CHAPTER 5

SUPPLEMENT:
Decision
Analysis

Slides prepared by
Romulus Cismaru
University of Regina

Introduction
Decision Theory Elements
A set of possible future conditions
exists that will have a bearing on the
results of the decision
A list of alternatives for the manager to
choose from
A known payoff for each alternative
under each possible future condition

5S-1

Introduction

5S-2

Fundamentals of
Decision Theory - continued

Decision Theory Process

1. Identify possible future conditions called
states of nature
2. Develop a list of possible alternatives, one
of which may be to do nothing
3. Determine the payoff associated with each
alternative for every future condition
4. Estimate the likelihood for each possible
future condition
5. Evaluate alternatives according to some
decision criterion

Terms:
Alternative: course of action or choice
State of nature: an occurrence over

which the decision maker has no control

5S-3

5S-4

Introduction

Fundamentals of
Decision Theory

Payoff table: table showing the payoffs for each alternative of a

decision in every possible state of nature, of a random variable

The three types of decision models:

Alternative

Decision making under uncertainty

Small
Facility
Medium
Facility
Large
Facility

Decision making under risk

Decision making under certainty

Possible Future Demand

Low
Moderate
High
(p=0.3)
(p=0.5)
(p=0.2)
10*
10
10
7

12

12

(4)

16

*Present value in $ millions

5S-5

5S-6

We calculate expected value

Alternative
Small
Facility

Alternative

Possible Future Demand

Low
Moderate
High
(p=0.3)
(p=0.5)
(p=0.2)
10*
10
10

Large
Facility

Medium
Facility

Low
(p=0.3)
7

Moderate
(p=0.5)
12

High
(p=0.2)
12

High
(p=0.2)
16

=3
Previously, we have

EVSMALL = 0.3 (10 ) + 0.5 (10 ) + 0.2 (10 ) = 10

EVMEDIUM = 0 .3 (7 ) + 0.5 (12 ) + 0.2 (12 ) = 10 .5

EVMEDIUM = 0.3 (7 ) + 0.5 (12 ) + 0.2 (12)

= 10.5

Moderate
(p=0.5)
2

EVLARGE = 0.3 ( 4 ) + 0.5 (2 ) + 0.2 (16 )

EVSMALL = 0.3 (10 ) + 0.5 (10 ) + 0.2 (10 ) = 10

Alternative

Low
(p=0.3)
(4)

We will select the medium facility

5S-7

5S-8

Decision Trees

Decision Trees

Symbols used in decision tree:

Decision Tree:
A schematic representation of the
decision variables, random variables,
and payoffs
Composed of a number of nodes that
have branches

A decision point from which one of several alternatives

may be selected
 A chance event node out of which various state of nature
will occur

5S-9

Example S2--A manager must decide on the size of a video

arcade to construct. The manager has narrowed the choices to
two: large or small. Information has been collected on payoffs,
and the following decision tree has been constructed. Analyze
the decision tree and determine which initial alternative (build
small or build large) should be chosen in order to maximize
expected monetary value.

Format of a Decision Tree

Decision Point
Chance Event

5S-10

Payoff 1
Payoff 2
2

Payoff 3
1

Possible second decision

Payoff 4

Payoff 5
Payoff 6

5S-11

5S-12

$55*0.6+$40*0.4=49

$55

$50

$50*0.4+$70*0.6=62

5S-13

Expected Value With Perfect Information

(EV|PI)

Expected Value of Perfect Information

Expected value of perfect information: the
difference between the expected payoff under
certainty and the expected payoff under risk

Expected value of
perfect information

Expected payoff
under certainty

5S-14

Expected value under certainty

Expected payoff

i =n

under risk

= Best outcome for the ith state of nature *P( S i )

i=1

EVPI places an upper bound on what one would pay for

additional information

where P(Si ) = Probability of the ith state of nature

and i = 1 to n, the number of states of nature

5S-15

5S-16

Expected Value of Perfect Information

Alternative

Small
Facility
Medium
Facility
Large
Facility

EVPI = Expected value under Certainty maximum Expected Monetary Value (EMV)

Possible Future Demand

Low
Moderate
High
(p=0.3)
(p=0.5)
(p=0.2)
10

10

10

Expected
monetary
value
10

12

12

10.5

(4)

16

With perfect info, our expected return will be:

10*0.3+12*0.5+16*0.2=12.2

Maximum EMV

EVPI=12.2-10.5=1.7
5S-17

5S-18

State of Nature

Sensitivity Analysis
Sensitivity Analysis: determining the range of
probability for which an alternative has the best
expected payoff

Alternative

Alternative

#2
(unfavourable
market)

12

16

12

We do not know the exact probability that #1 and #2 will occur

In the following discussion, we use P(1) represent probability of
#1, P(2) represent probability of #2.
P(1)+P(2)=1
5S-19

#1 Payoff

#2 Payoff

16
14
12
10
8
6
4
2
0

16
14
12
10
8
6
4
2
0

#2 Payoff

If P(2)=0, P(1)=1
Total payoff= 4*1+12*0=4

If P(2)=1, P(1)=0
Total payoff= 4*0+12*1=12

Probability of #2

#1 Payoff

#2 Payoff

16
14
12
10
8
6
4
2
0

5S-21

5S-22

State of Nature
#1(favourable
market)
Alternative

#1 Payoff

#2 Payoff

16
14
12
10
8
6
4
2
0

16
14
12
10
8
6
4
2
0

If P(2)=1, P(1)=0
EV= 4*0+12*1=12

#1(favourable market) #2 (unfavourable

market)

16
14
12
10
8
6
4
2
0

1
5S-20

State of Nature

16

16
14
12
10
8
6
4
2
0

0
Probability of #2
If P(2)=0, P(1)=1
EV= 4*1+12*0=4

Expected value (EV) =4*P(1)+12*P(2) ; P(1)+P(2)=1

P(1)=1-P(2);
EV=4*(1-P(2))+12*P(2)
=4-4*P(2)+12*P(2)
=4+8*P(2)

12

Probability of #2

Alternative

#1 Payoff

#1(favourable
market)

16
14
12
10
8
6
4
2
0

#2 (unfavourable market)

Expected value =4*P(1)+12*P(2) ; P(1)+P(2)=1

State of Nature

#1(favourable market)

Probability of #2

1
5S-23

#2
(unfavourable
market)

12

16

12

#1 Payoff

#2 Payoff

16
14
12
10
8
6
4
2
0

A
C

Probability of #2

16
14
12
10
8
6
4
2
0
1

5S-24

#1 Payoff

#1 Payoff

#2 Payoff

16
14
12
10
8
6
4
2
0

A
C

B best

C best

A best

?
?
Probability of #2

16
14
12
10
8
6
4
2
0

A
C

B best

#2 Payoff

16
14
12
10
8
6
4
2
0

C best

0.4
Line B: EV=16-14*P(2)
Line C: EV=12-4*P(2)

We have: 16-14*P(2)=12-4*P(2)
4=10*P(2)
P(2)=0.4
5S-25

#1 Payoff

A
C

B best

5S-26

#2 Payoff

16
14
12
10
8
6
4
2
0

A best

16
14
12
10
8
6
4
2
0
1

C best

0.4
Line A: EV=4+8*P(2)
Line C: EV=12-4*P(2)

A best

0.67

16
14
12
10
8
6
4
2
0
1

Homework
Problem 1, 2, 4, 5, 7, 9

We have: 4+8*P(2)=12-4*P(2)
12*P(2)=8
P(2)=0.67
5S-27

5S-28