Professional Documents
Culture Documents
Manahan Siallagan
Problems of Choice
C1 O1
D
C2 O2
D : a decision maker
C : possible courses of action
(alternatives)
O1 : desirable outcome;
2 O2 : undesirable outcome
Complex Rational Choice
Incomplete information
The other side may influences the
consequences (Strategic/Interactive
Decision).
3
Decision Analysis Problems
Decision analysis is designed to address
decision making in the face of great
uncertainty
Introducing new product into
marketplace:
What will the reaction of potential
customers ? Competitors?
Investing in securities :
How is the economy?
How about interest rates?
Selecting the mix of crops and livestock
for the upcoming season :
What will be the weather conditions?
Drilling for oil in particular location :
How likely is there to be oil in that
location?
How much?
Tools: Decision tree
Why Decision Tree?
It can help a decision maker to develop a clear view of the
structure of a problem anda make it easier to determine the
possible scenarios that can result if a particular course of
action is chosen.
Decision trees can also help a decision maker to judge the
nature of the information that needs to be gathered in order
to tacke a problem.
It can be an excellent medium for communicating one
person’s perception of a problem to other individuals.
5
Model of Decision Tree
p1,1
E1,1 O1
C1 p1,2
E1,2 O2
D p2,1 O1
E2,1
C2
E2,2 p2,2 O2
D : a decision maker
C : possible courses of action (alternatives)
O1 and O2 : possible outcomes/consequences/payoffs
Ei,j : Events (State of Natures/SON)
pi,j : probabilities
6
Structure of Decision Tree
Decision Node
Alternatives available for decision maker to choose;
Situation controllable by decision maker.
Alternatives of actions
7
Structure of Decision Tree
Event Node
Events may happen after every action made by decision maker;
Uncontrollable by decision maker;
Decision maker only has information about probability of each
event no complete information.
p1
E1
E2 p2
An action
E3
p3
8 Events
Building Decision Tree
9
Goferbroke Company Case
Goferbroke Company(1)
Max Flyer is the founder of and sole owner of the Goferbroke Company, which
develops oil wells in unproven territory. Max’s friends refer to him affectionately as
a wildcatter. However he prefers to think himself as an entrepreneur. He has poured
his life saving’s into the company in the hope of making it big with a large strike of oil.
Now his chance possibly has come. His company has purchased various tracts of land
that larger oil companies have spurned as unpromising even though they are near
some large oil fields. Now Max has received an exciting report about one of these tracts. A
consulting geologist has just informed Max that he believes there is one chance in four of oil
there.
Max has learned from bitter experience to be skeptical about the chances of oil
reported by consulting geologist. Drilling for oil on this tract would require an
investment of about $100,000. If the lands turns out to be dry (no oil), the entire
investment would be lost. Since his company doesn’t have much capital left,
this lost would be quite serious.
Goferbroke Company(2)
On the other hand, if the tract does contain oil, the consulting geologist estimates
that there would be enough there to generate a net revenue of approximately
$800,000, leaving an approximate profit of:
Profit if find oil = Revenue if find oil – Drilling cost
= $800,000 - $100,000
= $700,000
There is another option that another oil company has gotten wind of consulting
geologist’s report and so has offered to purchase the tract of land from Max for
$90,000. This is very tempting. This too would provide a welcome infusion of
capital into the company, but without incurring the large risk of a very
substansial loss of $100,000.
The Goferbroke Company
Problem
-100
Sell
90
DT of Goferbroke’s Case
Event nodes
Oil 0.25
800
Drill
90
DT of Goferbroke’s Case
Payoff
Oil 0.25
700
800
Drill
Oil 0.25
700
800
Drill
Action: Drill
100=(0.25*700) + (0.75*(-100))
Decision Analysis:
New Information or Posterior
Probability
23
Process in Revising Decision tree
Prior probability
New information
Posterior probability
24
Assessing Probability
There are three approaches to assessing the probability of an
uncertain event:
1. a priori classical probability
X number of ways the event can occur
probability of occurrence
T total number of elementary outcomes
3. subjective probability
an individual judgment or opinion about the probability of occurrence
Computing Joint and
Marginal Probabilities
Color
Type Red Black Total
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52
Marginal Probability Example
P(Ace)
2 2 4
P( Ace and Re d) P( Ace and Black )
52 52 52
Color
Type Red Black Total
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52
Computing Conditional Probabilities
A conditional probability is the probability of one event, given
that another event has occurred:
CD No CD Total
CD No CD Total
.3
Using Decision Trees
(continued)
.2
Given CD or no CD: .4 P(CD and AC) = 0.2
.6
Bayes’ Theorem
Bayes’ theorem is used to revise previously calculated probabilities after new information is
obtained
P(A | B i )P(B i )
P(B i | A)
P(A | B 1 )P(B 1 ) P(A | B 2 )P(B 2 ) P(A | B k )P(B k )
where:
Bi = ith event of k mutually exclusive and collectively
exhaustive events
A = new event that might impact P(Bi)
Goferbroke’s Case Continued
Survey by geologist will provide more accurate
information about P(oil);
How if Max has to decide two alternatives:
1. Do survey before drill/sell
2. Drill/sell without Survey
Events:
Do Survey
FSS : Favorable Seismic Sounding : Oil is fairly likely
USS : Unfavorable seismic sounding: Oil is quite unlikely.
Drill or Sell
Oil
Dry
P=?
Oil
Drill
P=?
P=? Dry
Unfavorable
Sell
Do Survey
P=?
30000 Oil
Drill
P=?
P=? Dry
Favorable
1
Sell
P=?
Oil
Drill
P=?
Dry
No Survey
Sell
Max`s Experience
•P(state) prior; which is P(Oil)=0.25 & P(Dry)=0.75;
•P (finding|state) being known based on Max’s
experiences; which is
•P(FSS|Oil)=0.6,
•P(USS|Oil)=0.4,
•P(FSS|Dry)=0.2, and
•P(USS|Dry)=0.8
Which:
•State : Oil and Dry;
•Finding : FSS and USS;
•FSS : favorable seismic sounding; oil is fairly likely;
•USS : unfavorable seismic sounding; oil is quite unlikely.
P(Oil│USS)
Oil
P(FSS│Oil) = 0,6 Drill
Do Survey
P(Oil│FSS)
Oil
Drill
P(Dry│FSS)
P(FSS) Dry
Favorable
Sell
P(Oil)
Oil
Drill
P(Dry)
Dry
No Survey
Sell
Posterior Probability Formula
43
Leveled Decision Analysis
Decision T ree for Goferbroke Co. Problem (With Survey)
0,143
Oil
P(Oil|USS)
P(USS) Drill 800 670
670
0,7
-100 -15,714 0,857
Dry P(Dry|USS)
Unfavorable -130
2 0 -130
Expected payoff
0 60
= MAX [123,100]
Sell
60
= 123
90 60
Do Survey
0,5 P(Oil|FSS)
-30 123 Oil
1 Sell
123 60
90 60
0,25
Oil P(Oil)
700
Drill 800 700
Sell
90
90 90
Posterior Probability
Given:
P(state)=prior probability: P(oil) and P(dry)
P(finding|state) = Max’s experience on probabilities of finding (FSS or
USS) could occur if some SoN (oil or dry) has been already happened.
0.
Dr 75 P(FSS|dry) 0.75*0.2=0.15 0.15/0.3=0.5
P(dry|FSS)
y Dry and FSS Dry, diket FSS
0.2 et Dry P(Dry and FSS)
k
P(dry) , di
F SS
US 0.
S , di 8 P(Dry and USS)
ket
Dry 0.75*0.8=0.6 0.6/0.7=0.86
P(USS|dry) Dry and USS Dry, diket USS
P(dry|USS)
0,143
Oil
670
Drill 800 670
Sell
60
90 60
Do Survey
0,5
-30 123 Oil
670
Drill 800 670
1 Sell
123 60
90 60
0,25
Oil
700
Drill 800 700
Sell
90
90 90
Thank You
47
Exercise
Von Holt was a general marketing manager. He was assigned to assess the prospect of a
new product to be manufactured. The approximately production cost was USD 90,000.
If it had been sold out then it would gain revenue USD 500,000. In other side, if he
didn’t decide to produce then the company would loss nothing. Based on his experience,
he knew that 0.2 was the probability that the market would accept the product. Even
though, he wasn’t sure whether it represented the current data. He had another option
to run market research and collect the last information, but it took investments as
many as USD 10,000. Again, based on experience, he had known that if the customer
accepted the product then the survey would exhibit that the result was favorable with
probability 0.6. However, the probability would reduce to 0.1, if the customer rejected.
Now, help Holt to decide the best strategy! …. and … don’t forget to :
Draw the tree diagram.
Show us how did you get the probability…