DECISION ANALYSIS

Q1
The Miramar Company is going to introduce one of three new products: a widget, a
hummer, or a nimnot. The market conditions, whether favorable, stable or unfavorable
will determine the profit or loss the company realizes, as shown in the following payoff
table:

Market Conditions
Product Favorable Stable Unfavorable
Widget $120,000 $70,000 -$30,000
Hummer $60,000 $40,000 $20,000
Nimnot $35,000 $30,000 $30,000

Determine the best decision using the following decision criteria;
a. Maximax
b. Maximin
c. Minimax regret
d. Hurwicz (with = 0.4)
e. Equal likelihood

If the probabilities of the market conditions are 0.20, 0.70 and 0.10 for favorable, stable
and unfavorable conditions, respectively;
a. Compute the expected value for each decision and select the best one.
b. Develop the opportunity loss table and compute the expected opportunity loss for
each product.
c. Determine how much the firm would be willing to pay a market research firm to
gain better information about future market conditions.

The company is considering contracting with a market research firm to do a survey to
determine future market conditions. The result of the survey will indicate positive or
negative market conditions. There is a 0.60 probability of a positive report, given
favorable conditions; a 0.30 probability of a positive report, given stable conditions; and
a 0.10 probability of a positive report, given unfavorable conditions. There is a 0.90
probability of negative report, given unfavorable conditions; a 0.70 probability, given
stable conditions; and a 0.40 probability, given favorable conditions. Using decision tree
analysis and posterior probability tables;
a. Determine the decision strategy the company should follow.
b. Determine the expected value of the strategy.
c. Determine the maximum amount the company should pay the market research
firm for the survey results.
d. Compute the efficiency of the survey results.

Q2
The following payoff table shows the profit for a decision problem with two states of
nature and two decision alternatives;
State of Nature
Decision Alternatives s
1
s
2

d
1
10 1
d
2
4 3

a. Use graphical sensitivity analysis to determine the range of probabilities of state
of nature s
1
for which each of the decision alternatives has the largest expected
value.
b. Suppose p(s
1
) = 0.2 and p(s
2
) = 0.8. What is the best decision using the expected
value approach?
c. Perform sensitivity analysis on the payoffs for decision alternative d
1
. Assume
the probabilities are as given in part (b) and find the range of payoffs under states
of nature s
1
and s
2
that will keep the solution found in part (b) optimal. Is the
solution more sensitive to the payoff under state of nature s
1
or s
2
?

21. Hales TV Productions is considering producing a pilot for a comedy series in the hope
of selling it to a major television network. The network may decide to reject the series,
but it may also decide to purchase the rights to the series for either 1 or 2 years. At this
point in time, Hale may either produce the pilot and wait for the networks decision or
transfer the rights for the pilot and series to a competitor for $100,000. Hales decision
alternatives and profits ($1000s) are as follows:

State of Nature
Decisions Alternative Reject, s
1
1 Year, s
2
2 Years, s
3

Produce Pilot, d
1
100 50 150
Sell to competitor, d
2
100 100 100

The probabilities for the states of nature are P(s
1
) = 0.20, P(s
2
) = 0.30, and P(s
3
) = 0.50. For a
consulting fee of $5,000, an agency will review the plans for the comedy series and indicate
the overall chances of a favorable network reaction to the series. Assume that the agency
review will result in a favorable (F) or an unfavorable (U) review and that the following
probabilities are relevant.

P(F) = 0.69 P(s
1
| F) = 0.09 P(s
1
| U) = 0.45
P(U) = 0.31 P(s
2
| F) = 0.26 P(s
2
| U) = 0.39
P(s
3
| F) = 0.65 P(s
3
| U) = 0.16

a. Construct a decision tree for this problem.
b. What is the recommended decision if the agency opinion is not used? What is the
expected value?
c. What is the expected value of perfect information?
d. What is Hales optimal decision strategy assuming the agencys information is
used?
e. What is the expected value of the agencys information?
f. Is the agencys information worth the $5,000 fee? What is the maximum that Hale
should be willing to pay for the information?
g. What is the recommended decision?
[3+2+2+6+1+1+1=16]


22. Suppose that you want to invest $ 10,000 in stock market by buying shares in one of
the two companies: A and B. Shares in company A, though risky, could yield a 50%
return on investment during the next year. If the stock market conditions are not
favourable (i.e. bear market), the stock may lose 20% of its value. Company B provides
safe investment with 15% return in a bull market and only 5% in a bear market. All
the publications you have consulted (and there is always a flood of them at the end of the
year!) are predicting a 60% chance for a bull market and 40% for a bear market.
a. Where should you invest your money?
Now, suppose that rather than relying solely on the publications, you have decided to
conduct a more personal investigation by consulting a friend who has done well in the
stock market. The friend offers the general opinion of for or against investment. This
opinion is further quantified in the following manner: If it is a bull market, there is a
90% chance the vote will be for. If it is a bear market, the chance of a for vote is
lowered to 50%.
b. How do you make use of this additional information?
c. What is the expected value of this information?
d. What is the efficiency of this additional information?
[3+7+4=14 marks]


Question 21.
A machine shop owner is attempting to decide whether to purchase a new drill press, a
lathe or a grinder. The return from each will be determined by whether the company
succeeds in getting a government military contract. The profit or loss from each purchase
and the probabilities associated with each contract outcome are shown in the following
payoff table:

Contract No Contract
Purchase 0.40 0.60

Drill press $ 40,000 $ 8,000
Lathe 20,000 4,000
Grinder 12,000 10,000

(a) Which machine should be purchased?

The machine shop owner is considering hiring a military consultant to ascertain whether
the shop will get the government contract. The consultant is a former military officer who
uses various personal contacts to find out such information. By talking to other shop
owners who have hired the consultant, the owner has estimated a 0.70 probability that the
consultant would present a favorable report, given that the contract is awarded to the shop
(P(f | c)), and a 0.80 probability that the consultant would present an unfavorable report,
given that the contract is not awarded (P(u | n)). Using decision tree analysis,
(b) Determine (i) the decision strategy the owner should follow, (ii) the expected value of
this strategy, and (iii) the maximum fee the owner should pay the consultant.
[2+17+1+2=22 marks]

A1
Note: Payoff in $1000s

Decision Analysis Without Probabilities (or Under Uncertainty)


Product
Market Conditions a.
Maximax
b.
Maximin Favorable Stable Unfavorable
Widget 120 70 -30 120 -30
Hummer 60 40 20 60 20
Nimnot 35 30 30 35 30


Product
Market Conditions d.
Hurwicz
e. Equal
Likelihood
Favorable Stable Unfavorable
Widget 120 70 -30 30 53.333
Hummer 60 40 20 36 40.000
Nimnot 35 30 30 32 31.667

Regret = Opportunity Loss
Product Market Conditions c.Minimax
Regret

Favorable Stable Unfavorable
Widget 0 0 60 60
Hummer 60 30 10 60
Nimnot 85 40 0 85

Decision Analysis With Probabilities (or Under Risk)

Decision Tree

70
120
-30
20
40
60
30
30
35
P(f) = 0.20
EV(W) = 70
EV(H) = 42
EV(N) = 31
EV(WoMR) = 70
Without
Market Research
P(s) = 0.70
P(u) = 0.10
P(f) = 0.20
P(f) = 0.20
P(s) = 0.70
P(s) = 0.70
P(u) = 0.10
P(u) = 0.10

Expected Value (or Expected Value without Perfect Information)

Product
Market Conditions a.
Expected
Value

Favorable
p = 0.20
Stable
p = 0.70
Unfavorable
p = 0.10
Widget 120 70 -30 70
= EVwoPI
Hummer 60 40 20 42
Nimnot 35 30 30 31

Opportunity Loss table
Product Market Conditions
b. Expected
Opportunit
y Loss

Favorable
p = 0.20
Stable
p = 0.70
Unfavorable
p = 0.10
Widget 0 0 60 6
Hummer 60 30 10 34
Nimnot 85 40 0 45

Expected Value with Perfect Information

Product
Market Conditions
Expected
Value

Favorable
p = 0.20
Stable
p = 0.70
Unfavorable
p = 0.10
Widget 120 70 -30 24 + 49
Hummer 60 40 20
Nimnot 35 30 30 3
76 = EVwPI

EVPI = EVwPI EVwoPI
= 76 70
= 6 (i.e. $6,000)

Therefore, the amount the firm would be willing to pay a market research firm would be
less than $6,000. (i.e the maximum gain from the market research is only $6,000, thus
should not pay the market research firm more than $6,000).

Decision Analysis With Sample Information

Let
P(f) = probability of favorable market condition
P(s) = probability of stable market condition
P(u) = probability of unfavorable market condition

P(p) = probability of positive market condition
P(n) = probability of negative market condition

Prior probabilities (Given above in decision Analysis under risk)
P(f) = 0.20
P(s) = 0.70
P(u) = 0.10

Conditional Probabilities
Positive market condition
P(p/f) = 0.60
P(p/s) = 0.30
P(p/u) = 0.10

Negative market condition
P(n/f) = 0.40
P(n/s) = 0.70
P(n/u) = 0.90

Posterior probability table for positive market condition
States of
Nature
Prior
Probabilities
Conditional
Probabilities
Joint
Probabilities
Posterior
Probabilities
Favorable P(f) = 0.20 P(p/f) = 0.60 0.2x0.6 = 0.12 P(f/p) = 0.353
Stable P(s) = 0.70 P(p/s) = 0.30 0.7x0.3 = 0.21 P(s/p) = 0.618
Unfavorable P(u) = 0.10 P(p/u) = 0.10 0.1x0.1 = 0.01 P(u/p) = 0.029
P(p) = 0.34

Posterior probability table for negative market condition
States of
Nature
Prior
Probabilities
Conditional
Probabilities
Joint
Probabilities
Posterior
Probabilities
Favorable P(f) = 0.20 P(n/f) = 0.40 0.2x0.4 = 0.08 P(f/n) = 0.121
Stable P(s) = 0.70 P(n/s) = 0.70 0.7x0.7 = 0.49 P(s/n) = 0.742
Unfavorable P(u) = 0.10 P(n/u) = 0.90 0.1x0.9 = 0.09 P(u/n) = 0.137
P(n) = 0.66


70
120
-30
30
35
30
70
120
-30
40
60
20
P(s/p) = 0.618
P(u/p) = 0.029
P(f/p) = 0.353
P(s/p) = 0.618
P(u/p) = 0.029
P(u/p) = 0.029
P(s/p) = 0.618
P(f/p) = 0.353
P(f/n) = 0.121
P(s/n) = 0.742
P(u/n) = 0.137
P(u/n) = 0.137
P(s/n) = 0.742
P(f/n) = 0.121
P(f/n) = 0.121
P(s/n) = 0.742
P(u/n) = 0.137
P(n) = 0.660
P(p) = 0.340
EV(W) = 84.750
EV(H) = 46.480
EV(N) = 30.605
EV(H) = 39.680
EV(W) = 62.350
EV(N) = 31.765
EV(N) = 62.350
EV(P) = 84.750
Positive
Market
Condition
Negative
Market
Condition
EV(MR)
= 69.966
Market
Research
30
35
30
40
60
20
P(f/p) = 0.353
a. Decision Strategy:
Produce the widget regardless of the report.

b. EVSI = EV(with sample information) EV(without sample information)
= $69,966 - $70,000
$0 (-$34)
The additional (or sample) information has no value; therefore decision is to
produce the widget.

c. Not to pay anything for additional survey. EVSI is almost zero.

d. The efficiency of sample information:
Efficiency, E = (EVSI/EVPI) x 100 %
= 0/6
= 0 %


A2
EV(d
1
) = 10p + 1(1-p)
= 9p + 1

EV(d
2
) = 4p + 3(1-p)
= p + 3

Plot the equations on EV of decision alternatives & Probability of states of natures


a. At the point A, the EV value is equal i.e. EV(d
1
) = EV(d
2
);
9p + 1 = p + 3; therefore, p = 0.25
Thus
d
2
is optimal for p 0.25
d
1
is optimal for p 0.25
b. Best decision is d2
c. As long as the payoff for s
1
2, then d
2
is optimal.
d
1

d
2

EV
p = 0
p = 0.25
p = 1
EV
10
4
3
1
A
21. s
1

a.
d
1
s
2


s
3

Favorable

s
1

d
2

s
2


Agency s
3


s
1


d
1
s
2


s
3

Unfavorable
s
1

d
2

s
2


s
3


s
1


d
1
s
2


s
3
No Agency

s
1


d
2
s
2


s
3

b. Using node 5,

EV (node 10) = 0.20 (-100) + 0.30 (50) + 0.50 (150) = 70
EV (node 11) = 100
Decision: Sell to Competitor, d
2
. Expected Value = $100

c. EVwPI = 0.20 (100) + 0.30 (100) + 0.50 (150) = $125
EVPI = $125 - $100 = $25
1
6
-100
50
150
7
100
100
100
3
2
8
-100
50
150
9
100
100
100
4
10
-100
50
150
11
100
100
100
5
d. EV (node 6) = 0.09 (-100) + 0.26 (50) + 0.65 (150) = 101.5
EV (node 7) = 100
EV (node 8) = 0.45 (-100) + 0.39 (50) + 0.16 (150) = -1.5
EV (node 9) = 100

EV (node 3) = Max (101.5, 100) = 101.5 Produce
EV (node 4) = Max (-1.5, 100) = 100 Sell

EV (node 2) = 0.69 (101.5 + 0.31 (100) = 101.04

If Favorable, Produce
If Unfavorable, Sell EV = $101.04

e. EVSI = $101.04 100 = $1.04 or $ 1,040.

f. No, maximum Hale should pay is $1,040.

g. No agency; sell the pilot.

22. a. The decision table corresponding to the problem is the following

States of Nature
Decision Alternative Bull Market= s
1
Bear Market= s
2
P(s
1
)= 0.6 P(s
1
)= 0.4
d
1
= choose company A 5000 -2000
d
2
= choose company B 1500 500

Since probability information about the states of nature are available, we use the expected
value approach.
We first calculate the expected values of the two decisions
EV(d
1
)= 5000 (0.6) + (-2000) (0.4)= 2,200
EV(d
2
)= 1500 (0.6) + (500) (0.4)= 1,100
Hence d
1
or invest in stock A is the best decision and EV= 2,200

b. In terms of probability, the given information can be represented as follows.
P(I
1
/ s
1
) = 0.9, P(I
2
/s
1
) = 0.1
P(I
1
/s
2
) = 0.5, P(I
2
/s
2
) = 0.5

Where
I
1
= the friend says for investment
I
2
= the friend is Against investment.

Let us know calculate the posterior probabilities and P(I
1
) and P(I
2
).


For I
1

State of nature Prior conditional joint Posterior
Probabilities probabilities probabilities probabilities
s
1

0.6 0.9 0.54 0.7297
s
2
0.4 0.5 0.20 0.2702
P(I
1
)= 0.74

Hence P(s
1
/I
1
) = 0.73, P(s
2
/I
1
) = 0.27 and P(I
1
)= 0.74




For I
2
State of nature Prior conditional Joint Posterior
Probabilities probabilities probabilities probabilities
s
1
0.6 0.1 0.06 0.231
s
2
0.4 0.5 0.20 0.769
P(I
2
)= 0.26

Hence P(s
1
/I
2
) = 0.231, P(s
2
/I
2
) = 0.769 and P(I
2
)= 0.26.
The problem can be represented by the following decision tree.


1
2
3
4
5
6
7
I
1
I
2
d
1
s
1
s
2
d
1
The expected of the branch I
1
or opinion for
EV(d
1
/I
1
) node 3= 5000 P(s
1
/I
1
) + (-200) P(s
2
/I
1
)= 5000 0.73 + (-200) 0.27 = 3110
EV(d
2
/I
1
) node 4= 1500 P(s
1
/I
1
) + (500) P(s
2
/I
1
)= 1500 0.73 + (500) 0.27 = 1230
The best decision is d
1
i.e. invest in stock A.

The expected of the branch I
2
or opinion Against
EV(d
1
/I
2
) node 6= 5000 P(s
1
/I
2
) + (-200) P(s
2
/I
2
)= 5000 0.231 + (-200) 0.769 = -383
EV(d
2
/I
2
) node 7= 1500 P(s
1
/I
2
) + (500) P(s
2
/I
2
)= 1500 0.231 + (500) 0.769 = 731
The best decision is d
2
i.e. invest in stock B.
Decision Rule:
If the friend advises to invest, then invest in stock A
If the friends advise to not invest, then invest in stock B

c. The expected value with sample information is

EVWSI= P(I
1
) 3110 + P(I
2
) 731 = 0.74 3110 + 0.26 731=2301.4+190.06=2491.46
Then
EVSI= 2491.46- EV= 2491.46-2,200= 291.46.
d. The efficiency of the information given by the friend.
First we have to calculate the expected value of perfect information.
We have
EVWPI= 5000 (0.6) + 500 (0.4)= 3000+ 200 = 3200
Hence EVPI= EVWPI- EV= 3200- 2200= 1000
Thus
Efficiency of the information = E = (EVSI / EVPI) 100%= (910/1000) 100%= 91 %.
We can conclude that the information is very efficient.


Answer 21.
(a)


(b)
P(c) = probability of contract = 0.40;
P(n) = probability of no contract = 0.60;
P(f | c) = 0.70; P(u | c) = 0.30
P(u | n) = 0.80; P(f | n) = 0.20

Computation of posterior probabilities:

If f - Favorable

State of Nature P(s
j
) P(f | s
j
) P(fs
j
) P(s
j
| f)

c P(c) = 0.40 P(f | c) = 0.70 P(fc) = 0.28 P(c | f) = 0.70

n P(n) = 0.60 P(f | n) = 0.20 P(fn) = 0.12 P(n | f) = 0.30
P(f) = 0.40

If u - Unfavorable

State of Nature P(s
j
) P(u | s
j
) P(us
j
) P(s
j
| u)

c P(c) = 0.40 P(u | c) = 0.30 P(uc) = 0.12 P(c | u) = 0.20

n P(n) = 0.60 P(u | n) = 0.80 P(un) = 0.48 P(n | u) = 0.80
P(u) = 0.60











(i) Decision strategy:
If report is favorable, purchase a Drill press;
If report is unfavorable, purchase a Grinder.

(ii) EV (strategy) = $ 16,480.

(iii) EVSI = EVwSI EvwoSI = $16,480 $11,200 = $ 5,280