Statistical Decision Theory:

Concepts, Methods and Applications

(Special topics in Probabilistic Graphical Models)


FIRST COMPLETE DRAFT
November 30, 2003




Supervisor: Professor J. Rosenthal
STA4000Y





Anjali Mazumder
950116380
Part I: Decision Theory Concepts and Methods
1
Part I: DECISION THEORY -
Concepts and Methods


Decision theory as the name would imply is concerned with the process of making
decisions. The extension to statistical decision theory includes decision making in the
presence of statistical knowledge which provides some information where there is
uncertainty. The elements of decision theory are quite logical and even perhaps intuitive.
The classical approach to decision theory facilitates the use of sample information in
making inferences about the unknown quantities. Other relevant information includes
that of the possible consequences which is quantified by loss and the prior information
which arises from statistical investigation. The use of Bayesian analysis in statistical
decision theory is natural. Their unification provides a foundational framework for
building and solving decision problems. The basic ideas of decision theory and of
decision theoretic methods lend themselves to a variety of applications and computational
and analytic advances.

This initial part of the report introduces the basic elements in (statistical) decision theory
and reviews some of the basic concepts of both frequentist statistics and Bayesian
analysis. This provides a foundational framework for developing the structure of
decision problems. The second section presents the main concepts and key methods
involved in decision theory. The last section of Part I extends this to statistical decision
theory that is, decision problems with some statistical knowledge about the unknown
quantities. This provides a comprehensive overview of the decision theoretic framework.
Part I: Decision Theory Concepts and Methods
2
Section 1: An Overview of the Decision Framework:
Concepts & Preliminaries

Decision theory is concerned with the problem of making decisions. The term statistical
decision theory pertains to decision making in the presence of statistical knowledge, by
shedding light on some of the uncertainties involved in the problem. For most of this
report, unless otherwise stated, it may be assumed that these uncertainties can be
considered to be unknown numerical quantities, denoted by . Decision making under
uncertainty draws on probability theory and graphical models. This report and more
particularly this Part focuses on the methodology and mathematical and statistical
concepts pertinent to statistical decision theory. This initial section presents the
decisional framework and introduces the notation used to model decision problems.

Section 1.1: Rationale

A decision problem in itself is not complicated to comprehend or describe and can be
simply summarized with a few basic elements. However, before proceeding any further,
it is important to note that this report focuses on the rational decision or choice models
based upon individual rationality. Models of strategic rationality (small-group behavior)
or competitive rationality (market behavior) branch into areas of game theory and asset
pricing theory, respectively. Thus for the purposes of this report, these latter models have
been neglected as the interest of study is statistical decision theory based on individual
rationality.

In a conventional rational choice model, individuals strive to satisfy their preferences for
the consequences of their actions given their beliefs about events, which are represented
by utility functions and probability distributions, and interactions among individuals are
governed by equilibrium conditions (Nau, 2002[1]). Decision models lend themselves
to a decision making process which involves the consideration of the set of possible
actions from which one must choose, the circumstances that prevail and the consequences
that result from taking any given action. The optimal decision is to make a choice in such
a way as to make the consequences as favorable as possible.

As mentioned above, the uncertainty in decision making which is defined as an unknown
quantity, , describing the combination of prevailing circumstances and governing
laws, is referred to as the state of nature (Lindgren, 1971). If this state is unknown, it is
simple to select the action according to the favorable degree of the consequences
resulting from the various actions and the known state. However, in many real problems
and those most pertinent to decision theory, the state of nature is not completely known.
Since these situations create ambiguity and uncertainty, the consequences and subsequent
results become complicated.

Decision problems under uncertainty involve many diverse ingredients - loss or gain
of money, security, satisfaction, etc., (Lindgren, 1971). Some of these ingredients can
be assessed while some may be unknown. Nevertheless, in order to construct a
mathematical framework in which to model decision problems, while providing a rational
Part I: Decision Theory Concepts and Methods
3
basis for making decisions, a numerical scale is assumed to measure consequences.
Because monetary gain is often neither an adequate nor accurate measure of
consequences, the notion of utility is introduced to quantify preferences among various
prospects which a decision maker may be faced with.

Usually something is known about the state of nature, allowing a consideration of a set of
states as being admissible (or at least theoretically so), and thereby ruling out many that
are not. It is sometimes possible to take measurements or conduct experiments in order
to gain more information about the state. A decision process is referred to as statistical
when experiments of chance related to the state of nature are performed. The results of
such experiments are called data or observations. These provide a basis for the selection
of an action defined as a statistical decision rule.

To summarize, the ingredients of a decision problem include (a) a set of available
actions, (b) a set of admissible states of nature, and (c) a loss associated with each
combination of a state if nature and action. When only these make up the elements of a
decision problem, the decision problem is referred to as the no-data or without
experimentation decision problem. However, if (d) observations from an experiment
defined by the state of nature are included with (a) to (c), then the decision problem is
known as a statistical decision problem. This initial overview of the decision framework
allows for a clear presentation of the mathematical and statistical concepts, notation and
structure involved in decision modeling.

Section 1.2 The Basic Elements

The previous section summarized the basic elements of decision problems. For brevity
purposes, this section will not repeat the description of the two types of decision models
and simply state the mathematical structure associated with each element. It is assumed
that a decision maker can specify the following basic elements of a decision problem.

1. Action Space: A = {a}.

The single action is denoted by an a, while the set of all possible actions is denoted as A.
It should be noted that the term actions is used in decision literature instead of decisions.
However, they can be used somewhat interchangeably. Thus, a decision maker is to
select a single action A a from a space of all possible actions.

2. State Space: = {}. (or Parameter Space)

The decision process is affected by the unknown quantity which signifies the state
of nature. The set of all possible states of nature is denoted by . Thus, a decision maker
perceives that a particular action a results in a corresponding state .

3. Consequence: C = {c}.

Part I: Decision Theory Concepts and Methods
4
The consequence of choosing a possible action and its state of nature may be multi-
dimensional and can be mathematically stated as C a c ) , ( .

4. Loss Function: A a l ) , ( .

The objectives of a decision maker are described as a real-valued loss function ) , ( a l ,
which measures the loss (or negative utility) of the consequence ) , ( a c .

5. Family of Experiments: E = {e}.

Typically experiments are performed to obtain further information about each . A
single experiment is denoted by an e, while the set of all possible experiments is denoted
as E. Thus, a decision maker may select a single experiment e from a family of potential
experiments which can assist in determining the importance of possible actions or
decisions.

6. Sample Space: X = {x}.

An outcome of a potential experiment E e is denoted as X x . The importance of this
outcome was explained in (3) and hence is not repeated here. However, it should be noted
that when a statistical investigation (such as an experiment) is performed to obtain
information about , the subsequent observed outcome x is a random variable. The set of
all possible outcomes is the sample space while a particular realization of X is denoted as
x. Notably, X is a subset of
n
.

7. Decision Rule: A x ) ( .

If a decision maker is to observe an outcome X = x and then choose a suitable action
A x ) ( , then the result is to use the data to minimize the loss ) ), ( ( x l . Sections 2 and
3 focus on discussing the appropriate measures of minimization in decision processes.

8. Utility Evaluation: ) , , , ( u on A X E .

The quantification of a decision makers preferences is described by a utility function
) , , , ( a x e u which is assigned to a particular conduct of e, a resulting observed x,
choosing a particular action a, with a corresponding . The evaluation of the utility
function u takes into account costs of an experiment as well as consequences of the
specific action which may be monetary and/or of other forms.

Section 1.3 Probability Measures

Statistical decision theory is based on probability theory and utility theory. Focusing on
the former, this sub-section presents the elementary probability theory used in decision
processes. The probability distribution of a random variable, such as X, which is
Part I: Decision Theory Concepts and Methods
5
dependent on , as stated above, is denoted as ) (E P

or ) ( E X P

where E is an event. It
should also be noted that the random variable X can be assumed to be either continuous
or discrete. Although, both cases are described here, the majority of this report focuses
on the discrete case. Thus, if X is continuous, then


= =
E
X
E
x dF dx x f E P ) | ( ) | ( ) (

.

Similarly, is X is discrete, then

=
E x
x f E P ) | ( ) (

.

Although, E has been used to describe a family of experiments, an event and will be used
in the next sub-section to denote expectations, the meaning of E will be clear from the
context.

For E e (where e represents an experiment or even an event), a joint probability
measure ) | , (
,
e P
x

or simply denoted
e x
P
| ,
is assigned and more commonly referred to as
the possibility space. This is used to determine other probability measures (Raiffa &
Schlaifer, 2000):

(i) The marginal measure ) (

P on the state space . Of course, here the

assumption is that ) (

P does no depend on e.
(ii) The conditional measure ) , | ( e P
x
on the sample space X for a given e and .
(iii) The marginal measure ) | ( e P
x
on the sample space X for a given e.
(iv) The conditional measure ) | ( x P

on the state space for a given e and x. The

condition e is not stated as x is a result of the experiment and hence the
relevant information is contained in x.

Before concluding this sub-section, it is important to make two remarks. The first is to
summarize the three basic methods for assigning the above set of probability measures.
That is (a) if a joint probability measure is assigned to X , then the marginal and
conditional measures on and X can be computed, (b) if a marginal measure (probability
distribution) is assigned to and the conditional for X, then the joint can be found and
similarly (c) if a marginal measure (probability distribution) is assigned to X and the
conditional for , then the joint can be determined. These elementary methods or
concepts of probability have a more practical importance.

The second remark is simply to clarify that the prime on the probability measure indicates
a prior probability where as the double prime indicates a posterior probability. For the
most part, these notations are redundant but at certain times will help to keep things clear.
When it is obvious these superscripts will not required. A further discussion of priors is
provided in Section 1.5.

Part I: Decision Theory Concepts and Methods
6
Section 1.4 Random Variables and Expectations

In many instances, real numbers or n-tuples (of numbers) describe the states of nature {)
and sample outcomes {x}. In the sections of this report a tilde sign may be used to
distinguish a random variable or function from a particular value of the function. For
example, the random variables x
~
and
~
may be used to define = ) , (
~
x and x x x = ) , (
~
,
respectively.

Expectations of random variables are almost always considered necessary when dealing
with decision processes such as loss functions. The expectation for a given value of , is
defined to be

X x
X
(discrete) ), | ( ) (
s) (continuou ), | ( ) (
) ( [

x f x h
x f x h
X h E

As before, the superscripts and subscripts on the expectation operator will perform in
much the same way as for the probability measure. When necessary, such scripts will be
minimized when the context is clear. Thus, with respect to points (i)-(iv) in the previous
section, the notation for the following expectations is provided below:

(i)

E or )
~
( E is taken with respect to

P .
(ii)
x
E
|
is taken with respect to
x
P
|
.
(iii)
, |e z
E is taken with respect to
, |e z
P .
(iv)
e x
E
|
is taken with respect to
e x
P
|
.

Section 1.5 Statistical Inference (Classical versus Bayesian)

Statistical inference is considered here within the decision framework. Both classical and
Bayesian perspectives are briefly presented to show the varying approaches. Classical
statistics uses the sample information to make inferences about the unknown quantity, .
These inferences (within decision theory) are combined with other relevant information
in order to choose the optimal decision. These other relevant information/sources include
the knowledge of the possible consequences of the decisions and prior information which
was previously mentioned. The former non-sample information, consequences, can be
quantified by determining the possible loss incurred for each possible decision. The
latter, prior information, is the information about arising from other relevant sources
such as past experiences.

Bayesian analysis is the approach which seeks to utilize prior information (Berger,
1985). This third type of information is best described in terms of a probability
distribution. The symbol ) ( or simply ) ( p will be used to represent a prior density of
Part I: Decision Theory Concepts and Methods
7
. Similar, to the other definitions, under both the continuous and discrete cases, the prior
probability distributions can be written as

= =

E
E
E
d
dF E P

(discrete) ), (
s) (continuou ), ( ) (
) ( ) (

The uses of prior probabilities are discussed in the proceeding sections. Both the non-
Bayes and Bayesian decision theory are discussed in this report.

Section 1.6: Convex Sets

Various concepts presented throughout this report make use of the concepts of convexity
and concavity; hence, the required definitions and properties are summarized below.

Definition:

A linear combination of the form
2 1
) 1 ( x x + with 1 0 is called a convex
combination of
1
x and
2
x . (Lindgren, 1971) If
1
x and
2
x in , then it can be said that
is convex if the line segment between any two points in is a subset of . (Berger,
1985).

This definition simply suggests that the set of all combinations of two given points is
precisely the set of points which make up the line segments jointing these two points. It
may be conceived that the values and ) 1 ( which fall between 0 and 1 may be
interpreted as probabilities. A convex combination of two points then becomes a
combination of probabilities.

Definition:

If ,...} , {
2 1
x x is a sequence of points in
m
R , and 1 0 are numbers such that

=
=
1
1
i
i
, then

=1 i
i i
x (and finite) is called a convex combination. The convex hull
of a set is the set of all points which are convex combinations of points in .
(Berger, 1985).

Figure 1-1:



1
2
Part I: Decision Theory Concepts and Methods
8
The set
1
is convex while the
2
is not, for the figure above. So a convex hull is a set
with no holes in its interior and no indentations on its exteriore.g. an egg is convex,
while a doughnut or a banana or a golf ball is not. Formally, X is a convex set if every
line segment connecting two distinct points in X is wholly contained in X, and it is strictly
convex if the interior points of such a line segment are in the strict interior of X. Thus, a
strictly convex set has no flat sides or edges: its exterior consists only of curved surfaces
that are bowed outwards. A sphere is strictly convex, while a cube is convex but not
strictly convex. (Nau, 2000).

Convex sets play a central role in the geometric representation of preferences (utility
theory) and choices (statistical decision theory), as will be shown.
Part I: Decision Theory Concepts and Methods
9
Section 2: Non-statistical Decision Processes

Statistical decision problems include data or observations on the unknown quantity, ,
(also referred to as the state of nature) which may be used to choose a more optimal
decision. One approach to handling such problems, is to consider the non-statistical
approach. Simply, this excludes the data available on the state of nature. This is reduces
the problem to a simpler one. The basic elements or ingredients of this no-data
problem were presented in the previous section.

In simple decision problems, the most important elements are the state space {}, the
action space {a} and the loss function ) , ( a l . These aspects form the theoretical
analysis of decision making. The state space and the action space A are both finite
i.e. there are only finitely many actions [states]. The loss incurred is assumed to be
measured in negative utility units where utility is defined by a function defining the
prospects of a decision maker. In this instance, however unrealistic, we assume that the
loss function is known. These concepts will be defined in the proceeding section within
the no-data decision problem constructs.

Section 2.1 The Set of Randomized Actions

A simple way to explain the general theory of decision making is to consider a typical
coin toss. This introduces an extraneous random device which is useful in providing
decision rules that under some criteria are better than those that use only the given,
nonrandom actions (Lindgren, 1971). In general, a random device (such as a coin
(ordinary or biased)) is an experiment of chance having as many possible outcomes as
there are actions from which to choose; each outcome is associated with an action, and
when a particular outcome is observed, the corresponding action is taken.

The use of a random device to select an action from the set of possible actions is called a
randomized or mixed action. Choosing a randomized action from among all possible
actions amounts to selecting a random device from among all random devices that could
be used to determine the action actually taken; and further selecting a set of probabilities
for the various actions. This leads to the following definition of a random action.

Definition:

A randomized action, for a problem with action space consisting of actions a
1
, a
2
,, a
k
,
is a probability vector (p
1
, p
2
,, p
k
), that is a sequence of nonnegative numbers p
i
whose
sum is 1.

To summarize, consider constructing an experiment of chance producing outcomes z
1
,
z
2
,, z
k
with probabilities p
1
, p
2
,, p
k
assigned, respectively. If the outcome of the
experiment performed is z
1
then action a
1
is taken. To distinguish between pure (or
original) actions a
1
, a
2
,, a
k
and randomized actions, probability vectors are used to
define the latter type. A singular probability vector can be used to determine a pure
action. For instance, the action a
2
can be equivalently written as the probability vector
Part I: Decision Theory Concepts and Methods
10
(0,1,0,0) that assigns all of the probability mass to action a
2
. Thus, pure actions
constitute a subset of the randomized actions.

Section 2.2 The Loss Function

The use of a randomized action in a decision problem with a given loss function
inevitably sets the loss to be a random variable, for each state of nature. The most natural
expected loss to consider when making a decision involves the uncertainty in . Thus,
taking the expected value of the random variable ( or ) , ( a l ) measures the consequence
of employing a given randomized action (when nature is in a given state). In particular, if
the loss of a function ) , ( a l and the randomized action (p
1
, p
2
,, p
k
) is used to choose
among the actions a
1
, a
2
,, a
k
, the expected loss is the following weighted sum:

k k
p a l a l p a l ) , ( ... ) , ( ) , (
2 1 1
+ + + .

Notably, this can be written as taking the integral over all ) , (
i
a l and p
i
, for the
continuous case. The above definition of expected loss is explained in detail in Chapter 2
of Bergers Statistical Decision Theory and Bayesian Analysis (1985).

In a decision problem with m states
1
,
2
,,
m
, there are m Ls corresponding to each
randomized action. For the case of k actions, these Ls are the following expected losses:

k k m m m
k k
k k
p a l p a l a l E L
p a l p a l a l E L
p a l p a l a l E L
) , ( ... ) , ( )] , ( [
) , ( ... ) , ( )] , ( [
) , ( ... ) , ( )] , ( [
1 1 1
2 1 1 2 2 2
1 1 1 1 1 1



+ + = =
+ + = =
+ + = =
M


defined by the randomized action (p
1
, p
2
,, p
k
). These relations can be written in the
matrix form

|
|
|
.
|

\
|
+ +
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
) , (
) , (
...
) , (
) , (
1
1
1 1
1
1
k m
k
k
m m
a l
a l
p
a l
a l
p
L
L

M M M ,

which suggests the interpretation of the vector of losses (L
1
, L
2
,, L
m
) is a point in m-
dimensional space computed as a convex combination of the points
( ) , ( ),..., , (
1 i m i
a l a l ), for i=1,,k. The notion of convex sets was introduced in sub-
section 1.6. The latter points are the loss vectors defined by the pure actions while those
defined by randomized actions are convex combinations of those defined by the pure
actions (Berger, 1985) and (Lindgren, 1971).

The closing example to this sub-section shows that the set of loss points (L
1
, L
2
,, L
m
)
defined by all possible randomized actions (p
1
, p
2
,, p
k
) is a convex set in m-
Part I: Decision Theory Concepts and Methods
11
dimensional space as described above. It forms a convex polyhedron where the extreme
points are pure actions, although some pure actions may fall inside the set. The following
example demonstrates a two dimensional case i.e. there are two states of nature.

Example 2-1:
(Lindgren, 1971)

The following table describes a problem with five possible actions, two states of nature
and the respective loss function.


a
1
a
2
a
3
a
4
a
5

2

2 4 3 5 3
3 0 3 2 3

The pure actions define the loss vectors (the columns in the table) and the randomized
actions define the convex set generated by these five actions which is founding the figure
below. Note that one action, a
3
falls within the convex polyhedron.

Figure 2-1:















Recall from Section 1.6 that a convex combination of a set of points corresponds to the
center of gravity of a system of point masses at those points where these masses are
proportional to the weights in the convex combination. Thus, the randomized action (p
1
,
p
2
,, p
k
) yields a point (L
1
, L
2
,, L
m
), which is the center of gravity of a system of
masses with p
1
units at a
1
, p
2
units at a
2
,, and p
k
units at a
k
.

Interpreting randomized actions as centers of gravity helps geometrically interpret the
state. For instance, if only p
1
and p
2
are positive, with no mass at a
3
,, a
k
, then the center
of gravity (and therefore the point (L
1
, L
2
)) must lie on the line segment joining a
1
and a
2
.
If these actions are represented by extreme points, then such a mixture of just these two
actions lies on the edge of the convex set of points representing all randomizations
(Lindgren, 1971). Thus, for this example, the action a
3
results in the same losses as a
L
1
L
2
a1
a5
a4
a2
a3
Part I: Decision Theory Concepts and Methods
12
certain mixture of a
1
, a
2
and a
5
, or as a mixture involving only a
1
, a
4
and a
5
, as well as
many other mixtures of a
1
, a
2
, a
4
and a
5
. However, it could not be obtained by mixing
actions a
2
, a
4
and a
5
.

Section 2.3 Regret

If the state of nature is known then the action which results in minimal lost would be
taken. Thus, if it were known that
i
were the state of nature, the action a for which
) , ( a l
i
is smallest should be taken, and the minimum loss

) , ( min a l m
i
A
i
= ,

is a loss that could not be avoided with even the best decision. Suppose, one takes the
action a
j
, which does not produce this minimum, and then discovers that nature is indeed
in state
i
, the decision maker would regret not having chosen the action that produces the
minimum; the amount of loss that could have saved by knowing that state of nature is
called the regret. Regret is defined for each state
i
and action a
i
as follows:

) , ( min ) , ( ) , ( a l a l a r
i
A
j i j i
= .

So for each state of nature, subtract the minimum loss m
i
from the losses involving that
state to obtain the regret.

Regret is often referred to as opportunity loss and represents a thinking in terms of gain
rather than loss (Lindgren, 1971). The gain resulting from taking action a when nature is
in state is the negative of the loss:

) , ( ) , ( a l a g = .

Hence, the minimum loss is the negative of the maximum gain:

) , ( max ) , ( min a g a l
A A
=

and the regret can be re-expressed in terms of gain as follows:

) , ( ) , ( max ) , ( min ) , ( ) , (
j i i
A
i
A
j i j i
a g a g a l a l a r = = .

This represents the maximum that could have been gained if the state of nature had been
known, minus the amount that actually was gained by taking action a
j
.

Example 2-1: (contd.)
(Lindgren, 1971)

Part I: Decision Theory Concepts and Methods
13
Recall the example presented in the previous sub-section. The table has been replicated
below with the addition of another column representing the minimum loss over all five
actions. The regret table is provided below and computed by subtracting the minimum
loss from each of the losses in their respective rows.


a
1
a
2
a
3
a
4
a
5
) , ( min a l
A

2

2 4 3 5 3
3 0 3 2 3
2
0


a
1
a
2
a
3
a
4
a
5

2

0 2 1 3 1
3 0 3 2 3

There is at least one zero in each state and the remaining entries are positive in the regret
table. Geometrically, the objective or effect is to translate the set of points so that at least
one action is on each axis. This is demonstrated in the figure below.

Figure 2-2:















Notice that the whole convex set of randomized actions shifts along with the five pure
actions. This is generally the case because the amount subtracted from each loss is
independent of the action a, upon which a probability distribution is imposed in a mixed
action (Lindgren, 1971):

i i i
A
i i i
m L a l a l E a r E R = = ) , ( min )] , ( [ )] , ( [ .

Question: Would it make any difference, in studying a decision problem, if one used
regret instead of loss? In some instances, the regret may be more painful then the losses,
depending on the role of the decision maker and his or her stakes. The classical treatment
of statistical problems in statistical decision theory, usually results in assuming a loss
L
1
L
2
a1
a5
a4
a2
a3
Part I: Decision Theory Concepts and Methods
14
function that is already a regret function; however this is not always the case and leads to
a discussion in cases where it does make a difference.

Section 2.4 The Minimax Principle

Decision problems present a difficulty in determining the best decision because an action
that is best under one state of nature is not necessarily the best under the other states of
nature. Although, various schemes have been proposed - decision principles that lead to
the selection of one or more actions as best according to the principle used none is
universally accepted. (See Berger, 1985 1.5.)

By linearly ordering the available actions, assigning values to each action according to
its desirability is a frequentist principle. The minimax principle places a value on each
action according to the worst that can happen with that action. For each action a, the
maximum loss over the various possible states of nature:

) , ( max ) ( a l a M

= ,

is determined and provides an ordering among the possible actions (Lindgren, 1971 and
French & Insua, 2000). Taking the action a for which the maximum loss M(a) is a
minimum lends itself to the name minimax.

Berger states the same principle within the context of a decision rule. If is a
randomized rule then the quantity ) , ( sup

R

represents the worst that could happen in
the decision is used. Furthermore, the decision rule
1
is preferred to a rule
2
if

) , ( sup ) , ( sup
2 1


R R

< .

Similarly, a minimax decision rule is a minimax decision rule if it minimizes
) , ( sup

R

among all randomized rules in .

Example 2-1: (contd.)
(Lindgren, 1971)

Again the loss table is repeated below with the addition a row stating the maximum loss
for the various actions. The smallest maximum loss is determined by action a
1
to be 1.


a
1
a
2
a
3
a
4
a
5

2

2 4 3 5 3
3 0 3 2 3
) , ( max a l

3 4 3 5 5
Part I: Decision Theory Concepts and Methods
15
The table of regrets is produced below and shows different results then that of the
maximum loss table. The table shows that the minimum maximum regret is determined
by action a
2
.


a
1
a
2
a
3
a
4
a
5

2

2 4 3 5 3
3 0 3 2 3
) , ( max a l

3 2 3 3 5

Recall the question posed at the end of the last sub-section:

Question: Would it make any difference, in studying a decision problem, if
one used regret instead of loss?

A graphical approach of determining the minimax point-which is feasible when there are
two states of nature is a useful in approaching the previously stated question. For a given
action a with losses ) , (
2 1
L L under ) , (
2 1
, respectively, the maximum of these losses is
the first co-ordinate if the point lies below the bisector of the first quadrant while if the
point lies above that bisector, or 45 line, the maximum loss is the second co-ordinate L
2
.
If two points lie above the bisector, the lower one has the smaller maximum; and if two
points both lie below it, the left-most point has the smaller maximum. This approach can
be generalized to many states, but becomes more messy in deciphering all the
combinations.

The graphical approach to the minimax action is simply that the minimax process is
related to the location of the origin of the co-ordinate system, and that moving the action
points relative to the co-ordinate system can alter the process of finding the minimax
point. Of course, in some instances, the minimax loss action and the minimax regret
action will not differ.

To determine the minimax action among the set of all randomized actions is generally
more complicated, because instead of choosing an action from a finite set of actions one
must choose a probability vector from a set of possible probability vectors that is infinite
in number (even if the set of actions is finite). There are two cases that can be considered
for brevity sake at this point - when there are just two states of nature, and when there are
just two actions. When there are just two states of nature, a graphical solution to the
problem of determining a minimax mixed action can be carried out by representing the
randomized actions in terms of ) , (
2 1
L L and ) , (
2 1
R R . This can be shown by returning
to the example.

Example 2-1: (contd.)
(Lindgren, 1971)

Continuing with the same example and looking at the figure below, it is clear that this
point (where the bisector meets the convex polyhedron) lies on the segment joining the
Part I: Decision Theory Concepts and Methods
16
points representing a
1
and a
2
, and so represents a mixture involving only those two
actions. The point (x,y) in question is a convex combination of a
1
and a
2
:

|
|
.
|

\
|
+
|
|
.
|

\
|
=
|
|
.
|

\
|
0
4
) 1 (
3
2
p p
y
x
.

Moreover, it is the point on that line segment with equal co-ordinates:

) 1 ( 0 3 ) 1 ( 4 2 p p y x p p + = = = + ,
and equating these two functions of p yields
5
4
= p .
Figure 2-3:
















The minimax action therefore puts
5
4
of the total probability (1) at a
1
,
5
1
at a
2
, and none
at any other action, producing the probability vector ) 0 , 0 , 0 ,
5
1
,
5
4
( . The minimax loss,
that is, the smallest maximum expected loss, is the value obtained by setting
5
4
= p ,
namely,
5
12
3 = p . The point on the graph representing the minimax actions is thus
(
5
12
,
5
12
). Notice that this minimax expected loss is actually less that the minimum
maximum loss achieved when only pure actions are admitted, 3, as determined in the
earlier example presented in the previous section.

The case of two action is discussed only briefly as it can be determined in a similar
fashion as above. The randomized actions are vectors of the form (p, 1 - p), defined by a
single variable p. The expected losses under the various states of nature can be computed
L
1
L
2
a1
a5
a4
a2
a3
Part I: Decision Theory Concepts and Methods
17
as functions of p, and from this one can determine (at least graphically) the function
)] , ( [ max a l E

. The minimum point of the latter function then defines the minimax
action. See both Berger (1985) and Lindgren (1971) for examples and further discussion.

Section 2.5 Bayes Solutions

The frequentist approach has considered the states of nature to be fixed. In contrast,
considering concept of randomness for the state of nature is the Bayes decision principle.
This stance considers nature as random or not, nevertheless, it is rational to incorporate
into the decision making process ones prior hunches, convictions, or information about
the state of nature-and how likely (whatever that means) the various states of nature are
to be governing the situation (Lindgren, 1971). This is accomplished by weighting the
states and ordering the actions to permit the selection of a best action. Thus, if a large
loss can occur for a given action when nature is in a state that the decision maker feels is
highly unlikely, the extreme loss is minimized slightly by the state of nature that would
have produced it.

The role of prior probabilities was briefly introduced in Section 1 and will be expanded
upon here. In a general decision problem, a probability weight ) ( g
1
is assigned to each
state of nature , where these assigned weights are nonnegative and add up to 1. Such a
set of probabilities or weights is called a prior distribution for . Given the distribution
) ( g , the loss incurred for a given action a is a random variable, with expected value

=
i
i i
a l g a B ) , ( ) ( ) ( .
This is referred to as the Bayes loss corresponding to action a (Lindgren, 1971). The
Bayes action is then defined to be the action a that minimizes the Bayes loss B(a). That
is, the computation of the expected loss according to a given prior distribution provides a
means of arranging or ordering the available actions on a scale (namely, B(a)) such that
the action farthest to the left on that scale is the most desirable, and is to be taken.

When randomized actions are considered, a Bayes loss can be defined as the expectation
with respect to a given prior distribution of the expected loss (with respect to the
randomized action): For a randomized action p = ) ,..., , (
2 1 k
p p p , which assigns
probability p
i
to action a
i
, the expected loss for a given state is

j
j
j
p a l a l E

= ) , ( )] , ( [ ,

and the Bayes loss is obtained by averaging these (for the various s) with respect to
) ( g :

1
This notation is used so as to diffuse any confusion from the probability vectors assigned to each action.
Part I: Decision Theory Concepts and Methods
18

)
`

= =
i i i
j j i i i i
p a l g a l E g B ) , ( ) ( )] , ( [ ) ( ) ( p .
Since this Bayes loss is a function of ) ,..., , (
2 1 k
p p p , or k 1 variables (p
k
is determined
as soon as
1 2 1
,..., ,
k
p p p are specified), the problem of determining the minimum Bayes
loss is that of minimizing a function of (k 1) variables.

Example 2-2:
(Lindgren, 1971)

Consider the following loss table where there are just two states of nature and two
actions. The prior probabilities are given and ) (
1
g = w, ) (
2
g = 1- w and the expected
losses are simply calculated as

. 4 5 ) 1 ( 5 1 ) (
6 6 ) 1 ( 6 0 ) (
2
1
w w w a B
w w w a B
= + =
= + =



1

2
B(a)
a
1

a
2

0 6
1 5
6 6w
5 4w
) ( g w 1 - w

The figure below illustrates that for any w to the left of 0.5, the value of w for which the
Bayes losses are equal, the smaller Bayes loss is incurred by taking action a
2
. For any w
to the right of 0.5, the Bayes action is a
1
as it yields the smaller Bayes loss. When w =
0.5 then it is irrelevant whether action a
1
or a
2
is taken. Examination of that figure shows
that for a prior distribution defined by a w in the range
1
0 w w < the Bayes action is a
1
;
for
2 1
w w w < < it is a
2
; for 1
2
< w w it is a
3
.

Figure 2-4:














w
w
.5
6
a1
a2
0 1
Part I: Decision Theory Concepts and Methods
19

The interpretation of small or large w is of course dependent on the problem; however, it
can be generalized that small w refers to a least favorable outcome where as w refers to a
more favorable outcome. In general, the Bayes losses for the various actions will be
linear functions of w, in a problem with two states of nature and ) (
1
g = w, ) (
2
g = 1-
w. These functions of w will be represented by straight lines, and for a given value of w
the action corresponding to the line whose ordinate at that w is smallest is the Bayes
action.

Now when considering randomized actions (p
1
, p
2
,, p
k
) for actions a
1
, a
k
,
respectively, produces the expected losses


)
`

=
)
`

=
j i
j i i j
i j
j j i i
a l g p p a l g B ) , ( ) ( ) , ( ) ( ) ( p .

Thus, the value of B(p) is a convex combination of the values of the Bayes losses for the
various pure actions, and is at least as great as the smallest of those values (Lindgren,
1971). This means that there is no gain possible in the use of randomized actions; a pure
action can always be found which yields the minimum Bayes loss.

The result that the Bayes actions are the same using the regret as using loss-is evident for
the problem involving only two states of nature; however, it is also true in general.
Substitution of

) , ( min ) , ( ) , ( a l a l a r
i j i j i
=

into the expression for expected regret:

) ( ) , ( )] , ( [
i
i
j i j
g a r a r E

=
yields
. ) , ( min ) ( )] , ( [
) , ( min ) ( ) ( ) , ( )] , ( [

=
=
i
i
a
i j
i
i
a
i i
i
j i j
a l g a l E
a l g g a l a r E




Thus, )] , ( [
j
a r E differs from )] , ( [
j
a l E by a term that does not involve a
j
. The action
that minimizes one must therefore minimize the other. This is illustrated the following
example.

Example 2-3:
(Lindgren, 1971)

Consider the following decision problem with its corresponding loss table.

Part I: Decision Theory Concepts and Methods
20

a
1
a
2
a
3

2

2 5 3
3 1 5

The regrets are

1 ) , ( ) , (
2 ) , ( ) , (
2 2
1 1
=
=
a l a r
a l a r




The expected regrets, given prior weights ) (
1
g and ) (
2
g , are

)] ( ) ( 2 [ ) ( 5 ) ( 3 )] , ( [
)] ( ) ( 2 [ ) ( ) ( 5 )] , ( [
)] ( ) ( 2 [ ) ( 3 ) ( 2 )] , ( [
2 1 2 1 3
2 1 2 1 2
2 1 2 1 1



g g g g a r E
g g g g a r E
g g g g a r E
+ + =
+ + =
+ + =

so that )]. ( ) ( 2 [ )] , ( [ )] , ( [
2 1
g g a l E a r E
i
+ =

Thus the action that minimizes )] , ( [
j
a r E also minimizes )] , ( [
j
a l E by a difference of,
irrespective of the action.

Section 2.6 Dominance and Admissibility

The concepts of dominance and admissibility are counterparts to decision rules. Some
examples have been encountered in which certain of the available actions would never be
used because there are others for which losses are always less. It is important to state
some definitions before discussing their importance any further.

Definition:

An action a* (pure or randomized) is said to dominate an action a if the loss incurred by
using action a is always at least as great as that incurred by using a:

*), , ( ) , ( a l a l for all .

Definition:

An action a* (pure or randomized) is said to dominate strictly an action a if it dominates
action a and if, in addition, there is some state of nature for which the loss inequality is
strict:
*), , ( ) , ( a l a l > for some .

Definition:

Part I: Decision Theory Concepts and Methods
21
An action (pure or randomized) is said to be admissible if no other action dominates it
strictly.

The proceeding paragraph was extracted from Lindgren (1971).

Returning to the case of two states of nature, an action is represented as a point in the (L
1
,
L
2
) plane, where L
i
is the loss (or expected loss, in the case of a randomized action)
incurred when that action is taken and
i
is the state of nature. The figure below shows
points corresponding to actions a*, a
1
and a
2
, for which losses are such that a* dominates
both a
1
and a
2
. In the case of a
1
the losses are greater than for a* for both states of
nature; in the case of a
2
only the loss for
1
is strictly greater than with a*. Incidentally
the action a* would strictly dominate every action represented by points in the shaded
quadrant (including the boundaries), with the exception of the point a* itself. (In this
kind of representation, an action that dominates action a but does not strictly dominate it
would be represented by the same point as action a, since the losses would be the same.)


Figure 2-5:














If an action a* dominates an action a there is no need to leave a in the competition for a
best action. If the dominance is not strict, then the losses are the same for a as for a*, and
a can be dispensed with; if it is strict, then one may actually do worse by using a than by
using a*.

Before ending this section, we can re-iterate this concept in terms of risk functions and
decision rules. In Chapter 5 of French and Insua (2000), it is stated that risk functions
induce a natural ordering among decision rule: a decision rule which performs uniformly
better in terms of risk than another for each value of seems better overall. Let ) (
1
and
) (
2
be two decision rules. Then ) (
1
dominates ) (
2
if , ), , ( ) , (
2 1
R R with
strict inequality. Similarly, it can be stated that the ) (
1
and ) (
2
are equivalent if
. ), , ( ) , (
2 1
= R R

a1
a* a2
L1
L2
Part I: Decision Theory Concepts and Methods
22
Definition:

A decision rule (or action) is admissible if there exists no R-better decision rule where R
is referring to the risk function. A decision rule is inadmissible is inadmissible if there
exists an R-better decision rule.

The above definition was provided by Berger (1985). An action that is not admissible is
said to be inadmissible, and can be dispensed with because there is an action that does at
least as well under the circumstances. On the other hand, an action that is close to the
lower left boundary of a set of mixed actions (in the L
1
, L
2
representation) may not be so
bad as the name inadmissible would imply (Lindgren, 1971). That is, there are degrees of
inadmissibility which the terminology ignores. In statistical problems, for example, there
may be solutions that are slightly inadmissible but are preferred for some reason to those
that dominate-because of computability, for instance.

Section 2.7 Bayesian and Classical Approaches
Bayes versus Minimax Principle

This section explores the connections between Bayesian and classical approaches through
their respective forms of decision principles, namely the Bayes and Minimax Principle.
The latter is essentially based on the risk function ) , ( R
2
which induces a partial
ordering among the decision rules
3
, leading to the concept of admissibility. Since this is
only a partial ordering, the Bayesian approach introduces a prior distribution which may
be used to weight the risk function and orders according to Bayes risk (French and Insua,
2000). Much of this discussion centers around the concept of admissibility. From the
preceding three sub-sections, some possible generalities can be made (1) Bayes
solutions are usually admissible; (2) A minimax action is a Bayes action; and (3)
Admissible actions are Bayes, for some prior distribution (Lindgren, 1971). These are
non-formal statements; however they are discussed in detail with proofs in 4.8 (Bayes
admissibility) and 5.5 (Minimax admissibility and Comparison with Bayes) of Berger
(1985). (See also Chapter 6 of French and Insua (2000).

Again a geometric representation of just two states of nature is instructive as the set of all
possible (randomized) actions is represented in the L
1
L
2
plane as a convex set. That a
minimax solution is Bayes for some prior distribution is evident, for the case of two states
of nature, from the geometrical representation in the L
1
L
2
plane (Lindgren, 1971). The
figures below illustrate four cases that may arise.

2
It is important to recall here that risk function is the expected loss (as defined by the Frequentist or
classical approach). The risk function is further explored in Section 3.
3
It is important to note that decisions and actions are sometimes interchangeable, especially in the no-data
decision problems. Thus, although the notion of decision rules has been brought in this section it is
discussed in more detail in the next section.
Part I: Decision Theory Concepts and Methods
23

Figure 2.6:

(a) The minimax action occurs on
the boundary of the set of
actions, and is a mixture of two
pure actions; this action would be
Bayes for the prior distribution
(w, 1- w) such that w/(1 w) is
equal to the slope of the line
through the two pure actions
involved.


(b) The minimax action, which is a
pure action, would be Bayes for
any prior distribution such that
w/(1 w) is a slope between the
slopes of the line segments which
meet in that pure action.



(c) The prior distribution which
produces the minimax action as a
Bayes action corresponds to the
tangent line at L
1
= L
2
; this kind
of set of randomized actions
would only occur if there are
infinitely many pure actions at
the outset.


(d) The minimax action would be
any that yields an (L
1
, L
2
) on the
bottom edge of the action set;
these are Bayes for the prior
distribution, which assigns
probability 1 to
2
.
Part I: Decision Theory Concepts and Methods
24

Example 2-3:
(Lindgren, 1971)

Revisiting the problem introduced in Section 2.5 produces the following Bayes losses
with given prior probabilities ) 1 , ( w w . The loss table has been repeated for ease.


a
1
a
2
a
3

2

2 5 3
3 1 5

. 2 5 ) 1 ( 5 3 ) (
4 1 ) 1 ( 5 ) (
3 ) 1 ( 3 2 ) (
3
2
1
w w w a B
w w w a B
w w w a B
= + =
+ = + =
= + =


The graphs of these are shown in figure 2.7 below. The lowest point of intersection and
the highest minimum is at
5
2
= w . That is, of all the prior distributions that Nature might
choose, the highest minimum Bayes loss (loss incurred by using the Bayes action) is
achieved for the prior distribution )
5
3
,
5
2
(
4
.
Figure 2.7:















The minimax randomized action is easily found (by the graphical procedure described in
Section 2.4) to be ) 0 ,
5
1
,
5
4
( with losses L
1
= L
2
= 13/5. The point on the line through (2,
3) and (5, 1) with equal co-ordinates:

4
This is said to be a least favorable prior distribution (Lindgren, 1971).
w
6
0 1
2/5
Part I: Decision Theory Concepts and Methods
25
5
13
or ,
3
2
2
3
1
1
1
= =

L
L
L
.

A prior distribution that would yield this randomized action as Bayes action is defined by
a w such that
3
2
1
=

w
w
,

where -2/3 is the slope of the line through (5, 1) and (2, 3). Notice that this w, which is
5 / 2 = w , is precisely the w of the least favorable distribution
5
determined above. A
graphical representation of this has not been shown here but can be achieved in much the
same manner described in Section 2.4 and 2.5.


The Bayes Perspective

Mathematically the Bayes approach is just postulating a weighting function that provides
an ordering among the actions; practically, the decision maker is incorporating into that
weighting function personal preferences about what that unknown state of nature is likely
to be. The concept of subjective probability is discussed in Part C on utility theory. In
the role of rational decision making, the inclusion of such personal preferences deems
reasonable. However, non-Bayesians do criticize this approach due to its view of
subjectivity. In defence of this approach, it is not terribly sensitive; therefore, in small
inaccuracies in specification is not treacherous. Furthermore, the Bayes solutions are
usually admissible.

The Minimax Approach

The minimax approach, on the other hand, is not nearly so easy to defend. Berger (1985)
goes on to say that when considered from a Bayesain viewpoint, it is clear that the
minimax approach can be unreasonable. It is pessimistic view - making the assumption
that the worst will happen. Although it is frequently admissible (and Bayes for some
prior distribution), the distribution is least favorable. A more significant objection is that
the minimax principle, by considering ) , ( sup

R , may violate the rationality principles

(Berger, 1985).

Sometimes a minimax solution can be computed by determining among the Bayes
solutions one for which the losses under the various states of nature are equal. That is, if
) ,..., ( *
* *
1 k
p p = p is a randomized action that is Bayes with respect to some prior ) ( g and
is such that the (expected) loss function

5
The notion of a least favorable distribution giving rise to the minimax action as a Bayes action is general,
but not trivial to establish. This idea is discussed more indepthly in sources on game theory which is not
included in this report.

Part I: Decision Theory Concepts and Methods
26

= =
i
i i
p a l a l E L
*
) , ( )] , ( [ *) , ( p

is constant in , then p* is minimax. The development follows (Lindgren, 1971): The
assumption that p* is Bayes for ) ( g means that for any randomized action p,

) ( ) ( min *) ( p p p B B B
P
= .

But since *) , ( p L is constant, its mean value with respect to (wrt) the weighting ) ( g is
just that constant value:

*) , ( *)] , ( [ *) ( p p p L L E B = = .

On the other hand, since B(p) is the expected value of ) , ( p L , which cannot exceed the
maximum value of ) , ( p L ) , ( max ) ( p p

L B and it follows for any p that

) , ( max *) , ( p p

L L .

Similarly, the constant *) , ( p L cannot exceed the smallest of these maxima

) , ( max min *) , ( p p

L L
P
,

where the right side of this inequality is the minimax loss.

Since *) , ( p L is defined to be constant in , it is equal to its maximum value, which in
turn is greater than or equal to the smallest such maximum:

) , ( max min *) , ( max *) , ( p p p

L L L
P
= .

And then because *) , ( p L is neither less than nor greater than the minimax loss, it must
be equal to it-and this means that p* is a minimax solution, as was asserted. This can
also be visually easing with just two states of nature. Lindgren (1985) has described this
phenomenon more in depth both algebraically and graphically. A similar proof can be
found in Berger (1985) and is discussed in brief in French and Insua (2000).

Before closing this section, I would like to make one note. Two of three key decision
rules have been discussed here. The third, the Invariance Principle, has not been included
in a theoretical discussion but for completeness is mentioned. The Invariance Principle,
as the name would have it imply, basically states that if two problems have identical
formal structures (sample size, parameter space, densities and loss function), then the
same decision rule should be used in each problem. An entire chapter in Bergers 1985
book Statistical Decision Theory and Bayesian Analysis is devoted to this principle.
Part I: Decision Theory Concepts and Methods
27
Section 3: Statistical Decision Processes

Statistical decision problems include data - meaning the results of making one or more
observations on some random quantity that is thought to be intimately related to the state
of nature in some decision problem (Lindgren, 1971). The availability of such data
provides some illumination in the selection of an action such that the state of nature is not
completely unknown. It will be shown that the use of data will define procedures which
result in an expected loss that is lower than what would be incurred if the data were not
available. However, even the availability of data will not avoid completely the kind of
situation encountered in the no-data case, in which there is no clear-cut criterion for
rating the various candidate procedures as a basis for choosing one of them as best.

Section 3.1 Data and the State of Nature

To obtain data for use in making decisions an appropriate experiment of chance should be
performed one in which the state of nature determines the generation of the data, and so
the probability distribution for the data depends on that state of nature.

The data of a given problem may consist of a single number (value of a random variable),
or a sequence of numbers - usually resulting from performing the same experiment
repeatedly, or sometimes a result or results that are not numerical. In general, a random
variable X will be employed to refer to the data, and in the problems considered here X
will denote either a single random variable, or a sequence of random variables:
(X
1
,,X
n
). In any case X will have certain possible values and a probability for each,
according to the state of nature. Thus, for each value of x of the random quantity X there
is a probability

) ( ) ; ( x X P x f = =



assigned to that value x by the state of nature . (The notation ) (E P

will mean the

probability of the event E when the state of nature is .)
6


Section 3.2 Decision Functions

Section 2 introduced the concept of a decision rule within the no-data context. Its
relevance develops in this section as a procedure for using data as an aid to decision
making involving a rule, or set of instructions, that assigns one of the available actions to
each possible value of the data X. Thus, when the pertinent experiment is performed and
a value of X obtained, say X = x, an action has been assigned by the rule to that value, and

6
It is important to realize that in order for the data to be of value in making a decision, the dependence of
the probability distribution for X on the state of nature must be known. That is, ) ; ( x f is assumed to be
given or known.

Part I: Decision Theory Concepts and Methods
28
that action is taken. A decision rule is a function a = (x), and is called a decision
function, or statistical decision function. Berger (1985) gives the following definition.

Definition:

A (nonrandomized) decision rule ) (x is a function from X into A. (It is always assumed
that the functions are measureable.) If X = x is the observed value of the sample
information, then ) (x is the action that will be taken. (Recall for a no-data problem, a
decision rule is simply an action.) Two decision rules, ) (
1
x and ) (
2
x , are considered
equivalent if 1 )) ( ) ( (
2 1
= = X X P

for all .

Question: How many distinct rules are there? If there are just k available actions (a
1
,
a
2
,, a
k
), and if the data X can have one of just m possible values (x
1
, x
2
,, x
m
), then
there are precisely k
m

distinct decision functions that can be specified. Of the k
m

possible
decision functions, some are sensible, some are foolish; some ignore the data, and some
will use it wrongly (Lindgren, 1971).

Example 3-1:
(Lindgren, 1971)

Consider the following table with 8 decision rules to between two actions and where the
observed value X={0,1,2}. The first decision rule ignores the data as it takes action a
2

regardless; the last decision rule performs in much the same way. The second decision
rule suggests taking action a
2
is X = 0 or 1.

x
1

1

1

0
1
2
a
2
a
2
a
2
a
1
a
2
a
1
a
1
a
1
a
2
a
2
a
1
a
2
a
1
a
2
a
1
a
1
a
2
a
1
a
2
a
2
a
1
a
1
a
2
a
1


Decision rules can be randomized in much the way actions are randomized an
extraneous random device to choose among the available rules. A randomized decision
function is then a probability distribution over the set of pure decision functions,
assigning probability p
i
to decision function
i
(x). A randomized decision rule can be
defined alternatively by attaching an outcome x
i
of the data X (from an experiment),
which selects one of the actions (a
1
, a
2
,, a
k
) according to some probability distribution
(g
1
, g
2
,, g
k
) (Lindgren, 1971). This is rule is equivalent to a randomization of pure
decision functions, when the numbers of actions and possible values of X are finite. The
following definition provided by Berger (1985) closes this part.

Definition:

A randomized decision rule ) , ( x is, for each x, a probability distribution on A, with the
interpretation that if x is observed, ) , ( a x is the probability that ac action in A will be
chosen. (Again a randomized decision rule in no-data problems is simply referred to as a
Part I: Decision Theory Concepts and Methods
29
randomized action.) Nonrandomized rules can be considered a special case of
randomized rules, in that they correspond to the randomized rules which, for each x, so
that a specific action chosen has probability one. Let denote the equivalent
randomized rule (at this time) for the nonrandomized rule ) (x given by

= =
. ) ( if 0
, ) ( if 1
)) ( ( ) , (
A x
A x
x I a x
A

Section 3.3 The Risk Function

Section 2 first introduced the concept of risk function as that understood by the classical
approach. This section defines and explores this concept more explicitly. Following
from the previous sub-section, when a given decision function (x) is used, the loss
incurred depends not only on the state of nature that governs it, but also on the value of X
that is observed. Since X is random, the loss incurred can be restated as,

)) ( , ( x l ,

and is a random variable. The frequentist decision-theoretic evaluates, for each , the
expected value of loss if such a decision rule (x) was used repeatedly with varying X in
the decision problem.

Definition:

The risk function of a decision rule (x) is defined by

))] ( , ( [ ) , ( x l E R =

which depends on the state of nature and on the decision rule . (Notably, for a no-data
problem, ) , ( ) , ( a L R = ).

Assuming a distribution for X defined by ) ; ( ) (

x f x X P = = , the risk function would be

calculated as

=
i
i i
x f x l R ) ; ( )) ( , ( ) , ( .
Or simply stated, the risk function is the weighted average of the various values of the
random loss. Notice that the dependence of risk on the state arises because of two
facts: the loss for a given action depends on , and the probability weights used in
computing the expected loss depends on .

Thus, when the decision is based on observed results of an experiment, a decision rule
(pure or randomized) can be selected from those available, knowing the risk function but
ignorant of the true state of nature. The problem of selecting a decision rule knowing the
risk function is mathematically exactly the same as that of selecting an action in the
Part I: Decision Theory Concepts and Methods
30
absence of data, knowing the loss function. The methods (minimax, Bayes) used in
attacking the no-data problem can be used for the statistical problem (with data).

In a similar fashion to a loss table, a risk table can be created in much the same way with
the number of rows representing the possible states of nature and the number of columns
producing the number of distinct decision rules. The decision rules are also representable
graphically as before, where (R
1
, R
2
) is plotted, with ) , (
i i
R R = , for each rule . The
plot in the figure below shows in addition to the pure decision rules the set of randomized
of the pure rules, as the convex set generated by them (French and Insua, 2000).

Figure 3-1:


















Several observations can be made (Lindgren, 1971) when using or neglecting the data:
The pure decision functions
1
and
8
, which ignore the data, give points (R
1
, R
2
)
which are exactly the same as the corresponding (L
1
, L
2
) for the no-data problem.
The straight line joining
1
and
8
would consist of randomizations that are exactly
equivalent (as regards risk) to randomizations of the pure actions a
1
and a
2
,
respectively, in the absence of data.
The data provides risk points which clearly dominate these no-data points; in
particular,
4
,
6
and
7
are all better, and indeed
4
and
7
are admissible.
There are several rules (
2
,
3
and
5
) which are worse than rules that make no use of
the data, and consequently make poor use of the data.

The availability of data permits a reduction of losses if the data is used properly and if the
set of (R
1
, R
2
) points representing the various procedures is pulled in toward the zero
regret point. In this instance, the data cannot be independent of the state of nature. If the
distribution of X is independent of :

) ( ) ; ( ) ( x k x f x X P = = =

,
6
5
1
R2
R1
d5
d2
d3
d6
d7
d4
d1
d8
Part I: Decision Theory Concepts and Methods
31

then the risks for a given rule (x) are

. ,..., 1 for ) ( )) ( , ( ))] ( , ( [ s i x k x l X l E R
j
j j i i i
= = =



In vector form this becomes

|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
j
j s
j
j
s
x l
x l
x k
R
R
)) ( , (
)) ( , (
) (
1 1


M M ,

which is a convex combination of the points (L
1
,, L
s
), where )) ( , (
1 j i
x l L = ,
corresponding to the m actions ) ( ),..., (
1 m
x x . These losses can be achieved by the
randomization ) ( ),..., (
1 m
x k x k of pure actions ) ( ),..., (
1 m
x x , and so the data does not
extend the convex set of loss points to risk points that are any better (Lindgren, 1971).

Section 3.4 Selecting a Decision Function

Section 2.6 introduced the concepts of dominance and admissibility which are extended
to the decision function, by defining them in terms of the risk function. (Although this
concept was addressed in the previous section, this section discusses more in depthly
within the constructs of modeling statistical decision problems. So, a decision function
* dominates a decision function if and only if

all for , ) , ( *) , ( R R .

The dominance is strict if the inequality is strict for at least one state of nature. A
decision function is admissible if it is not dominated strictly by any other decision
function. This was defined by Berger (1985) and stated in Section 2.6.

A decision function that involves an inadmissible action is inadmissible. If a is not
admissible, it is dominated by some action a* (Lindgren, 1971):

0 0 0
some for , ) , ( *) , ( a l a l < .

If (x) assigns the action a to some possible value x
j
of positive probability under
0
, a
new rule ) ( * x is defined to be identical with ) (x except that * ) ( * a x
j
= , and then

) , ( ) ; ( )) ( , (
) ; ( )) ( * , ( *) , (
0 0 0
0 0 0


R x f x l
x f x l R
i i
j
i i
j
= <
=

Part I: Decision Theory Concepts and Methods
32
(The inequality follows because the losses in the sums are identical except for the term
where i = j, in which case * = a* instead of a, yielding a smaller loss.) For states other
than
0
the inequalities < are replaced by , and the strict dominance of by * follows.

The Minimax Approach

The minimax principle provides a numerical measure of decision rules, namely, the
maximum risk over the various states of nature:

) , ( max ) (

R M = .

The minimax decision function is the that minimizes this maximum risk.

The Bayes Approach

Assigning prior probability weights ) ( g to the various states of nature determines the
average risk over the states:

= =
j
j j
g R R E B ) ( ) , ( )] , ( [ ) ( .
This is the Bayes risk. The preferred decision rule is the decision function which
minimizes this Bayes risk.

Recall the question posed at the last section:

Question: Would it make any difference, in studying a decision problem, if
one used regret instead of loss?


As in the no-data case, it can make a difference - at least, if one considesr a minimax
approach. There are two ways to introduce the idea of regret - by applying it to the initial
loss function, and by applying it to the risk, or expected loss. These result to the same
thing and are shown below. The regret function was defined as

) , ( min ) , ( ) , ( a l a l a r
a
i i
= ,

so for each x,

) , ( min )) ( , ( )) ( , ( a l x l x r
a
= ;

and the expected regret is then

) , ( min ))] ( , ( [ ))] ( , ( [ a l X l E X r E
a
= .

Part I: Decision Theory Concepts and Methods
33
Now for any decision rule ,

x a l x l
a
all for ), , ( min )) ( , ( ,

so that

) , ( min ))] ( , ( [ a l X l E
a


and

) , ( min ) , ( min ))] ( , ( [ min a l R X l E
a


= .

But if a* is the action that gives the minimum ) , ( a l , and one considers the decision rule
* ) ( * a x , then

) , ( min *) , ( *)] , ( [ *) , ( ) , ( min a l a l a l E R R
a

= = = (Lindgren, 1971).

Since the minimum regret over all rules is neither > nor < the minimum loss over all
actions a, these must be equal. Therefore, the expected regret is the same as the
regretized risk and is given as ) , ( min ) , ( ))] ( , ( [

R R X r E = .

Example 3-1: (contd)
(Lindgren, 1971)

Recall this example with the updated table of expected regrets. Shown also are the
maximum risks and the Bayes risk for the corresponding prior probabilities ) ( g .

) ( g
1

2

8

.8
.2
1 .9 .7 .4 .6 .3 .1 0
0 .5 .4 .1 .9 .6 .5 1
M()
B()
1 .9 .7 .4 .9 .6 .5 1
.8 .82 .64 .34 .66 .36 .18 .2

Suppose we now from graphically analyzing this problem that the minimax mixed
decision rule is a mixture decision rules 4 and 7 and can be computed as

|
|
.
|

\
|
+
|
|
.
|

\
|
5 .
1 .
) 1 (
1 .
4 .
p p

which gives

. 5 . 5 . 1 . 1 . 1 . 4 . p p p p + = +
Part I: Decision Theory Concepts and Methods
34
Thus, 7 / 4 = p and the minimum maximum risk is computed by substituting the value for
p back in the equation above and obtaining the value 19/70. The Bayes approach works
in much the same way, except that the prior distribution would be utilized.

Section 3.5: The Posterior Distribution

For completeness, a brief description of the posterior distribution is provided here within
the decision model framework. Some of the concepts or relationships between
conditional, marginal and joint were addressed in Section 1 on probability measures.

Let X represent data with possible values
k
x x ,...,
1
and let denote the state of nature,
with possible values
m
,...,
1
. Assume that the distributions of X under the various states
of nature are given:

) | ( ) | (
j i j i
x X P x f = = = ,

as well as the prior distribution for :

) ( ) (
j j
P g = = .

From these the joint probabilities ) , (
j i
x p :

) ( ) | ( ) , (
j j i j i
g x f x p = ,

and the marginal probabilities for X:

) ( ) | ( ) (
j
j
j i i
g x f x p

=
can be constructed. The conditional probabilities for given X=x
i
are

= =
j
j j i
j j i
i
j i
i j
g x f
g x f
x p
x p
x h
) ( ) | (
) ( ) | (
) (
) , (
) | (


.
This relation is essentially Bayes theorem. The function ) | (
i j
x h is the posterior
probability function for , corresponding to the given prior, ) ( g .

There are 2 notes to make before closing this section (Lindgren, 1971).
1. When the distribution of the data X is unrelated to the state of nature (that is, is the
same for all states), then the posterior probabilities are equal to the prior probabilities.
Thus, if ) ( ) | (
i i
x k x f ,
) (
) (
) ( ) | (
) | (

g
x k
g x f
x h
i
i
i
= = .
Part I: Decision Theory Concepts and Methods
35
So the observation X does not alter the odds on the various states of nature from what
they were before the observation.

2. If a prior belief is sufficiently strong, observations will not alter it. Thus if
0 ) ( and 1 *) ( = = g g for any other , then

= =
i
i i
x f g x f x k *); | ( ) ( ) | ( ) (

and then provided , 0 *) | ( x f

=
= =
. other any for , 0
*, 0 if , 1
*) | (
) ( ) | (
) | (

x f
g x f
x h

Section 3.6 Successive Observations

This is adapted from Lindgren (1971) and will be discussed further in the Part on
Sequential Statistical Decision Theory.

The previous subsection has indicated that an observation can alter prior odds to posterior
odds. The concern or question arises that if the first posterior distribution were
considered as if it were a prior, should it result in yet a new posterior distribution? The
interest holds as if a posterior distribution is used as a prior distribution with new data,
the resulting posterior distribution is the same as if one had waited until all the data were
at hand to use with the original prior distribution for a final posterior distribution.

Suppose that two observations are made, (X, Y), with probability function

) | , ( ) | , ( = = = = y Y x X P y x f .

Expressing conditional probabilities using the defining formulas in terms of joint
probabilities gives

) and | ( ) | ( ) | , ( = = = = = = = = = x X y Y P x X P y Y x X P ,

which can be re-written as

) , | ( ) | ( ) | , ( x y f x f y x f = .

The posterior probabilities for given X=x, and given a prior ) ( g are

) (
) ( ) | (
) ( ) | (
) ( ) | (
) | (
1
x k
g x f
g x f
g x f
x h
i i



= =

.

Part I: Decision Theory Concepts and Methods
36
Using this as a prior probability for = together with the new observation Y=y yields
the posterior probability

.
) ( ) | , (
) ( ) | , (
) ( / ) ( ) | ( ) , | (
) ( / ) ( ) | ( ) , | (
) | ( ) , | (
) | ( ) , | (
) , | (
1
1
2

=
=
=
j j
j j j
j j
g y x f
g y x f
x k g x f x y f
x k g x f x y f
x h x y f
x h x y f
y x h

This is precisely the posterior probability that would be computed based on data (X, Y)
and the prior ) ( g .

Section 3.7 Bayes Actions from Posterior Probabilities

The following discussion is found in Chapter 4 of Lindgren (1971), Chapter 4 of Berger
(1985), Chapter 6 of French and Insua (2000) and Chapter 3 of Raiffa and Schlaifer
(2000).

The Bayes decision rule for a given problem, corresponding to a certain prior distribution
can be found by applying the Bayes principle to the risk table - weighting the various
states of nature and choosing the decision function ) ( so as to minimize the Bayes risk,
) ( B . This function of is the expected value of the risk

=
i
i i
g R B ) ( ) , ( ) ( .

Consider a different formalization.

Step 1: Recall the expression for ) , ( R as it is computed from the loss function is:

=
j
j j
x f x l R ) | ( )) ( , ( ) , ( .

Step 2: Substitute this into ) ( B yields

=
i j
i i j j i
g x f x l B ) ( )} | ( )) ( , ( { ) ( .

Step 3: According to Bayes theorem, the product ) ( ) | (
i i j
g x f can be replaced by the
product of the conditional probability in which the condition is the value of X, and the
marginal probability X=x
j
:

Part I: Decision Theory Concepts and Methods
37
) ( ) | ( ) ( ) | (
j j i i i j
x p x h g x f = .

This is calculated by summing the joint probabilities for ) , ( X over (which would be
relevant in determining the posterior probabilities but is not at the moment):

. ) ( ) | (
) , ( ) (

=
= = =
i
i i j
i
j i j
g x f
x X P x p

Step 4: The indicated double summation can be calculated equally well by summing first
on i and then on j:

), ( ) | ( )) ( , (
) ( ) | ( )) ( , ( ) (
j
j i
j i j i
j i
i i j j i
x p x h x l
g x f x l B


)
`

=
)
`

=




where the last expression is obtained by making the substitution from Bayes theorem, as
given above.

Note: The quantity in braces depends on the observed value x
i
and on the action
assigned to x
i
by the decision function used:

) | ( )) ( , ( ) , (
j i
i
j i j h
x h x l x L

= .

It is the average of the losses )) ( , (
j
x l with respect to the posterior probability weight
which is referred to as the expected posterior loss.

Step 5: Since ) ( B is a weighted sum of expected posterior losses with nonnegative
weights:

) ( ) , ( ) (
j
j
j h
x p x L B

= ,

where L
h
is made as small as possible. So if (for the observed to x
i
) ) (
j
x is taken to be
the action that minimizes the expected posterior loss L
h
, the resulting rule is one that
minimizes the Bayes risk and is a Bayes procedure (Lindgren, 1971).

To obtain the Bayes action given a particular X, it is not necessary to go through the
computation of the whole decision rule where the number of decision functions is of a
higher order than the number of actions.

Part I: Decision Theory Concepts and Methods
38
Mathematically, the present approach is a simple process of minimizing a function of the
actions, namely, the expected posterior loss, by selecting one of those actions; the earlier
approach is a more complicated process of minimizing a function of the decision rules,
over all possible decision rules. In summary, the earlier approach incorporates the data
into the loss function to obtain the risk function where the original prior is then used on
those risks to determine the Bayes rule. The present approach incorporates the data into
the prior distribution to obtain the posterior distribution, which is used as an educated
prior distribution on the original losses. The results are equivalent.
Part II: Utility Theory - Concepts and Methods
39
Part II: UTILITY THEORY -
Concepts and Methods


Decision making under uncertainty places the evaluation of the consequences of possible
actions at the forefront of the problems concerning decision problems. There are two
main paradigms for modeling human uncertainty which has been applied to decision
making under uncertainty. One involves probabilistic and statistical reasoning. Most
common is the Bayesian perspective coupled with expected utility maximization. The
other classification is rule-based deductive systems which are based on axiomatic
foundations. Of particular interest is Savages expected utility which involves binary
relations over functions defined on a measurable space. In contrast, von Neumann-
Morgensterns theory of expected utility maximization under risk derived a basic set of
axioms from which was deduced the existence of mathematical functions which have
useful properties in comparing alternative states and preferences.

The first section of this part presents the basic ideas and concepts of utility theory. It also
introduces the utility within the context of monetary values. Sections 5 and 6 focus on
the development of utility theory based on axiomatic foundations. The middle section
focuses on the concept of ordinal utility and shifts to discuss the concept of subjective
probability. The last section is a comparative assessment of the various theories that
were developed, demonstrating the differences and similarities in their conception.
Part II: Utility Theory - Concepts and Methods
40
Section 4: Utility Theory From Axioms to Functions

An analytic study of a decision problem seems to require the assumption of a
mathematical model or structure of ordering among the various possible consequences of
taking an action in the face of a particular state of nature. In evaluating these
consequences of possible actions, two major problems are encountered. The first is that
the values of the consequences may not have any scale of measurement; and the second is
that even when there is a clear scale (usually monetary) by which consequences can be
evaluated, the scale may not reflect the true value to the decision maker (Berger, 1985).

In speaking about what one is faced with as the result of making a decision when nature
is in a certain state, the term consequence has been used, because the situation has been
brought about in part by the making of the decision. In discussing utility, it is preferable
to use the term prospect, without the implication that the future history has necessarily
been brought upon by a decision-which happens to be the case in decision theory but is
not generally so in the theory of utility.

A mathematical analysis is simpler, if it is possible to put prospects, not just in order, but
on a numerical scale-to assign a numerical measure to each prospect. With reasonable
assumptions about ones preferences among the various prospects, such an assignment, or
function, can be achieved. The numbers are referred to as utilities and subsequently
utility theory deals with the development of such numbers. Thus, utility is a function
defined on the various prospects (or consequences) with which one is faced, measuring
the relative desirability of these prospects on a numerical scale.

This section focuses on the basic axioms and general concept of utility while the
proceeding sections discuss the development of the different types of utility within
individual rational decision making.

Section 4.1: Preference Axioms

Every mathematical structure is based on a set of axioms. Acceptance of the axioms
consolidates the acceptance of a whole string of consequences, or theorems, that follow
from the axioms. This section presents the underpinning axioms, dealing with
preferences, which imply the existence of a utility function, providing a numerical scale
in terms of which the consequences of actions are assumed to be measured.

A notion of preference, or relative desirability, among prospects is assumed. The
following notation
1
of the basic binary relation represents a weak preference taken to be
at least as desirable:

2 1
~
P P f means: prospect P
1
is at least as desirable as prospect P
2
.

1
The symbols f and
~
f will occasionally be used in the other direction, with the obvious meaning, namely,
that the prospect on the small end of the symbol is the less desirable.
Part II: Utility Theory - Concepts and Methods
41
This relation is weak which assumes properties of completeness and transitivity (French
and Insua, 2000). This latter trait transitivity is stated below as axiom 2 and holds for
the following two relations as well. This aforementioned weak order can be used to
define the equal desirability of two prospects:

2 1
~ P P means: prospect P
1
and P
2
are equally desirable,

which is defined to mean that both
2 1
~
P P f and
1 2
~
P P f or simply that they are indifferent.
Strict preference is expressed in the following manner:

2 1
P P f means: prospect P
1
is preferred over prospect P
2
,

which is a condition that (by definition) exists when and only when
2 1
~
P P f , but P
1
and P
2

are not equally desirable. This latter relation ~ is reflexive, that is,
1 1
~ P P , if it is
understood that a prospect is at least as good as itself. Moreover, by definition it is
symmetric; that is
2 1
~ P P is equivalent to
1 2
~ P P (Lindgren, 1971).

These relations (along with axiom 2 transitivity) result in the following consequences:

(i) If Q P ~ and R Q ~ , then . ~ R P
(ii) If Q P
~
f and R Q ~ , then R P
~
f .
(iii) If Q P f and R Q ~ , then R P f .
(iv) If Q P f and R Q f , then R P f .

Before clearly stating the key axioms, it is necessary to address the concept of a
mixture of prospects (Lindgren, 1971). These are summarized into three aspects.

(1) If with probability p of a prospect P
1
and a probability (1-p) of a prospect P
2
,
this is called a random prospect and is considered to be a mixture of the prospects P
1
and
P
2
and is denoted by
p
P P ] , [
2 1
.

(2) More generally, if one faces P
1
with probability p
1
, P
2
with probability p
2
, and P
k
with probability p
k
, this is again a random prospect, called a mixture of P
1
,, P
k
and
denoted
) ,..., ( 1
1
] ,..., [
k
p p k
P P .

(3) Similarly, the notation for considering random prospects composed of infinite
prospects, P
1
with probability p
1
, P
2
with probability p
2
, and so forth, where p
1
+ p
2
+=1
is
,...) , ( 2 1
2 1
,...] , [
p p
P P .

These have been summarized into the adopted axioms as follows (Lindgren, 1971) &
(Berger, 1985):
Part II: Utility Theory - Concepts and Methods
42
AXIOM 1: Given any prospects P and Q, then either

Q P f , or Q P p , or Q P ~ .

Axiom 1 states that, given any two prospects, either one is preferred over the other, or the
other over the one, or they are equally desirable.

AXIOM 2: If Q P
~
f and R Q
~
f then R P
~
f .

Axiom 2 is the axiom of transitivity of the preference relation. Its assumption precludes a
type of inconsistency in the mathematical structure that may or may not accurately
describe ones preferences.

AXIOM 3: If
2 1
P P f , then for any probability p and prospect P, it follows that

. ] , [ ] , [
2 1 p p
P P P P f

AXIOM 3`: If P
1
, P
2
, and Q
1
, Q
2
, are sequences of prospects such that
i i
Q P f for i
=1,2,, then for any set of probabilities ) 1 ,...( ,
2 1
=
i

. ,...] , [ ,...] , [
,...) , ( 2 1 ,...) , ( 2 1
2 1 2 1

Q Q P P f

Axiom 3 says that improving one of the prospects in a finite mixture improves the
mixture, and Axiom 3` extends this notion to countably infinite mixtures.

AXIOM 4: Given three prospects in the order
3 2 1
P P P f f , there are mixtures
p
P P ] , [
3 1
and
r
P P ] , [
3 1
such that
. ] , [ ] , [
3 3 1 2 3 1 1
P P P P P P P
r p
f f f f

Axiom 4 says when
3 2 1
P P P f f that there is no P
1
so wonderful that the slightest chance
of encountering it instead of P
3
is better than any ordinary P
2
; and that there is no P
3
so
terrible that the slightest chance of encountering it instead of P
1
is worse than any
ordinary P
2
.

The following consequences are implied (Lindgren, 1971). For instance
0 1
P P f , it then
follows that

(v) . 1 0 for , ] , [
0 0 1 1
< < p P P P P
p
f f

Since P
1
can be thought of as
p
P P ] , [
1 1
and
p
P P ] , [
0 0
, so that (by Axiom 3)
Part II: Utility Theory - Concepts and Methods
43
. ] , [ ] [ ] , [
0 0 0 0 1 1 1 1
P P P P P P P P
p p p
= = f f f
2


(vi) . 1 0 and if , ] , [ ] , [
0 1 0 1 0 1
< p q P P P P P P
q p
f f

This states that one mixture of two prospects is preferred over another if there is a
stronger probability of the more desirable prospect in the first mixture. That is as p
increases from 0 to 1, the mixture
p
P P ] , [
0 1
becomes increasingly more desirable. A
further consequence of the axioms is the existence of a utility function which is to follow.

Section 4.2 Coding Intermediate Prospects

The previous sub-section showed that given any two distinct prospects
1 0
and P P
with
1 0
P P p , all mixtures of these prospects lie between them in order of desirability:

. ] , [
1 0 1 0
P P P P
p
p p

Moreover, the larger p the more desirable is the mixture. Now, consider that if P is an
arbitrary prospect between
1 0
and P P :

,
1 0
P P P p p

then there is some mixture of
1 0
and P P equivalent to P.

THEOREM: Given any two prospects
1 0
P and P such that
1 0
P P p , and given any prospect P
such that
1 0
P P P p p , then there is a unique number p between 0 and 1 such that
p
P P ] , [
0 1
is equivalent to P. (Lindgren, 1971)

This result means that the prospects intermediate to given prospects can be thought of as
lined up on the scale of numbers from 0 to 1, each being identified with a number on that
scale. Equivalent prospects are located at the same point on the scale, and the ordering of
prospects in desirability corresponds to ordering on the scale from least desirable to
more desirable prospects. A utility function is now easily constructible which provides a
coding of utilities that gives a numerical representation of preferences-by taking the
utility of a prospect to be just the number on the scale from 0 to 1. Thus, if
p
P P P ] , [ ~
0 1
,
define p P u = ) ( . For all prospects between
1 0
and P P , as well as for
1 0
and P P themselves

1 ) ( and , 0 ) (
1 0
= = P u P u .


2
The equality of two prospects means that they are precisely the same prospect.

Part II: Utility Theory - Concepts and Methods
44
There are certain properties satisfied by the utility function
3
, defined for any P between
given
1 0
and P P , as the value p in the mixture
p
P P ] , [
0 1
which is equivalent to P, as follows:

Utility Property A: If Q P f , then ) ( ) ( Q u P u .

Property A, for any prospects P and Q between
1 0
and P P , follows from the fact that
mixtures of
1 0
and P P are ordered according to the proportion of P
1
in the mixture; thus, if
p
P P P ] , [
0 1
= and
q
P P Q ] , [
0 1
= , and Q P f , then p > q. But p P u = ) ( and q Q u = ) ( , which
yields Property A.

Utility Property B: ). ( ) 1 ( ) ( ) ] , ([ Q u r P ru Q P u
r
+ =

Property B, for these P and Q, observe that

) 1 ( 0 1 0 1 0 1
] , [ ] ] , [ , ] , [[ ] , [
+
= =
r q pr r q p r
P P P P P P Q P

which implies that the utility in
r
Q P ] , [ is

). ( ) 1 ( ) ( ) 1 ( ) ] ([ Q u r P ru r q pr PQ u
r
+ = + =

Property B can be expressed in terms of expectation. For a mixed prospect
r
Q P ] , [ , the
utility is a random variable with possible values ) (P u and ) (Q u and corresponding
probabilities r and 1-r; the expected utility is therefore ) ( ) 1 ( ) ( Q u r P ru + , which is the
utility assigned to the random prospect. The utility of a random prospect is the expected
value of the utility (Berger, 1985).

Berger (1985) describes a 5 step procedure in constructing a utility function much of
which is described above. He also includes in his construction of the utility function the
fact that any linear function of such a utility would also satisfy Utility Properties A and
B
4
, and serve just as well as a utility function.

Defining a function ) (P v on prospects between
1 0
and P P as follows:

b P au P v + = ) ( ) ( ,

for a > 0, has the simple effect of shifting the origin and introducing a scale factor. The
utility of
1 0
and P P in this new scheme would be

b a P v b P v + = = ) ( and ) (
1 0
.


3
Berger, 1985.
4
French and Insua, 2000.
Part II: Utility Theory - Concepts and Methods
45
Property A, for ) (P v is satisfied. To obtain property B compute

). ( ) 1 ( ) (
] ) ( )[ 1 ( ] ) ( [
)] ( ) 1 ( ) ( [
) ] , ([ ) ] , ([
Q v r P rv
b Q au r b P au r
b Q u r P ru a
b Q P au Q P v
r r
+ =
+ + = =
+ + =
+ =


The matter of utilities for prospects that are not between two given prospects
1 0
and P P has
been neglected in this report. This concludes this sub-section.

Section 4.3 Utility for Money

In many practical situations, prospects are expressible in terms of amounts of money. In
such cases, it is tempting to treat the number of dollars as utility, or as proportional to
utility: M M u = ) ( or kM M u = ) ( . Recall the introduction to this section which addressed
that discounting the possibility that such a utility function overlooks other aspects of
prospects addresses the issue that this scale of values is not usually a totally adequate
basis in terms of which to analyze decision problems involving money. For one thing,
the function M M u = ) ( is not a bounded function of M, at least if M is allowed to range
over all real numbers. The famous example of the St. Petersburg Paradox illustrates
the difficulty (Lindgren, 1971) and (Berger, 1985):

Example 6-1:

You are offered, for a fee, the following random prospect. You will be given $2
N
if in
repeated tosses of a coin the first heads does not appear until the Nth toss. What entry fee
would you be willing to pay?

If money is utility, (that is M M u = ) ( ), you should be willing to pay any fee up to the
expected value of the payoff, because your utility would not be decreased by so doing. It
can be shown that the probability of obtaining heads for the first time on the Nth toss is

N
, and accepting this one obtains as the expected payoff:

. ... 1 1 1
2
1
2 ) (
1

= + + + = =
N
N
payoff E

(That is, the sum is not a finite number.) Despite the infinite expected payoff, it is found
that people generally will not pay even a large but finite entry for the proposed game.

On the other hand, if it is assumed that ones utility function is

> =

=
, 20 if 576 , 048 , 1 2
, 20 if 2
) (
20
M
M
M u
M

Part II: Utility Theory - Concepts and Methods
46

the expected utility of the payoff is

. 21 ...
4
1
2
1
20
2
1
) 2 (
2
1
2 ] 0 ( [
20
1 21
20

= |
.
|

\
|
+ + + = + =

N N
N
Payoff u E

The game then has the same utility as $21.

Another aspect of the paradox is that no one could in fact offer the game honestly - no
one has $2
40
to pay out in the event of 39 tails in a row before the first heads, for
example. On the other hand, if a gambling house with a capital of $1,048,576 agrees to
pay out the entire amount of N =20 or more, the expected payoff is $21, as the
computation above also shows.

Even without the paradox arising from permitting ones capital M to have any finite
value, as in the example above, most peoples utility for money is not strictly linear;
although, it may be approximately linear over a restricted range of values of M. Figure
4-1 shows a utility function ) (M u plotted against M that is something like most peoples
utility functions for money.

Figure 4-1:














The function shown above is an increasing function of M, corresponding to the
assumption that the greater the monetary value of a prospect the greater its desirability. It
is unusual to encounter a situation in which a greater amount of capital is worth less
than a smaller amount. The monotonic nature of the curve representing utility for money
would show that that if one is offered a favorable chance prospect involving money
repeatedly, the offer should be accepted. That is, if there is a net monetary gain each
time, the decision makers monetary assets increase - and therefore utility increases.

The expected utility is the appropriate guide for action in a single experiment, rather than
expected monetary gain, but in a long sequence of experiments the monetary gain is
relevant. In dealing with a given problem it is often convenient to focus attention on the
u(M)
M
0
Part II: Utility Theory - Concepts and Methods
47
small portion of the curve representing the function ) (M u . Label the money axis in terms
of the amount of money to be lost or gained, rather than in terms of total assets. If M
denotes an increase or decrease from an initial status M
0
, ) (M u is really ) (
0
M M u + . It
may also appear as though a persons utility function is different in different situations
reflected as different points on the overall utility curve. Figure 4-1 showed that it is
possible to have (locally) a utility for gain or loss that is concave down in some instances,
and concave up in others, as shown in the figure below.

Figure 4-2(a):




This would be appropriate if
the initial capital was near 0.



Figure 4-2(b):




This would be appropriate if
the initial capital was large.




Section 4.4 Bets, Fair and Unfair

A bet is a random or mixed prospect [of the type encountered at the beginning of the
previous section]: One starts with an initial capital M
0
and according to the outcome an
experiment of chance ends up either with M
L
, an amount less than M
0
, or with M
W
, an
amount greater than M
0
. In the former case he loses, his capital being reduced by the
amount
L
M M y =
0
, and in the latter case he wins, his capital being increased by the
amount
0
M M x
W
= . It is said he puts up with y and his opponent puts up with x,
the winner taking both amounts. (Lindgren, 1971)

Definition:

The money odds in such a bet are said to be y to x that one wins the bet, or y/x. The
probability odds in such a bet are said to be p to 1-p that one wins the bet, or p/(1-p),
where p is the probability that he wins. A bet is said to be a fair bet of the probability
odds and the money odds are equal.
M
0
0
M
Part II: Utility Theory - Concepts and Methods
48

A fair bet can be thought of as the invariant principle addressed in Section 2. It is fair
in the sense that neither side is favored. If the bet is fair, then

. 0 ) 1 ( or ,
1
=

= px p y
p
p
x
y


Substitution of
L
M M y =
0
and
0
M M x
W
= yields

, 0 ) ( ) 1 )( (
0 0
= p M M p M M
W L

or
. ) 1 (
0
M M p pM
L W
= +

A bet can be redefined as one in which the expected capital after the bet is equal to the
capital of before the bet. There is no loss nor gain in capital on the part of the one bettor;
however, if one player experienced a net expected loss, the bet would not be fair.

When utility is measured in terms of money, that is when kM M u = ) ( , the indifference
relation stands accepting or not accepting the bet are equally desirable:

). (
) ) 1 ( ( ) ( ) 1 ( ) ( ) (
0 0
M u kM
M p pM k M u p M pu bet u
L W L W
= =
+ = + =


The equal desirability follows from the fact that taking the bet has the same utility as the
initial capital and will be re-addressed in the sections concerning the development of
utility theory.

Consider a general non-linear utility function ) (M u , and a fair bet:

. ) 1 (
0 L W
M p pM M + =
The utility of the bet is

). ( ) 1 ( ) (
L W B
M u p M pu U + =

In vector notation
,
) (
) 1 (
) (
0
|
|
.
|

\
|
+
|
|
.
|

\
|
=
|
|
.
|

\
|
L
L
W
W
B
M u
M
p
M u
M
p
U
M


which is interpreted geometrically to mean that the point ) , (
0 B
U M is a convex
combination of the two points )) ( , (
W W
M u M and )) ( , (
L L
M u M . Thus, the
point ) , (
0 B
U M lies on the line segment joining those two points, as shown in the figures
below. Two cases are shown when the person is not indifferent to the fair bet.
Part II: Utility Theory - Concepts and Methods
49

Figure 4-3(a):




This represents a utility function
and fair bet that is attractive.





Figure 4-3(b):




This represents a utility function
and fair bet that is unattractive.







Consider a bet that is not fair, biased against the person whose interests are of concern
and in terms of whose utility the situation is being studied; in such a case the expected
capital after the bet is less than the initial capital:

, ) 1 (
0
M M M p M p
L W
< = +

where p is the probability of winning, and is smaller than the p corresponding to a fair
bet for the same amounts of money. The above inequality can be restated in the form

,
1
0
0
x
y
M M
M M
p
p
W
L
=

<

which says that the money odds are higher than the actual probability odds.

IfU denotes the utility in this unfair bet:

), ( ) 1 ( ) (
L W
M u p M u p U + =

M
Mw
M0 ML
U(ML)
UB
U(MW)
U(M)
MW
M0 ML
UB
M
U(M)
Part II: Utility Theory - Concepts and Methods
50
then the point ) , ( U M lies on the line segment joining the points )) ( , (
W W
M u M and
)) ( , (
L L
M u M :

.
) (
) 1 (
) (
|
|
.
|

\
|
+
|
|
.
|

\
|
=
|
|
.
|

\
|

L
L
W
W
M u
M
p
M u
M
p
U
M


This is shown in figure 4-4, in which is also plotted M
0
, the initial capital, which is
greater than the expected capital after the bet, M . Decreasing M amounts to
decreasing p , that is, altering the probability odds, and there is a p* corresponding to the
smallest M* for which the bet would be worth taking:

* *) 1 ( * M M p M p
L W
= +
or
.
*
*
L W
L
M M
M M
p

=

figure 4-4:

















It was shown above a case in which the utility is such that a fair bet is advantageous. In
much the same manner, it can be shown that a utility is such that a fair bet is not
advantageous, which can be used to determine how unfair it is. This is omitted here.
Nau (2000) discusses the issues surrounding fair bets and utility for money under
equilibrium in depth. He characterizes those who are risk averse and those who are not in
delimitating their actions under varying conditions.
M
U(M)
U
U(M0)
MW
M0
M
M*
ML
Part II: Utility Theory - Concepts and Methods
51
Section 5: Development of Utility Theory I Ordinal Utility

The development of rational choice
5
[decision] theory (in its modern form) dates back 50
years to a trio of publications: von Neumann and Morgensterns Theory of Games and
Economic Behavior (1944/1947), Kenneth Arrows Social Choice and Individual Values
(1951), and Savages Foundations of Statistics (1954)
6
. These papers laid the foundation
in the use of mathematical methods such as some of those discussed in Section 6. These
include axiomatic methods, concepts of measurable utility and personal probability, and
tools of general equilibrium theory and game theory. The focus of the previous section
was to address some of these aspects while these next two sections discuss the
development of utility theory.

For brevity purposes, this report only reviews models of individual rationality. These
include ordinal utility (for choice under conditions of certainty), expected utility (for
choice under conditions of risk, where probabilities for events are objectively
determined), subjective expected utility and state-preference theory (for choice under
conditions of uncertainty, where probabilities for events are subjectively determined
or perhaps undetermined), and several kinds of non-expected utility theory. The prior
presentation of the underpinning preference axioms is revisited briefly in this section,
providing some background on the concept of ordinal utility, prior to the discussions of
cardinal expected utility presented in the next section.

Section 5.1: Ordinal Utility

Returning to the notation for preference relations and the stated axioms, suppose that
there are only two preferences for instance, apples and bananas
7
. A pair of numbers (a,
b) then represents a possible bundle of commodities (namely a apples and b bananas) that
a person might possess. Now suppose that this person has preferences among such
groups of apples and bananas. If those preferences are complete, reflexive, transitive, and
continuous (see Section 6.1), then there exists a utility function U which represents them,
so that (a, b) = (a, b) if and only if U(a, b) = U(a, b). Recall the notion of indifference.
Then it can be said that for any group or bundle (a, b) it is possible to find a unique
number x such that the bundle (x, x), which has equal amounts of every preference, is
precisely indifferent to (a, b). Let that number x be defined as U(a, b). But this is not the
only possible way to define a utility function representing the same preferences. For
example, we could just as well define U(a, b) to be equal to 2
x
or f(x) where f is any
monotonic (i.e., strictly increasing) function. This was shown in Section 4.

Definition:

5
Several economics and operations research papers interchange between the terms choice and decision
theory.
6
Nau, 2000.
7
This could be anything. Lindgren uses beef and chicken in his example. The idea is to be able to assign a
numeric value to something which may be numerically measured in terms of preference for a particular
person. Much of this theory presented here is crucial to the understanding of consumer theory as found in
microeconomics.
Part II: Utility Theory - Concepts and Methods
52

An ordinal value function A v : is a real-valued function which represents or agrees
with a weak preference in the following sense:

b a b v a v A b a
~
) ( ) ( , , f .

The above definition was provided by French and Insua (2000) and simply states that an
ordinal value function is a numerical assignment to a set of alternatives which represents
the person or decision makers preference ranking by a numerical ranking. Thus, the
utility function representing a decision makers preferences is said to be merely an
ordinal utility because only the ordering property of the utility numbers is meaningful.

Example 5-1:

For example, suppose that U(1, 1) = 1, U(2, 1) = 2, U(1, 2) = 3, and U(2, 2) = 4. In other
words, referring back to apples and bananas, one apple and one banana yield one unit of
utility, two apples and one banana yield two units of utility, etc. Then this means only
that the preference ordering is (2, 2) > (1, 2) > (2, 1) > (1, 1), i.e., two apples and two
bananas are better than one apple and two bananas which are better than two apples and
one banana which are better than one apple and one banana. However, it may not be
concluded that two apples and one banana are twice as good as one apple and one
banana or that one additional apple yields the same increase in utility regardless of
whether you have one banana or two bananas to start with.

Recall that any monotonic transformation of U carries exactly the same preference
information: if f is a monotonic function, and if V is another utility function defined by
V(a, b) = f(U(a, b)), then V encodes exactly the same preferences as U. For example,
letting f(x) = 2
x
, we obtain a second utility function satisfying V(1, 1) = 2, V(2, 1) = 4,
V(1, 2) = 8, and V(2, 2) = 16, which provides a completely equivalent representation of
this hypothetical decision makers preferences.

Ordinal value functions represent preference rankings and nothing more. There is no
further information in the numbers used to represent the decision makers preferences,
such as strength of preference. More formally, the following theorem is given by French
and Insua (2000).

THEOREM: For any domain of objects A with a weak order
~
f , there exists an ordinal
value function if an only if there exists a countable order dense subset . , viz A B B is
such that B b a a A a a ,
~
, ,
2 1 2 1
f such that
2 1
~ ~
a b a f f .
Thus, any strictly increasing transformation of an ordinal value function also agrees with
the underlying weak preferences. Conversely, any two ordinal value functions which
agree with the same preference relation are related by a strictly increasing transformation.
Thus, the representation is said to be unique up to a strictly increasing transformation
(French and Insua, 2000).
Part II: Utility Theory - Concepts and Methods
53
Section 5.2: Marginal Utility

Suppose now that the non-unique ordinal utility function of concern is differentiable
i.e., it is a smooth function of the numbers of apples and bananas. Then marginal utility
(of an additional apple or banana)
8
can be defined as the partial derivative of the utility
function (with respect to apples or bananas), evaluated at the point of interest. Since it
was previously stated that ordinal utilities are nearly-meaningless numbers, it might be
plausible to believe that marginal utilities would be nearly-meaningless numbers as well;
however, the ratios of marginal ordinal utilities are always uniquely defined. The ratios
of marginal utilities are precisely the marginal rates of substitution between the
prospects that leave total utility unchanged. Marginal rates of substitution are uniquely
determined by preferences and as such they are observable, hence any two utility
functions that represent the same preferences must yield the same ratio of marginal
utilities between any two preference groups (Nau, 2000).

For example, if the ratio of the marginal utilities of apples to bananas is equal to 1/2 when
the decision maker already has one apple and one banana means that the person would
indifferently trade an fraction of an additional banana for a 2 fraction of an additional
apple. Then the same ratio must be obtained for any other utility function that is a
monotonic transformation of the original one.

Section 5.3: Indifference Curves

Section 6 illustrated the geometrical perspective of a decision makers utility curve. So,
to recap, geometrically, an ordinal utility function determines the shape of indifference
curves in the space of possible prospects or groups of prospects. An indifference curve is
a set of points representing endowments that all yield the same numerical utilityi.e. that
are equally preferred. A decision makers indifference curves in
2
space is illustrated in
figure 5-1.

Figure 5-1:
Points x and y are on the same
indifference curve, meaning that
they yield exactly the same utility
i.e., the decision maker is precisely
indifferent between themwhereas
point z lies on a higher indifference
curve, so it would be preferred to either
x or y. The slope of a tangent line
to an indifference curve (such as the
dotted line through point y) is precisely the marginal rate of substitution between
prospects at that point.

8
The marginal utility of an apple is not necessarily the increase in utility yielded by an additional whole
appleit is the increase in utility yielded by an additional fraction of an apple, divided by , where is
infinitesimally small.
y
x
z
Part II: Utility Theory - Concepts and Methods
54

Note 1: A person wishes to climb higher (to another indifference curve) if at all
possible. Thus, if the person started at point x on the map, he or she would be indifferent
to walking over to point y, which is at the same elevation, but would prefer to climb
higher up to point z.

Note 2: While the shapes of the indifference curves are uniquely determined by
preferences, the relative heights of the utility surface above different indifference curves
are completely arbitrary.

Note 3: Another utility function that represented the same preferences would have
to yield the same indifference curves, whose tangent lines would have exactly the same
slopes at all points, but the corresponding utility surface might otherwise look very
different.

Section 5.4: Assumptions - Marginal Utility and
Multi-Attributed Theory

The assumption of diminishing marginal utility was briefly addressed in Section 6. This
assumption means that if the holdings of all prospects are fixed except one, then the
marginal utility of that prospect should decrease as the endowment of it increases (Nau,
2000). The term non-satiation refers to the fact that the marginal utility of every prospect
always remains positivei.e., it approaches zero only asymptotically, so that more is
always better no matter how much you already have. (See Section 4.3.)

Decreasing marginal utility is actually not a strong enough condition for the decision
makers problem to always have a unique solution unless the utility function is also
additively separablei.e., of the form U(a,b) = u
1
(a) + u
2
(b). If the number of prospects
is increased to some n - i.e., there exists prospects a, b, c, d, , etc., then the additive
form of utilities refers to the consequences or alternatives to be multi-attributed in
n
.
9


A stronger assumption of strictly convex preferences is usually made, which means that if
x = z and y = z, then x+(1-)y > z for any number strictly between 0 and 1, where the
vectors x, y, and z denote general multidimensional preferences. In other words, if x and y
are both weakly preferred to z, then everything in between x and y is strictly preferred
to z
10
. In particular, if x and y are indifferent to each other, then x+(1-)y is strictly
preferred to either of themi.e., the decision maker would prefer to have an average of x
and y rather than either extreme.

This property captures the intuition of diminishing marginal utility, namely that x
provides more than half as much utility as x, but it does so by referring to observable
preferences rather than unobservable utility. Lindgren (1971) discusses the case of
arbitrary prospects more in depth in Chapter 2.3.

9
This is explored in Section 8.
10
See Section 6.2.
Part II: Utility Theory - Concepts and Methods
55

If preferences are strictly convex, then any utility function that represents those
preferences is necessarily strictly quasi-concave, which means that its level sets are
strictly convex sets, i.e., the set of all y such that U(y) = U(x) is a strictly convex set. The
strict convexity of the level sets ensures that the decision makers problem has a unique
solution (Nau, 2000)
11
.

Section 5.5 Subjective Probability

The classical concept of probability was initially introduced (in Part A) as a repeatable
experiment (of chance) that (at each trial) results in one of a given set of possible
outcomes. The probability assigned to each outcome is thought of as an idealization of
its relative frequency of occurrence in a long sequence of trials. In the case of a chance
or random variable, these outcomes are ordinary numbers, characterized by non-
numerical descriptions. When the outcomes are thought of as prospects with
corresponding probabilities is termed a random prospect. However, this frequency
concept does not always suffice when dealing with .

The theory of subjective probability was created to enable one to talk about probabilities
when the frequency viewpoint does not apply (Berger, 1985). A quantification of
chances involving ones beliefs or convictions concerning the occurrences of the event,
and embodying the odds indicates that the matter of chance in this kind of experiment is
actually personal. The term subjective probability is used to refer to probability that
represents a persons degree of belief concerning the occurrence of an event. Although it
can be assumed that the subjective probability of a given state exists, it is seldom easy to
determine that probability (Lindgren, 1971).

Nau (2000) states that there are four best-known concepts of probability (1) the
classical interpretation, (2) the frequentist (or objective) interpretation, (3) the logical (or
necessary) interpretation, and (4) the subjective interpretation. Although objective
probability and subjective probability are different in conception and interpretation, they
are not different as mathematical entities, in as much as the same basic axioms are
assumed to hold for both. Any definitions or theorems concerning objective probabilities
apply equally well to subjective probabilities. In particular, the expected value of a
random variable, defined earlier (in Section 6) for the case of objective probabilities,
would be defined in exactly the same way if the probabilities are subjective, namely, as
the weighted sum of the possible values, where the weights are the corresponding
(subjective probabilities).

This section discussed the role of ordinal utility. This closing sub-section has introduced
the topic to be discussed in the following section which more formally develops the
utility theory within its three comparable forms.


11
Nau (2000) discusses this within the constructs of consumer theory as understood in microeconomic
theory. He also provides a detail development of utility theory and equilibrium states as they formed in
utility theory and impacted microeconomic theory.
Part II: Utility Theory - Concepts and Methods
56
Section 6: Development of Utility Theory II
Comparing Axiomatic Theories

In the last section, ordinal utility functions were discussed according to the marginalist
view of modeling decision problems under conditions of certainty. This section compares
the main elements of the theory of individual rational modeling under risk and
uncertainty. These were developed in the mid-1900s: the theories of subjective
probability (SP), expected utility (EU), and subjective expected utility (SEU). The
primary sources of information for this section are Nau (2000) and French and Insua
(2000) and were stated at the beginning of Section 5. Both provided detailed accounts of
the developments of all three works and provide citations for the original publications
and other perspectives on these developments.

Nau discusses these three theories in terms of four attributes or concepts axiomatic
fever, primitive preferences, concepts of probability, and the independence
condition for preferences cardinal utility. Of these four concepts, the first two have
been discussed thoroughly in the Section 4. The third topic of interest was addressed
briefly in the closing sub-section of Section 5. However, this last concept has not been
addressed this far. Before beginning a comparative look at the three theories of concern,
a little insight into the importance of this last topic will be given first.

Section 6.1: The Independence Condition for Preferences
Cardinal Utility

Von Neumann and Morgenstern in their aims to establish a new game-theoretic
foundation for economics, decided it was necessary to first axiomatize a concept of
cardinal measurable utility that could serve as a single monetary commodity whose
expected value the players would seek to maximize through their strategy choices.

Recall from the previous section that decision making under conditions of certainty were
modeled as ordinal utility functions. It was discussed that under such conditions, it is
meaningless to say something like the utility of y is exactly halfway between the utility
of x and the utility of z. von Neumann and Morgenstern discovered that such a
statement can be made if the decision maker has preferences not only among definite
objects such as x, y, and z, but also among probability distributions over those objects.

Thus, it can be said that by definition, a 50-50 gamble between x and z has a utility that is
exactly halfway between the utility of x and the utility of z, and if y is indifferent to such
a gamble, then it too has a utility that is exactly halfway between the utility of x and the
utility of z. There are several important things to note here (Nau, 2000) and (French and
Insua, 2000).

Note 1: Additional psychological data is required to construct a cardinal utility
function, namely data about preferences among probability distributions over rewards,
not just data about preferences among the rewards themselves.
Part II: Utility Theory - Concepts and Methods
57

Note 2: Those preferences must satisfy an independence condition, namely that x
is preferred to y if and only if an chance of x and a 1 chance of z is preferred to an
chance of y and a 1 chance of z, regardless of the value of zi.e., a preference x
over y is independent of common consequences received in other events.
12


Note 3: Once probabilities have been introduced into the definition and
measurement of utilities, a cardinal meaning cannot be attached to the utility values
except in a context that involves risky choices: if the utility of y is found to lie exactly
halfway in between the utilities of x and z, then it cannot be conclude that the increase in
the measure results from the exchange of x for y to be exactly the same as the increase
that results from the exchange of y for z. All that can be said is that y is indifferent to a
50-50 gamble between x and z.

While von Neumann-Morgenstern utility function was being established other
economists had discovered that a simple behavioral restriction on preferences-under-
certainty implies that a consumer must have an additively-separable utility function, i.e.,
a utility function of the form U(x1, x2, , x3) = u1(x1) + u2(x2) + + un(xn), which is
unique up to an increasing linear transformation and is therefore cardinally measurable
(Nau, 2000).

Section 6.2: Comparative Axioms of SP, EU, and SEU

Many authors contributed to the development of axiomatic theories of rational decision
making under uncertainty; however this section concentrates on three main contributions:
de Finettis theory of subjective probability (SP), von Neumann and Morgensterns
theory of expected utility (EU), and Savages theory of subjective expected utility (SEU).
Savages theory is essentially a merger of the other two and will be presented in
conjunction with the works of Anscombe and Aumann. I have tried to be consistent with
my notation; however various authors present various different aspects and thus, this is an
amalgamation of work published by (Nau, 2000) and (French and Insua, 2000).

Table 6-1 (appended to the end of section 6) presents the axioms at a glance as a
comparative means and was adapted from Nau (2000). This is followed by a discussion
on some of the key elements of comparison for the three theories of concern.

In all three theories, there is a primitive ordering relation, which I will denote by
~
f . In
SP theory, the objects of comparison are events A, B, etc., which are subsets of some
grand set of possible states of nature. The ordering relation between events is one of
comparative likelihood: A = B means that event A is considered at least as likely as
event B. In EU theory, the objects of comparison are probability distributions f, g, etc.,
over some set of possible consequences, which could consist of amounts of money or

12
The independence condition is implicit in von Neumann and Morgensterns axiomatization.

Part II: Utility Theory - Concepts and Methods
58
other tangible rewards or prizes, or they could simply be elements of some abstract set.
The ordering relation is one of preference: f = g means that distribution f is at least as
preferred as distribution g. SEU theory merges the main elements of these two
frameworks: the objects of comparison are acts, which are real or imaginary mappings
from states of nature to consequences. In other words, an act is an assignment of some
definite consequence to each state of nature that might obtain. The ordering relation is
preference, as in EU theory.

Similarity of Axioms Across Theories

1. Assumption that the relation is complete: for any A and B, either A
~
f B or B
~
f A or both. Hence, it is always possible to determine at least a weak
direction of ordering between two alternatives.

2. Assumption that the ordering relation is transitive: i.e., A
~
f B and B
~
f C
implies A
~
f C.

3. Assumption that the relation has a property called independence or
cancellation, which means that in determining the order of two elements (such
as A
~
f B), there is some sense in which common events or consequences can
be ignored on both sides.

A Closer Look at the Independence Condition Across Probability Theories

1. The independence condition for subjective probability states:

C B C A B A
~ ~
f f

for any C that is disjoint from both A and B. Simply stated, if the same non-overlapping
event is joined to two events whose likelihoods are being compared, the balance of
likelihood is not tipped. This condition also implies:

*
~
*
~
C B C A C B C A f f

for any C, C* that are disjoint from both A and B. Thus, a common disjoint event on both
sides of a likelihood comparison can be replaced by another common disjoint event
without tipping the balance.

2. The independence condition for expected utility is:

Part II: Utility Theory - Concepts and Methods
59
. ) 1 (
~
) 1 (
~
h g h f g f + + f f

The expression f + (1-)h is an objective mixture of the distributions f and hi.e., an
chance of receiving f and a 1- chance of receiving h, where the chances are
objectively determined. Thus, if f and g are objectively mixed with the same other
distribution h, in exactly the same proportions, the balance of preference is not tipped
between them. The a decision-tree illustration of this condition is and its interpretation is
explained in Section 9.

The condition also implies:

* ) 1 (
~
* ) 1 ( ) 1 (
~
) 1 ( h g h f h g h f + + + + f f ,

which says that if f is preferred to g when they are both mixed with a common third
distribution h, then the direction of preference isnt changed if they are mixed with a
different common distribution h* instead. In other words, the common element h can
be replaced with any other common element.

3a. The independence condition for subjective expected utility (Savages axiom
P2, otherwise known as the sure thing principle as noted by Nau (2000)) states:

* ) 1 (
~
* ) 1 ( ) 1 (
~
) 1 ( h A Ag h A Af h A Ag h A Af + + + + f f ,

for any non-null event A
13
. The expression Af + (1A)h is a subjective mixture of f and
h: it means the consequence specified by act f in every state where event A is true is
achieved, and the consequence specified by act h in all other states is achieved. Simply,
this condition says that comparing two acts which happen to agree with each other in
some states (namely the states in which A is not true), then different agreeing
consequences in those states can be substituted without tipping the balance. This property
is necessary to define the concept of a conditional preference between two acts: the
relation Af + (1A)h
~
f Ag + (1A)h means that f is preferred to g conditional on event A.

3b. There is also a second kind of independence condition that also appears in SEU
theory, namely an assumption about the state-independence of preferences for particular
consequences. This assumption (Savages P3) states that if x, y, and z are constant acts
(acts that yield the same consequence in every state of nature) and A is any non-null
event, then:
z A Ay y A Ax y x ) 1 (
~
) 1 (
~
+ + f f .

13
A non-null event is an event that has non-negligible probability in the sense that at least some preferences
among acts are affected by the consequences received in that event.
Part II: Utility Theory - Concepts and Methods
60
Thus, if the consequence x is preferred to the consequence y for sure, then it is also
preferred to y conditional on any event, other things being equal. This assumption is
needed to help separate utilities from probabilitiesi.e., to ensure that relative utilities
for consequences dont depend on the states in which they are received.

The important thing to note is that, in all these conditions, the common additive factors
can be ignored or canceled (e.g., C, h, z, etc.) on opposite sides of the ordering relation.
This property is necessary in order for the relation to be represented by a probability
distribution that is additive across mutually exclusive events and/or a utility function that
is a linear in probability. The additivity or linearity of the preference representation, in
turn, means that the direction of preference or comparative likelihood between two
alternatives depends only on the difference between them.

Section 6.3: Subjective Probability versus Expected Utility theory

In de Finetti s 1937 paper, he pointed out that there are actually two equivalent ways to
axiomatize the theory of subjective probability. One way is in terms of a binary relation
of comparative likelihood (as illustrated in the table above). The other way is in terms of
the acceptance of monetary gambles. The two theories are dual to each otheri.e., they
are really the same theory but their working parts are merely labeled and interpreted in
different ways (Nau, 2000).

Suppose that there is some set S of mutually exclusive, collectively exhaustive states of
nature. Consider possible distributions of monetary wealth over those states. Thus, if f is
a vector representing a wealth distribution, then f (s) is the amount of money you get if
state S s occurs.


In the presence of the completeness axiom, the independence axiom also works in
reverse, i.e., . ) 1 (
~
) 1 (
~
h g h f g f + + f f for all 0 < < 1. This is so because
the completeness axiom requires the decision maker to have a definite direction of
preference between f and g, and if it were not the same as the direction of preference
between f + (1-)h and g + (1-)h, the independence axiom would produce a
contradiction.

A0: (reflexivity) f
~
f f for all f.
A1: (completeness) for any f and g, either f
~
f g or g
~
f f or both.
A2: (transitivity) if f
~
f g and g
~
f h, then f
~
f h.
A3: (strict monotonicity) if f(s) > g(s) for all s, then f f g (i.e., NOT g
~
f f).
A4: (independence) f
~
f g f + (1)h
~
f g + (1)h for all h and 0 < < 1.
Part II: Utility Theory - Concepts and Methods
61
This means the decision maker effectively has linear utility for money, because scaling
both f and g up or down by the same positive factor and/or increasing the decision
makers initial wealth by a constant amount h does not lead to a reversal of preference.

There are many results and important conclusions that follow from this line of thought
which are discussed in some depth in Nau (2000). Two of prominence are: The first of
which is that the direction of preference between any two wealth distributions depends
only on the difference between them. And the second of which states that the inequalities
between different pairs of wealth distributions can be added.

Now consider the following set of axioms. Consider now the differences between wealth
distributions as gambles of which there are two types: acceptable and unacceptable.



These are the assumptions used by de Finetti in his gamble-based method of
axiomatizing subjective probability, and (by the arguments above) they are logically
equivalent to A0A4 (Nau, 2000).

SP THEOREM: If preferences among wealth distributions over states satisfy A0-A1-A2-
A3- A4 (or equivalently, if acceptable gambles satisfy B0-B1-B2-B3-B4), then there exists
a unique subjective probability distribution such that f = g if and only if the expectation
of the wealth distribution f is greater than or equal to the expectation of distribution g
according to (or, equivalently, x is an acceptable $-gamble if and only if its expectation
is non-negative according to ) .

This is de Finettis theorem on subjective probability.

Consider reversing the role of money and probabilities. Let C be some set of
consequences or prizes, and let f, g, etc., denote probability distributions over those
prizes. Thus, f(c) now represents the probability of receiving prize c rather than an
amount of money. The axioms are as follows:


B0: (reflexivity) 0 G
B1: (completeness) for any x, either x G or x G or both
B2: (linearity) if x G, then x G for any > 0
B3: (additivity) if x G and y G, then x + yG
B4: (coherence) G contains no strictly negative vectors
Part II: Utility Theory - Concepts and Methods
62

There is a small difference in Axiom 3 which is the strict monotonicity condition is
weakened to a non-triviality condition.

The direction of preference between any two probability distributions depends only on
the difference between those two distributions. Note that a difference between two
probability distributions also a kind of gamble in the sense that it changes your risk
profileit just does so by shifting the probabilities attached to fixed prizes rather than by
shifting the amounts of money attached to events with presumably-fixed subjective
probabilities. Then the followings axioms are developed:



The continuity/closure (A5/B5) requirement is needed to rule out unbounded utilities as
well as lexicographic preferences (Nau, 2000) and French and Insua (2000).

Let u denote a utility function for prizes, because f = g if and only if fu = gu, and the
quantities on the left and right of this expression are just the expectations of u under the
distributions f and g, respectively. The function u is subject to arbitrary positive scaling,
and a constant can also be added to it without loss of generality (wlog), because this will
just add the same constant to the expected utility of every probability distribution.

EU THEOREM: The results are summarized as the expected utility theorem. If
preferences among probability distributions over consequences satisfy A0-A1-A2-A3-A4
(or equivalently, acceptable p-gambles satisfy B0-B1-B2-B3-B4), there exists a utility
function u, unique up to positive affine transformations, such that f = g if and only if the
expected utility of f is greater than or equal to the expected utility of g (or, equivalently, x
A0: (reflexivity) f
~
f f for all f
A1: (completeness) for any f and g, either f
~
f g or g
~
f f or both
A2: (transitivity) if f
~
f g and g
~
f h, then f
~
f h
A3: (non-triviality) there exist f* and g* such that f* f g* (i.e., NOT g*
~
f f*)
A4: (independence) f
~
f g f + (1-)h
~
f g + (1-)h where 0 < < 1.
A5: (continuity): for fixed f, the set of g such that f
~
f g is closed, and vice versa

B0: (reflexivity) 0 G.
B1: (completeness) for any x, either x G or x G or both.
B2: (linearity) if x G, then x G for any > 0.
B3: (additivity) if x G and y G, then x + yG.
B4: (non-triviality) there is at least one non-zero p-gamble not in G.
B5: (closure): G is closed.
Part II: Utility Theory - Concepts and Methods
63
is an acceptable p-gamble if and only if it yields a non-negative change in expected utility
according to u).

This is von Neumann-Morgensterns theorem on expected utility, and it is
isomorphic to de Finettis theorem on subjective probability, merely with the roles of
probabilities and payoffs reversed (French and Insua, 2000).

The axioms of subjective probability or expected utility are satisfied if and only if (a)
your set of acceptable directions of change in (stochastic) wealth is a convex cone, (b) it
excludes at least some directionsespecially those that lead to a sure lossand (c) it is
always the same set of directions, no matter what your current distribution.

Section 6.4: Subjective Expected Utility (Anscombe-Aumann & Savage)

Savage combined the features of subjective probability and expected utility theory in
order to model situations in which the decision maker may attach their own subjective
probabilities to events and their own subjective utilities to consequences. Anscombe &
Aumann followed in much the same way, but had a simpler approach by simply merging
Savages concept of an act (a mapping of states to consequences) with von Neumann
and Morgensterns concept (an objective probability distribution over consequences),
(French and Insua (2000).

Anscombe and Aumann proposed that the objects of choice should be mappings from
states to objective probability distributions over consequences. Such objects are known
as horse lotteries in the literature. This is supposed to conjure up an image of a horse
race in which each horse carries a different lottery ticket offering objective probabilities
of receiving various prizes. By applying the von Neumann-Morgenstern axioms of
expected utility to horse lotteries, together with one more assumption, you get
probabilities and utilities together. Henceforth, let f, g, and h denote horse lotteries.
Think of them as vectors with doubly-subscripted elements, where f (c,) denotes the
objective probability that the horse lottery f assigns to consequence c when state occurs
(i.e., when horse s wins the race). Furthermore, let x, y, and z, denote horse lotteries that
are constant in the sense that they yield the same objective probability distribution over
consequences in every state of the world (i.e., no matter which horse wins).

Let the usual axioms A0-A5 apply to preferences among horse lotteries, together with
one additional axiom, which is essentially the same as Savages P3:

A6: (state-independence): x
~
f y Ax + (1A)z
~
f Ay + (1A)z
for all constant x, y, z and every event A

Here, Ax + (1A)z denotes the horse lottery that agrees with x if A occurs and agrees with
z otherwise, where A is an event (a subset of the states of the world).

Part II: Utility Theory - Concepts and Methods
64
Note1: From axioms A0-A5 and some work, the existence of an expected-utility
vector v such that f = g if and only if fv = gv. The elements of the vector v are
subscripted the same as those of f and g, with v(c, ) representing the expected utility of
consequence c when it is received in state . Intuitively, v(c, ) combines the probability
of the state with the utility of the consequence.

Note 2: Axiom A6 then implies the further restriction that the expected utilities
assigned to different consequences in state must be proportional to the expected
utilities assigned to the same consequences in any other state, because it requires
conditional preferences among objective probability distributions over consequences to
be the same in all states of the world. It follows that v can be decomposed as v(c, s) =
p(s)u(c), where p(s) is a (unique!) non-negative probability assigned to state s and u(c) is
a state-independent utility assigned to consequence c.

Note 3: By convention, the utilities attached to particular consequences are
assumed to be identicalnot merely proportionalin different states, in which case the
ratio of v(c, ) to v(c, ) can be interpreted as the ratio of the subjective probabilities of
states and .

Note 4: Preferences among Savage acts are represented by a unique probability
distribution p over states and a state-independent utility function u over consequences,
with act f preferred to act g if and only if the expected utility of f is greater than or equal
to the expected utility of g. This is summarized as the subjective expected utility
theorem. However, before stating the theorem, one further remark is made which
addresses a weakness in this point.

Remark: It should be noted that the uniqueness of the derived probability
distribution depends on the unstated assumption that consequences are not only similarly
ordered by preference in every state of the world (which is the content of axiom A6
above), but they also have the very same numerical utilities in every state.

SEU THEOREM: If preferences among horse lotteries satisfy A0-A1-A2-A3-A4-A5-
A6, then there exists a unique probability distribution p and a state-independent utility
function u that is unique up to positive affine transformations such that f = g if and only if
the expected utility of f is greater than or equal to the expected utility of g.

Section 6.5: Incomplete Preferences

The completeness axiom causes some distress. It forces the notion that a gamble must
be accepted. So, although, it may be unacceptable according to some axioms it is still
acceptable according to the completeness axiom. The three theorems staed above with
respect to each theory is restated generally with incomplete preferences.

SP THEOREM with incomplete preferences: If preferences among wealth
distributions over states satisfy A0-A2-A3-A4-A5, then there exists a convex set P of
subjective probability distributions such that f = g if and only if the expectation of the
Part II: Utility Theory - Concepts and Methods
65
wealth distribution f is greater than or equal to the expectation of distribution g for every
distribution in P (or, equivalently, x is an acceptable gamble if and only if its
expectation is non-negative for every distribution in P) .

Similar results are obtained when you drop the completeness axiom from EU or SEU
theory: you end up with convex sets of utility functions or expected-utility functions.

EU THEOREM with incomplete preferences: If preferences among probability
distributions over consequences satisfy A0-A2-A3-A4-A5 (or equivalently, acceptable p-
gambles satisfy B0-B2-B3-B4-B5), there exists a convex set U of utility functions,
unique up to positive affine transformations,
14
such that f
~
f g if and only if the expected
utility of f is greater than or equal to the expected utility of g for every utility function u
in U (or, equivalently, x is an acceptable p-gamble if and only if it yields a non-negative
change in expected utility for every utility function u in U ). See French and Insua
(2000).

SEU THEOREM with incomplete preferences: If preferences among horse lotteries
satisfy A0-A2-A3-A4-A5-A6, then there exists a convex set V of expected-utility
functions, at least one of which can be decomposed as the product of a probability
distribution p and a state-independent utility function u, such that f
~
f g if and only if the
expected utility of f is greater than or equal to the expected utility of g for every
expected-utility function v in V.



14
Note: Theorem 3 addresses positive affine transformations in Chapter 2 of French and Insua, (2000).
Part II: Utility Theory Concepts and Methods
66
Table 6.1: Comparing Axioms: SP, EU & SEU
de Finetti Von Neumann-Morgenstern Savage
Theory of Subjective Probability Expected utility Subjective expected utility
Features States Abstract set closed under probability
mixtures
States, consequences
Objects of comparison Events A,B,C (sets of states) Probability distributions f,g,h Acts f,g,h, (mappings from states to
consequences); constant acts x,y,z
Primitive relation
~
f
Comparative Likelihood Preference Preference
Reflexivity axiom
A A
~
f f f
~
f f f
~
f
Completeness axiom
For all A,B: if B A
~
f
or A B
~
f or both
For all f,g: if g f
~
f or f g
~
f or both P1a:For all f,g: if g f
~
f or f g
~
f or both
Transitivity axiom
For all A,B,C: if B A
~
f
or C B
~
f then C A
~
f
For all f,g,h: if g f
~
f
or h g
~
f then h f
~
f
P1b: For all f,g,h:
if g f
~
f or h g
~
f then h f
~
f
Independence axiom
(a.k.a. substitution,
cancellation,
separability, sure-thing
principle)
If = = C B C A
then B A
~
f iff C B C A
~
f
If g f
~
f then
h g h f ) 1 (
~
) 1 ( + + f
for all strictly between 0 and 1. the
converse is also true as a theorem,
whence:
h g h f ) 1 (
~
) 1 ( + + f iff
* ) 1 (
~
* ) 1 ( h g h f + + f
P2: For all f,g,h,h*, if event A is non-null, then
h g h f ) 1 (
~
) 1 ( + + f iff
* ) 1 (
~
* ) 1 ( h g h f + + f
State-independent
utility axiom (value
can be purged of
belief)
P3: For all constant acts x,y,z, if event A is
non-null, then y x
~
f iff
z y z x ) 1 ( ) 1 ( + + f
Part II: Utility Theory Concepts and Methods
67
z y z x ) 1 (
~
) 1 ( + + f
Qualitative probability
axiom (belief can be
discovered from
preference)
P4: For all events A & B and constant acts
x,y,z*,y* such that y x f and
* * y x f : y B Bx y A Ax ) 1 ( ) 1 ( + + f
iff * ) 1 ( * * ) 1 ( * y B Bx y A Ax + + f
Non-triviality axiom
f f A for any A that is
uncertain
g f g f f such that and P5: g f g f f such that and
Continuity axiom There exists a fair coin
If , h g f f f then
h g h f ) 1 ( ) 1 ( + + f
for some and strictly between 0
and 1.
P6: If g f f , there exists a finite partition of
the set of states into events{A
i
} such that
h g h f
i i i i
+ + ) 1 ( ) 1 ( f for
any event A
i
in the partition and h.
Dominance axiom
P7: If ) ( ) ( g f f one every state in event
A, then h g h f ) 1 (
~
) 1 ( + + f
Conditional
probability axiom
If C B C A and then
B A C B C A
~
iff |
~
| f f


Part III: Sequential Statistical Decision Theory
68
Part III: SEQUENTIAL STATISTICAL
DECISION THEORY -
Introduction to Markov Decision Processes


Concepts of decision processes (as those presented in prior sections) have assumed single
decision making problem. However, this is rarely the case. In most instances, decisions
are nested in a series of related decisions (French and Insua, 2000). This iterates the
concept that a decision is contingent upon the outcome of previous decisions made. The
formulation of sequential problems is most naturally expressed as a recursive equation
and its solution is credited to Bellman. Subsequent developments in sequential methods
have instigated growth in sequential probability leading to a large body of theory on
Markov decision processes. This sequential pattern of decision processes is a concept
that has wide applications to all areas of the sciences, engineering, operations research,
finance, etc. Consequently, these developments and their applicability to a wide range of
problems have propagated the use of sequential methods in subsequent fields.

This final theoretical part of the report focuses on sequential decision processes. An
examination of sequential sampling leads to the formulations of decision rules and
stopping rules in statistical decision theory. These concepts establish the goal for pre-
posterior and sequential analysis. Since many problems can be formulated in Markovian
ways, the latter section focuses on Markov chains and Markov decision processes as an
extension to the developments in sequential probability. Emphasis is placed on abstract
and technical formulations of the concepts and methodology. This provides a framework
for formulating sequential decision problems.
Part III: Sequential Statistical Decision Theory
69
Section 7: Preposterior and Sequential Methods

The framework for decision problems as introduced in Part I assumed a fixed sample of
observations for a single decision. Noted in the framework, decisions lead to
consequences which may subsequently lead to further decision making. A natural
extension of the framework to encompass sequential decision processes establishes new
concepts for statistical decision theory. That is the option to experiment or make new
observations before making a decision a term which is coined pre-posterior analysis.
With a goal to minimize cost, sampling is the principle issue in sequential statistical
decision theory and establishes the concepts of optimal stopping rule and decision rules.
This instigated the expansion of hypothesis testing to encompass sequential methods.

Section 7.1: A Framework for Sequential Decision Problems

The framework for decision problems thus far, has centered on decision making either
with or without experimentation. However, the choice or the decision to experiment is
also a very important aspect of statistical decision theory. This decision making process
is frequently termed pre-posterior analysis. The goal is to minimize the overall cost
which incorporates both the decision loss as well as the cost of conducting the
experiment.

The first introduction to statistical decision problems introduced the concept of having
observations upon which a decision could be based. Those statistical procedures
assumed a fixed sample size, although it was not explicitly stated. Other strategies
suggest sequential sampling and moreover, multi-stage procedures. Extending the
framework for decision problems, denote the sample space for independent random
variables ,... ,
2 1
X X to be
i
and define ) ,...., , (
2 1 j
j
X X X = where
j
is assumed to have
density ) | (
j
j
f x . Now suppose that ,... ,
2 1
X X is a sequential sample from the
density ) | ( x f ; then

=
=
j
i
i
j
j
x f f
1
) | ( ) | ( x .

The cost of the experiment is attributed to two factors: n the number of observations
taken and s the way in which the observations are taken (Berger, 1985). Thus,
) , , , ( s n a l denotes the overall loss when is the true state of nature and a is the action
taken. Note that ) , , , ( s n a l can be considered to be a sum of the general loss function
) , ( a l and the sampling cost ) , ( s n c . Berger(1985) states that these functions are additive
when the decision maker has a linear utility function which can be stated as

=
+ =
n
i
i
c a l n a l
1
) , ( ) , , ( ,

Part III: Sequential Statistical Decision Theory
70
where ) , , ( n a l is the shortened form of the overall loss function for a given sampling
approach and
i
c represents the ith observation cost.

Recall that the loss function can be defined as ) , ( ) , ( a u a l = . Thus, if the utility
function is nonlinear and there is a monetary gain or loss, ) , ( a g , then
)) , ( ) , ( ( ) , , , ( s n c a g u s n a l = .

The difficulty in sequential decision problems resides in all the possible ways in which
the observations are taken. The two most common approaches are (a) the fixed sample
method and (b) the sequential sampling approach. Although the latter approach is of
primary interest, this section begins by describing the methodology of determining the
optimal fixed sample size, leaving the latter approach for the remainder of this section.

Recall that pre-posterior analysis was coined as such as the choice is made before the
data is obtained. Thus, the non-statistical decision problem that is the no-observation
problem first. Within the Bayesian context, let ) ( =

P and ) (
n
r be the Bayes risk of the
optimal policy with at most n stages with knowledge . Then the situation in which the
decision maker has no option to make an observation and must choose an action can be
expressed as:

)] , ( [ min ) (
0


a l E r
A a
=

where the expectation over is taken with respect to . Another way of expressing this is
to let

n
denote a Bayes decision rule for this problem and incorporating the loss in
observing ) ,..., (
1 n
n
X X = . The equivalent expression is then

)] ), ( , ( [ ) (
0
n l E E r
n
n
n
=

.

To determine the optimal fixed sample size in a decision problem requires resolving the n
which minimizes ) (
n
r . In simplicity, this can be resolved by differentiating ) (
n
r with
respect to n and setting the equation equal to zero.

If it assumed that the overall loss function has the aforementioned additive structure, then

n
is the Bayes decision rule for the loss function. Furthermore, if the fixed sample size
loss is equal to the sequential loss, a sequential analysis of the problem is considered
cheaper then a fixed sample size analysis (Berger, 1985). The advantages of sequential
analysis are somewhat obvious and at the forefront lies the decision maker choice to
gather the required amount of data needed to make a decision for a specified degree of
precision. The remainder of this section of the report focuses on the foundations,
concepts and methods of sequential analysis.


Part III: Sequential Statistical Decision Theory
71
Section 7.2: Sequential Analysis The Basics

The distinguishing feature of sequential analysis is the ability to take observations one at
a time with the decision maker or experimenter having the option of stopping the
experiment and making a decision. Keeping within the sequential decision problem
framework presented earlier, lets assume that the cost is proportional to the number of
observations; and moreover that the loss function is increasing in n. Thus, it can then be
reiterated that if n observations are taken sequentially, at which point the decision maker
chooses to take action A a , then the loss function when is the true state of nature can
be expressed as ) , , ( n a l .

A nonrandomized sequential decision procedure is denoted ) , ( = d and consists of
two components: a stopping rule; and a (terminal) decision rule. A stopping rule
is characterized by a family of functions of the form

)...} ( ), ( , {
2 2 1 1 0
X X = .

In the nonrandomized case,

=
ns observatio no the take to says rule the iff , 1
n observatio first the take to says rule the iff , 0
0


and

=
hand. at are ,...., given that
ns, observatio more no take to says rule the iff , 1
hand at are ,...., given that
n, observatio another take to says rule the iff , 0
,...) , (
1
1
2 1
n
n
n
X X
X X
X X

That is to say that
0
is the probability of making an immediate decision without
sampling while
n
is the probability (zero or one) of stopping sampling and making a
decision after
n
X is observed. Thus, given the functions
n
one can determine when to
stop; If the rule is given in other terms, one can determine the functions
n
from the rule.

Alternatively, the stopping rule can be characterized by the following family of functions

} ),...., ( ), ( , {
2 2 1 1 0
X X =

where ,
0 0
= and

Part III: Sequential Statistical Decision Theory
72

=
=

,... , stream given the ,
at first time for the sampling stopping for calls rule the if , 1
it after on go to says or n observatio
th the prior to sampling the stopped either rule the if , 0

) ,..., ( )] ,..., ( 1 )]...[ ( 1 )[ 1 ( ) ,..., (
2 1
1 1 1 1 1 1 0 1
X X X
n
X X X X X X X
n
n n n n n n



Similar to the
n
functions, given the
n
functions one can determine when to stop, or
given the stopping rule, one can determine the
n
functions.

The (terminal) decision rule is simply defined as a collection of decision rules of the type
used in problems with fixed sample size (Lindgren, 1971). Thus, a terminal decision rule
consists of a series of decision functions ),... ( ), ( ,
2 2 1 1 0
X X where ) (
i i
X is the action
taken after sampling has stopped after observing
i
X . Thus,
0
is the action taken when
no data is available and a decision is taken immediately.

Since the overall problem at hand, is to determine the final sample size at which says to
stop and make a decision, it is favorable to discuss this issue in terms of the stopping time
N. Thus, given a sequence of observations ,...., ,
2 1
X X the function
n
gives the
conditional probability that precisely n observations are called for:

) ,...., ( ,...) , | (
1 2 1 n n
X X X X n N P = = .

Further, the probability of stopping at the nth observation, is simply the expected value
assuming a particular decision and stopping rule:

)} ,...., ( {
1 } , { n n
X X E P

=
=
, (Lindgren, 1971).

More formally, the stopping time is the random function of X given (for a nonrandomized
sequential procedure) by

} 1 ) ( : 0 min{ ) ( = =
n
n
n N X X , (Berger, 1985).

Thus, } { n N = is the set of observations for which the sequential procedure stops at time
n; and hence there is nothing to prevent = N , as shown in Berger (1985):

=
=

=
+ = =
= + = = <
1
1
) | ( ) 0 (
) ( ) 0 ( ) (
i
n N
n
n
i
dF N P
n N P N P N P
x


Part III: Sequential Statistical Decision Theory
73
But, in applying sequential procedures it is favorable to have a rule for which
) ( < N P =1.

Section 7.3: Bayesian Sequential Procedures

Recall in section 7.1 that a pre-posterior analysis includes both the decision loss and the
sampling or experiment cost when a particular action is taken for a particular state of
nature. If a sequence of observations is taken at a cost of ) (N c , for n observations and a
sequential procedure ) , ( = d is used, the loss incurred is

) ( ) , ( N c d l +

where N is the random variable whose value is the number of observations actually used
in reaching a decision. And the expected loss, or risk function, is subsequently expressed

)] ( ) , ( [ ) , ( N c d l E d r + = .

The Bayes risk of a sequential procedure ) , ( = d is defined to be

)] , ( [ ) , ( d r E d r

= .

Bayesian analysis with fixed sample size problems is straightforward; Bayesian
sequential analysis is quite cumbersome. So the objective of Bayesian sequential
analysis is to find the sequential procedure which minimizes ) , ( d r . This is defined as

) , ( inf ) ( d r r
d
= .

Note that the idea here is that every stage of the procedure, one should compare the
(posterior) Bayes risk of making an immediate decision with the expected (posterior)
Bayes risk (Berger, 1985). Now suppose that there are potentially n stages,
corresponding to observations
n
X X X ,...., ,
2 1
. If the Bayes decision rule

calls for
taking all n observations in a particular application, the terminal decision is made
according to the Bayes criterion. That is, the posterior distribution is applied to the given
loss function to obtain averages over which the possible actions are ordered and the
optimum chosen (Lindgren, 1971). Assuming that K n a l ) , , ( , it then follows that

Part III: Sequential Statistical Decision Theory
74
). ( ) ), ( , ( ) 0 , , ( ) 0 (
) ( ) ( ) ), ( , ( )] 0 , , ( [ ) 0 (
) ( ) | ( ) ), ( , ( )] 0 , , ( [ ) 0 (
)] , ( [ ) , (
1
} {
0 0 0
1
} {
0
1
} {
0
n m
n
n N
n
n
n
n
n N
n m n
n
n
n
n
n N
n
n
n
n
n
dF n r r N P
dF dF n l l E N P
dF dF n l l E N P
r E r
x x
x x
x x
d d

=
=

=
=

=
=
+ = =
+ = =
+ = =
=

(Note that the subscript m refers to the marginal density.) Thus, ) , ( d r is minimized if
0
and
n
are chosen to minimize the posterior expected loss. This is equivalent to the
fixed sample size issue (Berger, 1985). Subsequently, if the stopping rule suggests at
least n k observations, then the problem of whether to stop (using the Bayes terminal
decision) or obtain more data is solved by comparing two conditional expected losses
(Lindgren, 1971). One of these conditional expressions is based on those n k
observations, while the other is to take more observations. This is summarized by the
following theorem found in Lindgren (1971).

If is a given stopping rule and a given prior, then the Bayes risk ) , ( d r
is minimized by that by the decision rule d where d
i
is the Bayes decision
rule based on the first i observations considered as a sample of fixed sample
size i.

Thus, half the problem of determining the Bayes sequential problem is deciphered as
regardless of the stopping rule used, the optimal action, once one has stopped, is simply
the Bayes action for the given observations (Berger, 1985). Furthermore, if the posterior
Bayes risk is at time n is a constant, independent of the actual observation then the
optimal stopping rule corresponds to the choice, before an experiment, of an optimal
fixed sample size n. However, this situation is rare. Yet when they are independent, the
problem of determining the optimal stopping time is still a question and is the focus of
the next section.

Section 7.4: Optimal Stopping Time

The difficulty of determining a Bayes sequential stopping rule resides in the fact that
there is an infinite stream of identically distributed observations upon which to base a
sequential test. However, this is made easier if the Bayes stopping rule can be
determined stage by stage. This simplification arises because at every stage the future
looks exactly the same (Berger, 1985). The conditional expected loss (given the
observations) is the function corresponding to the posterior probabilities at each stage.
Hence, those posterior probabilities depend on the observations (at hand) which enter the
decision process through the posterior distribution (Lindgren, 1971).

Part III: Sequential Statistical Decision Theory
75
There are many situations which may arise when trying to determine the optimal stopping
rule. Before considering these situations it is important to develop the framework for
such a test. So, for a given procedure ) , ( = d and given losses
a
l and
b
l corresponding to
the erroneous acceptance and rejection of the null hypothesis, respectively, the expected
loss is

= +
= +
=
, if , ) | (
if , ) | (
) , ; (
1 1 1
0 0 0
H R H N cE l
H R H N cE l
r
b
a




where and are the usual error sizes, c is the cost per observation and N is the
number of observations used in making a decision. Then assuming a prior distribution
assigned to
0
H , the Bayes risk is

, ) 1 ( ) , (
1 0
R R d r + =

and the Bayes procedure which minimizes ) , ( d r . Lindgren (1971) demonstrates that if
no observations are permitted by the stopping rule , the minimum Bayes risk is just its
value when the no-data Bayes procedure is used (as mentioned previously):

+
>
+

= =
. if ), 1 (
, if ,
) , ( min ) (
0
b a
a
a
b a
a
a
l l
l
l
l l
l
l
d r r




This is shown graphically in figure 7-1 below. Recall that this was shown in section 2 as
it is essentially the no data problem or non-statistical decision problem.

Figure 7-1:

Now consider a set of rules, ,
1
C which suggest obtaining at least one observation. The
minimum Bayes risk for this set of rules is denoted:

] ) 1 ( [ min ) (
1 0 1
1
R R r
C
+ = .

Figure 7-2:

The figure above represents a general graphical view of this function of and has the
following properties (Lindgren, 1971):

(a) , ) (
1
c r
(b) , ) 1 ( ) 0 (
1 1
c r r = =
(c) the graph of ) (
1
r is concave down.
Part III: Sequential Statistical Decision Theory
76
The first property suggests that at least one observation should be taken at cost c. The
second property suggests that if the prior is either 0 or 1, then no amount of sampling will
alter the distribution, so the cost is just c plus the 0 of the no-data curve. The last
property simply implies that the curve ) (
1
r is made up of a family of line segments
joining pairs of points ) , 0 (
0
R and ) , 1 (
1
R . Berger (1985) and Lindgren (1971) both
establish more formally the concavity. With these properties, it is now possible to
graphically compare the curves. For instance, if the graph of ) (
1
r lies above ) (
0
r then
this suggests not to take any observations. This visual analysis can be carried out for the
given hypotheses.

Lindgren (1971) provides three steps for determining the appropriate Bayes sequential
procedure. This can be summarized as follows:

1. Given losses
a
l and
b
l , and cost c per observation, the values of C and D as shown
in figure 7-2 can be determined from the graphs of ) (
0
r and ) (
1
r .
2. If C , reject
0
H , and if D , do not reject
0
H ; otherwise sample and
determine A and B (from C and D and ) where

.
1
1
and ,
1
1
D
D
B
C
C
A

This is established since the condition for continuing sampling, can be expressed in
terms of the likelihood ratio for the first n observations such that B A
n
< < .
3. After each observation
n
X determine the corresponding likelihood ratio
n
for
n
X X ,...,
1
; if A
n
, reject
0
H , and if B
n
, do not reject
0
H . If B A
n
< < ,
take any other observation.

The draw back to this procedure is that ) (
1
r is rarely known; however, given the
properties of ) (
1
r , it is possible to determine the form of the Bayes sequential procedure.

Section 7.5: Sequential Probability Ratio Test

The sequential probability ratio test is provides one of the first applications of sequential
analysis within statistical analysis (French and Insua, 2000). It tests a simple hypothesis
0
H against a simple alternative
1
H . As constructed in the previous sub-section, the
following constants are defined where and are the respective error sizes:

=
1
,
1
B A

Part III: Sequential Statistical Decision Theory
77
These constants form the limits for the likelihood ratio
n
computed after each
observation is taken. Then if A
n
, the sampling stops and the null hypothesis is
rejected. If B
n
, the sampling stops and the hypothesis is not rejected. And
subsequently, if B A
n
< < , then another observation is taken.

Notice that this is essentially the Bayes sequential procedure described earlier. The
essential difference is that there is no formal loss structure in this instance; however given
any sequential probability likelihood ratio test essentially means that there exist losses
and a sampling cost per observation such that the Bayes sequential test for some prior
distribution is the given sequential probability ratio test. Thus, the analysis both
statistically and graphically proceeds in the same manner.

The decision theoretic approach of balancing the competing factors of expected losses
and sampling costs resides in both the Bayesian and non-Bayesian approaches; and thus
makes it difficult to determine an optimal policy or rule. However, French and Insua
(2000) state that there is an intuitive structure for the optimal policy. That it is to say,
that if the likelihood ratio of the observations is not sufficiently small or large, then keep
sampling otherwise, stop and take action. Even the constant values of A and B remain
undefined, knowing the general structure of the optimal policy allows for finding possible
good values. Berger (1985), French and Insua (2000), and Lindgren (1971) provide
further details on the development, theory and other methodological issues (constraints)
with regards to the sequential probability ratio test.
Part III: Sequential Statistical Decision Theory
78
Section 8: Markov Decision Processes

The previous section provided a framework for sequential decision problems. Such
problems can be formulated in Markovian ways which has led to large body of theory on
Markov decision processes. Decision processes which make a sequence of probabilistic
transitions and in which the transition probabilities depend only on the current state of the
system are said to undergo a Markov process. Subsequently, if there are alternative
actions amongst which a choice can be made then this is referred to as a Markov decision
processes. Since such processes are comprised of Markov chains they are also attributed
with the Markovian properties which provide favorable analytic abilities. This section
begins with introducing the underlying concepts of Markov chains and their properties as
well as other attributes of both finite and infinite chains. This section concludes with the
framework and computational aspects of Markov decision processes for determining
optimal policies.

Section 8.1: Sequential Decision Problems Formulated in
Markovian Ways

The previous section introduced a framework for sequential decision making under
uncertainty. Intervals of time separate the stages at which decisions must be made, and
the effect of a decision at any stage is to influence the transition from current to
succeeding state. If the transition from state to state is a probabilistic sequence and the
transition probability from current to succeeding state is only dependent on the current
state, then the decision process is said to have the Markovian property. This section
begins by providing the basic notation and framework for sequential decision making
processes which can be formulated in Markovian ways.

A random process when observed over time will be in different states at different times;
and this change in state is referred to as state transition. Suppose a process has N states
and its behavior over time is specified by the state the system is in at each stage in
time. In this report, the stage structure for the sequential problems considered (whether
they are time based or not) will be discrete. More formally, a typical random process X is
a family } : { T t X
t
of random variables indexed by some set T. Further, if we define
,...} 2 , 1 , 0 { = T , the system is a discrete-time process (Grimmett and Stirzaker, 1982). In
sequential decision problems, we may define ,....} , , {
2 1 0
X X X to be a sequence of random
variables which take values in some countable set S, the state space. Thus each
n
X is a
discrete random variable taking on one of N possible values, where | | S N = . It is evident
that this system is not deterministic, and hence can be neither prophesied nor achieved. It
is possible, however, to deduce some statistical description about the behavior of the
process (Buchanan, 1982).

Definition: The process X is a Markov chain if it satisfies the Markov
property
) | ( ) ,..., , | (
1 1 1 0
= = =
n n n n
X s X P X X X s X P
Part III: Sequential Statistical Decision Theory
79
for all 1 n and S s . (Grimmett and Stirzaker, 1982)

For simplicity (of notation), let ) (n p
ij
denote the transition probability from i to j if the
transition takes place at the nth step. The Markovian assumption that only the current
stage (n) and the state (i) are relevant to the determination of the future behavior of the
process is described as being memoryless. This assumption is attributable to the
attractive use of Markov chains in sequential decision problems.

Much of theory of Markov chains is simplified by the condition that S is finite (Grimmett
and Stirzaker, 1982). A finite Markov chain is said to be time-homogenous if for every
pair of states i and j, ) (n p
ij
=
ij
p for all n. Such a chain is also described as having
stationary transition probabilities. The transition matrix for a Markov chain is the N N
matrix ] [
ij
p P = , where N is the number of states. The transition probability for a
Markov chain is a stochastic matrix.

Theorem: P is a stochastic matrix, which is to say that
(a) P has non-negative entries, or 0
ij
p
(b) P has row sums equal to one, 1 =

j
ij
p .

This summarizes the basic elements of Markov chains. The remainder of this section
presents the favorable attributes of Markov chains which demonstrate the potential
applicability of Markov chains, especially in infinite stage Markov decision processes.

Section 8.2: Multi-step Transition and State Probabilities

The previous subsection focused on finite stage Markov decision problems. This part
now shifts to work with infinite stage Markovian decision problems. The transition
probability matrix P describes the likelihood of transitions from state to state; and since
our interest lies in the evolution of X, it becomes important to determine the multi-step
transition probability values.

Define ) | ( ) (
0
X s X p n
n ij
= = for N j i , 1 and ... 2 , 1 , 0 = n as the n-step transition
probabilities for the Markov chain (defined by P). If the system starts in state i at time 0
and is in state j at time (n+1), the result is achieved by transition in n steps from state i to
some state k (for which the probability is ) (n
ik
) followed by transition from k to j (for
which the probability is
kj
p ). Thus, given that the state at the nth step is k, the
probability of transition to j in (n + 1) steps is
kj ik
p n) ( . These N stages for the
transitions from i to j given the nth state are mutually exclusive and exhaustive, hence

=
= +
N
k
kj ik ij
p n n
1
) ( ) 1 ( , (Buchanan, 1982).

Part III: Sequential Statistical Decision Theory
80
Buchanan (1982) provides the following justification.

. ) (
assumption Markovian by the
} | { } | {
y probabilit l conditiona of defintion the from
} , | { } | {
} | , { } | { ) 1 (
1
1 0
1
0 1 0
1
0 1 0 1

=
= = =
= = =
= = = = +
=
+
=
+
=
+ +
k
kj ik
N
k
n n n
N
k
n n n
N
k
n n n ij
p n
X s X P X s X P
X X s X P X s X P
X X s X P X s X P n

Since multi-step transition probabilities are probabilities, they must also adhere to the
regular conditions of probability. That is they must satisfy the relationship that
1 0
ij
and

=
=
N
j
ij
n
1
1 ) ( . The next step is to formulate this into a matrix form
which in turn develops the Chapman-Kolmogorov equations (Grimmett and Stirzaker,
1982).

The equation for the multi-step transition probabilities can be represented in (stochastic)
matrix form (quite simply). Define )] ( [ ) ( n n
ij
= as the n-step transition probability
matrix for all n. From the justification above, we can rewrite the final statement as

, ) 0 (
,..., 1 , 0 for , ) ( ) 1 (
I
n P n n
=
= = +


where I is the N N identity matrix. So,

, ) 2 ( ) 3 (
, ) 1 ( ) 2 (
, ) 0 ( ) 1 (
3
2
P P
P P
P P
= =
= =
= =


and thus more generally
n n
P P P P n n = = =
1
) 1 ( ) ( . This can then be deduced to
the special case of the Chapman-Kolmogorov equations as stated in Grimmett and
Stirzaker (1982):

. ) ( ) ( ) (

= +
k
kj ik
n p m n m

Hence,
n m n m
P P P =
+
and so
n
P is the nth power.

Part III: Sequential Statistical Decision Theory
81
Now define
n
n
P

= lim (if it exists) and call the limiting multi-step transition
probability matrix or summarized as the limiting distribution for the chain. Note as the
number of transitions increases, the influence of the original state diminishes. This is
expected since the Markovian property assumes no memory to the process. It is
important to keep clear that the probabilities of transitions from state to state are fully
described by P, while summarizes the long-term behavior of the process. Thus, the
above theorem relates the long-term development to short-term development, and
informs us how
n
X depends on
0
X .

Section 8.3: Some Classes of Markov Chains

This next sub-section considers the way in which the states of a Markov chain are related
to each other. This will lead to a classification of the states. First we begin with some
basic terminology which essentially focuses on the term communication (which exists
between states).

Definition: It is said that i communicates with j, written j i , if the
chain may ever visit j with positive probability, starting from i. That is,
j i if 0 ) ( > m
ij
for some 0 m . It is also said that i and j
intercommunicate if j i and i j , in which case we write j i .

Thus, two states intercommunicate if transition is possible in either direction in some
finite number of steps. The number need not be the same for the directions of
communication (Buchanan, 1982). Grimmett and Stirzaker (1982) proceed by stating the
following theorem.

Theorem: If j i then
(a) i and j have the same period
(b) i is transient if and only if j is transient
(c) i is null persistent if and only if j is null persistent

The first property, period is defined as the greatest common divisor of the epoch at which
return is possible (Grimmett and Stirzaker, 1982). Further, the state is said to be periodic
if the divisor is > 1 and aperiodic if the divisor is equal to one. The second is probably
the most important property of the relationship of communication. Buchanan (1982)
demonstrates this property by claiming that since j i and k j , then there exists
numbers
1
n and
2
n such that ) (
1
n
ij
and ) (
2
n
jk
are both positive. From the Chapman-
Kolmogorov equation, we get

=
> = +
N
l
jk ij lk il
n n n n n n
1
2 1 2 1 2 1
. 0 ) ( ) ( ) ( ) ( ) (

This establishes the communication from i k . The last property which draws upon
the term persistent simply claims that state i is persistent if the probability of eventual
Part III: Sequential Statistical Decision Theory
82
return to i, having started from i, is 1. Subsequently, if this probability is strictly less than
1, i is transient. In any Markov chain, sets of states (or at least one set of states) where all
states which are members of the same set can be found which communicate with one
another (Buchanan, 1982).

There are many classifications of states besides the ones already mentioned. We now
define an ergodic set of states which is said to be a set of in which every state
communicates with every other state of the set. Grimmett and Stirzaker (1982) define a
state to be ergodic if it is persistent, non-null, and aperiodic. Thus, an ergodic set of
states is a set of states in which every state can be reached from every other state of the
set, and once the set is entered there can be no transition out of the set. Of course, an
ergodic state is an element of an ergodic set. Buchanan (1982) suggests considering
ergodic states to be collective trapping states, whereby every Markov chain contains at
least one ergodic state. It should also be noted that there may be states which do not
belong to an ergodic state; these are referred to as transient states.

We now provide another definition or classification of states which leads to a
classification of chains.

Definition: A set of C of states is called
(a) closed if 0 =
ij
for all C j C i ,
(b) irreducible if j i for all C j i ,

Once a chain has taken a value in a closed set C of states, it never leaves. States of this
type are absorbing states. The equivalence class j i simply iterates that an irreducible
set C is aperiodic if all states in the set are aperiodic. (Grimmett and Stirzaker, 1982)

The final remark to be made here is with regard to defining a regular Markov chain. That
is a Markov chain whose states form a single ergodic set is an ergodic chain. If such an
ergodic set has all entries of the multi-step transition probability matrix
n
P n = ) ( greater
than zero, then it is said to be regular. Since ) ( ) 1 ( n P n = + , then
1 + n
P will have no
zero entries if
n
P does not have any (Buchanan, 1982). Thus, reaching a sufficient
number of transitions at which all state to state transitions are possible, any additional
transitions will not lead to any such transitions having zero probability again. And, such
an ergodic chain which is regular in subsequently termed a regular Markov chain.

It is a property of regular Markov chains that the limiting multi-step transition probability
matrix ] [
ij
= will have identical rows. Denote the state probability as ) (n
i
.
Buchanan (1982) shows that the state probability vector
n
P n n ) 0 ( ) ( ) 0 ( ) ( = = at
time n. From this, we get = ) 0 ( by taking the limit of both sides as n tends to
infinity. Buchanan (1982) uses this to show that for a regular Markov chain that the
limiting state probability vector is independent of the initial state probability vector
) 0 ( and is the same as the identical rows of the limiting multi-step transition probability
matrix . This concludes the introduction to Markov chains and their properties.
Part III: Sequential Statistical Decision Theory
83
Section 8.4: Markov Decision Processes

The section now extends the properties and method of Markov chains to develop the
body of knowledge known as Markov decision processes. In a Markov decision process
there is a system with states labeled N i ,..., 1 = . In state i there are a number of actions
available. If action k is chosen a return ) , ( i k r is generated and the system goes to state j
with probability ) , , ( k j i p . A set of actions, one for each state, constitutes a policy.
Under a given policy the systems is a Markov process with returns and has steady state
gain ) ( g . A policy which has the highest gain (or the lowest in a minimization
problem) is an optimal policy. A policy whose gain differs from the optimal by not more
than a known amount is called a tolerance optimal policy. The formulation and solution
of Markov decision problems will be illustrated by extending the decision structure.

Suppose a system has a finite number of states, } ,..., , {
2 1 m i
= . The system or
process may move between states at each infinite series of equal stages (or time steps)
,... 2 , 1 = t . At each time step t, the decision maker is to select an action A a a
k
t
=
where A is finite. Depending on the action
k
a chosen by the decision maker at time t and
its current state
t
, the system evolves to its next state
1 + t
. Then the probabilities

) , | (
1
1
k i
t
j
t k
ij
a p p
t

= = =
+
+


describe the evolution of the system. Thus, it is assumed that the probabilities hold the
Markovian property and subsequently, do not depend on either the earlier states of the
process nor any of the earlier actions. Recall that in a decision framework, every action
taken with the current state results in a consequence. Similarly, we define ) , (
i k
t
a c
which is the consequence a decision maker receives at each stage. Further, this can be
extended to show the overall timestream of consequences (French and Insua, 2000).

Now that Markov decision processes have been placed within a decision theoretic
framework, we now extend this to include the concepts of utility theory. That is, we now
place things within the context of rewards rather than losses. (Note that reward includes
the cost of taking the action.) Assume that the reward received at stage t is
) , ( )) , ( ( i k r a c u
t i k
t t
= . It follows that all ) , ( i k r
t
are bounded. Since the aim is to find
the optimal policy with minimal long-term average costs, it is necessary to consider the
increase in the value of state i from stage to stage. Hastings and Mello (1978) provide the
formulation for the bounds and convergence test.

There are two common ways of evaluating the overall timestream of rewards in Markov
decision processes. The first includes a discount factor and a discounted additive
utility function such that

=
1
1 2 2 2 1 1 1
) , ( ),...) , ( ), , ( (
t
t
t
i k r a c a c u .
Part III: Sequential Statistical Decision Theory
84

The other common approach is to choose a series of actions to maximize her average
reward:

T
i k r
a c a c u
T
t
t
T

=

=
1 2 2 2 1 1 1
) , (
lim ),...) , ( ), , ( ( .

In the first approach presented, the decision maker seeks a policy for choosing actions
which maximize the total expected discounted reward. The latter approach gives the
long-run average monetary return or the expected monetary value of the policy.

Finite Markovian decision processes decide upon a policy to be applied at a (previously
known) finite number of decision epochs with the objective of optimizing some measure
of performance. However, in certain instances, the finite stage aspect may be too limiting
a prospect which then unbounds the criterion presented above. Having an infinite
Markovian decision process has the problem of approximation itself, which due to the
attributes of Markov chains, the infinite approximation is a feasible proposition. For a
finite stage problem, the criterion for discriminating between policies was the
maximization of the expected reward associated with a policy. In the infinite stage
problem, the cumulative expected reward from using a given policy will not be finite and
hence, will increase without bound. Discounting the rewards by some factor as stated
above, obviates this problem and consequently gives an expected discounted reward for
each policy which is finite. There are other propositions for handling infinite Markov
decision process. Some of these alternatives are presented in Hastings and Mello (1978)
and Buchanan (1982). French and Insua (2000) also provide a discussion on the merits of
some of alternative functions of utility to solve Markov decision processes.

Now a decision policy ,...) , (
2 1
for a Markovian decision process is a sequence of
decision rules which prescribe for each stage t, the action the decision maker should take
if the current state of the process is
t
(French and Insua, 2000). If the decision rule
selected does not depend on the stage t, then the policies are said to be stationary. A
stationary policy applied to a Markov decision process determines the transition
probabilities from state to state and thus, induces a Markov chain. If it is assumed that
this Markov chain is single and ergodic then the assumption can be made that for each
policy there exists a state which can be reached from any other state under the policy. It
can then be further delineated to use the attributes of Markov chains to solve such
decision processes. (Computational issues are expounded in section 12.)

There are several algorithms (or classes of algorithms) which can utilized for solving
Markov decision processes. Linear programming is one approach used. However, value
iteration and policy iteration are the most common. The first of these, value iteration,
considers that if the decision maker takes action
k
a and receives ) , ( i k r
t
immediately and
then passes to state
j
with probability
k
ij
p , and continues optimally receiving the
expected total discounted reward, the sequence will eventually converge for any starting
point. There are many variants of this algorithmic procedure. French and Insua (2000)
Part III: Sequential Statistical Decision Theory
85
illustrate a couple of these and Mello and Hastings (1978) present another variant. The
latter algorithmic procedure, policy iteration has a similar objective. It begins with an
arbitrary policy, instead of an arbitrary function as defined for the value iteration
algorithm. This procedure begins with an arbitrary (stationary) policy, evaluates the
function which defines the total expected discounted reward and seeks for an improved
policy and until convergence is reached. This has described the possible approaches for
solving infinite Markov decision processes. Finite Markov decision processes are
simpler and can be solved by backward dynamic programming or backward induction
which is presented in section 13.

Part IV: Model Building for Decision Analysis
86
Part IV: MODEL BUILDING
FOR DECISION ANLYSIS:
Topics in Probabilistic Graphical Models


Methodologies for decision processes (as those presented in prior sections) are based
upon probability and utility or different ways of handling uncertainty. Subsequently,
certain criteria should be satisfied as a provision for guiding decision-based problems.
For instance, French and Insua, list axiomatic basis, lack of counter examples, feasibility,
robustness, transparency to users, and comparability with a wider philosophy as
criteria which should be satisfactorily determined. The first two provide the theoretical
merit; the second two, feasibility and robustness, relate to the practicality of performing
the analysis while the latter two entail the implementation of the analysis results. These
latter parts of the report focus on the practicality and implications of decision processes
and attempt to bridge the gap between the conceptual and practical components of
decision theory. However, none of this is applicable without a decision model upon
which the criteria is built and subsequently assessed.

This part of the report focuses on building models to illustrate decision problems under
various assumptions. Emphasis is placed on probabilistic graphical models. These
probability models are extensions of the procedures and methodology presented in earlier
sections of this report. Concepts of problem structuring, parameters and attributes lay the
foundation for model building and are introduced in the description of each inception of
the model building process. Each section presented in Part IV describes a modeling
approach for a particular formulation and framework for a given decision problem.
Part IV: Model Building for Decision Analysis
87
Section 9: Graphical Representation of Decision Problems

Section 1 introduced the framework for decision problems. The components of a
decision problem provide the construction for a graphical representation. An introduction
to graphical models for describing decision processes is illustrated through the
conception of decision trees and influence diagrams. A comparative assessment of these
two formulations demonstrates the strengths and weakness of the approaches in both
structural and practical settings. In this section, a formulation of a general decision
problem is revisited in a concise manner in order to introduce the assumptions and
criteria required for model building.

Section 9.1: Modeling Decision Problems

Sections 1 through 3 demonstrated the key concepts and ideas pertaining to decision
modeling. In essence, decision problems consist of actions, states of nature and
consequences. Without forgoing the complexities of modeling such problems, a decision
model can be concisely formulated as

c a .

That is, the interaction between an action and a state of nature leads to a consequence.

Recall that the choice of action or decision is under the control of the decision maker; but
the state which pertains is beyond his/her control. When both the action space A and the
state space are finite, the model can be presented in a decision table as shown below.

Actions States of Nature
n
L
2 1

m
a
a
a

2
1

mn m m
n
n
c c c
c c c
c c c
L
L
L
L
L
L
2 1
2 22 21
1 12 11





The simplest discussions of decision theory assume that the decision maker chooses an
action (row) in the table, whereupon nature will choose a state (column), leading to the
consequence. This tabular representation of decision problems has very close conceptual
and historical connections with game theory (which is not explored in this report).

With respect to the three elements actions, states and consequences, the terminology
may vary; however, the distinction between these elements is common. This separation
is found throughout statistical decision theory, and leads to a model of decision making in
which there is some representation of uncertainty relating to the unknown state, some
Part IV: Model Building for Decision Analysis
88
representation of preference between the possible consequences, and a mechanism for
bringing these two representations together to guide choice. This statement merely
emphasizes the adoption of the model c a .

Conceptually, the consequences considered thus far, need not have been considered to
be numerical. That it is to say, that they may be thought of as descriptions of the
outcome of actions chosen under various possible states of nature. Similarly, neither
the actions nor the states of nature need to be thought of quantitatively. Then the
previously defined sets C and A can be taken in a general sense without any further
mathematical structure other than the existence of suitable (-) fields required for the
introduction of probability measures, (French and Insua, 2000).

The tabular representation (shown above) is replaced by a functional one when the action
and state spaces are infinite. The notation C A c : is commonly used however,
other authors (such as Savage) employ an equivalent but more succinct notation which
identifies the actions from the state space to the consequence space: C a : . Notably,
neither notation recognizes the possibility that the set of possible states may depend upon
the action chosen (French and Insua, 2000).

Statistical decision theory, on the other hand, assumes that the observation X = x from an
observation space X is observed according to the conditional distribution ) | (
X
P . Thus,
decision problems can be formulated as } : | { A X d d A D
X
= = which relates the
decision makers actions with each possible observation and presents the set of all
possible choices. Thus, a choice D d induces a probability distribution for each pair
D d ) , ( as follows:

=
=
c x d c
C
x dP c P
) ), ( (
) | ( ) | (

.
Consequently, this structure of statistical decision theory reduces to the general form of a
decision problem. Thus, three representations of decision modeling have been presented
each shown to have the same general structure.

Section 9.2: Model Building Fundamental and Means Objectives

Modeling a decision problem (in practicality) requires three fundamental steps, as stated
by Robert T. Clemen in Making Hard Decisions. These can be summarized concisely as
(1) identifying and structuring the values and objectives, (2) structuring the elements of
the decision situation into a logical framework, and (3) refining the precise definition of
all of the elements of the decision model. The aforementioned steps not only provide the
foundation for the decision making process but also provide the construction process for
a graphical representation of decision problems and methodology.

Much of the work presented in this report has focused on single objective problems;
however, often, multiple objectives or multi-attribute problems surface which encompass
conflicting goals. For instance, the investor may wish to maximize the financial return of
an investment portfolio but also minimize the volatility of the portfolios value. Thus, it
Part IV: Model Building for Decision Analysis
89
is important to address the issue of value structuring which is necessary in order to
graphically display complex decision processes.

The consequence space C, thus far, has simply been stated as a set of objects which can
be defined on an interval of the real line. When considering multiple objectives, the
consequence space becomes complex and presents a multi-attributed structure. To
clarify, by an attribute refers to a factor to be considered and when given a direction of
preference, say minimize or maximize, it is termed objective. Thus, the problem arises of
structuring these objectives in a consequential manner.

Once a set of objectives, consistent with the decision context, has been established, the
objectives should be separated into means and fundamental objectives. This step
provides a value structuring process whereby distinguishing between those objectives that
are important because they help achieve other objectives and those that are important
because they reflect the goal what we really want to accomplish. This process of
arranging attributes holds cognitive advantages through graphical modeling and
representation.

For example, fundamental objectives are organized into hierarchies. The upper levels in a
hierarchy represent more general objectives, and the lower levels explain or describe
important elements of the more general levels. The figure below illustrates a possible
hierarchy that might arise in the context of defining vehicle regulations. A higher level
fundamental objective might be Maximize safety where lower level fundamental
objectives might be Minimize Loss of Life, Maximize Serious Injuries, and
Minimize Minor Injuries. Furthermore, these can be separated in order to pertain to
particular issues for a particular group. As seen in this example, these objectives are
parsed out separately for adults and children.

Figure 9-1:











In contrast to a hierarchy organization, means objectives are organized into networks.
For the same example, means objectives may include Minimize accidents and
Maximize Use of Vehicle Safety Features. There are several other possible means
objectives which may work together (network) in order to accomplish the maximization
of safety. That is means objectives can be connected to several objectives in order to
accomplish the task at hand.
Maximize Safety
Minimize
Minor Injuries
Minimize
Serious Injuries
Minimize
Loss of Life
Adults Children Adults Children
Part IV: Model Building for Decision Analysis
90

Figure 9-2:















Structuring the fundamental objectives into a hierarchy or tree is crucial for a multiple
decision process; however, the means objective network provides an important basis for
generating creative new alternatives. In some instances, a well measured means objective
can sometimes substitute for a more difficult to measure fundamental objective (Clemen,
1996). Brownlow and Watson (1987) confer that structuring attributes assist the
cognitive overload brought about by the complexities of a decision making process. In
reality, problems are much complex in structure than the one presented here. However,
the graphical interface that induces this methodology still requires the building of the
model or decision problem.

There are several ways in which a decision maker can choose to build such a model.
Although, much of this discussion is intuitive, there are methods or techniques which
facilitate this thinking process. French and Insua (2000) refer to the top-down
questions; subsequently, Clemen (1996) presents table 9-1 which summarizes the
questions or four techniques for organizing the two types of objectives which are useful
in constructing means objectives networks and fundamental objectives hierarchies.

Table 9-1: Constructing Mean-Objectives Networks and Fundamental-Objectives Hierarchies
Fundamental
Objectives
Mean
Objectives
To Move:

To Ask:

Downward in the hierarchy

What do you mean by that?
Away from Fundamental Objectives

How could you achieve this?
To Move:

To Ask:

Upward in the hierarchy

Of what more general objective
is this an aspect?
Towards Fundamental Objectives

Why is that important?

Maximize
Safety
Require
Safety features
Educate Public
Enforce
Traffic Laws
Reasonable
Traffic Laws
Minimize Driving
Under Alcohol
Influence
Maximize
Driving Quality
Minimize
Accidents
Maintain
Vehicle
Motivate Purchase
Of Safety Features
Maximize
Vehicle Safety
Part IV: Model Building for Decision Analysis
91
It is obvious that attributes must hold certain properties or meet certain requirements in
order to be useful. Recall, that the intention is to quantify such attributes. Hence, they
must be measurable on some scale for each consequence. French and Insua (2002)
distinguish three types of scale, noting that they may be objective or subjective measures.
The first, a natural scale, provides a direct measure such as cost. The second, a
constructed or subjective scale, defines the objective as well as indicates the impact of a
specific consequence. That is they are created specifically within the context of the
decision problem, e.g. minimizing caregiver burden. The third scale, a proxy, uses an
attribute which is perceived to describe the objective and is measurable. Keeney and
Raiffa (1976) affirm that no two attributes should measure the same aspect and yet should
distinguish between consequences. Other practical concerns such as decision ownership
and feasibility, although important in the practical setting, are not explored in this report.

Section 9.3: Model Building A Graphical Approach

The process of specifying, structuring, and sorting out the means objectives from the
fundamental objectives is the initial step of building a graphical model of the decision
problem. The focus now turns on the graphical representation of the elements of a
decision problem decisions or alternatives, uncertain events or outcomes, and
consequences. The most common graphical representation of decision problems is a
decision tree. It has been superceded, in recent years, by influence diagrams.

Decision trees and influence diagrams, both, provide a graphical approach to modeling
decision problems. This (sub-)section will focus on the common elements used is such
model building processes. The latter section delved into the specifics for each modeling
approach and concludes with a comparative assessment. Nonetheless, both approaches
require the elements of a decision problem. Although notation varies from source to
source, there are three types of nodes which are used both in influence diagrams and
decision trees and can be stated as follows:

Square nodes represent decisions (or actions) and mathematically are associated
with a decision set D.
Circular nodes represent random quantities or events which are associated with a
random outcome X.
Diamond or rounded square nodes represent consequences (value) of the decision
process. These are represented by the set of all possible consequences C.

These shapes are generally referred to as decision nodes, chance nodes and consequence
nodes. Nodes are integrated into graphs or networks, connected by arrows/branches or
(directed) arcs. These nodes are assimilated such that they coincide with the progression
of time. These are useful aids in model building. The following two sections describe a
general procedure for constructing and modifying influence diagrams and decision trees
to model the structure of a decision problem.

Section 9.4: Constructing Influence Diagrams

Part IV: Model Building for Decision Analysis
92
Influence diagrams provide a visual perspective of the decisions, uncertain events (states
of nature), and consequences and the subsequent interrelationships that exist within a
decision problem. An appropriate model ensures the probabilistic structure of a decision
problem, the timing of available information and interdependence of decisions that can be
taken and which may arise under certain states of nature, in a compact form (Marshall
and Oliver, 1995).

Model building of decision problems as seen can become quite complex; however,
influence diagrams hold many advantages. First, they provide a framework by which a
decision maker can reject or confirm assumptions and accurately model dependencies
through a graphical display. Secondly, complex decision problems have the innate
ability to become messy. Influence diagrams provide a format whereby the large
volume of information can be summarized into relevant and sufficient matters. From a
practical viewpoint, they provide alternative situations and are easily interpretable. The
use of algorithms and numerical techniques also enable an efficient and simple analysis.

The design and construction of influence diagrams are based on the aforementioned three
basic elements decision nodes, chance (states of nature) nodes, and consequence nodes,
connected by arcs. A node at the beginning of an arc is qualified as a predecessor; and
consequently, a node at the end of an arc is referred to as a successor. The rules for using
arcs to represent relationships among the nodes are shown in figures 9-3 and 9-4. In
general, an arc can represent either relevance or sequence (Clemen, 1996). The direction
of the arc indicates the meaning and brings into the relevance or sequence context.

Figure 9-3:














For example, the figure above illustrates an arrow pointing into a chance node, indicating
relevance. This demonstrates that the predecessor is relevant for assessing the chances
associated with the uncertain event. In the diagram above, the first cluster of nodes
shows an arrow (arc) from A to C. This suggests that the chances (states of nature)
associated with C may be different for different outcomes of A. Likewise, an arrow
pointing from a decision node to a chance node means that the chosen decision is relevant
for assessing the chances associated with the succeeding uncertain event. For instance,
Relevance
A
C
E
B
D
F
Part IV: Model Building for Decision Analysis
93
the choice taken in decision B is relevant for assessing the chances associated with Cs
possible outcomes. Relevance arcs can also point into consequence or calculation nodes,
indicating that the consequence or calculation depends on the specific outcome of the
predecessor node. The second cluster of nodes shows that consequence node F depends
both on decision D and event E.

Figure 9-4:












When the decision maker has a choice to make, the choice would normally be made on
the basis of information available at the time. Arrows that point to decisions represent
information available at the time of the decision and hence represent sequence (figure 9-
4). Such an arrow indicates that the decision is made knowing the outcome of the
predecessor node. An arrow from a chance node to a decision means that from a decision
makers point of view, all uncertainty associated with a chance event is resolved and the
outcome is known when the decision is made. Thus, information is available to the
decision maker regarding the events outcome. This is the case, as illustrated in the
figure above, with chance node H and decision node I. The decision maker waits to learn
the outcome of H before making decision I. An arrow from one decision to another
decision simply means that the first decision is made before the second, such as decision
nodes G and I. Thus, the sequential ordering of decisions is shown in an influence
diagram by the path of arcs through the decision nodes.

A simple procedure for constructing an influence diagram to model the structure of a
decision problem is stated in Decision Making and Forecasting by Marshall and Oliver
(1995). These sequential steps are summarized below.
1. Create a preliminary list of decisions and random events (or quantities of interest)
whose outcomes are believed to be important in the formulation of the problem.
Identify the attributes and objectives that are to be used to measure the
consequence of the decisions and outcomes.
2. Name each random quantity and decision. Represent each random quantity with a
circular node and a decision with a square node. Draw them in order of
occurrence from left to right.
3. Identify any influences or dependencies between random quantities and decision.
Insert directed arcs between nodes that influence one another with the direction
corresponding to the natural influence believed.
H
I
G
Sequence
Part IV: Model Building for Decision Analysis
94
4. Determine any conditional independencies and represent them accurately.
5. Check to see that there are no directed cycles i.e. a connected set of arcs in a
directed path that leads out of one node and back itself.
6. Check that there any decision node that occurs before a later decision node has a
directed arc from the former to the latter, Similarly, a chance node known to a
given decision mode must be known to a later decision node. This is a
requirement of the principle of coherence (Marshall and Oliver, 1995).

This process is fairly simple and thus alternative diagrams can be easily drawn. Clemen
(1996) offers some other remarks on the construction of influence diagrams. First, the
nature of the arc-relevance or sequence can be ascertained by the context of the arc
within the diagram. Secondly, as stated in 5 of the procedure above, an influence
diagram should not contain any cycles. Furthermore, although the construction of an
influence diagram may be technically correct, there is no clear cut supposition to suggest
that the influence diagram constructed is the only correct one. Thus, it cannot be stated
that there is a unique correct diagram but that there are many ways in which a diagram
can appropriately represent a decision problem. The representation that is the most
appropriate is the one that is requisite for the decision maker. That is, a requisite model
contains everything that the decision maker considers important in making the decision
(Raiffa and Schlaifer, 2000). Incorporating all of the important concerns
1
of the decision
is the only way to get a requisite model and adequate representation of the problem.

Section 9.5: Constructing Decision Trees

Influence diagrams are an excellent display of a decision problems basic structure;
however, they hide much of the detail which may be pertinent to a decision maker. To
display more of these details, a decision tree can be constructed. Yet, they hold the
drawback that the size of the problem cannot always be practically represented.

The design of a decision tree holds much of the character of an influence diagram. That
is, squares represent decisions to be made, circles represent chance nodes and
consequence nodes are found at the ends of the branches which connect the nodes. The
interpretation of decision trees follows much the same path as explained in section 9.4 on
influence diagrams.

In designing a decision tree, the options represented by branches from a decision node
must be such that the decision maker can choose only one option. However, in some
instances, combination strategies are possible. Also, each chance node must have
branches that correspond to a set of mutually exclusive and collectively exclusive
outcomes. Mutually exclusive means that only one of the outcomes can happen.
Collectively exclusive means that no other possibilities exist; one of the specified
outcomes has to occur. Putting these two specifications together means that when the
uncertainty is resolved, one and only one of the outcomes occurs.


1
Sensitivity analysis is helpful in determining which elements are important.
Part IV: Model Building for Decision Analysis
95
A decision tree represents all possible paths that the decision maker might follow through
time, including all possible decision alternatives and outcomes of chance events. In a
complicated decision situation with many sequential decisions or sources of uncertainty,
the number of potential paths may be very large. Each path, consequently, represents a
particular scenario that could unfold over time. It is sometimes useful to think of the
nodes as occurring in a time sequence.

Figure 9-5:














Including multiple objectives in a decision tree is straightforward; at the end of each
branch, simply list all of the relevant consequences. An easy way to accomplish this
systematically is with a consequence matrix as shown in the figure above. This is an
example of a decision tree representation of FAAs multiple objective bomb detection
decision (Clemen, 1996). Each column of the matrix represents a fundamental objective,
and each row represents an alternative. Evaluating the alternatives requires filling in the
boxes in the matrix; each alternative must be measured on every objective. Some basic
decision trees will be described later in this section in conjunction with influence
diagrams more illustratively.

Marshall and Oliver (1995) provide a procedure for constructing decision trees, once the
set of random events and actions have been defined together with their sets of
probabilities and respective utilities (cost/payoff). Much like (sequence) influence
diagrams, decision trees are constructed in chronological order and nodes are connected
by branches. The steps include:

1. Draw a branch for each possible action from the first (leftmost) decision node. If
it is a chance node, do the same drawing a branch for each possible consequence.
2. Label each branch emanating from a chance node i with a unique element from
set
i
, with the corresponding probability and consequence.
3. Label each branch emanating from a decision node and its respective loss or
consequence.
4. Place the consequence values from the set on the terminal nodes at the end of
each branch.
Best System
Detection
Effectiveness
Time to
Implement
Passenger
Acceptance
Cost
System1
System 2
System 3
System 4
System 5
Part IV: Model Building for Decision Analysis
96
The designation between decisions and chance nodes is critical. Placing a chance event
before a decision means that the decision is made conditional on the specific chance
outcome having occurred. Conversely, if a chance node is to the right of a decision node,
the decision must be made in anticipation of the chance event. The sequence of decisions
is shown in a decision tree by order in the tree from left to right. If chance events have a
logical time sequence between decisions, they may be appropriately ordered. If no
natural sequence exists, then the order in which they appear in the decision tree is not
critical, although the order used does suggest the conditioning sequence for modeling
uncertainty (Clemen, 1996).

The key to constructing a decision tree from an influence diagram is the specification of
every possible outcome of every node: chance outcomes from each chance node, actions
from each decision node, and all possible consequences defined. Thus, a path in a
decision tree is a series of decisions and random outcomes that lead from a single initial
chance or decision node to a distinct end point or terminal node. The one fundamental
problem with decision trees, as stated in Marshall and Oliver (1995), is that the
dependencies among branches on each path are not made evident as apparent by
influence diagrams.

Section 9.6: Comparing Problem Structuring

Modeling decision problems can be formulated by use of graphical methods, such as
those presented above. Thus, for analysis purposes, it is beneficial to construct either a
decision tree or influence diagram and bring the structure of the decision problem to the
forefront. In this section, a general formulation of decision problem is presented in both
graphical forms and provides the basis for a comparative assessment of these approaches.

Figure 9-6 below provides a decision tree representation of the general problem
presented in the table in section 9.1. The decision tree displays the different possible
scenarios, but does not provide a clear picture of the interrelation and influences between
the uncertainties and decisions. Thus, it is not immediately clear whether the m chance
nodes at the end of the action branches represent the same uncertainty about , i.e. the
probability distribution of is not conditioned on the choice of action. The influence
diagram in Figure 9-7 makes this clear.

Figure 9-6:

The mn possible scenarios (histories)
of the decision tree are represented
by the mn possible paths in the tree.






a1
a2
a3
1
2
n
c11
c12
c1n
Part IV: Model Building for Decision Analysis
97
Figure 9-7:

The arrows indicate that the consequence
depends on the choice of action and the
unknown state; but the absence of an arrow
from the action node to the state nodes
indicates that the uncertainty about the state
is not conditioned on the choice of action.

Figure 9-8 and 9-9 provide a decision tree and influence diagram for a statistical decision
problem. These emphasize a further difference between the two representations. From
the tree, it is clear that the observation X is made before an action is decided upon. So, in
this case, the uncertainty concerning differs between chance nodes, being conditional
upon the observed value of X. Within the influence diagram, it might appear that the
arrow from X to a indicates that X becomes known to the decision maker before the
action a is chosen. But if this interpretation is made for all influence arrows, it may be
assumed that the uncertainty about is resolved and becomes known to the decision
maker before X is observed, which it does not.


Figure 9-8:









Figure 9-9:

Generally in influence diagrams, an arrow entering a chance node indicates that the
probability distribution represented by that node is conditional on the quantity (random
variable or decision) at the other end of the arrow. An arrow entering a decision node
indicates that the quantity at the other end of the arrow is known to the decision maker at
the time of the decision. An arrow entering a value node indicates that the quantity in the
value node is partially determined by the quantity at the other end of the arrow. In
summary, a decision tree representation displays two facets of a problem particularly
clearly: contingency and temporal relationships between decisions and realizations of
random events. An influence diagram
2
representation hides these facets but does bring
influences-or, in probabilistic terms, conditionality-to the forefront. Together they bring
complementary perspectives on the issues facing a decision maker.

2
An influence diagram can be used to represent the structure of a decision makers knowledge, i.e. beliefs,
simply by avoiding the use of decision or value nodes. Such a diagram is referred to as a belief net and its
use is most common in the field of artificial intelligence.

a
c

X
a
c
X=x1
X=x2
X=xq
a1
c1n
c12
c1n
1
2
n
Part IV: Model Building for Decision Analysis
98
Decision trees have a difficulty in that for many problems they rapidly become very
large: too large for the eye to comprehend as one. As such they have been described as a
bushy mess (French and Insua, 2000). Thus, decision trees are often displayed as a
series of sub-trees. Influence diagrams are a much more compact representation.
However, their advantage in this respect is, in a sense, illusory. Decision trees can
represent asymmetric decision problems, i.e. problems in which a particular choice of
action at a decision node makes available different choices of action at subsequent
decision nodes that those available after an alternative choice (Raiffa & Schlaifer, 2000).
Such asymmetric problems are rather the rule than the exception in decision analysis.
Within the classes of problems commonly considered in statistical decision theory,
asymmetry is less common. It is the asymmetry within problems that causes the decision
trees to grow into bushy messes; and it is unfortunate that, as commonly formulated,
influence diagrams cannot model asymmetric problems.

The discussion and the examples shown demonstrate, on the surface at least, that decision
trees display considerably more information than do influence diagrams. And is
previously commented, decision trees get messy much faster than do influence
diagrams as decision problems become more complicated. Even one of the most
complicated decision trees may not be capable of showing all of the intricate details
contained in an influence diagram depicting the same decision problem. In practice, the
understanding of the graphical representation of influence diagrams is optimal as it is
regarded as especially easy to understand regardless of ones mathematical training
(Clemen, 1996).

Both methods are worthwhile, and they complement each other well. Influence diagrams
are particularly valuable for the structuring phase of problem solving and for representing
large problems. Decision trees display the details of a problem. Yet, the ultimate
decision need not depend on the representation, as influence diagrams and decision trees
are isomorphic. That is a properly built influence diagram can be converted into a
decision tree, and vice verse; although the conversion may not be easy. One strategy is to
start by using an influence diagram to help understand the major elements of the situation
and then convert to a decision tree to fill in details.

Influence diagrams and decision trees provide two approaches for modeling a decision.
Because the two approaches have different advantages, one may be more appropriate
than the other, depending on the modeling requirements of the particular situation. For
example, if it is important to communicate the overall structure of a model to other
people, an influence diagram may be more appropriate. Careful reflection and sensitivity
analysis on specific probability and value inputs may work better in the context of a
decision tree. Using both approaches together may prove useful; the goal, after all, is to
make sure that the model accurately represents the decision situation. Because the two
approaches have different strengths, they should be regarded as complementary
techniques rather than as competitors in the decision modeling process.
Part IV: Model Building for Decision Analysis
99
Section 10: Probabilistic Graphical Models

The axiomatic developments presented in Part II justify the subjective expected utility
representation of a rational decision makers preferences in a decision problem; but
ignore the structure in the state, observation or consequence spaces. This section focuses
on the process of structuring the unknowns into parameters and observations thereby
facilitating the probability model building. This sections begins be re-visiting a decision
model framework with emphasis on the statistical elements of parameters and
observations. This leads to probability modeling and the representation of probabilistic
graphical models from a Bayesian perspective. The development of models such as
Bayesian networks (belief nets), multi-level or hierarchical models and exchangeability
are the emphasis in the later portion of this section.

Section 10.1: Subjective Expected Utility Model Rebuilding the
Decision Framework

The modeling of a decision makers preferences or beliefs is justifiably represented
through the established subjective expected utility axioms. Such a model has been
described as having three essentials: the action {A}, states {}, and consequence {C}
spaces. Drawing upon the scientific process of modeling, French and Insua (2000)
restate the previously defined decision model in a more general framework containing
parameters and observable variables. Thus, lets consider a model with parameters and
input variables of the form ) , ( M . French and Insua (2000) proceed to develop
comments of such a modeling framework.

The model ) , ( M used to predict a set of observed values ) , ( M y = , consists of
values which are observed while the parameters contain information obtained from
previous studies. That is the uncertainty lies within whereas is known. It is
proposed that in decision modeling, partitioning into ) , (
a a
relates back to the model
previously defined. If
a
is defined to be the set of actions such that A a and
a
is
defined to be those random quantities which are unknown, then re-labeling
a
as
gives ) , ( M . As stated in section 9, there is no correct model. Such models simply
provide a means of encoding the current assumptions and stating the understood
relationships. These models are descriptive in nature and further taken to be
deterministic accept when allowing a prescriptive interpretation of probability.

The decision model presented in Part I and revisited in the previous section concedes that
the consequences of a decision are assumed to be determined by the action chosen and
the unknown state:

c a .

The decision model can be restated as

Part IV: Model Building for Decision Analysis
100
) , ( ) , (
a
M c = .
Based on the axiomatic developments in Part II, the subjective expected utility model
takes the following form:

Choose ))]. , ( ( [ max arg

a c u E a
a
=
Thus, encoded in the model is the decision makers uncertainty and preferences. The
observed value X is subtly introduced into the model by redefining the parameter to
include the observations: ) , ( X = . The justification for the use of conditional
probabilities is provided by the following axiom (French and Insua, 2000):

T S T R T S T R Q T S R
~ ~
) ) | ( ) | ( , , , f f .

DeGroot (1970) proceeds with the following theorem based on the axioms stated in Part
II of this report by asserting that ) (

P , a probability distribution on , such that
(a) ) ( ) ( : ,
~
S P R P S R Q S R

f ;
(b) ) | ( ) | ( ) | ( ) | ( : 0 , ,
~
T S P T R P T S T R T with Q T S R

/ f f .

DeGroots next step is to construct the utility function. Including the observed value
X=x, gives the subjective expected utility model to be

Choose ]. | )) , ( ( [ max arg x a c u E a
a

=

Note that the loss function a x a c u a l = = ) ( and )) , ( ( ) , ( which is the action taken
after observing x. This brings us back to the development of the statistical decision
problem presented in Part I within the context of the developments found in Part II. This
leads directly into the building of probability models.

Section 10.2: Building the Probability Framework

The decision model elements: A, , and C (subsequently defined as the action, state, and
consequence spaces) which constitute the parameters and random and/or observed
variables of the model have been prescribed as vectors of real or integer numbers or
categorical variables. In the previous section, both the general form of the model and the
consequence model ) , ( ) , ( = M c are given to be deterministic; unless accentuated by a
propensity interpretation of probability (French and Insua, 2000). Decision making
under uncertainty is quantified or assessed through the development of probability
distribution and epitomizes the intrinsic nature of statistical decision theory.

The joint distribution of the unknown states of nature and the observed random variable
X are expressed through the joint distribution ) , (
,
X P
X

. The relationship between the

deterministic model ) , (
X
M and the ascribed joint probability distribution ) , (
,
X P
X

Part IV: Model Building for Decision Analysis
101
accounts for the decision makers uncertainties and the confounding effects within the
modeling framework.

As opposed to the descriptive structure of decision modeling construed in earlier sections,
the prescriptive approach discussed here is indicative of the structure of a decision
makers thoughts or belief process (French and Insua, 2000) and resides in the
relationship between the construction of probability distributions and utility functions. A
review of the development of the form or structure of the joint probability distribution
(the Bayesian perspective) leads to the construction of probability models and an
understanding of the graphical approach.

The development of the distributions ) , (
,
X P
X

, ) | ( X P

, and ) | ( X P
X
is intrinsic in
determining the confounding effects of both observations and parameter estimates. The
construction of the joint probability distribution elicits the Bayes theorem. Furthermore,
the Bayes theorem relates the joint distribution to the marginal and conditional
distributions such that joint probability of two events A and B are given as:

) ( ) | ( ) , ( B P B A P B A P

= .

The Bayes theorem re-arranges this form to demonstrate that

) (
) ( ) | (
) | (
B P
A P A B P
B A P

= .

The events A and B are independent, denoted A B. Thus, the symmetry of the condition
given above is immediate. This concept of conditional probability within the utility
context is introduced by DeGroot (1970) in his presentation of the subjective expected
utility axioms as shown in section 10.1.

The concept of conditional probabilistic independence extends further the modeling
structure of a decision makers beliefs (French and Insua, 2000). And the Bayes theorem
tells us that our revised belief for A, the posterior probability ) | ( B A P

, can be
obtained by the product of the prior probability ) ( A P

and the ratio ) ( / ) | ( B P A B P

where the numerator of the ratio is the likelihood of event A. Thus, the posterior
probability can be expressed in the following form:

). | ( ) ( ) | ( A B P A P B A P


likelihood prior posterior


This process of identifying conditional independence allows for the beliefs of a decision
maker to be represented in the form of a probability distribution. Furthermore, they aid
in developing the structural form of the utilities and in the assessment of the problem.

Section 10.3: Directed Acyclic Graphs (DAGs) and Probability
Part IV: Model Building for Decision Analysis
102

As illustrated in section 9 decision models can be represented graphically and provide
insight into the structure of the problem. It was stated that influence diagrams constitute
the formation of a network through a graphical framework. A formal description of
directed acyclic graphs (DAGs) is given in this section and offers a graphical approach to
Bayesian inference. This section begins with a description of directed graphs as stated in
graph theory and leads to its abilities to illustrate the Bayesian inference process.

A directed graph consists of nodes and directed arcs, as stipulated in the section on
influence diagrams. Formally, we may consider a network with nodes n j i ,..., 2 , 1 , = and
a subset of the possible ordered pairs ) , ( j i which specifies the directed arcs. A path
consists of a sequence:

k
i i i i ...
3 2 1
.

Such a directed graph is said to be acyclic when there exists no path with
k
i i =
1
. The
order of the nodes can be rearranged so that every directed arc j i has j i < . Bather
(2000) gives the following proposition:

If a directed network is acyclic, then the vertices can be renumbered in such a way that i
< j for each directed arc j i .

Bather (2000) goes on to prove this proposition which is omitted from this report. It
should also be noted that a path only exists if there is a link from one node to another;
else they are disconnected. This representation is useful when discussing causation. For
completeness purposes, a few terms in relation to graph theory are provided below.

Much of the terminology surrounding graph theory is centered on kinship relationships
such as parents, child, ancestors, etc. A node in a directed graph is said to be a root if it
has no parents and a sink if it has no children (Pearl, 1988). Every DAG has at least one
root and one sink. The term tree is used to qualify a connected DAG in which every node
has at least one parent. Similarly, if every node has a child then it is referred to as a
chain. A graph is said to be complete if every pair of nodes is connected by an arc. The
figure below illustrates an example of a DAG containing four nodes.

Figure 10-1:


B
D
C
A
Part IV: Model Building for Decision Analysis
103
This mathematical structure, a directed graph, represents a causal network consisting of
variables and directed links. This causal framework suggests the way influence may run
within a causal network. Two nodes (variables) are said to be separated if new evidence
on one of them has no impact on our belief of the other (Jensen, 2001). There are three
types of connections between triplets of variables A, B, and C.


Figure 10-2a:


Figure 10-2b:



Figure10-2c:



In both the linear and diverging cases, we have ) | ( C B A while in the converging case
we have ) | ( C B A / .

A
B
C
B
A
C
Converging
B
C
A
Diverging
Part IV: Model Building for Decision Analysis
104
Definition: (Jensen, 2001)
Two variables A and B in a casual network are said to be d-separated if for all trails
between A and B there is an intermediate variable V such that either
i. the connection is serial (linear) or diverging and the state of V is known; or
ii. the connection is converging and neither V nor any of Vs descendents have
received evidence.

This follows the properties of conditional independence (described in Section 10.2) as the
quantification of uncertainty in causal structures must obey the principle that whenever A
and B are d-separated then new information on one of them does not change the certainty
of the other.

Figure 10-3(a): Figure 10-3(b): Figure 10-3(c):



For Bayesian inference, DAGs illustrate the prior to posterior inference process. Each
diagram above represents the joint distribution of two random variables A and B. A
causal interpretation follows from figure 10-3(a) which describes the prior beliefs. The
posterior beliefs are represented by figure 10-3(b) and elicits an inferential process. Such
a representation forms the basis of Bayesian networks or belief nets.

Section 10.4: Directed Acyclic Graphs (DAGs) for Inference on
Bayesian Networks

The use of DAGs for Bayesian inference illustrates the prior to posterior inference
process as demonstrated in the previous section. Bayesian networks, on the other hand,
are generally more complicated than those presented above. Robert Cowell in his article
Introduction to Inference for Bayesian Networks, defines Bayesian networks as a

model representation for the joint distribution of a set of variables in terms of
conditional and prior probabilities, in which the orientations of the arrows represent
B
A A
B
P(A)P(B|A)
B
A
P(A,B) P(B)P(A|B)
Part IV: Model Building for Decision Analysis
105
influence, usually though not always of a causal nature, such that these conditional
probabilities for these particular orientations are relatively straightforward to specify
(from data or eliciting from an expert).

Hence, in this section, the focus falls on the inferential procedure which involves the
calculation of marginal probabilities conditional on the observed data using Bayes
theorem. This is equivalent to (diagrammatically) to reversing one or more of the
Bayesian network arrows. This section defines a Bayesian network and shows how one
can be constructed from prior knowledge.

Lets first consider a simple causal network where A is a parent of B. Then it is simple to
calculate the ) | ( A B P

. However, if C is also a parent of B then the individual

conditional probabilities ) | ( A B P

and ) | ( C B P

are not sufficient in providing any

information on the interaction between A and B. Hence, a specification of ) , | ( C A B P

is
required. This ideology can be expanded to consider n random variables. Typically, the
interest lies in looking for relationships among a large number of variables for which the
Bayesian network is suitable for.

A Bayesian network for a set of variables } ,..., , {
2 1 n
X X X = X consists of a set of directed
arcs which in turn provide (a) a network structure S that encodes a set of conditional
independence assertions about variables in X, and (b) a set P of local probability
distributions associated with each variable (Heckerman, 1998; Jensen, 2001). Thus, the
variables together with the directed arcs form a directed acyclic graph. Together these
components:

i. define the joint probability distribution for X; and
ii. provide a one-to-one correspondence between S and X.

Thus, a Bayesian network is a DAG whose structure defines a set of conditional
independence properties. These properties can be found through graphical manipulations
such as those presented in section 10.3 (Pearl, 1988). It has been contended that any
uncertainty must obey the definition of d-separation (Jensen, 2001). This is to say, that a
conditional probability distribution is associated with each node where the conditioning is
on the parents of the node )) ( | (
i i
X par X P . Further, d-separation can be used to read off
conditional independencies from DAG representation of a Bayesian network.

Given a network structure S, the joint probability distribution over the set of all variables
U is given by

=
i
i i
X par X P U P )) ( | ( ) ( ,

where the ) (
i
X par is the parent set of
i
X . Thus, the local probability distributions P are
simply the distributions corresponding to the terms in the product of the equation given
above (Heckerman, 1999). Jensen (2001) defines this as the chain rule.
Part IV: Model Building for Decision Analysis
106

Next lets consider the process of building a Bayesian network. Heckerman (1999)
illustrates this process through an example. Here, we generalize his learning by
example approach. The first task is much like that of the one described in developing a
decision tree or influence diagram. That is to say this initial task entails the more logical
structuring of the parameters and/or variables of interest. This can be characterized to
include: (1) the correct identification of the goals of modeling (i.e. prediction versus
explanation versus exploration); (2) the identification of all possible observations that
may be relevant to the problem; (3) the identification of a subset of relevant observations
to model; and (4) the classification of observations into variables having mutually
exclusive and collectively exhaustive states. As seen earlier, this is a task embedded in
decision analysis and hence is not exclusive to Bayesian modeling. This concludes the
more logical framework development in the construction of a Bayesian network.

The next step in the construction of a Bayesian network entails the more mathematical or
statistical framework. It is at this stage a DAG encoding the assertions of conditional
independence are built. This approach is based on the chain rule of probability which is
equivalent to the ) (U P shown above. In general the chain rule of probability is defined as


= =

= =
n
i
i i
n
i
i i
x P x x x P X P
1 1
1 1
) | ( ) ,..., | ( ) ( .

Then for every
i
X there exists some subset } ,..., {
1 1

i i
X X such that
i
X and
i i
X X

\ } ,..., {
1 1
are conditionally independent given
i
. Thus, it is clear that the
variables sets ) ,..., (
1 n
correspond to the parent nodes of a Bayesian network and in
turn specifying the arcs in the network structure S.

It follows that in determining the structure of the Bayesian network requires ordering the
variables and determining the most appropriate subset of variables. DAGs can always
have their nodes linearly ordered so that for each node X all of its parents precedes it in
the ordering. Such an ordering is referred to as a topological ordering (Cowell, 1999).

Consider the graph shown below with nine nodes. This has been taken from Cowell
(1999).

Figure 10-4:

This example shows that (A, B, C, D, E, F, G, H, I) and (B, A, E, D, G, C, F, I, H) are two
possible topological orderings. Thus, this task (of ordering the variables) may not be the
most feasible or reasonable process to be used unless done so under a more logical
D
E
A
G
H
B
F
I
C
Part IV: Model Building for Decision Analysis
107
framework. For instance, if the variable ordering chosen is not probable, the resulting
network structure may fail to reveal some of the important conditional independencies or
in the worst case n! variable orderings may need to be explored. Thus, applying the
semantics of causal relationships (as observed naturally) readily asserts the corresponding
conditional dependencies.

Now, the task at hand is to compute the joint density over the set of all variables U as
defined earlier. According to the DAG, this is referred to as recursive factorization or
the distribution being graphical over the DAG (Cowell, 1999). It follows a similar
procedure illustrated above by simplifying the individual terms (or nodes) with respect to
their structural parents. Then, the final step in the construction of Bayesian networks
simply entails the assessment of the local probabilities, defined as )) ( | (
i i
X par X P for
each i. This concludes the systematic approach to the construction of Bayesian networks.

It has been illustrated that each of these models determines a set of conditional
constraints, represented implicitly in the DAG. However, the implied criteria or
assumptions have not been discussed explicitly, and hence is made mention of here which
Pearl (1988) refers to as stability. The stability condition requires that all of the
probabilistic independence relations implied by the model should be invariant across
(small) perturbations to the parameters of the model. That is the parameters of the model
should not be functionally related to each other.

Furthermore, Verma & Pearl (1990) proved that two DAGs are observationally
equivalent if they have (i) the same skeleton; and (ii) the same sets of nodal structure
i.e. two converging arcs whose tails are not connected by an arc. Using this criterion, it
can be seen that figure 10-5(a) and (b) that probabilistically they are indistinguishable
while that figure 10-5(c) and (d) are not. Thus, a variety of belief nets can represent the
same conditional independencies.

Figure 10-5:


E
D
B
C
E
D
C B
A
(a)
(b)
A
Part IV: Model Building for Decision Analysis
108



So far the emphasis has been much on the construction of a Bayesian network (from prior
knowledge, data or a combination). And the need is usually to determine various
probabilities of interest from the model. Thus, we now focus on probabilistic inference in
Bayesian networks. Because a Bayesian network for U determines a joint probability
distribution for U (a set of all variables), in principle, the Bayesian network can be used
to compute any probability of interest as described above. However, the task to refine the
structure and local probability distributions of a Bayesian network given data results in a
set of techniques for data analysis that combines prior knowledge with data to produce
improved knowledge (Heckerman, 1999). This is process referred to as belief updating
in Bayesian networks. Jensen (2001) summarizes the mathematical process involved:

1. Use the chain rule to calculate ) (U P .
2. Determine the

=
=
n
i
h
s i i
h
s
S X par X P S U P
1
) , ), ( | ( ) , | ( where
i
is the vector of
parameters for the distribution ) , ), ( | (
h
s i i
S X par X P ,
s
is the vector of
parameters ), ,..., (
1 n
and
h
S denotes the configuration of the network.
3. Marginalize

=
=
n
i
h
s i i
h
s
S X par X P S U P
1
) , ), ( | ( ) , | ( to ) , ), ( | (
h
s i i
S X par X P
for each
i
X in U.
4. Normalize ) , ), ( , (
h
s i i
S X par X P results in ) , ), ( | (
h
s i i
S X par X P .

This illustrates the basic ideas for learning probabilities (and structure) within the
Bayesian or belief net framework. This section has described the construction steps in a
sequential manner; however, it is important to assert that many of these steps are
intermingled in practice. Both the problem of structuring and the assessments of
probability can lead to changes in the network structure. The section following presents
an extension of both probability modeling and belief nets within a hierarchical form.



E
D
B
C
E
D
C B
A
(c)
(d)
A
Part IV: Model Building for Decision Analysis
109
Section 10.5: Hierarchical Structures in Belief Nets

The natural occurrence of hierarchical structures in physical phenomenon is quite
common. Moreover, these structures find themselves in belief net representations as
hierarchical models. Hierarchical models were introduced in statistical modeling in 1972
by Lindley and Smith (Gelman et. al, 1995). Such models hold several advantages.

The simplest form of a hierarchical model can be described as a representation of beliefs
which consists of a layered structure. For instance, consider a set of observations
n
Y Y Y ..., ,
2 1
each related independently to a set of parameters
n
,..., ,
2 1
which share some
similarity or characteristic. The assumption about
i
having a common distribution
) | (

P represents this similarity. A third level suggests that may be represented by a

prior distribution with parameters . Thus the model described is a three level model:

). | ( ~ : 3 Level
. ,..., 1 ), | ( ~ : 2 Level
. ,..., 1 ), | ( ~ : 1 Level

=
=
P
n i P
n i P Y
i
i Y i
i


Thus, the concept here is to simply extend a common parameter to model the
distribution of many observable quantities
i
X . If the parameter has many components
then it may be useful to specify their joint prior distribution using a common hyper-
parameter, say (Neal, 1996) which is given its own prior. This hierarchy of a structure
is referred to as hierarchical modeling.

If the
i
are independent given , then

=
= =
n
i
i n
d P P P P
1
1
) | ( ) ( ) ,..., ( ) ( .

Although the could have been dispensed (with given a direct prior); however, Neal
(1996) states that using a hyper-parameter may be much more intelligible. This could
be extended to the level 1 data which would then require the decision maker to integrate
over .

In the hypothetical model illustrated above, the distribution ) | (

P is common to all
i
,
while the distributions ) | (
i Y
i
P may vary. This allows for the articulation of dependence
or independence in the beliefs about the components, if the
i
Y are multi-dimensional
(French and Insua, 2000). Further, a variety of experimental conditions can be ascribed.

A simple and natural occurring example of a hierarchy structure is in determining the
school to school variability of student achievement. Suppose the response is math
achievement on a standardized test. The innate structural formation describes students to
Part IV: Model Building for Decision Analysis
110
be nested within classrooms, classrooms nested within schools, and this could go on and
on. This would mean that
i
is the mean math score for classroom i, specified by a
normal distribution for that particular classroom. Thus, this allows us to update or
modify our belief of the math ability of students in general by adjusting the likely value
of the hyper-parameter . Gelman et al. (1995) presents the advantages of hierarchical
models in terms of statistical inference. Such strengths draw upon the ability to learn
about the hyper-parameter as well as drawing upon some information about the
particular effects of
i
.

These three level hierarchical models are not restricted to the structural formation
illustrated above but have also been used to structure statistical inference in terms of
observational and modeling error and prior information on the parameters. Furthermore,
hierarchical models are not restricted to three levels; more may be appropriate. That
judgment is somewhat left to the decision maker.

Section 10.6: Exchangeability and Other Forms of Probability
Models

One of the most fundamental concepts inlaid within subjective probability modeling is
the concept of exchangeability introduced by De Finettis. Conditional independence,
Bayesian networks, and hierarchical models give the decision analysts the tools for
exploring and constructing the form of the joint distribution through a decomposition into
its marginal and conditional components; However, the independence conditions to do
not suggest the parametric form of any of the conditional or marginal distributions
whereas exchangeability can (French and Insua, 2000).

De Finettis twist of hypothetical permutation suggests that rather than judging the
resemblance between two groups, the decision maker should imagine a hypothetical
exchange of two groups and then decide whether the observed data under the swap would
be distinguishable from the actual data (Pearl, 1999). Let A and B denote two groups,
treated and untreated, and let ) (
1
y P
A
and ) (
0
y P
A
denote the distribution of group A under
two hypothetical conditions, treatment and no treatment. Pearl explains that if the
interest lies in some parameter of the response distribution then
1 A
and
0 A
denote the
values of the parameters in the corresponding distribution ) (
1
y P
A
and ) (
0
y P
A
, (with
1 B

and
0 B
defined similarly for group B. Thus, in measuring the pair ) , (
0 1 B A
, the
hypothetical swap then suggests measuring ) , (
0 1 A B
.

Pearl (1999) defines two groups to be exchangeable relative to parameter if the two
pairs are in indistinguishable, that is if

) , ( ) , (
0 1 0 1 A B B A
= .

French and Insua (2000) extend this concept and state the following proposition:
Part IV: Model Building for Decision Analysis
111

A collection of random variables is exchangeable if and only if any n-tuple, with n less
than or equal to the sixe of the collection, has the same distribution as any other n-tuple.

Thus, exchangeability develops the parametric form of a distribution from relatively
weak ideas and of symmetry between future observables rather than from modeling ideas
derived from scientific understanding (French and Insua, 2000). Literature also
contends that these sets of symmetry conditions are not easily identifiable, and thus,
sometimes the parametric structure of the distribution is based more on intuition.

The methods illustrated in Section 10 provide a framework for the structuring of the
functional form of the decision makers probability distributions. In practice, many of
the methods are mixed and matched to accomplish the ultimate goal. Hence, a decision
maker may choose to build a Bayesian network and then focus on some nodes and
borrow conditions of exchangeability and modify the structure. Either way, there are
many choices in the structuring of decision problems; and this section introduces some of
these concepts.
Part IV: Model Building for Decision Analysis
112
Section 11: Probabilistic Graphical Models with
Markovian Properties

The framework for constructing probabilistic graphical models as DAGS is an initial step
in modeling complex decision problems; however, the formalism of hidden components
or sequential decision making processes has been ignored, thus far. This section does not
survey sequential decision making but does strive to present some of the extensions of the
graphical models presented earlier. It focuses primarily on sequential problems which
can be formulated in Markovian ways. Such applications stem from the body of theory
presented in PART III. Thus, we begin with exact inference when countering hidden
nodes and then briefly introduce dynamic linear modeling which underpins many
Bayesian forecasting techniques. This extends both probability modeling and the
representation of probabilistic graphical models described in the previous section. The
development of models such as Bayesian networks (belief nets) or hierarchical models
are extended to the development of neural networks, hidden Markov models, and
dynamic linear models.

Section 11.1: Inference in Probabilistic Graphical Models

The modeling of probabilistic graphs was introduced in section 10. This section extends
such structures to discuss probabilistic inference in graphical models which hold hidden
components or nodes. The problem in such inference making resides in the computation
of the conditional probability distribution over the unobserved or hidden nodes given the
observed information.

Let H denote the set of hidden nodes and E denote the set of evidence or observed
nodes. Thus the goal is to calculate the

) (
) , (
) | (
E P
E H P
E H P = .

Further, another aim is to calculate the marginal probabilities in graphical models, in
particular the ) (E P . Notably this is the likelihood function which of course has a direct
relationship with the conditional probability ) | ( E H P . Thus, these distributions are
intertwined and hence, any inference or algorithmic approaches to computing such
probabilities coincide.

As shown in section 10, when belief updating in Bayesian networks, the joint probability
distribution ) , | (
h
s
S U P is sufficient for the calculations required above. However
because the joint probability and corresponding calculations (based on its decomposition)
increase exponentially with the number of variables or nodes, more efficient methods are
desired (Jensen, 2001). Jordan (1999) presents an array of such methods encompassing
both exact and approximation algorithms. The junction tree algorithm, an exact approach
is introduced through the concepts of moralization and triangulation.

Part IV: Model Building for Decision Analysis
113
The focus in this part of the report has been on graphical models more specifically on
DAGs. To recap, DAGs (directed acyclic graphs) can be numerically assessed
determining the local conditional probabilities associated with each mode. That is these
conditional probabilities give the )) ( | (
i i
X par X P . To determine the joint probability
distribution of all of the N nodes, the product is taken over all possible nodes:

=
i
i i
X par X P U P )) ( | ( ) ( .

Thus, the probability inference in DAGs involves the computation of conditional
probabilities under this joint distribution.

This report has neglected undirected graphical models, thus far, as the introduction to this
subject area was directed by Bayesian networks in a very systematic approach. However,
we introduce them here. First off, such models are also referred to as Markov random
fields. They are numerically assessed by associating potentials with the cliques of the
graph (Jordan, 1999). A potential is defined as a function on the set of configurations of
a clique that associates a positive number with each configuration. And a clique is a
subset of nodes which are fully connected and maximal. To compute the joint probability
distribution for all of the nodes, the product is taken over all the clique potentials:

=
=
=
U
M
i
i i
M
i
i i
C
C
U P
1
1
) (
) (
) (

,

where M is the total number of cliques and the normalization factor (the denominator)
sums the numerator over all configurations. Figure 11-1 is an example of an undirected
graph adapted from Jordan (1999).

Figure 11-1:
The cliques are } , , {
3 2 1 1
X X X C ,
} , , {
5 4 3 2
X X X C and } , , {
6 5 4 3
X X X C .

1(C1)
2(C2)
S1
S2
S3
S4
S5
S6
Part IV: Model Building for Decision Analysis
114
The junction tree algorithm is commonly applied as a means of making exact inferences
and compiles directed graphical models into undirected graphical models. Jensen (2001)
provides a complete description and sequential steps involved in this graph theoretic
representation of this approach. Recall, that it was stated that this approach required to
main steps, moralization and triangulation. These are described next.

The first stage, moralization, translates the directed graph into an undirected graph. Both
graphs use the produce of the local functions to obtain the joint probability distributions
of the nodes. The directed form, )) ( | (
i i
X par X P , does hold the property of being a real-
valued function over the configuration; however, these nodes are not always situated
together within a clique. Thus, the objective is to marry the parents of all of the
undirected edges in the graph. This is done by simply dropping the arcs on the other
edges in the graph (Jordan, 1999). The resulting graph is called a moral graph and can be
used to represent the probability distribution on the original directed graph within the
undirected structure.

The second stage of the algorithm is referred to as triangulation. This processes the
moral graph (taking it as input) and produces an undirected graph (perhaps with
additional edges). This graph holds a property which allows recursive calculations of
probabilities (Jordan, 1999). In a triangulated graph, joint probabilities can be built up
sequentially through the graph. Figure 11-2 illustrates two graphs (a) represents a non-
triangulated graph whereas (b) demonstrates its triangulated form. Thus, if there are 4
cycles which do not have an edge, it is considered not triangulated but can be simply
formulated to be by simply adding a chord as seen below.

Figure 11-2(a): Figure 11-2(b):



Once a graph has been triangulated, the cliques of the graph can be arranged into a data
structure known as a junction tree. The aforementioned algorithmic structure is made
possible for trees and not networks because of the independent properties. That is, if X is
instantiated then all its neighbors are independent (Jensen, 2001). To summarize,
through graph theoretic methods, the independence properties in a network are converted
and organized into a set of sets of variables (cliques) and to construct a tree over the
cliques, resulting in a junction tree.
(a
(b
Part IV: Model Building for Decision Analysis
115

Section 11.2: Neural Networks

Neural Networks are Layered graphs endowed with a nonlinear activation function at
each node (Jordan, 1999). A neural network is characterized by its: (1) architecture its
pattern of connections between the nodes; (2) learning algorithm its method of
determining the weights on the connections (probability distributions); and (3) activation
function which determines the output (Ripley, 1996). Figure 11-3 below illustrates the
layered graphical structure of a neural network.

Figure 11-3:



Typically, a neural network consists of a large number of processing elements (nodes), or
neurons (when speaking of artificial neural networks). Each node has an internal state,
referred to as its activity level or activation which is a function of the inputs it has
received. Thus, a node sends its activation as a signal to several other nodes; however, it
can only send one message at a time.

Lets first consider a typical example of a simple neural network. Actually, for
simplicity, lets consider a single output node Y which receives input (activation) from n
nodes
n
X X ,...,
1
. From each input node to the output node Y, there is an associated
weight
ij
. Then to determine the output of the node Y, simply sum the inputs with their
respective weights (consider multiple regression with
ij
as the regression coefficients):

nj nj j j j j i ij
x x x y + + + + = ...
2 2 1 1 0


The
0 i
is the bias parameter which allows one to change (or bias) the output
independently of the inputs. The next step is to apply an activation function, of which a
number of them could be used. However, a common activation function is the logistic
sigmoid function (an S-shape curve).

Part IV: Model Building for Decision Analysis
116
Lets consider an activation function that is bounded between 0 and 1, such as that
obtained through the logistic function:

) 1 /( 1 ) (
y
e y f

+ = .

Thus, a binary variable
i
X is associated with each node in a graphical model; and the
interpretation of the activation of the node is the probability that the associated binary
variable takes one of its two values. Thus, the corresponding logistic function is:

+
= =

) (
0
1
1
)) ( | 1 (
i
X par j
i j ij
X
i i
e
X par X P

.

Thus, the
ij
are the parameters associated with the edges between the parent nodes j and
node i, and
0 i
is the bias parameter associated with node i. This is the sigmoid belief
network introduced by Radford Neal (1992). Such treatments of neural networks hold
many advantages including the ability to perform diagnostic calculations and to handle
missing data (Jordan, 1999).

From figure 11-3 above, it is quite clear that a node in a neural network, generally, has
the preceding layer as all of its parent nodes. Thus, when applying the junction tree
algorithm, the moral graph links between all of the nodes in this layer, as illustrated
below. Further note that the by definition (Section 11.1) the output nodes are the
observed or evidence nodes and thus the hidden nodes are probabilistically dependent
and so are any of its ancestors (Jordan, 1999). Computationally this can be quite
intensive as the clique size due to the triangulation procedure will grow exponentially.

Section 11.3: Hidden Markov Models

This section introduces hidden Markov models which is one of the simplest kinds of a
dynamic Bayesian networks. As suggested by the models name, hidden Markov models
hold Markovian properties for which we refer to PART III. Thus, instead of regurgitating
such properties, we simply relay the directed Markovian property in graphical models.

This directed Markovian property is a conditional independence property which states
that a variable is conditionally independent of its non-descendents given its parents:

) ( | ) ( X par X ND X

where ) ( X ND denotes the non-descendents of X. From section 10, it was mentioned that
the conditional probability )) ( | (
i i
X par X P did not necessarily mean that if the
* ) ( = X par then the *) | ( ) ( x P x X P = = . That is the suggestion was that any other
information is irrelevant for this condition to hold. In DAGs, this information refers to
the knowledge about the node itself or any of its descendents. So, we can summarize this
Part IV: Model Building for Decision Analysis
117
by saying that having information about a non-descendent does not tell us anything more
about X, because either it cannot influence or be influenced by X either directly or
indirectly (Cowell, 1999). (Or if it can be influenced indirectly, then it can only be done
though influencing the parents which are all known anyway.)

Figure 11-4:



A hidden Markov model (HMM) is a graphical model in the form of a chain as seen in
the figure above. Applying the same property, consider a sequence of multinomial
state nodes
i
X and assume that the conditional probability of
i
X is independent of its
immediate predecessor
1 i
X . This forms a matrix of transition probabilities
) | (
1
=
i i
X X P A which is time invariant. The output nodes
i
Y have an associated
emission probability law ) | (
i i
X Y P B = which is also time invariant.

In determining probabilistic inferences in such graphical models, the output nodes are
treated as evidence nodes and the states as hidden nodes. The EM (expectation-
maximization) algorithm is generally applied to update the parameters , , B A . This two
step iterative procedure first computes the necessary conditional probabilities and then
updates the parameters via weighted maximum likelihood. Thus, the moralization and
triangulation procedures of the junction tree algorithm are innocuous or useless for such
graphical models as hidden Markov models (in this form).

Figure 11-5:


X
Y
Part IV: Model Building for Decision Analysis
118
Now consider a variation on the aforementioned hidden Markov model with a number of
chains. Such a graphical model is called a factorial HMM and is shown above. In
general, the structure is composed of m chains. Hence, the state node for the mth chain at
time i is denoted
) (m
i
X and corresponding transition matrix for the mth chain is denoted
) (m
A . Thus, the overall transitional probability for the full model is computed by taking
the product across the intra-chain transition probabilities:

=

=
m
i
m
i
m
i
m
i i
X X A X X P
1
) (
1
) ( ) (
1
) | ( ) | ( .

In this situation, the triangulation process will result in an exponential growth of cliques
as there are multiple chains to be considered. Thus, a factorial hidden Markov model
does not hold the tractable properties held by its more general formalism.

Another variation or amalgamation of two previously described models is hidden Markov
decision trees (HMDT). As the name suggests, this is a model which is essentially a
decision tree endowed with Markovian properties (Jordan, 1999). In an HMDT, the
decisions in the decision tree are not only conditional on the current data point, but are
also conditional on the decision at the previous moment in time.

Figure 11-6:



The figure above illustrates such a model where the horizontal edges represent the
Markovian temporal dependence. Note that the term temporal is used as it is assumed
that the model structure does not change (Murphy, 2003). Thus, given a sequence of
input vectors
i
U and a corresponding output vectors
i
Y , the task at hand is to compute the
conditional probability distribution over the hidden states again. This is much like the
case of the FHMM and is shown to be intractable when making inferences (numerically)
(Jordan, 1999).

Part IV: Model Building for Decision Analysis
119
Several other variations of the HMM exist including those of higher orders where each
state depends on the previous k states as opposed to the single previous state or those with
a mixture of both continuous or discrete nodes. Either way, the number of cliques for
such models grows exponentially. Thus, although these models provide a graphical
representation of complex problems, they are not easily tractable especially when
concerned with exact inference algorithms. However, many of these can still be assessed
using approximation methods which will be discussed generally in section 11.5.

Section 11.4: Linear Dynamic Models

Another important type of dynamic Bayesian networks is the class of decision problems
which has arisen out of the area of control of stochastic systems within the engineering
field. Essentially, the objective is to keep systems running over a number of stages along
target trajectories of states (French and Insua, 2000). They have also been developed for
the problem without controls, known as dynamic linear models (DLM). Their
importance resides in their formulation as a tool for Bayesian forecasting and sequential
procedures.

Linear dynamic models have the same topology as HMMs, but all the nodes are assumed
to have linear-Gaussian distributions. Lets consider the basic structure:

) , ( ~ |
) , ( ~ |
1 1 t t t t t
t t
T
t t t
W G
V F y





where
t
y is scalar (data) and
t
is the state vector. The model is defined by four quantities
} , , , {
t t t t
W V G F which are assumed to be known at time t:
t
F is a n vector,
t
G is a n n
matrix,
t
V is a non-negative scalar, and
t
W is a n n symmetric and positive (semi)-
definite variance matrix. A more general way of stating this model is:

Observation equation:
) , 0 ( ~ ,
t t t t
T
t t
V v v F y + =

System equation:
) , 0 ( ~ ,
1 t t t t t t
W w w G + =



Figure 11-7:


HMM with Gaussian
Part IV: Model Building for Decision Analysis
120
The best way to think of a DLM is through is graphical structure as shown above. This
graph has two noticeable features. The first, is that the state vector
t
follows a Markov
process, so that t k j
k j k


1 all for , |
1
. This implies that
k j
w w . The
second is that
k
separates
k
y from everything else, so that
k j j k
y y | , . This further
implies that
k k
w v and
j j k
w v v , (West et. al., 1997).

Let } ,..., {
1 k k
y y D = represent the data where
k
y takes on either a numeric or missing
value. Then the prior beliefs about the state vector can be written as:

Prior information:
) , ( ~ |
0 0 0 0
C m D .

The DLM allows us to compute
k
m and
k
C from
1 k
m ,
1 k
C , and
k
y . In this way, the
information sets
k
D are defined recursively and can be computed through stochastic
dynamic programming algorithms; however, can be manageably daunting. Nonetheless,
these models do provide highly effective means of modeling univariate time series
(French and Insua, 2000).

Section 11.5: Variational Methods for Dynamic Bayesian Networks

The junction tree algorithm and dynamic programming algorithms provide solutions for
probabilistic inferences in graphical models. However, as we have seen in this section, a
need for other approaches is crucial for many forms of dynamic Bayesian networks as
they grow in complexity. Even in cases where exact algorithms are manageable, it is still
important to consider approximation methods.
A graphical model specifies a complete joint probability distribution over all the nodes.
Given the joint probability distribution, all possible inferences queries can be determined
by their marginal distributions. Computing several marginal distributions at the same
time can be done using dynamic programming which avoids the redundant computation
required by other marginalization procedures. However, much like the junction tree
algorithm, this grows exponentially pending the size of its largest subset of nodes.

Approximation algorithms provide an alternate solution. Jordan (1999) provides an
overview of some of the valuable and existing approximation methods. Variational
methods and sampling methods are two approximation approaches readily used.

Variational methods generally provide bounds on probabilities of interests (Jordan,
1999). The simplest example is the mean-field approximation which exploits the law of
large numbers to approximate large sums of random variables by their means (Murphy,
2003). This procedure requires the decoupling of all the nodes and updating of the
variation parameters, formulating a lower bound on the likelihood. The objective of such
methods is to convert a complex problem into a simpler one.

Part IV: Model Building for Decision Analysis
121
Since the basic idea (stemming from above) is to simplify the joint probability
distribution by transforming the local probability functions, an appropriate choice can
lead to a simplified inference problem. Transforming some of the nodes may allow for
some of the original graphical structure to remain intact or introduce a new graphical
structure to which exact methods may be applied. The sequential approach makes use of
variational transformations and aims to transform the network until the resulting structure
is amenable to exact methods (Jordan, 1999; French and Insua, 2000). Other similar
approaches exist and have shown to be fruitful in accomplishing the inference task. This
has been touched on briefly through some of the examples in this section.

Another approach to the design of approximation algorithms involves sampling (Monte
Carlo) methods. Markov chain Monte Carlo (MCMC) methods are a more efficient
approach and many of these algorithms have been applied to the inference problem in
graphical models. Their simplicity in implementation and theoretical overtures of
convergence make them advantageous; however, they can be slow to converge and it can
be hard to diagnose their convergence (Jordan, 1999).

The general inference problem is the computation of the conditional distribution over the
hidden values given the observed information. There is a lot of literature in this area and
especially on algorithms to accomplish this task. Some of these have been briefly
discussed in this section. These various approaches to inference are not mutually
exclusive, and in many instances, an amalgamation of such methods may prove to be the
best solution for a given graphical model. Some of these more common methods are
described in more detail in the PART V to illustrate analysis procedures.

Part V: Analytic & Computational Methods for Decision Problems
122
Part V: ANALYTIC &
COMPUTATIONAL METHODS
FOR DECISION PROBLEMS


The complexity of decision problems has led to the rapid development of methodological
solutions to these problems. The graphical structure of probabilistic models has also
added a more intuitive approach to the problem at hand. These developments have also
led to the advancement of computational methods to deal with the complexities of the
numerical assessment of these problems which arises. The task at hand is probabilistic
inference, whether it lies in graphical models or in expected losses. Recall that French
and Insua (2000) commented on the feasibility and robustness which relate to the
practicality and implications of decision processes. Thus, the need for computational
methods which meet the criteria is essential to decision modeling.

Earlier parts of this report introduced the framework for modeling decision problems in
introduced the decision theoretic aspects. PART IV of this report focused on building
models to illustrate decision problems with an emphasis on probabilistic graphical
models. This part of the report concludes this paper by discussing some of the
computational issues which arise in decision analysis. Computational methods including
Monte Carlo methods and dynamic programming are introduced as both feasible and
efficient approaches for the analytic assessment of decision problems. These analytic
concepts are the focus of the beginning sections. The last section is an application of the
typical methodology used in a prototypical example. This concludes the methodological
issues which arise in decision problems.
Part V: Analytic & Computational Methods for Decision Problems
123
Section 12: Decision Theoretic Computations

Part I and Part IV introduced the framework for decision models and the construction of
graphical models, respectively. Both approaches introduced the computational issues
which arise. Much of these issues reside in the calculation and or minimization of
probability distributions. Some of the methodological approaches were introduced;
however were never developed. This section re-introduces the problem and begins to
address algorithms which aim to solve some of these computational constraints. A
review of analytic approaches and numerical integration are presented but demonstrate
some limitations which are resolved though Monte Carlo methods. Although this section
concentrates on Bayesian decision theoretic computations, other statistical decision
theoretic approaches face the same computational problem. Therefore, they provide
insight into solving the computational issues which arise through the classical approach.

Section 12.1: Computational Issues in Decision Problems

The first half of this report focused on the construction and development of decision
models. Recall that the loss function ) , ( a l is one of the key attributes of decision
theory. Moreover, the process of calculating and minimizing expected losses is the key
objective. This section addresses the computation issues which arise in the modeling of
decision problems and specifically these objectives.

French and Insua (2000) state that there are two objectives which need to be solved:

=

d x p a l x a l E
A a A a
) | ( ) , ( min ] | ) , ( [ min

and

d a x p a l
A a
) , | ( ) , ( min .

The former is simply the calculation of an expectation. In this latter case, the probability
model involves dependencies on a which occurs in influence diagrams and decision trees
formulations. Assuming the optimal action is known means that the explicit computation
of the posterior probability is only required. Thus the solution of these decision problems
requires the computation of a posterior expectation.

In most instances, the integrals involved are difficult to evaluate analytically; and hence
more powerful integration methods need to be implemented. This section reviews
analytical and numerical approaches before introducing simulation or Monte Carlo
methods. The limitation of the analytic and numeric approaches draws the importance
for more computationally efficient and plausible methods. However, these methods are
not without their drawbacks and are addressed. The latter part of this section attends to
combining the issues of optimization and integration. Although, there is a focus on the
Part V: Analytic & Computational Methods for Decision Problems
124
Bayesian decision theoretic computations, these issues are synonymous to other statistical
decision theoretic issues; and hence provide insightful possibilities.

Section 12.2: The Bayesian Framework

In addressing the computational issues within a Bayesian framework, it deems necessary
to describe the Bayesian perspective in order to fully understand the issues which arise is
such methodology. Thus, we begin with an overview of Bayesian data analysis.

The essential characteristic of Bayesian methods is their explicit use of probability
models for quantifying uncertainty in inferences based on statistical data analysis. It can
be conceptualized by dividing it into the following three steps: (1) setting up a full
probability model; (2) conditioning on the observed data; and (3) evaluating the fit of the
model and the implications of the resulting posterior distribution (Gelman et al. 1995)

Setting up a full probability model entails the construction of a joint probability
distribution for all observable and unobservable quantities in a problem. The model
should be consistent with knowledge about the underlying scientific problem. The
second step involves calculating and interpreting the appropriate posterior distribution
the conditional probability distribution of the unobserved quantities of ultimate interest,
given the observed data. Lastly, questions addressing does the model fit the data, are the
substantive conclusions reasonable, and how sensitive are the results to the modeling
assumptions in the first step (Gelman et al. 1995) should be tended to.

Contextually, it is often easier (with the Bayesian approach) to build highly complex
models when such complexity is realistic. The central feature to Bayesian inference is
the direct quantification of uncertainty which in principle allows models with multiple
parameters and complex layers to be fit (Gelman et al. 1995) with a conceptually simple
method. The purpose of this report is not to glorify Bayesian inference over the
frequentist approach as there is no need to choose exclusively between the two
perspectives nor is it without its constraints. However, it is the purpose of this section to
introduce and outline the general concept of the Bayesian paradigm. Before launching
into a discussion on computational advances in Bayesian methods, a review of some
terminology and standard notation and a formal presentation of the problem are provided.

The task in decision problems has been to make probabilistic inferences. Statistical
inference refers to the process of drawing conclusions about a population on the basis of
measurement or observations made on a sample of individuals from the population
(Everitt, 2002). From a Bayesian perspective, there is no fundamental distinction
between observables and parameters of a statistical model as they are all considered
random quantities. Thus, here in lies the task the quantification of such uncertainty.

Recall that Bayesian data analysis involves (first) setting up the full (joint) probability
model. Let D denote the observed data, and denote model parameters and missing data.
The joint distribution is comprised of two parts: a likelihood ) | ( D P and a prior
Part V: Analytic & Computational Methods for Decision Problems
125
distribution ) ( P . To summarize, obtaining the likelihood ) | ( D P describes the process
which gives rise to the data D in terms of the unknown parameters while the prior
distribution ) ( P expresses what is known about , prior to observing the data.
Specifying ) | ( D P and ) ( P gives a full probability model, in which

) ( ) | ( ) , ( P D P D P = .

The second step in Bayesian data analysis commemorates the Bayes Theorem is used to
determine the distribution of conditional on D, after observing the data:

.
) ( ) | ( ) (
) | ( ) (
) | (

d D P P
D P P
D P

Applying the Bayes Theorem derives the posterior distribution of and is the object of
all Bayesian inference (Gilks et al. 1996).

Moments, quantiles and other features of the posterior distributions can be expressed in
terms of posterior expectations of functions of . The posterior expectation of a function
) ( f is
.
) | ( ) (
) | ( ) ( ) (
] | ) ( [

d D P P
d D P P f
D f E

The integration of this expression has until recently been the source of most of the
practical difficulties in Bayesian inference. The problem of calculating expectations in
high-dimensional distributions adheres both to Bayesian inference and some areas of
frequentist inference (Geyer, 1995). To avoid an unnecessarily Bayesian flavor to this
discussion, the problem is restated in more general terms.

Let X be a vector of k random variables, with distribution ) ( . In Bayesian applications,
X will comprise of both model parameters and missing data; in frequentist applications, it
may comprise of data or random effects (Gilks et al. 1996) and Draper (1997). For
Bayesians, ) ( will be a posterior distribution (as described above) while for frequentists
it will refer to a likelihood. However, either way, the task is to evaluate the expectation

=
dx x
dx x x f
f E
) (
) ( ) (
)] ( [

for some function of interest ) ( f .

A common situation arises in such that the normalizing constant (the denominator of the
above equation) is unknown. In Bayesian practice, ) | ( ) ( ) | ( D P P D P ; however the
Part V: Analytic & Computational Methods for Decision Problems
126
normalizing constant

) ( ) | ( ) ( d D P P is not easily evaluated and is the focus of the

next section. Here, it has been assumed that X takes values in k-dimensional space, i.e. it
is comprised of k vectors of continuous random variables. Although, this problem has
been described generally, X could consist of discrete random variables (in which case the
integral would be replaced by a summation) or by a mixture of both continuous and
discrete random variables.

Section 12.3: Integration Methods

As discussed in the previous section, the difficulty and the interest in Bayesian inference
is in evaluating expectations

dx x x f ) ( ) ( for various functions ) (x f . Integration is

usually simple in conjugate models priors and posteriors are members of the same
parametric family of distributions and thus posteriors are easily determined (French and
Insua, 2002). Even for conjugate models, there may be cases (moments or probabilities)
for which the solution may not be computed explicitly.

In the last decade alone, there have been a number of advances in numerical (Tierney and
Kadane, 1986) and analytic (Smith et al. 1987) approximations for such calculations,
largely in part due to increased computing power. Some of these alternatives such as
numerical evaluation are difficult and inaccurate in k > 20 dimensions; analytic
approximations such as the Laplace approximation which is sometimes appropriate
(Gilks et al. 1996). Numerical quadrature methods for approximating integrals such as
the common trapezoid and Simpsons rules (CSC260H, 2001) are commonly applied.
Better rules are obtained when the form of the integrand is taken into account such as
Gaussian quadrature methods which approximates well when the density function is a
normal kernel (French and Insua, 2002). Such procedures also extend into k dimensions.
Asymptotic methods based on asymptotic normality arguments also exist. However,
integration strategies based on these arguments are only valid if samples sizes are large
and other necessary conditions apply. These methods are efficient in problems with
specific structure and/or low dimensionality.

In more complex problems, simulation or Monte Carlo integration is required. Monte
Carlo methods are often the method of choice involving high-dimensional problems, but
it is important to note that many of these computational methods complement each other
rather than compete (Tierney and Mira, 1999).

Monte Carlo Integration

The basic objective of the Monte Carlo approach is to draw an approximate i.i.d. sample
from ) ( which can then be used to compute sample averages as approximations to
population averages (STA4276H, 2003). Although this is an oversimplification of the
approach it introduces the concept concisely. More formally, Monte Carlo integration
evaluates )] ( [ X f E by drawing samples } ,..., 1 , { n t X
t
= from ) ( and then approximating

Part V: Analytic & Computational Methods for Decision Problems
127
. ) (
1
)] ( [
1

n
t
t
X f
n
X f E

So, the population mean of ) ( X f is estimated by a sample mean; the average value has
some basic properties which are very important. When the samples } {
t
X are
independent, the Law of Large Numbers ensures that the approximation can be made as
accurate as desired by increasing the sample size n (Gilks et al. 1996). Thus, n is under
the control of the analyst; it is not the size of a fixed data sample.

The problem at hand is to simulate observations from a posterior distribution, obtained
via Bayes Rule as

.
) ( ) | ( ) (
) | ( ) (
) | (

d X P P
X P P
X P

In general, drawing samples } {
t
X from ) | ( ) ( X P = is not feasible, since ) ( can be
quite complex and non-standard. However the samples } {
t
X need not be independent; it
can be generated by any process which (loosely) draws samples throughout the support
of ) ( in the correct proportions (Gilks et al. 1996). One way this is accomplished is
through a Markov chain having ) ( as its stationary distribution.

Let ,... ,..., ,
2 1 t
X X X be a sequence of random variables which have outcomes from some
set S. Also, assume that the conditional distribution of
t
X given all previous
observations ,... ,
2 1 t t
X X only depends on the last observation. That is, if the current
value is known then the prediction of the next value does not require the previous values
(CHL5223H, 2003). This property is known as the Markovian property and such a
sequence of random variables is known as a Markov chain. More formally this is stated
as suppose a sequence of random variables } ,..., 1 , { n t X
t
= are generated such that at each
time 1 t , the next state
1 + t
X is sampled from a distribution ) | (
1 t t
X X P
+
which depends
only on the current state of the chain,
t
X . Thus, to summarize, given
t
X , the next state
1 + t
X does not depend further on the history of the chain }. ,..., , {
1 2 1 t
X X X

An important issue in basic Markov chain properties is the affect of the starting value of
the chain or state
1
X affect
t
X . The trait of the distribution of
1
| X X
t
, denoted
) | (
1
) (
X X P
t
t
, without the intervening variables } ,..., , {
1 3 2 t
X X X suggests that
t
X
depends directly on
1
X . Subject to some conditions, the chain will gradually forget its
initial state and ) | (
1
) (
X P
t
will eventually converge to a unique limiting distribution
(Gilks et al, 1996). That is,
t
X settles down to a limiting distribution no matter what the
value of the starting value of
1
X is.

Part V: Analytic & Computational Methods for Decision Problems
128
There are some basic properties of Markov chains which should be stated for
completeness. The first is that if the set of states, S, is finite then the Markov chain holds
two properties: aperiodicity and irreducibility; if the set of states is infinite then an
additional property of an invariant distribution exists (CHL5223H, 2003). Thus, for a
finite Markov chain, the limiting distribution exists of it is aperiodic (the chain is not
cyclic) and irreducible (possible to move from one state to another) while infinite Markov
chains hold the additional property of having an existing invariant or stationary
distribution. The stationarity of a distribution simply refers to the limit as n is ) ( .
Thus, as discussed earlier, as t increases, the sample points } {
t
X look increasingly like
dependent samples from the stationary distribution denoted as ) ( based on a long burn-in
of m iterations, where n m t ,..., 1 + = . The output from the Markov chain is used to
estimate the expectation )] ( [ X f E , where X has distribution ) ( . The important by-
product is the path averages to the expected value under the limiting distribution where
burn-in samples are usually discarded for the calculation of the estimator:

)]. ( [ ) (
1
1
X f E X f
m n
f
n
m t
t
+ =

=



The convergence to the expectation is confirmed by the ergodic theorem whereby the
above estimator is referred to as the ergodic average (Gilks et al. 1996). Therefore these
path averages can be used to estimates expected values of the limiting distribution.

(See Part III for a discussion on Markov chains and their properties.)

Section 12.4: Markov Chain Monte Carlo Methods

Recall that is was stated that the basic objective of the Monte Carlo approach was to draw
an approximate i.i.d. sample from ) ( which could then be used to compute sample
averages as approximations to population averages. Since direct i.i.d. sampling is rarely
possible, a sample from a similar distribution is obtained and a Markov chain as its
unique invariant distribution is constructed (Tierney and Mira, 1999). These are the
concepts which formulate the Markov chain Monte Carlo (MCMC) method.

As explained the Monte Carlo techniques generate random variables having certain
discrete distributions. However, once it becomes too complex, Markov chains can be
used. If a Markov chain with a stationary distribution is the same as the desired
probability distribution ) ( (the target distribution), then the Markov chain can be run for
a long time, say m iterations. The probability that the chain is in state i will be
approximately the same as the probability that the discrete random variable equals i. The
idea behind the method is simple. Simply, a Markov chain with invariant
distribution ) ( is run and sample path averages are used to approximate expectations
under ) ( . If the chain is irreducible and the expectations exist, then the sample path
averages converge to the expectations. The problem of finding the Markov chain with
the desired stationary distribution still exists.
Part V: Analytic & Computational Methods for Decision Problems
129

The ergodic average shows how a Markov chain can be used to estimate )] ( [ X f E , where
the expectation is taken over its stationary distribution ) ( . This would seem to provide
the solution to the initial problem; however, first the construction of a Markov chain such
that its stationary distribution ) ( is precisely the distribution of interest ) ( needs to be
established. There are two widely established ideas which are presented in the next two
subsections dimension reduction by conditioning (Gibbs sampling approach) and
acceptance and rejection (Metropolis-Hastings algorithm).

The practical appeal of simulation methods, including MCMC, is that, given a set of
random draws from the posterior distribution, one can estimate all summary statistics
from the posterior distribution directly from the simulations. MCMC methods have been
widely successful because they allow one to draw simulations from a wide range of
distributions, including many that arise in statistical work, for which simulation methods
were previously much more difficult to implement. To apply the MCMC method in a
particular problem a sampler has to be constructed. There are two central ideas for
building samplers and are guided by the two most common methods the Gibbs sampler
and the Metropolis-Hastings algorithm which are described in sections 4.2 and 4.3.
These algorithms are not in competition with each other and in fact complement each
other. The Metropolis within Gibbs algorithm is identified as a conceptual blend in
which one parameter is updated at a time; this was the initial proposed algorithm which
can be automated (Gilks et al. 1996).

Gibbs Sampling

The Gibbs sampling algorithm holds the central idea of dimension reduction by
conditioning (Tierney and Mira, 1999) and is best described mathematically by its
transition kernel (Gilks et al. 1996). Suppose ) ( is the joint distribution of
} ,..., 1 , { n t X
t
= where t 1, a Markov chain. Update each component based on the value
of each other component

) ,..., , ,..., | ( ) | (
1 1 1 1 n t t t t t
X X X X X X X
+
=

These distributions are called full conditionals. The transition kernel describes the
density of going from one point X to another point Y (Gilks et al. 1996, Brooks et al.
1998):

}) , { }, , { | ( ) , (
1
i j X i j Y Y Y X K
j
d
i
j i
< < =

=



This is a product of the conditional densities of the individual steps required to produce
an iteration of a d-dimensional Gibbs sampler. A thorough theoretical discussion is
omitted for brevity sake.

Part V: Analytic & Computational Methods for Decision Problems
130
The Gibbs sampling algorithm is quite simpler in concept and thus, a simple example is
featured below. Let be 3-dimensional and the parameters of a Bayesian model. The
algorithm follows:

1. Start with a set of initial values:
) 0 (
.

2. Given the m-th update, get the (m+1)th sample by:


) data , , | ( ~
) data , , | ( ~
) data , , | ( ~
) (
2 2
) (
1 1 3
) 1 (
3
) (
3 3
) (
1 1 2
) 1 (
2
) (
3 3
) (
2 2 1
) 1 (
1
m m m
m m m
m m m
f
f
f



= =
= =
= =
+
+
+


3. The joint posterior is invariant, therefore:

)]. ( [ ) (
1
1
) (
f E f
m n
f
n
m t
m

+ =

=



It should be noted that when this sampling was developed by Geman and Geman (1984)
its purpose was to sample from a Gibbs distribution, which is a distribution over a lattice;
however since its inception it has expanded over many distributions and thus, being
called a Gibbs sampling algorithm is a bit of a misnomer. The Gibbs sampler is a special
case of the Metropolis-Hastings algorithm which is explained next.

Metropolis-Hastings Algorithm

The notion that if the chain is irreducible and the expectations exist, then the sample path
averages converge to the expectations is the basic idea proposed by Metropolis et al.
(1953) and was extended by Hastings (1970). The central idea to the Metropolis-
Hastings algorithm is acceptance (or proposals) and rejection (Tierney and Mira, 1999).
This algorithm proposes a new point on the Markov chain which is either accepted or
rejected. If the point is accepted, the Markov chain moves to a new point. If it is
rejected, the Markov chain remains in the same state. By choosing the acceptance
probability correctly, a Markov chain which has ) ( as a stationary distribution is created.

Let S be a state space with probability distribution ) ( on S. Then choose a proposal
distribution } , , : { S j i q
ij
with . each for 1 and 0 S i q q
S j
ij ij
=

Given that
1
,
+
=
n n
X i X is computed as the M-H algorithm follows:

1. Choose j Y
n
=
+1
according to the Markov chain } , , : { S j i q
ij

2. Set

=
ij
ij
ij
q i
q j
) (
) (
min

Part V: Analytic & Computational Methods for Decision Problems
131
3. With probability
proposal) (reject let Otherwise,
proposal) (accept let ,
1
1 1
i X X
j Y X
n n
n n ij
= =
= =
+
+ +

As desired, this will create a chain with stationary distribution ) ( . The Metropolis-
Hastings algorithm can also be used for continuous random variable by using densities
and continuous proposal distributions, but is not explored further here. It is also possible
to extend the concept to a multidimensional case. The Gibbs sampler, is a special case
of the multivariate Metropolis-Hastings algorithm where the proposals q are the full
conditionals and the acceptance probability is always 1 as explained above.

Convergence Issues

A properly derived and implemented MCMC method will produce draws from the joint
posterior density once it has converged to stationarity ) ( . As a result, a primary concern
in applying such methodology is determining that it has in fact essentially converged; that
is, that after an initial burn-in period (designed to remove dependence of the simulated
chain on its starting location), all further samples may be safely though of as coming
from the stationary distribution. This is complicated by two factors. First, since what is
produced at convergence is not a single value but a random sample of values, somehow
the natural variability in the converged chain and the typically greater variability in the
pre-convergence samples must be distinguishable. Second, since the sampled results
come from a Markov chain, they will typically be serially correlated.

Although MCMC methods have effectively revolutionized the field of Bayesian statistics
over the past decade, any inference based upon MCMC output relies critically upon the
assumption that the Markov chain being simulated has achieved a steady state or
converged. Many techniques have been developed for trying to determine whether or
not a particular Markov chain has converged, and the paper by Brooks and Roberts
(1998) reviews some of these methods with an emphasis on the mathematics
underpinning these techniques in an attempt to summarize the current state-of-play for
convergence assessment. These are not elaborated here for brevity purposes.

A round table discussion held at the Joint Statistical meetings in August of 1996 with a
panel of experts in the field published parts of the discussion in which they discuss more
practical applications and procedures they follow. As various diagnostics are available,
these experts mentioned that use of autocorrelation plots and trace plots are amongst the
most useful and practical. The former is simply a plot demonstrating the path of the
parameter; while the latter is simply the internal correlations. These diagnostics are often
used to estimate the degree of mixing in a simulation which is the extent to which a
simulated chain traverses the entire parameter space (Kass et al. 1998).

Section 12.5: Integrating Integration & Optimization Methods

To summarize, some of the aspects addressed in the introductory section on Bayesian
framework ( 12.2) such as awkward posterior distributions and further distributional
Part V: Analytic & Computational Methods for Decision Problems
132
complexity introduced by model parameters would (otherwise) require subtle and
sophisticated or analytic approximation; however dimensionality problems typically put
out of reach the implementation of other sophisticated approximation techniques as those
introduced in 12.3. Markov chain Monte Carlo methods put to ease much of these
constraints which have otherwise limited Bayesian data analysis with the included
aspects of providing general functions of models parameters and alleviating much
awkward predictive inference. Thus, the problem of computing expectations or making
probabilistic inferences in this instance is remedied.

In problems with optimization requirements such as general loss functions, such
computational effort is not sufficient. That is, combining problems of optimization and
integration are required for decision theoretic computations. For general loss functions,
the objective is to determine the alternative a* which minimizes the expected loss. There
are two operations: (1) compute the expected loss; and (2) minimize the expected loss.

French and Insua (2000) review several optimization methods which are useful within
statistical decision theory. It is also important to note that some of the integration or
sampling methods previously described also have an optimization step to compute
maximum likelihood estimators, for instance. Thus, it only seems plausible to have
Monte Carlo optimization methods to solve such problems. Adaptive methods which try
to accomplish such a task have been developed; however, they are not without their
limitations.

An alternative approach was introduced by Shao (1989) in the statistical decision theory
literature; and is referred to as sample path optimization. The strategy follows:

1. Select a sample ) | ( ~ ,...,
1
x p
m


.

2. Solve the optimization problem

m
i
i
A a
a l
m
1
) , (
1
min

yielding ) (
m
a .

By the law of large numbers, it holds that ) (
m
a converges to a minimum expected loss
alternative a*. This approach can be extended to any form of the loss function and thus
presents some alternatives to the computational problem.

This section has introduced some of the main computational tools used in statistical
decision theory. These problems require both powerful integration and optimization
methods as well as algorithms that achieve both simultaneously.
Part V: Analytic & Computational Methods for Decision Problems
133
Section 13: Analytic Approaches to Solving Decision Problems

Part I, Part II and Part IV introduced the framework for decision models and the
construction of graphical models, respectively. The previous section emphasized some of
the computational issues which arise in decision problems. However, this was removed
from within the sequential framework described in Part III and which is eminent in
decision tree structures. This section develops upon the concepts introduced in earlier
sections and relates them to more analytic approaches to solving the problems. The
emphasis is placed on dynamic programming and progresses into its important as a
computational tool for decision problems. Sensitivity analysis is addressed last yet is
important as means of checking the sensitivity of the output, and the implications of the
findings and possible inconsistencies.

Section 13.1: Dynamic Programming

The computational methods presented in section 12 neglected decision problems which
involved a sequential approach or which had been transformed such that they could be
assessed sequentially. Sequential problems lend themselves to another extension of
optimization methods. Dynamic programming is a mathematical technique which allows
for a sequence of interrelated decisions to be made. And further, it provides a systematic
procedure for determining optimal combinations of decisions.

Hillier and Lierberman (2001) present the basic features that characterize dynamic
programming problems. These include:

1. The problem can be divided into stages, with a decision required at each stage.
2. Each stage has a number of states associated with the beginning of that stage.
3. The consequence of the decision at each stage is to transform the current state to a
state associated with the beginning of the next stage.
4. The solution procedure is designed to find an optimal choice for the overall
problem.
5. Bellmans principle (Bather, 2000): Given the current state, an optimal policy for
the remaining stages is independent of the decisions adopted in previous stages.
6. The solution begins by finding an optimal choice for the last stage.

Dynamic programming is defined by a recursive relationship. The general notation used
to describe a dynamic programming problem is summarized below:

N = number of stages
n = index for current stage
n
= current state for stage n
n
x = decision variable for stage n
*
n
x = optimal value of
n
x |
n

) , (
n n n
x f = contribution of stages N n n ,..., 1 , + to objective function

Part V: Analytic & Computational Methods for Decision Problems
134
The recursive relationship will lead to two possible forms, depending on the problem:

)} , ( { max ) (
*
n n n
x
n n
x f f
n
=
or
)} , ( { min ) (
*
n n n
x
n n
x f f
n
=

This recursive procedure induces a backward form of mathematical induction in order to
achieve the required task. This approach (as dynamic programming) was first outlined by
Bellman, and was coined such to describe the techniques which he had brought together
to study a class of optimization problems involving sequential decisions (Bather, 2000).

Sequential problems and subsequently dynamic programming problems can be classified
into two groups: deterministic and stochastic. The former approach suggests that the
state at the next stage is completely determined by the state and decision at the current
stage. The latter approach (which is probabilistic) implies that a probability distribution
will dictate what the next state will be. This probabilistic approach is more conducive to
our needs and is associated with solving decision tree diagrams.

Consider the diagram above illustrating the general structure of a stochastic dynamic
programming problem. Let S denotes the number of possible states at stage n + 1. The
system goes to state i with probability
i
p for S i ,..., 2 , 1 = , given state
n
and decision
n
x at
stage n. At state i, the cumulative information of stage n to the objective function is
represented by
i
C . This figure can be extended in such a manner for all possible stages;
and diagrammatically has the form of a decision tree.

With the inclusion of a probability distribution dictating the consequence of the next
state, means that the precise form of the objective function will differ slightly from the
one given above. It can now be written as:

), , ( min ) (
with
)] ( [ ) , (
1 1
*
1
1
*
1
1
+ + +
=
+
+
=
+ =

n n
x
n
S
i
n i i n n n
x i f i f
i f C p x f
n

where the minimization is taken over all feasible values of
1 + n
x .

In statistical decision theory
1
, it might be said that the transition from one stage to another
is controlled by a sequence of actions, given the state
n
at stage n, the choice of action
n
a
determines the probability distribution of the next state. Essentially because, we are

1
Bather provides a concise introduction to both deterministic and probabilistic dynamic programming and
its application to utility theory.
Part V: Analytic & Computational Methods for Decision Problems
135
dealing with a Markov system, only the current state is important. The state and action
variables may be discrete or continuous and the range of possible choices of an action
may vary state to state. The essential characteristic of such modeling (in summary) is
that given
n
at stage n, the choice of action or decision
n
x determines both the probability
distribution of the next state
1 + n
and the expected cost
2
of the transition
1 +

n n
.

Section 13.2: Bellmans Principle and the Bayesian Perspective

Recall that one of the fundamental elements of decision problems is the loss function and
in dynamic programming it is this objective function we tend to want to minimize. Now
consider an additive function which by definition is monotonic and separable. (See Part
II on Utility Theory.) That is if the first few terms are fixed then minimizing its whole
sum is equivalent to minimizing its individual terms - a property which holds when
taking expectations. This expounds the aforementioned Bellman Principle of Optimality:

The optimal sequential decision policy for the problem which begins with
) (

P as the decision makers prior for and has R stages to run must have the
property that is, at any stage n < N, the observations
n n
x X x X = = ,...,
1 1
have
been made, then the continuation of the optimal policy must be the optimal
sequential policy for the problem beginning with ) ,..., | (
1 n
x x P

as the prior
and having N n stages to run. (French and Insua, 2000)

French and Insua make it a point to emphasize the importance of the decision makers
prior in Bellmans principle. Since the prior describes the state of knowledge, it also
describes the state of the decision making process.

For simplicity of notation, let ) ( =

P and ) (
n
r be the Bayes risk of the optimal policy
with at most n stages left to run with knowledge . Then the situation in which the
decision maker has no option to make an observation and must choose an action can be
expressed as:

)] , ( [ min ) (
0


a l E r
A a
=

where the expectation over is taken with respect to . Next consider that the decision
maker is given the chance to make an observation. The decision maker has two options:
1. Take an action A a without making an observation at an expected loss of ) (
0
r .
2. Make a single observation X at cost and choose an action A a in light of her
current knowledge ) ( X at an expected loss of ))] ( ( [
0
X r E
X
.

Bellmans Principle assumes that after the observation(s), the optimal Bayes action is
taken (French and Insua, 2000). Accordingly, this can be extended to n observations

2
This refers to the expected loss function.
Part V: Analytic & Computational Methods for Decision Problems
136
which then give her option (1) stated above or an extension of option (2) which would
result in observations made for the remaining n -1 stages with an expected loss of

))] ( ( [
1
X r E
n X

.

Thus, for N n ,..., 2 , 1 =
))]} ( ( [ ), ( min{ ) (
1 0
X r E r r
n X n


+ = .

Note the form of this recursion formula. This defines the dynamic programming or
backward induction form introduced in the previous subsection. Thus, dynamic
programming allows for both the calculation of ) (
n
r and the characterization of the
optimal policy. This following section now extends the basic principles demonstrated in
these earlier subsections to illustrate the analytic approach to solving decision problems
as applied to utility theory or more precisely in the maximization of utilities.

Section 13.3: Analysis in Extensive Form

There are two basic modes of analysis which can be utilized to determine which course of
action will maximize the decision makers utility: the extensive form of analysis and the
normal form. The two forms are mathematically equivalent and lead to identical results;
each has something to contribute to the insight into the decision problem and have
separate technical advantages in certain situations. This section focuses on the extensive
form which equates the use of decision trees more readily.

Backwards Induction

Consider a simple decision tree whereby an initial decision results in a chance and a
subsequent action results in a final state. The extensive form of analysis proceeds by
working backwards from the end of the decision tree (the right side of the tree) to the
initial starting point: instead of starting by asking which experiment e the decision maker
should choose, the procedure starts by asking which terminal act he should choose if he
had already performed a particular experiment e and observed a particular outcome x.
Even at this point, with a known history (e, x), the utilities of the various possible
terminal acts are uncertain because which will be chosen by chance at the end is still
unknown; but this difficulty is easily resolved by treating the utility of any a for given (e,
x) as a random variable u(e, x, a,
~
)
3
and applying the operator
x
E
|
which takes the
expected value of u(e, x, a,
~
) with respect to the conditional measure
x
P
|
.
Symbolically, we can compute for any given history (e, x) and any terminal act a

)
~
, , , ( ) , , ( *
|

a x e u E a x e u
x
;


3
Recall notation introduced in Section 1 for clarification. Notation for unknown quantity is described as a
random variable in this case.
Part V: Analytic & Computational Methods for Decision Problems
137
this is the utility of being at the juncture ) , , ( a x e looking forward, before chance has made
a choice of (Raiffa and Schlaifer, 2000).

Since the decision makers objective is to maximize his expected utility, he will, if faced
with a given history (e, x), wish to choose the a (or one of the as if more than one exist)
for which ) , , ( * a x e u is greatest; and the utility of being at the terminal with history (e, x)
and the choice of a still to make is

) , , ( * max ) , ( * a x e u x e u
a
.

After ) , ( * x e u has been computed in this way for all possible histories (e, x), the problem
of the initial choice of an experiment can be addressed. At this point, the initial move,
the utilities of the various possible experiments are uncertain only because x which will
be chosen by chance is still unknown, and this difficulty is resolved in exactly the same
way that the difficulty in choosing a given (e, x) was resolved: by putting a probability
measure over the chances moves and taking expected values. In other words, )
~
, ( * x e u is
a random variable at the initial decision point because x
~
is a random variable, and
therefore it can be defined for any e

)
~
, ( * ) ( *
|
x e u E e u
e x


where
e x
E
|
expects with respect to the marginal measure
e x
P
|
.

Again, the decision maker will wish to choose the e for which ) ( * e u is greatest; and
therefore may suggest that the utility of being at the initial decision node with the choice
of e still to make is

).
~
, ,
~
, ( max max ) ( * max *
| |

a x e u E E e u u
x
a
e x
e e
=

This procedure of working back from the outermost branches of the decision tree to the
base of the trunk is often called backward induction. More descriptively it could be
called a process of averaging out and folding back.

Section 13.4: Analysis in Normal Form

The final product of the extensive form of analysis presented in the previous section can
be thought of as a description of the optimal strategy consisting of two parts:

1. A prescription of the experiment e which should be performed,
2. A decision rule prescribing the optimal terminal act a for every possible
outcome x of the chosen e.

Part V: Analytic & Computational Methods for Decision Problems
138
The whole decision rule for the optimal e can be simply determined from the part of the
analysis which determined the optimal a for every x in X; and incidentally these same
results also enable the optimal decision rule to accompany any other e in E, even though
the e in question is not itself optimal.

The normal form of analysis, also has as its end product the description of an optimal
strategy, and arrives at the same optimal strategy as the extensive form but via a different
route. Instead of first determining the optimal action a for every possible outcome x, and
thus implicitly defining the optimal decision rule for any e, the normal form of analysis
starts by explicitly considering every possible decision rule for a given e and then
choosing the optimal rule for that e. This can be done for E e such that an optimal e
can be found as in the extensive form of analysis.

Recall the decision rules as presented in Sections 2 and 3. Mathematically, a decision
rule for a given experiment e is a mapping which carries x in X into ) (x in A. Given a
particular strategy ) , ( e and a particular pair of values ) , ( x , the decision makers act as
prescribed by the rule will be ) (x a = and his utility will be ) ), ( , , ( x x e u ; but before
the experiment has been conducted and its outcome observed, )
~
), ( ,
~
, ( x x e u is a random
variable because x
~
and
~
are random variables.

The decision makers objective is therefore to choose the strategy ) , ( e which maximizes
his expected utility

)
~
),
~
( ,
~
, ( ) , ( *
| ,


x x e u E e u
e x
.

This double expectation will actually be accomplished by iterated expectation and the
iterated expectation can be carried out in either order: we can first expect over
~
holding
x
~
fixed and then over x
~
, using the same measures
, |e x
P and

P .

If e and are given and
~
is held fixed, then by taking the expectation of
] ),
~
( ,
~
, [ x d x e u with respect to
, |e x
P we obtain

] ),
~
( ,
~
, [ ) , , ( *
, |


x d x e u E e u
e x
,

which will be called the conditional utility of ) , ( e for a given state . Next taking the
expected value over
~
with respect to the unconditional measure

P , we obtain

)
~
, , ( * ) , ( *

e u E e u = ,

which can be referred to as the unconditional utility of ) , ( e .

Part V: Analytic & Computational Methods for Decision Problems
139
For any particular experiment e, the decision maker is free to choose the decision rule
whose expected utility is greatest; and therefore it may be said that the utility of any
experiment is

) , ( * max ) ( * e u e u
d
.

After computing the utility of every E e , the decision maker is free to choose the
experiment wit the greatest utility such that

].
~
),
~
( ,
~
, [ max max ) ( * max *
, |


x x e u E E e u u
e x
d e e
=

Section 13.5: Equivalence of the Extensive and Normal Form
4


The extensive and normal forms of analysis will equivalent if and only if they assign the
same utility to every potential e in E, i.e. if the formula

]
~
),
~
( ,
~
, [ max ) ( *
, |


x x e u E E e u
e x
d
n
=

derived as ) , ( * max ) ( * e u e u
d
by the normal form of analysis agrees for all e with the
formula
)
~
, ,
~
, ( max ) ( *
| |

a x e u E E e u
x
a
e x e
=

derived as )
~
, ( * ) ( *
|
x e u E e u
e x
by the extensive for. The operation
, |e z
E E is equivalent
to the expectation over the entire possibility space X and is therefore equivalent
to
x e z
E E
| |
. It follows that the formal result as presented above can be written as

]
~
),
~
( ,
~
, [ max ) ( *
| |

x x e u E E e u
x e x
d
= ,

and it is then obvious that the best will be the one which for every x maximizes

].
~
), ( , , [
|

x x e u E
x


This, however, is exactly the same thing as selecting for every x an a
x
which satisfies

)
~
, , , ( max )
~
, , , (
| |


a x e u E a x e u E
x
a
x x
=


4
See Raiffa and Schlaiffer (2000) for further details on extensive and normal form of analysis. This has
been adapted from the authors book on analysis of statistical decision problems.
Part V: Analytic & Computational Methods for Decision Problems
140
as stated by the extensive form of analysis. Letting ) ( * x denote the optimal decision
rule selected by the normal form, it has just been shown that
x
a x = ) ( * and that the
formulas ) ( * e u
n
and for ) ( * e u
e
are equivalent.

Thus, in order to choose the best e and must therefore evaluate ) ( * e u for all e in E, the
extensive and normal forms of analysis require exactly the same inputs of information
and yield exactly the same results even though the intermediate steps in the analysis are
different. If, however, e, is fixed and one wishes merely to choose an optimal terminal
action a, the extensive forma has the merit that one has only to choose an appropriate
action for the particular x which actually materializes; there is no need to find the
decision rule which selects the best action for every x which might have occurred but in
fact did not occur.

Section 13.6: Combination of Formal and Informal Analysis
5


The general model stated in the overview of modeling a decision problem is often
criticized on the grounds that utilities cannot be rationally assigned to the various
possible ) , , , ( a x e combinations because the costs, profits, or in general the
consequences of these combinations would not be certain even if were known. In
principle, such criticisms represent nothing but an incomplete definition of the state space
which can be made rich enough to include all possible pairs of value of these
unknowns. The decision makers uncertainties about these values can then be evaluated
together with his other uncertainties in the probability measure which is assigned to ,
and the analysis of the decision problem can the proceed as before.

Consider the state expressed as a doublet ) , (
) 2 ( ) 1 (
so that the state space is of the
form
) 2 ( ) 1 (
= . Thus,
) 1 (
might be the parameter of a Bernoulli process while
) 2 (
might be the cost of the product (for example). In terms of the original decision tree
in figure 4, a play was a 4-tuple ) , , , ( a x e and utilities were assigned directly to
each ) , , , ( a x e . If is split into ) , (
) 2 ( ) 1 (
, a play is 5-tuple ) , , , , (
) 2 ( ) 1 (
a x e ; utilities
are assigned to each ) , , , , (
) 2 ( ) 1 (
a x e and the utility of any ) , , , (
) 1 (
a x e is the expected
value of the random variable )
~
, , , , (
) 2 ( ) 1 (
a x e , the expectation being taken with respect
to the conditional measure on
) 2 (
given the history ) , , , (
) 1 (
a x e . This asserts the idea
that it is possible to further consider the split of a tree by only conducting a partial
analysis (and partial construction of a tree) based on
) 1 (
while holding
) 2 (
constant.

Besides cutting the decision tree before it is logically complete, the decision maker may
rationally decide not to make a complete formal analysis of even a truncated tree which
he has constructed. Thus if E consists of two experiments
1
e and
2
e , ) ( *
1
e u may be
formally worked out by evaluating


5
Raiffa and Schlaiffer (2000), French and Insua (2000), and Hillier and Lieberman (2001).
Part V: Analytic & Computational Methods for Decision Problems
141
)
~
, ,
~
, ( max ) ( *
1 | | 1
1

a x e u E E e u
x
a
e x
= ;

but after the formal analysis of
1
e is completed, it may be concluded without any formal
analysis at all that
2
e is not as good as
1
e and adopt
1
e .

That behavior is perfectly consistent with the principle of choice described in Sections 2
and 3 and readdressed in Section 6. Before making a formal analysis of
2
e , the decision
maker can think of the unknown quantity ) ( *
2
e u as a random variable v
~
. If the number
v, resulting from a formal analysis was known, was greater than the known
number ) ( *
1
e u ,
2
e would be adopted rather
1
e and the value of the information that
v v =
~
could be measured by the difference ) ( *
1
e u v in the decision makers utility which
results from this change of choice. If on the contrary v were less than ) ( *
1
e u , the
decision maker would adhere to the original choice of
1
e and the information would have
been worthless.

In other words, the random variable can be defined as

= )} ( *
~
, 0 max{
1
e u v value of information regarding
2
e ,

and before expounding such information at the cost of making a formal analysis of
2
e the
decision maker may prefer to compute its expected value by assigning a probability
measure tov
~
and then expecting with respect to this measure. If the expected value is
less that the cost, the decision maker will quite rationally decide to use
1
e without
formally evaluating ) ( *
2
e u v = . Operationally one usually does not formally compute
either the value or the cost of information on
2
e : these are subjectively assessed. The
computations could be formalized, of course, but ultimately direct subjective assessments
must be used if the decision maker is to avoid an infinite regress.

Before closing this section and the subject of incomplete analysis, it should be said that
completely formal analysis and completely intuitive analysis are not the only possible
methods of determining a utility such as ) ( *
2
e u . In many instances it is possible to make
a partial analysis in order to gain some insight but at a less prohibitive cost than a full
analysis entails.

Section 13.7: Sensitivity Analysis
6


Sensitivity analysis is an essential element of decision analysis. The principle of
sensitivity analysis is also directly applied to areas such as meta-analysis and cost-
effectiveness analysis most readily but is not confined to such approaches. This section

6
See Petitti (2000), Hillier and Lieberman (2001), and Clemen (1996).
Part V: Analytic & Computational Methods for Decision Problems
142
simply describes the overall purpose of sensitivity analysis and describes one-way and its
expansion to n-way analysis as applied to decision analysis on a very general level.

Sensitivity analysis evaluates the stability of the conclusions of an analysis to
assumptions made in the analysis. When a conclusion is shown to be invariant to the
assumptions, confidence in the validity of the conclusions of the analysis is enhanced.
Such analysis also helps identify the most critical assumptions of the analysis (Petitti,
2000).

An implicit assumption of decision analysis is that the values of the probabilities and of
the utility measure are the correct values for these variables. In one-way sensitivity
analysis, the assumed values of each variable in the analysis are varied, one at a time,
while the values of the other variables in the analysis remain fixed. When the assumed
value of a variable affects the conclusion of the analysis, the analysis is said to be
sensitive to that variable. When the conclusion does not change, when the sensitivity
analysis includes the values of the variables that are within a reasonable range, the
analysis is said to be insensitive to that variable.

If an analysis is sensitive to the assumed value of a variable, the likelihood that the
extreme value is the true value can be assessed qualitatively; perhaps, weighting the
benefit of one strategy over the other under the extreme assumption.

An extension of the one-way sensitivity analysis is the threshold analysis. In such a case,
the value of one variable is varied until the alternative decision strategies are to have
equal outcomes, and there is no benefit of one alternative over the other in terms of
estimated outcome. The threshold point is also called the break-even point at the
decision is a too-up. That is, neither of the alternative decision options being compared
is clearly favored over the other. Threshold analysis is especially useful when the
intervention is being considered for use in groups that can be defined a priori based on
the values of the variable that is the subject of the threshold analysis.

In two-way sensitivity analysis, the expected outcome is determined for every
combination of estimates of two variables, while the values of all other variables in the
analysis are held constant at baseline. It is usual to identify the pairs of values that
equalize the expected or expected utility of the alternatives and to present the results of
the analysis graphically. It is simpler to interpret the results of a two-way sensitivity
analysis with the aid of graphs.

In n-way sensitivity analysis, the expected outcome is determined for every possible
combination of every reasonable value of every variable. N-way sensitivity analysis is
analogous to n-way regression and is seemingly difficult to interpret and is not discussed
any further in this report.

It is usual to do one-way sensitivity analysis for each variable in the analysis. The
highest and the lowest values within reasonable range of values are first substituted for
the baseline estimate in the decision tree. If substitution of the highest or the lowest
Part V: Analytic & Computational Methods for Decision Problems
143
value changes the conclusions, more values within the range are substituted to determine
the range of values.

In an analysis with many probabilities, there are numerous combinations of two and three
variables, and the computational burden of doing all possible two-way and three-way
sensitivity analysis is large. For this reason, it is not usually feasible to conduct two-way
sensitivity analysis for all possible combinations let alone n-way. The choice of variables
for multiple way analysis requires considerable judgment, and therefore is not laid down
by any fast and hard rules. However, the graphical approach applied in these instances
also lends itself to the discussion of dominance considerations. In section 3, the notion of
dominant alternatives was introduced and can be considered a type of sensitivity analysis.
A graphical approach, in this instance suggests when one alternative may supercede
another and suggests possible implications.

Another area of emphasis for sensitivity analysis is the sensitivity with respect to the
prior, when applying Bayesian methodology. These are typically performed when there
is little imprecision un the loss because a standard choice of inference loss such as the
quadratic was adopted, for instance. It is usually suggested to start with this case as (a) it
is simplest and most thoroughly studied and (b) provide many insights for more general
problems. It is also notably one of the most difficult elements to assess.

The overview of statistical decision theory provided in this report places has tried to
maintain a balance between the classical and the Bayesian approach. In simple terms, the
solution of a statistical decision problem proceeds by modeling a decision makers
judgments by means of the loss function, probability model of the observation process
and a prior, and then uses these to identify a good decision rule. Thus, this presents a
variety of reasons as to why a sensitivity analysis should be conducted that is, checking
the sensitivity of the decision rule (output) with respect to the model and decision
makers judgments (inputs). In other words, the objective is to check the impact of the
loss function, the prior and the model on the Bayes decision rule or Bayes alternative, and
their posterior expected loss.


Part V: Analytic & Computational Methods for Decision Problems
144
Section 14: Prototype Example

The conceptual ideas presented thus far have laid the foundation of statistical decision
theory. The purpose of the following section is to present a prototype example which
exemplifies the key ideas and methods discussed in this report. This example has been
illustrated in many statistical decision theory books in various forms. It is illustrated in
this report and develops in much of the same way the methodological sections of this
report have.

Section 14.1: Summary of the Problem

An oil company owns a tract of land that may contain oil. A consulting geologist has
reported to management that it is believed that there is a 1 in 4 chance of oil. Because of
this prospect, another oil company has offered to purchase the land for $90,000.
However, the land-owning oil company is considering holding the land in order to drill
for oil itself. The cost of drilling is $100,000. If oil is found, the resulting expected
revenue will be $800,000, so the companys expected profit (after deducing the cost of
drilling) will be $700,000. A loss of $100,000 will be incurred if the land is dry (no oil).

Table 14.1: Prospective profits of oil company
Status of Land Payoff
Alternative Oil Dry
Drill for oil
Sell the land
$700,000
$90,000
-$100,000
$90,000
Chance of status 1 in 4

Table 14.1 summarizes the prospective profits for this land-owning company. This oil
company is operating without much capital so a loss of $100,000 would be quite serious.
Deciding whether to drill or sell also hinges on the option to conduct a detailed seismic
survey of the land to obtain a better estimate of the probability of finding oil. Thus, first
we present this prototype problem of decision without experimentation and then with
experimentation and conclude with ways of refining the evaluation of the consequences
of the various possible outcomes.

Section 14.2: Summary of the Decision Modeling Framework

The proceeding sections have explained the decision modeling framework. Here we re-
cap the framework before proceeding with the prototype example. Simply, statistical
decision problems refer to those problems containing data or observations on the state of
nature. We first consider those cases without that information; that is problems of
making decisions in the absence of data (or without experimentation). This lays a
framework for decision analysis, for the problem at hand, which is later extended to
incorporate data or decision problems with experimentation and various other decision
methodologies.

Framework for Decision Analysis:
Part V: Analytic & Computational Methods for Decision Problems
145

1. Decision maker needs to choose one of the alternatives:
A a
2. Nature would choose one of the possible states of nature:

3. Each combination of an action and state of nature would result in a
payoff/decision, which is given as one of the entries in a payoff/decision table.
C a c ) , (
4. This payoff/decision table should be used to find an optimal action for the
decision maker according to an appropriate criterion.

An additional element needs to be incorporated into this framework prior probabilities.
Many decision makers would generally want to incorporate additional information to
account for the relative likelihood of the possible states of nature. This information is
translated into a probability distribution where the state of nature is considered to be a
random variable - making up the prior probability distribution.

In general terms, the decision maker must choose an action from a set of possible actions.
The set contains all the feasible alternatives under consideration for how to proceed with
the problem of concern. This choice of an action must be made in the face of uncertainty,
because the outcome will be affected by random factors that are outside the control of the
decision maker. These random factors determine what situation is referred to as a
possible state of nature. For each combination of an action and a state of nature, the
decision maker knows what the resulting payoff (or consequence) would be. The payoff
is a quantitative measure of the value to the decision maker of the consequences of the
outcome. Although in many instances the payoff is a monetary gain, there are other
measures that can be used (as explained in utility theory). If the consequences of the
outcome do no become completely certain even when the state of nature is given, then the
payoff becomes an expected value (in the statistical sense) of the measure of the
consequences. The payoff table can be used to determine an optimal action according to
an appropriate criterion which suits the beliefs of the decision maker.

The decision problem faced by the oil company can now be placed within the decision
framework just presented. This can be summarized in the following decision
7
table:

Table 14.2: Formulation of the problem within the framework of decision analysis
Status of Land State of Nature
Alternative A
1

2

a
1
a
2
c
11
=700
c
21
=90
c
12
= -100
c
22
=90
Prior Probability 0.25 0.75

Section 14.3: Decision Making without Experimentation


7
Payoff table and decision table can be used interchangeably.
Part V: Analytic & Computational Methods for Decision Problems
146
This section illustrates the decision making process without experimentation. A
formulation of the problem being assessed has two possible actions under consideration:
drill for oil or sell the land. The possible states of nature are that the land contains oil and
that it is does not. Since the consulting geologist has estimates that there is a 1 in 4
chance of oil, the prior probabilities of the two states of nature are 0.25 (for oil) and 0.75
(for no oil). Table 14.1 has been redesigned in Table 14.2 with the payoff units in
thousands of dollars of profit. This payoff table will be used to determine the optimal
action under the three main criterions discussed here.

1. Minimax Criterion:

The minimax criterion was described in section 2. Its rationale is that it provides the best
guarantee of the payoff that will be obtained. That is, one determines, for each action a,
the maximum loss over the various possible states of nature:

) , ( max ) ( a l a M

= ,

and this provides an ordering among the possible actions. In words, for each possible
action, find the minimum payoff over all possible states of nature. Next find the
maximum of these minimum payoffs. Choose the maximum of the minimum payoff
gives the maximum.

The application of this criterion to the prototype example suggests that selling the land is
the optimal action to take. Regardless of what the true state of nature turns out to be for
the problem, the payoff from selling the land cannot be less than 90, which provides the
best available guarantee. Thus, this criterion provides the pessimistic viewpoint that
regardless of which action is selected, the worst state of nature for that action is likely to
occur, so one should choose the action which provides the best payoff with its worst state
of nature.

2. Maximum Likelihood Criterion:

The maximum likelihood function focuses on the most likely state of nature. Recall a
simple general definition of the likelihood function: For the observed data, x, the
function ) | ( ) ( x f l = , considered as a function of , is called the likelihood function.
The intuitive reason for the name maximum likelihood function is that a for which
) | ( x f is small, in that x would be more plausible occurrence if ) | ( x f were large. In
simplicity, the steps in this approach begin by identifying the most likely state of nature
(largest prior probability). For this state of nature, find the action with the maximum.
Choose this decision.

The application of this criterion to the prototype example indicates that the dry state has
the largest prior probability. In Table 10.2, in the dry cell column, the sell alternative has
the maximum payoff, so the choice is to sell the land.

Part V: Analytic & Computational Methods for Decision Problems
147
The appeal of this criterion is that the most important state of nature is most likely one, so
the action chosen is the best one for this particularly important state of nature. Basing the
decision on the assumption that this state of nature will occur tends to give a more, the
criterion does not rely on questionable subjective estimates of the probabilities of the
respective states of nature other than identifying the most likely state. However, the
major drawback of this criterion is that it completely ignores some relevant information.
No state of nature besides the most likely one is considered. Therefore, a problem with
many possible states of nature, the probability of the most likely one may be quite small
and or show little difference between quite likely states of nature.

3. Bayes Decision Rule (Expected Monetary Value Criterion):

The Bayes decision rule was introduced in Section 2. In this instance, the probability
weight assigned to each state of nature , the loss incurred for a given action incurs the
expected value:

=
i
i i
a l g a B ) , ( ) ( ) ( .

This approach uses the best available estimates of the probabilities of the respective states
of nature (current prior probabilities) and calculates the expected value of the payoff for
each of the possible actions. Choose the action with the maximum expected payoff.

In this application of the criterion, it can be easily determined that the optimal action is to
drill. The expected payoffs can be calculated from Table 14.2 directly as follows:

90
) 90 ( 75 . 0 ) 90 ( 25 . 0
) , ( ) ( ) , ( ) ( ] [
100
) 100 ( 75 . 0 ) 700 ( 25 . 0
) , ( ) ( ) , ( ) ( ] [
2 2 2 2 1 1 2
1 2 2 1 1 1 1
=
+ =
+ =
=
+ =
+ =
a l g a l g c E
a l g a l g c E




Since 100 > 90, the alternative action to drill is selected. Note that this choice differs
from the other two preceding criteria.

The advantage to the Bayes decision rule is that it incorporates all the available
information, including payoffs and the best available estimates of the probabilities of the
respective states of nature. It is sometimes argued that these estimates of the probabilities
are largely subjective and so are too shaky to be trusted. Nevertheless, under many
circumstances, past experience and current evidence enables one to develop reasonable
estimates of the probabilities. The methodology of including such information was
described in Section 3. Before applying this approach to the problem at hand, we will
consider the use of sensitivity analysis to assess the effect of possible inaccuracies in the
prior probabilities.
Part V: Analytic & Computational Methods for Decision Problems
148

Section 13 briefly discussed the role and importance of sensitivity analysis in various
applications to study the effect if some of the elements included in the mathematical
model were not correct. The decision table in Table 14.2 representing the payoffs is the
mathematical model of concern. The prior probabilities in this model are most
questionable and will be the focus of the sensitivity analysis to be conducted; however, a
similar approach could be applied to the payoffs given in the table.

Basic probability theory suggests that the sum of the two prior probabilities must equal 1,
so increasing one of these probabilities automatically decreases the other one by the same
amount, and vice versa. The oil companys management team feels that the true
chances of having oil on the tract of land are more likely to lie between the range from
0.15 to 0.35. Thus, the corresponding prior probability of the land being dry would range
from 0.85 to 0.65, respectively.

Conducting a sensitivity analysis in this situation requires the application of the Bayes
decision rule twice once when the prior probability of the oil is at the lower end (0.15)
of this range and next when it is at the upper end (0.35). When the prior probability is
conjectured to be 0.15, we find

90
) 90 ( 85 . 0 ) 90 ( 15 . 0
) , ( ) ( ) , ( ) ( ] [
20
) 100 ( 85 . 0 ) 700 ( 15 . 0
) , ( ) ( ) , ( ) ( ] [
2 2 2 2 1 1 2
1 2 2 1 1 1 1
=
+ =
+ =
=
+ =
+ =
a l g a l g c E
a l g a l g c E




and when the prior probability is thought to be 0.35, the Bayes decision rule finds that

. 90
) 90 ( 65 . 0 ) 90 ( 35 . 0
) , ( ) ( ) , ( ) ( ] [
180
) 100 ( 65 . 0 ) 700 ( 35 . 0
) , ( ) ( ) , ( ) ( ] [
2 2 2 2 1 1 2
1 2 2 1 1 1 1
=
+ =
+ =
=
+ =
+ =
a l g a l g c E
a l g a l g c E




Thus, the decision is very sensitive to the prior probability of oil as the expected payoff to
drill shifts from 20 to100 to180 when the prior probabilities are 0.15, 0.25, and 0.35,
respectively. Thus, if the prior probability of oil is closer to 0.15, the optimal action
would be to sell the land rather than to drill for oil as suggested by the other prior
probabilities. This suggests that it would be more plausible to determine the true value of
the probability of oil.

Part V: Analytic & Computational Methods for Decision Problems
149
Let p = prior probability of oil. Then the expected payoff from drilling for any p is
. 100 800
) 1 ( 100 700 ] [
=
=
p
p p c E


Figure 14-1:

















A graphical display of how the expected payoff for each alternative changes when the
prior probability of oil changes for the oil companys problem of whether to drill or sell is
illustrated in figure 14-1. The point in this figure where the two lines intersect is the
threshold point where the decision shifts from one alternative (selling the land) to the
other (drill for oil) as the prior probability increases. Algebraically, this is simple to
determine as we set

, 2375 . 0
800
190
90 100 800
] [ ] [
2 1
= =
=
=
p
p
c E c E


where c
1
is the expected payoff of the action to drill and subsequently c
2
is the expected
payoff of the action to sell the land. Thus, the conclusion should be to sell the land if p <
0.2375 and should drill for oil if p > 0.2375. Because, the decision for the oil company
decides heavily on the true probability of oil, serious consideration should be given to
conducting a seismic survey to estimate the probability more accurately. This is
considered in the next subsection.

Section 14.4: Decision Making with Experimentation

Here another element is added to the decision analysis framework posterior
probabilities. This additional element allows for testing or experimentation to be
Expected
Payoff
0.2 0.4
Drill for oil
Sell the Land
Prior Probability
Of Oil
Part V: Analytic & Computational Methods for Decision Problems
150
conducted; thus, improving the preliminary estimates of the probabilities of the respective
states of natures, i.e. the prior probabilities.

For this problem, an available option before making a decision is to conduct a detailed
seismic survey of the land to obtain a better estimate of the probability of oil. The cost is
$30,000. A seismic survey obtains seismic soundings that indicate whether the
geological structure if favorable to the presence of oil. Dividing the possible findings of
the survey into the following two categories:

USS: unfavorable seismic soundings; oil is unlikely, and
FSS: favorable seismic soundings; oil is likely to be found.

Based on past experience, if there is oil, then the probability of unfavorable seismic
soundings (USS) is

6 . 0 4 . 0 1 ) Oil State | FSS ( so , 4 . 0 ) Oil State | USS ( = = = = = P P .

Similarly, if there is no oil (state of nature = Dry), then the probability of unfavorable
seismic soundings is estimated to be

. 2 . 0 8 . 0 1 ) Dry State | FSS ( so , 8 . 0 ) Dry State | USS ( = = = = = P P

This data is used to find the posterior probabilities of the respective states of nature given
the seismic readings.

The main criterion implemented here is Bayes Theorem. Now suppose before choosing
an action, an outcome from an experiment is observed X = x. Therefore for each
i=1,2,..,n, the corresponding posterior probability is

=
= = =
= = =
= = =
n
k
k k
i i
i
P x X P
P x X P
x X P
1
) ( ) | (
) ( ) | (
) | (




Proceeding in general terms, let

n = number of possible states of nature;
P( =
i
) = prior probability that true state of nature is state i,
for i =1, 2, , n;
X = finding from experimentation ( a random variable);
x
j
= one possible value of the finding;
P( =
i
|X = x
j
) = posterior probability that true state of nature is state i, given
X = x
j
, for j = 1, 2, , n.

Thus, the question being addressed is: Given P( =
i
) and P(X = x
j
| =
i
), for i =1, 2,
, n, what is P( =
i
|X = x
j
)? The answer is solved by following standard formulas of
probability theory which states that the conditional probability,
Part V: Analytic & Computational Methods for Decision Problems
151

). ( ) | ( ) | (
gives
, ) , ( ) (
where
,
) (
) , (
) | (
1
i i j j i
n
k
j k j
j
j i
j i
P x X P x X P
x X P x X P
x X P
x X P
x X P

= = = = = =
= = = =
=
= =
= = =

=


Therefore, for i =1, 2, , n, the desired formula for the corresponding posterior
probability is the Bayes theorem as stated above.

Returning to the prototype example and applying this formula, one finds if the finding of
the seismic survey is unfavorable, then the posterior probabilities are

.
7
6
7
1
1 ) | ( ) USS Finding | Dry State (
,
7
1
) 75 . 0 ( 8 . 0 ) 25 . 0 ( 4 . 0
) 25 . 0 ( 4 . 0
) | ( USS) Finding | Oil State (
1 2
1 1
= = = = = = =
=
+
= = = = = =
x X P P
x X P P

Note that USS = x
1
and FSS = x
2
. Similarly, if the seismic survey is favorable, then
.
2
1
2
1
1 ) | ( ) FSS Finding | Dry State (
,
2
1
) 75 . 0 ( 2 . 0 ) 25 . 0 ( 6 . 0
) 25 . 0 ( 6 . 0
) | ( SS) F Finding | Oil State (
2 2
2 1
= = = = = = =
=
+
= = = = = =
x X P P
x X P P

Probability Tree diagrams can be a useful and visually appealing way of organizing the
outcomes and the corresponding probabilities. Such a diagram is presented in Figure 14-
2. Reading the probability diagram from left to right one can see all the probabilities
prior probabilities to conditional probabilities to joint probabilities leading to the
posterior probabilities. After these computations have been completed, Bayes decision
rule can be applied again just as before, with the posterior probabilities replacing the
prior probabilities. Again using the payoffs (in units of thousands of dollars) from
Table 14.2 and subtracting the cost of experimentation, we obtain the results shown
below.

Figure 14-2:






Prior
Probabilities
Conditional
Probabilities
Joint
Probabilities
Posterior
Probabilities
0
.2
5
0.6
0
.
7
5
0.4
0.2
0.8
0.25(0.6)=0.15
0.25(0.4)=0.1
0.75(0.2)=0.15
0.75(0.8)=0.6
0.15/0.3=0.5
0.1/0.7=0.14
0.15/0.3=0.5
0.6/0.7=0.86
Part V: Analytic & Computational Methods for Decision Problems
152

The expected payoffs if finding is unfavorable seismic soundings:
60
30 ) 90 (
7
6
) 90 (
7
1
)] | ( [
7 . 15
30 ) 100 (
7
6
) 700 (
7
1
)] | ( [
1 2 2
1 1 1
=
+ = =
=
+ = =
x X a c E
x X a c E


And the expected payoffs if the finding is favorable seismic surroundings:

60
30 ) 90 (
2
1
) 90 (
2
1
)] | ( [
270
30 ) 100 (
2
1
) 700 (
2
1
)] | ( [
2 2 2
2 1 1
=
+ = =
=
+ = =
x X a c E
x X a c E


Table 14-3: Optimal Policies
Finding from
Seismic Survey
Optimal
Action
Expected Payoff
Excluding Cost of Survey
Expected Payoff Including
Cost of Survey
USS
FSS
Sell
Drill
90
300
60
270

Since the objective is to maximize the expected payoff, these results yield the optimal
policy shown in Table 14-3. However, this analysis has not yet addressed the issue of
whether the expense of conducting a seismic survey is truly valuable or whether one
should choose the optimal solution without experimentation. This issue is addressed
next.

The Value of Experimentation can be determined by using two complementary
methods. The first assumes (unrealistically) that the experiment will remove all
uncertainty about what the true state of nature is, and then calculates the resulting
improvement in the expected payoff (ignoring the cost of the experiment). This
quantity, the expected value of perfect information, provides an upper bound on the
potential value of the experiment. Therefore, if the upper bound is less than the cost of
experiment, than the experiment should be forgone. However, if this upper bound
exceeds the cost of experiment, then second methods should be implemented. This
method calculates the actual improvement in the expected payoff (ignoring the cost of
experiment) that would result from performing the experiment. Comparing the
improvement with the cost indicates whether the experiment should be performed.

1. Expected Value of Perfect Information

Suppose that the experiment could definitely identify the true state of nature thereby
providing perfect information. Whichever state of nature is identified, you naturally
Part V: Analytic & Computational Methods for Decision Problems
153
choose the action with the maximum payoff for the state. Since we do not know in
advance the state of nature which will be identified, a calculation of the expected payoff
or consequence with perfect information (ignoring the cost of the experiment), requiring
the weighting of the maximum payoff for each state of nature by the prior probability of
that state of nature is needed.

Expected payoff with perfect information = 0.25(700) + 0.75(90) = 242.5.

Thus, if the oil company could learn more before choosing its action whether the land
contains oil, the expected payoff as of now (before acquiring this information) would be
$242,500 (excluding the cost of the experiment generation the information.)

To evaluate whether the experiment should be conducted, we calculate the expected
value of perfect information (EPVI)
8
:

EPVI = E[payoff with perfect information] E[payoff without experimentation]

Thus, since experimentation usually cannot provide perfect information, EVPI can
provide an upper bound on the expected value of experimentation. For this prototype
example, EVPI = 242.5 100 = 142.5, where the expected payoff without
experimentation was determined earlier to be 100 under Bayes decision rule. Since
142.5 far exceeds 30, the cost of experimentation (a seismic survey) is shown to be
worthwhile. Thus, we carry on and implement the second method of evaluating the
potential benefit of experimentation.

2. Expected Value of Experimentation

Now we want to determine expected increase directly which is referred to as the expected
value of experimentation. Calculating this quantity requires first computing the expected
payoff with experimentation (excluding the cost of experimentation). Obtaining this
latter quantity requires the previously determined posterior probabilities, the optimal
policy with experimentation, and the corresponding expected payoff (excluding the cost
of experimentation) for each possible finding from the experiment. Then each of these
expected payoff needs to be weighted by the probability of the corresponding finding,
that is,
Expected payoff with experimentation =

= =
j
j j
x X c E x X P ] | [ ) ( ,
where the summation is taken over all possible j and c denotes the payoff or consequence.
For the prototype example much of the work has been done for the right side of the
equation. The values of ) (
j
x X P = for each of the two possible findings from the seismic
survey unfavorable or favorable were calculated at the bottom of the probability tree
diagram in Figure 14.2 to be 7 . 0 ) (
1
= x P and 3 . 0 ) (
2
= x P . For the optimal policy with

8
The value of perfect information is a random variable equal to the payoff with perfect information minus
the payoff without experimentation. Thus the expected value of perfect information is the expected value of
this random variable.
Part V: Analytic & Computational Methods for Decision Problems
154
experimentation, the corresponding expected payoff for each finding can be obtained
from Table 14.3 as

. 270 ) | (
, 90 ) | (
2
1
= =
= =
x X c E
x X c E


Then the expected payoff with experimentation is determined to be 0.7(90) + 0.3(300) =
153. Similar to before the expected value of experimentation (EVE) can be calculated as

EVE = 153 = 100 = 53

and identifies the potential value of the experimentation. Since this value exceeds 30, the
cost of conducting a detailed seismic survey shows valuable.

Section 14.5: Decision Trees

Decision trees are useful in providing a visual display of the sequential decision
processes and subsequent consequences. It can help in organizing the computational
work that has been described thus far.

This prototype problem involves a sequence of two decisions which each result in
possible consequences and in turn resulting in further decisions and consequences. It
involves a sequence of two decisions:

1. Should a seismic survey be conducted before an action is chosen?
2. Which action (drill for oil or sell the land) should be chosen?

The corresponding decision tree (with partially added numbers and performing
computations) is displayed in Figure 14.3. Note that this is the final decision tree and
was done to save space and time. Recall from Section 9, the interpretation of the specific
types of nodes. The nodes of the decision tree are referred to as forks, and the arcs are
called branches. A decision fork, represented by a square, indicates that decision needs
to be made at that point in the process. A chance fork, represented by a circle, indicates
that a random event occurs at that point.

In this example, the first decision is represented by a decision fork a. Fork b is a chance
fork representing the random event of the outcome of the seismic survey. The two
branches emanating from fork b represent the two possible outcomes of the survey. The
decisions c and d follow the possible outcomes and result in the consequences from the
random events of f and g. Similarly, decision fork e leads to a chance fork h, where
again the two branches correspond to the two possible states of nature.

Since the decision tree is filled in with the available information, thus far some
interpretation can be deduced before the actual analysis proceeds. The numbers under or
over the branches that are not in parentheses are the cash flows that occur at those
branches. The resulting in end payoff is recorded in boldface at the end of the terminal
Part V: Analytic & Computational Methods for Decision Problems
155
branch. At each chance fork, the probabilities of random events are recorded in
parentheses. From chance fork h, the probabilities are the prior probabilities as no
seismic survey was conducted. The probabilities emanating from chance fork b are the
probabilities of these findings while the probabilities emanating from chance fork f and g
are the posterior probabilities of the states of nature, given the finding from the seismic
survey.

Performing the Analysis

The backward induction procedure was introduced in Section 10 and is implemented here
for the prototype example. The steps involved can be summarized as follows:

1. Start at the right side of the decision tree and move left one column at a time.
For each column, perform either step 2 or 3 depending on whether the forks in
that column are chance forks or decision forks.
2. For each chance fork, calculate the expected payoff by multiplying the
expected payoff of each branch (shown in boldface to the right of the branch)
by the probability of that branch and then summing these products. Record
this expected payoff for each decision fork in boldface next to the fork, and
designate this quantity as also being the expected payoff for the branch
leading to the fork.
3. For each decision fork, compare the expected payoffs of its branches and
choose the alternative whose branch has the largest expected payoff. In each
case, record the choice on the decision tree by inserting a double dash as a
barrier through each rejected branch.

To begin the procedure, consider the rightmost column of forks, namely, chance forks f,
g, and h. Applying step 2, their expected payoffs are calculated as

. 100 ) 100 (
4
3
) 700 (
4
1
] [
, 270 ) 130 (
2
1
) 670 (
2
1
] [
, 7 . 15 ) 130 (
7
6
) 670 (
7
1
] [
= + =
= + =
= + =
h
g
f
c E
c E
c E


Note that ] [
k
c E denotes the expected payoff or consequence of the k
th
chance fork. These
expected payoffs are placed above these forks as displayed in Figure 14.3. Next, moving
one column to the left, are the decision forks c, d, and e. The expected payoff for a
branch that leads to a chance fork now is recorded in boldface over that chance fork.
Therefore, step 3 can be applied as follows.

Part V: Analytic & Computational Methods for Decision Problems
156
drill. choose so , 90 100
. 90 )] ( [
, 100 )] ( [
drill. choose so , 60 270
. 60 )] ( [
, 270 )] ( [
sell. choose so , 7 . 15 60
. 60 )] ( [
, 7 . 15 )] ( [
1
2
1
1
2
1
2
2
1
= >
=
=
= >
=
=
= >
=
=
a
a c E
a c E
a
a c E
a c E
a
a c E
a c E
e
e
d
d
c
c


Next, move one column to the left again and apply step to the chance fork b. Here we
find that . 123 ) 270 ( 3 . 0 ) 60 ( 7 . 0 ] [ = + =
b
c E In the final step, we consider the last decision
fork a and apply step 3 as before:

survey. seismic do choose so , 100 123
. 100 )] ( [
, 123 )] ( [
01
02
01
= >
=
=
a
a c E
a c E
a
a


Note a
01
denotes the action to do a seismic survey where a
02
denotes the action to not
conduct a seismic survey. Now the decision tree is complete where the payoffs are given
on the far right side.

Figure 14-3:


















D
o

S
e
i
s
m
i
c

S
u
r
v
e
y
N
o

S
e
i
s
m
i
c

S
u
r
v
e
y
U
n
fa
v
o
r
a
b
le
F
a
v
o
r
a
b
l
e
Drill
Sell
Drill
Sell
Drill
Sell
Oil(0.143)
0
800
-100
670
-130
60
670
-130
60
700
-100
90
-15.7
60
123
123 270
100
270
100
90
Dry(0.857)
Part V: Analytic & Computational Methods for Decision Problems
157
The double dashes have blocked off the undesirable paths. According to Bayes decision
rule, follow the open paths from left to right. Thus, the optimal policy is:

Do the seismic survey.
If the result is unfavorable, sell the land.
If the result is favorable, drill for oil.
The expected payoff (including the cost of the seismic survey) is $123,000.

This was the same unique optimal solution obtained in the earlier section without the
decision tree which was shown in Table 14.3. The optimal policy via the backward
induction process leads to the same policy or policies via the more formal process.

Section 14.6: Utility Theory

This section will focus on various models of individual rationality which can be
categorized into an individuals traits. Thus far, when applying the Bayes decision rule,
we have assumed that the expected payoff or consequence in monetary terms is the
appropriate measure of the consequences of taking an action. However, in many
situations this assumption is inappropriate. Fortunately, there is a way of transforming
monetary values to an appropriate scale that reflects the decision makers preferences.
This scale is referred to as the utility function for money.

A utility function for money illustrates an individuals behavior pertaining to money. A
person who is risk-averse will exhibit a decreasing marginal utility function. However,
individuals who are risk seekers demonstrate an increasing marginal utility for money.
The intermediate case is that of a risk-neutral individual, who prizes money at its face
value. Such an individuals utility for money is simply proportional to the amount of
money involved. It is possible to exhibit a mixture of these kinds of behavior. For
example, an individual might be essentially risk-neutral with small amounts of money,
then become a risk seeker with moderate amounts, and then turn risk-averse with large
amounts. Moreover, ones attitude toward risk can change over time and circumstances.

The fact that different people have different utility functions for money has an important
implication for decision making in the face of uncertainty. When a utility function for
money is incorporated into a decision analysis approach to a problem, this utility function
must be constructed to fit the preferences and values of the decision maker involved. The
key to constructing the utility function for money to fit the decision maker is based on the
fundamental properties explained in Section 6. The following fundamental property
summarizes in words the central notion that under the assumptions of utility theory, the
decision makers utility for money has the property that the decision maker is in different
between two alternative courses of action if the two alternatives have the same expected
utility.

The scale of the utility function is irrelevant. It is only the relative values of the utilities
that matter. All the utilities can be multiplied by any positive constant without affecting
which alternative course of action will have the largest expected utility. To summarize
Part V: Analytic & Computational Methods for Decision Problems
158
the basic role of utility function in decision analysis is to simply state that when the
decision makers utility function for money is used to measure the relative worth of the
various possible monetary outcomes, Bayes decision rules replaces monetary payoffs by
the corresponding utilities. Therefore, the optimal action (or sequence of actions) is the
one which maximizes the expected utility. Although only utility functions for money are
discussed in this section, they can be constructed for consequences of the alternatives of
action that are not monetary.

Returning to the prototype example, recall in the summary of the problem it was stated
that the oil company was operating without much capital, so a loss of $100,000 would be
steep. The worst case scenario is to conduct a seismic survey and then drill for $100,000
and drill when there is no oil. On the other hand, striking oil is an exciting prospect of
earning $700,000. To apply the decision makers utility function for money to the
problem as described earlier, it is necessary to identify the utilities for all possible
monetary payoffs. These payoffs and their corresponding utilities are presented in Table
14-4 and can be obtained by the following methodology.

Table14-4: Utilities for oil company
Monetary Payoff Utility
-130
-100
60
90
670
700
-150
-105
60
90
580
600

As a starting point in constructing the utility function, it is natural to let the utility of zero
money be zero, so 0 ) 0 ( = u . An appropriate next step is to consider the worst scenario
and best scenario and then to address the question of what value of p would make the
decision maker indifferent between two alternatives. Suppose the decision makers
choice is
5
1
= p . If ) (M u denotes the utility of a monetary payoff of M, this choice of p
implies that
1). e alternativ of (utility 0 ) 700 (
5
1
) 130 (
5
4
= + u u

The value of either ) 130 ( u or ) 700 ( u can be set arbitrarily to establish the scale of the
utility function. By choosing 150 ) 130 ( = u , this equation yields . 600 ) 700 ( = u To
identify u(-100), a choice of p is made that makes the decision maker indifferent between
a payoff of -130 with probability p or definitely incurring a payoff of -100. The choice is
p = 0.7, so

. 105 ) 150 ( 7 . 0 ) 130 ( ) 100 ( = = = u p u

Part V: Analytic & Computational Methods for Decision Problems
159
To obtain ) 90 ( u , a value of p is selected that makes the decision maker in different
between a payoff of 700 with probability p or definitely obtaining a payoff of 90. The
value chosen is p = 0.15, so

. 90 ) 600 ( 15 . 0 ) 700 ( ) 90 ( = = = u p u

To obtain the decision makers utility function for money, a smooth curve was drawn
through ) 700 ( and ), 90 ( ), 100 ( ), 130 ( u u u u as shown in Figure 10-4. The values on this
curve at M = 60 and M = 670 provide the corresponding utilities, 60 ) 60 ( = u and
580 ) 670 ( = u , which completes the list of utilities displayed in Table 10.4. For contrast,
the dashed line drawn at a 45 shows the monetary value of the payoffs used exclusively
in the preceding sections. Note how ) (M u essentially equals M for small values of M,
and then how ) (M u gradually falls off M for larger values of M. This is a typical of a
moderately risk-averse individual.

There are other approaches of estimating ) (M u ; however, they are not necessarily
appropriate in this instance. Decision trees can also be used in an identical fashion to the
analysis in the preceding section except for substitution utilities for monetary payoffs.
For this analysis of a drilling decision we add an extra element, for variety purposes. We
also give a more general analysis perspective to end this section.

14.7: Combination of Formal and Informal Analysis

Continuing with the same problem, the desirability of drilling depends on the amount of
oil which will be found oil or no oil. Before making this decision, the oil company
wishes to obtain more geological and geophysical evidence by means of a seismographic
recording which is quite expensive. It is also assumed that these recordings, if made, will
give completely reliable information that one of the tree conditions prevails; (1) there is
no subsurface structure, (2) there is an open subsurface structure, or (3) there is a closed
subsurface structure. The descriptions of the four spaces, A, , E, X, are summarized in
Table 14-5 and the possible sequence of choices are displayed in the decision tree in
Figure 14-5.

Table 14.5: Possible Choices
Space Elements Interpretations
A a
1
a
2

Drill, do not sell location
Do not drill, sell location

1

2
Oil
No oil
E e
1
e
2

Do not take seismic readings
Take seismic readings
X x
0
x
1
x
2
x
3

Dummy outcome of e
0

e
1
reveals no structure
e
2
reveals open structure
e
3
reveals closed structure
Part V: Analytic & Computational Methods for Decision Problems
160

Assignment of Utilities

The psychological stimulus associated in this problem with a ) , , , ( a x e 4-tuple is highly
complicated. Different wells entertain different drilling costs, and different strike
produce different quantities and qualities of oil which can be recovered over different
periods of time and sold at different prices. Furthermore, each potential consequence of
the present drilling venture may interact with future potential drilling ventures such as
geological information gained.

There are uncertainties surrounding any particular ) , , , ( a x e complex which must be
compared formally or informally. Assume, nevertheless, that the decision maker can
assign to utility numbers to reflect his preferences. This presents the idea of cutting the
decision tree presented in Section 4 and 9.

Assignment of Probabilities

The assignment of a probability measure to the probability space X bears more
importance on the conditional (or posterior) measure
x
P
|
and the marginal measure
e x
P
|
than on the complementary measures
, |e x
P and

P . Previous experience with the
amounts of oil found in the three possible types of geological structure (x
1
= no structure,
x
2
= open structure, x
3
= closed structure) may make it possible to assign a nearly
objective measure
x
P
|
to the amount of oil which will be found given any particular
experiment result, whereas it would be much less clear what measure

P should be
assigned to the amount of oil in the absence of knowledge of the structure. At the same
time it will in general be much more meaningful to a geologist to assign a marginal
measure
e x
P
|
to the various structures and thus to the sample space X than it would be to
assign conditional measures
, |e x
P to X depending on the amount of oil which will be
found. The hypothetical measures
x
P
|
and
e x
P
|
are shown on those branches of the decision
tree in Figure 6.11 which emanate from e
1
; the prior probabilities } {
1

P =0.2 and
} {
2

P =0.8 shown on the branches emanating from e

0
were computed from them by use
if the formula

). | ( ) | ( ) | ( ) | ( ) | ( ) | ( ) (
1 3 3 1 2 2 1 1 1
e x P x P e x P x P e x P x P P
x i x i x i i


+ + =

Analysis

Since all the data required for analysis appears in the decision tree in Figure 14-5, it can
be easily verified that the optimal decision is to pay for seismographic recordings (e
1
) and
then drill (a
1
) if and only if the recordings reveal open (x
2
) or closed (x
3
) structures. It is
worthwhile to pay for the recordings because the expected utility of this decision is 15.25
whereas the expected utility of the optimal act without seismic information is 0.

References
161
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Courses and Professors:

STA4276H (2003): MCMC algorithms by Professor Jeffrey Rosenthal.
CHL5223H (2002/3): Applied Bayesian Methods by Professor Michael Escobar
(meetings).