Dr.

Tchantchane

Decision Analysis
with Additional
Information
Bayesian Analysis

12-1

Decision Analysis with Additional

Information
Bayesian Analysis
P ( A | B)

P ( A & B) P ( B | A) P ( A)

P ( B)
P ( B)

P( A | B )
1

P ( B1 ) P ( B1 | A1 ) P ( A1 ) P ( B1 | A2 ) P ( A2 ) ... P ( B1 | An ) P ( An )

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

P (B )
P ( B | A ) P ( A ) P ( B | A ) P ( A ) ... P ( B | A ) P ( A )
1

P ( A1 | B1 ) P ( A2 | B1 ) ... P ( An | B1 ) 1

12-2

Decision Analysis with Additional Information

Bayesian Analysis

Bayesian analysis uses additional information to alter the marginal

probability of the occurrence of an event.
In real estate investment example, using expected value criterion,
best decision was to purchase office building with expected value
of $444,000, and EVPI of $28,000.

12-3

Decision Analysis with Additional Information

Bayesian Analysis (2 of 3)
A conditional probability is the probability that
an event will occur given that another event has
already occurred.
Economic analyst provides additional
information for real estate investment decision,
forming conditional probabilities:
g = good economic conditions
p = poor economic conditions
P = positive economic report
N = negative economic report
12-4

Additional Information: Bayesian Analysis

P(P good) = .80

P(P poor) = .10

P(N good) = .20

P(N poor) = .90

A posterior probability is the altered marginal

probability of an event based on additional information.

Prior probabilities for good or poor economic

conditions in real estate decision: P(g) = .60;
P(p) = .40

Posterior probabilities by Bayes rule (or use

probability tree):
P(g P) = P(g and P)/P(P)=
P(P g)P(g)/[P(P g)P(g) + P(P p)P(p)]
= (.80)(.60)/[(.80)(.60) + (.10)(.40)] = .923

Posterior (revised) probabilities for decision:

P(g N) = .250

P(p P) = .077

P(p N) = .750
12-5

Decision Analysis with Additional

Information
Decision Trees with Posterior
Probabilities

12-6

Decision Analysis with Additional Information

Posterior Probabilities

Decision tree with posterior probabilities differ from

earlier versions in that:
Two Decision
new branches
at beginning
tree represent
Tree with
PosteriorofProbabilities
report
outcomes.

12-7

Decision Analysis with Additional Information

Decision Trees with Posterior Probabilities (4 of 4)

EV (apartment building) = $50,000(.923) + 30,000(.077)

= $48,460
EV (strategy) = $89,220(.52) + 35,000(.48) = $63,194

12-8

Decision Analysis with Additional Information

Computing Posterior Probabilities with Tables

Computation of Posterior Probabilities

12-9

Decision Analysis with Additional Information

Expected Value of Sample Information

The expected value of sample information

(EVSI) is the difference between the expected
value with and without information:

For example problem, EVSI = $63,194 - 44,000 =

$19,194

The efficiency of sample information is the ratio

of the expected value of sample information to
the expected value of perfect information:
efficiency = EVSI /EVPI = $19,194/ 28,000 = .68

12-

Example 2

12-

Example 2 (to solve)

Considering construction of a clinic. If the medical demand is high (Favorable

profit is 100 K $. Otherwise a loss of 40 K $. Of course they may not constru
there is no cost. Construct the decision tree and the course of action.

12-

Market research (example 2

continued)
Market research firm offer to perform a study at a
fee of 5 K $.
P(FavMark | FavResea) = 0.82
P(FavMark | UnfResea) = 0.11
a) Develop a new decision tree
b) Course of action
c) EVSI and how much might the doctor be willing
to pay for the market research?
12-

Solution

12-

Example 3

12-

Decision Analysis
Example Problem Solution (1 of 9)

12-

Decision Analysis: Questions

a. Determine the best decision without
probabilities using the 5 criteria of the chapter.
b. Determine best decision with probabilities
assuming .70 probability of good conditions, .
30 of poor conditions. Use expected value and
expected opportunity loss criteria.
c. Compute expected value of perfect information.
d. Develop a decision tree with expected value at
the nodes.
e. Given following,
P(P g) = .70, P(N g) = .30, P(P not good)
= .20,
P(N not good) = .80,
12-

Decision Analysis
Example Problem Solution (3 of 9)
Step 1 (part a): Determine decisions without
probabilities.
1. Maximax Decision: Maintain status quo
Decisions
Expand
Status quo
Sell

Maximum Payoffs
$800,000
1,300,000 (maximum)
320,000

2. Maximin Decision: Expand

Decisions
Expand
Status quo
Sell

Minimum Payoffs
$500,000 (maximum)
-150,000
320,000
12-

Decision Analysis
Example Problem Solution (4 of 9)
3. Minimax Regret Decision: Expand
Decisions
Expand
Status quo
Sell

Maximum Regrets
$500,000 (minimum)
650,000
980,000

4. Hurwicz ( = .3) Decision: Expand

Expand
$590,000
Status quo
= $285,000
Sell
$320,000

$800,000(.3) + 500,000(.7) =
$1,300,000(.3) - 150,000(.7)
$320,000(.3) + 320,000(.7) =
12-

Decision Analysis
Example Problem Solution (5 of 9)
5. Equal Likelihood Decision: Expand
Expand
$650,000
Status quo
$575,000
Sell
$320,000

$800,000(.5) + 500,000(.5) =
$1,300,000(.5) - 150,000(.5) =
$320,000(.5) + 320,000(.5) =

Step 2 (part b): Determine Decisions with EV and

EOL.
6. Expected value decision: Maintain status quo
Expand

$800,000(.7) + 500,000(.3) =

12-

Decision Analysis
Example Problem Solution (6 of 9)
Expected opportunity loss decision: Maintain
status quo
Expand
Status quo
$195,000
Sell
$740,000

$500,000(.7) + 0(.3) = $350,000

0(.7) + 650,000(.3) =
$980,000(.7) + 180,000(.3) =

Step 3 (part c): Compute EVPI.

EV given perfect information = 1,300,000(.7) +
500,000(.3) = $1,060,000
EV without perfect information =

12-

Decision Analysis
Example Problem Solution (7 of 9)
Step 4 (part d): Develop a decision tree.

12-

Decision Analysis
Example Problem Solution (8 of 9)
Step 5 (part e): Determine posterior probabilities.
P(g P) = P(P g)P(g)/[P(P g)P(g) + P(P p)P(p)]
= (.70)(.70)/[(.70)(.70) + (.20)(.30)] = .891
P(p P) =1-.891= .109
P(g N) = P(N g)P(g)/[P(N g)P(g) + P(N p)P(p)]
= (.30)(.70)/[(.30)(.70) + (.80)(.30)] = .467
P(p N) =1-.467= .533

12-

Decision Analysis
Example Problem Solution (9 of 9)
Step 6 (part f): Decision tree analysis.

12-