Decision & Game Theory

Chapter 4: Decision Analysis under Risk with

Additional Information

Sonia REBAI
Tunis Business School
University of Tunis
• In a risky environment, the probability distribution of the states of
nature plays an important role in the choice of the optimal decision.

• DMs have preliminary or prior probability assessments that are the

best values available at that time.

• It would then be of importance to seek additional information before

making a final decision.

• This new information can be used to revise or update the prior

probabilities so that the final decision is based on more accurate
probabilities.
• The revised probabilities are called posterior probabilities.
• Most often, additional information is obtained through experiments, a
consulting advice, or a forecast.
• Such information is usually acquired at some cost. The question is
whether the cost paid is worth.

• To answer this question we need to calculate the Expected Value of the

additional information.
Example 1
A company has the choice between producing itself or buying from a supplier
one of the electronic components that it uses in its activity. Net profit depends
on the level of demand for the product requiring this component. This
demand can be low, medium or high. The a priori distribution is estimated at
0.35; 0.35 and 0.30.
S1 S2 S3
Low Demand Medium Demand High Demand
Produce -20 40 100
buy 10 45 70 4
The company has the opportunity to test the demand on the market. Two
results are possible for this test favorable (F) or unfavorable (U). The
following conditional probabilities were estimated:

S1 S2 S3
Favorable P(F|S1)=0.10 P(F|S2)=0.40 P(F|S3)=0.60
Unfavorable P(U|S1)=0.90 P(U|S2)=0.60 P(U|S3)=0.40

Find the optimal strategy to adopt.

5
 S1 -20
e S2 40
u c
Pr od S3 100
S1 10

F
Buy S2 45
S3 70
S1 -20
e S2
duc 40
ey

Pr o S3
v

U 100
Sur

S1 10
Buy S2 45
S3 70
No S1 -20
Su S2
r ve Produce 40
y S3 100
Bu S1
y 10
S2 45
S3 70
Bayes’ theorem

Si: State of Nature (i = 1, …, n)

P(Si): Prior Probability

Ij: Professional Information (Experiment)( j = 1, …, n)

P(Ij | Si): Conditional Probability

P(IjÇSi) = P(SiÇIj): Joint Probability

P(Si | Ij): Posterior Probability

P(Si Ç I j ) P( I j | Si ) P(Si )
P(Si | Ij) = =
P( I j ) n
å P( I j | Si ) P(Si )
i =1
 S1 S2 S3 The
P(S1│“.”) P(S2│“.”) P(S3│“.”)
0.35 0.35 0.30 sum

F 0.1 0.4 0.6 0.035 0.14 0.18 0.355 0.09859 0.39437 0.50704

U 0.9 0.6 0.4 0.315 0.21 0.12 0.645 0.48837 0.32558 0.18605

8
 64.51 S1 (0.09859) -20
S2 (0.39437)
40
u ce S3 (0.50704)
d 100
64,51 Pro
F (0.355) S1 (0.09859) 10
54.23
43.90 S2 (0.39437) 45
Buy S3 (0.50704) 70
U S1 (0.48837)
(0. 21.86 -20
6 45
ve y
) e S2 (0.32558)
c 40
32,56 Produ S3 (0.18605) 100
S ur

32.56 S1 (0.48837) 10
Buy S2 (0.32558)
43.90 45
S3 (0.18605) 70
S1(0.35)
37 -20
No S2(0.35)
e
Su 40.25 Produc 40
rve S3(0.30)
y 100
S1(0.35) 10
Bu 40.25
y S2(0.35) 45
S3(0.30) 70
• Thus, the optimal strategy is to perform the survey, if the result of
the survey is favorable then the company should produce the
product, however, if the result is unfavorable, the company should
buy the product.

• EVII = 43.90 – 40.25 = 3.65

• So if the cost paid for this information is less than 3.65, it will be
worthy to acquire. Otherwise, the information will be worthless.
• Additional information reduces risk in decision making. It can in some
extreme situations completely remove the risk and provide a certainty
environment. In General, such information is very expensive.

• How to evaluate the value of perfect information (EVPI)?

• The idea behind EVPI is that if the state of nature that will occur is
known with certainty, then the best alternative can be determined
with certainty as well.
• The value of EPVI is just simply the expected value under certainty minus the

expected value under uncertainty.

EVPI = Expected Payoff - Expected payoff
under Certainty with no information

• To compute the expected value under certainty simply take the best payoff

under each state of nature and multiply it by its prior probability and sum

these.

• EVPI places an upper bound on what one would pay for additional information.
• Expected Payoff under certainty = 10*0.35+45*0.35+100*0.30 = 49.25

• EVPI = 49.25 – 40.25 = 9

• This means that we should not be willing to pay more than 9.

• The Efficiency of the imperfect information is the ratio of EVII to EVPI.

• As the EVPI provides an upper bound for the EVII, efficiency is always a
number between 0 and 1.

• The efficiency of the survey = EVII/EVPI = (3.65)/(9) = 40.556%

Example 2: Marketing a new product

Assume that a feasibility study at Getz company of a new product led to

encouraging the introduction of this product to the market. The management
of Getz is not sure whether a large plant or a small one should be built to
manufacture the product. The relevant data is presented in the table below.

1. A marketing research company requests $65000 for a perfect information.

How much does this information worth?
 15

(0.5) (0.5)
Favorable market Unfavorable market
Construct a large plant $200,000 -$180,000
Construct a small plant $100,000 -$20,000
Do nothing $0 $0

2. Getz has the possibility to conduct a survey for $10,000. The survey will result in
a positive or a negative report. Past experience shows that given a favorable
market, there is 0.7 chance of a positive report and a 0.2 chance of a positive
report under unfavorable market. What should be the optimal strategy of the
company?
3. Calculate the efficiency of the survey
 16

(0.5) (0.5)
EMV
Favorable market Unfavorable market
Construct a
$200,000 -$180,000 $10,000
large plant
Construct a
$100,000 -$20,000 $40,000
small plant
Do nothing $0 $0 $0

1. EVPI = Expected Value Under Certainty - Max(EMV)

= ($200,000*0.50 + 0*0.50) - $40,000
= $100,000 - $40,000 = $60,000
So Getz should not be willing to pay more than $60,000
2. Posterior distribution calculations

States FAV UNF The P(FAV│ “.”) P(UNF│ “.”)

0.5 0.5 sum
Survey
Positive 0.7 0.2 0.35 0.10 0.45 0.78 0.22
Negative 0.3 0.8 0.15 0.40 0.55 0.27 0.73
 25

1st decision point 2nd decision point $106,400 Fav. Mkt (0.78)
$190,000

plant
2 Unfav. Mkt (0.22)

$106,400
-$190,000
La r ge
Small $63,600 Fav. Mkt (0.78) $90,000

R es. ) No
plant 3 Unfav. Mkt (0.22) -$30,000
r. 5 pla
Su s. (.4 nt -$10,000
$49,200 Po
-$87,400 Fav. Mkt (0.27)
1 $190,000
S ur
Neg . Res. 4 Unfav. Mkt (0.73)
plant -$190,000

y
. (.5 ar ge

Surve
L

$2,400
5) $2,400 Fav. Mkt (0.27)
Small $90,000
No plant 5 Unfav. Mkt (0.73) -$30,000
$49,200
pla
nt -$10,000
$10,000 Fav. Mkt (0.5)
No
s urv $200,000
ey t 6 Unfav. Mkt (0.5)
e plan -$180,000

$40,000
Larg Sm $40,000 Fav. Mkt (0.5)
all $100,000
No p pl ant 7 Unfav. Mkt (0.5)
-$20,000
lant
$0

Hence, if the survey results are favorable, the company should build a large
plant. However, if they are unfavorable, it should build a small plant.
The efficiency of the survey = EVII/EVPI = (19,200)/(60,000) = 32%
Example 3: Texaco vs. Pennzoil

In early 1984, Pennzoil and Getty Oil agreed to the terms of a merger. But

before any formal documents could be signed, Texaco offered Getty a

substantially better price, and Gordon Getty, who controlled most of the

Getty stock, reneged on the Pennzoil deal and sold to Texaco. Naturally,

Pennzoil felt as if it had been dealt with unfairly and immediately filed a

lawsuit against Texaco alleging that Texaco had interfered illegally in the

Pennzoil-Getty negotiations.
Pennzoil won the case; in late 1985, it was awarded $11.1 billion, the largest
judgment ever in the United States at that time. A Texas appeals court
reduced the judgment by $2 billion, but interest and penalties drove the total
back up to $10.3 billion. James Kinnear, Texaco’s chief executive officer, had
said that Texaco would file for bankruptcy if Pennzoil obtained court
permission to secure the judgment by filing liens against Texaco’s assets.
Furthermore, Kinnear had promised to fight the case all the way to the U.S.
Supreme Court if necessary, arguing in part that Pennzoil had not followed
Security and Exchange Commission regulations in its negotiations with Getty.
In April 1987, just before Pennzoil began to file the liens, Texaco offered to
pay Pennzoil $2 billion to settle the entire case. Hugh Liedtke, chairman of
Pennzoil, indicated that his advisors were telling him that a settlement
between $3 and $5 billion would be fair.

What do you think Liedtke should do? Should he accept the offer of $2
billion, or should he refuse and make a firm counteroffer? If he refuses the
sure $2 billion, he faces a risky situation. Texaco might agree to pay $5 billion,
a reasonable amount in Liedtke’s mind. If he counteroffered $5 billion as a
settlement amount, perhaps Texaco would counter with $3 billion or simply
pursue further appeals.
Below is a decision tree that shows a simplified version of Liedtke’ s
problem.
Experts expect that the Supreme Court will keep the fine with only 20%
chance, will reduce it to $5 billion with 50% chance or will eliminate it
completely with a 30% chance.
It was also believed that Texaco accepts a counter-offer of $5 billion with
1/6 chance and would place a counter-offer of $3 billion with 1/3 chance.
1. Find the optimal strategy.
2. Calculate the EVPI regarding Texaco’s reaction to a counteroffer of $5
billion? Can you explain this result intuitively?
3. The timing of information acquisition may make a difference.

a. suppose that Penzoil could obtain information about the final court
decision before making his current decision (taking the $2 billion or
counteroffer $5 billion). What would be the EVPI of this information?

b. Suppose that Penzoil knew that it would be able to obtain perfect

information only after it has made its current decision but before it
would have to respond to a potential Texaco counteroffer of $3 billion.
What would be the EVPI in this case?
4. In question 3, EVPI for (b) should be less than EVPI calculated in (a). Can
you explain why?

5. What is EVPI if Liedtke can learn both Texaco’s reaction and the final
court decision before he makes up his mind about the current $2 billion
offer? Can you explain why the interaction of the two bits of information
should have this effect?