Decision Trees and Utility

ISL354E Managerial Decision Making

06-07.04.2016

Engineering Managerial Decision Making 1

Utility Theory

Low High
Attendance Attendance
Probability 40% 60%
Luxuria Hotel
Profit 11000 30000

Maxima Probability 50% 50%

Center Profit -10000 60000

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Utility Theory
Limitations of the EMV criterion

It assumes that the decision maker is neutral

to risk

It assumes a linear value function for money

It considers only one attribute : money

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Utility Theory
Single Attribute Utility

Utility assessment assigns the worst outcome a utility

of 0, and the best outcome, a utility of 1.
A standard gamble is used to determine utility values:
When you are indifferent, the utility values are equal.
Choose the alternative with the maximum expected
utility

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 Single Attribute Utility
Applying Utilities

Monetary Sum Utility

60,000 1.0
30,000 Not yet known
11,000 Not yet known
-10,000 0

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Utility Theory
Utility Assesment
Utility assessment assigns the worst outcome a utility of 0,
and the best outcome, a utility of 1.

A standard gamble is used to determine utility values.

When you are indifferent, the utility values are equal.

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Utility Theory
Standard Gamble for Utility Assessment

(p) Best outcome

Utility = 1

(1-p)
Worst outcome
Utility = 0

Other outcome
Utility = ??

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 Utility Assessment (1st approach)
(0.5) v*
(0.5) Best outcome (v*) u(v*) = 1
I u(v*) = 1 II
(0.5) x1
(0.5) Worst outcome (v ) u(x1) = 0.5
u(v ) = 0
x2
Certain outcome (x1) u(x2) = 0.75
u(x1) = 0.5

For example:
(0.5) x1 u(-180) = 0 and u(200) = 1
III u(v*) = 0.5 X1= 100 u(100) = 0.5
X2 = 175 u(175) = 0.75
(0.5) X3 = 5 u(5) = 0.25
Worst outcome (v )
u(v ) = 0

x3
u(x3) = 0.25

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 Utility Assessment (2nd approach)

(p) Best outcome (v*)

u(v*) = 1

(1 p) Worst outcome (v )
u(v ) = 0

Certain outcome (vij)

u(vij) = p

For example:
u(-180) = 0 and u(200) = 1
For vij= 20, p=%70 u( 20) = 0.7
For vij=0, p=%75 u(0) = 0.75
For vij=100, p=%90 u(100) = 0.9

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Utility Theory
Utility Assessment for Conference Organizer
(70%)
60,000
Utility = 1

(30%)
-10,000
Utility = 0

30,000
Utility = ??

Answer: A 30% change of losing 10,000 is too risky, I will take 30,000.

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 Utility Theory
Utility Assessment for Conference Organizer
(90%)
60,000
Utility = 1

(10%)
-10,000
Utility = 0

30,000
Utility = ??

Answer: Such a good chance of winning the lottery, I will buy the lottery ticket.

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 Utility Theory
Utility Assessment for Conference Organizer
(85%)
60,000
Utility = 1

(15%)
-10,000
Utility = 0

30,000
Utility = ??

Answer: I am now indifferent between certain money and the lottery ticket.

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Utility Theory

Monetary Sum Utility

60,000 1.0
30,000 0.85
11,000 0.60
-10,000 0

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 Utility Theory
A utility function for the conference organizer -indicating she is
risk averse

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Utility Theory
Preferences for Risk

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 Utility Theory

Development 1 year 2 years 4 years 6 years 8 Years

Time

Proceed with - - 40% 60% -

Probability

existing research
methods
Switch to new 20% 40% - - %40
approach

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 Maurice Allais (1953)

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 An analysis of decision under risk
Kahneman and Tversky 1979

240 TL
84%

Gains 0.25 1000 TL Non-risk taking

16%
0.75 0 TL

-750 TL

13%
Losses 0.75
-1000 TL Risk Taking
87%
0.25 0 TL

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 Prospect Theory

Value Function

Losses Gains
- +

"We have an irrational tendency to be less willing to gamble with profits

than with losses."
Kahneman & Tversky (1981)
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 Two programs to combat disease:

If program A is adopted, 200 people will be saved.

If program B is adopted, there is a 1/3 probability that 600 people will be

saved, and 2/3 probability that no one will be saved.

If program C is adopted, 400 people will be die.

If program D is adopted, there is a 1/3 probability that nobody will die, and
2/3 probability that 600 people will die.

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 The consequences of choice

There Are No Good Men in New York!

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 When choice is demotivating
Iyengar & Lepper (2000):
Subjects choose one chocolate to sample

Condition 1: Limited Condition 2: Extensive

selection selection

% who choose chocolate as 48% 12%

compensation:
Satisfaction with sampled
chocolate (1-7 scale): 6.28 5.46
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 Avoidance of Choice
Tversky & Shafir (1992)

Control Condition Conflict Condition

$1.50 v. $1.50 v. v.
($2 value) ($2 value)

($2 value)

75% choose pen 47% choose a pen (53% choose money)!

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 Instant vs Delayed gratification

It is the ability to resist the temptation for an

immediate reward and wait for a later reward.

https://goo.gl/GIfHUW

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Utility Theory
Multi-attribute Utility: Contact of Engineering Corporation

Overrun 0 weeks 1 week 3 weeks 6 weeks

time
Probability 0.1 0.6 0.3
Work
Normally Project 50,000 60,000 80,000
Costs
Probability 0.8 0.2
Hire Extra
labor, etc. Project 120,000 140,000
Costs

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Utility Theory
Utility independence

Attribute A is utility independent of attribute B, if the

different levels of A, but the same level of B, do not

depend on the level of attribute B.

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 Preferential Independence
Attribute Y is said to be preferentially independent of attribute X if preferences for
specific outcomes of Y do not depend on the level of attribute X

>

>

If Y is preferentially independent of X and X is preferentially independent

of Y, then X and Y are mutually preferentially independent

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Utility Theory
Utility independence

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 Utility Theory
Deriving the multi-attribute utility function

1. Derive single-attribute utility functions

2. Combine the single attribute functions to
obtain a multi-attribute utility function
3. Perform consistency checks

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Utility Theory
Stage 1: Utility functions for overrun time and project
cost

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 Utility Theory

Overrun Cost of
(weeks) Utility project Utility
0 1.0 50000 1.00
1 0.9 60000 0.96
3 0.6 80000 0.90
6 0.0 120000 0.55
140000 0.00

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 Utility Theory
Stage 2 - Multiattribute utility function

u(x1,x2) =k1u(x1) + k2u(x2) + k3u(x1)u(x2)

where: k3 = 1-k1-k2

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Utility Theory
Determining k1

Determining k1

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Utility Theory
Determining k2

Determining k2

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Utility Theory

Overrun Time Project Cost Utility

0 weeks $50,000 1.0
3 weeks $60,000 0.8256
6 weeks $80,000 0.54
0 weeks $120,000 0.91
1 week $140,000 0.72

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 Utility Theory
Stage 3 Checking Consistency
Overrun Cost Overrun Cost Overrun Cost
1 week 80000 6 weeks 50000 0 weeks 120000
0.5 0.5 0.5

0.5 0.5 0.5

3 week 50000 1 week 120000 6 week 120000

Utility:0.726 Utility:0.888 Utility:0.620

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Decision Trees
Constructing a decision tree:
An initial tree.

Success Failure
Electric Power Probability 0.75 0.25
Design
Return 10m -3m
Gas Power Probability 0.6 0.4
Design
Return 15m -7m
No product Return 0 0

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Decision Trees
Constructing a decision tree:
A new decision problem for food processor

Success Failure
Electric Modify Probability 0.3 0.7
Power Design Return $6m -$7m
Design
Abandon Return $0 $0
Project
Gas Power Modify Probability 0.8 0.2
Design Design Return $10m -$12m
Abandon Return $0 $0
Project

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Decision Trees

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Decision Trees
Applying rollback to utilities

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 Decision Trees
Continous probability distributions: The extended Pearson-Tukey
approximation method

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 References

Goodwin, P. and Wright, G. (2010), Decision

Analysis for Management Judgment, 4th
Edition, Wiley; Chapters 6 & 7.

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