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Description

We have all had to make important decisions where we were uncertain about factors that were relevant to the decisions. In todays class, we study situations in which decisions are made in an uncertain environment.

Decision Making Under Uncertainty Decision Criteria Decision Trees EVPI Bayes Theorem

Types of Decision-Making

If future states of nature are known Decision-making with certainty If future states of nature are uncertain Decision-making under uncertainty Decision Theory focuses on uncertainty

Identify alternatives open to decision maker

under control of decision maker Determine payoffs and construct payoff table Select a criterion for evaluating alternative decisions

Decision Criteria

No knowledge of future probabilities Criterion of Pessimism (e.g., MaxiMin) Criterion of Optimism (e.g., MaxiMax) Criterion of Regret (e.g., MiniMax Regret) Future Probabilities Estimated or Known Expected Value Expected Opportunity Loss

Kn Video Productions, needs to decide to produce a pilot for a T.V. show or to sell the idea to another production firm:

PAYOFF TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years ? ? ? -100 50 150 100 100 100

Decision Criteria

Dominated Actions Definition: An action ai dominated by an action ai' for all sj S, rij ri' j, and for some state si', rij' < ri' j'.

The Maximin Criterion For each action, determine the worst outcome (smallest reward). The maximin criterion chooses the action with the best worst outcome.

Definition: The maximin criterion chooses the action ai with the largest value of minjSrij.

The Maximax Criterion For each action, determine the best outcome (largest reward). The maximax criterion chooses the action with the best best outcome. Definition: The maximax criterion chooses the action ai with the largest value of maxj Srij.

Minimax Regret

The maximax regret criterion (developed by L. J. Savage) uses the concept of opportunity cost to arrive at a decision. For each possible state of the world sj, find an action i* (j) that maximizes rij. i*(j) is the best possible action to choose if the state of the world is actually sj. For any action ai and state sj, the opportunity loss or regret for ai in sj is ri*(j),jrij. The Expected Value Criterion Chooses the action that yields the largest expected reward.

Criterion of Pessimism

What is the worst that can happen?

MaxiMin or MiniMax

PAYOFF TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years ? ? ? -100 50 150 100 100 100

Criterion of Optimism

What is the best that can happen?

MaxiMax or MiniMin

PAYOFF TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years ? ? ? -100 50 150 100 100 100

Criterion of Regret

What is the opportunity loss (regret) for each

possible decision? Choose alternative with the minimum regret. MiniMax Regret

PAYOFF TABLE Produce Pilot Sell to Competitor REGRET TABLE Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years -100 50 150 100 100 100 States of Nature Reject 1 Year 2 Years 200 50 0 0 0 50

Bansals Real Estate Co. (BRE), needs to decide how large a development to construct in the face of uncertain demand for resort properties. BRE wishes maximize profits.

Demand for Resorts Low Medium High 4 4 4 1 6 6 -3 3 9 Profit in Rupees crores

Further investigation by Kn Video Productions, indicates that the probabilities of success for its proposed pilot are as shown:

PAYOFF TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years 0.2 0.5 0.3 -100 50 150 100 100 100

Multiply payoffs by probability of occurrence

PAYOFF TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years 0.2 0.5 0.3 -100 50 150 100 100 100

-20 20

25 50

45 30

EV 50 100

Calculate regret table Multiply regret by probabilities Add together to calculate opportunity loss

REGRET TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years 0.2 0.5 0.3 200 50 0 0 0 50

40 0

25 0

0 15

EOL 65 15

Exercise

Suppose that Pizza King and Fast Pizza must determine the price they will charge for each Pizza sold. Pizza King believes that fast Pizzas price is random variable D having the following mass function: P(D = Rs. 16) = .25, P(D = Rs. 18) = . 5, P(D = Rs. 20) = .25. If Pizza King charges a price of p1 and Fast Pizza charges a price of p2, Pizza King will sell 100 + 25(p2 p1) pizzas. It costs Piza King Rs. 14 to make a pizza. Pizza King is considering charging Rs. 15, Rs. 16, Rs. 17, Rs. 18 or Rs. 19 for a pizza. Use each decision criteria discussed today to determine the price that Pizza King should charge.

Decision Trees

Decision Trees

Often, people must make a series of decisions at

different points in time. Then decision trees can often be used to determine optimal decisions. A decision tree enables a decision maker to decompose a large complex decision problem into several smaller problems.

determine which of several random events will occur. Each branch of an event fork represents a possible outcome, and the number on each branch represents the probability that the event will occur. A branch of a decision tree is a terminal branch if no forks emanate from the branch.

Squares represent decision nodes

Branches represent alternative paths

s1 Payoff 1 Payoff 2 Payoff 3 Payoff 4

d1

s2 s1

d2

s2

From the payoff and regret tables for Kn Video Productions:

PAYOFF TABLE Probability Produce Pilot Sell to Competitor States of Nature Reject 1 Year 2 Years 0.2 0.5 0.3 -100 50 150 100 100 100

The probability of a joint event, A and B:

Computing a marginal (or simple) probability:

Where B1, B2, , Bk are k mutually exclusive and collectively exhaustive events

P(Red and Ace)

number of cards that are red and ace 2 total number of cards 52

Color

Red Black

Total 4 48

2 24

2 24

26

26

52

P(Ace)

P( Ace and Re d) P( Ace and Black) 2 2 4 52 52 52

Color

Red Black

Total 4 48

2 24

2 24

26

26

52

Event

Event

A1 A2 B1 B2

Total

P(A1)

Total

Joint Probabilities

General Addition Rule:

P(A or B) = P(A) + P(B) - P(A and B) If A and B are mutually exclusive, then P(A and B) = 0, so the rule can be simplified: P(A or B) = P(A) + P(B) For mutually exclusive events A and B

P(Red or Ace) = P(Red) +P(Ace) - P(Red and Ace) = 26/52 + 4/52 - 2/52 = 28/52

Dont count the two red aces twice!

Type Ace

Non-Ace Total

Color

Red Black

Total 4

24

26

24

26

48

52

A conditional probability is the

P(A and B) P(A | B) P(B) P(A and B) P(B | A) P(A)

The conditional probability of A given that B has occurred The conditional probability of B given that A has occurred

Where P(A and B) = joint probability of A and B P(A) = marginal probability of A P(B) = marginal probability of B

Of the cars on a used car lot, 70% have air

conditioning (AC) and 40% have a CD player (CD). 20% of the cars have both.

Of the cars on a used car lot, 70% have air

(continued)

conditioning (AC) and 40% have a CD player (CD). 20% of the cars have both.

CD No CD Total

AC No AC Total

.2 .2

.5 .1

.7 .3

.4

.6

1.0

these, 20% have a CD player. 20% of 70% is about 28.57%.

CD No CD Total

(continued)

Given AC, we only consider the top row (70% of the cars). Of

AC No AC Total

.2 .2

.5 .1

.7

.3

1.0

.4

.6

Given AC or no AC:

.2 .7

P(AC and CD) = .2

.5 .7

All Cars

.2 .3

.1 .3

Given CD or no CD:

.2 .4

(continued) P(CD and AC) = .2

.2 .4

All Cars

.5 .6

.1 .6

Statistical Independence

Two events are independent if and

only if:

P(A | B) P(A)

Events A and B are independent when the

Multiplication Rules

Multiplication rule for two events A and

B:

P(A | B) P(A)

Note: If A and B are independent, then and the multiplication rule simplifies to

Marginal Probability

Marginal probability for event A:

P(A) P(A | B1 ) P(B1 ) P(A | B2 ) P(B 2 ) P(A | Bk ) P(B k )

Where B1, B2, , Bk are k mutually exclusive and collectively exhaustive events

Question

A company has 2 machines that produce widgets. An older machine produces 23% defective widgets, while the new machine produces only 8% defective widgets. In addition, the new machine produces 3 times as many widgets as the older machine does. What is the probability that a randomly chosen widget produced by the company is defective?

Bayes Theorem

P(A | Bi )P(B i ) P(B i | A) P(A | B1 )P(B 1 ) P(A | B2 )P(B 2 ) P(A | Bk )P(B k )

where:

Bi = ith event of k mutually exclusive and collectively exhaustive events A = new event that might impact P(Bi)

Question

A company has 2 machines that produce widgets. An older machine produces 23% defective widgets, while the new machine produces only 8% defective widgets. In addition, the new machine produces 3 times as many widgets as the older machine does. Given that a randomly chosen widget was tested and found to be defective, what is the probability it was produced by the new machine?

Answer

P(D | M 2 )P(M2 ) P(M2 | D) P(D | M1 )P(M1 ) P(D | M 2 )P(M2 ) 3 0.08x 4 0.1175 0.511

A drilling company has estimated a 40%

A detailed test has been scheduled for more

information. Historically, 60% of successful wells have had detailed tests, and 20% of unsuccessful wells have had detailed tests.

Given that this well has been scheduled for a

detailed test, what is the probability that the well will be successful?

(continued)

U = unsuccessful well

P(S) = .4 , P(U) = .6

(prior probabilities)

P(D|S) = .6

Goal is to find P(S|D)

P(D|U) = .2

Apply Bayes Theorem:

(continued)

P(D | S)P(S) P(S | D) P(D | S)P(S) P(D | U)P(U) (.6)(.4) (.6)(.4) (.2)(.6) .24 .667 .24 .12

So the revised probability of success, given that this well has been scheduled for a detailed test, is .667

(continued)

Event S (successful)

Prior Prob. .4

Conditional Prob. .6

U (unsuccessful)

.6

.2

.6*.2 = .12

.12/.36 = .333

Sum = .36

Knowledge of sample or survey information can be

used to revise the probability estimates for the states of nature. Prior to obtaining this information, the probability estimates for the states of nature are called prior probabilities. With knowledge of conditional probabilities for the outcomes or indicators of the sample or survey information, these prior probabilities can be revised by employing Bayes' Theorem. The outcomes of this analysis are called posterior probabilities or branch probabilities for decision trees.

Burger Prince Restaurant is contemplating opening a new restaurant on Main Street. It has three different models, each with a different seating capacity. Burger Prince estimates that the average number of customers per hour will be 80, 100, or 120. The payoff table for the three models is as follows: Average Number of Customers Per Hour s1 = 80 s2 = 100 s3 = 120 Model A Model B Model C $10,000 $ 8,000 $ 6,000 $15,000 $18,000 $16,000 $14,000 $12,000 $21,000

Expected Value Approach

Calculate the expected value for each decision. The decision tree on the next slide can assist in this calculation. Here d1, d2, d3 represent the decision alternatives of models A, B, C, and s1, s2, s3 represent the states of nature of 80, 100, and 120.

Payoffs

Decision Tree

2 d1 d2 1 d3 3

s1 s2 s3 s1 s2 s3 s1 s2 s3

.4 .2 .4

.4 .2 .4

8,000 18,000

12,000

.4 6,000

.2 16,000

.4 21,000

d1 Model A Model B d2 EMV = .4(10,000) + .2(15,000) + .4(14,000) = $12,600 2

Model C

Frequently information is available which can

improve the probability estimates for the states of nature. The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur. The EVPI provides an upper bound on the expected value of any sample or survey information.

EVPI Calculation

Step 1: Determine the optimal return corresponding to each state of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision from the amount determined in step (2).

Expected Value of Perfect Information

Calculate the expected value for the optimum payoff for each state of nature and subtract the EV of the optimal decision. EVPI= .4(10,000) + .2(18,000) + .4(21,000) 14,000 = $2,000

Risk Analysis

Risk analysis helps the decision maker

the expected value of a decision alternative and the payoff that might actually occur

shows the possible payoffs for the decision alternative along with their associated probabilities.

Risk Profile for the Model C Decision

Alternative

.50 Probability .40 .30 .20 .10 5 10 15 20 25

Sensitivity Analysis

Sensitivity analysis can be used to determine how changes

to the following inputs affect the recommended decision alternative: probabilities for the states of nature values of the payoffs If a small change in the value of one of the inputs causes a change in the recommended decision alternative, extra effort and care should be taken in estimating the input value.

Branch (Posterior) Probabilities Calculation

Step 1: For each state of nature, multiply the prior probability by its conditional probability for the indicator -- this gives the joint probabilities for the states and indicator. Step 2: Sum these joint probabilities over all states -- this gives the marginal probability for the indicator. Step 3: For each state, divide its joint probability by the marginal probability for the indicator -- this gives the posterior probability distribution.

The expected value of sample information

(EVSI) is the additional expected profit possible through knowledge of the sample or survey information.

EVSI Calculation

Step 1: Determine the optimal decision and its expected return for the possible outcomes of the sample or survey using the posterior probabilities for the states of nature. Step 2: Compute the expected value of these optimal returns. Step 3: Subtract the EV of the optimal decision obtained without using the sample information from the amount determined in step (2).

Efficiency of sample information is the ratio

of EVSI to EVPI. As the EVPI provides an upper bound for the EVSI, efficiency is always a number between 0 and 1.

Sample Information

Burger Prince must decide whether or not to purchase a marketing survey from Stanton Marketing for $1,000. The results of the survey are "favorable" or "unfavorable". The conditional probabilities are: P(favorable | 80 customers per hour) = .2 P(favorable | 100 customers per hour) = .5 P(favorable | 120 customers per hour) = .9 Should Burger Prince have the survey performed by Stanton Marketing?

Legend: Decision Chance Consequence

Influence Diagram

Market Survey Results Avg. Number of Customers Per Hour

Market Survey

Restaurant Size

Profit

Posterior Probabilities

Favorable

Joint Posterior .08 .148 .10 .185 .36 .667 .54 1.000

P(favorable) = .54

Posterior Probabilities

Unfavorable

Joint Posterior .32 .696 .10 .217 .04 .087 .46 1.000

P(unfavorable) = .46

Decision Tree (top half)

4 d1 d2 2 I1 (.54) d3 6 1 s1 (.148) s2 (.185) s3 (.667) s1 (.148) 5 $10,000

$15,000

$14,000

$8,000

s2 (.185) $18,000 s3 (.667) $12,000 s1 (.148) $6,000 s2 (.185) $16,000 s3 (.667) $21,000

1

I2 (.46)

$10,000

$15,000 $14,000 $8,000 $18,000

d1

d2 3

d3

s1 (.696) s2 (.217) s3 (.087)

$12,000

$6,000 $16,000 $21,000

d1 $17,855 2 I1 (.54) d3 6 1 I2 (.46) 3 $11,433 d3 9 d1 d2 8 7 EMV = .696(10,000) + .217(15,000) +.087(14,000)= $11,433 EMV = .696(8,000) + .217(18,000) + .087(12,000) = $10,554 4 5 EMV = .148(10,000) + .185(15,000) + .667(14,000) = $13,593

d2

EMV = .148(6,000) + .185(16,000) +.667(21,000) = $17,855

Expected Value of Sample Information

If the outcome of the survey is "favorable" choose Model C. If it is unfavorable, choose model A. EVSI = .54($17,855) + .46($11,433) $14,000 = $900.88 Since this is less than the cost of the survey, the survey should not be purchased.

Efficiency of Sample Information

Example: L. S. Clothiers

A proposed shopping center will provide strong competition for downtown businesses like L. S. Clothiers. If the shopping center is built, the owner of L. S. Clothiers feels it would be best to relocate. The shopping center cannot be built unless a zoning change is approved by the town council. The planning board must first make a recommendation, for or against the zoning change, to the council. Let: A1 = town council approves the zoning change A2 = town council disapproves the change Prior Probabilities Using subjective judgment: P(A1) = .7, P(A2) = .3

Example: L. S. Clothiers

New Information

The planning board has recommended against the zoning change. Let B denote the event of a negative recommendation by the planning board. Given that B has occurred, should L. S. Clothiers revise the probabilities that the town council will approve or disapprove the zoning change? Conditional Probabilities Past history with the planning board and the town council indicates the following: P(B|A1) = .2 P(B|A2) = .9

Example: L. S. Clothiers

Tree Diagram

P(B|A1) = .2 P(A1) = .7

P(Bc|A1) = .8 P(B|A2) = .9 P(A1 Bc) = .56 P(A2 B) = .27

P(A1 B) = .14

P(A2) = .3

P(Bc|A2) = .1 P(A2 Bc) = .03

Posterior Probabilities

Example: L. S. Clothiers

Given the planning boards recommendation not to approve the zoning change, we revise the prior probabilities as follows. P ( A1 ) P ( B| A1 ) (. 7)(. 2) P ( A1| B ) P ( A1 ) P ( B| A1 ) P ( A2 ) P ( B| A2 ) (. 7)(. 2) (.3)(.9) = .34 Conclusion The planning boards recommendation is good news for L. S. Clothiers. The posterior probability of the town council approving the zoning change is .34 versus a prior probability of .70.

QUESTION

A costumer has approached a bank for a Rs. 50,000 one

year loan at 12% interest. If the bank does not approve the loan, the Rs. 50,000 will be invested in bonds that earns a 6% annual return. Without further information the bank feels that there is a 4% chance that the customer will totally default on the loan. If the customer totally defaults, the bank loses Rs. 50,000. At a cost of Rs. 5000, the bank can thoroughly investigate the customers credit record and supply a favorable or unfavorable recommendation. Past experience indicate that

Question (contd.)

/96 P (favourable recommendation | customer default) = 1 /4 How the bank maximize its expected profits? Also find EVSI and EVPI.

Value of Information

If we had better or perfect information

about future states of nature, what would that information be worth? How much would we be willing to pay for better information?

EVPI Example

Tobys Ski-Cat Service is considering buying either another snow cat for the coming winter ski season. Large-capacity and medium-capacity ski-cats are available. The expected net payoffs for various outcomes are shown here:

Snowfall Light Medium Heavy 30% 30% 40% Large Capacity -90 20 70 Medium Capacity -15 10 35 No Purchase 0 0 0 Thousands of dollars

EV 7 12.5 0

Snowfall Light M edium Heavy 30% 30% 40% -90 20 70 -15 10 35 0 0 0 Thousands of dollars

EV 7 12.5 0

REGRET TABLE Large Capacity Medium Capacity No Purchase Snowfall Light Medium Heavy 30% 30% 40% 90 0 0 15 10 35 0 20 70 Thousands of dollars

Experimentation

Perfect Information usually unattainable

Improve knowledge with experimentation Market research Product testing Material sampling

Experimentation provides better (but

Suppose that it is known that if September is unusually cold (I), then there is an increased chance that snowfall will be heavy. An experiment then is to observe the weather in September before deciding which snowcat to purchase: P( I | s1 ) = 0.05 P( I | s2 ) = 0.20 P( I | s3 ) = 0.30 s1 = light snow s2 = medium snow s3 = heavy snow

Bayes Theorem

Prior Probabilities Likelihood Estimates Posterior Probabilities

sj

P( I k ) j P( I k s j )

P( s j | I k ) P( I k | s j ) P( s j ) P( I k )

States of Nature Light snow (s1) Medium snow (s2) Heavy snow (s3)

But what if September is not cold (I)? States of Nature Light snow (s1) Medium snow (s2) Heavy snow (s3)

P(sj) 0.3 0.3 0.4 P(I|sj) P(Isj) 0.95 0.285 0.8 0.24 0.7 0.28 P(I)=0.805 P(sj|I) 0.354 0.298 0.348 1.000

Cold September

PAYOFF TABLE Large Capacity Medium Capacity No Purchase Snowfall Light Medium Heavy 7.70% 30.80% 61.50% -90 20 70 -15 10 35 0 0 0 Thousands of dollars

EV 42.28 23.5 0

Warm September

Snowfall PAYOFF TABLE Light Medium Heavy 35.40% 29.80% 34.80% Large Capacity -90 20 70 Medium Capacity -15 10 35 No Purchase 0 0 0 Thousands of dollars

EV -1.54 9.9 0

Manufacturing Example

Gorman Manufacturing has the following payoff table for a make vs. buy decision:

Demand Low (s1) Med (s2) High (s3) Probability 35.0% 35.0% 30.0% Make component (d1) -20 40 100 Purchase component (d2) 10 45 70 Demand Low (s1) Med (s2) High (s3) Probability 35.0% 35.0% 30.0% Make component (d1) 30 5 0 Purchase component (d2) 0 0 30 REGRET TABLE PAYOFF TABLE

EV 37.00 40.25

Gorman decides to conduct a test market survey to better understand the potential demand for the new product. Based on past experience, the market research firm employed says that the survey will provide either indication of high demand (I1) or low demand (I2) with the following outcomes: High Demand P( I1 | s1 ) =0.10 P( I1 | s2 ) =0.40 P( I1 | s3 ) =0.60 Low Demand P( I2 | s1 ) =0.90 P( I2 | s2 ) =0.60 P( I2 | s3 ) =0.40

Utility Theory

Linear marginal utility for money Risk Neutral Decreasing marginal utility for money Risk Averse Increasing marginal utility for money Risk Seeking

Utility Risk Averse

Risk Neutral

Risk Seeking

Money

Utility

Risk Averse for large sums

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