COMM

290
Introduc1on to Quan1ta1ve Decision Making

Lecture 10B

Decision Analysis:
Sequen1al Decisions

Review & Overview

Last class
Expected monetary value (EMV)
Expected value of perfect informa1on:
EVPI = EPPI EMV
This class
Expected value of sample informa4on
Dealing with sequen4al decisions

1
 Sequen1al Decisions: Good-Lame
An investor intends to purchase one piece of real estate. She must now decide among an
apartment, a warehouse, and retail space. The prot made by the investor will depend
on future economic condi1ons, which may be Good or Lame. Purchase of the apartment
will result in a $55,000 prot if future economic condi1ons are Good, and $10,000 if they
are Lame. The corresponding gures for the purchase of a warehouse are $30,000 for
Good economic condi1ons, and $20,000 for Lame condi1ons. The purchase of the retail
space will result in a $100,000 prot if future economic condi1ons are Good, and a loss of
$40,000 if they are Lame.

Assume that there is a 60% chance that future economic condi1ons will be Good. Also
assume that the investor will use expected prot as the basis for her decisions.

Probability 0.6 0.4

Prots ($1,000s) Good G Lame L
A (apartment) 55 10
W (warehouse) 30 20
R (retail) 100 (-40)

Probability 0.6 0.4 Expected Monetary Value EMV

Prots ($1,000s) Good G Lame L
A (apartment) 55 10
Recall
W (warehouse) 30 20
R (retail) 100 (-40)
Decision States
A priori probability A, W, R G, L
TIME
P(G) = 0.6
P(L) = 0.4
37 Payo
A 0.6
// G 55
0.4
44 26 L 10
Decision W 0.6
// G 30
Maker
0.4
44 L 20
R 0.6
G 100
0.4
The best decision is Retail. L (-40)
EMV is 44

2
 Probability 0.6 0.4
EPPI
Prots ($1,000s) Good G Lame L
A (apartment) 55 10
Expected Prot Recall
W (warehouse) 30 20
R (retail) 100 (-40)
with Perfect Informa4on
States Decision
G, L A, W, R
TIME
Payo
100 // A 55
G
68 // W 30
0.6
Decision R 100
Maker
0.4 10
20 // A
L
EPPI is 68 W 20
// R (-40)

Expected Value
of Perfect Informa4on EVPI = 68 44 = 24

EPPI = expected prot with perfect informa1on

EMV = expected prot with uncertainty (Expected monetary value)
EVPI = expected value of perfect informa1on
EVPI = EPPI - EMV
EPPI
EVPI (68K)
(24K)

EMV
(44K)

Imperfect Perfect
Informa4on Informa4on

What if your informa1on was somewhere

between imperfect and perfect?

3
 Good-Lame (Con1nued)
Our investor may hire a professional economist who will provide addi1onal informa1on
about future economic condi1ons. Ader preliminary discussions with the economist, the
investor realizes that the economist's report will boil down to a forecast that the
economy will be either Booming, Coas4ng, or Declining. An examina1on of past
forecasts indicate that, when the future economic condi1ons turned out to be Good, the
economist had a 30% chance of forecas1ng a Booming economy, and a 50% chance of
forecas1ng a Coas4ng economy; whereas when the future economic condi1ons turned
out to be Lame, the economist had a 45% chance of forecas1ng a Declining economy,
and a 50% chance of forecas1ng a Coas4ng economy.

Prots ($1,000s) Good Lame

(f) Construct a decision tree to represent this situa1on.
A (apartment) 55 10
Follow all instruc1ons in ques1on (b) above, and show
W (warehouse) 30 20 all your detailed probability calcula1ons.
R (retail) 100 (-40)
(g) Assuming as in ques1on (f) above that the investor
will be using the economist's forecast, what is the
decision strategy that maximizes her expected prot?
What is the value of this best expected prot?

Decision States Decision States

H, H B, C, D A, W, R G, L
ots ($1,000s) Good Lame 55*P(G|B) TIME
+ 10*P(L|B)
apartment) 55 10 Payo
A ? P(G|B) 55
(warehouse) 30 20 G
P(L|B)
L 10
retail) 100 (-40) B W ? P(G|B)
G 30
P(B) P(L|B)
L 20
R ? P(G|B)
G 100
P(L|B)
L (-40)

A P(G|C) 55
//
G
P(L|C) 10
L
C W P(G|C) 30
G
H P(C) P(L|C)
L 20
R P(G|C) 100
G
P(L|C)
L (-40)

A P(G|D)
G 55 //
P(L|D)
Decision L 10
D W P(G|D)
Maker G 30
P(D) P(L|D)
L 20
R P(G|D)
G 100
Considered previously. P(L|D)
L (-40)
H EMV is 44

4
Our investor may hire a professional economist who will provide addi1onal informa1on
about future economic condi1ons. Ader preliminary discussions with the economist, the
investor realizes that the economist's report will boil down to a forecast that the
economy will be either Booming, Coas4ng, or Declining. An examina1on of past
forecasts indicate that, when the future economic condi1ons turned out to be Good, the
economist had a 30% chance of forecas1ng a Booming economy, and a 50% chance of
forecas1ng a Coas4ng economy; whereas when the future economic condi1ons turned
out to be Lame, the economist had a 45% chance of forecas1ng a Declining economy,
and a 50% chance of forecas1ng a Coas4ng economy.

We know
A priori probability ASIDE: We need P(G|B), P(G|C) and P(G|D).
P(G) = 0.6 We also need P(B), P(C) and P(D).
P(L) = 0.4

Given here
condi&onal joint
P(B|G) = 0.30 P(GB)
P(G | B) =
P(C|G) = 0.50 P(B)
marginal
P(D|L) = 0.45
P(C|L) = 0.50

ASIDE: We need P(G|B), P(G|C) and P(G|D).

We also need P(B), P(C) and P(D).

We know Probability tree. {G,L} rst or {B,C,D} rst? SS Prob

A priori probability P(B|G) = .3 GB .18
B
P(G) = 0.6 0.6 P(C|G) = .5
G C GC .30
P(L) = 0.4
P(D|G) = .2
D GD .12
Given here P(B|L) = .05
B LB .02
P(B|G) = 0.30 0.4 P(C|L) = .50
P(C|G) = 0.50 L C LC .20
P(D|L) = .45
P(D|L) = 0.45 D LD .18
P(C|L) = 0.50 sum 1.0

We need P(G|B), P(G|C) and D(G|D).

Joint Probability Table
condi&onal joint
Joint B C D P(GB) .18
P(G | B) = = = 0.9
G .18 .30 .12 .60 P(B) .20
marginal
L .02 .20 .18 .40
.20 .50 .30 1.00 P(GC) .30
P(G | C) = = = 0.6
P(C) .50
P(GD) .12
P(G | D) = = = 0.4
P(D) .30

5
Complete the
decision tree
Decision States Decision States
H, H B, C, D A, W, R G, L TIME
Payo
P(B) = 0.2 P(G|B) = 0.9
A 50.5 P(G|B)=0.9
P(C) = 0.5 P(G|C) = 0.6 // P(L|B)=0.1
G 55
P(D) = 0.3 P(G|D) = 0.4 86 L 10
B
//
W 29 0.9
G 30
P(B)=0.2 0.1
L 20
R 86 0.9
G 100
0.1
L (-40)

A 37 P(G|C)=0.6 //
.2(86)+.5(44)+.3(28)
// P(L|C)=0.4
G
55

= 47.6 44 L 10
C
//
W 26 0.6
G 30
H P(C)=0.5 0.4
L 20
R 44 0.6
G 100
0.4
L (-40)

A 28 P(G|D)=0.4 55
G
P(L|D)=0.6
Decision 28 L 10
Maker
D W 24 0.4
P(D)=0.3 // 0.6
G 30
L 20
R 16 0.4
Considered previously.
// 0.6
G 100
L (-40)
H EMV is 44

Solve the
decision tree Decision States Decision States
by folding back
H, H B, C, D A, W, R G, L TIME
.9(55) + .1(10)
Payo
A 50.5 P(G|B)=0.9
// P(L|B)=0.1
G 55

86 L 10
B
//
W 29 0.9
G 30
P(B)=0.2 0.1
L 20
R 86 0.9
G 100
0.1
L (-40)

A 37 P(G|C)=0.6 //
.2(86)+.5(44)+.3(28)
// P(L|C)=0.4
G
55

= 47.6 44 L 10
C
//
W 26 0.6
G 30
H P(C)=0.5 0.4
L 20
R 44 0.6
G 100
0.4
L (-40)

A 28 P(G|D)=0.4 55
G
P(L|D)=0.6
Decision 28 L 10
Maker
D W 24 0.4
P(D)=0.3 // 0.6
G 30
L 20
R 16 0.4
Considered previously.
// 0.6
G 100
L (-40)
H EMV is 44

6
 Solve the
decision tree
by folding back

Payo
A 50.5 P(G|B)=0.9
// P(L|B)=0.1
G 55

86 L 10
B
//
W 29 0.9
G 30
P(B)=0.2 0.1
L 20
R 86 0.9
G 100
0.1
L (-40)

A 37 P(G|C)=0.6 //
.2(86)+.5(44)+.3(28)
// P(L|C)=0.4
G
55

= 47.6 44 L 10
C
//
W 26 0.6
G 30
H P(C)=0.5 0.4
L 20
R 44 0.6
G 100
0.4
L (-40)

A 28 P(G|D)=0.4 55
G
P(L|D)=0.6
Decision 28 L 10
Maker
D W 24 0.4
P(D)=0.3 // 0.6
G 30
L 20
R 16 0.4
Considered previously.
// 0.6
G 100
L (-40)
H EMV is 44

Solve the
decision tree
by folding back

Payo
A 50.5 P(G|B)=0.9
// L P(L|B)=0.1
G 55

86 L 10

L 29
B W 0.9
P(B)=0.2
// 0.1
G 30

L 20
R
L
86 0.9
G 100
0.1
L (-40)

A 37 P(G|C)=0.6 //
.2(86)+.5(44)+.3(28)
// L P(L|C)=0.4
G
55

= 47.6 44 L 10

L 26
C W 0.6
P(C)=0.5
// 0.4
G 30
H L 20
R
L
44 0.6
G 100
0.4
L (-40)

A 28 P(G|D)=0.4
L P(L|D)=0.6
G 55

Decision 28 L 10
Maker
D W
L 24 0.4
P(D)=0.3 // 0.6
G 30
L 20
R
L
16 0.4
Considered previously.
// 0.6
G 100
L (-40)
H EMV is 44

7
 Solve the
decision tree Decision States Decision States
on one page
H, H B, C, D A, W, R G, L TIME
.9(55) + .1(10)
Payo
A 50.5 P(G|B)=0.9
// P(L|B)=0.1
G 55

86 L 10
B
//
W 29 0.9
G 30
P(B)=0.2 0.1
L 20
R 86 0.9
G 100
0.1
L (-40)

A 37 P(G|C)=0.6 //
.2(86)+.5(44)+.3(28)
// P(L|C)=0.4
G
55

= 47.6 44 L 10
C
//
W 26 0.6
G 30
H P(C)=0.5 0.4
L 20
R 44 0.6
G 100
0.4
L (-40)

A 28 P(G|D)=0.4 55
G
P(L|D)=0.6
Decision 28 L 10
Maker
D W 24 0.4
P(D)=0.3 // 0.6
G 30
L 20
R 16 0.4
Considered previously.
// 0.6
G 100
L (-40)
H EMV is 44

(h) What is the expected value of sample informa1on from the economist's forecast?
What is its eciency?

Expected Prot If the cost of the economist < $3,600, hire the economist.
With Without Depending on what the economist says, choose R if
Economist Economist forecast is B or C, and choose A if forecast is D.
If the cost > $3,600, dont hire the economist, and choose
47.6K 44K R (last class).

Expected Prot/Payo with Sample Informa4on (EPSI)

Expected Value of Sample Informa4on (EVSI)

EVSI = EPSI - EMV

3.6K 47.6K 44K
Suppose a test is out of 100.
Eciency = EVSI / EVPI * 100% You are expected to get 70.
EVPI is 24K (last class) An expert helped you to get
= 2.6K/24K 80. Then, the eciency of the
= 15% expert is 10/30 = 33.3%

8
 EPPI = expected prot with perfect informa1on
EMV = expected prot with uncertainty (Expected monetary value)
EVPI = expected value of perfect informa1on
EVPI = EPPI - EMV
EPPI
EVPI (68K)
(24K) EVSI
(3.6K) EPSI
EMV (47.6K)
(44K)

Imperfect Sample Perfect

Informa4on Informa4on Informa4on

EVSI = expected value of sample informa1on

EVSI = EPSI - EMV

Summary
Decision tree with sequen1al decisions
Expected value of sample informa1on (EVSI)

EVSI = EPSI - EMV

EPPI: Expected prot/payo with sample
informa1on
EMV: Expected monetary value (with imperfect
informa1on)