A Heuristic Approach to Explore: The Value of Perfect Information

50 Pages Posted: 21 May 2019 Last revised: 2 Oct 2019

See all articles by Shervin Shahrokhi Tehrani

Shervin Shahrokhi Tehrani

University of Texas at Dallas

Andrew T. Ching

Johns Hopkins University - Carey Business School

Date Written: April 30, 2019

Abstract

How do people make choices in a dynamic stochastic environment when they face uncertainty about the return of their choices? The classical approach to this problem is to assume consumers use dynamic programming to obtain the optimal decision rule. However, this approach has two drawbacks. First, it is computationally very expensive to implement in practice because it requires solving a dynamic programming problem with a continuous state space. Second, it assumes decision-makers have unbounded cognitive ability to optimally process and use information. To address these two issues, we propose a new heuristic decision process called the Value of Perfect Information (VPI), which extends the idea first proposed by Howard (1966) in the engineering literature. This approach provides an intuitive and computationally tractable way to capture the value of exploring uncertain alternatives. In VPI, a decision-maker investigates the benefits of a subset of information, which can improve her myopic decision outcome. We argue that our VPI approach provides a "fast and frugal" way to balance the trade-off between exploration and exploitation. More specifically, the VPI approach only involves ranking the alternatives and computing a one-dimensional integration to obtain the expected future value of exploration. In terms of computational costs, we show that the VPI approach is significantly simpler than the standard dynamic programming approach, making it a much more practical model for people to employ. Using individual-level scanner data, we find evidence that our VPI approach is able to effectively capture consumers' choices.

Keywords: Learning, Bounded Rationality, Heuristic Approach, Value of Perfect Information

JEL Classification: D3, D12, D83, D90, M21, M31

Suggested Citation

Shahrokhi Tehrani, Shervin and Ching, Andrew T., A Heuristic Approach to Explore: The Value of Perfect Information (April 30, 2019). Johns Hopkins Carey Business School Research Paper No. 19-05, Available at SSRN: https://ssrn.com/abstract=3386737 or http://dx.doi.org/10.2139/ssrn.3386737

Shervin Shahrokhi Tehrani

University of Texas at Dallas ( email )

800 West Campbell Rd, SM32
SOM 13.219
Dallas, TX TX 75080
United States

Andrew T. Ching (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States

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