 The purpose of business analytic models is to provide

decision-makers with information needed to make

decisions.
 Making good decisions requires an assessment of
intangible factors and risk attitudes.
 Decision making 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.
 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.
 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.
 Minimize Objective (e.g. 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)
 Determine the lowest payoff (interest cost) for
each type of mortgage, and then choose the
decision with the smallest value (minimin).
 Determine the largest payoff (interest cost) for
each type of mortgage, and then choose the
decision with the smallest value (minimax).
 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.
  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.
 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.
 Maximize Objective (e.g. 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.
 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.
 From Figure 14.19, 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).
 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 1/N,
where N is the number of possible outcomes. This is called 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.
 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 (5.9) in Chapter 5.
 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.
 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 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.
 Standard deviation of each decision:

 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.
 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.
 Click Decision Tree button
 To add a node, select Add Node from the Node
dropdown list.
 Click on the radio button for the
type of node you wish to create
(decision or event). This
displays one of the dialogs
shown.
◦ For a decision node, enter the name
of the node and names of the
branches that emanate from the
node (you may also add additional
ones). The Value field can be used
to input cash flows, costs, or
revenues that result from choosing a
particular branch.
◦ For an event node, enter the name
of the node and branches. The
Chance field allows you to enter the
probabilities of the events.
 Mortgage selection problem

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

loan type.
 Then, for each type of loan, add a node for selection of
the uncertain interest rate conditions.
 Finally, enter the payoffs of the outcomes associated
with each event in the cells immediately below the
branches
 First partial decision tree

 Second partial decision tree

 payoffs

 Full decision tree

with rollback
Expected value
calculations

Best decision branch

(#2: 3 Year ARM)
 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
FDA approval, costing $25 million.
◦ Likelihood of FDA approval is 60%.
◦ If released to the market, revenue potential and probabilities are:
 If successful,
seek approval

Choose to
conduct trials

If approved,
expected revenue
 With Analytic Solver Platform, you can use the Excel
model to develop a Monte Carlo simulation or an
optimization model using the decision tree.
 Payoffs are uncertain.
 Large response: =PsiLogNormal(4500, 1000)
 Medium response: =PsiLogNormal(2200, 500)
 Small response: =PsiNormal(1500, 200)
 Clinical trial cost is uncertain
◦ =PsiTriangular(-700, -550, -500)
 To define the changing output cell, we
cannot use the decision tree’s net revenue
cell (A29). Choose any empty cell and enter
◦ =A29 + PsiOutput()
 Results
 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.
 Developing the new drug maximizes the maximum
payoff.
 Stopping development of the new drug maximizes the
minimum payoff.
 Opportunity Losses

 Developing the new drug minimizes the maximum

opportunity loss.
 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:

◦ The probabilities are computed by multiplying the probabilities on

the event branches along the path to the terminal outcome.

18-
 Computing the probability of “Market large”

Probability = 0.3 × 0.6 × 0.6

 We may use Excel data tables to investigate the
sensitivity of the optimal decision to changes in
probabilities or payoff values.
 Airline Revenue Management example (Example 5.22,
Chapter 5)
 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 = p($560) or p = 0.714
 Decision tree and data table for varying the probability of success
with two output columns, one providing the expected value from cell
A10 in the tree and the second providing the best decision.
◦ The formula in cell N3 is =A10
◦ The formula in cell O3 is =IF(B9=1, “Full”, “Discount”).
◦ The formula in cell H6 is =1-H1. Use H1 as column input cell in the data
tables.
 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.
 Find the minimum expected opportunity loss

Opportunity Losses

= EVPI
 Alternate interpretation
 For each outcome (perfect information), find the best decision;
then compute the expected value

 Compute expected payoff of the best decisions:

0.6 × $54,658 + 0.3 × $46,443 + 0.1 × $40,161=$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.
 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.
 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 allows revising historical probabilities based
on sample information.
 Define
◦ A1 = High consumer demand P(A1) = 0.70
◦ A2 = Low consumer demand P(A2) = 0.30
◦ B1 = High survey response
◦ B2 = Low survey response
 P(B1 |A1) = 0.90; therefore, P(ML |DH) = 1 − 0.90 = 0.10
 P(B1 |A2) = 0.20; therefore, P(ML |DL) = 1 − 0.20 = 0.80

 Using Bayes’s rule

P(A1 |B1) = (.9)(.7) / [(.9)(.7)+(.2)(.3)] = 0.913

P(A2 |B1) = 1 − 0.913 = 0.087

P(A1 |B1) = (.1)(.7) / [(.1)(.7)+(.8)(.3)] = 0.226

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
 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 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.
 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
 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.
 U(1700) = 1
U(1000) = the probability you would give up
a certain $1000 to possibly win a
$1700 payoff. Suppose this is 0.9.

U(−900) = 0

Decision tree
characterization:
 Final utility function
 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.
 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
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.
 Replace payoffs with utilities.
 Example using average payoff strategy:

 If probabilities are known, find the expected utility.

 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.
 Find the maximum payoff $R for which the
decision maker believes that taking a chance to
win $R is equivalent to losing $R/2.
 Would you take on a bet of possibly winning $10 versus
losing $5?
 How about risking $5,000 to win $10,000?
 For the personal investment example, suppose that R =
$400.
◦ U(X) = 1 – e-X/400

 Use these utilities in the payoff table