IIMT 2641 Introduction to Business Analytics

Module 1: Probability & Decision Analysis

Topic 2: Decision Analysis

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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

2
The Science of Decision Making
▪ Making a decision is basically making a choice.
– Whether to pursue a graduate study
– Whether to buy a stock and how much money to invest
– Whether to expand the product line and how to expand

▪ Six Steps in Decision Making

– Clearly define the problem (Goal to achieve)
– List the possible alternatives
– Identify the possible outcomes or states of nature
– List the payoff of each alternative in each state of nature
– Select one of the decision theory models
– Apply the model and make your decision

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Thompson Lumber Company

▪ John Thompson, the founder and president, needs to

make the decision on whether to expand his product
line by manufacturing and marketing a new product.
▪ First step: define the problem

STATE OF NATURE

FAVORABLE MARKET UNFAVORABLE MARKET

ALTERNATIVE (profit in $) (profit in $)

Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000
Do nothing 0 0

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Thompson Lumber Company
▪ List all possible alternatives
– Defined as a course of action or strategy that decision maker can choose.
– E.g. (1) large plant (2) small plant (3) no plant
▪ Identify possible outcomes/states of nature
– E.g. Market could be (a) favorable (b) unfavorable for the new product
▪ List the payoff
– Conditional values

STATE OF NATURE
STATE OF NATURE Expected
FAVORABLE MARKET UNFAVORABLEMonetary MARKET
ALTERNATIVE (profit
FAVORABLE MARKET in $) UNFAVORABLE (profit in $) Value
ALTERNATIVE (profit in $) MARKET (profit in $) (EMV, $)
Construct a large plant 200,000 –180,000
Construct a large
Construct plantplant
a small 200,000100,000 –180,000 –20,000 –9,000
Construct a small plant
Do nothing 100,000 0 –20,000 34,000
0
Do nothing 0 0 0
Probability 0.45 0.55

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Types of Decision-Making Environments
▪ Decision making under certainty
– The decision maker knows with certainty the consequences of every alternative
or decision choice.
– E.g. saving accounts/government bond with fixed interest

▪ Decision making under risk

– There are several possible outcomes for each alternative, and decision maker
knows the probabilities of each outcome.

▪ Decision making under uncertainty

– There are several possible outcomes for each alternative, and decision maker
does not know the probabilities of the various outcomes.

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Decision Making under Risk

STATE OF NATURE Expected

Monetary
FAVORABLE MARKET UNFAVORABLE Value
ALTERNATIVE (profit in $) MARKET (profit in $) (EMV, $)

Construct a large plant 200,000 –180,000 –9,000

Construct a small plant 100,000 –20,000 34,000
Do nothing 0 0 0
Probability 0.45 0.55

Expected Monetary Value (EMV) – EMV is the weighted sum

of possible payoffs for each alternative
If John maximize the EMV, then he should choose to construct
a small plant.

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Decision Making under Risk
▪ Scientific Marketing, Inc. offers analysis that will provide certainty about
market conditions. S.M. would charge $65,000 for the information. Should
John buy the information?

▪ To make this decision, John has to evaluate the expected value of perfect
information (EVPI) by computing the expected value with perfect
information (EVwPI) and the best EMV under risk.

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Decision Making under Risk
▪ EVwPI = σ best payoff in state 𝑖 ∙ probability of state 𝑖
▪ EVPI = expected value of perfect information
▪ EVPI = expected value with perfect information (EVwPI) – expected value
without perfect information (i.e. best EMV).

STATE OF NATURE Expected

Monetary
FAVORABLE MARKET UNFAVORABLE Value
ALTERNATIVE (profit in $) MARKET (profit in $) (EMV, $)

Construct a large plant 200,000 –180,000 –9,000

Construct a small plant 100,000 –20,000 34,000
Do nothing 0 0 0
Best payoff 200,000 0 90,000
Probability 0.45 0.55

EVPI = EVwPI – Best EMV

= $90,000 – $34,000 = $56,000 < $65,000. Don’t buy!

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Decision Making under Risk

▪ To minimize expected opportunity loss (EOL)

STATE OF NATURE Expected

Monetary
FAVORABLE MktMARKET(Opp. UNFAVORABLE
UNFAVORABLE Mkt EOL
Value
ALTERNATIVE Loss inin$)$)
(profit (Opp. Loss
MARKET in $)
(profit in $) (in $)
(EMV,

Construct a large plant 0

200,000 180,000
–180,000 99,000
–9,000
Construct a small plant 100,000 20,000
–20,000 56,000
34,000
Do nothing 200,000
0 0 90,0000
Probability 0.45 0.55

▪ Minimizing EOL always results in the same decision as maximizing EMV.

▪ The minimum EOL always equal the EVPI.

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Decision Making under Risk

Favorable Market VwPI Unfavorable Market

OL2
OL
3 VwPI
MV1
OL2
MV2 OL1 MV3
MV3
MV2
MV1
Optio Optio Option Optio Optio Option
n1 n2 3 n1 n2 3

EVwPI
EOL EOL EOL
1 2 3

EMV EMV EMV

1 2 3
Option 1 Option 2 Option 3

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In-class Exercise: Café du Donut
▪ The Café buys donuts each day for $40 per carton of 20 dozen donuts. Any cartons
not sold are thrown away at the end of the day. If a carton is sold, the total revenue
is $60.

DAILY PROBABILITY CUMULATIVE

DEMAND PROBABILITY
• The original plan is (CARTONS)
4 0.05 0.05
to order 6 cartons
5 0.15 0.2
per day. Should the 6 0.15 0.35
Café increase the 7 0.20 0.55
order size to 7? 8 0.25 0.8
9 0.10 0.9
10 0.10 1.0
Total 1.00

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In-class Exercise: Café du Donut
▪ Monetary Payoff (Profit) Table

DD==44 D D
==5 5 D =D6= 6 D = D
7 = 7D = 8D = D
8 = 9 D =D9= 10D EMV
= 10 EMV
EOL
Q=6 0 60 120 120 120 120 120 105
Q=7 -40 20 80 140 140 140 140 104
Prob. 0.05
0.05 0.15
0.15 0.15
0.15 0.200.20 0.25 0.250.10 0.10
0.10 0.10

• Should we reduce the order size from 6 to 5? What is the EMV

of Q=5?
• No.

• If we can only choose between 6 and 7, what is the EVPI?

• EOL(6) = 0 + 20(0.65) = 13

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Decision Making under Risk
▪ If the estimation of probability is changed, how will John change his decision?
▪ A sensitivity analysis is needed!

STATE OF NATURE

FAVORABLE UNFAVORABLE EMV

ALTERNATIVE MARKET (profit in $) MARKET (profit in $) (in $1,000)

Construct a large plant 200,000 –180,000 380p – 180

Construct a small plant 100,000 –20,000 120p – 20
Do nothing 0 0 0
Probability p 1–p

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Decision Making under Risk

EMV

$300,000

$200,000 EMV (large plant)

Point 2 380,000p-180,000

$100,000 EMV (small plant)

Point 1 120,000p-20,000

0 EMV (do nothing)

0
.167 .615 1
–$100,000 Values of p

–$200,000

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Results of Sensitivity Analysis

BEST ALTERNATIVE RANGE OF P VALUES

Construct a large plant >0.615

Construct a small plant 0.167 - 0.615

Do nothing <0.167

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In-class Exercises
▪ The Monty Hall Problem Revisited
– Suppose you're on a game show, and you're given the choice of three doors: Behind one door is
a car; behind the others, goats. You pick a door, say No. 1, and the host, who knows what's
behind the doors, opens another door, say No. 3, which has a goat. He then says to you, "Do
you want to pick door No. 2?" Is it to your advantage to switch your choice?

Given door 1 is Car behind Car behind Car behind Expected

chosen door 1 door 2 door 3 Value
Switch 0 1 1 2/3
Do not switch 1 0 0 1/3
Probability 1/3 1/3 1/3

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Decision Making under Uncertainty
What if we do not know the probabilities?

▪ Maximax (optimistic)
▪ Maximin (pessimistic)
▪ Criterion of realism (Hurwicz)
▪ Minimax regret

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Decision Making under Uncertainty
▪ Maximax (optimistic)

STATE OF NATURE

FAVORABLE UNFAVORABLE MAXIMUM IN A

ALTERNATIVE MARKET ($) MARKET ($) ROW ($)
Construct a large plant 200,000 –180,000 200,000

Construct a small plant 100,000 –20,000 100,000

Do nothing 0 0 0

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Decision Making under Uncertainty
▪ Maximin (pessimistic)

STATE OF NATURE

FAVORABLE UNFAVORABLE MINIMUM IN A

ALTERNATIVE MARKET ($) MARKET ($) ROW ($)
Construct a large plant 200,000 –180,000 –180,000

Construct a small plant 100,000 –20,000 –20,000

Do nothing 0 0 0

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Decision Making under Uncertainty
▪ Criterion of realism (Hurwicz)
– Select a coefficient of realism α, with 0 ≤ α ≤ 1.
– Weighted average = α(best in row) + (1 – α)(worst in row).

STATE OF NATURE WEIGHTED

AVERAGE
FAVORABLE UNFAVORABLE WITH α = 0.8 ($)
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000 124,000

Construct a small plant 100,000 –20,000 76,000

Do nothing 0 0 0

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Decision Making under Uncertainty
▪ Minimax regret
– Based on opportunity loss or regret.

STATE OF NATURE

FAVORABLE UNFAVORABLE MAXIMUM IN A

ALTERNATIVE MARKET ($) MARKET ($) ROW ($)
Construct a large plant 0 180,000 180,000

Construct a small plant 100,000 20,000 100,000

Do nothing 200,000 0 200,000

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In-Class Exercise

▪ Consider the following payoff table

Scenario 1 Scenario 2 Scenario 3
Optimistic Pessimistic Hurwicz Max Regret
Option
OptionA
A 2.5 0 -1.5 2.5 4a – 1.5 2.5 -1.5
Option B 1 0 a 2.5
Option B 1 0 1
Option C 1 -1 2a – 1 2
Option C -1 1 1

– If you want to sell option A, which criterion should you use?

– If you want to sell option B, which criterion should you use?
– If you want to sell option C, which criterion should you use?

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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

25
Decision Tree
▪ Any problem that can be presented in a decision table can also be
graphically illustrated in a decision tree.

▪ Advantages of decision tree:

– Incorporate sequential decision making
– Incorporate different states and probabilities for different options

▪ Any decision tree has two types of node:

– Decision node, from which one of several alternatives may be chosen
– State-of-nature node, out of which one state of nature will occur

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Decision Making under Risk

STATE OF NATURE Expected

Monetary
FAVORABLE MARKET UNFAVORABLE Value
ALTERNATIVE (profit in $) MARKET (profit in $) (EMV, $)

Construct a large plant 200,000 –180,000 –9,000

Construct a small plant 100,000 –20,000 34,000
Do nothing 0 0 0
Probability 0.45 0.55

Expected Monetary Value (EMV) – EMV is the weighted sum

of possible payoffs for each alternative
If John maximize the EMV, then he should choose to construct
a small plant.

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Thompson’s Decision Tree

A State-of-Nature Node Payoffs

Favorable Market (0.45)
$200,000
A Decision Node EMV1 = -9k 1
Unfavorable Market (0.55)
–$180,000

EMV2 = Favorable Market (0.45)

$100,000
Construct
34k a 2
Small Plant Unfavorable Market (0.55)
–$20,000

$0

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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 quitted 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?

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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

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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

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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 Percentage of Students Who Received This
Pay 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 events
would emanate from there

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Decision tree

Accept John’s Offer Accept Vanessa’s Offer 5%

$21600
25%
Reject Offer Reject Vanessa’s $16800
John’s from Offer 40%
A Offer B C E $12000
Vanessa
60%
5% 25%
$21600 $6000
No Offer from
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 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
▪ Bill assigns the probability of receives a job offer from Vanessa's firm to be 60%

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Decision tree

Accept John’s Offer Accept Vanessa’s Offer

5%
$12000 $14000 $21600
25%
Reject Offer Reject Vanessa’s $16800
John’s from Offer 40%
A Offer B C E $12000
Vanessa
60%
5% 25%
$21600 $6000
No Offer from
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

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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 Reject Vanessa’s $16800
John’s from Offer 40%
A Offer B C E $12000
Vanessa
60%
5% 25%
$21600 $6000
No Offer from
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 Reject Vanessa’s $16800
John’s from Offer
$11580 40%
A Offer B C E $12000
Vanessa
60%
5% 25%
$21600 $6000
No Offer from
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 Reject Vanessa’s$11580 $16800
John’s from Offer 40%
A Offer B C E $12000
Vanessa
60%
5% 25%
$21600 $6000
No Offer from
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

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Folding back the decision tree

Accept Vanessa’s Offer 5%

$12000 $14000 $21600
25%
Reject Offer Reject Vanessa’s $16800
John’s from Offer
$11580 40%
A Offer B C E $12000
Vanessa
60%
5% 25%
$21600 $6000
No Offer from
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

43
Folding back the decision tree

Accept John’s Offer Accept Vanessa’s Offer 5%

$12000 $14000 $21600
25%
Reject Offer Reject Vanessa’s $16800
$13032 $14000
John’s from Offer
$11580 40%
A Offer B C E $12000
Vanessa
60%
$13032 5% 25%
$21600 $6000
No Offer from
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 is0.6×$14,000+0.4×$11,580=$13,032

44
Folding back the decision tree

Accept John’s Offer Accept Vanessa’s Offer 5%

$12000 $14000 $21600
25%
Reject Offer Reject Vanessa’s $16800
$13032 $14000
John’s from Offer
$11580 40%
A Offer B C E $12000
Vanessa
60%
$13032 5% 25%
$21600 $6000
No Offer from
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

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

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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%
D 40%
$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 branch of the tree

47
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

48