Value of Information

The starting point in all of this is to define what information is , Information is knowledge , facts,
data ,details about a subject. Information reduces uncertainty. To perform better than the
competition, companies need to make effective decisions. This requires valuable information and
Business Intelligence.

Value of Information (VoI) is a concept from decision analysis that explains how much
answering a question allows a decision-maker to improve its decision.

To understand the real meaning of value of information lets take a simple case.

Say there are two bags. One contains $50 and the other is empty. You have to pick a big , and
whatever is in the bag becomes yours . What amount would you pay to someone to reveal it to
you which bag contains $50? Well you wouldnt pay $50, and you would probably pay more
than $1. You might probably pay $49. Thus the value of information referring to which bag
contains the $50 is $49.

Such decisions are taken often regularly in a business. Businesses place a value on information
every time they buy competitive intelligence, recruit a consultant, invest in information systems,
or hire a knowledge worker.

There are two extremely important characteristics of VoI that always hold for any decision
situation;

Value of information can never be less than zero since the decision-maker can always
ignore the additional information and makes decision as if such information is not
available.

No other information gathering/sharing activities can be more valuable than that

We use decision analysis to assess the value of collecting information.

Value of information is further divide into :

1. Value of perfect information

Value of Perfect Information :

In decision theory, the expected value of perfect information (EVPI) is the price that one would
be willing to pay with a goal to gain access to perfect information.
EVPI measures how much better we could do on a certain decision if we could always know
when each state of nature would occur, where

EVwPI = Expected Value Under Perfect Information

EVUII = Expected Value of the best action with imperfect information (also
called EVBest )

EVPI = EVUPI EVUII

Problem 1:
Balbies Candy Shop is considering the introduction of a new line of products. In order to
produce the new line, the bakery is considering either a major or minor renovation of the current
plant. The market for the new line of products could be either favorable or unfavorable.
Bascombs Candy has the option of not developing the new product line at all. Develop the
appropriate decision tree.
Solution :

Steps for constructing decision tree :

Step 1 Identify all decisions (and their alternatives) to be made and the order in which they
must be made. In this case it is to choose one out of three decisions that are , either go for major
renovation or minor renovation or nothing at all.

Step 2 Identify the chance events that can occur after each decision. In this case , market can
be either favorable or unfavorable.

Step 3 Develop a tree diagram showing the sequence of decisions and chance events. The tree
is built starting from left and moving towards right.
The square box signifies a decision point at which the numerous available strategies are
considered. The circle O represents the chance Node or Event, the various state of nature or
outcomes comes out from this node.

Step 4 The next step is to calculate the value at every branch by applying the appropriate
probability values and financial data to each of the branches and sub-branches of the decision.

Step 5 Solve the decision tree using steps mentioned above and then we proceed to choose
that branch of the tree that has the largest expected value , that maximizes the decision criteria .
Problem 2:
With major renovation, at Balbies Candy Shop the payoff from a favorable market is $500,000,
from an unfavorable market $-70,000 . Minor renovations and favorable market has a payoff of
$20,000 and an unfavorable market $-10,000. Assuming that a favorable market and an
unfavorable market are equally likely, solve the decision tree.

Solution :
Therefore, the appropriate choice under equally likely market conditions is to make the minor
( EMV $10,000.)
modifications

Problem 3:
Jeff Heyl, the owner of Bascombs Candy (Problem 1 and 2 above) realizes that he should get
more information before making his final decision. He decides to contract with a market research
firm to conduct a market survey. How much should Jeff be willing to pay for accurate
information (i.e. What is the Expected Value of Perfect Information, EVPI?)?

Solution :
With knowledge of when a favorable market will occur, Jeffs best payoff is major renovation.
1
2 $100,000 * .5 $50,000
This happens the time.

1
2
When unfavorable market exists, Jeff will do nothing, which happens the time.
0 * .5 = $0.0

yields ($100,000 * .5) (0 * .5) $50,000

Therefore EMV is $10,000 vs. $50,000 with Perfect Information

Value of Imperfect Information

Imperfect information - The forecast is usually correct, but can be incorrect. Imperfect
information is not as valuable as perfect information

To determine the value of the imperfect information, we see how much better it is compared to
making the decision under uncertainty. This value is called EVSI = Expected Value of Sample
Information or EVII = Expected Value of Imperfect Information.

Problem :
You have the mineral rights to a piece of land that you believe may have oil underground. There
is only a 10% chance that you will strike oil if you drill, but the profit is $200,000.

It costs $10,000 to drill. The alternative is not to drill at all, in which case your profit is zero.

Should you drill? Draw a decision tree to represent your problem.

(b) Before you drill, you may consult a geologist who can assess the promise of the piece of land.
She can tell you whether the prospects are good or poor, but she is not a perfect predictor. If there
is oil, the probability that she will say there are good prospects is 95%. If there is no oil, the
probability that she will say prospects are poor is 85%.

Draw a decision tree and calculate the value of imperfect information for this geologist. If the
geologist charges $7,000, would you use her services?

Solution :

EV ('Drill') = ($190K 0.1) + (-$10K 0.9) = $10K.

b) We will calculate the Expected Value of profits if we employ the geologist.

If this exceeds $10,000, the geologist would be worth employing as long as the benefit of
employing her exceeds her charge of $7,000.

If we employ the geologist, the probabilities of her possible assessments can be tabulated as
follows (assume 1,000 drills in total):

A decision tree can be drawn to calculate the expected value of profits if a geologist is employed:
Working from right to left:

EVA = (41.30% $200,000) - $10,000 drilling costs = $72,600.The decision at 'C' should be to
drill, as this generates higher benefits than not drilling.

EVB = (0.65% $200,000) - $10,000 drilling costs = -$8,700. The decision at 'D' should be not
to drill.

EVC = 0.23 $72,600 = $16,698. This is the expected value of profits if a geologist is employed
and exceeds the EV of profits if she is not employed.

Expected Value of Imperfect Information = $16,698 - $10,000 =$6,698.

Since this is less than the cost of buying the information($7,000), we should not employ the
geologist.