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Decision Analysis

Chapter 12
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Components of Decision Making
Decision Making without Probabilities
Decision Making with Probabilities
Decision Analysis with Additional Information
Utility
Chapter Topics
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Table 12.1 Payoff Table
A state of nature is an actual event that may occur in the future.
A payoff table is a means of organizing a decision situation,
presenting the payoffs from different decisions given the various
states of nature.
Decision Analysis
Components of Decision Making
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Decision Analysis
Decision Making Without Probabilities
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Figure 12.1
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Decision-Making Criteria
maximax maximin
minimax regret Hurwicz equal likelihood
Decision Analysis
Decision Making without Probabilities
Table 12.2
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Table 12.3 Payoff Table Illustrating a Maximax Decision
In the maximax criterion the decision maker selects the decision
that will result in the maximum of maximum payoffs; an
optimistic criterion.
Decision Making without Probabilities
Maximax Criterion
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Table 12.4 Payoff Table Illustrating a Maximin Decision
In the maximin criterion the decision maker selects the decision
that will reflect the maximum of the minimum payoffs; a
pessimistic criterion.
Decision Making without Probabilities
Maximin Criterion
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The Hurwicz criterion is a compromise between the maximax
and maximin criterion.
A coefficient of optimism, , is a measure of the decision
makers optimism.
The Hurwicz criterion multiplies the best payoff by and the
worst payoff by (1- ), for each decision, and the best result is
selected.
Decision Values
Apartment building $50,000(.4) + 30,000(.6) = 38,000
Office building $100,000(.4) - 40,000(.6) = 16,000
Warehouse $30,000(.4) + 10,000(.6) = 18,000
Decision Making without Probabilities
Hurwicz Criterion
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Table 12.6 Regret Table Illustrating the Minimax Regret Decision
Regret is the difference between the payoff from the best
decision and all other decision payoffs (opportunity cost).
The decision maker attempts to avoid regret by selecting the
decision alternative that minimizes the maximum regret.
Decision Making without Probabilities
Minimax Regret Criterion
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The equal likelihood (or Laplace) criterion multiplies the
decision payoff for each state of nature by an equal weight, thus
assuming that the states of nature are equally likely to occur.
Decision Values
Apartment building $50,000(.5) + 30,000(.5) = 40,000
Office building $100,000(.5) - 40,000(.5) = 30,000
Warehouse $30,000(.5) + 10,000(.5) = 20,000
Decision Making without Probabilities
Equal Likelihood Criterion
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A dominant decision is one that has a better payoff than another
decision under each state of nature.
The appropriate criterion is dependent on the risk personality
and philosophy of the decision maker.
Criterion Decision (Purchase)
Maximax Office building
Maximin Apartment building
Minimax regret Apartment building
Hurwicz Apartment building
Equal likelihood Apartment building
Decision Making without Probabilities
Summary of Criteria Results
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Exhibit 12.1
Decision Making without Probabilities
Solution with QM for Windows (1 of 3)
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Exhibit 12.2
Decision Making without Probabilities
Solution with QM for Windows (2 of 3)
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Exhibit 12.3
Decision Making without Probabilities
Solution with QM for Windows (3 of 3)
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Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence.








EV(Apartment) = $50,000(.6) + 30,000(.4) = 42,000
EV(Office) = $100,000(.6) - 40,000(.4) = 44,000
EV(Warehouse) = $30,000(.6) + 10,000(.4) = 22,000
Table 12.7
Decision Making with Probabilities
Expected Value
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The expected opportunity loss is the expected value of the
regret for each decision.
The expected value and expected opportunity loss criterion
result in the same decision.





EOL(Apartment) = $50,000(.6) + 0(.4) = 30,000
EOL(Office) = $0(.6) + 70,000(.4) = 28,000
EOL(Warehouse) = $70,000(.6) + 20,000(.4) = 50,000
Table 12.8
Decision Making with Probabilities
Expected Opportunity Loss
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The expected value of perfect information (EVPI) is the
maximum amount a decision maker would pay for additional
information.

EVPI equals the expected value given perfect information
minus the expected value without perfect information.

EVPI equals the expected opportunity loss (EOL) for the best
decision.
Decision Making with Probabilities
Expected Value of Perfect Information
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Table 12.9 Payoff Table with Decisions, Given Perfect Information
Decision Making with Probabilities
EVPI Example (1 of 2)
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EV of Decision with perfect information:
$100,000(.60) + 30,000(.40) = $72,000

EV of Decision without this perfect information:
EV(office) = $100,000(.60) - 40,000(.40) = $44,000

EVPI = $72,000 - 44,000 = $28,000
EOL(office) = $0(.60) + 70,000(.4) = $28,000

Decision Making with Probabilities
EVPI Example (2 of 2)
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A decision tree is a diagram consisting of decision nodes
(represented as squares), probability nodes (circles), and
decision alternatives (branches).
Table 12.10 Payoff Table for Real Estate Investment Example
Decision Making with Probabilities
Decision Trees (1 of 4)
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Figure 12.2 Decision Tree for Real Estate Investment Example
Decision Making with Probabilities
Decision Trees (2 of 4)
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The expected value is computed at each probability node:
EV(node 2) = .60($50,000) + .40(30,000) = $42,000
EV(node 3) = .60($100,000) + .40(-40,000) = $44,000
EV(node 4) = .60($30,000) + .40(10,000) = $22,000

Branches with the greatest expected value are selected.
Decision Making with Probabilities
Decision Trees (3 of 4)
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Figure 12.3 Decision Tree with Expected Value at Probability Nodes
Decision Making with Probabilities
Decision Trees (4 of 4)
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Exhibit 12.9
Decision Making with Probabilities
Decision Trees with QM for Windows
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Decision Making with Probabilities
Sequential Decision Trees (1 of 4)
A sequential decision tree is used to illustrate a situation
requiring a series of decisions.

Used where a payoff table, limited to a single decision, cannot
be used.

Real estate investment example modified to encompass a ten-
year period in which several decisions must be made:

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Figure 12.4 Sequential Decision Tree
Decision Making with Probabilities
Sequential Decision Trees (2 of 4)
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Figure 12.5 Sequential Decision Tree with Nodal Expected Values
Decision Making with Probabilities
Sequential Decision Trees (3 of 4)
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Decision Making with Probabilities
Sequential Decision Trees (4 of 4)
Decision is to purchase land; highest net expected value
($1,160,000).

Payoff of the decision is $1,160,000.
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Exhibit 12.14
Sequential Decision Tree Analysis
Solution with QM for Windows
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Table 12.13 Payoff Table for Auto Insurance Example
Decision Analysis with Additional Information
Utility (1 of 2)
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Expected Cost (insurance) = .992($500) + .008(500) = $500
Expected Cost (no insurance) = .992($0) + .008(10,000) = $80
Decision should be do not purchase insurance, but people
almost always do purchase insurance.
Utility is a measure of personal satisfaction derived from money.
Utiles are units of subjective measures of utility.
Risk averters forgo a high expected value to avoid a low-
probability disaster.
Risk takers take a chance on a very low-probability event in
spite of a sure thing.
Decision Analysis with Additional Information
Utility (2 of 2)
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States of Nature
Decision
Good Foreign Competitive
Conditions
Poor Foreign Competitive
Conditions
Expand
Maintain Status Quo
Sell now
$ 800,000
1,300,000
320,000
$ 500,000
-150,000
320,000


Decision Analysis
Example Problem Solution (1 of 9)
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Decision Analysis
Example Problem Solution (2 of 9)
a. Determine the best decision without probabilities using the 5
criteria of the chapter.
b. Determine best decision with probabilities assuming .70
probability of good conditions, .30 of poor conditions. Use
expected value and expected opportunity loss criteria.
c. Compute expected value of perfect information.
d. Develop a decision tree with expected value at the nodes.
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Step 1 (part a): Determine decisions without probabilities.
Maximax Decision: Maintain status quo
Decisions Maximum Payoffs
Expand $800,000
Status quo 1,300,000 (maximum)
Sell 320,000
Maximin Decision: Expand
Decisions Minimum Payoffs
Expand $500,000 (maximum)
Status quo -150,000
Sell 320,000
Decision Analysis
Example Problem Solution (3 of 9)
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Minimax Regret Decision: Expand
Decisions Maximum Regrets
Expand $500,000 (minimum)
Status quo 650,000
Sell 980,000
Hurwicz ( = .3) Decision: Expand
Expand $800,000(.3) + 500,000(.7) = $590,000
Status quo $1,300,000(.3) - 150,000(.7) = $285,000
Sell $320,000(.3) + 320,000(.7) = $320,000
Decision Analysis
Example Problem Solution (4 of 9)
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Equal Likelihood Decision: Expand
Expand $800,000(.5) + 500,000(.5) = $650,000
Status quo $1,300,000(.5) - 150,000(.5) = $575,000
Sell $320,000(.5) + 320,000(.5) = $320,000
Step 2 (part b): Determine Decisions with EV and EOL.
Expected value decision: Maintain status quo
Expand $800,000(.7) + 500,000(.3) = $710,000
Status quo $1,300,000(.7) - 150,000(.3) = $865,000
Sell $320,000(.7) + 320,000(.3) = $320,000
Decision Analysis
Example Problem Solution (5 of 9)
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Expected opportunity loss decision: Maintain status quo
Expand $500,000(.7) + 0(.3) = $350,000
Status quo 0(.7) + 650,000(.3) = $195,000
Sell $980,000(.7) + 180,000(.3) = $740,000
Step 3 (part c): Compute EVPI.
EV given perfect information = 1,300,000(.7) + 500,000(.3) =
$1,060,000
EV without perfect information = $1,300,000(.7) - 150,000(.3) =
$865,000
EVPI = $1.060,000 - 865,000 = $195,000
Decision Analysis
Example Problem Solution (6 of 9)
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Step 4 (part d): Develop a decision tree.
Decision Analysis
Example Problem Solution (7 of 9)
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