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Tecnologico de Monterrey
Dra. Ileana Castillo

Solved exercise using decision analysis strategies

You are the author oI what promises to be a successIul novel. You have the option oI
publishing the novel yourselI or through an editor. The editor oIIers you $20 000 dollars
Ior signing the contract. II the novel is successIul, 200 000 copies will be sold.
Otherwise, only 10 000 copies will be sold. The editor pays royalties oI one dollar per
copy. A marketing study done by the editor indicates that there is a chance oI 0.7 oI the
novel being successIul.

On the other hand, iI you publish your novel, you will have to incur an initial cost oI
$90 000 dollars Ior printing and marketing, but each sold copy will generate $2 net
dollars.


(a) Based on the given inIormation, would you accept the oIIer oI the editor or publish
yourselI the book?

Solution: We begin with the results table. In this case the possible results are possible
proIits Ior the author.

Table 1. Results Table

State of nature (random event)
Possible decision s
1
the novel is successful s
2
the novel is not a success
d
1
Publishes the
author
$310 000 -$70 000
d
2
Publishes the editor $220 000 $30,000


Decision Tree

We have two types oI nodes:

Decision
node




Decision Iork:


State oI
nature
(random
event) node
d
1

d
2

2
Event Iork:




A branch oI a tree is a terminal branch iI no Iorks emanate Irom the branch.


Decision making without probabilities.

1. Optimist approach (maximum oI the results). Decision made: d
1


2. Conservative approach (maximum oI the minimum results). Decision made: d
2


3. Regret approach (minimax):

Let R
ij
be the

regret (amount) associated with the alternative oI decision d
i
and the state
oI nature s
j
.
V
j
* the largest value (or the smallest iI the results table is cost Ior instance) in the jth
column.
V
ij
the result (proIit in the example) oI the decision d
i
and the state oI nature s
j
.
Then,
*
if f if
R J J = .

Step 1. Determine the regret table.

Table 2. Regret or Loss of opportunity Table
State of nature
Alternative s
1
s
2

d
1
0 $100 000
d
2
$90 000 0

Step 2. For each alternative choose the maximum regret value.

Table 3. Table of the maximum regret values
Alternative Maximum regret
d
1
$100 000
d
2
$90 000

Step 3.
Choose the minimum oI the maximum regret values ($90 000). ThereIore, the decision
would be d
2
(the editor publishes).



s
1

s
2

3
Decision making with probabilities

Using the values in Table 2. we obtain the Iollowing expected opportunity loss values:

. 000 63 $ ) ( and 000 30 $ ) (
2 1
= = d EOL d EOL

Since the EOL is less with d
1
. The author would publish the novel.

The expected value with original inIormation oI a decision is:

=
=
n
f
if f i
J s P d EJWOI
1
) ( ) ( ,
where n is the number oI random events.

For our example, P(s
1
)0.70 and P(s
2
)0.30. ThereIore,

. 000 163 ) ( 000 196 ) (
2 1
= = d EJWOI and d EJWOI

In this case, EVWOI 196 000. (We choose the maximum oI the two because the result
values are proIit values.)

Expected value of perfect information

The expected value oI perIect inIormation (EVPI) is deIined as:

EVPI EVWPI EVWOI,

where the expected value with perIect inIormation (EVWPI) is Iound by drawing a
decision tree in which the decision maker has perIect inIormation about which state has
occurred beIore making a decision.

Exercise: Draw the decision tree Ior the EVWPI.


For the example, EVWPI226 000 and EVWOI196 000. Hence,

) ( min 000 30
i i
d EOL EJWOI EJWPI EJPI = = = .

EVPI is a useIul upper bound on the value oI simple or market inIormation; that is, no
sample or test market inIormation (no matter how good) can be worth more than $30 000.
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Sensitivitv analvsis

Let us assume that P(s
1
)p and P(s
2
)1-p, 0 _ p _ 1.

Exercise: Graph in the same coordinate axis, EVWOI(d
1
) and EVWOI(d
2
) as Iunctions oI
p. Find the value oI p where they are equal.


(b) Suppose that you hire a literary agent to do a test market regarding the
potential success oI your novel. The agent charges $2500 dollars Ior the test.
According to past experience, the agent`s company tells you that when a novel
is a success, the test Iails in predicting the result 20 oI the times. When the
novel is not a success, the test will give the correct prediction 85 oI the
times.

Do a decision tree to make the decision about the oIIer oI the editor.


Decision analvsis with sample information

Expected value with sample inIormation: EVWSI.
Expected value oI sample inIormation EVSI ,EVWSI-EVWOI,.

Calculation of Posterior Probabilities.

U: unIavorable towards the success oI the novel
F: Iavorable towards the success oI the novel

From the inIormation given we have: P(U,s
1
)0.2 and (U,s
2
)0.85.

And, Ior probability principles we have: P(F,s
1
).8 and P(F,s
2
)0.15.

Market test Iavorable
Nature state s
j
Prior
Probabilities
P(s
j
)
Likelihoods
(Probabilidades
condicionales)
P(F[s
j
)
1oint
Probabilities
(Probabilidades
Conjuntas)
P(Fs
j
)
Posterior
Probabilities
P(s
j
[F)
s
1
0.7 0.8 .7*0.80.56 0.56/0.605
s
2
0.3 0.15 0.3*0.150.045 0.045/0.605

P(F)0.605


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Market test unIavorable
Nature states s
j
Prior
Probabilities
P(s
j
)
Likelihoods
(Probabilidades
condicionales)
P(U[s
j
)
1oint
Probabilities
(Probabilidades
Conjuntas)
P(Us
j
)
Posterior
Probabilities
P(s
j
[U)
s
1
0.7 0.2 .7*0.2
s
2
0.3 0.85 0.3*0.85

P(U)


Exercise. Do the decision tree.