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Lind 18e Chap020 PPT
Lind 18e Chap020 PPT
Theory
Chapter 20
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the prior written consent of McGraw-Hill Education.
Learning Objectives
LO20-1 Identify and apply the three components of a
decision
LO20-2 Analyze a decision using expected monetary
value
LO20-3 Analyze a decision using opportunity loss
LO20-4 Apply maximin, maximax, and minimax regret
strategies to make a decision
LO20-5 Compute and explain the expected value of
perfect information
LO20-6 Apply sensitivity analysis to evaluate a decision
subject to uncertainty
LO20-7 Use a decision tree to illustrate and analyze
decision making under uncertainty
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Statistical Decision Theory
Statistical decision theory is concerned with making decisions
from a set of alternatives
Examples
Ford Motor Company must decide whether to purchase
assembled door locks for the 2017 F-150 or to manufacture
the locks themselves
If sales increase – it’s more profitable to make
If sales level off or decline – it’s more profitable to buy
GE is considering three options regarding the prices of their
refrigerators next year, raise the prices 5%, 2.5%, or leave the
prices as they are
The decision will be based on sales estimates and what the
other refrigerator producers might do
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Elements of a Decision
The choices available
The various courses of action are called the acts or
alternatives
The states of nature
The uncontrollable future events are called the states of
nature
The payoffs
The consequence of a particular decision alternative and
state of nature is the payoff
We can make better decisions if we establish probabilities
for the states of nature
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the prior written consent of McGraw-Hill Education.
Decision Making under Uncertainty
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the prior written consent of McGraw-Hill Education.
Payoff Table
Bob Hill, a small investor, has $1,100 to invest. He has studied several common
stocks and narrowed his choices to three: Kayser Chemicals, Rim Homes, and
Texas Electronics. He estimates that if stock prices increase drastically (a bull
market), his investment in Kayser stock would more than double. However, if
stock prices decrease (a bear market), the value of the Kayser stock could drop to
$1000. His predictions for the three stocks are shown in the Payoff Table below.
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Expected Payoff
In the expected
monetary value (EMV)
criterion, the expected
value for each decision
alternative is
computed, and the
optimal one is selected
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Opportunity Loss
The difference between the optimal decision and any
other decision is the opportunity loss or regret due to
making a decision other than the optimum
An opportunity loss table can be developed
An opportunity loss table is constructed by taking the
difference between the optimal decision for each state of
nature and the other decision alternatives
The expected opportunity loss (EOL) is similar to the
expected monetary value
The opportunity loss is combined with the probabilities
of the various states of nature for each decision
alternative to determine the expected opportunity loss
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Opportunity Loss Table
Suppose Bob Hill had purchased Rim Homes stock and then a bull market
developed.The value of the Rim Homes stock did increase from $1,100 to $2,200 as
expected. But had Bob bought Kayser Chemicals stock and market values increased,
the value of his stock purchase would be $2,400; so he missed making an extra $200.
The $200 is the opportunity loss for not knowing the future state of the market.
Notice, that Kayser Chemicals stock would be a good investment choice in a rising
(bull) market,Texas Electronics stock would be the best buy in a declining (bear)
market, and Rim Homes stock is a compromise.
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the prior written consent of McGraw-Hill Education.
Expected Opportunity Loss
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Maximin, Maximax, and Minimax Regret
Strategies
Maximin
The strategy of maximizing the minimum gain
Investment advisors may urge the investor to be
conservative and buy Texas Electronics stock
The investor is assured of at least $1,150
Maximax
The strategy of maximizing the maximum gain
Under this strategy, the investor would buy Kayser stock
There’s a possibility of selling the stock later for $2,400
Minimax regret
The strategy that minimizes the maximum regret
Buy Kayser, there’s a maximum opportunity loss of $150
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Value of Perfect Information
VALUE OF PERFECT INFORMATION The difference between the
maximum expected payoff under conditions of certainty and the
maximum expected payoff under uncertainty.
If Bob knew precisely what the market would do, he could maximize profit by
always buying the correct stock.What if someone could supply him with
information about when the market will rise or decline? What would this
information be worth?
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Decision Trees
Decision trees are useful for structuring the various
alternatives
They present a picture of the various courses of action
and the possible states of nature
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Chapter 20 Practice Problems
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Question 3 LO20-3
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Question 5 LO20-3
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Question 7 LO20-5
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Question 9 LO20-6
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