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Questions and Answers
What does EMV stand for in the context of decision trees?
What does EMV stand for in the context of decision trees?
What is the expected monetary value (EMV) of Investment A?
What is the expected monetary value (EMV) of Investment A?
In what direction do you work when calculating EMVs using the folding-back process in decision trees?
In what direction do you work when calculating EMVs using the folding-back process in decision trees?
What was the calculated utility of Investment A?
What was the calculated utility of Investment A?
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What is represented by the 'spike' chart known as the risk profile?
What is represented by the 'spike' chart known as the risk profile?
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In what percentage of business decision analyses is risk aversion considered a practical concern?
In what percentage of business decision analyses is risk aversion considered a practical concern?
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What do you do at each decision node when identifying the optimal decision?
What do you do at each decision node when identifying the optimal decision?
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Which utility value corresponds to the highest cash inflow for Investment B?
Which utility value corresponds to the highest cash inflow for Investment B?
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Which of the following costs is associated with preparing a bid according to the example provided?
Which of the following costs is associated with preparing a bid according to the example provided?
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What might be a more common approach than expected utility maximization in business decisions?
What might be a more common approach than expected utility maximization in business decisions?
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What role does the PrecisionTree add-in serve in the context of decision trees?
What role does the PrecisionTree add-in serve in the context of decision trees?
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If there is a 30% chance that there will be no competing bids, what is the implication on the decision-making process?
If there is a 30% chance that there will be no competing bids, what is the implication on the decision-making process?
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Which of the following best describes the calculation of EMVs at chance nodes?
Which of the following best describes the calculation of EMVs at chance nodes?
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What is the primary purpose of conducting sensitivity analysis in decision analysis?
What is the primary purpose of conducting sensitivity analysis in decision analysis?
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Which component of a decision tree represents a point where a decision is made?
Which component of a decision tree represents a point where a decision is made?
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In a decision tree, what does a chance node signify?
In a decision tree, what does a chance node signify?
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How do the branches of a decision tree function in terms of decisions and outcomes?
How do the branches of a decision tree function in terms of decisions and outcomes?
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What is indicated by an end node in a decision tree?
What is indicated by an end node in a decision tree?
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When should probabilities be assigned to branches in a decision tree?
When should probabilities be assigned to branches in a decision tree?
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What is the sequence direction in a decision tree?
What is the sequence direction in a decision tree?
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Why is a sensitivity analysis considered crucial in real-world business problems?
Why is a sensitivity analysis considered crucial in real-world business problems?
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What does EVSI represent in terms of sample information?
What does EVSI represent in terms of sample information?
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What condition must hold for a decision maker to consider purchasing information?
What condition must hold for a decision maker to consider purchasing information?
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Which statement regarding the value of information is true?
Which statement regarding the value of information is true?
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How do most individuals typically respond to risk, according to the content?
How do most individuals typically respond to risk, according to the content?
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What is the main purpose of a utility function in decision-making?
What is the main purpose of a utility function in decision-making?
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Which of the following statements best describes expected utility maximizers?
Which of the following statements best describes expected utility maximizers?
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What does the expected value of perfect information (EVPI) indicate?
What does the expected value of perfect information (EVPI) indicate?
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Which type of utility functions has been created to evaluate individual risk preferences?
Which type of utility functions has been created to evaluate individual risk preferences?
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What does the risk tolerance parameter in an exponential utility function represent?
What does the risk tolerance parameter in an exponential utility function represent?
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How is the risk tolerance of Venture Limited defined in the example?
How is the risk tolerance of Venture Limited defined in the example?
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Which outcome has the highest probability in the less risky venture for Venture Limited?
Which outcome has the highest probability in the less risky venture for Venture Limited?
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In an exponential utility function, which of the following statements is true regarding risk tolerance?
In an exponential utility function, which of the following statements is true regarding risk tolerance?
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What is a characteristic of an exponential utility function?
What is a characteristic of an exponential utility function?
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Which of the following best describes the outcomes of the more risky venture for Venture Limited?
Which of the following best describes the outcomes of the more risky venture for Venture Limited?
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Based on the example, what is the sure gain offered to Venture Limited?
Based on the example, what is the sure gain offered to Venture Limited?
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Which of the following outcomes has the lowest probability in the more risky venture?
Which of the following outcomes has the lowest probability in the more risky venture?
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Study Notes
Sensitivity Analysis
- It is important to analyze the sensitivity of the data used in decision models
- Sensitivity analysis examines how outputs, such as EMVs and the preferred decision, change in reaction to variations in the input variables.
Decision Trees
- Decision trees are visual tools for representing decision problems
- They illustrate the sequence of events, including decisions, outcomes, probabilities, and monetary values
- Nodes are points in time represented by circles (chance nodes), squares (decision nodes) and triangles (end nodes)
- Branches depict possible choices, uncertain outcomes, probabilities and monetary values
- Probabilities on branches leaving chance nodes must always add up to 1
- The expected monetary value is calculated using a folding-back process
Risk Profiles
- A risk profile shows the probability distribution of monetary outcomes for a given decision using a spike chart
- It helps visualize the risks and rewards associated with a specific decision
- Comparing risk profiles for multiple choices reveals their relative strengths and weaknesses
Example 6.1: SciTools Bidding Decision
- SciTools must decide whether to bid on a government contract
- They need to consider estimated low bids from competitors and their associated probabilities
- Additionally, they must factor in the cost of preparing a bid and the cost of supplying the instruments
The Value of Information
- The expected value of sample information (EVSI) is the maximum amount one would pay for additional information
- The expected value of perfect information (EVPI) is the maximum one would pay for perfect information that eliminates all uncertainty
- The value of information is directly related to its potential to increase decision-making accuracy and benefit
- Information that doesn't influence a decision is considered worthless
Risk Aversion and Expected Utility
- Rational decision-makers are sometimes willing to prioritize reducing risk over maximizing the expected monetary value (EMV), especially when large sums of money are involved
- People who prefer avoiding risk are considered risk-averse
- According to research, decision-makers tend to maximize expected utility, meaning they favor choices that maximize their personal preference for outcomes rather than just maximizing the EMV
Utility Functions
- A utility function converts monetary values (payoffs and costs) into utility values
- It describes individual preferences for monetary outcomes and reflects their attitude towards risk
- Risk-averse individuals are willing to trade some EMV to avoid risky situations
Exponential Utility
- Exponential utility functions have a single adjustable parameter: risk tolerance
- Risk tolerance dictates how risk-averse an individual is, with higher values indicating less risk aversion
- The exponential utility function formula is a simplified approach to quantify risk attitude
Example 6.5: Using Exponential Utility
- Venture Limited must choose between risky ventures and a safe investment
- The company's risk tolerance influences its decision, as determined by the exponential utility function
- By considering the utility values associated with each venture, a better-informed decision can be made
Example: Investment Projects
- Investment projects A and B have different expected monetary values (EMV) but generate different utilities based on risk preferences
- The utility function assigns a utility value to each possible monetary outcome, reflecting the decision-maker's attitude toward risk
- Choosing the option with the higher utility value for a given risk tolerance maximizes the individual's expected utility
Is Expected Utility Maximization Used?
- Maximizing expected utility is a complex process, and its theoretical research value might outweigh its practical application
- Expected utility maximization is not widely used in business decision analysis
- In practice, EMV is considered sufficient for most decision-making scenarios and is used more frequently than expected utility maximization
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Description
This quiz covers key concepts in sensitivity analysis and decision trees, essential tools for effective decision-making. You'll explore how changes in input variables affect outputs and learn about visualizing decision problems. Test your knowledge on risk profiles and their applications in decision models.
