DA Lecture - 5

AP / ADMS 3300
DECISION ANALYSIS
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Week 5
Chapter 8
Subjective Probability
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In Last lecture we covered
What is Sensitivity Analysis?
One-Way Sensitivity Analysis
Tornado Diagrams
Two way Sensitivity Analysis
Sensitivity to Probabilities
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Lecture 5 Objectives
 Subjective Probability. What is it? Why do we need it?
 Assessing Subjective Probabilities
 Assessing Discrete Probabilities
 Direct Method
 Betting Strategies
 Reference Lotteries
 Assessing Continuous Probabilities
 Reference Lottery
 Fractile Method
 Using Continuous CDF􀁠s in Decision Trees
 Pitfalls: Heuristics and Biases
 Experts and Probability Assessment: Putting It All Together
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Objective

Probability
An event or a random event is simply a collection of
possible happenings or scenarios.
Objective probabilities are a more accurate way to
determine probabilities than observations based on
subjective measures, such as personal estimates.
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Objective Probability
An event occurs if one of those scenarios actually
occurs.
For example, the event that a die lands ‘even’ is the
collection of three possible scenarios:
 The die is thrown and it lands ‘two’
 The die is thrown and it lands ‘four’
 The die is thrown and it lands ‘six’
 How many events do we have when we throw a die?
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ALittle Probability Theory
Three requirements:
 Probabilities must be between 0 and 1
 Probabilities must add up
 Total probability must equal 1
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Subjective Probability
Subjective assessments of uncertainty are an
important element of decision analysis.
A basic tenet of modern decision analysis is that
subjective judgments of uncertainty can be made in
terms of probability. In this session we will explore
how to make such judgments and what they imply.
Decision makers who face uncertain prospects
often gather information with the intention of
reducing uncertainty. We will learn the principles
behind information valuation.
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Subjective

Probability
In modern decision analysis subjective judgments of
uncertainty can be made in terms of probability.
Need to develop a approach to measure the
uncertainty that we feel.
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Probability: A Subjective
Interpretation
Many public policy issues and decisions involve
probabilities, often a mix of formal (e.g., computer
models) and subjective (e.g., verbal statements such as
“likely” or “rarely”) probability assessments.
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Uncertainty and Public Policy
Fruit Frost, Farmers occasionally must decide whether to
protect a crop from potentially damaging frost.
Decision must be made in terms of probability
Earthquake Prediction, Geologists are beginning to
develop ways to assess the probability of major
earthquakes.
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Environment Impact Statements, like global warming and
public policies on fuels
Require assessments of the risks assessments of the risks
associated with proposed projects.
Projects involving pesticides and herbicides, the chances
of cancer and other health risks are assessed.
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Public Policy and Scientific Research
Scientists learn of the possible presence of conditions that
may require action by the government.
Medical Diagnosis
Many physicians in hospital intensive-care units (ICUs)
have access to a complex computer system known as
APACHE III.
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APACHE III (Acute Physiology, Age, and Chronic Health
Evaluation).
APACHE III evaluates the patient’s risk as a probability of
dying either in the ICU or later in the hospital.
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Interpretation
Probability theory may be presented in different ways.
In terms of long-run frequencies, e.g., tossing a coin
 This approach is most useful for events that recur often and
have not yet happened, e.g., gabling with cards or stock
prices.
In terms of subjective judgments or degrees of belief
 This approach is most useful for rare or unique events or
events that have already happened, e.g., nuclear war or
Marilyn Monroe’s death in 1962.
Interpretation
If decision analysis is to be precise and rigorous, it
must operate with numbers, not verbal phrases, for
probabilities.
Calculations require some type of quantification.
Also, verbal representations of uncertainty are subject
to varied interpretations depending on people and
contexts.
Example: Accounting for Contingent Losses
Statement of Financial Accounting Standards No. 5,
“Accounting for Contingencies,” provides guidance
to companies on reporting various kinds of losses
that might happen. They are to be reported as
“probable,” “remote,” or “reasonably possible.”
These terms in turn are defined verbally, e.g.,
“probable” means “likely to occur.” Defining such
terms verbally instead of numerically allows for a
wide range of interpretations by those doing the
reporting (companies) and those interpreting the
reports (e.g., accountants, analysts, stockholders,
etc.).
Probability: A Subjective Interpretation
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 Direct Method
 Fractile Method
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Assessing Discrete Probabilities
There are three basic methods for assessing
probabilities:
Method #1 – Directly as the probability of an event
occurring
Method #2 – Indirectly as placing a bet
Method #3 – Indirectly as a comparison of two
lotteries, one for the event in question, the other as a
benchmark.
Method #1: As Probabilities
Simply ask the decision maker to assess the
probability directly
“What is your belief regarding the probability that event
such and such will occur?”
Disadvantages of this method:
May or may not be able or willing to give a direct
answer to the question
May place little confidence in the answer given
Method #1: Lakers Example
Suppose that the Los Angeles Lakers are playing the
Boston Celtics in the NBA finals this year.
We are interested in finding the decision maker’s
probability that the Lakers will win the championship.
Using Method #1 directly ask, “What do you think are
the chances of the Lakers winning?”
Method #2: As Bets
Ask about bets that the person would be willing to place
Find a bet with a specific amount such that the decision
maker is indifferent no matter which side of the bet
wins.
This means that the expected value of the bet is the same
regardless of which side of the bet is taken.
 Now solve for the probability.

Some people don’t like betting out of principle.
People as risk averse – they value a loss higher than an
equivalent win. This will skew any bets.
Method #2: Lakers Example
Continuing with the Lakers vs. the Celtics
Set up a general framework in which the two sides of a
bet are opposites
Assessing Subjective Discrete Probabilities:
Betting Strategies
Event: Lakers winning the NBA title this season
Step 1: Offer the decision maker to choose between the
following two bets, where X=100 and Y=0
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Betting Strategies
Step 2: Offer the decision maker to choose between the following
two bets, where X=0 and Y=100 (Consistency Check!)
• This is to make sure that the decision maker is not a fanatic supporter of
Lakers!!
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Betting Strategies
Step 3: Offer the decision maker (DM) to choose between the
• At this point, the DM’s choice tells you whether s/he is thinking
Lakers has a a greater than or less than 50% chance of winning the
title! How!!
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Betting Strategies
 If the decision maker prefers to bet for Lakers, what does this mean? (very
important to understand this!) Let the subjective probability of the DM for
Lakers’ winning the title is p. Calculate the expected profit for both
alternatives (bets)
 EV( Bet for Lakers)=p*100+(1-p)*(-100)=200p-100
 EV(Bet against Lakers)=p*(-100)+(1-p)*100=-200p+100
 If the DM prefers to Bet for Lakers, this means that in her/his mind the
EV for the Bet for Lakers is at least as big as the EV for the Bet against
Lakers. That is,
 200p-100>=-200p+100, and hence p>=200/400=.5
 So, this means that the DM thinks that Lakers has a higher chance of
winning the title than not winning it.
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Betting Strategies
After figuring out this, what we need to do is to make the Bet
for Lakers bet less and less attractive (in terms of possible
profits) until the DM is indifferent between the two Bets.
• How do you do this?
 Decrease X’s value, let’s say make it X=50. Can you see
that picking the Bet for Lakers (LW) is less attractive
than Bet Against Lakers (LL) in terms of the possible
payoffs. This of course depends on the DM’s subjective
probability of LW. If DM thinks that p=.99, s/he will still
prefer to Bet for Lakers. But if in the DM’s mind his/her
probability p=.5, with these new payoffs, which one s/he
should pick?
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Betting Strategies
Step 3: Ask the DM to choose between the same two bets with
this updated X and Y values, that is X=50 and Y=100.
Based on the answer of the DM, continually change the value of

X
and/or Y until the DM is indifferent between the two alternatives.
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Betting Strategies
Assumption: When a person is indifferent between bets the
expected payoffs from the bets must be same.
Thus:
X * P(LW) – Y * P(LL) = -X * P(LW) + Y *P(LL)
X * P(LW) +X * P(LW) = Y *P(LL) + Y * P(LL)
2 * X * P(LW) = 2 * Y *P(LL) [we know P(LW) + P(LL) =1)]
2 * X * P(LW) = 2 * Y *[1 - P(LW)]
X * P(LW) = Y - Y*P(LW)
X * P(LW) + Y*P(LW) = Y
P(LW)[X + Y] = Y
Example : X = 50, Y = 100 then P(LW) = (100 / (50 + 100) = 66.66%
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 Direct Method
 Fractile Method
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Method # 3: As Lotteries
Start with two lotteries with prizes for the person to
compare:
Lottery 1: the event in question
Lottery 2: a lottery (called the reference lottery) with known
probabilities, (p) and (1 – p)
Begin with a wide range in the probabilities and adjust
them until indifference is reached between the two
lotteries
Method # 3: As Lotteries
More difficult to comprehend than the other two
methods.
Some object to the frivolous atmosphere of the set-up
Check for consistency
In all three methods, make sure that the probabilities
you finally arrive at obey the probability laws (Chapter
7)
 For example, that they do not add up to more than 100%
Reference Lotteries
Choose two prizes A and B, such that A >> B, that is A is much better
than B, but B is not a negative prize, just a small treat
In the example below, let A be the Hawaiian Trip and B is a case of
Beer
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Reference Lotteries
 To find the subjective probability of the DM’s LW, call this
probability p.
 We call Lottery 2 as the reference lottery
 DMs might not be Statistics experts and they might have
difficulty to pick among the two lotteries based on some funny
number such as p=.2235. To make sure that the DM answers our
questions in as reasonable way as possible, we should introduce
probability mechanisms, that any DM can understand and relate
to.
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Reference Lotteries
Some understandable Probability Mechanisms are:
 Throwing a fair coin
 Drawing balls from and urn
 Throwing a die
 Using a Wheel of Fortune
For example, we can ask the DM,
 Suppose that we have a wheel of fortune, and p=25% of the wheel
of fortune is painted to green, and the remaining is red. So, one
lottery (Lottery 2, the reference Lottery) is spinning this wheel of
fortune is and if green comes you win the prize A=Hawaiian Trip,
and if Red comes you win the prize B=Case of Beer
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Reference Lotteries
On the other hand, Lottery 1 is as follows: If Lakers win the title
you
win the prize A=Hawaiian Trip, and if Lakers lose you win the
prize
B=Case of Beer. Which of the Lotteries (Lottery 1 or 2) do you
pick?
This is a pretty easy to understand concept for any DM.
And, s/he can pick a lotto among the two. In our case if the DM
picks Lottery 1, what does this mean?
 S/he thinks that Lakers’ winning chances is greater than
25%!!
 Then, increase p to 90% (this number is totally arbitrary) and
ask him/her the same question again. If s/he picks Lottery 2,
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Reference Lotteries
Assumption:
When Indifference Point has been reached
P(LW) = p
Consistency Checking:
Subjective Probabilities must follow the laws of probability
Example:
If expert specifies P(A), P(B|A) and P(A ∩B) then
P(A) * P(B|A) = P(A ∩B)
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Reference Lotteries
 So the strategy is as follows:
1. Specify p1 as your first p value.
2. If Lottery 1 is preferred, change pi to pi+1 > pi
3. If Lottery 2 is preferred, change pi to pi+1 < pi
4. When indifference point is reached STOP, else go to Step 2.
 When indifference is reached the value of p is the DM’s

subjective probability of Lakers’ winning the title.
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 Direct Method
 Fractile Method
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Assessing Continuous
Probabilities
It is always possible to model a decision maker’s
uncertainty using probabilities.
How would this be done in the case of an uncertain but
continuous quantity.
Two strategies for assessing a subjective CDF (Cumulative
Distribution Function).
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Probabilities
Two strategies for assessing a subjective CDF:
1. Using a reference lottery and probability
wheel:
Adjusting the probability in the reference lottery
to assess probability of uncertain value in the
upper lottery.
2. Using the Fractile method:
Fixing the probability in the reference lottery at a
defined probability value and changing the
uncertain value in the upper lottery.
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Probabilities
Example: Movie Star Age
The problem is to derive a probability distribution
representing a probability assessor’s uncertainty
regarding a particular movie star’s age. Several
probabilities are found, and these are transformed into
cumulative probabilities.
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Probabilities
Example: Movie Star Age
A typical cumulative assessment would be to assess
P(Age ≤ a), where a is a particular value. For example,
consider P (Age ≤ 46). A probability wheel can be used
to assess the value of p in the reference lottery of the
following decision tree, until the decision maker is
indifferent at a value of p.
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Probabilities
Fractiles are especially useful for subjective assessments
– they have an intuitive appeal.
A fractile is the general term for a cumulative
probability.
Median – uncertain quantity is as likely above as below
Quartiles (0.25) – probability divided into four parts
Percentiles – based on cumulative percentages
The Fractile Method
Fixing the probability in the reference lottery at a
defined probability value and changing the uncertain
value in the upper lottery.
Decision tree for assessing the 0.35 fractile of a continuous
distribution for X. i.e. P (X ≤ x0.35)=0.35, where x0.35 is the .35 fractile.
 The decision maker`s task is to find x (x0.35 in this case) in
lottery 1 that results in indifference between the two
lotteries where the 0.35 value is fixed in the reference
lottery (the 0.35 fractile).
The 0.35 fractile is approximately 42 years. The remaining fractiles can be seen in
the CDF shown in graph.
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The Median in the Fractile
Method
Decision tree for assessing the Median of the
distribution for the movie star’s age. The assessment
task is to adjust the number of years a in Lottery 1 to
achieve indifference. The median of 0.5 fractile is at age
of 46 years.
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 Direct Method
 Fractile Method
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Using Continuous CDF’s in Decision Trees
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Methods of Discretizing Continuous Distributions
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Extended Pearson – Tukey Method
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Extended Pearson – Tukey Method
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Extended Swanson – Megill Method
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 Direct Method
 Fractile Method
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Pitfalls: Heuristics and Biases
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Individuals tend to under-adjust their initial judgments in
face of uncertainty or randomness.
Anchor and adjustment heuristic: choosing an initial

anchor of some sort and then adjusting – usually
insufficiently – from the anchor
Affects assessing continuous probabilities more than it
affects assessing discrete probabilities
 Direct Method
 Fractile Method
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Experts and Probability
Assessment
Assessment
1. Background: identify those variables for which
expert assessment is needed; assess the
appropriateness of using an expert
2. Identifying and recruiting experts: in-house experts
might be available or an external search is needed
3. Motivating experts: show them that a decision must
be made with the available information; build
rapport and enthusiasm
Assessment
4. Structuring and decomposition: explore the expert’s
understanding of the problem; develop a model of the
expert’s thinking about the problem
5. Probability-assessment training: many experts lack this
training; explain the principles of probability assessment
and allow them to practice; make aware of heuristics and
biases
Assessment
6. Probability elicitation and verification: expert makes the
assessment, which is then checked by someone trained
in probability assessment
7. Aggregating multiple probability distributions: when
using several experts, combine their distribution
assessments into one for use by the decision maker
Suggested Problems and
Readings
Suggest Problems
8.6, 8.7, 8.10, 8.11, 8.12 parts (a) and (c)
We will continue with

 Chapter 7 Probability basics refresher and then
 Ch 12 Value of Information, please read the chapter.
77

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AP / ADMS 3300

Disadvantages of this method:

Based on the answer of the DM, continually change the value of

Example : X = 50, Y = 100 then P(LW) = (100 / (50 + 100) = 66.66%

P(A) * P(B|A) = P(A ∩B)

 When indifference is reached the value of p is the DM’s

Anchor and adjustment heuristic: choosing an initial

We will continue with

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