Dr. C. Lightner Fayet Teville State University 1

Chapter 14
Decision Analysis
Problem Formulation
Decision Making without Probabilities
Decision Making with Probabilities
Risk Analysis and Sensitivity Analysis
Decision Analysis with Sample Information
Computing Branch Probabilities
Utility and Decision Making
Dr. C. Lightner Fayet 1

teville State University
Problem Formulation
A decision problem is characterized by decision alternatives,

states of nature, and resulting payoffs.
The decision alternatives are the different possible strategies the
decision maker can employ.
The states of nature refer to future events, not under the control
of the decision maker, which will ultimately affect decision
results. States of nature should be defined so that they are
mutually exclusive and contain all possible future events that
could affect the results of all potential decisions.

Decision Theory Models
Decision theory problems are generally represented as one of the

following:
– Influence Diagram
– Payoff Table
– Decision Tree

Influence Diagrams
An influence diagram is a graphical device showing the relationships

among the decisions, the chance events, and the consequences.
Squares or rectangles depict decision nodes.
Circles or ovals depict chance nodes.
Diamonds depict consequence nodes.
Lines or arcs connecting the nodes show the direction of influence.

Payoff Tables
The consequence resulting from a specific combination of a

decision alternative and a state of nature is a payoff.
A table showing payoffs for all combinations of decision alternatives
and states of nature is a payoff table.
Payoffs can be expressed in terms of profit, cost, time, distance or
any other appropriate measure.

Decision Trees
A decision tree is a chronological representation of the decision

problem.
Each decision tree has two types of nodes; round nodes
correspond to the states of nature while square nodes
correspond to the decision alternatives.
The branches leaving each round node represent the different
states of nature while the branches leaving each square node
represent the different decision alternatives.
At the end of each limb of a tree are the payoffs attained from the
series of branches making up that limb.

Example: CAL Condominium Complex
A developer must decide how large a luxury condominium

complex to build – small, medium, or large. The
profitability of this complex depends upon the future level
of demand for the complex’s condominiums.

CAL Condos: Elements of Decision Theory
States of nature: The states of nature could be defined as

low demand and high demand.
Alternatives: CAL could decide to build a small, medium,
or large condominium complex.
Payoffs: The profit for each alternative under each potential
state of nature is going to be determined.
We develop different models for this problem on the following slides.

CAL Condos: Payoff Table
THIS IS A PROFIT PAYOFF TABLE
States of Nature
Alternatives Low High
Small 8 8
Medium 5 15
Large -11 22
(payoffs in millions of dollars)

CAL Condos: Decision Tree
m and 8
de
Low
High
x dema
m ple nd 8
C o
a ll
Sm em and 5
d
Low
Medium Complex High dem
and 15
La
r ge
Co
m -
ple
x Low demand 11
High demand
22

Decision Making without Probabilities
Three commonly used criteria for decision making when

probability information regarding the likelihood of the states of
nature is unavailable are:
– the optimistic approach
– the conservative approach
– the minimax regret approach.

Optimistic Approach
The optimistic approach would be used by an optimistic decision
maker.
The decision with the best possible payoff is chosen.
If the payoff table was in terms of costs, the decision with the
lowest cost would be chosen.
If the payoff table was in terms of profits, the decision with the
highest profit would be chosen.

Conservative Approach
The conservative approach would be used by a conservative decision maker.

For each decision the worst payoff is listed and then the decision
corresponding to the best of these worst payoffs is selected. (Hence, the
worst possible payoff is maximized.)
If the payoff was in terms of costs, the maximum costs would be determined
for each decision and then the decision corresponding to the minimum of
these maximum costs is selected. (Hence, the maximum possible cost is
minimized.)
If the payoff was in terms of profits, the minimum profits would be determined
for each decision and then the decision corresponding to the maximum of
these minimum profits is selected. (Hence, the minimum possible profit is
maximized.)

Minimax Regret Approach
1. The minimax regret approach requires the construction of a

regret table or an opportunity loss table. This is done by
calculating for each state of nature the difference between each
payoff and the best payoff for that state of nature.
2. Then, using this regret table, the maximum regret for each
possible decision is listed.
3. The decision chosen is the one corresponding to the minimum of
the maximum regrets.

Solving CAL Condominiums Problem
Suppose that information regarding the probability (or likelihood) that there will be
a high or low demand is unavailable.
– A conservative or pessimistic decision maker would select the
decision alternative determined by the conservative approach.
– An optimistic decision maker would select the decision
alternative rendered by the optimistic approach.
– The minimax regret approach is generally selected by a
decision maker who reflects on decisions “after the fact”, and
complains about or “regrets” their decisions based upon the
profits that they could have made (or cheaper costs that they
could have spent) had a different decision been selected.

CAL Condos: Optimistic Decision
If the optimistic approach is selected:

STATES OF NATURE BEST
Alternatives Low High PROFIT
Small 8 8 8
Medium 5 15 15 Maximax
payoff
Large -11 22 22
Maxima
x
decision

CAL Condos: Conservative Decision
If the conservative approach is selected:

STATES OF NATURE WORST
Maximi Alternatives Low High PROFIT
n Maximin
decision Small 8 8 8 payoff
Medium 5 15 5
Large -11 22 -11
The decision with the best profit from the column of worst profits is selected.

CAL Condos: Minimax Regret Decision
If the minimax regret approach is selected:

Step 1: Determine the best payoff for each state of nature and create a regret
table.
STATES OF NATURE
Small 8 8
Medium 5 15
Large -11 22
Best Profit Best Profit

for Low for High
8 22


Step 1: Create a regret table (continued).
STATES OF NATURE For a profit payoff
table, entries in
Alternatives Low High the regret table
Small 0 14 represent profits
that could have
Medium 3 7 been earned.
Large 19 0
If they knew in advanced that the demand would be low, they would have built a
small complex. Without this “psychic insight”, if they decided to build a medium
facility and the demand turned out to be low, they would regret building a medium
complex because they only made 5 million dollars instead of 8 million had they built
a small facility instead. They regret their decision by 3 million dollars.

Step 2: Create a regret table (continued).
Step 3: Determine the maximum regret for each decision.
STATES OF NATURE Max
Alternatives Low High Regret
Small 0 14 14
Medium 3 7 7
Large 19 0 19
Regret not getting a profit

of 19 more than not making
a profit of 0.


Step 4: Select the decision with the minimum value from the column of max
regrets.
STATES OF NATURE Max
Alternatives Low High Regret
Small 0 14 14 Minima
Minimax Medium 3 7 7 x
Regret
Regret
decision
Large 19 0 19 payoff

Generic Example
Consider the following problem with three decision alternatives

and three states of nature with the following payoff table
representing costs:
States of Nature
s1 s2 s3
COST PAYOFF TABLE
d1 4.5 3 2
Decisions d2 0.5 4 1
d3 1 5 3

Generic Example : Optimistic Decision
Optimistic Approach
An optimistic decision maker would use the optimistic
(maximax) approach. We choose the decision that has the best
single value in the payoff table.
Best
Decision Cost Maximax
Maximax d1 2 payoff
decision d2 0.5
d3 1

Generic Example: Conservative Approach
Conservative Approach
A conservative decision maker would use the conservative
(maximin) approach. List the worst payoff for each decision.
Choose the decision with the best of these worst payoffs.
Worst
Decision Payoff Maximin
Maximin d1 4.5 payoff
decision
d2 4
d3 5

Generic Example: Minimax Regret Decision
Minimax Regret Approach
States of Nature
For a cost payoff
s1 s2 s3 table, entries in
the regret table
represent
d1 4.5 3 2
overpayments
Decisions d2 0.5 4 1 (i.e. higher costs
incurred).
d3 1 5 3
Best cost for each state of nature.

Example
Minimax Regret Approach (continued)

For each decision list the maximum regret. Choose the
decision with the minimum of these values.
States of Nature Max

s1 s2 s3 Regret
d1 4 0 1 4
Decisions d2 0 1 0 1
d3 0.5 2 2 2 Minimax
regret
Minimax
decision
Decision Making with Probabilities
Expected Value Approach

– If probabilistic information regarding the states of nature is
available, one may use the expected value (EV) approach.
– Here the expected return for each decision is calculated by
summing the products of the payoff under each state of
nature and the probability of the respective state of nature
occurring.
– The decision yielding the best expected return is chosen.

Expected Value of a Decision Alternative
The expected value of a decision alternative is the sum of weighted

payoffs for the decision alternative.
The expected value (EV) of decision alternative di is defined as:
N
EV( d i )   P( s j )Vij
j 1
where: N = the number of states of nature

P(sj ) = the probability of state of nature sj
Vij = the payoff corresponding to decision
alternative di and state of nature sj

Example: Burger Prince
Burger Prince Restaurant is contemplating opening a new

restaurant on Main Street. It has three different models, each
with a different seating capacity. Burger Prince estimates that
the average number of customers per hour will be 80, 100, or
120. The payoff table (profits) for the three models is on the next
slide.

Payoff Table
Average Number of Customers Per Hour

s1 = 80 s2 = 100 s3 = 120
Model A $10,000 $15,000 $14,000

Model B $ 8,000 $18,000 $12,000
Model C $ 6,000 $16,000 $21,000

Expected Value Approach

Calculate the expected value for each decision. The decision
tree on the next slide can assist in this calculation. Here d1, d2, d3
represent the decision alternatives of models A, B, C, and s1, s2, s3
represent the states of nature of 80, 100, and 120.

Payoffs
Decision Tree
s1 .4
10,000
s2 .2
2 s3 15,000
.4
d1 14,000
s1 .4
d2 8,000
1 s2 .2
3 18,000
d3 s3 .4
12,000
s1 .4
6,000
s2 .2
4 16,000
s3
.4
21,000
Expected Value For Each Decision

EMV = .4(10,000) + .2(15,000) + .4(14,000)
= $12,600
d1 2
Model A
EMV = .4(8,000) + .2(18,000) + .4(12,000)
Model B d2 = $11,600
1 3
d3 EMV = .4(6,000) + .2(16,000) + .4(21,000)

Model C
= $14,000
4
Choose the model with largest EV, Model C.

CAL Condos Revisited
Suppose market research was conducted in the community where

the complex will be built. This research allowed the company to
estimate that the probability of low demand will be 0.35, and the
probability of high demand will be 0.65. Which decision alternative
should they select.

STATES OF NATURE
Alternatives Low (0.35) High (0.65)
Small 8 8
Medium 5 15
Large -11 22

STATES OF NATURE
(0.35) (0.65) Expected value (EV)
Small 8 8 8(0.35) + 8(0.65) = 8
Medium5 15 5(0.35) + 15(0.65) = 11.5
Large -11 22 -11(0.35) + 22(0.65) = 10.45
Recall that this is a profit payoff table. Thus since the decision to build a medium
complex has the highest expected profit, this is our best decision.

Expected Value of Perfect Information
Frequently information is available which can improve the

probability estimates for the states of nature.
The expected value of perfect information (EVPI) is the increase
in the expected profit that would result if one knew with certainty
which state of nature would occur.
The EVPI provides an upper bound on the expected value of any
sample or survey information.

EVPI Calculation
– Step 1:
Determine the optimal return corresponding to each state of
nature.
– Step 2:
Compute the expected value of these optimal returns.
– Step 3:
Subtract the EV of the optimal decision from the amount
determined in step (2).


Calculate the expected value for the optimum payoff for each
state of nature and subtract the EV of the optimal decision.
EVPI= .4(10,000) + .2(18,000) + .4(21,000) - 14,000 = $2,000

Sensitivity Analysis
Some of the quantities in a decision analysis, particularly the

probabilities, are often intelligent guesses at best.
It is important to accompany any decision analysis with a sensitivity
analysis.
Sensitivity analysis can be used to determine how changes to the
following inputs affect the recommended decision alternative:
– probabilities for the states of nature
– values of the payoffs
If a small change in the value of one of the inputs causes a change
in the recommended decision alternative, extra effort and care
should be taken in estimating the input value.

Sensitivity Analysis
One approach to sensitivity analysis is to arbitrarily assign different

values to the probabilities of the states of nature and/or the payoffs
and resolve the problem. If the recommended decision changes,
then you know that the solution is sensitive to the changes.
For the special case of two states of nature, a graphical technique
can be used to determine how sensitive the solution is to the
probabilities associated with the states of nature.

CAL Condos: Sensitivity Analysis
This problem has two states of nature. Previously, we stated that

CAL Condominiums estimated that the probability of future low
demand is 0.35 and 0.65 is the probability of high demand. These
probabilities yielded the recommended decision to build the medium
complex.
In order to see how sensitive this recommendation is to changing
probability values, we will let p equal the probability of low demand.
Thus (1-p) is the probability of high demand. Therefore
EV( small) = 8*p + 8*(1-p)= 8
EV( medium) = 5*p + 15*(1-p) = 15 – 10p
EV( large) = -11*p + 22*(1-p) = 22 – 33p

Next we will plot the expected value lines for each decision by
plotting p on the x axis and EV on the y axis.
EV( small) = 8
EV( medium) = 15 – 10p
EV( large) = 22 – 33p

25
EV
( la
20 rg
e)
15
EV( m
edium
10 )
EV( small)
0
0 0.2 0.4 0.6 0.8 1

Since CAL condominiums list payoffs are in terms of profits, we

know that the highest profits is desirable.
Look over the entire range of p (p=0 to p=1) and determine the
range over which each decision yields the highest profits.

25
EV
( la
20 rg
e)
15
EV( m
edium
10 )
EV( small)
0
0 0.2 0.4 0.6 0.8 1
B1 B2
Do not estimate the values of B1 or B2 (the points where the intersection of lines
occur). Determine the exact intersection points.
B1 is the point where the EV( large) line intersects with the EV( medium) line:
To find this point set these two lines equal to each other and solve for p.
22-33p= 15-10p
7= 23p
p=7/23= 0.3403 So B1 equals 0.3403
B2 is the point where the EV( medium) line intersects with the EV( small) line:
15-10p = 8
7 = 10p
p = 0.7 So B2 equals 0.7

25
EV
( la
20 rg
e)
15
EV( m
edium
10 )
EV( small)
0
0 0.2 0.4 0.6 0.8 1
0.3403 0.7
From the graph we see that if the probability of low demand (p) is
between 0 and 0.3403, we recommend building a large complex.
between 0.3403 and 0.7, we recommend building a medium
complex.
between 0.7 and 1, we recommend building a large complex.
From this sensitivity analysis we see that if CAL Condos estimate of

0.35 for the probability of low demand was slightly lower, the
recommended decision would change.

End of Chapter 14
See your textbook for more

examples and detailed explanations
of all topics discussed in these notes.


Dr. C. Lightner Fayet Teville State University 1

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Chapter 14

Dr. C. Lightner Fayet 1

A decision problem is characterized by decision alternatives,

Dr. C. Lightner Fayet 2

Decision theory problems are generally represented as one of the

Dr. C. Lightner Fayet 3

An influence diagram is a graphical device showing the relationships

Dr. C. Lightner Fayet 4

The consequence resulting from a specific combination of a

Dr. C. Lightner Fayet 5

A decision tree is a chronological representation of the decision

Dr. C. Lightner Fayet 6

A developer must decide how large a luxury condominium

Dr. C. Lightner Fayet 7

States of nature: The states of nature could be defined as

We develop different models for this problem on the following slides.

Dr. C. Lightner Fayet 8

THIS IS A PROFIT PAYOFF TABLE

Dr. C. Lightner Fayet 9

Dr. C. Lightner Fayet 10

Three commonly used criteria for decision making when

Dr. C. Lightner Fayet 11

Dr. C. Lightner Fayet 12

The conservative approach would be used by a conservative decision maker.

Dr. C. Lightner Fayet 13

1. The minimax regret approach requires the construction of a

Dr. C. Lightner Fayet 14

Dr. C. Lightner Fayet 15

If the optimistic approach is selected:

Dr. C. Lightner Fayet 16

If the conservative approach is selected:

Dr. C. Lightner Fayet 17

If the minimax regret approach is selected:

Best Profit Best Profit

Dr. C. Lightner Fayet 18

If the minimax regret approach is selected:

If the minimax regret approach is selected:

Regret not getting a profit

Dr. C. Lightner Fayet 20

If the minimax regret approach is selected:

Dr. C. Lightner Fayet 21

Consider the following problem with three decision alternatives

Dr. C. Lightner Fayet 22

Dr. C. Lightner Fayet 23

Dr. C. Lightner Fayet 24

Best cost for each state of nature.

Dr. C. Lightner Fayet 25

Minimax Regret Approach (continued)

States of Nature Max

Expected Value Approach

Dr. C. Lightner Fayet 27

The expected value of a decision alternative is the sum of weighted

where: N = the number of states of nature

Dr. C. Lightner Fayet 28

Burger Prince Restaurant is contemplating opening a new

Dr. C. Lightner Fayet 29

Average Number of Customers Per Hour

Model A $10,000 $15,000 $14,000

Dr. C. Lightner Fayet 30

Expected Value Approach

Dr. C. Lightner Fayet 31

Expected Value For Each Decision

d3 EMV = .4(6,000) + .2(16,000) + .4(21,000)