You are on page 1of 4

Decision-Making in Business – use of probability and expected values, and standard

deviation as risk

Actions
Get
money
Prob of Possible Sell ice Sell hot from
event events cream dogs parents
Good
0.8 weather 100 50 100
0.2 Rain -50 50 100

From business considerations – you make a payoff table or a table of profits that you
expect when you take certain actions given some events are true. However, the events
are not certain. In the table above, the actions you need to decide among are selling ice
cream at The Big Game, selling hot dogs, or getting money from your parents. What the
weather (possible event) will be is uncertain, so there is a probability associated with
each possible weather event. (In real life, these tables involve lots of research. For
example, you would look at old newspapers to see how often it has rained on the day of
the Big Game as opposed to being good weather. You might do a pilot study to see how
many people buy hot dogs vs ice cream on good days, and on rainy days. Etc. However,
we’re ignoring all this for the moment.)

One of the first things to look for is a dominating action. Basically, a dominating action
is an action that is obviously better than all the others. For example , in the table above,
you can see that the action ‘Get money from parents’ is at least as good as selling ice
cream in good weather, and better than both the other two actions in bad weather.
Obviously, you should get money from your parents if you can. When there is a
dominating action, the actions it dominates (ie is better than) are called inadmissible.

In a nutshell, a dominating action is one where the choice of action is obvious, so you
don’t need to go through the calculations to decide between it and the inadmissible
events.

However, dominating actions aren’t ‘interesting’. So we’ll pretend that your parents have
decided you are nuts to ask them for money, so we’re down to the following table:

Actions
Prob of Possible Sell ice Sell hot
event events cream dogs
Good
0.8 weather 100 50
0.2 Rain -50 50
The easiest way to make decisions is to calculate the Expected Monetary Value (EMV)
of each action, and then choose the action that gives the highest expected profit.
EMV1 =

EMV2 =

The higher one is:


So the action decided upon is:

The next way to make a decision is to look at Expected Opportunity Lost.


This is based on the above payoff table, but we need to do some calculations first:

Lost opportunity
(money 'lost' by
making 'wrong'
Payoff/profit decision for event)
Actions Actions

Maximum
Opportunity
(Maximum
profit over
all
decisions
Prob of Possible Sell ice Sell hot for given Sell ice Sell hot
event events cream dogs event) cream dogs
Good
0.8 weather 100 50
0.2 Rain -50 50

First, we have to find the maximum profit for each event from the payoff table. In other
words, which action would have given us the biggest profit? Take that biggest profit – it’s
the most we had the opportunity to make in that event.
Then we subtract each cell in profit table from the maximum. The maximum is the
first number – we subtract from it. The numbers in the table should all be positive,
but they denote a loss even though they don’t have a minus sign. (note there should
be zeroes where the maximum profit occurred.). That is the opportunity lost. We have
lost no opportunity to make more profit if we chose the right action for the event that
occurred, and we have lost opportunity

To make a decision based on EOL, we take the expected value of each action for the
opportunity loss table:

EOL1 =

EOL2 =

Another way to make a decision is based on the Return-to-Risk-Ratio. We go back to the


expected payoff table we used for EMV. The expected profit (or monetary value) is our
return for that action. The risk is the standard deviation of the profit.

So the RRR = EMV/SD(MV)

Var(MV)1 =

SD(MV)1 = , so RRR1 =

Var(MV)2 =

SD(MV)2 = , so RRR2 =
The final one we learn is Expected Value of Perfect Information (EVPI). Let’s go back
to the table where we calculated EOL. What does ‘perfect information’ mean? It means
that if we knew it was going to rain, we’d sell hot dogs. If we knew it would be nice,
we’d have sold ice cream. In other words, if we could mix and match our actions based
on the event, rather than getting stuck with only one action, we’d get the maximu profit.

So let’s look at the amount we expect to get if we had the perfect information:

E(PI) = E(Maximum profit column) =

EVPI is the amount we should be willing to pay to get that perfect information.

So

EVPI 1 =

EVPI2 =