DECISION ANALYSIS

Decision analysis addresses the

issue of making the right decision
in the face of great uncertainty.
It provides a framework and
methodology for rational decision
making when the outcomes are
uncertain.
CASES
1. A manufacturer introducing a new
product into the market place.
Questions are:
• How much should be
produced?
• Should the product be test
marketed?
• How much advertising?
2. A financial firm investing in
securities:
• What are the market sectors
and individual securities with
the best prospects?
• Where is the economy
heading?
• How will interest rates behave?
• How should these factors affect
the investment decisions?
3. A government contractor
bidding on a new contract:
• What other companies are
bidding?
• What are there likely bids?
• What will be cost of the
project?
 4. An agricultural company selecting
the mix of crops:
• What will be the weather
conditions?
• Where are prices headed?
• What will costs be?
5. An oil company deciding to drill for
oil at a particular location:
• How likely is oil there?
• How much?
• How deep to drill?
• Should Geologists do further
investigation before drilling?
In all these cases the decision maker has
to answer his questions and arrive at the
right decision when the environment has
uncertainty. Decision analysis is used to
answer questions in these types of
scenarios.
Decision analysis is divided into
two types:
1. Decision making without
experimentation

2. Decision making with

experimentation
In the first case decision-
making is done immediately.

In the second case decision-

making is done after some
testing is done to reduce the
level of uncertainty.
Framework for decision analysis
1. The decision maker must choose an
action from a set of possible actions.
2. Different situations would be there
when the action is undertaken. Each
of these situations is called a state of
nature.
3. Each combination of action and state
of nature would give rise to some
monetary gain. These are known as
payoffs.
4. A payoff table is used to provide the
payoff for each combination.
5. The decision maker will also have
some information about the
likelihood of a state of nature
occurring. These are known as prior
probabilities.
Example
 An oil company ‘A’ owns a
tract of land that may contain
oil. A Geologist has told
management that there is 1
chance in 4 that it contain oil.
Another oil company has offered
to purchase the land for $90,000.
Company ‘A’ is considering
drilling for oil itself. The cost of
drilling is $100,000. Expected
revenue is $800,000, Expected
profit is $700,000. A loss of
$100,000 will be incurred if the
land contains no oil.
Profit Table
  PAYOFF

ALTERNATIVE OIL DRY

Drill for Oil $700,000 -$100,000

Sell the Land $90,000 $90,000

Chance 25% 75%

Payoff Table
  STATE OF NATURE

ALTERNATIVE OIL DRY

Drill for Oil 700 -100

Sell the Land 90 90
Prior Probability 0.25 0.75
 Decision Analysis without
experimentation has three criterions by
which to select the action to be
undertaken:
1. The maxmin payoff criterion
2. The maximum likelihood criterion
3. Bays decision rule
1. The Maximin Pay Off Criterion
For each possible action, find the
minimum payoff over all possible states
of nature. Find the maximum of these
minimums. Choose the action whose
minimum payoff gives this maximum.
State of Nature
ALTERNATIVE OIL DRY MINIMUM
Drill 700 -100 -100
Sell 90 90 90 maximum

Under this criterion for the example the

action to be taken is to sell the land.
2. Maximum Likelihood Criterion
Identify the most likely state
of nature (the one with the
largest prior probability). For
this state of nature, find the
action with the maximum
payoff. Choose this action:
  State of Nature

ALTERNATIVE OIL DRY MAXIMUM

Drill 700 -100  

Sell 90 90 Maximum

  0.25 0.75  

 
3. Bayes Decision Rule
Using the prior probability calculate
the expected value of the payoff for
each of the possible actions. Choose
the action with the maximum
expected payoff.
E [Payoff (Drill)]
= 0.25 (700) + 0.75 (-100) = 100
E [Payoff (Sell)]
= 0.25 (90) + 0.75 (90) = 90
  State Of Nature
ALTERNATIVE OIL DRY EXPECTED
PAYOFF
Drill 700 -100 100
Maximum
Sell 90 90 90
Prior Probability 0.25 0.75  
CLASS WORK
There are 3 courses of action
with 3 state of nature, as
follows:
  State Of Nature

Alternative Improving Stable Worsening

Economy Economy Economy

Conservative $30M $5M &10M

Investment

Speculative &40M $10M -$30M

Investment
Counter -$10M1 0 $15M
Cyclical 0.1 0.5 0.4

Which action should betaken under:

1. Maximum Payoff Criteria
2. Maximum Likelihood
3. Bayes Decision Rule
CLASS WORK
1. A manager of a Grocery store
needs to replenish her supply of
apples. Her regular supplier can
provide as many cases as she
wants. However, because these
apples already are very ripe, she
will need to sell them tomorrow
and discard any that remain
unsold. The manager estimates
that she will be able to sell 10, 11,
12 or 13 cases tomorrow. She can
purchase the apples for $3 per
cases and sell them for $8 per
case. The manager now needs to
decide how many cases to
purchase. The prior probabilities
are 0.2,0.4, 0.3 and 0.1 of being
able to sell 10, 11, 12 and 13
cases.
a. Develop a decision analysis
formulation of this problem
b. How many cases of apples should be
purchased under the maximin payoff
criterion?
c. How many cases should be purchased
according to the maximum likelihood
criterion?
d. How many cases should be purchased
according to bayes decision rule?
2. Consider a decision analysis problem
whose payoffs are:
ALTERNATIVE STATE OF NATURE
S1 S2
A1 80 25

A2 30 50
A3 60 40

Prior Probabilities 0.4 0.6

a. Which alternative should be
chosen under the maximum payoff
criterion
b. Which alternative should be
chosen under maximum likelihood
criterion
c. Which alternative should be
chosen under bayes decision rule
3. The following is a payoff table
for a decision analysis problem:
ALTERNATIVE STATE OF NATURE

S1 S2 S3

A1 220 170 110

A2 200 180 150

Prior 0.6 0.3 0.1

Probabilities
 a. Which alternative should be
chosen under the maxmin payoff
criterion?
b. Which alternative should be
chosen under the maximum
likelihood criterion?
c. Which alternative should be
chosen under bayes decision rule?
4. There is a manager of a large farm
with 1000 acres of arable land. For
greater efficiency, the manager
always devotes the farm to growing
one crop at a time. He now needs to
make a decision on which one of
four crops to grow. For each of
these crops, the manager has
obtained the following estimates of
crop yields and net incomes per
bushel under various weather
conditions.
Weather Crop 1 Crop 2 Crop 3 Crop 4

Dry 20 15 30 40

Moderate 35 20 25 40

Damp 40 30 25 40

Net income $1.00 $1.50 $1.00 $0.50

per bushel

The prior probabilities are 0.3,

0.5, 0.2 for dry, moderate, damp
weather
a. Develop a decision analysis
formulation of this problem.
b. Determine which crop to
grow using Bayes Decision
Decision analysis with experimentation
 

Many times additional testing can be done

to improve the prior probabilities of the
states of nature. These improved estimates
are called posterior probabilities.
Notations
 

n = Number of possible states of nature

 

P (State = State i) = Prior probability for

state of nature i
i = 1, 2,3 …. n.
 

Finding = Finding from experimentation or

testing
 

Finding j = One value of finding

P [State = State i | Finding = Finding j] = posterior
probability that, state of nature is i., given that
finding = finding j.
 

To obtain posterior probabilities we are given;

 

P (State = State i) and P (Finding = Finding j| State

= State i) .
For each I = 1, 2, 3, …………n the formula
for the posterior probability is
P(STATE = STATE i FINDING =
FINDING j)
P( FINDING  FINDINGj STATE  STATEi ) P( STATE  STATEi )
 n

 P( FINDING  FINDINGj STATE  STATEk ) P(STATE  STATEk )

k 1

Example:
 

For Oil Company ‘A’ there is an option of

carrying out extra testing or a detailed
seismic survey of the land. This will enable
the company to obtain an improved
estimate of oil. The cost of doing the
survey is $30, 000.
The findings from the survey can be
divided into two categories:
 

USS: Unfavorable Seismic Soundings, oil

is unlikely
FSS: Favorable Seismic Sounding, oil is
 

likely.
Based on past experience
 

P (USSSTATE = OIL) = 0.4

P (FSS STATE = OIL) = 0.6
P (USS STATE = DRY) = 0.8
P (FSS I STATE = DRY = 0.2
 

PRIOR PROBABILITIES
 

P (STATE=OIL) = 0.25, P (STATE =DRY) = 0.75

 

P (STATE = OIL FINDING = USS)

0.4(0.25)
  0.14
0.4(0.25)  0.8(0.75)

P (STATE = DRY FINDING = USS) =

0.8(0.25)
 0.86
0.4(0.25)  0.8(0.75)
P (STATE = OIL  FINDING = FSS) =
0.6(0.25)
 0.5
0.6(0.25)  0.2(0.75)
P (STATE = DRY  FINDING = FSS) =
0.2(0.75)
 0. 5
0.6(0.25)  0.2(0.75)
 We next apply Bayes Decision Rule to
obtain the expected payoffs
PROBABILITIES STATE
FINDING P (FINDING) OIL DRY
FSS 0.3 0.5 0.5
USS 0.7 0.14 0.86
All these calculations can be organized in a
Probability Tree Diagram
0.25(0.6) = 0.15 0.15/0.3 = 0.5
OIL & FSS OIL, GIVEN FSS

0.25(0.4) = 0.1 0.1/0.7 = 0.14

OIL & USS OIL, GIVEN USS

0.75(0.2) = 0.18 0.15/0.3 = 0.5

DRY & FSS DRY, GIVEN
FSS
0.75(0.8) = 0.6 0.6/0.7 = 0.86
DRY & USS DRY, GIVEN USS

Prior Conditional Probabilities Joint Probabilities Posterior Probabilities

Probabilities
  P (FINDINGSTATE) P (STATE AND FINDING) P(STATEFINDING)

After the calculations are done, Bayes

Decision Rule can be applied with the
posterior probabilities replacing the prior
probabilities
Payoff Table:
Alternative Oil Dry
1. Drill 700 - 100
2. Sell 90 90
USS 0.14 0.86
FSS 0.5 0.5
If finding is unfavourable:
 

E [Payoff (Drill)Finding = USS]

= 0.14(700) + 0.86(- 100) – 30 = - 18
E [Payoff (Sell)Finding = USS]
= 0.14(90) + 0.86(90) – 30 = 60
If finding is favourable:
 

E [Payoff (Drill)Finding = FSS]

= 0.5(700) + 0.5(-100) – 30 = 270
 

E [Payoff (Sell)Finding = FSS]

= 0.5(90) + 0.5(90) – 30 = 60
 Finding Action Expected
Payoff
USS Sell 60
FSS Drill 270
Class Work
For the oil company example a
consulting geologist has given more
precise estimates on the likelihood of
obtaining favorable seismic soundings.
Specifically when the land contains oil,
favorable seismic soundings are
obtained 80% of the time. When the
land is dry, favourable seismic
soundings are obtained 40% of the time.
1. What are the posterior probabilities,
show in a probability tree diagram?
Solution
= (0.25)(0.8)
1. 0.2 0.4
02/05
OIL & FSS OIL, GIVEN FSS

0.05 0.1
0.05/0.5
OIL & USS OIL, GIVEN USS

0.3 0.6
0.3/0.5
DRY & FSS DRY, GIVEN
FSS

0.45 0.9
0.45/0.5
DRY & USS DRY, GIVEN USS

2. The optimal policy is to do a

seismic survey and sell if it is
unfavourable and drill if it is
favourable.
Class Work – 2
The following Payoff Table is given
Alternative State of nature
S1 S2
A1 400 -100
A2 0 100
Price Prob. 0.4 0.6
 Can pay $100 to have research done to
better predict which state of nature will
occur. When the true state of nature is S1,
the research will accurately predict S1,
60% of the time, (but will inaccurately
predict S2, 40% of the time). When the
  true state of nature is S2, the research will
accurately predict S2, 80% of the time (but
will inaccurately predict S1 20% of the
time
 

Given that research is done, determine the

posterior probabilities of the states of
nature
1. P(S forand
eachS of
) the
= two
0.4 x cases.
0.6 = 0.24
1 1
P(S1 and S2) = 0.4 x 0.4 = 0.16
P(S2 and S1) = 0.5 x 0.2 = 0.12
P(S2 and S2) = 0.6 x 0.8 = 0.48
P(S1) = 0.24 + 0.12 = 0.36
 S1S1 0.24 0.24/0.26 = 0.677 P(S1 S1)
0.6 S1 & S1
0.4 0.16 0.16/0.64
S1 0.25 P(S1 S2)
S1 and S2
S2,S1 0.12 0.12/0.36
0.2 0.333 P(S2 S1)
S2 S2 & S1
0.48 0.48/0.64
S2, S2 0.8 0.75 P(S2 S2)
S2 and S2

Example
There is a manager of a fabric mill. He is
currently faced with the question of whether to
extend $100,000 credit to a new customer. He
has three categories for the credit-worthiness of
a company, poor risk, average risk, good risk.
He does not know which category this new
customer fits. Experience indicates that 20%
of companies similar to this dress manufacturer
are poor risks, 50% are average risks and 30%
are good risks. If credit is extended the
expected profit for poor risks is - $15,000 for
average risk $10,000 and $20,000 for good
risks.
The manager is able to consult a consult a
credit rating organization for a fee of
$5000 per company evaluated. For
companies whose actual credit record
with the mill turns out to fall into each of
the three categories, the following table
shows the percentages that were given,
each of the three possible credit
evaluations by the credit rating
organization.
Actual Credit Record
State
Credit Poor Average Good
Evaluation

Poor Finding 50% 40% 20%

Average 40% 50% 40%
Good 10% 10% 40%
a. Develop a decision analysis
formation of this programme
b. Assume the credit rating
organization is not used. Use
Bayes Decision Rule to
determine which decision
alternative should be chosen.

c. Assume now that the credit

rating organization is used.
Develop a probability Tree
Diagram to find the Posterior
Probabilities of the respective
states of nature. For each of the
three possible credit evaluations
of this potential customer.
 Solution
a.
State
Alternative Poor Average Good
Extend credit -15000 10000 20000
Do not extend 0 0 0
credit
Prior probabilities 0.2 0.5 0.3

b.
Alternative Poor Average Good
Extend credit -15000 10000 20000 8000
Do not 0 0 0 Maxi
extend credit mum
0
Prior 0.2 0.5 0.3
probabilities
Extend credit
(Expected payoff is
$8000
3.
PF = AF = GF =
Poor Average Good
Finding Finding Finding
     
PE = AS = GS =
Poor Average Good
State State State
0.1 0.28
PF, PS PS & PF PS PF
0.5
0.4 0.08 0.1778
AF, PS PS & AF PS AF
GF, PS 0.1 0.02 0.1053
0.2 PS PS & GF PS GF
0.02 0.5556
PF, AS AS & PF AS PF
0.4
0.5 0.5 0.25 0.5556
AS AF, AS AS & AF AS AF
0.1 0.05 0.2632
GF, AS
AS & GF AS GF
0.3 GS 0.1657
0.06
PF, GS
0. 2 GS & PF GS PF
0.4 0.12 0.2667
AF, GS GS & AF GS AF
GF, GS 0.4 0.12 0.6316
GS, GF GS GF
 DECISION TREES
Decision trees provide away of visually
displaying the decision analysis problem
Example
 

For the oil company ‘A’ problem the

decision tree is
Oil
Drill f
Dry
c
Unfavor

Sell Oil
b
Seismic Drill g
Favor Dry
d
a
Sell Oil
h
No Seismic Survey Drill
Dry
e
Sell
Sell

The nodes of the Decision Tree are referred

to as forks and the arcs are called branches.
Forks are of two types
1. Decision Fork – Represented by a
square, indicates a decision needs to be
made at that point in process
2. Chance Fork – Represented by a
circle, indicates that a random event
occurs at that point.
Path required to reach a terminal branch is
determined both by the decision made and
by random events. Oil (0.143)
670
Drill f 800
0 - 130
- 100 Dry (0.857)
Unfavor (0.7) c
90
Sell 60
Oil (0.5) 670
b 800
Seismic Drill g
0
- 30 - 100 - 130
Favor 0.3 Dry (0.5)
d
a Sell 90
60
Oil (0.25) 700
h 800
No Seismic Drill 0
- 100 - 100
e Dry (0.75)

90 90
Decision Tree after adding both
probabilities and pay offs.
Analysis
1. Start at the last column of the tree
and move left one column at a
time. For each column do either
step 2 or step 3 depending upon
whether the Fork is a Chance Fork
or a Decision Fork.

2. For each Chance Fork, calculate

the expected payoff of each branch
by the probability of that branch
and summing these products.
Record this payoff next to the
relevant Fork

3. For each Decision Fork, compare

the expected payoffs of its
branches and choose the alternative
whose branch has the largest
expected payoff, cut out each
rejected branch by inserting a
double dash.
Example
 

Consider oil company example with

Chance Fork f, g, h. Apply step 2.
 

For Fork f
 

EP = 0.143(670) + 0.857(-130) = -15.7

 

For Fork g
 

EP = 0.5(670) + 0.5(-130) = 270

 

For Fork h
 

EP = 0.25(700) + 0.75(-100) = 100

Moving one step to the left brings us to
Decision Forks c,d and e.
For Fork c
 

Drill Alternative has EP = - 15.7

Sell Alternative has EP = 60
60 > -15.7 so choose Sell Alternative
Fork d
 

Drill Alternative has EP = 270

Sell Alternative has EP = 60
2.70 > 60, so choose Drill Alternative
 

Fork e
 

Drill Alternative has EP = 100

Sell Alternative has EP = 90
100 > 90, so choose Drill Alternative
We move one more column to the left
 

For Fork b
 

EP = 0.7(60) + 0.3(270) = 123

Moving one column to the left
 

Fork a
 

Do Seismic Survey has EP = 123

No Seismic Survey has EP = 100
123 > 100, so choose Do Seismic Survey.
Final Tree Oil (0.143)
- 15.7
670
Drill f
0
60 - 100 Dry (0.857) - 130
Unfavor (0.7) c
90
123 Sell 60
270 Oil (0.5) 670
b
Seismic Drill g 800
0
- 30 100 - 100 Dry (0.5) - 130
Favor 0.3 d
a 270 90
60
Sell 100 Oil (0.25) 700
0
h 800
No Seismic Survey Drill 0
100 - 100 - 100
e Dry (0.75)
90
Sell 90
Class Work
0.4 2500
d 0.6
- 700
c
0.2

b 0.8 900

a 800

750

1. Do the analysis to obtain the final tree

Solution
0.4
25005
06
d
0.6
580
c - 700
0.2
900
b 900

a 820 0.8
800
820
750

Class Work 10

d
0
0.5
0.5
f
b
0.5
0.5 30

-10
a

-5
e
0.4 40

c 0.3
g

0.6 0.4

-10

1. Do the analysis 10
Solution 10

0.5 0.5
15 0

15 0.5
30
2.5
0.5
- 10

-5
8

0.3
40
5

8
5
0.7 - 10

10
Class work
 

On Monday a certain stock closed at $10

per share, on Tuesday you expect the stock
to close at $9, $10,$11 per share with
respective probabilities 0.3, 0.3 and 0.4 on
Wednesday, you expect the stock to close
10% lower, unchanged or 10% higher than
Tuesday’s close with the following
probabilities
 Tuesday’s 10% Unchanged 10%
Close lower higher

$9 0.4 0.3 0.3

$ 10 0.2 0.2 0.6
$ 11 0.1 0.2 0.7

On Tuesday, you are directed to buy 100

shares of the stock before Thursday. All
purchases are made at the end of the day,
at the known closing price of the day, so
your options are to buy at the end of
Tuesday or at the end of Wednesday.
You wish to determine the optimal
strategy for whether to buy on Tuesday
or defer the purchase until Wednesday to
minimize the expected purchase price.
1. Develop and analyze a decision free
for determining the optimal strategy.
Solution - 900

0.3 0.4
10% lower
- 810
0
0.3
- 891 Wait Unchanged - 900
Cl 0.3
os - 891 10% Higher - 990
e
at
$
9

Buy
- 1000

0.3 0.2
10% lower
- 900
Close at $ 10
0.2
- 1000 Wait Unchanged
- 1000
0.6
- 1040 10% Higher
- 1100

Cl
os
e
at
$
11 Buy
- 1000
0.1
0.4 10% lower
- 990
0.2
- 1100 Wait Unchanged
- 1100
0.7
- 1168 10% Higher
- 1210

The optimal policy is to wait until Wednesday If

the price is $ 9 on Tuesday. If the price is $10 or $
11 on Tuesday than buy on Tuesday