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Chapter 17 Decision Making

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-1

Learning Objectives

In this chapter, you learn: To use payoff tables and decision trees to evaluate alternative courses of action To use several criteria to select an alternative course of action To use Bayes’ theorem to revise probabilities in light of sample information About the concept of utility

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-2

**Steps in Decision Making
**

List Alternative Courses of Action

Choices or actions

** List Uncertain Events
**

Possible events or outcomes

Determine „Payoffs‟

Associate a Payoff with Each Event/Outcome

combination

Adopt Decision Criteria

Evaluate Criteria for Selecting the Best Course

of Action

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-3

Payoff Table

A payoff table shows alternatives, states of nature, and payoffs

Profit in $1,000‟s (Events)

Strong Economy Stable Economy Weak Economy

**Investment Choice (Action) Large Average Small Factory Factory Factory
**

200 50 -120 90 120 -30 40 30 20

Chap 17-4

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Decision Tree

Strong Economy 200 50 -120 90 120 -30

Large factory

Stable Economy Weak Economy Strong Economy

Average factory

Stable Economy Weak Economy Strong Economy

40

30 20

Small factory

Stable Economy Weak Economy

Payoffs

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-5

Opportunity Loss

Opportunity loss is the difference between an actual payoff for an action and the optimal payoff, given a particular event

Profit in $1,000‟s (Events) Strong Economy Stable Economy Weak Economy Investment Choice (Action)

Large Factory

200 50 -120

Average Factory

90 120 -30

Small Factory

40 30 20

Payoff Table

The action “Average factory” has payoff 90 for “Strong Economy”. Given “Strong Economy”, the choice of “Large factory” would have given a payoff of 200, or 110 higher. Opportunity loss = 110 for this cell.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-6

Opportunity Loss

Investment Choice (Action) Profit in $1,000‟s (Events) Strong Economy Stable Economy Weak Economy Large Factory 200 50 -120 Average Factory 90 120 -30 Small Factory 40 30 20

**Payoff Table Opportunity Loss Table
**

Investment Choice (Action)

**Opportunity Loss in $1,000‟s (Events) Strong Economy Stable Economy Weak Economy
**

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Large Factory 0 70 140

Average Factory 110 0 50

**Small Factory 160 90 0
**

Chap 17-7

Decision Criteria

Expected Monetary Value (EMV)

The expected profit for taking action Aj

** Expected Opportunity Loss (EOL)
**

The expected opportunity loss for taking action Aj

** Expected Value of Perfect Information (EVPI)
**

The expected opportunity loss from the best

decision

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-8

**Expected Monetary Value
**

Goal: Maximize expected value

The expected monetary value is the weighted

**average payoff, given specified probabilities for each event N EMV ( j ) X ij Pi
**

i 1

Where EMV(j) = expected monetary value of action j Xij = payoff for action j when event i occurs Pi = probability of event i

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-9

**Expected Monetary Value
**

The expected value is the weighted average

**payoff, given specified probabilities for each event
**

Profit in $1,000‟s (Events) Investment Choice (Action) Large Factory 200 50 -120 Average Factory 90 120 -30 Small Factory

Strong Economy (0.3) Stable Economy (0.5) Weak Economy (0.2)

40 30 20

Suppose these probabilities have been assessed for these three events

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-10

**Expected Monetary Value
**

Payoff Table:

Profit in $1,000‟s (Events) Investment Choice (Action) Large Factory 200 50 -120 Average Factory 90 120 -30 Small Factory 40 30 20

Strong Economy (0.3) Stable Economy (0.5) Weak Economy (0.2)

EMV (Expected Values)

61

81

31

Example: EMV (Average factory) = 90(.3) + 120(.5)

+ (-30)(.2) = 81

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-11

**Expected Opportunity Loss
**

Goal: Minimize expected opportunity loss

The expected opportunity loss is the weighted

average loss, given specified probabilities for each event

EOL(j) LijPi

i 1

N

Where EOL(j) = expected monetary value of action j Lij = opportunity loss for action j when event i occurs Pi = probability of event i

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-12

**Expected Opportunity Loss
**

Opportunity Loss Table

Investment Choice (Action)

Opportunity Loss in $1,000‟s (Events) Large Factory Average Factory Small Factory

**Strong Economy (0.3) Stable Economy (0.5) Weak Economy (0.2)
**

Expected Opportunity Loss (EOL)

0 70 140

63

110 0 50

43

160 90 0

93

Example: EOL (Large factory) = 0(.3) + 70(.5) +

(140)(.2) = 63

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-13

Value of Information

Expected Value of Perfect Information, EVPI

Expected Value of Perfect Information

EVPI = Expected profit under certainty – expected monetary value of the best alternative EVPI is equal to the expected opportunity loss from the best decision

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-14

**Expected Profit Under Certainty
**

Expected

profit under certainty = expected value of the best decision, given perfect information

Profit in $1,000‟s (Events)

Investment Choice (Action)

Large Factory

Average Factory

Small Factory

Strong Economy (0.3) Stable Economy (0.5) Weak Economy (0.2)

200 50 -120

90 120 -30

40 30 20

Value of best decision for each event:

200

120

20

**Example: Best decision given “Strong Economy” is “Large factory”
**

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-15

**Expected Profit Under Certainty
**

Profit in $1,000‟s (Events) Investment Choice (Action)

Large Factory

Average Factory

Small Factory

Now weight

these outcomes with their probabilities to find the expected profit under certainty:

Strong Economy (0.3) Stable Economy (0.5) Weak Economy (0.2)

200 50 -120

90 120 -30

40 30 20

200

120

20

**200(.3)+120(.5)+20(.2) = 124
**

Chap 17-16

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

**Value of Information Solution
**

Expected Value of Perfect Information (EVPI)

EVPI = Expected profit under certainty – Expected monetary value of the best decision Recall: Expected profit under certainty = 124 EMV is maximized by choosing “Average factory,” where EMV = 81

so:

EVPI = 124 – 81 = 43

Chap 17-17

**(EVPI is the maximum you would be willing to spend to obtain perfect information)
**

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

**Accounting for Variability
**

Consider the choice of Stock A vs. Stock B

Stock Choice (Action) Percent Return (Events) Strong Economy (.7) Weak Economy (.3) Expected Return (EMV) Stock A Stock B

30 -10 18.0

14 8 12.2

Stock A has a higher EMV, but what about risk?

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-18

**Accounting for Variability
**

Calculate the variance and standard deviation

Stock Choice (Action) Percent Return (Events) Stock A Stock B

Strong Economy (.7)

Weak Economy (.3) Expected Return (EMV) Variance

30

-10 18.0 336.0

14

8 12.2 7.56

Standard Deviation

18.33

2.75

Example:

σ ( Xi μ)2 P( Xi ) (30 18)2 (.7) ( 10 18)2 (.3) 336.0

2 A i1

Chap 17-19

N

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

**Accounting for Variability
**

Calculate the coefficient of variation for each stock:

σA 18.33 100% 100% 101.83% EMV A 18.0

CVA

Stock A has much more relative variability

CVB

σB 2.75 100% 100% 22.54% EMVB 12.2

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-20

**Return-to-Risk Ratio
**

Return-to-Risk Ratio (RTRR):

EMV(j) RTRR(j) σj

Expresses the relationship between the return (expected payoff) and the risk (standard deviation)

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-21

**Return-to-Risk Ratio
**

RTRR(j) EMV(j) σj

RTRR(A) RTRR(B)

EMV(A) 18.0 0.982 σA 18.33 EMV(B) 12.2 4.436 σB 2.75

You might want to consider Stock B if you don’t like risk. Although Stock A has a higher Expected Return, Stock B has a much larger return to risk ratio and a much smaller CV.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-22

**Decision Making with Sample Information
**

Permits revising old

Prior Probability New Information Revised Probability

probabilities based on new information

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-23

**Revised Probabilities Example
**

Additional Information: Economic forecast is strong economy When the economy was strong, the forecaster was correct 90% of the time.

When the economy was weak, the forecaster was correct 70% of the time.

F1 = strong forecast

**F2 = weak forecast
**

E1 = strong economy = 0.70 E2 = weak economy = 0.30 P(F1 | E1) = 0.90 P(F1 | E2) = 0.30

Prior probabilities from stock choice example

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-24

**Revised Probabilities Example
**

P(F1 | E1 ) .9 , P(F1 | E2 ) .3 P(E1 ) .7 , P(E2 ) .3

Revised Probabilities (Bayes’ Theorem)

P( F1 | E1 ) P( E1 ) (.9)(.7) P( E1 | F1 ) .875 P( F1 ) (.9)(.7) (.3)(.3) P( F1 | E2 ) P( E2 ) P( E2 | F1 ) .125 P( F1 )

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-25

**EMV with Revised Probabilities
**

Pi

.875 .125 Revised probabilities EMV Stock A = 25.0

Event

strong weak

Stock A

30 -10

XijPi

26.25 -1.25

Stock B

14 8

XijPi

12.25 1.00

Σ = 25.0

**Σ = 13.25 EMV Stock B = 13.25 Maximum EMV
**

Chap 17-26

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

**EOL Table with Revised Probabilities
**

Pi

.875 .125 Revised probabilities EOL Stock A = 2.25

Event

strong weak

Stock A

0 18

XijPi

0 2.25

Stock B

16 0

XijPi

14.00 0

Σ = 2.25

**Σ = 14.00 EOL Stock B = 14.00 Minimum EOL
**

Chap 17-27

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

**Accounting for Variability with Revised Probabilities
**

Calculate the variance and standard deviation

Stock Choice (Action) Percent Return (Events) Stock A Stock B

**Strong Economy (.875)
**

Weak Economy (.125) Expected Return (EMV) Variance

30

-10 25.0 175.0

14

8 13.25 3.94

Standard Deviation

13.229

1.984

Example:

**σ ( X i μ) 2 P( X i ) (30 25) 2 (.875) (10 25) 2 (.125) 175.0
**

2 A i 1

Chap 17-28

N

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

**Accounting for Variability with Revised Probabilities
**

The coefficient of variation for each stock using the results from the revised probabilities:

CVA σA 13.229 100% 100% 52.92% EMV A 25.0 σB 1.984 100% 100% 14.97% EMVB 13.25

CVB

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-29

**Return-to-Risk Ratio with Revised Probabilities
**

EMV(A) 25.0 RTRR(A) 1.890 σA 13.229

**EMV(B) 13.25 RTRR(B) 6.678 σB 1.984
**

With the revised probabilities, both stocks have higher expected returns, lower CV’s, and larger return to risk ratios

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-30

Utility

Utility is the pleasure or satisfaction obtained

from an action.

The utility of an outcome may not be the

same for each individual.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-31

Utility Example

Each incremental $1 of profit does not have the same value to every individual:

A risk averse person, once reaching a goal,

assigns less utility to each incremental $1. A risk seeker assigns more utility to each incremental $1. A risk neutral person assigns the same utility to each extra $1.

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-32

Three Types of Utility Curves

$

Risk Averter

Risk Seeker

$

Risk-Neutral

$

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-33

**Maximizing Expected Utility
**

Making decisions in terms of utility, not $

Translate $ outcomes into utility outcomes Calculate expected utilities for each action Choose the action to maximize expected utility

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc.

Chap 17-34

Chapter Summary

In this chapter, we have

Described the payoff table and decision trees Opportunity loss Provided criteria for decision making Expected monetary value Expected opportunity loss Return to risk ratio Introduced expected profit under certainty and the

**value of perfect information Discussed decision making with sample information Addressed the concept of utility
**

Statistics for Managers Using Microsoft Excel, 5e © 2008 Prentice-Hall, Inc. Chap 17-35

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Levine, D. M., Stephan, D. F., Krehbiel, T. C. & Berenson, M. L. (2008). Statistics for Managers Using Mic...

Materi ini merupakan bahan ajar sebagai pelengkap e-materi mata kuliah statistika bisnis.

Levine, D. M., Stephan, D. F., Krehbiel, T. C. & Berenson, M. L. (2008). Statistics for Managers Using Microsoft Excel. Pearson.

Levine, D. M., Stephan, D. F., Krehbiel, T. C. & Berenson, M. L. (2008). Statistics for Managers Using Microsoft Excel. Pearson.

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