Basic Decision Analysis

Expected value criterion

 Suppose you face a situation where you must choose
between alternatives A and B as follows:
 Alternative A: $10,000 for sure.
 Alternative B: 70% chance of receiving $18,000 and 30%
chance of loosing $4,000.
What is your personal choice?

 Compare now Alternative B with:

 Alternative C: 70% chance of winning $24,600 and 30%
chance of loosing $19,400

 Note that EMV(B) = EMV(C), but are they “equivalent”?

 Alternative C seems to be “more risky” than Alternative B
even thought they have the same EMV.
 Conclusion: EMV does not take Risk into account
 The Petersburg Paradox
 In 1713 Nicolas Bernoulli suggested playing the following games:
 An unbiased coin is tossed until it lands with Tails
 The player is paid $2 if tails comes up the opening toss, $4 if
tails first appears on the second toss, $8 if tails appears on third
toss, $16 if tails appears on the forth toss, and so forth
 What is the maximum you would pay to play the above game?
 If we follow the EMV criterion:
 k
1 1 1 1
EMV     ($2)   ($2)   ($4)   ($8)  ...  
k

k 1  2  2 4 8

 This means that you should be willing to pay up to an infinite
amount of money to play the game, but why people are unwilling to
pay more than a few dollars?
 The Petersburg Paradox
 25 years later, Nicolas’s cousin, Daniel Bernoulli, arrived at a
solution that contained the first seeds of contemporary decision
theory
 Daniel reasoned that the marginal increase the value or “utility” of
money declines with the amount already possessed.
 A gain of $1,000 is more significant to a poor person than to a rich
man through both gain same amount
 Specifically, Daniel Bernoulli argued that the value or utility of money
should exhibit some form of diminishing marginal return with
increase in wealth:
The measure to use to value the
game is then the “expected utility”
k

EU     u  2 k 

1
k 1  2 

 u is an increasing concave
function, converge to a finite
number
 The rules of actional thought
 How a person should acts or decides rationally under uncertainty?
 Answer: by following the following rules or axioms:
 The ordering rule
 The equivalence or continuity rule
 The substitution or independence rule
 Decomposition rule
 The choice rule

 The above five rules form the axioms for Decision Theory
 The ordering rule
 The decision maker must be able to state his preference among the
prospects, outcomes, or prizes of any deal
 Furthermore, the transitivity property must be satisfied: that is, if he
prefers X to Y, and Y to Z, then he must prefer X to Z
 Mathematically,
 The ordering rule implies that the decision maker can provide a
complete preference ordering of all the outcomes from the best to
the worst
 Suppose a person does not follow the transitivity property: the
money pump argument
 The equivalence or continuity rule
 Given a prospect A, B, and C such that A  B C , then there
exists p where 0 < p < 1 such that the decision maker will be
indifferent between receiving the prospect B for sure and receiving a
deal with a probability p for prospect A and a probability of 1 – p for
prospect C

 Given that A  B C
 B: certain equivalent of the uncertain deal on the right
 p: preference probability of prospect B with respect to prospects A and
C
 The substitution rule
 We can always substitute a deal with its certainty equivalent without
affecting preference
 For example, suppose the decision maker is indifferent between B
and the A – C deal below

 Then he must be indifferent between the two deals below where B is

substituted for the A – C deal
 The decomposition rule
 We can reduce compound deals to simple ones using the rules of
probabilities
 For example, a decision maker should be indifferent between the
following two deals:
 The choice or monotonicity rule
 Suppose that a decision maker can choose between two deals L1
and L2 as follows:

 If the decision maker prefers A to B, then he must prefer L1 to L2 if

and only if p1 > p2. That is, if A  B

 In other words, the decision maker must prefer the deal that offers
the greater chance of receiving the better outcome
 Maximum expected utility principle
 Let a decision maker faces the choice between two uncertain deals
or lotteries L1 and L2 with outcomes A1, A2, …, An as follows:

 There is no loss of generality in assuming that L1 and L2 have the

same set of outcomes A1, A2, …, An because we can always assign
zero probability to those outcomes that do not exist in either L1 and
L 2.
 It’s not clear whether L1 or L2 is preferred
 By ordering rule, let 1
A  A2 ...  An
 Maximum expected utility principle
 Again, there is no loss of generality as we can always renumber the
subscripts according to the preference ordering
 We note that A1 is the most preferred outcome, while An is the least
preferred outcome
 By equivalent rule, for each outcome Ai (i =1, …, n) there is a
number ui such that 0 ≤ ui ≤ 1 and

 Note that u1 = 1 and un = 0. Why?

 Maximum expected utility principle
 By the substitution rule, we replace each Ai (i=1,…,n) in L1 and L2
with the above constructed equivalent lotteries
 Maximum expected utility principle
 By the decomposition rule, L1 and L2 may be reduced to equivalent
deals with only two outcomes (A1 and An) each having different
probabilities
 Finally, by the choice rule, since A1  An , the decision maker should
prefer lottery L1 to lottery L2 if and only if
n n

u p  u q
i 1
i i
i 1
i i
 Utilities and utility functions
 We define the quantity ui (i=1,…,n) as the utility of outcome Ai and
the function that returns the values ui given Ai as a utility function,
i.e. u(Ai) = ui
 The quantities
n n

 p u( A ) and  q u( A )
i 1
i i
i 1
i i

are known as the expected utilities for lotteries L1 and L2

respectively
 Hence the decision maker must prefer the lottery with a higher
expected utility
 Case for more than 2 alternatives
 The previous may be generalized to the case when a decision
maker is faced with more than two uncertain alternatives. He should
choose the one with maximum expected utility
 Hence
n
best alternativ e  arg Max  pij u ( Ai )
j
i 1

where pij is the probability for the outcome Ai in the alternative j

 Comparing expected utility criterion with
expected monetary value criterion
 The expected utility criterion takes into account both return and risk
whereas expected monetary value criterion does not consider risk
 The alternative with the maximum expected utility is the best taking
into account the trade off between return and risk
 The best preference trade-off depends on a person’s risk attitude
 Different types of utility function represent different attitudes and
degree of aversion to risk taking
 The party problem

 Kim ingin mengadakan

pesta ulang tahun. Dia
mempertimbangkan 3
lokasi tempat: outdoor,
indoor, teras (porch)

Decision node

Chance node
 Nodes
 Decision node:
 Berbentuk persegi
 Melambangkan titik dalam tree yang menyatakan
titik pengambilan keputusan, decision maker
mempunyai kebebasan penuh untuk mengambil
keputusan
 Chance node:
 Berbentuk bulat
 Melambangkan uncertain variable, decision
maker tidak mempunyai kontrol terhadap
outcome variable ini
 Solving party problem
Dengan menggunakan 5 rules:
 Ordering rule
 Equivalence rule
 Substitution rule
 Decomposition rule
 Choice rule
 Ordering rule
 Possible outcome:
 Outdoor – sunny
 Outdoor – rainy
 Porch – sunny
 Porch – rainy
 Indoor – sunny
 Indoor – rainy
 Objective: memaksimumkan kepuasan
 Best outcome: outdoor -- sunny
 Worst outcome: outdoor -- rainy
 Equivalence rule

 Semua
intermediate
outcome
ditentukan
equivalensinya
terhadap best
outcome dan
worst outcome.
 Membuat decision tree

Misalkan:
 Probability cuaca
besok cerah = 0.4
 Probability cuaca
besok hujan = 0.6
Substitution rule – decomposition rule
 Choice rule

Jadi dipilih lokasi pesta indoor, memaksimalkan probability

untuk mendapatkan best outcome
Expected utility untuk setiap alternatif
 Equivalent Monetary or Dollars Values

 Cara lain selain

menggunakan utility
value adalah
menggunakan
equivalent monetary
value untuk setiap
outcome.
Dollar value vs utility value

Utility function u(x)

 Certain equivalent
 The certainty equivalent (CE) is the amount in
which a person is just indifferent between receiving
it for sure and an uncertain or risky prospect that
might either pays more or less than this amount.

 The Certainty Equivalent of a deal is the Personal

Indifferent Selling Price (PISP)

 To find the CE of an alternative, we first compute

its expected utility and then take its inverse to
convert it back into equivalent dollar value.
 Contoh
Outdoors:
Expected utility = 0.4.
Hence certainty
equivalent = u-1( 0.4 )
= $26

Porch:
Expected utility =
0.57. Hence certainty
equivalent = u-1( 0.57
) = $40

Indoors:
Expected utility =
0.63. Hence
equivalent
= u-1( 0.63 ) = $46
Note that the best decision is also the one with the highest certainty equivalent.
 Mengunakan utility function untuk kasus lain

 Misalkan Kim menghadapi deal sebagai berikut:

 EU = 0,5
 PISP = u-1(0,5) = $32 (dari grafik utility vs dollar
value)
 Readings
 Clemen, R.T. and Reilly, T. (2001). Making Hard
Decisions with Decision Tools. Chapter 14