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Decision Theory: Professor Ahmadi
Decision Theory: Professor Ahmadi
Professor Ahmadi
Slide 1
Learning Objectives
Structuring the decision problem and decision trees Types of decision making environments: Decision making under uncertainty when probabilities are not known Decision making under risk when probabilities are known Expected Value of Perfect Information Decision Analysis with Sample Information Developing a Decision Strategy Expected Value of Sample Information
Slide 2
Type 1: Decision Making under Certainty. Decision maker know for sure (that is, with certainty) outcome or consequence of every decision alternative. Type 2: Decision Making under Uncertainty. Decision maker has no information at all about various outcomes or states of nature. Type 3: Decision Making under Risk. Decision maker has some knowledge regarding probability of occurrence of each outcome or state of nature.
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Decision Trees
A decision tree is a chronological representation of the decision problem. Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives. The branches leaving each round node represent the different states of nature while the branches leaving each square node represent the different decision alternatives. At the end of each limb of a tree are the payoffs attained from the series of branches making up that limb.
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If the decision maker does not know with certainty which state of nature will occur, then he/she is said to be making decision under uncertainty. The five commonly used criteria for decision making under uncertainty are: 1. the optimistic approach (Maximax) 2. the conservative approach (Maximin) 3. the minimax regret approach (Minimax regret) 4. Equally likely (Laplace criterion) 5. Criterion of realism with (Hurwicz criterion)
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Optimistic Approach
The optimistic approach would be used by an optimistic decision maker. The decision with the largest possible payoff is chosen. If the payoff table was in terms of costs, the decision with the lowest cost would be chosen.
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Conservative Approach
The conservative approach would be used by a conservative decision maker. For each decision the minimum payoff is listed and then the decision corresponding to the maximum of these minimum payoffs is selected. (Hence, the minimum possible payoff is maximized.) If the payoff was in terms of costs, the maximum costs would be determined for each decision and then the decision corresponding to the minimum of these maximum costs is selected. (Hence, the maximum possible cost is minimized.)
Slide 7
The minimax regret approach requires the construction of a regret table or an opportunity loss table. This is done by calculating for each state of nature the difference between each payoff and the largest payoff for that state of nature. Then, using this regret table, the maximum regret for each possible decision is listed. The decision chosen is the one corresponding to the minimum of the maximum regrets.
Slide 8
Decisions
d1 d2
20 25
6 3
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s1
d1 d2 5 0
s2
0 3
Maximum
5 3
minimum
Slide 12
Average for d1 = (20 + 6)/2 = 13 Average for d2 = (25 + 3)/2 = 14 Thus, d2 is selected
Slide 13
Often called weighted average, the criterion of realism (or Hurwicz) decision criterion is a compromise between optimistic and a pessimistic decision. First, select coefficient of realism, , with a value between 0 and 1. When is close to 1, decision maker is optimistic about future, and when is close to 0, decision maker is pessimistic about future.
Payoff = x (maximum payoff) + (1-) x (minimum payoff)
In our example let = 0.8 Payoff for d1 = 0.8*20+0.2*6=17.2 Payoff for d2 = 0.8*25+0.2*3=20.6 Thus, select d2
Slide 14
Expected Value Approach If probabilistic information regarding the states of nature is available, one may use the expected Monetary value (EMV) approach (also known as Expected Value or EV). Here the expected return for each decision is calculated by summing the products of the payoff under each state of nature and the probability of the respective state of nature occurring. The decision yielding the best expected return is chosen.
Slide 15
The expected value of a decision alternative is the sum of weighted payoffs for the decision alternative. The expected value (EV) of decision alternative di is defined as:
EV( d i ) P( s j )Vij
j 1 N
where:
N = the number of states of nature P(sj) = the probability of state of nature sj Vij = the payoff corresponding to decision alternative di and state of nature sj
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Frequently information is available that can improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.
Slide 18
EVPI Calculation Step 1: Determine the optimal return corresponding to each state of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision from the amount determined in step (2).
Slide 19
Expected Value of Perfect Information Calculate the expected value for the best action for each state of nature and subtract the EV of the optimal decision.
Slide 20
Knowledge of sample or survey information can be used to revise the probability estimates for the states of nature. Prior to obtaining this information, the probability estimates for the states of nature are called prior probabilities. With knowledge of conditional probabilities for the outcomes or indicators of the sample or survey information, these prior probabilities can be revised by employing Bayes' Theorem. The outcomes of this analysis are called posterior probabilities.
Slide 21
Posterior Probabilities
Posterior Probabilities Calculation Step 1: For each state of nature, multiply the prior probability by its conditional probability for the indicator -- this gives the joint probabilities for the states and indicator. Step 2: Sum these joint probabilities over all states -- this gives the marginal probability for the indicator. Step 3: For each state, divide its joint probability by the marginal probability for the indicator -- this gives the posterior probability distribution.
Slide 22
The expected value of sample information (EVSI) is the additional expected profit possible through knowledge of the sample or survey information. EVSI Calculation Step 1: Determine the optimal decision and its expected return for the possible outcomes of the sample using the posterior probabilities for the states of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision obtained without using the sample information from the amount determined in step (2).
Slide 23
Efficiency of sample information is the ratio of EVSI to EVPI. As the EVPI provides an upper bound for the EVSI, efficiency is always a number between 0 and 1.
Slide 24
It is known from past experience that of all the cases when the market was receptive, a research company predicted it in 90 percent of the cases. (In the other 10 percent, they predicted an unfavorable market). Also, of all the cases when the market proved to be unfavorable, the research company predicted it correctly in 85 percent of the cases. (In the other 15 percent of the cases, they predicted it incorrectly.) Answer the following questions based on the above information.
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