Introduction

Decisionoftenmustbemadeinuncertainenvironments
DECISIONANALYSIS
(Hillier&LiebermanIntroductiontoOperationsResearch,8th edition)
Examples:
Manufacturerintroducinganewproductinthemarketplace.
Governmentcontractorbiddingonanewcontract.
Oilcompanydecidingtodrillforoilinaparticularlocation.
Decisionanalysis:decisionmakinginfaceofgreat
uncertainty;rationaldecisionwhentheoutcomesare
uncertain.
Makingdecisionswith orwithoutexperimentation.

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Prototypeexample Decisionmakingwithoutexperimentation

Goferbroke Companyownsatractoflandthatcan Analogy togametheory:

containoil.
Players:decisionmaker(player1)andnature(player2).
Contractedgeologistreportsthatchanceofoilis1in4.
Availablestrategiesfor2players:alternativeactionsand
Anotheroilcompanyoffers90.000 fortheland. possiblestatesofnature,respectively.
Costofdrillingis100.000.Ifoilisfound,expectedrevenue
Costofdrillingis100 000 Ifoilisfound expectedrevenue Combinationofstrategiesresultsinsomepayofftoplayer1
is800.000 (expectedprofitis700.000). (decisionmaker).
Statusofland Payoff
Alternative Oil Dry But,arebothplayersstillrational?
Drillforoil 700.000 100.000
Selltheland 90.000 90.000
Chanceofstatus 1in4 3in4

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Decision analysis framework PayofftableforGoferbrokeCo.problem

1. Decisionmakerneedstochooseoneofalternative
actions.
2. Nature thenchoosesoneofpossiblestatesofnature. Stateofnature
3. Eachcombinationofanactionandstateofnature Alternative Oil Dry
resultsinapayoff oneoftheentriesinapayoff
resultsinapayoff,oneoftheentriesinapayoff 1 Drillforoil
1.Drillforoil 700 100
100
table. 2.Selltheland 90 90
4. Probabilitiesforstatesofnatureprovidedbyprior Priorprobability 0.25 0.75
distributionarepriorprobabilities.
5. Payofftableshouldbeusedtofindanoptimalaction
forthedecisionmakeraccordingtoan appropriate
criterion.
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 Maximinpayoffcriterion Maximumlikelihoodcriterion
Maximin payoffcriterion: foreachpossibleaction, Maximumlikelihood criterion: Identifymostlikely
findtheminimumpayoff overallstatesofnature. stateofnature(withlargestpriorprobability).For
Next,findthemaximum oftheseminimumpayoffs. thisstateofnature,findtheactionwithmaximum
Choosetheactionwhoseminimumpayoffgivesthis payoff.Choosethisaction.
maximum. Mostlikelyy state:ignoresimportantinformationand
g p
Bestguarantee ofpayoff:pessimisticviewpoint. lowprobabilitybigpayoff.
Stateofnature Stateofnature
Alternative Alternative Oil Dry
Oil Dry Minimum
1.Drillforoil 700 100 100 1.Drillforoil 700 100
2.Selltheland 90 90 Maximuminthiscolumn
2.Selltheland 90 90 90 Maximinvalue
Priorprobability 0.25 0.75
Priorprobability 0.25 0.75

Optimization and Decision 2009 535 Optimization and Decision 2009 Mostlikely 536

Bayesdecisionrule SensitivityanalysiswithBayesrules
Bayesdecisionrule: Usingpriorprobabilities, Priorprobabilitiescanbequestionable.
calculatetheexpectedvalueofpayoffforeach Trueprobabilitiesofhavingoilare0.15to0.35(so,
possibledecisionalternative.Choosethedecision probabilitiesfordrylandarefrom0.85to0.65).
alternativewiththemaximumexpectedpayoff.
p=priorprobabilityofoil.
Fortheprototypeexample:
Example:expectedpayofffromdrillingforanyp:
E[Payoff(drill)]=0.25(700)+0.75(100)=100.
E[Payoff(drill)]=700p 100(1 p)=800p 100.
E[Payoff(sell)]=0.25(90)+0.75(90)=90.
Infigure,thecrossoverpoint iswherethedecision
Incorporatesallavailableinformation(payoffsand
changesfromonealternativetoanother:
priorprobabilities).
E[Payoff(drill)]=E[Payoff(sell)]
Whatifprobabilitiesarewrong? 800p 100=90 p =0.2375
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Expectedpayoffforalternativechanges Decisionmakingwithexperimentation

Improvedestimatesarecalledposterior
probabilities.
Andformore
than2variables? Example:adetailedseismicsurveycosts30.000.
UseExcelSensIt. USS:unfavorableseismicsoundings:oilisfairlyunlikely.
g y y
FSS:favorableseismicsoundings:oilisfairlylikely.
Thedecisionis
verysensitive Basedonpastexperience,thefollowingprobabilities
top! aregiven:
P(USS|State=Oil)=0.4;P(FSS|State=Oil)=1 0.4=0.6.
P(USS|State=Dry)=0.8;P(FSS|State=Dry)=1 0.8=0.2.

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 Posteriorprobabilities Posteriorprobabilities
n =numberofpossiblestatesofnature.
Fromprobabilitytheory,theBayestheorem canbe
P(State=statei)=priorprobabilitythattruestateof
obtained:
natureisstatei,fori=1,2,,n.
Finding=findingfromexperimentation(randomvar.)
g j) =
P(State=statei ||Finding=finding
g
d
Findingj =onepossiblevalueoffinding.
bl l ff d
P(State=statei |Finding =finding j)=posterior P(Finding=findingj |State=statei )P(State=statei )
=
probability thattruestateofnatureisstatei,given n

Finding =finding j ,fori=1,2,,n. P(Finding=findingj |State=statek )P(State=statek )

k =1

GivenP(State=statei) andP(Finding=findingj|State=statei)
fori=1,2,,n, whatisP(State=statei |Finding=finding j)?
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Bayestheoreminprototypeexample Probabilitytreediagram

Ifseismicsurveyinunfavorable(USS,j=1):
0.4(0.25) 1
P(State=Oil|Finding=USS) = = ,
0.4(0.25) + 0.8(0.75) 7
1 6
y| g )=1 = .
P((State=Dry|Finding=USS)
7 7
Ifseismicsurveyinfavorable(FSS,j=2):
0.6(0.25) 1
P(State=Oil|Finding=FSS) = = ,
0.6(0.25) + 0.2(0.75) 2
1 1
P(State=Dry|Finding=FSS) = 1 = .
2 2
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Expectedpayoffs Optimalpolicy
ExpectedpayoffscanbefoundagainusingBayes
decisionrulefortheprototypeexample,with UsingBayesdecisionrule,theoptimalpolicyof
posteriorprobabilitiesreplacing priorprobabilities: optimizingpayoffisgivenby:
ExpectedpayoffsiffindingisUSS:
1 6
) = (7
E[[Payoff(drill|Finding=USS)
y ( | g (700)) + (100)) 30 = 155.77 Findingfrom Optimal
Expectedpayoff Expectedpayoff
7 7 excludingcostof includingcostof
seismicsurvey alternative
1 6 survey survey
E[Payoff(sell|Finding=USS) = (90) + (90) 30 = 60 USS Selltheland 90 60
7 7
ExpectedpayoffsiffindingisFSS: FSS Drillforoil 300 270
1 1
E[Payoff(drill|Finding=FSS) = (700) + (100) 30 = 270
2 2 Isitworthspending30.000 toconduct
1 1
E[Payoff(sell|Finding=FSS) = (90) + (90) 30 = 60 theexperimentation?
2 2
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 Valueofexperimentation Expectedvalueofperfectinformation

Stateofnature
Beforeperforminganexperimentation,determineits Alternative Oil Dry
potentialvalue. 1.Drillforoil 700 100
Twocomplementarymethods: 2.Selltheland 90 90
Maximumpayoff 700 90
1. Expectedvalueofperfectinformation itis P i b bili
Priorprobability 0.25 0.75
assumedthatexperimentwillremovealluncertainty. Expectedpayoffwithperfectinformation=0.25(700)+0.75(90)=242.5
Providesanupperbound onpotentialvalueof
experiment. Expectedvalueofperfectinformation(EVPI) is:
EVPI=expectedpayoffwithperfectinformation expectedpayoffwithout
2. Expectedvalueofinformation istheactual experimentation
improvementinexpectedpayoff. Example:EVPI=242.5 100=142.5.Thisvalueis>30.

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Expectedvalueofinformation Expectedvalueofinformation

Requiresexpectedpayoffwithexperimentation: So,expectedpayoffwithexperimentation is
Expectedpayoffwithexperimentation = Expectedpayoffwithexperim.=0.7(90)+0.3(300)=153.

P(Finding=findingj )E[payoff|Finding=findingj ] Expectedvalueofexperimentation(EVE) is:

j

Example:seeprobabilitytreediagram,where: EVE=expectedpayoffwithexperimentation expected

P(USS)=0.7, P(FSS)=0.3. payoffwithoutexperimentation
Expectedpayoff(excludingcostofsurvey)was
obtainedinoptimalpolicy: Example: EVE=153 100=53.
As53exceeds30,theseismicsurveyshouldbedone.
E(Payoff|Finding=USS)=90,
E(Payoff|Finding=FSS)=300.
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Decisiontrees Decisiontreeforprototypeexample

Prototypeexamplehasasequenceoftwodecisions:
Shouldaseismicsurveybeconductedbeforeanactionis
chosen?
Whichaction(drillforoilorselltheland)shouldbechosen?
Thesequestionshaveacorrespondingdecisiontree.
h h d d
Junctionpointsarenodes,andlinesarebranches.
Adecisionnode,representedbyasquare,indicates
thatadecision needstobemadeatthatpoint.
Aneventnode,representedbyacircle,indicatesthat
arandomevent occursatthatpoint.
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 Decisiontreewithprobabilities Performingtheanalysis
1. Startatrightsideofdecisiontreeandmoveleftone
column atatime.Foreachcolumn,performstep2or
probability
step3dependingifnodesareevent ordecision nodes.
2. Foreacheventnode,calculateitsexpectedpayoff by
multiplyingexpectedpayoffofeachbranchby
probabilityofthatbranchandsummingthese
products.Recordvaluenexttoeachnodeinbold.
cash flow 3. Foreachdecisionnode,comparetheexpectedpayoffs
ofitsbranches,andchoosealternativewithlargest
expectedpayoff.Recordthechoicebyinsertinga
doubledashineachrejectedbranch.
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Decisiontreewithanalysis Optimalpolicyforprototypeexample

Optimization and Decision 2009
Thedecisiontreeresultsinthefollowingdecisions:
1. Dotheseismicsurvey.
2. Iftheresultisunfavorable,selltheland.
3. Iftheresultisfavorable,drillforoil.
4. Theexpectedpayoff(includingthecostofthe
seismicsurvey)is123(123000).
Sameresultasobtainedwithexperimentation
Foranydecisiontree,thebackwardinduction
procedure alwaysleadstooptimalpolicy.
555 Optimization and Decision 2009 556

Utilitytheory Utilityfunctionformoney
Utilityfunctions(u(M))formoney(M):usuallythereisa
Youareofferedthechoiceof: decreasingmarginalutilityformoney (individualisrisk
averse).

1. Acceptinga50:50chanceofwinning$100.000
ornothing;
2. Receiving$40.000withcertainty.

Whatdoyouchoose?

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 Utility function formoney
Italsoispossibletoexhibitamixtureofthesekindsof
behavior(riskaverse,riskseeker,riskneutral)
Anindividualsattitudetowardriskmaybedifferent
whendealingwithonespersonalfinancesthanwhen
makingdecisionsonbehalfofanorganization.
Whenautilityfunctionformoneyisincorporatedinto
adecisionanalysisapproachtoaproblem,thisutility
functionmustbeconstructedtofitthepreferences
andvaluesofthedecisionmakerinvolved.(The
decisionmakercanbeeitherasingleindividualora
groupofpeople.)
OptimizationandDecision2009
Utilitytheory
Fundamentalproperty:thedecisionmakersutility
functionformoney hasthepropertythatthedecision
makerisindifferent betweentwoalternativecourses
ofactioniftheyhavethesameexpectedutility.
Example.p Offer: anopportunitytoobtaineither
pp y
$100.000(utility=4)withprobabilityp ornothing
(utility=0)withprobability1 p.Thus,E(utility)=4p.
Decisionmakerisindifferentfore.g.:
Offerwithp =0.25(E(utility)=1)ordefinitelyobtaining
$10.000(utility=1).
Offerwithp =0.75(E(utility)=3)ordefinitelyobtaining
$60.000(utility=3).
559 Optimization and Decision 2009 560

Roleofutilitytheory Applyingutilitytheorytoexample
TheGoferbroke Co.doesnothavemuchcapital,soalossof
Whendecisionmakersutilityfunctionformoneyis 100.000 wouldbequiteserious.
usedtomeasurerelativeworthofvariouspossible Scaleofutilityfunctionisirrelevant.Onlytherelativevaluesof
monetaryoutcomes,Bayesdecisionrulereplaces theutilitiesmatter.
monetarypayoffsbycorrespondingutilities. Thecompleteutilityfunctioncanbefoundusingthefollowing
values:
Thus,optimalaction istheonethatmaximizesthe Monetarypayoff Utility
expectedutility. 130 150
100 105
Notethatutilityfunctionsmaynotbemonetary. 60 60

Example:doctorsdecisionoftreatingornotapatient 90 90

involvesfuturehealthofthepatient. 670 580

700 600
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UtilityfunctionforGoferborkeCo. Estimatingu(M)

Apopularformistheexponentialutilityfunction:

M
u (M ) = R 1 e R

R =decisionmaker
=decisionmakersrisktolerance
srisktolerance.
Designedtofitariskaverseindividual.
Forprototypeexample,R =2250foru(670)=580and
u(700)=600,andR =465foru(130)=150.
However,itisnotpossibletohavedifferentvaluesof
R forthesameutilityfunction.

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 Decisiontreewithutilityfunction Decisiontreeusingutilityfunction

Thesolutionisexactlythesameasbefore,except for Different decision tree

substitutingutilities formonetarypayoffs. but same optimal
Thus,thevalueobtainedtoevaluateeachforkofthe policy.
treeisnowtheexpectedutilityy ratherthanthe
expectedmonetarypayoff.
OptimaldecisionsselectedbyBayesdecisionrule
maximizetheexpectedutilityfortheoverallproblem.

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