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Decision
trees constructed early in the analyst/decision maker interaction may be
incomplete representations of the decision problem facing the decision maker.
To complete the tree, the possible choices at each decision node and the possible
events at each event node must now be specified. Very complex decision trees
can be represented as one-page influence diagrams.
By inspecting graphs of the two probability distributions the decision maker can
compare the probabilities of each product making a loss or the probabilities that
each product would reach a target level of profit.
utility theory can be used to identify the option which the decision maker should
choose
Stochastic dominance
The NPV figures are obviously only as good as the estimates on which the
calculations are based. In general, there will be uncertainty about the size of the
future cash flows and about the lifetime of the project
Using simulation
the
simulation approach can be extended to handle investment problems
involving sequences of decisions using a method known as stochastic
decision tree analysis.
value of
perfect information, we will need to consider the possible indications
the test will give, what the probabilities of these indications are and the
decision the manager should take in the light of a given indication.
the more reliable the new
information, the closer its expected value will be to the EVPI.
A summary of the main stages in the above analysis is given below:
(1) Determine the course of action which would be chosen using only
the prior probabilities and record the expected payoff of this course
of action;
(2) Identify the possible indications which the new information can give;
(3) For each indication:
(a) Determine the probability that this indication will occur;
(b) Use Bayes theorem to revise the probabilities in the light of
this indication;
(c) Determine the best course of action in the light of this indication
(i.e. using the posterior probabilities) and the expected payoff of
this course of action;
(4) Multiply the probability of each indication occurring by the expected
payoff of the course of action which should be taken if that indication
occurs and sum the resulting products. This will give the expected
payoff with imperfect information;
(5) The expected value of the imperfect information is equal to the
expected payoff with imperfect information (derived in stage 4) less
the expected payoff of the course of action which would be selected
using the prior probabilities (which was derived in stage 1).
Practical considerations