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Value of Perfect Information

Evaluating decisions using decision trees has limitations: (1) Decision trees become too complex for complex decisions. (2) Decision trees rely on expected value, so they have the same benefits and limitations as expected value. (3) Probabilities in decision trees are estimates that may be unreliable. Perfect information predicts the future with 100% accuracy while imperfect information is better than none. The value of information is the difference between expected value with and without that information. Information reduces risk and improves the ability to make the best decision. The value of information is calculated as the difference in expected values with and without that information.

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SHIVAM BARANWAL
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152 views2 pages

Value of Perfect Information

Evaluating decisions using decision trees has limitations: (1) Decision trees become too complex for complex decisions. (2) Decision trees rely on expected value, so they have the same benefits and limitations as expected value. (3) Probabilities in decision trees are estimates that may be unreliable. Perfect information predicts the future with 100% accuracy while imperfect information is better than none. The value of information is the difference between expected value with and without that information. Information reduces risk and improves the ability to make the best decision. The value of information is calculated as the difference in expected values with and without that information.

Uploaded by

SHIVAM BARANWAL
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Evaluating decisions by using decision trees has a number of limitations.

(a) Decision trees are not very suitable for use with complex decisions because the decision tree
becomes too big and complicated to follow.
(b) Decision trees are just a graphical way of making a decision based on the expected value rule. So
the decision tree method has all the benefits and limitations of EV as a decision rule.
(c) The probabilities associated with different branches of the 'tree' are likely to be estimates, and
possibly unreliable or inaccurate. (In the same way, estimates of probabilities with the EV decision
rule method may be unreliable.)

6 The value of information


FAST FORWARD
Perfect information is guaranteed to predict the future with 100% accuracy. Imperfect information is
better than no information at all but could be wrong in its prediction of the future.
The value of perfect information is the difference between the EV of profit with perfect information and
the EV of profit without perfect information.

The risk or uncertainty in a decision can be reduced by obtaining information about the likely outcome
situation. Information about the likely outcome has value, because it improves the likelihood of making the
best possible decision when faced with a number of different options.
The value of information can be calculated on the assumption that the EV decision criterion is used. The
value of information is the difference between the EV of a decision if no information is available and the EV
of the decision if the information is made available.
Information may be either perfect or imperfect.

Key term Perfect information is information that predicts with 100% accuracy what the outcome situation will be.
Having perfect information removes all doubt and uncertainty from a decision, and enables managers to
make decisions with complete confidence that they have selected the best decision option.

6.1 The value of perfect information 6/13


Step 1 If we do not have perfect information and we must choose between two or more decision
options, we would select the decision option which offers the highest EV of profit (or lowest EV
of cost). This option will not be the best decision under all circumstances. There will be some
probability that what was really the best option will not have been selected, given the way actual
events turn out.
Step 2 With perfect information, the best decision option will always be selected. The decision
option that is selected will differ according to what the outcome situation will be. The choice
will be the outcome that gives the highest profit (or lowest cost) in the circumstances that
we know will occur. We can calculate an EV of profit, given the different possible outcomes
and their associated probabilities. The EV of profit with perfect information should be higher
than the EV of profit without the information.
Step 3 The value of perfect information is the difference between the EV of profit with perfect
information and the EV of profit with the information.

Part B Decision-making techniques  7: Risk and uncertainty 201


6.2 Example: The value of perfect information
The management of Ivor Ore must choose whether to go ahead with either of two mutually exclusive
projects, A and B. The expected profits are as follows.

Profit if there is Profit if there is Profit/(loss) if there


strong demand moderate demand is weak demand
Option A $4,000 $1,200 $(1,000)
Option B $1,500 $1,000 $500
Probability of demand 0.2 0.3 0.5

Required
(a) Ascertain what the decision would be, based on expected values, if no information about demand
were available.
(b) Calculate the value of perfect information about demand.

Solution
Step 1 If there is no information to help with the decision, the project with the higher EV of profit
would be selected.
Probability Project A Project B
Profit EV Profit EV
$ $ $ $
0.2 4,000 800 1,500 300
0.3 1,200 360 1,000 300
0.5 (1,000) (500) 500 250
660 850

Project B would be selected and the EV of the decision is + $850.


This is clearly the better option if demand turns out to be weak. However, if demand were to
turn out to be moderate or strong, project A would be more profitable. There is a 50%
chance that this could happen (30% + 20%).
Step 2 Perfect information will indicate for certain whether demand will be weak, moderate or
strong. If demand is forecast 'weak', project B would be selected. If demand is forecast as
'moderate', project A would be selected, and perfect information would improve the profit
from $1,000, which would have been earned by selecting B, to $1,200.
If demand is forecast as 'strong', project A would again be selected, and perfect information
would improve the profit from $1,500, which would have been earned by selecting B, to
$4,000.

Forecast Project
demand Probability chosen Profit EV of profit
$ $
Weak 0.5 B 500 250
Moderate 0.3 A 1,200 360
Strong 0.2 A 4,000 800
EV of profit with perfect information 1,410

Step 3 $
EV of profit without perfect information (ie if project B is always chosen) 850
EV of profit with perfect information 1,410
Value of perfect information 560
Provided that the information does not cost more than $560 to collect, it would be worth
having, on the assumption that the EV decision rule is applied.

202 7: Risk and uncertainty  Part B Decision-making techniques

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