An Introduction to Decision Theory web only Chapter

An Introduction to Decision Theory (web only) Chapter 20 Copyright © 2015 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Learning Objectives n n n n LO 20 -1 Identify and apply the three components of a decision. LO 20 -2 Analyze a decision using expected monetary value. LO 20 -3 Analyze a decision using opportunity loss. LO 20 -4 Apply maximin, maximax, and minimax regret strategies to make a decision. LO 20 -5 Compute and explain the expected value of perfect information. LO 20 -6 Apply sensitivity analysis to evaluate a decision subject to uncertainty. LO 20 -7 Use a decision tree to illustrate and analyze decision making under uncertainty. 20 -2

LO 20 -1 Identify and apply the three components of a decision. Elements of a Decision There are three components to any decisionmaking situation: 1. 2. 3. The available choices (alternatives or acts). The states of nature, which are not under the control of the decision maker - uncontrollable future events. The payoffs - needed for each combination of decision alternative and state of nature. 20 -3

LO 20 -1 Statistical Decision Theory n Classical statistics focuses on estimating a population parameter, such as the population mean, and constructing confidence intervals, or testing hypotheses to make inferences about the population. n Statistical Decision Theory evaluates a set of alternatives and selects the best decision alternative based on a selected criterion or basis. 20 -4

LO 20 -1 Decision Making 20 -5

LO 20 -2 Analyze a decision using expected monetary value. Payoff Table and Expected Payoff n A Payoff Table is a listing of all possible combinations of decision alternatives and states of nature, and the payoffs for each combination. n The Expected Payoff or the Expected Monetary Value (EMV) is the expected value for each decision. 20 -6

LO 20 -2 Calculating the EMV n n Let Ai be the ith decision alternative. Let P(Sj) be the probability of the jth state of nature. Let V(Ai, Sj) be the value of the payoff for the combination of decision alternative Ai and state of nature Sj. Let EMV (Ai) be the expected monetary value for the decision alternative Ai. 20 -7

LO 20 -2 Decision Making Under Conditions of Uncertainty - Example Bob Hill, a small investor, has $1, 100 to invest. His choices are Kayser Chemicals, Rim Homes, and Texas Electronics. He estimated that, if his $1, 100 were invested in Kayser Chemicals and a strong bull market developed by the end of the year (that is, stock prices increased drastically), the value of his Kayser stock would more than double, to $2, 400. However, if there were a bear market (i. e. , stock prices declined), the value of his Kayser stock could conceivably drop to $1, 000 by the end of the year. His predictions regarding the value of his $1, 100 investment for the three stocks for a bull market and for a bear market are shown below. A study of historical records revealed that during the past 10 years stock market prices increased six times and declined only four times. According to this information, the probability of a market rise is. 60 and the probability of a market decline is. 40. 20 -8

LO 20 -2 Expected Monetary Value (EMV)Example (A 1)=(. 6)($2, 400)+(. 4)($1, 000) =$1, 840 (A 2)=(. 6)($2, 400)+(. 4)($1, 000) =$1, 760 (A 3)=(. 6)($2, 400)+(. 4)($1, 000) =$1, 600 20 -9

LO 20 -3 Analyze a decision using opportunity loss. Opportunity Loss or Regret is another criterion for evaluating and selecting a decision alternative. It is based on the concept of opportunity costs or buyers regret. n Opportunity loss is computed by taking the difference between the payoff of the best decision for each state of nature and payoff for each of the other decision alternatives. 20 -10

LO 20 -3 Expected Opportunity Loss 20 -11

LO 20 -3 Opportunity Loss - Example Opportunity Loss when Market Rises Kayser: $2, 400 - $2, 400= $0 Rim Homes: $2, 400 - $2, 200 = $200 Texas Electronics: $2, 400 - $1, 900 = $500 Opportunity Loss when Market Declines Kayser: $1, 150 - $1, 000= $150 Rim Homes: $1, 150 - $1, 100 = $50 Texas Electronics: $1, 150 - $1, 150 = $0 20 -12

LO 20 -3 Opportunity Loss - Example (A 1)=(. 6)($0)+(. 4)($150) =$60 (A 2)=(. 6)($200)+(. 4)($50) =$140 (A 3)=(. 6)($500)+(. 4)($0) =$300 20 -13

LO 20 -4 Apply maximin, maximax, and minimax regret strategies to make a decision. Maximin, Maximax, and Minimax Regret Strategies to Evaluate Decision Alternatives Maximin strategy selects the alternative that maximizes the minimum gain. It is a pessimistic or conservative strategy. Maximax strategy selects the alternative that maximizes the maximum gain. It is an optimistic strategy. Minimax regret strategy selects the alternative that minimizes the maximum regret (opportunity loss). 20 -14

LO 20 -4 Maximin, Maximax, and Minimax Regret Strategies Payoff Table Maximin 1, 000 1, 150 Maximax 2, 400 2, 200 1, 900 Opportunity Loss Table Minimax Regret 150 200 500 20 -15

LO 20 -5 Compute and explain the expected value of perfect information. Value of Perfect Information What is the worth of additional information when making a decision based on Expected Monetary Value? Expected Value of Perfect Information (EVPI) is the difference between the expected payoff if the state of nature were known and the best decision under the conditions of uncertainty. 20 -16

LO 20 -5 EVPI Example Step 1: Computing Expected value under conditions of certainty. Expected Value Under Certainty 20 -17

LO 20 -5 EVPI Example Step 2: Compute the Expected Value Under Uncertainty Step 3: Subtract the Expected Value Under Uncertainty from the Expected Value Under Certainty 20 -18

LO 20 -6 Apply sensitivity analysis to evaluate a decision subject to uncertainty. Sensitivity Analysis n Sensitivity Analysis examines the effects of various probabilities for the states of nature on the expected values for the decision alternatives. n Decision Trees are useful for structuring the various alternatives. They present a picture of the various courses of action and the possible states of nature. 20 -19

LO 20 -6 Sensitivity Analysis Conclusion: Based on EMV, the decision is to purchase Kayser Chemicals regardless of the three sets of probabilities. 20 -20

LO 20 -7 Use a decision tree to illustrate and analyze decision making under uncertainty. Decision Tree A decision tree is a picture of all the possible courses of action and the consequent possible outcomes. ¨A box is used to indicate the point at which a decision must be made. ¨The branches going out from the box indicate the alternatives under consideration 20 -21

LO 20 -7 Decision Tree Example $2, 400 20 -22