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Abdul Quadir
XLRI
0.5
0
Lotteries
0.5
0
How to Evaluate Random Outcomes?
I In the R%D example which action the manager would choose?
I Observe that it is very easy to compare the lotteries that
follow g and s.
I Since both have the same set outcomes, the choice of g yields
higher chance to get payoffs 10.
I Let us tweak the outcome set a little bit assuming there is a
fixed cost to undertake R%D.
9
0.75
N
g
0.25 −1
Decision Maker
s N 0.5 10
0.5
0
How to Evaluate Random Outcomes?
I In the R%D example which action the manager would choose?
I Observe that it is very easy to compare the lotteries that
follow g and s.
I Since both have the same set outcomes, the choice of g yields
higher chance to get payoffs 10.
I Let us tweak the outcome set a little bit assuming there is a
fixed cost to undertake R%D.
9
0.75
N
g
0.25 −1
Decision Maker
s N 0.5 10
0.5
0
Expected Payoff
I We need a methodology to compare lotteries.
I The good news is that there exists already a methodology to
compare lotteries.
I This is known as expected utility theory.
I It was developed by John von Neumann and Oskar
Morgenestern in 1944.
I The detail of their theory is beyond this course.
I The intuition lies behind the idea of averages.
I If on average the outcome which we choose provides more
payoff, then we view our outcome as good outcome.
I Technically, let u(x) be the player’s payoff function over
outcomes in X = {x1 , x2 , . . . , xn }, and p = (p1 , p2 , . . . , pn ) be
lottery over X such that pk = Pr [x = xk ]. Then we define the
player’s expected payoff from the lottery p as
n
X
E [u(x)|p] = pk u(xk ) = p1 u1 (x1 ) + p2 u(x2 ) + · · · + pn u(xn )
k=1
Expected Payoff
I We need a methodology to compare lotteries.
I The good news is that there exists already a methodology to
compare lotteries.
I This is known as expected utility theory.
I It was developed by John von Neumann and Oskar
Morgenestern in 1944.
I The detail of their theory is beyond this course.
I The intuition lies behind the idea of averages.
I If on average the outcome which we choose provides more
payoff, then we view our outcome as good outcome.
I Technically, let u(x) be the player’s payoff function over
outcomes in X = {x1 , x2 , . . . , xn }, and p = (p1 , p2 , . . . , pn ) be
lottery over X such that pk = Pr [x = xk ]. Then we define the
player’s expected payoff from the lottery p as
n
X
E [u(x)|p] = pk u(xk ) = p1 u1 (x1 ) + p2 u(x2 ) + · · · + pn u(xn )
k=1
Expected Payoff
I We need a methodology to compare lotteries.
I The good news is that there exists already a methodology to
compare lotteries.
I This is known as expected utility theory.
I It was developed by John von Neumann and Oskar
Morgenestern in 1944.
I The detail of their theory is beyond this course.
I The intuition lies behind the idea of averages.
I If on average the outcome which we choose provides more
payoff, then we view our outcome as good outcome.
I Technically, let u(x) be the player’s payoff function over
outcomes in X = {x1 , x2 , . . . , xn }, and p = (p1 , p2 , . . . , pn ) be
lottery over X such that pk = Pr [x = xk ]. Then we define the
player’s expected payoff from the lottery p as
n
X
E [u(x)|p] = pk u(xk ) = p1 u1 (x1 ) + p2 u(x2 ) + · · · + pn u(xn )
k=1
Example
I What are the expected payoff of the modified R%D example
for each action?
0.25 12 − 10
You
12
0.25
Dont’t N 0.5
8
0.25
4
Example: Getting MBA Degree
I Suppose after extensive research you are convinced that the
probabilities of each state of labor market.
I For strong, average and weak, they are 0.25, 0.5, and 0.25,
respectively.
I Given these information, what would you decide?
I Let us draw decision tree:
32 − 10
0.25
N 0.5
Get MBA 16 − 10
0.25 12 − 10
You
12
0.25
Dont’t N 0.5
8
0.25
4
Example: Getting MBA Degree
Don’t Get 12
0.25
Get MBA 6
0.5
N
Don’t Get 8
0.25
Don’t Get 4
Application: Value of Information
I With 8 coins, the next player can leave 5,6, or 7 coins for the
opponent to choose.
I Thus, the previous Player will win.
I Thus, the positions with 0,4,8,12,16, . . . coins are target
positions.
I Since 21 is not divisible by 4, the player who moves first will
win.
I In the sequential game, we use backward induction
argument to solve the problem.
Entry Game
Out In
P
0, 20
F A
−5, 0 10, 10
Game Trees
Out In
P
0, 20
F A
−5, 0 10, 10
1 C 2 c 1 C
2, 4
S s S
1, 0 0, 2 3, 1
1 C 2 c 1 C
2, 4
S s S
1, 0 0, 2 3, 1
1 C 2 c 1 C
2, 4
S s S
1, 0 0, 2 3, 1
1 C 2 c 1 C
2, 4
S s S
1, 0 0, 2 3, 1