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MS&E 252
Decision Analysis I
Problem Session 4
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Announcements
• Case Study Groups
– Start forming groups of 4 inside your problem
session;
– Email your TA by Monday, Nov. 8
th
, with the
names of your team members.
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What concepts do we expect you to
master?
· Relevance
· Relevance Diagrams
· The Rules oI Arrow
Flipping
· Associative Logic
Errors
· The Five Rules of
Actional Thought
· Five Rules Problems
· U-Curves
· When do we need them?
· How do we use them?
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In this class. we recommend that you
'Ily by the instruments.¨
· Instead oI trusting your
intuition. trust the calculations.
· Think oI pilots Ilying in Iog:
In good weather. beginners use the
instruments. and experts 'Ily by the
seat oI their pants¨ i.e. intuitively.
In Iog. even the experts use their
instruments.
With probabilitv. were alwavs flving in fog'
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What are the ~Five Rules of Actional
Thought¨?
They are rules that ensure you will:
· Be consistent in your decisions.
· Have organized thought about the problem.
· Have the analytical ability to solve a problem
by breaking it down into small pieces.
If vou chose not to follow them... Then we cannot
help vou make a decision'
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How to remember the Five Rules
· Probability rule
· Order rule
· Equivalence rule
· Substitution rule
· Choice rule
Mnemonic:
POE`S Choice
The rules prevent us from becoming a 'monev pump.` or someone
who can be rationallv convinced to give awav all of his or her assets.
The rules also dictate how we think about decisions.
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The Probability Rule Iorces us to use
probabilities and prospects.
Because we characterize a situation using prospects. we
only care about things that will happen in the Iuture.
No sunk costs
No regret
The Wheel
We cant use other forms of representing
uncertaintv than probabilitv.
We cannot say 'I don`t know the probability¨ or 'There
is no probability.¨
RULE #1
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>
X
The Order Rule Iorces us to compare
any two prospects.
'We can make a list of prospects. ordered
according to our preference (ties allowed).`
RULE #2
You can always create the necessary
distinctions to express preIerences. So
you must always be able to compare two
prospects.
You have to know what you want. or
you`ll become a money pump!
>
>
>
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The Equivalence Rule Iorces us to state
indiIIerence between prospects and deals.
p
1-p
A
C
~
B
'Given prospects A ~ B ~ C. we can assign a
probabilitv p such that voure iust indifferent between B
and a deal with chance p of getting A. 1-p of getting C.`
RULE #3
The Wheel
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The Equivalence Rule Iorces us to state
indiIIerence between prospects and deals.
No matter how
diIIicult. you must
be able to assign a
preIerence
probability.
~
Your current liIe
The Wheel
PerIect liIe
Instant.
painless death
Blue
Orange
p
1-p
'Given prospects A ~ B ~ C. we can assign a
probabilitv p such that voure iust indifferent between B
and a deal with chance p of getting A. 1-p of getting C.`
RULE #3
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A Iew more notes
on the Equivalence Rule.
· PreIerence probabilities do not
describe a belieI about an uncertain
event; they only represent your
preIerences.
· The Clairvoyant cannot help you
with these probabilities. In Iact
nobody can!
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· 'You`re not kidding¨ rule
· Connects preIerence
probabilities with probabilities
assigned to distinctions.
The Substitution Rule builds on the
Equivalence Rule.
'You can actuallv take vour preference probabilities.
and treat them as real probabilities'`
RULE #4
p
1-p
A
C
~
B
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The Choice Rule dictates
our decisions Ior us.
p
1-p
A
B
q
1-q
A
B
Deal 1: Deal 2:
You can have an agent act Ior you!
You will always choose the deal with the highest probability oI
the prospect you like best!
'Given the following deals. if vou prefer A over B. and
p ~ q . then vou must choose deal 1 over deal 2.`
RULE #5
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What concepts do we expect you to
master?
· Relevance
· Relevance Diagrams
· The Rules oI Arrow
Flipping
· Associative Logic
Errors
· The Five Rules oI
Actional Thought
· Five Rules Problems
· U-Curves
· When do we need them?
· How do we use them?
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'Five Rules Problems¨
First strategy: Iind a trick.
$50
0.75
0.25
~
$100
$0
0.5
0.5
~
$35
$100
$0
Eunice has certain equivalents Ior two deals as Iollows:
Find her certain
equivalent Ior the
Iollowing deal:
0.25
0.375
$100
$0
0.25
0.125
$50
$35
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'Five Rules Problems¨
First strategy: Iind a trick.
0.25
0.375
$100
$0
0.25
0.125
$50
$35
0.75
0.25
~
$100
$0
0.5
0.5
~
$100
$0
.25¹.25*.75¹.125*.5
.25*.25¹.125*.5¹.375
$100
$0
÷ .5
÷ .5
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Let`s try it here is a typical 'Five
Rules Problem¨.
John preIers more money to less and has the
Iollowing certain equivalents:
0.5
0.5
~
$30
$100
$0
0.7
0.3
~
$50
$100
$0
0.6
0.4
~
$40
$50
$30
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Let`s try it here is a typical
'Five Rules Problem¨
0.7
0.3
$50
$30
0.6
0.4
$40
$30
0.6
0.4
0.5
0.5
$100
$0
0.7
0.3
$50
$40
Deal A:
Deal B:
Deal C:
How should John rank these deals?
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'Worksheet¨ Ior this problem.
0.5
0.5
~
$30
$100
$0
0.7
0.3
~
$50
$100
$0
0.6
0.4
~
$40
$50
$30
0.7
0.3
$50
$30
0.6
0.4
$40
$30
Deal A:
Deal B:
0.6
0.4
0.5
0.5
$100
$0
0.7
0.3
$50
$40
Deal C:
Step 1 Find the
Iundamental outcomes in
terms oI which you will
rewrite every deal.
Step 2 Plug the deals
whose certain
equivalents you know
into deals A. B. C.
Etc.
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Second strategy: algebra!
Each deal represents an equation such as.
0.5
0.5
~
$30
$80
$20
means p
30
÷ 0.5p
80
¹ 0.5p
20
p
x
1- p
x
~
$x
$100
$0
where we deIine p
x
as
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II you can`t Iind a trick. rank prospects.
Iind preIerence probabilities. and choose.
List and rank
prospects
$100
$50
$35
$0
p
100
÷ 1
p
50
p
35
p
0
÷ 0
Assign
preference
probabilities
0.75
0.25
~
$50
$100
$0
50 100 0
0.75 0.25 0.75 p p p = + =
0.5
0.5
~
$35
$100
$0
35 100 0
0.5 0.5 0.5 p p p = + =
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II you can`t Iind a trick. rank prospects.
Iind preIerence probabilities. and choose.
List and rank
prospects
$100
$50
$35
$0
p
100
÷ 1
p
50
÷ 0.75
p
35
÷ 0.5
p
0
÷ 0
Assign
preference
probabilities
0.25
0.375
$100 1
$0 0
0.25
0.125
$50 0.75
$35 0.5
100 50 35 0
0.25 0.25 0.125 0.375
0.25 (0.25)(0.75) (0.125)(0.5)
0.5
$35
CE
p p p p p
CE
= + + +
= + +
=
=
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What concepts do we expect you to
master?
· Relevance
· Relevance Diagrams
· The Rules oI Arrow
Flipping
· Associative Logic
Errors
· The Five Rules oI
Actional Thought
· Five Rules Problems
· U-Curves
· When do we need them?
· How do we use them?
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How much do you value a deal?
· When Iaced with certainty people
value monetary deals the same.
· These types oI problems are easy to
solve and would have the Iorm:
· Do you preIer $1000 or $5000 ?
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· People react diIIerently due to many Iactors:
their taste Ior risk
their wealth state
How much do you value a deal?
· When there is no uncertainty. we do not need u-values at all...
· . But people place diIIerent values on uncertain deals.
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When we study risk preIerence. we
study U-curves.
'A persons risk preference (or risk attitude)
describes the relation between an uncertain deal and
that persons PISP and PIBP for the deal.`
TradeoII between greed and Iear
$150.000
-$75.000
0.5
~
?
Greed
Fear
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Why do we need U-curves?
U-curves are a good
means Ior us to assess the
values people place on
uncertain deals.
In this session. we will show how to
assess the U-curves for different individuals.
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Why do we use the term 'u-value¨
instead oI utility?
Utility
Value model
Kim
O - S
Kim
¹$100
~
u-curve
0.5
$100
$0
$34
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One method of assessment is to follow a similar
procedure to Kims partv problem.
Arrange all prospects according to
the order rule .
Calculate the preIerence probability
oI each prospect.
This applies no matter how many
prospects you have.
How do we assess U-values?
> p?
>
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Why can we scale and shiIt u-values?
u
1
p u
A
u
2
1 2
(1 )
A
u pu p u = + −
p u
B
a · bu
1
a · bu
2
1 2
1 2
1 2
1 2
( ) (1 )( )
(1 ) (1 )
( (1 )) ( (1 ) )
( (1 ) )
B
B
B
B
B A
u p a bu p a bu
u pa pbu p a p bu
u a p p b pu p u
u a b pu p u
u a bu
= + + − +
= + + − + −
= + − + + −
= + + −
= +
Deal A:
Deal B:
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Using U-curves How do we 'roll
back¨ a tree?
0.4
0.6
S
R
0.95
0.32
.4*.95·.6*.32
Uncertainties:
Take e-value of u-values
÷ 0.63
Decisions:
Pick best u-value
O
I
0.40
0.63
0.57
P
÷ 0.57
Max(.4. .57. .63)
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Using U-curves Finding a Certain
Equivalent graphically.
Example -
Finding the CE oI a deal with 50° chance oI $80 and
50° chance oI $10.
$100 $0 $80 $10
u($10)
u($80)
.5u($80)¹.5u($10)
÷ u(CE)
CE
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Using U-curves Why is it important
to remember this construction?
· Reminds you that you should calculate
the e-value oI the u-values. not the e-
value of the dollar amounts placed on
the prospects.
· Can also be used to determine the Value
oI Clairvoyance (iterative construction).
'When faced with a decision tree. unless the decision maker
is risk-neutral. alwavs remember to go to u-space. then take
the e-value. then go back to $-space.`
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Old Slides Revisited
ReIer to previous problem session slides