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Homework Assignment #6 Solutions


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Score on HW Question (./1)
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Question 1
10% 50% 90%
Question 2
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Question 3
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Question 4
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Question 5
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Question 6
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Question 7
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Question 10
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Distinctions
These distinctions were prepared by the teaching team and reIlect our best belieI oI the meanings
oI these terms.
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.
Posterior: Conditional distribution oI the distinction oI interest given the observed
distinction.
Preposterior: The probability distribution oI the observed distinction (e.g.. test results)
Sensitivity is the probability that the test says positive given that the distinction oI
interest is really positive.
Specificity is the probability that the test says negative given that the distinction oI
interest is negative.
Symmetric test: A test is symmetric iI sensitivity ÷ speciIicity. Otherwise it is
asymmetric.
Relevant test: A test is relevant iI the probabilities assigned to the test outcome are
diIIerent depending on the state oI the distinction oI interest (or. equivalently. vice versa)
Material test: A test is material iI its results possibly change the preIerred alternative. II
the decision is the same regardless oI test outcome. the test is immaterial. Note that the
assumption here is that it is a Iree test.


Probabilistic questions
1) Solution: a
Statement I is Ialse: In Iact. in the party problem. Mary`s Values oI Clairvoyance are lower than
Kim`s. Kim and Mary have the same belieIs but diIIerent risk-attitudes. but we cannot draw
conclusions about Value oI Clairvoyance Irom risk attitude only.

Statement II is Ialse because. Ior a risk-neutral decision maker. we have:
VOC ÷ VFC VNC
Mary`s Value oI Clairvoyance is greatest when p÷0.47.

Statement III is Ialse because Mary`s sensitivity curve has the same switch points as Kim. not
Jane. This is due to the Iact that they have the same preIerence probabilities and would choose
the same alternative given the same probability p oI sunshine.

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0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
5
10
15
20
25
p
Value of Clairvoyance Sensitivity to p for Kim and Mary
(0.47, 20.9)
(0.87, 8.9)
Mary
Kim
(0.47, 24.4)
(0.87, 15.2)
$


2) Solution: c
Without any inIormation. the migraine drug proiect is worth $0 to Raymond because iI he
invests. the certain equivalent is 0.6* $2.000.000 ¹ 0.4 * (-$3.000.000) ÷ $0. and iI he does not
invest. it is by deIault worth $0.

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You are given the probabilities that the advisor is correct given the success or Iailure oI the drug
in the market. which are reIlected in the probability tree on the leIt in the Iollowing diagram:
0.8
'Success¨
0.2
'Failure¨
Success
Failure
0.4
'Success¨
0.6
'Failure¨
0.6
0.4
0.48
0.12
0.16
0.24
0.75
Success
0.25
Failure
'Success¨
'Failure¨
0.33
Success
0.67
Failure
0.64
0.36
0.48
0.16
0.12
0.24
0.75
Success
0.25
Failure
'Success¨
'Failure¨
0.33
Success
0.67
Failure
0.64
0.36
0.48
0.16
0.12
0.24
Flip tree


In order to Iind the probabilities that the drug succeeds or Iails given that Dr. Headache says
'Success¨ or 'Failure¨. you need to Ilip the tree as shown in the tree to the right.

Finally. to Iind the value oI Dr. Headache`s inIormation. you use the 'Ilipped¨ tree to inIer the
probabilities oI Success or Failure and roll back the tree to Iind a Value oI ImperIect InIormation
oI $480.000 - $0 ÷ $480.000.
0.75
Invest
$750 K
Not invest
'Success¨
'Failure¨
Invest
Not invest
0.64
0.36
Success
Success
Failure
Failure
0.25
$2.000.000
-$3.000.000
$0
$2.000.000
-$3.000.000
$0
0.33
0.67
-$1.33 M
$480.000 ~
$
0.75
Invest
$750 K
Not invest
'Success¨
'Failure¨
Invest
Not invest
0.64
0.36
Success
Success
Failure
Failure
0.25
$2.000.000
-$3.000.000
$0
$2.000.000
-$3.000.000
$0
0.33
0.67
-$1.33 M
$480.000 ~
$

Given the above calculations. Statement I is Ialse because hiring Dr. Headache is not economic
since his inIormation is worth $480.000 but he is demanding a Iee oI $750.000. Statement II is
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true. Dr. Headache`s inIormation is relevant because it changes Raymond`s belieIs about the
probability oI the proiect`s success or Iailure. and it is material because Raymond would take a
diIIerent action depending on whether Dr. Headache says 'Success¨ or 'Failure.¨ Finally.
Statement III is true because having a risk odds oI 0.5 (e.g. Kim) means that he Iollows the delta
property. His certain equivalent Ior Dr. Headache`s services can be Iound by subtracting the
value with no inIormation Irom the value with Iree inIormation

3) Solution: d

First. we structure the tree below using Bob T. Driller`s probabilities Ior each oI the three
possibilities oI drilling results conditioned on the presence oI the dome in the Iield under study.

Mr.Driller's decision -- all figures are in $ million
Drilling Decision Presence of Dome Drilling Results
Large $60
0.2
Dome 0.3 Small $25
$19.50
0.7 0.5 Dry Hole $0
Drill (Drilling Cost: $10)
$16.425-$10=$6.425
Large $60
0.3 0.05
No Dome 0.25 Small $25
$6.425 $9.25
0.7 Dry Hole $0
Do Not Drill $0
$0


We are told that Mr. Driller`s u-curve is linear (i.e. he is risk-neutral). so the dollar measures Ior
the prospects he is Iacing can be used as his u-values Ior these prospects. Also. since Mr. Driller
is risk-neutral. we deduce that he Iollows the delta property. so we can deduct the drilling cost oI
$10 million dollars aIter calculating the certain equivalent oI the drilling site exclusive oI the
drilling costs. As shown above. his certain equivalent Ior the drilling site is $6.425 million. So.
the correct answer is d).

4) Solution: b

Since Mr. Driller Iollows the delta property. we can calculate the value oI perIect inIormation
(÷value oI clairvoyance) on the presence oI the dome as the diIIerence between the value oI the
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deal with Iree clairvoyance on the presence oI the dome and the value oI the deal without
clairvoyance.


Calculating the value of perfect information
on the dome uncertainty
(all figures are in $ million)
Drilling Decision Presence of Dome Drilling Results
Large $60
0.2
Dome 0.3 Small $25
$19.50
0.7 0.5 Dry Hole $0
Drill (Drilling Cost: $10)
$16.425-$10=$6.425
Large $60
0.3 0.05
No Dome 0.25 Small $25
$6.425 $9.25
w/o Perfect Info on Dome 0.7 Dry Hole $0
Do Not Drill $0
$0
Large $60
0.2
Drill (Cost: $10) Dome 0.3 Small $25
$19.5-$10=$9.5 $19.50
Dome 0.5 Dry Hole $0
$9.50
Do Not Drill $0
0.7 $0
$6.650
w/Perfect Information Large $60
0.05
0.3 Drill (Cost: $10) No Dome 0.25 Small $25
$9.25-$10=-$0.75 $9.25
No Dome 0.7 Dry Hole $0
$0
Do Not Drill $0
$0


The solution is shown in the Iigure above. Again. we make use oI the Iact that Mr. Driller is risk-
neutral and thus the dollar measures Ior the prospects serve as his u-values Ior the prospects. We
Iind the value oI the deal with Iree clairvoyance on the presence oI the dome. Then the value oI
clairvoyance on the presence oI the dome is:

VOC on presence oI dome ÷ VFC VNC ÷ $6.65 million - $6.425 million ÷ $0.225 million

So answer b) is correct.

5) Solution: b

Janice is not a delta person so we cannot compute the Value oI Clairvoyance as being Value oI
the deal with Free Clairvoyance (VFC) Value oI the deal with No Clairvoyance (VNC).
However. we can use the iterative method described in the manuscript to determine the Value oI
Clairvoyance on this deal and doing this. we Iind out that the certain equivalent Ior the deal
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when she purchases clairvoyance Ior $77.304 is equal to the certain equivalent Ior the deal when
she does not have clairvoyance (when rounding to the nearest dollar amount).
Tree without clairvoyance:
Prospect u_value
Hit
$1,200,000 15.00
Invest 0.4
14.4725509
Flop
$500,000 14.12
1 0.6
14.47
$709,667
Don't Invest
$600,000 14.30
14.30

Tree with clairvoyance Ior a cost oI $77.304:
Prospect u_value
Invest
$1,122,696 14.93
"Hit"
1
0.4 14.93
Don't Invest
$522,696 14.17
14.47
$709,667 Invest
$422,696 13.95
"Flop"
2
0.6 14.17
Don't Invest
$522,696 14.17


6) Solution: b

Since Alex`s utility curve is piecewise linear. on the ranges |0. 100| and |100. 200|. he will be
risk-neutral with respect to any deals whose outcomes only take values in one oI those ranges.
ThereIore. he is risk-neutral towards Deals A and C.
For Deal B. note that his u-values Ior $125 and $75 are 225 and 150. respectively. His e-value
Ior these u-values is 225p ¹ 150(1-p) ÷ 75p ¹ 150. and:
- For p > 2/3. his certain equivalent Ior the deal is $(75p ¹ 50). This is less than the e-value
oI the monetary values: $(125p ¹ 75(1-p)) ÷ $(50p ¹ 75);
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- For p < 2/3. his certain equivalent Ior the deal is $(75p/2 ¹ 75). which is also less than the
e-value oI the monetary values $(50p ¹ 75).
ThereIore. his certain equivalent Ior this deal is less than the e-value oI the monetary prospects
Ior any value oI p. This shows that Alex is risk-averse with respect to Deal B.
Note: One could also see this directly Irom the shape oI Alex`s u-curve using a concavity /
convexity argument.

7) Solution: c

Statement I is true. Being risk-neutral implies having a linear utility Iunction. which satisIies the
delta-property. However. there are other utility Iunctions which satisIy the delta-property and are
not linear.
Statement II is Ialse. A decision-maker with a risk-preIerring utility Iunction can apply the Five
Rules oI Actional Thought without contradiction. iust as a risk-averse or risk-neutral person can
Iollow these rules.
Statement III is true. A risk-neutral person is a delta-person. and hence their level oI initial
wealth is immaterial to their valuation oI an uncertain deal.
Statement IV is Ialse. Question 6 provides an example oI someone whose decisions do not
depend on their initial wealth. even though their u-curve does not satisIy the delta property.

8) Solution: a
You need to use the inIormation provided to compute the probability oI the stock price going up
or down (inIerred) given that Eric says that the price will go up or down (assessed). The situation
can be described by the Iollowing tree:
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Exercise option
0.763 $40.00
Price goes up 50 40
2 0.56
90
0.84 Do not exercise option
$90.00
Buy option 100 90
0.84
-10 72.82168
0.77 Exercise option
0.237 $40.00
Price goes down 50 40
0.590 1 0.56
Eric says "UP" 40
1 0.56 Do not exercise option
72.82168 $20.00
0.77 30 20
0.33
0.763
Price goes up
$100.00
Do Not buy option 100 100
0.87
0 72.57861 0.237
0.77 Price goes down
$30.00
30 30
0.46
Exercise option
$63.76 0.366 $40.00
0.73 Price goes up 50 40
2 0.56
90
0.84 Do not exercise option
$90.00
Buy option 100 90
0.84
-10 53.09044
0.66 Exercise option
0.634 $40.00
Price goes down 50 40
0.410 1 0.56
Eric says "Down" 40
1 0.56 Do not exercise option
53.09044 $20.00
0.66 30 20
0.33
0.366
Price goes up
$100.00
Do Not buy option 100 100
0.87
0 46.02223 0.634
0.61 Price goes down
$30.00
30 30
0.46

No matter what Eric says. Alicia`s optimal decision is to buy the option; his inIormation is
immaterial to the decision. Thus. the value oI Eric`s inIormation is $0.

9) Solution: b
The situation can be represented by the Iollowing tree:

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Exercise option
0.319 $40.00
Price goes up 50 40
2 0.56
90
0.84 Do not exercise option
$90.00
Buy option 100 90
0.84
-10 51.21278
0.65 Exercise option
0.681 $40.00
Price goes down 50 40
0.470 1 0.56
Josh says "UP" 40
1 0.56 Do not exercise option
51.21278 $20.00
0.65 30 20
0.33
0.319
Price goes up
$100.00
Do Not buy option 100 100
0.87
0 43.66289 0.681
0.59 Price goes down
$30.00
30 30
0.46
Exercise option
$64.73 0.849 $40.00
0.73 Price goes up 50 40
2 0.56
90
0.84 Do not exercise option
$90.00
Buy option 100 90
0.84
-10 78.40452
0.80 Exercise option
0.151 $40.00
Price goes down 50 40
0.530 1 0.56
Josh says "Down" 40
2 0.56 Do not exercise option
80.89652 $20.00
0.81 30 20
0.33
0.849
Price goes up
$100.00
Do Not buy option 100 100
0.87
0 80.89652 0.151
0.81 Price goes down
$30.00
30 30
0.46

The value oI the deal with Iree inIormation (Josh`s inIormation) is VFI
J
≈ $64.73
The value oI the deal without inIormation is VNC ≈ $63.76 (c.I. solutions to HW5)
Alicia Iollows the delta property. and the maximum she should be willing to pay Ior Josh`s
inIormation (B) is his value oI clairvoyance on Josh`s report.
VOC
J
÷ max(B) ÷ VFI
J
VNC ≈ $.97
Note that the value oI Josh`s inIormation is higher than the value oI Eric`s inIormation despite
his low accuracy when predicting stock prices. In Iact. it is precisely because Alicia can take
advantage oI her belieI that Josh is almost always wrong that Josh`s inIormation is valuable to
her.
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Note again that Eric and Josh both provide imperIect inIormation about the Iuture price oI the
stock. which is less valuable than inIormation provided by the clairvoyant (÷ value oI
clairvoyance).

10) Solution: c
Using the same tree as above. but Ior a risk-neutral decision maker. we Iind that
Betty`s certain equivalent Ior the deal with Iree inIormation (Eric`s inIormation) is ≈ $73.10.
Betty`s certain equivalent Ior the deal with Iree inIormation (Josh`s inIormation) is ≈ $73.70.
Betty`s certain equivalent without inIormation is $72.00.
She is risk-neutral and her willingness to pay Ior Eric`s inIormation is ≈ 73.10 72÷ $1.10.
Here willingness to pay Ior Josh`s inIormation is ≈ 73.70 72÷ $1.70.
Statements I and II are thus true. Statement III is Ialse.

Note that it is enough to notice that Betty`s optimal buying decision changes with what Eric says.
which shows that she has a positive willingness to pay Ior Eric`s inIormation
Note also that the value oI the deal with Eric`s inIormation is higher Ior Betty than Ior Alicia
(same with Josh`s inIormation). The value oI an uncertain deal Ior a risk-neutral decision maker
is always as high as the value oI the same deal Ior a risk-averse decision maker iI both decision
makers share the same beliefs.


Quantitative Problems

1) Bozo`s Party Problem
a) His u-curve can be inverted to obtain the Iollowing equation used to convert u-values back to
dollar equivalents: x(u) ÷ (10.000*u)`0.5. From this. we can see that he has the Iollowing u-
values Ior the deal:
u(outdoors) ÷ 0.4
u(porch) ÷ 0.348
u(inside) ÷ 0.214
ThereIore he would choose outside with the Iollowing certain equivalent:
x ÷ CE ÷ (0.4*10.000)`0.5 ÷ $63.25

b) Value with Clairvoyance Ior $15

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Because the value oI the deal with clairvoyance Ior $15 is less than the value Ior the deal with no
clairvoyance. Bozo should not pay $15 Ior clairvoyance.
0.3625 · 0.4
0.3625 ÷ x`2/10.000
x ÷ $60.21
$60.21·$63.25 thereIore don`t buy.

c) Value oI the deal with Iree clairvoyance:
0.55

0.55 ÷ x`2/10.000
x ÷ CE ÷ $74.16

d) Value oI Iree clairvoyance:
For a non-delta person. we must solve the Iollowing equation in order to Iind the value oI
clairvoyance.

We can set the CE when paying c Ior clairvoyance equal to the CE with no clairvoyance. Then
solve to Iind c:
0.4*(10.000 - 200c ¹ c`2) / 10.000 ¹ 0.6*(2500 - 100c ¹ c`2) / 10.000 ÷ 0.4
4.000 - 80c ¹ 0.4c`2 ¹ 1500 - 60c ¹ 0.6c`2 ÷ 4000
c ÷ 11.69
Note that the CE (with free clairvoyance) - CE (no clairvoyance) DOES NOT EQUAL
VOC.
74.16 -63.25 ÷ 10.91
VOC÷ 11.69
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2) Sensitivity to Probability
The three alternatives can be represented as Iollows where p equals the percentage oI red balls in
either iar:


a. For alternative 1 to be equivalent to alternative 2. the Iollowing equation must hold:
p(2500) ¹ (1-p)1000 ÷ p(3000) ¹ (1-p)0
ThereIore p ÷ 2/3.
b. Using the same reasoning.
p(2500) ¹ (1-p)1000 ÷ 1500
thereIore p ÷ 1/3
c. p(3000) ¹ (1-p)0 ÷ 1500
thereIore p ÷ 1/2
d. The answers to part a-c are labeled on the graph. The vertical axes represent the certain
equivalents Ior each alternative as a Iunction oI p. the percentage oI red balls in each iar (or
the probability that Eduardo will pick a red ball). Eduardo's best alternative Iollows the bold
line. When 0 · p · 1/3. his best alternative is number three. From 1/3 · p · 2/3. his best
alternative is number one. From 2/3· p · 1. his best alternative is number two.

3) Value of Clairvoyance Sensitivity
a) Free clairvoyance is represented by the bold line in the graph below.

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b) The dotted lines on the graph below represent the certain equivalents Ior each alternative at p
÷ 1/6 and p ÷ 5/6. The values are listed in the table below with the certain equivalent Ior the
entire deal in bold.


c) At p ÷ 1/6. Eduardo's best alternative is number three. and at p ÷ 5/6. it is alternative number
one. As the number oI red balls increases. the certain equivalents Ior alternatives one and two
increase because he has a better chance oI picking a red ball and winning.

d) Because Eduardo Iollows the delta property. his value oI clairvoyance is equal to the value oI
the deal with Iree clairvoyance minus the certain equivalent oI the deal without clairvoyance. His
value with Iree clairvoyance can be determined Irom the Iollowing tree:
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e)

4) Ellen
a) II Ellen assigns p ÷ 1. her value oI this deal is equal to negative inIinity whenever q~0. The
certain equivalent Ior the deal can be computed as Iollows:
0 · q < 1: CE ÷ q(-inIinity) ¹ (1-q)*6.667 ÷ negative inIinity
q ÷ 0: CE ÷ 6.667
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So. iI there is ANY chance oI making a mistake. the e-value oI assigning 0 to any answer is
negative inIinity. even iI q ÷ 0.0001 (a very small probability. but on a very. very bad prospect).
We`ll have more to say about this kind oI situation when we talk about micromorts.


b) The Iollowing graph shows the sensitivity to q. At q ÷ 1. the CE ÷ -4.4. and at
q ÷ 0.0001. the CE ÷ 2.144


c) For the case when s ÷ 1: when p is chosen to be 1. the certain equivalent is 6.67 at q ÷ 0 and
negative inIinity Ior all other q. When p is chosen to be 0.25. the certain equivalent is always
equal to zero as shown by the dashed line below. When p is chosen to be 0.7. the certain
equivalent as shown by the solid line below.



Hence. the Iollowing indicates the optimal decision as a Iunction oI q. when s ÷ 1.
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p÷1 iI q÷0
p÷.7 iI 0·q<.53
p÷.25 iI q~.53

For the case when s ÷ 0.7: when p is chosen to be 1. the certain equivalent is always negative
inIinity. When p is chosen to be 0.25. the certain equivalent is always equal to zero as shown by
the dashed line below. When p is chosen to be 0.7. the certain equivalent as shown by the solid
line below.


For s ÷ 0.7. her optimal decision as a Iunction oI q would be:

p÷.7 iI q·.327
p÷.25 iI q~÷. 327

d) When Ellen`s risk odds is equal to 2. the curve oI her certain equivalent changes as seen in the
graphs below. when p÷0.7. For q ÷ 0. p ÷ 1 the certain equivalent is 6.67. but otherwise the other
curves remain the same when p÷1 and p÷0.25. She is now risk averse and it makes sense that her
certain equivalent would decrease as compared to the risk neutral case.


For r ÷ 2 and s ÷ 1. her optimal decision as a Iunction oI q would be:
p÷1 iI q÷0
p÷.7 iI 0·q<.046
p÷.25 iI q~.046
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For r ÷ 2 and s ÷ 0.7. her optimal decision. as a Iunction oI q would be: always choose
p ÷ 0.25.

e) When Ellen`s risk odds is equal to 1/2. the curve oI her certain equivalent changes as seen in
the graph below. when p÷0.7. The Certain equivalent when p÷1 and q÷0 is now 6.67; otherwise
the curves Ior p÷1 and p÷0.25 remain the same as above. She is now risk seeking and it makes
sense that her certain equivalent would increase as compared to the risk neutral case.


So when she becomes risk preIerring. the range over which she chooses p ÷ 0.7 increases
dramatically. For r ÷ 1/2. s ÷ 1. the Iollowing p values are optimal as a Iunction oI q:

p÷1 iI q÷0
p÷.7 iI 0·q<.97
p÷.25 iI q~.97
Finally. when we consider s ÷ 0.7 Ior risk preIerring Ellen.

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p÷.7 iI q<.96
p÷.25 iI q~.96

In sum. you should see that there is only one very special case in which Ellen would consider
assigning p ÷ 1. That is when she is absolutely certain that an answer is correct (s ÷ 1) and it is
completely unconceivable that she could make a mistake (q ÷ 0). II you allow the decision p to be
continuous. instead oI a choice between 1. 0.7. and 0.25. then you`ll see this is clearly the case.
Our contention is that a belieI oI s ÷ 1 should be rare and that q ÷ 0 even more rare.




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