D AT E | M O N T H | Y E A R BU275: Business Decision

Presented by
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Instructor – Dr Jason Hurley
WINTER 2023
 Decision Analysis (part 3)
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Obtaining More Information

• Is it possible to spend money to acquire more information (i.e.,

better estimates of the true state of nature/outcome that will occur)?

• If so, is the expenditure worthwhile?

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• Check by calculating
Presented by
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EVPI and comparing to the cost of obtaining the
information
• If EVPI > Cost, then it may be worthwhile to obtain more info
• If EVPI < Cost, then it is not worthwhile to obtain more info

• Recall: EV of PI (EVPI) = EV with PI – EV without PI

 Decision Tree with Perfect Information
• Obtain “perfect information” about the state of nature before making a
decision – reverse the chronological order of outcome and alternatives

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Presented by
EV WITH perfect information = Expected Payoff =
(0.25*700,000)+(0.75*90,000)Last
First Name = Name Max(700,000,90,000)

Expected Payoff =
Max(-100,000,90,000)
Decision Making with Sample Information
Obtaining perfect information about the future is rare, but what if we could gain some
amount of additional (imperfect) information that will improve decisions?

• New knowledge of sample/survey information can be used to revise

probability estimates for potential outcomes
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Presented by
• The prior
First probabilities
of the possible states of nature often are quite
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subjective in nature; potentially rough estimates

• It is often possible to do additional research, testing or surveying (at

some expense) to improve these estimates
• The improved estimates are called posterior probabilities
Calculating Posterior Probabilities

• With knowledge of conditional probabilities, P(finding|state), for

findings (indicator) of the sample or survey, prior probabilities, P(state),
can be revised
• For each state of nature, multiply prior probability by conditional
probability
D AT E | 
M O Ngives
T H | Y E Ajoint
R probabilities, P(finding and state)
• Sum joint probabilities
Presented by over all states  gives marginal (prior)
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probability for findings (indicator)
• For each state, divide joint probability by marginal (prior) probability for
findings (indicator)  gives posterior probabilities
Bayesian Updating

The formula for calculating posterior probability is known as

Bayes’ theorem:

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where: Presented by
P(B|A)First
is Name Last Name that event B will occur given that event A has occurred
the probability
P(A|B) is the probability that event A will occur given that event B has occurred
P(A|B’) is the probability that event A will occur given that event B’ has occurred
P(A) is the probability that event A will occur
P(B) is the probability that event B will occur
P(B’) is the probability that event B’ will occur
Bayesian Updating

The formula to compute posterior probability is known as

Bayes’ theorem

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Goferbroke Example continued…

The Goferbroke Co. can obtain improved estimates of the

chance of oil by conducting a detailed seismic survey of the
land (at a cost of $30,000).
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Possible findings from a seismic survey:
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1. FSS: Favorable Seismic Soundings – oil is likely.

2. USS: Unfavorable Seismic Soundings – oil is unlikely.
Goferbroke Example continued…

Conditional findings, P(finding|state), from a seismic survey:

• If the land has oil, 60% of the time the test result is Favorable
•D AT EP(FSS|Oil)
| M O N T H | Y E A=
R 0.6

•Presented
Therefore,
by P(USS|Oil) = 0.4
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• If the land is dry, 80% of the time the test result is Unfavorable
• P(USS|Dry) = 0.8
• Therefore, P(FSS|Dry) = 0.2
Goferbroke Example continued…
Using Bayes’ Theorem to calculate Posterior Probabilities

Example:

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Goferbroke Example continued…

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Goferbroke Example continued…
Event Prior Conditional Joint Posterior
Bi P(Bi) x P(FSS|Bi) = P(Bi and FSS) P(Bi|FSS)

Oil 0.25 0.6 0.25(0.6) = 0.15 0.15/0.3 = 0.5

Dry 0.75 0.2 0.75(0.2) = 0.15 0.15/0.3 = 0.5

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Presented by P(FSS) = 0.3

Event First Prior
Name Last NameConditional Joint Posterior
Bi P(Bi) P(USS|Bi) P(Bi and USS) P(Bi|USS)

Oil 0.25 0.4 0.25(0.4) = 0.1 0.1/0.7 = 0.14

Dry 0.75 0.8 0.75(0.8) = 0.6 0.6/0.7 = 0.86

P(USS) = 0.7
Goferbroke Example continued…

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 Goferbroke Example continued…
If FSS, choose to
drill for oil.

CHOOSE TO DO
THE SURVEY AS
IT YIELDS
HIGHEST EV

Expected Payoff = D AT E | M O N T H | Y E A R
Max(237,000,100,00)
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If USS, choose to
sell the land.
Expected Value of Sample Information (EVSI)

• EVSI is the maximum amount a decision maker would be

willing to pay for the sample/survey information

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HowPresented
muchby better off does the info leave the decision maker?
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EV of SI (EVSI)= EV with Sample Information - EV without Sample Information

EVSI = 237,000 – 100,000 = $137,000

 Goferbroke Example continued…

What if we include the cost of

the information/survey (i.e.,
reduce payoffs by cost of info)?

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Presented by
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Expected Payoff =
Max(207,000,100,000)
CHOOSE TO DO
THE SURVEY AS
IT YIELDS
HIGHEST EV
EVSI for the Goferbroke Company

• To calculate the EV with sample information (when payoffs are

reduced by the cost of the test/survey prior to rolling back
decision tree), you need to add back the cost of the info/test:

EV with Sample Information = 207,000 + 30,000 = $237,000

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Presented by
First Name LastEV without Sample Information = $100,000
Name
EVSI = 237,000 – 100,000 = $137,000

Is the $30,000 cost to perform the survey justifiable?

EVSI > Cost, therefore it is justifiable.

Efficiency of Sample Information

• The efficiency of sample information is the ratio of the EV of

sample information to the EV of perfect information:
𝑬𝑽𝑺𝑰
𝑬𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒄𝒚 𝒐𝒇 𝑺𝒂𝒎𝒑𝒍𝒆 𝑰𝒏𝒇𝒐𝒓𝒎𝒂𝒕𝒊𝒐𝒏=
D AT E | MONTH | YEAR
𝑬𝑽𝑷𝑰
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Efficiency for Goferbroke’s Seismic survey:
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Efficiency = 137,000/142,500 = 96.14%

A high efficiency rating indicates that the information is very

good, or close to being perfect
 Thanks for your attention!
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Next class:
• Decision Analysis problem solving session
Review: Prior (Marginal) Probabilities
Sample space

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𝑨
P(A) = 5/18 P(B) = 10/18
P() = 13/18 P() = 8/18
Review: Conditional Probabilities
What is the probability of A occurring, given that B has
occurred?
P(A|B) = P(A and B)/P(B)
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P(A and B) = 3/18
Presented by P(A|B) = 3/10
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P(B) = 10/18

P(A and B)/ P(B) = = = P(A|B)

 Review: Bayesian Updating (Bayes’ Theorem)
𝟑 𝟏𝟎
( )( )
𝑷 ( 𝑨∨ 𝑩) × 𝑷 ( 𝑩) 𝟏𝟎 𝟏𝟖 𝟑
𝑷 ( 𝑩| 𝑨 )= = =
( )( ) ( )( )
𝑷 ( 𝑨∨ 𝑩) × 𝑷 ( 𝑩 ) + 𝑷 ( 𝑨∨ 𝑩) × 𝑷 ( 𝑩) 𝟑 𝟏𝟎
𝟏𝟎 𝟏𝟖
+
𝟐
𝟖 𝟏𝟖
𝟖 𝟓

P(B|A) = 3/5
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𝑨
Review: Bayesian Updating using Tables
Event Prior Conditional Joint Posterior
Bi P(Bi) x P(A|Bi) = P(Bi and A) P(Bi|A)

B 10/18 = 0.556 3/10 = 0.3 3/18 = 0.167 (3/18)/(5/18) = 3/5 = 0.6

B’ 8/18 = 0.444 2/8 = 0.25 2/18 = 0.111 (2/18)/(5/18) = 2/5 = 0.4

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Presented by P(A) = 5/18 = 0.278

Event First Prior
Name Last NameConditional Joint Posterior
Bi P(Bi) P(A’|Bi) P(Bi and A’) P(Bi|)

B 10/18 = 0.556 7/10 = 0.7 7/18 = 0.389 (7/18)/(13/18) = 7/13 = 0.538

B’ 8/18 = 0.444 6/8 = 0.75 6/18 = 0.333 (6/18)/(13/18) = 6/13 = 0.462

P() = 13/18 = 0.722