Management Science Chapter 13

Anderson Sweeney Williams Camm Cochran Fry Ohlmann

An Introduction to
Management Science, 15e
Quantitative Approaches to Decision Making

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Chapter 13: Decision Analysis

13.1 – Problem Formulation

13.2 – Decision Making without Probabilities
13.3 – Decision Making with Probabilities
13.4 – Risk Analysis and Sensitivity Analysis
13.5 – Decision Analysis with Sample Information
13.6 – Computing Branch Probabilities with Bayes’ Theorem
13.7 – Utility Theory
2
Decision Analysis
• Decision analysis can be used to develop an optimal

strategy when a decision maker is faced with several
decision alternatives and an uncertain or risk-filled pattern
of future events.
• Even when a careful decision analysis has been conducted,
the uncertain future events make the final consequence
uncertain.
• The risk associated with any decision alternative is a direct
result of the uncertainty associated with the final
consequence.
• Good decision analysis includes risk analysis that provides
probability information about the favorable as well as the
unfavorable consequences that may occur.
3
Problem Formulation
• A decision problem is characterized by decision

alternatives, states of nature, and resulting payoffs.
• The decision alternatives are the different possible
strategies the decision maker can employ.
• The states of nature refer to future events, not under the
control of the decision maker, which may occur. States of
nature should be defined so that they are mutually exclusive
and collectively exhaustive.
4
Example: Pittsburgh Development Corp.
Pittsburgh Development Corporation (PDC) purchased land

that will be the site of a new luxury condominium complex.
PDC commissioned preliminary architectural drawings for
three different projects: one with 30, one with 60, and one
with 90 condominiums.
The financial success of the project depends upon the size of

the condominium complex and the chance event concerning
the demand for the condominiums. The statement of the PDC
decision problem is to select the size of the new complex that
will lead to the largest profit given the uncertainty concerning
the demand for the condominiums.
5
Influence Diagrams (1 of 2)
• An influence diagram is a graphical device showing the

relationships among the decisions, the chance events, and
the consequences.
• Squares or rectangles depict decision nodes.
• Circles or ovals depict chance nodes.
• Diamonds depict consequence nodes.
• Lines or arcs connecting the nodes show the direction of
influence.
6
Influence Diagrams (2 of 2)
7
Payoff Tables
• The consequence resulting from a specific combination of a

decision alternative and a state of nature is a payoff.
• A table showing payoffs for all combinations of decision
alternatives and states of nature is a payoff table.
• Payoffs can be expressed in terms of profit, cost, time,
distance or any other appropriate measure.
8
Consider the following problem with three decision

alternatives and two states of nature with the following payoff
table representing profits:
9
Decision Making without Probabilities
Three commonly used criteria for decision making when

probability information regarding the likelihood of the states of
nature is unavailable are:
• the optimistic approach – the decision with the largest
payoff or lowest cost is chosen.
• the conservative approach – for each decision the
minimum payoff is listed and the decision corresponding
to the maximum of these payoffs is selected. Or the
maximum costs are determined and the minimum of
those is selected.
• the minimax regret approach.
10
Example: Optimistic Approach
An optimistic decision maker would use the optimistic

(maximax) approach. We choose the decision that
has the largest single value in the payoff table.
Maximum
Decision Payoff
8
Maximax Maximax
decision 14 payoff
20
11
Example: Conservative Approach
A conservative decision maker would use the

conservative (maximin) approach. List the minimum
payoff for each decision. Choose the decision with the
maximum of these minimum payoffs.
Minimum
Decision Payoff
7
7
5
5
Maximin
–9
Maximin payoff
–9
decision
12
Minimax Regret Approach
• The minimax regret approach requires the construction of a

regret table or an opportunity loss table.
• This is done by calculating for each state of nature the
difference between each payoff and the largest payoff for
that state of nature.
• Then, using this regret table, the maximum regret for each
possible decision is listed.
• The decision chosen is the one corresponding to the
minimum of the maximum regrets.
13
Example: Minimax Regret Approach (1 of 2)
For the minimax regret approach, first compute a regret

table by subtracting each payoff in a column from the
largest payoff in that column. In this example, in the first
column subtract 8, 14, and 20 from 20; etc.
14
Example: Minimax Regret Approach (2 of 2)
For each decision list the maximum regret. Choose

the decision with the minimum of these values.
Maximum
Decision Regret
Minimax 12
12
decision 6
6
Minimax
16
regret
16
15
Decision Making with Probabilities
Expected Value Approach

• If probabilistic information regarding the states of nature
is available, one may use the expected value (EV)
approach.
• Here the expected return for each decision is calculated
by summing the products of the payoff under each state
of nature and the probability of the respective state of
nature occurring.
• The decision yielding the best expected return is chosen.
16
Expected Value of a Decision Alternative
• The expected value of a decision alternative is the sum of

weighted payoffs for the decision alternative.
• The expected value (EV) of decision alternative di is
defined as: N
EV(di )   P( s j )Vij
j 1
where:
N  the number of states of nature
P( s j )  the probability of state of nature s j
Vij  the payoff corresponding to decision
alternative d j and state of nature s j
17
Decision Tree (1 of 2)
• A decision tree is a chronological representation of the

decision problem.
• Each decision tree has two types of nodes; round nodes
correspond to the states of nature while square nodes
correspond to the decision alternatives.
• The branches leaving each round node represent the
different states of nature while the branches leaving each
square node represent the different decision alternatives.
• At the end of each limb of a tree are the payoffs attained
from the series of branches making up that limb.
18
Decision Tree (2 of 2)
19
Expected Value for Each Decision
Choose the decision alternative with the largest EV. Build

the large complex.
20
Expected Value of Perfect Information (1 of 2)
• Frequently information is available which can improve the

probability estimates for the states of nature.
• The expected value of perfect information (EVPI) is the
increase in the expected profit that would result if one knew
with certainty which state of nature would occur.
• The EVPI provides an upper bound on the expected value of
any sample or survey information.
EVPI = |EVwPI – EVwoPI|
21
Expected Value of Perfect Information (2 of 2)
• Expected Value with Perfect Information (EVwPI)

EVwPI = 0.8(20 mil) + 0.2(7 mil) = $17.4 mil
• Expected Value without Perfect Information (EVwoPI)

EVwoPI = 0.8(20 mil) + 0.2(-9 mil) = $14.2 mil
• Expected Value of Perfect Information (EVPI)

EVPI = |EVwPI – EVwoPI| = |17.4 – 14.2| = $3.2 mil
22
Risk Analysis
• Risk analysis helps the decision maker recognize the

difference between:
• the expected value of a decision alternative, and
• the payoff that might actually occur
• The risk profile for a decision alternative shows the
possible payoffs for the decision alternative along with their
associated probabilities.
23
Risk Profile
Large Complex Decision Alternative
24
Sensitivity Analysis
• Sensitivity analysis can be used to determine how

changes to the following inputs affect the recommended
decision alternative:
• probabilities for the states of nature
• values of the payoffs
• If a small change in the value of one of the inputs causes a
change in the recommended decision alternative, extra
effort and care should be taken in estimating the input value.
25
Decision Analysis with Sample Information
• Frequently, decision makers have preliminary or prior

probability assessments for the states of nature that are
the best probability values available at that time.
• To make the best possible decision, the decision maker may
want to seek additional information about the states of
nature.
• This new information, often obtained through sampling, can
be used to revise the prior probabilities so that the final
decision is based on more accurate probabilities for the
states of nature.
• These revised probabilities are called posterior
probabilities.
26
• Let us return to the PDC problem and assume that

management is considering a 6-month market research
study designed to learn more about potential market
acceptance of the PDC condominium project. Management
anticipates that the market research study will provide one
of the following two results:
1. Favorable report: A significant number of the individuals
contacted express interest in purchasing a PDC
condominium.
2. Unfavorable report: Very few of the individuals contacted
express interest in purchasing a PDC condominium.
27
Influence Diagram
28
Sample Information (1 of 2)
PDC has developed the following branch probabilities.

If the market research study is undertaken:
P(Favorable report) = P(F) = 0.77
P(Unfavorable report) = P(U) = 0.23
If the market research report is favorable:
P(Strong demand | favorable report) = P(s1|F) = 0.94

P(Weak demand | favorable report) = P(s2|F) = 0.06
29
Sample Information (2 of 2)
If the market research report is unfavorable:

P(Strong demand | unfavorable report) = P(s1|U) = 0.35
P(Weak demand | unfavorable report) = P(s2|U) = 0.65
If the market research study is not undertaken, the prior

probabilities are applicable:
P(Favorable report) = P(F) = 0.80
P(Unfavorable report) = P(U) = 0.20
30
Decision Tree 1
31
Decision Strategy
• A decision strategy is a sequence of decisions and chance

outcomes where the decisions chosen depend on the yet-
to-be-determined outcomes of chance events.
• The approach used to determine the optimal decision
strategy is based on a backward pass through the decision
tree using the following steps:
• At chance nodes, compute the expected value by
multiplying the payoff at the end of each branch by the
corresponding branch probabilities.
• At decision nodes, select the decision branch that leads
to the best expected value. This expected value
becomes the expected value at the decision node.
32
Decision Tree 2
33
PDC’s Decision Strategy
PDC’s optimal decision strategy is:

• Conduct the market research study.
• If the market research report is favorable, construct the
large condominium complex.
• If the market research report is unfavorable, construct
the medium condominium complex.
34
Risk Profile
PDC’s Risk Profile
35
Expected Value of Sample Information
• The expected value of sample information (EVSI) is the

additional expected profit possible through knowledge of
the sample or survey information.
• The expected value associated with the market research
study is $15.93.
• The best expected value if the market research study is not
undertaken is $14.20.
• We can conclude that the difference, $15.93  $14.20 =
$1.73, is the expected value of sample information.
• Conducting the market research study adds $1.73 million
to the PDC expected value.
36
Efficiency of Sample Information
• Efficiency of sample information is the ratio of EVSI to

EVPI.
• As the EVPI provides an upper bound for the EVSI,
efficiency is always a number between 0 and 1.
The efficiency of the survey:
E = (EVSI/EVPI) X 100
= [($1.73 mil)/($3.20 mil)] X 100
= 54.1%
The information from the market research study is

54.1% as efficient as perfect information.
37
Computing Branch Probabilities (1 of 2)
We will need conditional probabilities for all sample outcomes

given all states of nature, that is, P(F | s1), P(F | s2), P(U | s1),
and P(U | s2).
Market Research
State of Nature Favorable, F Unfavorable, U
Strong demand, s1 P(F| s1) = 0.90 P(U| s1) = 0.10
Weak demand, s1 P(F| s2) = 0.25 P(U| s2) = 0.75
38
Computing Branch Probabilities (2 of 2)
Branch (Posterior) Probabilities Calculation

• Step 1:
For each state of nature, multiply the prior probability
by its conditional probability for the indicator -- this
gives the joint probabilities for the states and indicator.
• Step 2:
Sum these joint probabilities over all states -- this gives
the marginal probability for the indicator.
• Step 3:
For each state, divide its joint probability by the
marginal probability for the indicator -- this gives the
posterior probability distribution.
39
Bayes’ Theorem and Posterior Probabilities
• Knowledge of sample (survey) information can be used to

revise the probability estimates for the states of nature.
• Prior to obtaining this information, the probability estimates
for the states of nature are called prior probabilities.
• With knowledge of conditional probabilities for the
outcomes or indicators of the sample or survey information,
these prior probabilities can be revised by employing
Bayes' Theorem.
• The outcomes of this analysis are called posterior
probabilities or branch probabilities for decision trees.
40
Posterior Probabilities (1 of 2)
Favorable
State of Prior Conditional Joint Posterior
Nature Probability Probability Probability Probability
sj P(sj) P(F|sj) P(F I sj) P(sj |F)
s1 0.8 0.90 0.72 0.94
s2 0.2 0.25 0.05 0.06
P(favorable) = P(F) = 0.77 1.00
41
Posterior Probabilities (2 of 2)
Unfavorable
State of Prior Conditional Joint Posterior
Nature Probability Probability Probability Probability
sj P(sj) P(U|sj) P(U I sj) P(sj |U)
s1 0.8 0.10 0.08 0.35
s2 0.2 0.75 0.15 0.65
P(unfavorable) = P(U) = 0.23 1.00
42
End of Presentation: Chapter 13
43

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Anderson Sweeney Williams Camm Cochran Fry Ohlmann

13.1 – Problem Formulation

• Decision analysis can be used to develop an optimal

• A decision problem is characterized by decision

Pittsburgh Development Corporation (PDC) purchased land

The financial success of the project depends upon the size of

• An influence diagram is a graphical device showing the

• The consequence resulting from a specific combination of a

Consider the following problem with three decision

Three commonly used criteria for decision making when

An optimistic decision maker would use the optimistic

A conservative decision maker would use the

• The minimax regret approach requires the construction of a

For the minimax regret approach, first compute a regret

For each decision list the maximum regret. Choose

Expected Value Approach

• The expected value of a decision alternative is the sum of

• A decision tree is a chronological representation of the

Choose the decision alternative with the largest EV. Build

• Frequently information is available which can improve the

EVPI = |EVwPI – EVwoPI|

• Expected Value with Perfect Information (EVwPI)

• Expected Value without Perfect Information (EVwoPI)

• Expected Value of Perfect Information (EVPI)

• Risk analysis helps the decision maker recognize the

Large Complex Decision Alternative

• Sensitivity analysis can be used to determine how

• Frequently, decision makers have preliminary or prior

• Let us return to the PDC problem and assume that

PDC has developed the following branch probabilities.

If the market research report is favorable:

P(Strong demand | favorable report) = P(s1|F) = 0.94

If the market research report is unfavorable:

If the market research study is not undertaken, the prior

• A decision strategy is a sequence of decisions and chance

PDC’s optimal decision strategy is:

PDC’s Risk Profile

• The expected value of sample information (EVSI) is the

• Efficiency of sample information is the ratio of EVSI to

The efficiency of the survey:

The information from the market research study is

We will need conditional probabilities for all sample outcomes

Branch (Posterior) Probabilities Calculation

• Knowledge of sample (survey) information can be used to

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