Decision Analysis

DEFINITIONS
Simon 1960 Decision making comprises of three principle phases: finding occasions for making decisions, finding possible course of action, and choosing among courses of action. Shull 1970 A continuous and human process, involving both individual and social phenomena, based upon factual and value premises, which includes a choice of one or more alternatives with the intention of moving towards some desired state of affairs. Eilon 1969 observed The decision maker has several alternatives and that his choice involves a comparison between these and an evaluation of their outcomes

Golub A good decision is the end result of carefully selecting a preferred course of action after studying what might happen were a variety of alternatives chosen. The emphasis in this definition is placed on the process of making the decision and not on the decision itself.

Significance of decision making

Characterises the behaviour of managers It differentiates managers from other occupations in society Koontz 1980 The central focus of management is on decision making

Decision theory since1940

Individual decision making (selfish) Group decision making (strong characters) Organisational decision making (sometimes individual but on behalf of organisation)

Types of decision
1. 2. 3. 4. Routine decisions e.g. breakfast. Creative decisions imagination comes in. Negotiated decisions Entrepreneurial decisions dragons den - high levels of uncertainty - oriented towards growth - proactive go out and do something 5. Adaptive decision - high levels of certainty - reactive problem? Solve it! - intermediate orientation varied motive. 6. Planning decisions - high levels of certainty - proactive and reactive in response to competitor - orientated towards growth and efficiency.

Decision making strategies

1. Computational strategy working out the sums for the answer. Numbers get results. 2. Judgemental strategy value base. Preferences. Personal choice. Bias. Cultural and historical factors. Do I do this because..? 3. Compromise strategy a mixture of the above. What else is there to take into account? The answer is not taken at face value. 4. Inspirational strategy. Brainwave and go with it. Sometimes it works well but other times ideas are foolish.

Category I and II decisions

Category I Routine, recurring and certain. Category II Non-routine, uncertain outcomes, non-recurring. In business it tends to be financial risk. PURPOSE OF DECISION ANALYSIS TO INCREASE THE LIKELIHOOD OF GOOD OUTCOMES BY MAKING GOOD DECISIONS.

Decision problems have some or all of the following characteristics

Uniqueness one of a kind decision Importance- requires significant resources Complex many factors affect the decision Uncertainty many factors are known only imperfectly. Long-term effects an organisation will be affected by the results of the decision for many years. Complex preferences the desires of the decision maker are not clear. What is the meaning of good ? Trade offs, opportunity costs etc.

Functions of decision making

Setting the managerial objectives the end point towards which management directs its decision making

Functions of decision making continued

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Relevance are they related to and supportive of the basic purposes of the organisation Practicality Do they recognise obvious constraints? Challenge do they provide a challenge to managers? Measurability can they be measured, if only by order of importance ranking? Scheduling ability can they be scheduled and monitored to ensure progress towards their achievement? Balance Do objectives provide for a proportional emphasis on all activities and keep the strengths and weaknesses of an organisation I proper balance. Flexibility are the objectives sufficiently flexible or is the organisation likely to find itself locked into a particular course of action? Timeliness is it the proper tie to adopt these objectives State of the art do objectives fall within the boundaries of current technological development. Growth do objectives point towards growth rather than pure survival? Cost effectiveness are objectives cost effective? Are benefits greater than the cost? Accountability do the attainment of the objectives permit the assessment of performance?

The Decision Making Process

The structure of the search for information

Undirected viewing general exposure to information where the viewer has no specific purpose in mind with the possible exception of exploration. Conditioned viewing directed exposure, not involving active search to a more or less clearly identified area or type of information. Informal search a limited and unstructured effort to obtain specific info for a specific purpose. The info is actively sought. Formal search a deliberate effort, usually follows a preestablished plan, procedure or method, to secure info relating to a specific issue. Looking in a systematic and organised way.

Flaws in searching for alternatives

To gather information and not use it. To ask for more info and ignore it. To justify your choice retrospectively, make decision before looking for info. To gather irrelevant info. Often you can t know in advance the info is not going to be useful.

Assumptions underlying the search process

Search is motivated by the objective Search is simplistic, you can t get full information as tomorrow will be different. Search is biased. Some bias s are inbuilt and you don t notice them

Comparing and evaluating the alternatives

This is a multistage, repetitive function that involves a deeper and deeper investigation of various courses of action. Reviewing info gathered constantly, updating it. There exist: A good alternative likely to produce a positively valued state of affairs. A bland alternative likely to produce either a positively or a negatively valued state of affairs. A mixed alternative likely to produce a positively and negatively valued state of affairs. A poor alternative likely to produce a negatively valued state of affairs. These all depend on view of judgement.

The anticipation of outcome

The objective in making a decision is to choose from amongst promising alternatives the one (or ones) which will produce the largest number of desirable consequences and the smallest number of unwanted consequences. Utility Theory attempts to value preferences. Outcomes can be affected by 3 possible states of nature Certainty (very few are!) Uncertainty (involves subjectivity) Risk (can be calculated absolutely) (Frank Knight valued risk & uncertainty 1921)

Principles of comparing and evaluating outcomes

Make an evaluation of the anticipated costs and benefits for each alternative. Develop an estimate of the risks and uncertainties related to each alternative. Refine the number of choices Analyse the attributes of each choice Evaluate the outcome likely to result from the chosen alternatives

The act of choice the decision is the culmination of the process

Characteristics of choice Unfamiliarity of the decision maker. Ambiguity the choice may be unclear. Complexity number of alternatives or criteria. Amount of information. Instability criteria, objectives and constraints may change. Reversibility the degree to which the choice can be reversed. Significance the importance of choice. Accountability the degree to which the decision maker (e.g. government) is accountable for the results of choice. Time/ money constraints limits of time and money in process of decision making and the act of choice.

The analysis of decision involves (summary)

Theology, philosophy Morals, ethics, problem of free thought. Sociology group behaviour. Psychology - individual behaviour. Statistics actuarial approaches, just sums! Management science presents an ordered and systematic approach to decision problems.

Rational decision making

Distinction between reasoning and rationalising in decision-making

Reasoning a person who reasons uses his mind to take impartial stock of the evidence and permits his conclusions to be determined by what he finds; he doesn t allow the operation of his reason to be biased by his hopes or wishes Rationalising a person who rationalises uses his reason to arrive only at those conclusions he consciously or unconsciously desires

Rational and non-rational behaviour

The term rational is subject to widely different interpretations. An action is judged to be rational or non-rational according to the perspectives of the participants or observers

Rational means
Having or exercising the ability to reason; of sound mind; sane manifesting or based on reason; logical. Simon (1957) said that in the context of an organisation rationality is concerned with the selection of preferred behaviour alternatives in terms of some system of values whereby the consequences of behaviour can be evaluated.

Rational behaviour or rationality is a core concept of decision analysis

Just because a decision maker has been rational in the past does not necessarily mean that the Decision Maker will be rational in the future. According to economic theory the end (ie objective) of rational behaviour is the maximisation of profits on the case of business and maximisation of utility in the case of people in general. All that is necessary to make a choice a rational one is that an objective exists and that the Decision Maker perceives and selects some alternative that promises to meet that objective.

Emotionality is not the other extreme of rationality

It may be rational to strive to satisfy an emotional objective, e.g. honour, prestige etc, but not if emotion obscures a clear view of the consequences of an act

Non-rationality can take the form of:

Commitment to dogma or theory that is not relevant to situation or ignores relevant data. Education, training and experience can prevent attainment of a whole view. Limited or distorted perspectives resulting from bureaucratic narrow mindedness.

Non rational behaviour may be attributed to decision makers beliefs

Sometimes a decision makers set of beliefs may be regarded as non rational if They are illogical Inconsistent Partly or wholly false Nonsensical Specific and bound by particular occasions Deficient because of the manner in which they are held eg. Insufficient evidence, regarded as sacred to avoid modification.

Non-rational and rational

Decision making is only non-rational when decision makers do not use their faculties to accomplish some objective and pay attention to the consequences of the choices available. Some people believe that Decision Makers can never be clever enough to behave rationally and that not even experts can be completely rational. There are practical restrictions on full rationality. Decision Makers can only have imperfect information or more information than they can grasp.

Factors limiting rational behaviour

1. 2. 3. Information. Lack of information or inaccurate information. Time and cost constraints. In organisations of all types there are schedules to be met and budgets to be observed. Communication failures. Reasonably complete information may be present but not circulated to the decision makers who need to perform their roles satisfactorily. An organisation may be resistant to new information or may not recognise its significance. Precedent. Previous actions or policies may automatically narrow the deliberations of decision makers. Perception. The perception and judgement of a decision maker effectively limits decision- making ability.

4. 5.

Maximising Behaviour
An economic person is assumed to be concerned with maximising personal preferences, and is assumed to have complete knowledge of the means of achieving these preferences. Many economists accept the primacy of profit maximisation in business, but some suggest that businesses ought to maximise other objectives other than profit, e.g sales or growth in terms of the book value of fixed assets.

Case against maximising behaviour

1. Objectives are not fixed goals are not clear cut. 2. Known alternatives are not all the alternatives. 3. Public opinion and political pressures can mean that the choice which would lead to maximising behaviour is not acceptable. 4. Quantifying all potential outcomes may not be possible

The concept of satisficing behaviour

The concept of satisficing behaviour Satisficing (a portmanteau of satisfy and suffice) is a decision-making strategy that attempts to meet criteria for adequacy, rather than to identify an optimal solution. A satisficing strategy may often be (near) optimal if the costs of the decision-making process itself, such as the cost of obtaining complete information, are considered in the outcome calculus. The word satisfice was coined by Herbert Simon. He pointed out that human beings lack the cognitive resources to maximize: we usually do not know the relevant probabilities of outcomes, we can rarely evaluate all outcomes with sufficient precision, and our memories are weak and unreliable.

Satisficing behaviour
Strategy of attempting to meet criteria for adequacy rather then to identify an optimal solution. As good as its gonna get!! Satisficing behaviour depends on the makers level of aspiration which are a limiting factor and may not be in the best interests of the organisation. Satisficing behaviour depends on: The decision maker s level of aspiration, which is a limiting factor and may or may not be in the best interest of the organisation.

Decision analysis decomposes a decision problem into its most basic parts
Express choices available Gather information about each choice Set criteria by which the alternatives will be judged. Process the information available. Make a decision and act and monitor.

Identify the problem

Identify objectives and alternatives

Decompose and model the problem 1.Model of problem structure 2.Model of preferences 3.Model of uncertainty

Choose best alternatives

Sensitivity analysis

Further analysis needed?

Implement the chosen alternative

Subjective and Objective Judgements

Subjective Judgements
A subjective judgement can be defined as a judgement to the effect that the experience of the person making the judgement is being modified in some way ie something is happening in or to the subject. e.g. If X judges that These gooseberries are sour and Y judges that These gooseberries are sweet then most people would say that what X and Y are judging is the effect the gooseberries have on their palates rather than some quality possessed by the gooseberries. The palates being different, the effects produced are different and the experiences of X and Y are different. So the two judgements do not contradict each other.

Objective Judgement
An objective judgement can be defined as a judgement to the effect that the world external to the person judging is characterised by a certain quality. e.g. 3+2=5 or 7x7=49 or that the temperature in this room is 15C.

Cases of blurring between objective and subjective

There are cases when subjective judgements appear to shade into objective judgements and vice versa. eg. Consider someone looking along a straight railway line. He or she may say These railway lines are parallel which is an objective statement or that These railway lines converge at a certain distance along the track which is a subjective statement.

Investment decisions

Investment Decisions
Accept or reject: with no budgetary constraint, a decision maker must decide which, from a set of independent projects/investments/choices, if any are worthwhile. Ranking: If some input such as capital is in limited supply, then it is possible that all acceptable choices cannot be undertaken. The decision rule for accept-reject situations cannot be easily generalised to cover this problem. Choices must be ranked or ordered in terms of the objective function. Choosing between exclusive projects/investments/choices: Often projects are not independent of each other e.g. two different ways of achieving the same objective. The choices are then said to be mutually exclusive . A special case is where an action can be made at different times the problem of time-phasing.

QUALITATIVE approach likely to be used by managers, increasing with experience. These approaches are useful where the problem is simple or has been experienced previously. QUANTITATIVE analysis of quantitative facts and data associated with the problem. Mathematical expressions will describe the objectives and constraints of the problem.

Investment appraisal
Qualitative methods - Renewing broken equipment - Replacing equipment because of its appearance - By experience These qualitative methods are usually unsatisfactory!!

Quantitative Methods
Payback period Average annual cost Net present value Internal rate of return Parametric discounting Simulation methods Cost-benefit analysis Decision trees Etc .

Payback
Payback period = Investment required / Net annual cash inflow*
Using Payback Rule Assume we will accept the project if it pays back the initial cost of 160,000 within 2 years. (from start to end of year i) Cumulative cash flow (1,000) Cash outflow Cash inflow Year 0: Year 1: Year 2: Year 3: -160 +60 +70 +90 -160 + 60 = -100 still to recover -100 + 70 = -30 still to recover -30 + 90 = +60 (to receive)

Solution: Project pays back = 2 + [(30/90)x12] = 2 years 4 months. Do we accept or reject the project? Reject, according to the Payback Rule, as it exceeds 2 years target. (It takes longer than 2 years target to recover the initial cost of 160,000.) The decision rule is accept if t=T (Bt Ct) > 0 T=0 where T is some minimum time horizon.

Annual Average Cost

Net profit or loss of investment/time cash flows take place. Expressed as percentage:
AnnualAverageCost x100 InitialCapitalCost

Disadvantage is that it does not always provide a means of differentiating between investments which have different total net cash flows.Also like the payback period method it does not  take into account the time value of money

NPV

Cost/benefit analysis
Could postpone construction for 1 year, saving interest on K. saving rk/1+r

IRR
Disount rate when NPV = 0

NPV vs IRR
IRR -not good for mutual exclusivity -Inflates desirability of short life project -Sensitivity to time phasing of income -multiple roots -changes in discount rates

Risk and Uncertainty

Pure risk or uncertainty possible outcomes are either a loss or no loss (i.e no possibility of a gain) e.g. risk of fire, storm, theft, fraud. Speculative risk - exists where there is a potential for change that can result in a loss, no loss or gain or a gain e.g. change in interest rate, change in government technology Often it is worth taking out insurance against pure risk. There exist forms of insurance against speculative risk, but one of the main purposes of taking on speculative risk is to make some gain.

Methods of accounting for risk

Sensitivity analysis Investigates effects of changes in assumptions made. Eg. Magnitude and timing of cash flows, interest rates etc

Parametric Discounting
Constant value assumed for all parameters accept the parameter under investigation.

Methods of Decision Criteria

General form of a decision table or payoff matrix

Uncertain events or states of nature, Potential decisions or strategies d1, d2, d3 Consequences C11, C12 , C13 ...
1, 2, 3

Probabilities (not always included)

p(

1),

p(

2),

p(

3)

Maximin Payoff Criterion (Wald Criterion)

For each potential decision or strategy, consider the minimum payoff it could give. Decision rule: Choose the strategy with the highest minimum payoff. Choose the strategy with the lowest maximum loss Chooses strategy that is the best of the worst! e.g.
1 d1 d2 d3 2 5 1 2 3 0 2 3 -1 0 -2 4 0 1 4 Minimums from each row 4 0 = maximin strategy 1

Maximin cont
This decision rule can give paradoxical results for example

s1 d1 d2 100,000 0

s2 -1 0

Minimum -1 0

Here d2 would be chosen as it has the lowest maximum loss. A chance of a very high positive outcome (d1,s1) is rejected as there is a chance of a very small loss, which is greater than any potential loss if d2 is adopted.

Maximin example 2
Choose the strategy which gives the maximum, from among all the minimum pay-offs.
s1 a1 a2 a3 16 13 8 s2 37 41 45 s3 58 67 76 Minimum 16 = maximum of the minimums! 13 8

Minimax regret criterion (savage criterion)

Savage suggested that individuals when faced with uncertain outcomes were motivated by a desire to avoid regret Measure of regret in this case is actual payoff for strategy best attainable payoff under strategy.

s1 a1 a2 a3 16 13 8

s2 37 41 45

s3 58 67 76

Minimax example
s1 a1 a2 a3 16 13 8 s2 37 41 45 s3 58 67 76

For each of the entries below we have the actual payoff -greatest potential payoff for each state of nature. The action which has the lowest maximum regret is chosen. In this case the optimum action is the minimum maximum payoff a3. The lowest maximum regret. Regret is the differences in values of the states of natures. s1 s2 s3 a1 a2 a3 0 3( 16-13) 8 8 4 0 18 9 0

Maximax criterion
s1 a1 a2 a3 16 13 8 s2 37 41 45 s3 58 67 76 Maximum 58 67 76

Action is to maximise the maximum payoff so in this case a3

Principle of insufficient reason (Laplace Criterion)

This decision rule assumes all states of nature have equal probability of occurring. n = number of states 1 Vij Vij = payoff for action I under state j n We choose the maximum, a1

s1 a1 a2 a3 a4 2 1 0 1

s2 2 1 4 3

s3 0 1 0 0

s4

Max 1V n 5/4 1 1 1

ij

1 1 0 0

Hurwicz criterion
Hurwicz proposed that decisions should b based on weighted worst and best outcomes. Let there be an index of pessimism for which any decision maker lies between 0-1. mi =minimum payoff for strategy I (i= 1,2,3 ) Mi =maximum payoff for strategy I (i= 1,2,3 ) mi + (1- )Mi That is the weighted average of the lowest and highest payoffs that results from the ith strategy. We choose the strategy with the highest value index.

Discussion of the criterion methods Maximin (wald) criterion uses only a small part of the info provided
i.e. the worst outcome for each strategy. Its leads to a conservative bias. Minimax regret (savage) criterion suffers from the same limitation and additional doubt about the appropriateness of measuring regret . E.g. in one case actual payoff 9 when expected payoff 10 regret is 1. In another case actual payoff was 99 when expected payoff was 100, regret is 1. Same regret in both cases but is this really realistic? The laplace approach is based on a contradiction. I attempts to bring probability into a situation of complete ignorance. The index of pessimism is more appealing in that it takes into account more of the available information

Abilene Paradox
The Abilene Paradox is a paradox in which the limits of a particular situation force a group of people to act in a way that is directly the opposite of their actual preferences. It is a phenomenon that occurs when groups continue with misguided activities which no group member desires because no member is willing to raise objections. Explained by psychology theories of social conformity and social cognition which suggest that human being soften feel great disincentives to acting in a manner contrary to the trend of the group. Helps to highlight that groups have as much trouble managing their agreements as they do their disagreements. Groups with inclusion of diverse backgrounds helps avoid the situation of abilene paradox and the group di is more effective and makes better decisions.

Simpsons paradox

In probability and statistics, Simpson s paradox is an apparent paradox in which a correlation present in different groups is reversed when the groups are combined. This occurs when frequency data are hastily given causal interpretations. Usually the results contradict each other when combined as a third variable (related to the other two variables) has not been included and it will affect the results if not accounted for.

Russell s Paradox
Most of the sets you are likely to think of will not be members of themselves. E.g. the set of whole numbers is not a whole number, the set of nations is not a nation and the set of Frenchwomen is not a Frenchwomen. But the set of everything which is not a Frenchwomen is a member of itself, since it is not a Frenchwomen so is the set of sets, since it is a set. However the set of those sets which are not member of themselves is both selfmembered and not self-membered.

Subjective Estimation
e.g. Optical illusions Perceptional distortion examples shown in lectures

Sources of error in subjective estimating

1. Representatives 2. Availability 3. Adjustment and anchoring

1. Representativeness
If an element X is considered highly representative of a set A then it will be given a high probability of belonging to a set A REMINDER - Example of description of shy, quiet person, then list of possible jobs and most people pick librarian as they feel the description represents the stereotypical librarian most. This heuristic is employed when people are required to assess than an event belongs to a particular class. HEURISTIC -- -- -> a commonsense rule (or set of rules) intended to increase the probability of solving some problem.

Errors with Representiveness

Errors arise because of: - Insensitivity to prior probability outcomes ( i.e. people should think that there is a much higher number of farmers than librarians in the population and therefore higher probability he is a farmer) - Insensitivity to sample size e.g. probability of boy or girl birth 50:50, small and large hospital, people often say both would have similar days of over 60% male births but in fact large hospital less likely to stray from this average. - Insensitivity to predictability. E.g. if predictability is nil (i.e. not a good chance of a good realistic prediction) then same profit prediction should be given for all companies. - The illusion of validity increasing confidence in one s judgement especially with larger and larger amounts of information even though the accuracy of the judgement remains unchanged. - Misconceptions of regressions e.g. if 50 students have IQ 100 on average, if one student has IQ150 then the average goes up to 101. e.g.2. coin tosses. HHHHHT just as likely as HTHTHH

Availability
Sometimes people assess an event by the case with which instances or occurrences can be brought to mind. E.g. one may evaluate the probability that a business venture will fail by imagining various difficulties it could encounter. Availability is a useful clue for assessing frequency or probability because instances of large classes are usually reached better and faster than instances of less frequent classes. e.g. one may assess the risk of heart attack among middle aged people by recalling such occurrences among people of that age that you know.

Errors in Availability
1. 2. 3. 4. Bias due to the irretrievability of instances Bias due to the effectiveness of a search set Biases of imaginability Illusory correlation

Adjustment and Anchoring

In some situations people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial starting point may be suggested by the formulation of the problem, but typically the adjustment is insufficient Different starting points yield different estimates.

Biases of adjustment and anchoring

1. Insufficient adjustment 2. Biases in the evaluation of conjuctive ( and events) and disjunctive( or events) events. People tend to over estimate the probabilities of conjunctive events and under estimate the probabilities of disjunctive events. 3. Anchoring

Overconfidence in subjective assessments

experts tend to be over-confident in their assessments. A person s confidence or skill in estimating can be measured using one of two indices - Interquartile index - Surprise index

The value of information

The amount a decision maker would be willing to pay for information prior to making a decision.
(value of the outcome with the Information) (value of the outcome without the Information)

Decision making under certainty

The most elementary of decision making scenarios is decision making under certainty. Here the state of nature is known and the decision maker needs to examine the payoffs under different decision alternatives and select the alternative with the largest payoff.

Value of perfect information notes

How much would the decision maker be prepared to pay to find out for certain how the stock was going to behave? The value of the advise depends on the probabilities that the stock will appreciate. If the decision maker is fairly certain that the stock price will move one way or another then there is little to be gained in buying certainty.

Suppose that:
P( 1) = P( 2) = 0.5 And the stockbrokers fee is paid in advance (there is no payment by results) Either the decision maker is told that the stock will appreciate ( 1 is true) or that it will depreciate ( 2 is true)

Stock appreciates 1 D1 Invest D2 Leave money in bacnk 5100 5000

Stock depreciates 2 4900 5000

The expected outcome with perfect information is: 5100 x 0.5 + 5000 x 0.5 = 5050 Without information the expected value of the information is 5000 Therefore the expected worth of perfect information is the difference between the two i.e 50.

An alternative approach to the same q

(what is the value of perfect information)

Stock appreciates 1 D1 Invest D2 Leave money in bank 5100 -f 5000 -f

Stock depreciates 2 4900 -f 5000 -f

Suppose a fee f is paid for the information. The expectation is (5050 f) which is 5000 available without information plus a fee of 50.

Expected value of perfect information - general case:

1 d1 d2 d3 U11 U21 U31 p1 2 U12 U22 U32 p2 3 U13 U23 U33 p3

Here utility is : relative values for the possible outcomes of a decision taking into account the preferences of the decision maker. The expected utility of di is: n = number of states of nature n

U
j !1

ij

Pj

If there is perfect information

For j one selects the decision which gives the greatest utility in the column corresponding to that state of nature. The expected utility with perfect information is obtained by multiplying this maximal utility by the corresponding probability of the uncertain event and summing all the products for different events. i.e
n

maxU
j !1

ij

Pj

The best information without perfect information is:

n

max U ij P j
j !1

The difference between the two quantities is the expected value of perfect information.
n

n
ij

maxU
j !1

Pj

- max U ij P j
j !1

Example
1 a1 a2 a3 P= 16 13 8 0.2 2 37 41 45 0.4 3 58 67 76 0.4 EV s 41.2 45.8 50 Here max = 50

With perfect information: d1 a1 a2 a3 P= 16 13 8 0.2 d2 37 41 45 0.4 d3 58 67 76 0.4 EV s 3.2 18 30.4 51.6 EV of decision given perfect information 51.6 50 = 1.6

Utility
In real life it is not always possible or appropriate to use monetary values to find the best decisions. For example because the relevant features are not naturally quantifiable, for example the benefits of fresh air the enjoyment of a concert. Sometimes there is a measured element in some such situations e.g. the price of a theatre ticket may reflect the amount of enjoyment.

Decision tree, with perfect information shown.

Example 1
A fair coin is to be tossed and the payoff matrix for outcomes and decision shown below.
1: Heads d1 d2 20,000 40,000 2: Tails 20,000 0

Most people when faced with this choice between d1 and d2 will choose d1. Suppose someone needs 40,000 desperately to pay off a creditor then that person may prefer d2. They would appear not to be acting rationally but would in fact be. Therefore it is not clear that the two alternatives are equivalent regardless of circumstances.

Relative vs Absolute
Relative values or absolute values, people often ignore absolute values. e.g. 10,000 to 20,000 380,000 to 390,000 Relative value in the first case is larger than the relative value of the second case. The absolute difference in values are the same, 10,000. Humans tend to define value on a relative basis rather than on an absolute basis

Example 2 St Petersburg Paradox

Casino makes repeated independent tosses of a coin until a tail occurs. Gambler with 1 stake has two choices 1. He can take his winning from previous tosses and the game will end. 2. He may use his winning as original stake money and as a stake for the next toss of the coin. If heads, stake will triple, if tails, gambler loses all his winnings plus stake money.

Suppose the gambler applies the expected monetary value EMV to the game
r = consecutive heads thrown Sr = original stake plus winning Expected payoff for continuing: (0) + (3Sr) = 1 Sr This results in a value greater than the value of walking away as the expected payoff for not continuing to play is Sr. So under EMV criterion the gambler should continue to play until a tail is thrown, when he loses everything. The EMV ensures the gambler loses his money with certainty.

Preferences and Utility

Preferences or wants are states of nature Preferences are assumed to be selfish, individuals behave in such a way that they choose on the basis of the outcome of a decision as it affects them and not as it affects others. Given that preferences exist, individuals must be able to rank alternatives states as either 1. A strict preference 2. A relationship or indifference

Notation of preferences
xPy x is prefered to y U(x) > U(y) xIy there is indifference between x and y U(x) = U(y) xRy marginal preferences between x and y U(x) U(y)

Axioms of of utility
Connectedness an individual must at least be indifferent if given two choices. Transitivity (consistency) Reflexivity xRx Continuity xPy and z is close to x, xPy.

Measurement of utility
Ordinal! Cant put a value on utility. We can only say utility is greater or less in one situation than in another. It is possible to have an interval scale that shows the relative preferences, e.g. x1 is greater than x2 by 12 units.

The Utility of Money EMV appraoch

Contract K Probability 0.6 0.1 0.3 Outcome 80,000 10,000 -30,000 Probability 0.5 0.3 0.2 Contract L Outcome 50,000 30,000 -10,000

EMV approach: EMV(k) = 0.6 x 80,000 + 0.1 x 10,000 + 0.3 x -30,000 = 40,000 EMV(l) = 0.5 x 50,000 + 0.3 x 30,000 + 0.2 x -10,000 = 32,000 Therefore you would select contract K.

The Utilities of money the utility values approach

U(80,000) = 100 U(50,000) = 90 U(30,000) = 80 U(10,000) = 50 U(0) = 30 U(-10,000) = 18 U(-30,000) = 0 EUV expected utility value becomes the decision criterion. EUV(k) =0.6 x 100 + 0.1 x 50 + 0.3 x 0 = 65 EUV(l) = 0.5 x 90 + 0.3 x 80 + 0.2 x 18 = 72.6 EUV of choosing neither contract = 30