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Taylor III

Chapter 12 - Decision Analysis 1

Chapter Topics

Components of Decision Making Decision Making without Probabilities Decision Making with Probabilities Decision Analysis with Additional Information

A state of nature is an actual event that may occur in the future.

A payoff table is a means of organizing a decision situation, presenting the payoffs from different decisions given the various states of nature.

Decision situation:

Decision-Making Criteria: maximax, maximin, minimax, minimax regret, Hurwicz, and equal likelihood

Chapter 12 - Decision Analysis 4

In the maximax criterion the decision maker selects the decision that will result in the maximum of maximum payoffs; an optimistic criterion.

Chapter 12 - Decision Analysis 5

In the maximin criterion the decision maker selects the decision that will reflect the maximum of the minimum payoffs; a pessimistic criterion.

Regret is the difference between the payoff from the best decision and all other decision payoffs.

The decision maker attempts to avoid regret by selecting the decision alternative that minimizes the maximum regret.

Chapter 12 - Decision Analysis 7

The Hurwicz criterion is a compromise between the maximax and maximin criterion.

A coefficient of optimism, , is a measure of the decision makers optimism. The Hurwicz criterion multiplies the best payoff by and the worst payoff by 1- ., for each decision, and the best result is selected.

Decision

Apartment building Office building

Values

$ 50,000(0.4) + 30,000(0.6) = 38,000 $ 100,000(0.4) - 40,000(0.6) = 16,000

Warehouse

Chapter 12 - Decision Analysis

8

The equal likelihood (or Laplace) criterion multiplies the decision payoff for each state of nature by an equal weight, thus assuming that the states of nature are equally likely to occur. Decision Apartment building Office building Warehouse Values $50,000(0.5) + 30,000(0.5) = 40,000 $100,000(0.5) - 40,000(0.5) = 30,000 $30,000(0.5) + 10,000(0.5) = 20,000

A dominant decision is one that has a better payoff than another decision under each state of nature.

The appropriate criterion is dependent on the risk personality and philosophy of the decision maker. Criterion Maximax Maximin Minimax regret Hurwicz Equal likelihood

Chapter 12 - Decision Analysis

Decision (Purchase) Office building Apartment building Apartment building Apartment building Apartment building

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Expected value is computed by multiplying each decision outcome under each state of nature by the probability of its occurrence.

Table 12.7 Payoff table with Probabilities for States of Nature

EV(Apartment) = EV(Warehouse) =

Chapter 12 - Decision Analysis

11

The expected opportunity loss is the expected value of the regret for each decision. The expected value and expected opportunity loss criterion result in the same decision.

Table 12.8 Regret (Opportunity Loss) Table with Probabilities for States of Nature

Chapter 12 - Decision Analysis

12

The Expected Value of Perfect Information (EVPI) is the maximum amount a decision maker would pay for additional information.

EVPI equals the expected value given perfect information minus the expected value without perfect information.

EVPI equals the expected opportunity loss (EOL) for the best decision.

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Decision with perfect information: $100,000(0.60) + 30,000(0.40) = $72,000 Decision without perfect information: EV(office) = $100,000(0.60) - 40,000(0.40) = $44,000 EVPI = $72,000 - 44,000 = $28,000 EOL(office) = $0(0.60) + 70,000(0.4) = $28,000

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A decision tree is a diagram consisting of decision nodes, represented as (squares), probability nodes (circles), and decision alternatives (branches).

Chapter 12 - Decision Analysis 16

Chapter 12 - Decision Analysis 17

The expected value is computed at each probability node:

EV(node 2) = 0.60($50,000) + 0.40(30,000) = $42,000

EV(node 4) = 0.60($30,000) + 0.40(10,000) = $22,000

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Figure 12.2 Decision Tree with Expected Value at Probability Nodes Chapter 12 - Decision Analysis 19

Bayesian analysis uses additional information to alter the marginal probability of the occurrence of an event. In real estate investment example, using expected value criterion, best decision was to purchase office building with expected value of $44,000, and EVPI of $28,000.

Table 12.11 Payoff Table for the Real Estate Investment Example

Chapter 12 - Decision Analysis 20

A conditional probability is the probability that an event will occur given that another event has already occurred.

Economic analyst provides additional information for real estate investment decision, forming conditional probabilities:

g = good economic conditions

P = positive economic report N = negative economic report

P(Pg) = 0.80

P(Pp) = 0.10

Chapter 12 - Decision Analysis

P(Ng) = 0.20

P(Np) = 0.90

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A posteria probability is the altered marginal probability of an event based on additional information.

Prior probabilities for good or poor economic conditions in real estate decision: P(g) = 0.60; P(p) = 0.40 Posteria probabilities by Bayes rule:

Posteria (revised) probabilities for decision: P(gN) = 0.250 P(pP) = 0.077 P(pN) = 0.750

Chapter 12 - Decision Analysis 22

Decision Analysis with Additional Information Computing Posterior Probabilities with Tables

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (1 of 4)

Decision tree with posterior probabilities differ from earlier versions in that: Two new branches at beginning of tree represent report outcomes.

probabilities from Bayes rule.

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (2 of 4)

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (3 of 4)

EV (apartment building) = $50,000(0.923) + 30,000(0.077) = $48,460 EV (strategy) = $89,220(0.52) + 35,000(0.48) = $63,194

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Decision Analysis with Additional Information Decision Trees with Posterior Probabilities (4 of 4)

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The expected value of sample information (EVSI) is the

difference between the expected value with and without information:

The efficiency of sample information is the ratio of the expected value of sample information to the expected value of perfect information: efficiency = EVSI /EVPI = $19,194/ 28,000 = .68

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Expected Cost (insurance) = 0.992($500) + 0.008(500) = $500

Decision should be do not purchase insurance, but people almost always do purchase insurance.

Utiles are units of subjective measures of utility. Risk averters forgo a high expected value to avoid a lowprobability disaster. Risk takers take a chance for a bonanza on a very lowprobability event in lieu of a sure thing.

Chapter 12 - Decision Analysis 30

States of Nature Decision Expand Maintain Status Quo Sell now Good Foreign Competitive Conditions $ 800,000 1,300,000 320,000 Poor Foreign Competitive Conditions $ 500,000 -150,000 320,000

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a. Determine the best decision without probabilities using the 5 criteria of the chapter. b. Determine best decision with probabilities assuming 0.70 probability of good conditions, 0.30 of poor conditions. Use expected value and expected opportunity loss criteria. c. Compute expected value of perfect information. d. Develop a decision tree with expected value at the nodes. e. Given following, P(Pg) = 0.70, P(Ng) = 0.30, P(Pp) = 20, P(Np) = 0.80, determine posteria probabilities using Bayes rule. f. Perform a decision tree analysis using the posterior probability obtained in part e.

Chapter 12 - Decision Analysis 32

Step 1 (part a): Determine decisions without probabilities.

Maximax Decision: Maintain status quo Decisions Maximum Payoffs

Decisions Expand Status quo Sell

Chapter 12 - Decision Analysis

Minimum Payoffs $500,000 (maximum) -150,000 320,000

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Minimax Regret Decision: Expand

Decisions Expand Maximum Regrets $500,000 (minimum)

Status quo

Sell

650,000

980,000

Expand

Status quo Sell

$1,300,000(0.3) - 150,000(0.7) = $285,000 $320,000(0.3) + 320,000(0.7) = $320,000

34

Equal Likelihood Decision: Expand

Expand Status quo $800,000(0.5) + 500,000(0.5) = $650,000 $1,300,000(0.5) - 150,000(0.5) = $575,000

Sell

Step 2 (part b): Determine Decisions with EV and EOL. Expected value decision: Maintain status quo

Expand

Status quo Sell

$1,300,000(0.7) - 150,000(0.3) = $865,000 $320,000(0.7) + 320,000(0.3) = $320,000

35

Expected opportunity loss decision: Maintain status quo

Expand Status quo $500,000(0.7) + 0(0.3) = $350,000 0(0.7) + 650,000(0.3) = $195,000

Sell

Step 3 (part c): Compute EVPI. EV given perfect information = 1,300,000(0.7) + 500,000(0.3)

= $1,060,000

EV without perfect information = $1,300,000(0.7) - 150,000(0.3) = $865,000

Chapter 12 - Decision Analysis 36

Step 4 (part d): Develop a decision tree.

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Step 5 (part e): Determine posterior probabilities.

P(gP) = P(Pg) P(g) / [P(Pg) P(g) + P(Pp) P(p)] = (0.70)(0.70)/[(0.70)(0.70) + (0.20)(0.30)] = 0.891 P(pP) = 0.109

= (0.30)(0.70)/[(0.30)(0.70) + (0.80)(0.30)] = 0.467 P(pN) = 0.533

38

Step 6 (part f):

Decision tree analysis.

39

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