Newbold_chap21.ppt

Chap 21-1
Statistics for Business and Economics, 6e © 2007 Pearson Education, Inc.
Chapter 21
Statistical Decision Theory
Statistics for
Business and Economics
6th Edition

Statistics for Business and Economics, 6e © 2007 Pearson Education, Inc. Chap 21-2
Chapter Goals
After completing this chapter, you should be
able to:
 Describe basic features of decision making
 Construct a payoff table and an opportunity-loss table
 Define and apply the expected monetary value criterion for
decision making
 Compute the value of sample information
 Describe utility and attitudes toward risk

Steps in Decision Making
 List Alternative Courses of Action
 Choices or actions
 List States of Nature
 Possible events or outcomes
 Determine ‘Payoffs’
 Associate a Payoff with Each Event/Outcome
combination
 Adopt Decision Criteria
 Evaluate Criteria for Selecting the Best Course
of Action

List Possible Actions or Events
Payoff Table Decision Tree
Two Methods
of Listing

Payoff Table
 Form of a payoff table
 Mij is the payoff that corresponds to action ai and
state of nature sj
Actions
States of nature
s1 s2 . . . sH
a1
a2
.
.
.
aK
M11
M21
.
.
.
MK1
M12
M22
.
.
.
MK2
. . .
. . .
.
.
.
. . .
M1H
M2H
.
.
.
MKH

Payoff Table Example
A payoff table shows actions (alternatives),
states of nature, and payoffs
Investment
Choice
(Action)
Profit in $1,000’s
(States of nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20

Decision Tree Example
Large factory
Small factory
Average factory
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
Payoffs
200
50
-120
40
30
20
90
120
-30

Decision Making Overview
No probabilities
known
Probabilities
are known
Decision Criteria
Nonprobabilistic Decision Criteria:
Decision rules that can be applied
if the probabilities of uncertain
events are not known
*
 maximin criterion
 minimax regret criterion

The Maximin Criterion
 Consider K actions a1, a2, . . ., aK and H possible states of nature
s1, s2, . . ., sH
 Let Mij denote the payoff corresponding to the ith action and jth state
of nature
 For each action, find the smallest possible payoff and denote the
minimum M1
* where
 More generally, the smallest possible payoff for action ai is given by
 Maximin criterion: select the action ai for which the
corresponding Mi
* is largest (that is, the action with the
greatest minimum payoff)
)
M
,
,
M
,
Min(M
M 1H
12
11
*
1 

)
M
,
,
M
,
(M
M 1H
12
11
*
i 


Maximin Example
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
1.
Minimum
Profit
-120
-30
20
The maximin criterion
1. For each option, find the minimum payoff

Maximin Solution
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
1.
Minimum
Profit
-120
-30
20
The maximin criterion
1. For each option, find the minimum payoff
2. Choose the option with the greatest minimum payoff
2.
Greatest
minimum
is to
choose
Small
factory
(continued)

Regret or Opportunity Loss
 Suppose that a payoff table is arranged as a
rectangular array, with rows corresponding to
actions and columns to states of nature
 If each payoff in the table is subtracted from the
largest payoff in its column . . .
 . . . the resulting array is called a regret table, or
opportunity loss table

Minimax Regret Criterion
 Consider the regret table
 For each row (action), find the maximum
regret
 Minimax regret criterion: Choose the action
corresponding to the minimum of the
maximum regrets (i.e., the action that
produces the smallest possible opportunity
loss)

Opportunity Loss Example
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
The choice “Average factory” has payoff 90 for “Strong Economy”. Given
“Strong Economy”, the choice of “Large factory” would have given a
payoff of 200, or 110 higher. Opportunity loss = 110 for this cell.
Opportunity loss (regret) is the difference between an
actual payoff for a decision and the optimal payoff for
that state of nature
Payoff
Table

Opportunity Loss
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
(continued)
Investment
Choice
(Alternatives)
Opportunity Loss in $1,000’s
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
0
110
160
70
0
90
140
50
0
Payoff
Table
Opportunity
Loss Table

Minimax Regret Example
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
0
110
160
70
0
90
140
50
0
Opportunity Loss Table
The minimax regret criterion:
1. For each alternative, find the maximum opportunity
loss (or “regret”)
1.
Maximum
Op. Loss
140
110
160

Minimax Regret Example
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
Stable
Economy
Weak
Economy
Large factory
Average factory
Small factory
0
110
160
70
0
90
140
50
0
Opportunity Loss Table
The minimax regret criterion:
1. For each alternative, find the maximum opportunity
loss (or “regret”)
2. Choose the option with the smallest maximum loss
1.
Maximum
Op. Loss
140
110
160
2.
Smallest
maximum
loss is to
choose
Average
factory
(continued)

Decision Making Overview
No probabilities
known
Probabilities
are known
Decision Criteria
*
Probabilistic Decision Criteria:
Consider the probabilities of
uncertain events and select an
alternative to maximize the
expected payoff of minimize the
expected loss
 maximize expected monetary value

Payoff Table
 Form of a payoff table with probabilities
 Each state of nature sj has an associated
probability Pi
Actions
States of nature
s1
(P1)
s2
(P2)
. . . sH
(PH)
a1
a2
.
.
.
aK
M11
M21
.
.
.
MK1
M12
M22
.
.
.
MK2
. . .
. . .
.
.
.
. . .
M1H
M2H
.
.
.
MKH

Expected Monetary Value (EMV)
Criterion
 Consider possible actions a1, a2, . . ., aK and H states
of nature
 Let Mij denote the payoff corresponding to the ith action
and jth state and Pj the probability of occurrence of the
jth state of nature with
 The expected monetary value of action ai is
 The Expected Monetary Value Criterion: adopt the
action with the largest expected monetary value







H
1
j
ij
j
iH
H
i2
2
i1
1
i M
P
M
P
M
P
M
P
)
EMV(a 
1
P
H
1
j
j 



Expected Monetary
Value Example
 The expected monetary value is the weighted
average payoff, given specified probabilities for
each state of nature
Investment
Choice
(Alternatives)
(States of Nature)
Strong
Economy
(.3)
Stable
Economy
(.5)
Weak
Economy
(.2)
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
Suppose these
probabilities
have been
assessed for
these states of
nature

Investment
Choice
(Action)
(States of nature)
Strong
Economy
(.3)
Stable
Economy
(.5)
Weak
Economy
(.2)
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
Example: EMV (Average factory) = 90(.3) + 120(.5) + (-30)(.2)
= 81
Expected
Values
(EMV)
61
81
31
Maximize
expected
value by
choosing
Average
factory
(continued)
Payoff Table:
Goal: Maximize expected monetary value
Expected Monetary Value
Solution

Decision Tree Analysis
 A Decision tree shows a decision problem,
beginning with the initial decision and ending
will all possible outcomes and payoffs
Use a square to denote decision nodes
Use a circle to denote uncertain events

Add Probabilities and Payoffs
Large factory
Small factory
Decision
Average factory
States of nature
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
(continued)
Payoffs
Probabilities
200
50
-120
40
30
20
90
120
-30
(.3)
(.5)
(.2)
(.3)
(.5)
(.2)
(.3)
(.5)
(.2)

Fold Back the Tree
Large factory
Small factory
Average factory
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
200
50
-120
40
30
20
90
120
-30
(.3)
(.5)
(.2)
(.3)
(.5)
(.2)
(.3)
(.5)
(.2)
EMV=200(.3)+50(.5)+(-120)(.2)=61
EMV=90(.3)+120(.5)+(-30)(.2)=81
EMV=40(.3)+30(.5)+20(.2)=31

Make the Decision
Large factory
Small factory
Average factory
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
Strong Economy
Stable Economy
Weak Economy
200
50
-120
40
30
20
90
120
-30
(.3)
(.5)
(.2)
(.3)
(.5)
(.2)
(.3)
(.5)
(.2)
EV=61
EV=81
EV=31
Maximum
EMV=81

Bayes’ Theorem
 Let s1, s2, . . ., sH be H mutually exclusive and collectively
exhaustive events, corresponding to the H states of nature of a
decision problem
 Let A be some other event. Denote the conditional probability that
si will occur, given that A occurs, by P(si|A) , and the probability
of A , given si , by P(A|si)
 Bayes’ Theorem states that the conditional probability of si, given A,
can be expressed as
 In the terminology of this section, P(si) is the prior probability of si
and is modified to the posterior probability, P(si|A), given the
sample information that event A has occurred
)
)P(s
s
|
P(A
)
)P(s
s
|
P(A
)
)P(s
s
|
P(A
)
)P(s
s
|
P(A
P(A)
)
)P(s
s
|
P(A
A)
|
P(s
H
H
2
2
1
1
i
i
i
i
i







Expected Value of
Perfect Information, EVPI
Perfect information corresponds to knowledge of which
state of nature will arise
 To determine the expected value of perfect
information:
 Determine which action will be chosen if only the prior
probabilities P(s1), P(s2), . . ., P(sH) are used
 For each possible state of nature, si, find the
difference, Wi, between the payoff for the best choice
of action, if it were known that state would arise, and
the payoff for the action chosen if only prior
probabilities are used
 This is the value of perfect information, when it is
known that si will occur

Expected Value of
Perfect Information, EVPI
 The expected value of perfect information (EVPI) is
H
H
2
2
1
1 )W
P(s
)W
P(s
)W
P(s
EVPI 


 
(continued)
 Another way to view the expected value of perfect
information
Expected Value of Perfect Information
EVPI = Expected monetary value under certainty
– expected monetary value of the best alternative

Expected Value Under Certainty
 Expected
value under
certainty
= expected
value of the
best
decision,
given perfect
information
Investment
Choice
(Action)
(Events)
Strong
Economy
(.3)
Stable
Economy
(.5)
Weak
Economy
(.2)
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
Example: Best decision
given “Strong Economy” is
“Large factory”
200 120 20
Value of best decision
for each event:

Expected Value Under Certainty
Investment
Choice
(Action)
(Events)
Strong
Economy
(.3)
Stable
Economy
(.5)
Weak
Economy
(.2)
Large factory
Average factory
Small factory
200
90
40
50
120
30
-120
-30
20
200 120 20
(continued)
 Now weight
these outcomes
with their
probabilities to
find the
expected value: 200(.3)+120(.5)+20(.2)
= 124
Expected
value under
certainty

Expected Value of
Perfect Information
Expected Value of Perfect Information (EVPI)
EVPI = Expected profit under certainty
– Expected monetary value of the best decision
so: EVPI = 124 – 81
= 43
Recall: Expected profit under certainty = 124
EMV is maximized by choosing “Average factory”,
where EMV = 81
(EVPI is the maximum you would be willing to spend to obtain
perfect information)

Bayes’ Theorem Example
Stock Choice
(Action)
Percent Return
(Events)
Strong
Economy
(.7)
Weak
Economy
(.3)
Stock A 30 -10
Stock B 14 8
Consider the choice of Stock A vs. Stock B
Expected
Return:
18.0
12.2
Stock A has a
higher EMV

 Permits revising old
probabilities based on new
information
New
Information
Revised
Probability
Prior
Probability
(continued)

Additional Information: Economic forecast is strong economy
 When the economy was strong, the forecaster was correct
90% of the time.
 When the economy was weak, the forecaster was correct 70%
of the time.
Prior probabilities
from stock choice
example
F1 = strong forecast
F2 = weak forecast
E1 = strong economy = 0.70
E2 = weak economy = 0.30
P(F1 | E1) = 0.90 P(F1 | E2) = 0.30
(continued)

EMV with
Revised Probabilities
EMV Stock A = 25.0
EMV Stock B = 11.25
Revised
probabilities
Pi Event Stock A xijPi Stock B xijPi
.875 strong 30 26.25 14 12.25
.125 weak -10 -1.25 8 1.00
Σ = 25.0 Σ = 11.25
Maximum
EMV

Expected Value of
Sample Information, EVSI
 Suppose there are K possible actions and H
states of nature, s1, s2, . . ., sH
 The decision-maker may obtain sample information.
Let there be M possible sample results,
A1, A2, . . . , AM
 The expected value of sample information is
obtained as follows:
 Determine which action will be chosen if only the prior
probabilities were used
 Determine the probabilities of obtaining each sample
result:
)
(
)
|
(
)
(
)
|
(
)
(
)
|
(
)
( 2
2
1
1 H
H
i
i
i
i s
P
s
A
P
s
P
s
A
P
s
P
s
A
P
A
P 


 

 For each possible sample result, Ai, find the
difference, Vi, between the expected monetary value
for the optimal action and that for the action chosen if
only the prior probabilities are used.
 This is the value of the sample information, given that
Ai was observed
M
M
2
2
1
1 )V
P(A
)V
P(A
)V
P(A
EVSI 


 
Expected Value of
Sample Information, EVSI
(continued)

Utility
 Utility is the pleasure or satisfaction
obtained from an action
 The utility of an outcome may not be the same for
each individual
 Utility units are arbitrary

Utility
 Example: each incremental $1 of profit does not
have the same value to every individual:
 A risk averse person, once reaching a goal,
assigns less utility to each incremental $1
 A risk seeker assigns more utility to each
incremental $1
 A risk neutral person assigns the same utility to
each extra $1
(continued)

Three Types of Utility Curves
$ $ $
Risk Aversion Risk Seeker Risk-Neutral

Maximizing Expected Utility
 Making decisions in terms of utility, not $
 Translate $ outcomes into utility outcomes
 Calculate expected utilities for each action
 Choose the action to maximize expected utility

The Expected Utility Criterion
 Consider K possible actions, a1, a2, . . ., aK and H states
of nature.
 Let Uij denote the utility corresponding to the ith action and
jth state and Pj the probability of occurrence of the jth state
of nature
 Then the expected utility, EU(ai), of the action ai is
 The expected utility criterion: choose the action to maximize
expected utility
 If the decision-maker is indifferent to risk, the expected utility
criterion and expected monetary value criterion are equivalent







H
1
j
ij
j
iH
H
i2
2
i1
1
i U
P
U
P
U
P
U
P
)
EU(a 

Chapter Summary
 Described the payoff table and decision trees
 Defined opportunity loss (regret)
 Provided criteria for decision making
 If no probabilities are known: maximin, minimax regret
 When probabilities are known: expected monetary
value
 Introduced expected profit under certainty and the
value of perfect information
 Discussed decision making with sample
information and Bayes’ theorem
 Addressed the concept of utility

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