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MS&E 252
Decision Analysis I
Problem Session 6
2
What concepts do we expect you to
master?
· Sensitivity Analysis
· Why is it important?
· Examples oI Sensitivity
Analysis
· InIormation Gathering
· Value oI InIormation
· Decision Diagrams
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3
Sensitivity Analysis
4
What do we mean by sensitivity
analysis? Why is it important?
· How does the best decision change as
the probability oI sun changes?
· How does the certain equivalent change
as the probability oI sun changes?
· How does the value oI clairvoyance
change as the probability oI sun
changes?
'How does this change when vou change that?`
p
0 0.2 0.4 0.6 0.8 1
$150
$100
$50
$0
3
5
· Sensitivity analysis helps derive
important insights about the
decision situation.
· Using sensitivity analysis. we can
tell how accurate our assessments
need to be.
p
0 0.2 0.4 0.6 0.8 1
$150
$100
$50
$0
'How does this change when vou change that?`
What do we mean by sensitivity
analysis? Why is it important?
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· Eduardo. a conIused graduate student.
has iust won the MS&E weekly Bingo
prize in which he has his choice among
three alternatives.
Here is an example oI what Sensitivity
Analysis allows you to do.
· Although he Iollows the Iive rules oI
actional thought. he can't decide which
alternative to pick and has asked Ior
your help.
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7
Here is an example oI what Sensitivity
Analysis allows you to do.
· In the Iirst alternative. he is given a iar
oI balls. some are red and the others
are white. II Eduardo picks a red ball.
he wins $750. iI he picks a white ball.
he wins $400.
· The second alternative is a similar
deal. However iI he picks a red ball
Irom the iar. he wins $1000. iI not. he
wins nothing.
· The third alternative is a sure $500.
· Assume he is risk neutral.
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Value oI
Clairvoyance
?
Best
alternative?
Sensitivity
to probability
oI drawing
a red ball?
Here is an example oI what Sensitivity
Analysis allows you to do.
Certain
equivalent?
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9
The best alternative is to go with Deal B.
0.7 70 $-value u-value
Red Ball
$750 0.75
Deal A 0.75
0.65 0.3
White Ball
$400 0.40
0.40
0.7
Red Ball
$1,000 1.00
>>> Deal B 1.00
2
0.70 0.70 0.3
$700 White Ball
$0 0.00
0.00
Deal C
$500 0.50
0.50
'But what if one of the pavoffs changes?`
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But what iI one oI the payoIIs changes?
For Eduardo to be indiIIerent between deals A and B.
0.7 70 $-value
Red Ball
$x
Deal A ########
######## 0.3
White Ball
$400
0.40
0.7
Red Ball
$1,000
Deal B 1.00
0
######## 0.70 0.3
#VALEUR! White Ball
$0
0.00
Deal C
$500
.7 * x ¹ .3 * 400
.7 * 1000 ¹ .3 * 0
x ÷ $829
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$0
$100
$200
$300
$400
$500
$600
$700
$800
$900
$0 $100 $200 $300 $400 $500 $600 $700 $800 $900 $1,000
Payoff 1
C
e
r
t
a
i
n

E
q
u
i
v
a
l
e
n
t
Deal A
Deal B
Deal C
Best
We can also plot this on a graph.
Go for B Go for A
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Now let us examine Sensitivity to the
probability oI drawing a red ball.
p 70 $-value
Red Ball
$750
Deal A 0.75
#N/A 1-p
#N/A White Ball
$400
0.40
p
Red Ball
$1,000
Deal B 1.00
0
#N/A #N/A 1-p
#N/A #N/A White Ball
$0
0.00
Deal C
$500
CE ÷ p*750
¹ (1-p)*400
CE ÷ p*1000
¹ (1-p)*0
CE ÷ 500
Find the
CE for each
alternative
as a
function of
p.
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13
Now let us examine Sensitivity to the
probability oI drawing a red ball.
· Finding these equations will help you.
Plot the graph
Find the values oI p Ior which an alternative will be the
best available.
CE ÷ p*750
¹ (1-p)*400
CE ÷ p*1000
¹ (1-p)*0
Deal A
Deal B
· For example. B is optimal but.
Solve in p
B preIerred iI p ~ 0.61
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$0
$200
$400
$600
$800
$1,000
$1,200
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
Proba of Red Ball
C
e
r
t
a
i
n

E
q
u
i
v
a
l
e
n
t
Deal A
Deal B
Deal C
Best
This is conIirmed by our spreadsheet.
and also by plotting the sensitivity graph.
Go for C Go for B Go for A
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How would you represent the Value oI
Clairvoyance on the same graph?
$-value u-value
Deal A
$750 0.75
0.75
0.7 70
Red Ball >>> Deal B
2 $1,000 1.00
1 1.00
Deal C
$500 0.50
0.50
0.85
$850 Deal A
$400 0.40
0.40
0.3
White Ball Deal B
3 $0 0.00
0.5 0.00
>>> Deal C
$500 0.50
0.50
First. let us look at the deal with
Free Clairvoyance.
. Then. use this tree to Iind the
equation giving the CE oI the
deal with Free Clairvoyance as
a Iunction oI p.
CE ÷ .7 ` 1000 + .3 ` 500
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You can then plot this on the graph!
$0
$200
$400
$600
$800
$1,000
$1,200
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
Proba of Red Ball
C
e
r
t
a
i
n

E
q
u
i
v
a
l
e
n
t
Deal A
Deal B
Deal C
Free Clairv
Where is the Jalue of Clairvovance on this graph?
JOC ÷ JFC - JNC
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$0
$50
$100
$150
$200
$250
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
Proba of Red Ball
C
e
r
t
a
i
n

E
q
u
i
v
a
l
e
n
t
VoC
Here is a graph showing the Value oI
Clairvoyance as a Iunction oI p.
We Iind the same
breakpoints as in
the previous graph.
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We can also perIorm sensitivity analysis
on the risk aversion coeIIicient.
Sensitivity to Gamma
$0
$200
$400
$600
$800
$1,000
$1,200
-0.07 -0.05 -0.03 -0.01 0.01 0.03 0.05 0.07
Gamma
C
e
r
t
a
i
n

E
q
u
i
v
a
l
e
n
t
Deal A
Deal B
Deal C
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What concepts do we expect you to
master?
· Sensitivity Analysis
· Why is it important?
· Examples oI Sensitivity
Analysis
· Information Gathering
· Value of Information
· Decision Diagrams
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Information Gathering
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21
What do we mean by 'InIormation
Gathering¨?
'We will get clairvovance about a distinction
that is relevant to our distinction of interest.`
Distinction
oI interest
Relevant
(observed)
Distinction
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InIormation gathering involves using a test to
illuminate an unobservable distinction.
'What we can observe¨ 'What we really want to know¨
Uncertainty Test
Uncertainty Test
Inferential form
Assessed form
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Let`s look at this on a concrete
example!
· Suppose that you want to study a virus.
· 1/400th oI the population is inIected.
· A test is available iI used on an inIected
person. the test is 99° likely to indicate that
the person is indeed inIected; similarly. iI the
person is not inIected. the test is 99° likely
to indicate that the person is not inIected.
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The 'assessed¨ tree determines the ioint
probabilities Irom the prior and the likelihood.
Assessed Form
Virus 'Test¨
1/400
÷ 0.0025
399/400
÷ 0.9975
Virus
No Virus
'Prior` 'Likelihood`
'Positive¨
'Negative¨
'Negative¨
'Positive¨
0.99
0.01
0.01
0.99
0.002475
0.009975
0.000025
0.987525
True Pos
True Neg
False Pos
False Neg
¦'Pos¨ ' Pos } ÷ Test Sensitivity
¦'Neg¨ ' Neg } ÷ Test Specificity
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The 'inIerential¨ tree determines the posterior
and pre-posterior probabilities Irom the ioint.
Inferential Form
'Test¨ Virus
÷ 0.01240
÷ 0.98755
'Positive¨
'Negative¨
Virus
No Virus
No Virus
Virus
'Pre-Posterior` 'Posterior`
0.20
0.000025
0.80
0.999975
0.002475
0. 000025
0. 009975
0.987525
Lets flip this tree'
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When is it worthwhile to obtain
inIormation Irom an imperIect test?
· The test must be observable.
· The test must be relevant to the distinction of interest.
· The test must be material to the decision.
That is. the alternative with the highest CE mav change
based on the results of the test.
Even one potential change is enough to make a test material.
· The test must be economic (create more value than it
costs to perform).
Need all four. or else the test is a no go!
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Case study: DA Studios
· DA Studios. a maior entertainment
corporation. has iust produced a motion
picture called 'Claire the Clairvoyant
Goes to College¨.
· Fanny. VP oI Movie Marketing. needs
to decide whether to release the Iilm or
not.
· The decision is diIIicult because Fanny
does not know whether the movie will
be a 'Blockbuster¨ or a 'Flop¨.
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Fanny characterizes her situation as
Iollows.
· Fanny says the probability the movie will be a
'Blockbuster¨ if released. ¦Blockbuster '
Released.&}. is 0.6.
· II it is a Blockbuster. Flicks will earn $70M.
II it is a Flop. Flicks will lose $50M.
· Fanny says iI they do not release the movie.
Flicks will lose $25 million because that is
how much they spent on the production oI the
Iilm.
· Fanny also explains that this is a small deal
compared to the company as a whole. so she
is comIortable being risk-neutral.
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An imperIect sneak preview 'test¨ is
available. but is it worth it?
· Fanny explains that Irom time to time they do
have 'Sneak Previews¨ Ior selected Iilms.
· A sneak preview is a special showing. aIter
which the audience Iills out a questionnaire
stating their opinion.
· The questionnaire contains only two boxes:
'Thumbs Up¨ or 'Thumbs Down¨.
· Fanny provides you with the Iollowing sneak
preview data Irom past Iilms:
¦'Thumbs Up¨ ' Blockbuster} ÷ 2/3
¦'Thumbs Down¨ ' Flop} ÷ 3/4
Sneak Preview cost ÷ $0.5 million
· What should Fanny do?
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First let`s calculate the CE and the VoC.
Release
No Release
0.6
0.4
$70
Blockbuster
Flop
-$50
$0
· CE ÷ 42 - 20 ÷ $22M
· Value with Free Clairvoyance
÷ 0.6 (70) ¹ 0.4 (0) ÷ $42M

Observable? Relevant?
Material? Economic?
Is the sneak preview "test".
? ?
· VoC ÷ 42 - 22 ÷ $20M
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We need to inIer the posterior
probabilities oI a Blockbuster or Flop.
0.6
0.4
Blockbuster
Flop
'Thumbs Up¨
'Thumbs Down¨
'Thumbs Down¨
'Thumbs Up¨
2/3
1/3
1/4
3/4
0.4
0.2
0.1
0.3
0.5
0.5
'Thumbs Up¨
'Thumbs Down¨
Blockbuster
Flop
Flop
Blockbuster
0.8
0.2
0.4
0.6
0.4
0.2
0.1
0.3
Prior Likelihood Pre-Posterior Posterior
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Now we can determine the certain
equivalent with the test included.
0.5
0.5
'Thumbs Up¨
'Thumbs Down¨
Release
No Release
No Release
Release
0.4
0.6
0.8
0.2
$70
Blockbuster
Flop
Flop
Blockbuster
-$50
-$50
$70
$0
$0
$46
-$2
× ×× ×
× × × ×
With the test
CE ÷ $23M
We now know
that the test is
material'
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Is the sneak preview economic?
· CE with the sneak preview ÷ $23M
· CE without the sneak preview ÷ $22M
· Value added by sneak preview ÷ $1M
· Cost oI sneak preview ÷ $0.5M
· Net Improvement ÷ $0.5M
In this case. the test is worth its price!
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A Iew more questions Ior you!
· Would you perIorm Sensitivity Analysis
in this example?
· II yes. on which parameters?
· Sensitivity on speciIicity. sensitivity
on. sensitivity.
Trv it' This would be a good preparation
for the Case Studv'
'Information Gathering` meets 'Sensitivitv Analvsis`
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35
What concepts do we expect you to
master?
· Sensitivity Analysis
· Why is it important?
· Examples oI Sensitivity
Analysis
· InIormation Gathering
· Value oI InIormation
· Decision Diagrams
36
Decision Diagrams
19
37
Why are decision diagrams important?
· Facilitates communication.
· Grows linearly. unlike trees that grow
exponentially.
· No degrees and no probabilities yet!
ThereIore no clarity test required
Enables high level abstraction
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Decision diagrams contain Iour kinds
oI nodes.
Decision Node Uncertainty Node
Deterministic Node Value Node
F(x.y)
x
y
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For example. in Kim`s party
problem.
Uncertainty Sunny or rainy weather?
Value Value to Kim ($)
Decision Where to have the party?
Type oI Node Corresponds to
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Four kinds oI arrows indicate
conditioning.
InIormational Arrow Relevance Arrow
Functional Arrow
InIluence Arrow
A B C
D
2
D
1
E
D F
D C
'B is conditioned on A.
and mav be relevant to A.`
'C and D
1
are known when D
2
is made.`
'F is a deterministic function of D and E.`
'Mv choice in decision D mav affect
the distribution of uncertaintv C.`
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Let`s draw the decision diagram Ior
Kim`s party problem.
Kim decides without
knowing the weather
Kim`s value ÷ fcn(W.L)
$
??
Kim`s decision does not
modiIy the weather
Weather
Location
Watch out for 'rookie mistakes`'
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Let`s try it on another example!
· DA Corp. is thinking oI investing in research on a new
drug. 'Clear Voyance¨. 'Clear Voyance¨ would
instantly and painlessly cure any eyesight problem.
· They estimate that iI they decide to invest in research.
technical success will only be 20° likely. However.
once they have technical success. they have a 90°
chance oI marketing success.
· DA Corp. also needs to decide whether they should
proceed to preliminary testing that will give an
indication on the chances oI technical success.
How would vou set up a decision diagram for this
example?
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Here is a possible decision diagram Ior
DA Corp.`s decision
$
Marketing Success
Proceed to Tests Report
Technical Success
Test Indication
Invest in Research
Exercise Name all the kinds of arrows on this diagram

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