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# Week 13

Decision Making

Week 13-1

## Week 13 - Learning Objectives

 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

## Steps in Decision Making

 List Alternative Courses of Action (Options)
 Choices or actions

##  List Uncertain Events

 Possible events or outcomes

 Determine Payoffs
 Associate a Payoff with Each Event/Outcome combination

##  Adopt Decision Criteria

 Evaluate Criteria for Selecting the Best Course of Action
(Option)

Week 13-3

## List Possible Actions (Options) and

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

## Opportunity Loss Table

(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

## Opportunity Loss in \$1,000s

(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)

##  The Minimum Coefficient

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

## Common Decision Criteria

 Based on Expected Monetary Value (EMV)
 Choose the maximum expected profit for taking
action Aj.

##  Based on Expected Opportunity Loss (EOL)

 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

## Expected Monetary Value

Solution
Goal: Maximize expected value

##  The expected monetary value is the weighted

average payoff, given specified probabilities
for each event
N

EMV( j) = x ijPi
i=1

## Where EMV(j) = expected monetary value of action j

xij = payoff for action j when event i occurs
Pi = probability of event i
Week 13-11

Solution
(continued)

##  The expected value is the weighted average

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)

## Goal: Maximize expected value

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

## Decision Tree Analysis

 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

## Add Probabilities and Payoffs

(continued)
Strong Economy (0.3) 200

Large factory

Weak Economy

(0.2) -120

Average factory

Decision
Small factory

50

90

## Stable Economy (0.5) 120

Weak Economy (0.2) -30
Strong Economy (0.3)

40

## Stable Economy (0.5)

30

Weak Economy

(0.2)

20

Uncertain Events
Probabilities Payoffs
Week 13-15

## Fold Back the Tree

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

Large factory

## Strong Economy (0.3) 200

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

## Stable Economy (0.5) 120

Weak Economy (0.2) -30
Strong Economy (0.3)

40

30

Weak Economy

(0.2)

20

Week 13-16

EV=61

Large factory

## Strong Economy (0.3) 200

Stable Economy (0.5)
Weak Economy

EV=81

Average factory

EV=31

Small factory

50

(0.2) -120

90

## Stable Economy (0.5) 120

Weak Economy (0.2) -30
Strong Economy (0.3)

40

30

Weak Economy

(0.2)

Maximum
EMV=81

20

Week 13-17

## Expected Opportunity Loss

Solution
Goal: Minimize expected opportunity loss

##  The expected opportunity loss is the weighted

average loss, given specified probabilities for
each event
N

EOL( j) = L ijPi
i=1

## Where EOL(j) = expected monetary value of action j

Lij = opp. loss for action j when event i occurs
Pi = probability of event i
Week 13-18

## Expected Opportunity Loss

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

## The Value of Information

 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)

## (EVPI is equal to the minimum expected

opportunity loss ( from the best decision)

Week 13-20

## Expected Profit Under Certainty

 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

## Example: Best decision

given Strong Economy is
Large factory
Week 13-21

## Expected Profit Under Certainty

(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

## The Value of Information Solution

Expected Value of Perfect Information (EVPI)
EVPI = Expected monetary value under certainty
Expected monetary value under uncertainty (the best
alternative)
Recall:

## Expected profit under certainty = 124

EMV is maximized by choosing Average factory,
where EMV = 81

so:

EVPI = 124 81
= 43

## (EVPI is the maximum amount of value that you would be

willing to spend to obtain perfect information)
Week 13-23

## Accounting for Variability

is the standard deviation for certain option.

Min CV j =

j
EMV j

100%

Week 13-24

(continued)

Example:

## Consider the choice of Stock A vs. Stock B

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)

## Calculate the variance and standard deviation for

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 (RRR)

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

## You might want to consider Stock B if you dont

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

##  Permits revising old

probabilities based on new
information

New
Information
Revised
Probability

Week 13-30

## Bayes Theorem for the

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

## E2 = weak economy = 0.30

P(F1 | E1) = 0.90

## P(F1 | E2) = 0.30

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

## Accounting for Variability with

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

## Accounting for Variability with

Revised Probabilities
(continued)

## The coefficient of variation for each stock using the

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

## Return-to-Risk Ratio with

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

## Past Year Question

(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

## Past Year Question

(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.

## Calculate the expected monetary value (EMV)

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)

## (i) EMV (restaurant) = (0.2)(-15,000) + (0.5)(20,000)

+ (0.3)(60,000) = \$ 25,000
EMV (no restaurant) = \$ 0

Week 13-43

## Past Year Question

(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)

## (ii) EOL (restaurant) = (0.2)(15,000) + (0.5)(0) +

(0.3)(0) = \$ 3,000
EOL (no restaurant) = (0. 2)(0) + (0.5)(20,000) +
(0.3)(60,000) = \$ 28,000

Week 13-45

## Past Year Question

(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

## (iv) Based on EMV, EOL and RRR, the manager

should establish a restaurant in Sungai Long.

Week 13-47

Summary
 Described the payoff table and decision trees
 Opportunity loss

##  Provided criteria for decision making

 Expected monetary value
 Expected opportunity loss
 Return to risk ratio

##  Introduced expected profit under certainty and the

value of perfect information
 Discussed decision making with sample
information
 Addressed the concept of utility
Week 13-48