IIMT 2641 Introduction to Business Analytics

Module 1: Probability and Decision Analysis

Topic 2: Developing a New Product, Summer Job
Decision

1
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision

One-Stage Decision Analysis
Elements of decision analysis:
§ What alternative decisions are available?

§ What uncertain outcomes (states of nature) are possible, and

what are their probabilities?

§ What is the payoff (profit/revenue/loss/cost) corresponding to

each decision-outcome combination?

3
3
One-Stage Decision Analysis
For the upcoming launch of a new product, your company has to
decide how many to produce before the launch date. The
following payoff table describes the outcomes depending on
production quantity and market state:
Uncertain Outcomes Probability information
(States of Nature) not available

Production Hit Okay Flop

Quantity
5 million $600M $200M -$300M
Decisions
2 million -$100M $250M $100M

Is it better to produce 5
million or 2 million?
4
4
One-Stage Decision Analysis
Three criteria for making decisions under uncertainty:
Probability information not available

1. Maximax - choose the decision that has the best, best outcome
Produce 5 million
2. Maximin – choose the decision that has the best, worst outcome
Produce 2 million

3. Expected Monetary Value (EMV) – choose the decision that has

the best probability-weighted average outcome
Production Hit Okay Flop
Quantity
5 million $600M $200M -$300M
Decisions
2 million -$100M $250M $100M

5
5
One-Stage Decision Analysis
How to calculate the Expected Monetary Value (EMV) optimizing decision:
Probability information is available
Production Hit Okay Flop
Quantity
5 million $600M $200M -$300M
Decisions
2 million -$100M $250M $100M
Probability 0.3 0.5 0.2
Step 1: Calculate the EMV for all decisions
Expected Profit For 5 Million Production Decision:
600*(0.3) + 200*(0.5)+ -300*(0.2) = $220 Million
Expected Profit For 2 Million Production Decision:
-100*(0.3) + 250*(0.5)+ 100*(0.2) = $115 Million

Step 2: Compare and select decision with highest EMV.

Produce 5 million
6
6
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision

Summer job decision
§ Bill is a first-year MBA student at the HKU
§ He met Vanessa, an investment banker, on a flight in August before the
school began
§ Impressed by his background, Vanessa asked Bill to contact her in
November for a potential job opportunity for the next summer
§ When Bill quit his job before studying for his MBA, his former boss, John,
had promised him a job for the next summer
§ The summer salary would be $12,000, but the offer would expire by the end
of October
§ Questions:
– Should Bill accept John's summer job offer before he knows any details about
Vanessa's potential job offer?
– If Bill were to turn down John's offer and if Vanessa's potential job offer indeed
were to materialize, should he accept the job offer, or decline it and search for a
different summer job by participating in the corporate summer recruiting
program that HKU offers early next year?
8
Bill’s decision criterion
§ Assume Bill's only criterion on which to differentiate between summer jobs
is the summer salary
– He feels all summer job opportunities would offer him similar learning,
networking, and resumé-building experiences

9
Decision tree
§ A decision tree is a systematic way of organizing and representing the
various decisions and uncertainties that a decision-maker faces

§ There are two decisions that Bill needs to make

– Whether or not to accept John's summer job offer
– If he were to decline John's offer, and Vanessa's firm were to offer him a job in
November, he must then decide whether to accept Vanessa's offer or to instead
participate in the school's corporate summer recruiting program

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Decision tree
Accept John’s Offer

Reject John’s Offer

A

§ A decision is represented with a box that is called a decision node

§ Each possible choice is represented as a line called a branch that emanates
from the decision node
§ If he were to accept John's job offer, then there are no other decisions or
uncertainties Bill would need to consider
§ If he were to reject John's job offer, then Bill would face the uncertainty of
whether or not Vanessa's firm would subsequently offer Bill a summer job
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Decision tree
Accept John’s Offer

Reject John’s Offer Offer from Vanessa

A B

No Offer from Vanessa

§ An uncertain event is represented with a circle called an event node

§ Each possible outcome of the event is also represented as a branch
§ The outcome branches must represent a mutually
exclusive and collectively exhaustive set of possible events
§ At an event node, the decision-maker cannot select which branch to opt for

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Decision tree
Accept John’s Offer Accept Vanessa’s Offer

Reject John’s Offer Offer from Vanessa Reject Vanessa’s Offer

A B C

No Offer from Vanessa

§ If Vanessa's firm were to make Bill a job offer, then Bill would
subsequently have to decide to accept or to reject the firm's job offer
§ In this case, and if Bill were to accept the firm's job offer, then his summer
job problem would be resolved
§ If Bill were to instead reject their offer, then Bill would then have to search
for summer employment through the school's corporate summer recruiting
program
13
Assigning probabilities
§ Another aspect of constructing a decision tree is the assignment of the
probability that each of the various uncertain outcomes will occur
§ Bill has visited the career service center at HKU and learned that on
average, Vanessa's firm would make summer job offers of $14,000 for
MBA students
§ Bill has also gathered some data on the salary range for all summer jobs
that went to MBA students last year

Total Summer Pay Percentage of Students Who Received This Salary

$21600 5%
$16800 25%
$12000 40%
$6000 25%
$0 5%

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Decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$21600
25%
Offer from $16800
Reject John’s Reject Vanessa’s
Vanessa 40%
A Offer B C Offer E $12000
5% 25%
$6000
No Offer from $21600
Vanessa 25% 5%
$16800 $0
40%
D $12000
25%
$6000
5% $0

§ Bill believes the likelihood that he would receive the indicated salaries if he
were to participate in the school's corporate summer recruiting is the similar
to other MBA students last year
§ An end node (a triangle) indicates that the no further decisions or uncertain
15 events would emanate from there
Decision tree
Accept John’s Offer Accept Vanessa’s Offer
5%
$21600
25%
Reject Offer from Reject Vanessa’s $16800
John’s Offer Vanessa Offer 40%
A B C E $12000
60% 25%
5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
25%
$6000
5% $0

§ Bill needs to estimate the likelihood that Vanessa's firm will offer him a job
§ On reflection, he believes Vanessa was very impressed with him, and she sounded
certain that she wanted to hire him
§ However, the competition for investment banking jobs is very intense, and many of
Bill's classmates are equally talented
16
§ Bill assigns the probability of receives a job offer from Vanessa's firm to be 60%
Decision tree
Accept John’s Offer Accept Vanessa’s Offer
5%
$12000 $14000 $21600
25%
Reject Offer from Reject Vanessa’s $16800
John’s Offer Vanessa Offer 40%
A B C E $12000
60% 25%
5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
25%
$6000
5% $0

The next step in the decision analysis modelling methodology is to assign numerical
values to the outcomes associated with the end nodes, based on the decision criterion
that has been adopted

Bill's decision criterion is his summer salary

17
Key characteristics of a decision tree
§ Time in a decision tree flows from left to right, and the placement of the
decision nodes and the event nodes is logically consistent with the way
events will play out in reality
– Any event or decision that must logically precede certain other events and
decisions is appropriately placed in the tree to reflect this logical dependence
§ The branches emanating from each decision node represent all of the
possible decisions under consideration at that point in time under the
appropriate circumstances
§ The branches emanating from each event node represent a set of mutually
exclusive and collectively exhaustive outcomes of the event node
§ The sum of the probabilities of each outcome branch emanating from a
given event node must sum to one
§ Each and every "final" branch of the decision tree has a numerical value
associated with it. This numerical value usually represents some measure of
monetary value, such as salary, revenue, cost, etc.

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Expected monetary value (EMV)
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from Reject Vanessa’s $16800
John’s Offer Vanessa Offer 40%
A B C E $12000
60% 25%
5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
25%
$6000
5% $0

§ At node C of the decision tree, how would he decide between obtaining a summer
salary of $14,000 with certainty, and the distribution of possible salaries he might
obtain from participating in the school's corporate summer recruiting?
§ A common criterion in this setting is to convert the distribution of possible salaries
to a single numerical value using the EMV of the possible outcomes
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Expected monetary value (EMV)
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from Reject Vanessa’s $16800
John’s Offer Vanessa $11580 40%
A B C Offer E $12000
60% 25%
5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
25%
$6000
5% $0
§ The EMV of an uncertain event is the weighted average of all possible numerical
outcomes, with the probabilities of each of the possible outcomes used as the
weights
– The EMV of participating in corporate summer recruiting is:

EMV=0.05×21.6+0.25×16.8+0.40×12+0.25×6+0.05×0=11.58 (thousand $)
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Expected monetary value (EMV)
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from Reject Vanessa’s $16800
John’s Offer $11580 40%
Vanessa Offer
A B C E $12000
60% 25%
5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
25%
$6000
5% $0
§ The EMV of a certain event is defined to be the monetary value of the event
– Suppose that Bill were to receive a job offer from Vanessa's firm, and that he
were to accept the job offer
– The EMV of this choice would simply be $14,000

21
Folding back the decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from Reject Vanessa’s $16800
John’s Offer $11580 40%
Vanessa Offer
A B C E $12000
60% 25%
5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
25%
$6000
5% $0

§ Begin with the end nodes of the tree, and then work "backwards" to the
starting node
– Evaluate each event node using the EMV of the event node
– Evaluate each decision node by choosing that decision which has the best EMV

22
Folding back the decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from $16800
$13032 $14000 Reject Vanessa’s
$11580
John’s Offer Vanessa Offer 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
$11580 25%
$6000
5% $0

§ The EMV of node D is the same as node E

§ Node C is a decision node, having two choices
– Choice 1 has an EMV of $14,000 and choice 2 has an EMV of $11,580
– The EMV of node C is $14,000
§ Node B is an event node, so its EMV is
23 0.6×$14,000+0.4×$11,580=$13,032
Folding back the decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from $16800
$13032 $14000 Reject Vanessa’s
$11580
John’s Offer Vanessa Offer 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
$11580 25%
$6000
5% $0

§ Remove the inferior choice at each decision node by crossing off the branch

§ The solution of the decision tree is a decision strategy, which states what decisions
should be made under each possible uncertain outcome that might prevail

24
Bill's optimal decision strategy
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
25%
Reject Offer from $16800
$13032 $14000 Reject Vanessa’s
$11580
John’s Offer Vanessa Offer 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from $21600
25% 5%
Vanessa $16800 $0
40%
40%
D $12000
$11580 25%
$6000
5% $0

§ Bill should reject John's offer in October

§ If Vanessa's firm offers him a job, he should accept it
§ If Vanessa's firm does not offer him a summer job, he should participate in the
school's corporate summer recruiting
§ The EMV of this strategy is $13,032 (Node A)
25
Procedure for solving a decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s $16800
Offer $13032 Vanessa $14000 Offer $11580 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from $21600
Vanessa 25% 5%
$16800 $0
40%
40%
D $12000
$11580 25%
$6000
5% $0
§ Start with the end nodes of the decision tree, and evaluate each event node and each
decision node
– For an event node, compute the EMV of the node by computing the weighted
average of the EMV of each branch weighted by its probability
– For a decision node, compute the EMV of the node by choosing that branch
emanating from the node with the best EMV value
§ The decision tree is solved when all nodes have been evaluated
§ The EMV of the optimal decision strategy is the EMV computed for the starting
26
branch of the tree
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision

New Product "Suds-Away"
§ Caroline is the marketing manager for a company that is considering
whether to produce a new automatic dishwashing detergent called "Suds-
Away"

§ The market for Suds-Away will either be weak or strong

– If the market is strong, the company will make $18 million on Suds-Away
– If the market is weak, the company will lose $8 million

§ Caroline has estimated that there is a 30% chance that the market will be
strong

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Market survey test
§ Prior to deciding whether or not to produce Suds-Away, Caroline can
conduct a nationwide market survey test of Suds-Away with cost $2.4
million

§ Such market survey tests cannot predict the market for new products with
certainty
– If the market is weak, there is a 10% chance that the test will be positive
– If the market is strong, there is a 20% chance that the test will be negative

29
Caroline's decisions
§ Should the company not produce Suds-Away?

§ Or should it go ahead with production without conducting such a market

survey test?

§ Or should it conduct the market survey test first (with additional cost) and
then decide whether or not to produce?

30
Decision Tree

Do not produce
0

Strong 0.3
$18 Million
No Survey, Produce
A B
Weak 0.7
-$8 Million

Conduct Market
Survey Test
C

32
Decision Tree
PMarketi Positin p() =

Do not produce $15.6 Million

0 Strong

!# =?
Strong 0.3 E
$18 Million
A No Survey, Produce B !$ =?
Weak 0.7 Weak
-$8 Million -$10.4 Million
Produce
Conduct Market
Survey Test Positive survey results
C D -$2.4 Million
!! =? Do not produce
0 : 31

$15.6 Million
Strong
!" =? !% =?

Negative survey results G

Produce !& =?
Weak
-$10.4 Million
F

Do not produce
33 -$2.4 Million
Decision contingent on the survey results
§ After she receives the market survey results, Caroline will need to decide
whether or not to produce Suds-Away: node D and node F (decision node
and branches)
§ The accuracy of the survey and the potential revenue implications of the
state of the market for Suds-Away makes this seemingly obvious decision
non-trivial

§ Suppose that the market survey test outcome is positive and that Caroline
decides to produce Suds-Away
§ Even though the market survey test is positive in this case, there is still the
possibility that the test will misread the market and that the market for
Suds-Away might be weak rather than strong
§ Hence, we must place an event node (chances branch), node E, after
Caroline's decision to produce Suds-Away

34
Assigning probabilities
§ For node B, without taking the market survey, Caroline knows from her
experience that there is a 30% chance that the market for Suds-Away will
be strong and a 70% chance that the market will be weak

§ However, it is a bit of difficult to determine the probabilities for the other

branches
– E.g., What values are !! and !" for the branches emanating from node C?

§ We will derive the unknown probabilities based on probability theory we

learned

35
 A
0 2)x0 3

P(S(Q)
. .

= -
=

(1 -

0 2)x0 ) + P(QIN) .
PCW)
Probability table
.
.

-0
=

07 ,

§ S: "the market for Suds-Away is strong”

=
-

§ W: "the market for Suds-Away is weak”

§ Q: "the market survey test results are positive"
P(Q) 0 3/
=
.

§ N: "the market survey test results are negative”

§ The information we have:
– There is a 30% chance that the market will be strong
– If the market is weak, there is a 10% chance that the test will be positive
– If the market is strong, there is a 20% chance that the test will be negative
! " = 0.3, ! ( ) = 0.1, +,- ! / " = 0.2

Market is Market is Weak

Total
Strong (S) (W)
Market Test is
? ? ?
Positive
Market Test is ? ?
?
Negative

36 Total 0.3 0.7 1.00

The missing probabilities in the decision tree
§ !! is simply the probability that the
outcome of the market survey is
positive

§ !" is simply the probability that the

outcome of the market survey is
negative

§ !# is the probability that the market is

strong, given that the survey results are
positive

37
Probability table (Continued)
§ ! ( ) = 0.1 implies that ! / ) = 1 − ! ( ) = 0.9
§ ! / " = 0.2 implies that ! ( " = 1 − ! / " = 0.8
§ Apply the multiplication rule:
– ! $ ∩ & = ! $ & ⋅ ! & = 0.1 ⋅ 0.7 = 0.07
– ! , ∩ & = ! , & ⋅ ! & = 0.9 ⋅ 0.7 = 0.63
– ! $ ∩ 0 = ! $ 0 ⋅ ! 0 = 0.8 ⋅ 0.3 = 0.24
– ! , ∩ 0 = ! , 0 ⋅ ! 0 = 0.2 ⋅ 0.3 = 0.06

Market is Market is Weak

Total
Strong (S) (W)
Market Test is
0.24 0.07 ?
Positive
Market Test is 0.06 0.63
?
Negative

Total 0.3 0.7 1.00

38
The missing probabilities in the decision tree
§ !! is simply the probability that the
outcome of the market survey is
positive
– ! ( =! (∩" +! (∩) =
0.24 + 0.07 = 0.31

§ !" is simply the probability that the

outcome of the market survey is
negative
– ! / = 1 − ! ( = 0.69

§ !# is the probability that the market is

strong, given that the survey results are
positive
'()∩+) -."$
– ! 0|$ = '(+)
= -.#!

39
The missing probabilities in the decision tree
§ Likewise, we can compute !$ . !% , !&
using the third law of probability
!(& ∩ $) 0.07
!$ = ! & $ = =
!($) 0.31

!(0 ∩ ,) 0.06
!% = ! 0 , = =
!(,) 0.69

!(& ∩ ,) 0.63
!& = ! & , = =
!(,) 0.69

40
Making decisions
§ Given the probabilities, we can now solve the decision tree using the folding-back
procedure
– Start with the end nodes of the decision tree, and evaluate each event node and
each decision node
q For an event node, compute the EMV of the node by computing the weighted
average of the EMV of each branch weighted by its probability
q For a decision node, compute the EMV of the node by choosing that branch
emanating from the node with the best EMV value
– The decision tree is solved when all nodes have been evaluated
– The EMV of the optimal decision strategy is the EMV computed for the starting
branch of the tree

41
 E = 24(31 x 15 .

6 +
/31 x (10 4/
.

Decision Tree
Do not produce $15.6 Million
0 Strong

②
24/31
Strong 0.3 E
$18 Million
A No Survey, Produce B 7/31
Weak 0.7 Weak
-$8 Million -$10.4 Million
Produce
Conduct Market

⑤ ⑳
Survey Test Positive survey results
C D -$2.4 Million
31% Do not produce

$15.6 Million

O
69% Strong
2/23
Negative survey results G
Produce 21/23
Weak
-$10.4 Million
F

Do not produce
42 -$2.4 Million
Caroline’s optimal decision strategy

§ Caroline should conduct the market survey test?

§ If the survey results are positive, she should decide to produce the new
product

§ If the survey results are negative, she should decide not to produce the new
product

§ The EMV of the optimal strategy is ?

43
Decision Tree

X
Do not produce
0
$9.73 Million
Strong
$15.6 Million

36] 24/31
max 10 -0 2
, 1 .

CE
.

,
-$0.2 Million Strong 0.3
$18 Million
O
A X
No Survey, Produce B
Weak 0.7
-$8 Million
Weak
7/31
-$10.4 Million
Produce

Va maxi
Conduct Market
Survey Test Positive survey results
C D -$2.4 Million
31% Do not produce
$1.36 Million $9.73 Million
31 x9 73 + 69
% % x72 4)
-
.

$15.6 Million
69% Strong -

-$8.14 Million 2/23

-
Negative survey results G
Produce 21/23

max 4
,2 Weak
-$10.4 Million
.

-
-$2.4 Million F

6
Do not produce
44 -$2.4 Million
Caroline’s optimal decision strategy

§ Caroline should conduct the market survey test?

§ If the survey results are positive, she should decide to produce the new
product
– The EMV of the this decision is $9.73 million

§ If the survey results are negative, she should decide not to produce the new
product
– The EMV of this decision is -$2.4 million

§ The EMV of the above strategy is $1.36 million

45
Decision Tree
Do not produce $15.6 Million
0 Strong
77.4%
Strong 0.3 E
$18 Million
A No Survey, Produce B 22.6%
Weak 0.7 Weak
-$8 Million -$10.4 Million
Produce
Conduct Market
Survey Test Positive survey results
C D -$2.4 Million
31% Do not produce

$15.6 Million
69% Strong
8.7%
Negative survey results G
Produce 91.3%
Weak
-$10.4 Million
F

Do not produce
46 -$2.4 Million
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision

Summer Job - decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60% L
-

$13032 5% 25%
$6000
No Offer from Vanessa $21600
25% 5%
$16800 $0
40%
40%
D $12000
25%
-
C
$11580
$6000
5% $0

48
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

49
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

3. The distribution of summer salaries that Bill could expect to receive was assumed to
be the same as the MBA students last year
How might changes in this distribution of salaries affect the optimal decision strategy?

50
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

3. The distribution of summer salaries that Bill could expect to receive was assumed to
be the same as the MBA students last year
How might changes in this distribution of salaries affect the optimal decision strategy?

The process of testing and evaluating how the solution to a decision tree behaves in the
presence of changes in the data is referred to as sensitivity analysis

51
Using Excel spreadsheet for sensitivity analysis

§ In order to evaluate how the optimal decision strategy behaves as a function

of changes in the data assumptions, we will have to solve and re-solve the
decision tree model many times, each time with slightly different values of
certain data
§ This approach is tedious and can be expedited with the help of Excel

§ The data for the decision tree is given in the upper part of the spreadsheet
§ The "solution" is computed in the lower part in the "EMV of Nodes" table
– The computation of the EMV of each node is performed automatically as a
function of the data

52
 Data

Using Excel spreadsheet for sensitivity analysis

Data

§ EMV of node D (and node E) can be computed using Excel function SUMPRODUCT
§ EMV of node C = MAX(EMV of node E, 14000)
§ EMV of node B = 0.6 × (EMV of node C) + (1 - 0.6) × (EMV of node D)
§ EMV of node A = MAX(EMV of node B, 12000)

53
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

54
Summer Job - decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60% 25%
$13032 5% $6000
No Offer from Vanessa p $21600
25% 5%
$16800 $0
40%
40%
D $12000
$11580 25%
$6000
5% $0

P X /4000 + (1-p) X /1580 =

12000

solve the threshold for p.

55
Sensitivity relative to key data issue 1
Data

§ Denote the probability that Vanessa's firm will offer Bill a summer job by p
§ Vary the value of p to see when the optimal strategy changes

56
Sensitivity relative to key data issue 1
Data

§ EMVs of node A and node B remain equal to each other while we reduce p from 60%
to 18%
§ EMV of node A being equal to EMV of node B means the optimal decision is to reject
John's offer

57
Sensitivity relative to key data issue 1
Data

§ EMV of node A becomes to be greater than EMV of node B for p is 17%

§ This means the optimal decision is to accept John's offer
§ Hence, as long as p ≥ 18%, then the optimal decision strategy will still be to reject
John's offer and to accept a summer job with Vanessa's firm if they offer it to him
– This is reassuring, as Bill is very confident that the probability of Vanessa's firm
offering him a summer job is surely greater than 18%
58
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

59
Summer Job - decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60% 25% -c
$13032 5% $6000
No Offer from Vanessa $21600
25% 5%
$16800 $0
40%
40%
D $12000
-c
$11580 25%
$6000
5% $0
12000 = 60%
% x 14000 + 0 .
4x (11580 -

Solve the threshold for c.

60
Sensitivity relative to key data issue 2
Data

§ Denote implicit cost to Bill of participating in the school's corporate summer

recruiting program by c
§ Vary the value of c to see when the optimal strategy changes

61
Sensitivity relative to key data issue 2
Data

§ The cost c should now be subtracted from the previous EMV of node D
EMV of node D = 0.05×21600 + 0.25×16800 + 0.4×12000 + 0.25×6000 + 0.05×0 − c
§ EMV of node E is treated in the same way
§ EMVs of node A and node B are equal for c ≤ 2580

62
Sensitivity relative to key data issue 2
Data

§ EMV of node A becomes to be greater than EMV of node B for c ≥ 2581

§ Hence, as long as c ≤ 2580, then the optimal decision strategy will still be to reject
John's offer and to accept a summer job with Vanessa's firm if they offer it to him
– This is reassuring, as the implicit cost to Bill of participating in the school's corporate
summer recruiting program is much less than $2,580

63
Sensitivity analysis of the optimal decision
One must be careful about the key data assumptions
1. The probability that Vanessa's firm would offer Bill a summer job was assumed to
be 60%
How would changes in this probability might affect the optimal decision strategy?

2. The cost of Bill's time and effort in participating in the school's corporate summer
recruiting was assumed to be zero
How high would this implicit cost have to be before the optimal decision strategy would
change?

3. The distribution of summer salaries that Bill could expect to receive was assumed to
be the same as the MBA students last year
How might changes in this distribution of salaries affect the optimal decision strategy?

The process of testing and evaluating how the solution to a decision tree behaves in the
presence of changes in the data is referred to as sensitivity analysis

64
Summer Job - decision tree
Accept John’s Offer Accept Vanessa’s Offer 5%
$12000 $14000 $21600
Reject John’s 25%
Offer from Reject Vanessa’s Offer $16800
Offer $13032 Vanessa $14000 $11580 40%
A B C E $12000
60%
5% 25% +S
$13032 $6000
No Offer from Vanessa $21600
25% 5%
$16800 $0
40%
40%
D $12000
+S
$11580 25%
$6000
5% $0

5 + 11580 = 14000 .

Threshold for S
.

65
Sensitivity relative to key data issue 3
Data

§ Suppose we modify all of the possible salary offers by an amount S

§ Vary the value of S to see when the optimal strategy changes

66
Sensitivity relative to key data issue 3
Data

§ Each possible summer salary is added by S

§ Recall that EMV of node C = MAX(EMV of node E, 14000)
§ EMV of node C is equal to 14,000 for S ≤ 2420
§ EMV of node C being equal to 14000 means that Bill should accept an offer from
Vanessa's firm if it materialized
67
Sensitivity relative to key data issue 3
Data

§ EMV of node C becomes to be greater than $14,000 for S ≥ 2421

§ This means Bill should reject an offer from Vanessa's firm if it materialized
§ Hence, as long as S ≤ 2420, then the optimal decision strategy will still be to accept an
offer from Vanessa's firm if it materialized
– This is reassuring, as summer salaries from corporate summer recruiting in general would
not increase by $2,421 within a year

68
Summary of sensitivity analysis
§ We have explored three data issues
– The probability p of Vanessa's firm offering Bill a summer job
– The implicit cost c of participating in corporate summer recruiting
– An increase S in all possible salary values from corporate summer recruiting

§ We have found that the optimal decision strategy does not change unless the
three quantities take on unreasonable values

§ Hence, it is safe to proceed with confidence in recommending to Bill that he

adopt the optimal decision strategy found in the solution to the decision tree
model
– He should reject John's job offer, and he should accept a job offer from Vanessa's
firm if such an offer is made

69
Principal steps of decision analysis
1. Structure the decision problem
– List all of the decisions that have to be made
– List all of the uncertain events in the problem and all of their possible outcomes
2. Construct the basic decision tree by placing the decision nodes and the event nodes in
their chronological and logically consistent order
3. Determine the probability of each possible outcome of each uncertain event
4. Determine the numerical values of each end node of the decision tree
5. Solve the decision tree using the folding-back procedure
– Start with the end nodes of the decision tree, and evaluate each event node and
each decision node
– The decision tree is solved when all nodes have been evaluated
– The EMV of the optimal decision strategy is the EMV computed for the starting
branch of the tree
6. Perform sensitivity analysis on all key data values
– For each data value for which the decision-maker lacks confidence, test how the
optimal decision strategy will change relative to a change in the data value, one
data value at a time
70
Today’s Objectives
1. Use probabilities to determine optimal decisions under
uncertainty (based on expected value criterion) .

2. Set up and solve decision trees - Summer Job Decision

3. Developing a new product case

4. Sensitivity analysis – revisit Summer Job Decision