The Efficient Use of an Imperfect Forecast

This paper illustrates how individual forecasts and forecasting techniques may be evaluated by the use of established decision theory. Given the probability distribution of the forecast error, we first find the optimal strategy for a decision process, i.e., how to make the most efficient use of a forecast. After expressing the expected profit of the optimal strategies in terms of the probability of a correct forecast, we illustrate how to find (1) the value of an imperfect forecast, and (2) the value of a forecasting technique. With this information, we can then determine when to use a forecast, the maximum amount to pay for both a forecast and a forecasting method, and the conditions under which it is worthwhile to attempt to improve the accuracy of a forecasting method.