Decision analysis: part 2

BSAD 30
Dave Novak
Source: Anderson et al., 2013
Quantitative Methods for Business 12th
edition some slides are directly from
J. Loucks 2013 Cengage Learning
1

Overview

Risk analysis
Risk

profile
Sensitivity analysis
Changes in states of nature
Changes in payoffs

EVPI calculation
EOL calculation
Building and using decision trees

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
Recall

that a payoff is the result of a

combination of: 1) a decision alternative
(you control this), and 2) a state of nature
probability (you do not control this)

Risk analysis

The risk profile for a decision alternative

shows the possible payoffs for the decision
alternative along with their associated
probabilities
We

want to identify the probability or

likelihood that a particular payoff will occur
Basically, we want to list out ALL possible
payoffs, and their probabilities of occurrence

PDC example - lecture 15

Payoff table with P(s1) = 0.8 and P(s2) = 0.2

PAYOFF TABLE

Decision Alternative

States of Nature
Strong Demand Weak Demand
s1
s2

Small complex, d1

Medium complex, d2

14

Large complex, d3

20

7
5
-9

PDC example lecture 15

Payoffs

d1
1

d2
d3

s1

.8

s2

.2

s1

.8

s2

.2

$8 mil
$7 mil
$14 mil
$5 mil

s1

.8

s2

.2

$20 mil
-$9 mil

PDC example - lecture 15

small d1
1

medium d2

large d3

Risk profile

d3 (90 unit) decision alternative versus d2

(60 unit) decision alternative

Value of perfect information

Calculate EV assuming MOST OPTIMISTIC
payoff for both states of nature (does not
need to be the same decision) = EVwPI
Take the EV associated with your decision
(this is the largest EV value across all
decisions) = EVwoPI

Given

imperfect information, this is what we

would choose to do

Value of perfect information

10

EVPI =

EVPI =

EVPI =

Expected opportunity loss

Using the regret table from lecture #15, we

can calculate the expected opportunity lost
(EOL) associated with each decision
States of Nature
REGRET TABLE

Decision Alternative
Small complex, d1
Medium complex, d2
Large complex, d3
11

Strong Demand Weak Demand

s1
s2
12

0
6

2
16

Expected opportunity loss

12

Expected opportunity loss

13

The minimum of the EOL values always

provides the optimal decision

Notice that EVPI = Expected Opportunity

Loss (EOL) for decision d3 (90 units)

EVPI is ALWAYS equal to the EOL for the

optimal decision

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 can be

subjective, and therefore subject to change
values of the payoffs

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Sensitivity analysis
If a small change in the value of one of the
inputs (state of nature probabilities or
payoff values) causes a change in the
recommended decision alternative, extra
effort and care should be taken in
estimating the input value
If changes to inputs do not really impact
your decision, you can feel more confident
about this decision

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Sensitivity analysis
One way to address the sensitivity question
is to select different values for either the
state of nature probabilities or the payoff
values, and then do some what if
calculations
Say we flip our state of nature probabilities
for the PDC problem

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Modified PDC example

Payoffs

d1
1

d2
d3

s1

.2

s2

.8

s1

.2

s2

.8

$8 mil
$7 mil
$14 mil
$5 mil

s1

.2

s2

.8

$20 mil
-$9 mil

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Modified PDC example

small d1
1

medium d2

large d3

18

Modified PDC example

Payoffs

d1
1

d2
d3

s1

.5

s2

.5

s1

.5

s2

.5

$8 mil
$7 mil
$14 mil
$5 mil

s1

.5

s2

.5

$20 mil
-$9 mil

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Modified PDC example

small d1
1

medium d2

large d3

20

EV comparison

Graphing for 2 state of

nature problem

22

Like a LP with two decision variables, if we

only have two states of nature, we can
perform sensitivity analysis graphically

Generalize relationship for P(s1) and P(s2)

EV calculations for decision

variables

23

Sensitivity graph

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Sensitivity graph
d1 provides
highest EV

d2 provides
highest EV

d3 provides
highest EV

Solve for each

intersection point
way we solved for
internal points in LP
Set two linear
equations
equal to one another
and solve for p
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Solving for inflection points

Intersection of EV(d1) and EV(d2) lines

EV(d1)

=p+7

EV(d2)

= 9p + 5

So, p + 7 = 9p + 5

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2 = 8p
p = = 0.25

Solving for inflection points

Intersection of EV(d2) and EV(d3) lines

EV(d2)

= 9p + 5

EV(d3)

= 2p - 9

So, 9p + 5 = 29p - 9

27

14 = 20p
p = = = 0.7

Sensitivity graph
p = 0.25
d1 provides
highest EV

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p = 0.7
d2 provides
highest EV

d3 provides
highest EV

What are managerial

implications?

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If probability of strong demand, P(s1) < 0.25,

then choose d1 (30 units)

If probability of strong demand, P(s1) = 0.25,

then choose either d1 (30 units) or d2 (60 units)

If probability of strong demand, 0.25 < P(s1) <

0.7, then choose d2 (60 units)

If probability of strong demand, P(s1) = 0.7,

then choose either d2 (60 units) or d3 (90 units)

If probability of strong demand, P(s1) > 7 then

choose d3 (90 units)

What about changes in

payoff values?

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From the PDC problem, we have:

EV(d1)

= 7.8

EV(d2)

= 12.2

EV(d3)

= 14.2

So, we conclude that building 90 units is the

optimal decision (d3) as long as EV(d3) 12.2

What about changes in

payoff values?

Lets look at changing one of the payoff

values for decision alternative d3 (90 units)

Hold the state of nature probabilities

constant for both s1 (strong demand) and s2
(weak demand)
P(s1)

Let
S

= payoff value for d3 assuming s1

W=
31

= 0.8, and P(s2) = 0.2

payoff value for d3 assuming s2

What about changes in

payoff values?

We can write EV(d3) as:

Examine a change in one of the payoff

values for a particular decision alternative
Here,

we will hold payoff for weak demand

constant at -9

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What about changes in

payoff values?

Solve for S
0.8S

1.8 12.2
0.8S 14
S 17.5

What does this mean?

As

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long as our original state of nature

probabilities hold, we should build d 3, as
long as the payoff under the strong demand
scenario is 17.5 mil

What about changes in

payoff values?

Examine a change in the other payoff value

for decision alternative d3
we

will hold payoff for strong demand

constant at 20, and investigate changes in
weak demand

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What about changes in

payoff values?

Solve for W
16

+ 0.2W 12.2
0.2W -3.8
W -19

What does this mean?

As

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long as our original state of nature

probabilities hold, we should build d 3, as
long as the payoff under the weak demand
scenario is -19 mil

What about changes in

payoff values?

When we hold the state of nature probabilities

constant at P(s1) = 0.8, and P(s2) = 0.2, the d3
decision does not seem to be particularly
sensitive to variations in the payoff

Why?
Probability

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that demand is strong, P(s1), is

very high AND expected payoff is very high
Using the EV approach, this combination
leads us to choose d3

Decision trees

Just a graphical representation of the

decision-making process
Shows

a progression over time

Squares: decision nodes that we control

Circles: chance nodes that we do not
control

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Decision tree
Given each decision, we are
then subject to demand, which
we cannot control
d1-build
30 units

d2-build
60 units

For each decision alternative

and state of nature pair,
we have an expected payoff

Payoffs
s1

.8

s2

.2

s1

.8

s2

.2

$8 mil
$7 mil
$14 mil
$5 mil

d3-build
90 units

s1

.8

s2

.2

$20 mil
-$9 mil

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Decision trees
Hemmingway, Inc., is considering a $5 million research
and development (R&D) project. Profit projections appear
promising, but Hemmingway's president is concerned
because the probability that the R&D project will be
successful is only 0.50.
Furthermore, the president knows that even if the project
is successful, it will require that the company build a new
production facility at a cost of $20 million in order to
manufacture the product.

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Decision trees
If the facility is built, uncertainty remains about the
demand and thus uncertainty about the profit that will be
realized.
Another option is that if the R&D project is successful, the
company could sell the rights to the product for an
estimated $25 million. Under this option, the company
would not build the $20 million production facility.

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Decision trees
Identify the pieces or nodes associated
with this problem
We have to present this information in a
time dependent sequence of events

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Decision trees
1.

Make a decision whether to start the R&D

project or not
a)
b)

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Start R&D project (cost of $5 mil)

proceed
Do not start R&D project (cost of zero)
stop

Decision trees

43

Decision trees
2.

If we start R&D, there is a state of nature

or chance event that the project will be
successful, where:
a)
b)

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P(R&D success) = 0.5 proceed

P(R&D failure) = 0.5 stop and lose $5
mil

Decision trees

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Decision trees
3.

If R&D is successful, we make a decision

whether to:
a)
b)

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Build the production facility (cost of $20 mil)

proceed
Sell the rights to the product for $20 mil
stop

Decision trees

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Decision trees
4.

If we decide to build the facility, we are

subject to state of nature or chance events
regarding demand for the product:
a)
b)
c)

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P(high demand) = 0.5, and the

corresponding payoff is $34 mil
P(med demand) = 0.3, and the
corresponding payoff is $20 mil
P(low demand) = 0.2, and the
corresponding payoff is $10 mil

Decision tree

Decision trees
Populate the decision tree with probabilities,
so we can calculate EV for different
scenarios
We work BACKWARDS to calculate EV for
each chance or state of nature node

EV

(node 4)
EV (node 2)

50

Decision trees

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Decision tree

Using the decision tree to

guide decision-making

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Should the company undertake the R&D

project?

If R&D is successful, what should company

do, sell or build?

Using the decision tree to

guide decision-making

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What is EV of your decision strategy?

What would selling price need to be for

company to consider selling?

What about for recovering R&D cost?

Item 9
5
6
7
8

Using the decision tree to

guide decision-making
Developing a risk profile for the optimal
strategy
Possible Profit
$34 M
$20 M
$10 M
-$5 M

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Corresponding probability

What would the payoff table

look like?
States of Nature

PAYOFF TABLE
High Demand

Med Demand

Low Demand

Decision Alternatives
Build
Sell

56

34

20

10

20

20

20

What would the regret table

look like?
REGRET TABLE

States of Nature
High Demand

Med Demand

Low Demand

Decision Alternatives
Build
Sell

57

10

14

Value of perfect information

58

EVwPI =

EVwoPI =

EVPI =

Expected opportunity loss

Using the regret table

REGRET TABLE

States of Nature
High Demand

Med Demand

Low Demand

Decision Alternatives
Build
Sell

10

14

Summary

Risk analysis
Risk

profile
Sensitivity analysis
Changes in states of nature
Changes in payoffs

EVPI calculation
EOL calculation
Building and using decision trees

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