Risk Management in

Construction
Lec 7
Decision Analysis
Decision Analysis
• To a great extent, the successes or failures that a person experiences in life
depend on the decisions that he or she makes.
• Decision theory is an analytic and systematic approach to the study of decision
making.
• Mathematical models are useful in helping managers make the best possible
decisions.
Decision Analysis
• What makes the difference between good and bad decisions?
• A good decision is one that is based on logic, considers all available data and
possible alternatives, and applies a suitable quantitative approach.
• Occasionally, a good decision results in an unexpected or unfavorable
outcome. But if it is made properly, it is still a good decision.
• A bad decision is one that is not based on logic, does not use all available
information, does not consider all alternatives, and does not employ
appropriate quantitative techniques.
• If you make a bad decision but are lucky and a favorable outcome occurs, you
have still made a bad decision.
• Although occasionally good decisions yield bad results, in the long run, using
decision theory will result in successful outcomes.
The Six Steps in Decision Making
• Whether you are deciding about getting a haircut today, building a multimillion-
dollar plant, or buying a new camera, the steps in making a good decision are
basically the same:
The Six Steps in Decision Making
• Example: Thompson Lumber Company case as an example (John Thompson is the
founder and president of Thompson Lumber Company, a profitable firm located
in Portland, Oregon)
The Six Steps in Decision Making
The Six Steps in Decision Making
Types of Decision-Making Environments
• The types of decisions people make depend on how much knowledge or
information they have about the situation. There are three decision-making
environments:
• Decision making under certainty
• Decision making under uncertainty
• Decision making under risk
• In the environment of decision making under certainty, decision makers know
with certainty the consequence of every alternative or decision choice. Naturally,
they will choose the alternative that will maximize their well-being or will result in
the best outcome.
• For example, let’s say that you have $1,000 to invest for a 1-year period. One
alternative is to open a savings account paying 4% interest, and another is to
invest in a government Treasury bond paying 6% interest. If both investments are
secure and guaranteed, there is a certainty that the Treasury bond will pay a
higher return. The return after 1 year will be $60 in interest.
Types of Decision-Making Environments
• In decision making under uncertainty, there are several possible outcomes for
each alternative, and the decision maker does not know the probabilities of the
various outcomes.
• As an example, the probability that a Democrat will be president of the United
States 25 years from now is not known. Sometimes it is impossible to assess the
probability of success of a new undertaking or product.
Types of Decision-Making Environments
• In decision making under risk, there are several possible outcomes for each
alternative, and the decision maker knows the probability of occurrence of each
outcome.
• We know, for example, that when playing cards using a standard deck, the
probability of being dealt a club is 0.25. The probability of rolling a 5 on a die is
1/6.
• In decision making under risk, the decision maker usually attempts to maximize
his or her expected well-being.
• Decision theory models for business problems in this environment typically
employ two equivalent criteria: maximization of expected monetary value and
minimization of expected opportunity loss.
Types of Decision-Making Environments
• In the Thompson Lumber example, John Thompson is faced with decision making
under uncertainty.
• If either a large plant or a small plant is constructed, the actual payoff depends on
the state of nature, and probabilities are not known.
• If probabilities for a favorable market and for an unfavorable market were known,
the environment would change from uncertainty to risk.
• For the third alternative, do nothing, the payoff does not depend on the state of
nature and is known with certainty.
Decision Making Under Uncertainty
• For payoffs such as profit, total sales, total return on investment, and interest earned,
the best decision would be one that resulted in some type of maximum payoff.
• However, there are situations in which lower payoff values (e.g., cost) are better, and
these payoffs would be minimized rather than maximized.
• Several criteria exist for making decisions under conditions of uncertainty (when
probabilities of the states of nature are not known and cannot be estimated.).
• The ones that we cover in this section are as follows:
1. Optimistic
2. Pessimistic
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax regret
Decision Making Under Uncertainty
1. Optimistic
• In using the optimistic criterion, the best (maximum) payoff for each alternative is
considered, and the alternative with the best (maximum) of these is selected.
• Hence, the optimistic criterion is sometimes called the maximax criterion.

• In the table above, we see that Thompson’s optimistic choice is the first alternative,
“construct a large plant.”
• By using this criterion, the highest of all possible payoffs ($200,000 in this example) may
be achieved, while if any other alternative were selected, it would be impossible to
achieve a payoff this high.
Decision Making Under Uncertainty
2. Pessimistic
• In using the pessimistic criterion, the worst (minimum) payoff for each alternative is
considered, and the alternative with the best (maximum) of these is selected.
• Hence, the pessimistic criterion is sometimes called the maximin criterion.

• This criterion guarantees the payoff will be at least the maximin value (the best of the
worst values). Choosing any other alternative may allow a worse (lower) payoff to occur.
• Thompson’s maximin choice, “do nothing,” is shown in table above. This decision is
associated with the maximum of the minimum number within each row or alternative.
Decision Making Under Uncertainty
3. Criterion of Realism (Hurwicz Criterion)
• Both the maximax and maximin criteria consider only one extreme payoff for each
alternative, while all other payoffs are ignored. This criterion considers both of these
extremes.
• Often called the weighted average, the criterion of realism (the Hurwicz criterion) is a
compromise between an optimistic and a pessimistic decision.
• To begin, a coefficient of realism, α, is selected. This measures the degree of optimism of
the decision maker and is between 0 and 1.
• When α is 1, the decision maker is 100% optimistic about the future. When α is 0, the
decision maker is 100% pessimistic about the future.
• The advantage of this approach is that it allows the decision maker to build in personal
feelings about relative optimism and pessimism.
• The weighted average is computed as follows:
Decision Making Under Uncertainty
3. Criterion of Realism (Hurwicz Criterion)
• For a maximization problem, the best payoff for an alternative is the highest value, and
the worst payoff is the lowest value.
• Note that when α = 1, this is the same as the optimistic criterion, and when α = 0, this is
the same as the pessimistic criterion.
• This value is computed for each alternative, and the alternative with the highest
weighted average is then chosen.
• If we assume that John Thompson sets his coefficient of realism, α, to be 0.80, the best
decision would be to construct a large plant. As seen in Table below, this alternative has
the highest weighted average: $124,000 = (0.80)($200,000) + (0.20)(-$180,000).
• Because there are only two states of nature in the Thompson Lumber example, only two
payoffs for each alternative are present and both are considered. However, if there are
more than two states of nature, this criterion will ignore all payoffs except the best and
the worst. The next criterion will consider all possible payoffs for each decision.
Decision Making Under Uncertainty
3. Criterion of Realism (Hurwicz Criterion)
Decision Making Under Uncertainty
4. Equally Likely (Laplace)
• One criterion that uses all the payoffs for each alternative is the equally likely,
also called Laplace, decision criterion.
• This involves finding the average payoff for each alternative and selecting the
alternative with the best or highest average.
• The equally likely approach assumes that all probabilities of occurrence for the
states of nature are equal, and thus each state of nature is equally likely.
• The equally likely choice for Thompson Lumber is the second alternative,
“construct a small plant.”
• This strategy, shown in Table below, is the one with the maximum average payoff.
Decision Making Under Uncertainty
4. Equally Likely (Laplace)
Decision Making Under Uncertainty
5. Minimax Regret
• This decision criterion is based on opportunity loss or regret.
• Opportunity loss refers to the difference between the optimal profit or payoff for
a given state of nature and the actual payoff received for a particular decision for
that state of nature.
• In other words, it’s the amount lost by not picking the best alternative in a given
state of nature.
• The first step is to create the opportunity loss table by determining the
opportunity loss for not choosing the best alternative for each state of nature.
• Opportunity loss for any state of nature, or any column, is calculated by
subtracting each payoff in the column from the best payoff in the same column.
Decision Making Under Uncertainty
5. Minimax Regret
• For a favorable market, the best payoff is $200,000 as a result of the first
alternative, “construct a large plant.” The opportunity loss is 0, meaning that it is
impossible to achieve a higher payoff in this state of nature.
• If the second alternative is selected, a profit of $100,000 would be realized in a
favorable market, and this is compared to the best payoff of $200,000. Thus, the
opportunity loss is 200,000 - 100,000 = 100,000. Similarly, if “do nothing” is
selected, the opportunity loss would be 200,000 - 0 = 200,000.
• For an unfavorable market, the best payoff is $0 as a result of the third
alternative, “do nothing,” so this has 0 opportunity loss.
• The opportunity losses for the other alternatives are found by subtracting the
payoffs from this best payoff ($0) in this state of nature, as shown in Table 3.6.
Thompson’s opportunity loss table is shown as Table 3.7.
Decision Making Under Uncertainty
5. Minimax Regret
Decision Making Under Uncertainty
5. Minimax Regret
• Using the opportunity loss (regret) table, the minimax regret criterion first considers the
maximum (worst) opportunity loss for each alternative. Next, looking at these maximum
values, pick the alternative with the minimum (or best) number.
• By doing this, the opportunity loss actually realized is guaranteed to be no more than this
minimax value.
• In Table 3.8, we can see that the minimax regret choice is the second alternative,
“construct a small plant.” When this alternative is selected, we know the maximum
opportunity loss cannot be more than 100,000 (the minimum of the maximum regrets).
Decision Making Under Risk
• Decision making under risk is a decision situation in which several possible states
of nature may occur and the probabilities of these states of nature are known.

• One of the most popular methods of making decisions under risk is selecting the
alternative with the highest expected monetary value (or simply expected value).

• We can also use the probabilities with the opportunity loss table to minimize the
expected opportunity loss.
Decision Making Under Risk
- Expected Monetary Value
• Given a decision table with conditional values (payoffs) that are monetary values
and probability assessments for all states of nature, it is possible to determine the
expected monetary value (EMV) for each alternative.
• The expected value, or the mean value, is the long-run average value of that
decision.
• The EMV for an alternative is just the sum of possible payoffs of the alternative,
each weighted by the probability of that payoff occurring.
• This could also be expressed simply as the expected value of X, or E(X).
Decision Making Under Risk
- Expected Monetary Value

• If this were expanded, it would become

• The alternative with the maximum EMV is then chosen.

Decision Making Under Risk
- Expected Monetary Value
• Suppose that John Thompson now believes that the probability of a favorable market is exactly
the same as the probability of an unfavorable market; that is, each state of nature has a 0.50
probability. Which alternative would give the greatest EMV?
• To determine this, John has expanded the decision table, as shown in Table 3.9. His calculations
follow:

The largest expected value

($40,000) results from the second
alternative, “construct a small
plant.” Thus, Thompson should
proceed with the project and put
up a small plant to manufacture
storage sheds.
Decision Making Under Risk
- Expected Value of Perfect Information
• John Thompson has been approached by Scientific Marketing, Inc., a firm that
proposes to help John make the decision about whether to build the plant to
produce storage sheds.
• Scientific Marketing claims that its technical analysis will tell John with certainty
whether the market is favorable for his proposed product (it will change his
environment from one of decision making under risk to one of decision making
under certainty)
• Scientific Marketing would charge Thompson $65,000 for the information.
• What would you recommend to John?
• Should he hire the firm to make the marketing study?
• Even if the information from the study is perfectly accurate, is it worth $65,000?
• What would it be worth?
Decision Making Under Risk
- Expected Value of Perfect Information
• Although some of these questions are difficult to answer, determining the value of such perfect
information can be very useful.
• It places an upper bound on what you should be willing to spend on information such as that
being sold by Scientific Marketing.
• Two related terms are investigated: the expected value of perfect information (EVPI) and the
expected value with perfect information (EVwPI).
• The expected value with perfect information is the expected or average return, in the long run, if
we have perfect information before a decision has to be made.
• To calculate this value, we choose the best alternative for each state of nature and multiply its
payoff times the probability of occurrence of that state of nature.
Decision Making Under Risk
- Expected Value of Perfect Information
• The EVPI is the expected value with perfect information minus the expected
value without perfect information (i.e., the best or maximum EMV). Thus, the
EVPI is the improvement in EMV that results from having perfect information.

• Following information in Table 3.9,

• First, the best payoff in each state of nature is found.
• If the perfect information says the market will be favorable, the large plant will be
constructed, and the profit will be $200,000.
• If the perfect information says the market will be unfavorable, the “do nothing” alternative is
selected, and the profit will be 0.
• These values are shown in the “with perfect information” row in Table 3.10.
• Second, the expected value with perfect information is computed.
• Then, using this result, EVPI is calculated.
Decision Making Under Risk
- Expected Value of Perfect Information

• The expected value with perfect information is:

• Thus, if we had perfect information, the payoff would average $100,000.

Decision Making Under Risk
- Expected Value of Perfect Information
• The maximum EMV without additional information is $40,000 (from Table 3.9 ).
Therefore, the increase in EMV is:

• Thus, the most Thompson would be willing to pay for perfect information is
$60,000. This, of course, is again based on the assumption that the probability of
each state of nature is 0.50.
Decision Making Under Risk
- Expected Opportunity Loss
• An alternative approach to maximizing EMV is to minimize expected opportunity
loss (EOL).
• First, an opportunity loss table is constructed.
• Then the EOL is computed for each alternative by multiplying the opportunity loss
by the probability and adding these together.
• In Table 3.7, the opportunity loss table for the Thompson Lumber example is
presented.
Decision Making Under Risk
- Expected Opportunity Loss

• Table 3.11 gives these results. Using minimum EOL as the decision criterion, the
best decision would be the second alternative, “construct a small plant.”
• It is important to note that minimum EOL will always result in the same decision
as maximum EMV and that the EVPI will always equal the minimum EOL.
Decision Making Under Risk
- Sensitivity Analysis
• In previous sections, we determined that the best decision (with the probabilities
known) for Thompson Lumber was to construct the small plant, with an expected
value of $40,000.
• This conclusion depends on the values of the economic consequences and the
two probability values of a favorable and an unfavorable market.
• Sensitivity analysis investigates how our decision might change given a change in
the problem data.
• In this section, we investigate the impact that a change in the probability values
would have on the decision facing Thompson Lumber.
• We first define the following variable:
Decision Making Under Risk
- Sensitivity Analysis
• Because there are only two states of nature, the probability of an unfavorable
market must be 1 - P.
• We can now express the EMVs in terms of P, as shown in the following equations.
A graph of these EMV values is shown in Figure 3.1.
Decision Making Under Risk
- Sensitivity Analysis
Decision Making Under Risk
- Sensitivity Analysis
• As you can see in Figure 3.1, the best decision is to do nothing as long as P is
between 0 and the probability associated with point 1, where the EMV for doing
nothing is equal to the EMV for the small plant.
• When P is between the probabilities for points 1 and 2, the best decision is to
build the small plant.
• Point 2 is where the EMV for the small plant is equal to the EMV for the large
plant.
• When P is greater than the probability for point 2, the best decision is to
construct the large plant.
• Of course, this is what you would expect as P increases.
Decision Trees
• Any problem that can be presented in a decision table can also be graphically
illustrated in a decision tree.
• All decision trees are similar in that they contain decision nodes or decision
points and state-of-nature nodes or state-of-nature points:
• A decision node from which one of several alternatives may be chosen
• A state-of-nature node out of which one state of nature will occur
Decision Trees

• In drawing the tree, we begin at the left and move to the right. Thus, the tree
presents the decisions and outcomes in sequential order.
• Lines or branches from the squares (decision nodes) represent alternatives, and
branches from the circles represent the states of nature.
Decision Trees
• Figure 3.2 gives the basic decision tree for the Thompson Lumber example.
• First, John decides whether to construct a large plant, a small plant, or no plant.
• Then, once that decision is made, the possible states of nature or outcomes
(favorable or unfavorable market) will occur.
• The next step is to put the payoffs and probabilities on the tree and begin the
analysis.
• The final decision tree with the payoffs and probabilities for John Thompson’s
decision situation is shown in Figure 3.3.
Decision Trees
Decision Trees
• When sequential decisions need to be made, decision trees are much more
powerful tools than decision tables.
• Let’s say that John Thompson has two decisions to make, with the second
decision dependent on the outcome of the first.
• Before deciding about building a new plant, John has the option of conducting his
own marketing research survey, at a cost of $10,000.
• The information from his survey could help him decide whether to construct a
large plant or a small plant or not to build at all.
• John recognizes that such a market survey will not provide him with perfect
information, but it may help quite a bit nevertheless.
• John’s new decision tree is represented in Figure 3.4. The rest of the probabilities
shown in parentheses in Figure 3.4 are all conditional probabilities or posterior
probabilities (these probabilities will also be discussed in the next section).
Decision Trees
Decision Trees
Decision Trees
Decision Trees
Decision Trees
Decision Trees
- Expected Value of Sample Information
• With the market survey he intends to conduct, John Thompson knows that his
best decision will be to build a large plant if the survey is favorable or a small
plant if the survey results are negative. But John also realizes that conducting the
market research is not free. He would like to know what the actual value of doing
a survey is.
• One way of measuring the value of market information is to compute the
expected value of sample information (EVSI), which is the increase in expected
value resulting from the sample information.
• The expected value with sample information (EV with SI) is found from the
decision tree, and the cost of the sample information is added to this, since this
was subtracted from all the payoffs before the EV with SI was calculated.
• The expected value without sample information (EV without SI) is then
subtracted from this to find the value of the sample information.
Decision Trees
- Expected Value of Sample Information

• In John’s case, his EMV would be $59,200 if he hadn’t already subtracted the $10,000
study cost from each payoff. (Do you see why this is so? If not, add $10,000 back into
each payoff, as in the original Thompson problem, and recompute the EMV of
conducting the market study.) From the lower branch of Figure 3.5, we see that the EMV
of not gathering the sample information is $40,000. Thus,

• This means that John could have paid up to $19,200 for a market study and still come out
ahead. Since it costs only $10,000, the survey is indeed worthwhile.
Decision Trees
- Efficiency of Sample Information
• There may be many types of sample information available to a decision maker.
• In developing a new product, information could be obtained from a survey, from a focus group,
from other market research techniques, or from actual use of a test market to see how sales will
be.
• While none of these sources of information are perfect, they can be evaluated by comparing the
EVSI with the EVPI. If the sample information was perfect, then the efficiency would be 100%.
• The efficiency of sample information is
Decision Trees
- Sensitivity Analysis
• As with payoff tables, sensitivity analysis can be applied to decision trees as well.
• Consider the decision tree for the expanded Thompson Lumber problem shown
in Figure 3.5.
• How sensitive is our decision (to conduct the marketing survey) to the probability
of favorable survey results?
• Let p be the probability of favorable survey results. Then (1 – p) is the probability
of negative survey results.
• Given this information, we can develop an expression for the EMV of conducting
the survey, which is node 1:
Decision Trees
- Sensitivity Analysis
• We are indifferent when the EMV of conducting the marketing survey, node 1, is the
same as the EMV of not conducting the survey, which is $40,000.
• We can find the indifference point by equating EMV(node 1) to $40,000:

• As long as the probability of favorable survey results, p, is greater than 0.36, our decision
will stay the same. When p is less than 0.36, our decision will be not to conduct the
survey.
• We could also perform sensitivity analysis for other problem parameters. For example,
we could find how sensitive our decision is to the probability of a favorable market given
favorable survey results. (what if the probability of 0.78 goes down?)
How Probability Values are Estimated by Bayesian
Analysis
• There are many ways of getting probability data for a problem such as
Thompson’s.
• The numbers (such as 0.78, 0.22, 0.27, and 0.73 in Figure 3.4) can be assessed by
a manager based on experience and intuition.
• They can be derived from historical data, or they can be computed from other
available data using Bayes’ Theorem.
• The advantage of Bayes’ Theorem is that it incorporates both our initial estimates
of the probabilities and information about the accuracy of the information source
(e.g., market research survey).
• The Bayes’ Theorem approach recognizes that a decision maker does not know
with certainty what state of nature will occur.
• It allows the manager to revise his or her initial or prior probability assessments
based on new information.
• The revised probabilities are called posterior probabilities.
How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities
• In the Thompson Lumber case solved in Section 3.7, we made the assumption that the
following four conditional probabilities were known:

• We now show how John Thompson was able to derive these values with Bayes’
Theorem.
• From discussions with market research specialists at the local university, John knows that
special surveys such as his can either be positive (i.e., predict a favorable market) or be
negative (i.e., predict an unfavorable market).
• The experts have told John that, statistically, of all new products with a favorable market
(FM), market surveys were positive and predicted success correctly 70% of the time.
How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities
• 30% of the time the surveys falsely predicted negative results or an unfavorable
market (UM).
• On the other hand, when there was actually an unfavorable market for a new
product, 80% of the surveys correctly predicted negative results.
• The surveys incorrectly predicted positive results the remaining 20% of the time.
• These conditional probabilities are an indication of the accuracy of the survey
that John is thinking of undertaking.
• Recall that without any market survey information, John’s best estimates of a
favorable and unfavorable market are:

• These are referred to as the prior probabilities.

How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities
• We are now ready to compute Thompson’s revised or posterior probabilities.
• These desired probabilities are the reverse of the probabilities discussed above.
• We need the probability of a favorable or unfavorable market given a positive or
negative result from the market study.
How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities
• We can let A represent a favorable market and B represent a positive survey.
Then, substituting the appropriate numbers into this equation, we obtain the
conditional probabilities given that the market survey is positive:

• Note that the denominator (0.45) in these calculations is the probability of a

positive survey. An alternative method for these calculations is to use a
probability table as shown in Table 3.17.
How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities

• The conditional probabilities, given that the market survey is negative, are:
How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities
• Note that the denominator (0.55) in these calculations is the probability of a
negative survey.
• These computations could also have been performed in a table instead, as in
Table 3.18.

• The posterior probabilities now provide John Thompson with estimates for each
state of nature if the survey results are positive or negative.
How Probability Values are Estimated by Bayesian
Analysis
- Calculating Revised Probabilities
• As you know, John’s prior probability of success without a market survey was only
0.50. Now he is aware that the probability of successfully marketing storage
sheds will be 0.78 if his survey shows positive results. His chances of success drop
to 27% if the survey report is negative.
• This is valuable management information, as we saw in the earlier decision tree
analysis.
How Probability Values are Estimated by Bayesian
Analysis
- Potential Problem in Using Survey Results
• In many decision-making problems, survey results or pilot studies are done before an actual
decision (such as building a new plant or taking a particular course of action) is made.
• As discussed earlier in this section, Bayes’ analysis is used to help determine the correct
conditional probabilities that are needed to solve these types of decision theory problems.
• In computing these conditional probabilities, we need to have data about the surveys and their
accuracies.
• If a decision to build a plant or to take another course of action is actually made, we can
determine the accuracy of our surveys.
• Unfortunately, we cannot always get data about those situations in which the decision was not to
build a plant or not to take some course of action.
• Thus, sometimes when we use survey results, we are basing our probabilities only on those cases
in which a decision to build a plant or take some course of action is actually made.
• This means that, in some situations, conditional probability information may not be not quite as
accurate as we would like. Even so, calculating conditional probabilities helps to refine the
decision-making process and, in general, to make better decisions.
The End