17-1 of 18

Chapter Seventeen
Decision Theory

17-2 of 18
McGraw-Hill/Irwin

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved.

Decision Theory
17.1
17.2
17.3
17.4

17-3 of 18

Bayes Theorem
Introduction to Decision Theory
Decision Making Using Posterior Probabilities
Introduction to Utility Theory

17.1 Bayes Theorem: An Example,

AIDS Testing
Question: Suppose that a person selected randomly for testing,
tests positive for AIDS. The test is known to be highly accurate
(99.9% for people who have AIDS, 99% for people who dont.)
What is the probability that the person actually has AIDS?
Answer:
guess!

Surprisingly, much lower than most of us would

The Facts :
AIDS Incidence Rate : 6 cases per 1000 Americans
P(AIDS) 0.006
P( AIDS ) 0.994
Testing Accuracy :
P(POS|AIDS) 0.999
P(POS|AIDS ) 0.01
Solution : P(AIDS|POS)
17-4 of 18

An Example, AIDS Testing (Continued)

P(AIDS|POS)

P(AIDS POS)
P(AIDS POS) P( AIDS POS)

P(AIDS)P(POS|AIDS)
P(AIDS)P(POS|AIDS) P( AIDS )P(POS|AIDS )

( 0.006 )( 0.999 )
0.005994

( 0.006 )( 0.999 ) ( 0.994 )( 0.01 ) 0.005994 0.00994

0.005994
0.015934

0.3762

17-5 of 18

P(AIDS POS)

P(POS)

( Bayes' Theorem )

Bayes Theorem
S1, S2, , Sk represents k mutually exclusive possible states of
nature, one of which must be true.
P(S1), P(S2), , P(Sk) represents the prior probabilities of the k
possible states of nature.
If E is a particular outcome of an experiment designed to
determine which is the true state of nature, then the posterior
(or revised) probability of a state Si, given the experimental
outcome E, is:

P(Si E)
P(Si|E) =
P(E)

P(Si )P(E|Si )

P(E)
P(Si )P(E|Si )

P(S1 )P(E|S1 )+P(S 2 )P(E|S 2 )+ ...+P(S k )P(E|S k )

17-6 of 18

17.2 Introduction to Decision

Theory
Example:
A developer must decide how large a luxury
condominium complex to build small, medium, or large
when profitability depends on the level of future demand
low or high for luxury condominiums.
Elements of Decision Theory
States of nature: Set of potential future conditions that
affects decision results. (e.g. low demand versus high
demand)
Alternatives: Set of alternative actions for the decision
maker to chose from. (e.g. small, medium, large)

17-7 of 18

Payoffs: Set of payoffs for each alternative under each

potential state of nature, often summarized in a payoff
table.)

Payoff Tables and Decision Trees

Example: Condominium Complex Situation

Decision Tree
Payoff Table

States of Nature
Alternatives
Low
High
Small
8
8
Medium
5
15
Large
-11
22
(payoffs in millions of dollars)

Decision Tree Legend

Branch
Decision point (node)
State of nature (node)
17-8 of 18

Decision Making Under

Uncertainty
Maximin: Identify the
minimum (or worst) possible
payoff for each alternative and
select the alternative that
maximizes the worst possible
payoff. Pessimistic.

Condominium Example

Condominium Example
Maximax: Identify the
maximum (or best) possible
payoff for each alternative and
select the alternative that
maximizes the best possible
payoff. Optimistic.
17-9 of 18

Decision Making Under Risk

Expected value criterion: Using prior probabilities for the
states of nature, compute the expected payoff for each
alternative and select the alternative with the largest expected
payoff.
Condominium
Example
Expected payoff under
Expected payoff under risk
certainty

Expected value of perfect information (EVPI)

EVPI = expected payoff under certainty expected value
under risk
17-10 of 18

= 17.8 12.1 = 5.7

17.3 Decision Making Using

Posterior Probabilities
Example 17.3: The Oil Drilling Case

Decision Tree and Payoff Table for Prior Analysis

E(Payoff|Drill) = -190,000
E(Payoff|Do Not Drill) = 0*
Decision: Do Not Drill

Suppose now that the oil company can obtain sample

information in the form of a seismic study that can yield three
possible readings low, medium and high.
17-11 of 18

Computing Posterior Probabilities,

Given Sample
Information
Example: The Oil Drilling
Case
Prior and conditional probabilities

Prior Probabilities of Oil

P(Oil)
O
none
0.7
i
some
0.2
l
much
0.1

An application
of Bayes
Theorem

Seismic Experiment Accuracy: P(Reading|Oil)

Reading
P(high|Oil) P(medium|Oil)
O
none
0.04
0.05
i
some
0.02
0.94
l
much
0.96
0.03

P(low|Oil)
0.91
0.04
0.01

Joint Probabilities: P(Oil&Reading) = P(Oil)P(Reading|Oil)

Reading
P(Oil&high) P(Oil&medium)
P(Oil&low)
O
none
0.028
0.035
0.637
i
some
0.004
0.188
0.008
l
much
0.096
0.003
0.001
Total
0.128
0.226
0.646
P(Reading)
P(high)
P(medium)
P(low)
Posterior Probabilities: P(Oil|Reading) = P(Oil&Reading)/P(Reading)
Reading
P(Oil|high) P(Oil|medium)
P(Oil|low)
O
none
0.21875
0.15487
0.98607
i
some
0.03125
0.83186
0.01238
l
much
0.75000
0.01327
0.00155

17-12 of 18

Posterior Decision Tree

17-13 of 18

Expected Payoffs, Given Sample

Information
Posterior Probabilities: P(Oil|Reading) = P(Oil&Reading)/P(Reading)
Reading
P(Oil|high)
P(Oil|medium)
P(Oil|low)
O
none
0.21875
0.15487
0.98607
i
some
0.03125
0.83186
0.01238
l
much
0.75000
0.01327
0.00155
Drilling Decision Payoff Table: Payoff(Decision|Oil)
Decision
drill
no drill
O
none
-700,000
0
i
some
500,000
0
l
much
2,000,000
0
Conditional Payoffs for Drilling: Payoff(drill|Reading) = Payoff(drill|Oil)P(Oil|Reading)
[Conditional Payoffs for No Drilling are Zero for all Readings: Payoff(no drill|Reading) = 0]
Reading
high
medium
low
O
none
-153,125
-108,407
-690,248
i
some
15,625
415,929
6,192
l
much
1,500,000
26,549
3,096
Total
1,362,500
334,071
-680,960
Pay(drill|Read)
Pay(drill|high) Pay(drill|medium)
Pay(drill|low)

17-14 of 18

Summary of Posterior Analysis and

the Expected
Value of Sample
Information
Summary of Posterior Analysis (Optimal decision and payoff for each reading)
Reading
high
medium
low
Pay(drill|Read)
1,362,500
334,071
-680,960
Pay(no drill|Read)
0
0
0
Decision
drill
drill
no drill
Exp(Pay|Read)
1,362,500
334,071
0
Expected Payoff of Sampling (EPS)

Exp(Pay|Read)
P(Reading)
Product

high
1,362,500
0.128
174,400

Reading
medium
334,071
0.226
75,500

Expected Payoff of No Sampling (EPNS)

Expected payoff for optimal decision from prior analysis, 0 (Do Not Drill)
Expected Value of Sample Information (EVSI)
EVSI = EPS - EPNS

17-15 of 18

low
0
0.646
0

249,900
EPS
0
EPNS
249,900
EVSI

17.4 Example: Utility Theory

Investment 1 Profits
Profit
Prob Prof x Prob
$50,000
0.7
35000
$10,000
0.1
1000
-$20,000
0.2
-4000
Expected Profit
$32,000
Investment 2 Profits
Profit
Prob Prof x Prob
$40,000
0.6
24000
$30,000
0.2
6000
-$10,000
0.2
-2000
Expected Profit
$28,000
No Investment Profit
Profit
Prob Prof x Prob
$0
1
0
Expected Profit
$0

17-16 of 18

Utilities
Profit
$50,000
$40,000
$30,000
$10,000
$0
-$10,000
-$20,000

Utility
1.00
0.95
0.90
0.75
0.60
0.45
0.00

Investment 1 Utilities
Utility
Prob Util x Prob
1.00
0.7
0.700
0.75
0.1
0.075
0.00
0.2
0.000
Expected Utility
0.775
Investment 2 Utilities
Utility
Prob Util x Prob
0.95
0.6
0.570
0.90
0.2
0.180
0.45
0.2
0.090
Expected Utility
0.840
No Investment Utility
Utility
Prob Util x Prob
0.60
1
0.600
Expected Utility
0.600

Utilities
Utilities are measures of the relative value of varying dollar
payoffs for an individual decision maker and thus capture the
decision makers attitude toward risk. Under certain mild
assumptions about rational behavior, decision makers should
replace dollar payoffs with their respective utilities and
maximize expected utility.
Example Utility Curves

17-17 of 18

Decision Theory

Summary
:17.1 Bayes Theorem
17.2
17.3
17.4

17-18 of 18

Introduction to Decision Theory

Decision Making Using Posterior Probabilities
Introduction to Utility Theory