2 Deciding Between Job Offers Company AIn a new industry that could boom or bust.Low starting salary, but could increase rapidly.Located near friends, family and favorite sports team.Company BEstablished firm with financial strength and commitment to employees.Higher starting salary but slower advancement opportunity.Distant location, offering few cultural or sporting activities.Which job would you take?
3 Good Decisions vs. Good Outcomes A structured approach to decision making can help us make good decisions, but can’t guarantee good outcomes.Good decisions sometimes result in bad outcomes.
4 IntroductionDecision theory is an analytical and systematic way to tackle problems A good decision is based on logic.
5 The Six Steps in Decision Theory Clearly define the problem at handList the possible alternativesIdentify the possible outcomes & criteriaList the payoff or profit of each combination of alternatives and outcomesSelect one of the mathematical decision theory modelsApply the model and make your decision
6 Types of Decision-Making Environments Type 1: Decision-making under certaintydecision-maker knows with certainty the consequences of every alternative or decision choice. (You know exact outcome; eg Savings Account)Type 2: Decision-making under riskdecision-maker does know the probabilities of the various outcomes (You know the probability of each outcome; e.g. roll of die)Type 3: Decision-making under uncertaintydecision-maker does not know the probabilities of the various outcomes (You know nothing, it is a wild guess at best)
7 Decision-Making Under Risk Expected Monetary Value:(Sum of the probabilities and outcome)nnature,ofstatesnumbertheto1jwhere)P(S*Payoffi)ativeEMV(AlternS=å
8 ExampleYou recently inherited $1,000 and are considering investing it in varied financial instruments. After Analyzing the economy (possibility of it being good or poor ) and the returns you can make in these conditions, you develop the following payoff table…
9 Decision TableState Of NatureDecision AlternativeGood EconomyPoor EconomyPortfolio 1 (high risk)80-20Portfolio 2 (med risk)3020Portfolio 3 (low risk)23Probability0.30.7Which portfolio should you invest in, that will maximize your returns?
10 Decision TableState Of NatureDecision AlternativeGood EconomyPoor EconomyEMVPortfolio 1 (high risk)80-2010Portfolio 2 (med risk)302023Portfolio 3 (low risk)22Probability0.30.7What is the maximum amount that should be paid for perfect forecast of the economy?
11 Expected Value of Perfect Information (EVPI) EVPI places an upper bound on what one would pay for additional information EVPI is the expected value with perfect information minus the maximum EMVEVPI = EV|PI - maximum EMV
12 EVPI = Expected Value with Perfect Information - max(EMV) = State Of NatureDecision AlternativeGood EconomyPoor EconomyEMVPortfolio 1 (high risk)80-20Portfolio 2 (med risk)302023Portfolio 3 (low risk)22Probability0.30.7EVPI = Expected Value with Perfect Information - max(EMV) =[80 0.7] – 23 = $16.4
13 Expected Opportunity Loss EOL is the cost of not picking the best solutionEOL = Expected RegretWork it the same way as EMV but just use the regret instead of payoffs.
17 Sensitivity Analysis - continued 0.4440.2EMV (Med Risk)EMV(low Risk)EMV(High Risk)
18 Decision Making Under Uncertainty MaximaxMaximinEqually likely (Laplace)Criterion of RealismMinimax Regret
19 Decision Making Under Uncertainty Maximax - Choose the alternative with the maximum outputStates of NatureFavorable Mkt ($)Unfavorable Mkt ($)MaximaxConstruct Large Plant200,000-180,000Construct Small Plant100,000-20,000Do Nothing
20 Decision Making Under Uncertainty Maximin - Choose the alternative with the maximum minimum outputStates of NatureFavorable Mkt ($)Unfavorable Mkt ($)MaximinConstruct Large Plant200,000-180,000-18,000Construct Small Plant100,000-20,000Do Nothing
21 Decision Making Under Uncertainty Equally likely (Laplace) - Assume all states of nature to be equally likely, choose maximum EMVStates of NatureFavorable Mkt ($)Unfavorable Mkt ($)Equally LikelyConstruct Large Plant200,000-180,00010,000Construct Small Plant100,000-20,00040,000Do NothingProbabilities0.5
22 Decision Making Under Uncertainty Criterion of Realism (Hurwicz): CR = *(row max) + (1-)*(row min)=0.8States of NatureFavorable Mkt ($)Unfavorable Mkt ($)CRConstruct Large Plant200,000-180,000124,000Construct Small Plant100,000-20,00076,000Do Nothing
23 Decision Making Under Uncertainty Minimax - choose the alternative with the minimum maximum Opportunity Loss - this is using EOL tableStates of NatureFavorable Mkt ($)Unfavorable Mkt ($)Minimax RegretConstruct Large Plant180,000Construct Small Plant100,00020,000Do Nothing200,000Probabilities0.5
24 Summary Decision theory Decision Making under Risk Decision Making under Uncertainty