Making Hard Decisions: An Introduction to Decision Analysis (Business Statistics)

632 Pages·1997·10.67 MB·English

by  Robert T.(Robert T. Clemen) Clemen

MAKING HARD DECISIONS

An Introduction to Decision Analysis

SECOND E D I T I O N
Robert T. Clemen,
Duke University
H
ere's a straightforward book that teaches the fundamental ideas of decision analysis-without an
overly technical explanation of the mathematics used in management
science.
This new Second Edition of Making Hard Decisions, by Robert T.
Clemen, continues to provide readers with a thoroughly enjoyable, easy-
to-understand text. The book emphasizes the practical application of
decision analysis through interesting case studies and useful exercises that represent the broad range
of fields and industries that benefit from systematic decision analysis.
Making Hard Decisions also contains up-to-date coverage of modern computer applications. Special
attention to the role of the computer in decision analysis, as well as descriptions of the many software
packages avaiiable-like DPL, Excel and Data-make this book a handy resource.
NEW TO THE SECOND EDITION
■ Value-focused thinking integrated into the text
■ Updated coverage of decision analysis software and discussion of dedicated simulation software
■ New decision-analytic approach to regression
ABOUT THE AUTHOR
Robert T. Clemen is a Professor at the Fuqua School of Business at Duke University, An active contributor
to the field of decision analysis since earning his Ph.D. at Indiana University in 1984, he has become an
authority in the use of expert information in risk analysis. Aside from his research interests, Bob has a
strong focus on making decision analysis accessible to students at all levels, ranging from creating teach-
ing materials for high school students to teaching in executive education programs.
Making
Hard Decisions

An Introduction to Decision Analysis
2nd Edition

Robert T. Clemen
Fuqua School of Business
Duke University
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under license. Duxbury Press and the leaf logo are trademarks used under license. recycled paper.
Crystal Ball ® screen shots © 1993; reprinted with permission from Decisioneering. DATA ™ screen shots © 1994-1995; reprinted
with permission from TreeAge Software, Inc. Microsoft ® Excel screen shots © 1985-1995 by Microsoft Corporation; reprinted with permission from
Microsoft corporation. DPL ™ screen shots © 1992-1995 by ADA Decision Systems; reprinted with permission. @RISK and BestFit ® screen shots ©
1990-1995 by Palisade Corporation; reprinted with permission. Logical Decisions ® screen shots © 1993-1995 by Logical Decisions; reprinted with
permission.
Crystal Ball is a registered trademark of Decisioneering. DATA and Decision Analysis by TreeAge are trademarks of TreeAge Software, Inc. Microsoft is
a registered trademark and Windows is a trademark of Microsoft Corporation. DPL and Decision Programming Language are trademarks of ADA Decision
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trademarks of Palisade Corporation. Logical Decisions is a registered trademark of Logical Decisions. Apple and Macintosh are registered trademarks of
Apple Computer, Inc.
The following cases and examples are fictional. Any resemblance to actual people or organizations is purely coincidental: Larkin Oil (p. 31); The Value of
Patience (p. 36); Early Bird, Inc. (p. 37); Hiring a Summer Intern (p. 42); The Summer Job (p. 128); GPC'S New Product Design (p. 145); Southern
Electronics, Part I (p. 146); Southern Electronics, Part II (p. 147); Strenlar (p. 148); Job Offers (p. 150); Eagle Airlines (p. 155); Dumond International,
Part I (p. 182); Strenlar, Part II (p. 183); Job Offers, Part II (p. 184); Decision Analysis Monthly (p. 256); Overbooking (p. 345); Municipal Solid Waste
(p. 350); Taco Shells (p. 405); Forecasting Sales (p. 406); Overbooking, Part II (p. 408); Fashions (p. 411); Choosing a Manufacturing Process (p. 428);
Organic Farming (p. 430); Overbooking, Part III (p. 433); Dumond International, Part II (p. 456); Interplants, Inc. (p. 497); Strenlar, Part III (p. 501); The
Life Insurance Game (p. 524); Nuclear Power Paranoia (p. 525); The Manager's Perspective (p. 526); A Matter of Ethics (p. 572). E. H. Harriman Fights
for the Northern Pacific Railroad (p. 462) is a fictionalized account of historical events.
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Library of Congress Cataloging-in-Publication Data
Clemen, Robert T. (Robert Taylor, 1952-
Making hard decisions : an introduction to decision analysis /
Robert T. Clemen. — 2nd ed.
p. cm.
Includes bibliographical references and index.
ISBN 0-534-26034-9 1. Decision-making. I.
Title.
HD30.23.C577 1995 95-42073
658.4'03-dc20 CIP
Brief Contents

1 Introduction to Decision Analysis 1
Section 1 Modeling Decisions 17
2 Elements of Decision Problems 19
3 Structuring Decisions 41
4 Making Choices 101
5 Sensitivity Analysis 155
6 Creativity and Decision Making 187
Section 2 Modeling Uncertainty 217
7 Probability Basics 219
8 Subjective Probability 265
9 Theoretical Probability Models 314

10 Using Data 355
11 Monte Carlo Simulation 410
12 Value of Information 435
Section 3 Modeling Preferences 459
13 Risk Attitudes 461
14 Utility Axioms, Paradoxes, and Implications 503
15 Conflicting Objectives I: Fundamental Objectives and the Additive
Utility Function 530
16 Conflicting Objectives II: Multiattribute Utility Models with
Interactions 576
17 Conclusion and Further Reading 607
Contents

Preface xix
Chapter 1 Introduction to Decision Analysis 1
Gypsy Moths and the ODA 1
Why Are Decisions Hard? 2
Why Study Decision Analysis? 3
Subjective Judgments and Decision Making 5
The Decision-Analysis Process 5
Requisite Decision Models 8
Where Is Decision Analysis Used? 8
Where Are We Going from Here? 9
Summary 10
Questions and Problems 10
Case Studies: Dr. Joycelyn Elders and the War on Drugs 11
Lloyd Bentsen for Vice President? 12 Du Pont
and Chlorofluorocarbons 13
References 14
Epilogue 15
viii CONTENTS
Section 1 Modeling Decisions 17 Chapter
2 Elements of Decision Problems 19
Values and Objectives 19 Making Money: A
Special Objective 20 Values and the Current
Decision Context 21 Boeing's Supercomputer
22 Decisions to Make 23 Sequential
Decisions 24 Uncertain Events 25
Consequences 27
The Time Value of Money: A Special Kind of Trade-Off 28
Larkin Oil 31 Summary 34
Questions and Problems 34 Case Studies:
The Value of Patience 36 Early Bird, Inc. 37
References 39
Epilogue 39
Chapter 3 Structuring Decisions 41
Structuring Values 42
Hiring a Summer Intern 42
Fundamental and Means Objectives 44
Getting the Decision Context Right 49
Structuring Decisions: Influence Diagrams 50
Influence Diagrams and the Fundamental Objectives Hierarchy 52
Using Arcs to Represent Relationships 53
Some Basic Influence Diagrams 55
The Basic Risky Decision 55 Imperfect Information 56
Sequential Decisions 59 Intermediate Calculations 61
Constructing an Influence Diagram (Optional) 63 Toxic
Chemicals and the EPA 63
Some Common Mistakes 65 Multiple Representations and
Requisite Models 67
CONTENTS ix
Structuring Decisions: Decision Trees 67
Decision Trees and the Objectives Hierarchy 69
Some Basic Decision Trees 70
The Basic Risky Decision 70 Imperfect Information 72
Sequential Decisions 72
Decision Trees and Influence Diagrams Compared 74
Decision Details: Defining Elements of the Decision 74 More
Decision Details: Cash Flows and Probabilities 76 Defining
Measurement Scales for Fundamental Objectives 77 Using
Computers for Structuring Decisions 82
Logical Decisions 83 DPL (Decision Programming Language) 85
DATA 88
Summary 89
Exercises 90
Questions and Problems 92 Case
Studies: Cold Fusion 96
Prescribed Fire 97 The
SS Kuniang 97
References 98
Epilogue 100
Chapter 4 Making Choices 101
Texaco Versus Pennzoil 101
Decision Trees and Expected Monetary Value 105
Solving Influence Diagrams: Overview 109
Solving Influence Diagrams: The Details (Optional) 112
Solving Influence Diagrams: An Algorithm (Optional) 117
Risk Profiles 118
Cumulative Risk Profiles 122 Dominance: An Alternative to EMV
123 Making Decisions with Multiple Objectives 127 The Summer Job
128 Analysis: One Objective at a Time 130 Subjective Ratings for
Constructed Attribute Scales 130 Assessing Trade-Off Weights 132
Analysis: Expected Values and Risk Profiles for Two Objectives 133
x CONTENTS
Computer Programs for Decision Analysis 136
DPL 136 DATA 137 Electronic Spreadsheets 140
Summary 140
Exercises 141
Questions and Problems 142
Case Studies: GPC's New Product Decision 145
Southern Electronics, Part I 146
Southern Electronics, Part II 147
Strenlar 148 Job Offers 150 SS
Kuniang, Part II 152
References 152
Epilogue 154
Chapter 5 Sensitivity Analysis 155
Eagle Airlines 155
Sensitivity Analysis: A Modeling Approach 156
Problem Identification and Structure 157
One-Way Sensitivity Analysis 160
Tornado Diagrams 161
Dominance Considerations 162
Two-Way Sensitivity Analysis 164
Sensitivity to Probabilities 165
Two-Way Sensitivity Analysis for Three Alternatives
(Optional) 169
Investing in the Stock Market 169
Sensitivity Analysis in Action 172
Heart Disease in Infants 173 Sensitivity
Analysis by Computer 174
Sensitivity Analysis with DPL 174 Sensitivity Analysis
with DATA 176
Sensitivity Analysis: A Built-in Irony 178
Summary 178 Exercises 178 Questions
and Problems 179
CONTENTS xi
Case Studies: The Stars and Stripes 181
Dumond International, Part I 182 Strenlar,
Part II 183 Facilities Investment and
Expansion 184 Job Offers, Part II 184
References 186
Epilogue 186
Chapter 6 Creativity and Decision Making 187
What Is Creativity? 188 Theories
of Creativity 189 Chains of
Thought 189 Phases of the
Creative Process 190 Blocks to
Creativity 192
Framing and Perceptual Blocks 192
The Monk and the Mountain 192
Making Cigars 193
Value-Based Blocks 195 Cultural and Environmental Blocks 197
Ping-Pong Ball in a Pipe 197
Organizational Issues 199 Value-Focused Thinking for
Creating Alternatives 200
Fundamental Objectives 200 Means Objectives 200
Transportation of Nuclear Waste 201
The Decision Context 202 Other
Creativity Techniques 203
Fluent and Flexible Thinking 203 Idea Checklists 203
Brainstorming 206 Metaphorical Thinking 206
Other Techniques 208 Creating
Decision Opportunities 209 Summary
209 Questions and Problems 210 Case
Studies: Modular Olympics 211
Burning Grass-Seed Fields 212
References 212
Epilogue 214