IndE 311

Stochastic Models and Decision Analysis

UW Industrial Engineering

Instructor: Prof. Zelda Zabinsky

Decision Analysis-1
Operations Research
“The Science of Better”

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 Operations Research
Modeling Toolset
311
Queueing 310
Markov
Theory PERT/
Chains
CPM Network
Simulation Programming
Decision Stochastic
Inventory Analysis Programming Linear
Theory Programming
Markov
Dynamic Nonlinear
Forecasting Decision
Programming Integer Programming
Processes
Programming
Game
Theory
312
Decision Analysis-3
 IndE 311
• Decision analysis • Queueing theory
– Decision making without – Basic structure and modeling
experimentation – Exponential distribution
– Decision making with – Birth-and-death processes
experimentation – Models based on birth-and-death
– Decision trees
– Models with non-exponential
– Utility theory distributions
• Markov chains • Applications of queueing
– Modeling theory
– Chapman-Kolmogorov equations – Waiting cost functions
– Classification of states – Decision models
– Long-run properties
– First passage times
– Absorbing states

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Decision Analysis

Chapter 15

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 Decision Analysis
• Decision making without experimentation
– Decision making criteria
• Decision making with experimentation
– Expected value of experimentation
– Decision trees
• Utility theory

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Decision Making without
Experimentation

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 Goferbroke Example
• Goferbroke Company owns a tract of land that may contain oil
• Consulting geologist: “1 chance in 4 of oil”
• Offer for purchase from another company: $90k
• Can also hold the land and drill for oil with cost $100k
• If oil, expected revenue $800k, if not, nothing
Payoff
Alternative Oil Dry
Drill for oil
Sell the land
Chance 1 in 4 3 in 4

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 Notation and Terminology

• Actions: {a1, a2, …}

– The set of actions the decision maker must choose from
– Example:

• States of nature: {1, 2, ...}

– Possible outcomes of the uncertain event.
– Example:

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 Notation and Terminology

• Payoff/Loss Function: L(ai, k)

– The payoff/loss incurred by taking action a i when state k occurs.
– Example:

• Prior distribution:
– Distribution representing the relative likelihood of the possible
states of nature.

• Prior probabilities: P( = k)

– Probabilities (provided by prior distribution) for various states of
nature.
– Example:
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 Decision Making Criteria

Can “optimize” the decision with respect to several criteria

• Maximin payoff
• Minimax regret
• Maximum likelihood
• Bayes’ decision rule (expected value)

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 Maximin Payoff Criterion
• For each action, find minimum payoff over all states of nature
• Then choose the action with the maximum of these minimum
payoffs

State of Nature
Min
Action Oil Dry
Payoff

Drill for oil 700 -100

Sell the land 90 90

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 Minimax Regret Criterion
• For each action, find maximum regret over all states of nature
• Then choose the action with the minimum of these maximum
regrets
(Payoffs) State of Nature
Action Oil Dry
Drill for oil 700 -100
Sell the land 90 90

(Regrets) State of Nature

Max
Action Oil Dry
Regret

Drill for oil

Sell the land
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 Maximum Likelihood Criterion
• Identify the most likely state of nature
• Then choose the action with the maximum payoff under that state of
nature

State of Nature
Action Oil Dry
Drill for oil 700 -100
Sell the land 90 90
Prior probability 0.25 0.75

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 Bayes’ Decision Rule
(Expected Value Criterion)
• For each action, find expectation of payoff over all states of nature
• Then choose the action with the maximum of these expected
payoffs

State of Nature
Expected
Action Oil Dry
Payoff

Drill for oil 700 -100

Sell the land 90 90
Prior probability 0.25 0.75

Decision Analysis-15
 Sensitivity Analysis with
Bayes’ Decision Rule
• What is the minimum probability of oil such that we choose to drill
the land under Bayes’ decision rule?

State of Nature
Expected
Action Oil Dry
Payoff

Drill for oil 700 -100

Sell the land 90 90
Prior probability p 1-p

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Decision Making with
Experimentation

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 Goferbroke Example (cont’d)
State of Nature
Action Oil Dry
Drill for oil 700 -100
Sell the land 90 90
Prior probability 0.25 0.75

• Option available to conduct a detailed seismic survey to obtain a

better estimate of oil probability
• Costs $30k
• Possible findings:
– Unfavorable seismic soundings (USS), oil is fairly unlikely
– Favorable seismic soundings (FSS), oil is fairly likely

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 Posterior Probabilities
• Do experiments to get better information and improve
estimates for the probabilities of states of nature. These
improved estimates are called posterior probabilities.
• Experimental Outcomes: {x1, x2, …}
Example:

• Cost of experiment: 
Example:

• Posterior Distribution: P( = k | X = xj)

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 Goferbroke Example (cont’d)
• Based on past experience:
If there is oil, then
– the probability that seismic survey findings is USS = 0.4 =
P(USS | oil)
– the probability that seismic survey findings is FSS = 0.6 =
P(FSS | oil)
If there is no oil, then
– the probability that seismic survey findings is USS = 0.8 =
P(USS |
dry)
– the probability that seismic survey findings is FSS = 0.2 =
P(FSS |
dry)

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 Bayes’ Theorem
• Calculate posterior probabilities using Bayes’ theorem:
Given P(X = xj |  = k), find P( = k | X = xj)

P(X  x j |   k ) P(  k )
P(  k | X  x j ) 


P(X  x j |  i ) P( i )
i

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 Goferbroke Example (cont’d)
• We have
P(USS | oil) = 0.4 P(FSS | oil) = 0.6 P(oil) = 0.25
P(USS | dry) = 0.8 P(FSS | dry) = 0.2 P(dry) = 0.75

• P(oil | USS) =

• P(oil | FSS) =

• P(dry | USS) =

• P(dry | FSS) =

Decision Analysis-22
 Goferbroke Example (cont’d)

Optimal policies
• If finding is USS: State of Nature
Expected
Action Oil Dry
Payoff

Drill for oil 700 -100

Sell the land 90 90
Posterior probability
• If finding is FSS: State of Nature
Expected
Action Oil Dry
Payoff

Drill for oil 700 -100

Sell the land 90 90
Posterior probability Decision Analysis-23
 The Value of Experimentation
• Do we need to perform the experiment?
As evidenced by the experimental data, the experimental outcome
is not always “correct”. We sometimes have imperfect information.
• 2 ways to access value of information
– Expected value of perfect information (EVPI)
What is the value of having a crystal ball that can identify true
state of nature?
– Expected value of experimentation (EVE)
Is the experiment worth the cost?

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 Expected Value of Perfect Information
• Suppose we know the true state of nature. Then we will
pick the optimal action given this true state of nature.

State of Nature
Action Oil Dry
Drill for oil 700 -100
Sell the land 90 90
Prior probability 0.25 0.75

• E[PI] = expected payoff with perfect information =

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 Expected Value of Perfect Information
• Expected Value of Perfect Information:
EVPI = E[PI] – E[OI]
where E[OI] is expected value with original information
(i.e. without experimentation)
• EVPI for the Goferbroke problem =

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 Expected Value of Experimentation
• We are interested in the value of the experiment. If the
value is greater than the cost, then it is worthwhile to do
the experiment.
• Expected Value of Experimentation:
EVE = E[EI] – E[OI]
where E[EI] is expected value with experimental
information.
E [EI ]  E [value | experimental result j ] P (result j )
j

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 Goferbroke Example (cont’d)
• Expected Value of Experimentation:
EVE = E[EI] – E[OI]
E [EI ]  E [value | experimental result j ] P (result j )
j

EVE =

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Decision Trees

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 Decision Tree
• Tool to display decision problem and relevant
computations

• Nodes on a decision tree called __________.

• Arcs on a decision tree called ___________.

• Decision forks represented by a __________.

• Chance forks represented by a ___________.

• Outcome is determined by both ___________ and ____________.

Outcomes noted at the end of a path.
• Can also include payoff information on a decision tree branch
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Goferbroke Example (cont’d)
Decision Tree

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 Analysis Using Decision Trees
1. Start at the right side of tree and move left a column at a time. For
each column, if chance fork, go to (2). If decision fork, go to (3).
2. At each chance fork, calculate its expected value. Record this
value in bold next to the fork. This value is also the expected value
for branch leading into that fork.
3. At each decision fork, compare expected value and choose
alternative of branch with best value. Record choice by putting
slash marks through each rejected branch.
• Comments:
– This is a backward induction procedure.
– For any decision tree, such a procedure always leads to an optimal
solution.

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Goferbroke Example (cont’d)
Decision Tree Analysis

Decision Analysis-33
 Painting problem
• Painting at an art gallery, you think is worth $12,000
• Dealer asks $10,000 if you buy today (Wednesday)
• You can buy or wait until tomorrow, if not sold by then, can be yours
for $8,000
• Tomorrow you can buy or wait until the next day: if not sold by then,
can be yours for $7,000
• In any day, the probability that the painting will be sold to someone
else is 50%
• What is the optimal policy?

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 Drawer problem
• Two drawers
– One drawer contains three gold coins,
– The other contains one gold and two silver.
• Choose one drawer
• You will be paid $500 for each gold coin and $100 for each silver
coin in that drawer
• Before choosing, you may pay me $200 and I will draw a randomly
selected coin, and tell you whether it’s gold or silver and which
drawer it comes from (e.g. “gold coin from drawer 1”)
• What is the optimal decision policy? EVPI? EVE? Should you pay
me $200?

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Utility Theory

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Validity of Monetary Value Assumption
• Thus far, when applying Bayes’ decision rule, we
assumed that expected monetary value is the
appropriate measure
• In many situations and many applications, this
assumption may be inappropriate

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 Choosing between ‘Lotteries’
• Assume you were given the option to choose from two
‘lotteries’
.5
– Lottery 1 $1,000
50:50 chance of winning $1,000 or $0 .5
$0
– Lottery 2
1
Receive $50 for certain $50
• Which one would you pick?

Decision Analysis-38
 Choosing between ‘lotteries’

• How about between these two?

.5
– Lottery 1 $1,000
.5
50:50 chance of winning $1,000 or $0 $0
– Lottery 2 1
Receive $400 for certain $400

• Or these two?
.5
– Lottery 1 $1,000
.5
50:50 chance of winning $1,000 or $0 $0
– Lottery 2 1
Receive $700 for certain $700

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 Utility
• Think of a capital investment firm deciding whether or
not to invest in a firm developing a technology that is
unproven but has high potential impact
• How many people buy insurance?
Is this monetarily sound according to Bayes’ rule?
• So... is Bayes’ rule invalidated?
No- because we can use it with the utility for money
when choosing between decisions
– We’ll focus on utility for money, but in general it could be utility
for anything (e.g. consequences of a doctor’s actions)

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A Typical Utility Function for Money
u(M)

3
What does
this mean?
2

0 M
$100 $250 $500 $1,000
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 Decision Maker’s Preferences
• Risk-averse u(M)
– Avoid risk
– Decreasing utility for money M

• Risk-neutral u(M)

– Monetary value = Utility

– Linear utility for money M

• Risk-seeking (or risk-prone) u(M)

– Seek risk
– Increasing utility for money M

• Combination of these u(M)

…
M
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 Constructing Utility Functions
• When utility theory is incorporated into a real decision
analysis problem, a utility function must be constructed
to fit the preferences and the values of the decision
maker(s) involved
• Fundamental property:
The decision maker is indifferent between two alternative
courses of action that have the same utility

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 Indifference in Utility
• Consider two lotteries
p
$1,000 1
1-p
$X
$0

• The example decision maker we discussed earlier

would be indifferent between the two lotteries if
– p is 0.25 and X is …
– p is 0.50 and X is …
– p is 0.75 and X is …

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 Goferbroke Example (with Utility)
• We need the utility values for the following possible
monetary payoffs:
45°
Monetary u(M)
Payoff Utility

-130
-100
60
90
M
670
700

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 Constructing Utility Functions
Goferbroke Example
• u(0) is usually set to 0. So u(0)=0
• We ask the decision maker what value of p makes
him/her indifferent between the following lotteries:
p
700 1
1-p
0
-130

• The decision maker’s response is p=0.2

• So…

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 Constructing Utility Functions
Goferbroke Example
• We now ask the decision maker what value of p makes
him/her indifferent between the following lotteries:
p
700 1
1-p
90
0

• The decision maker’s response is p=0.15

• So…

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 Constructing Utility Functions
Goferbroke Example
• We now ask the decision maker what value of p makes
him/her indifferent between the following lotteries:
p
700 1
1-p
60
0

• The decision maker’s response is p=0.1

• So…

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Goferbroke Example (with Utility)
Decision Tree

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 Exponential Utility Functions
• One of the many mathematically prescribed forms of a “closed-form”
utility function
 
M

u(M ) R  1  e 
R

 

• It is used for risk-averse decision makers only

• Can be used in cases where it is not feasible or desirable for the
decision maker to answer lottery questions for all possible outcomes
• The single parameter R is the one such that the decision maker is
indifferent between
0.5
R 1
and 0 (approximately)
0.5
-R/2

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