36 views

Original Title: Decision Making

Uploaded by Miiss Cathymiao

- Psychology Decision Making
- Decision Making
- Business Economic and Managerial Decision Making
- The Oxford Handbook of Organizational Decision Making2
- Decision Making
- Decision Making
- Systematically Irrational Decision Making: An Evaluation of Decision Making Competence of Technical Experts and Decision Makers at Scania R&D
- The Secrets of Wise Decision Making
- Chapter 11
- Inventories and COGS
- How We Decide
- Kahneman, Klein - 2009 - Conditions for Intuitive Expertise a Failure to Disagree
- Problem Solving and Decision Making
- Working Minds
- 0 Deborah Stone Policy Paradox the Art of Political Decision Making
- Quantitative Analysis -1 (Problems)QA Problems
- Decision Making Final Draft
- Decision Making
- Decision Analysis for the Professional
- Extendable Rationality - Understanding Decision Making in Organizations (Organizational Change and Innovation)

You are on page 1of 48

Decision Making

Week 13-1

Describe basic features of decision making

Construct a payoff table and an opportunity-loss

table

Define and apply the expected value criterion for

decision making

Compute the value of perfect information

Describe utility and attitudes toward risk

Week 13-2

List Alternative Courses of Action (Options)

Choices or actions

Possible events or outcomes

Determine Payoffs

Associate a Payoff with Each Event/Outcome combination

Evaluate Criteria for Selecting the Best Course of Action

(Option)

Week 13-3

Events

Two Methods

of Listing

Table

Payoff

Decision Tree

Opportunity Loss

Payoff

Week 13-4

A Payoff Table

A payoff table shows alternatives,

states of nature, and payoffs

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Profit in $1,000s

(Events / States of Nature)

Strong

Stable

Weak

Economy

Economy

Economy

200

90

40

50

120

30

-120

-30

20

Week 13-5

Opportunity Loss

Opportunity loss is the difference between an actual

payoff for an action and the optimal payoff, given a

particular event / state of nature

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Payoff

Table

Profit in $1,000s

(Events)

Strong

Economy

Stable

Economy

Weak

Economy

200

90

40

50

120

30

-120

-30

20

The action Average factory has payoff 90 for Strong Economy. Given

Strong Economy, the choice of Large factory would have given a

payoff of 200, or 110 higher. Opportunity loss = 110 for this cell.

Week 13-6

(continued)

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Payoff

Table

Profit in $1,000s

(States of Nature)

Strong

Economy

Stable

Economy

Weak

Economy

200

90

40

50

120

30

-120

-30

20

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Build

Opportunity

Loss Table

(Events)

Strong

Economy

Stable

Economy

Weak

Economy

0

110

160

70

0

90

140

50

0

Week 13-7

A Decision Tree

Large factory

Average factory

Small factory

Strong Economy

200

Stable Economy

50

Weak Economy

-120

Strong Economy

90

Stable Economy

120

Weak Economy

-30

Strong Economy

40

Stable Economy

30

Weak Economy

20

Payoffs

Week 13-8

Decision Criteria

The Maximum Expected

Monetary Value (EMV)

The Minimum Expected

Opportunity Loss (EOL)

= Expected Value of

Perfect Information

(EVPI)

of variation (CV)

The Maximum Return to

risk ratio (RRR)

Disadvantages:

The risk or

variability of certain

option is not

taken into account.

Advantages:

The risk or

variability of certain

option is

taken into account.

Week 13-9

Based on Expected Monetary Value (EMV)

Choose the maximum expected profit for taking

action Aj.

Choose the minimum expected opportunity loss for

taking action Aj.

Expected Value of Perfect Information (EVPI) is

the expected opportunity loss from the best decision

Week 13-10

Solution

Goal: Maximize expected value

average payoff, given specified probabilities

for each event

N

EMV( j) = x ijPi

i=1

xij = payoff for action j when event i occurs

Pi = probability of event i

Week 13-11

Solution

(continued)

payoff, given specified probabilities for each event

Profit in $1,000s

(Events)

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Strong

Economy

(0.3)

Stable

Economy

(0.5)

Weak

Economy

(0.2)

200

90

40

50

120

30

-120

-30

20

Suppose these

probabilities

have been

assessed for

these three

events

Week 13-12

Solution

(continued)

Payoff Table:

Profit in $1,000s

(Events)

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Strong

Economy

(0.3)

Stable

Economy

(0.5)

Weak

Economy

(0.2)

200

90

40

50

120

30

-120

-30

20

Expected

Values

(EMV)

61

81

31

Maximize

expected

value by

choosing

Average

factory

= 81

Week 13-13

A Decision tree shows a decision problem,

beginning with the initial decision and ending

will all possible outcomes and payoffs.

Use a square to denote decision nodes

Use a circle to denote uncertain events

Week 13-14

(continued)

Strong Economy (0.3) 200

Large factory

Weak Economy

(0.2) -120

Average factory

Decision

Small factory

50

90

Weak Economy (0.2) -30

Strong Economy (0.3)

40

30

Weak Economy

(0.2)

20

Uncertain Events

Probabilities Payoffs

Week 13-15

EMV=200(.3)+50(.5)+(-120)(.2)=61

Large factory

Stable Economy (0.5)

Weak Economy

EMV=90(.3)+120(.5)+(-30)(.2)=81

Average factory

EMV=40(.3)+30(.5)+20(.2)=31

Small factory

50

(0.2) -120

90

Weak Economy (0.2) -30

Strong Economy (0.3)

40

30

Weak Economy

(0.2)

20

Week 13-16

EV=61

Large factory

Stable Economy (0.5)

Weak Economy

EV=81

Average factory

EV=31

Small factory

50

(0.2) -120

90

Weak Economy (0.2) -30

Strong Economy (0.3)

40

30

Weak Economy

(0.2)

Maximum

EMV=81

20

Week 13-17

Solution

Goal: Minimize expected opportunity loss

average loss, given specified probabilities for

each event

N

EOL( j) = L ijPi

i=1

Lij = opp. loss for action j when event i occurs

Pi = probability of event i

Week 13-18

Solution

Goal: Minimize expected opportunity loss

Opportunity Loss Table

Opportunity Loss in $1,000s

(Events)

Investment

Choice

(Action)

Large factory

Average factory

Small factory

Strong

Economy

(0.3)

Stable

Economy

(0.5)

Weak

Economy

(0.2)

0

110

160

70

0

90

140

50

0

Expected

Op. Loss

(EOL)

63

43

93

Minimize

expected

op. loss by

choosing

Average

factory

= 63

Week 13-19

Expected Value of Perfect Information, EVPI

Expected Value of Perfect Information

EVPI = Expected monetary value under certainty

Expected monetary value under

uncertainty (the best alternative)

opportunity loss ( from the best decision)

Week 13-20

Expected

profit under

certainty

= expected

value of the

best

decision,

given perfect

information

Profit in $1,000s

(Events)

Investment

Choice

(Action)

Strong

Economy

(0.3)

Stable

Economy

(0.5)

Weak

Economy

(0.2)

200

90

40

50

120

30

-120

-30

20

200

for each event:

120

20

Large factory

Average factory

Small factory

given Strong Economy is

Large factory

Week 13-21

(continued)

Profit in $1,000s

(Events)

Investment

Choice

(Action)

Now weight

these outcomes

with their

probabilities to

find the

expected value:

Large factory

Average factory

Small factory

Strong

Economy

(0.3)

Stable

Economy

(0.5)

Weak

Economy

(0.2)

200

90

40

50

120

30

-120

-30

20

200

120

20

200(0.3)+120(0.5)+20(0.2)

= 124

Expected

profit under

certainty

Week 13-22

Expected Value of Perfect Information (EVPI)

EVPI = Expected monetary value under certainty

Expected monetary value under uncertainty (the best

alternative)

Recall:

EMV is maximized by choosing Average factory,

where EMV = 81

so:

EVPI = 124 81

= 43

willing to spend to obtain perfect information)

Week 13-23

is the standard deviation for certain option.

Min CV j =

j

EMV j

100%

Week 13-24

(continued)

Example:

Percent Return

(Events)

Stock Choice

(Action)

Strong

Economy

(0.7)

Weak

Economy

(0.3)

Stock A

30

-10

18.0

Stock B

14

12.2

Expected

Return:

Stock A has a higher

EMV, but what about

risk?

Week 13-25

(continued)

Stock A and Stock B:

Percent Return

(Events)

Stock Choice

(Action)

Strong

Economy

(0.7)

Weak

Economy

(0.3)

Stock A

30

-10

18.0

336.0

18.33

Stock B

14

12.2

7.56

2.75

Expected

Standard

Return:

Variance: Deviation:

N

2

2

2

Example: = ( X i ) P( X i ) = (30 18) (0.7) + (10 18) (0.3) = 336.0

2

A

i =1

Week 13-26

(continued)

CVA =

A

18.33

100% =

100% = 101.83%

EMVA

18.0

B

2.75

CVB =

100% =

100% = 22.54%

EMVB

12.2

Stock A has

much more

relative

variability

Choose stock B

because CVB is

lesser than CVA.

Week 13-27

Return-to-Risk Ratio (RTRR):

EMV(j)

RRR(j) =

j

Expresses the relationship between the return

(expected payoff) and the risk (standard deviation)

Week 13-28

Return-to-Risk Ratio

EMV(j)

RRR(j) =

j

RRR(A) =

EMV(A) 18.0

=

= 0.982

A

18.33

EMV(B) 12.2

RRR(B) =

=

= 4.436

B

2.75

like risk. Although Stock A has a higher Expected

Return, Stock B has a much larger return to risk

ratio and a much smaller CV

Week 13-29

Decision Making

with Sample Information

Prior

Probability

probabilities based on new

information

New

Information

Revised

Probability

Week 13-30

Revision of Probability

In the 1700s, Thomas Bayes developed a

way to revise the probability that a first

event occurred from information obtained

from a second event.

Bayes Theorem: For two events A and B

P( A| B) = P( A and B)

P(B)

P( A)P(B| A)

=

[P( A)P(B| A)] + [P( A')P(B| A')]

Copyright 2005 Brooks/Cole, a division of Thomson Learning,

Inc.

Week 13-31

Bayes Theorem

P(A | Bi )P(Bi )

P(Bi | A) =

P(A | B1)P(B1) + P(A | B2 )P(B2 ) + + P(A | Bk )P(Bk )

where:

Bi = ith event of k mutually exclusive and collectively

exhaustive events

A = new event that might impact P(Bi)

Week 13-32

Revised Probabilities

Example

Additional Information: Economic forecast is strong economy

When the economy was strong, the forecaster was correct

90% of the time.

When the economy was weak, the forecaster was correct

30% of the time.

F1 = the forecast is strong economy

F2 = weak forecast

E1 = strong economy = 0.70

Prior probabilities

from stock choice

example

P(F1 | E1) = 0.90

Week 13-33

Revised Probabilities

Example

(continued)

P(F1 | E1 ) = .9 , P(F1 | E 2 ) = .3

P(E1 ) = .7 , P(E2 ) = .3

Revised Probabilities (Bayes Theorem)

P(E1 )P(F1 | E1 )

(.7)(.9)

P(E1 | F1 ) =

=

= .875

P(F1 )

(.7)(.9) + (.3)(.3)

P(E 2 )P(F1 | E 2 )

P(E 2 | F1 ) =

= .125

P(F1 )

Week 13-34

Revised Probabilities

Example

(continued)

Event

E1 (strong

economy)

E2 (weak

economy)

Prior

Prob.

P(Ei)

0.70

0.30

Conditional

Prob.

P(F1 | Ei)

Joint

Prob.

P(F1 Ei)

Revised

Prob.

P(Ei | F1)

0.90

0.70.9 =

0.63

0.63 / 0.72 =

0.875

0.30

0.30.3 =

0.09

0.09 / 0.72 =

0.125

P(F1) = 0.72

Week 13-35

Revised Probabilities

Calculate the variance and standard deviation for

Stock A and Stock B:

Percent Return

(Events)

Stock Choice

(Action)

Strong

Economy

(0.875)

Weak

Economy

(0.125)

Stock A

30

-10

25.0

175.0

13.229

Stock B

14

13.25

3.94

1.984

Expected

Standard

Return:

Variance: Deviation:

N

2

2

2

Example: = ( Xi ) P( X i ) = (30 25) (0.875) + (10 25) (0.125) = 175.0

2

A

i =1

Week 13-36

Revised Probabilities

(continued)

results from the revised probabilities:

A

13.229

CVA =

100% =

100% = 52.92%

EMVA

25.0

B

1.984

CVB =

100% =

100% = 14.97%

EMVB

13.25

Week 13-37

Revised Probabilities

EMV(A)

25.0

RTRR(A) =

=

= 1.890

A

13.229

EMV(B) 13.25

RTRR(B) =

=

= 6.678

B

1.984

With the revised probabilities, both stocks have

higher expected returns, lower CVs, and larger

return to risk ratios

Week 13-38

(April 2005 Q2a)

ABC Restaurant would like to determine

whether it would be profitable to establish a new

branch in Sungai Long. The manager believes

that there are three possible levels of demand

for this services: low, moderate and high

demand levels. Based on the past experience in

Kajang branch, the manager expects the

following probabilities to the various demand

levels:

Week 13-39

(April 2005 Q2a)

P(L) = 0.2, P(M) = 0.5, P(H) = 0.3

Where L = low demand; M = moderate demand;

H = high demand

The manager has reported the following profits or

losses of this restaurant service for each

demand level (over a period of 6 months):

Week 13-40

(April 2005 Q2a)

Action

Demand

Establish

restaurant ($)

Do not establish

restaurant ($)

Low (0.2)

-15,000

Moderate (0.5)

20,000

High (0.3)

60,000

Week 13-41

(April 2005 Q2a)

i.

for both actions.

ii. Compute the expected opportunity loss (EOL)

for both actions.

iii. Calculate the return-to-risk for establishing

this restaurant.

iv. Based on the results of (i) or (ii) and (iii),

should the manager establish this restaurant?

Why?

Week 13-42

(April 2005 Q2a)

+ (0.3)(60,000) = $ 25,000

EMV (no restaurant) = $ 0

Week 13-43

(April 2005 Q2a)

Opportunity Loss Table

Action

Demand

Establish

restaurant ($)

Do not establish

restaurant ($)

Low (0.2)

15,000

Moderate (0.5)

20,000

High (0.3)

60,000

Week 13-44

(April 2005 Q2a)

(0.3)(0) = $ 3,000

EOL (no restaurant) = (0. 2)(0) + (0.5)(20,000) +

(0.3)(60,000) = $ 28,000

Week 13-45

(April 2005 Q2a)

(iii) Return-to-risk, RRR =

EMVi

i

Restaurant

0.2(15000 25000) 2

No Restaurant

= $0

= + 0.5(20000 25000) 2

+ 0.3(60000 25000) 2

= $26,457.51

Week 13-46

(April 2005 Q2a)

Restaurant

No Restaurant

25000

RRR =

= 0.9449

26457.51

RRR = 0

should establish a restaurant in Sungai Long.

Week 13-47

Summary

Described the payoff table and decision trees

Opportunity loss

Expected monetary value

Expected opportunity loss

Return to risk ratio

value of perfect information

Discussed decision making with sample

information

Addressed the concept of utility

Week 13-48

- Psychology Decision MakingUploaded bytomasbrabec
- Decision MakingUploaded bytopherski
- Business Economic and Managerial Decision MakingUploaded byNajeeb Khan
- The Oxford Handbook of Organizational Decision Making2Uploaded byBojan Georgievski
- Decision MakingUploaded byRahul Mandal
- Decision MakingUploaded byHamaad Tariq
- Systematically Irrational Decision Making: An Evaluation of Decision Making Competence of Technical Experts and Decision Makers at Scania R&DUploaded bySaheer Sayyed
- The Secrets of Wise Decision MakingUploaded bysuman_94103
- Chapter 11Uploaded byEkta Saraswat Vig
- Inventories and COGSUploaded byJek
- How We DecideUploaded byrkrish67
- Kahneman, Klein - 2009 - Conditions for Intuitive Expertise a Failure to DisagreeUploaded bygreen_alien
- Problem Solving and Decision MakingUploaded bykamranali
- Working MindsUploaded byDaniela Mendes Boechat
- 0 Deborah Stone Policy Paradox the Art of Political Decision MakingUploaded bynik mart
- Quantitative Analysis -1 (Problems)QA ProblemsUploaded byKenneth Rono
- Decision Making Final DraftUploaded byRohan Sharma
- Decision MakingUploaded byshubhugupta1992
- Decision Analysis for the ProfessionalUploaded byEnhbilguun
- Extendable Rationality - Understanding Decision Making in Organizations (Organizational Change and Innovation)Uploaded byin_angel03
- McKinsey Quarterly_ the Onl..Uploaded byzigbee1976
- ch04Uploaded byShaiful Hussain
- Judgement and Decision MakingUploaded byanasmbr
- Gigerenzer & Gaissmaier (2011) Heuristic Decision MakingUploaded byPablo Camacho Lazarraga
- Developing Decision-Making Skills for BusinessUploaded byhutsup
- Decision Making Problem SolvingUploaded bywaleedjutt
- Ch 1 [Www.jamaa Bzu.com]Uploaded byBayan Sharif
- 32761435 Theory of Financial Decision MakingUploaded byMikkel Eliasen
- Complex Decision MakingUploaded byRasha Abduldaiem Elmalik

- Taleb TextUploaded byFabian Harris
- 8. %E0%B8%9B%E0%B8%A3%E0%B8%B0%E0%B8%97%E0%B8%B1%E0%B8%9A%E0%B9%83%E0%B8%88Uploaded byIrwan Suirwan
- e2Uploaded byarimadayo
- The T-TestUploaded byRoxane Rivera
- IntroductionUploaded byRenee San Gabriel
- SpcUploaded byprateek gandhi
- A Beginner's Notes on Bayesian Econometrics (Art)Uploaded byamerd
- Machine Learning: ProjectUploaded bygp_peixoto
- Practitioner Notes 6Uploaded bySmita Gaikwad
- Hayashi Econometrics Ch 2 Sec 3-6 Executive SummaryUploaded bysilvio de paula
- Homework 7 SolutionsUploaded byEric Yan
- JASA2007Uploaded byLakshmi Seth
- weaam_-_215_lectures_-_print6Uploaded byJia Syuen
- Probability & Random Process QBUploaded bywizardvenkat
- Excel Regression ToolsUploaded byruperto99
- econometrics_I definitions , theorems and factsUploaded byshere0002923
- Rancob PhiaUploaded byHans Kristian Akar
- SemUploaded byUmar Ghani
- Anexo 03_VW_10130Uploaded byJosé María Moreno
- AbstractUploaded byHery Apha's
- 12-Maths-Exemplar-Chapter-13.pdfUploaded byMohammed Irshad
- Flach Roc AnalysisUploaded byAnonymous PsEz5kGVae
- CivilUploaded byarunveeramany3717
- 5620- T2R-F14Uploaded byLibyaFlower
- Work SamplingUploaded byrkhurana00727
- MKT 367 - Statistical Testing - Student NotesUploaded bypujarze2
- Rhemtulla_2012.pdfUploaded byLyly Magnan
- Output Analisa DistribusiUploaded byZahra Muslimah-Nuryati Zahra
- ch04b.pptUploaded byPamelaIride
- Information Theory, Coding and Cryptography Unit-1 by Arun Pratap SinghUploaded byArunPratapSingh