Decision Analysis:

Choice of the Best Alternative

DMSN Fascilitators
Review

● Decision Analysis: AHP Method (Multi-Criteria Decision Making)

● Decision Analysis: Decision Tree
 Course Objectives

• Ability to choose the best alternative

among available alternatives by:
– Identifying their consequences;
More about AHP: Pros and Cons
AHP is technique for formalizing decision making such that
• It is applicable when it is difficult to formulate criteria evaluations, i.e., it allows
qualitative evaluation as well as quantitative evaluation.
• It is applicable for group decision making environments

However
•There are hidden assumptions like consistency
•Difficult to use when there are large number of evaluations Use GDSS
Use constraints to
eliminate some
alternatives

•Difficult to add a new criterion or alternative Use cost/benefit

ratio if applicable

•Difficult to take out an existing criterion or alternative, since

the best alternative might differ if the worst one is excluded.

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AHP Software:

Professional commercial software Expert Choice

developed by Expert Choice Inc. is available which
simplifies the implementation of the AHP’s steps and
automates many of its computations

◦ computations
◦ sensitivity analysis
◦ graphs, tables

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Decision Making in Context

6
Problems of Choice

C1 O1
D
C2 O2

• D : a decision maker
• C : possible courses of action
(alternatives)
• O1 : desirable outcome; O2 :
undesirable outcome
 Complex Rational Choice

The information and insight

needed to predict the I can’t see
consequences of each option
need not immediately known
or available:
– Incomplete information
– The other side may influences
the consequences
(Strategic/Interactive Decision).
It is assumed that we can calculate
probability of the consequences
Decision Analysis Problems

• Decision analysis is designed to address

decision making in the face of great
uncertainty
– Introducing new product into
marketplace:
• What will the reaction of potential
customers ? Competitors?
– Investing in securities :
• How is the economy?
• How about interest rates?
– Selecting the mix of crops and livestock
for the upcoming season :
• What will be the weather conditions?
– Drilling for oil in particular location :
• How likely is there to be oil in that
location?
• How much?
• Tools: Decision tree
 Model of Decision Analysis

E1,1 p1,1
O1
C1 p1,2
E1,2 O2
D O1
E2,1 p2,1
C2
E2,2 O2
p2,2

• D : a decision maker
• C : possible courses of action (alternatives)
• O1 and O2 : possible outcomes/consequences/payoffs
• Ei,j : Events (State of Natures/SON)
• pi,j : probabilities
Structure of Decision Tree

• Decision Node
– Alternatives available for decision maker
to choose;
– Situation controllable by decision maker.

Alternatives of actions
Structure of Decision Tree

• Event Node
– Events may happen after every action
made by decision maker;
– Uncontrollable by decision maker;
– Decision maker only has information
about probability of each event → no
complete information.
p1
E1

E2 p2
An action
E3
p3

Events
Building Decision Tree

1. Identify what decisions should be made

by DM;
– What are the first decision, and next
decisions to be made?
2. Identify what SON happen after each
decision;
3. Draw decision node and event node
(SON);
4. Complete information about probabilities;
5. Complete information about payoff.
Goferbroke Company Case
 Oil Company(1)

• Max Flyer is the founder of and sole owner of the Oil Company,
which develops oil wells in unproven territory. Max’s friends refer
to him affectionately as a wildcatter. However he prefers to think
himself as an entrepreneur. He has poured his life saving’s into
the company in the hope of making it big with a large strike of oil.
• Now his chance possibly has come. His company has purchased
various tracts of land that larger oil companies have spurned as
unpromising even though they are near some large oil fields.
Now Max has received an exciting report about one of these tracts.
A consulting geologist has just informed Max that he believes there
is one chance in four of oil there.
• Max has learned from bitter experience to be skeptical about the
chances of oil reported by consulting geologist. Drilling for oil on
this tract would require an investment of about $100,000. If the
lands turns out to be dry (no oil), the entire investment would be
lost. Since his company doesn’t have much capital left, this lost
would be quite serious.
 Oil Company(2)
• On the other hand, if the tract does contain oil, the consulting geologist estimates that there
would be enough there to generate a net revenue of approximately $800,000, leaving an
approximate profit of:
• Profit if find oil = Revenue if find oil – Drilling cost
= $800,000 - $100,000
= $700,000

• There is another option that another oil company has gotten wind of consulting geologist’s
report and so has offered to purchase the tract of land from Max for $90,000. This is very
tempting. This too would provide a welcome infusion of capital into the company, but
without incurring the large risk of a very substansial loss of $100,000.
The Oil Company Problem

• Decision that must be taken:

Should Max sell his land or doing drilling?
• Alternative:
1. Sell land
2. Drilling
• Possibility event that could happen (state of nature):
- Found Oil
- No Oil (dry)
• Payoff Table (Information from the case)
Payoffs
State of Nature (thousands)
Alternative Oil Dry
Drill for oil $700 -$100
Sell the land $90 $90
Prior Probability 0.25 0.75

If you are Max, which alternatives that you would

choose?
The Maximax Decision Criterion

• Focus only on the best that can happen “ the

maximax criterion always chooses the decision
alternative that can give the largest possible
payoff “→Total Optimist
• Identify the maximum payoff from any SoN for
each decision alternative
• Find the maximum of these maximum payoffs
and choose the corresponding decision
alternative
• Weakness : abandoning prior probability and
abandoning other payoff beside only the
biggest.

State of Nature Max in Row

Alternative Oil Dry
Drill for oil $700 -$100 700 Maximax
Sell the land $90 $90 90
The Maximin Decision Criterion

• Focus only on the worst that can happen to us

(total pessimist)
• Identify the minimum payoff from any SoN for
each decision alternatives
• Find the maximum of these minimum payoffs and
choose the corresponding decision alternative
• Weakness : abandoning prior probability and
abandoning other payoff beside only the maximin.

State of Nature Min in Row

Alternative Oil Dry
Drill for oil $700 -$100 -$100
Sell the land $90 $90 90 Maximin
The Maximum Likelyhood Criterion
• Focus on the most likely state of nature.
• Identify the state of nature with the
largest prior probability;
• Choose the decision alternative that has
the largest payoff for this state of nature.
• Weakness: abandoning payoff, that
actually payoff maybe very big.

State of Nature (thousands)

Alternative Oil Dry
Drill for oil $700 -$100
Sell the land $90 $90 Step 2 : Maximum
Prior Probability 0.25 0.75
Step 1 : Maximum
Bayes’ Decision Rule

• Bayes’ Decision Rule choose best alternative by considering

entire information that being owned by doing steps mentioned:
– Calculate Expected Value for every decision alternative
EV = (prior prob x payoff)
– Choose the decision alternative that has the largest
Expected Value
• Advantage :
– Considering entire information (alternatives, payoffs, and
prior probabilities);
– In long term, if the decision occur sequential, then this
criteria will resulting payoff that mostly probably happen.

State of Nature (thousands)

Alternative Oil Dry EV
Drill for oil $700 -$100 100 Maximum
Sell the land $90 $90 90
Prior Probability 0,25 0,75
Decision Trees of Oil Company

• Decision tree is decision making

help tools that could describe
entire alternatives with whole
events that may happen (SoN).
• Showing : Alternatives, SoN, Prior
Probability, and Payoff.
• Using Bayes’ Decision Rule to
choose the best action.
DT of Oil’s Company Case
• Decision:
– Drill or Sell the Land
• SON
– Oil or Dry

Decision nodes
Drill

-100

Sell

90
 DT of Oil’s Company Case
• Event nodes
Oil 0.25
800
Drill

-100 Dry 0,75

0
Sell

90
 DT of Goferbroke’s Case
• Payoff
Oil 0.25
700
800
Drill

-100 Dry 0,75

-100
0
Sell
90
90
 DT of Oil’s Company Case
• Payoff
Oil 0.25
700
800
Drill

-100 100 Dry 0,75

-100
0
Sell
100
90
90 90

• Expected Value (EV) per event node;

100=(0.25*700) + (0.75*(-100))
Using Treeplan software

0.25
Event node Oil
700
Drill 800 700 100=(0.25*700) + (0.75*(-100))

Decision node -100 100 0.75 Expected payoff

Dry = MAX [100,90]
-100 = 100
1 0 -100
100
Action: Drill
Sell
90
90 90
Case Example
• An engineer who works for a company which produces
equipment for the food processing industry has been
asked to consider the development of a new type of
processor and to make a recommendation to the
company’s board. Two alternative power sources could
be used for the processor, namely gas and electricity, but
for technical reasons each power source would require a
fundamentally different design. Resource constraints
mean that the company will only be able to pursue one of
the designs, and because the processor would be more
advanced than others which have been developed it is by
no means certain that either design would be a success.
The engineer estimates that there is a 75% chance that
the electricity-powered design would be successful and
only a 60% chance that the gas-powered design would be
a success.
 Case Example
• After considering this tree the engineer realizes that if
either design failed then the company would still
consider modifying the design, though this would involve
more investment and would still not guarantee success.
He estimates that the probability that the electrical
design could be successfully modified is only 30%,
though the gas design would have an 80% chance of
being modified successfully.
• Construct decision tree and choose the best alternative?
Constructing a decision tree:
An initial tree...

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Decision Analysis:
New Information or Posterior
Probability

31
Goferbroke’s Case Continued

• Survey by geologist will provide more

accurate information about P(oil) for
$30,000
• How if Max has to decide two
alternatives:
1. Do survey before drill/sell
2. Drill/sell without Survey
• Events:
– Do Survey
• FSS : Favorable Seismic Sounding : Oil is fairly likely
• USS : Unfavorable seismic sounding: Oil is quite unlikely.
– Drill or Sell
• Oil
• Dry
 P=?
Oil

Drill

P=?
P=? Dry
Unfavorable

Sell

Do Survey
P=?
Oil

Drill

P=?
P=? Dry
Favorable
1

Sell

P=?
Oil

Drill

P=?
Dry
No Survey

Sell
Max`s Experience
•P(state)→ prior; which is P(Oil)=0.25 & P(Dry)=0.75;
•P (finding|state)→ being known based on Max’s
experiences; which is
•P(FSS|Oil)=0.6,
•P(USS|Oil)=0.4,
•P(FSS|Dry)=0.2, and
•P(USS|Dry)=0.8

Which:
•State : Oil and Dry;
•Finding : FSS and USS;
•FSS : favorable seismic sounding; oil is fairly likely;
•USS : unfavorable seismic sounding; oil is quite unlikely.
 P(Oil│USS)
Oil 0.14
P(FSS│Oil) = 0,6 Drill

P(USS│Oil) = 0,4 P(Dry│USS)

P(USS) 0.7 Dry 0.86
Unfavorable
P(FSS│Dry) = 0,2 1
P(USS│Dry) = 0,8
Sell

Do Survey
P(Oil│FSS)
Oil 0.5
Drill

P(Dry│FSS)

P(oil│FSS) = P(oil&FSS)/P(FSS)
P(FSS)
0.3
Dry 0.5
Favorable

= 0.15/0.3= 0.5
P(oil│USS) = P(oil & USS)/ P(USS) Sell

= 0.1/ 0.7= 0.14

P(Oil)
P(Dry│FSS) = 1-0.5 =0.5 Oil
P(Dry│USS) =1-0.14 = 0.86 Drill

P(Dry)
Dry
No Survey

Sell
P(FSS│Oil) = 0,6 P(FSS|Oil) = P(FSS&Oil) / P(Oil)
P(USS│Oil) = 0,4
P(USS│Dry) = P(USS&dry) / P(dry)
P(FSS│Dry) = 0,2
P(USS│Dry) = 0,8
P(oil│FSS) = P(oil&FSS)/P(FSS)
= 0.15/0.3= 0.5
FSS USS Total P(oil│USS) = P(oil & USS)/ P(USS)

Oil 0.15 0.1 0.25 = 0.1/ 0.7= 0.14

Dry 0.15 0.6 0.75 P(Dry│FSS) = 1-0.5 =0.5

Total 0.3 0.7 1 P(Dry│USS) =1-0.14 = 0.86

P(USS&Oil)

P(FSS&Oil) = P(FSS|Oil)* P(Oil) = 0.6*0.25=0.15

P(USS&Dry) = P(USS|dry) * P(dry) =0.8*0.75=0.6

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Posterior Probability Formula

P(FSS|Oil) = P(FSS&Oil) / P(Oil)

P(FSS|Dry) = P(FSS&Dry) / P(Dry)
P(Oil|FSS) = P(Oil&FSS) / P(FSS)
P(Dry|FSS) = P(Dry&FSS) / P(FSS)
P(Oil|USS) = P(Oil&USS) / P(USS)
P(Dry|USS) = P(Dry&USS) / P(USS)
P(FSS&Oil) = P(Oil&FSS) → Law of Probability
Contingency table

P(FSS|Oil) = P(FSS& Oil) / P(Oil)

FSS USS Since :
P (Oil) = 0.25; P(FSS|Oil) = 0.6
Then
Oil 0.15 0.1 0.25 P(FSS & Oil) = P(FSS|Oil) x P(Oil)
= 0.6 X 0.25
= 0.15
Dry 0.15 0.6 0.75 Do same step for find P (FSS&Dry) = 0.15
So :
0.3 0.7 P(FSS) = P(FSS&Oil)+P(FSS&Dry)
= 0.3
Posterior Probability Formula (cont’d)

P(Oil|FSS) = P(Oil&FSS) / P(FSS)

Since : P(FSS) = 0.3; → from contigency table
P(Oil&FSS) = P(FSS&Oil) = 0.15
Then : P(Oil|FSS) = 0.15 / 0.3 = 0.5
Do same step for P(Oil|FSS); P(Dry|FSS);
P(Oil|USS); P(Dry|USS)
 Posterior Probability

• Given:
– P(state)=prior probability: P(oil) and P(dry)
– P(finding|state) = Max’s experience on probabilities of finding (FSS or USS) could
occur if some SoN (oil or dry) has been already happened.

P(FSS|oil) 0.25*0.6=0.15 0.15/0.3=0.5 P(oil|FSS)

Oil and FSS Oil, diket FSS
0.6 et Oil
dik P(Oil and FSS) P(state|finding)
FS S, Prob. posterior
US 0
P(oil) S, .4 P(Oil and USS)
dik
et O
25 il 0.25*0.4=0.1 0.1/0.7=0.14
P(oil|USS)
0. il P(USS|oil) Oil and USS Oil, diket USS
O

P(finding and state)

0.
Dr 75 P(FSS|dry) 0.75*0.2=0.15 0.15/0.3=0.5
P(dry|FSS)
y Dry and FSS Dry, diket FSS
0.2 t Dry P(Dry and FSS)
ke
P(dry) S , di
FS
US 0.
S, di 8 P(Dry and USS)
ket
Dry 0.75*0.8=0.6 0.6/0.7=0.86
P(USS|dry) Dry and USS Dry, diket USS
P(dry|USS)
Leveled Decision Analysis
Decision T ree for Goferbroke Co. Problem (With Survey)
0,143
Oil
P(Oil|USS)
P(USS) Drill 800 670
670

0,7
-100 -15,714 0,857
Dry P(Dry|USS)
Unfavorable -130
2 0 -130
0 60

Sell
60
90 60
Do Survey
0,5 P(Oil|FSS)
-30 123 Oil

P(FSS) Drill 800 670

670

-100 270 0,5 P(Dry|FSS)

0,3 Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

0,25
Oil P(Oil)
700
Drill 800 700

-100 100 0,75

Dry P(Dry)
No Survey -100
1 0 -100
0 100

Sell
90
90 90
 Exercise
Management of the Telemore Company is considering developing and
marketing a new product. It is estimated to be 66.67% that the product
would be successful. If it were successful, the expected profit would be
$1,500,000. If unsuccessful, the expected loss would be $1,800,000. A
marketing survey can be conducted as a cost of $100,000 to predict whether
the product would be successful. Past experience with such surveys
indicates if the survey shows favorable result, the product will be successful
80 percent of time. If the survey shows unfavorable result, the product will
be unsuccessful 70 percent of time. The probability that the marketing
survey show a favorable result is 50%.
• Develop a decision tree for the problem.
• Which is the best solution?
Decision Analysis:
Sensitivity Analysis

43
Sensitivity Analysis

The Study of how different

assumptions about future
(parameters) would affect the
recommended decision.
 Current Solution
Decision T ree for Goferbroke Co. Problem (With Survey)
0,143
Oil
670
Drill 800 670

-100 -15,714 0,857

0,7 Dry
Unfavorable -130
2 0 -130
0 60

Sell
60
90 60
Do Survey
0,5
-30 123 Oil
670
Drill 800 670

-100 270 0,5

0,3 Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

0,25
Oil
700
Drill 800 700

-100 100 0,75

Dry
No Survey -100
1 0 -100
0 100

Sell
90
90 90

Do survey, if USS then Sell, else Drill

Sensitivity Analysis Graph

• There are three Sensitivity Analysis tools that being

depicted in graph to help analyze Decision Tree
solution:
– Plot graph
– Spider graph
– Tornado graph
• All of these graphs are built by Sensit-Sensitivity
Analysis software.
Sensitivity Analysis Graph Tips

• Plot graph were sensitivity analysis tools that being

used to investigating the effect of prior probability of
finding oil on the expected payoff;
• Spider graph were sensitivity analysis tool that being
used to investigating how the expected payoff would
change if one of parameters changes (the cost or
revenues) by up to plus or minus 10%;
• Tornado diagram are being used to analyze different
parameters that had different degrees of variability
on the expected payoff.
 Sensitivity Analysis(1)
Decision T ree for Goferbroke Co. Problem (With Survey)
0,143
Oil
670
Drill 800 670

-100 -15,714 0,857

0,7 Dry
Unfavorable -130
2 0 -130
0 60

Sell
60
90 60
Do Survey
0,5
-30 123 Oil
670
Drill 800 670

-100 270 0,5

0,3 Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

0,25
Oil
700
Drill 800 700

-100 100 0,75

Dry
No Survey -100
1 0 -100
0 100

Sell
90
90 90

Effect of P(oil) and P(dry) on expected payoff

 Sensitivity Analysis(2)
Decision T ree for Goferbroke Co. Problem (With Survey)
0,143
Oil
670
Drill 800 670

-100 -15,714 0,857

0,7 Dry
Unfavorable -130
2 0 -130
0 60

Sell
60
90 60
Do Survey
0,5
-30 123 Oil
670
Drill 800 670

-100 270 0,5

0,3 Dry
Favorable -130
1 0 -130
0 270

1 Sell
123 60
90 60

0,25
Oil
700
Drill 800 700

-100 100 0,75

Dry
No Survey -100
1 0 -100
0 100

Sell
90
90 90

Effect of revenue and costs on expected payoff

Sensit-Sensitivity Analysis-Plot

SensIt - Sensitivity Analysis - Plot

700
0.168 0.308

Expected Payoff
600
500
400
300
200
100
0
0 0,2 0,4 0,6 0,8 1
Prior Probability Of Oil

Let p = prior probability of oil;

• If p ≤ 0.168, then sell the land (no seismic survey);
• If 0.169 ≤ p ≤ 0.308, then do the survey,
•drill if favorable and sell if not;
• If p ≥ 0.309, then drill for oil (no seismic survey)
Sensit-Sensitivity Analysis-Spider

Sensit - Sensitivity Analysis - Spider

Most Sensitive
136
134
132 Current Situation
130
Expected Payoff Value

128
126 Cost of Survey
124 Cost of Drilling
122 Revenue if Oil
120 Revenue if Sell

118
116
114
112
110
90% 92% 94% 96% 98% 100% 102% 104% 106% 108% 110%
% Change in Input Value

Conclusion : Payoff more influenced by Revenue if Oil variable than others.

Sensit-Sensitivity Analysis-Tornado
Sensit - Sensitivity Analysis - Tornado

Revenue if Oil 600 800 1000

Cost of Drilling 140 100 75

Revenue if Sell 85 90 95

Cost of Survey 32 30 28

90 100 110 120123 130 140 150 160

Expected Payoff

Conclusion : Although revenue if oil 25% reduced, but expected payoff still > $ 90,000
(Drill is robust)
THANK YOU