Quantitative

methods for
business
Chapter 3: Decision Analysis

Instructor: Dr. Huynh Thi Ngoc Hien

Email: htnhien@hcmiu.edu.vn
Chapter Outline
PART 1
• The Six Steps in Decision Making
• Types of Decision-Making Environments
• Decision Making under Uncertainty
• Decision Making under Risk
• Sensitivity Analysis
PART 2
• Decision Trees
• How Probability Values Are Estimated by Bayesian Analysis
• Utility Theory
 PAR
T1

DECISION ANALYSIS
 Type of Decision Making Environment

Ex: $1000 invest for 1-year 1. Maximax (optimistic) 1. Expected monetary value
period 2. Maximin (pessimistic) (EMV)
Alternatives: invest in gov bond: 3. Criterion of realism 2. Expected value of perfect
5%/year, open a saving account: (Hurwicz) information (EVPI)
6%/year 4. Equally likely (Laplace) 3. Expected value with
5. Minimax Regret perfect information
(EVwPI)
4. Expected opportunity loss
 Six steps in decision analysis

Thompson Lumber
company STATE OF NATURE

FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)

Construct a large plant 200,000 –180,000

Construct a small plant 100,000 –20,000

Do nothing 0 0
Decision making under uncertainty

• Probability data are not available

• Some criteria exist for making decision:
1. Maximax (Optimistic)
2. Maximin (Pessimistic)
3. Criterion on realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
Decision making under uncertainty
1/5 Maximax (Optimistic)
Used to find the alternative that maximizes
the maximum payoff
 Locate the maximum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 200,000
plant
Maximax
Construct a small
100,000 –20,000 100,000
plant
Do nothing 0 0 0
Decision making under uncertainty
2/5 Maximin (Pessimistic)
Used to find the alternative that maximizes
the minimum payoff
 Locate the minimum payoff for each alternative
 Select the alternative with the maximum
number
STATE OF NATURE
FAVORABLE UNFAVORABLE MINIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
200,000 –180,000 –180,000
plant
Construct a small
100,000 –20,000 –20,000
plant
Do nothing 0 0 0
Maximin
Decision making under uncertainty
3/5 Criterion of Realism (Hurwicz)
A weighted average compromise between
optimistic and pessimistic (personal feelings)
 Select a coefficient of realism 
 Coefficient is between 0 and 1
 A value of 1 is 100% optimistic
 Compute the weighted averages for each
alternative
 Select the alternative with the highest value

Weighted average = (maximum in row)

+ (1 – )(minimum in row)
Decision making under uncertainty
3/5 Criterion of Realism (Hurwicz)
 For the large plant alternative using  = 0.8
(0.8)(200,000) + (1 – 0.8)(–180,000) = 124,000
 For the small plant alternative using  = 0.8
(0.8)(100,000) + (1 – 0.8)(–20,000) = 76,000

STATE OF NATURE
CRITERION
FAVORABLE UNFAVORABLE OF REALISM
ALTERNATIVE MARKET ($) MARKET ($) ( = 0.8)$
Construct a large
200,000 –180,000 124,000
plant
Realism
Construct a small
100,000 –20,000 76,000
plant
Do nothing 0 0 0
Decision making under uncertainty
4/5 Equally Likely (Laplace)
Considers all the payoffs for each alternative
 Find the average payoff for each alternative
 Select the alternative with the highest average

STATE OF NATURE
FAVORABLE UNFAVORABLE ROW
ALTERNATIVE MARKET ($) MARKET ($) AVERAGE ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Equally likely
Do nothing 0 0 0
Decision making under uncertainty
5/5 Minimax Regret
(Based on the opportunity loss or
regret)
 Step 1: Create the opportunity loss by
subtracting each payoff in the column from the
best payoff in the same column
 Step 2: Find the maximum (worst) opportunity
loss within each alternative.
 Step 3: Select the alternative that minimizes the
maximum opportunity loss within each
alternative.
Decision making under uncertainty
5/5 Minimax Regret Opportunity Loss Tables
STATE OF NATURE STATE OF NATURE
FAVORABLE UNFAVORABLE FAVORABLE UNFAVORABLE
MARKET ($) MARKET ($) MARKET ($) MARKET ($)
200,000 – 200,000 0 – (–180,000) 0 180,000
200,000 – 100,000 0 – (–20,000) 100,000 20,000
200,000 – 0 0–0 200,000 0

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
ALTERNATIVE MARKET ($) MARKET ($) A ROW ($)
Construct a large
0 180,000 180,000
plant
Construct a small
100,000 20,000 100,000
plant
Minimax
Do nothing 200,000 0 200,000
 Decision making under risk
• Decision making when there are several possible states of
nature and we know the probabilities associated with each
possible state.
• Most popular method is to choose the alternative with the
highest expected monetary value (EMV)
• The expected value or the mean value (EMV) is the long
run average value of that decision.
• EMV for an alternative is just the sum of possible payoffs of
the alternative, each weighted by the probability of that
payoff occurring.

rnative i) = (payoff of first state of nature)

x (probability of first state of nature)
+ (payoff of second state of nature)
x (probability of second state of nature)
+ … + (payoff of last state of nature)
x (probability of last state of nature)
Decision making under risk
EMV for Thompson Lumber
 Each market has a probability of 0.50
 Which alternative would give the highest EMV?
 The calculations are
EMV (large plant) = (0.50)($200,000) + (0.50)(–$180,000)
= $10,000
EMV (small plant) = (0.50)($100,000) + (0.50)(–$20,000)
= $40,000
EMV (do nothing) = (0.50)($0) + (0.50)($0) = $0
STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EMV ($)
Construct a large
200,000 –180,000 10,000
plant
Construct a small
100,000 –20,000 40,000
plant
Do nothing 0 0 0
Probabilities 0.50 0.50

Largest EMV
Decision making under risk
Expected value of perfect information
Two steps processes:
1. Determine the Expected Value with Perfect Information
2. Compute Expected Value of Perfect Information (EVPI)
■ EVwPI is the long run average return if we have perfect
information before a decision is made.
EVwPI = (best payoff for first state of nature)
x (probability of first state of nature)
+ (best payoff for second state of nature)
x (probability of second state of nature)
+ … + (best payoff for last state of nature)
x (probability of last state of nature)
■ EVPI places an upper bound on what you should pay for
additional information.
EVPI = EVwPI – Maximum EMV
 Decision making under risk
Expected value of perfect information
■ Scientific Marketing, Inc. offers analysis that will
provide certainty about market conditions (favorable)
■ Additional information will cost $65,000
■ Is it worth purchasing the information?
With perfect information
Best alternative (max EMV) for favorable state
Thompson Lumber of nature is build a large plant with a payoff of
company STATE OF NATURE $200,000
Best alternative (max EMV) for unfavorable
UNFAVORA state of nature is to do nothing with a payoff of
FAVORABLE BLE $0
ALTERNATIVE MARKET ($) MARKET ($)
EVwPI = ($200,000)(0.50) + ($0)(0.50) =
Construct a large plant $100,000
200,000 –180,000
The maximum EMV without additional
Construct a small plant information is $40,000
100,000 –20,000
EVPI = EVwPI – Maximum EMV without PI
Do nothing = $100,000 - $40,000
0 0
= $60,000

The cost of purchasing additional information

should not exceed $60,000
Decision making under risk
Expected Opportunity Loss

• Expected opportunity loss (EOL) is the cost of not

picking the best solution
• First construct an opportunity loss table
• For each alternative, multiply the opportunity loss
by the probability of that loss for each possible
outcome and add these together
• Minimum EOL will always result in the same
decision as maximum EMV
• Minimum EOL will always equal EVPI
 Decision making under risk
Expected Opportunity Loss

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($) EOL
Construct a large plant 0 180,000 90,000
Construct a small
100,000 20,000 60,000
plant
Do nothing 200,000 0 100,000
Probabilities 0.50 0.50
Minimum EOL
rge plant) = (0.50)($0) + (0.50)($180,000)
= $90,000
mall plant) = (0.50)($100,000) + (0.50)($20,000)
= $60,000
o nothing) = (0.50)($200,000) + (0.50)($0)
= $100,000
SENSITIVITY ANALYSIS
 Sensitivity analysis examines how our decision might
change with different input data
 For the Thompson Lumber example

P = probability of a favorable market

(1 – P) = probability of an unfavorable market
EMV(Large Plant) = $200,000P – $180,000(1 – P)
= $200,000P – $180,000 + $180,000P
= $380,000P – $180,000
EMV(Small Plant) = $100,000P – $20,000(1 – P)
= $100,000P – $20,000 + $20,000P
= $120,000P – $20,000
EMV(Do Nothing) = $0P + 0(1 – P)
= $0
 BEST RANGE OF P
SENSITIVITY ANALYSIS
ALTERNATIVE VALUES
Do nothing Less than 0.167
EMV Values
Construct a small plant 0.167 – 0.615
$300,000
Construct a large plant Greater than 0.615
$200,000 Point 2 EMV (large plant)

$100,000 Point 1 EMV (small plant)

0 EMV (do nothing)

.167 .615 1
–$100,000 Values of P

–$200,000

Point 1: Point 2:
EMV(small plant) = EMV(large plant)
EMV(do nothing) = EMV(small
20plant)
$120,000 P  $20,000  $380,000 P  $180,000
,000
P
0  $120,000 P  $20,000 0.167 160,000
120,000 P  0.615
260,000
Using Excel QM
HOMEWORK
• Assignments (Chapter 3): 3-17, 3-20, 3-23, 3-25, 3-28
and 3-29. (It is better if you can do all problems in the
textbook ^_^)
• One-page summary of Decision Analysis – Part 1
 PAR
T2

DECISION TREE
1. Develop accurate and useful decision trees
2. Revise probabilities using Bayesian analysis
3. Understand the importance and use of utility theory in
decision making
4. Use computers to solve basic decision-making problems
 A 3-min instruction on how to
Structure of Decision Trees draw a decision tree
https://youtu.be/ydvnVw80I_8
■ Trees start from left to right
■ Represent decisions and outcomes in
sequential order
■ Squares represent decision nodes
■ Circles represent states of nature nodes
■ Lines or branches connect the decisions nodes
and the states of nature

decision nodes

State of nature nodes

 Five steps of decision tree analysis

STATE OF NATURE
FAVORABLE UNFAVORABLE
ALTERNATIVE MARKET ($) MARKET ($)
Construct a large plant 200,000 –180,000
Construct a small plant 100,000 –20,000
Do nothing 0 0
 STATE OF NATURE
FAVORABL

EXAMPLE 1.1 ALTERNATIVE

E
MARKET ($)
UNFAVORABLE
MARKET ($)
Construct a
–180,000
large plant 200,000
Construct a
–20,000
small plant 100,000

Do nothing 0
0
EMV for Node 1 = (0.5)($200,000) + (0.5)(–$180,000)
= $10,000
Payoffs
Favorable Market (0.5)
$200,000
Alternative with best
EMV is selected 1
Unfavorable Market (0.5)
–$180,000
uct t
n st Plan
r
Co rge
La Favorable Market (0.5)
$100,000
Construct
2
Small Plant Unfavorable Market (0.5)
–$20,000
Do
N ot
h EMV for Node 2 = (0.5)($100,000)
ing
= $40,000 + (0.5)(–$20,000)

$0
EXAMPLE 1.2
A MORE COMPLEX DECISION
FOR THOMPSOM LUMBER –
SAMPLE INFORMATION
Let’s say that John Thompson has two decisions to make, with the second
decision dependent on the outcome of the first. Before deciding about building a
new plant, John has the option of conducting his own marketing research
survey, at a cost at $10,000. The information from his survey could help him
decide whether to construct a large plant, a small plant, or not to build at all.
John recognizes that such a market survey will not provide him perfect
information, but it may help quite a bit nevertheless.
•There is a 45% chance that the survey will indicate a favorable market.
•78% is the probability of a actual favorable market given a favorable result from the market
survey.
•There is a 27% chance the market will be actually favorable given that John’s survey results
are negative.
Thompson’s Complex Decision Tree

First Decision Second Decision Payoffs

Point Point
Favorable Market (0.78)
$190,000
an t 2 Unfavorable Market (0.22)
e Pl –$190,000
Larg Favorable Market (0.78)
Small $90,000
) 3 Unfavorable Market (0.22)
0 .4 5 Plant –$30,000
(
v ey lts le No Plant
r
Su esu orab –$10,000
R av
1 ur F
S Favorable Market (0.27)
ve $190,000
Re y (0 4
ey

Ne sul .55 l an t Unfavorable Market (0.73)

–$190,000
rv

eP
Larg
Su

ga ts ) Favorable Market (0.27)

tiv $90,000
t

Small
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct
du

No Plant
–$10,000
n
Co

Do Favorable Market (0.50)

Not $200,000
Con t 6 Unfavorable Market (0.50)
d uct e P l an –$180,000
Su r v Larg Favorable Market (0.50)
ey Small $100,000
Plant
7 Unfavorable Market (0.50)
–$20,000
No Plant
$0
Thompson’s Complex Decision Tree
1. Given favorable survey results,
EMV(node 2) = EMV(large plant | positive survey)
= (0.78)($190,000) + (0.22)(–$190,000) = $106,400
EMV(node 3) = EMV(small plant | positive survey)
= (0.78)($90,000) + (0.22)(–$30,000) = $63,600
EMV for no plant = –$10,000
2. Given negative survey results,
EMV(node 4) = EMV(large plant | negative survey)
= (0.27)($190,000) + (0.73)(–$190,000) = –$87,400
EMV(node 5) = EMV(small plant | negative survey)
= (0.27)($90,000) + (0.73)(–$30,000) = $2,400
EMV for no plant = –$10,000
3. Compute the expected value of the market survey,
EMV(node 1) = EMV(conduct survey)
= (0.45)($106,400) + (0.55)($2,400)
= $47,880 + $1,320 = $49,200
4. If the market survey is not conducted,
EMV(node 6) = EMV(large plant)
= (0.50)($200,000) + (0.50)(–$180,000) = $10,000
EMV(node 7) = EMV(small plant)
= (0.50)($100,000) + (0.50)(–$20,000) = $40,000
EMV for no plant = $0
 Best choice is to seek marketing information
Thompson’s Complex Decision Tree
First Decision Second Decision Payoffs
Point Point
$106,400 Favorable Market (0.78)
$190,000
Pla
n t
2 Unfavorable Market (0.22)

$106,400
–$190,000
a rge $63,600 Favorable Market (0.78)
L $90,000
) Small
(0
. 45 Plant 3 Unfavorable Market (0.22)
–$30,000
e y ts le
u rv sul ab No Plant
–$10,000
S Re vor
S a
1 urveF –$87,400 Favorable Market (0.27)
$190,000
y

y
ve

R
Ne esu (0.5 Pla
n t 4 Unfavorable Market (0.73)
ur

–$190,000
5) ge
tS

ga lts r $2,400
$2,400
La Favorable Market (0.27)
tiv Small $90,000
ke

e 5 Unfavorable Market (0.73)

ar

Plant –$30,000
M
ct

No Plant
du

–$10,000
on
$49,200
C

Do $10,000 Favorable Market (0.50)

Not $200,000
Con nt 6 Unfavorable Market (0.50)
duc e Pla –$180,000
$40,000

t g
Sur
ve y Lar $40,000 Favorable Market (0.50)
$100,000
Small
Plant 7 Unfavorable Market (0.50)
–$20,000
No Plant
$0

// indicates that a particular alternative is dropped from further consideration

because its EMV is lower than the EMV for the best alternative.
Expected Value of Sample Information
• Thompson wants to know the actual value of
doing the survey
Expected value Expected value
with sample of best decision
EVSI = information, assuming – without sample
no cost to gather it information

= (EV with sample information + cost)

– (EV without sample information)
EVSI = ($49,200 + $10,000) – $40,000 = $19,200

Note: The cost of the sample information is added to this since this was
subtracted from all the payoffs before the EV with SI was calculated.
Sensitivity analysis
• Let p be the probability of favorable survey results.

• Then (1 –p) is the probability of negative survey results.

EMV (node 1) = (106.4)p + 2.4 (1 –p) = 104p + 2.4

When EMV of conducting the market survey and not conducting

the market survey are indifferent:
If EMV (node 1) = 40
Then 104p + 2.4 = 40 and then p = 0.36

If EMV (node 1) > 40 then p >0.36  Should conduct the

survey
 EXAMPLE 1.3 Calculating Revised Probabilities
• when there was actually a favorable market for the product, 70% of the survey
correctly predicted positive results.
• On the other hand, when there was actually an unfavorable market for the
product, 80% of the survey correctly predicted negative results.
• Recall that without any market survey information, John’s best estimates of a
favorable and unfavorable market are: P(FM)= 0.5, P(UM=0.5)

What is the probability of a favorable or unfavorable market given a positive

or negative result from the market study?
Using the new probability to draw the decision tree again and make decision.
EXAMPLE 1.3 Calculating Revised Probabilities
Utility Theory explain behavior of individuals based on the premise people
can consistently rank order their choices depending upon their preferences.
1. Monetary value is not always a true indicator of the overall value of the result of a
decision
2. The overall value of a decision is called utility
3. Rational people make decisions to maximize their utility

• Utility assessment assigns the worst outcome a utility of 0, and the best outcome, a utility of 1.
• A standard gamble is used to determine utility values.
• When you are indifferent, the utility values are equal.
Expected utility of alternative 2 = Expected utility of alternative 1
Utility of other outcome = (p)(utility of best outcome, which is 1)
+ (1 – p)(utility of the worst outcome, which is 0) = (p)(1) + (1 – p)(0) = p

(p) Best Outcome

Utility = 1
ti ve1 (1 – p)
rna Worst Outcome
Alte Utility = 0

Alte
r nat
iv e Other Outcome
2
Utility = p
 Investment Example Utility Theory
• Jane Dickson wants to construct a utility curve revealing her preference for money
between $0 and $10,000. A utility curve plots the utility value versus the monetary
value
• An investment in a bank will result in $5,000
• An investment in real estate will result in $0 or $10,000
• Unless there is an 80% chance of getting $10,000 from the real estate deal, Jane
would prefer to have her money in the bank
• So if p = 0.80, Jane is indifferent between the bank or the real estate investment
p = 0.80 $10,000
U($10,000) = 1.0
e st in
Inv state (1 – p) = 0.20
$0
e alE
R U($0.00) = 0.0
Inv
est
in B
ank
$5,000
U($5,000) = p = 0.8

Utility for $5,000 = U($5,000) = pU($10,000) + (1 – p)U($0)

= (0.8)(1) + (0.2)(0) = 0.8
 Utility Theory
 For Jane’s preference, these are
Utility for $5000 = 0.80 U ($10,000) = 1.0
1.0 –
U ($7,000) = 0.90
0.9 –

 Using the three utilities U ($5,000) = 0.80

0.8 –
for different dollar
amounts, she can 0.7 –
construct a utility curve 0.6 –
U ($3,000) = 0.50
Utility

0.5 –

0.4 –

0.3 –

0.2 –

0.1 – U ($0) = 0
| | | | | | | | | | |
$0 $1,000 $3,000 $5,000 $7,000 $10,000

Monetary Value

Utility Curve
 Utility Curve Utility Theory

 Jane’s utility curve is typical of

a risk avoider
 A risk avoider gets less
utility from greater risk,
avoid situations where high
losses might occur  As
monetary value increases,
the utility curve increases at
a slower rate.
 A risk seeker gets more
utility from greater risk. As
monetary value increases,
the utility curve increases at
a faster rate Income
 Someone who is indifferent
will have a linear utility
curve
Utility as a Decision-Making Criteria
e Win (0.45)
am E = 0.162 Win (0.45) Utility
i ve1 eG $10,000
0.30
t h 1
e r na ys t t i ve me
a
Alt rk Pl Lose(0.55)
t
a
ern he G
a
Lose (0.55)
l
Ma –$10,000 A
a ys
t
P l 0.05
Al Alt
te e rn
rn
at ati
i ve ve
2 2
Mark Does Not Play the Game Don’t Play
$0 0.15

 Step 1– Define Mark’s utilities

U (–$10,000) = 0.05
U ($0) = 0.15
U ($10,000) = 0.30
 Step 2 – Replace monetary values with utility values

E(alternative 1: play the game) = (0.45)

(0.30) + (0.55)(0.05) = 0.135 + 0.027 = 0.162
E(alternative 2: don’t play the game) = 0.15
 CLASS’ S
WEDDING STUDIO
A group of QM PROJECT
class’s students is planning to open a wedding studio. They are evaluating
three alternatives: a luxury studio, a standard studio, or no studio. If the market is good,
they will earn $50,000 for luxury studio and earn $35,000 for standard studio. If the market
is fair, they will earn $25,000 for the luxury and $10,000 for the standard one. If the
market is poor, they will lose $28,000 for the luxury and $15,000 for the standard one. On
the other hand, if they don’t open the studio, they will earn nothing and lose nothing
regardless of the states of nature. At present, they believe that the market will be good, fair,
and poor with the probabilities of 0.2, 0.5 and 0.3, respectively. Please give recommendation
of selecting the best decisions alternatives in accordance with EMV approach.
Decision State of nature
alternatives Good Fair Poor

Luxury studio 50000 25000 -28000

Standard studio 35000 10000 -15000
No studio 0 0 0
Probability 0.2 0.5 0.3

Draw a completed decision tree for the problem including all the information of
payoffs, probabilities, and EMVs and then give recommendations to the group.
PRACTICE A.2: AN EVEN MORE COMPLEX
AND TIRED DECISION FOR QM CLASS –
SAMPLE INFORMATION
Since the fluctuation of the market condition, the group is also thinking about hiring their
old marketing professor to conduct a marketing research study. If the market is actual
good, the study result will indicate 50% of good market, 30% of fair market, and 20% of
poor market. If the market is actually fair, the study result will indicate 20% of good
market, 60% of fair market, and 20% of poor market. If the market is actually poor, the
study result will indicate 25% of good market, 25% of fair market, and 50% of poor
market. Since the cost of the study they are announced is $2000 that is relatively high for
them, they are not sure whether the study worth the cost. For such complication, the group
are really confused.
•Use Bayes theorem to calculate the revised probabilities.
•Draw a completed decision tree.
•Is it worth to pay for the research study?

Decision alternatives State of nature

Good Fair Poor
Luxury studio 50000 25000 -28000
Standard studio 35000 10000 -15000
No studio 0 0 0
Probability 0.2 0.5 0.3
Using Excel QM to Solve
Decision Tree
ASSIGNMENTS
Text book: “Quantitative Analysis for Management, 11 th edition”, Barry Render et. al.,
McGraw Hill, 2012.

Homework:
1.Assignments (Chapter 3): 3-34, 3-36, 3-37, 3-39, 3-41,
3-42, 3-48 and 3-52. (It is better if you can do all
problems in the textbook ^_^)
2.One-page summary of chapter 3 - part 2.