MS&E 252 Handout #16

Decision Analysis I November 8th. 2004

Page 1 oI 12 HW#4 Solutions
Homework Assignment #4 - Solutions


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MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 2 oI 12 HW#4 Solutions
Distinctions
These distinctions were prepared by the teaching team and reIlect our best belieI oI the
meanings oI these terms.
Prospect: a Iully deIined possible Iuture state oI the world. a particular Iuture.
your liIe going Iorward with a particular event or possibility occurring. A prospect
by deIinition must not involve any uncertainty.

Deal: A deal is consists oI a set oI Iuture prospects and their associated
probabilities.

Test - assessed Iorm: Prior: The probability distribution oI the distinction oI
interest conditioned on your inIormation. Likelihood: Conditional distribution
oI the observed distinction given the distinction oI interest.

Test - inIerential Iorm: Posterior: Conditional distribution oI the distinction oI
interest given the observed distinction. Pre-posterior: The probability
distribution oI the observed distinction (e.g.. test results)

PreIerence Probability: The preIerence probability Ior prospect P among a given
ordered set oI prospects B~.~W (B and W are the best and worst prospects.
respectively) is the probability p at which the decision maker is indiIIerent
between receiving prospect P Ior sure and receiving a deal on prospects B and W
with probability p oI B and probability (1-p) oI W. Notes: 1) People with same
preIerence probabilities will make the same decisions (though maybe diIIerent
VOI which depends on risk attitude). 2) preIerence probabilities are not really
probabilities. but can be treated as such (substitution rule).

Five Rules oI Actional Thought: the Iive rules can be remembered by using the
phrase "POE'S Choice." since the Iive rules consist oI the probability rule. the
order rule. the equivalence rule. the substitution rule. and the choice rule.

The probability rule: states that we shall consider the world (or all inIormation
relevant to a decision making) in terms oI possible prospects (elemental
possibilities) and their associated probabilities.

The order rule: states that we can make a list oI possible prospects such that any
prospect higher on the list is at least as good as ones lower on the list. This
implies transitivity oI prospects (iI A is preIerred to B and B is preIerred to C.
then A is preIerred to C). When you violate the order rule you create a potential
Ior a money pump. This means that someone can create a situation in which they
can make an inIinite amount oI money Irom you.

The equivalence rule: states that. given three prospects A. B. and C. where A is
preIerred to B. and B is preIerred to C. there exists a probability p such that
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 3 oI 12 HW#4 Solutions
1-p
p
B ∼
C
A

In other words. there is some p that makes you indiIIerent between receiving B Ior
certain and receiving a deal with probability p oI prospect A and 1-p oI prospect
C. This probability p is a preference probability and is based on your
preIerences. not an event that can be Ioretold by the clairvoyant. This rule states
that a certain equivalent can be Iound.

The substitution rule: states that. given the situation described in the equivalence
rule. you are willing to exchange the prospect B with the A or C` deal.

The choice rule: states that. given the choice between the Iollowing two deals

1-p
p

B
A

1-q
q

B
A

you will choose the Iirst deal iI p~q. and you will choose the second deal iI q~p.
In other words. you must preIer the deal with the highest probability oI the
prospect you like best.

Money pump: A person is a money pump iI they exhibit behavior that allows you
to get as much money Irom them as you want. In particular. a person who violates
the Order Rule by having preIerences that are not transitive is a money pump.
Such a person preIers A to B and B to C. but also preIers C to A. Ior some
prospects A. B. and C. Then. Ior example. iI this person started with prospect A.
we could get him to pay us something to exchange A Ior C. some more to
exchange C Ior B. and some more to exchange B Ior A. We could repeat this
cycle indeIinitely and make a bundle.

e-value: is a probability weighted average oI a measure. The weighted sum oI
some measure associated with each prospect. where the weights are iust the
elemental probabilities oI each prospect and the sum is taken over all possible
prospects. We usually talk about the e-value oI the u-value or the e-value oI the
monetary measures oI our prospects.

u-value: is a preIerence probability that has been scaled and shiIted by means oI a
positive linear transIormation to a convenient scale. In other words. we can take a
preIerence probability. add or subtract any number and multiply or divide by any
positive number and get a u-value.
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 4 oI 12 HW#4 Solutions



Probabilistic questions
1) Solution: a
You believe that each ball is equally likely to be drawn. so you assign a 5/10 or 1/2
chance to selecting a red ball. Your belieIs should not change aIter Samir takes one ball
out because you do not have any new inIormation about what is inside the urn. The ball
he selected could have been red. but equally likely. it could have been black.
This can also be seen on a probability tree. with two distinctions: 'color oI the ball drawn
by Samir¨. and 'color oI the ball drawn by the speaker¨.

2) Solution: c
Let pA. pI and pH be the preIerence probabilities Ior the Audi. the InIiniti. and the
Honda. respectively. Based on the inIormation provided. we know that:
i) pA ~ pI ~ pH
ii) .4pA ¹ .6pI ~ .9pI ¹ .1pH ( pA ~ .75pI ¹ .25pH)
iii) pI ~ .3pA ¹ .7pH
These statements do not contradict each other (take pA ÷ 1. pI ÷ .5 and pH ÷ 0 Ior
example) and so statement I is NOT true. Statement II is true (Iollows Irom statements i
and iii): pI ~ .3pA ¹ .7pH ~ .25pA ¹ .75pH). Statement III is true as well: preIerences can
change over time.

3) Solution: c
Statement I violates the Probability Rule: probability ranges are not allowed by the
probability rule. Statement II does not violate any oI the 5 rules. Adding or deleting
alternatives should not change the preIerence order oI the other alternatives. Statement III
violates the Order Rule. as there is no consistent ordering oI Silvia`s preIerences.

4) Solution: a
I. is Ialse You may not remove an arrow Irom a relevance diagram without Iurther
inIormation (at the level oI numbers);
II. is Ialse Adding an arrow Irom 'Fever` to 'Outdoor Activities` would create a cycle
in the relevance diagram: 'Outdoor Activities` ÷ 'Cold` ÷'Fever` ÷ 'Outdoor
Activities`;
III. is Ialse In order to Ilip this arrow without any Iurther manipulation oI the diagram.
'Pneumonia` and 'Cough` would need to be based on the same state oI inIormation.
Here. there is an arrow Irom 'Outdoor Activities` to 'Pneumonia` but no arrow Irom
'Outdoor Activities` to 'Cough`.

MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 5 oI 12 HW#4 Solutions
5) Solution: b
I. is Ialse Since relevance cannot be read oII a relevance diagram (only irrelevance can).
we do not even need to proceed to any arrow manipulations to see that statement I. cannot
be inIerred;
II. is true PerIorm the Iollowing operations:
• Add an arrow Irom 'Outdoor Activities` to 'Sneezing`. which is allowed since
this does not create any cycle in the diagram;
• Flip the arrow Irom 'Cold` to 'Sneezing`. which is allowed since both are now
conditioned on the same state oI inIormation. namely 'Outdoor Activities`.
Then 'Pneumonia` and 'Sneezing` are conditioned on 'Outdoor Activities` only and
we can see that there is no arrow between them. ThereIore. 'Pneumonia` and
'Sneezing` are irrelevant given 'Outdoor Activities`;
III. is Ialse PerIorm the Iollowing operations on the graph you obtained aIter going
through the two steps detailed above:
• Flip the arrow Irom 'Outdoor Activities` to 'Pneumonia`. which is allowed
since both are now conditioned on the same state oI inIormation. namely &;
• In order to Ilip the last arrow. Irom 'Outdoor Activities` to 'Sneezing`. we Iirst
need to ensure that both oI them are conditioned on the same state oI inIormation.
UnIortunately. because oI the arrow that goes Irom 'Pneumonia` to 'Outdoor
Activities`. the only way we can Ilip 'Outdoor Activities` to 'Sneezing` is by
adding an arrow Irom 'Pneumonia` to 'Sneezing`.
The existence oI an arrow Irom 'Outdoor Activities` to 'Sneezing` shows that we
cannot inIer that statement II. is valid iust by manipulating the structure oI this relevance
diagram;
IV. is Ialse The two nodes we are interested in are already conditioned on 'Outdoor
Activities`. We now want to condition them on 'Fever` as well. and so we need to Ilip
the two arrows that go Irom 'Fever` to 'Pneumonia` and 'Cold`. UnIortunately. the
only way we can do this is iI we Iirst add an arrow that links 'Pneumonia` and 'Cold`.
We can thus not inIer that IV. is valid.

6) Solution: a
We need to renormalize the preIerence probabilities so that 'Hawaii and Snorkeling¨
corresponds to 1.0 and 'Hawaii and Sailing¨ corresponds to 0.0. The preIerence
probability Ior 'Australia and Snorkeling¨ is then equal to
6 . 0
4 . 0 9 . 0
4 . 0 7 . 0
) Sailing" & Hawaii P(" - ) " Snorkeling & Hawaii P("
) Sailing" & Hawaii P(" - ) " Snorkeling & Australia P("
=


=

7) Solution: c
We can work with either the original preIerence probabilities or with the renormalized
preIerence probabilities oI the last question Ior this problem because all the preIerence
probabilities are linearly rescaled. the outcome will be the same in terms oI which
outcome Emily preIers. We will work with the original probabilities oI question 6.
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 6 oI 12 HW#4 Solutions
Emily`s preIerence probability Ior 'Australia & Bungee Jumping¨ can be computed as

0.5 (0.8)(0.4) (0.2)(0.9) ) Sailing" & Hawaii (0.8)P(" ) " Snorkeling & Hawaii P(" ) 2 . 0 ( = + = +

Since her original preIerence probability Ior 'Australia & Sailing¨ is also 0.5. she is
indiIIerent between the two options.

8) Solution: a
Based on Jason`s values Ior the simple deals pictured in the problem. we can rewrite the
complex deal in question as:













This can now be reduced to the Iollowing simple deal:






This is Deal B. and we know Irom the problem statement that Jason`s certain equivalent
is $20 Ior this deal.

9) Solution: b
Susan is indiIIerent between participating in the contest (and winning one oI the prizes)
and $40 Ior sure. This implies that Susan`s preIerence probability Ior the contest. and her
preIerence probability Ior $40 Ior sure must equal:

0.5 ÷ q* 0.8 ¹ (1-q)*0.3

Solving Ior q gives you 0.4. ThereIore the correct answer is b).

0.2
0.5
$100

0.8
0.4
0.1
$0
0.9
0.1
$0
$100

0.6
0.4
$0
$100

0.7
$100
$0
0.3
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 7 oI 12 HW#4 Solutions
10) Solution: d
Answer a) is wrong because what Gael had paid Ior the Ilowers is a sunk cost. and should
not be taken into account when setting the sale price Ior the remaining roses. Answer b) is
also wrong because. according to Gael`s belieIs. his revenues Irom this point onward will
be higher iI he reduces the price. Answer c) is another common mistake made by people
who Iorget the distinction between a good decision and good outcome. ThereIore all oI
the above answers are wrong and the correct answer is d).

Quantitative Problems

1) Relevance
a.
¦B'A&} ÷ 0.5 ÷ ¦B'A`&} thereIore A and B are not relevant given &.
¦C'BA&} ≠ ¦C'B`A&} thereIore B and C are relevant given A&.
¦C'AB&} ≠ ¦C'A'B&} thereIore A and C are relevant given B&.

The relevance diagram is the Iollowing:
A
C
B













b.
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 8 oI 12 HW#4 Solutions
A
.38
.9
.63
.37
C
C'
A
A'
A'
.1
.62
B
.67
B'
.33
B
.57
B'
.43
B
.43
B'
.57
B
.33
B'
.67
0.02
0.04
0.24
0.32
0.08
0.06
0.16
0.08


¦A'C&} ≠ ¦A'C`&} thereIore C and A are relevant given &.
¦B'AC&} ≠ ¦B'A`C&} thereIore A and B are relevant given C&.
¦B'AC&} ≠ ¦B'AC'&} thereIore C and B are relevant given B&.

The relevance diagram is the Iollowing:

A
C
B



2) Soojin`s prospects
Deal B can be compared to Deal A by replacing the $35 with the equivalent uncertain
deal using the Substitution Rule. Deal B becomes:
=
$0
.5
.5
$80
.7
.3
$80
$0
.35
.65
$0


by the Choice Rule. A ~ B. Using the Probability Rule. we can simpliIy Deal C to:
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 9 oI 12 HW#4 Solutions
$0
$20
.5
$80
.1
.4


This is better than A because C has a .5 chance oI $20 instead oI $0 and Ed preIers
more money to less. Hence Ed`s preIerence ordering is C ~ A ~ B.
3) Carolina`s certain equivalence.

By the Substitution Rule one can replace the $50 and $35 with their equivalent
uncertain deals:
.125
.25
.25
.375
$0
$100
.25
.75
$100
$0
$0
.50
.50
$100


but this is equivalent to the Iollowing deal (by collecting like terms in the
outcomes).

$0
.50
.50
$100


Carolina has already identiIied she is indiIIerent between owning this deal or $35.
hence her certain equivalent is $35.
4) Allais Big Deal
a. Rik`s preIerences A ~ B and D ~ C are inconsistent with the rules oI actional
thought.

By the order rule. 5~1~0
By the equivalence rule. Ior some

p .
5
0
p
1p
1 ~

MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 10 oI 12 HW#4 Solutions

Consider A and B:

Thc 5ubstItutInn Ru!c
5
O
O.1O
O.O1
1
O.89
1
ß
A
O.1O
O.O1
O.89
O
ß
A
5

1-

O
5

1-

5
O
~
O
5
O.1O + O.89

O.9O - O.89

ß
A
~
5

1-

O


By the choice rule. A ~ B

p ~ 0.10 ¹ 0.89p
0.11p ~ 0.10
p ~ 10/11

Now consider D and C:

Thc 5ubstItutInn Ru!c
O
1
O.11
O.89
C
D
5
O.1O
O.9O
O
O
O.11
O.89
C
D
~
5
O.1O
O.9O
O
5

1-

O
O
5
O.11

1-O.11

C
D
5
O.1O
O.9O
O
~


By the choice rule. D ~ C

0.10 ~ 0.11p
p · 10/11;

Thus we have a contradiction. i.e.. iI p ~ 10/11. the choice rule is violated.

The only consistent preIerences are: A ~ B
.
C ~ D

MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 11 oI 12 HW#4 Solutions
B ~ A
.
D ~ C

A ~ B
.
D ~ C.

Hence. Rik`s choices oI A and D violated the choice rule.

Since Rik is risk neutral and preIers more money to less. he should choose B over
A and D over C. since the e-values are 1.14 ~ 1 and .25 ~ .11

Your answer will depend on your aversion to risk. but to be consistent with the
choice rule. you must hold one oI the three preIerences listed in the solution to (a).
OI course this assumes that you preIer more money to less. but keep in mind. you
could always give money to charity.

5) Taxi Cabs
a. Here is a relevance diagram showing all the inIormation in the problem except Ior
what the witness actually said. Color oI cab is given unconditionally. and our
belieIs on what the witness will say are conditioned on the color oI the cab he
saw.
witness
says
color of
cab


'Accuracy oI witness¨ or 'distribution oI cab colors¨ are bad distinctions Ior
decision-making. The distinctions we draw should always be ones which bear
concretely on the issue at hand. We include our understanding oI accuracy oI
witness in the probabilities inside the node 'witness says¨; we include our prior
distribution oI cab colors in the probabilities on color oI this particular cab.
Employing observable distinctions like what the witness says. allows us to
perIorm probabilistic inIerence and update our belieIs.

b.
Blue
Green
Says Blue
Says Green
Says Blue
Says Green
Blue, Says Blue
Blue, Says Green
Green, Says Blue
Green, Says Green
.8
.2
.2
.8
.72
.18
.02
.08
.9
.1

c. Here is a Ilipped tree. Now we are prepared to incorporate the evidence.
Previously the branches which had 'witness says green¨ were scattered
throughout the tree; now they are all in the 'says green¨ sub tree.
MS&E 252 Handout #16
Decision Analysis I November 8th. 2004

Page 12 oI 12 HW#4 Solutions
Says Blue
Blue
Green
Blue
Green
Says Blue, Blue
Says Blue, Green
Says Green, Blue
Says Green, Green
.74
.26
.97
.03
.69
.31
.72
.02
.18
.08
Says Green


d. In the relevance diagram corresponding to the tree Ilip. the arc has been reversed.
witness
says
color of
cab

e. Our conditional probability oI the cab being green is 0.31. Conditioning
probabilities on evidence is the correct way to incorporate evidence into one`s
probabilistic belieIs.
f. It may seem surprising that a person with 80° accuracy would have only a 31°
chance oI being right. but this number is also a Iunction oI the low ratio oI green
cabs in the city.

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