Bayesian Decision Making

The Reverend Bayes shows us how to

do it with posterior distributions.

The Quote of the Day

You too will quickly pass into oblivion when viewing the
grand cosmos from afar within a temporal setting which
transcends and obfuscates the brief moment in time in which
your existence is comprehended by a relatively few
inconsequential humans with limited perceptions of the
universal order of which their own mere presence is but
an annoying speck among the infiniteness greatness
which lies hopelessly beyond their modest and infantile reach.
from U. R. Knots book, Feeling Good About Yourself

I am a somebody!

The Three Distributions

Prior
theoretical, empirical, subjective

Likelihood
conditional probabilities

Posterior
integrates prior with likelihood using Bayes
theorem

Bayes Theorem

d i

P Aj | B

P ( B| Ai ) P ( Ai )
n

P ( B| A ) P ( A )
i

j 1,2,..., n

i 1

P(Aj) = prior distribution

B = event, sampling (new) information
P(B|Ai) = likelihood distribution
P(Aj|B) = posterior distribution

Why does it work?

P ( B A1 ) P ( B| A1 ) P ( A1 )

P ( B A2 ) P ( B| A2 ) P ( A2 )

A2

A1
B

A3
P ( B A3 ) P ( B| A3 ) P ( A3 )

The Decision Table

State of
Nature Prior

Likelihood

Product

Posterior

A1

P(A1)

P(B|A1)

P(B|A1) P(A1)

P(A1|B)= P(B|A1) P(A1)/P(B)

A2
.
.
.
.
An

P(A2)

P(B|A2)

P(B|A2) P(A2)

P(A2|B)= P(B|A2) P(A1)/P(B)

P(An)

P(B|An)

P(B|An) P(An)

P(An|B)= P(B|An) P(An)/P(B)

SUM

1.0

P(B)

1.0
n

P ( B) P ( B| Ai ) P ( Ai )
i 1

The Inevitable Urn Problem

5 red
5 green

Urn I

2 red
8 green

Urn II

8 red
2 green

Urn III

Select an urn and draw a ball at random.

Prior: P(Urn I) = P(Urn II) = P(Urn III) = 1/3
Let B = event, draw a red ball
Likelihoods: P(Red|Urn I) = .5
P(Red|Urn II) = .2
P(Red|Urn III) = .8

The Urns & the Decision Table

Urn

Prior Likelihood

Joint Prob

Posterior

1/3

1/2

1/6

(1/6)/(1/2)=1/3

1/3

1/5

1/15

(1/15)/(1/2)=2/15

1/3

4/5

4/15

(4/15)/(1/2)=8/15

P(Red)=1/2

1.0

1.0

Returning to our investment decision...

Investment decision: $1,000 to invest.
probability
alternatives

.5
.3
solid
growth stagnation

.2

bonds

12

9.2

stocks

15

-2

8.0

credit union

7.0

inflation

E(bonds) = .5 (12) + .3 (8) + .2 (4) = 9.2

E(stocks) = .5 (15) + .3 (3) + .2 (-2) = 8.0
E(CU)
= .5 (7) + .3 (7) + .2 (7) = 7.0

expected
value

The Likelihood Distribution

Can purchase an economic forecast having the following
historical performance:
When observed
Growth
Stagnation
Inflation

Forecast predicted
Growth
Stagnation

Inflation

.7
.1
0

.2
.1
.7

.1
.8
.3

Pr(Forecast Stagnation|Stagnation)
Pr(Forecast Stagnation|Inflation)

Revision - The Posterior

Forecast says GROWTH:
Prior Likelihood
Joint
Growth
.5
.7
.35
Stagnation
.3
.1
.03
Inflation
.2
0
0
P(forecast growth) = .38

Posterior
.921
.079
0
1.00

Forecast says STAGNATION:

Prior Likelihood
Joint
Growth
.5
.1
.05
Stagnation
.3
.8
.24
Inflation
.2
.3
.06
P(forecast Stagnation) = .35

Posterior
.143
.686
.171
1.00

More Revisions
Forecast says INFLATION:
Prior Likelihood
Joint Posterior
Growth
.5
.2
.10
.370
Stagnation
.3
.1
.03
.111
Inflation
.2
.7
.14
.519
P(forecast Inflation) = .27 1.00

I wholeheartedly endorse
this Bayesian thing.

The Pre-Posterior Analysis

If GROWTH is forecasted:
E(bonds) = .921(12) + .079 (8) + 0 (4) = 11.68
E(stocks) = .921 (15) + .079 (3) + 0 (-2) = 14.05
E(credit union) = 7.0
If STAGNATION is forecasted:
E(bonds) = .143(12) + . 686 (8) + .171 (4) = 7.89
E(stocks) = .143 (15) + .686 (3) + .171 (-2) = 3.86
E(credit union) = 7.0
If INFLATION is forecasted:
E(bonds) = .370 (12) + .111(8) + .519 (4) = 7.40
E(stocks) = .370 (15) + .111 (3) + .519 (-2) = 4.85
E(credit union) = 7.0
EVSI = .38 (14.05) + .35 (7.89) + .27 (7.40) - 9.20
= 10.10 - 9.2 = .9
or .009 x $1,000 = $ 9.00
Can I watch?

The New Health Plan

Prior
Alternatives
Introduce
Do not intro

.3
High
60,000
0

.5
Moderate
20,000
0

.2
Low
-70,000
0

I need to get
me some of that.

EMV
14,000
0

EVPI = .3 (60,000) + .5 (20,000) + .2 (0) - 14,000 = $14,000

State
of nature
High
.3
Mod
.5
Low
.2

Likelihood
Joint
Prior High Mod Low High Mod Low
.6
.2
.2
.18 .06
.06
.72
.1
.8
.1
.05 .40
.05
.20
.1
.2
.7
.02 .04
.14
.08
.25 .50
.25

Posterior
High Mod L
.12
.24
.80
.20
.08
.56

Why didnt I make

the optimal Bayesian
decision? I said no to
the survey!

The New Health Plan

E(profit|High) = .72 (60,000) + .20 (20,000) - .08 (70,000) = 41,600

E(profit|Mod) = .12 (60,000) + .80 (20,000) - .08 (70,000) = 17,600
E(profit|Low) = .24 (60,000) + .20 (20,000) - .56 (70,000) = -20,800
EVSI = .25 (41,600) + .50 (17,600) - .25 (0) - 14,000 = $ 5,200

Optimal Decision: The company should pay for the survey.

If the survey forecasts high or moderate demand then introduce
the new plan; otherwise do not introduce it.

Theoretical Likelihoods
let m = the expected number of system failures per month
Event
Prior
Poisson likelihood Function:
m = 1/mo.
.60
x = number of failures per month
m = 2/mo.
.30
m x
e
m
m = 3/mo.
.10
P ( x| m)

x!

If one failure is observed (x = 1) during the initial trial month, find posterior.
m
1
2
3

Prior
.6
.3
.1
1.0
e-2 2

Likelihood
Joint
.368
.2208
.271
.0813
e-1
.149
.0149
p(1) = .317
e-3 3

Posterior
.6965
.2565
.0470
1.0

If two failures are observed:

m
1
2
3

Prior
.6
.3
.1
1.0

Likelihood
.184
.271
.224

Joint
.1104
.0813
.0224
p(1) = .2141

e m m2
P (2| m)
2!

Posterior
.5156
.3797
.1046
1.0

The Application of Basic Business

Principles to Day-to-Day Living
See? I told you it takes
money to make money.
The
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