Chapter 12

Making Hard
Decisions

Value of Information

Draft: Version 1

R. T. Clemen, T. Reilly

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 1 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

[Link]

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Introduction

Draft: Version 1

Often you pay for information you are asking for:

Investment Advice
Management Consultants
Market Investigation
Palm Reading
You need this information to make a decision in the
future:
To invest in a particular stock or not
To restructure the organization of your company or not
To introduce a product or not
Should I marry this person or not

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 2 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

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Introduction
Problem at hand:
Given your decision problem, how much should
you be willing to pay for this information?

Draft: Version 1

To answer this questions you have to determine the

value (in dollars) of information.
We will first discuss a method for determining the value
of perfect information and next for imperfect
information.
WHICH ONE DO YOU VALUE MORE?
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 3 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

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Probability and Perfect Information

Definition: Clairvoyant Expert on event A
If event A is about to occur, the expert says, it will. If event
A is not to occur, the expert says, it will not. The expert is
NEVER wrong. His information is PERFECT.

Draft: Version 1

A = { Dow Jones index goes up}

"A" = {Expert Says Dow Jones index goes up}
You are considering investing in a company, but before
you do you want to make sure that the Dow Jones
index will go up as this increases your chances of
making a good investment. Therefore, you decide to
consult a clairvoyant expert on the event A.

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 4 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

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Probability and Perfect Information

What does it mean to be clairvoyant in probabilistic terms?
Pr( { Expert Says Dow Jones } | { Dow Jones } ) =
Pr( "A" | A ) = 1
Similarly:

Pr(" A" | A) = 1 1 Pr(" A" | A) = 1 Pr(" A" | A) = 0

Draft: Version 1

Pr(" A" | A) = 0 1 Pr(" A" | A) = 0 Pr(" A" | A) = 1

Perhaps more importantly, what about?
Pr({ Dow Jones } | { Expert Says Dow Jones } ) =
Pr( "A" | A )
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 5 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

[Link]

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Probability and Perfect Information

Pr(" A " | A) Pr( A)
Pr( A | " A ") =
=
Pr(" A ")
Pr(" A " | A) Pr( A)
=
Pr(" A " | A) Pr( A) + Pr(" A " | A) Pr( A)

Draft: Version 1

1 Pr( A)
=1
1 Pr( A) + 0 Pr( A)
Conclusion:
Pr(A|"A") equals 1 no matter what the value of Pr(A) is.
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 6 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

[Link]

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Probability and Perfect Information

What about the probability Pr( {Expert Says Dow Jones } )?
Pr("A") = Pr( {Expert Says Dow Jones } ) =

Pr(" A" | A) Pr( A) + Pr(" A" | A) Pr( A) =

1 Pr( A) + 0 Pr( A) = Pr( A) = Pr({Dow Jones })

Draft: Version 1

This is true in general: if we consult a clairvoyant expert

about an event a with possible outcomes { A1 ,", An } then:

Pr(" Ai ") = Pr( Ai ), for all i = 1," , n

After consulting the clairvoyant expert about event a, no
uncertainty remains about event a.
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Slide 7 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

[Link]

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Expected Value of Perfect Information

STOCK MARKET EXAMPLE:
MAX. PROFIT
EMV=
580
High Risk

Up (0.5)
Flat (0.3)

Stock

EMV=
580

EMV=
540
Low Risk

-1000

Up (0.5)

1000

Flat (0.3)

Draft: Version 1

Down (0.2)

Savings Account

R. T. Clemen, T. Reilly

100

Down (0.2)

Stock

Making Hard Decisions

1500

200
-100

500

Chapter 12 Value of Information

Slide 8 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

[Link]

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Expected Value of Perfect Information

Consider first talking to a clairvoyant expert and then
making the investment decision:
MAX. PROFIT
EMV=
1500
Up (0.5)

High Risk Stock

Low Risk Stock
Savings Account

EMV=
1000

EMV=
500
Flat (0.3)

High Risk Stock

Low Risk Stock

Draft: Version 1

Savings Account

Down (0.2)

EMV=
500

High Risk Stock

Low Risk Stock
Savings Account

Making Hard Decisions

R. T. Clemen, T. Reilly

1500
1000
500

100
200
500
-1000
-100
500

Chapter 12 Value of Information

Slide 9 of 29

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi

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Expected Value of Perfect Information

Of course, the clairvoyant expert will charge a fee and
you would like to know how much you would be willing
to pay before using his services.
MAX. PROFIT
Do not Consult Clairvoyant

Consult Clairvoyant

Draft: Version 1

- X = Consulting Fee

EMV=
580

EMV=
1000 - X

Conclusion:
You would be willing to consult the clairvoyant expert if:
1000 - X 580 X 1000 - 580 = 420 (=EVPI)
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 10 of 29
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Expected Value of Perfect Information

EVPI = Expected Value of Perfect Information
Interpretation:
EVPI is the maximum amount of money you would be
willing to pay for the services of the clairvoyant expert.
If he charges more than $420 you would not consult the
expert.

Draft: Version 1

A = { Dow Jones index goes up}

"A" = {Expert Says Dow Jones index goes up}
Consider an Expert about event A, who is not
clairvoyant, but is considered to be an expert. What does
it mean in for an expert not to be perfect in his
assessment about event A?
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 11 of 29
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Expected Value of Imperfect Information

Pr( {Expert Says Dow Jones } | {Dow Jones } ) =

Pr(" A"| A) < 1

Hopefully, the probability above is close to 1
(otherwise why consider him/her and Expert?)

Pr( {Expert Says Dow Jones } | {Dow Jones } ) =

Pr(" A " | A) > 0

Draft: Version 1

Hopefully, the probability above is close to 0

(otherwise why consider him/her and Expert?)
When an expert about an event is not clairvoyant you
need to express your trust in his assessment by for
example, checking his past performances and interviewing references.
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 12 of 29
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Expected Value of Imperfect Information

Based on your background-check of the expert you
assess your trust in terms of subjective probabilities.

Draft: Version 1

True Market State

Expert
Prediction

UP

FLAT

DOWN

"UP"

Pr("UP"|UP)

Pr("UP"|FLAT)

Pr("UP"|DOWN)

"FLAT"

Pr("FLAT"|UP)

Pr("FLAT"| FLAT)

Pr("FLAT"|"|DOWN)

"DOWN"

Pr("DOWN"|UP)

Pr("DOWN"|
FLAT)

Pr("DOWN"|"|DOWN)

Total

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 13 of 29
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Expected Value of Imperfect Information

Actual Assessment of the Expert:
True Market State

Draft: Version 1

Expert
Prediction

UP

FLAT

DOWN

"UP"

80%

15%

20%

"FLAT"

10%

70%

20%

"DOWN"

10%

15%

60%

Total

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 14 of 29
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Expected Value of Imperfect Information

STOCK MARKET EXAMPLE:
MAX. PROFIT
EMV=
580
High Risk

Up (0.5)
Flat (0.3)

Stock

EMV=
580

EMV=
540
Low Risk

-1000

Up (0.5)

1000

Flat (0.3)

Draft: Version 1

Down (0.2)

Savings Account

R. T. Clemen, T. Reilly

100

Down (0.2)

Stock

Making Hard Decisions

1500

200
-100

500

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 15 of 29
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Expected Value of Imperfect Information

Consider first talking to an "Imperfect expert and then
making the investment decision:
Up (?)

Flat (?)

{Original Decision Problem | Flat }

{ Original Decision Problem | Down }

Draft: Version 1

Down (?)

{ Original Decision Problem | Up }

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 16 of 29
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Expected Value of Imperfect Information

Suppose the Imperfect expert said Dow Jones will go
UP
Up (?)

High Risk
Stock

Flat (?)
Down (?)
Up (?)

Up (?)

Low Risk

Flat (?)

Stock

Down (?)

100
-1000
1000
200
-100
500

Draft: Version 1

Savings Account

1500

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 17 of 29
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Expected Value of Imperfect Information

Suppose the Imperfect expert said Dow Jones will stay
FLAT
Up (?)
High Risk
Stock

Flat (?)
Down (?)
Up (?)

Flat (?)

Low Risk

Flat (?)

Stock

Down (?)

1500
100
-1000
1000
200
-100
500

Draft: Version 1

Savings Account

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 18 of 29
COPYRIGHT 2006
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Expected Value of Imperfect Information

Suppose the Imperfect expert said Dow Jones will go
DOWN
Up (?)
High Risk
Stock

Flat (?)
Down (?)
Up (?)

Down (?)

Low Risk

Flat (?)

Stock

Down (?)

Draft: Version 1

Savings Account

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

1500
100
-1000
1000
200
-100
500

Slide 19 of 29
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Expected Value of Imperfect Information

Note That:
After consulting the expert the uncertainty remains

Draft: Version 1

After consulting an imperfect expert, the original

decision problem still remains. The only difference is
that probabilities of the original decision problem have
changed to reflect the additional information, i.e the
expert's advise.
To calculate the EMV of the decision problem after
consulting the imperfect expert we have to solve for the
probabilities in the decision tree above. Calculating these
probabilities is equivalent with FLIPPING the order of the
uncertainty nodes.
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 20 of 29
COPYRIGHT 2006
by GWU

Expected Value of Imperfect Information

Market
Behavior

Experts
Forecast

Experts
Forecast
Up (0.80)

Up (0.5)

Flat (0.3)

Draft: Version 1

Down (0.2)

Flat (0.10)

Market
Behavior
Up (?)

Up (?)

Flat (?)

Down (0.10)

Down (?)

Up (0.15)

Up (?)

Flat (0.70)

Flat (?)

Flat (?)

Down (0.15)

Down (?)

Up (0.20)

Up (?)

Flat (0.20)

Flat (?)

Down (0.60)

Down (?)

Down (?)

How can we solve for these probabilities?

Via Bayes theorem using a probability table
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 21 of 29
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Expected Value of Imperfect Information

STEP 1: Construct a probability table
Pr(Up)

Pr(Flat)

Pr(Down)

0.500

0.300

0.200

"A"

Pr("A"|Up)

Pr("A"|Flat)

Pr("A"|Down)

"Up"

0.800

0.150

0.200

"Flat"

0.100

0.700

0.200

"Down"

0.100

0.150

0.600

Check

1.000

1.000

1.000

Draft: Version 1

Pr("A" Up) Pr("A" Flat) Pr("A" Down) Pr("A") Pr(Up|"A") Pr(Flat|"A") Pr(Down|"A") Check

Check

0.400
0.050
0.050
0.500

0.045
0.210
0.045
0.300

Making Hard Decisions

R. T. Clemen, T. Reilly

0.040
0.040
0.120
0.200

0.485 0.825
0.300 0.167
0.215 0.233
1.000

0.093
0.700
0.209

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

0.082
0.133
0.558

1.000
1.000
1.000

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Expected Value of Imperfect Information

STEP 2: Insert the probabilities in the probability tree
Market
Behavior

Experts
Forecast

Experts
Forecast
Up (0.80)

Up (0.5)

Draft: Version 1

Flat (0.3)

Down (0.2)

Making Hard Decisions

R. T. Clemen, T. Reilly

Flat (0.10)

Market
Behavior
Up (0.825)

Up (0.485)

Flat (0.093)

Down (0.10)

Down (0.082)

Up (0.15)

Up (0.167)

Flat (0.70)

Flat (0.300)

Flat (0.700)

Down (0.15)

Down (0.133)

Up (0.20)

Up (0.233)

Flat (0.20)

Flat (0.209)

Down (0.60)

Down (0.215)

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Down (0.558)

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Expected Value of Imperfect Information

STEP 3: Calculate EMV after consulting the expert
Up (0.825)
High Risk 1164
Stock

1164
Up (0.485)

Low Risk
Stock

Flat (0.093)
Down (0.082)

835

Up (0.825)
Flat (0.093)
Down (0.082)

100
-1000
1000
200
-100
500

Draft: Version 1

Savings Account

1500

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 24 of 29
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Expected Value of Imperfect Information

STEP 3B: Calculate EMV after consulting the expert

High Risk

187

Down (0.133)

500
Low Risk
Stock

1500

Flat (0.700)

Stock

Flat (0.300)

Up (0.167)

293

100
-1000

Up (0.167)
Flat (0.700)
Down (0.133)

200
-100
500

Draft: Version 1

Savings Account

1000

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 25 of 29
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Expected Value of Imperfect Information

STEP 3C: Calculate EMV after consulting the expert

High Risk

-188

Flat (0.209)

Stock

Down (0.215)

Down (0.558)
219

500

Up (0.233)

Up (0.233)

Low Risk

Flat (0.209)

Stock

Down (0.558)

100
-1000
1000
200
-100
500

Draft: Version 1

Savings Account

1500

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 26 of 29
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Expected Value of Imperfect Information

STEP 3D: Calculate EMV after consulting the expert
Up (0.485) 1164

822

{ Original Decision Problem | Up }

500
Flat (0.300)

{Original Decision Problem | Flat }

500

{ Original Decision Problem | Down }

Draft: Version 1

Down (0.215)

Making Hard Decisions

R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 27 of 29
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Expected Value of Imperfect Information

STEP 4: Calculate EVII for consulting the expert
MAX. PROFIT
Do not Consult Imperfect Expert

EMV=
580

Consult Imperfect Expert

EMV=
822 - X

- X = Consulting Fee

Draft: Version 1

Conclusion:
You would be willing to consult the clairvoyant expert if:
822 - X 580 X 822 - 580 = 242 (=EVII)
EVII = Expected Value of Imperfect Information
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 28 of 29
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Expected Value of Imperfect Information

Interpretation:
EVII is the maximum amount of money you would be
willing to pay for the services of the imperfect expert.
If he charges more than $242 you would not consult the
expert.

Draft: Version 1

Note:
EVPI EVII. Interpretation: Perfect Information is
always better than imperfect information.
When performing sensitivity analysis EVPI calculation
of every uncertain event should be considered. When
EVPI is high for a particular uncertain event, investment
to reduce uncertainty may be warranted.
Making Hard Decisions
R. T. Clemen, T. Reilly

Chapter 12 Value of Information

Lecture Notes by: J.R. van Dorp and T.A. Mazzuchi
[Link]

Slide 29 of 29
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