CHAPTER 8

Decision
Analysis

PowerPoint presentation to accompany

Balakrishnan/Render/Stair
Managerial Decision Modeling with Spreadsheets, 3/e
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 LEARNING OBJECTIVES
1. List the steps of the decision-making
process and describe the different
types of decision-making environments.
2. Make decisions under uncertainty and
under risk.
3. Use Excel to set up and solve problems
involving decision tables.
4. Develop accurate and useful decision
trees.

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 LEARNING OBJECTIVES
5. Use TreePlan to set up and analyze
decision tree problems with Excel.
6. Revise probability estimates using
Bayesian analysis.
7. Understand the importance and use
of utility theory in decision making.

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 Decision Analysis

An analytic and systematic approach

to the study of decision making
Based on logic
Considers all possible alternatives
Examines all available information about
the future
Applies the decision modeling approach

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 Five Steps
1. Clearly define the problem
2. List all possible alternatives
3. Identify all possible outcomes for
each alternative
4. Identify the payoff for each alternative
and outcome combination
5. Use a decision modeling technique to
choose an alternative

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 Thompson Lumber
1. Decision: Should he make and sell
storage sheds
2. Alternatives:
1. Build a large plant
2. Build a small plant
3. Do nothing
3. Outcomes: Demand for sheds will be
1. High
2. Moderate
3. Low
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 Thompson Lumber
4. Payoff table
OUTCOMES
HIGH MODERATE LOW
ALTERNATIVES DEMAND DEMAND DEMAND
Build large plant $200,000 $100,000 $120,000
Build small plant $ 90,000 $ 50,000 $ 20,000
No plant $ 0 $ 0 $ 0
Table 8.1

5. Select and apply decision analysis

model

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 Decision-Making Environments

Type 1: Decision making under

certainty
Type 2: Decision making under
uncertainty
Type 3: Decision making under risk

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 Certainty

Consequence of every alternative is

known
Usually only one outcome for each
alternative
Seldom occurs in reality

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 Uncertainty

Probabilities of possible outcomes not

known
Decision making methods:
1. Maximax
2. Maximin
3. Criterion of realism
4. Equally likely
5. Minimax regret

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 Thompson Lumber
Maximax Criterion
Maximizes the maximum payoff
OUTCOMES
HIGH MODERATE LOW
ALTERNATIVES DEMAND DEMAND DEMAND
Build large plant $200,000 $100,000 $120,000
Build small plant $ 90,000 $ 50,000 $ 20,000
No plant $ 0 $ 0 $ 0

Table 8.2
Maximax

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 Thompson Lumber
Maximin Criterion
Maximizes the minimum payoff
OUTCOMES
HIGH MODERATE LOW
ALTERNATIVES DEMAND DEMAND DEMAND
Build large plant $200,000 $100,000 $120,000
Build small plant $ 90,000 $ 50,000 $ 20,000
No plant $ 0 $ 0 $ 0

Table 8.3
Maximin

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 Thompson Lumber
Criterion of Realism (Hurwicz)
Thompsons coefficient of realism = 0.45
Realism payoff for = x (Maximum payoff for alternative)
alternative + (1 ) x (Minimum payoff for alternative)

OUTCOMES
HIGH MODERATE LOW WT. AVG. FOR
ALTERNATIVES DEMAND DEMAND DEMAND ALTERNATIVE
Build large plant $200,000 $100,000 $120,000 $24,000
Build small plant $ 90,000 $ 50,000 $ 20,000 $29,500
No plant $ 0 $ 0 $ 0 $ 0

Table 8.4
Realism
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 Thompson Lumber
Equally Likely (Laplace) Criterion
Highest average payoff
OUTCOMES
HIGH MODERATE LOW AVERAGE FOR
ALTERNATIVES DEMAND DEMAND DEMAND ALTERNATIVE
Build large plant $200,000 $100,000 $120,000 $60,000
Build small plant $ 90,000 $ 50,000 $ 20,000 $40,000
No plant $ 0 $ 0 $ 0 $ 0

Table 8.5 Equally

likely

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 Thompson Lumber
Minimax Regret Criterion
OUTCOMES
ALTERNATIVES HIGH DEMAND
Build large plant $200,000 $200,000 = $ 0
Build small plant $200,000 $ 90,000 = $110,000
No plant $200,000 $ 0 = $200,000
MODERATE DEMAND
Build large plant $100,000 $100,000 = $ 0
Build small plant $100,000 $ 50,000 = $ 50,000
No plant $100,000 $ 0 = $100,000
LOW DEMAND
Build large plant $0 ($120,000) = $120,000
Build small plant $0 ($ 20,000) = $ 20,000
Table 8.6 No plant $0 $ 0 =$ 0

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 Thompson Lumber
Minimax Regret Criterion

OUTCOMES
HIGH MODERATE LOW MAXIMUM FOR
ALTERNATIVES DEMAND DEMAND DEMAND ALTERNATIVE
Build large plant $ 0 $ 0 $120,000 $120,000
Build small plant $110,000 $ 50,000 $ 20,000 $110,000
No plant $200,000 $100,000 $ 0 $200,000

Table 8.7
Minimax

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 Using Excel

Screenshot 8-1A

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 Using Excel Screenshot 8-1B

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 Under Risk

Expected Monetary Value (EMV)

ternative i) = (Payoff of first outcome)
x (Probability of first outcome)
+ (Payoff of second outcome)
x (Probability of second outcome)
+ + (Payoff of last outcome)
x (Probability of last outcome)

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 Thompson Lumber
OUTCOMES
HIGH MODERATE LOW EMV FOR
ALTERNATIVES DEMAND DEMAND DEMAND ALTERNATIVE
Build large plant $200,000 $100,000 $120,000 $200,000 x 0.3
+ $100,000 x 0.5
+ ($120,000) x 0.2
= $86,000
Build small plant $ 90,000 $ 50,000 $ 20,000 $90,000 x 0.3
+ $50,000 x 0.5
+ ($20,000) x 0.2
= $48,000
No plant $ 0 $ 0 $ 0 $0 x 0.3 + $0 x 0.5
+ $0 x 0.2 = $ 0
Probabilities 0.3 0.5 0.2
Table 8.8

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 Under Risk

Expected Opportunity Loss (EOL)

ernative i) = (Regret of first outcome)
x (Probability of first outcome)
+ (Regret of second outcome)
x (Probability of second outcome)
+ + (Regret of last outcome)
x (Probability of last outcome)

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 Thompson Lumber
OUTCOMES
HIGH MODERATE LOW EOL FOR
ALTERNATIVES DEMAND DEMAND DEMAND ALTERNATIVE
Build large plant $ 0 $ 0 $120,000 $0 x 0.3 + $0 x 0.5
+ $120,000 x 0.2
= $24,000
Build small plant $110,000 $ 50,000 $ 20,000 $110,000 x 0.3
+ $50,000 x 0.5
+ $20,000 x 0.2
= $62,000
No plant $200,000 $100,000 $ 0 $200,000 x 0.3
+ $100,000 x 0.5
+ $0 x 0.2 = $110,000
Probabilities 0.3 0.5 0.2
Table 8.9

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 Perfect Information
Expected Value with Perfect
Information (EVwPI)

EVwPI = (Best payoff of first outcome)

x (Probability of first outcome)
+ (Best payoff of second outcome)
x (Probability of second outcome)
+ + (Best payoff of last outcome)
x (Probability of last outcome)

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 Perfect Information

Expected Value of Perfect Information

(EVPI)

= EVwPI Maximum EMV

= Minimum EOL

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 Perfect Information
Expected Value with Perfect Information
EVwPI = $200,000 x 0.3 + $100,000 x 0.5 + $0 x 0.20
= $110,000

Expected Value of Perfect Information

EVPI = EVwPI Maximum EMV
= $110,000 $86,000 = $24,000

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 Using Excel

Screenshot 8-2A

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 Using Excel

Screenshot 8-2B

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 Decision Trees

Presents decision alternatives and

outcomes in a sequential manner

Decision node
Outcome node

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 Decision Trees
Thompson Lumber
Payoffs
High Demand $200,000
Outcome Node
Moderate Demand $100,000
1
t $120,000
an Low Demand
Decision Node Pl
e
a rg $90,000
L High Demand

Small Plant Moderate Demand $50,000

2
No Low Demand $20,000
P lan
t
All Demands
3 $0
Figure 8.1

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 Decision Trees
Thompson Lumber Probability

Payoffs
High Demand (0.30) $200,000
Outcome Node $86,000
Moderate Demand (0.50) $100,000
1
t $120,000
an Low Demand (0.20)
Decision Node Pl
e
a rg $90,000
L High Demand (0.30)
$48,000
Small Plant Moderate Demand (0.50) $50,000
2
No Low Demand (0.20) $20,000
P lan
t
Figure 8.2 $0
All Demands
3 $0

EMV 1 = $200,000 x 0.3 + $100,000 x 0.05 + ($120,000) x 0.2 = $86,000

EMV 2 = $90,000 x 0.3 + $50,000 x 0.05 + ($20,000) x 0.2 = $48,000

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 Decision Trees
Thompson Lumber
1 EMV = $86,000
t
an
Decision Node Pl
e
a rg
L

Small Plant 2 EMV = $48,000

No
P lan
t
$0
3 EMV = $0

Figure 8.3

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 Using TreePlan With Excel

Screenshot 8-3A

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 Using TreePlan With Excel
(a)

(b)

Screenshot 8-3B

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 Using TreePlan With Excel

Screenshot 8-3B

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 Using TreePlan With Excel

Screenshot 8-3C

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 Using TreePlan With Excel

Screenshot 8-3D

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 Second Decision Payoffs
Point

Multistage
High Demand (0.023)
$200,000
Moderate Demand (0.543)
1 $100,000
t
Plan Low Demand (0.434)
$120,000

Decision
e
rg
La High Demand (0.30)
$90,000
Small Plant Moderate Demand (0.50)
2 $50,000
No Low Demand (0.20)

Trees
Pla $20,000
nt
All Demands
3 $0

y
ve
First Decision High Demand (0.509)

r
Su
Point $196,000

o
N
Moderate Demand (0.486)
4 $96,000
t
Plan Low Demand (0.023)
$124,000
e
rg
La High Demand (0.509)
$86,000
Small Plant Moderate Demand (0.486)
5 $46,000

7)
No Low Demand (0.023)
Co

.5
$24,000

(0
Pla
nd

lts
nt
uc

su
t
Su

Re
All Demands
rv

6 $4,000
e
tiv
ey

si
Po

High Demand (0.023)

$196,000
Moderate Demand (0.543)
7 $96,000
Ne

t
ga

lan Low Demand (0.434)

$124,000
tiv

e P
e

rg
Re

La High Demand (0.023)

su

$86,000
lts

Small Plant Moderate Demand (0.543)

(0

8 $46,000
.4

Figure 8.4
3)

No Low Demand (0.434)

Pla $24,000
nt
All Demands
9 $4,000
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 Folding Back
No market survey
EMV (node 1) = EMV (Large plant)
= $200,000 x 0.30 + $100,000 x 0.50
+ ($120,000) x 0.20
= $86,000
EMV (node 2) = EMV (Small plant)
= $90,000 x 0.30 + $50,000 x 0.50
+ ($20,000) x 0.20
= $48,000
EMV (node 3) = EMV (No plant)
= $0

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 Folding Back
Positive market survey
EMV (node 4) = EMV (Large plant | Positive result)
= $196,000 x 0.509 + $96,000 x 0.468
+ ($124,000) x 0.023
= $141,840
EMV (node 5) = EMV (Small plant | Positive result)
= $86,000 x 0.509 + $46,000 x 0.468
+ ($24,000) x 0.023
= $64,750
EMV (node 6) = EMV (No plant | Positive result)
= $4,000

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 Folding Back
Negative market survey
EMV (node 7) = EMV (Large plant | Negative result)
= $196,000 x 0.023 + $96,000 x 0.543
+ ($124,000) x 0.434
= $2,820
EMV (node 8) = EMV (Small plant | Negative result)
= $86,000 x 0.023 + $46,000 x 0.543
+ ($24,000) x 0.434
= $16,540
EMV (node 9) = EMV (No plant | Negative result)
= $4,000

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 Folding Back
Node 10 analysis
EMV (node 10) = EMV (Conduct survey)
= $141,840 x 0.57 + $16540 x 0.43
= $87,961

Decision is to conduct the survey and await

the results
If positive, build large plant
If negative, build small plant

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 Second Decision Payoffs
Point

Multistage
High Demand (0.023)
$86,000 $200,000
Moderate Demand (0.543)
1 $100,000
e Low Demand (0.434)
rg || $120,000

Decision
La ant
Pl High Demand (0.30)
$86,000 $48,000 $90,000
Small Plant Moderate Demand (0.50)
2 $50,000
No Low Demand (0.20)

Trees
Pla $20,000
nt
$0
All Demands
3 $0

y
ve
First Decision High Demand (0.509)

r
Su
Point $141,000 $196,000

o
N
Moderate Demand (0.486)
4 $96,000

||
Low Demand (0.023)
e $124,000
rg
La ant High Demand (0.509)
$141,000 Pl $64,750 $86,000
$87,961 Small Plant Moderate Demand (0.486)
5 $46,000

7)
No Low Demand (0.023)
Co

.5
$24,000

(0
Pla
nd

lts
nt
uc

su $4,000
t
Su

Re
All Demands
rv

6 $4,000
ive
ey

sit
Po
||

10 High Demand (0.023)

$2,820 $196,000
$87,961 Moderate Demand (0.543)
7 $96,000
Ne

t
ga

lan Low Demand (0.434)

$124,000
tiv

e P
e

rg
Re

La High Demand (0.023)

su

$16,540 $86,000
lts

Small Moderate Demand (0.543)

Plant | |
(0

8 $46,000
.4

Figure 8.5
3)

No Low Demand (0.434)

$16,540 Pla $24,000
nt
$4,000
All Demands
9 $4,000
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 Expected Value
Sample Information (EVSI)
EVSI = (EMV of best decision with sample
information, assuming no cost to get it)
(EMV of best decision without any
information)
EVSI = $91,961 $86,000 = $5,961

Efficiency of Sample Information

Efficiency of sample information = EMSI / EVPI
= $5,961 / $24,000 = 0.2484 or 24.84%

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 Bayesian Analysis

Probability values can be revised

based on new information
Prior probabilities
Revised probabilities
Appendix A

Prior Probabilities
P(HD) = 0.30, P(MD) = 0.50, P(LD) = 0.30

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 Revised Probabilities
Revised Probabilities

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 Revised Probabilities

Survey reliability
SURVEY RESULT WAS
WHEN ACTUAL
OUTCOME WAS POSITIVE (PS) NEGATIVE (NS)
High (HD) P(PS | HD) = 29/30 = 0.967 P(NS | HD) = 1/30 = 0.333
Moderate (MD) P(PS | MD) = 8/15 = 0.533 P(NS | MD) = 7/15 = 0.467
Low (LD) P(PS | LD) = 2/30 = 0.067 P(NS | LD) = 28/30 = 0.933

Table 8.10

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 Revised Probabilities

Positive survey results

CONDITIONAL REVISED
PROB. PRIOR JOINT PROB.
OUTCOME P(PS | OUTCOME) PROB. PROB. P(OUTCOME | PS)
High (HD) 0.967 X 0.30 = 0.290 0.290/0.57 = 0.509
Mod. (MD) 0.533 X 0.50 = 0.267 0.267/0.57 = 0.468
Low (LD) 0.067 X 0.20 = 0.013 0.013/0.57 = 0.023
P(PS) = P(Positive Survey) = 0.570 1.000

Table 8.11

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 Revised Probabilities

Negative survey results

CONDITIONAL REVISED
PROB. PRIOR JOINT PROB.
OUTCOME P(NS | OUTCOME) PROB. PROB. P(OUTCOME | NS)
High (HD) 0.033 X 0.30 = 0.010 0.010/0.43 = 0.023
Mod. (MD) 0.467 X 0.50 = 0.233 0.233/0.43 = 0.543
Low (LD) 0.933 X 0.20 = 0.187 0.187/0.43 = 0.434
P(NS) = P(Negative Survey) = 0.430 1.000

Table 8.12

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 Utility Theory

An alternative to EMV
Incorporates a persons attitude toward
risk
A utility function converts a persons
attitude toward money and risk into a
number between 0 and 1

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 Utility Theory
$35,000 Payoffs
$35,000
r
Offe
ept
c
Ac

Re
$50,000 jec
tO
ffe Heads (0.5)
r $0

Tails (0.5)
$50,000 $100,000

= $100,000 x 0.5 + $0 x 0.5

Figure 8.6

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 Janes Utility Function
Outcome 1 (0.5)
EMV = $25,000 $0

Outcome 2 (0.5)
ative $50,000
n
Al ter

alt
ern
ati
ve Certainty Equivalent
r

?
$50,000

Figure 8.7

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 Janes Utility Function
Worst payoff utility = 0
Best payoff utility = 1
Certainty equivalent the minimum
guaranteed amount you are willing to
accept to avoid the risk associated with
a gamble

U($15,000) = U($0) x 0.5 + U($50,000) x 0.5

= 0 x 0.5 + 1 x 0.5 = 0.5

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 Janes Utility Function
Repeat for multiple amounts
Utility
Figure 8.8
Value
1.00
U ($50,000) = 1.00

0.80

0.60 U ($27,000) = 0.75

0.40 U ($15,000) = 0.50

0.20
U ($6,000) = 0.25

0.00 U ($50) = 0.00

| | | | | |
$0 $10,000 $20,000 $30,000 $40,000 $50,000 Monetary
Value

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 Janes Utility Function

Risk premium
The EMV a person is willing to give up to
avoid the risk associated with a gamble

Risk premium = (EMV of gamble)

(Certainty equivalent)

Risk avoider/risk adverse: Risk premium > 0

Risk indifferent/risk-neutral: Risk premium = 0
Risk seeker/risk-prone: Risk premium < 0

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 Exponential Utility Function

Risk avoider
U(X) = 1 eX/R
Risk
Avoider

nt
re
Utility

ffe
di
In
k
is
R
Risk
Seeker

Figure 8.9
Monetary Outcome

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 Utility as a Criteria
Utility replaces monetary values in
decision tree
Payoffs
Big Success (0.2)
$40,000
EMV = $4,000
Moderate Success (0.3)
t 1 $10,000
Inves
Failure (0.5)
$30,000
|| Do
N ot I Best Choice
$0 nve
st
2 $0
Figure 8.10 $0

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 Utility as a Criteria
Figure 8.11

Utility
1.00
Value
U ($40,000) = 1.00
0.80

0.60

0.40

0.20
U ($10,000) = 0.30
U ($30,000) = 0.00
0.00 U ($0) = 0.15
| | | | | | | |
$30,000 $20,000 $10,000 $0 $10,000 $20,000 $30,000 $40,000 Monetary
Value

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 Utility as a Criteria
Utility replaces monetary values in
decision tree
Expected Utility
Best Choice Utilities
Big Success (0.2)
0.29 1.00
Moderate Success (0.3)
t 1 0.30
Inves
Failure (0.5)
|| Do
0.00
Not
0.29 Inv
est
2 0.15
Figure 8.10 0.15

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