Midterm

Question 2

Risk Attitude

Answer 2

A person’s risk attitude is determined by the relationship between his or hercertain equivalent of a monetary deal and the e-value of the monetary measure

Question 3

Risk neutral

Answer 3

certain equivalent for any monetary deal is the e-value of monetarymeasure. U-curve is linear

Question 4

Risk averse

Answer 4

certain equivalent for any monetary deal is always < e-value of monetary measure. U-curve is concave.

Question 5

Risk preferring

Answer 5

certain equivalent for any monetary deal is always > e-value of monetary measure. U-curve is convex.

Question 6

Risk Odds

Answer 6

r characterizes the risk attitude of a person who satisfies the delta property. Risk odds, r = p/(1-p), equals the odds of winning one monetary unit versus losing one monetary unit so that person is indifferent between accepting and rejecting the deal.

Question 7

Risk tolerance

Answer 7

1/ln(r) where r is the risk odds as described above.

Question 8

Risk aversion

Answer 8

ln(r) where r is the risk odds as described above

Question 9

Delta property

Answer 9

A person satisfies the delta property if adding a constant amount b to all prospects of a deal increases the certain equivalent of that deal by b. For such a person, PISP and PIBP of a deal are the same. Also, his/her certain equivalent can be computed without considering the person’s current wealth.

Question 10

Value of Clairvoyance

Answer 10

The most decision maker D would be willing to pay (PIBP) for a clairvoyant’s services to eliminate uncertainties in a particular decision situation. Value of experiment = value of clairvoyance on result of experiment.

Question 11

Value with free clairvoyance

Answer 11

is the certain equivalent of a deal with clairvoyance on a given uncertainty, when the PIBP of clairvoyance on that uncertainty is $0.

Question 12

Prospect

Answer 12

a fully defined possible future state of the world, a particular future, your life going forward with a particular event or possibility occurring. A prospect by definition must not involve any uncertainty

Question 13

Deal

Answer 13

A deal consists of a set of future prospects and their associated probabilities.

Question 14

Preference Probability

Answer 14

The preference probability for prospect P among a given ordered set of prospects B>…>W (B and W are the best and worst prospects, respectively) is the probability p at which the decision maker is indifferent between receiving prospect P for sure and receiving a deal on prospects B and W with probability p of B and probability (1-p) of W. Notes 1) People with same preference probabilities will make the same decisions (though maybe different VOI – which depends on risk attitude), 2) preference probabilities are not really probabilities, but can be treated as such (substitution rule)

Question 15

Five Rules of Actional Though

Answer 15

the five rules can be remembered by using the phrase “POE’S Choice,” since the five rules consist of the probability rule, the order rule, the equivalence rule, the substitution rule, and the choice rule.

Question 16

The probability rule

Answer 16

states that we shall consider the world (or all information relevant to a decision making) in terms of possible prospects (elemental possibilities) and their associated probabilities.

Question 17

The order rule

Answer 17

states that we can make a list of possible prospects such that any prospect higher on the list is at least as good as ones lower on the list. This implies transitivity of prospects (if A is preferred to B and B is preferred to C, then A is preferred to C). When you violate the order rule you create a potential for a money pump. This means that someone can create a situation in which they can make an infinite amount of money from you

Question 18

The equivalence rule

Answer 18

states that, given three prospects A, B, and C, where A is preferred to B, and B is preferred to C, there exists a probability p such that [ABC diagram].In other words, there is some p that makes you indifferent between receiving B for certain and receiving a deal with probability p of prospect A and 1-p of prospect C. This probability p is a preference probability and is based on your preferences, not an event that can be foretold by the clairvoyant. This rule states that a certain equivalent can be found.

Question 19

The substitution rule

Answer 19

states that, given the situation described in the equivalence rule, you are willing to exchange the prospect B with the ‘A or C’ deal

Question 20

The choice rule

Answer 20

states that, given the choice between the following two deals [x>y, p>q] you will choose the first deal if p>q, and you will choose the second deal if q>p. In other words, you must prefer the deal with the highest probability of the prospect you like best

Question 21

Money pump

Answer 21

A person is a money pump if they exhibit behavior that allows you to get as much money from them as you want. In particular, a person who violates the Order Rule by having preferences that are not transitive is a money pump. Such a person prefers A to B and B to C, but also prefers C to A, for some prospects A, B, and C. Then, for example, if this person started with prospect A, we could get him to pay us something to exchange A for C, some more to exchange C for B, and some more to exchange B for A. We could repeat this cycle indefinitely and make a bundle.

Question 22

e-value

Answer 22

is a probability weighted average of a measure. The weighted sum of some measure associated with each prospect, where the weights are just the elemental probabilities of each prospect and the sum is taken over all possible prospects. We usually talk about the e-value of the u-value or the e-value of the monetary measures of our prospects.

Question 23

u-value

Answer 23

is a preference probability that has been scaled and shifted by means of a positive linear transformation to a convenient scale. In other words, we can take a preference probability, add or subtract any number and multiply or divide by any positive number and get a u-value.

Question 24

Expert (4)

Answer 24

has powerful distinctions and knows how they relate to each other, in some cases, has required physical skills, knows the history and borders of the field, and has humility (and knows what he or she does not know)

Question 25

Clairvoyance

Answer 25

We define clairvoyance as information, which resolves all uncertainty about an uncertain distinction. We call the PIBP of clairvoyance on a distinction the value of clairvoyance on that distinction.

Question 27

We call a distinction clear when ….

Answer 27

We call a distinction clear when it satisfies the clarity test. This means that a clairvoyant could, without exercise of judgment, tell in which degree any particular thing falls.

Question 28

We call a distinction observable when …

Answer 28

We call a distinction observable when we “know it when we see it.” In other words, the decision maker could tell in which degree any particular thing falls.

Question 29

We call a distinction useful when it …

Answer 29

We call a distinction useful when it means what we want it to mean, and/or helps us achieve clarity of action

Question 30

Decision Basis

Answer 30

Alternatives are what you can do. Need more than one. Preferences are what you want. You must care about what might happen. Information is what you know. Information links what you want to what you can do.

Question 31

Probability (and &)

Answer 31

The probability of an event is a number from 0 to 1 describing a person’s beliefs about the likelihood of that event occurring. Since a probability describes a person’s belief, we say that it is conditioned on that person’s background state of information (written &), or the sum of all that person’s knowledge and experience, which affects his or her belief.

Question 32

Associative logic error (opposite of?)

Answer 32

An associative logic error occurs when a person confuses conditional probabilities for one another. For example, if a person thinks that since most hemophiliacs are male, most males are hemophiliac. In probabilistic notation, if a person thinks that since {A | B, &} is large, then {B | A, &} must also be large. We use the word associative, since people who make this error think that A and B are associated with each other, and thus tend to occur together. The opposite of associative logic we call distinctive logic.

Question 33

Relevant

Answer 33

We say that two uncertain distinctions are relevant when knowledge of one will affect our beliefs about the other. In probabilistic notation, A is relevant to B given & if and only if {A | B, &} ≠ {A | ¬B, &}.

Question 34

Possibility

Answer 34

We call a possibility a possible event that could occur, usually with a particular probability.

Question 35

Sunk Cost

Answer 35

Sunk cost is a past irrevocable allocation of resources. You could also think of it as how you got into a particular situation. We only make decisions about the future, and normatively speaking, sunk costs are irrelevant to the evaluation of future decisions (ignoring taxation) and therefore should not be considered. From a descriptive perspective, decision-makers are often improperly influenced by sunk costs. E.g., “We’ve put $10M into this venture. We can’t abandon it now!”

Question 36

PIBP

Answer 36

(PIBP) is the most you would be willing to pay in return for something that you will use and not sell. The PIBP for good G for person P is a sum of money M at which P is indifferent between {paying M and getting G}and {keeping M and not getting G}, with the important caveat that P must pretend in assessing M that G cannot be resold (so that this is a use value rather than an exchange value concept). At any price less than M, P prefers to buy G, while at any price greater than M, P prefers not to buy G. Note that M is a function not just of the good but of the specific person considering the purchase of that good, which accounts for the “personal” in the name.

Question 37

PISP

Answer 37

(PISP) is the least you would be willing to accept to forgo the use of something that you own and cannot replace. The PISP for good G for person P is a sum of money M at which P is indifferent between {selling G and getting M} and {keeping G and not getting M}, with the important caveat that P must pretend in assessing M that G cannot be replaced (so that M represents the loss in value associated with forgoing use). PISP=CE.

Question 38

Cycle of Ownership

Answer 38

The PIBP and PISP are equal around a cycle of ownership. A cycle of ownership implies either no passage of time or no new information and no change in the state of wealth. A cycle of ownership only occurs when the price paid for the item is equal to the PIBP for the item. If we pay less there cannot be a cycle of ownership because of our new state of wealth.

Question 39

Market Buying/Selling Price

Answer 39

Market buying and selling price The market price is the price one would have to pay in the market for a particular good. Note that this price is easily observable only for goods for which a market actually exists. The market price for a unique good (e.g., a particular house) may be quite difficult to observe. In a “wellbehaved” market one could define market price = market buying price = market selling price. However, this is rarely the case due to transaction costs and to differential “power” in the marketplace. For example, I can buy used CD’s for $7 but can only sell them for $5 (unless I expend a great deal of effort looking for the right buyers, in which case I would probably want to attach the value of my time to my assessment of what I made in the deal, likely resulting in a lot less than $5).

Question 40

Value in Use

Answer 40

How much value an object creates for you once it is integrated into your life, given that you cannot sell it nor exchange it.

Question 41

Value in Exchange

Answer 41

Value in exchange The value you could obtain by selling or exchanging an object to another person (your preferences do not come into consideration; a diabetic could own a candy store).

Question 42

Responsible

Answer 42

Responsible means we have the ability to choose our response to environmental stimuli.

Question 43

Proactive

Answer 43

Proactive is the recognition that we are responsible for our own lives. We are where we are today because of decisions we made yesterday.

Question 44

Circle of Concern/Influence

Answer 44

Circle of concern contains the things we care about. Our Circle of influence are those things that we have some degree of control over. These two regions overlap and we have the set of things we care about and can control. This is where we should focus our energy.

Question 45

All 7 Habits

Answer 45

1) Be Proactive (circles of influence, concern), 2) Begin with the end in mind (decide on personal principles), 3) First things first (effective personal management based on principles), 4) Think win-win, 5) Seek first to understand, then to be understood, 6) Synergize (creative cooperation), and 7) Sharpen the saw (self renewal). Habits 1 through 3 are directly related to the way we approach decision problems.

Question 46

Actional Thought

Answer 46

Actional thought At times we contemplate our actions before taking them. That is, we design our actions or think about action. This is called actional thought. Note, we have not mentioned the quality of this thought. quality actional thought is the process of designing your actions through the use of a systematized method of reasoning whose axioms you accept as valid. In other words, actional thought is of high quality if it clarifies the decision problem and thereby leads to clarity of action. Decision analysis is a high quality conversation about a decision.

Question 47

High Quality Actional Thought

Answer 47

High quality actional thought is the process of designing your actions through the use of a systematized method of reasoning whose axioms you accept as valid. In other words, actional thought is of high quality if it clarifies the decision problem and thereby leads to clarity of action. Decision analysis is a high quality conversation about a decision.MS&E 252

Question 48

Clairty of Action

Answer 48

Clarity of action essentially means knowing what to do and knowing what course of action is consistent with one’s information, preferences, and alternatives. The goal of decision analysis is to achieve clarity of action.

Question 49

Decision

Answer 49

Decision is an irrevocable or irreversible (the world has changed) choice among alternative ways to allocate resources. Irrevocable in the sense that undoing the prior allocation may either be impossible or may require the allocation of additional resources (sometimes in prohibitive amounts). Resources may include many things, like time, money and integrity. In some sense, every moment of either action or inaction represents either an explicit or tacit decision, as every moment that slips by represents a resource that is gone, and the nature of the opportunities and problems with which one is presented changes continuously (however slightly). It is useful in decision analysis to ignore the slight continuous changes and focus instead on those discrete decision points at which changes in a person’s or a company’s future possibilities are made.

Question 50

Outcome

Answer 50

Outcome is a resulting state of the world once a decision has been made. Good decisions can have bad outcomes and vice-versa. We have control over our decisions, but no control over our outcomes.

Question 51

Normative vs Descriptive

Answer 51

Normative versus Descriptive a normative system is one which is based upon a set of norms (axioms, rules, …) such that the validity of any statement within the system is determinable solely based on its consistency with those norms. In contrast, a descriptive system is one that seeks to reproduce or describe the way some observable system behaves or will behave. Thus, the ultimate test of truth in a descriptive system is whether the behavior described or predicted by the system matches the behavior it models in reality. In summary, a descriptive system tells us ‘what is so’, while a normative system tells us ‘what should be so’ how they are. Physics and Biology are examples of descriptive sciences; Decision Analysis is an example of a normative science. Decision analysis tells us what decision should be made, given our alternatives, information, and preferences. Failure to follow its norms is considered a mistake, even though whether people follow them or not is a descriptive matter.

Question 52

Decision Analysis Cycle

Answer 52

FEAD Formulation, Evaluation, Appraisal, Decision