minimum possible payoff is maximized.) If the payoff was in terms of costs, the maximum costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible cost is minimized.)
2005 Thomson/South-Western
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The minimax regret approach requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the largest payoff for that state of nature. Then, using this regret table, the maximum regret for each possible decision is listed. The decision chosen is the one corresponding to the minimum of the maximum regrets.
2005 Thomson/South-Western
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Example
Consider the following problem with three decision alternatives and three states of nature with the following payoff table representing profits: States of Nature s1 s2 s3 d1 Decisions d2 d3 4 0 1 4 3 5 -2 -1 -3
2005 Thomson/South-Western
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Maximax decision
2005 Thomson/South-Western
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Solution Spreadsheet
A B PAYOFF TABLE Decision Alternative d1 d2 d3 C D E F
1 2 3 4 5 6 7 8 9
Maximum Payoff 4 3 5 5
Recommended Decision
d3
2005 Thomson/South-Western
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Maximin decision
Maximin payoff
2005 Thomson/South-Western
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Solution Spreadsheet
E F
Minimum Payoff -2 -1 -3 -1
Recommended Decision d2
2005 Thomson/South-Western
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d1 d2 d3
0 4 3
1 2 0
1 0 2
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Minimax decision
Minimax regret
2005 Thomson/South-Western
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Solution Spreadsheet
A B C D PAYOFF TABLE Decision State of Nature Alternative s1 s2 s3 d1 4 4 -2 d2 0 3 -1 d3 1 5 -3 E F
1 2 3 4 5 6 7 8 OPPORTUNITY LOSS TABLE 9 Decision State of Nature 10 Alternative s1 s2 s3 11 d1 0 1 1 12 d2 4 2 0 13 d3 3 0 2 14 Minimax Regret Value
2005 Thomson/South-Western
Maximum Regret 1 4 3 1
Recommended Decision d1
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Expected Value Approach If probabilistic information regarding the states of nature is available, one may use the expected value (EV) approach. Here the expected return for each decision is calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring. The decision yielding the best expected return is chosen.
2005 Thomson/South-Western
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The expected value of a decision alternative is the sum of weighted payoffs for the decision alternative. The expected value (EV) of decision alternative di is defined as:
EV( d i ) P( s j )Vij
j 1
where:
N = the number of states of nature P(sj ) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj
2005 Thomson/South-Western
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2005 Thomson/South-Western
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Payoff Table
2005 Thomson/South-Western
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Calculate the expected value for each decision. The decision tree on the next slide can assist in this calculation. Here d1, d2, d3 represent the decision alternatives of models A, B, C, and s1, s2, s3 represent the states of nature of 80, 100, and 120.
2005 Thomson/South-Western
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Decision Tree
Payoffs 10,000 15,000 14,000 8,000
d1 1
s1 s2 s3 s1
.4
.2
.4 .4
d2
d3
s2 s3 s1 s2 s3
.2
.4 .4 .2
18,000
12,000 6,000 16,000 21,000
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.4
2005 Thomson/South-Western
Model A
1
d1
Model B d2
Model C
Solution Spreadsheet
E F
A B C D 1 PAYOFF TABLE 2 3 Decision State of Nature 4 Alternative s1 = 80 s2 = 100 s3 = 120 5 d1 = Model A 10,000 15,000 14,000 6 d2 = Model B 8,000 18,000 12,000 7 d3 = Model C 6,000 16,000 21,000 8 Probability 0.4 0.2 0.4 9 Maximum Expected Value
Recommended Decision
d3 = Model C
2005 Thomson/South-Western
Slide 26
Frequently information is available which can improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.
2005 Thomson/South-Western
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EVPI Calculation Step 1: Determine the optimal return corresponding to each state of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision from the amount determined in step (2).
2005 Thomson/South-Western
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2005 Thomson/South-Western
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Spreadsheet
F
A B C D E 1 PAYOFF TABLE 2 3 Decision State of Nature Expected 4 Alternative s1 = 80 s2 = 100 s3 = 120 Value 5 d1 = Model A 10,000 15,000 14,000 12600 6 d2 = Model B 8,000 18,000 12,000 11600 7 d3 = Model C 6,000 16,000 21,000 14000 8 Probability 0.4 0.2 0.4 9 Maximum Expected Value 14000 10 11 Maximum Payoff EVwPI 12 10,000 18,000 21,000 16000
Recommended Decision
d3 = Model C
EVPI 2000
2005 Thomson/South-Western
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Risk Analysis
Risk analysis helps the decision maker recognize the difference between: the expected value of a decision alternative, and the payoff that might actually occur The risk profile for a decision alternative shows the possible payoffs for the decision alternative along with their associated probabilities.
2005 Thomson/South-Western
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Risk Profile
2005 Thomson/South-Western
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Sensitivity Analysis
Sensitivity analysis can be used to determine how changes to the following inputs affect the recommended decision alternative: probabilities for the states of nature values of the payoffs If a small change in the value of one of the inputs causes a change in the recommended decision alternative, extra effort and care should be taken in estimating the input value.
2005 Thomson/South-Western
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Knowledge of sample (survey) information can be used to revise the probability estimates for the states of nature. Prior to obtaining this information, the probability estimates for the states of nature are called prior probabilities. With knowledge of conditional probabilities for the outcomes or indicators of the sample or survey information, these prior probabilities can be revised by employing Bayes' Theorem. The outcomes of this analysis are called posterior probabilities or branch probabilities for decision trees.
2005 Thomson/South-Western
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Branch (Posterior) Probabilities Calculation Step 1: For each state of nature, multiply the prior probability by its conditional probability for the indicator -- this gives the joint probabilities for the states and indicator.
2005 Thomson/South-Western
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Branch (Posterior) Probabilities Calculation Step 2: Sum these joint probabilities over all states -- this gives the marginal probability for the indicator. Step 3: For each state, divide its joint probability by the marginal probability for the indicator -- this gives the posterior probability distribution.
2005 Thomson/South-Western
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The expected value of sample information (EVSI) is the additional expected profit possible through knowledge of the sample or survey information.
2005 Thomson/South-Western
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EVSI Calculation Step 1: Determine the optimal decision and its expected return for the possible outcomes of the sample using the posterior probabilities for the states of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision obtained without using the sample information from the amount determined in step (2).
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2005 Thomson/South-Western
Efficiency of sample information is the ratio of EVSI to EVPI. As the EVPI provides an upper bound for the EVSI, efficiency is always a number between 0 and 1.
2005 Thomson/South-Western
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Sample Information
Burger Prince must decide whether or not to purchase a marketing survey from Stanton Marketing for $1,000. The results of the survey are "favorable" or "unfavorable". The conditional probabilities are: P(favorable | 80 customers per hour) = .2 P(favorable | 100 customers per hour) = .5 P(favorable | 120 customers per hour) = .9 Should Burger Prince have the survey performed by Stanton Marketing?
2005 Thomson/South-Western
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Influence Diagram
Market Survey
Restaurant Size
Profit
2005 Thomson/South-Western
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Posterior Probabilities
Favorable
Prior .4 .2 .4
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Posterior Probabilities
Unfavorable
Prior .4 .2 .4
Conditional .8 .5 .1 Total
P(unfavorable) = .46
2005 Thomson/South-Western
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Posterior Probabilities
Solution Spreadsheet
A B Market Research Favorable Prior State of Nature Probabilities s1 = 80 0.4 s2 = 100 0.2 s3 = 120 0.4 C D Joint Probabilities 0.08 0.10 0.36 0.54 E Posterior Probabilities 0.148 0.185 0.667
1 2 Conditional 3 Probabilities 4 0.2 5 0.5 6 0.9 7 P(Favorable) = 8 9 Market Research Unfavorable 10 Prior Conditional 11 State of Nature Probabilities Probabilities 12 s1 = 80 0.4 0.8 13 s2 = 100 0.2 0.5 14 s3 = 120 0.4 0.1 15 P(Favorable) =
2005 Thomson/South-Western
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Decision Tree
Top Half
s1 (.148) s2 (.185) $15,000 s3 (.667)
$10,000
d1 d2 d3
I1
(.54)
1
s2 (.185) s3 (.667)
2005 Thomson/South-Western
Decision Tree
Bottom Half
1
I2 (.46)
d1 d2 d3
2005 Thomson/South-Western
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Decision Tree
d1 d2 d3
4
$17,855 I1 (.54)
1 2
EMV = .148(10,000) + .185(15,000) + .667(14,000) = $13,593 EMV = .148 (8,000) + .185(18,000) + .667(12,000) = $12,518
EMV = .148(6,000) + .185(16,000) +.667(21,000) = $17,855
5
6 7 8 9
I2 (.46)
d1
3
d2 d3
$11,433
2005 Thomson/South-Western
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2005 Thomson/South-Western
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Bayes Decision Rule: Using the best available estimates of the probabilities of the respective states of nature (currently the prior probabilities), calculate the expected value of the payoff for each of the possible actions. Choose the action with the maximum expected payoff.
2005 Thomson/South-Western Slide 50
Bayes theory Si: State of Nature (i = 1 ~ n) P(Si): Prior Probability Ij: Professional Information (Experiment)( j = 1 ~ n)
P(Ij | Si): Conditional Probability
i 1
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Home Work
Problem Problem Due
13-10 13-21
2005 Thomson/South-Western
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