The option to Buy Perfect Information

In the preceding example, it was illustrated how the president of YDM used the decision theory to analyze the
company’s problem. The president in this case operates in an environment of risk, since probabilities are involved in the
analysis.
Suppose that another company, the GREAT Corporation sells an information about the Traditional and Modern
Methods of developing the product. The Great Corporation has done research on the two methods of development and
information it will give to YDM is 100% certain. It will inform the president whether only the “ Modern, only the
Traditional, both methods or neither of them can be successful.
For the purpose of estimating the reasonable cost of the information, let us indicate in the tree diagram, the option
to buy the perfect information and the total possibilities that may happen in buying the information.
Neither .12 ( -500 )

Y Traditional only .28 (4350)

A To purchase X buy the info 3759 Modern only .18 (4300)

the patent do not buy B either .42 ( 4350)

DO NOT purchase 2850 modern C success .6 4300

2300 Failure .4 -700

Traditional D success .7 4350

2850
failure .3 -650

To indicate the option to buy the perfect information, add another decision point after the branch “ to purchase the
patent”. Let this be position X.

If the company decides not to buy the information the branch goes to the old decision situations ( lower
branch). If it decides to but the perfect information, there are 4 possibilities: it can be that neither method is successful ,
only the Traditional Method should be successful, only the Modern Method, or both could be successful. If both are
successful , select the one having a higher financial value.

Determining the Probabilities of Events with Perfect Information

The values of probabilities can be determined by the following process:

Neither can succeed = product of probability of failures

= ( . 4 ) ( .3 ) = .12

Either can succeed = product of probability of success

= ( .6 ) ( .7) = .42

Traditional only = success of traditional times failure of modern

= ( .7 ) ( .4 ) = .28

Modern only = probability of success of modern, times failure of traditional

= ( .6 ) (.3) = .18

*Note that the total probability is =1 (.12+.42+.28+.18 = 1.00)

Computing for the Value of Perfect Information

First compute for the expected value of events with perfect information.

EV= .12 ( -500) + .28 ( 4350) + .18 (4300) + .42(4350) = P 3759.00 thousands ( this is the expected value with
perfect information)

Hence P P3759.00 is indicated in position Y.

To compute for the amount to pay for the perfect information, subtract the EV without the perfect information, from
the expected value with perfect information.

3759 – 2850 = 909 thousand (this is the value of the perfect information). IF YDM decides to buy the information,
the price should not exceed P 909,000.00.