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Unformatted text preview: 1 1 Econ1320- Lecture 11 Decision Theory Readings: Sections 19.1-19.4 2 Todays Topics s Overview on decision making problem s Decision Table s Decision making under uncertainty s Maximax s Maximin s Opportunity loss table & Minimax regret s Decision making under risk s Expected Monetary Value s Expected Opportunity Loss s Decision Trees s Return-to-Risk ratio s Decision making under perfect information & expected value of perfect information. s Return & risk s Risk & utility s Decision making with updated information 3 Background s How do we make decisions when we are faced with numerous alternative courses of action and consequences? s A basic objective of decision theory is to provide a structure wherein information concerning the relative likelihood of different occurrences may be evaluated to enable the decision maker to identify the best course of action. s In general there are three decision-making scenarios: s Decision-making under certainty s Decision-making under uncertainty s Decision-making under risk 4 Three variables in decision making problem s Decision alternatives: are the various choices or options available to the decision maker in any given problem situation. s States of nature: are the occurrences of nature that can happen after a decision has been made. They can affect the outcome of the decision and over which the decision maker has little or no control. s Payoffs: are the benefits or rewards that result from selecting a particular decision alternative. They are often expressed in dollars, but may be stated in other units, such as market share. 5 Decision Table where: s j = state of nature d i = decision alternative P i,j = payoff for decision i under state j Table 19.1 from page 799 of text 6 E 1: Decision table for an investor s The decision maker is considering three alternatives to invest in: s d1: office building (Action 1) s d2: apartment building (Action 2) s d3: warehouse (Action 3) s The are three possible states of nature s s1: strong economy (Event 1) s s2: stable economy (Event 2) s s3: weak economy (Event 3) 2 7 Example 1: cont.-120-30 20 50 120 30 200 90 40 Office bld Apartment bld Warehouse Weak Economy Stable Economy Strong Economy Investment Choice (Decision alternative) d i Profit in $1,000s States of nature s j (Events) 8 Criteria for Decision Making under Uncertainty s A decision making situation in which the states of nature that may occur are unknown and the probability of a state of nature occurring is also unknown. We have following strategies: s Maximax payoff: Choose the best of the best s Maximin payoff: Choose the best of the worst s Minimax regret: Minimise the maximum opportunity loss 9 Maximax Criterion 1. Identify the maximum payoff for each alternative....
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