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Decision Theory - Part 2

The document discusses decision making under risk and expected monetary value. It covers topics like computing expected value, expected value of perfect information, and minimizing expected opportunity loss. Formulas and examples are provided to demonstrate how to calculate expected monetary values, expected values with and without perfect information, and opportunity losses under different alternatives and states of nature.

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Helaena Ruvie Quitoras Pallaya
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37 views15 pages

Decision Theory - Part 2

The document discusses decision making under risk and expected monetary value. It covers topics like computing expected value, expected value of perfect information, and minimizing expected opportunity loss. Formulas and examples are provided to demonstrate how to calculate expected monetary values, expected values with and without perfect information, and opportunity losses under different alternatives and states of nature.

Uploaded by

Helaena Ruvie Quitoras Pallaya
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Decision Theory

Part II
Decision making under risk
Maximization of Expected
REVIEW: Monetary Value (EMV)
“How much money you can expect
to make from a certain decision.”

Compute for the SUM of the


PRODUCTS of p and X
where: p = probability
X = outcome

Then come up with the best decision


using the computed EMVs.
Expected value of perfect information (Evpi)
✓ How much a decision-maker will pay to know with certainty
which State of Nature will occur.

Assumptions:
1. We assume the information is available.
2. We assume the information is accurate.
3. As long as EVPI is less than the EMV (without information),
the decision-maker will pay for the information

Example: Cost of information for Pareto, Inc. is


P65,000.00. Is this information worth
P65,000.00?
To find evpi:
1. Determine the EMV of the decision alternatives.
2. Find EMV with Perfect Information:
a. Find the highest payoff under each State of Nature
b. Weigh the payoff by the probability of that State of
Nature
c. Get the Sum of the weighted payoffs to find the EMV
with Perfect Information
3. The Difference between EVwPI and EVwoPI is the amount of
that a decision-maker will pay to know the future
Formula: EVPI = EVwPI – max EMV
Where EVwPI is the expected value with perfect information

Example: Cost of information for Pareto, Inc. is


P65,000.00. Is this information worth
P65,000.00?
Step 1. Find for the max EMV

STATES OF NATURE
ALTERNATIVES Favorable Market Unfavorable EMV
(PhP) Market
(PhP)
Construct a large 200,000 (180,000)
new factory 0.5(200,000) 0.5(180,000) 10,000
Construct a small 100,000 (20,000)
New factory 0.5(100,000) 0.5(20,000) 40,000

factory
Do nothing 0 0
0.5(0) 0.5(0) 0
Probabilities (pi) 0.5 0.5
Step 2. Find for the EVwPI
STATES OF NATURE
ALTERNATIVES Favorable Market Unfavorable
(PhP) Market
(PhP)
Construct a large 200,000 (180,000)
new factory 0.5(200,000)
Construct a small 100,000 (20,000)
New factory
Do nothing 0 0

factory
0.5(0)
Probabilities (pi) 0.5 0.5

EVwPI = 0.5(200,000) + 0.5 (0)


= 100,000
Step 3. Find for the EVPI

EVPI = EVwPI – max EMV


= 100,000 – 40,000
= 60,000
Example: Cost of information for Pareto, Inc. is
P65,000.00. Is this information worth
P65,000.00?

Decision: ?
Next topic:
Minimization of Expected
Opportunity Loss (EOL)
“How much money is lost by not picking
the best alternative.”
Opportunity loss table

STATES OF NATURE
ALTERNATIVES Favorable Market Unfavorable Market
(PhP) (PhP)
Construct a large 0 180,000
new factory
Construct a small 100,000 20,000
New factory

factory
Do nothing 200,000 0
Probabilities (pi) 0.5 0.5
Opportunity loss table
EOL (LF) = 0.5(0) + 0.5(180,000)
= 90,000
EOL (SF) = 0.5(100,000) + 0.5(20,000)
= 60,000
EOL (DN) = 0.5(200,000) + 0.5(0)
= 100,000
factory
Decision: Alternative 2 has the least amount of
lost money among the three alternatives
Opportunity loss table
STATES OF NATURE
ALTERNATIVES Favorable Market Unfavorable EOL
(PhP) Market
(PhP)
Construct a large 0 180,000 90,000
new factory
Construct a small 100,000 20,000 60,000
New factory

factory
Do nothing 200,000 0 100,000
Probabilities (pi) 0.5 0.5
Sample problem 1
Sample problem 1

Probabilities (pi) 0.2 0.5 0.3


Sample problem 2

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