Chapter 3

DECISION UNDER RISK (PART II)

BY DR. A MOR MESSA OUD (MA RCH 2017)

March 2017 ISBL (SPRING 2016-17) BY DR. AMOR MESSAOUD 1

Table of contents
6. Expected value of perfect information
7. Bayes theorem & expected value of imperfect Information
8. Risk profile

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The value of information
The value of information represents the improvement in the expected return
that can be achieved if the decision maker is able to aquire– before making
a decision– additional information about the future event that will take place
Sample information is the result of conducting some type of experiment, such
as market reasearch study or interviewing an expert. Sample information is
always imperfect
Perfect information tells us with certainty what outcome will occur

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Section 6
EXPECTED VALUE OF PERFECT INFORMATION

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Example : 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

States of Nature
Alternatives Favorable Unfavorable
Market Market P(0.5)
P(0.5)
Construct $200,000 -$180,000
large plant
Construct $100,000 -$20,000
small plant
Do nothing $0 $0

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Decision making under certainty
What if Getz knows the state of the nature with certainty?
Then there is no risk for the state of the nature!
A marketing research company requests $65000 for this information
Questions:
Should Getz hire the firm to make this study?
How much does this information worth?
What is the value of perfect information?

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Expected Value With Perfect
Information (EVPI)
EVPI = Expected Payoff under certainty - Maximum expected payoff
with no information
Let N be the number of states of nature and k be the number of
alternatives N

the expected Payoff under Ceratinty is equal to Maxi X ij Pj

j 1

Maximum expected payoff with no information=Max {EMVi; i=1,..,k}

EVPI places an upper bound on what one would pay for additional
information

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 Example: Expected Value of
Perfect Information
State of Nature
Alternative Favorable Market Unfavorable
EMV
($) Market ($)
Construct a 200,000 -$180,000 $10,000
large plant
Construct a small plant
$100,000 -$20,000 $40,000

Do nothing $0 $0 $0

Probabilities 0.50 0.50

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 Expected Value of Perfect
Information
Expected Value Under Certainty
=($200,000*0.50 + 0*0.50)= $100,000

Max(EMV)= Max{10,000, 40,000, 0}=$40,000

EVPI = Expected Value Under Certainty - Max(EMV)

= $100,000 - $40,000
= $60,000
So Getz should not be willing to pay more than $60,000

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Section 7
EXPECTED VALUE OF IMPERFECT INFORMATION

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Value of sample information
Consider the case where some information can be useful to help make a
decision but need not give the exact state of nature that would happen:
imperfect information
This information may arise from a market survey, a consulting advice, a study,
a forecast, research work, expert, etc.
Such information is usually acquired at some cost
The question is whether the cost paid is worth.

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Value of sample information
Frequently decision makers have preliminary or prior probability assessments
for the states of nature
The best probability values available at that time
The decision maker may want to seek additional information about the states
of nature to make the best possible decision
This new information can be used to revise or update the prior probabilities
The final decision is based on more accurate probabilities for the states of
nature
These revised probabilities are called posterior probabilities

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Bayes’ Theorem and Posterior
Probabilities
Knowledge of sample (survey) information can be used to revise the
probability estimates for the states of nature.
Prior to obtaining this information, the probability estimates for the states of
nature are called prior probabilities.
With knowledge of conditional probabilities for the outcomes or indicators of
the sample or survey information, these prior probabilities can be revised by
employing Bayes' Theorem.
The outcomes of this analysis are called posterior probabilities or branch
probabilities for decision trees.

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Bayes theorem
Si: State of Nature (i = 1, 2, …, N)
P(Si): Prior Probability
Ij: Professional Information (Experiment)( j = 1, 2, …, N)
P(Ij | Si): Conditional Probability
P(Ij ∩ Si) = P(Si ∩ Ij): Joint Probability
P(Si | Ij): Posterior Probability

P( Si Ij) P( I j | Si ) P( Si )
P( Si | I j ) N
P( I j )
P( I j | Si ) P( Si )
i 1

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Aapplying Bayes theorem for Getz
products with additional information
Let’s say Getz Products has two sequential decisions to make:
Conduct a survey for $10000?
Build a large or small plant or not build?
The survey will result in 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

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Posterior distribution calculations

FAV UNF The P(FAV│ “.”) P(UNF│ “.”)

0.5 0.5 sum

Positive 0.7 0.2 0.35 0.10 0.45 0.78 0.22

Negativ 0.3 0.8 0.15 0.40 0.55 0.27 0.73

e

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Computing Branch Probabilities
Branch (Posterior) Probabilities Calculation
Step #1: For each state of nature, multiply the prior probability by its
conditional probability for the indicator -- this gives the joint probabilities for
the states and indicator.
Step #2: Sum these joint probabilities over all states -- this gives the marginal
probability for the indicator.
Step #3: For each state, divide its joint probability by the marginal probability for the
indicator -- this gives the posterior probability distribution.

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Expected Value of Imperfect
Information (EVII)
EVII Calculation
Step #1: Determine the optimal decision and its expected return for the possible
outcomes of the imperfect information (II) using the posterior probabilities for the
states of nature.
Step #2: Compute the expected value of these optimal returns.
Step #3: Subtract the EV of the optimal decision obtained without using the sample
information from the amount determined in step (2).

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Efficiency of Imperfect
Information
Efficiency of 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.

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Decsion tree
EMV of conducting the
survey=$49,200
EMV of not conducting the
survey=$40,000
So Getz should conduct the survey!
If the survey results are favourable,
build large plant.
If the survey results are
infavourable, build small plant.

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Example #2 – Ponderosa Record
Company
Decide whether or not to market the recordings of a rock group.
Alternative1: test market 5000 units and if favorable, market 45000 units
nationally
Alternative2: Market 50000 units nationally
Outcome is a complete success (all are sold) or failure

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Example #2: Ponderosa-costs,
prices
Fixed payment to group: $5000

Production cost: $5000 and $0.75/cd

Handling, distribution: $0.25/cd

Price of a cd: $2/cd

Cost of producing 5,000 cd’s =5,000+5,000+(0.25+0.75)5,000=$15,000

Cost of producing 45,000 cd’s = 0+5,000+(0.25+0.75)45,000=$50,000

Cost of producing 50,000 cd’s = 5,000+5,000+(0.25+0.75)50,000=$60,000

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Example #2: Ponderosa-Event
Probabilities
Without testing P(success)=P(failure)=0.5

With testing
P(success|test result is favorable)=0.8
P(failure|test result is favorable)=0.2
P(success|test result is unfavorable)=0.2
P(failure|test result is unfavorable)=0.8

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Example #2: Decision tree

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Example #2: Backward approach

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Example #2: Optimal decision
policy
Optimal decision is: Test market
If the market is favorable, market nationally
Else, abort

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Example #3: Burger prince
restaurant
Burger Prince must decide whether or not to purchase a marketing
survey from Stanton Marketing for $1,000. The results of the survey are
"favorable" or "unfavorable". The conditional probabilities are:
P(favorable | 80 customers per hour) = .2
P(favorable | 100 customers per hour) = .5
P(favorable | 120 customers per hour) = .9

Should Burger Prince have the survey performed by Stanton Marketing?

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Example #3: Posterior probabilities

Favorable
State Prior Conditional Joint Posterior
80 .4 .2 .08 .148
100 .2 .5 .10 .185
120 .4 .9 .36 .667
Total .54 1.000

P(favorable) = .54

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Example #3: Posterior probabilities
Unfavorable

State Prior Conditional Joint Posterior

80 .4 .8 .32 .696
100 .2 .5 .10 .217
120 .4 .1 .04 .087
Total .46 1.000

P(unfavorable) = .46

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Example #3: Posterior probabilities
A B C D E
1 Market Research Favorable
2 Prior Conditional Joint Posterior
3 State of Nature Probabilities
Probabilities Probabilities Probabilities
4 s1 = 80 0.4 0.2 0.08 0.148
5 s2 = 100 0.2 0.5 0.10 0.185
6 s3 = 120 0.4 0.9 0.36 0.667
7 P(Favorable) = 0.54
8
9 Market Research Unfavorable
10 Prior Conditional Joint Posterior
11 State of Nature Probabilities Probabilities Probabilities Probabilities
12 s1 = 80 0.4 0.8 0.32 0.696
13 s2 = 100 0.2 0.5 0.10 0.217
14 s3 = 120 0.4 0.1 0.04 0.087
15 P(Favorable) = 0.46

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Example #3: Decision tree
Top Half s1 (.148)
$10,000
s2 (.185)
d1 4
s3 (.667)
$15,000
$14,000
s1 (.148)
d2 $8,000
s2 (.185)
2 5 $18,000
s3 (.667)
I1 d3 $12,000
s1 (.148)
(.54) $6,000
s2 (.185)
6 $16,000
s3 (.667)
1 $21,000

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Example #3: Decision tree
Bottom
1 Half s1 (.696) $10,000
I2 s2 (.217)
(.46) d1 7
s3 (.087)
$15,000
$14,000
s1 (.696)
d2 $8,000
s2 (.217)
3 8 $18,000
s3 (.087)
d3 $12,000
s1 (.696) $6,000
s2 (.217)
9 $16,000
s3 (.087)
$21,000

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Example #3: Decision tree
d1 4 EMV = .148(10,000) + .185(15,000)
$17,855 + .667(14,000) = $13,593
d2 5 EMV = .148 (8,000) + .185(18,000)
2
I1 d3 + .667(12,000) = $12,518
(.54) 6 EMV = .148(6,000) + .185(16,000)
+.667(21,000) = $17,855
1
7 EMV = .696(10,000) + .217(15,000)
d1
I2 +.087(14,000)= $11,433
d2 8 EMV = .696(8,000) + .217(18,000)
(.46) 3
d3 + .087(12,000) = $10,554
$11,433
9 EMV = .696(6,000) + .217(16,000)
+.087(21,000) = $9,475
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Expected Value of Imperfect
Information
If the outcome of the survey is "favorable”, choose Model C.

If it is “unfavorable”, choose Model A.

EVII = .54($17,855) + .46($11,433) - $14,000 = $900.88

Since this is less than the cost of the survey, the survey should not be
purchased.

The efficiency of the survey: EVII/EVPI = ($900.88)/($2000) = .4504

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Section 8
RISK PROFILE

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Critics for EMV
EMV totally neglects risk in choosing among alternative actions
It may favor an action with average higher payoff while the good outcomes are
unlikely
It can be adequate when fluctuations in outcomes are not very important and
probabilities do not take extreme values
It is also adequate for repetitive decisions

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 Incorporating risk-Risk Profile
One interesting tool to account for risk is risk-profile
It is a graph that allows to visualize risk for each given strategy
A strategy is a sub-tree that starts from the initial decision node and that selects a single
decision alternative whenever a decision node is encountered in a backward path till the
payoffs column

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Risk Profile
In a decision strategy, when the same random event is encountered more than
once, its probability of occurrence is obtained as the sum of all probabilities
leading to the same event
This will help better represent the risk profile through a simple graph allowing to
visualize risk

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 Risk Profile
In order to incorporate risk in the decision-making process, one may consider the best
strategies according to EMV and tries to balance expected payoff with the corresponding
risk through the strategy risk profile
Such an assessment could be made subjectively

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Risk Profile for Ponderosa Example
Risk Profile
Possible outcomes for the opt. soln.
$35,000 with probability 0.4
-$55,000 with probability 0.1
-$15,000 with probability 0.5

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Risk Profile
for Ponderosa Record Co.

Risk Profile For Ponderosa Record Company

0.6

0.5

0.4
Probability

0.3

0.2

0.1

0
-70000 -60000 -50000 -40000 -30000 -20000 -10000 0 10000 20000 30000 40000 50000
Expected Value, $

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Burger Prince Restaurant Example
revisited
Model C Decision strategy

.40
Probability
.30

.20

.10

5 10 15 20 25

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Texaco vs. Penzoil
Experts expect that the Supreme Court will keep the fine with only 20% chance,
will reduce it to half 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

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Decision tree
The above decision tree is the one in the book: Making hard Decisions: An
introduction to decision analysis, by Robert Clemen.
Wile the optimal solution is correct, some alternative is missing
Could you determine it?

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Risk Profile

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Texaco vs. Penzoil
In 1996, with the intervention of several civil society organizations, Texaco paid to
Penzoil $ 3 billion as final settlement of the case.

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 Thank you

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