Expected Values of Perfect Information in Business

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  • 0:05 Business Decisions
  • 1:06 Expected Value
  • 4:40 Perfect Information
  • 6:29 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

When making a business decision, the more information you have, the better. But how much is information worth to a company? This lesson will help explain the expected values of perfect information.

Business Decisions

Laurie has just been hired as the CEO of a tech company and she's now in charge of all of the company's operations. That's a big job! One of the idea's she has to boost the company's profit is to outsource the company's customer service division. That is, she wants to have a different company do all the customer service for their products and pay them a fee rather than paying the salaries, benefits, and office space of having a customer service division. That seems like a good idea, but what if something goes wrong? What if the new plant ends up costing Laurie's company more money? Laurie needs more information. But what is that information worth to her?

The expected value of perfect information (EVPI) measures how much better a decision-maker could do if she or he knows for certain which state of nature would occur. It gives a person like Laurie an idea of how much money it would be worth to continue gathering information until she reaches certainty. To help Laurie figure out the EVPI for her situation though, first we have to understand and calculate the expected value.

Expected Value

Okay, Laurie wants to figure out whether to keep things as they are, or outsource the customer service part of her company to a subcontractor. But there are a lot of things that could happen. For example, the state where the subcontractor is located is considering charging a tax on all companies that do business in that state. If Laurie subcontracts the customer service and then the new tax goes into effect, her business could end up owing a lot of money.

What Laurie is facing a state of nature, which in business is something over which a company has no control but that can impact a company's bottom line. Laurie can't control whether the tax will go into effect or not, but she can consider it when making her decision. As Laurie sees it, she has two decision alternatives or, options to choose from: keep the customer service division as it is or outsource it.

Of course, there are many other options that Laurie could consider, such as changing the structure of the customer service division or outsourcing to another company. But right now she's only considering those two alternatives: leave it unchanged or outsource it to Company A. So Laurie needs to figure out which is the best option- but how? One way to do that is to calculate the expected value of each decision alternative, which is the weighted sum of a decision alternative across different states of nature. If that sounds complicated, don't worry! We'll help Laurie calculate the expected value of each option and that should make it more clear.

The first thing Laurie does is construct a table so that she can see all her options and all possible states of nature. Along the left side, she's labeled each row to represent a decision alternative, keep the division or outsource to Company A. Along the top, she's labeled each column according to different states of nature: the tax does, or does not, go through. Now, in each cell, Laurie fills in what will happen with her company for that decision alternative in that state of nature. In Laurie's case, she wants to know the cost of each decision alternative in each state of nature.

For example, if she keeps the customer service department as it is, her company will spend $750,000 on it in the next year. This is the same number whether or not the tax goes through because the tax won't affect the company's costs if the department stays in the company. But what if she chooses to outsource? In that case, she has two different numbers. If the tax does not pass, she calculates that her company's costs will only be $450,000. That's good! But if the tax does pass, then she has to factor in the cost of the tax, which means it will end up costing her $950,000. Not so good!

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