Evans Analytics3e PPT 16 Accessible

Business Analytics: Methods,
Models, and Decisions

Third Edition, Global Edition
Chapter 16
Decision Analysis
Copyright © 2021 Pearson Education Ltd. Slide - 1

Role of Decision Analysis
• The purpose of business analytics is to provide decision-
makers with information needed to make decisions.
• Making good decisions requires an assessment of
intangible factors and risk attitudes.
• Decision analysis is the study of how people make
decisions, particularly when faced with imperfect or
uncertain information, as well as a collection of techniques
to support decision choices.

Formulating Decision Problems
• Many decisions involve making a choice between a small set of decisions with
uncertain consequences.
• Decision problems involve:
1. decision alternatives
2. uncertain events that may occur after a decision is made along with their
possible outcomes (which are often called states of nature), and are
defined so that one and only one of them will occur.
3. consequences associated with each decision and outcome, which are

usually expressed as payoffs. Payoffs are often summarized in a payoff
table, a matrix whose rows correspond to decisions and whose columns
correspond to events.
– The decision maker first selects a decision alternative, after which one of
the outcomes of the uncertain event occurs, resulting in the payoff.
Example 16.1: Selecting a Mortgage
Instrument
• A family is considering purchasing a new home and wants to finance
$150,000. Three mortgage options are available and the payoff table for the
outcomes is shown below. The payoffs represent total interest paid under three
future interest rate situations.
Decision Outcome: Rates Outcome: Rates Outcome: Rates

Rise Stable Fall
1-year A RM $61,134 $46,443 $40,161
3-year A RM $56,901 $51,075 $46,721
30-year fixed $54,658 $54,658 $54,658
– The best decision depends on the outcome that may occur. Since you
cannot predict the future outcome with certainty, the question is how to
choose the best decision, considering risk.

Decision Strategies Without Outcome
Probabilities: Minimize Objective
• With a minimize objective, the payoffs are costs.
• Aggressive (Optimistic) Strategy
– Choose the decision that minimizes the smallest payoff that can
occur among all outcomes for each decision (minimin strategy).
• Conservative (Pessimistic) Strategy
– Choose the decision that minimizes the largest payoff that can
occur among all outcomes for each decision (minimax strategy).
• Opportunity Loss Strategy
– Choose the decision that minimizes the largest opportunity loss
among all outcomes for each decision (minimax regret)

Example 16.2: Mortgage Decision
with the Aggressive Strategy
• Determine the lowest payoff (interest cost) for each type of
mortgage, and then choose the decision with the smallest
value (minimin).

with the Conservative Strategy
• Determine the largest payoff (interest cost) for each type of
mortgage, and then choose the decision with the smallest
value (minimax).

Understanding Opportunity Loss
• Opportunity loss represents the “regret” that people often
feel after making a nonoptimal decision.
• In general, the opportunity loss associated with any
decision and event is the difference between the best
decision for that particular outcome and the payoff for the
decision that was chosen.
– Opportunity losses can be only nonnegative values.

Example 16.4: Mortgage Decision with
the Opportunity-Loss Strategy (1 of 2)
• Compute the opportunity loss matrix.
Step 1:Find
the best
outcome
(minimum
cost) in each
column.
Decision Outcome: Rates Outcome: Rates Outcome: Rates
Step Rise Stable Fall
2:Subtract the
1-year ARM $6,476 $− $−
best column
3-year ARM $2,243 $4,632 $6,560
value from
each value in 30-year fixed $− $8,215 $14,497
the column.
Example 16.4: Mortgage Decision with the
Opportunity-Loss Strategy (2 of 2)
• Find the “minimax regret” decision
Step 3: Determine the maximum opportunity loss for each decision, and
then choose the decision with the smallest of these.
• Using this strategy, we would choose the 1-year ARM. This ensures
that, no matter what outcome occurs, we will never be more than
$6,476 away from the least cost we could have incurred.

Decision Strategies Without Outcome
Probabilities: Maximize Objective
• With a maximize objective, the payoffs are profits.
• Aggressive (Optimistic) Strategy

– Choose the decision that maximizes the largest payoff that can occur
among all outcomes for each decision (maximax strategy).
• Conservative (Pessimistic) Strategy
– Choose the decision that maximizes the smallest payoff that can occur
among all outcomes for each decision (maximin strategy).
• Opportunity Loss Strategy
– Choose the decision that minimizes the maximum opportunity loss among
all outcomes for each decision (minimax regret).
▪ Note that this is the same as for a minimize objective; however,
calculation of the opportunity losses is different.

Decisions with Conflicting Objectives
• Many decisions require some type of tradeoff among conflicting objectives,
such as risk versus reward.
• A simple decision rule can be used whenever one wishes to make an optimal
tradeoff between any two conflicting objectives, one of which is good, and
one of which is bad, that maximizes the ratio of the good objective to the bad.
– First, display the tradeoffs on a chart with the “good” objective on the x-
axis, and the “bad” objective on the y-axis, making sure to scale the
axes properly to display the origin (0,0).
– Then graph the tangent line to the tradeoff curve that goes through the
origin.
– The point at which the tangent line touches the curve (which represents
the smallest slope) represents the best return to risk tradeoff.

Example 16.5: Risk-Reward Tradeoff
Decision for Innis Investments Example
• From Figure 15.2, if we take the ratios of the weighted returns to the
minimum risk values in the table, we will find that the largest ratio
occurs for the target return of 6%.
• We can explain this easily from the chart by noting that for any other
return, the risk is relatively larger (if all points fell on the tangent line,
the risk would increase proportionately with the return).

Summary of Decision Strategies
Under Uncertainty (1 of 2)
Objective Strategy Aggressive Conservative Opportunity-Loss

Strategy Strategy Strategy
Minimize Choose the Find the smallest Find the largest pay- For each outcome,
objective decision with payoff for each deci- off for each decision cornpute the
the smallest Sion among all Out- among all opportunity loss for
average payoff. comes and choose Outcomes each decision as
the decision with the and choose the the absolute
smallest of these deci-Sion with the difference between
(minim in). smallest of these its payoff and the
(minimax). smallest payoff for
that outcome. Find
the maximum
opportunity loss for
each decision and
choose the decision
with the smallest
opportunity loss
(minimax regret).

Summary of Decision Strategies
Under Uncertainty (2 of 2)
Objective Strategy Aggressive Conservative Opportunity-Loss

Strategy Strategy Strategy
Maximize Choose the Find the largest Find the smallest For each outcome,
objective decision with pay-off for each pay- compute the
the largest decision off for each opportunity loss for
average payoff. among all decision each decision as
outcomes among all the absolute
and choose the outcomes difference between
decision with the and choose the its payoff and the
largest decision with the largest payoff for
of these largest of that outcome. Find
(maximax). these (maximin). the maximum
opportunity loss for
each decision and
choose the
decision with the
smallest
opportunity loss
(minimax regret).

Decision Strategies with Outcome
Probabilities
• In many situations, we might have some assessment of these
probabilities, either through some method of forecasting or reliance on
expert opinions.
• If we can assess a probability for each outcome, we can choose the
best decision based on the expected value.
– The simplest case is to assume that each outcome is equally likely
1
to occur; that is, the probability of each outcome is ,
N
where N is the number of possible outcomes. This is

called the average payoff strategy.

with the Average Payoff Strategy
• Estimates for the probabilities of each outcome are shown
in the table below.
• For each loan type, compute the expected value of the
interest cost and choose the minimum.

Expected Value Strategy
• A more general case is when the probabilities of the
outcomes are not all the same. This is called the expected
value strategy.
• We may use the expected value calculation that we
introduced in formula (5.12) in Chapter 5.

E  X    xi f ( xi ) (5.12)
i 1

with the Expected Value Strategy
• Estimates for the probabilities of each outcome are shown
in the table below.
• For each loan type, compute the expected value of the
interest cost and choose the minimum.

Evaluating Risk
• An implicit assumption in using the average payoff or
expected value strategy is that the decision is repeated a
large number of times. However, for any one-time decision
(with the trivial exception of equal payoffs), the expected
value outcome will never occur-only one of the actual
outcomes will occur for the decision chosen.
• For a one-time decision, we must carefully weigh the risk
associated with the decision in lieu of blindly choosing the
expected value decision.

Example 16.8: Evaluating Risk in the
Mortgage Decision
• Standard deviation of each decision:
Decision Standard Deviation

1-year ARM $10,763,80
3-year ARM $5,107.71
30-year fixed $−
• Based solely on the standard deviation, the 30-year fixed mortgage

has no risk at all, whereas the 1-year ARM appears to be the riskiest.
– While none of the previous decision strategies chose the 3-year
ARM, it may be attractive to the family due to its moderate risk
level and potential upside at stable and falling interest rates.

Decision Trees
• A decision tree is a graphical model used to structure a decision
problem involving uncertainty.
– Nodes are points in time at which events take place.
– Decision nodes are nodes in which a decision takes place by
choosing among several alternatives (typically denoted as
squares).
– Event nodes are nodes in which an event occurs not controlled
by the decision-maker (typically denoted as circles).
– Branches are associated with decisions and events.
• Decision trees model sequences of decisions and outcomes over time.

Example 16.9: Creating a Decision
Tree (1 of 3)
• Mortgage selection problem
• To start the decision tree, add a node for selection of the

loan type.

Tree (2 of 3)
• Next, for each type of loan,
add a node for selection of
the uncertain interest rate
conditions.

Tree (3 of 3)
• Finally, enter the payoffs of
the outcomes associated
with each event in the
cells immediately below
the branches.
• Sum all payoffs along the
paths and place these
values next to the terminal
nodes.

Example 16.10: Analyzing a Decision Tree
(1 of 2)
• To find the best decision

strategy in a decision tree, “roll
back” the tree by computing
expected values at event
nodes and selecting the
optimal value of alternative
decisions at decision nodes.
• If the one-year ARM is chosen,
the expected value of the
chance events is
0.6*  $61,134   0.3*  $46, 443 

0.1*  40,161   $54,629.40.

Example 16.10: Analyzing a Decision Tree
(2 of 2)
• At the decision node, the

maximum expected value
is chosen from among all
decisions; this is -
$54,135.20.
• This corresponds to the
three-year ARM, which is
branch 2.

Example 16.11: A Pharmaceutical
R&D Model (1 of 2)
• Moore Pharmaceuticals (Chapter 11) needs to decide whether to conduct clinical trials
and seek FDA approval for a newly developed drug.
– $300 million has already been spent on research.
– The next decision is whether to conduct clinical trials at a cost of $250 million.
– Probability of success following trials is 0.3.
– If the trials are successful, the next decision is whether to seek F DA approval,
costing $25 million.
– Likelihood of FDA approval is 60%.
– If released to the market, revenue potential and probabilities are:
Market Potential Expected

blank Revenues (millions of $) Probability
Large 4,500 0.6
Medium 2,200 0.3
Small 1,500 0.1

Example 16.11: A Pharmaceutical R&D
Model (2 of 2)

Decision Trees and Risk
• Decision trees are an example of expected value decision
making and do not explicitly consider risk.
• For Moore Pharmaceutical’s decision tree, we can form a
classical decision table.
Unsuccessful Successful Successful Successful Successful
blank
Clinical Trials Clinical Trials; Trials and Trials and Trials and
No FDA Approval; Approval; Approval;
Approval Large Market Medium Market Small Market
Develop drug ($550) ($575) $3,925 $1,625 $925
Stop ($300) ($300) ($300) ($300) ($300)

development
• We can then apply aggressive, conservative, and

opportunity loss decision strategies.
Aggressive Strategy (Maximax)
blank
Develop drug ($550) ($575) $3,925 $1,625 $925
Stop ($300) ($300) ($300) ($300) ($300)

development
• Developing the new drug maximizes the maximum payoff.

Conservative Strategy (Maximin)
blank
Develop drug ($550) ($575) $3,925 $1,625 $925
Stop ($300) ($300) ($300) ($300) ($300)

development
• Stopping development of the new drug maximizes the

minimum payoff.

Opportunity Loss Strategy
blank Unsuccessful Successful Successful Successful Successful
Develop drug ($550) ($575) $3,925 $1,625 $925
Stop ($300) ($300) ($300) ($300) ($300)

development
Opportunity Losses
Unsuccessf Successful Successful Successful Successful Maximum
blank
ul Clinical Trials and Trials and Trials and

Clinical Trials; No F Approval; Approval; Approval;
Trials DA Large Medium Small
Approval Market Market Market
Develop drug $250 $275 $− $− $− $275
Stop $− $− $4,225 $1,925 $1,225 $4,225

development
• Developing the new drug minimizes the maximum opportunity loss.

Example 16.12: Constructing a Risk
Profile (1 of 2)
• Each decision strategy has an associated payoff distribution, called a risk profile.
– Risk profiles show the possible payoff values that can occur and their probabilities.
• Outcomes and probabilities:
Terminal Outcome Net Revenue Probability

Market large $3,925 0.108
Market medium $1,625 0.054
Market small $925 0.018
FDA not approved ($575) 0.120
Clinical trials not successful ($550) 0.700
• The probabilities are computed by multiplying the probabilities on the event branches
along the path to the terminal outcome.

Example 16.12: Constructing a Risk
Profile (2 of 2)
• For example, the probability of getting to “Market large” is
0.3 * 0.6 * 0.6 = 0.108.

Sensitivity Analysis in Decision Trees
• We may use Excel data tables to investigate the sensitivity of the
optimal decision to changes in probabilities or payoff values.
• Example 5.26 Airline Revenue Management
– Full and discount airfares are available for a flight.
– Full-fare ticket costs $560
– Discount ticket costs $400
– X = selling price of a ticket
– p = 0.75 (the probability of selling a full-fare ticket)
E  X   0.75($560)  0.25(0)  $420
Breakeven point: $400   ($560) or  =0.714

Example 16.13: Sensitivity Analysis for
Airline Revenue Management Decision
• What-if analysis of the impact of changing the probability
that a full-fare ticket sells before the flight.
• From the data table results, we see that if the probability of

selling the full-fare ticket is 0.7 or less, then the best
decision is to discount the price.

The Value of Information
• The value of information is the improvement in the expected return if
the decision maker can acquire additional information about the future
event that will take place.
• Perfect information tell us, with certainty, which outcome will occur.
• Expected value of perfect information (EVPI) is expected value with
perfect information minus the expected value without it.
• Expected opportunity loss is the average additional amount the
decision maker would have achieved if the correct decision had been
made.
– Minimizing expected opportunity loss always results in the same
decision as maximizing expected value.

Example 16.14: Finding EVPI for the
Mortgage-Selection Decision (1 of 2)
• Find the minimum expected opportunity loss
Decision Outcome: Rates Outcome: Rates Outcome: Rates Fall

Rise Stable
1-year A RM $61,134 $46,443 $40,161
3-year A RM $56,901 $51,075 $46,721
30-year fixed $54,658 $54,658 $54,658
Opportunity Losses
Decision Outcome: 0.6 Outcome: 0.3 Outcome: 0.1 Outcome:
Rates Rise Rates Stable Rates Fall Expected
Opportunity
Loss
1-year A RM $6,476 $− $− $3,885.60
3-year A RM $2,243 $4,632 $6,560 $3,391.40=E VPI
30-year fixed $− $8,215 $14,497 $3,914.20

Example 16.14: Finding EVPI for the
Mortgage-Selection Decision (2 of 2)
• Alternate interpretation
• For each outcome (perfect information), find the best decision; then compute
the expected value
Decision Outcome: 0.6 Outcome:0.3 Outcome: 0.1 Outcome:

Rates Rise Rates Stable Rates Fall Expected Payoff
1-year ARM $61,134 $46,443 $40,161 $54,629.40
3-year ARM $56,901 $51,075 $46,721 $54,135.20
30-year fixed $54,658 $54,658 $54,658 $54,658.00
• Compute expected payoff of the best decisions:

0.6  $54,658  0.3  $46, 443  0.1 $40,16,  $50,743.80
• Without perfect information, the best decision is the 3-year ARM with an
expected cost of $54,135.20. EVPI is the difference (amount saved by having
perfect information): $54,135.20 − $50,743.80 = $3,391.40.

Decisions with Sample Information
• Sample information is the result of conducting some type
of experiment, such as a market research study or
interviewing an expert.
• The expected value of sample information (EVSI) is the
expected value with sample information (assumed at no
cost) minus the expected value without sample
information; it represents the most you should be willing to
pay for the sample information.

Example 16.15: Decisions with
Sample Information (1 of 3)
• A company is developing a new cell phone and currently has
two models under consideration.
• Historically, 70% of their new phones have had high consumer
demand and 30% have had low consumer demand.
• Model 1 requires $200,000 investment.
– If demand is high, revenue = $500,000
– If demand is low, revenue = $160,000
• Model 2 requires $175,000 investment.
– If demand is high, revenue = $450,000
– If demand is low, revenue = $160,000

• Decision tree (values in thousands)
Best decision is
to select model
1.

• A market research study is conducted to obtain sample information about
consumer demand.
• Similar studies have found:
– 90% of all products that had high consumer demand had previously
received high market survey responses.
– 20% of all products that had low consumer demand had previously
received high market survey responses.
– We should expect that a high survey response would increase the
historical probability of high demand, whereas a low survey response
would increase the historical probability of a low demand.
• We need to compute conditional probabilities:
P  demand survey response 

Bayes’s Rule
• Bayes’s rule allows revising historical probabilities based
on sample information.
P  B Ai  P  Ai 
P  Ai B   (16.1)
P  B A1  P  A1   P  B A2  P  A2   ...  P  B Ak  P  Ak 

Example 16.16: Applying Bayes’s Rule to
Compute Conditional Probabilities (1 of 3)
• Define
– A1  High consumer demand P  A1   0.7

– A2  Low consumer demand P  A2   0.3
– B1  High survey response
P  B1 | A1   0.9
– B2  Low survey response
P ( B1 | A2 )  0.2
• P  B2 A1   1  P  B1 A1   0.1
• P  B2 A2   1  P  B1 A2   0.8
(.9)(.7)
• Using Bayes’s rule P( A1 | B1 ) 
[(.9)(.7)  (.2)(.3)]
 0.913
P ( A2 | B1 )  1  0.913  0.087
(.1)(.7)
P ( A1 | B1 )   0.226
[(.1)(.7)  (.8)(.3)]
P ( A2 | B 2)  1  0.226  0.774

• Using Bayes’s rule
P  B1 A1  P  A1 
P  A1 B1  
P  B1 A1  P  A1   P  B1 A2  P  A2 
P  A1 B1  
.9 .7   0.913
.9 .7   .2 .3
P  A2 B1   1  0.913  0.087
P  B2 A1  P  A1 
P  A1 B2  
P  B2 A1  P  A1   P  B2 A2  P  A2 
P  A1 B1  
.1.7   0.226
.1.7   .8 .3 
P  A2 B2   1  0.226  0.774

• Compute marginal probabilities
•
P  B1   P  B1 A1   P  A1   P  B1 A2   P  A2 
 .9 .7   .2 .3
 0.69
• P  B2   P  B2 A1   P  A1   P  B2 A2   P  A2 
 .1.7   .8 .3
 0.31

Decision Tree with Market Survey
Information
• Select model 1 if the
survey response is
high; and if the
response is low, then
select model 2.
• EVSI = $202,257 −
$198,000 = $4,257.

Utility and Decision Making
• Utility theory is an approach for assessing risk attitudes
quantitatively.
• This approach quantifies a decision maker’s relative
preferences for particular outcomes.
• We can determine an individual’s utility function by posing
a series of decision scenarios.

Example 16.17: A Personal
Investment Decision
• Suppose you have $10,000 to invest short-term.
• You are considering 3 options:
1. Bank CD paying 4% return
2. Bond fund with uncertain return
3. Stock fund with uncertain return
• Bond and stock funds are sensitive to interest rates
Decision/Event Rates Rise Rates Stable Rates Fall
Bank CD $400 $400 $400

Bond fund −$500 $840 $1,000
Stock fund −$900 $600 $1,700
Constructing a Utility Function
• Sort the payoffs from highest to lowest.
– Assign a utility to the highest payoff of U  X   1.
– Assign a utility to the lowest payoff of U  X   0.
• For each payoff between the highest and lowest, consider the following
situation:
– Suppose you have the opportunity of achieving a guaranteed return of x
or taking a chance of receiving the highest payoff with probability p or the
lowest payoff with probability 1 − p.
– The term certainty equivalent represents the amount that a decision
maker feels is equivalent to an uncertain gamble.
– What value of p would make you indifferent to these two choices?
• Then repeat this process for each payoff.

Example 16.18: Constructing a Utility Function
for the Personal Investment Decision (1 of 2)
Payoff, X Utility ,U(X)

$1,700 1.0 U 1700   1
$1000
blank
$840
Blank
U 1000   the probability you would give up a
$600
blank
certain $1000 to possibly win a

$400
$1700 payoff. Suppose this is 0.9.
blank
−$500
blank
−$900 0.0
U  900   0
Decision tree
characterization:

Example 16.18: Constructing a Utility Function
for the Personal Investment Decision (2 of 2)
• Final utility function

$1,700 1.0
$1000 0.90
$840 0.85
$600 0.80
$400 0.75
$(500) 0.35
$(900) 0.0

Risk Premium
• The risk premium is the amount an individual is willing to forgo to avoid risk.
• For the payoff of $1000, the expected value of taking the gamble is
0.9 $1, 700   0.1 $900   $1, 440. You require a risk premium
of $1,440 − $1,000 = $440 to feel comfortable enough to risk losing $900 if
you take the gamble. Such an individual is risk-averse.

Example Utility Function for Risk-
Takers
• For the payoff of $1,000, this individual
would be indifferent between receiving Payoff, X Utility ,U(X)
$1,000 and taking a chance at $1,700 with $1,700 1.0
probability 0.6 and losing $900 with $1000

$840
0.6
0.55
probability 0.4. $600 0.45
$400 0.40
• The expected value of this gamble is −$500 0.1

−$900 0.0
0.6 $1, 700   0.4  $900   $660
– Because this is considerably less than $1,000, the individual

is taking a larger risk to try to receive $1,700.

Using Utility Functions in Decision
Analysis
• Replace payoffs with utilities.
• Example using average payoff strategy:
– If probabilities are known, find the expected utility.

Exponential Utility Functions
• An exponential utility function approximates those of risk-
averse individuals:
x

U  x  1 e R
– R is a shape parameter indicative of risk tolerance.

– Smaller values of R result in a more concave shape
and are more risk averse.

Estimating the Value of R
• Find the maximum payoff $R for which the decision maker
believes that taking a chance to win $R is
R
$ .
equivalent to losing 2
– Would you take on a bet of possibly winning $10

versus losing $5?
– How about risking $5,000 to win $10,000?

Example 16.19: Using an Exponential
Utility Function
• For the personal investment example, suppose that R = $400.

– 
X
$1,700 0.9857
U  X   1 e 400
$1000 0.9179
$840 0.8775
$600 0.7769
$400 0.6321
−$500 −2.4903
−$900 −8.4877
• Use these utilities in the payoff table

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Business Analytics: Methods,

Models, and Decisions

Copyright © 2021 Pearson Education Ltd. Slide - 1

Copyright © 2021 Pearson Education Ltd. Slide - 2

3. consequences associated with each decision and outcome, which are

Decision Outcome: Rates Outcome: Rates Outcome: Rates

3-year A RM $56,901 $51,075 $46,721

30-year fixed $54,658 $54,658 $54,658

Copyright © 2021 Pearson Education Ltd. Slide - 4

Copyright © 2021 Pearson Education Ltd. Slide - 5

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• Aggressive (Optimistic) Strategy

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Objective Strategy Aggressive Conservative Opportunity-Loss

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Objective Strategy Aggressive Conservative Opportunity-Loss

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where N is the number of possible outcomes. This is

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Decision Standard Deviation

• Based solely on the standard deviation, the 30-year fixed mortgage

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• To start the decision tree, add a node for selection of the

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• To find the best decision

0.6*  $61,134   0.3*  $46, 443 

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• At the decision node, the

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Market Potential Expected

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Stop ($300) ($300) ($300) ($300) ($300)

• We can then apply aggressive, conservative, and

Stop ($300) ($300) ($300) ($300) ($300)

• Developing the new drug maximizes the maximum payoff.

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Stop ($300) ($300) ($300) ($300) ($300)

• Stopping development of the new drug maximizes the

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Stop ($300) ($300) ($300) ($300) ($300)

ul Clinical Trials and Trials and Trials and

Stop $− $− $4,225 $1,925 $1,225 $4,225

• Developing the new drug minimizes the maximum opportunity loss.

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• Outcomes and probabilities:

Terminal Outcome Net Revenue Probability