CHAPTER 1

DECISION ANALYSIS
MAKING TOUGH CHOICES: MANAGING
UNCERTAINTY AND RISK, BAYES’ THEOREM,
THE ACCURACY OF INFORMATION, AND
RATIONAL DECISIONS
For every complex problem there is a
simple solution that is wrong
George Bernard Shaw

|1.1| INTRODUCTION
The time has come to make a decision. And it’s extremely difficult—
one that might make or break you or your company. Worse, the con-
siderations in making this decision are a bit fuzzy and you are wor-
ried about being able to clearly explain your reasoning to others …
especially your manager. What are you going to do?

Everyone tries to make good decisions. So, what is meant by the statement, “That
was a good decision”? Most likely, the person making this observation was
pleased with the way things turned out. However, modern decision analysis sug-
gests this observation is incorrect: decision analysis is a rational, systematic pro-
cess for making better decisions, not necessarily the level of satisfaction associat-
ed with the outcome. It deals with concerns of how should competing strategies
be assessed when the consequences are
uncertain and, possibly, different?
Decision analysis neither functions as a
number-crunching tool nor attempts to
ignore the fact that human decisions of-
ten are highly subjective and sometimes
can be emotionally charged. Instead, de-
cision analysis attempts to incorporate
these visceral realities within an objective
framework, so that the process can be
understood, and the chances for in-
formed dialogue preserved.
To grasp the materials covered in this

© Joel Oberstone, Ch. 1 1 May 18, 2015

chapter—as well as in the next one—you will find it helpful to have a basic under-
standing of probability. Most readers will have already taken a course in statis-
tics, which covers the concepts of probability. However, for those people who ei-
ther (1) have never been exposed to, or (2) are experiencing the dreaded “memory
fade” phenomenon with these materials, a brief review of probability is presented
in Appendix A.

|1.2| THE PURPOSE OF RATIONAL

DECISION ANALYSIS
The use of rational decision analysis does not in itself guarantee a “good deci-
sion.” In fact, in any single instance, a manager using intuition could conceivably
make a decision that results in an ultimate outcome more desirable than the out-
come of one made by a manager using the most sophisticated of rational decision
processes. The outcome of an individual case, however, is not what concerns us.
Rational decision analysis, over the long term, will give “batting averages” that
are considerably more impressive than are those of the more visceral approaches.
So, armed with our desire to make “good choices,” how can we take into ac-
count the many factors involved in the selection among two or more competing
options so that we can make decisions that are both compelling and defensible?

|1.3| APPLICATIONS OF DECISION

ANALYSIS
Examples of the application of decision analysis are numerous. Consider the fol-
lowing:
§ Podgorelec V, Kokol P, Stiglic B, Rozman I., Decision trees: an overview
and their use in medicine, Journal of Medical Systems October 2002, Vol.
26, No. 5, pp. 445-463.
§ Decision analysis can help health professionals to determine whether a
person should receive the swine influenza vaccination (Zalkind and
Shachtman, 1980).
§ Norman Dalkey, Information Systems in Management Science—A Case
Study of a Decision Analysis: Hamlet’s Soliloquy, Vol. 11, No. 5, October
1981, pp. 45-49.
• Determining how effective security screening of airline passengers really
is, (Martonosi and Barnett, 2006).
§ Risk analysis using decision trees can help regulatory bodies to assess the
safety of nuclear facilities (Judd and Weissenberger, 1982).
§ Robert Luna and Reid, Richard, Mortgage Selection Using a Decision Tree
Approach, Interfaces, Vol. 16, No. 3, May-June 1986, pp. 73-81.

© Joel Oberstone, Ch. 1 2 May 18, 2015

 § A decision analysis model can help doctors to diagnose and treat undiffer-
entiated liver disease in conjunction with jaundice (De Rivera, 1980).
§ Decision analysis can help lawyers to determine when a company should
go to court in a legal dispute (Bodily, 1979).
§ Decision analysis can help hotel managers to set a reservation policy (Wil-
liams, 1977).
§ Decision analysis can help marketing staff to develop an airlines discount-
coupon program (Digman, 1980).
§ Decision analysis can help us to glean a lesson from the Iran hostages res-
cue operation (Saaty, et al., 1982).
§ A decision model can help us to assess the implications of the Bakke deci-
sion in implementing affirmative action programs (Solomon and Mess-
mer, 1980).

|1.4| STRUCTURING SMART

DECISIONS
This chapter is going to explore one of the most popular analytical methods used
in decision analysis: decision tree analysis.
A decision tree is a diagram we can use to clarify the choices, risks, and out-
comes inherent in many types of problems. It provides a chronological display for
helping to clarify the features comprising a decision setting with greater clarity
than is possible by simply attempting to describe it verbally.
The decision tree presents a visual roadmap of the choices, risky events that fol-
low such choices, the possible outcomes of these events, and the effect that each
outcome has on each event. Although decision trees offer a clear view of the prob-
lem, it does so at a cost in portraying the information in somewhat simplistic
terms.
Also, the size of a decision tree increases exponentially with the number of deci-
sion and chance events and may become too complicated to display on a single
page for an even moderately sized problem. Regardless, decision tree analysis is a
very useful analysis method to introduce decision analysis and will be the prima-
ry method in this chapter.
An example that illustrates the use of decision tree analysis using a potential real
estate purchase in New York City is presented next.

Example #1 The Greenwich Village Apartment

Investment Decision
A Manhattan real estate broker is considering a sizeable investment in a Green-
wich Village apartment for herself (Figure 1). She has made many other transac-

© Joel Oberstone, Ch. 1 3 May 18, 2015

tions in her 10-year career but those have been for clients. This time it is for her-
self and she does not want to make a mistake.

The neighborhood where the investment property is located has stabilized since
the disastrous stock market and real estate bubble burst of 2009. The details of
the investment follow:

• She is first in line to buy the apartment if she acts fast. If she acts immediate-
ly, without conducting any further analysis, she can jump in front of the com-
petition and submit an offer that will likely be accepted for about $1,100,000.
However, this is a high risk approach because best estimates suggest that only
33 percent of the investments can be categorized as ultimately successful, i.e.,
have at least a 10% return on the original investment (purchase) price.

• In about three years, if the real estate market stays healthy and progresses
successfully, the broker es-
timates she will be able to
sell the apartment for ap- Figure 1. Greenwich Village Map.
proximately $2,000,000 in
the next 24 to 36 months—
thereby almost doubling her
investment in a very short
time frame. This apartment
is viewed as a unusually at-
tractive investment.

• However, in the worse case

scenario if the market stag-
nates, the apartment might
only sell for $700,000 at
the end of this same time
period.

• Instead of deciding to immediately buy, she may first have a competent real
estate consulting firm, Greenwich Village Property Consultants (GVPC) per-
form a careful assessment of this specific property and determine if it is a wise
investment (indicated by a favorable investment report) or not. This will, of
course, forgo her “first in line” opportunity to purchase the apartment without
bidding competition.

• GVPC charges $50,000 in fees and, more troubling than this fee to the inves-
tor, is the 2-3 weeks it will take to finish their analysis and report. Even this
relatively short delay will place the investor in a more competitive bidding
pool of additional investors and likely increase the property purchase price to
$1,250,000.

The real estate broker must now decide if she should either:

© Joel Oberstone, Ch. 1 4 May 18, 2015

 (1) Pay for GVPC to conduct a thorough property analysis before deciding
what to do with the property or
(2) Forgo the analysis and either buy the property now or walk away from the
investment?

The broker’s mind is spinning. She is confused. There are too many facts for her
brain to manage this! Spinning plates! She decides to try and draw a basic picture
of these considerations to help clear things up so she sketches out the chronologi-
cal sequence of these decision that use the basic components of a decision tree.

___________________________________

Basic Decision Tree Components

The common symbols used in standard decision tree analysis include the following collection of elements
(Figure 2):
1. The squares represent decision nodes that occur at point
when the broker must decide which strategy she wishes to use— Figure 2. Basic Decision
she is in control in these situations. The initial decision is given Tree Components
a blue color and all other subsequent decision nodes are light
green.

2. The yellow circles are event or chance nodes that occur after
a decision is made. The branches that arise from these nodes are
uncertain (possess risk) and remain out of the control of the de-
cision maker who “makes her choice and takes a chance.” Most
important, all node events must have an associated probability
of occurrence—the sum of which must be equal to 1.00. We
have not yet established what these probability values are—but they can be found from the infor-
mation provided from the historical GVPC analysis data already provided.

3. The red triangles are called terminal nodes—they indicate the end of the path; the adjacent val-
ues are the path net profit (in bolded black). The net profits of the strategies along each branch
path leading to this end point are always the sum totals at these nodes.

4. The cash flows associated with the costs and revenues are shown directly underneath the branch
incurred, e.g., if the broker hires the consultant, there is a -$50,000 cash flow (cost); every event
branch the property investment is considered a success (there are three of them), there is a
$2,000,000 cash flow (revenue).

5. The connecting lines between nodes are called branches. If you follow a branch from its origin to
the end (terminal node), it describes a path. You can sum the cash flows along a common path to
find the net profit at the terminal node of that path.
___________________________________

The broker lays out her tree in Figure 3. Here is what she envisions as her options.

If she does not hire GVPC she is either going to invest in the property or not. If
she buys the apartment she will find out if it was a good buy. However, even
though it is a simple strategy it is also an extremely risky strategy. Remember,
only 33 percent of the purchases in this neighborhood are ultimately successful
investments: there is a 2/3 chance she will lose money!

© Joel Oberstone, Ch. 1 5 May 18, 2015

On the other hand, if
the broker hires the Figure 3. Basic Broker Decision Tree (Sans Numerical In-
consultant, GVPC formation).
will provide her with
a report telling her if
they believe her spe-
cific investment is a
wise venture or not
prior to her having
to decide on the pur-
chase. This is poten-
tially valuable in-
sight for the broker
depending upon a
very important
point—she has no
idea how accurate
GVPC’s predictions
are: who knows,
GVPC may provide
questionable advice
or they may be won-
derfully insightful.
So, before hiring
GVPC, the broker
would like to learn
how accurate the consultant predictions have been in the past.

Next, the broker calls GVPC and tells them that she will pay the $50,000 consult-
ing fee for them to assess a specific Greenwich Village property she wants to pur-
chase, with conditions. She first needs to see more hard data regarding how
“good” GVPC’s investment predictions are. The CEO of the GVPC asks her what
she needs to “be convinced.” Here is what the broker requires from GVPC:

Greenwich Village Property Consultants Past Performance:

The broker asks for and is allowed to randomly sample one hundred (100)
Greenwich Village property assessments GVPC conducted on real estate units
sold twice over the past 36 months.
Each of these apartments were evaluated by GVPC for a client, purchased (not necessarily
by that client), and ultimately resold during this 36 month period. All details are carefully
recorded including GVPC prediction in terms of its favorable (≥10% ROI) or unfavorable
(<10% ROI) forecast of the unit prior to the original sale, e.g., GVPC may assess a prop-
erty favorably that originally has a sales price of $800,000.

It is assumed that at the assessment point by GVPC, the property sales might have a mi-
nor amount of flexibility in the actual sales price but to assume it is essentially negligible

© Joel Oberstone, Ch. 1 6 May 18, 2015

 and that it will sell for the asking price of $800,000. Since they have evaluated it favora-
bly, GVPC is predicting it will be a successful investment and deliver at least at 10% ROI—
it should resell for at least $880,000. If not, the GVPC prediction is incorrect. Conversely,
if they evaluate this property unfavorably, and they are correct, then the resale value
should not exceed the 10% ROI.

The broker organizes the 100 properties into two stacks of either successful or
unsuccessful investment outcomes by comparing the difference between the
GVPC assessed value sales price and resale sales price using the ROI standard,
i.e., either the ROI ≥10% or ROI<10%.

These two groups are further divided into their predictive reports of either favor-
able or unfavorable assessments. 1,2

1. Only 33 of these 100 properties were ultimately successful, i.e., achieved at

least a 10 percent return on investment (ROI ≥ 10%).

2. GVPC managers wrote a total of 20 favorable assessments.

3. Of the 33 proper- Figure 4. Historical Assessments of GVPC Conduct-

ties that ultimately ed During Past 18 Months.
turned out to be
successful invest-
ments, 17 received
favorable reviews
by GVPC.

4. However, GVPC al-

so gave favorable
reviews on 3 of the
ultimately unsuc-
cessful invest-
ments as well.

The broker organizes the-

se historical data into the
flowchart of Figure 4. She
realizes that this histori-
cal information unfolds in a non-chronological time flow and that she in order to
make these events usable, she needs to be able to “flip” them into real time.

1 Initially, the possible categories of outcomes for real estate investments is limited to only suc-
cessful or unsuccessful and its forecast possibilities as either favorable or unfavorable, but later
we will become a bit more sophisticated.
2 It is extremely important to use this order of division because the ultimate outcome, in terms of
success or failure, is the primary information. This allows the evaluation of the investment to be
from a variety of different outside consultant groups who specialize in product assessment.

© Joel Oberstone, Ch. 1 7 May 18, 2015

This incongruity in sequence will need to be revised before it is usable in “real
time.” It is accomplished by using a brilliant decision analysis tool called Bayes’
Theorem—also commonly referred to as Bayes’ Rule.

Since the occurrence of the historical assessments do not represent, a “real-time”

or chronological flow of events, she needs to be able to use these numerical fre-
quencies of events and flip them into real time setting in a chronological decision
tree.

But before we can do that, we need to make a brief review of basic probability no-
tation in order to make our decision trees easier to read and less cluttered. So far
we have been writing out the names of the various strategies and chance events
without concern for their proper terminology, but at some point we need to dis-
tinguish important, subtle differences. Now is that time.

A Short Break: Use of Probabilities in Decision Tree Analy-

sis
The broker decides to simplify the notation she used in the design of her basic
Greenwich Village decision tree (Figure 3). This should also have an added ad-
vantage when it comes to numerically evaluating the strategies in the tree. The
replacement notation is:
I Invest in apartment
I’ Don’t invest in apartment
H Hire GVPC to conduct a market analysis of property before deciding anything
H’ Don’t hire GVPC
P(F) Marginal probability of a favorable marketing report;
P(F’) Marginal probability consultant will predict unfavorable
P(S) Marginal probability of investment success;
P(S’) Marginal probability of investment being unsuccessful;
P(S/F) Conditional probability of a successful investment outcome after a favora-
ble review (accurate prediction);
P(S’/F) Conditional probability of an unsuccessful investment outcome after a fa-
vorable report (inaccurate prediction);
P(S/F’) Conditional probability of a successful investment outcome after receiving
an unfavorable report (inaccurate prediction);
P(S’/F’) Conditional probability of an unsuccessful investment outcome after an
unfavorable review (accurate prediction)

Probability definitions:
• Marginal probability is the chance of a single event occurring , e.g., the chance of the realtor
receiving a favorable report from GVPC.
• Conditional probability is the chance of an event occurring given that it has been preceded by
an earlier event, e.g., the chance of the investment being successful even though the broker
had received an earlier unfavorable GVPC report.
• Joint probability (or path probability) is the chance that two (or more) probabilities will oc-
cur—usually one after the other, e.g., the chance that the broker will receive both a favorable
report and then be successful (given the earlier favorable report). The product of several event
probabilities (usually two but not necessarily limited to two).

© Joel Oberstone, Ch. 1 8 May 18, 2015

The decision tree using the correct Figure 5. Broker Basic Decision Tree Us-
probability notation is shown in Figure ing Probability Notation (San Numbers).
5. There is a significant value-added
element in this version of the tree
that was not apparent in the earlier
version: the different probability
branches of successful and unsuc-
cessful events are now distinguisha-
ble and seen as unique!

The broker now feels she is ready to

tackle the information she has from
the broker with the help of Bayes’
Theorem. Here’s how she proceeds.

Revising GVPC’s Historical

Data Using Bayes’ Theorem
The probability of GVRA writing a fa-
vorable report, P(F), is simply the to-
tal number of favorable reports writ-
ten out of the total sample, i..e, 17
were written when the outcome of the
investment was successful and 3 were
written for unsuccessful investment outcomes

favorable reports
"$$ #$$%
succussful unsuccussful
!
investment
!investment

17 + 3
P(F ) = = 0.20
100
&
total
sample

The probability of the investment being successful given the consultants have
written a favorable report are the proportion of all favorable reports written
(which we already know is 20) that are written when the investment was success-
ful. So it is the 17 times favorable reports were written out of the 20 that were
winning (successful) investments, i.e.,

P(S/F)=17/(17+3)=17/20=0.85

This means, conversely, that the proportion of times that the consultant wrote fa-
vorable reports that were for ultimately unsuccessful investments were the 3 out
of the 20 total times that favorable reports were written

© Joel Oberstone, Ch. 1 9 May 18, 2015

 P(S’/F)= 3/(17+3)=3/20=0.15
Or
P(S’/F)=1- P(S/F)=1-0.85=0.15

The probability that invest- Figure 6. Broker Decision Tree Illustrating Cash
ments were ultimately success- Flow Values and Probability Information.
ful is simply the total number
of successful investments out
of the total sample

P(S)=33/100 = 0.33

Next, the broker wants to

know what her chances are of
actually being unsuccessful if
GVPC assesses her property as
an unfavorable investment.
She knows that this must be
equal to the proportion of all
unfavorable reports that are
associated with unsuccessful
outcomes. Well, GVPC wrote
16 + 64 or 80 unfavorable re-
ports written in the total sam-
ple of historical data and 64
were associated with unsuc-
cessful investments. So, the
chance or probability that the
investment will be unsuccess-
ful if you first receive an unfavorable report from GVPC is

64
( )
P S '/ F ' =
16+ 64
= 0.80

Conversely, sixteen (16) of these 80 unfavorable predictions were also made for
investments that ultimately became good investments

P(S/F’)=1-P(S’/F’)=1-.0.80 = 0.20

The broker now has all of the probabilities she needs to fill in the events in the
decision tree and, along with the cash flows that were given in the beginning of
the problem, she is almost ready to determine which strategy to select. The re-
vised tree using all of the new information is shown in Figure 6. The broker revises
her earlier decision tree using this new information and illustrates her latest
findings.

© Joel Oberstone, Ch. 1 10 May 18, 2015

The picture is becoming a bit more clear. The risk associated with each event in
the form of its probability, the payoff associated with each outcome in the form of
a specific cash flow value—they are all helping to clear away the fog.

What is needed for the next step is to choose an evaluation method for the com-
peting strategies that will provide a rational selection … a best choice. That’s dis-
cussed next.

Evaluating the Decision Tree: The Expected Monetary Val-

ue Method of Analysis.
The Principal of Exected Monetary Values or, for short, EMV is one of the most
popular ways of assessing decision trees. It’s an easy-to-understand, rational
right-to-left method of calculating a type of weighted average between the risk
and rewards of the various elements of the tree. The process is a sort of rolling or
folding back progression moving from right to left and top to bottom. Here’s how
it works.

1. At each event node (circle) calculate the

weighted value of the sum of the probability
of each event (there are two in our example)
times the payoff for that event. Start in the
upper right-hand corner. In our case, as-
sume the broker has decided to invest, I, af-
ter receiving a favorable report from GVPC,
P(F), so

( )( ) ( )( )
EMV = ∑ piVi = 0.85 700,000 + 0.15 −600,000 = $505,000
i=1

2. Compare this EMV with the value of the adjacent branch option, I’, where
she decides not to invest. In other words, compare her investment EMV

with her non-investment EMV. The latter you can see is simply a guaran-
teed loss of -$50,000.

© Joel Oberstone, Ch. 1 11 May 18, 2015

 3. Eliminate the weakest option of these two. That is, prune the tree (as indi-
cated by the dashed branch for option I’. So you choose to invest in the
apartment, I, because, that EMV is smarter to not investing, I’, and is
worth (on the average), $505,000 (and a lot better than losing $50,000!).
Bring the best EMV value back to the decision node of making the receiv-
ing a favorable report from the consultants, P(F). This means that if the
broker receives a favorable assessment from GVPC, she will make the in-
vestment because it is worth an average payoff of $505,000!
Key point: The EMV is an average payoff that suggests that if you had an infi-
nite number of identical investment opportunities, on the average this is what
you would make if you followed this strategy. In actuality, you are about 5 or 6
times as likely to either make $700,000 as lose $600,000 if you invest in the
property if GVPC give you a favorable assessment.

4. You can’t fold back any further along this upper path any longer. You will
now need to switch over to the path extending from the unfavorable fore-
cast and begin at the extreme right in the same manner as you did in the
beginning step and, essentially, repeat the folding back process. So, the
EMV for assessing the I vs I’ options after receiving an unfavorable report
from GVPC—which is four times as likely to occur as a favorable report—is

( )( ) ( )(
EMV = 0.20 700,000 + 0.80 −600,000 = −$340,000 )

5. In this scenario, when you compare the I vs I’ option, you find that even
though I’ loses $50,000 it is the much preferred option to I and losing -
$340,000. Getting an unfavorable report from the consultant signals a
poor investment opportunity.

Accordingly the broker will eliminate I, chose I’, and bring the EMV of -
$50,000 back to represent the value of receiving an unfavorable assess-
ment, P(F’), from GVPC. Why? Because if you receive an unfavorable re-
port, P(F’), you eliminate the invest option—as indicated by the dashed
branch—you will not invest in the property, and you will lose the $50,000
consulting fee since it is the smallest loss possible.

6. Now the broker can finish her evaluation of the strategy of hiring the con-
sultant, prior to deciding on if she wishes to buy the apartment or not. The

© Joel Oberstone, Ch. 1 12 May 18, 2015

 EMV of hiring the consultant results in an average payout of $61,000. This
includes the $50,000 consulting fee.

( )( ) ( )( )
EMV = 0.20 505,000 + 0.80 −50,000 = 61,000

The broker has not yet examined her other option: don’t hire the consultant
(GVPC), I’. That’s next.

1. If the broker does not hire the consultant she can

save the $50,000 consulting fee. But on the other
hand, she faces the investment risk of knowing
that properties in the neighborhood she wants to
buy in have only been successful 33% of the time
and without the GVPC, she will get no advice re-
garding her specific property prior to having to
decide on her purchase decision.
2. Also, if the broker does not hire the GVPC, she
can purchase the property without waiting for
$1,100,000. The same sales revenues for successful and unsuccessful out-
comes are anticipated although the chances of achieving these different re-
sults will be different from the “immediate purchase” strategy.
The broker’s decision tree used to organize her potential investment information
is shown below. The broker sees that the “quick buy” advantage she has if she

does not higher the broker—the potential purchase price of $1,100,000 that is
$150,000 lower than what she will likely have to pay and wait for the consultant
report and then lose her buyer’s advantage she now has is offset by the high risk
of only having a 33% chance of being successful. With a favorable consultant re-
port in hand, her chance of success is 85%—almost 300% higher! Of course, if
GVPC gives her an unfavorable report, that signals sure doom for the invest-
ment—only a 20% chance of success.

© Joel Oberstone, Ch. 1 13 May 18, 2015

 ( )( ) ( )(
EMV = 0.33 900,000 + 0.67 −400,000 = $29,000)
The results here bare out her concern. Even though she would have no consultant
fee, if she does not hire the consultant, this strategy suggests to take the high risk
approach and invest the money and make an average payoff of $29,000 (versus
$0 if you don’t invest the money). But in reality it also means that two-thirds of
the time she will lose $400,000! Very sobering to face that amount of risk.

However, the final optimal strategy—the one that maximizes your EMV—is to pay
for the consultant, I, and make and an EMV of $61,000 (versus only $29,000). It
has not only the advantage of the higher payoff but the insight of the consultant
report and the reduced risk prior to having to decide on if you wish to invest or
not—the element that is missing when you choose the I’ option. The completed
decision tree is shown in Figure 7.

Figure 7. Broker's Solved Decision Tree for Greenwich Village Apartment In-
vestment.

© Joel Oberstone, Ch. 1 14 May 18, 2015

To be sure, the EMV method is no pancea. The broker does not have an infinite
number of identical opportunities at this same investment in Greenwich Village:
she only has this single opportunity although there may be others that are “simi-
lar.” And, truth be told, if she makes the investment, it will either be a successful
or unsuccessful outcome—not some weighted average of both.

Regardless, the decision tree provides the broker with a useful method that can
help her organize, control, and make sense of the the elements she needs to con-
sider so that she can make an informed and rational choice on her investment. It
is not primarily important if others that view this scenario agree with it: the pri-
mary value of the decision tree is that it rationally illustrates the ideas and val-
ue estimates of the parameters that can either be validated, agued with and,
possibly, altered to achieve a consensus opinion. If there is disagreement, there
is a body of reference for an exchange of different ideas and possible changes and
improvements that can be viewed in an unbiased environment of merit.

Calculating the Consultant Forecast Accuracy: RF, RF’, R*

The accuracy or reliability of a forecast describes if the outcome was what the
consultant predicted or if it was different. In our situation, here are the two cor-
rect predictions:

1. If GVPC’s forecast is favorable, P(F), the product should ultimately be-

come a success, given that forecast—P(S/F).
2. Conversely, an unfavorable forecast by GVPC, P(F’), should have preceded
an unsuccessful outcome, P(S’/F’).

For GVPC, the reliability of a favorable prediction, RF, is P(S/F)=0.85. That’s not
bad. However, the unfavorable prediction reliability, RF’ is P(S’/F’)=0,80. So what
do you think the overall reliability of the consultant reports are? How about the
average of the two forecasts reliabilities? Only if they wrote the same number of
favorable reports as unfavorable reports—which is clearly not the case.

Since they write many more unfavorable reports, the overall reliability of GVPC’s
reports, R*, should be much closer to its unfavorable accuracy.

R* = P(F )• RF + P(F ')• RF '

accuracy /reliability of accuracy /reliability of
favorable forecast unfavorable forecast
!#"# $ !#"# $
= P(F )• P(S / F ) + P(F ')• P(S '/ F ')
( )( ) (
= 0.20 0.85 + 0.80 0.80 = 0.81 )( )
Voila!

© Joel Oberstone, Ch. 1 15 May 18, 2015

|1.5| VALUE OF INFORMATION
When the broker pays for the consultant report, how good is the information it
provides? Is it perfect— always predicts the outcome correctly—or not (imper-
fect)? Think of how unlikely it would be to receive perfect assessments, i.e., the
consultant would always be able to identify and predict the ultimate product out-
come:
• A positive report would always be followed by a successful product
• A negative assessment would always be followed by a product failure (unsuc-
cessful)
We already know that is not exactly the case with the broker. In a more realistic
setting when the consultant findings are not always “on the money,” how much
would this imperfect information be worth? Placing a value on pursuing “better”
information through the use of better “expert” sources such as other property
consultants is the next important issue that will be examined.

1.5.1 IMPERFECT INFORMATION: EVII AND VII

It is important to contrast the benefit or value added, if any, of having paid for
the consultant services. The expected value of imperfect information refers to the
less-than-infallible information expert opinion, survey, market study, or diagnos-
tic test provides management that is hoped will provide and advantage in deci-
sion making as compared to not having it. In the broker’s case, she is hoping that
GVPC provides her with accurate insight into their ultimate decision regarding if
they wish to develop Doppler or not. So, the expected value of hiring the consult-
ant, EV(C) is the expected value of imperfect information, EVII. And,

EVII=EV(C)=$61,000

The value of imperfect information, VII, is the difference between the expected
value of the alternative incorporating an expert forecast source (e.g., property
consultant) and the expected value provided by the next best available alterna-
tive. That is,

! expected value of alternative $

# & ! expected value of next $
# using imperfect information, e.g., & # &
VII = # & − # best alternative not using &
# consultant or expert opinion, & ## imperfect information &&
# diagnostic test, forecast, etc. & " %
" %
= EVII − EV (next best option)
The value of this information, when contrasted with not using their services,
EV(C’), will tell us if they were worth the investment of $50,000. Based on the
decision tree solution in Figure 7, the expected value of having used the consult-
ants, including the $50,000 fee, is still better than the expected value of not using
them, i.e., EV(C) > EV(C’). The value added by the GVPC is

© Joel Oberstone, Ch. 1 16 May 18, 2015

 VII = EV (H) − EV (H ') = $61,000 −$29,000
= $32,000

This suggests that even though the broker paid the GVPC $50,000 for the analy-
sis, the EMV for that strategy was still superior to risking the purchase with no
prior information by $32,000. You could also look at it another way: GVPC could
have charged the broker up to an additional $32,000 above the $50,000 fee and
still outperformed the “go it alone” strategy.

On the other hand, if it had turned out that EV(H) < EV(H’), the EVII would have
been negative. That would indicate the either the (1) reliability of the GVPC fore-
casts, or (2) the cost of hiring them or (3) the lack of sufficient reliability and con-
sultant cost makes it more sensible to forgo using them. That was not the case in
our situation.

1.5.2 PERFECT INFORMATION: EVPI, VPI

The most ideal situation would be for a broker to know what the ultimate out-
come would be ahead of time—that is, prior to committing to a strategy, deci-
sions would always be successful: she would know whether they would be suc-
cessful before deciding to commit the cash investment needed to pay for the con-
sultant? An illustration of a perfect information decision tree for the property in-
vestment is shown in Figure 8. It’s highly presumptuous and requires a bit of ex-
planation.

Figure 8. EVPI Decision Tree for Investment.

© Joel Oberstone, Ch. 1 17 May 18, 2015

Yes, it is a “fairy tale” situation. The manager “magically” learns of the ultimate
success or failure of the product now. It is not associated with the option that us-
es a consultant prediction because you don’t need any consultant—you have the
knowledge of what will happen immediately. The chance of success, P(S) and
failure, P(S’), are always the marginal probabilities associated of the option that
does not seek predictive information—in the broker’s case, the “do not hire con-
sultant” strategy. Also, the broker cannot manipulate the chance of success or
failure. It is what it is. So, P(S) remains at 33% and P(S’) is 67%. Then, in either
case, the broker must decide to invest, I, or not invest, I’, in the property. Well,
this is a no-brainer, isn’t it? If the broker learns of the ultimate success of the
property purchas and makes the investment, she will make $2,000,000 in reve-
nue minus the purchase price of $1,100,000 or a cool $900,000: the do not de-
velop, D’, option would be eliminated. Conversely, if the ultimate fate of the
property is learned to be a failure—and that will be the case in 67% of the situa-
tions—the broker will rationally decide to forgo the investment and choose I’. In
this latter, more likely discovery, she will learn the product will fail, walk away
from it, and lose nothing. Make sense?

Using this insight, the expected value of perfect information, EVPI, is

found from

( )( ) (
EVPI = 0.33 900,000 + 0.67 0 = $297,000 )( )
So, the broker will learn of success 33 percent of the time, will invest in the prop-
erty, and will make a net profit of $900,000; the other 67 percent of the time,
she will know that the apartment is doomed to be unsuccessful, will not buy it,
and will lose nothing ($0) resulting in an average payoff of $297,000.
The value of perfect information, VPI—of knowing, with certainty, whether
they will successfully market Doppler or not—is the difference between the ex-
pected values of the perfect information just calculated, EVPI, and the next best
opportunity available, i.e., the strategy with the highest expected value not using
perfect information—of “hire the consultant.”

VII = EVPI – EVII = 297,000-61,000=$236,000

Unfortunately, managers are not privy to such fairy tale arrangements as perfect
or infallible information sources.4 So why spend time discussing perfect infor-
mation? The answer is that perfect information simply provides the manager
with the theoretical upper-bound value of how good a decision outcome could be
and establishes the maximum value the most accurate information.

4 The majority of perfect-information examples in business seem to fly in the face of ethical behavior and fair play. If
you consider, for example, such situations as insider trading in the stock market and inside tips on competitive con-
tract awards, you will have a pretty good idea of why perfect information is such a squeamish issue. Anyone privy to
such information has a huge and almost certainly unfair advantage over any ``competition'—and, very likely, jail time
waiting for them.

© Joel Oberstone, Ch. 1 18 May 18, 2015

|1.6| SENSITIVITY ANALYSIS AND
SAMPLE SIZE
1.6.1 Changing Parameter Values. What if some of the parameters in our
problem were different. How much of an impact, if any, might these variations
have on our current strategy, if any?

For example, what if the presumed purchase price for the apartment when the
broker had the “inside track” if she purchased it immediately without doing any
prior property analysis, were lower than the $1,100,000? More specifically, at
what lower sales price for the apartment would the broker become indifferent be-
tween hiring GVPC and not hiring them?

It’s the same issue as the difference between the EMVs of the two strategies: H
and H’. If the broker could somehow work an additional $32,000 reduction in
the purchase price of the apartment to $1,068,000 she would technically become
indifferent her options. But would it make sense? Even though both EMVs would
both H and H’ would be $61,000, she would still face a much higher risk if she
plunged ahead and made the purchase, wouldn’t she? One of the problems you
are now encountering is that EMV ignores hu-
man aversion to risk: it simply maximizes EMV.
Here is an example of two gambles with identi-
cal EMVs:

Gamble #1: One chance in 1,000 of win-

ning $1,000,000 or losing nothing.

Gamble #2: A 50-50 chance of winning

$4,000 or losing $2,000.

Gamble #3: No gamble. A guaranteed $1,000.

Although the EMV is $1,000 for all gambles, not all people would choose the
same option. EMV does not reflect value or need.

1.6.2 Sample Size Considerations. Another issue we might consider is that

the influence of the amount of information we have available. The consulting firm
has found that 33 of the 100 properties they have analyzed were ultimately con-
sidered successful investments. However, there is a margin of error associated
with this information that we need to take into consideration. What we need to
establish is the 95% confidence interval that establishes the upper and lower limit
of the likelihood of success, P(S). This is a simple calculation given by the bino-
mial relationship of

© Joel Oberstone, Ch. 1 19 May 18, 2015

 p = p̂ ± Z 95%CL
( p̂) (1 − p̂)
n

= 0.33±1.96
(0.33) (0.67 ) = 0.33± 0.09
100

So a more realistic range—one that is 95% reliable—that captures the true per-
centage of successful investments is somewhere between 24 and 42 percent. Now
we’d need to recalculate the consultant reliability using these bounds but there
would have to be some bold assumptions regarding their forecast accuracy, e.g., if
the chance of an apartment investment were as low as 24 percent or grew to 42
percent, how would that effect the forecast accuracy of GVPC? Would it stay the
same? Could it stay constant? These are difficult and important issues that are
beyond the scope of this introduction to decision tree analysis and yet important
to consider for future work.

|1.7| A FEW PRACTICAL RULES OF

THUMB IN TREE LAYOUT
Every decision tree has alternatives that fall into one or more of the following
three model types:
1. “Do nothing” model: Forgo whatever it is you are considering doing (e.g.,
don't market the product, don't produce the play, don't drill for oil).
2. “Take the plunge” model: Do whatever you are considering doing without
seeking improved information. You will have no need to revise probabilities
(e.g., market the product, produce the play, drill for oil).
3. “Seek more information” model: Prior to deciding to “do nothing” or “take the
plunge,” obtain better information so that you can make a more informed de-
cision (e.g., hire the market research firm to conduct survey, use the diagnos-
tic test).
Absolutely every act in every decision tree falls into one of these three different
“types.” So now you have a helpful design guideline to use when sketching out
your tree.

|1.8| DECISION ANALYSIS SOFTWARE

The availability of microcomputer software changes dramatically each year. The
following list represents the decision analysis software available for decision trees
and decision matrices at the time of this book's printing.
§ TreePlan, Decision Support Services, San Francisco, CA 94115
§ Analytica. Lumina Decision Systems, Inc., Los Gatos, CA 95033
§ DATA. TreeAge Software, Inc., Williamstown, MA 01267
§ DPL, Applied Decision Analysis, Menlo Park, CA 94025
§ Precision Tree. Palisade Corp., Newfield, NY 14867
§ Supertree. Menlo Park, CA: SDG Decision Systems, Menlo Park, CA 94025.

© Joel Oberstone, Ch. 1 20 May 18, 2015

|1.9| EXERCISES
1-1 Explain the net profits shown in the Exhibit 1. Test Market Decision
far right-hand side of the decision Tree.
tree shown in Exhibit 1, e.g., why is
the net profit associated with experi-
encing a successful outcome after re-
ceiving a favorable market report re-
sult in a value of $2,100? What are
the implied costs and revenues and
with which elements of the tree are
they associated?
1-2 Again using Exhibit 1, calculate the
expected value of the Test Survey, T,
by rolling back the tree. Show all cal-
culations and be sure to illustrate
which intermediate decision branches
are eliminated along this rolling back
process. What is the best decision
strategy to employ in this option?
1-3 Over the past 3 years, weather forecasts for Honolulu during the month of
March have predicted the likelihood of rain to be .73. When the prediction
was for rain, rain actually occurred 84 percent of the time dur-
ing this time period. However, rain fell on 34 percent of the oc-
casions for which the forecast was for no rain.
ASSIGNMENT
Assume that the weather forecast included only the climate
events of rain or no rain. What percent of the time did it actual-
ly rain in Honolulu during March over this 3-year period? Use r
=forecast for rain, r’=forecast for no rain; R=actually rained; R’=actually
did not rain.

1-4 A San Francisco metals broker has just acquired an option to buy 400,000
tons of tungsten ore from the Thailand government for $10 per ton, which
is well below the current world market price for this ore. Since other bro-
kers have not yet received the same option, the broker thinks he must
make a decision immediately if he is not to lose this opportunity. He is
quite certain that he can get about $15 per ton for the ore if he is able to
import it, but there is a catch. The United States government may refuse to
grant an import license. If this happens, the contract will be annulled and
a penalty of $1.50 per ton will be imposed on the broker.

The broker knows that, if he acts now, prior to the decision of the United
States government ruling on the acceptability of the transaction, he is vir-
tually guaranteed the rights to the tungsten ore. Based on previous rulings,

© Joel Oberstone, Ch. 1 21 May 18, 2015

 the chance that the government will approve the license is about 50 per-
cent. However, if the broker waits for government approval before com-
mitting to the ore purchase (the ruling is a license approval), he will no
longer have the inside track; there will be many other metals brokers with
whom he must now contend. In fact, the chances of his being able to pur-
chase the ore in this more highly contested setting will be only one in
three.
ASSIGNMENT
Assume the following notation: B=buy ore; GA=government approves con-
tract;
1. Using only your intuition—ignoring the techniques discussed in this
chapter—how would you advise the broker? Are you able to incorpo-
rate all of the information provided in the problem using an intuitive
approach?
2. Using decision tree analysis, draw the various options available to the
broker. Which strategy provides the highest expected value? Is this
expected value what the broker can expect to make (or lose) on this
particular venture? Explain your answer.

1-5 The Ford Motor Company manufactured the Pinto automobile from 1970
to 1977. During this period, the Pinto developed a serious problem: Be-
cause the rear bumper was believed by many to
be inadequately separated from the adjacent gas
tank, the gas tank would rupture as a result of
moderate rear-end impact or rollover, and would
burst into flame. Certain experts concluded that
the problem of gas-tank rupture could be resolved
if a small, inexpensive metal baffle was placed between the interior of the
rear bumper and the gas tank. In this way, much of the shock of a rear-end
collision or rollover would be absorbed by the new part.
A national magazine reproduced an alleged Ford internal memoran-
dum that included dollar estimates of the worth of human life lost on the
highway as well as Ford's own in-house estimates regarding the number of
accidents that were anticipated to result in death, serious injury, or simple
property loss if no changes were made in the gas-tank design (Dowie,
1977). The article suggested that the final decision boiled down to one of
two possible alternatives for Ford:
1. Recall the Pinto as well as other Ford models of compacts and light
trucks that also had the same potential safety defect. The recall would
include 11 million compact cars and 1.5 million light trucks manufac-
tured by Ford in previous years. The replacement part would cost Ford
an estimated $11 per car or light truck.
2. Ignore the design-defect recall and defend them against any litigation
that might be brought against them on a case-by-case basis. The article
also reported that Ford estimated that an equal number of burn deaths
and serious burn injuries were likely to occur—180 of each. Further,
Ford also projected 2100 burn-destroyed vehicles. The projected costs

© Joel Oberstone, Ch. 1 22 May 18, 2015

 associated with each death, serious burn, and destroyed vehicle were
$200,000, $67,000, and $700, respectively.
ASSIGNMENT
Assume that the data presented here are accurate. Use decision tree anal-
ysis, and the given estimates of deaths, injuries, and property damage, to
illustrate Ford's choices and determine what the company is likely to con-
clude based solely on the assumption that the expected monetary values
are appropriate. Assume that Ford anticipates a worst-case scenario of
having to replace the part on all 12.5 million vehicles if it chooses option 1.

1-6 For the decision tree shown in Exhibit 1, find the marginal probability of
success for a strategy that does not employ the test survey, T’? Draw that
strategy as a decision tree, assume the same cash flows as those, which are
experienced in the test, survey option, T. but, of course, do not include the
survey cost.

1-7 The Very Crude Oil Company (VCOC) was established shortly after the
OPEC boycott precipitated the oil crisis in the United States during the
mid-1970s. VCOC leases land solely to explore for oil reserves, not to run
the long-term oil-field
operations. The typical
mode of operation is to
lease the land short-term,
run consultants, and drill.
If oil is discovered, VCOC
will obtain a long-term
lease on the land, then
will sell the development
rights to an oil refining
company.
During VCOC's first
year of operation, one
project after another led
to dry wells. Now, the net liquid assets of the company have shrunk to
$275,000, and the president, George C. Scott, is very concerned. “George,
we're close to going broke,” says Vice President, Jack Palance. “We need to
study the alternatives, try to define the possible outcomes in terms of their
associated probabilities and payoffs, and then make our decision thought-
fully. We don't have enough money to survive another bad decision.”
George agrees, “You're right. If we fail this time, we're back hustling life
insurance!”
The situation to which Scott and Palance are referring is on an option
that VCOC purchased 4 weeks ago for $25,000. The option gives the com-
pany the right to make tests and to drill for oil over a 7-week period. Until
the option expires, VCOC can sign a long-term lease agreement on the
property for a fixed fee of $250,000. The current short-term option ex-
pires in 3 weeks, and until now VCOC has not conducted tests or initiated

© Joel Oberstone, Ch. 1 23 May 18, 2015

 drilling operations. This land represents the only business opportunity
that VCOC is presently considering.
Palance plays with the brass oil rig paperweight on his desk while he
thinks over the situation. Finally, he says, “George, I think we have three
choices. Either we let the current option run out, or we order consultants,
or we take a chance and drill without any initial testing. Our geologist
thinks that there is a twenty-percent chance that any tests conducted in
this region covered by the option will result in positive test results.”
Scott thinks for a moment, then asks, “If our consultants are positive
and we drill, what is your best guess for the probability that we will find
oil?”
”If I were forced to give you a number now, I would guess 80 percent,”
says Palance.
”What if we get a negative consultant result? Should we consider drill-
ing under those conditions?” asks Scott.
”I don't know,” answers Palance. “Our chances of finding oil given a
negative test result drop to five percent. It doesn't sound too promising
under those conditions.”
”Hold on, Jack,” exclaims Scott. “This decision is too important for us
to attempt to assess it in our heads. We need more than dialogue to exam-
ine our situation. Let's take a look at the likely payoffs and costs.”
”According to the best information available,” Palance replies, “a con-
sultant will cost us seventy-five thousand dollars, and drilling a well will
run another two-hundred thousand dollars. Both can be completed in
about ten days. If we are lucky and strike oil, we can sell the rights to this
land for about one and a half million bucks.”
Scott ponders the situation. Finally, he looks over to Palance and says,
“I must tell you that I feel overwhelmed. What do you think we should
do?”
Palance replies, “The chances of striking oil don't seem very good if we
just go ahead and drill. Because of this, I favor taking a test first. In my
opinion, this is the safest approach. The consultant at least provides us
with valuable insight. I think that it will pay for itself! In fact, after speak-
ing to our geologist, I believe that the chance that a consultant will be posi-
tive is actually closer to 30 or 40 percent, rather than 20 percent. Our ge-
ologist was probably too restrained in his estimate. We ought to consider
getting rid of him if we survive the next couple of weeks!”

ASSIGNMENT
Assume the following notation: T=pay for seismic test; O=strike oil; +=
seismic test indicates oil; - = seismic test indicates no oil; D=drill
1. Structure this problem as a decision tree and determine, on the basis of
expected values, what decision you would recommend to VCOC.
2. How did you, as the decision analyst, deal with the difference in judg-
ment between the geologist and Jack Palance? What is the shortcom-
ing, if any, of the expected-dollar-payoff criterion when it is used to
reach a decision in this case?

© Joel Oberstone, Ch. 1 24 May 18, 2015

 3. For the geologist tree, determine the EVII and VII.
4. Again, for the geologist’s estimates, draw a “perfect information” deci-
sion tree and determine what the values for EVPI and VPI.

1-8 A successful entrepreneur must decide about an telemarketing investment

opportunity she has open to her with the QVC network. She believes that
there are three feasible outcomes that could result from
this investment: the investment outcome could be a fi-
nancial failure (O1), have a moderate outcome (O2), or be
highly successful (O3), with respective probabilities of
.6607, .1644, and .1749. If the investment is a failure, the
revenues generated will be about $100,000; if it is mod-
erate, the revenues will be about $500,000; and if it's
highly successful, $1,250,000 in revenue will be generat-
ed. The initial investment, if she decides to proceed, requires that she
commit $350,000 to the venture.
At an additional cost of $50,000, the entrepreneur can hire an investment
consultant to analyze the situation and to provide a report that will suggest
whether the investment will be advisable or not. The consultant's reports are
denoted by the following notation:
A = advisable investment
A’ = unadvisable investment
I = decision to proceed with the investment
I’ = decision to not proceed with the investment
Past experience with the consultant has shown the following results:
1. When the reports suggested an advisable investment, the results were
moderate 20.0 percent of the time and flopped 10.0 percent of the
time.
2. The outcomes were terrific 11.0 percent and good 16.00 percent of the
time when the consultant predicted that the investment was not advis-
able.
ASSIGNMENT
Using the given information, find the following (it would be preferred if
you use TreePlan software that is included with your Microsoft Excel ap-
plication):
1. Layout (design) the decision tree by using all of the given probabilities.
2. Calculate any missing probabilities that, although not provided direct-
ly, are implied by the given information.
3. Determine what strategy the tycoon should incorporate in this risky in-
vestment opportunity using expected monetary values, e.g., should
make her decision to invest immediately or should she wait and pay for
the consultant’s advice?.
4. Is the $50,000 consultant fee a fair price? From a theoretical stand-
point, exactly how much could the consultant justifiably expect to be
paid?
5. What are the accuracies of the forecast if you assume that advisable
forecasts that result in either moderate or highly successful outcomes

© Joel Oberstone, Ch. 1 25 May 18, 2015

 are justified and unadvisable forecasts that only result in failures are
also justified?
6. What is the overall accuracy of the consultant?
7. What are the EVII and VII?
8. Generate a “perfect information” tree and find the EVPI and VPI.

1-9 The metals broker in Exercise 1-4 is interested in reassessing his earlier es-
timates. In particular, he would like to know by exactly how much the fol-
lowing parameters could change before the change causes him to select a
different strategy, i.e., find the “tipping-point values” for :
1. The probability of the government approving the import contract
2. The actual per-ton price that he could obtain for the tungsten
3. The actual per-ton price that he would have to pay for the tungsten
4. The probability of winning the contract if he decides to wait and to see
what the government decision will be.

1-10 A meat packing company is concerned that the sodium nitrite preservative
it uses in its bacon products is carcinogenic (cancer-causing). Although
there has been no formal investigation to date, the Food and Drug Admin-
istration (FDA) is about to begin tests.

The findings of these tests will be either favorable (i.e., approve the ni-
trites) or unfavorable (i.e., ban the nitrites). The FDA's history of testing
similar meat nitrites indicates that there is a 75 percent chance that the
FDA will rule favorably (i.e., will find the existing nitrites safe for human
consumption). Fortunately, the company has a substitute for these nitrites
and is considering immediately replacing the potentially carcinogenic pre-
servative with this new ingredient.

This move would avoid a quick—and expensive—changeover if the FDA

bans the nitrites later. The conversion, if done now, will cost the company
approximately $5 million. Of course, the company can choose to do noth-
ing and hope that the FDA will issue a favorable test finding. If this hap-
pens, the company will sustain no costs.

If, however, the FDA issues an unfavorable report, the company would
have to recall all nitrite products from the markets and, in addition, close
down production until the new preservative can be introduced. The associ-
ated costs for such an outcome are estimated at $15 million, which in-
cludes lost sales, consumer ill-will, and the overtime and downtime ex-
penses of the conversion to the new preservative.
ASSIGNMENT
1. Using decision tree analysis and the principle of expected values, what
would you suggest that the company do?

© Joel Oberstone, Ch. 1 26 May 18, 2015

 2. By how much can the estimate that there is a 75 percent chance of the
FDA ruling favorably be in error before your optimum strategy is af-
fected? Include illustrations in your answer.
3. By how much can the $15 million conversion-cost estimate vary before
your optimum strategy changes? Include illustrations in your answer.
4. Calculate the EVII and VII for this problem.

1-11 Calculate the value of perfect information for the San Francisco metals
broker of Exercise 1-4. Why is it not possible for you to determine the EVII
and VII for this problem?

1-12 The results of a lie detector test are not admissible evidence in court. Typi-
cally, these tests label as untruthful 96 percent of the statements that are
actually lies. Unfortunately, these same tests label as untruthful 11 percent
of statements that are true. Suppose
that a person in a civil case insists
on taking a lie detector test, even
though the findings are not admis-
sible evidence. Based on hours of in-
terviews by opposition lawyers, the
test results indicate that she lies 20
percent of the time on a similar
group of questions.
ASSIGNMENT
Assume the following notation:
L=person actually lied; l=test sug-
gests lie
Answer the following questions af-
ter sketching an appropriate chart
for the data you’ve been given:
1. The lie-detector test has just indicated that the person lied. What is
the likelihood that the lie detector is incorrect (that this is a false-
negative result)?
2. The lie detector test has just indicated that the person told the
truth. What is the likelihood that the lie detector is incorrect (i.e.,
that this is a false-positive result)?

1-13 A forty-five year old man arrives at the emergency room of San Francisco
General Hospital complaining of severe chest pains. Based on 3,240 simi-
lar cases experienced over the past 7 years at SFGH, the following infor-
mation is known:
• Only 486 of the cases in this database were ultimately determined
to have been heart attacks.

© Joel Oberstone, Ch. 1 27 May 18, 2015

 • Of the 486 actual heart attacks, the electrocardiogram (EKG) used
in evaluating the presence of this potentially life-threatening condi-
tion correctly predicted that 434 were, in-
deed, actual heart attack cases; the rest were
incorrectly diagnosed by the EKG to be
“heart burn” or indigestion cases.
• This same test determined that among the
cases in which there actually was not a heart
attack, only 40 were diagnosed by the EKG
to have had a heart attack.
ASSIGNMENT
Assume the following notation: H=patient experienced heart attack;
h=EKG test suggests heart attack
1. Draw the chart of past experiences for SFGH showing the outcomes
of the actual patient condition and the EKG findings of each out-
come
2. Use this information to help you determine the chances of the pa-
tient testing positive and not having a heart attack but, rather, indi-
gestion (false positive)
3. Also determine the chance that an EKG findings suggest heart burn
or indigestion when, in actuality, the patient has truly suffered a
heart attack (false negative).
4. How accurate is the EKG when it tests positive for a heart attack?
5. How accurate is the EKG when it tests negative for a heart attack?
6. What is the overall accuracy of the EKG?

1-14 Fatigue has been blamed in numerous aviation accidents over the years
and is a continuing problem especially facing commercial
crews flying aircraft of all sizes. Although it is rare, drugs,
such as amphetamines (“uppers”), are used by pilots to
stay awake and alert. Regardless, it is absolutely illegal and
the Federal Aviation Agency (FAA) randomly tests pilots to
insure that such a violation does not occur. Here are the
results of their efforts:
• Thirty (30) pilots out of 10,000 were discovered to
have actually taken amphetamines.
• Of the 30 drug-takers, 27 had positive test results while 3 had nega-
tive test results.
• Of the remaining 9,970 pilots who were truly not taking ampheta-
mines, 54 had positive test results while the remainder had negative
test results
ASSIGNMENT
Assume the following notation: D=pilot actually took drugs; d= test indi-
cates presence of drugs

© Joel Oberstone, Ch. 1 28 May 18, 2015

 1. Draw the chart of past experiences for the FAA showing the out-
comes of the actual pilot condition and the drug test findings of
each case.
2. Use this information to help you determine the chances of the pilot
testing positive and not having taken drugs (false positive)
3. Also determine the chance that a drug test finding suggests no
drugs when, in actuality, the pilot has actually taken drugs (false
negative).
4. How accurate is the test when it predicts drugs are present?
5. How accurate is the test when it predicts no drugs are present?
6. What is the overall accuracy of the test?

1-15 Medical imaging is a new, highly lucrative investment area. You are con-
sidering making an investment with one
of the following three investment firms
that specialize in this industry. Data are
collected regarding the past investment
performance of each company.

You immediately see that there is quite

a bit of difference between these com-
panies regarding the amount of experience they have accumulated. From
what you have already learned from
research you have done that this in-
dustry is a high risk-high gain in-
vestment area. The overall success
rate of medical imaging investments
is approximately 14 percent: only one
in seven are successful.

You decide to further analyze these

data to determine more about the
chance of success for each company. More specifically, which company will
you choose to invest in if:
1. You will only consider a company whose 95% confidence interval
lower limit for success does not fall below 27.5%.
2. You will only consider a company whose 95% confidence interval
upper limit for success is at least 42.5%.
ASSIGNMENT
Identify the company or companies that satisfy both of these two condi-
tions, if any.

© Joel Oberstone, Ch. 1 29 May 18, 2015

REFERENCES
• Bickel, Eric, “On the Decision to Take a Pitch,” Decision Analysis, Vol. 6,
Issue 3, pp. 186-193, Published Online: July 13, 2009.
• Bodily, Samuel E. “When Should You Go to Court?” Harvard Business
Review 59 (No. 3: May - June 1981): 103 - 113.
• Clarke, John R. “The Application of Decision Analysis to Clinical Medi-
cine.” Interfaces 17 (No. 2: March - April 1987): 27 - 34.
• Cohen, Izack “Improving Time-Critical Decision Making in Life-
Threatening Situations: Observations and Insights, Decision Analysis, Vol.
6, Issue 2, pp. 100–110, Published Online: June 1, 2008
• De Rivera, Daniel Peña Sanchez. “A Decision Analysis Model for a Serious
Medical Problem.” Management Science 26 (No. 7: July 1980): 707 - 718.
• Digman, Lester A. “A Decision Analysis of the Airline Coupon Strategy.”
Interfaces 10 (No. 2: April 1980): 97 - 101.
• Dowie, Mark. “Pinto Madness.” Mother Jones 11 (No. 8: September - Oc-
tober 1977): 18 - 32.
• Fabusuyi, Tayo, Robert C. Hampshire, Victoria A. Hill, and Katsunobu
Sasanuma, “Decision Analytics for Parking Availability in Downtown
Pittsburgh,” Interfaces, pp. 286 – 299, Published Online: June 4, 2014
• Forst, Brian E., “Decision Analysis and Medical Malpractice, “ Journal of
Operations Research, Volume Number: 22, Issues: Jan-Feb, 1974
• Heian, Betty, Gale, James R.Mortgage Selection Using a Decision Tree
Approach: An Extension, Interfaces, Volume Number: 18:4, July-August
1988, pp. 72-83.
• Judd, Bruce R., and Stein Weissenberger. “A Systematic Approach to Nu-
clear Safeguards Decision-Making.” Management Science 28 (No. 3:
March 1982): 289 - 302.
• Luna, Robert E., Reid, Richard A., “Mortgage Selection Using a Decision
Tree Approach.” Interfaces, Volume Number: 16, Issues: May-June, pp.
73-81.
• Martonosi, Susan E. and Arnold Barnett, “How Effective Is Security
Screening of Airline Passengers?”, Interfaces, pp. 545 – 552, Published
Online: December 1, 2006.
• Merrick, Jason R. W. and John R. Harrald, “Making Decisions About Safe-
ty in US Ports and Waterways,” pp. 240-252, Interfaces, Published Online:
June 1, 2007.
• Saaty, Thomas L., Luis G. Vargas, and Amos Barzilay. “High-Level Deci-
sions: A Lesson from the Iran Hostage Rescue Operation.” Decision Sci-
ences 13 (No. 2: April 1982): 185 - 206.
• Solomon, Robert J., and Donald J. Messmer. “Implications of the Bakke
Decision in Implementing Affirmative Action Programs: A Decision Mod-
el.” Decision Sciences 11 (No. 2: April 1980): 312 - 324.

© Joel Oberstone, Ch. 1 30 May 18, 2015

 • Stonebraker, Jeffrey S. “How Bayer Makes Decisions to Develop New
Drugs, Interfaces, Vol. 32, Issue 6, pp. 77-90, Published Online: December
1, 2002.
• Ulvila, Jacob W. “Postal Automatic (ZIP + 4) Technology: A Decision
Analysis.” Interfaces 17 (No. 2: March - April 1987): 27 - 34.
• Ulvila, Jacob W., Rex V. Brown, and Karale S. Packard. “A Case in On-Line
Decision Analysis for Product Planning.” Paper presented at the OR-
SA/TIMS National Convention, Chicago, April 30, 1975.
• von Winterfeldt, Detlof, “Setting Standards for Offshore Oil Discharges: A
Regulatory Decision Analysis.” Operations Research, Volume Number:
30, Issues: Sep-Oct 1982, pp. 867-886.
• Williams, Fred E. “Decision Theory and the Innkeeper: An Approach for
Setting Hotel Reservation Policy.” Interfaces 7 (No. 4: August 1977), pp.
18 - 30.

© Joel Oberstone, Ch. 1 31 May 18, 2015