Exam 25: Decision Analysis

Describe how to use a decision tree.

In most business situations, the choice of the best alternative will be made under conditions of:

Opportunity loss is the difference between what the decision maker's payoff for an act is and what the payoff would have been had the best decision been made.

Define the expected value of perfect information (EVPI).

The prior probabilities determine whether or not sample information should be purchased to revise the posterior probabilities associated with the state of nature.

We calculate the expected payoff with perfect information (EPPI) by multiplying the probability of each state of nature by the largest payoff associated with that state of nature, and then summing the products.

Three different designs are being considered for a new refrigerator, and profits will depend on the combination of the refrigerator design and market condition. The following payoff table summarises the decision situation, with amounts in millions of dollars. Alternative State of Nature (Market condition) \ 30 \ 20 \ 10 \ 19 \ 21 \ 15 \ 11 \ 23 \ 35 Assume that the following probabilities are assigned to the three market conditions: P( $S _ { 1 }$ ) = 0.2, P( $S _ { 2 }$ ) = 0.4, P( $S _ { 3 }$ ) = 0.4. a. Calculate the expected monetary value for each design with present information. Which design should be selected in order to maximise the firm's expected profit? b. Convert the payoff table to an opportunity loss table. c. Calculate the expected opportunity loss for each design with present information. Which design should be selected in order to minimise the firm's expected loss? d. Determine the expected payoff that would be realised if perfect information were available. e. What is the most the firm would be willing to pay for a research study designed to reduce its uncertainty about market conditions?

A company must decide whether or not to change its packaging to a more environmentally safe material. The impact of the decision on profits depends on which of the following three possible scenarios develops in the future. Scenario 1: The media do not focus heavily on concerns about packaging, and no new laws requiring changes in packaging are passed. Under this scenario, the company will make $35 million if they change their packaging now, but will make $75 million if they do not change their packaging now. Scenario 2: The media focus heavily on concerns about packaging, and no new laws requiring changes in packaging are passed. Under this scenario, the company will make $50 million if they change their packaging now, but will make $55 million if they do not change their packaging now. Scenario 3: The media focus heavily on concerns about packaging, and new laws requiring changes in packaging are passed. Under this scenario, the company will make $60 million if they change their packaging now, but will make only $15 million if they do not change their packaging now. The prior probabilities of the three scenarios are 0.3, 0.5 and 0.2, respectively. a. Develop a payoff table for this decision situation. b. What decision will be made to maximise expected payoff? c. What is the most the company should be willing to pay for a research study designed to reduce its uncertainty about media and legal developments concerning packaging? d. Set up the opportunity loss table. e. Which decision has the minimum expected opportunity loss?

The expected value of perfect information (EVPI) is always the same as the expected opportunity loss for the best alternative. That is, EVPI = EOL*.

Which of the following statements is the same as the expected opportunity loss for the best alternative?

The expected value of perfect information (EVPI) equals the largest expected opportunity loss (EOL*).