ajaz_eco204_2009_chapter_7.2

Ajaz_eco204_2009_cha - University of Toronto Department of Economics ECO 204 20092010 S Ajaz Hussain ECO 204 2009 2010 S Ajaz Hussain(Draft Chapter

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University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain ECO 204 2009 2010 S. Ajaz Hussain (Draft) Chapter 7.2: Decision Making Under Uncertainty with Information (Testing) 1 Please help improve the course by sending me an e mail about typos or suggestions for improvements In chapter 7.1 we showed how to use the expected utility criterion to make decisions under uncertainty. In this chapter we show how to make decisions under uncertainty when the decision maker has an opportunity to acquire information, typically test results, which partially resolves uncertainty. As such, the decision maker can make the decision with or without test results: what should the decision maker do? If she makes an informed decision (on the basis of test results) what should she do if the test is (say) “positive” or “negative”? Here are some examples: A company must decide whether to enter or stay out of the Chinese market. If the company enters China the business may be a success or a failure. The company can hire an investment bank to “test” the market conditions in China where the test results may be positive or negative. Should the company hire the investment bank and if so what will it do if the test results are positive or negative? Or should it make the decision without test results? An oil driller must decide whether to drill or not drill for oil. If the oil driller drills for oil it may or may not strike oil. The oil driller can hire a geological engineering company to “test” soil samples in the drill area and the test results may be positive or negative. Should the oil driller hire the testing company and if so what will it do if the test results are positive or negative? Or should it make the decision without test results? An individual suspects he has a tumor (say in his head). He must decide whether or not to have surgery. If there is surgery, there’s a chance surgeons do not find a tumor. The individual can hire a laboratory or an MRI center to conduct medical “tests” where the test results may be positive, neutral, or negative. Should this individual hire the laboratory to conduct tests and if so what will he do if the test results are positive, neutral, or negative? Or should he make the decision without test results? In each of the examples above the decision maker must decide whether to make the decision with or without test results. You’d think that decision makers should always decide on the basis of test results. 1 Note to self: insert section on sensitivity analysis (how robust is the decision with respect to probabilities) and some applications such as crime etc. 1 ECO 204 (Draft) Chapter 7.2
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University of Toronto, Department of Economics, ECO 204 2009 2010 S. Ajaz Hussain However, you have to keep in mind that testing is imperfect and costly: there is no such thing as a perfect test and surely the decision maker should weigh the added value of decision making with testing
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This note was uploaded on 05/02/2011 for the course ECO 204 taught by Professor Hussein during the Fall '08 term at University of Toronto- Toronto.

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Ajaz_eco204_2009_cha - University of Toronto Department of Economics ECO 204 20092010 S Ajaz Hussain ECO 204 2009 2010 S Ajaz Hussain(Draft Chapter

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