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Decision Theory
Chapter 20
McGraw-Hill/Irwin
Learning Objectives
LO1 Identify and apply the three components of a
decision.
LO2 Compute and interpret the expected values
for a payoff table.
LO3 Explain and interpret opportunity loss.
LO4 Describe three strategies for decision making.
LO5 Compute and describe the expected value of
information.
LO6 Organize possible outcomes into a decision
tree and interpret the result.
20-2
2.
3.
The Expected Payoff or the Expected Monetary Value (EMV) is the expected value
for each decision.
20-3
LO1
Decision Making
20-4
LO2
(.60)
(.40)
Calculation
(A1)=(.6)($2,400)+(.4)($1,000) =$1,840
(A2)=(.6)($2,400)+(.4)($1,000) =$1,760
(A3)=(.6)($2,400)+(.4)($1,000) =$1,600
20-6
Opportunity Loss
Opportunity Loss or Regret is the loss because the exact state of nature is not
known at the time a decision is made.
The opportunity loss is computed by taking the difference between the optimal
decision for each state of nature and the other decision alternatives.
EOL ( Ai ) [ P( S j ) R( Ai , S j )
20-7
LO3
Opportunity Loss
EOL ( Ai ) [ P( S j ) R( Ai , S j )
Kayser:
$2,400 - $2,400= $0
Kayser:
$1,150 - $1,000= $150
Rim Homes:
$2,400 - $2,200 = $200
Rim Homes:
$1,150 - $1,100 = $50
Texas Electronics:
$2,400 - $1,900 = $500
Texas Electronics:
$1,150 - $1,150 = $0
20-8
LO3
0.60
0.40
(A1)=(.6)($0)+(.4)($150) =$60
(A2)=(.6)($200)+(.4)($50) =$140
(A3)=(.6)($500)+(.4)($0) =$300
20-9
Payoff Table
Maximin
1,000
1,100
1,150
Maximax
2,400
2,200
1,900
20-10
20-11
LO5
Value of Perfect
Information
Step 1: Compute the Expected Value Under Certainty
(.60)
20-12
20-13
LO6
Decision Trees
$2,400
20-14