Decision Analysis

Chapter 12

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Chapter Topics

■ Components of Decision Making

■ Decision Making without Probabilities
■ Decision Making with Probabilities
■ Decision Analysis with Additional Information
■ Utility

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Decision Analysis
Components of Decision Making
■ 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.

Table 12.1 Payoff Table

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Decision Analysis
Decision Making Without Probabilities

Figure 12.1

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Decision Analysis
Decision Making without Probabilities

Table 12.2
Decision-Making Criteria
maximax maximin minimax regret
Hurwicz equal likelihood

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Decision Making without Probabilities
Maximax Criterion
In the maximax criterion the decision maker selects the decision
that will result in the maximum of maximum payoffs; an
optimistic criterion.

Table 12.3 Payoff Table Illustrating a Maximax Decision

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Decision Making without Probabilities
Maximin Criterion
In the maximin criterion the decision maker selects the decision
that will reflect the maximum of the minimum payoffs; a
pessimistic criterion.

Table 12.4 Payoff Table Illustrating a Maximin Decision

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Decision Making without Probabilities
Minimax Regret Criterion
Regret is the difference between the payoff from the best
decision and all other decision payoffs.
The decision maker attempts to avoid regret by selecting the
decision alternative that minimizes the maximum regret.

Table 12.6 Regret Table Illustrating the Minimax Regret Decision

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Decision Making without Probabilities
Hurwicz Criterion
The Hurwicz criterion is a compromise between the maximax
and maximin criterion.
A coefficient of optimism, , is a measure of the decision
maker’s 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

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Decision Making without Probabilities
Equal Likelihood Criterion

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

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Decision Making without Probabilities
Summary of Criteria Results
■ 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

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Decision Making with Probabilities
Expected Value
Expected value is computed by multiplying each decision
outcome under each state of nature by the probability of its
occurrence.

Table 12.7
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
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Decision Making with Probabilities
Expected Value of Perfect Information

■ 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.

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Decision Making with Probabilities
EVPI Example (1 of 2)

Table 12.9 Payoff Table with Decisions, Given Perfect Information

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Decision Making with Probabilities
EVPI Example (2 of 2)

■ Decision with perfect information:

$100,000(.60) + 30,000(.40) = $72,000

■ Decision without 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
(from regret table/office)

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Decision Making with Probabilities
Decision Trees (1 of 4)
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

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Decision Making with Probabilities
Decision Trees (2 of 4)

Figure 12.2 Decision Tree for Real Estate Investment Example

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Decision Making with Probabilities
Decision Trees (3 of 4)

■ 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.

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Decision Making with Probabilities
Decision Trees (4 of 4)

Figure 12.3 Decision Tree with Expected Value at Probability Nodes

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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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Decision Making with Probabilities
Sequential Decision Trees (2 of 4)

Figure 12.4 Sequential Decision Tree

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Decision Making with Probabilities
Sequential Decision Trees (3 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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Decision Making with Probabilities
Sequential Decision Trees (4 of 4)

Figure 12.5 Sequential Decision Tree with Nodal Expected Values

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