The Little Blue Reasoning Book - Brandon Royal [21]
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UTILITY ANALYSIS
Tip #16: Utility analysis takes into account desirability of outcomes, which may be different from monetary payoffs.
Utility is “desirability.” Utility analysis is useful in those situations in which we seek to match utility with probability. In other words, these two terms must be distinguished at the outset. Utility is “what we want”; probability is “what we get.”
Consider for a moment the dilemma of a fourth-year college student who is trying to decide what to do with his or her future. The student knows that he or she wants to do one of three things: pursue work as a travel writer, join the diplomatic service, or go into business and work as a sales representative. In terms of how rewarding these experiences would be, the student believes that pursuing work as a travel writer is to be rated first, joining the diplomatic service is to be rated second, and going into business is to be rated third. But how do we assign a value to the desirability of these options? Money will not be an appropriate utility because the person is likely not thinking in terms of how much money can be earned, but rather how much he or she would like to pursue each of these options. The world might be our “oyster,” but how do we evaluate our options? Expected Value (EV) is defined as the product (multiplication) of a given utility and its corresponding probability.
Note that the probabilities assigned incorporate the risk and/or skill level required to pursue each option. According to the above analysis, “Join the diplomatic service” provides the greatest Expected Value (EV) and, objectively, this option should be chosen.
The following rules can be used to choose values for utilities. Always pick a value of 100 for the most desirable (non-monetary) outcome. This provides an analytical boundary and makes choosing other values easier. In reality, “Work as a travel writer” might be less than 100. A “100” might represent a dream scenario in which a person wins the lottery and retires to a deserted island to paint sunsets. This is not showed as an option owing to the incredibly low probability associated with it. One more rule is to make each utility a multiple of 10 (i.e., 10, 20, 70, 100), for any more precision would be suspect.
Of course, utility could still be calculated in terms of money. Utility measured in monetary terms is the focus of our next problem. Four teams have made the semi-finals of the NBA Championships. It is time to place a bet.
If there were costs associated with the opportunity to place a bet, then we would have to subtract this cost from our Expected Value in order to arrive at our price. However, such a fixed cost would not affect the result of our Utility Analysis. The team with the highest Expected Value would be the best bet.
In the summary that follows, we see that option 1 has the highest probability and option 4 has the highest payoff (utility), but neither results in the highest expected value (EV). It turns out that placing a bet for team 2 or team 3 leads to the highest expected value (EV). This is because expected payoff must be tempered with probability of the outcome. The analysis below helps us see the optimal outcomes quickly.
SUNK COSTS
Tip #17: Sunk costs are irrelevant to future decision making.
Suppose you bought a discounted, nonrefundable plane ticket for $500, which you had planned to use when going on vacation.
No sooner had you bought the ticket did an important meeting arise, one that you had been waiting months to arrange. It could definitely