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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 =

So the action decided upon is:

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 =

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.

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:

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

So

EVPI 1 =

EVPI2 =

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