Decision Making Under

Risk Continued:
BayesTheorem and
Posterior Probabilities
MGS3100 - Chapter 8
Slides 8c

Bayesian Methods
There is a continuing debate among statisticians, little
known to those outside the field, over the proper
definition of probability. The frequentist definition
sees probability as the long-run expected frequency of
occurrence. P(A) = n/N, where n is the number of
times event A occurs in N opportunities. The Bayesian
view of probability is related to degree of belief. It is a
measure of the plausibility of an event given
incomplete knowledge.

The Market Research Question

P(Red/Urn1) = 8/10 = 0.8

8 Red

(Known Population)

2 White
Urn 1

Have P(A/B)

Vs.

?
Urn 2

What is in the urn?

R

Select a sample, and

then make inferences
about the population
(Unknown Population)
Want P(B/A)

How We Will Use Bayes' Theorem

Prior information can be based on the results of
previous experiments, or expert opinion, and
can be expressed as probabilities. If it is
desirable to improve on this state of knowledge,
an experiment can be conducted. Bayes'
Theorem is the mechanism used to update the
state of knowledge with the results of the
experiment to provide a posterior distribution.

Bayes Theorem
Used to revise probabilities based
upon new data
Prior
probabilities

New data

Posterior
probabilities

How Bayes' Theorem Works

Let the experiment be A and the prediction be B. Lets
assume that both have occurred. The probability of both A
and B together is P(AB), or simply P(AB). The law of
conditional probability says that this probability can be
found as the product of the conditional probability of one,
given the other, times the probability of the other. That is:
P(A|B) * P(B) = P(AB) = P(B|A) * P(A)
Simple algebra shows that:
P(B|A) = P(A|B) * P(B) / P(A)
This is Bayes' Theorem.

Example Problem:
Thompson Lumber Company
Thompson Lumber Company is trying to decide
whether to expand its product line by
manufacturing and marketing a new product
which is backyard storage sheds.
The courses of action that may be chosen
include:
(1) large plant to manufacture storage sheds,
(2) small plant to manufacture storage sheds, or
(3) build no plant at all.

Thompson Lumber Company

Probability

0.5

0.5

Expected Monetary Value

Thompson Lumber Company

Probability of favorable market is same as probability of

unfavorable market.
Each state of nature has a 0.50 probability.

Calculating the EVPI

Best outcome for state of nature "favorable market" is
"build a large plant" with a payoff of $200,000.
Best outcome for state of nature "unfavorable market"
is "do nothing," with payoff of $0.
Therefore, Expected value with perfect information
EVwPI = ($200,000)(0.50) + ($0)(0.50) = $ 100,000
If one had perfect information, an average payoff of
$100,000 could be achieved in the long run.
However, the maximum EMV (EVBEST) or expected
value without perfect information, is $40,000.
Therefore, EVPI = $100,000 - $40,000 = $60,000.

To Test or Not to Test

Often, companies have the option to perform market
tests/surveys, usually at a price, to get additional
information prior to making decisions.
However, some interesting questions need to be
answered before this decision is made:
How will the test results be combined with prior information?
How much should you be willing to pay to test?

The good news is that Bayes Theorem can be used to

combine the information, and we can use our decision
tree to find EVSI, the Expected Value of Sample
Information.
In order to perform these calculations, we first need to
know how reliable the potential test may be.

Market Survey Reliability in Predicting

Actual States of Nature

Assuming that the above information is available, we

can combine these conditional probabilities with our
prior probabilities using Bayes Theorem.

Market Survey Reliability in

Predicting Actual States of Nature

Probability Revisions Given

Positive Survey
Alternatively, the following table will produce the same results:

Probability Revisions Given

Negative Survey

Placing Posterior Probabilities on the

Decision Tree
The bottom of the tree is the no test part of the analysis; therefore, the prior probabilities are assigned to these events. P(favorable market) =
P(FM) = 0.5
P(unfavorable market) = P(UM) = 0.5

The calculations here will be identical to the EMV calculations performed without a decision tree.
The top of the tree is the test part of the analysis; therefore, the posterior probabilities are assigned to these events.

Decision Trees for Test/No Test

Multi-stage Decision Problems

Decision Tree Solution

Thompson Lumber Company

Expected Value of Sample Information

= EV of the top of the tree - EV of the bottom of the tree

This calculation ignores the cost of the test. Once you
compute the EVSI, you can compare it to the cost of the test
to determine the desirability to test. The ratio of the EVSI
to the EVPI times 100 will also give you a measure of
efficiency of the proposed test, expressed as a percentage.

Expected Value of Sample Information

For Thompson Lumber Company,

EVSI = $49,200 - $40,000 = $9,200

And since the EVPI was previously calculated to be $60,000,
Thompson would be willing to pay up to $9,200 for this test
information, with an efficiency of (9200/60000)*100 = 15.3%

Decision Tree Class Exercise:

Jenny Lind, Part 2 (see text, #8-16 and 8-37)
Jenny Lind may hire a market research firm to conduct a
survey at a cost of $100,000. The result of the survey
would be either a favorable (F) or unfavorable (U) public
response to the movie. The firms ability to assess the
market is:
P(F/S) = 0.3
P(U/S) = 0.7
P(F/M) = 0.6
P(U/M) = 0.4
P(F/L) = 0.8
P(U/L) = 0.2
Should Jenny conduct the survey?
What is the most she should be willing to pay for the
survey? What is the efficiency of this survey?