Business Analytics: Methods, Models,
and Decisions
Third Edition
Chapter 16
Decision Analysis
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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.
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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.
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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.
– 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.
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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)
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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).
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Example 16.3: Mortgage Decision
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).
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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.
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Example 16.4: Mortgage Decision with
the Opportunity-Loss Strategy
• Compute the opportunity loss matrix.
Step 1:
Find the best
outcome
(minimum cost)
in each
column.
Step 2:
Subtract the
best column
value from each
value in the
column.
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Example 16.4 Continued
• 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 A RM. 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.
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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.
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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.
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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).
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Summary of Decision Strategies
Under Uncertainty
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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
to occur; that is, the probability of each outcome is
where N is the number of possible outcomes. This is called the
average payoff strategy.
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Example 16.6: Mortgage Decision
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.
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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.
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Example 16.7: Mortgage Decision
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.
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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.
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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.
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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.
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Example 16.9: Creating a Decision
Tree
• Mortgage selection problem
• To start the decision tree, add a node for selection of the
loan type.
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Example 16.9 Continued
• Next, for each type of loan,
add a node for selection of
the uncertain interest rate
conditions.
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Example 16.9 Continued
• 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.
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Example 16.10: Analyzing a Decision
Tree
• 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.
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Example 16.10 Continued
• 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.
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Example 16.11: A Pharmaceutical
R&D Model
• 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
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Example 16.11 Continued
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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.
• We can then apply aggressive, conservative, and
opportunity loss decision strategies.
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Aggressive Strategy (Maximax)
• Developing the new drug maximizes the maximum payoff.
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Conservative Strategy (Maximin)
• Stopping development of the new drug maximizes the
minimum payoff.
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Opportunity Loss Strategy
Opportunity Losses
• Developing the new drug minimizes the maximum
opportunity loss.
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Example 16.12: Constructing a Risk
Profile
• 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.
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Example 16.12 Continued
• For example, the probability of getting to “Market large”
is 0.3 * 0.6 * 0.6 = 0.108.
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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)
Breakeven point:
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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.
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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 (E VPI) 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.
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Example 16.14: Finding EVPI for the
Mortgage-Selection Decision
• Find the minimum expected opportunity loss
Opportunity Losses
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Example 16.14 Continued
• Alternate interpretation
• For each outcome (perfect information), find the best decision; then
compute the expected value
• Compute expected payoff of the best decisions:
• Without perfect information, the best decision is the 3-year A RM 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.
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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.
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Example 16.15: Decisions with
Sample Information
• 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
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Example 16.15 Continued
• Decision tree (values in thousands)
Best decision is to
select model 1.
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Example 16.15 Continued
• 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:
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Bayes’s Rule
• Bayes’s rule allows revising historical probabilities based
on sample information.
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Example 16.16: Applying Bayes’s Rule to
Compute Conditional Probabilities
• Define
– A1 = High consumer demand
– A2 = Low consumer demand
–
–
•
•
• Using Bayes’s rule
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Example 16.16 Continued
• Using Bayes’s rule
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Example 16.16 Continued
• Compute marginal probabilities
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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.
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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.
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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
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Constructing a Utility Function
• Sort the payoffs from highest to lowest.
– Assign a utility to the highest payoff of
– Assign a utility to the lowest payoff of
• 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.
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Example 16.18: Constructing a Utility Function
for the Personal Investment Decision
the probability you would give up a
certain $1000 to possibly win a $1700
payoff. Suppose this is 0.9.
Decision tree
characterization:
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Example 16.18 Continued
• Final utility function
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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
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.
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Example Utility Function for
Risk-Takers
• For the payoff of $1,000, this individual
would be indifferent between receiving
$1,000 and taking a chance at $1,700
with probability 0.6 and losing $900 with
probability 0.4.
• The expected value of this gamble is
– Because this is considerably less than $1,000, the individual is
taking a larger risk to try to receive $1,700.
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Using Utility Functions in Decision
Analysis
• Replace payoffs with utilities.
• Example using average payoff strategy:
– If probabilities are known, find the expected utility.
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Exponential Utility Functions
• An exponential utility function approximates those of
risk-averse individuals:
– R is a shape parameter indicative of risk tolerance.
– Smaller values of R result in a more concave shape and
are more risk averse.
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Estimating the Value of R
• Find the maximum payoff $R for which the decision
maker believes that taking a chance to win $R is
equivalent to losing
– Would you take on a bet of possibly winning $10 versus
losing $5?
– How about risking $5,000 to win $10,000?
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Example 16.19: Using an Exponential
Utility Function
• For the personal investment example, suppose that
R = $400.
–
• Use these utilities in the payoff table
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