1

MS&E 252
Decision Analysis I
Problem Session 2
Contacting me.
Gael Le Mens
glemens@stanford.edu
Office hours: Thurs 9:30-11am Terman 348 or
Terman 406A
2
What we will cover today:
· DA cycle
· Distinctions
· Name
· Kind. degree
· Clear. observable.
useIul
· Expert
· Decisions and
outcomes
· Decision basis
· Alternatives
· InIormation
· PreIerences
· Personal indiIIerent
buying and selling
prices
· Sunk cost
· Certain equivalent
· Value oI clairvoyance
· Cycle oI ownership
The Decision Analysis Cycle
Deterministic
Analysis
Probabilistic
Analysis
Appraisal Structure
IniliaI
Silualion ecision
Ileialion
oinuIalion vaIualion ppiaisaI
Refer to the reading. The Evolution of Decision Analvsis
Compare to . Decision Analvsis- Applied Decision Theorv
3
Decision-makers need to perIorm two
Iundamentally diIIerent tasks.
Making Strategic
Decisions
Managing
Operations
'Choosing which mountain to climb¨ 'Climbing the chosen mountain in
the best possible way¨
· DA cycle
· Distinctions
· Name
· Kind. degree
· Clear. observable.
useful
· Expert
· Decision basis
· Alternatives
· InIormation
· PreIerences
· Personal indiIIerent
buying and selling
prices
· Sunk cost
· Certain equivalent
· Value oI clairvoyance
· Cycle oI ownership
What we will cover today:
4
What are the important distinctions about
distinctions?
· You can have different kinds of distinctions.
i.e. different wavs to split the same group.
· We call the smaller groups the degrees of
the distinction.
A Distinction is a thought that splits a
big group into two or more little groups.
What are the important distinctions about
distinctions?
· We call a distinction clear if it passes the
clarity test. i.e. if the clairvoyant can tell
which degree has occurred.
· If vou can tell which degree of the
distinction has occurred. we call it an
observable distinction.
· If the distinction helps vou in thinking about
a decision situation. we call it a useful
distinction.
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What are the important distinctions about
distinctions?
· Mutually exclusive - at most one can
occur.
· Collectively exhaustive - at least one must
occur.
· Mutually exclusive and collectively
exhaustive - exactlv one must occur.
The degrees oI a distinction must be mutually exclusive
and collectively exhaustive.
· Think about the temperature outside...
· Think about these pairs oI possibilities:
Under 10°C. over 20°C
Under 20°C. over 10°C
Under 20°C. over 20°C
Example
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DeIinition oI an Expert
· Uses powerful distinctions
(glossary)
· Knows the relationships
between distinctions
· Has particular skills
(sometimes)
· Has Sense of history and
knows connection oI current
practice to history
· Humility knows what
he/she doesn`t know
Our goal is Ior you to become
experts in decision making
· We will need to create powerful distinctions.
· We are working on changing vour conversation
about decision making.
In fact. weve alreadv started doing that'
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· DA cycle
· Distinctions
· Name
· Kind. degree
· Clear. observable.
useIul
· Expert
· Decision basis
· Alternatives
· Information
· Preferences
· Personal indiIIerent
buying and selling
prices
· Sunk cost
· Certain equivalent
· Value oI clairvoyance
· Cycle oI ownership
What we will cover today:
I
n
f
o
r
m
a
t
i
o
n
P
r
e
f
e
r
e
n
c
e
s
Frame
A
l
t
e
r
n
a
t
i
v
e
s
Logic
Decision
Basis
Commitment
to action
The Six Elements of Decision Quality
8
The basis Ior any decision is given by
the legs oI the stool
Preferences: What we want'
Alternatives: What we can do'
Information: What we know'
· DA cycle
· Distinctions
· Name
· Kind. degree
· Clear. observable.
useIul
· Expert
· Decision basis
· Alternatives
· InIormation
· PreIerences
· Personal indifferent
buying and selling
prices
· Sunk cost
· Certain equivalent
· Value of clairvoyance
· Cycle of ownership
What we will cover today:
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A deIinition and an example oI PISP and
PIBP.
Me
Shirt
Me
¹ $20
~
PISP - The least you would accept to part with something you own.
ignoring market Iorces. such that you would be indiIIerent to
whether you parted with it or not.
'Mv PISP for
the Shirt
equals $20.`
Me
Me
Watch
- $35 ~
PIBP - The most you would pay to get something you do not own.
ignoring market Iorces. such that you would be indiIIerent to
whether you got it or not.
'Mv PIBP for
the Watch
equals $35.`
You should be able to assess your own
PIBP and PISP.
· Imagine you have the class deal; call the
medallion correctly and win $50.
· Write your PISP Ior the deal.
· Imagine the clairvoyant comes and oIIers her
services; write your PIBP Ior her services.
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. And you should be able to determine iI
people`s prices make sense!
· II we know that David bid $25 Ior the
class deal. what do we know about his
PIBP Ior the deal?
· Can PIBP / PISP be diIIerent Ior
diIIerent people?
· Can PIBP / PISP be diIIerent Ior the
same person at diIIerent times?
· Can a person`s PIBP and PISP be
diIIerent Ior the same thing?
. And you should be able to determine iI
people`s prices make sense!
· Can a person`s PIBP / PISP be
negative?
· How should past events aIIect our
PISP and PIBP?
Sunk cost principle: ignore past events
and non recoverable loss oI resources
unless they aIIect your thoughts about the
present or the Iuture
Information
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What is your PISP Ior the car you own?
AIter Car Sale
- -
-
-
-
-
-
-
$
State 2
BeIore Car Sale
$
State 1
~
What is your PIBP Ior a new car?
BeIore Car Purchase
- -
-
-
-
-
-
-
$
AIter Car Purchase
$
State 2 State 1
~
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Cycle oI Ownership
What is it?
What changes it?
$
State 1
- -
-
-
-
-
-
-
$
State 2
Let`s explain the concept oI Cycle oI
Ownership using our example.
You start with the car. and with vour present bank account.
Someone offers vour PISP in exchange for the car.
You answer « Yes. sure. whv not? »
Then this someone offers vou the same car for vour PIBP.
Again. vou answer « Yes. sure. whv not? »
Then someone offers vou vour PISP in exchange for the car.
As usual. vou answer « Yes. sure. whv not? »
Etc.
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This is the idea behind the Cycle oI
Ownership.
« You can cvcle back and forth between states 1 and
2 forever. without ever losing or gaining wealth. »
But here vou see what the problem is going to be a Cycle of
Ownership is very easy to break!
II at some point. Ior any reason. your overall state oI wealth
changes. the Cycle oI Ownership is broken.
« Around a cvcle of ownership. PIBP ÷ PISP. »
$
State 1
- -
-
-
-
-
-
-
$
State 2
Again. let`s illustrate this
using our example.
You start with the car. and with vour present bank account.
Someone offers vour PISP in exchange for the car.
You answer « Yes. sure. whv not? »
You happen to find a $50 note.
But then vou can get the car back for what used to be vour PIBP.
Would vou still answer « Yes. sure. whv not? »
?
Here you`re not in state 1 or state 2 any more.
So there is no reason why you should accept this offer!
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Wealth eIIect
A change in vour overall state of wealth
mav incur changes in vour PIBP / PISP.
Imagine your PISP Ior the car in a diIIerent world.
where you got the car Ior Iree.
$
BeIore Car Sale
- -
-
-
-
-
-
-
AIter Car Sale
$
The 'wealth effect` mav alter vour PISP
State 1 State 2
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More questions on the Cycle oI Ownership
· You already own a gold coin.
· What is your PIBP Ior another gold coin?
· What is your PISP Ior the gold coin you own?
· Are the two prices necessarily equal?
The 'Certain Equivalent¨ and 'Value oI Clairvoyance¨
are both based on PISP and PIBP.
Two of the central concepts in decision
analysis are the certain equivalent (CE)
and the value of clairvoyance (VOC).
CE simply means your PISP Ior an
uncertain deal.
VOC simply means your PIBP Ior
the clairvoyant`s inIormation.
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Probabilistic Questions (Again!)
You will be required to place a measure oI
belieI on the correct answer.
Probabilistic Questions
ln4
ln
Score ÷ 1 ¹
p
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· Rationale behind Probabilistic Questions:
(Strictly Proper Scoring Rule)
Requires you to express your belieIs about an
uncertainty;
You maximize your expected score by
reIlecting your true belieIs.
Probabilistic Questions
Why are we making you suIIer
though probabilistic questions?
· This course is about decision making.
· The hardest part oI making decisions is dealing
with uncertainty.
· ThereIore. we want you to become Iamiliar with
expressing your uncertainty with probabilities.
· What letter occurs most in the word 'bubble¨?
a) l
b) u
c) b
d) e
a b c d
.so allow for mistakes. we all make them'
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What iI I assign a probability 0 to the correct answer?
I get a 0 to the question
AND
My Letter grade Ior the class is lowered by 2
marks
A becomes B¹
A- becomes B
.
Never assign a probability 0!!!
In Class Exercises
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Question 1
Your company has already invested $10 M in an expensive
R&D proiect. Now the proiect team is coming to you once
again. asking Ior $1 M more to complete the proiect.
Completion would bring $2 M to the company.
What should you do?
a. Invest the extra $1 M.
b. ReIuse to give them the money.
Question 2
How many oI the Iollowing questions can`t be answered
by the Clairvoyant?
I. What will be the outcome oI today`s recall vote.
II. Whether the next person entering the room will be male or Iemale.
III. How many points the NASDAQ will total at the opening oI
NYSE on Jan. 27
th
2017.
IV. What the population oI Los Angeles will be on Jan. 27
th
2017.
a. 1
b. 2
c. 3
d. 4
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Question 3
As a newly-claimed deIender oI the Decision Analysis Iaith.
you decide to go to the StanIord bookstore and sell your old
Statistics books. and buy a DA manuscript.
You sell the Statistics books Ior $130 and buy ProI. Howard`s
manuscript Ior $13.
What can be inIerred about your PISP Ior the books and your
PIBP Ior the manuscript?
a. PISP ·÷ $130. PIBP ·÷ $13.
b. PISP ~÷ $130. PIBP ·÷ $13.
c. PISP ·÷ $130. PIBP ~÷ $13.
d. PISP ~÷ $130. PIBP ~÷ $13.
Question 4
You acquired the certiIicate.
Your PISP Ior it is $60. and the thumbtack is tossed. Right
beIore you call 'heads¨ or 'tails¨. the SITN cameraman steps
in and says he saw the outcome oI the thumbtack toss.
Fortunately. he would be happy to reveal this inIormation in
exchange Ior money.
How much should you be willing to pay Ior this inIormation?
a. $0
b. $40
c. $60
d. Something between $0 and $40.
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Question 5
This time you acquired the certiIicate Ior $60.
What can be inIerred about your PIBP Ior the
certiIicate?
a. It equals $60.
b. It is less than $60.
c. It is more than $60.

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