Class Notes

Management Science
6.0 r 6.0
r r 5.5 5.5 A2 r EV r 5.0 5.0 A 1 A r 4 4.5 4.5 r 4.0 4.0 A3 3.5 3.5 r
3.0
.4
.2
.2
3.0
Lecture Notes Edition April 28, 2010 D.M. Tulett
c April 28, 2010 D.M. Tulett
This work is c D.M. Tulett, 2010. Some of the problems at the end of the document were created by A.R. Redlack, and are used with his permission. Excel R is a registered trademark of Microsoft, OpenOfce.org 3 R is a registered trademark of OpenOfce.org, and LINDO R is a registered trademark of LINDO Systems Inc. The Solver used by Excel was made by Frontline Systems, Inc. The graph on the cover is a modied version of the one that appears near the end of Lecture 4.
ii
Preface
In this e-book, a word, phrase, or page number in red indicates a link to somewhere else in this document; a word or phrase in pink indicates a link to the web. In particular, both the Table of Contents and the Index are linked to the appropriate places in the main body of the material. The table of contents is divided into 22 sections. Each of these corresponds with a lecture given at a rate of two per week. Each lecture (except the very last one) ends with an exercise, which consists of one or more problems. The learning which comes from doing these exercises will prepare you for the tests and the nal exam. Your professor may require that some of these be done for credit. It would be benecial, of course, to do all the other exercises as well. It is assumed that the reader has learn the basics of spreadsheets. In this book, the syntax of Microsoft R Excel R is used, but there are other programs which could be used such as the free OpenOfce.org 3 OpenOfce R software. A companion volume called Mathematics for Management Science: A Bridging Course (hereafter simply called Mathematics for Management Science) addresses in detail some of the material which is covered here: special applications of spreadsheets; probability; probability trees; binomial distribution; Bayesian revision; and graphing. In this e-book, we concentrate on management science assuming that the details of the mathematics have been seen either in Mathematics for Management Science or elsewhere. In addition to the above, this e-book should be read in conjunction with any other materials which have been required for your course. dtulett@mun.ca
iii
Contents
1 Introduction 1.1 The Paradigm of Management Science 1.2 Example Cellular Phone Plans . . . 1.2.1 Problem Identication . . . . 1.2.2 Building the Model . . . . . . 1.2.3 Model Solution . . . . . . . . 1.2.4 Implementation . . . . . . . . 1.2.5 Commentary . . . . . . . . . 1.3 Exercise . . . . . . . . . . . . . . . . Uncertainty 1 2.1 Introduction . . . . . . . . . 2.2 Example . . . . . . . . . . . 2.2.1 Problem Description 2.2.2 Model Formulation . 2.2.3 Model Solution . . . 2.2.4 Recommendation . . 2.3 Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 1 1 2 3 4 6 6 7 10 10 10 10 11 13 19 20 21 21 21 25 26 27 28 28 29 29 30 31 32
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Uncertainty 2 3.1 Salvage Value . . . . . . . . . . . . . . . . . 3.1.1 Theatre Example with Salvage Value 3.2 Expected Value of Perfect Information . . . . 3.2.1 Direct Calculation of the EVPI . . . . 3.2.2 Indirect Calculation of the EVPI . . . 3.3 Decision Criteria . . . . . . . . . . . . . . . 3.3.1 Pessimism . . . . . . . . . . . . . . 3.3.2 Optimism . . . . . . . . . . . . . . . 3.3.3 Hurwicz . . . . . . . . . . . . . . . . 3.3.4 Laplace . . . . . . . . . . . . . . . . 3.3.5 The Regret Matrix . . . . . . . . . . 3.4 Exercise . . . . . . . . . . . . . . . . . . . .
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Uncertainty 3 34 4.1 Marginal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 34 4.1.1 Computer Example . . . . . . . . . . . . . . . . . . . . . 35
iv 4.2 Sensitivity Analysis . . . . . . . . . . 4.2.1 Theatre Example . . . . . . . 4.2.2 A More Complicated Example Exercise . . . . . . . . . . . . . . . . 4.3.1 Marginal Analysis Problem . 4.3.2 Sensitivity Problem 1 . . . . . 4.3.3 Sensitivity Problem 2 . . . . . . . . . . . .
c April 28, 2010 D.M. Tulett . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 36 40 46 46 46 46 47 47 49 51 55 60 62 62 63 66 71 72 72 72 75 81 87 88 88 88 88 90 92 94 94 95 99
4.3
Decision Trees 1 5.1 Introduction . . . . . . . . . . . . . . . . . 5.2 Theatre Problem in Tree Form . . . . . . . 5.2.1 Without Cost Gates . . . . . . . . . 5.2.2 With Cost Gates . . . . . . . . . . 5.3 The Expected Value of Perfect Information 5.4 Sequential Decision Making . . . . . . . . 5.4.1 Example . . . . . . . . . . . . . . 5.4.2 Solution . . . . . . . . . . . . . . . 5.4.3 Finding the EVPI . . . . . . . . . . 5.5 Exercise . . . . . . . . . . . . . . . . . . . Decision Trees 2 6.1 Case: New Detergent Marketing Campaign 6.1.1 Problem Description . . . . . . . . 6.1.2 Formulation . . . . . . . . . . . . . 6.1.3 Solution and Recommendation . . . 6.2 Exercise . . . . . . . . . . . . . . . . . . . Decision Trees 3 7.1 Airfare Problem . . . . . . . . . . . . . 7.1.1 Problem Description . . . . . . 7.1.2 Formulation . . . . . . . . . . . 7.1.3 Solution . . . . . . . . . . . . . 7.1.4 The EVPI . . . . . . . . . . . . 7.2 New Detergent Case: Some Extensions 7.2.1 The EVPI . . . . . . . . . . . . 7.2.2 Sensitivity Analysis . . . . . . 7.3 Exercise . . . . . . . . . . . . . . . . .
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c April 28, 2010 D.M. Tulett 8 Imperfect Information 1 8.1 Introduction . . . . . . . . . . . . . . 8.2 Example Seismic Testing . . . . . . 8.2.1 Problem Description . . . . . 8.2.2 Problem Formulation . . . . . 8.2.3 Bayesian Revision . . . . . . 8.2.4 Solution and Recommendation 8.2.5 Commentary . . . . . . . . . 8.3 Exercise . . . . . . . . . . . . . . . . Imperfect Information 2 9.1 Introduction . . . . . . . . . 9.2 Example Wood Finishers . 9.2.1 Problem Description 9.2.2 Part A . . . . . . . . 9.2.3 Part B . . . . . . . . 9.2.4 Part C . . . . . . . . 9.3 Exercise . . . . . . . . . . .
v 101 101 101 101 101 104 116 118 120 121 121 121 121 122 124 130 132 137 137 137 138 138 138 139 152 152 153 154 154 155 155 155 156 156 158
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10 Imperfect Information 3 10.1 Introduction . . . . . . . . . . . . . . . . . . . 10.1.1 Binomial Probability Distribution . . . 10.1.2 Destructive vs. Non-Destructive Testing 10.2 Example . . . . . . . . . . . . . . . . . . . . . 10.2.1 Problem Description . . . . . . . . . . 10.2.2 Solution . . . . . . . . . . . . . . . . . 10.2.3 Recommendation . . . . . . . . . . . . 10.3 Commentary . . . . . . . . . . . . . . . . . . 10.4 Exercise . . . . . . . . . . . . . . . . . . . . .
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11 Linear Optimization 1 11.1 Example Cement Problem . . . . . . . . . . . . 11.2 Making a Model . . . . . . . . . . . . . . . . . . . 11.2.1 Verbal, Algebraic, and Spreadsheet Models 11.2.2 Denition of the Variables . . . . . . . . . 11.2.3 The Objective Function . . . . . . . . . . . 11.2.4 The Constraints . . . . . . . . . . . . . . . 11.2.5 Summary . . . . . . . . . . . . . . . . . .
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vi 11.3 Graphical Solution . . . . . . . . . . 11.4 Extensions . . . . . . . . . . . . . . . 11.4.1 General Form . . . . . . . . . 11.4.2 A Right-Hand Side Value of 0 11.4.3 Comment . . . . . . . . . . . 11.5 Exercise . . . . . . . . . . . . . . . . 11.5.1 Garment Problem . . . . . . . 11.5.2 Baseball Bat Problem . . . . . 11.5.3 Quarry Problem . . . . . . . . 12 Linear Optimization 2 12.1 Example Diet Problem . . . 12.1.1 Problem Description . 12.1.2 Formulation . . . . . . 12.1.3 Graphical Solution . . 12.2 Example 2 . . . . . . . . . . . 12.2.1 Problem Description . 12.2.2 Formulation . . . . . . 12.3 Exercises . . . . . . . . . . . 12.3.1 Ofce Rental . . . . . 12.3.2 Diet Problem . . . . . 12.3.3 Fruit Buying Problem . . . . . . . . .
c April 28, 2010 D.M. Tulett . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 167 167 167 173 173 173 174 174 175 175 175 175 179 183 183 183 193 193 193 193 194 194 194 196 196 199 202 205 205 207 212 212 212 213 213
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13 Linear Optimization 3 13.1 Introduction . . . . . . . . . . . . . . . 13.2 Slack and Surplus . . . . . . . . . . . . 13.3 LINDO . . . . . . . . . . . . . . . . . 13.3.1 LINDO for Linear Optimization 13.3.2 LINDO for Integer Optimization 13.4 Optimization using Spreadsheets . . . . 13.5 Blending Problem . . . . . . . . . . . . 13.5.1 Problem Description . . . . . . 13.5.2 Formulation and Solution . . . 13.6 Exercise . . . . . . . . . . . . . . . . . 13.6.1 Problem Description . . . . . . 13.6.2 Decision Variables . . . . . . . 13.6.3 Discussion . . . . . . . . . . . 13.6.4 What Needs to be Done . . . .
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c April 28, 2010 D.M. Tulett 14 Linear Optimization 4 14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . 14.2 New Concepts . . . . . . . . . . . . . . . . . . . . . . 14.2.1 Solution and Non-Solution Variables . . . . . 14.2.2 Reduced Cost . . . . . . . . . . . . . . . . . . 14.2.3 Dual Price and Shadow Price . . . . . . . . . . 14.2.4 Allowable Range . . . . . . . . . . . . . . . . 14.3 Example 1: Maximization . . . . . . . . . . . . . . . 14.3.1 Changes to the Objective Function Coefcients 14.3.2 Changes to the Right-Hand-Side Values . . . . 14.4 Example 2: Minimization . . . . . . . . . . . . . . . . 14.4.1 Changes to the Objective Function Coefcients 14.4.2 Changes to the Right-Hand-Side Values . . . . 14.5 Example 3: Blending Model . . . . . . . . . . . . . . 14.5.1 LINDO Sensitivity Output . . . . . . . . . . . 14.5.2 Changes to the Objective Function Coefcients 14.5.3 Changes to the Right-Hand Side Values . . . . 14.6 Exercise . . . . . . . . . . . . . . . . . . . . . . . . . 14.6.1 A Maximization Problem . . . . . . . . . . . . 14.6.2 A Minimization Problem . . . . . . . . . . . . 15 Markov Chains 1 15.1 Introduction . . . . . . . . . . . . . . . . . . . . . 15.2 Example: Brand Switching . . . . . . . . . . . . . 15.2.1 Description of the Situation . . . . . . . . 15.2.2 State Transition (Probability) Diagram . . . 15.2.3 State Transition (Probability) Matrix . . . . 15.2.4 Finite Number of Transitions . . . . . . . . 15.3 Determining Steady-State Probabilities Analytically 15.3.1 Three State Brand Switching Example . . . 15.3.2 Two State Markov Chain . . . . . . . . . . 15.3.3 Example . . . . . . . . . . . . . . . . . . 15.3.4 Solution by Computer . . . . . . . . . . . 15.4 Exercise . . . . . . . . . . . . . . . . . . . . . . . 15.4.1 Problem 1 . . . . . . . . . . . . . . . . . . 15.4.2 Problem 2 . . . . . . . . . . . . . . . . . .
vii 214 214 215 215 215 215 216 218 220 221 223 225 226 228 228 231 233 235 235 235 237 237 237 237 238 242 243 246 246 249 249 250 252 252 252
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viii 16 Markov Chains 2 16.1 Introduction . . . . . . . . . . . . . . 16.2 Absorbing States Analysis . . . . . . 16.3 Solution by Computer . . . . . . . . . 16.4 An Application: Credit Card Analysis 16.4.1 Situation Description . . . . . 16.4.2 Formulation . . . . . . . . . . 16.4.3 Analysis . . . . . . . . . . . 16.5 Exercise . . . . . . . . . . . . . . . . 16.5.1 Problem 1 . . . . . . . . . . . 16.5.2 Problem 2 . . . . . . . . . . . 17 Markov Chains 3 17.1 Gamblers Ruin . . . . . . . 17.2 Educational Model . . . . . 17.2.1 Extension 1 . . . . . 17.2.2 Extension 2 . . . . . 17.3 Repair Problem A . . . . . . 17.3.1 Situation Description 17.3.2 Formulation . . . . . 17.4 Repair Problem B . . . . . . 17.5 Exercise . . . . . . . . . . . 17.5.1 Educational Model . 17.5.2 Repair Problem . . .
c April 28, 2010 D.M. Tulett 253 253 254 258 261 261 262 262 265 265 266 267 267 271 271 271 272 272 272 275 278 278 278 279 279 280 284 287 292 292 293 296 296 297
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18 Utility Theory 1 18.1 Introduction . . . . . . . . . . . . . . . 18.2 Obtaining the Data for a Utility Function 18.3 Using the Graph with a Payoff Matrix . 18.4 A More Complicated Graph . . . . . . 18.5 Utility Functions . . . . . . . . . . . . 18.5.1 Introduction . . . . . . . . . . . 18.5.2 A Simple Decision . . . . . . . 18.6 Exercise . . . . . . . . . . . . . . . . . 18.6.1 Problem 1 . . . . . . . . . . . . 18.6.2 Problem 2 . . . . . . . . . . . .
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c April 28, 2010 D.M. Tulett 19 Utility Theory 2 19.1 Introduction . . . . . . . . . . . . . . . . . 19.2 Three Useful Properties . . . . . . . . . . . 19.3 Finding the EVPI . . . . . . . . . . . . . . 19.4 Using Utility Functions with Decision Trees 19.4.1 The EVPI . . . . . . . . . . . . . . 19.5 Exercise . . . . . . . . . . . . . . . . . . . 19.5.1 Problem 1 . . . . . . . . . . . . . . 19.5.2 Problem 2 . . . . . . . . . . . . . . 20 Game Theory 1 20.1 Introduction . . . . . . . . . . 20.2 Pure Strategy . . . . . . . . . 20.2.1 Example 1 . . . . . . 20.2.2 Example 2 . . . . . . 20.3 Mixed Strategy . . . . . . . . 20.3.1 Example . . . . . . . 20.3.2 Dominance . . . . . . 20.3.3 DARS Algorithm . . . 20.4 Prisoners Dilemma . . . . . . 20.4.1 Situation Description . 20.4.2 Solution . . . . . . . . 20.5 Obtaining the Payoffs . . . . . 20.6 Exercise . . . . . . . . . . . . 20.6.1 Mixed Strategy Game 20.6.2 Jack and Jill Problem . 20.6.3 Formulation Problem .
ix 298 298 298 299 302 310 311 311 311 312 312 313 313 314 316 316 316 321 323 323 324 324 326 326 326 326 327 327 327 335 342 343 347 347 347 347
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21 Game Theory 2 21.1 Graphical Solution . . . . . . . . . . . . . . 21.1.1 Example 1 . . . . . . . . . . . . . . 21.1.2 Example 2 . . . . . . . . . . . . . . 21.1.3 General Methodology . . . . . . . . 21.2 Formulation as a Linear Optimization Model 21.3 Exercise . . . . . . . . . . . . . . . . . . . . 21.3.1 Problem 1 . . . . . . . . . . . . . . . 21.3.2 Problem 2 . . . . . . . . . . . . . . . 21.3.3 Problem 3 . . . . . . . . . . . . . . .
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c April 28, 2010 D.M. Tulett 21.3.4 Problem 4 . . . . . . . . . . . . . . . . . . . . . . . . . . 348 21.3.5 Problem 5 . . . . . . . . . . . . . . . . . . . . . . . . . . 348
22 Moving Forward 23 Supplement Extra Problems 23.1 Introduction . . . . . . . . . . . . . 23.1.1 Advanced Problems . . . . 23.2 Uncertainty . . . . . . . . . . . . . 23.3 Decision Trees . . . . . . . . . . . 23.4 Imperfect Information . . . . . . . . 23.5 Linear Optimization Introduction . 23.6 Markov Chains . . . . . . . . . . . 23.7 Utility Theory . . . . . . . . . . . . 23.8 Game Theory . . . . . . . . . . . . 23.9 Linear Optimization Applications
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Introduction
Management Science involves the application of mathematics to management problems. As mentioned in the Preface, the mathematics that we need is covered in Mathematics for Management Science. We will, for example, use such things as Bayesian revision and graphing for linear optimization that are covered in that book. Also, the numerical calculations can often be left to a spreadsheet or other software tools. If theres a difculty with this subject, its probably not the mathematics. Instead, the difculty is likely to be the building of the model which the mathematics seeks to solve. The important thing is always going from a problem description to a model for the problem. This is part of the paradigm of management science, which is the focus of this section.
1.1
The Paradigm of Management Science
A paradigm is a pattern for the general understanding of something. A common paradigm for management science is to think of it being composed of four phases: problem denition model building solution implementation. When the fourth phase has been done, it is appropriate to ask whether or not it addressed the original problem. Because we are working in an academic context, we cannot observe the entire paradigm. The problem is not for us a real-world observation, but instead it a written description (a word or story problem). Also, we cannot implement the solutions. We are left with looking at the second and third phases of the paradigm.
1.2
Example Cellular Phone Plans
We use this example as a way to illustrate the paradigm.
2 1.2.1 Problem Identication
Alison has decided to buy a cellular telephone, partly for safety in case of a breakdown in an isolated area, but also because of the convenience that it will provide. Shes not concerned about the initial cost of the telephone itself, especially when some cellular phone companies give the phones away in order to attract business. However, she is concerned about the monthly operating cost, especially since she would use the cellphone almost entirely during working hours Monday to Friday. Most plans operate on the user paying a xed charge to obtain a set number of minutes per month, with a per-charge premium if extra minutes are used. For example, one company offers a 200 minute calling plan for $25 per month with a surcharge of 25 cents per minute for all calls (local or long-distance) beyond the 200 minutes, and long-distance charges are 35 cents per minute at any time. For example if a user of this plan made 160 minutes of local calls, and 90 minutes of long-distance calls, the cost would be $25 plus $0.25(160 + 90 200) + $0.35(90) for a total of $69.00. Other plans treat both local and long-distance (within the country) calls the same. A summary of the plans available appears in the following table (the perminute column refers to charges for calls not covered by the plan): Plan Type Pay-as-you-go Basic User Local Regular User Local Extended User Local Basic User Anywhere Regular User Anywhere Heavy User Anywhere Cost Minutes Per-Minute None None $0.35 all calls $0.35 long-distance $25 200 $0.25 all calls $0.35 long-distance $45 400 $0.20 all calls $0.35 long-distance $69 600 $0.20 all calls $0.35 long-distance $39 200 $0.30 anywhere $59 400 $0.25 anywhere $109 800 $0.25 anywhere
Alison plans to make 240 minutes of local calls and 60 minutes of longdistance calls each month. Which plan should she buy? Hers is a specic example, but without too much extra work we can solve a more general problem: for any given numbers of minutes of local and long-distance calls, which plan should be bought? By building a spreadsheet model, we can easily solve this problem.
c April 28, 2010 D.M. Tulett 1.2.2 Building the Model
Minimizing the total monthly cost should be her objective. The monthly cost is the xed cost of the plan, plus the cost of the calls (if any) which exceed the plans limit. We can quickly solve Alisons problem by hand, but lets look at the general problem of a person who needs x minutes of local calls and y minutes of long-distance calls each month. The cost of the plans (the seven alternatives) can be written terms of x and y. The Pay-as-you-go plan is easy; its cost is $0.35(x + y) + $0.35y For the Basic User Local plan, the xed charge is of course $25, and the longdistance charge is $0.35y. The cost of extra calls is, however, a bit trickier. If x + y 200, then there is no extra charge. However, if x + y > 200, then the user must pay for an extra x + y 200 minutes. Hence the number of extra minutes is either 0 or x + y 200, whichever is greater. The number of extra minutes can be represented by the expression max{0, x + y 200}, and the cost of these extra minutes is $0.25 max{0, x + y 200}. Overall, the expression for the cost of this plan is: $25 + $0.25 max{0, x + y 200} + $0.35y Continuing to develop cost expressions for each alternative, we obtain: 1 2 3 4 5 6 7 Alternative Pay-as-you-go Basic User Local Regular User Local Extended User Local Basic User Anywhere Regular User Anywhere Heavy User Anywhere Cost with x local and y long-distance minutes $0.35(x + y) + $0.35y $25 + $0.25 max{0, x + y 200} + $0.35y $45 + $0.20 max{0, x + y 400} + $0.35y $69 + $0.20 max{0, x + y 600} + $0.35y $39 + $0.30 max{0, x + y 200} $59 + $0.25 max{0, x + y 400} $109 + $0.25 max{0, x + y 800}
Every plan is of the form a + b max{0, x + y c} + dy where some of parameters a, b, c, and d may be 0. These four parameters represent, respectively: the xed cost per month; the per-minute cost when over the limit of the plan; the number of minutes for the plan; and the per-minute longdistance supplementary charge. Seeing patterns like this helps when making a
spreadsheet model, because then a formula can be entered once, and then be copied for every alternative. This is why, for example, the pay-as-you-go plan (which costs $0.35(x + y) + $0.35y), would be thought of as 0 + $0.35 max{0, x + y 0} + $0.35y so that it ts the pattern, rather than being simplied to $0.35x + $0.70y. 1.2.3 Model Solution
What we have done so far is make an algebraic model of the problem. Because this problem is simple, we could solve it using a calculator with specic values of x and y. However, it is useful to make a spreadsheet model to do the calculations if we wish to calculate the cost of each plan for several values of x and y.1 We need to reserve two cells, one for x, and one for y. In one column every alternative is listed, their values for a, b, c, and d are put into the next four columns, and in the sixth column the monthly cost is calculated. For example, we could put the values for the number of local and long-distance minutes into cells B1 and F1 respectively. Allowing some room for column labels, the values of a, b, c, and d for alternatives 1 to 7 could go into the range B8:E14. Doing this much we have: A Local Alternative B C D Long-Distance Plan Limit (minutes) E F
1 2 3 4 5 6 7 8 9 10 11 12 13 14
1 It
Fixed Charge Per Month $0.00 $25.00 $45.00 $69.00 $39.00 $59.00 $109.00
Per-Minute Charge over the Plan Limit $0.35 $0.25 $0.20 $0.20 $0.30 $0.25 $0.25
LongDistance Per-Minute
Total Monthly Cost
1 2 3 4 5 6 7
0 200 400 600 200 400 800
$0.35 $0.35 $0.35 $0.35 $0.00 $0.00 $0.00
is assumed that the reader has at least a basic familiarity with spreadsheets.
In columns B, C, and E, the data was entered as a number, but the cell format was set to currency with two decimal places, hence entering 25 produces $25.00. Cells B8, and the range E12:E14 are not left blank, but instead a 0 is entered (which the spreadsheet formats as $0.00). This is because the formulas to be entered in column F need to read a 0; a blank cell would produce an error message. In the sixth column (F) we calculate the cost of the plans. In cell F8 we input =B8+C8*MAX(0,$B$1+$F$1-D8)+E8*$F$1 This is then copied in the range F8:F14. Doing this we see that with the specic values of 240 in cell B1 and 60 in cell F1, that alternatives 1 to 7 cost respectively $126, $71, $66, $90, $69, $59, and $109. The cheapest plan for Alison is the Regular User Anywhere Plan (alternative 6), at a cost of $59 per month. A Local Alternative B 240 Fixed Charge Per Month $0.00 $25.00 $45.00 $69.00 $39.00 $59.00 $109.00 C D Long-Distance Plan Limit (minutes) E F 60 Total Monthly Cost
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Per-Minute Charge over the Plan Limit $0.35 $0.25 $0.20 $0.20 $0.30 $0.25 $0.25
LongDistance Per-Minute
1 2 3 4 5 6 7
0 200 400 600 200 400 800
$0.35 $0.35 $0.35 $0.35 $0.00 $0.00 $0.00
$126.00 $71.00 $66.00 $90.00 $69.00 $59.00 $109.00
The developer of the model, whether using a calculator or a spreadsheet, must make the recommendation clear. The customer of the model (in this case, Alison) might not be familiar with spreadsheets, so the emphasis should be on giving the recommendation:
6 Recommendation
Alison should sign up for the Regular User Anywhere plan, at a cost of $59 per month. Now suppose that Alison isnt sure about her long-distance usage, and that it could be anywhere from 40 to 80 minutes, rather than exactly 60. Its easy to plug the values 40 and 80 into the spreadsheet and see what happens. At 40 minutes, plans 2, 3 and 6 are tied at $59. At 80 minutes, plan 6 is still uniquely the best. Hence alternative 6 is best everywhere from 40 to 80 minutes of long-distance use, at a constant cost of $59. What we have done here is a primitive form of sensitivity analysis , in which a parameter of the model is varied to examine the effect (if any) on the recommended solution. 1.2.4 Implementation
Models only approximate reality. Sometimes, things can be left out because they dont affect the choice. For example, we have ignored taxes. Whatever the tax rate, be it 15% or something different, the cheapest alternative will still be the cheapest alternative. On the other hand, a model cannot capture every nuance, even if it might change the optimal choice. It may be that some plans have extra features like call forwarding, but some plans do not. If we try to capture this in the model, it will quickly become very big. For this reason, the recommended solution is only optimal for the model, and is not necessarily best at solving the original problem. To complete the paradigm, we should go back to Alison to see if she is happy with the recommended plan. 1.2.5 Commentary
The four phases of the management science paradigm are not totally distinct. When we had completed the algebraic model, we saw that it was useful to build another model, this one using a spreadsheet, so that we could solve it. This model only involved cost, so we found the alternative with the minimum cost. In many management science examples, however, we seek the alternative with the highest prot.
1.3
Exercise
Two types of big boxes are about to be loaded onto a small cargo plane. A Type 1 box has a volume of 2.9 cubic metres (m3 ), and a mass of 470 kilograms (kg), while a Type 2 box has a volume of 1.8 m3 and a mass of 530 kg. There are six Type 1 boxes and eight Type 2 boxes waiting to be loaded. There is only one cargo plane, and it has a volume capacity of 15 m3 and a mass capacity of 3600 kg. Obviously, not all the boxes can be put onto the plane, therefore suppose that the objective is to maximize the value of the load. We will consider the following three situations: (i) both type of boxes are worth $400 each; (ii) a Type 1 box is worth $600, and a Type 2 box is worth $250; and (iii) a Type 1 box is worth $300, and a Type 2 box is worth $750. Later in this course we shall see an efcient approach for solving this type of problem, but for now we use the following simple approach: (a) Let x and y represent the number of Type 1 and Type 2 boxes respectively which are put onto the plane. Where x and y are of course positive integers (including 0), determine all the feasible combinations (x, y), using a spreadsheet to help with the calculations. (To be feasible the total volume carried must be 15m3 , and the total mass carried must be 3600 kg.) (b) Consider a combination found in (a) which can be augmented by adding one box (of either type) with the capacities still not being exceeded. One example is (3, 1), i.e. three Type 1 boxes, plus one Type 2 box, because (3 + 1, 1) = (4, 1), which is feasible, would be a better solution, as would the feasible solution (3, 1 + 1) = (3, 2). This combination (3, 1) (and all others like it) is therefore trivially sub-optimal, because we would obtain more money by adding the extra box. Therefore, we should narrow the search by looking only at the feasible combinations which are so near the limit of either the mass or volume capacity that putting one more box (of either type) onto the plane would make it unable to y. Mathematically, these are the combinations for which (x, y) is feasible, but both (x + 1, y) and (x, y + 1) are not feasible. Find these combinations. (c) Make a spreadsheet in which the alternatives are the combinations from (b), and which has two cells reserved for the value of each type of box. Use the spreadsheet to determine, for each of the three nancial scenarios, how many boxes of each type are carried, and the value of the load. Work on this on your own and come up with your own method. If youre stuck after 15 minutes or so, then look at the hints on the next page.
8 Hints
Obviously carrying no boxes is feasible, so this is a good starting point. This solution is represented as (x, y) = (0, 0). We could then determine using trial-anderror if (0,1) is feasible, and if so, then see if (0,2) is feasible, and so on. A faster way, however, is to start by xing x = 0, and then nd the largest value for y. There are three restrictions: we cannot exceed the volume available; we cannot exceed the mass available; and y must be an integer. When x = 0 the volume available is of course the full 15 m3 , and the mass available is 3600 kg. Each unit of y (each Type 2 box) takes up 1.8 m3 and 530 kg, therefore y is the largest integer such that both 1.8y 15 and 530y 3600. Hence y 8.333..., and y 6.792.... Hence the most that y can be is 6. Therefore all combinations (x, y) = (0,0), (0,1), (0,2), (0,3), (0,4), (0,5), and (0,6) are feasible. Now suppose that x = 1. This takes up 2.9 m3 and 470 kg, therefore the type 2 boxes can use up to 15 2.9 = 12.1m3 and up to 3600 470 = 3130 kg. Based on this, it can be seen that y can be at most 5. Keep repeating this for higher values of x until no more type 1 boxes can be carried, even if no type 2 boxes are carried. You should nd a total of 26 feasible combinations. Using the rules of part (b), we see that the search can be limited to just ve combinations. A spreadsheet to do the calculations for part (a) could begin as follows:
1 2 3 4 5 6 7 8 9 10 11
A x
B Remaining Volume =15-2.9*A4
C Remaining Mass
D Max. y (Volume)
E Max. y (Mass)
F Overall Max. y
0 1 2 3 4 5 6 7
Find the formula for each of the cells C4, D4, E4, and F4. For F4, you will need the INT function (look at your spreadsheets Help menu). The range B4:F4 is then copied to the rows below. There will be a row in which it and all subsequent
rows contain one or more negative numbers; this means that the corresponding value of x is infeasible.
10
2
2.1
Uncertainty 1
Introduction
The simplest situation involving decision making under uncertainty has the following attributes: There is one decision; the decision maker must choose one of several alternatives. There is one event; one of several possible outcomes will occur. For each combination of alternative and outcome we can calculate the payoff (which may be negative) to the decision maker. The order is very important: the decision must precede the event . First an alternative is chosen, and then an outcome occurs. Here are some common examples: 1. At 8 a.m. you must decide whether or not to carry an umbrella; later that day you nd out whether or not it rains. 2. Before a hockey game, you decide whether or not to place a bet on the outcome; and at the end of the game you nd out which team has won.
2.2
2.2.1
Example
Problem Description
A theatre company wishes to mount a play. A three night run is planned. They have already spent or have committed to spend $2500 for such things as costumes, makeup, and so on. They are denitely going ahead with the play; the only decision they must make is where to hold it. Small, medium, and large theatres are available for rent which hold 100, 400, and 1200 people respectively. Three nights rent at each theatre would cost $600, $1800, and $5500 respectively. They must make a commitment to one of these theatres several weeks before the run begins. The demand for the play is uncertain until the run begins. Demand is heavily inuenced by the critics reviews. The critics will attend a dress rehearsal the night before the rst performance, and their opinions will be printed and broadcast in the media the next morning. The theatre company has already decided to price all
11
the tickets at $12.50 each. From this, they must pay $2.50 per ticket sold in taxes, leaving them with a net revenue of $10 per ticket sold. They know from experience that demand for plays falls into four broad categories of interest: fringe; average; great; and heavy. The number of people who wish to see the play is typically 250 for fringe, 800 for average, 2300 for great, and 4500 for heavy. These are demand levels, not necessarily the number of tickets sold. For example, if a play sells every seat in a 250 seat theatre for three nights, and if another 50 people were wait-listed for tickets but could not obtain them, then 750 tickets were sold, but the demand was for 800 tickets. The demand is an event in which one of four outcomes will occur. To estimate the probabilities of these four outcomes, the theatre company could look at the historical data for plays of this type with tickets sold in this price range. Suppose that of one hundred plays in the past, the interest attracted was twenty for fringe, seventy for average, nine for great, and one for heavy. We would then estimate the chance of the next play attracting fringe interest as P(fringe interest) = 20 = 0.20 100
Continuing in this manner we would estimate the probabilities for average, great, and heavy as 0.70, 0.09, and 0.01 respectively. Using historical data to estimate probabilities ignores such factors as changing consumer tastes and economic conditions, but we have to start somewhere. Using these numbers we will obtain one conclusion after solving the model, but another set of numbers will often lead to a different conclusion. We will examine some of these issues later in the course. This model has been kept simple in that everything has been decided except one thing which theatre to rent. This is the problem which we shall now solve. 2.2.2 Model Formulation
In all models with decision making under uncertainty, we must dene the decisions, their alternatives, the events, and their outcomes. Some textbooks stress the use of symbols for this purpose, however another approach is to use words only, and then dene a shortcut word to use in place of each longer phrase. For both approaches we have the following: They must decide where to hold the play. The alternatives are to rent a small theatre with 100 seats, or rent a medium-sized theatre with 400 seats, or rent a
12
large theatre with 1200 seats. The event is the demand for tickets. The possible outcomes are as follows: there is fringe interest with demand for 250 tickets; there is average interest with demand for 800 tickets; there is great interest with demand for 2300 tickets; or there is heavy interest with demand for 4500 tickets. Because it takes a lot of space to write all these words every time we wish to refer to them, we need a shortcut form. In the method of using symbols, the decision is symbolized with the letter D, and the three alternatives have subscripts on the letter A, making them A1 , A2 , and A3 . The event is symbolized with the letter E , and its four outcomes have subscripts on the letter O, making them O1 , O2 , O3 , and O4 . The alternative and outcome symbols mean the following: Alternative rent a small theatre with 100 seats rent a medium-sized theatre with 400 seats rent a large theatre with 1200 seats Outcome there is fringe interest; the demand is for 250 tickets there is average interest; the demand for 800 tickets there is great interest; the demand is for 2300 tickets there is heavy interest; the demand is for 4500 tickets Cost $600 $1800 $5500 Probability 0.20 0.70 0.09 0.01
A1 A2 A3 O1 O2 O3 O4
The other approach is to use one word (or a very short phrase) to mean the entire long phrase. Such words must be unique . For example, we cannot use medium to refer to both a medium-sized theatre and to average interest. Using this approach we could use the following words: Alternatives small rent a small theatre with 100 seats medium rent a medium-sized theatre with 400 seats large rent a large theatre with 1200 seats Outcomes fringe there is fringe interest; the demand is for 250 tickets average there is average interest; the demand for 800 tickets great there is great interest; the demand is for 2300 tickets heavy there is heavy interest; the demand is for 4500 tickets Cost $600 $1800 $5500 Probability 0.20 0.70 0.09 0.01
13
Whichever method is used, the important thing is that the person making the model must understand what the alternatives and outcomes are. The only other pieces of information we need from the problem description is that the net revenue after taxes is $10 per ticket sold, and that the play runs for three nights. The other expenses such as costumes, makeup, and so on are what are called sunk costs . A sunk cost is money which is either already spent or has already been committed, and is therefore irrelevant to the decision. Indeed, even if these xed expenses (which total $2500) were not already committed, they would not affect the decision in this example, because all alternatives would contain these same expenses. 2.2.3 Model Solution
There are three alternatives, and four outcomes, hence there are three times four equals twelve situations which need to be evaluated. First we see what happens if a small theatre is rented, and the play only attracts fringe interest. The 100-seat small theatre can hold 300 people over three nights, but only 250 people want to see the play, so only 250 tickets are sold. The net revenue from the ticket sales is therefore $10 times 250 = $2500. We can now nd what is often called the prot, but we dene a new term payoff , which can mean prot, cost, or revenue depending on the context. The payoff is found by subtracting the $600 rent from the $2500 from the sales of tickets, i.e. $1900. If a small theatre is rented, but the demand turns out to be average, then there are more willing customers (800) than there are seats (300). The number of ticket sales is therefore just 300. For any situation, we can say that the number of tickets sold is the capacity of the theatre (over three nights), or the demand for tickets, whichever is less. The payoff is $10(300) $600 = $2400 We do not need to analyze in detail what happens if more potential customers (great or heavy) show up when only a small theatre has been rented; no more tickets can be sold, so the payoff will remain at $2400. Now suppose that a medium-sized theatre is rented at a cost of $1800. With a 400 seat capacity, a three-night run gives a maximum sales capacity of 1200 tickets. Theres plenty of space with fringe or average demand, but the capacity of 1200 is reached with great or heavy demand. With fringe interest the payoff is: $10(250) $1800 = $700
14 With average interest the payoff is:
$10(800) $1800 = $6200 With either great or heavy demand the payoff is $10(1200) $1800 = $10, 200 If a large theatre with 1200 seats is rented for $5500, the three-night capacity is 3600 people. This is sufcient for all but heavy demand. The number of tickets sold will equal the demand if interest is fringe, average, or great, and will equal the total capacity (3600) if there is heavy demand. Hence we have: Outcome 3-Night Capacity Demand # of Tickets Sold Net Ticket Revenue Rent Payoff fringe 3600 250 250 $2500 $5500 $3000 average great heavy 3600 3600 3600 800 2300 4500 800 2300 3600 $8000 $23,000 $36,000 $5500 $5500 $5500 $2500 $17,500 $30,500
The preceding calculations do not need to be always explicitly written out as we have done here. Often the calculations can be done on a calculator, with just the nal payoffs being written down. Or, as we soon shall see, we can use a spreadsheet to do the calculations. Of course, to do this by any means we must understand how the nal payoff is derived. In all twelve cases, the payoff is computed as: payoff = $10 min{ three-night capacity, demand } rent All of this information can be conveniently summarized in what is called a payoff matrix (also called a payoff table). In doing this by hand, just one payoff matrix is drawn . However, to help explain it, we draw it once with just the borders, then with the main body lled in, and then with the right-hand side lled in. In the main body of the payoff matrix, each row represents an alternative, and each column represents an outcome. Labels for the alternatives appear on the lefthand side, and labels for the outcomes appear on the top. The nal row lists the
15
probabilities of the outcomes. The nal column is reserved for the expected value of each alternative this will be explained shortly. It is helpful if we put the theatre capacity (over three nights) and the cost of the rent next to the name of the alternative, and the demand as a number next to the names for the four levels of demand. Doing this the payoff matrix begins as: Demand for Tickets Average Great Heavy 800 2300 4500
Theatre 3-Night Size Capacity Rent Small 300 $600 Medium 1200 $1800 Large 3600 $5500 Probability
Fringe 250
Expected Value
0.20
0.70
0.09
0.01
Using the formula =$10 min{ three-night capacity, demand } rent, each payoff is calculated and put into the table. If we are doing these calculations using a calculator, we would look for shortcuts like noticing the repetition of the 2400 for the rst alternative. We of course have already done these calculations by hand, and hence we have (dropping the dollar signs):
Theatre Size Small Medium Large
3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability
Fringe 250 1900 700 3000 0.20
Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10,200 10,200 2500 17,500 30,500 0.70 0.09 0.01
Expected Value
If we wish to use a spreadsheet, we will input the theatre size, and let the 3night capacity be found as part of the formula, which is entered once and then is copied. Besides doing the calculations, using a spreadsheet makes it easy to change colours and/or fonts to highlight information. The real advantage, however, is that it easily allows us to see what happens when some of the information is changed. In spreadsheet form we begin with:
16
A 1 2 3 4 5 6 7 Theatre Size Small Medium Large
# of Seats Rent 100 $600 400 $1800 1200 $5500 Probability
E F G Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500
H Expected Value
0.20
0.70
0.09
0.01
We want to make a formula in cell D4 which we can copy to the range D4:G6. The number of seats available is in cell B4, hence the 3-night capacity is 3*B4. The demand is in cell D3, and the cost of the rent is in cell C4. Remember that a dollar sign creates an absolute rather than a relative cell address. Hence we must use a dollar sign to freeze the B in B4, the 3 in D3, and the C in C4. The formula to be placed in cell D4 is therefore: =10*MIN(3*$B4,D$3)-$C4 With the numbers in the main body of the payoff matrix being calculated by the spreadsheet (commas will not appear unless special formatting is used) we have: A 1 2 3 4 5 6 7 Theatre Size Small Medium Large B C D Fringe 250 1900 700 3000 0.20 E F G Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10200 10200 2500 17500 30500 0.70 0.09 0.01 H Expected Value
There is an expected value associated with each alternative. Recall from having studied random variables that in general, if there are n outcomes, and the probability of outcome i is pi , and the payoff of outcome i is xi , then the expected value is dened as: E (X) = pi xi
i=1 n
(1)
17
The current example has four outcomes. The expected value associated with renting a large theatre is EV(large) = 0.20(3000) + 0.70(2500) + 0.09(17, 500) + 0.01(30, 500) = 600 + 1750 + 1575 + 305 = 3030 What this gure means is that if the theatre company were to face the same situation many times, and if they were to choose a large theatre each time, then over time their prots/losses would average out to $3,030. The actual payoff on a particular play will be either $3000, or $2500, or $17,500, or $30,500. Hence the expected value is none of the actual values; it is simply a long-term average value. When some of the outcomes are the same, as occurs for the medium-sized theatre alternative, we can factor the numbers if we wish: EV(medium) = 0.20(700) + 0.70(6200) + (0.09 + 0.01)(10, 200) = 140 + 4340 + 1020 = 5500 The small theatre alternative is even easier: EV(small) = 0.20(1900) + (0.70 + 0.09 + 0.01)(2400) = 380 + 1920 = 2300 We have shown these calculations in detail because the material is new, but from now on we will simply calculate the numbers and write only the nal answer. Filling in the numbers in the Expected Value column we have: Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10,200 10,200 2500 17,500 30,500 0.70 0.09 0.01
Fringe 250 1900 700 3000 0.20
Expected Value $2300 $5500 $3030
18
Now let us see how to do this using a spreadsheet. In cell H4, we wish to write a formula which will nd the dot product of the probabilities in D7:G7 with the payoffs in D4:G4. One way to do this (ignoring absolute cell addresses for the moment) is: =D7*D4+E7*E4+F7*F4+G7*G4 Because we only have four outcomes, we could do it this way. However, this approach would be very cumbersome if we had say twenty outcomes. Therefore, we will instead use the spreadsheet SUMPRODUCT function. The SUMPRODUCT function nds the dot product of the numbers in range1 with the numbers in range2, where both ranges are rows (or columns) of equal size. The syntax is SUMPRODUCT(range1,range2). We must put absolute cell addresses on row 7 (the probabilities), hence the formula to be placed in cell H4 is: =SUMPRODUCT(D$7:G$7,D4:G4) This formula is copied into cells H5 and H6. If we format the range H4:H6 as currency, we will obtain:
D Fringe 250 1900 700 3000 0.20
E F G Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10200 10200 2500 17500 30500 0.70 0.09 0.01
H Expected Value $2300.00 $5500.00 $3030.00
The formatting of the numbers is a matter of individual preference. For example, any of 2300, $2300, or $2300.00 could be used. On average, the best alternative is the one with the highest expected value. In the next section, we shall look at alternate decision criteria, but in the absence of reason to the contrary the preferred criterion for decision making under uncertainty will be to choose the alternative with the highest expected value.
c April 28, 2010 D.M. Tulett 2.2.4 Recommendation
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For the example at hand, the best alternative is clearly to rent a medium-sized theatre, with an expected payoff of $5500. As we said in the introductory section, the developer of the model must make the recommendation clear to the customer of the model. In this example, the customer is the theatre company. They might not be familiar with payoff matrices or spreadsheets, so we focus on giving the recommendation - the spreadsheet itself is just an appendix. For the sake of this course, lets say that the term expected payoff can be used; in real life more explanation would be required. Hence within this course we would write the recommendation as: Recommendation
Rent a medium-sized theatre, with an expected payoff of $5500. In giving a recommendation to the theatre company in real-life, something along the following lines might be appropriate:
To: From: Subject:
The Management Committee, Amateur Theatre Group J. Blow, MS Consulting Company Theatre Rental
Thankyou for this opportunity to assist your theatre company, which I am happy to provide on a pro-bono basis. After studying the three alternatives, I conclude that renting a medium-sized theatre would be best. Based on the assumptions which you provided, the prot (before deducting xed expenses such as costumes and makeup) will be either $700, $6200, or $10,200; if a situation like this were to be repeated many times the prot would average out to $5500. After deducting the $2500 in xed expenses the company will be left with a prot (loss) of ($1800), $3700, or $7700; if a situation like this were to be repeated many times the prot would average out to $3000. A spreadsheet which I used to make the gross prot calculations appears as an appendix to this memo. J. Blow Analyst
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D Fringe 250 1900 700 3000 0.20
E F G Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10200 10200 2500 17500 30500 0.70 0.09 0.01
H Expected Value $2300.00 $5500.00 $3030.00
2.3
Exercise
A computer retailer is about to order some computers from the manufacturer. Over the next two months the retailer believes that there is a 20% chance of demand for ten computers, a 30% chance of demand for eleven, a 20% chance of demand for twelve, a 20% chance for thirteen, and nally a 10% chance that fourteen computers will be demanded. On a per-unit basis, the wholesale cost is $1500, and the retail price is $1950. [Assume that any computers leftover after the two month period become worthless.] (a) Solve this problem by hand by using a payoff matrix. Rather than develop a formula, it is easier to rst nd out what happens if 10 computers are ordered, and then 10 are demanded. Then, calculate the payoff when 11 are ordered, and 11 are demanded, and then continue to nd the rest of the payoffs on the main diagonal. Next, write the payoffs in the top right-hand triangle (very easy). Finally, write the payoffs in the bottom left-hand triangle. Begin this latter step by determining what happens if 11 computers are ordered, but only 10 are demanded. By how much worse should this be than the (10,10) situation? By how much worse should this be than the (11,11) situation? Both answers should lead to the same payoff for the (11,10) case. Continue in this manner to nd all the payoffs. Then, compute the expected values and determine the best policy. (b) Solve this problem using a spreadsheet. This will require the development of a formula for the (10,10) situation, which is then copied for all situations. Create a formula for the order 10 alternative, and copy this formula to all alternatives. [Save the spreadsheet le for later use.] Obviously the recommendation which follows from (a) or (b) must be the same. State this recommendation clearly.
21
3
3.1
Uncertainty 2
Salvage Value
In this section we consider an extension to the basic model of decision making under uncertainty when there is one decision and one event. First, we introduce the concept of a salvage value , which is the remaining value of something which has not sold at the regular price. It could also be called a clearance price . It is often used when a company needs to clear inventory quickly; here are some examples: 1. A newspaper has a regular price of 75 cents. The next morning, the left-over copies are sold to a paper recycling operation for 5 cents each. 2. A winter coat is priced at $300. If its not sold by the end of March, its priced to clear at $160. 3. A hardcover book lists for $39.95. Some people buy it at this price, but when sales drop to nothing, the book is priced to clear at $9.99. Sometimes items for sale pass through multiple price levels. For example, a videotape of a recent release may be priced as high as $34.99, but then the price is progressively lowered to $19.99, then $12.99, and nally the product is priced to clear at $5.00. However, we will not make models with more than two price levels, for this only makes the problem complex. Also, unless stated to the contrary, we will assume that all the inventory which remains after trying to sell the product at the regular price can in fact be sold at the salvage value. Another assumption is that the existence of a clearance price does not affect the regular sales. The solution to the model depends on the assumptions made if the assumptions are unrealistic, then so too will be the solution. 3.1.1 Theatre Example with Salvage Value
Suppose that fteen minutes before showtime, the theatre company decides to price all unsold seats at $2.40 each, netting a revenue of $2 each after taxes. A sign is placed outside the theatre announcing the price reduction, and hopefully bargain-hunters and passers-by who see the sign will pay the reduced price to see the play. We will begin by investigating what happens if we make the following assumptions:
22
c April 28, 2010 D.M. Tulett 1. All seats not sold at the regular price will sell-out at the reduced price. 2. The demand at the regular price is not affected by the existence of the cheaper tickets.
Because we have already solved the problem without the salvage revenue, all we need do is nd what the salvage revenue will be in each of the twelve situations (3 alternatives; 4 outcomes) and add it to the previously found payoff in that situation. Clearly, the sell-out situations are unchanged. These are: small theatre with average, great, or heavy demand; a medium-sized theatre with great or heavy demand; and a large theatre with heavy demand. For the non-sellout situations, the salvage revenue is: $2 (three-night capacity the demand for tickets at the regular price) Using this formula we obtain: Fringe 250 2(300 250) = 100 2(1200 250) = 1900 2(3600 250) = 6700 Average 800 Great 2300 Heavy 4500
Small Medium Large
300 1200 3600
2(1200 800) = 800 2(3600 800) 2(3600 2300) = 5600 = 2600
Before proceeding further we should question whether these results seem reasonable. The extreme situation is when a large theatre has been rented, but the play only attracts fringe interest. According to the above model, 250 people pay the regular price, and then ten minutes before showtime 3350 people (spread over three nights) arrive to ll the theatre. This is clearly not reasonable. First of all, not that many people would walk by the theatre to obtain tickets, especially a play which has been panned by the critics. A new assumption about demand is therefore required. One possibility would be to limit demand to say 300 tickets (100 per night) at the discount price. Doing this would limit the salvage revenue to a maximum of $2(300) = $600. With this assumption the table becomes: Fringe 250 100 600 600 Average 800 600 600 Great 2300 600 Heavy 4500
Small Medium Large
300 1200 3600
23
If we now believe that this table seems reasonable we can proceed to the next step, which is to add these payoffs to those obtained before. Doing this, and then nding the new expected values, we obtain: Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500 2000 2400 2400 2400 1300 6800 10,200 10,200 2400 3100 18,100 30,500 0.20 0.70 0.09 0.01
As an aside, we note that there are two ways to nd the new expected values. Using the alternative of renting a large theatre to illustrate, one way is to calculate: 0.20(2400) + 0.70(3100) + 0.09(18, 100) + 0.01(30, 500) = 3624 The other way is to note that the previous EV in this row was 3030. We added 600 to each of the rst three columns, therefore the new EV is: 3030 + (0.20 + 0.70 + 0.09)600 = 3624 With the assumption that discount tickets sales are limited to 300, we see that while each of the three EVs changes, the optimal alternative remains the same, i.e. rent a medium-sized theatre. To do these calculations on a spreadsheet, we modify what we did earlier (page 16). The formula in cell D4 is currently: =10*MIN(3*$B4,D$3)-$C4 The number of unsold seats is either 0 or 3*$B4-D$3, whichever is greater. This is represented as MAX(0,3*$B4-D$3). By our assumption that we cannot sell more than 300 discount tickets, the number of discount tickets sold is either 300, or MAX(0,3*$B4-D$3), whichever is fewer. Hence the number of discount tickets sold is MIN(300,MAX(0,3*$B4-D$3)) They net $2 for each ticket, and hence the salvage revenue is 2*MIN(300,MAX(0,3*$B4-D$3))
24
Adding this revenue the formula in cell D4 becomes: =10*MIN(3*$B4,D$3)+2*MIN(300,MAX(0,3*$B4-D$3))-$C4 There may be more than one way to correctly write a formula. For example, if the demand equals or exceeds the number of seats, then the revenue is the number of seats multiplied by $10, otherwise the revenue is the demand multiplied by $10, plus $2 for each seat not sold at the regular price up to a maximum demand of 300 at the lower price. This logic is captured in the following IF statement for cell D4, from which the rent is subtracted: =IF(D$3>=3*$B4,10*3*$B4,10*D$3+2*MIN(300,3*$B4-D$3))-$C4 This alternate formula is no shorter, but it may be easier to understand. Either formula is entered into cell D4 and is then copied into the range D4:G6. Doing this we obtain: E F G H Demand for Tickets Theatre # of Fringe Average Great Heavy Expected Size Seats Rent 250 800 2300 4500 Value Small 100 $600 2000 2400 2400 2400 $2320.00 Medium 400 $1800 1300 6800 10200 10200 $6040.00 Large 1200 $5500 2400 3100 18100 30500 $3624.00 Probability 0.20 0.70 0.09 0.01 Salvage Model with up to 300 discount-priced last-minute tickets A B C D
1 2 3 4 5 6 7 8
Note that a few words have been added on the spreadsheet to make it clear that we are looking at variation of the basic model in which up to 300 discount-priced last-minute tickets may be sold. When a model has been made using a spreadsheet, it is easy to see what happens if one or more of the assumptions of the model is changed. For example, suppose that we believed that up to 1800 (rather than just 300) discount-priced last-minute tickets could be sold. All we need do is replace the 300 in the formulas in cell D4 with 1800, and then copy this new formula to the range D4:G6. The modied formula in cell D4 is: =10*MIN(3*$B4,D$3)+2*MIN(1800,MAX(0,3*$B4-D$3))-$C4
25
Of course, a better spreadsheet design would be to place this number in its own cell, and have the formula in D4 refer to the cell that contains the number. With the change from 300 to 1800 everywhere in D4:G6 we obtain: E F G H Demand for Tickets Theatre # of Fringe Average Great Heavy Expected Size Seats Rent 250 800 2300 4500 Value Small 100 $600 2000 2400 2400 2400 $2320.00 Medium 400 $1800 2600 7000 10200 10200 $6440.00 Large 1200 $5500 600 6100 18100 20100 $6504.00 Probability 0.20 0.70 0.09 0.01 Salvage Model with up to 1800 discount-priced last-minute tickets A B C D
1 2 3 4 5 6 7 8
Based on this assumption, the recommendation for the theatre rental would change from a medium-sized to a large theatre. A decision analysis model will always be mathematically easy to solve, but whether or not we have solved the real problem (where to hold the play) depends heavily on the assumptions on which the model is based.
3.2
Expected Value of Perfect Information
Suppose that in situations of decision making under uncertainty, it might be possible to obtain perfect information about the uncertain event. For example, suppose that tomorrows weather will be either sunny, cloudy, or rainy. Perfect information about this event would imply that todays forecast for tomorrow is certain to be correct. Of course, a perfect weather forecast is not possible, but the hypothetical construct of perfect information is useful because it establishes an upper bound for the expected value of any information about the event. For example, if a person would pay $5.00 to hear a perfect weather forecast, then a real forecast can be worth no more than $5.00. We are interested in determining the expected value of perfect information (EVPI). We now show how to calculate the EVPI, using the theatre problem as an example. In this case, the uncertainty is the level of demand. Having perfect information means that we are told the demand level before having to commit to one of the three theatres. With perfect information we can choose the best alternative with respect to the level of demand. For any level of demand, we are interested in the highest payoff (i.e. the highest payoff in the column). We recall
26
the payoff matrix for the basic model (i.e. no salvage value), and on this we highlight the best payoff in each column: Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500 1900 2400 2400 2400 700 6200 10,200 10,200 3000 2500 17,500 30,500 0.20 0.70 0.09 0.01
If we are told that the demand will be fringe, then we will choose a small theatre for a payoff of $1900 (the highest payoff in the fringe column). If we are told that the demand will be average, then we will choose a medium-sized theatre for a payoff of $6200. If we are told that the demand will be great or heavy, then we will choose a large theatre, with a payoff of $17,500 for great and $30,500 for heavy. There are now two ways to complete the calculation of the EVPI. 3.2.1 Direct Calculation of the EVPI
The new information only has value if it would change the recommendation that we had before. Before receiving the perfect information, we would have recommended renting a medium-sized theatre. If the perfect information is that demand will be average, then we will still make the same recommendation. However, in the other three outcomes of demand, we will change the recommendation, thereby increasing the payoff over what it would have been. If the perfect information is that demand will be fringe, then we would change the recommendation from medium to small, thereby increasing the payoff from 700 to 1900. If the perfect information is that demand will be great, then we would change the recommendation from medium to large, thereby increasing the payoff from 10,200 to 17,500. If the perfect information is that demand will be heavy, then we would change the recommendation from medium to large, thereby increasing the payoff from 10,200 to 30,500. The probabilities of the perfect information being that these outcomes will occur are 0.20 for fringe, 0.09 for great, and 0.01 for heavy. Hence there is a 20% chance of increasing the payoff from 700 to 1900, a 9% chance of increasing the payoff from 10,200 to 17,500, and a 1% chance of
c April 28, 2010 D.M. Tulett increasing the payoff from 10,200 to 30,500. The EVPI is therefore: EVPI = = = =
27
0.20(1900 700) + 0 + 0.09(17, 500 10, 200) + 0.01(30, 500 10, 200) 0.20(1200) + 0 + 0.09(7300) + 0.01(20, 300) 240 + 0 + 657 + 203 1100
The expected value of perfect information in the theatre example is $1100. [Note: We could have written the second term of the rst line of the EVPI calculation as 0.70(6200 6200), which of course is 0, or we could have omitted it altogether.] 3.2.2 Indirect Calculation of the EVPI
To indirectly calculate the EVPI, we rst nd the expected value with perfect information. To avoid confusion with the EVPI, the short form is EV with PI . The EV with PI is found by calculating the expected payoff based on the best alternative for each outcome. This is done by calculating the expected payoff using the highest payoff in each column. EV with PI = 0.20(1900) + 0.70(6200) + 0.09(17, 500) + 0.01(30, 500) = 380 + 4340 + 1575 + 305 = 6600 The EV with PI is $6600. If we did not have the perfect information, we would have chosen the medium-sized theatre alternative, which has an expected payoff of $5500. The EVPI is the expected amount of the prot increase from not having perfect information to having it. The EVPI is therefore: EVPI = EV with PI EV without PI = 6600 5500 = 1100 As before, the EVPI is $1100. You are expected to know how to calculate the EVPI using both of these methods. For the theatre example, the $1100 establishes an upper bound to the value of any information concerning the demand. If more information were available, the most that they would pay for it would be $1100. If the price were say $500, then it might be worthwhile purchasing it; it would depend on how good the information
28
is. However, if the price were $2000, it would not be worth purchasing no matter how good it is. While a small theatre company would not try to obtain more information about the demand, a company with millions of dollars at risk probably would.
3.3
Decision Criteria
Up to this point our sole decision criterion has been Expected Value. For a prot maximization example, we would choose the alternative with the highest expected value. For a cost minimization example (in which all the payoffs are costs) we would choose the alternative with the lowest expected value. This will remain our preferred decision criterion, but there are other criteria as well, and they are reviewed here. They are illustrated using the theatre example: Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10,200 10,200 2500 17,500 30,500 0.70 0.09 0.01
Fringe 250 1900 700 3000 0.20
3.3.1
Pessimism
If a small theatre is chosen, the payoff will be either $1900 or $2400. Hence, the payoff will be at least $1900. If a medium-sized theatre is chosen, the payoff will be either $700, or $6200, or $10,200, hence the payoff will be at least $700. From the four outcomes in the Large alternative row, we see that the payoff will be at least $3000. Of these three minimum payoffs, $1900, $700, and $3000, the highest is the $1900 payoff. A pessimist would choose the alternative associated with this payoff, i.e. the small theatre. A pessimist would recommend that the small theatre be rented. For any maximization problem, the alternative associated with pessimism is the one which contains the maximum of the row minimums. [Note: In this example, all the rows minimums were in the same column, but this will not be true
29
in general.] For any minimization problem, the alternative associated with pessimism is the one which contains the minimum of the row maximums. Pessimism is an extreme form of risk-aversion which ignores all the information about probabilities. The subject of risk-aversion will be studied in more detail later in the course. 3.3.2 Optimism
An optimist seeks the maximum for each alternative, and then seeks the maximum of the maximums. For the theatre example, the row maximums for Small, Medium, and Large are $2400, $10,200, and $30,500 respectively. The maximum of these three is $30,500, and the alternative associated with this payoff is to rent a large theatre. An optimist would recommend that the large theatre be rented. Like pessimism, optimism ignore the information about probabilities. When optimism is applied to a cost minimization problem, we nd the minimum of the row minimums. 3.3.3 Hurwicz
The Hurwicz criterion is a mixture of the criteria of Pessimism and Optimism. Either a coefcient of Pessimism (CoP) or a coefcient of Optimism (CoO) (one is the complement of the other) is chosen, and then (for maximization) a weighted average of the row minimums and maximums is found; the alternative with the highest weighted average is then chosen. For the purposes of this course the CoP or CoO will be an exogenously given number. For example, suppose we wish to solve the theatre problem with an exogenously given coefcient of pessimism of 0.85. Hence, the coefcient of optimism is 1 0.85 = 0.15, and we have: Small Medium Large Pess. Opt. 1900 2400 700 10,200 3000 30,500 0.85 0.15 Hurwicz 1975 2125 2025
30
The highest weighted average in the Hurwicz column is 2125; a medium-sized theatre is recommended. Based on Hurwicz with CoP = 0.85, a medium-sized theatre is recommended. For a cost minimization problem, the pessimism column is based on row maximums, the optimism column is based on row minimums, and the chosen alternative is based on the lowest number in the Hurwicz column. 3.3.4 Laplace
The Laplace and Expected Value criteria are similar, except that for the Laplace equal probabilities are used. With n outcomes, the probability that any one of them occurs is 1/n. The ranking for the Laplace criterion is conveniently found by summing, for every alternative, all n payoffs, and then dividing by n. We choose the highest ranking for maximization, and the lowest ranking for minimization. For the theatre example with its four outcomes we have: Small Medium Large (1900 + 3(2400))/4 = 2275 (700 + 6200 + 2(10,200))/4 = 6825 (3000 + 2500 + 17,500 + 30,500)/4 = 11,875
The highest of these is 11,875, which is associated with the large theatre. Based on the Laplace criterion the large theatre is recommended. The calculations for the four criteria of Pessimism, Optimism, Hurwicz, and Laplace can all be done on one payoff matrix. The best payoff for each criterion is highlighted; from these payoffs the best alternative for each criterion can be seen.
Fringe 1900 700 3000
Demand for Tickets Average Great Heavy 2400 2400 2400 6200 10,200 10,200 2500 17,500 30,500
Pess. 1900 700 3000 0.85
Opt. 2400 10,200 30,500 0.15
Hurwicz 1975 2125 2025
Laplace 2275 6825 11,875
c April 28, 2010 D.M. Tulett 3.3.5 The Regret Matrix
31
The regret matrix gives the cost of having not chosen, with hindsight, the best alternative for a given outcome. For example, in the theatre problem if the demand turns out to be average, then the payoff is $2400 for small, $6200 for medium, and $2500 for large. With hindsight, renting a medium-sized theatre is best for this particular outcome. In this case, there is no foregone prot. However, if the small theatre alternative were chosen, the foregone prot would be $6200 $2400 = $3800 and if the large theatre alternative were chosen, the foregone prot would be $6200 $2500 = $3700 The foregone prot is also called the opportunity loss . To nd the opportunity loss for each situation from an already existing payoff matrix, we work with one column at a time. In every column of the payoff matrix, we subtract each number in the column from the largest number in that column. It is also possible to obtain the regret matrix without rst nding the payoff matrix, and indeed one reason for obtaining the regret matrix is that it is sometimes easier to calculate than the payoff matrix. No matter how it is obtained, one property that the regret matrix will always have is that there must be at least one zero in every column . In a payoff matrix we found the expected value for every alternative; in a regret matrix we nd the expected opportunity loss (EOL) for every alternative. It is found in an analogous manner to the EV by nding the dot product of the probability row with every payoff row. The objective is to minimize the expected opportunity loss, so the best alternative is the one with the lowest number in the EOL column. The regret matrix along with EOL column for the theatre example is: Regret Matrix Theatre 3-Night Size Capacity Rent Small 300 $600 Medium 1200 $1800 Large 3600 $5500 Probability Fringe 250 0 1200 4900 0.20 Demand for Tickets Average Great Heavy 800 2300 4500 3800 15,100 28,100 0 7,300 20,300 3700 0 0 0.70 0.09 0.01
EOL $4300 $1100 $3570
Therefore, the recommendation is:
32
Rent a medium-sized theatre, with an expected opportunity loss of $1100. Some interesting comparisons can be made with the solution obtained by using a payoff matrix: 1. We obtained the same alternative using the regret matrix as we did when using the payoff matrix. This is not a coincidence whether we maximize the expected value or minimize the expected opportunity loss, we always obtain the same alternative . Hence minimizing EOL, unlike pessimism, optimism, Hurwicz, and Laplace, is not a new decision criterion, but instead is just a variation on the maximizing expected value approach. 2. The minimum EOL, which is $1100, equals the EVPI. Again, this is not a coincidence it is always true. While this gives us a third method for nding the EVPI, usually one does not not take this approach to nding it if the payoff matrix has already been found. 3. For every alternative, the sum of the expected value and the expected opportunity loss is the same. Moreover, this sum is the EV with PI. EV + 2300 + 5500 + 3030 + EOL = EV with PI 4300 = 6600 1100 = 6600 3570 = 6600
Small Medium Large
This property is true for all examples.
3.4
Exercise
(a) For the Exercise at the end of Uncertainty 1 (Exercise 2), determine the EVPI both directly and indirectly. For parts (b) to (f), the data is the same as in part (a), except that now any leftover computers are sold for $1400 each. (b) Re-solve Exercise 2 by hand, this time using the $1400 salvage value. (c) Using a spreadsheet, re-solve Exercise 2, now using a $1400 salvage value. [To save work, begin by copying the spreadsheet you made before. Obviously, (b) and (c) should produce the same result.]
c April 28, 2010 D.M. Tulett (d) Determine the EVPI both directly and indirectly.
33
(e) Which alternative would be picked using: (i) Pessimism; (ii) Optimism; (iii) Hurwicz with a coefcient of optimism of 0.8; (iv) Laplace? (f) By hand, nd the regret matrix, and determine the alternative with the minimum EOL. Try to nd the regret matrix just from the data of the problem, without looking at the payoff matrix from part (b).
34
4
4.1
Uncertainty 3
Marginal Analysis
Some problems involving one decision and one event can be solved by a method that requires less work than is required for making a payoff matrix. This new method is called marginal analysis . It is applicable in problems such as the computer example (with or without salvage) in which there is a cost per unit ordered (w), a price at which items are sold (r) where the demand has any kind of discrete distribution (P(d )), and a price per unit at which all leftover items are sold (s). The marginal analysis method is not applicable for irregular problems such as the theatre example. Let x (an integer) represent the optimal order quantity. The parameters of the model are: Symbol r s w Meaning r etail price s alvage price w holesale price
The context requires that the retail price be greater than the wholesale price, for otherwise the business could not exist. Also, the salvage value must be less than the wholesale price, for otherwise any amount of stock could be ordered at no risk to the retailer. Putting these observations into symbolic terms we have: r>w>s The distribution P(d ) gives the probability that the demand at price r is for exactly d units. We let F (d ) represent the cumulative probability function, which is the probability that d or fewer units are demanded. We can write F (d ) in terms of P(d ) as follows: F (0) F (1) F (2) F (3) = = = = P(0) P(0) + P(1) P(0) + P(1) + P(2) P(0) + P(1) + P(2) + P(3)
and so on. Also, for d 1, we can use the recursive formula: F (d ) = F (d 1) + P(d ) (d 1)
35
The optimal order quantity is given by the marginal analysis formula . It is not proved here, because the proof is somewhat advanced for an introductory course. [You will not be tested on the proof all that is required is that you know how to use the formula.] The value of x (the optimal order quantity) is chosen such that: F (x 1) < rw F (x) rs (2)
Another way of saying this is that we want the smallest value of x such that: rw F (x) rs 4.1.1 Computer Example
In the computer example, the retail price is $1950, the wholesale price is $1500, and the salvage value is $1400. Therefore, rw 1950 1500 = rs 1950 1400 450 = 550 0.818 The chance that the demand is for exactly 10, 11, 12, 13, and 14 units is 20%, 30%, 20%, 20%, and 10% respectively. Hence P(10) = 0.2, P(11) = 0.3, P(12) = 0.2, P(13) = 0.2, and P(14) = 0.1. All P(d ) from d = 0 to d = 9 inclusive are 0, hence F (d ) = 0 from d = 0 to d = 9 inclusive. Hence F (10) = F (9) + P(10) = 0 + 0.2 = 0.2 We can make a table to nd F (d ), in which d goes from 10 to 14 inclusive, P(d ) comes from the given probabilities, and F (d ) is found recursively (for example the two numbers highlighted in blue are summed to nd the number highlighted in red): d P(d ) F (d ) 10 0.2 0.2 11 12 0.3 0.2 0.5 0.7 13 0.2 0.9 14 0.1 1.0
36
The critical value is about 0.818; the number just above this in the F (d ) line is 0.9 (highlighted in yellow), and this is in the d = 13 column. In terms of the formula we have: F (13 1) = 0.7 < 0.818 0.9 = F (13) The recommendation is to order 13 computers. In this case, the critical fraction 0.818 is closer to 0.9 than it is to 0.7, but this fact is irrelevant . Even if the critical fraction were say 0.703, we would order 13 (and not 12) computers. Note that while the formula gives us the best order quantity, it does not also give us the expected payoff associated with this quantity. If we want this too, we can easily nd it by solving for only the optimal row in the payoff matrix.
4.2
Sensitivity Analysis
The subject of sensitivity analysis (also called what-if analysis ) is a recurring theme throughout the eld of management science. The whole point to building a model is that it is much cheaper than building what the model represents. We can play around with the model quite inexpensively, and one of the things that we should do is see how sensitive it is to changes in the built-in assumptions of the model. The Greek symbol (pronounced delta) is often used to represent a change to something. We might use p (read as delta p) to represent a change in probability, or c to represent a change in cost; where the context is clear, we can simply use . Usually, can be either positive or negative. To keeps things simple, we often just vary one parameter at a time, but changing probabilities is an important exception. If one probability is increased, then at least one other probability must be decreased (by the same absolute amount) so that the probabilities remain summed to one. Also, in this situation, we must establish a domain for p based on the fact that no probability can go below 0 or above 1. 4.2.1 Theatre Example
Included in the original parameters are that the probability of fringe interest is 0.2, and the probability of average interest is 0.7. Suppose that we now wish to see what happens if we vary these two probabilities, with everything else remaining
37
constant. Suppose that the rst is increased by p, and the other is decreased by p. (Doing it the other way around would be ne; everything will work out in the end.) Hence we have: p(fringe) = 0.2 + p p(average) = 0.7 p We must ensure that neither probability goes below 0. If we do this, we will automatically ensure that neither probability goes above 1. The condition that 0.2 + p 0 will be true provided that p 0.2. The condition that 0.7 p 0 will be true provided that p 0.7. Hence, the domain of p is: 0.2 p 0.7 [Note: In general if the two probabilities are a + p and b p, then we must have a p b.] When we rst solved the problem we obtained: Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500 1900 2400 2400 2400 700 6200 10,200 10,200 3000 2500 17,500 30,500 0.20 0.70 0.09 0.01
Now, in the probability row, the 0.20 becomes 0.20 + p, and the 0.70 becomes 0.70 p, and we wish to determine the revised Expected Values. Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10,200 10,200 2500 17,500 30,500 0.70 0.09 0.01 p
Fringe 250 1900 700 3000 0.20 + p
Expected Value
38
The long way to do this, using the Small alternative to illustrate, is to re-compute the entire dot product (Small row and the Probability row). EV(small) = = = = (0.2 + p)1900 + (0.7 p)2400 + .09(2400) + .01(2400) 0.2(1900) + 1900 p + 0.7(2400) 2400 p + .09(2400) + .01(2400) 0.2(1900) + (0.7 + 0.09 + 0.01)2400 + (1900 2400) p 2300 500 p
The short way to do this is to recognize that the 2300 has been computed already all we need to do is include the terms involving p. [If p = 0, we must obtain the original result.] All we need are the columns which contain the ps and the original Expected Values. Expected Value Original p Term 2300 5500 3030
Small Medium Large
Fringe Average 1900 2400 700 6200 3000 2500 p p
The short way is simply: EV(small) = 2300 + 1900 p + 2400( p) = 2300 + 1900 p 2400 p = 2300 500 p For the medium and large theatre alternatives we have: EV(medium) = 5500 + 700 p + 6200( p) = 5500 5500 p EV(large) = 3030 + (3000) p + 2500( p) = 3030 5500 p The completed table is:
c April 28, 2010 D.M. Tulett Expected Value Original p Term 2300 500 p 5500 5500 p 3030 5500 p
39
Small Medium Large
Fringe 1900 700 3000 p
Average 2400 6200 2500 p
Comparing Medium with Large, we see that for any value of p, 5500 5500 p > 3030 5500 p and hence Medium is better than Large. These lines are parallel (because of the 5500) and therefore they never intercept. If we compare Small with Medium, we have EV(Small) = 2300 500 p versus EV(Medium) = 5500 5500 p. We are indifferent between two alternatives when neither is preferred to the other. To nd the point of indifference, we set the two payoffs equal to each other: EV(Small) 2300 500 p 5000 p p = = = = EV(Medium) 5500 5500 p 3200 0.64
This value is within the domain 0.2 p 0.7. [Were it not so, there would be no point of indifference.] We know that Medium is preferred at p = 0 (the current situation), and we have found that we would switch to Small at p = 0.64. Since these are the only alternatives (because Large was eliminated), Medium must be best for any p in the domain < 0.64, theres a tie at 0.64, and Small is best for all other values. By letting both alternatives be considered best at the tie, we can state the regions of preference as: 0.2 p 0.64 Medium 0.64 p 0.70 Small We can also show this information on a number line for p (where 0.2 p 0.7), highlighting with colour the regions for the recommended theatre size.
40
Medium .2 0 .2 .4 p
Small .6 T 0.64
p = 0.64 is a very large change for a probability. If we believe that the initial estimate of 0.2 couldnt be off the true value by all that much, then we would be quite condent that our initial choice of Medium is correct. The point of indifference can also be expressed in terms of the original probabilities. These are: p(fringe) = 0.2 + 0.64 = 0.84 p(average) = 0.7 0.64 = 0.06 4.2.2 A More Complicated Example
The preceding example was fairly easy in that we were able to reduce it down to two alternatives, and so we only had to nd a single point of indifference. Usually, however, we cannot eliminate any alternative simply by inspection. When this happens, a conceptually easy approach is to make a graph of EV versus p. Doing it rst this way gives us a shorter analytical method for this type of problem. The example presented here provides an illustration of these concepts. Consider an example with four alternatives and three outcomes, for which we begin with all payoffs having been found, and the expected values having been calculated: A1 A2 A3 A4 Prob. O1 O2 O3 7 5 4 5 5 6 4 6 3 6 4 6 .2 .5 .3 EV 5.1 5.3 4.7 5.0
41
Hence the recommendation is to choose alternative A2 , with an expected payoff of 5.3. Now suppose that we wish to vary the probabilities for O2 and O3 . We will let the probability of O2 be 0.5 + p, and the probability of O3 be 0.3 p. The domain for p is therefore: 0.5 p 0.3 The new expected values are: A1 A2 A3 A4 O2 5 5 6 4 p O3 4 6 3 6 p EV 5.1 + p 5.3 p 4.7 + 3 p 5.0 2 p
Unlike the previous example, it is difcult to remove an alternative simply by inspection; one approach is to draw a graph. Graphical Solution Each of the EV equations is a straight line. For each of these, all we need do is nd the EV for any p = 0, and this along with the original EV (i.e. at p = 0) gives the two distinct points needed to dene the line. However, with a little bit of extra work we can obtain each line with a check on the calculations. To do this we nd the EV at the lower limit for p, and then nd the EV at the upper limit for p. These two points are used to dene the line, and the check on the calculations comes from making sure that the line passes through the original EV at p = 0. In this example, the lower and upper limits for p are at 0.5 and 0.3 respectively. For alternative 1, the EV ranges from 5.1 + (0.5) = 4.6 to 5.1 + 0.3 = 5.4. For alternative 2, the EV ranges from 5.3 (0.5) = 5.8 to 5.3 0.3 = 5.0. For alternative 3, the EV ranges from 4.7 + 3(0.5) = 3.2 to 4.7 + 3(0.3) = 5.6. Finally, for alternative 4 the EV ranges from 5 2(0.5) = 6.0 to 5 2(0.3) = 4.4. In summary we have: p = 0.5 4.6 5.8 3.2 6.0 EV at p = 0 5.1 5.3 4.7 5.0 p = 0.3 5.4 5.0 5.6 4.4
A1 A2 A3 A4
42
The horizontal axis goes from p = 0.5 to p = 0.3. Since the smallest EV is 3.2, and the largest is 6.0, we can save vertical space by having the axis run only between 3 and 6 (rather than starting at 0). It is helpful to draw this graph with three vertical axes: one through the lower limit for p; one through 0; and one through the upper limit for p. With the axes drawn, we proceed with drawing the four lines. The A1 line goes from 4.6 on the left vertical axis to 5.4 on the right vertical axis. Next to this line the A1 symbol is drawn. On the centre vertical axis, we see indeed that the line passes through the point (0,5.1). The other three lines are drawn with their symbols, each time verifying that the point on the centre vertical axis is where it should be.
r 6.0 r
6.0
r 5.5 5.5 A r 2 EV r 5.0 5.0 A 1 A r 4 4.5 4.5 r 4.0 4.0 A3 3.5 3.5 r
3.0
.4
.2
.2
3.0
43
We want, of course, the line segments which maximize the expected value. These line segments have been highlighted on the graph. At p = 0.5, A4 is best. As we move to the right, the best alternative switches to A2 , then A1 , and then A3 . Hence we need to nd where the following pairs of lines intercept: A4 and A2 ; A2 and A1 ; and A1 and A3 . To nd the value of p at which the A4 and A2 lines intercept, we set the EV equations equal to each other: EV(A4 ) 5.0 2 p p p = = = = EV(A2 ) 5.3 p 0.3 0.3
At this value for p, EV(A4 ) = 5.0 2(0.3) = 5.6. [Also, EV(A2 ) = 5.3 (0.3) = 5.6.] Hence the two lines intercept at (0.3, 5.6). We then nd the other two interception points: EV(A2 ) 5.3 p 2 p p = = = = EV(A1 ) 5.1 + p 0.2 0.1
At this value for p, EV(A2 ) = 5.3 (0.1) = 5.2. EV(A1 ) 5.1 + p 2 p p = = = = EV(A3 ) 4.7 + 3 p 0.4 0.2
At this value for p, EV(A1 ) = 5.1 + (0.2) = 5.3. There are three ways that we could report these values. As we did in the previous example, we could draw a number line, highlighting the regions where a particular alternative is best. Secondly, we could indicate this information on the graph, which of course gives the absolute rather than just the relative ranking of each alternative. Thirdly, we could simply report the regions as follows:
44 Region for p 0.5 p 0.3 0.3 p 0.1 0.1 p 0.2 0.2 p 0.3
c April 28, 2010 D.M. Tulett Best Alternative A4 A2 A1 A3
Sometimes, we do not need to know the best alternatives over the entire domain of p. Instead, we might only wish to determine the values for p for which the current solution (i.e. at p = 0) remains optimal. For this example, the current solution remains A2 provided that: 0.3 p 0.1 Analytical Solution We can also solve such a problem quickly as follows. First, here are some general comments for any situation. Consider two alternatives, with expected payoffs a + b, and c + d , where a > c and b = d (i.e. the two lines are not parallel). (For simplicity, we are using rather than p.) These alternatives have the same expected payoff when: c + d = a + b (d b) = a c ac = d b If the critical value (a c)/(d b) turns out to be outside of the domain of , then the c + d alternative is not best for any value of . If, however, it is inside the domain, then we must consider this alternative along with any others. With many alternatives we nd the critical value of for each one (where the comparison alternative is the one optimal at = 0); we seek the ones whose critical values are immediately on either side of 0. Now we solve the example from before, rst going back to the table showing the effects of . A1 A2 A3 A4 O2 5 5 6 4 O3 4 6 3 6 EV 5.1 + 5.3 4.7 + 3 5.0 2
45
At = 0, A2 is best. Hence we nd where the A1 , A3 , and A4 lines meet the A2 line: EV(A2 ) 5.3 2 EV(A2 ) 5.3 4 = = = = = = = = EV(A1 ) 5.1 + 0.2 0.1 EV(A3 ) 4.7 + 3 0.6 0.15
EV(A2 ) = EV(A4 ) 5.3 = 5.0 2 = 0.3 Comparing the critical values 0.1, 0.15, and 0.3, the ones immediately on either side of 0 are 0.3 (line A4 ) and 0.1 (line A1 ). Hence A2 remains optimal from 0.3 to 0.1. Below 0.3, A4 is best, and just above 0.1, A1 is best. Further on, the A1 and A3 lines will intercept: EV(A1 ) 5.1 + 2 = = = = EV(A3 ) 4.7 + 3 0.4 0.2
Over the entire domain of we have: Region for 0.5 0.3 0.3 0.1 0.1 0.2 0.2 0.3 Best Alternative A4 A2 A1 A3
46
4.3
4.3.1
Exercise
Marginal Analysis Problem
A vendor has found that demand for newspapers can vary from 31 to 70 inclusive with each number being equally likely. Newspapers are bought by the vendor at 50 cents each, and are sold for 75 cents each. Any left-over copies at the end of the day are sold to a recycling operation at 5 cents per copy. By using the marginal analysis formula, determine the number of copies that the vendor should order. 4.3.2 Sensitivity Problem 1
In this problem we use the data of the computer example with salvage value, except that we now allow the probabilities of demand for 10 and demand for 14 computers to vary. Make a graph of Expected Value vs. p for the ve alternatives, and from this determine all the regions of p where one of the alternatives is better than the others. 4.3.3 Sensitivity Problem 2 A1 A2 A3 A4 Prob. O1 O2 O3 8 2 4 9 7 3 70 15 30 40 60 20 .3 .1 .6 EV
(a) Find the best alternative, using expected value as the decision criterion. Now suppose that the probability of O1 increases by , the probability of O2 increases by 3, the probability of O3 decreases by 4. (b) What is the domain of ? (c) Find, by the analytical method, the regions of where each alternative is best.
47
5
5.1
Decision Trees 1
Introduction
In the previous three sections, we examined simple situations in which there was only one decision, and each alternative was followed by the same event (same outcomes, with the same probabilities). Of course, problems in real-life are not that simple. Even when there is only one decision, the alternatives may be followed by different events. Also, there may be multiple decisions to be made. Either of these complications means that a payoff matrix cannot be used. Beginning with this section, we show how to handle more complex examples. Such problems will be analysed by rst drawing what is called a decision tree . The drawing of the tree, along with the denitions of any symbols or abbreviated forms used on the tree, constitutes the formulation of the problem. The problem is then solved by performing a rollback procedure on the tree. Finally, the recommendation should be stated clearly. The overall procedure involves three phases: 1. The tree is drawn from left to right. 2. The rollback procedure is performed from right to left. 3. The recommendation is given, both in writing and by highlighting on the tree, by going from left to right. In this introduction we explain the graphical symbols used in the decision tree method. Just as real trees have branches , so do decision trees. On a decision tree, the point at which two or more branches meet is called a node . All decision trees have at least two kinds of nodes decision nodes and event nodes . A decision node is drawn as a square, and an event node is drawn as a circle. Associated with each type of node is a corresponding branch emanating from the right side of the node. A decision node is followed by an alternative branch , and an event node is followed by an outcome branch . An alternative branch is represented by a double line, and an outcome branch by a single line. Some textbooks only use what we have described so far, but we nd that it is useful (whenever the decision criterion is expected value) to use three more symbols a cost gate, a payoff node, and a null branch. A cost gate resembles a toll gate on a highway. It is drawn as two small squares (posts) joined by a straight
48
decision node
event
alternative branch outcome branch null branch
node node
d d payoff
cost gate
Figure 1: Symbols for Drawing Decision Trees (from Left to Right) line (the gate). The cost associated with the gate is written next to it; if its a revenue rather than a cost, then the number is placed in parentheses. A payoff node is represented by a crossed circle, which is used to keep track of payoffs which occur before the ending branches of the tree. At the ending branch of the tree (on the extreme right-hand side), the payoff at that point is simply written down a payoff node is not used. A payoff node is followed by a null branch , which is represented as a dashed line. Cost gates can appear on both alternative and null branches, usually representing a cost on the former, and a revenue on the latter. As an alternative to using cost gates (with the cost or revenue next to the gate), payoff nodes, and null branches, the maker of the decision tree could keep track of all costs and revenues and then subtract/add them to the appropriate nal payoffs. Indeed, when dealing with utility functions (which we shall study later) that approach must be used . (This is why some textbooks avoid these three latter symbols.) However, whenever expected value is the decision criterion, using these three extra symbols makes the solution easier to nd. These symbols with their meanings are shown in Figure 1. These seven (or just four) symbols are all that are used when formulating a problem using a decision tree. However, when solving the tree (from right to left), we will use an eighth symbol, which is applied at every square to every branch except that of the best alternative at that square. This symbol consists of two short parallel lines which are drawn at a right angle to the alternative branch: non-recommended alternative
49
In addition to doing this, we can highlight the alternatives which are recommended, should the decision maker possibly arrive at that square. We shall see in the next section that some squares are not part of the optimal solution, hence there is no point in highlighting the best alternative at such a square. This highlighting is part of the third phase, in which one proceeds from left to right.
recommended as part of the overall solution
As has been stated, a decision tree is drawn from left to right, and is then solved (rolled-back) from right to left. The tree is not drawn to scale with respect to time, but the relative position in time must be preserved. Hence if something appears to the right of something else, then the thing on the right must come after (or be at exactly the same time) as the thing on the left.
5.2
Theatre Problem in Tree Form
To illustrate the nature of this approach, we will begin by formulating the theatre problem as a decision tree. [The problem description appears in Section 2.2.1.] This problem needs no payoff nodes; it can be done with or without cost gates on the alternative branches. We will do it both ways, rst without cost gates to show the equivalence with the payoff matrix approach, and then with cost gates to show how these are used. The basic shape of the tree is the same for both approaches, so we will start with that. It should be emphasized that in using this method only one tree needs to be drawn. However, to illustrate this methodology, several trees are shown for one problem so that the order in which the material is drawn is made clear. We begin with a square on the left-hand side which represents the theatre rental decision. Emanating from the right-hand side of the square are three alternative branches (double lines). Next to these branches is a word describing the meaning of the alternative. These words are emphasized here in red, but of course using colour is not required.
50
Theatre Rental medium d d d d d d d d d d d d d d d d d d
At the end of each of the alternative branches, there is a circle for the demand for tickets. Coming out of each circle there are four outcome branches (single lines). Again, words are written to describe the meaning of each outcome. These words have been emphasized in blue. Adding all this to the tree we obtain:
sm
al l
la
e rg
c April 28, 2010 D.M. Tulett Demand

.2 0 e g in e @ fr @ g @ 0.7 ra@ ve@ a@
51
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre e g n i fr Rental 0.7 @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh .0 hh0 9 h d h d h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h heav y 0
sm al l la e rg
.01
5.2.1
Without Cost Gates
When cost gates are not used, all costs are imbedded in the nal payoffs. There are twelve nal branches, and the payoffs which go to their right are in fact the twelve numbers which we calculated earlier and placed in the main body of the payoff matrix. Writing these numbers onto the tree we obtain:
52 Demand

.2 0 e g in e @ fr @ g @ 0.7 ra@ ve@ a@
1900 2400 2400 2400 700 6200 10,200 10,200 3000 2500 17,500 30,500
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre e g n i fr Rental 0.7 @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh .0 hh0 9 h d h d h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h heav y 0
sm
al l
We have nished the left-to-right formulation of the model, and we now proceed with the roll-back procedure, which proceeds from right to left. At each circle, we compute the expected value. Just as we saw when we did it as a payoff matrix, the expected payoff at the circle which ends the small alternative branch is: EV(small) = 0.20(1900) + (0.70 + 0.09 + 0.01)(2400) = 380 + 1920 = 2300 Similarly, EV(medium) = 0.20(700) + 0.70(6200) + (0.09 + 0.01)(10, 200) = 140 + 4340 + 1020 = 5500
la
e rg
.01
53
EV(large) = 0.20(3000) + 0.70(2500) + 0.09(17, 500) + 0.01(30, 500) = 600 + 1750 + 1575 + 305 = 3030 Though not essential, it is helpful to differentiate numbers which are calculated as part of the rollback procedure (right-to-left) from numbers which are part of the formulation (left-to-right). This can be done by highlighting the numbers calculated as part of the rollback. Putting these numbers onto the tree we obtain:
Demand
@@ @ @ hhhh gre at hhh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre e g n i Rental fr 0.7 @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh .0 hh0 9 h d d h 5500 h d e d avy d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a@ d d d d @ @ @ @ h hhhh great hh .0 hh0 9 h h 3030 heav y 0.0
.2 0 e g n i fr 0.7 @ ge@@ 2300 ra@ ve@ a@ @
1900 2400 2400 2400 700 6200 10,200 10,200 3000 2500 17,500 30,500
sm
al
Moving to the left, we come to the square. At a square the best (highest, for prot maximization) payoff is chosen. Clearly, this is the $5500 associated with the medium-sized theatre alternative, and this number goes next to the square. The sub-optimal alternatives are marked with short double lines at right angles to the alternative branches. Putting these things on the tree we have:
la
e rg
54 Demand

.2 0 e g in e @ fr @ g @ 0.7 2300 ra@ ve@ a@
1900 2400 2400 2400 700 6200 10,200 10,200 3000 2500 17,500 30,500
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre e g n i fr Rental 0.7 @ ge@@ ra@ ve@ d a d @ @ @ @ medium @ @ hhhh gre at hhh .0 hh0 9 h d h d 5500 5500 h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h 3030 he avy 0
sm
al l
As with any problem, the recommendation should be stated clearly:
Rent a medium-sized theatre, with an expected payoff of $5500.
Highlighting the optimal alternative we have:
la
e rg
.01

.2 0 e g in e @ fr @ g @ 0.7 2300 ra@ ve@ a@
55 1900 2400 2400 2400 700 6200 10,200 10,200 3000 2500 17,500 30,500
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre e g n i fr Rental 0.7 @ ge@@ ra@ ve@ d a d @ @ @ @ medium @ @ hhhh gre at hhh .0 hh0 9 h d h d 5500 5500 h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h 3030 he avy 0
sm al l la e rg
.01
5.2.2
With Cost Gates
In the theatre problem there is a cost associated with each alternative, which is the rent for the theatre. Recall that this was $600 for the small theatre, $1800 for the medium-sized thatre, and $5500 for the large one. Though we are starting with the tree having being drawn in this instance, normally one would begin to draw the tree and put on the cost gates as the alternative branches are drawn. The tree with cost gates (but without the nal payoffs) is:
56 Demand

.2 0 e g in e @ fr @ g @ 0.7 ra@ ve@ a@
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre d e g n i fr Rental 0.7 d @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh 1800 .0 hh0 9 h d h d h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h heav y 0
60
sm
al l
la
e rg
Now we must determine the nal payoffs. For some problems, these payoffs are given exogenously in the problem description, but for this example we must work them out. These payoffs are all revenues from ticket sales. Recall that the small, medium, and large theatres can hold, over three nights, 300, 1200, and 3600 people respectively. The demand levels for fringe, average, great, and heavy are 250, 800, 2300, and 4500 respectively. The tickets net $10 each. A small theatre obtains a revenue of $10(250) = $2500 with fringe demand, but otherwise the theatre is lled for a revenue of $10(300) = $3000. A medium-sized theatre has a revenue of $2500 for fringe demand, $10(800) = $8000 for average demand, but otherwise the theatre is lled for a revenue of $10(1200) = $12,000. A large theatre has a revenue of $2500 for fringe demand, $8000 for average demand, $10(2300) = $23,000 for great demand, and is lled with heavy demand with a revenue of $10(3600) = $36,000. An advantage of using the cost-gate approach is that it is creates a fair amount of repetition in the nal payoffs. Adding these payoffs to the tree we obtain:
55
00
.01

.2 0 e g in e @ fr @ g @ 0.7 ra@ ve@ a@
57 2500 3000 3000 3000 2500 8000 12,000 12,000 2500 8000 23,000 36,000
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre d e g n i fr Rental 0.7 d @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh 1800 .0 hh0 9 h d h d h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h heav y 0
60 0
sm al l la e rg
Now we calculate the expected value at each circle. Normally we would not write all the details out; we would simply calculate the numbers and then write them on the tree. However, since this is the introductory section for this material, the full workings are shown: EV(small) = 0.20(2500) + (0.70 + 0.09 + 0.01)(3000) = 500 + 2400 = 2900 EV(medium) = 0.20(2500) + 0.70(8000) + (0.09 + 0.01)(12, 000) = 500 + 5600 + 1200 = 7300 EV(large) = 0.20(2500) + 0.70(8000) + 0.09(23, 000) + 0.01(36, 000)
55
00
.01
58 = 500 + 5600 + 2070 + 360 = 8530
Putting these numbers onto the tree we have:
Demand
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre d e g n i e @ fr Rental d @ g @ 0.7 ra@ @ ve@ a @ @ @ medium @ @ hhhh gre at hhh 1800 .0 hh0 9 h d d h 7300 h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ ve@ a d d @ d @ d @ @ @ @ hhhh gre at hhh .0 hh0 9 h h 8530 he avy 0
.2 0 e g in e @ fr @ g @ 0.7 2900 ra@ ve@ a@
2500 3000 3000 3000 2500 8000 12,000 12,000 2500 8000 23,000 36,000
60
sm
al
la
e rg
We are now interested in nding the highest net payoff at the square, each net payoff being the expected value at the circle minus the cost at the gate. The choices are: small, 2900 600 = 2300; medium, 7300 1800 = 5500; and large, 8530 5500 = 3030. The best of these (as we saw before) is medium with an expected payoff of 5500. We write the 5500 next to the square, and highlight the best alternative to obtain:
55
00
.01

.2 0 e g in e @ fr @ g @ 0.7 2900 ra@ ve@ a@
59 2500 3000 3000 3000 2500 8000 12,000 12,000 2500 8000 23,000 36,000
@@@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .2 0 Theatre d e g n i fr Rental 0.7 d @ ge@@ ra@ ve@ d a d @ @ @ @ medium @ @ hhhh gre at hhh 1800 .0 hh0 9 h d h d 7300 5500 h d eavy d d d 0. 01 d d d d .2 0 d d e g n i d fr d 0.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h 8530 he avy 0
60 0
sm al l la e rg
Once again, it is emphasized that the recommendation should be stated clearly: Rent a medium-sized theatre, with an expected payoff of $5500.
55
00
.01
60
5.3
The Expected Value of Perfect Information
To nd the EVPI using a decision tree, the event must precede the decision. This is because the decision maker receives the perfect information (which is that a particular outcome will occur) and then chooses the best alternative afterwards. Technically, the event is not the demand per se, but instead is the prediction about the demand. However, because the prediction is perfect, it has the same outcomes and probabilities as the demand itself. The tree therefore begins with an event node, followed by the four outcomes.
e fri ng he

[The perfect prediction 0.7 for the] e g a r e v Demand a

gre d d at 0.09 d d d d d d d d d d
For each outcome, we can simplify the choices down to one or two reasonable alternatives. For example, if we are told that there will be fringe demand, it makes no sense to pay more rent for a medium-sized or large theatre, when a small one can easily handle all the demand. At the other extreme, not even the large theatre can handle heavy demand, so we wouldnt even consider a small or mediumsized theatre in this situation. With the other outcomes, its not clear whether we should choose a theatre which is a size less than the demand (to save on the
0. 2
y av
0.
01
61
rent), or whether we should rent a theatre which is a size bigger than the demand. Hence with average demand we could investigate both a small and a mediumsized theatre, and with great demand we could consider both a medium-sized and a large theatre. Adding the reasonable alternatives with their cost gates and nal payoffs, we obtain:
Theatre Rental small

2500
ng
0.
600
ll @@ a@ sm @ @@@ @ @ @ @ @ @@
h m dium hh hhh hhe h hhh hh hh
[The perfect prediction 0.7 for the] ge a r e v Demand a

fri
600
3000
gre d d at 0.09 d d d d d d d d d d
ium@@ ed@ m@ @@ @ @ @ @ @ @ @ @
h la ge hhh hh hhr h hhh hhh h
1800 1800
8000 12,000
We now perform the rollback to obtain:
he
y av
5500
23,000
0.
01
large 5500
36,000
62
Theatre Rental small
2500
0. 2
1900
600
ng e
600 [The perfect ll @@ 3000 a@ sm @ @@ @ @ @ @ @ prediction @ @ @ .7 0 for the] ge h m dium ra hhh ve Demand a hh hhe h hhh hhh h 6200 8000 1800 1800 gre m @ iu@ d ed@ m@ d at @@@ 12,000 @ @ @ 0.09 @ 6600 d @ @ @ @
d d
fri
d d
h large hhh hhh hh hhh hhh h 17,500
Calculating the EVPI by the indirect method, we obtain (as we did before): EVPI = EV with PI EV without PI = 6600 5500 = 1100 The expected value of perfect information is $1100.
he y av
d
5500
23,000
0 0.
d d d
large
36,000
30,500 5500
5.4
5.4.1
Sequential Decision Making

Example
Bill operates a hardware store doing a reasonable amount of business for its size. Theres a possibility of a smelter being built nearby, which will boost the towns population and his business if it goes ahead. Because of this, Bill wonders whether
63
or not he should expand the store. The company which would operate the smelter has said that they will know one way or the other by late September, but that would be too late to look for a contractor to get the work done before the onset of winter. At the present time, theres about a 40% chance of the smelter going ahead. Bill gures that relative to the prot that he would make anyway, the expansion would generate a prot margin of $5,000,000 (net present value, excluding the capital costs of the expansion) if the smelter goes ahead, but only about $1,600,000 if it does not. A contractor has quoted him a rm construction cost of $2,900,000, provided that a contract is signed by July. If he does nothing before October, he could then make a deal for the expansion. If the smelter company has then said that they are indenitely delaying the project, then the $2,900,000 price is still available, but with a surcharge of $150,000 for winter work. On the other hand, if the smelter company is going ahead with the project, then the construction cost will jump to a total of $4,500,000, because everyone will be looking for construction work to be done. 5.4.2 Solution
Bill has two opportunities to expand his store. He could do it in July, when the construction cost would be lowest. Alternatively, he could do it in October, after he hears about a proposed smelter. The tree for this problem will have three parts: a decision about expanding now, an event concerning the smelter, and a decision about expanding in October. We begin the tree by considering only the initial decision. He can either expand now, or wait to hear about the smelter. Expanding now would cost $2,900,000, which we write on the tree as 2.9, making a note that all nancial information is in millions of dollars. The initial formulation of the tree is shown in Figure 2. No matter which alternative is chosen, we then hear some information about the smelter. Either we nd out that the smelter company is proceeding with its construction, or they have decided to delay construction for an indenite period. While this is a decision from the point of view of the smelter company, it is an event from Bills perspective, because he has no control over it. Adding this event with its two outcomes, we obtain the partial formulation of the tree shown in Figure 3. On the top part of the tree we place the two payoffs, which are the $5,000,000 and $1,600,000 gures mentioned in the text of the case. On the bottom part of the tree, we draw the structure for the second decision. The construction costs are
64
Note: All nancial information is in millions of dollars.
Possible Early Signing d d
sig th
d d d d d d d d d d d d d d d d d d
Figure 2: Bills Hardware Store: Initial Part of the Formulation
Ju l g
2.
in
do
no
be
in
fo
re
ob ct O
er
65
Note: All nancial information is in millions of dollars. Smelter oc r p Info

.4 0 s d ee
del rr aye d0 rr r .6 rr Possible r r Early Signing d d

sig th 2.
d d d d d d d d .4 d d s0 Smelter d e d d ce ro p d Info d d d d d
Ju
ly
in
do
no
be
in
fo
Figure 3: Bills Hardware Store: Partial Formulation of the Tree
re
ct O
ob
er
del rr ay r ed 0 r r .6 r rr r
66
different from what they were before, either because of a price increase caused by all the smelter activity, or because of the extra cost for construction during the winter. There are four nal payoffs; the two of these which are 0 are not mentioned explicitly in the case. For these we must see that if Bill does not expand his store, then the prot margin relative to what he is doing now must be 0. The complete formulation of the tree is shown in Figure 4. Proceeding from right to left, we rollback the tree, nding the highest net payoff at each square, and the expected payoff at each circle. The rollbacked tree is shown in Figure 5. The completed tree showing the recommended course of action using highlighting is shown in Figure 6. The recommendation is to wait until October. If its announced that the smelter will proceed, then Bill should expand his store. If its announced that the smelter is indenitely delayed, then Bill should do nothing. The ranking payoff is $200,000. 5.4.3 Finding the EVPI
We nd the EV with PI by using a tree as shown in Figure 7. Note that because all the information comes at the outset, that if the expansion is to be done at all it would be best to do it in July, when the construction cost would be lowest. The EV with PI calculated on the tree is 0.84, i.e. $840,000. Since we would have obtained $200,000 without the perfect information, the EVPI is: EVPI = EV with PI EV without PI = $840, 000 $200, 000 = $640, 000
67

.4 0 s d ee
5.0
del rr aye d0 rr r .6 rr Possible r r Early Signing d d

sig n in 2. Ju ly 9 do no
1.6
4.5 it$$ d in d n$ sig $ $ d d October $$$ $ $ d d $$ d d 4 . d d s0 do no Smelter d e e d thi g d c o Info r n p d d d d d d

th be in g fo re ct O ob er
Contract
5.0
0 1.6
Contract del rr ay 0.15 n it $ in r ed 0 sig $$$ rr .6 October $ $$ $ $ $ $ r $ $$$ rr r do no thing
2.9 +
Figure 4: Bills Hardware Store: Complete Formulation of the Tree
68

.4 0 s d ee
5.0
del rr aye d0 rr 2.96 r .6 rr Possible r r Early Signing d d d d

sig n in 9 Ju l 2. y do no
1.6
4.5 it$$ d in d n$ sig $ $ 0.2 d d October $$$ $ $ d d $$ d d 4 . d d s0 do no ed d Smelter oce thi g d Info r 0.5 n p d d d d d d
i th be ng fo re ct O ob er
Contract
5.0
0 1.6
Contract del rr aye 0.15 n it $ in d r sig 0.2 $$$ rr0.6 October $ $$ $ $ $ $ r $$$ $ rr r do no thing 0
2.9 +
Figure 5: Bills Hardware Store: Rollbacked Tree
69

.4 0 s d ee
5.0
del rr aye d0 rr 2.96 r .6 rr Possible r r Early Signing d d d d

sig n in 2. Ju ly 9 do no
1.6
4.5 it$$ d in d n$ sig $ $ 0.2 d d October $$$ $ $ d d $$ d d 4 . d d s0 do no Smelter d e e d thi g d c o Info r 0.5 n p d d d d d d
th be in g fo re ct O ob er
Contract
5.0
0 1.6
Contract del rr aye 0.15 n it $ in d r sig 0.2 $$$ rr0.6 October $ $$ $ $ $ $ r $ $$$ rr r do no thing 0
2.9 +
Figure 6: Bills Hardware Store: Completed Tree
70
Note: All nancial information is in millions of dollars.
[The perfect prediction $$ $$ for the] .4 s0 do no Smelter d e e thi g c o Info r 2.1 n p

Contract 2.9 it$$ in n$ sig $$ 5.0 $ $ July $ $ $$
0 1.6
Contract r delay 2.9 rr ed in $ n it$ sig 0.84 $$ r 0.6 July $$ $ $ rr $ $$$ $ $$ r r r do no thing 0
Figure 7: Bills Hardware Store: Finding the EV with PI
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5.5
Exercise
Make a decision tree for the situation described in the following case, and provide a recommendation. Case: Niagara Frontier Winery Driving to her ofce in St. Catherines, Ontario, Betty Johnson, the production manager of Niagara Frontier Winery, heard a very disturbing weather forecast. Environment Canada has issued a severe frost warning for the Niagara Region for later in the week. This was only the 27th of September, and the grapes would not be ready for harvest for another three weeks. Telephoning the weather ofce for more detailed information, she was told that in three days time there would be a 60% chance of a mild frost, and a 30% chance of a severe frost. A mild frost could at least be contained by erecting heaters in the elds at a cost of $350,000. Using heaters, the damage would be minimal; about 80% of the crop could still be made into high-quality wine, and a further 10% could be made into low-quality wine. A severe frost, on the other hand, would destroy the crop entirely; even an attempt at using heaters would be in vain. As long as she made up her mind by 1 p.m., there was enough time to erect the heaters. Also, there was enough time to order that all the crop be picked immediately, which would cost $400,000. It could either be sold as grape juice or made into low-quality wine at a value of $1,200,000. If the crop were picked in good condition in three weeks time, however, it would be worth about $3,000,000, but from this the $400,000 harvesting cost would have to be paid. There was one more complication. The research department had come up with something called ice-wine. If the heaters were not used and a mild frost was experienced, none of the crop could be made into high-quality wine, but perhaps this could be made into ice-wine. This would cost $400,000 to pick the crop, and would have a 75% chance of success. A successful product would be worth $2,600,000, but a failure would be worth nothing. Alternatively, about 85% of the crop with mild frost damage could be sold as low-quality wine. Betty made herself a pot of tea and then looked at her watch. The one oclock deadline was fast approaching.
72
Decision Trees 2
In the previous section, we saw most of the technical operations to handle decision trees. If theres any difculty using trees, it is the formulation the rollback procedure is very straightforward. In this section we solve a fairly long case. Doing this case adds one more technical operation the use of payoff nodes. More importantly, though, solving this case illustrates the application of the decision tree methodology to a somewhat complex situation.
6.1
6.1.1
Case: New Detergent Marketing Campaign

Problem Description
Elizabeth, John, and Susan work for a consumer products company. They come from widely different academic backgrounds. Elizabeth has a B.Sc. and M.Sc. in biochemistry, and she has been on a research team which has come up with a new type of detergent. John has a joint B.A. in English literature and art, and works on all advertising campaigns. Susan has a B.Comm., specializing in marketing, but has taken a few management science electives as well. They recently held a meeting to discuss what to do about the newly-developed detergent. The meeting began with Elizabeth welcoming the others. John and Susan, thanks for coming. The research team is very pleased with this new product. We tested it extensively in the laboratory, and found that there was virtually no fading of colours even after 100 washes. I hope that with your help we can bring this product to market. John and I have read the report, Susan replied, but its the part where it says that the cost will have to be 20% higher than even full-priced brands that has me worried. I fear that when it comes to the typical shopper looking at the prices in the store, that a claim of technical excellence is not going to amount to much. Ive been thinking about that, said John. We have to make it clear right in the ad campaign that the consumer is paying more for the detergent but saving much more than that in the long-term on the cost of replacing clothes. I grant you that the average shopper will be skeptical, but we hope that a least some segment of the market will understand the trade-off and therefore buy our product. Susan knew that Elizabeth was excited about the new detergent because she had helped develop it, and that John was looking forward to a challenge in writing the ad copy. However, she also knew that only about one in ten new products eventually succeeded in the market place. Thinking that the others would want to
73
proceed, she had come up with some approximate numbers. Im assuming that for now at least, our market is Canada, Susan said. The United States is just next door, with nearly ten times as many people, but we dont have a distribution network there, so the best that we could hope for in the States is a licensing agreement several years down the road, if everything works out here rst. For now, we should see if this product will be protable in the Canadian market alone. Elizabeth and John nodded their heads, and Susan continued. If we try for the whole Canadian market, the start-up costs would be about $800,000. After that would come some revenue, whether the product turns out to be a success or not. A success would bring in about $4,000,000, but a failure would provide only a tenth of that. If success or failure were 50/50, Id proceed, but the chance of success is only one in ten. Elizabeth wondered how accurate Susans gures were. Perhaps if the start-up costs could be lowered, or the revenues raised, or the probability of success raised, the project would make sense. Susan, your numbers are at best estimates. With different numbers this project could go ahead. Sure, replied Susan, and with different numbers the project could be even less viable than it is now. Im not saying that this new detergent couldnt do well for us, but maybe we should try to test-market this product before launching it into the entire Canadian market. John broke in when he heard this idea. We did test-marketing when I was at my former employer. Usually, if a product succeeded in the test-market, it did well everywhere. There were exceptions, though. Chocolate-covered seaweed did well when we tried it in Halifax, but bombed when we tried to go national you couldnt give it away in Toronto. On the other hand, we test-marketed a new quick-cook rice in Regina, and it didnt do well, but when on a hunch we went ahead with a national campaign anyway, it suddenly became a success. It did best in cities with large immigrant populations, and in hindsight we saw that Regina wasnt a good test-market for that kind of product. Youve hit on a good point, John, said Susan, the test-market should ideally reect the country as a whole, but thats not always easy to do. Since advertising is expensive, we concentrate on small geographic areas away from high-priced media buys in large cities. For example, Pickering [just east of Toronto] would be an expensive place to test-market, because wed have to buy airtime on Toronto stations and pay to reach eight million people in central southern Ontario, when we only want to reach the ones who live in Pickering. In Ontario, Peterborough is often used as a test-market because we can buy air-time just in Peterborough at a reasonable price. For the same reason, test-marketing in Alberta is often done in Lethbridge, which is large enough to have its own media outlets, but doesnt have
74
the high rates that are found in Edmonton and Calgary. Elizabeth wondered aloud about some of Johns comments. What does it prove once we get the result from the test market? The detergent could be like the chocolate-covered seaweed, or like the rice, rather than being a perfect predictor for what should be done. Youre right, Elizabeth, replied Susan, testmarketing is not a perfect predictor, but it should give us a better idea of what to do. If we believe that theres one chance in ten of the product being a success in the country, then there should be more-or-less a 10% chance of success in any test-market. However, we know from past experience that people in British Columbia are most open to new products, and this gure generally declines as one heads east. If we just test in one market, Id say that theres about a 12% chance of success in Lethbridge, about 10% chance of success in Peterborough, and just 8% in St. Johns. If we test in one of these places and its a failure, then the chance of success in the rest of Canada certainly becomes less than 10% I dont know how much less, but it really doesnt matter. This project is tenuous enough as it is, without having to deal with a negative test result. On the other hand, a success in a test market would be a good omen for the rest of the country. As John said, theres no guarantee of success elsewhere, but I have to believe that on average the chance of success has increased from 10% to say 60%, though I think that this gure would range from 50% in Lethbridge to 70% in St. Johns. While the purpose of the test-marketing is to obtain information, there would be some revenues as well, perhaps $30,000 for a success, but only a tenth of that for a failure. We could test in two of these markets, or perhaps even all three of them, Elizabeth suggested. But if we test in two markets our advertising costs would double, and if we test in three these costs will triple, John said. Testing in all three is probably not going to y, Susan said, but a case could be made for testing in two markets. I think that Lethbridge and St. Johns would give us a better sense of the country as a whole than using either of these cities with Peterborough. That brings us to the question of how we should use these two markets. Should we test simultaneously in both, or should we test sequentially, beginning with one of the two cities, and then based on what we nd there, possibly proceeding to the other? At this point Elizabeth jumped in. Whatever we make in the lab, someone else can make too. I worry that if we do the test marketing, a competitor will buy a litre of it, have it chemically analyzed, and then reverse-engineer it in their own labs. This would take some time, of course, but if we test in two markets, and do it sequentially rather than simultaneously, we might just give them the time that they need. After taking all the risk, we would then have to share the market
75
with someone else. Point taken, said Susan. If we test in both Lethbridge and St. Johns, lets agree that we will do the testing simultaneously. This gives us four possibilities for the test results. If we fail in both places, we can forget about proceeding further with this product. Should we succeed in both, Im almost certain that we would have a winner on our hands; Id put the probability at 0.99. If we fail in one, but succeed in the other, I would want to boost the advertising expenditures by $50,000, and based on that Id put our chances of success in the rest of the country at about 35%. From his experience, John had some gures on test-marketing. Before we spend anything on advertising, we would have to spend about $15,000 to develop an ad campaign. The three test markets arent much different in size. Id say that in each the cost to buy air time would be about $10,000. Elizabeth wondered if spending this money now would save some money later should they decide to undertake a national campaign. Heres a hypothetical one for you, John. Suppose that we test in Lethbridge and St. Johns, and both tests turn out to be a success, so we decide to go national. Having spent $15,000 plus two times $10,000 for a total of $35,000, can we deduct this amount from the $800,000 cost of the national campaign? I wouldnt count on that, John replied. We would probably want to modify the test-market advertising, so that will cost money. More importantly, when we buy national advertising, we obtain economies of scale by making one nation-wide media buy. It would be cheaper to do it that way than to buy air time in every city individually except where we test-marketed. Id say that no matter what we do with test-marketing, the cost of the national campaign would be $800,000. At the same time, this would be a new campaign as far as the testmarket is concerned, so the national revenues wouldnt be diminished. Its time to wrap this up for this morning, Susan said. Senior management will want to see a business plan, and the basis for this will be the recommendation which will come from making a decision tree of what weve been discussing. Ill work on this later this morning, and well meet again at 2 p.m. to discuss it. 6.1.2 Formulation
We wish to develop and solve the decision tree to which Susan refers. Its too complicated to think of all the decisions and events at once in a long case like this. Instead, we should think about what must come rst. It is more-or-less obvious that the case presents us with at least four alternatives for the test-marketing: Lethbridge only; Peterborough only; St. Johns only; and testing simultaneously in both Lethbridge and St. Johns. The three persons seem to agree that other types
76
of multiple testing (sequential testing, or all three cities, or another pair of cities) should not be considered, and we will therefore leave these options out of the decision tree. At the other extreme, going directly to a national campaign without doing any test-marketing was not clearly opposed by Elizabeth, so we might wish to investigate this course of action. Also, we should consider doing nothing whatsoever, which for many business situations may be best of all. Based on the foregoing, we could begin with a square followed by six alternative branches: one for each of the four testing alternatives; one for proceeding to national marketing directly; and nally a do-nothing alternative. Doing it this way would be correct, but things become clearer if we rst have a test-marketing decision which has just two alternatives: test market; and do not test market. The rst of these alternatives then requires a decision about the manner of the test marketing. The second has a decision about the national campaign with two alternatives: proceed with the national campaign; or do nothing. Aside from the clarity provided by this approach, it allows the $15,000 cost of preparing the test-market ad campaign to be by itself on the test market alternative branch, with the advertising costs being handled separately. If we proceed with the national campaign with no test marketing, then this alternative is followed by a result event, with its two outcomes: there is a 10% chance of making $4,000,000, and a 90% chance of making $400,000. Because of space limitations all nancial gures will be written on the tree in thousands of dollars, hence for example $4,000,000 is written on the tree simply as 4000. The manner of the test marketing could be one decision with four alternatives, but again it makes things conceptually easier if we have two decisions. First, we decide whether we want one or two test markets. If one test market is chosen, then we must decide whether it will be in Lethbridge, Peterborough, or St. Johns, and if we want two test markets it is understood from the case that these will be in Lethbridge and St. Johns, hence the event for the result on one of the test markets comes next. In making the tree it turns out that we already have too much to put on one piece of letter-size paper. Hence, on this piece of paper we end with two nodes, one a decision node and one an event node, after alternative branches for testing in one or two markets. Because the cost of test marketing is $10,000 per market tested, we place $10,000 and $20,000 cost gates (written as 10 and 20) on the test in one market and test in two markets alternative branches respectively. The beginning of the tree is shown in Figure 8.
77
Note: All nancial information is in thousands of dollars.
d ee 800 roc p National failur e 0.9 Campaign

Preparation for Test Marketing rr a r rr ban rr d rr r on rr r rr r r
0.1 $ 4000 ss$$ e c Result c u $ s $$

$$
400
no
ne
d d d d City d d d d Number d d of Test 10 one d d dMarkets d d d d
Continued on Figure 9
ea ak
15
Figure 8: New Detergent Case: Beginning of the Tree
ds
rr t r rr Lethbridge r wo rr r rr r Result rr Continued r 20 r Figure 10
on
78
.5 0 s$ $$ 4000 es Result c c $ u s $$
Continued from Figure 8
Lethbridge 2 d 1 . 0 Result $ s $$ d es cc $ u s $ $$
$$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $$ $ re 0. 400 $$ 5 a bando n 0 .6 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p $$ $$ $$ Campaign $$ $$ failur $ $ $ $ $ e 0.4 400 ab andon
.7 0 s$ $$ 4000 es Result c c $ u s $ $
$$ National 800 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ f $ a $ ilure $ $ $ 0.3 ab andon
400

$ (30) failu re 0. 3 e g 88 d ri b h et L Peterborough 0 d 1 . 0 City $ Result d ess $ cc su $$$ Peterborough $ $ $ (30) failur d S d e 0.9 d t. d 0 3 J d oh d d ns d d d d St. Johns d 8 d 0 . 0 d Result d $ s d es cc $$$ u d s d $ d $ d $ $ (30) failur e
0.92
Figure 9: New Detergent Case: First Continuation
79
On Figure 8 two continuations are indicated. The rst of these occurs at the decision node for choosing between Lethbridge, Peterborough, and St. Johns as the solitary test market. After each of these comes a similar structure, with only some of the numbers being different. First, there is a result event, with the test campaign in every city being either a success or a failure. There is a payoff of $30,000 associated with a success, and a payoff of $3000 associated with a failure. Since it is implied in the case that a failure in a test market would immediately end the venture, all we need do is put a 3 (for $3000) at the end of every outcome branch which represents failure. However, every success outcome branch is treated differently. Because each of these is followed by more tree structure, we handle the $30,000 in revenue by using a payoff node followed by a null branch. On the null branch we place a cost gate, with the gure placed in parenthesis indicating that we have a revenue rather than a cost. Hence a revenue of $30,000 is indicated as:
d d
(30) When the tree is rolled-back, the 30 is added to the number on the right of the null branch to obtain the number at the payoff node. After every null branch comes a decision about the national campaign, and then a result event if the proceed alternative is followed. The tree structure of the rst continuation is shown in Figure 9. The second continuation comes after the alternative of testing in two markets. Since the places of these markets have been stated in the case as being Lethbridge and St. Johns, we next have the result events for these two markets. Here is an example where the order does not matter it can either be the Lethbridge result event followed by the St. Johns result event, or vice versa. In real life, these results would be announced more-or-less simultaneously. This is why the payoffs are combined for example, if we are successful in both markets, then $60,000 in revenue (i.e. $30,000 from each place) is obtained. If one is a success, but the other is a failure, then $30,000 + $3000 = $33,000 is obtained. Finally, if both are failures then the revenue is $6000 (i.e. $3000 from each place). The rest of the tree is similar in structure to the rst continuation, but we note that the cost of a national campaign after one failing test market is now $800,000 + $50,000 = $850,000. The second continuation of the tree is shown in Figure 10.
80
.99 0 s$ $$ 4000 es Result c c $ u s $ $
d d 08 . 0 St. Johns ss (60) e Result su cc Continued from r fai Figure 8 r lur rre 12 . 0 r 0.92 rr s s e r c c d d su Lethbridge (33) Result
d d fa d ilu d re d 0. d88 d d d d r fai r lur rre 0.9 rr 2 rr
St. Johns ss e Result su cc (33)
d d 08 . 0
$$ National 800 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ failu $$ $ re 0. 400 $$ 01 aband on 0 .35 0 s$ $$ 4000 s e Result c c su $$ $$$ National 850 roceed$ p$ $$ $ $$ Campaign $$ $ $ f $ a $ ilure $ $ $ 400 0.65 aband on 0 5 .3$ 0 s$ 4000 $ s e Result c c su $$$ $ $ National 850 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $ $ $ re 0. 400 $$ 65 aband on 0
Figure 10: New Detergent Case: Second Continuation
c April 28, 2010 D.M. Tulett 6.1.3 Solution and Recommendation
81
We perform the rollback beginning with the rst continuation. Next, we perform the rollback for the second continuation. At the extreme left, we obtain the gure 188.2224. The question arises as to how many decimal places we should report. Because the gures are in thousands of dollars, this gure represents $188,222.40, so at least we arent trying to report a fraction of a cent. Even so, some would argue that its pretentious to report any gure closer than say the nearest ten dollars. My preference is to do things accurately, and then round the nal answer, should that be desirable. It turns out in this example that the nal answer is unaffected by this gure anyway. The gures from the extreme left of the rst and second continuations are then transferred to the initial part of the tree. That part of the tree is then rolledback. In words, we can state the recommendation as: Make the ads for a test market campaign, and run this campaign in Peterborough. If this turns out to be a success, then proceed with the national campaign. If the test campaign turns out to be a failure, then abandon the project. The ranking payoff is $156,700. The recommended courses of action have been highlighted on Figures 14 and 15.
82
.5 0 s$ $$ 4000 es Result c c $ u s $$
failu re 0. 3 e g 88 d 174.24 ri b h et L Peterborough 0 d 1 . 0 City d $ Result d d ess $ cc su $$$ Peterborough $ $ $ 1790 (30) fa d S 181.70 d 181.70 ilure 0. d t. 90 3 d J d oh d d ns d d d d St. Johns d 8 d 0 . 0 d Result d $ s d es cc $$$ u d s d $ d $ d $ $ 2150 (30) fa 174.76 ilure
Lethbridge 2 d 1 . 0 Result $ s $$ d es cc $ u s $ $ $ $ 1430 (30)
$$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $$ $ re 0. 400 $$ 2200 5 a bando n 1400 0 .6 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p $$ $$ $$ Campaign $$ $$ failur $ $ $ $ $ e 0 .4 2560 400 aband on 1760 0 .7 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p$ $$ $ $$ Campaign $$ $ $ f $ a $ ilure $ $ $ 2920 400 0 .3 aband on 2120 0
0.92
Figure 11: Rollback of the First Continuation
9 .9$ 0 s$ 4000 $ s e Result c c su $$
$$
d d 08 0. St. Johns ss 3224 (60) e Result su cc Continued on r fai Figure 13 r lur rre 12 . 0 r 0.92 rr s 1033.48 s e r c c d d su Lethbridge 843 (33) Result
d d fa ilu 188.2224 dd re d 0. d88 d d d 08 . 0 St. Johns ss 843 (33) e d Result su cc d d r fai r lur rre 72.96 0.9 rr 2 rr 6
$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $ $ $ re 0. 400 $$ 3964 01 aband on 3164 0 .35 0 s$ $$ 4000 s e Result c c $ su $ $$$ National 850 roceed$ p$ $$ $$ Campaign $$ $$ $ f $ a $ ilure $ $ $ 1660 400 0.65 aband on 810 0 .35 0 s$ $$ 4000 s e Result c c $ u s $$ $$ National 850 roceed$ p$ $$ $$ Campaign $$ $$ $ failu $ $ $ re 0. 400 $$ 1660 65 aband on 810 0
Figure 12: Rollback of the Second Continuation
83
84
d ee 800 roc p National failur 760 e 0.9 Campaign

Preparation for Test Marketing d d
0.1 $ 4000 ss$$ e c Result c u $ s $$

$$
400
rr a r rr ban rr d rr r on rr r rr r r
no
ne
156.70 dd d
d
d City d d d Number d d of Test 10 one d d 181.70 dMarkets d d d d
ea ak m
15
Figure 13: Rollback of the Beginning of the Tree
ds
171.70
on
188.2224
85

0.1 $ 4000 ss$$ e c Result c u $ s $$

$$
400
no
ne
156.70 dd d
d
d City d d d Number d d of Test 10 one d d 181.70 dMarkets d d d d d
ea ak
15
ds
171.70
on
188.2224 Figure 14: Recommendation Part 1
86
.5 0 s$ $$ 4000 es Result c c $ u s $$
failur d S d e 0 .9 181.70 181.70 t d d .J 0 3 d oh d d ns d d d d St. Johns d 8 d 0 . 0 d Result d $ s d es cc $$$ u d s d $ d $ d $ $ 2150 (30) fa 174.76 ilure
Continued from Figure 14 failu re 0. 3 e g 88 d 174.24 ri b h et L Peterborough 0 d 1 . 0 City d $ Result d d ess $ cc su $$$ Peterborough $ $ $ 1790 (30)
Lethbridge 2 d 1 . 0 Result $ s $$ d es cc $ u s $ $ $ $ 1430 (30)
$$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $$ $ re 0. 400 $$ 2200 5 a bando n 1400 0 .6 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p $$ $$ $$ Campaign $$ $$ failur $ $ $ $ $ e 0 .4 2560 400 aband on 1760 0 .7 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p$ $$ $ $$ Campaign $$ $ $ f $ a $ ilure $ $ $ 2920 400 0 .3 aband on 2120 0
0.92
Figure 15: Recommendation Part 2
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6.2
Exercise
Newlab has come up with a new product in its research lab. The technical success is clear, but as with any new product the commercial success is risky. Because of this, they would sometimes test-market a product rst, and then make a decision about national marketing after the test-market results had come in; at other times they would proceed directly to national marketing. On some occasions, they would abandon the product without even test-marketing it. The test-marketing would cost about $120,000. If successful (probability 0.4) there would be revenues of $40,000; if unsuccessful the revenues would only be $10,000. Should the test market be successful, a followup national campaign at a cost of $500,000 would have a 70% chance of success with a revenue of $1,800,000, otherwise it would be a failure with a revenue of $150,000. Should the test market be unsuccessful, a followup national campaign would have only a 0.2 chance of success (with the same cost, and the same revenues for success and failure). A national campaign not preceded by a test campaign would have a 45% chance of success. It would cost $600,000, and would produce a revenue of $1,900,000 if successful, but only $175,000 otherwise. (a) Draw and solve a decision tree for the situation (using payoff nodes where appropriate), and state the recommendation for Newlab clearly. (b) If the $600,000 gure in the last paragraph were changed to $800,000, what would be the revised recommendation?
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Decision Trees 3
In this section we begin with an example which contains only costs. We then look at sensitivity analysis in the context of decision trees.
7.1
7.1.1
Airfare Problem
Problem Description
An ofce manager in St. Johns has been informed that a compulsory companywide meeting might need to be held in Vancouver in fteen days time. At the present time, there is about a 30% chance that the meeting will go ahead. There is about a 40% chance that in about ve days from now they will know for sure whether or not the meeting will be held. If they still are not sure at that point, then theres still, as there is now, only a 30% chance that the meeting will go ahead. There is a 100% chance that in ten days time they will know for sure about the meeting one way or the other. A full-fare economy return ticket, which would cost $3500, could be purchased as late as the day of the trip. Another option would be to buy a non-refundable ticket for $1300 which must be purchased at least seven days before departure. Another choice is to buy a non-refundable seat-sale ticket for $800, which would have to be purchased no later than tomorrow. Assuming that a non-refundable ticket would be worthless should the meeting not go ahead, develop and solve a decision tree to analyze the managers problem. 7.1.2 Formulation
This example only mentions costs, not revenues, so if we put all the numbers onto the tree as we did in the previous section we will be rolling back negative numbers. Instead of dealing with negative numbers, we could write costs on the tree as positive numbers, and rollback the tree as before, except that at each square, we would choose the alternative with the lowest cost . We will solve this problem using the alternate approach; the nal tree will have all nancial information being the absolute value of what we would have had if we had not used this approach. While there is a fteen day continuum of time in this problem, only certain points in time are relevant. If we call today day 0, then there is the possibility of more information on day 5; if theres no announcement on day 5, then there will be an announcement on day 10. To attend a meeting on day 15, the manager must y across the country no later than day 14. Then there are the deadlines for the
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purchase of the various classes of tickets: day 1 for the $800 ticket; day 7 for the $1300 ticket; and day 14 for the full-fare $3500 ticket. Hence our focus should be on days 1, 5, 7, 10, and 14. While the $3500 ticket can be purchased at any time, there is no advantage to purchasing it early. If the ticket is bought early, then a few days extra interest is charged, and more importantly, there would be the hassle of returning the ticket should the trip become unnecessary. If the few days interest is not important, then the ticket could be bought after day 10. There is no sense in buying a $1300 ticket today or tomorrow, because an $800 ticket is available during this time with the same privileges. After tomorrow, the ofce manager might as well wait until at least the end of day 5 to possibly obtain more information. Hence the $800 seatsale ticket would be bought on either on days 0 or 1 (or not at all), the $1300 7 day advance ticket would be bought on days 6 or 7 (or not at all), and the $3500 full-fare ticket would be bought on days 11 to 14 inclusive (or not at all). At the outset, the manager could buy an $800 ticket, or he could wait ve days for more information. Hence the tree begins with two alternatives; there are no further branches after the alternative branch to buy a seat-sale ticket for $800. Because this is a nal branch, and because we are writing costs as positive numbers, we do not need a cost gate all we need to do is write 800 to the right of the branch. The wait ve days option, however, then has an event with two outcomes: an announcement is made; or no announcement is made. The tree so far is: Seat-Sale Ticket
y u b
800
Possible Announcement 0 .4 rrdo r rr n r ot e wa rr buy ad itr m 5r r dar rr ysr r

r nr otr mr
adr e rr 0.6r r
After the outcome branch for the announcement being made there is an event with two outcomes: the meeting will go ahead, or it will not go ahead. It is
90
possible, but not advisable, to combine the two events into one event with three outcomes: the meeting will go ahead; it will not go ahead; and no announcement. Doing it this way would shorten the tree, but it would require computing some joint probabilities this confuses the formulation process with the solution process. We will therefore write what is happening as two events. After the will go ahead outcome branch, we could have a square with two alternatives, one for buying a 7 day advance ticket, and one for buying a full-fare ticket for $3500. However, it is obvious that the manager should buy a 7 day advance ticket for $1300, so we will only draw this alternative. After the will not go ahead outcome branch, no action needs to be taken, so we simply write a payoff of 0 to the right of this branch. If theres no announcement after ve days, then our choices are to either buy a 7 day advance ticket or wait another ve days. If the latter is chosen, then an event occurs giving information about the meeting. After the go ahead branch, the manager must buy a full-fare ticket; after the will not go ahead branch, no action is required. The entire tree, printed in landscape form, appears in Figure 16. Because the nancial information is all costs, a note has been placed on the gure to that effect. 7.1.3 Solution
To rollback the tree, we need to choose the lowest cost at each square. With this modication, the rolled-back tree appears in Figure 17. The recommended course of action can be followed on the tree, but the analyst should also make the recommendation by clearing stating it in words. In trees with multiple decisions, we often use the term ranking prot (or ranking cost in this example) to indicate that the number being presented is a mixture of measures (best at a square, expected value at a circle). This is reported along with the best course of action. In words, the recommendation is:
7 Day Advance Ticket 800

.3 ad News: The 0 e Meeting go ah will

buy 1300
y u b Seat-Sale Ticket
Possible r Announcement 0 .4 rrdo r w 0.7 ilr rr not l nr r e otr wa r d rr b rr a u go it 5 r ry m aherr dar r adr 0 ysrr r 7 Day Full-Fare Ticket buy 1300 buy 3500 Advance ade r Ticket 0r r .6 r
rr notr mrr
Note: All nancial gures are costs .
r do r rr no r 3 . News: The d 0 a rr t bu wa r it r y Meeting o ahe for r r g r ne r r will r ws r rr w 0.7 ill nrr ot g r o arr hea r dr
Figure 16: Airfare Problem before Rollback 91
92
c April 28, 2010 D.M. Tulett Recommendation Do not buy the $800 seat-sale ticket, but instead wait to see if theres an announcement in ve days time. If theres an announcement that the meeting will go ahead, then buy a $1300 7 day advance ticket at that time. If theres an announcement that the meeting is not going ahead, then do nothing. If theres no announcement after ve days, then wait for a further announcement. If the meeting is going ahead, then buy a $3500 full-fare ticket; otherwise, do nothing. The ranking cost is $786.
Although the $786 gure is the most important one on the tree, the other rolled-back numbers are also important, because they give the ranking cost to be incurred for proceeding further down that path. For example, if an announcement is not made after ve days, then the ranking cost increases from $786 to $1050. 7.1.4 The EVPI
In this example we need to nd the expected cost with perfect information (EC with PI). If at the outset we were to receive perfect information that the meeting will be going ahead, then we would buy the seat-sale ticket for $800, otherwise we would do nothing. The chance that we will be told that the meeting will be going ahead is 30%, hence EC with PI = 0.3(800) + 0.7(0) = $240. The expected cost without information is $786. We subtract to nd the EVPI, in reverse order because these are costs.2 EVPI = EC without PI EC with PI = $786 $240 = $546
2 This
is the same as saying that the EVPI is $240 ($786) = $546.
7 Day Advance Ticket 800

.3 ad 1300 News: The 0 e Meeting go ah will

buy 1300
y u b Seat-Sale Ticket
Possible r Announcement 0 .4 rrdo r w 0.7 ilr r n l nr o r 786 wrr 390 e t otr d b rr a ait rr u go m 5r ry aherr dar r adr 0 ysrr r 7 Day Full-Fare Ticket buy 1300 Advance ade r Ticket 0r r .6 r
rr n 786 otr mrr
buy
3500
Note: All nancial gures are costs .
r do r rr no r 3 . News: The d 0 a 3500 1050 w rr t bu ait rr y Meeting o ahe for r r g r ne r r will r ws r rr w 0.7 i 1050 ll nr otr r go ar her r 0 adr
Figure 17: Airfare Problem after Rollback 93
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7.2
New Detergent Case: Some Extensions
Here we look at some extensions to the case which was analyzed in the previous section.
7.2.1
The EVPI
There are four pieces of uncertainty in the case: the result in each of the three test markets; and the result of a national campaign. While it would be possible to compute the EVPI based on knowing perfect information about any of these four things, or any combination of these four things, it is the uncertainty about the national campaign which is of primary importance. If we know that the product would be successful, then clearly we would spend $800,000 to make $4,000,000, for a net of $3,200,000. If we know that the product would be a failure, then clearly we would not spend $800,000 to make only $400,000. There is a 10% chance of being told that a success will occur, and a 90% chance of being told that a failure will occur, hence the EV with PI is: 0.10($3, 200, 000) + 0.90(0) = $320, 000
Without perfect information, the ranking payoff is $156,700, hence the EVPI is: EVPI = EV with PI EV without PI = $320, 000 $156, 700 = $163, 300
Though we did not need to draw a tree the nd the EV with PI, we can do so if we wish. We begin with the event, being the prediction about the success or failure of the national campaign, followed by the decision about whether or not to proceed with the national campaign. Making this tree and performing the rollback we have:
c April 28, 2010 D.M. Tulett National d $ 4000 Campaign 800 rocee $ p$ $$ $ $ $$
95
[The perfect $$ $$ $ $$ prediction for the] Result of the aband 1 0. National on s 3200 es 0 Campaign c c su 320
r rr fa r
National d$ ee ilur r Campaign 800 proc $ $$ $ $ e rr $ $ $ 0.9 r $$ $$ $ $$ 0

aband on
400
Hence the EV with PI is $320,000, and then subtracting the $156,700 we see that the EVPI is $163,300. 7.2.2 Sensitivity Analysis
While we could examine the effect of changing one or more of the parameters by any amount, usually we are only interested in nding the point(s) at which the recommendation would change. Sometimes nding the region for which the same recommendation hold also means that the ranking payoff is unchanged as well. At other times the ranking payoff will change as a parameter is changed. First, we will look at changing costs, and then we shall look at changing probabilities. Changing Costs The effect of changing the cost of making the ads is very easy to analyze. From Figure 14, we see that not making the ads leads to a payoff of 0, and the payoff at the square on the right of the make ads alternative branch has a ranking payoff of $171,700. Therefore, the ads can cost up to $171,700 before making the other alternative better. At the other extreme, if the ads cost nothing then the make ads alternative is of course still preferred. Since the ads currently cost $15,000, we could say that the cost could be decreased by $15,000 or increased by $156,700 without affecting the current recommendation. The effect of changing the cost of the test market campaigns is a bit trickier. While only one cost is being changed, two costs are affected by this change. Suppose that the cost (in thousands of dollars) of a test market campaign is now 10 +
96
(where is 10). The cost next to the alternative branch for testing in two markets is therefore 20 + 2. Therefore, the ranking payoff at the square labelled Number of Test Markets is either 181.70 (10 + ) or 188.2224 (20 + 2), whichever is higher. These expressions simplify to 171.70 and 168.2224 2 respectively. We now need to nd the value for which causes indifference between the two alternatives. Setting the two expressions equal, we solve to nd : 171.70 = 168.2224 2 = 3.4776 This gure is in thousands of dollars, hence if the cost per test market is less than $10, 000 $3, 477.60 = $6522.40, then the recommended solution is to test in two markets. If > 3.4776, then one test market is preferred to two, but if becomes too high, then the company would be better off doing nothing. This critical value of is where: Ranking Payoff(make ads) 171.70 15 = = = = Ranking Payoff(do nothing) 0 156.70 156.70
Hence the recommendation remains unchanged provided that: 3.4776 156.70 The current cost of the test market campaign is $10,000. Hence, in absolute terms, the recommendation remains unchanged provided that the cost of the test market campaign remains between $6522.40 and $166,700. Changing Probabilities To illustrate the effect of changing probabilities, consider the probabilities of success and failure in the national campaign, after two markets have been tested, and where one success and one failure has been obtained. These numbers are currently 0.35 and 0.65 for success and failure respectively. Now we will let the probability of success be 0.35 + , and hence the probability of failure is 0.65 . We must place the condition that 0.35 0.65. These adjustments are shown on the appropriate outcome branches on the righthand side of Figure 18.
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These changes cascade through the tree, affecting most of the ranking payoffs. At the two bottom circles on the right, we increase the payoffs by 4000 + 400() = 3600. The 1660 gure does not need to be recomputed this is the advantage of dealing with changes to the current probabilities rather than looking at absolute probabilities. At the squares immediately to the left, the payoffs will also increase by 3600, provided that the proceed alternative remains better than the abandon alternative. This will be the case provided that: 810 + 3600 0 This condition simplies to 0.225. If goes below this gure, then the abandon alternative would be preferred to the proceed alternative, but this change would not affect the overall recommendation, because this part of the tree is not part of the current recommendation. Now let us suppose that 0.225, and see what affect this has on the rest of the tree. The bottom two payoff nodes also increase by 3600, and then the rollback increases the payoffs by 0.92(3600) = 3312 after a success in Lethbridge, and by 0.08(3600) = 288 after a failure in Lethbridge. Finally, we obtain an increase of 0.12(3312) + 0.88(288) = 650.88 at the circle on the extreme left, and this increase is transferred to the appropriate place on Figure 19. For the current recommendation to remain unchanged, we must have 171.70 171.70 3.4776 0.00534... 188.2224 + 650.88 20 168.2224 + 650.88 650.88
Hence the recommendation remains unchanged provided that 0.00534. This is not much, when the current probability of success nationally (after one success, and one failure) is 0.35, with all probabilities being reported to the nearest 5%. All it would take is an increase to say 36%, and the recommendation would change to testing in two markets, and then proceeding if at least one of these turns out to be a success.
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.99 0 s$ $$ 4000 es Result c c $ u s $ $
d d 08 . 0 St. Johns ss 3224 (60) e Result su cc Continued on r fai Figure 19 r lur rre 12 . 0 r 0.92 1033.48 rr s s e r c + 3312 c d d su Lethbridge 843 (33) Result + 3600
d d fa ilu 188.2224 dd re + 650.88 d 0.8 d 8 d d d d r fai r lur rre 72.96 0.9 rr 2 + 288 rr
St. Johns ss e Result su cc
d d 08 . 0
843 (33) + 3600
$$ National 800 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ failu $$ $ re 0. 400 $$ 3964 01 aband on 3164 0 5+ .3$ 0 s 4000 $ s e Result cc su $$$ $ $$ National 850 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ f $ a $ ilure $ $ $ 1660 0.65 400 + 3600 aband on 810 0 + 3600 5+ .3$ 0 s 4000 $ s Result cce $ su $$$ $ $ National 850 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $ $ $ re 0. 400 $$ 1660 65 + 3600 aband on 810 0 + 3600
Figure 18: Sensitivity Analysis Second Continuation ( 0.225)
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7.3
Exercise
A farmer has been in the habit of always planting potatoes on his farm. In previous years, the seeds for the potatoes were planted in the spring, and were ready to harvest in mid-July. After that, a second planting took place in late July, which was ready to harvest in early October. This year, however, there is concern that a blight might destroy some or all of the potato crop. One thing he could do would be to plant a different crop such as peas which would not be affected by the blight. The peas would have only a single planting at a cost of $40,000. This planting would yield a crop in October worth $70,000 if the weather turns out to be good, or $30,000 if the weather turns out to be poor. There is a 60% chance that the weather will be good. If, however, he decides to plant potatoes, he will have to worry about the blight (but the weather has little effect on the potato crop and can be ignored). The potato crop would cost $60,000 to plant. There is a 10% chance of a severe blight, which would destroy the crop, and render any attempt at a second planting in late July not worth doing. A mild blight (20% chance) would partially destroy the crop, making it worth only $35,000, while having no blight (70% chance) would produce a crop worth $80,000. After either a mild blight or no blight, a second planting could be undertaken, with the same costs and revenues as the rst. The probability of a severe, mild, or no blight would be 15%, 30%, and 55% if the rst planting had a mild blight, but would be 0%, 5%, and 95% if the rst planting had no blight. NOTE: The crop planted in the Spring will be either peas or potatoes; doing a bit of both is not an option in this problem. (a) Draw the tree, solve it using the rollback procedure, and state the recommendation and the ranking payoff. When drawing the tree, use payoff nodes for intermediate payoffs. (b) Now suppose that the cost of planting potatoes is $60, 000 + c. For c both positive and negative, nd the limits for which the recommendation from part (a) does not change. (c) Now suppose that the cost of planting potatoes is xed at $60,000, but the probability of a mild blight on the rst planting is 0.2 + p, with the probability of a severe blight on the rst planting being unchanged. For p both positive and negative, nd the limits for which the recommendation from part (a) does not change.
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0.1 $ 4000 ss$$ e c Result c u $ s $$

$$
400
no
ne
156.70 dd d
d
d City d d d Number d d of Test 10 one d d 181.70 dMarkets d d d d
ea ak m
15
Figure 19: Sensitivity Analysis Beginning of the Tree
ds
rr t r Lethbridge r wo 171.70 rr rr r r Continued on r Result r (if rr r 20 r Figure 18 0.00534)
188.2224 + 650.88
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8
8.1
Imperfect Information 1
Introduction
In this and the next two sections, we examine decision trees for which the use of Bayesian revision (covered extensively in Mathematics for Management Science) is needed in order to compute some of the probabilities. Starting with a problem description, we begin to develop the decision tree, except that not all of the probabilities can be written down immediately. We then perform a Bayesian revision to nd these probabilities, and then transfer these numbers to the decision tree. The tree is then rolled-back to obtain a recommendation for the situation. In Mathematics for Management Science, Bayesian revision is performed by making three tables. That method can be used here too, but we also demonstrate a different method, that of using prior and posterior trees.
8.2
8.2.1
Example Seismic Testing

Problem Description
An oil exploration company has identied a site under which there may be a pocket of oil. The probability that oil exists at this location is 1%. It would cost $3,000,000 to drill for oil. If the oil exists, it would be worth $40,000,000. A seismic test is available which would cost $40,000. The result of the test would be one of the following: positive,inconclusive, or negative. If there really is oil present, then there is a 60% chance of a positive reading, a 30% chance of an inconclusive reading, and a 10% chance of a negative reading. If theres no oil at that location, then theres a 0.04 probability of a positive reading, and a 0.2 probability of an inconclusive reading. We wish to develop a decision tree for this situation, and solve it to obtain a recommendation for the oil exploration company. 8.2.2 Problem Formulation
There are two decisions to be made in this situation. What we might call the major decision is whether or not to spend $3,000,000 drilling for oil. The other decision is whether or not to spend $40,000 to do the seismic test. The purpose of the seismic test is to obtain information which would help us with the major decision. We will call the decision about the seismic test the information decision.
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Not just in this situation, but in all problems of this type, the information decision must precede the major decision . Indeed, the information decision precedes everything else. This decision, with its two alternatives, is as follows:
Seismic Testing d d d d d d d d d d d d d d d d d d
no
se ism ic se ism
If the seismic is not done, then this becomes an easy problem. We must choose whether or not to drill at a cost of $3,000,000, and if we drill we then have an oil event with two outcomes: oil is present with probability 0.01; and oil is not present with probability 0.99. Adding these things to the tree we obtain:
01$$ 0.$ l $$ i o $ $$ no oil ,000 l 3 0 3 0 3 0 l 3 0.99 i3 3 r3 3, d 3 3 3 3 v 3 3 v 3 3 33 v
do not dril l
Seismic Testing
ism
ic
d d d d d d d d d d d d d d d d d d
no
se
40
,0
ic
00
Drilling for Oil
te
st
Oil Event
40,000,000
ism se
,0 40
ic
00
te
st
103
After the alternative to do the seismic test, comes the seismic event, with its three outcomes: positive; inconclusive; and negative. This is an example of a common pattern in this type of problem an alternative of the information decision for which information is sought is followed by an information event, which in turn is followed by the major decision. When we draw the outcome branches for this situation, we cannot immediately write the probabilities, for we do not know what they are. We will nd them later using Bayesian revision, and will then transfer these numbers to the decision tree. Adding these outcome branches we obtain:
01$$ 0.$ l $$ i o $ $$ no oil ,000 l 3 0 3 0 3 0 l 3 0.99 i3 3 r3 3, d 3 3 3 3 v 3 3 v 3 3 33 v
do not dril l
Oil Event
40,000,000
Drilling for Oil
Seismic Testing
ism
ic
d d d d d d d Seismic d d Event d d d d d d d d inconclusive d
no
se
se
ism
d d d
po sit
iv e
At this point, a fair bit of repetition appears in the rest of the tree. After each
40
,0
ic
00
st te
t ga ne
d d d d d d d
e iv
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of the outcomes of the seismic result event, there is the decision about drilling. If the drilling is done, it is followed by the oil event. This of course is like what we have already drawn at the top of the tree, but theres one important exception. The probabilities of oil and no oil are not 0.01 and 0.99 as they were before. Instead, these are now conditional probabilities, and they must be calculated using Bayesian revision. The decision tree with the probabilities absent on the bottom part of the tree is shown in Figure 20. To reduce the clutter on this part of the tree, the words Drilling for Oil and Oil Event only appear once rather than in all three places. 8.2.3 Bayesian Revision
Now, we must do the Bayesian revision. In Mathematics for Management Science, Bayesian revision was done using tables. If your memory of this topic is fuzzy, you might wish to go back and re-read this topic before proceeding further with this discussion. The event for which the marginal probabilities are known is that of the presence of oil. These probabilities are 0.01 for the existence of oil at that location, and 0.99 for the absence of oil. For the other event, the seismic testing, we have probabilities (given in the problem description) which are conditional on whether there is or is not oil in the ground. These probabilities, and the two marginal probabilities, are given in the following table. Note that since one of the three outcomes of the seismic test must occur, we nd P(negative/no oil) as 1 (0.04 + 0.20) = 0.76. Seismic Event positive inconclusive negative 0.60 0.30 0.10 0.04 0.20 0.76
Oil oil Event no oil
0.01 0.99
Multiplying the conditional probabilities by the marginal probabilities of the oil event we obtain the joint probabilities, and summing these gives the marginal probabilities of the seismic event. The second table is: positive 0.0060 0.0396 0.0456 Seismic Event inconclusive 0.0030 0.1980 0.2010 negative 0.0010 0.7524 0.7534
Oil oil Event no oil P(seismic result)
0.01 0.99
Oil Event 40,000,000
Drilling for Oil 0 Oil Event 0 0

$ l $$$$ i o $ $$ no oil ,000 l 3 0 3 0 3 0 l 3 i 3 r 3, 3 d 3 3 3 3 3 v 3 3 v 3 3 33 v
01$$ 0.$ $ l i $ o $ $$ no oil ,000 l 3 0 3 0 3 0.99 il 3 3 r3 3,0 d 3 33 3 3 v 3 3 v 3 3 3 3 v

do not dril l
c i ism se Seismic no Testing
40,000,000
40,000,000
d d d d s d eis 40 d d mi Seismic ve d ,0 c i 00 d te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d
do not dril l 0 $ l $$$$ i o $ $$ no oil ,000 l 3 0 3 0 3 l3 i3 3 r3 3,0 d 3 3 3 3 v 3 3 v 3 3 3 3 v
d ne d gat d ive d d d d d d d
40,000,000
do not dril l 0 $ l $$$$ oi $ $ 0 $n o oil 0,00 ll 33 3 0 3 0 , i 3 r3 3 d 3 3 3 3 3 v 3 3 v 3 3 33 v do not dril l
105
Figure 20: Seismic Testing Decision Tree without Revised Probabilities
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Finally, dividing the joint probabilities by the marginal probabilities underneath we obtain the posterior conditional probabilities. The third table using veplace decimals is: Seismic Event inconclusive 0.01493 0.98507 0.2010
Oil oil Event no oil P(seismic)
positive 0.13158 0.86842 0.0456
negative 0.00133 0.99867 0.7534
We read this as P(oil/positive) = 0.13158, P(no oil/positive) = 0.86842, and so on. These gures, even though there are ve-place decimals, are approximations of exact fractions. If we wish, we can use fractions instead. If this is done, it makes sense to remove the decimals from the numerator and the denominator. However, it does not make sense to reduce the fraction to the lowest common denominator, as this only adds work. For example, instead of calculating the decimal quantity 3 , 0.01493, we could have expressed 0.0030 divided by 0.2010 as the fraction 201 1 but we need not reduce this fraction to 67 . As unreduced fractions the third table is: Seismic Event inconclusive negative
3 201 198 201 10 7534 7524 7534
positive Oil oil Event no oil P(seismic)

60 456 396 456
0.0456
0.2010
0.7534
The concern about accuracy may seem to be misplaced when all the original probabilities in the rst table are approximations anyway. However, some of the probabilities will be multiplied by large numbers, specically the $40,000,000 gure. Heres what happens depending on the level of accuracy when we approx60 imate 456 using decimals. The decimal expansion is 0.13157947... When multiplied by $40,000,000, we obtain (to the nearest cent) $5,263,157.90. If we approximate the decimal we obtain (using rounding) 0.132 for three places, 0.1316 for four places, and 0.13158 for ve places. The values of these numbers times $40,000,000, and the differences between these values and the theoretical value are:
c April 28, 2010 D.M. Tulett Value 0.13157947... 0.13158 0.1316 0.132 Value $40,000,000 $5,263,157.90 $5,263,200.00 $5,264,000.00 $5,280,000.00 Variation $42.10 $842.10 $16,842.10
107
These variations are what would be present at the Oil Event node which comes after a positive seismic result. By the time everything is rolled back, the error would be diminished, but it would still be considerable. For this reason, I store all probabilities in my calculators memory, so that the nearly exact value is used, even if I only write ve decimal places doing it this way is equivalent to using fractions. For student use, I would recommend that you either do it that way, or use ve decimal places (rounded). At the very least, use four decimal places (rounded); using only three can cause substantial errors. Before transferring these probabilities to the decision tree, we will look at the prior and posterior tree method of performing Bayesian revision. This method takes a little bit longer to do, but its conceptually easy because it mimics a subset of the decision tree. We work with two probability trees, called the prior tree and the posterior tree. Both the prior and posterior trees contain two events. The prior tree (which is done rst) has the two events of the decision tree in the reverse order of how they appear in the decision tree. The posterior tree (which is done after completing the prior tree) has the two events in the reverse order of how they appear in the prior tree . Equivalently, the posterior tree has the two events in the same order as they appear in the decision tree . For this example, the two events of the decision tree are the seismic event and the oil event, in that order. Since the prior tree contains these events in reverse order, the prior tree consists of the oil event followed by the seismic event. Writing the outcomes of the oil event with their marginal probabilities, and the three outcomes of the seismic event with their conditional probabilities, gives us the following picture.
108
s po inconclusive r nega D rr tiv 0.3 D e rr D 0 1 r .1 D 0 rr . D 0 D l i oD D D

l no l oi ll l 0.9 l9 l
.6 0 e itiv
e tiv si l o p l l inconclusive r nega r tiv 0.20 rr e r 0.7 rr6 r
.04 0
On this tree we write the joint probabilities at each node and at the ends of the branches. The node on the left begins with a probability of 1, meaning that it is certain that something will occur. For any outcome branch on the tree, the joint probability at the ending node (on the right) is the joint probability at the beginning node (on the left) multiplied by the probability (be it marginal or conditional) on that outcome branch. For example, the joint probability at the top seismic event node is 1 (the joint probability at the oil event node) multiplied by 0.01 (the marginal probability along the oil outcome branch, which is simply 0.01). Similarly, the joint probability at the bottom seismic event node is 0.99. So far, everything is trivial. The joint probability at the end of the top positive branch equals 0.01 (the joint probability at the seismic event node) multiplied by 0.6 (the conditional probability along the positive outcome branch), which is 0.006. Similarly, the joint probabilities at the end of the top inconclusive and negative outcome branches are 0.01(0.3) = 0.003 and 0.01(0.01) = 0.001 respectively. The joint probability at the end of the bottom positive branch equals 0.99 (the joint probability
109
at the seismic event node) multiplied by 0.04 (the conditional probability along the positive outcome branch), which is 0.0396. Similarly, the joint probabilities at the end of the bottom inconclusive and negative outcome branches are 0.99(0.20) = 0.1980 and 0.99(0.76) = 0.7524 respectively. Comparing this approach with the table method, it is seen that the prior tree is simply a visual way of displaying the information which appears in the rst table and in part of the second table. Adding the joint probabilities the completed prior tree is:
.6 0.006 0 e v siti
po inconclusive r r nega 0.3 D tive D 0.01 rr r D r 0.1 1 rr D 0 . 0D r D l i oD D D no 1 ll o lil l 0.9 l9 l
0.003
0.001
s l po l l inconclusive
4 0.0396 .0 0 e itiv
neg r rr ativ 0.20 0.99 r e rr 0.7 rr 6 r
0.1980
0.7524
The sum of the joint probabilities on the extreme right of the tree must sum to 1, so it is wise to verify this fact before proceeding to the posterior tree. .006 + .003 + .001 + .0396 + .1980 + .7524 = 1.000 This sum doesnt have to be written out as it is here, but you should at least verify that sum is 1 on your calculator. As stated earlier, the posterior tree contains the same events, but in reverse order. For this problem, the posterior tree begins
110
with the seismic event, which is followed by the oil event. We begin drawing the posterior tree by outlining its shape; the probabilities need to be computed by transferring the nal joint probabilities from the prior tree. The shape of the tree is:
l oi no o l i

po
sit
iv e

l oi inconclusive no o l i d
d
Throughout the development of the decision, prior, and posterior trees, we have maintained consistency in the vertical ordering of the outcomes. We have always placed oil above no oil, and positive above inconclusive which in turn is above negative. This consistency will help us when transferring the joint probabilities from the prior tree to the posterior tree, and when transferring marginal and conditional probabilities from the posterior tree to the decision tree. The nal joint probabilities on the prior and posterior trees are the same, except that they are placed in a different order. The rst (top) joint probability on the posterior tree is the joint probability of positive and oil. This is numerically the same as the joint probability of oil and positive, which is found on the prior tree (at the top), and its value is 0.006.
t ga ne
d
d d d d l d i o d n o oil
e iv
111
The second (from the top) joint probability on the posterior tree is the joint probability of positive and no oil. This is numerically the same as the joint probability of no oil and positive, which is found on the prior tree (fourth from the top), and its value is 0.0396. Placing these values on the posterior tree we have: 0.006
l i o n o oil
0.0396
d d d
po
sit iv e
l i o n o oil
inconclusive
Going to the third place, we need the joint probability of inconclusive and oil, which from the prior tree is seen to be 0.003. Because of the consistent vertical labelling of the outcomes, a nice pattern emerges. The top three joint probabilities on the prior tree become the joint probabilities at the top of each pair of outcomes on the posterior tree, and the bottom three joint probabilities on the prior tree become the joint probabilities at the bottom of each pair of outcomes on the posterior tree. Though the patterns differ from one Bayesian revision to the next, there will always be a type of pattern to nd whenever the outcomes have been labelled consistently. If there is any doubt, remember that for each joint probability the
e tiv ga ne
d d d
d l d oi d no o l i
112
words on the outcomes of the prior and posterior trees must match up (in reverse order). Completing the remaining four joint probabilities the posterior tree becomes:
l oi no o l i

0.006
0.0396 0.003

po
sit
iv e

l oi inconclusive no o l i d
d
After transferring the ending joint probabilities from the prior tree, the next step is to compute the other joint probabilities on the posterior tree. This is done simply by addition. At the top oil event node, we add 0.006 and 0.0396 to obtain 0.0456, at the middle node we add 0.003 and 0.198 to obtain 0.201, and at the bottom the sum of 0.001 and 0.7524 is 0.7534. Each of these numbers is written next to its corresponding event node. Then, taking the numbers we have just computed, we sum them to obtain 0.0456 + 0.201 + 0.7534 = 1.0000 This number 1 is written next to the left-hand node. It is always true that we should obtain a 1 next to this node, so this acts as a check on our calculations. Had we not
t ga ne
d
0.198 0.001
d d d d l d oi d no o l i
e iv
0.7524
113
obtained a 1, this would have indicated that an error had been made. The probability on every outcome branch is obtained by dividing the ending (right-side) joint probability by the beginning (left-side) joint probability. For the outcomes on the left-side event, these are just the ending joint probabilities divided by 1, producing the same numbers. Doing this much the posterior tree becomes:
l oi no o l i 0.0456
0.006
45 6
po
sit iv e
l i o no o l i 0.201
0. 0
0.0396 0.003

inconclusive 0.201 1d
d
At this point we have found all the information in the second table of the table method of Bayesian revision. We now complete the Bayesian revision on the posterior tree, which provides the information found on the third table. We continue the process of dividing joint probabilities, which provides the conditional probabilities. Starting with the top oil event (which comes after a positive seismic outcome), the conditional probability of oil is computed as 0.006 0.13158 P(oil/positive) = 0.0456 As stated earlier, we may wish to give the exact value by writing the conditional 60 probability as an unreduced fraction, i.e. 456 . Writing all six conditional probabilities rounded to ve decimal places the posterior tree becomes:
e tiv ga ne
d
0.198 0.001
d d
0.
d
75
d l d oi d no o il 0.7534
34
0.7524
114
3 0.003 49 01 0. l i o inconclusive n o oil 0.201 0.9 8507 1d 0.201 d 0.198 d

po s
iti ve t ga ne
d d
0. 04
8 0.006 15 13 0. l i o no o l 0 .8 i 6842 0.0456 0.0396
56 e iv 75 0.
d
3 13 d 00 . 0 l d oi d no o il .9 9867 0.7534 0

34
0.001
0.7524
While we have developed the prior and posterior trees slowly to illustrate the process, when doing this in practice all that is needed is a single sheet of paper on which both trees are written. This is shown in Figure 21. This methodology for performing Bayesian revision is entirely optional if you feel more comfortable using the table method, then by all means use the table method. However, you should try the tree method of a couple of problems before you make this decision. When you become used to both methods, there really isnt much difference in time.
Prior Tree
s .6 0.006 0 e itiv
Posterior Tree
0.006
0.003 0.0396 0.003
po inconclusive r nega 0.3 D tive D 0.01 rr r D r 0.1 1 rr D 0 . 0D r D l i oD D D
0.001
no 1 ll o lil l 0.9 l9 l l
.04 0.0396 0
0.198 0.001
e tiv i s o p l l inconclusive 0.1980 r nega 0.20 r tive 0.99 rr r 0.7 rr6 r 0.7524
8 15 13 . 0 l oi no o il 0.8 6842 6 0.0456 5 4 0 . 0 e v i sit o p 3 49 01 . 0 l oi inconclusive no o 0.201 il 0.9 n d 8507 1 0.201 eg d at d ive d 0 d .75 d 34 3 13 d 00 . 0 l d oi d no o il .9 9867 0.7534 0
0.7524
115
Figure 21: Prior and Posterior Trees for the Oil Drilling Problem
116
The main advantage of the table approach is that it can be done on a spreadsheet (though this wont help you on a test). The main advantage of the tree method is that it ties in nicely with the decision tree for which the Bayesian revision is being performed. Once the posterior tree has been completed, it is very easy to see where to transfer the marginal and conditional probabilities onto the decision tree. To review, the steps involved in making the prior and posterior trees are: 1. Taking the events from the decision tree in reverse order, make the prior tree showing its shape, putting labels on the outcomes, and write the marginal and conditional probabilities. 2. Using multiplication, nd all the joint probabilities on the prior tree, and verify that they sum to 1. 3. Taking the events from the prior tree in reverse order, make the posterior tree showing its shape, and put labels on the outcomes. 4. Transfer the nal (right side) joint probabilities from the prior tree to the appropriate places (i.e. matching pairs of outcomes) on the right side of the posterior tree. 5. Using addition, nd the other joint probabilities, and verify that the initial (extreme left side) joint probability is 1. 6. For every outcome branch, nd the probability on the branch by dividing the joint probability at the end of the branch by the joint probability at the beginning of the branch. 8.2.4 Solution and Recommendation
Now we can complete the formulation of the decision tree. Again, the consistency in the vertical labelling of the outcomes makes the transfer of the marginal and conditional probabilities from the posterior tree to the decision tree very easy. With Figures 20 and 21 in hand, we can easily see what needs to be transferred where. The events are in the same order, the difference being that in the decision tree there is a decision between the two events. There are a total of three marginal probabilities, and six conditional probabilities, to be transferred from the posterior tree to the decision tree. (Alternatively, if the table method is used, we transfer these numbers from the third table.) Doing this, we obtain the decision tree shown in Figure 22.
Drilling for Oil 0 Oil Event
01$$ 0.$ $ l i $ o $ $$ no oil ,000 l 3 0 3 0 3 0.99 il 3 3 r3 3,0 d 3 33 3 3 v 3 3 v 3 3 3 3 v

do not dril l
40,000,000
0 0
58 $ 1$ .13 $ 0 $ l i $ o $ $$ no oil ,000 l 3 0 3 0 3 0 0.868 l 3 i 3 r 3, 3 d 3 42 3 3 3 3 v 3 3 v 3 3 3 3 v
40,000,000
d d 56 4 d d dse .0 0 ism 40 d d i Seismic ve d ,0 i 00 d c te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d
do not dril l 0 93 $ 4$ .01 $ 0$ l$ i o $ $$ no oil ,000 l 3 0 3 0 3 0.985 l3 i3 3 r3 3,0 d 0 7 3 3 3 3 v 3 3 v 3 3 3 3 v
0.201 d ne d gat d ive d 0 d .7 d 5 34 d d d d
40,000,000
do not dril l 0 33 $ 1$ .00 $ 0$ l i $ o $ $ 0 $n o oil 0 0,00 ll 33 3 0 3 0 , i .9986 3 r3 3 d 3 7 3 3 3 3 v 3 3 v 3 3 33 v do not dril l
117
Figure 22: Seismic Testing Decision Tree with Revised Probabilities
118
This tree is then rolled-back to obtain a recommendation. The rolled-back tree with highlighted recommended alternatives is shown in Figure 23. The conditional probabilities are shown to ve-place accuracy, and the rolled-back payoffs are shown to the nearest dollar, but in fact all this information was stored to the accuracy of the calculator. Recommendation Do the seismic test. If the result is positive, then drill for oil; otherwise, do not drill. The ranking payoff is $63,200. 8.2.5 Commentary
In problems of this type, it is often useful to nd the EVPI at the outset. If the cost of obtaining information is higher than the EVPI, then we can eliminate the alternative to seek information. In this case, the EVPI is: [0.01(40, 000, 000 3, 000, 000) + 0.99(0)] 0 = 370, 000 The cost of the seismic test, which is $40,000, is much less than $370,000. Hence, the seismic test cannot be trivially eliminated. You may be wondering why we even considered the drill alternative after a negative seismic test. This is because the information is not perfect, so there is a chance that doing the non-obvious thing may be right. Sensitivity analysis can be performed as usual, except on the marginal and conditional probabilities which come after the seismic test alternative. To consider a change to the probabilities, we would have to go back to the prior tree, changing at least two numbers (one increasing by , and another decreasing by ), and then observing how these changes cascade through the posterior tree. This sort of analysis can quickly become quite complex.
Drilling for Oil 0 Oil Event
01$$ 0.$ $ l i $ o $ $$ no oil ,000 l 3 0 3 0 3 0.99 il 3 3 r3 3,0 d 3 33 400,000 3 3 v 3 3 v 3 3 3 3 v

do not dril l
40,000,000
c i ism se Seismic no Testing d d
58 $ 1$ .13 $ 0 $ l i $ o $ $$ 0 no oil ,000 l 3 0 3 0 3 0 0.868 l 3 i 3 r 3, 3 d 3 42 3 3 3 3 2,263,158 3v 5,263,158 3 3 v 3 3 3 v
40,000,000
do not dril l 0 93 $ 4$ .01 $ 0$ l$ i o $ $$ no oil ,000 l 3 0 3 0 3 0.985 l3 i3 3 r3 3,0 d 0 7 3 3 3 3 597,015 v 3 3 v 3 3 3 3 v
40,000,000
d 56 63,200 dd 4 d dse .0 0 ism 40 d d i Seismic ve d ,0 i 00 d c te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d 0.201 do d n not 103,200 dega 0 dril l t d ive 0 33 $ 1$ d 0 .00 $ 0$ l i $ o . d 7 $ $ 0 $n d 5 34 o oil 0 0,00 ll 33 3 0 3 0 , i .9986 3 d r3 3 d 3 7 3 3 d 3 53,096 v 3 33 3v d d 3 33 v
119
do not dril l
Figure 23: Seismic Testing Rolled-Back Decision Tree
120
8.3
Exercise
A consumer products company has identied a potential product which would require $1,800,000 in start-up costs to launch. If it turns out to be a major success, there will be a $10,000,000 contribution to prot. A minor success would give a prot contribution of $2,000,000, while a failure would have a prot contribution of only $500,000. The company is most worried about this third possibility, since in this case the net prot would be $500,000 minus $1,800,000, i.e. a loss of $1,300,000. In the past, only one new product in twenty became a major success, while three-quarters of them became failures; there is no reason to suspect that this product would be any different from the rest. Some of their competitors use an outside independent market research rm to give them advice about new products. The fee for the research rm is $50,000; in return, the consumer products company would be told that the proposed product either looks good or looks bad. The research company had established a track record which gave them condence about saying the following: - if a product would be a major success, they would say looks good with probability 0.8; - if a product would be a minor success, they would say looks bad with probability 0.7; - if a product would be a failure, they would say looks bad with probability 0.9. Develop a decision tree and solve it to obtain a recommendation for the consumer products company.
121
9
9.1
Introduction
In this section we look at sequential Bayesian revision. This is used when new information is used to revise the probabilities, and then more new information arrives. This necessitates a second revision of the probabilities. The example is quite long, so it has been analyzed one paragraph at a time. Part A can be solved simply by using a payoff matrix. From this we can nd the EVPI, which gives an upper bound to the expected value of any information. We see that the cost of this information is less than the EVPI, so in Part B we proceed with making a decision tree to analyze this situation. This leads to a decision tree and prior and posterior trees which are very similar to those of the oil drilling example of the previous section. Then in Part C we present the concept which is new to this section.
9.2
9.2.1
Example Wood Finishers

Problem Description
Wood Finishers produces a line of executive-type ofce desks. A high quality desk nets a prot of $1000. A poorly-made desk, however, due to refunds and loss of customer goodwill, has a net loss of $6000. (High or low quality does not refer to the visible part of the desk, which is always of high quality, but rather to the ability to last years of use.) Ninety-six per cent of the production is of high quality. Adding a rework section to the assembly line would guarantee that each desk would be of high quality, but this would cost $400 for each desk reworked. Suppose that the company can inspect each desk at a cost of $50 (per desk) before deciding whether or not to rework it. The results of the inspection at this station would be one of the following: looks good, inconclusive, or looks bad. If the inspected desk is of high quality, then there is a 70% chance that the inspection will indicate looks good, a 20% chance that the inspection will be inconclusive, and a 10% chance of a looks bad result. If the inspected desk is of poor quality then there is a 90% chance of a looks bad result, an 8% chance that the inspection will be inconclusive, and a 2% chance of looks good result. In addition to the inspection station mentioned above, Wood Finishers can add a second inspection station (which can only inspect a desk which was inspected at the rst station). The result of the inspection at the second station is reported as being either pass or fail. If the desk is of high quality there is a 95% chance
122
of a pass. If the desk is of poor quality there is a 97% chance of a fail. The cost of this test would be $60 per desk inspected. For now, let us suppose that we only need to consider adding the second station if the result of the rst test was inconclusive. 9.2.2 Part A
The rst paragraph of the problem description contains a decision (rework) and an event (quality): Wood Finishers produces a line of executive-type ofce desks. A high quality desk nets a prot of $1000. A poorly-made desk, however, due to refunds and loss of customer goodwill, has a net loss of $6000. (High or low quality does not refer to the visible part of the desk, which is always of high quality, but rather to the ability to last years of use.) Ninety-six per cent of the production is of high quality. Adding a rework section to the assembly line would guarantee that each desk would be of high quality, but this would cost $400 for each desk reworked. We can analyze this situation with a payoff matrix or a decision tree. The rework decision has two alternatives: do not rework; and rework. If the rework is not done, then there is an event for which there are two possible outcomes: high quality; and low quality. We do not know how many desks are being made, so we cannot nd the absolute level of prot. Instead, we will work out the prot per desk. Rework Decision Alternatives Do not Rework Rework Prob. Quality Event Outcomes High Low 1000 6000 600 600 0.96 0.04
EV 720 600
Hence, we would choose to not rework, for an expected prot of $720 per desk. The EV with PI is: EV with PI = 0.96(1000) + 0.04(600) = 960 + 24 = 984
123
Hence the EVPI is $984 $720 = $264 per desk. Although a payoff matrix is perfectly adequate for solving this part of the problem, it is also possible to use a decision tree. Using a tree now helps when drawing the tree for Part B (the second paragraph), because the large tree contains three sub-trees which are similar to the one drawn here. Using a tree we obtain:
0.96$ $$$ gh i $ h $ $$ k r3 ow l 3 o 3 w 3 e 3 0.04 r3 Rework t 3 o 3 n 3 o 3 3 d3 720 Decision 3 3 3 33
Quality Event
1000
6000
720
rew ork 400
1000
If we wish to calculate the EV with PI also using a tree, we have: Rework Decision
$ [The perfect $$ $ $$ prediction for the] rewor Quality of 6 k 9 . 0 1000 the Desk 1000 h g hi 400
rk$ o ew $ tr $$ o $ n $ $ 1000 o $ d $ $ $$
984 r Rework r rr rk$ o low Decision ew $ 6000 r $ t $ o r $ n $ o$ $ 0.0 rr $ d $$ $ $ 4 r $$ $ $$

rewor k 600
400
1000
As before, the EVPI is $984 $720 = $264 per desk.
124 9.2.3 Part B
The second paragraph adds an inspection decision and an inspection event: Suppose that the company can inspect each desk at a cost of $50 (per desk) before deciding whether or not to rework it. The results of the inspection at this station would be one of the following: looks good, inconclusive, or looks bad. If the inspected desk is of high quality, then there is a 70% chance that the inspection will indicate looks good, a 20% chance that the inspection will be inconclusive, and a 10% chance of a looks bad result. If the inspected desk is of poor quality then there is a 90% chance of a looks bad result, an 8% chance that the inspection will be inconclusive, and a 2% chance of looks good result. The $50 cost (per desk) of doing the inspection is much less than the EVPI, which is $264 (per desk). Hence we must proceed with the analysis to see if it would be worthwhile to do the inspection. The inspection decision must precede the inspection event, which in turn must precede the main (rework) decision. After the no inspection alternative, we are left with the situation which was analyzed in Part A. Therefore, we do not need to redraw this section, but instead merely write the ranking payoff which we calculated to be $720. For now, we cannot write the probabilities on the inspection outcomes, as these must be determined using Bayesian revision. This part of the tree is shown in Figure 24. After every outcome node we have a sub-tree which resembles the tree made in Part A. Indeed, the only differences are the probabilities, which we need to calculate using Bayesian revision. The tree for Part B without the probabilities is shown in Figure 25. We then draw the prior and posterior trees for the Bayesian revision. The completed trees are shown in Figure 26. These probabilities are transferred to the decision tree shown in Figure 27. Finally, the tree is rolled back to obtain a recommendation. The rolled-back tree is shown in Figure 28. Based on this, the recommendation is: Recommendation Inspect every desk and rework it if and only if a looks bad result is obtained. The ranking payoff is $869.20 per desk.
125
Inspection Decision
d d d d d d Inspection d d d d Event d d d d d d d inconclusive d d d d
no
in
sp
ec
tio n
720 (from Part A)
lo
ok
sg ks
oo
s in
50
Figure 24: Desk Making Decision Tree - Information Decision and Event
pe
io ct
o lo
ba d
d d d d d d
126
i ct e p s in
$$ gh $$$ hi $ $ $ k r3 ow l 3 o 3 w 3 e r3 t3 33 o 3 n o 3 3 d3 3 3 3 3 3
on
720 (from Part A) 1000
Quality Event
Inspection no Decision

6000
1000
rew ork d d d d i 400 1000 $ ns d d d 50 $$$ p gh o i $ h Inspection e $ o d d ct g $$ k s d io Event r3 ow d l 3 o k 3 n w 3 e o 3 r3 d Rework t d o 3 o l 3 n 3 o 3 d 3 d Decision d 3 3 3 3 d d 3 3 d inconclusive d
6000
d lo doks d ba dd d d d d d d
1000
rew ork 400 1000 $ $$$ gh i $ h $ $$ k r ow l 3 o 3 3 w 3 e 3 r t 3 3 o 3 n 3 o 3 3 d3 3 3 3 3 3 rew ork 400
6000
1000
Figure 25: Desk Making Decision Tree without Probabilities
Prior Tree
od o g s .7 0 ook
Posterior Tree
0.672
0.192
od o g s
D igh hD
l inconclusive r loo 0.2 D sb D 0.96 rrk a r rd 0 96 D rr.1 0.D D r
1 0.672 88 9 .9 0 gh hi low 8 0.00 2 7 19 6 0.6728 1 . 0 0.0008
0.096
ok lo
1 0.192 36 8 .9 0 D gh hi D inconclusive low 0.1952 0.016 l lo l d o 39 1 lw 1 0.1952 o d ks l 0. 0.0032 b d 0 l 4 ad 0.0008 d d l oo l d 0.1 sg 0.02 k o l o d 32 l 7 0.096 72 l 2 l .7 d inconclusive 0 gh 0.0032 d hi r loo d 0.08 r k sb 0.04 rr low a .272 rd 0 0 rr.9 73 0.132 r 0.036 0.036

127
Figure 26: Prior and Posterior Trees for the Desk Rework Problem
128
28 7 6 . 0 3 33
pe s in
i ct
on
720 (from Part A)

1 1000 88 $ 99 .$ $ 0 h $ hig $ $$$ k r ow 0 l 3 o3 3 w 3 e .0011 r3 t3 33 o 9 3 n 6000 o 3 3 d3 33
Quality Event
1000
rew ork d d d d i 400 1 36 1000 $ ns 98 $ 0.$ d d d h 50 $ p g o i $ h Inspection o d ec d g $$$ k s d tio Event r ow 0 d 3 o 3 l w 3 e ok .0163 33 r3 dn Rework t d o 3 o 9 l 3 n 3 o 3 d 3 d Decision d 3 3 3 d d 3 33 d inconclusive d
6000
0.1952 d lo doks d ba dd d 0. d132 d d d d
1000
rew ork 400 7 72 1000 $ 72 .$ $ 0 h $ g hi $ $$$ k r ow 0 l 3 o3 w 3 e .2727 33 r t 3 3 o 3 3 n 3 o 3 3 d3 3 3 3 3 3 rew ork 400
6000
1000
Figure 27: Desk Making Decision Tree with Probabilities
3 33 28 7 6 0.
pe s in
i ct
on
720 (from Part A)

1 1000 88 $ 99 .$ $ 0 h $ g hi $ $$$ k r ow 0 l 3 o3 w 3 e .0011 33 r t 3 3 o 9 3 n 3 6000 o 3 3 991.68 d3 991.68 33
Quality Event
d d
1000
rew ork d d 869.20 d d 4 1 00 36 1000 d in $ 98 $ 0.$ sp d h 50 d $ g o i $ h Inspection o d ec d g $$$ k s d tio Event r ow 0 d l 3 o 3 k w 3 e o .0163 33 r3 dn Rework t d o 3 o 9 l 3 n 3 o 3 d 3 d Decision d 885.25 3 3 3 3 d d 3 3 d inconclusive d
6000
0.1952 d lo rew 919.20 dok 885.25 ork s d ba 400 7 1000 72 1000 $ 72 dd $ 0.$ h $ g i h $ d 0. $$$ d132 k r ow 0 3 o3 l w 3 e .2727 33 d r3 t 3 o 3 3 n 3 d 6000 o 3 3 d3 909 . 09 3 3 d d 3 33
600
rew ork 400
1000 129
Figure 28: Desk Making Rolled-Back Decision Tree
130 9.2.4 Part C
Solving Parts A and B required knowing only what we saw in the previous section. However, dealing with the third paragraph requires a bit of thought on how to begin the prior tree: In addition to the inspection station mentioned above, Wood Finishers can add a second inspection station (which can only inspect a desk which was inspected at the rst station). The result of the inspection at the second station is reported as being either pass or fail. If the desk is of high quality there is a 95% chance of a pass. If the desk is of poor quality there is a 97% chance of a fail. The cost of this test would be $60 per desk inspected. For now, let us suppose that we only need to consider adding the second station if the result of the rst test was inconclusive. We will only modify the part of the tree which is affected by this paragraph. We begin with the inconclusive outcome branch. After this we can either do or not do the second inspection. If we choose the no 2nd inspection alternative, then we are left with the situation which was analyzed in Part B. Therefore, we do not need to redraw this section, but instead merely write the ranking payoff which we calculated to be $885.25. On the other hand, if we choose to do the second test, then we have an alternative branch with a $60 cost gate, followed by the test event with its two outcomes, pass, and fail. For now, we cannot write the probabilities on the inspection outcomes, as these must be determined using Bayesian revision. This part of the tree is shown in Figure 29. After both outcome nodes we have a sub-tree which resembles the tree made in Part A. The tree for Part C without the probabilities is shown in Figure 30. The only tricky thing about the Bayesian revision is the determination of the beginning probabilities. The prior tree begins with the high and low quality outcomes, but the associated probabilities are not the 0.96 and 0.04 that we had originally. Instead, we must use the probabilities which are conditional on the rst test result being inconclusive, because they come after the inconclusive outcome. Hence we want P(high/inconclusive), which is 0.98361, and P(low/inconclusive), which is 0.01639. We then draw the prior and posterior trees for the Bayesian revision. The completed trees are shown in Figure 31. These probabilities are transferred to the decision tree shown in Figure 32. Finally, the tree is rolled back, which is shown in
131
inconclusive 0.1952 (from part (b))
Second Inspection Decision
d d d d Second d d 4 Inspection d d 4 4 d d Event 4 d 4 d s 4 s d a4 d p 4 d d d d 4
no
2n d
in
sp ec tio n in sp ec
885.25 (from part (b))
2n
Figure 29: Second Test Beginning of the Decision Tree
60
tio

fai l
132
Figure 33. Because the payoff after the inconclusive branch has increased, the overall recommendation is changed. The increased payoff will cascade through the tree for Part B, increasing the payoff at the outset by: 0.1952(910.52 885.25) = 4.93 Hence the ranking payoff becomes 869.20 + 4.93 = 874.13 Recommendation Inspect every desk. If a looks good result is obtained, then do not rework it. If an inconclusive result is obtained, then do the second inspection, and rework it if and only if the result of the second inspection is fail. If the result of the rst inspection is looks bad, then rework it. The ranking payoff is $874.13 per desk.
9.3
Exercise
Now suppose that in the desk rework problem the second inspection could also be used after a looks good or a looks bad outcome from the rst test. Determine if the second inspection would be used in either (or both) of these situations, and if so restate the recommendation and the revised ranking payoff at the outset of the tree.
p s in
n 885.25 (from part (b)) tio c e
Second nd Inspection o 2 n Decision Quality Event 1000
Rework Decision

rew ork 400
$ $$$ gh i $ h $ $$ k r ow l 3 o 3 3 w 3 e 3 r t 3 3 o3 n 3 o 3 3 d 3 3 3 3 3 3
6000
d d d d 2 Second d nd 60 d 4 Inspection d in d 4 s p 4 d e Event d 4 d cti d 4 o s 4 s d n a4 d p 4 d d d d 4
1000 1000
fa
il

$ $$$ gh i $ h $ $$ k r3 low 3 o 3 w 3 e 3 r3 t 3 o 3 n 3 o 3 3 d 3 3 3 3 33 rew ork 400
6000
1000
133
Figure 30: Second Test Decision Tree without Probabilities
134
Prior Tree
ss pa 0.98361 gh hi 0.93492 5 0.9
Posterior Tree
0.93443
47 0.93443 9 9 9 . 0
r fail D r 1 D 6 0.0 rr 3 8 D r5 9 . rr 0D D r h g D i hD D D
0.04918
low r rr D 2 D 9 rr 0.0 D 34 r 005 9 . rr 3 0D D r s sD a pD D D
0.00049
low 1 ll l 0. l01 l639 l l
ss a p l
3 0.0
0.00049
0.04918
fai 1 ll l l 0.0 l 65 67 55 l 08 7 . 0 l gh l i h l l
r fail r 0.9 0.01639 rr r7 r rr
0.06508 0.01590
r r low rr 0.2 r 443 rr 3 r r
0.01590
Figure 31: Prior and Posterior Trees for the Second Inspection
Second nd Inspection o 2 n Decision Quality Event
p s in
n 885.25 (from part (b)) tio c e
Rework Decision
3 33 rew ork 400
7 1000 94 $ 99 .$ $ 0 h $ g hi $$ $$ k r l ow 0 3 o3 w 3 e .0005 33 r t 3 3 o3 3 n 3 o 3 3 d 6000 3 33
d d d d 2 Second d nd 60 d Inspection d in 244 d 9 s 4 p 4 d e Event d .93 4 04 d cti d o s 4 s d n a4 d p 4 d d d d 4
1000
fa
il 0.0 65 08
3 33
7 1000 56 $ 75 $ 0.$ h $ g i h $ $$$ k r ow 0 3 o3 l w 3 e .2443 33 r3 t 3 o 3 3 n 3 o 3 3 d 6000 3 3 3
rew ork 400
1000
135
Figure 32: Second Test Decision Tree with Probabilities
136
n 885.25 (from part (b)) tio c e sp
in d Second n Inspection o 2 n Decision
Quality Event
d d 3 33
7 1000 94 $ 99 .$ $ 0 h $ g$ Rework hi $ $$ Decision k r l ow 0 3 o3 3 w 3 e .0005 r3 t3 33 o 3 3 n o 3 3 996.32 3 d3 996.32 6000 3
inconclusive 0.1952 (from d 910.52 dd d part (b)) d 2n 60 d d i Second

rew ork 400
Inspection d n 244 d 49 4 d spe Event 3 d .9 4 04 d cti d o s 4 s d n a4 d p 4 d d d d 4

970.52 fa
1000
il 0.0 65 08
3 33
7 1000 56 $ 75 .$ $ 0 h $ g hi $ $$$ k r low 0 3 o3 w 3 e .2443 33 r t 3 3 o3 3 n 3 o 3 3 710.33 d3 6000 33
600
rew ork 400
1000
Figure 33: Second Test Rolled-Back Decision Tree
137
10
10.1
Introduction
In this section there is only one Bayesian revision to be done, but to obtain the probabilities for the prior tree we need to use the formula for the binomial probability distribution. The binomial is discussed extensively in Mathematics for Management Science. A very quick overview is provided here. 10.1.1 Binomial Probability Distribution
Consider an event with two outcomes, one called success which occurs with probability p, and the other called failure which occurs with probability 1 p. If this event is repeated n times (where each event is identical and independent of the others), then the probability of obtaining (exactly) x successes (where x is an integer from 0 to n inclusive) is given by the following binomial probability formula: n! px (1 p)nx P(x; n, p) = x!(n x)! This formula is accessed on a spreadsheet using the BINOMDIST function. The expected value of this distribution is simply pn.
Example An assembly line has been producing defects at a rate of 5%. A sample of twenty units is taken from the line. What is the probability of nding three defective units? [Note: Unless indicated to the contrary, in all problems of this type we mean exactly x, not at least x.] Solution Here n = 20 and x = 3. A defect rate of 5% means that a unit chosen from the line at random has probability p = 0.05 of being defective. Hence P(3; 20, .05) = 20! .053 (1 .05)203 3!(20 3)! (20)(19)(18)17! 3 17 = .05 .95 (6)17! = (1140)(0.000125)(0.418120...) = 0.059582...
138
Shortcuts When x is at or near either 0 or n, the formula simplies greatly. For example if x = 0, then P(0; n, p) = (1 p)n , and if x = n, P(n; n, p) = pn . If x = 1, then P(1; n, p) = np(1 p)n1 , and if x = n 1, then P(n 1; n, p) = npn1 (1 p). For 2 x n 2, the original formula should be used. 10.1.2 Destructive vs. Non-Destructive Testing
When something is tested, the test may destroy the item. An example of this is a car operated by remote control which is driven at a research laboratory into a wall to test its ability to withstand a real collision. This is an example of destructive testing. An example of a non-destructive test is that of testing the voltage of a battery. The battery is not destroyed by the test, so provided that it worked during the test it can then be used in the intended manner. For our purposes, if after testing an acceptable product it can be sent to a customer, then the test is non-destructive. If after testing the item cannot be sent to a customer, then the test is destructive.
10.2
10.2.1
Example
Problem Description
At the outset of each production day, a machine which has a capacity to make 1000 units per day is cleaned and made ready for use. On ninety percent of the production days, the defect rate is only 1%. Defects are independent from one unit to the next. The other ten percent of the time, the defect rate is 20%. Until now, they have simply produced all 1000 units and have hoped for the best. Using a special reset process would guarantee that the defect rate will be only 1%, but it costs $600, and during the time it takes to reset the machine using this special process, 30 units could have been produced. Each unit costs $10 to make, and sells for $14. If a unit is defective, the customer receives a refund, plus a $15 gift certicate to compensate for the inconvenience. The production manager has suggested that after the machine has been cleaned and made ready for use that they produce two units, and then stop the production while these units are tested (destructively). The direct testing cost is two times $10 for the destroyed units plus another $70 for a total of $90, but there is an indirect cost as well: in the time it takes to test the two units, they could have produced another 18 units.
c April 28, 2010 D.M. Tulett 10.2.2 Solution
139
This problem contains a major decision (whether or not to reset the machine), and an information decision (whether or not to destructively test two units). The problem is complicated enough that we should start by ignoring the information decision. Once we have determined what to do when no testing is done (Part A), we can then consider whether or not two units should be tested (Part B). Part A If the special setup is not used, then 1000 units are produced. The production cost would be 1000($10) = $10,000. There is a 0.9 probability that defects are produced at a rate of 1%. This does not necessarily imply that exactly 10 of the 1000 are defective, but rather than any one unit chosen at random has a 1% chance of being defective. The number of defectives in a 1000 unit production run is governed by the binomial probability distribution, for which the expected number of defectives is pn = .01(1000) = 10. There is 0.1 probability that defects are produced at a rate of 20%. There is a revenue of $14 for each unit, but for each defective unit the $14 is returned to the customer plus theres a further loss $15 for a total of $29 each. Hence the net total revenue when 1% of the 1000 units are defective is:3 1000($14 0.01($14 + $15)) = = = = 1000($14 0.01($29)) 1000($14.00 $0.29) 1000($13.71) $13, 710
When 20% of the units are defective the net total revenue becomes: 1000($14 0.20($29)) = 1000($14.00 5.80) = 1000($8.20) = $8, 200
alternate approach is to think of 99% as the non-defective rate, with a gain of $14 for a good unit and a net loss of $15 for a defective unit. Hence the net revenue is: 1000(0.99($14) + 0.01($15)) = 1000($13.86 $0.15) = 1000($13.71) = $13, 710
3 An
140
If the special setup is used, then 1000 30 = 970 units are produced. The cost will be $600 for the setup plus a production cost of 970($10) for a total of $10,300. The defect rate will be 1%, hence we could nd the net total revenue from the 970 units as: 970($14 0.01($29)) = $13, 298.70 An alternate approach it to recognize that since 970 is 97% of 1000, producing 970 units gives 97% of the net revenue associated with producing 1000 units: 970 $13, 710 = 0.97($13, 710) 1000 = $13, 298.70 The tree has a fair amount of information on it, so we will build it in stages. First, we show the decision with its two alternatives. To save space, we simply write no to mean that the special setup is not done. Associated with this alternative is the number of units made, which is 1000. Similarly, yes means that the special setup is done, which causes the number of units made to be 30 fewer than 1000, which is 970.
e Special mak its ; o 3 n3 n 0 u3 3 Setup 0 3 33 03 1 3 3 Decision 33 33 3 33

9 s; mak 70 u e nits
ye
There is a cost associated with each alternative, so we draw cost gates on the branches. Each cost is a calculated number, which depends not only on whether the special setup procedure is done, but also on the number of units made.
141
) 0(10 0 0 0 1 e Special = 10,00 mak its ; o 3 n3 n 0 u3 3 Setup 0 3 33 03 1 3 3 Decision 3v 3 33 v

3 33 v 9 s; mak 70 u e nits 600 +
ye
= 10 970( ,300 10)
We now have the defect rate event, which has two outcomes: a defect rate of 1%; and a defect rate of 20%. The probabilities of these two outcomes are 0.9 and 0.1 respectively. Since sometimes probabilities are written as percentages, it is important that we not confuse what we have written. For example, on the top branch the 1% refers to the proportion of the units which are defective; the 0.9 is the probability that this proportion will occur.
.9 $ $ (10) 0$ 0 0 $ % $ 1 10 ,000 ake Special = 10 ; m $$$ s t i o 0% 0 3 n n 3 2 3 u3 Setup 03 3 .1 0 3 0 1 3 3 3 3 Decision v 3 3 v

3 3 33 v 9 s; mak 70 u e nits 600 +
Defect Rate Event
ye
= 10 970( ,300 10)
We calculate the ending payoffs and show these calculations and the results on the tree:
142
1000(14 1%(14 + 15)) ) 0 $ = 13, 710 1 9 . 0$$ 0( $ % $ 1 100 ,000 ake $ Special = 10 ; m $$ s it o 2 0% 0 3 n n 3 3 u 3 Setup 03 1000(14 20%(14 + 15)) 3 .1 0 3 0 1 3 3 3 3 Decision v = 8200 3 3 3v
3 33 v 9 s; mak 70 u e nits 600 +
Defect Rate Event
ye
= 10 970( ,300 10)
97%(13,710) = 13, 298.70
Rolling back the tree we obtain:
1000(14 1%(14 + 15)) ) 0 = 13, 710 $ 1 9 . $ 0$ 0( $ % $ 1 100 ,000 ake $ Special = 10 ; m $$ s it o 2 0% 0 3 n n 3 3 u 3 Setup 03 1000(14 20%(14 + 15)) .1 0 33 03 1 3 3 3 Decision v 13,159 = 8200 3 3 3v
3 33 v 9 s; mak 70 u e 3159 nits 600 +
Defect Rate Event
ye
= 10
97 ,300 0(10)
97%(13,710) = 13, 298.70
If we wish to calculate the EV with PI also using a tree, we have:
c April 28, 2010 D.M. Tulett Special 10,000 ; make ts i3 3 13,710 n no 0 u3 Setup 33 0 3 3 0 13 3 3 Decision v 3 33 v
3 3 33 v
143
[The perfect prediction] for the] Defect Rate

d 3638.87 dd d
9 s; mak 70 u e nits 3710 10,3 0 0
ye
0. 9
13,298.70
1%
The EV with PI is $3,638.87, hence the EVPI is: EVPI = $3, 638.87 $3, 159.00 = $479.87 Part B We now come to the information decision, that is to say we must choose between testing or not testing two units. Intuitively, we hope to nd that neither unit is defective, for then it is highly likely that the machine is producing defects at a 1% rate rather than a 20% rate. On the other hand, if either (or both) of the two units is defective, then the defect rate is more likely to be 20% rather than 1%, and we will probably want to use the special reset procedure. The analysis presented here quanties these intuitive ideas. To make and then test two units would cost 2($10) = $20 plus $70 for a total of $90. This is less than the EVPI, so we proceed with further analysis.4
4 The
indirect cost of not being able to produce 18 units while the testing is in progress adds to
20
d d d d
v 3 3 3v 3 33 v
00 ake s 10,0 no; m unit 3 8200 3 3 03 33 0 3 0 1 3 3 33 ye
1 0.
9 s; mak 70 u e 2998.70 nits 10,3
00
13,298.70
144
Destructive Testing Decision
c April 28, 2010 D.M. Tulett 3159 (from Part A)
no
te sti n
7 7 7
d d 7 Number of d d 7 Defective d d 7 d Units d 7 d d Event 7 d d 7 d d 7 d d d 7 one d
o tw st te
e e e
no n
Figure 34: Machine Reset Problem Beginning of the Decision Tree The tree begins with the decision concerning the testing of the two units. If the testing is not done, then we have the situation which was analyzed in Part A, which had a ranking payoff of $3159. If the testing is done, then we have the testing event. Although both units are destroyed by the test, what we nd out is whether or not the tested units were defective. There are three possibilities: neither unit is defective; one unit is defective (it does not matter which); or both units are defective. Hence we need three outcome branches. The probabilities on the branches will be found using Bayesian revision. The tree so far is shown in Figure 34. At the end of every outcome branch we have a tree similar to the one found
the $90, but we cannot quantify this without further analysis. Indeed, we need not nd this gure, because to do so would require more work than is required to solve the original problem.
90
un
its
o tw
e e e e e e e e
145
in Part A. Because two units of the days production have already been made (for the test), and because during the time of the test eighteen units could have been made, the days production capacity has been reduced by 2 + 18 = 20 units by the time we reach the major decision. So, if the special setup is not done, then we would produce 1000 20 = 980 units; if the special setup is used then we would produce 970 20 = 950 units during the rest of the day. These changes affect the costs on the cost gates, and the nal net revenues. These nal payoffs are found by pro-rating what the gure would be if 1000 units were produced and sold. Adding these sub-trees with all costs and revenues (but without the probabilities) we obtain the tree shown in Figure 35. Putting the two events from the decision tree in reverse order, we create the prior tree, putting the outcomes of the defect rate event rst, and then the outcomes of the testing event (the number of defectives found) second. In doing this, we can easily write the marginal probabilities of the defect rate event. However, the conditional probabilities for the second event need to be calculated. Before doing these calculations the prior tree is:
ne no one r two 9 .D rr 0 D rr D e t r raD t rr c D e fD e d %D 1 D D
2 l 0% l d lefe l ct l ra t le ne l 0.1 o n l l one r two r rr r rr r
3159 (from Part A)

3 33 v
Defect Rate Event 146
98%(13, 710) ) $ = 13, 435.80 0 (1 $$$ % $ 1 980 00 ake $ Special = 98 ; m $$ s3 o 2 t 0% 3 i n 3 n u 3 Setup 98%(8200) 3 0 3 3 8 9 3 3 3 3 Decision v = 8036 3 3 3v
ye
7 7 7 9 s; mak 50 u e nits 600 +
g tin s Destructive te Testing no Decision
= 10
95%(13, 710) = 13, 024.50
no
ne
d d 7 Number of d d 7 t e Defective d st 90 d 7 d tw Units d 7 o d u Event d 7 d nit d 7 s d d 7 d d d 7 one d 3 33 v
95 ,100 0(10) $ 13,435.80 $$$ % $ 1 e $ ak $$ o; m nits3 2 0% 3 n 3 0 u 3 3 0 3 3 980 983 3 3 3 v 8036 3 3 3v ye

9 s; mak 50 u e nits 10,1
e e e
Figure 35: Machine Reset Problem Decision Tree without Probabilities
o tw
e e e e e e e e
00
13,024.50
$$
$ 1% e $$$ k $ a $ ; m its3 20% 3 n3 0 no80 u 33 0 8 3 3 9 93 3 3 v 3 33 3v 3 33 v
13,435.80
8036
ye
9 s; mak 50 u e nits 10,1 0
13,024.50
c April 28, 2010 D.M. Tulett Now we wish to compute the six conditional probabilities.
147
We need to determine the parameters n and p for the binomial probability distribution. Two units are being tested, therefore n = 2. The number of defects x can range from 0 to n, i.e. in this situation x can be 0 (neither is defective), 1 (exactly one is defective), or 2 (both are defective). To obtain p, consider rst the top branch where the defect rate is 1%. If any unit is pulled at random from the production line, there is a 1% (or 0.01) chance that it is defective, and therefore a 99% that it is not defective. Hence p = 0.01, i.e. it is simply the defect rate. For example, the probability of nding neither unit defective (x = 0) is (1 .01)2 = 0.9801. On the bottom branch, where the defect rate is 20%, we have the binomial probability distribution with n = 2 and p = 0.2. and x being 0, 1, or 2. All six numbers (two values for p times three values for x) are worked out in the following table.
Defect Rate ( p) 1%
20%
Number of Defects (x) 0 1 2 0 1 2
Formula (n = 2) (1 .01)2 2(.01)(1 .01) (.01)2 (1 .2)2 2(.2)(1 .2) (.2)2
Probability 0.9801 0.0198 0.0001 0.64 0.32 0.04
Putting these six conditional probabilities on the tree we have:
148
no one 0.0198 r two 9 .D rr 0 D 0.0 r D e 001 t rr aD r t rr ecD fD e d %D 1 D D
ne
01 98 . 0
2 l 0% l d lefe l ct l rat 64 . 0 le ne l 0. 1 o n l l one 0.32 r two r rr 0.0 r4 rr r
We then compute the joint probabilities to complete the prior tree, and then nd the posterior tree in the usual manner. These trees are shown in Figure 36.
Prior Tree
ne
0.88209 01 98 . 0
Posterior Tree
0.88209
0.01782 0.064 0.01782
no one 0.0198 r two 9 .D 0 D 0.9 rrr 0.0 eD t r 001 a rr rD t cD r e f eD d %D 1D D
0.00009
0.064
0.032 0.00009
20 % 1 ll d lefe l ct l rat 64 . e 0 l ne l 0.1 o n l l one 0.32 r two 0.1 rrr 0.0 r4 rr r
0.032
0.004
35 32 .9 0 1% 20% 0.0 6765 0.94609 9 0 6 4 .9 0 ne 69 no 57 .3 0 1% one 0.04982 20% 0.6 t d w 4231 1 0.04982 do d 0.0 d 04 d 09 d 00 22 d .0 0 d 1% d 20% 0.9 7800 0.00409
0.004
149
Figure 36: Prior and Posterior Trees for the Machine Reset Problem
3159 (from Part A)

3 33 v
Defect Rate Event 150
98%(13, 710) 5 = 13, 435.80 3 ) 2 3 $ 0 9 0. $ (1 1% $$$ 980 Special = 9800; make $$$ 2 ts3 0% 0 3 i3 no un3 3 Setup 06765 98%(8200) . 0 3 3 8 9 3 3 3 3 Decision v = 8036 3 3 3v
ye
7 7 7 9 s; mak 50 u e nits 600 +
g tin s Destructive te Testing no Decision
09
no
ne
. 94 6
d d 7 Number of d d 7 t e Defective d st 90 d 7 d tw Units d 7 o d u Event d 7 d nit d 7 s d d 7 d d d 7 one 0.04982 d 3 33 v
95 ,100 0(10) 9 13,435.80 76 $ 35 $ 0.$ $ % $ 1$ e $$ mak ts ; o 0% 0 3 i 3 2 n3 0n 0u 33 64231 . 3 3 980 983 3 3 3 v 8036 3 3 3v = 10 ye
95%(13, 710) = 13, 024.50
e e e
Figure 37: Machine Reset Problem Decision Tree with Probabilities
o tw 4 .00
e e e e e e e e
0 09
9 s; mak 50 u e nits 10,1
00
13,024.50
2200 13,435.80
0 $$ 0.$ $ % $ 1 e $ k a $$ o; m nits3 20% 3 n 3 0.978 0 u 3 3 0 3 3 83 980 3 0 0 9 3 3 v 3 3 v 3 3 33 v

ye
8036
9 s; mak 50 u e nits 10,1 0
13,024.50
3159 (from Part A)

3 33 v
98%(13, 710) 5 3 ) 2 93 $$ = 13, 435.80 0.$ (10 $ % $ 1 980 00 ake $ Special = 98 ; m $$ s3 o 2 t 0% 0 3 i n 3 n u 3 Setup 3 06765 98%(8200) . 0 3 3 83 9 3 3 3 Decision v 13,070.52 = 8036 3 3 3v
ye
7 7 7 9 s; mak 50 u e nits 600 +
Defect Rate Event
g tin s Destructive te Testing no Decision d d
3270.52 95%(13, 710) = 13, 024.50
09
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e 3251.87 e e
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Figure 38: Machine Reset Problem Rolled-Back Decision Tree
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152 10.2.3 Recommendation
At the outset of the day, two units should be made and be tested. If neither unit is defective, then continue to produce for the rest of the day, making 980 units for sale. However, if either (or both) of the units is defective, then use the special reset procedure, and then proceed with making 950 units for the rest of the day. The ranking prot is $3161.87.
10.3
Commentary
Though the situation here involved destructive testing, its not hard to change the analysis to handle non-destructive testing. Since only non-defective units would be sent on to a customer, the nal payoffs would increase by $14 when one defective is found (because this means that the other unit was ne), and would increase by $28 if neither unit was found to be defective. The number of units to be tested (should the test be done at all) was set in the problem description to be two. Perhaps a higher ranking payoff could be obtained if only one unit were tested, or if three (or possibly more) units were tested. To answer this question, we would have to begin with a decision about the number of units to be tested, be it 0, 1, 2, 3, and so on. It may seem as though up to 1000 units could be tested in theory (though this wouldnt make any sense when the test is destructive). A practical limit can be established by determining the ranking prot when 0, 1, 2 and so on units are tested. If the prot obtained for testing n + 1 units is higher than that for testing n of them, then keep going on to n + 2. However, if its lower, then a peak has been obtained and theres no point in considering testing one more unit. Sometimes, the testing of multiple units can be done sequentially rather than simultaneously. In that case, we have a situation like that of the previous section.
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10.4
Exercise
Every day a machine can produce 1000 computer chips. The machine has both normal and erratic days. On 4 days out of 5 (normal day), the defect rate is only 2%, but on 1 day in 5 (erratic day) the defect rate is 16%. A good chip is worth $50, but a bad one has a net cost of $300. As an alternative to producing defects as described above, they could use a special reset procedure. This procedure costs $14,000 and takes up 50 units worth of production time; using it guarantees that there will be no defects. (a) What should the company do? (b) What is the expected value of perfect information? Now suppose that they can make three units at the outset of the day and then test all three units simultaneously. The test is destructive. The test would cost $200, and takes up 47 units worth of production time. Assume that if the test is done, and if two or three defective units are found, that they will reset the machine. (c) Should they do the test, and if so what should they do if none or one defective unit is found? Note: You may omit any calculations of posterior probabilities which are not needed for the decision tree.
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11
Linear Optimization 1
In this the rst of four lectures on the subject of linear optimization , we begin with an example to illustrate this topic. We then consider variations which lead to a more general understanding of what linear optimization is.
11.1
Example Cement Problem
A cement company makes two types of cement, which they market under registered tradenames, but for our purposes we will simply call them Type 1 and Type 2. Cement is sold by the Tonne (= 1000 kg), and production is measured in Tonnes per Day, abbreviated as TPD. The company has contractual sales obligations to produce at least 40 TPD of Type 1 cement, and at least 30 TPD of Type 2 cement. The physical capacity of the plant, which is governed by such things as conveyor belt speed, storage size, and so on, is limited to 200 TPD. A new labour agreement has increased the length of breaks, and restricts and makes more costly the use of overtime. The company therefore wishes to nd its best production plan using the new work rules with everyone working a 40 hour week. Work is measured in this company by the labour-hour, which is one person working for one hour. Each type of cement is made in three departments, labeled A, B, and C. To make each Tonne of Type 1 cement requires three labour-hours in Department A, one and a half labour-hours in Department B, and four labour-hours in Department C. The amounts of work per Tonne of Type 2 cement are two, ve, and six labour-hours in Departments A, B, and C respectively. Based on the current authorized strength in each department, and factoring in allowances for breaks, absenteeism, and so on, Department A has 585 labourhours available each day. Departments B and C are allowed to use up to 500 and 900 labour-hours per day respectively. These are the most they can use for the making of cement. If a department has some time leftover (i.e. if the time to make the cement is less than the number of labour-hours available), then the workers will be idle for a few minutes at the end of the day. The three departments require workers with very different training and skills, so the possibility of transferring employees from one department to another is not something that is factored into the planning process. Taking the market price of each type of cement and from this subtracting all the variable costs of making the cement leaves the company with a prot of $8 per Tonne of Type 1 cement, and $10 per Tonne of Type 2 cement. There are also
155
xed costs (taxes, security, and so on) which total $1400 per day. The company wants to know how much should be produced of each type of cement, so that the prot is maximized.
11.2
11.2.1
Making a Model
Verbal, Algebraic, and Spreadsheet Models
Someone has already gone into the cement plant to obtain the relevant facts and from this research a verbal model has been made, which appears as the Problem Description. This model is complete in that the nal sentence states the essence of the problem, and gives the objective. Often, only the data is provided with a general question of the what should the company do? variety. In order to solve the problem, we need to transform the verbal model into an algebraic model . Models with just two variables can be solved graphically, but of course this is of limited practical use. Algebraic models can be solved by a software package designed for this purpose, up to a size limit set by the writers of the software. One such package is LINDO, to be described later. Another option is to transform the algebraic model into a spreadsheet model . It can then be solved by Excel or a similar package, as we shall later see. Indeed, for a very simple problem like the cement problem, one can bypass the algebraic model and go directly to the spreadsheet model. However, this shortcut will not help us for more complex models, so we will not take this route. 11.2.2 Denition of the Variables
In beginning to make an algebraic model, we wish to determine the unknowns which will be represented using variables. The emphasis here is to focus in on the unknowns which are at the heart of the problem, and to skip those things which can easily be determined once the essential unknowns have been determined. In this problem, these unknowns come from the last sentence of the problem description: the TPD of Type 1 cement that should be made; and the TPD of Type 2 cement that should be made. Everything else, such as the total prot, or the idle time (if any) in one of the departments, can be determined if we know these two essential things. With just two unknowns we could label them x and y, but it is more common to use subscripts, calling them x1 and x2 . This way of labelling the unknowns is what is required when we consider realistically sized models, which can have thousands of variables. Hence we have:
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c April 28, 2010 D.M. Tulett x1 = the number of TPD of Type 1 cement made x2 = the number of TPD of Type 2 cement made
It is very important that the denitions of the variables be made as clearly as possible. For example, a shorthand such as x1 = Type 1 is not acceptable. 11.2.3 The Objective Function
We now need to write an expression for the prot in terms of the variables. Looking at the Type 1 cement alone, one Tonne gives a contribution of $8 to the prot. Since we are producing x1 TPD, the daily prot from the production of Type 1 cement is 8x1 . Similarly, the daily prot from the production of Type 2 cement is 10x2 . Putting these together we have 8x1 + 10x2 . The $1400 in daily xed costs needs to be subtracted from this expression, but most traditional software (before spreadsheets) is not set up to handle this. Therefore we omit subtracting it for now, but we can easily subtract it at the very end when everything else has been calculated. We write the word maximize in front of the expression, because that is the objective in this situation. The word maximize is often abbreviated to simply max. What we call the objective function is: maximize f (x1 , x2 ) = 8x1 + 10x2 In this document we call refer to the value of the objective function as OFV (for objective function value). (A more traditional (but less intuitive) symbol is Z .) Again, anticipating that we will use software such as LINDO for these problems, we do not write the f (x1 , x2 ) = (or anything else such as OFV or Z ), because the syntax of the software does not handle this notation. Hence we simplify the objective function to: maximize 8x1 + 10x2 11.2.4 The Constraints
The objective function is subject to a set of constraints which represent, in this example, the minimum sales contract requirements, the limit on total production, and the limit on labour availability in each of the three departments. Also present in this and in almost every linear optimization model are non-negativity restrictions on the variables. Since we cannot produce a negative quantity of cement, we require that x1 be greater than or equal to 0, and that x2 be greater than or equal to 0. When writing the algebraic model, we will indicate this by writing x1 0 and
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x2 0 at the end, or in short form simply x1 , x2 0. (Most software programs assume these restrictions and therefore they do not need to be explicitly entered.) By convention, this short form is only used for the non-negativity restrictions; it is not used for the other constraints. The rst three constraints are quite easy. Their sales contracts for 40 TPD of Type 1 cement and 30 TPD of Type 2 cement means that we must have x1 40 and x2 30. Theoretically, these constraints make the non-negativity restrictions superuous, but we keep them anyway. This is because the model might later change should the sales constraints be removed, then the non-negativity restrictions would become the new lower bounds on the variables. The third constraint that the total production cannot exceed 200 TPD is represented by x1 + x2 200. So far the constraint list is: Type 1 Sales x1 40 Type 2 Sales x2 30 Total Production x1 + x2 200 Now we determine the three labour constraints, one for each department. The data for these constraints is written both from a product perspective and a departmental perspective. From the product perspective we have: To make each Tonne of Type 1 cement requires three labour-hours in Department A, one and a half labour-hours in Department B, and four labour-hours in Department C. The amounts of work per Tonne of Type 2 cement are two, ve, and six labour-hours in Departments A, B, and C respectively. From the departmental perspective we have: Based on the current authorized strength in each department, and factoring in allowances for breaks, absenteeism, and so on, Department A has 585 labour-hours available each day. Departments B and C could use up to 500 and 900 labour-hours per day respectively. It may be helpful to put all this data into a table with two rows, one for each type of cement, and three columns for the labour-hours to make one Tonne of Type 1, the labour-hours to make one Tonne of Type 2, and the number of labour-hours available per day. Note that in this example, the data from the problem description go into the columns. (Be careful about this, in other problems some of the data might go into the rows).
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c April 28, 2010 D.M. Tulett Labour-Hours per Tonne of Type 1 Cement of Type 2 Cement 3 2 1.5 5 4 6 Labour-Hours Available each day 585 500 900
Department A B C
In each department, the labour-hours (LH) used cannot exceed the labour-hours available. Lets look at Department A in particular. LH used LH available LH to make Type 1 + LH to make Type 2 585 3x1 + 2x2 585 Once the pattern has been established, it becomes easy to write the labour constraints for Departments B and C. For Department B we must have 1.5x1 + 5x2 500, and for Department C, we require that 4x1 + 6x2 900. Once you have become used to problems like this, you may wish to write the constraints directly from the problem description without doing the table as an intermediate step. In summary the labour constraints are: Dept. A Labour 3x1 + 2x2 585 Dept. B Labour 1.5x1 + 5x2 500 Dept. C Labour 4x1 + 6x2 900 11.2.5 Summary
The algebraic model needs to be summarized in one place. This summary consists of: the denition of the variables; the objective function; the words subject to followed by the constraints with their word descriptions; and the non-negativity restrictions written in one line at the end. For questions of this type on a test or examination in this course, just writing such a summary will sufce. Doing this we have: x1 = the number of TPD of Type 1 cement made x2 = the number of TPD of Type 2 cement made
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maximize subject to
8x1 + 10x2 40 30 200 585 500 900 0
Type 1 Sales x1 Type 2 Sales Total Production x1 Dept. A Labour 3x1 Dept. B Labour 1.5x1 Dept. C Labour 4x1 non-negativity x1
+ + + + ,
x2 x2 2x2 5x2 6x2
x2
11.3
Graphical Solution
Because the methodology of graphing linear optimization models is studied extensively in Mathematics for Management Science, we shall omit most of the details in solving the Cement Problem. From the Total Production constraint x1 + x2 200, we can see that a 200 by 200 grid is adequate for solving this problem. Recall that the convention is that the x1 variable is on the horizontal axis, and the x2 variable is on the vertical axis. A picture of the grid, with word descriptions on the axes, is shown in Figure 39. Though you will no doubt work with lined paper, here we suppress the printing of the grid lines to make the plotted lines easier to see. We now need to plot the boundaries of the six constraints, and to do this we must nd two points for each boundary line. Also, since all the constraints are inequalities, for each we must determine the direction of the arrow which indicates the inequality. Some of the constraints are easy. The rst one, x1 40, is simply a vertical line through x1 = 40, and the arrow points to the right (because the inequality makes the origin false). The second one, x2 30, is a horizontal line through x2 = 30, with the arrow pointing upwards. The third constraint, which is x1 + x2 200, passes through 200 on both axes. Since the origin is true, the arrow points towards the origin. The other three constraints require some calculations. The Department A Labour constraint is 3x1 + 2x2 585. The boundary line of this constraint is given by the equation 3x1 + 2x2 = 585. Setting x1 = 0, we obtain x2 = 292.5, which is off the grid. When this happens we try to nd an interception point on either the right-hand side or top boundary of the grid. In this situation, we nd the value of x1 where the line crosses the top boundary, at which x2 = 200.
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200 Tonnes per Day of Type 2 Cement
150
100
50
50
100 150 200 Tonnes per Day of Type 1 Cement
Figure 39: Cement Problem Axes
c April 28, 2010 D.M. Tulett Hence we solve 3x1 + 2(200) 3x1 + 400 3x1 x1 = = = = 585 585 185 61.666...
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2 Hence the line passes through the point (61 3 ,200). Now setting x2 = 0, we obtain x1 = 195, which is on the grid. Therefore the boundary of the Department A Labour constraint passes through the points (61 2 3 ,200) and (195,0). For Department B we require that 1.5x1 + 5x2 500. Setting x1 = 0, we obtain x2 = 100, which is ne. Setting x2 = 0 makes x1 = 333.333..., which is off the grid. Therefore we set x1 = 200 (the right-hand side of the grid), and solve to obtain x2 = 40. For Department C we require that 4x1 + 6x2 900. Setting x1 = 0, we obtain x2 = 150, which is ne. Setting x2 = 0 makes x1 = 225, which is off the grid. Therefore we set x1 = 200 and solve to obtain x2 = 16.666.... The origin is true for all three labour constaints, so the arrow for each one points towards the origin. In summary, the points for the boundary lines of the constraints are as follows:
Constraint Type 1 Sales Type 2 Sales Total Production Dept. A Labour Dept. B Labour Dept. C Labour
First Point (40,0) (0,30) (0,200) (61 2 3 ,200) (0,100) (0,150)
Second Point vertical horizontal (200,0) (195,0) (200,40) 2 ) (200,16 3
A picture of this is shown in Figure 40. We must remember not to plot the points for the constraints backwards. For example, (0,100) lies 100 points above the origin, not 100 points to the right. The title of each constraint is written next to its boundary line. With these titles on the constraints, and with word descriptions on the axes, it makes the graph easy to understand. We have not drawn arrows to explicitly indicate the two non-negativity restrictions, but of course these restrictions are present nevertheless. Considering all the constraints and the non-negativity restrictions, we nd the feasible region. This region, which is labelled and highlighted, is shown in Figure 41. We now nd a trial isovalue line, a line in which all points have the same objective function value. This being done, we then the nd the optimal isovalue
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Type 1 Sales 0 0 50 100 150 200 Tonnes per Day of Type 1 Cement
Figure 40: Cement Problem Constraints
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Figure 41: Cement Problem Feasible Region
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line, a line parallel with the trial isovalue line which passes through the optimal solution. This procedure is discussed extensively in Mathematics for Management Science; a quick summary is provided here. In general the objective function is of the form max or min c1 x1 + c2 x2 Except when either c1 = 0 or c2 = 0 (which lead to vertical and horizontal isovalue lines respectively), we pick any value v (except 0) and solve c1 x1 + c2 x2 = v Using this equation we set each variable equal to 0 to obtain the intercepts on the axes. These two points dene the isovalue line, which is indicated by drawing a dashed line between them. For example, suppose we have 8x1 + 10x2 in the objective function and wish to try v = 200, i.e. 8x1 + 10x2 = 200. If x1 = 0, then 10x2 = 200, and hence x2 = 20. If x2 = 0, then 8x1 = 200 and hence x1 = 25. Therefore this particular isovalue line passes through (x1 , x2 ) = (0, 20) and (25,0), and we connect these two points with a dashed line. However, while any non-zero value of v can be used, the special case where v is the product of c1 and c2 leads to an easy shortcut: c1 x1 + c2 x2 = c1 c2 If x1 = 0, then x2 = c1 , and if x2 = 0, then x1 = c2 . In other words, the shortcut is that the coefcient of x1 goes on the vertical axis, and the coefcient of x2 goes on the horizontal axis. Of course, the shortcut may produce points that are too close to the origin to be able to draw the connecting line, in which case we need to multiple each intercept by a number greater than 1. At the other extreme, the shortcut may produce intercepts which are off the page, in which case we need to multiply each intercept by a number between 0 and 1. For the example at hand, we seek to maximize 8x1 + 10x2 . Using the shortcut we obtain a vertical intercept of 8 and a horizontal intercept of 10. However, this does not help us much here, because (0,8) and (10,0) are in the bottom lefthand corner, so its hard to draw the line between them. Hence we multiple each of these intercepts by a number greater than 1. For example, multiplying each intercept by 10 we obtain a vertical intercept of 80 and a horizontal intercept of 100. These points (0,80) and (100,0) are what we would have obtained if we had
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set 8x1 + 10x2 to a trial value of v = 800, and then solved for the intercepts. Of course, there are an innite number of trial isovalue lines, and any one of them will sufce. We now nd a line parallel with the trial isovalue line, which just passes through the boundary5 of the feasible region such that the objective function value is maximized. A convenient means of doing this is to use a rolling ruler, but a triangle moved along a straightedge will work too. This optimal isovalue line is also drawn on the graph (again, as a dashed line), and the optimal solution is identied. From the graph we can see that the binding constraints are the ones for (i) Total Production and (ii) Department C Labour, and that the optimal solution appears to be at about x1 = 150 and x2 = 50. A picture of this is shown in Figure 42. By taking the boundaries of the two binding constraints, we can obtain the solution exactly: Total Production x1 + x2 = 200 Dept. C Labour 4x1 + 6x2 = 900 6x1 + 6x2 = 1200 4x1 + 6x2 = 900 2x1 + 0x2 = x1 = 300 150
By substituting x1 = 150 into x1 + x2 = 200, we obtain x2 = 50. The optimal = 150 and x = 50. The objective function value at mathematical solution is x1 2 the point of optimality is OFV = = = = is: Recommendation
the optimal solution occurs at a corner of the feasible region, but when there is multiple optimality an entire edge of the feasible region will be optimal. In any case, no part of the optimal isovalue line will appear inside the feasible region.
5 Usually
8x1 + 10x2 8(150) + 10(50) 1200 + 500 1700
Going back to the original problem, the solution expressed in managerial terms
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Figure 42: Cement Problem Optimal Solution
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The cement plant should produce 150 Tonnes per day of Type 1 cement, and 50 Tonnes per day of Type 2 cement, for a contribution to prot of $1700 per day. After deducting the $1400 daily xed costs, the net prot is $300 per day.
11.4
11.4.1
Extensions
General Form
To be considered a linear optimization model, we must have a linear objective function and linear constraints. By linear we mean that in each expression: (1) each variable appear on its own (we cannot have something like 7x1 x2 ) ; and (2) every variable is multiplied by a number (which can be positive, zero, or negative) only (we cannot have something like 5 x1 ). Thirdly, no uncertainty is permitted. These three assumptions are common to both linear and integer optimization. If we require that these three assumptions hold, and that some or all of the variables must be integer, then we have a variation called integer optimization. If, however, all the variables may take on fractional values (e.g. 7.2), then we have a linear optimization model. In the literature, you will often see integer optimization and linear optimization referred to as integer programming and linear programming . We can, however, make the model with minimization rather than maximization as the objective, and the constraints can be equalities as well as the more usual and inequalities. The number on the right-hand side can be zero (considered below). The non-negativity restrictions are almost always present, but these can be removed when it is appropriate to do so. The number of variables and the number of constraints is theoretically unlimited, but the software to solve the model will come with limitations. There is no problem in practice solving models with thousands of variables, and indeed solving models with millions of variables is sometimes done. With a few exceptions, requiring that some or all of the variables be integer can drastically cut down the size of problem which can be handled. 11.4.2 A Right-Hand Side Value of 0
It is possible for the number on the right-hand side of a constraint to be 0. Such a constraint can arise, for example, if the amount of Type 1 cement production cannot exceed two-thirds of the total amount produced. This is not necessarily
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two-thirds of 200 TPD, because we do not know that in advance that this constraint will be binding. Hence we have a new unknown which we will denote as x3 . x3 = the total production of cement in TPD
2 x1 3 x3
The variable x1 cannot exceed two-thirds of x3 , which we write as or equivalently x1 2 3 x3 0 We need to add this proportion constraint to the existing model. Also, we need write the relationship between x3 and the other variables, which is: x3 = x1 + x2 As a constraint with all variables on the left, this is: x3 x1 x2 = 0 which can be re-arranged to: x1 + x2 x3 = 0 With this third variable present the total production constraint can be written in terms of it. Doing this and then adding the new third variable and the two new constraints we obtain: x1 = the number of TPD of Type 1 cement made x2 = the number of TPD of Type 2 cement made x3 = the total production of cement in TPD maximize subject to Type 1 Sales x1 Type 2 Sales Total Production Dept. A Labour 3x1 + Dept. B Labour 1.5x1 + Dept. C Labour 4x1 + Proportion x1 Balance non-negativity x1 + x1 , x2 x3 2x2 5x2 6x2 x2
2 3 x3
8x1 + 10x2 40 30 200 585 500 900 0 0 0
x3 = x3
x2
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Modelling in this manner is the best form in that no calculations are required for any of the parameters. The advantages of doing no calculations are twofold: the original data are preserved; and theres less likely to be a mistake. If a problem on a test asks you to formulate a model without doing any calculations, then the approach used here is what is desired. If we wish to use a computer to solve this model, all we need do is make the minor calculation of converting the two-thirds to decimal form, i.e. 0.66667. However, if we wish to solve by using the graphical approach, we must revert to a model with just two variables. In general, a three-variable model cannot be converted to a two-variable model, but we can do it here, because of the equality constraint.
x1 3x1 2x1 + 2x2 x1 2x2 0
x1
2 3 x3 2 3 (x1 + x2 )
In the second line, we used the fact that x3 = x1 + x2 . In the third line, we crossmultiplied by 3, to avoid the repeating decimal.6 If we think of the original two-variable model as part (a), we will call part (b) the model which now includes the proportion constraint. This new two-variable model is:
x1 = the number of TPD of Type 1 cement made x2 = the number of TPD of Type 2 cement made
the fraction had been something like 3 4 , we would have used the decimal equivalent 0.75; there would be no need for cross-multiplication.
6 If
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maximize subject to
8x1 + 10x2 40 30 200 585 500 900 0 0
Type 1 Sales x1 Type 2 Sales Total Production x1 Dept. A Labour 3x1 Dept. B Labour 1.5x1 Dept. C Labour 4x1 Part (b) Proportion x1 non-negativity x1
+ + + +
x2 x2 2x2 5x2 6x2 2x2
x2
If a problem on a test involves both formulation and graphing, and if no specic mention has been made of doing the formulation with no calculations, then you may simply dene two variables and proceed with making the model. Whats new here is that we now must plot a constraint whose right-hand-side value is 0. The boundary of any constraint with a 0 on the right-hand-side will pass through the origin. Since at the boundary x1 = 2x2 , this particular constraint also passes through, for example, the point (200,100). On any constraint which has a negative number of the left-hand side, and especially for one where the right-hand side value is 0, a great deal of care must be taken to make sure that the arrow is drawn in the correct direction. We must pick a point which is not on the line, such as (100,0). Substituting x1 = 100 and x2 = 0 into x1 2x2 0 gives us 100 2(0) = 100, and 100 0 is false, therefore the arrow points away from the point (100,0). Superimposing this constraint on the existing solution produces an altered feasible region; a part of the former feasible region has now become infeasible. In Figure 43, the new feasible region is shown in gold, the now infeasible part of the former feasible region is shown in light blue, and the old and new optimal solutions are shown. The binding constraints now are the Department B Labour constraint and the Proportion constraint, with the optimal solution occuring at x1 125 and x2 60. At the boundaries of these constraints we obtain the exact
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Figure 43: Cement Problem Altered Optimal Solution
172 solution:
Dept. B Labour 1.5x1 + Proportion x1
5x2 = 2x2 =
500 0
3x1 + 10x2 = 1000 5x1 10x2 = 0 8x1 + x1 0x2 = 1000 = 125
By substituting x1 = 125 into x1 2x2 = 0, we obtain x2 = 62.5. The optimal = 125 and x = 62.5. The obmathematical solution for the altered model is x1 2 jective function value at the point of optimality is OFV = = = = is:
8x1 + 10x2 8(125) + 10(62.5) 1000 + 625 1625
Going back to the original problem, the solution expressed in managerial terms
c April 28, 2010 D.M. Tulett Recommendation
173
With the added requirement that the level of Type 1 production cannot exceed twothirds of the total production, the cement plant should produce 125 Tonnes per day of Type 1 cement, and 62.5 Tonnes per day of Type 2 cement, for a contribution to prot of $1625 per day. After deducting xed costs of $1400 per day, the net daily prot will be $225.
11.4.3
Comment
The initial model with its six constraints leads to a solution which creates a (daily contribution to) prot of $1700. Then, after adding a seventh constraint, the prot fell to $1625. Whenever a constraint is added, the prot can at best stay the same, and often it will fall. In general, adding another constraint (or making an existing one more stringent) can at best keep the OFV the same, otherwise it will be impaired. By impaired, we mean that the OFV will decrease if the objective is maximization, and will increase if the objective is minimization. Note that while the prot went down, only one of the variables did. The Type 1 cement production decreased from 150 to 125 TPD, but the Type 2 cement production increased from 50 to 62.5 TPD.
11.5
Exercise
Using just two variables, formulate a linear optimization model for the following problems. Solve each model graphically, clearly indicating the feasible region, and both the trial and optimal isovalue lines. For each model, use algebra to determine the exact solution.
11.5.1
Garment Problem
When solving the following model, use a piece of graph paper with each axis labelled from 0 to 300, and draw all lines within the 300 by 300 grid. A garment factory makes blouses and dresses. Each blouse gives a prot of $2, while each dress gives a prot of $3. They can sell at most 190 dresses. Each garment spends time on three machines as follows:
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c April 28, 2010 D.M. Tulett Minutes per Garment Blouse Dress 3 6 6 2 5 4 Minutes Available 1413 1218 1317
Machine Cutting Sewing Assembly
The number of dresses must be at least 30% of the total number of garments made. 11.5.2 Baseball Bat Problem
A baseball bat company makes two models, the slugger and the whacker. Each slugger requires four minutes of lathework, and one minute of varnishing. Each whacker requires ve minutes of lathework and 45 seconds of varnishing. Each day, the combined production cannot exceed 980 bats. The woodworking shop operates 16 hours/day, with one room containing ve lathes, and one varnishing room. Each of the ve lathes is available for 55 minutes each hour, and the varnishing room is available for 50 minutes each hour. Each slugger contributes $5 to prot, and each whacker contributes $6. The company wishes to determine how many sluggers and whackers should be made each day. 11.5.3 Quarry Problem
Background Note: The density of an object is its mass divided by its volume. Hence mass is density times volume, and volume is mass divided by density. Two types of rock are mined in a quarry. Softrock has an density of 5 Tonnes per cubic metre, and hardrock has a density of 8 Tonnes per cubic metre. Up to 600 Tonnes of softrock can be mined each hour, and independent of this, up to 300 Tonnes of hardrock can be mined each hour. The mined rock is crushed and then travels on a conveyor belt. (To avoid mixing the two types of rock they will crush one type of rock, then switch over to the other type, and then keep switching back and forth). The conveyor belt can handle up to 110 cubic metres of rock per hour. The crusher can handle up to 1000 Tonnes per hour when crushing softrock, or up to 400 Tonnes per hour when crushing hardrock. The company makes $10/Tonne for softrock and $14/Tonne for hardrock. The quarry operator wishes to know how many Tonnes of each type of rock they should produce each hour.
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12
There are two examples presented here. The rst is a minimization example, for which we shall obtain the data from the WWW, and then solve graphically. The second example looks at a situation in which the variables must take on integer values.
12.1
12.1.1
Example Diet Problem

Problem Description
This example is made to illustrate linear optimization. Dont take it as nutritional advice. A real diet shouldnt contain only these two items. A twenty-two year old student lives on a diet of double hamburgers and orange juice. To make a double hamburger (bun, two patties of beef, and condiments) costs about $1.25, and a serving (249 g) of unsweetened orange juice costs about $0.32. She wants to minimize her daily cost of buying these things, but she has decided to make sure that she obtains the recommended daily intake of all vitamins and minerals. To keep the problem simple, she wants the protein, iron, and Vitamin C to meet or exceed the recommended amounts for a woman of her age, and to restrict the amount of iron from hamburgers to be no more than 90% of her total iron intake. 12.1.2 Formulation
The problem as stated doesnt contain enough information. We do not know, for example, how many grams of protein are contained in a double hamburger, or how many grams per day of protein that a 22 year old woman needs. For this information, we must look elsewhere. The web 7 can be used to obtain information about the nutrients contained in food and drinks. We do searches on: (1) hamburger, and then look up a hamburger, regular, with double patty and condiments; and (2) juice, and then look up orange juice, canned, unsweetened, 1 cup (249 g) size, we nd the following:
electronic form of this document is linked to the URLs. If you are viewing this in hard copy, the URLs are http://www.nal.usda.gov/fnic/cgi-bin/nut search.pl and http://www.nal.usda.gov/fnic/etext/000105.html
7 The
176 Nutrient Protein (g) Iron (mg) Vitamin C (mg) Double Hamburger (per 215 g sandwich) 31.820 5.547 1.075
c April 28, 2010 D.M. Tulett Orange Juice (per 249 g serving) 1.469 1.096 85.656
Looking for dietary requirements, we go to the Table of 1989 RDA and 19971998 RDI 8 (a pdf le), and look up Female 19-24 to nd a daily need for 46 g of Protein, 15 mg of Iron, and 60 mg of Vitamin C. Now that we have all the data, we can begin the formulation of the model. Looking at the cost information, we see that we need to know the amounts consumed each day. We must therefore have at least the two following decision variables: x1 = the number of double hamburgers eaten each day x2 = the number of servings of orange juice drunk each day Her objective is to minimize the cost of her diet. Each double hamburger costs $1.25, and each serving of orange juice costs $0.32, hence the objective function is: minimize 1.25x1 + 0.32x2 We begin with the rst three constraints, one for each of three nutrients. The purpose of these three constraints is to ensure that the recommended daily intake (RDI) is met. For any constraint the units must match up on the left-hand and right-hand sides. The amount of protein consumed each day is: total protein = protein from hamburgers + protein from orange juice = 31.820 grams/hamburger x1 hamburgers + 1.469 grams/serving of orange juice x2 servings of orange juice = 31.820x1 grams + 1.469x2 grams Her RDI is for 46 grams of protein. To ensure that she obtains at least this amount we use a constraint: 31.820x1 grams + 1.469x2 grams 46 grams
original source is the Food and Nutrition Board - National Academy of Sciences, 1998 (University of California, Davis).
8 The
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With the sameness of the units on both sides, we can remove the word grams to obtain: 31.820x1 + 1.469x2 46 The iron and Vitamin C constraints are in milligrams rather than grams, but the idea is the same. We obtain units of milligrams on both sides of the inequality, and hence the word milligrams can be dropped from both sides. The constraint for the iron requirement is: 5.547x1 + 1.096x2 15 The constraint for the Vitamin C requirement is: 1.075x1 + 85.656x2 60 Now we must restrict the iron from hamburgers to be no more than 90% of the total iron consumed. We can represent the total amount of iron consumed by a third variable: x3 = the amount of iron consumed each day (in mg) The daily intake of iron from hamburgers (in mg) is 5.547x1 . Hence we must have: 5.547x1 0.9x3 5.547x1 0.9x3 0 The total iron intake x3 is the amount from hamburgers, which is 5.547x1 , plus the amount from orange juice, which is 1.096x2 . Therefore, we must have: x3 = 5.547x1 + 1.096x2 which we can re-arrange as 5.547x1 + 1.096x2 x3 = 0 Finally, we have the non-negativity restrictions. The completed model is: x1 = the number of double hamburgers eaten each day x2 = the number of servings of orange juice drunk each day x3 = the amount of iron consumed each day (in mg)
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minimize subject to
1.25x1 +
0.32x2 46 15 60 0 = 0 0
Protein RDI 31.820x1 Iron RDI 5.547x1 Vitamin C RDI 1.075x1 Iron Proportion 5.547x1 Iron Balance 5.547x1 non-negativity x1
+ 1.469x2 + 1.096x2 + 85.656x2 + , 1.096x2 x2 0.9x3 x3 ,
x3
The model required no calculations. If we wish to solve this problem graphically, then we will have to imbed the nal constraint into the Iron Proportion constraint. After doing some calculations to revise the Iron Proportion constraint, the Iron Balance constraint and the third variable are removed.
5.547x1 0.9x3 5.547x1 0.9(5.547x1 + 1.096x2 ) 5.547x1 4.9923x1 0.9864x2 0.5547x1 0.9864x2
0 0 0 0
Making the last line above the revised Iron Proportion constraint the model becomes: x1 = the number of double hamburgers eaten each day x2 = the number of servings of orange juice drunk each day 1.25x1 + 0.32x2 46 15 60 0 0
minimize subject to
Protein RDI 31.820x1 Iron RDI 5.547x1 Vitamin C RDI 1.075x1 Iron Proportion 0.5547x1 non-negativity x1
+ 1.469x2 + 1.096x2 + 85.656x2 0.9864x2 ,
x2
c April 28, 2010 D.M. Tulett 12.1.3 Graphical Solution
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To establish a reasonable scale for the graph, we can think of the context from which the model came. Suppose that she eats three meals a day, each being a double hamburger and a serving of orange juice. Mathematically, this would imply that x1 = 3, and x2 = 3. By plugging these values into the four constraints, we can see that this solution is feasible. Since we are trying to minimize the cost, the solution must be less than 3 for one of the two variables, and we can hope that it will be less than 3 for both of them. If the grid from (0,0) to (3,3) turns out to be too small, we can always expand it later. We try to nd where the boundary of every constraint intercepts the axes. When this yields a point outside the grid, we use nd the intercept on the righthand side (x1 = 3) or top (x2 = 3) boundary instead. For example, the boundary of the Protein RDI constraint is 31.820x1 + 1.469x2 = 46 Setting x1 = 0 causes x2 to be off the 3 by 3 grid. Hence we set x2 = 3, and solve 31.820x1 + 1.469(3) = 46, obtaining x1 1.307. Setting x2 = 0 causes x1 to be about 1.446, which is on the grid. Hence the two points for this constraint are (1.307,3) and (1.446,0). Doing this for every constraint we obtain: Constraint Protein RDI Iron RDI Vitamin C RDI Iron Proportion First Point (1.307,3) (2.111,3) (0,0.7005) (0,0) Second Point (1.446,0) (2.704,0) (3,0.6628) (3,1.687)
Because the origin is false for each of the rst three constraints, all three arrows point away from the origin. The fourth constraint passes through the origin, so we test a point which is not on the constraint boundary, such as (0,2). This point is true with respect to the inequality, so the arrow points toward this point, i.e. upwards and to the left. These four constraints, along with their arrows and word descriptions, are shown in Figure 44. We now nd and highlight the feasible region. In this example, the feasible region is of innite size, but it is clipped by the boundaries of the grid. Plotting the trial isovalue line is quite easy in this situation. The objective function is to minimize 1.25x1 + 0.32x2 , so we try the shortcut of plotting 1.25 on the vertical axis and 0.32 on the horizontal axis, and connect them with a dashed line. We then move a rolling ruler over to the feasible region, stopping at the corner where the
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3.0 Number of Servings of Orange Juice
Protein RDI
2.5
2.0
1.5
1.0
Iro
t por o r P
ion
Iron R DI
Vitamin C RDI
0.5
0.5
1.0
1.5 2.0 2.5 Number of Double Hamburgers
3.0
Figure 44: Diet Problem Constraints
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boundaries of the Iron RDI constraint and the Iron Proportion constraint intercept. This is shown in Figure 45. We can see that the optimal solution lies at about 2.4 double hamburgers per day, and 1.4 servings of orange juice per day. To nd the exact solution, we nd the interception point of the boundaries of the Iron RDI and Iron Proportion constraints. Iron RDI 5.547x1 + 1.096x2 = Iron Proportion 0.5547x1 0.9864x2 = 5.547x1 + 5.547x1 0x1 + 1.096x2 = 9.864x2 = 10.96x2 = 15 0 15 0 15
x2 1.369 By substituting this value into either of the original constraints, we obtain x1 2.438. The objective function value is about $1.25(2.438) + $0.32(1.369) $3.48. The question now arises as to whether we should recommend values for the variables which are not integer. To answer this question we need to consider the context of the problem. The orange juice is not a problem, because if we want 1.369 servings of 249 g each, all we have to do is make 2 servings of 249/1.369 181.9 g each. The hamburgers are more of a problem, however, since its hard to cook 0.438 of a burger. However, for both the hamburgers and the orange juice, we can interpret the DRI for each nutrient as an average to be obtained over a period of time. For example, suppose that she eats two hamburgers and drinks one serving of orange juice on one day, and then eats three hamburgers and drinks two servings of orange juice on the next, and repeats this cycle. She would average 2.5 double hamburgers and 1.5 servings of orange juice over time. This would certainly meet the requirements of the DRI constraints (2.5 > 2.438, and 1.5 > 1.369), and in the Iron Proportion constraint we have: 0.5547(2.5) 0.9864(1.5) = 0.09285 < 0 Hence (2.5,1.5) is a feasible solution. Its daily cost is $1.25(2.5) + $0.32(1.5) = $3.605 which is about 12.5 cents higher than the theoretical optimal solution. We are now ready to make a recommendation.
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3.0 Number of Servings of Orange Juice
Protein RDI
2.5
Feasible Region
Optim al
2.0
1.5
1.0
n Iro
Optimal Solution n tio r o p Pro
Iron R DI
Vitamin C RDI
Trial
0 0.5 1.0 1.5 2.0 2.5 Number of Double Hamburgers 3.0
Figure 45: Diet Problem Optimal Solution
0.5
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Based on a self-imposed diet of double hamburgers and orange juice, and considering only the four stated nutritional requirements, a near-optimal solution can be implemented by eating two hamburgers and drinking one serving of orange juice on one day, and then eating three hamburgers and drinking two servings of orange juice on the next, and repeating this cycle. This gives a daily cost of $3.605.
12.2
Example 2
In the rst lecture, we presented the following exercise: 12.2.1 Problem Description
Two types of big boxes are about to be loaded onto a small cargo plane. A Type 1 box has a volume of 2.9 cubic metres (m3 ), and a mass of 470 kilograms (kg), while a Type 2 box has a volume of 1.8 m3 and a mass of 530 kg. There are six Type 1 boxes and eight Type 2 boxes waiting to be loaded. There is only one cargo plane, and it has a volume capacity of 15 m3 and a mass capacity of 3600 kg. Obviously, not all the boxes can be put onto the plane, therefore suppose that the objective is to maximize the value of the load. We will consider the following three situations: (i) both type of boxes are worth $400 each; (ii) a Type 1 box is worth $600, and a Type 2 box is worth $250; and (iii) a Type 1 box is worth $300, and a Type 2 box is worth $750. Back then, we used an enumerative method to nd all potential solutions, and then evaluated each of these to nd the optimal ones. Now, we will formulate and solve this problem using integer optimization. 12.2.2 Formulation
We need to determine how many boxes of each type are carried on the plane, so we dene: x1 = the number of Type 1 boxes carried on the plane x2 = the number of Type 2 boxes carried on the plane
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There are three cases of prot data. Each gives rise to a different objective function: (i) maximize 400x1 + 400x2 (ii) maximize 600x1 + 250x2 (iii) maximize 300x1 + 750x2 There is a constraint for the volume capacity of the plane. By now it should be easy to write this constraint: Volume 2.9x1 + 1.8x2 15 Next, there is a constraint for the mass capacity of the plane: Mass 470x1 + 530x2 3600 The plane cannot carry more boxes than are available to be carried, therefore we have two more constraints: Type 1 x1 6 and Type 2 x2 8
In this example, we have not only the non-negativity restrictions, but also the requirement that both variables must be integer. The complete formulation is therefore: x1 = the number of Type 1 boxes carried on the plane x2 = the number of Type 2 boxes carried on the plane One of: (i) maximize 400x1 + 400x2 (ii) maximize 600x1 + 250x2 (iii) maximize 300x1 + 750x2 subject to Volume 2.9x1 + 1.8x2 Mass 470x1 + 530x2 Type 1 x1 Type 2 x2 non-negativity integer x1 x1 , , 15 3600 6 8 0
x2 x2
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We begin as always by making a grid and plotting the boundaries of the constraints. The last two constraints tell us that the optimal solution must be contained within a 6 by 8 grid, so we will make it this size. The boundary of the volume constraint is: 2.9x1 + 1.8x2 = 15 Setting x1 = 0 makes x2 = 8.333..., which is just above the grid. Hence we set x2 = 8, and solve 2.9x1 + 1.8(8) = 15 obtaining x1 0.207. Setting x2 = 0 makes x1 5.172, which is on the grid. We apply the same approach to the mass constraint, to obtain the following table: Constraint Volume Mass Type 1 Type 2 First Point (0.207,8) (0,6.792) (6,0) (0,8) Second Point (5.172,0) (6,1.472) (6,8) (6,8)
All the arrows are easy; the origin is true for every constraint, so every arrow points toward the origin. These four constraints, along with their arrows and word descriptions, are shown in Figure 46. We can now ll-in with colour what would be the feasible region if the model had not contained integer variables. This is shown in Figure 47. Because the variables must be integer, only those points in the coloured area which represent integer values for both variables are feasible.9 Finding all these points, which we represent as dots, is fairly easy except when a point is very near one of the constraint boundaries. In this example, the points (1,6), (2,5) are near the boundary of the mass constraint, and the point (4,2) is near the boundary of the volume constraint. We can test these contentious points by substituting the values into the appropriate constraint. For example, for the point (1,6): 470(1) + 530(6) = 470 + 3180 = 3650 3600
x1 were integer, but x2 not integer, then we would have a set of feasible vertical lines. If x2 were integer, but x1 not integer, then we would have a set of feasible horizontal lines.
9 If
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Type 2
e lum Vo
6 Number of Type 2 Boxes Carried
5 Type 1
as
3 5 4 Number of Type 1 Boxes Carried
Figure 46: Cargo Plane Problem Constraints
187
Type 2
lum Vo
5 Type 1
as
Figure 47: Cargo Plane Problem Non-Integer Region
188
Hence the point (1,6) is infeasible, and is therefore excluded from consideration. On the other hand, for the point (2,5) we obtain: 470(2) + 530(5) = 940 + 2650 = 3590 3600 Therefore, the point (2,5) is feasible. Finally, for the point (4,2) we use the volume constraint: 2.9(4) + 1.8(2) = 11.6 + 3.6 = 15.2 15 We see that the point (4,2) is infeasible, and it is therefore excluded. We are left with 26 feasible points, which are shown in Figure 48. Beginning with the rst of the three objective functions, we seek to maximize 400x1 + 400x2 . The shortcut produces points which are off the graph, but dividing by 100 gives the points 4 on the vertical axis and 4 on the horizontal axis. These are connected to form the rst of three trial lines. We then move the rolling ruler, stopping not at the corner of the volume and mass constraints (because this point is infeasible), but instead at the integer solution (2,5). This is shown in Figure 49. The optimal objective function value is: $400(2) + $400(5) = $2800 If an integer solution had not been required, we would have obtained a solution at the corner of the volume and mass constraints. By using linear algebra we 2.12735, x 4.90593, and OFV $2813.31. Since we would have found x1 2 = 2, x = 5, and OFV = $2800.00. do require integer values we have instead x1 2 By imposing the requirement that the variables be integer, we have impaired the objective function value by $13.31. This will always be true adding a requirement that the variables must be integers will impair (i.e. lower for a maximization model, higher for a minimization model) the objective function value. Using the same diagram we draw the trial and optimal isovalue lines for situations (ii) (in green) and (iii) (in blue). In order to obtain the intercepts on the axes for the trial line used here for situation (iii), the objective function coefcients were divided by 200. All this is shown in Figure 50. We identify the
189
Type 2
e lum Vo
5 Type 1
as s
Figure 48: Cargo Plane Problem Set of Feasible Points
190
Type 2
lu Vo
me
(i) (2,5) Type 1
as
ia Tr i) l(
pt O im al (i)
Figure 49: Cargo Plane Problem Optimal Solution for Part (i)
191
optimal solution for case (ii) as (5,0), i.e. ve boxes of Type 1 only, the OFV is $600(5) + $250(0) = $3000. The optimal solution for case (iii) is (0,6), i.e. six boxes of Type 2 only, the OFV is $300(0) + $750(6) = $4500. In summary we have: Recommendation Situation (i) (ii) (iii) Prot per Box Type 1 Type 2 400 400 600 250 300 750 Optimal Load Type 1 Type 2 2 5 5 0 0 6 Total Prot $2800 $3000 $4500
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Type 2
lu Vo
7 (iii) (0,6)
me
(i) (2,5)
Opt
ima l (ii
i)
Type 1
l( Tria ii)
as
ima Opt
ia Tr i) l(
l (ii
pt O
Tria l
1
im
(iii)
al (i)
(ii) (5,0)
Figure 50: Cargo Plane Problem Optimal Solution for Parts (i), (ii), (iii)
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12.3
12.3.1
Exercises
Ofce Rental
A company needs to rent space for its ofce employees both in the suburbs and downtown. Space is available in suburbia at a rate of $100 per square metre (per annum), while downtown space rents for $210 per square metre (per annum). In suburbia, only 30% of the space is executive quality, while the rest is ordinary quality. At the downtown location, 60% of the space is executive quality, while the rest is ordinary quality. The company needs a total of at least 900 square metres of space, of which at least 420 square metres must be executive quality. No more than three quarters of the entire space is to be at either location. They wish to know how much space they should rent in each place. Formulate and solve by the graphical method. 12.3.2 Diet Problem
Suppose that a kilogram of beef contains 600 grams of protein, and 80 grams of fat, but no Vitamin C. A litre of orange juice contains 6 grams of protein, no fat, and four times the required daily intake of Vitamin C. A person needs 54 grams of protein per day, and the fat should be between 10 and 60 grams per day. No more than 95% of the protein consumed should come from beef. A kilogram of beef costs $6, while a litre of orange juice costs $2. Based on these two foods alone, and only the stated requirements, we seek the minimum cost daily diet. Formulate and solve by the graphical method. 12.3.3 Fruit Buying Problem
Jennifer is making a large fruit salad for a party. She has everything she needs at home, except for pineapples and bananas. She needs 12 pineapples, and 31 bananas. She goes to a nearby fruit stand, where she nds two vendors selling bags of mixed fruit. Vendor 1 is selling bags containing two pineapples and ten bananas for $3 per bag. Vendor 2 is selling bags containing four pineapples and ve bananas for $4 per bag. She wants to know how many bags she should buy from each vendor to meet (or exceed) the requirements for the punch, but at the least cost possible. Formulate and solve by the graphical method to determine the best integer solution.
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13
13.1
Introduction
The two-dimensional world of the previous two lectures is useful for providing an understanding of what linear optimization is about, but it has very limited usefulness for practical problems. Real-world applications may involve thousands or even millions of decision variables. We wont be doing anything that big, but we do want to extend what we can do beyond just two variables. To do this requires an algorithm, which is a structured sequential approach for solving a problem. For example, the roll-back procedure for decision trees that we saw earlier is a type of algorithm. There are several algorithms for linear optimization, but the one most commonly used is called the simplex algorithm. At one time, learning the basics of how the simplex algorithm works was a core topic of the compulsory management science course. When solving problems using the simplex algorithm in which some or all of the variables must be integer, we may fortuitously nd a solution which is integer anyway. Usually, however, an even more complicated algorithm is needed when some or all of the variables must be integer. This algorithm is called the branch-and-bound algorithm. Again, the study of this subject is not part of this course. The simplex and branch-and-bound algorithms have been incorporated into software for linear and integer optimization. There are purpose-built software packages for optimization (such as LINDO, to be seen here), and spreadsheets can solve optimization problems as well. We will look at both types of software. We conclude with an example which illustrates a particular type of problem for which linear optimization is applicable, that of blending gasoline. The size of this problem requires that it be solved using a computer.
13.2
Slack and Surplus
For a constraint, the slack is dened as the right-hand side value minus the value of the left-hand side at the point of optimality. For a constraint, the surplus is dened as the value of the left-hand side at the point of optimality minus the righthand side value. For a model for which the optimal solution has been computed, the slack or surplus can easily be found by hand. For example, the formulation of the cement model is: x1 = the number of TPD of Type 1 cement made x2 = the number of TPD of Type 2 cement made
195
maximize subject to
8x1 + 10x2 40 30 200 585 500 900 0
Type 1 Sales x1 Type 2 Sales Total Production x1 Dept. A Labour 3x1 Dept. B Labour 1.5x1 Dept. C Labour 4x1 non-negativity x1
+ + + + ,
x2 x2 2x2 5x2 6x2
x2
We know that the optimal solution is x1 = 150 and x2 = 50. Lets calculate the surplus on the Type 1 Sales constraint, and the slack on the Department A Labour constraint. The Type 1 Sales constraint is x1 40 (or 1x1 + 0x2 40). The optimal values of x1 and x2 are 150 and 50 respectively, hence the value of the left-hand side of the constraint is 1(150) + 0(50) = 150. Since the number on the right-hand side is only 40, the left-hand side value is 150 40 = 110 more than it needs to be; the surplus on the Type 1 Sales Constraint is 110. The Department A Labour constraint is 3x1 + 2x2 585. At the optimal solution of (150,50) the left-hand side value is: 3(150) + 2(50) = 550 By subtracting 550 from 585, we obtain a slack of 35. In general, if the slack or surplus is 0, then the constraint is binding; if the slack or surplus is greater than 0, then the constraint is non-binding. Knowing the slack or surplus gives information for the easiest kind of sensitivity analysis. For a constraint, the right-hand side value can be decreased by up to the amount of the slack (or be increased indenitely) without affecting the optimal solution. For a constraint, the right-hand side value can be increased by up to the amount of the surplus (or be decreased indenitely) without affecting the optimal solution. For example, suppose that the number of labour-hours in Department A were decreased from 585 to 555, i.e. a decrease of 30. Since the slack is 35, this change is within the range in which the optimal solution is not affected. All that would happen is that the new slack in Department A would be 35 30 = 5. The traditional wording of slack and surplus is maintained by LINDO, but Excel uses the single term slack for both senses.
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13.3
LINDO
LINDO is a registered trademark of LINDO Systems Inc., and is both part of the name of the company, and the name of its rst software program. LINDO was one of the rst programs of its type to address the educational as well as the commercial/industrial market. On their website at lindo.com they make available trial versions of LINDO and other software. To obtain the version that is appropriate for this course, click on Downloads, then in the page with the title Download trial versions of our products click on Download Classic LINDO, then open the zip le. LINDO is also available as a subset of LINGO 11.0 for Windows. (LINDO API is a different kind of software.) This free version is of course the least powerful version of the software, but it is nevertheless more than adequate for anything in this course. It is also possible to buy at an educational price ($25 US as of April 28, 2010) a Solver Suite CD which contains a version of LINDO API, LINGO, and Whats Best!, a spreadsheet optimizer. 13.3.1 LINDO for Linear Optimization
To illustrate the use of LINDO for a linear optimization model (no integer variables), we will use the formulation of the cement problem. We are not required to enter the variable denitions, because they are not needed to solve the problem mathematically. However, we may wish to enter them as comments in order to make the LINDO printout easier to understand. A comment is made by rst typing an exclamation mark. Anything on the same line which follows an exclamation mark is ignored by LINDO. Comments could also be made to give the name of the model, the name of the person who made it, the date of its creation, or anything else that might make the le easier to understand when viewing it at a later point in time. Also, blank lines may be inserted at will to help improve the appearance of the le. We do not enter the non-negativity restrictions, because they are always assumed to be present. Some adjustments have to be made because of the limitations of the keyboard. We cannot enter a subscripted variable, hence x1 and x2 are entered as x1 and x2. Also, since there are no or symbols on the keyboard, we enter <= and >= instead. For the names of the constraints, each is restricted to eight spaces, and must be followed by a right parenthesis this restriction has resulted in making modications to the names given in the algebraic model. There are several shortcuts available (not used here) such as just typing st instead of
197
subject to. Further information is available from the LINDO Help menu. We open the LINDO software and in the initial window we type (put the names of your group as the Analyst when submitting homework problems): ! Cement Plant Model Analyst: D.M. Tulett
! x1 = the number of TPD of Type 1 cement made ! x2 = the number of TPD of Type 2 cement made maximize 8x1 + 10x2 subject to Sales 1) x1 >= 40 Sales 2) x2 >= 30 Tot.Prod) x1 + x2 <= 200 Labour A) 3x1 + 2x2 <= 585 Labour B) 1.5x1 + 5x2 <= 500 Labour C) 4x1 + 6x2 <= 900
This le can be saved using a .ltx extension. We could call it cement.ltx, for example. We then go to the Solve menu, and release the mouse button under Solve (the rst line of the menu). This action causes LINDO to solve the model, and then LINDO asks DO RANGE(SENSITIVITY) ANALYSIS?. For now, click on No. This leaves a box called LINDO Solver Status, which should say Optimal under Status. We close this box, and go to the Window menu, and release the mouse button under Reports Window. Doing this we obtain the following (whether the input be small or capital letters, the output is always in capitals):
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LP OPTIMUM FOUND AT STEP
OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 1700.000 VALUE 150.000000 50.000000 REDUCED COST 0.000000 0.000000
ROW SALES 1) SALES 2) TOT.PROD) LABOUR A) LABOUR B) LABOUR C)
SLACK OR SURPLUS 110.000000 20.000000 0.000000 35.000000 25.000000 0.000000 3
DUAL PRICES 0.000000 0.000000 4.000000 0.000000 0.000000 1.000000
NO. ITERATIONS=
The rst and last lines give us a measure of how much work the computer did to nd the optimal solution this is of technical rather than managerial interest, and we shall not use this information. The 1) which appears after Objective Function Value refers to the fact that LINDO numbers the objective function as row 1, and internally calls the rst constraint row 2, and so on. Had we not named the constraints, LINDO would have numbered them as rows 2) to 7). The columns marked Reduced Cost and Dual Prices will be explained in the next lecture. = 150, x = 50, and OFV = 1700. It Clearly, we see from the output that x1 2 is up to the user of the software to translate this into the words needed to express a recommendation. The other information provided by this output is in the column labelled Slack or Surplus. For a non-binding constraint, the information provided in the Slack or Surplus column lets us answer a question about a proposed change to the right-hand side without having to solve an altered model. Other than the substitution of the word minimize for maximize, there is no
199
special procedure required to handle a minimization model. In models with many variables, it is likely that many of them will have optimal values of 0. To suppress the printing of these variables, go to the Report menu and release the mouse on Solution. A dialog box will appear with a radio button to indicate that only nonzeros should be reported. 13.3.2 LINDO for Integer Optimization
There is one more step that needs to be done when entering the data for a model with integer variables, and theres usually one more step to obtain the solution. To illustrate, we will use the cargo plane example: x1 = the number of Type 1 boxes carried on the plane x2 = the number of Type 2 boxes carried on the plane
One of: (i) maximize 400x1 + 400x2 (ii) maximize 600x1 + 250x2 (iii) maximize 300x1 + 750x2 subject to Volume 2.9x1 + 1.8x2 Mass 470x1 + 530x2 Type 1 x1 Type 2 x2 non-negativity integer x1 x1 , , 15 3600 6 8 0
x2 x2
LINDO has an integer command, but this is used to declare 0 and 1 to be the only possible variables. For an integer variable which can take on values 0, 1, 2, 3, and so on, we use the gin command. After the model has been entered up to the last constraint, we write gin x1 followed by gin x2. There is a shortcut in which we could enter gin 2 to declare the rst two variables found to be integer. This shortcut would work well here, but care must be taken for a model in which some but not all of the variables are required to be integer. Using the rst objective function variation, the model is entered into LINDO as:
200 ! Cargo Plane Model
c April 28, 2010 D.M. Tulett Analyst: D.M. Tulett
! x1 = the number of Type 1 boxes carried on the plane ! x2 = the number of Type 2 boxes carried on the plane maximize 400x1 + 400x2 subject to Volume) 2.9x1 Mass) 470x1 + Type 1) x1 <= Type 2) x2 <= end gin x1 gin x2 + 1.8x2 <= 15 530x2 <= 3600 6 8
Solving using the same procedure as before we obtain:

LP OPTIMUM FOUND AT STEP 2 OBJECTIVE VALUE = 2813.31396 SET X1 TO <= 2 AT 1, BND= 2800. TWIN= 2600. 1 PIVOT 12 12
NEW INTEGER SOLUTION OF 2799.99976 AT BRANCH BOUND ON OPTIMUM: 2800.000 DELETE X1 AT LEVEL 1 ENUMERATION COMPLETE. BRANCHES= 1 PIVOTS= 12 LAST INTEGER SOLUTION IS THE BEST FOUND RE-INSTALLING BEST SOLUTION... OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 2800.000 VALUE 2.000000 5.000000 REDUCED COST -400.000000 -400.000000

ROW VOLUME) MASS) TYPE 1) TYPE 2) SLACK OR SURPLUS 0.200000 10.000000 4.000000 3.000000 DUAL PRICES 0.000000 0.000000 0.000000 0.000000
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NO. ITERATIONS= 12 BRANCHES= 1 DETERM.=
1.000E
This example is very small, so this report is ne as it is. It begins with some technical information about how the solution was obtained, but then describes the solution as it would for a problem without integer variables. However, in a large example the amount of technical material can be enormous, and what is worse the optimal solution might not be at the end, but instead be buried somewhere in the middle. The reason for this is that the software often cannot tell that it has the optimal solution until more potential solutions have been examined. Because of this, it is useful to delete the complete report and ask for the Solution under the Reports menu. Doing this gives: OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 2800.000 VALUE 2.000000 5.000000 REDUCED COST -400.000000 -400.000000
ROW VOLUME) MASS) TYPE 1) TYPE 2)
SLACK OR SURPLUS 0.200000 10.000000 4.000000 3.000000
DUAL PRICES 0.000000 0.000000 0.000000 0.000000
NO. ITERATIONS= 12 BRANCHES= 1 DETERM.=
1.000E
Note that the concept of a binding constraint does not apply when integer variables are present. In this example, no constraint has a slack of 0. Again, it
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= 2, x = 5, is up to the user of LINDO to take this mathematical solution (x1 2 OFV = 2800) and report it as we did before in managerial terms. The objective function can easily be altered to solve parts (ii) and (iii).
13.4
Optimization using Spreadsheets
Spreadsheets (which are really a multi-purpose mathematical tool) can be used for optimization. However, entering the model is much slower on a spreadsheet than it is with a dedicated program such as LINDO. Also, for anything but very small models, the size of the worksheet will be much larger than the size of the monitor, making data entry even more difcult. A spreadsheet may make sense when the data is already in spreadsheet form. We present a brief overview here, but then return to LINDO exclusively. The user begins by entering three types of information. First of all, there are labels. Secondly, there is the numerical information of the problem. Thirdly, there are formulas. Labels are used to help make the model understood to the user and other persons who may look at the spreadsheet. Any cell containing a label has no effect on the calculations. Some of these labels are obvious, such as Tonnes per Day and Total Production. However, there is also a column which gives the direction of the inequality of the constraints, be it <= to mean , or >= to mean , or = for an equality constraint. These may appear to be commands, but they are simply labels. To illustrate the second and third types of information, suppose that the objective function or one of the constraints contained an expression such as 5x1 + 4x2 6x3 + 3x4 . This expression can be thought of as the dot product of a vector of numbers (5, 4, 6, 3) and a vector of variables (x1 , x2 , x3 , x4 ). To use a spreadsheet we would input the numbers in one row, and leave space for the variables in another row. On a spreadsheet, the dot product of two rows is made using the SUMPRODUCT function (discussed in Mathematics for Management Science).10 The set of variables is used by the objective function and by every constraint. Hence we have a row for the variables, a row for the coefcients (numbers) of the objective function, and a row for the coefcients of each of the constraints. The value calculated by the SUMPRODUCT function goes to the right of the left-hand side data, the
syntax can be found using the Excel Help menu. This function can also handle more than just a dot product. It should also be noted that the SUM function could do this calculation, but would have to be dened as an array.
10 The
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label indicating the direction of the inequality goes to the right of this, and nally on the extreme right we enter the right-hand side value of the constraint. We calculate the OFV by using the SUMPRODUCT function, and we also use this function to calculate the numerical value of the left-hand side of each constraint. These numerical values must obey the relationship of the constraint. To save work, we can enter the SUMPRODUCT function for the OFV using absolute labels for the range containing the variables, and then copy the formula to where it is used by the constraints. As an example, we use the model which we developed for the cement company. In the spreadsheet which follows, the cells which are reserved for the variables are highlighted in yellow, and the cells for which the copy command should be used are highlighted in blue. The formula for cell A3 is =SUMPRODUCT(B4:C4,B$5:C$5) The formula for cell D8 is =SUMPRODUCT(B8:C8,B$5:C$5)
A 1 2 3 4 5 6 7 8 9 10 11 12 13 OFV =SUMPR... maximize Tonnes per Day Constraints Type 1 Sales Type 2 Sales Total Production Dept. A Labour Dept. B Labour Dept. C Labour B Cement x1 Type 1 8 C Model x2 Type 2 10 D E F
1 0 1 3 1.5 4
0 1 1 2 5 6
=SUMPR... copy D8 copy D8 copy D8 copy D8 copy D8
>= >= <= <= <= <=
RHS 40 30 200 585 500 900
In optimizing a model, we let Excel choose the values of the variables. To do this, we need to use the spreadsheet Solver , which is used in Mathematics for Management Science for nonlinear functions. The overview provided here should be sufcient, but if needed a Solver tutorial is available from Frontline Systems, Inc. at solver.com. If the solver has not already been installed, the installation in Excel 2007 is accessed as follows: Click on the Ofce Button (top left of the screen).
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A pop-up box appears. Click on Excel Options at the bottom of the box. A new box appears. On the left, click on Add-Ins. Under Add-ins, click on Solver add-in, and below click on Go. After a minute or so, the Solver should be ready to be used. After entering the model, the spreadsheets solver is invoked (in Excel 2007 click on Data, then Analysis, then Solver). The user species the following: 1. the cell which is to be optimized (called the target cell), which is the cell which will contain the OFV) 2. the objective (e.g. maximization) 3. a range of cells which the computer may vary, i.e. the range of cells reserved for the values of the variables (called the changing cells), and 4. the constraints. [OpenOfce uses the same terminology as Excel, but other brands of software use different names. The cell to be optimized is called the solution cell in Quattro Pro, the optimal cell in Lotus 1-2-3, and the optimum cell in the What-If Solver add-in for Lotus 1-2-3. The cells which the computer may vary are called the variable cells in Quattro Pro, the adjustable cells in Lotus 1-2-3, and the what-if cells in What-If Solver.] For every constraint we will compare the cell which contains the value of the left hand side with the cell which contains the right hand side value, specifying the relationship (, =, or ) between these two cells. Constraints which are next to one another of the same type (, =, or ) can be entered as a range rather than specifying each one separately. In the Solver window, under Options, the user needs to click on Assume Linear Model and Assume Non-Negative . Doing the former invokes the appropriate solution procedure for this type of problem; doing the latter enters the non-negativity restrictions. For technical reasons, it might be also useful to click on Use Automatic Scaling , though its not required for any of the models in this document.11
model is said to be poorly scaled when the coefcients of one row are very much greater than those of another, for example if one constraint is 2x1 + 5x2 41 while another is 450, 000x1 + 195, 000x2 2, 715, 000. When the computer tries to solve a poorly scaled model,
11 A
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For this example, the target cell is A3, the objective is maximization, and the changing cells are in the range B5:C5. The constraints are entered as D8:D9 F8:F9, and D10:D13 F10:F13. Optimizing the model we obtain (the optimal values of the variables are highlighted): A 1 2 3 4 5 6 7 8 9 10 11 12 13 OFV 1700 maximize 0 Tonnes per Day Constraints Type 1 Sales Type 2 Sales Total Production Dept. A Labour Dept. B Labour Dept. C Labour B Cement x1 Type 1 8 150 C Model x2 Type 2 10 50 D E F
1 0 1 3 1.5 4
0 1 1 2 5 6
150 50 200 550 475 900
>= >= <= <= <= <=
RHS 40 30 200 585 500 900
As one would expect, cell A3 contains the optimal OFV of 1700, and cells B5 and C5 contain 150 and 50 respectively, which are the optimal Tonnes per Day of type 1 and type 2 cement respectively. The user can request an Answer Report which will give the value of the target cell (the OFV), the values of all the variables, and the slack or surplus (described simply as slack), if any, on each constraint. For a model in which some or all of the variables must be integer, the user enters a range under Constraints and declares the range to be int.
13.5
13.5.1
Blending Problem
Problem Description
A small gasoline blending operation called Blendex buys gasoline from four nearby reneries. These are then blended to make three commercial products: low-octane
it may experience numerical problems in nding the optimal solution. Automatic rescaling helps eliminate such problems. See D. Flystra, A. Lasdon, J. Watson, and A. Waren, Design and Use of the Microsoft Excel Solver, Interfaces, 28:5 September-October 1998, pp. 29-55.
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gasoline for cars, high-octane gasoline for cars, and fuel for propeller-driven aircraft. The (minimum) octane requirements are 86 for low-octane, 92 for highoctane, and 105 for fuel for propeller-driven aircraft. Though consumers buy gasoline by the litre, these companies quote prices and quantities by the cubic metre (equivalent to 1000 litres). Every week someone from Blendex contacts the four reneries to see what they have to sell. They are given: the octane rating of the gasoline available; the quantity available in cubic metres; and the price per cubic metre. These quotes are valid for one hour; after that time, the reneries are free to sell to anyone. At about the same time each week, Blendex obtains the wholesale market prices for the three types of gasolines. Based on all this information, Blendex can decide to buy none, some, or all of what each renery has to sell. Each week the Blendex operation can handle up to 500 cubic metres of gasoline in total. There are three storage tanks, each with a capacity of 260 cubic metres, so this becomes the upper limit for the production of any one type of gasoline. The octane rating of a blend of gasolines is approximately the weighted average of the octane ratings of the inputs to the blend. For example, if 20 cubic metres of 80 octane gasoline is mixed with 30 cubic metres of 100 octane gasoline, the octane rating of the 20 + 30 = 50 cubic metres is about: 20(80) + 30(100) = 92 20 + 30 Its Saturday afternoon and the Blendex planning ofce must decide what it wants to receive by truck on Monday morning. They have just received the following information: Renery A-One Petroleum Better Grade Fuels Clearly Superior Deluxe Gasoline Octane 81 87 98 115 Quantity (m3 ) 280 400 200 130 Price per m3 $350 $400 $450 $600
The current market prices per cubic metre are $570 for low-octane gasoline, $600 for high-octane gasoline, and $700 for propeller-driven aviation fuel. They have about 45 minutes to come up with a plan, leaving a few minutes for Blendex to conrm what they are buying from the four reneries.
c April 28, 2010 D.M. Tulett 13.5.2 Formulation and Solution
207
We could start naming the variables for this problem as x1 , x2 , x3 , and so on, but instead we will name them so that it will be easy to recall what each variable name means. Clearly Blendex must decide how much gasoline to buy from each of the four sources. Hence we let A, B, C, and D represent the number of cubic metres of gasoline purchased from A-One Petroleum, Better Grade Fuels, Clearly Superior, and Deluxe Gasoline respectively. They must also decide how much to make of each product, so we let L, H, P represent the number of cubic metres of low-octane, high-octane, and propeller-driven aviation fuel made respectively. To determine the octane ratings of the nal products, we need to know how much gasoline comes from each source. For example, we need to know how much gasoline from A-One Petroleum is used to make low-octane gasoline. Since A is associated with A-One Petroleum, and L with low-grade gasoline, we can denote this unknown with two letters, AL. Keeping this pattern going we have 4(3) = 12 variables with double-letter names, the rst letter indication the input gasoline, and the second indicating the output gasoline. We can summarize this by saying that AL, AH, AP, BL, BH, BP, CL, CH, CP, DL, DH, and DP represent the number of cubic metres of gasoline from source {A, B, C, or D} used to make output {L, H, or P}. In a problem like this, where there are both revenues and costs, we subtract the costs from the revenues to make a prot maximization model. The objective function is: maximize 570L + 600H + 700P 350A 400B 450C 600D If we assume that no gasoline is wasted, the total of the amounts of gasoline from the four reneries used to make low-octane gasoline becomes the amount of low-octane gasoline made. Hence AL + BL + CL + DL = L Subtracting L from both sides gives: AL + BL + CL + DL L = 0 Similar constraints are needed for high-octane and aviation fuel. A volume balance on the gasoline from each renery is also needed. For example, for the gasoline from the rst renery we must have:
208
c April 28, 2010 D.M. Tulett AL + AH + AP A = 0
Similar constraints are required for the other three input gasolines. We require four constraints for the amount available of each input (A 280, and so on), and there are three constraints for the outputs individually (L 260),12 and so on, and one more constraint for the total production (L + H + P 500). Finally, we need a constraint for each product to ensure that the minimum octane rating is met. For example, the octane rating of the low-octane gasoline must be at least 86. Hence we must have 81AL + 87BL + 98CL + 115DL 86 AL + BL + CL + DL The denominator is simply L, hence we have 81AL + 87BL + 98CL + 115DL 86 L The constraint as it stands is not linear, but we can make it so by multiplying both sides by L (doing this also avoids a potential division by 0 problem). This gives: 81AL + 87BL + 98CL + 115DL 86L Finally, to put the constraint into the standard form in which all variables are on the left-hand side, we subtract 86L from both sides to obtain: 81AL + 87BL + 98CL + 115DL 86L 0 Similar constraints are made for high-octane gasoline and aviation fuel. To solve this model using LINDO we need the complete algebraic model. However with what we have done so far we can develop the algebraic model directly on LINDO. Doing this we obtain:
! Blending Model
Analyst: D.M. Tulett
! A, B, C, and D represent the number of cubic metres ! of gasoline purchased from A-One Petroleum, Better
mentioned in Linear Optimization 1, the shortcut that we used for the non-negativity restrictions is not used for the constraints; we write these three constraints using three lines.
12 As
209
! Grade Fuels, Clearly Superior, and Deluxe Gasoline ! respectively. L, H, P represent the number of cubic ! metres of low-octane, high-octane, and propeller-driven ! aviation fuel made respectively. AL, AH, AP, BL, BH, ! BP, CL, CH, CP, DL, DH, and DP represent the number ! of cubic metres of gasoline from source {A, B, C, or ! D} used to make output {L, H, or P}.
maximize 570L + 600H + 700P - 350A - 400B - 450C - 600D subject to ! Balance on the Products Bal. L) AL + BL + CL + DL - L = 0 Bal. H) AH + BH + CH + DH - H = 0 Bal. P) AP + BP + CP + DP - P = 0 ! Balance on the Inputs Bal. A) AL + AH + AP - A = 0 Bal. B) BL + BH + BP - B = 0 Bal. C) CL + CH + CP - C = 0 Bal. D) DL + DH + DP - D = 0
210 ! Input Availability Input Input Input Input A) B) C) D) A B C D <= <= <= <= 280 400 200 130
! Production Limitations Output L) L <= 260 Output H) H <= 260 Output P) P <= 260 Total) L + H + P <= 500
! Octane Rating Constraints Octane L) 81AL + 87BL + 98CL + 115DL - 86L >= 0 Octane H) 81AH + 87BH + 98CH + 115DH - 92H >= 0 Octane P) 81AP + 87BP + 98CP + 115DP - 105P >= 0
Solving we obtain (only the non-zero variables and the binding constraints are listed):
OBJECTIVE FUNCTION VALUE 1) VARIABLE L P A C 94288.23 VALUE 260.000000 240.000000 192.352936 200.000000 REDUCED COST 0.000000 0.000000 0.000000 0.000000
c April 28, 2010 D.M. Tulett D AL CL AP CP DP 107.647057 183.529419 76.470589 8.823529 123.529411 107.647057 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000
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ROW BAL. L) BAL. H) BAL. P) BAL. A) BAL. B) BAL. C) BAL. D) INPUT C) OUTPUT L) TOTAL) OCTANE L) OCTANE H) OCTANE P)
SLACK OR SURPLUS 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 9
DUAL PRICES 245.588242 245.588242 245.588242 350.000000 400.000000 475.000000 600.000000 25.000000 9.705882 173.529419 -7.352941 -7.352941 -7.352941
NO. ITERATIONS=
Blendexs immediate concern is to notify the suppliers of what they want to buy. They send emails to A-One Petroleum, Clearly Superior, and Deluxe Gasoline conrming the amounts as 192.353, 200.000, and 107.647 cubic metres respectively. Better Grade Fuels is sent an email thanking them for their bid, but stating that none will be purchased this week. For their own production crew which must blend the gasolines, more information is required. The recommendation could be stated as follows: Recommendation Produce low-grade gasoline and aviation fuel by blending fuel from A-One Petroleum, Clearly Superior, and Deluxe Gasoline as follows (all gures are in cubic metres):
212 Source A-One Petroleum Clearly Superior Deluxe Gasoline Total Low-Grade 183.529 76.471 260.000
c April 28, 2010 D.M. Tulett Aviation Fuel 8.824 123.529 107.647 240.000 Total 192.353 200.000 107.647 500.000
The contribution to prot based on this plan is $94,288.23.
13.6
13.6.1
Exercise
Problem Description
A woodworking company buys lumber from which they make tables and chairs. They then outsource the painting of the tables and chairs, and sell the nished products. They buy the lumber at a cost of $2 per board-metre. Each table requires 30 board-metres of lumber, while each chair requires 4 board-metres. Each product spends time in three operations: cutting; polishing; and assembly. The times in minutes per unit are: Cutting Table 45 Chair 18 Polishing 12 7 Assembly 15 9
Each day, the shop is available for six hours of productive time. There are three cutting machines, one polisher, and one person to do the assembly. The painting rm charges $54 per hour. When painting tables, they can paint 6 tables per hour; when painting chairs, they can paint 20 chairs per hour. The woodworking company sells its products to a wholesaler at $90 per table and $28 per chair. The market requires that at least four chairs be made for every table made. They wish to use a linear optimization model to help determine what they should do. 13.6.2 Decision Variables
We dene (all on a daily basis): T = the number of tables made C = the number of chairs made L = the amount of lumber purchased (board-metres) P = the number of hours of painting purchased
c April 28, 2010 D.M. Tulett 13.6.3 Discussion
213
We are modelling this problem using the four variables as dened above. Alternatively, a problem like this could be modelled with just the two product variables, which would allow for a graphical solution. However, since we can use a computer to solve the model, this advantage is not all that important. We are better off modelling this problem with four variables, because this preserves the original data of the problem, so if later a price changes (e.g. if the painting cost goes from $54 to $56 per hour) we can more easily determine the effect of this change. Also, by using four variables we avoid a potential calculation error which could occur when calculating the objective function coefcients of the two-variable version. 13.6.4 What Needs to be Done
Finish this problem by completing the algebraic model, and then obtain the optimal solution by solving it using either LINDO or a spreadsheet. As always, report the solution so that a manager can understand it. The variable names given above are to be used for the algebraic model. If you decide to use a spreadsheet, words instead of symbols (e.g. Tables Made instead of T) may be used.
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14
14.1
Introduction
In the previous lecture we saw the terms reduced cost and dual price on the LINDO output, which now need to be explained. Also, there is more output available, which is obtained by answering Yes when prompted with the question DO RANGE (SENSITIVITY) ANALYSIS?. Earlier in this course we did sensitivity analysis by hand for solutions obtained using a payoff matrix. Sensitivity analysis by hand in the context of linear optimization can be done using either graphical solutions or the nal iteration of the simplex algorithm. Here in this course, however, we shall simply use the LINDO output to give us the data we need to answer some managerial what-if questions. Everything that we are doing here assumes that none of the variables is required to be integer . Except for problems which are naturally integer (i.e. the variables turn out to be integer without forcing them to be integer), sensitivity analysis in the presence of integer variables is essentially meaningless. In what follows, we are looking at predicting the effect of a single change to the model at one time. Analyzing the effect of two or more concurrent changes is beyond the scope of this course; however, we can nd this effect on the computer by re-running the model with these multiple changes. Also, we would need to re-run the model if a proposed single change falls outside of the allowable range (dened below) and if we desire the exact change to the OFV. The explanation which follows is based on the usual situation in which there is a unique nondegenerate optimal solution.13 We could, of course, run an altered model every time a proposed change was made. For a small model, this could be done in seconds on a computer. However, for large models, the analysis provided here gives a fast way to evaluate one-at-atime changes just by looking at the sensitivity output from the initial run.
computer output is still valid for non-usual cases in the sense that within the allowable range the predicted change is correct. However, the reported allowable range might understate the true range.
13 The
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14.2
14.2.1
New Concepts
Solution and Non-Solution Variables
When we run anything other than a very small model we are likely to nd that some (and indeed many) of the variables have an optimal value of 0. Just as we consider separately the binding and non-binding constraints, so it is useful to consider separately the variables which have optimal values greater than 0 from those variables whose optimal value is 0. The former we call solution variables (or variables in the solution). The latter we call non-solution variables (or variables not in the solution). 14.2.2 Reduced Cost
The term reduced cost was originally developed for minimization models. The idea is that a variable has a value of 0 because the cost is too high. To make the value greater than 0, i.e. to make the variable part of the solution, the objective function coefcient of that variable needs to be reduced. This reduction in cost must be at least the amount given by the reduced cost. For example, if a variable has an objective function coefcient of 5 and a reduced cost of 2, then the coefcient would have to fall below 3 in order for the variable to become part of the solution. In a minimization model, both the Solver in Excel and LINDO will nd the same value for the reduced cost associated with each variable. However, in a maximization model, the Solver in Excel and LINDO treat the reduced cost concept differently. The reported numbers are the same in magnitude, but are opposite in sign. For example, suppose that a variable with an objective function coefcient of 7 has an optimal value of 0. If increasing the coefcient to 10 would cause the variable to start increasing from 0, then the magnitude of the required change in the coefcient is 3. Excel would report the reduced cost to be 3, but LINDO would report it as 3. 14.2.3 Dual Price and Shadow Price
In Mathematics for Management Science, when we studied how to optimize a non-linear function subject to an equality constraint, we saw the concept of a Lagrangian multiplier. This gives us the rate of change of the OFV with respect to a small change to the right-hand side of the equality constraint. Dual and/or shadow prices provide something similar in the context of linear optimization
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(though the sign may be reversed). Dual prices are used by LINDO; spreadsheets use shadow prices. A dual or shadow price can only be non-zero for a binding constraint; a nonbinding constraint always has a dual or shadow price of 0. Within an allowable range, the dual price gives the improvement in the OFV per unit change in the right-hand side value of the constraint. Improvement means increase for a maximization model, and decrease for a minimization model. The related term shadow price gives the change in the OFV per unit change in the right-hand side value of the constraint (within the allowable range). The terms dual price and shadow price mean the same thing for a maximization model; for a minimization model they are opposite in sign. 14.2.4 Allowable Range
The computer will nd an allowable range for both objective function coefcients and right-hand side values. The word allowable has nothing to do with granting permission. What it gives instead is a range in which changes to the model occur in a predictable manner. This allowable range could be given as absolute upper and lower limits, but LINDOs approach is to report both an allowable increase and an allowable decrease compared with the current value. Sometimes, the allowable increase or decrease may be innite. Changes to the Objective Function Coefcients For a non-solution variable in a maximization model, the allowable increase equals (theoretically) the reduced cost, and the allowable decrease is innite. For a non-solution variable in a minimization model, the allowable increase is innite, and the allowable decrease equals the reduced cost. For changes to the coefcient within the allowable range, there is no change to the values of any of the variables, and there is no change to the OFV. For a variable which is in the solution, there will be an allowable range for changes to its objective function coefcient in which the values of the variables do not change. However, the change in the objective function coefcient will change the OFV. Within the allowable range, the change in the OFV will equal the change to the coefcient multiplied by the current value of the variable. Theres nothing profound about this if instead of selling 150 books at $20 per copy you sell 150 books at $23 per copy, then youll make an extra $3(150) = $450. Of course, most sellers cannot by themselves raise the price of anything. However, we are looking at what happens to the OFV if in the market as a whole the price rises or falls.
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Changes to the Right-Hand Side Values First, we consider the easier case of a non-binding constraint. Within the allowable range, the values of the variables will remain the same, and the OFV will remain the same. As was mentioned in the previous lecture, the right-hand side value of a non-binding constraint can be decreased by up to the amount of the slack, or be increased indenitely. The right-hand side value of a non-binding constraint can be increased by up to the amount of the surplus, or be decreased indenitely. For a binding constraint, a change to the right-hand side value will change the values of the variables, and therefore also the OFV. However, within the allowable range, the effect on the OFV is a predictable one. Suppose that the change (increase or decrease) to the right-hand side value is an amount called rhs, where rhs is in the allowable range. Since the allowable decrease is reported as a positive number, we must have: allowable decrease rhs allowable increase On LINDO, the output reports the dual price. We denote the change in the OFV as OFV. For a maximization model: OFV = (dual price) ( rhs) For a minimization model: OFV = (dual price) ( rhs) For a computer output which reports the shadow price rather than the dual price, we have for both maximization and minimization: OFV = (shadow price) ( rhs) This analysis alone will not help us predict what will happen to the variables; all it does is predict the change to the OFV. If we want the new value of the OFV it is simply: new OFV = old OFV + ( OFV) Though we cannot predict the new OFV if rhs falls outside the allowable range, we can establish bounds on this number, provided that the model remains feasible. (If a constraint is made more stringent it could eliminate the feasible
218
region, thereby making the model infeasible.) For a maximization model, if rhs > allowable increase, then: OFV (dual price)(allowable increase) If the rhs < allowable decrease, then: OFV (dual price)( allowable decrease) For a minimization model, if rhs > allowable increase, then: OFV (dual price)(allowable increase) If the rhs < allowable decrease, then: OFV (dual price)( allowable decrease) These concepts are now illustrated using three examples. The rst two are quite simple, while the third is the more complex blending model which we saw in the previous section.
14.3
Example 1: Maximization
A chemical laboratory can make three types of chemical powders. The variables x1 , x2 , and x3 represent the number of kilograms per day of the three chemicals. The chemical company has made the following prot-maximization model: maximize subject to conveyor) shipping) min.prod) mixing) 3x1 5x1 2x1 8x1 + + + + 5x2 6x2 4x2 9x2 + + + + 7x3 3x3 8x3 4x3 <= <= >= <= 550 800 360 880 32x1 + 25x2 + 18x3
Running this model on LINDO, and asking for the sensitivity analysis, we obtain:
219
OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 X3 3600.000 VALUE 90.000000 0.000000 40.000000 REDUCED COST 0.000000 11.590909 0.000000
ROW CONVEYOR) SHIPPING) MIN.PROD) MIXING)
SLACK OR SURPLUS 0.000000 230.000000 140.000000 0.000000 2
DUAL PRICES 0.363636 0.000000 0.000000 3.863636
NO. ITERATIONS=
RANGES IN WHICH THE BASIS IS UNCHANGED: OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 4.000000 11.860464 11.590908 INFINITY 56.666664 2.000000 RIGHTHAND SIDE RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 990.000000 110.000000 INFINITY 230.000000 140.000000 INFINITY 389.230774 565.714294
VARIABLE X1 X2 X3
CURRENT COEF 32.000000 25.000000 18.000000
ROW CONVEYOR SHIPPING MIN.PROD MIXING
CURRENT RHS 550.000000 800.000000 360.000000 880.000000
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We see that the solution is to produce 90 kg (all units are per day) of chemical 1, none of chemical 2, and 40 kg of chemical 3. The solution variables are therefore x1 and x3 . The prot obtained using this production plan is $3600. The slack on the conveyor and mixing constraints is zero, hence these are the binding constraints. 14.3.1 Changes to the Objective Function Coefcients
We consider what happens to the OFV in each of the following situations: 1. The price of powder 1: (a) decreases by $10; (b) increases by $5. 2. The price of powder 2: (a) decreases by $18; (b) increases by $9; (c) increases by $15. 3. The price of powder 3: (a) increases by $30; (b) decreases by $7. The amount of powder 1 made and sold is represented by variable x1 , which is a solution variable. The price per kg is the coefcient of this variable, which is currently $32 (dont confuse this with the value of the variable itself, which is 90 kg). From the OBJ COEFFICIENT RANGES section of the sensitivity report, we see that the allowable increase is 4, and the allowable decrease is 11.860464. In other words, we would obtain the same solution even if the coefcient were to rise from 32 to 32 + 4 = 36, or if it were to fall to 32 11.860464 = 20.139536. Hence a decrease of $10 (which is 11.860464) would have no effect on the solution; they would still make 90 kg per day of powder 1, and 40 kg per day of powder 3. However, the OFV would decrease by $10(90) = $900, i.e. it would fall from $3600 to $2700. We could also state this as OFV = $900. A rise of $5 (> 4) is beyond the allowable increase, so we would obtain a new solution, and we therefore cannot predict the new value of the OFV exactly. We would have to re-run the model on the computer replacing the 32 with 37, if we wanted to know the new value exactly. However, we can state that the new OFV will be at least what it would be based on the allowable increase. An increase of 4 would cause the prot to increase by $4(90) = $360, hence an increase of 5 would cause an increase of at least this much, i.e. OFV $360. Variable x2 is not in the solution; the current price of $25 per kg isnt high enough to justify making any quantity of powder 2. Ordinary logic therefore tells
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us that a price decrease is not going to change anything; a decrease in the price of $18 per kg does not change either the solution or the OFV. Note that the allowable decrease is innite. For a price increase, we cannot determine what will happen by logic we need to look at the allowable increase from the sensitivity report. This gure is seen to be 11.590908. Hence an increase of $9 per kg is less than the allowable increase, and there would be no change to the solution. Furthermore, there would be no change to the OFV, because we are not making any powder 2. If however the price were to rise by $15 per kg, this would surpass the allowable increase. The solution would change, and the OFV would increase, but neither of these things could be quantied without re-running the model. The amount of powder 3 made and sold is represented by variable x3 . The current coefcient of this solution variable is $18. We see from the printout that the allowable increase is 56 2 3 , and the allowable decrease is 2. In other words, we would obtain the same solution even if the coefcient were to fall from 18 to 2 = 74 2 18 2 = 16, or if it were to rise to 18 + 56 3 3 . Hence an increase of $30 2 (which is 56 3 ) would have no effect on the solution; they would still make 90 kg per day of powder 1, and 40 kg per day of powder 3. However, the OFV would increase by $30(40) = $1200. A decrease of $7 (> 2) is beyond the allowable decrease, so we would obtain a new solution. The new OFV will be at most what it would be based on the allowable decrease. A decrease of 2 in the rhs would cause the prot to decrease by $2(40) = $80, hence a decrease of 7 would cause a decrease of at least this much. We must be careful with the inequality here; the magnitude is at least $80. Hence if the change is say $80 or more downwards, then OFV $80. 14.3.2 Changes to the Right-Hand-Side Values
We consider what happens to the OFV in each of the following situations: 1. The right-hand side value (rhs) of the conveyor constraint: (a) decreases by 100; (b) decreases by 800; (c) increases by 550; (d) increases by 1200. 2. The rhs of the shipping constraint: (a) decreases by 100; (b) increases by 200; (c) decreases by 300. 3. The rhs of the minimum production constraint: (a) increases by 150; (b) increases by 110. 4. The rhs of the mixing constraint: (a) decreases by 330; (b) decreases by 600; (c) increases by 275.
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Since the conveyor constraint is binding, any change to the rhs will affect the solution. While the new solution is not easily found without re-running the model, the change to the OFV is easy to predict within the allowable range. We see from the sensitivity report that this constraint has an allowable increase of 990 and an allowable decrease of 110. Hence a decrease of 100 is within the allowable range. To see the effect on the OFV, we need the dual price for this constraint, which is 0.363636. [On Excel for a maximization model we would look at the shadow price.] The OFV will therefore change by: OFV = (dual price) ( rhs) = 0.363636(100) = 36.36 (Note: we can say that the change is 36.36, or the decrease is 36.36.) If we want the new OFV this is 3600 36.3636 = 3563.64. A decrease of 800 would be beyond the allowable decrease of 110. The decrease in the OFV would therefore be at least 0.363636(110) = $40, or we could write OFV $40. An increase of 550 would be allowable, and would cause the OFV to increase by 0.363636(550) = $200. An increase of 1200 would exceed the allowable increase of 990, so the OFV would increase by at least 0.363636(990) = $360. The shipping and minimum production constraints are non-binding, so the sensitivity analysis is very easy. If the proposed change is within the allowable range, then there is no change to the OFV. If the proposed change is beyond this range, then the OFV will be impaired, i.e. it would decline for a maximization model. The rhs of the shipping constraint can be increased indenitely or be decreased by up to 230. Hence a decrease of 100 or an increase of 200 would not affect the OFV. A decrease of 300 would cause the OFV to decrease, though we cannot predict by how much. The minimum production constraint has an allowable increase of 140, and it can be decreased indenitely. An increase of 150 would cause the OFV to fall; an increase of 110 would leave it unchanged. Finally, the mixing constraint is binding. It has an allowable increase of 389.230774, an allowable decrease of 565.714294, and a dual price of 3.863636. Hence a decrease of 330 is within the allowable range and the OFV will fall by 3.863636(330) = 1275.00. A decrease of 600 would be beyond the allowable range; the OFV would fall by at least 3.863636(565.714294) = 2185.71. An increase of 275 would be within the allowable range, and the OFV would increase by 3.863636(275) = 1062.50.
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14.4
Example 2: Minimization
A company buys food products from some or all of ve suppliers. These are mixed together. The mixture must meet minimum requirements for three nutrients, have no more than a specic amount of fat, and then be packed into 14.4 kg bags. The variables have been dened as the amount of input of each of the ve suppliers that goes into one bag of mixed product, and are denoted as x1 to x5 . In this example the objective function coefcients are costs rather than revenues. The company has made the following cost minimization model: minimize subject to 3.7x1 + 8.3x2 + 5.1x3 + 2.9x4 + 3.1x5
N 1) 3x1 N 2) 8x1 N 3) 4x1 Fat) 5x1 Mass) x1
+ + + + +
4x2 + 6x3 6x2 + 2x3 5x2 + 8x3 3x2 + 5x3 x2 + x3 +
+ 5x4 + + 3x4 + + 7x4 + + 6x4 + x4 + x5
2x5 >= 5x5 >= 3x5 >= 4x5 <= = 14.4
40.5 81.0 54.9 64.8
Solving the model on LINDO we obtain:
OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 X3 X4 X5 49.94000 VALUE 4.700000 0.000000 1.300000 0.600000 7.800000 REDUCED COST 0.000000 1.288889 0.000000 0.000000 0.000000
ROW
SLACK OR SURPLUS
DUAL PRICES
224 N 1) N 2) N 3) FAT) MASS) NO. ITERATIONS= 0.000000 0.000000 1.900000 0.000000 0.000000 7
c April 28, 2010 D.M. Tulett -1.088889 -0.311111 0.000000 1.422222 -5.055555
RANGES IN WHICH THE BASIS IS UNCHANGED: OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 1.657143 1.120000 INFINITY 1.288889 0.828572 2.327273 1.706667 0.773334 1.866667 8.533333 RIGHTHAND SIDE RANGES ALLOWABLE INCREASE 1.800000 3.600000 1.900000 2.127273 0.327273
VARIABLE X1 X2 X3 X4 X5
CURRENT COEF 3.700000 8.300000 5.100000 2.900000 3.100000
ROW N 1 N 2 N 3 FAT MASS
CURRENT RHS 40.500000 81.000000 54.900002 64.800003 14.400000
ALLOWABLE DECREASE 1.710000 16.919998 INFINITY 0.720000 1.017391
The optimal solution is for each bag of product to be composed of 4.7 kg from supplier 1, none from supplier 2, 1.3 kg from supplier 3, 0.6 kg from supplier 4, and 7.8 kg from supplier 5. The cost of the optimal mixture is $49.94. All constraints except the one for Nutrient 3 are binding.
c April 28, 2010 D.M. Tulett 14.4.1 Changes to the Objective Function Coefcients
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We consider what happens to the OFV in each of the following situations: 1. The cost [per kg] from supplier 1: (a) increases by $1.50; (b) decreases by $2.50. 2. The cost from supplier 2: (a) decreases by $1.28; (b) increases by $50. 3. The cost from supplier 3: (a) increases by 30 cents; (b) increases by 85 cents; (c) decreases by $2. 4. The cost from supplier 4: (a) decreases by 50 cents; (b) decreases by $1.00; increases by $1.50. 5. The cost from supplier 5: (a) decreases by $5; (b) increases by $5. Doing a sensitivity analysis on the objective function coefcients is no different for minimization than it is for maximization. The company is currently paying $3.70 per kg to purchase 4.7 kg (per bag of nished product) from Supplier 1; there is an allowable increase of 1.657143 and an allowable decrease of 1.12. An increase of $1.50 is within the allowable range, and the OFV would increase by $1.50(4.7) = $7.05. A decrease of $2.50 is outside the allowable range, so the OFV would fall by at least $1.12(4.7) = $5.264. The coefcient of x2 can be increased indenitely or be decreased by 1.288889. Hence a decrease of $1.28 or an increase of $50 are both within the allowable range, and since x2 is not in the solution, there would be no change to the OFV. The range for the coefcient of x3 is an increase of 0.828572 and a decrease of 2.327273 from its current value of 5.1. Since x3 = 1.3, an increase of 30 cents (i.e. 0.30) would increase the OFV by 0.30(1.3) = $0.39. An increase of 85 cents would be beyond the range; the OFV would increase by at least 0.828572(1.3) $1.077. A decrease by $2 would cause the OFV to fall by $2(1.3) = $2.60. The current cost for purchases from Supplier 4 is $2.90 per kg; this has an allowable increase of $1.706667 and an allowable decrease of $0.773334. Hence a decrease of 50 cents is within the range, a decrease of a dollar would be outside the range, and an increase of $1.50 would be within the range. Since x4 = 0.6, a 50 cent decrease would cause the OFV to fall by $0.50(0.6) = $0.30, a one dollar decrease would cause the OFV to fall by at least $0.773334(0.6) $0.464, and $1.50 increase would cause the OFV to rise by $1.50(0.6) = $0.90.
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They pay $3.10 per kg from Supplier 5 and are currently ordering 7.8 kg per bag of nal product. The allowable increase is $1.866667 and the allowable decrease is $8.533333. Hence a decrease of $5 would be within the allowable range but an increase of $5 would be outside the range. A decrease of $5 would cause the OFV to fall by $5.00(7.8) = $39.00. An increase of $5 would cause the OFV to rise by at least $1.866667(7.8) = $14.56. 14.4.2 Changes to the Right-Hand-Side Values
In doing the sensitivity analysis for minimization using the LINDO output, we must be careful when using the dual price, which gives the improvement per unit change to the rhs. As stated earlier, improvement for a minimization model refers to a decline in the OFV (if the improvement is negative, then the OFV rises). If Excel is used, then the shadow price gives the change to the OFV per unit change to the right-hand side. For a minimization model the dual price and the shadow price are opposite in sign. If a question is asking about what happens to the OFV, as opposed to asking about its improvement, it may be helpful to work with the shadow price instead. Going to the LINDO printout we nd the dual prices, and by multiplying by 1 we obtain the shadow price. 14 We consider what happens to the OFV in each of the following situations: 1. The right-hand side value (rhs) of the Nutrient 1 constraint: (a) increases by 1.5; (b) decreases by 1.6; (c) increases by 2.1. 2. The rhs of the Nutrient 2 constraint: (a) increases by 3.0; (b) decreases by 15; (c) decreases by 20. 3. The rhs of the Nutrient 3 constraint: (a) increases by 1.5; (b) increases by 2.5. 4. The rhs of the fat constraint: (a) decreases by 0.5; (b) decreases by 1.8; (c) increases by 0.34. 5. The rhs of the mass constraint: (a) decreases by 0.9 kg; (b) increases by 300 g; (c) increases by 700 g.
that this is not the same thing as nding the absolute value, because the dual price may already be positive, in which case the shadow price is negative.
14 Note
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The rhs of the Nutrient 1 constraint is currently 40.5. This binding constraint has an allowable increase of 1.8 and an allowable decrease of 1.71. The dual price as given by LINDO is 1.088889; the Excel sensitivity report would state that the shadow price is 1.088889. An increase of 1.5 would cause the OFV to improve by 1.088889(1.5) $1.633. A negative improvement for a minimization model is an increase, i.e. the OFV would increase by about $1.633. Alternatively, we can use the shadow price directly: the change to the OFV would be 1.088889(1.5) $1.633. A decrease of 1.6 is allowable, so the improvement to the OFV would be (1.088889)(1.6) $1.742. This improvement being positive for a minimization model means that the OFV would decline by this amount, i.e. OFV = $1.742. Notice that decreasing the rhs of this constraint makes the restriction less stringent, and the cost decreases as a result. A decrease of 2.1 is beyond the allowable range; the OFV would improve by at least (1.08889)(1.71) = $1.862, or OFV 1.862. For the Nutrient 2 constraint, the allowable range is 16.919998 rhs 3.6, and the dual price is $0.311111. Hence an increase of 3 would be allowable, as would a decrease of 15, but a decrease of 20 would be beyond the allowable range. An increase of 3 would cause an improvement of ($0.311111)3 $0.933, i.e. the OFV would increase by $0.933. A decrease of 15 would cause an improvement of ($0.311111)(15) $4.667, i.e. the OFV would decrease by $4.667. A decrease of 20 would cause an improvement of at least ($0.311111) (16.919998) = $5.264, i.e. the OFV would decrease by at least $5.264. The Nutrient 3 constraint is non-binding, which makes things easy. The allowable increase is 1.9, hence an increase of 1.5 would have no effect at all, while an increase of 2.5 would cause there to be a new solution. Because such a change would reduce the feasible region, it would cause the OFV to be impaired (i.e. rise in this situation). The fat constraint has an allowable increase of 2.127273, an allowable decrease of 0.72, and a dual price of 1.422222. A decrease of 0.5 is therefore allowable, and would cause the OFV to improve by 1.422222(0.5) $0.711, i.e. OFV = $0.711. A decrease of 1.8 is beyond the allowable range; the OFV would improve by at least 1.422222(0.72) = $1.024, i.e. OFV 1.024. An increase of 0.34 is allowable, and would cause the OFV to improve by 1.422222(0.34) $0.484, i.e. OFV = $0.484. Finally the mass constraint has an allowable increase of 0.327273, an allowable decrease of 1.017391, and a dual price of 5.055555. The current rhs value is 14.4, and the units are kg (kilograms). A decrease of 0.9 kg is therefore allowable, and the improvement to the OFV would be (5.055555)(0.9) = $4.55. In other
228
words, the OFV would fall by $4.55. Occasionally a conversion factor is required to analyze something; we re-state the 300 grams as 0.3 kg for consistency with the way the constraint was written. An increase of 0.3 kg is allowable, and the improvement to the OFV is (5.055555)0.3 $1.5174, i.e. OFV = $1.517. An increase of 700 g or 0.7 kg exceeds the allowable increase, the OFV would rise by at least 5.055555(0.327273) = $1.655.
14.5
14.5.1
Example 3: Blending Model

LINDO Sensitivity Output
In the previous lecture the solution for the Blending Model reported only the variables which have non-zero values. Now we will show the full report, because it is only the variables whose value is zero which can have positive reduced costs. Also, we will answer Yes when prompted with the DO RANGE (SENSITIVITY) ANALYSIS? question. Doing this we obtain:
13
OBJECTIVE FUNCTION VALUE 1) VARIABLE L H P A B C D AL BL CL DL AH BH CH DH 94288.23 VALUE 260.000000 0.000000 240.000000 192.352936 0.000000 200.000000 107.647057 192.352936 0.000000 58.823528 8.823529 0.000000 0.000000 0.000000 0.000000 REDUCED COST 0.000000 4.411765 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 5.882353 0.000000 0.000000 0.000000 5.882353 0.000000 0.000000

AP BP CP DP 0.000000 0.000000 141.176468 98.823532 0.000000 5.882353 0.000000 0.000000
229
ROW BAL. L) BAL. H) BAL. P) BAL. A) BAL. B) BAL. C) BAL. D) INPUT A) INPUT B) INPUT C) INPUT D) OUTPUT L) OUTPUT H) OUTPUT P) TOTAL) OCTANE L) OCTANE H) OCTANE P)
SLACK OR SURPLUS 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 87.647057 400.000000 0.000000 22.352942 0.000000 260.000000 20.000000 0.000000 0.000000 0.000000 0.000000 13
DUAL PRICES 245.588242 245.588242 245.588242 350.000000 400.000000 475.000000 600.000000 0.000000 0.000000 25.000000 0.000000 9.705882 0.000000 0.000000 173.529419 -7.352941 -7.352941 -7.352941
NO. ITERATIONS=
RANGES IN WHICH THE BASIS IS UNCHANGED: OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE INFINITY 9.705882 4.411753 INFINITY 9.705882 4.411753 11.538434 7.142880 5.882371 INFINITY INFINITY 25.000000
VARIABLE L H P A B C
CURRENT COEF 570.000000 600.000000 700.000000 -350.000000 -400.000000 -450.000000
230
D AL BL CL DL AH BH CH DH AP BP CP DP -600.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000

17.368422 50.000000 5.882371 0.000009 50.000000 0.000022 5.882371 6.818161 0.000022 0.000018 5.882371 16.499998 0.000018 11.538433 0.000018 INFINITY 16.499998 0.000018 9.090940 INFINITY 0.000011 INFINITY INFINITY INFINITY 0.000009 10.714256
ROW BAL. L BAL. H BAL. P BAL. A BAL. B BAL. C BAL. D INPUT A INPUT B INPUT C INPUT D OUTPUT L OUTPUT H OUTPUT P TOTAL OCTANE L OCTANE H OCTANE P
CURRENT RHS 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 0.000000 280.000000 400.000000 200.000000 130.000000 260.000000 260.000000 260.000000 500.000000 0.000000 0.000000 0.000000
RIGHTHAND SIDE RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 3.703704 9.382716 0.000000 0.000000 8.695652 2.608696 192.352936 87.647057 0.000000 400.000000 17.647058 44.705883 107.647057 22.352942 INFINITY 87.647057 INFINITY 400.000000 17.647058 44.705883 INFINITY 22.352942 59.999996 20.000000 INFINITY 260.000000 INFINITY 20.000000 20.000000 29.999998 760.000000 300.000000 0.000000 0.000000 300.000000 1000.000000
We will now examine the effect of some changes to the current parameters. All of these are done one at a time, with everything else remaining as it is in the
c April 28, 2010 D.M. Tulett current model. 14.5.2 Changes to the Objective Function Coefcients
231
For this problem, we restrict the analysis to those variables which appear in the objective function, i.e. L, H, P, A, B, C, and D. We ignore the other twelve variables (AL, BL, etc.). Non-Solution Variables In the current solution there is no production of highoctane gasoline for cars. This is seen on the solution report, where variable H has a value of 0 and a reduced cost of 4.411765. Also, if we look at the variable H row on the sensitivity report, we see that its current coefcient is 600, the allowable increase is 4.411765, and the allowable decrease is innite. The latter piece of information is intuitively obvious, for if we do not wish to make and sell high-octane gasoline when the price is $600 per cubic metre, then we certainly wouldnt want to make it and sell it if the market price were to fall. If the price rises by say $4 per cubic metre, this would not be enough to change the solution because 4 < 4.411765. If the price were to rise by say $5 per cubic metre, then the solution would change, but we would have to re-run the model with the new price to determine exactly what would happen. Variable B, representing how much is purchased from Better Grade Fuels, is also a non-solution variable. Curiously, variable B has a reported reduced cost of 0. Normally, a reduced cost of 0 for a non-solution variable would indicate that an alternative optimal solution exists, but thats not the case here. We can tell that the price must change by more than 0 by looking at the variable B row in the sensitivity report. There we see that the current coefcient is 400, the allowable increase is 5.882371, and the allowable decrease is innite. Note that in this example and for this variable, the price ($400) and the coefcient (400) are opposite in sign. Hence, for example, if the price were to fall by say $5 per cubic metre (to $395), the coefcient would rise by 5 (to 395). Such a change would not affect the optimal solution. A fall in price to say $390 would however affect the solution (a change of 10 > 5.882371); we would have to re-run the model to determine exactly how. The computer has done more work to come up with the sensitivity report in addition to the solution report. In this case, we see that the sensitivity report provides better information, so it is wise to check this report, especially if the solution report shows a reduced cost of 0.
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Solution Variables For changes to the objective function coefcient of a solution variable, we must turn to the sensitivity report. The variables left to examine are L, P, A, C, and D. Extracting just these rows we have:
VARIABLE L P A C D
CURRENT COEF 570.000000 700.000000 -350.000000 -450.000000 -600.000000
OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE INFINITY 9.705882 9.705882 4.411753 11.538434 7.142880 INFINITY 25.000000 17.368422 11.538433
From the variable L row, we see that an increase in price for low-octane gasoline would not affect the variables. However, Blendex would make more money. They are currently making 260 cubic metres of low-grade gasoline. If the price were to rise by say $19 per cubic metre (from $570 to $589) the extra prot would be $19(260) = $4940. The new OFV would be $94,288.13 + $4940 = $99,228.13. Conversely, a fall in the price of low-octane gasoline would cause the OFV to fall. If the price were to fall by $8 per cubic metre, we verify that 8 < 9.705882 (allowable decrease), meaning that the OFV would fall by $8(260) = $2080. The effect of a fall in price to say $558 (a drop of 12) is beyond the allowable range. However, we can say that the OFV would fall by at least $9.705882(260) = $2523.53. Variables A, C, and D, because they are quantities which are bought rather than sold, have negative objective function coefcients. Hence if we are asked What would happen if the price from A-One Petroleum were to rise by $9 per cubic metre? (i.e. from $350 to $359), this is equivalent to the coefcient decreasing from 350 to 359. Because the coefcient is decreasing we must examine the allowable decrease, which is 7.142880. The change proposed in the question is greater than this amount, so a new solution needs to be obtained by re-running LINDO. However, since A = 192.352936, we can predict that the OFV will decline (because the cost of an input is rising) by at least $7.14288(192.352936) = $1373.95. As another example, suppose that the price of Clearly Superior were to fall by $30 per cubic metre. This would cause the coefcient (which is negative) to rise by 30, which is ne (the allowable increase is innite). Since C = 300, the prot for Blendex would rise by $30(200) = $6000.
c April 28, 2010 D.M. Tulett 14.5.3 Changes to the Right-Hand Side Values
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It makes no sense to do a sensitivity analysis on the volume balance constraints or the octane constraints. For these, the context requires that the right-hand side value must be 0. Because they are equality constraints, all of the volume constraints are binding. The octane constraints are binding in this example. Removing these volume balance and octane constraints leaves us with: ROW INPUT A) INPUT B) INPUT C) INPUT D) OUTPUT L) OUTPUT H) OUTPUT P) TOTAL) SLACK OR SURPLUS 87.647057 400.000000 0.000000 22.352942 0.000000 260.000000 20.000000 0.000000 DUAL PRICES 0.000000 0.000000 25.000000 0.000000 9.705882 0.000000 0.000000 173.529419
The non-binding constraints (the ones for which the slack or surplus is greater than 0) are for the amounts available of inputs A, B, and D, and the production of H and P. Besides the volume balance and octane constraints, the binding constraints (the ones for which the slack or surplus is 0) are the ones for the amount available of input C, the production of L, and the total production. Non-Binding Constraints All of the non-binding constraints are in this example constraints, so we are dealing with a slack on each one. The right-hand side of any of these constraints can be increased indenitely, or be decreased by the amount of the slack, without affecting the current solution. For example, the supply of gasoline from A-One Petroleum could be increased indenitely, or be decreased by up to 87.647 cubic metres, without affecting the current solution. A change such as reducing the supply from Deluxe Gasoline by 30 cubic metres exceeds the slack, and hence a new solution would have to be found using LINDO. Binding Constraints Any change to the binding constraints will affect the values of the variables. However, within the allowable range such a change would have a predictable effect on the OFV. The allowable ranges come from the sensitivity report:
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ROW INPUT C OUTPUT L TOTAL
CURRENT RHS 200.000000 260.000000 500.000000
RIGHTHAND SIDE RANGES ALLOWABLE INCREASE 17.647058 59.999996 20.000000
ALLOWABLE DECREASE 44.705883 20.000000 29.999998
The total production is currently limited to 500 cubic metres, and all of this capacity is being utilized. The dual price is 173.529419. The allowable increase is 20. An increase in the right-hand side from 500 to 510 would increase the OFV by $173.5294(10) = $1735.29. The allowable decrease is 30. A decrease from 500 to 475 would cause the OFV to fall by $173.5294(25) = $4338.24. An increase of 35 (> 20) would change the solution; the OFV would go up by at least $173.5294(20) = $3470.59. Now lets take a look at changes to the availability of gasoline from Clearly Superior. This may seem a bit more complicated, because increasing the righthand side isnt free in that we have to buy more @ $450 per cubic metre in order to obtain more. Actually, its no more difcult than the previous case. The dual price on this availability constraint is $25. The allowance increase is 17.647058; the allowable decrease is 44.705883. Now suppose that we increase the righthand side by say 14 units, from 200 to 214. The dual price of $25 means that the OFV will increase by $25(14) = $350.00. The $450 per cubic metre that has to be paid to buy the extra gasoline has already been factored into the dual price. The dual price nets out everything. As the right-hand side is changed, the values of the variables change. Some go up, and some go down, and there are many credits and debits which sum up to the dual price. Hence this situation is not more complicated. When evaluating the effect of a right-hand side change, see if its within the allowable range, and if so the improvement to the OFV is simply the dual price multiplied by the change to the right-hand side.
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14.6
14.6.1
Exercise
A Maximization Problem
A garment factory can make skirts, blouses, and dresses. After deducting all variable costs, the net revenue is $32 per skirt, $27 per blouse, and $40 per dress. There are three operations, each of which limits the amount of production: cutting, assembly, and nishing. In addition, each garment must be inspected. Since union rules require that at least one inspector be on duty at all times, they will make a constraint to keep at least one inspector busy. The model has been formulated as: Let x1 , x2 , and x3 represent respectively the number of skirts, blouses, and dresses to be made each hour. maximize 32x1 + 27x2 + 40x3 subject to Cutting 5x1 Assembly 12x1 Finishing 7x1 Inspection 6x1 non-negativity x1 + + + + , 4x2 6x2 5x2 4x2 x2 + + + + , 2x3 8x3 8x3 3x3 64 160 146 72
x3
(a) Solve using a computer, and print this solution and the sensitivity report. (b) State the solution in words, and indicate which constraints are binding. (c) By using the information from the sensitivity report (NOT by re-running the model each time), give the predicted change to the objective function value (and the reasoning behind your answer) for the following situations (taken one at a time). If the OFV cannot be predicted exactly, then give an answer such as the OFV will increase by at least $90. (i) The price of each skirt rises by $5.00. (ii) There are three fewer units of assembly. (iii) The price of each dress falls from $40 to $27. (iv) The number of units of cutting increases by 10. (v) The number of units of nishing increases by 6. 14.6.2 A Minimization Problem
A company which makes chocolate bars needs to buy some exotic nuts: walnuts, chestnuts, and hazelnuts. They do not have to buy any of any one type, but they do need to satisfy certain combinations of types, which has been modelled using three
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constraints. Also, there is a capacity restriction. The model has been formulated as: Let x1 , x2 , and x3 represent respectively the number of kilograms of walnuts, chestnuts, and hazelnuts to be used each hour in the chocolate bar plant. minimize 2x1 + 7x2 + 4x3 subject to Combination 1 Combination 2 Combination 3 Capacity non-negativity 5x1 2x1 3x1 8x1 x1 + 8x2 + x2 + 4x2 + 9x2 , x2 + + + + , 6x3 4x3 5x3 4x3 230 145 196 252 0
x3
(a) Solve using a computer, and print this solution and the sensitivity report. (b) State the solution in words, and indicate which constraints are binding. (c) By using the information from the sensitivity report (NOT by re-running the model each time), give the predicted change to the objective function value (and the reasoning behind your answer) for the following situations (taken one at a time). If the OFV cannot be predicted exactly, then give an answer such as the OFV will decrease by at least $50. (i) The price of hazelnuts rises by $1.20 per kg. (ii) The price of chestnuts falls by $2.70 per kg. (iii) An extra 100 units of capacity becomes available. (iv) The requirement for combination 1 falls by 25 units. (v) The requirement for combination 3 increases by 92 units.
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15
15.1
Markov Chains 1
Introduction
Whenever we have a managerial problem which requires formulation as a mathematical model, we look for the type of model which is most appropriate. Decision trees are useful when we have decisions and events. Linear optimization is useful when we have a model which obeys the assumptions of this subject. Markov chains are a third approach, used for multi-period models which are governed by probabilities which are constant over time. Learning about Markov chains involves formulation and problem solution techniques which can be difcult. Many textbooks which contain a chapter on Markov chains will discuss the topic of rst passage time analysis, however this subject is omitted in this course. To learn about Markov chains, a good knowledge of matrix algebra as seen in Mathematics for Management Science is required. Matrix operations such as addition, subtraction, multiplication, and inversion will be used extensively. If the knowledge of these topics is rusty, you should review them. Unlike most of the material in this course, this is not a chapter about decision making. What is seen here can be imbedded into a decision making model, but that is a subject for a subsequent optional course. We begin with an example for which modelling as a Markov chain is appropriate.
15.2
15.2.1
Example: Brand Switching

Description of the Situation
A supermarket has a points program based on the amount purchased. The purpose of having the program is to give them information about how each consumer changes (or doesnt change) brands from month to month. In particular, they have studied the three brands of detergent which they sell, here referred to simply as Brands 1, 2, and 3. Of the consumers who bought Brand 1 last month, 47% stayed with this brand. Thirty-six percent switched to Brand 2, and seventeen percent switched to Brand 3. [A small number of shoppers who did not buy in both months are not considered, meaning that the percentages will add up to 100%.] Of those who bought Brand 2 last month, 52% stayed with brand 2, 9% went to Brand 1, and 39% are purchasing Brand 3 this month. Among last months Brand 3 shoppers, 61% stayed with Brand 3, while eighteen percent switched to Brand
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1, and 21% switched to Brand 2. They have been tracking the percentages of consumers who stay or switch for several months, and have found that these numbers are very stable. Assuming that this stability continues into the future, they would like to be able to predict the long-term market share for each brand of detergent. 15.2.2 State Transition (Probability) Diagram
A Markov chain consists of what are called states in which the probabilities of transitions between the states obey certain properties. The central idea in Markov chains is that history is irrelevant . The only thing that matters is the present, called the state of the system. A system is a Markov chain if the number of states is nite, if the probabilities of transition between the states are known, and if these probabilities do not change over time. For example, what matters in the brand switching situation described above is what brand the consumer is buying this month. This chain has three brands, and hence three states. We sometimes display a Markov chain on what is called a state transition probability diagram (or simply the state transition diagram ). We begin to make this diagram by making a circle for each state, labeled as Brand 1, Brand 2, and Brand 3. This is shown in Figure 51. From one month to the next, the consumer either stays with the same brand, or switches to another brand. On the Markov chain, staying with the same brand is a transition from one state to itself; switching from one brand to another brand is a transition from one state to another. A transition from a state to itself is drawn as a loop with an arrowhead entering the state. A transition from one state to another is drawn as an line or curve with an arrowhead touching the new state. This is shown in Figure 52. Next to each transition we place the probability of this transition, called the state transition probability . When we are given, for example, a statement that 36% of those buying Brand 1 will switch to Brand 2 next month, this is the same as saying that a Brand 1 consumer chosen at random has a 0.36 probability of switching to Brand 2 next month. There are nine (3 3) pieces of data to be extracted from the situation description. Doing this, and then placing each piece of data next to the arrow which represents the transition, we obtain the completed state transition diagram. This is shown in Figure 53. In this example, it is possible to buy any brand next month no matter what is being purchased this month. Because of this, all the arrows needed to be drawn. However, in many examples of Markov chains there are some impossible tran-
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Brand 1
Brand 2
Brand 3
Figure 51: Brand Switching: States
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Brand 1
Brand 2
Brand 3
Figure 52: Brand Switching: States with Transitions
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0.47 0.36 Brand 1 0.09 Brand 2
0.52
Brand 3
0.61
Figure 53: Brand Switching: State Transition Diagram
0.2 1
0.3 9
7 0.1
8 0.1
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sitions. When this happens, we do not draw an arrow for a transition with a 0 probability. By omitting such arrows, the clutter on the diagram is greatly reduced. State transition diagrams are useful for providing a conceptual grasp of the situation. However, they are not suited as a computational tool. For doing calculations based on the state transition probabilities, we are better off displaying the data in a matrix. 15.2.3 State Transition (Probability) Matrix
A Markov chain can be described by a square matrix in which the number of rows (or the number of columns) is the same as the number of states. This matrix is called the state transition probability matrix (or simply the state transition matrix ). For example, the brand switching situation which has three states can be described by a 3 by 3 matrix. Unless indicated to the contrary, the rows and columns match up with the states, i.e. row 1 and column 1 refer to state 1, and so on. By convention, the row is the current state and the column is the subsequent state, i.e. the number in row i and column j is the probability of going in one transition from state i to state j. Because these numbers are probabilities, every number is between 0 and 1 inclusive, and the sum of each row must be 1. Obtaining the probabilities either from the original situation description, or from the state transition diagram, the state transition matrix is:
To State 1 2 3 From 1 0.47 0.36 0.17 State 2 0.09 0.52 0.39 3 0.18 0.21 0.61
For emphasis, we have added the state numbers on the left and at the top, but where these are clear they will in future be omitted. In this more compact form the state transition probability matrix, which we denote as P, is simply: 0.47 0.36 0.17 P = 0.09 0.52 0.39 0.18 0.21 0.61
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However, when using a spreadsheet it is useful to put labels to the left and on top of the space reserved for the transition probabilities. On a spreadsheet the information could be displayed as: A 1 2 3 4 5 6 15.2.4 B C E F To State 1 2 3 0.47 0.36 0.17 0.09 0.52 0.39 0.18 0.21 0.61 D G H Brand Switching Example
Matrix P
From State
1 2 3
Finite Number of Transitions
The matrix P gives the probabilities of going from one state to another in one transition. We denote the number in row i and column j of this matrix as pi j , which represents the probability of going from state i to state j in one transition. Now suppose that we want to know the probability of going from state i to state j in two transitions. For example if i = 3 and j = 1, we are asking If a consumer buys Brand 3 this month, what is the probability that he or she will buy Brand 1 two months from now?. Note that we are not precluding the purchase of Brand 1 next month. (If we wanted to exclude this from happening, we would be involved with rst passage time analysis, which as stated earlier is not part of this course). There are three ways for this to happen: 1. The consumer switches to Brand 1 next month, and then stays with Brand 1 for the subsequent month. 2. The consumer switches to Brand 2 next month, and then switches to Brand 1 for the subsequent month. 3. The consumer stays with Brand 3 next month, and then switches to Brand 1 for the subsequent month. The probability which we seek is the sum of the joint probabilities of each of the three possibilities. In nding each joint probability, we are using the fact that the transition probabilities do not vary from one transition to another (this is a property of a Markov chain). Hence, for example, the probability of switching to Brand 1 next month, and then staying with Brand 1 for the subsequent month, is given by p3,1 p1,1 .
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In general, we denote the probability of going from state i to state j in k tran(2) (k) sitions as pi j . Here we seek p3,1 : p3,1 = p3,1 p1,1 + p3,2 p2,1 + p3,3 p3,1 = 0.18(0.47) + 0.21(0.09) + 0.61(0.18) = 0.0846 + 0.0189 + 0.1098 = 0.2133 To nd p3,1 , we calculated the dot product of row 3 and column 1. In general to nd pi j , we nd the dot product of row i and column j. For example, suppose we want the probability that a consumer who is currently buying Brand 2 will buy Brand 3 in two months time. This is: p2,3 = (row 2) (column 3)
(2) (2) (2) (2)
0.17 = (0.09 0.52 0.39) 0.39 0.61
= 0.09(0.17) + 0.52(0.39) + 0.39(0.61) = 0.0153 + 0.2028 + 0.2379 = 0.4560 Since matrix multiplication involves nding the dot products of all rows and (2) columns, we can nd all the pi j s by calculating P times P. We will denote this product as P2 . 0.47 0.36 0.17 0.47 0.36 0.17 P2 = 0.09 0.52 0.39 0.09 0.52 0.39 0.18 0.21 0.61 0.18 0.21 0.61 0.2839 0.3921 0.3240 = 0.1593 0.3847 0.4560 0.2133 0.3021 0.4846 While nding P2 by hand is easy enough, doing this operation on a spreadsheet is very fast and avoids a potential calculation error. With P in the range D3:F5, we can put P2 below it, say in the range D8:F10. To do this we drag the mouse over the range D8:F10, and in cell D8 we enter the appropriate formula:
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=MMULT(D3:F5,D3:F5)
The commands Ctrl (keep it held down) Shift (keep it held down) and Enter then produce: A 1 2 3 4 5 6 7 8 9 10 11 B C E To State 1 2 0.47 0.36 0.09 0.52 0.18 0.21 1 0.2839 0.1593 0.2133 2 0.3921 0.3847 0.3021 D F 3 0.17 0.39 0.61 3 0.3240 0.4560 0.4846 G H Brand Switching Example
Matrix P
From State
1 2 3
Matrix P2
1 2 3
We can continue in this fashion for any power of P. In general, matrix multiplication is not commutative, but in this context it is commutative. Hence we can nd P3 either as P2 P or as P P2 . There are three ways to nd P4 : (1) P3 P; (2) P2 P2 ; or (3) PP3 . Note that if we wanted something like P9 , the fast way to nd it starting with P would be to rst obtain P2 , then square this to obtain P4 , then square this to obtain P8 , and then multiply this by P to obtain P9 . Doing this on a spreadsheet we nd: 0.209147670 0.349827600 0.441024731 P9 = 0.209188246 0.349799030 0.441012724 0.209183334 0.349835786 0.440980880 We see that in every column the probabilities are essentially independent of the initial state. For example, whether the consumer is buying Brand 1, 2, or 3 this month, there is about a 0.209 probability of buying Brand 1 nine months from now. After many transitions (k of them), the nine probabilities in the Pk matrix are reduced to only three distinct probabilities, one for each column. Rather than nding these numbers numerically by nding Pk for higher and higher values of k,
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these numbers can be found analytically. Things will work out properly provided that for some value k all the numbers in the matrix Pk are non-zero. Theres clearly no problem in this example, since even P itself is entirely non-zero.
15.3
Determining Steady-State Probabilities Analytically
The analytical method of nding steady-state (also called long-term) probabilities nds the exact solution in one use of the procedure. This is in contrast with the numerical method of the previous section, which after many uses of the procedure nds successive approximations. The analytical method is what we shall use from now on. The implementation of the analytical method is different depending on whether the chain has just two states, or whether it has three states and we seek a solution by hand, or whether it has many states and we seek a solution using a computer. We begin with the three-state brand switching example to illustrate. 15.3.1 Three State Brand Switching Example
The numbers which we seek are the steady-state probabilities of the system being in state 1, state 2, or state 3. In the context of switching brands, these are the probabilities of the consumers purchase being Brand 1, Brand 2, or Brand 3 many months into the future. In this document these numbers are represented by the symbols x1 , x2 , and x3 . Each of these is an unknown, for which we shall solve three equations in three unknowns. One of these three equations is easy to obtain; these probabilities must sum to 1, so we can write: x1 + x2 + x3 = 1 Now we need two more equations. Heres how to obtain another one. After many iterations, the probability of being in state 1 next month is the same as the probability of being in state 1 this month; both are x1 . For any matrix P, we can be at state 1 next month in one of three ways: 1. We are in state 1 this month (probability x1 ), and we stay in state 1 (probability p1,1 ). 2. We are in state 2 this month (probability x2 ), and we move to state 1 (probability p2,1 ).
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3. We are in state 3 this month (probability x3 ), and we move to state 1 (probability p3,1 ). Each of these possibilities has a joint probability, and the sum of these joint probabilities is: x1 = p1,1 x1 + p2,1 x2 + p3,1 x3 Doing a similar analysis for state 2 we obtain: x2 = p1,2 x1 + p2,2 x2 + p3,2 x3 We now have three equations in three unknowns: x1 = p1,1 x1 + p2,1 x2 + p3,1 x3 x2 = p1,2 x1 + p2,2 x2 + p3,2 x3 x1 + x2 + x3 = 1 There is also an equation which could be written for state 3; this equation could replace either of the state 1 or state 2 equations. The one equation which cannot be replaced is the one for the sum being 1. Now lets determine the steady-state probabilities for the brand-switching example, for which the transition probability matrix is: 0.47 0.36 0.17 P = 0.09 0.52 0.39 0.18 0.21 0.61 Substituting the relevant pi j s, the system of equations in numerical form is: x1 = 0.47x1 + 0.09x2 + 0.18x3 x2 = 0.36x1 + 0.52x2 + 0.21x3 x1 + x2 + x3 = 1 (Note: the numbers in the rst two rows come from the rst two columns of P.) This system can easily be reduced to two equations in two unknowns by rewriting the third equation as x3 = 1 x1 x2 , and then substituting this into the rst two equations. This gives: x1 = 0.47x1 + 0.09x2 + 0.18(1 x1 x2 ) x2 = 0.36x1 + 0.52x2 + 0.21(1 x1 x2 )
248 Simplifying the right-hand side we obtain:
x1 = 0.29x1 0.09x2 + 0.18 x2 = 0.15x1 + 0.31x2 + 0.21 Putting all variables on the left we obtain: 0.71x1 + 0.09x2 = 0.18 0.15x1 + 0.69x2 = 0.21 Multiplying the rst row by 15, and the second row by 71, gives: 10.65x1 + 1.35x2 = 2.70 10.65x1 + 48.99x2 = 14.91 Adding we obtain: 0x1 + 50.34x2 = 17.61 and therefore x2 = 0.34982... We then substitute this result into one of the two equations in two unknowns to nd x1 : 0.71x1 + 0.09(0.34982...) = 0.18 Solving, we obtain x1 = 0.20917.... Now we nd x3 : 0.20917... + 0.34982... + x3 = 1 Solving, we obtain x3 = 0.44100... Hence the steady-state probabilities are: x1 = 0.20917..., x2 = 0.34982..., and x3 = 0.44100... In the context of the brand-switching example, this means that the market shares of the three brands are about 20.9% for Brand 1, 35.0% for Brand 2, and 44.1% for Brand 3. The method shown here is useful for models with three states. However, when there are just two states, there is a special formula which should be used instead. Conversely, when there are more than three states, you will probably want to use a computer to do part of the calculations. We now show how to use these methods.
c April 28, 2010 D.M. Tulett 15.3.2 Two State Markov Chain
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For a Markov chain with only two states, there is a formula for determining each states steady-state probability. Its easy to derive these formulas. An arbitrary matrix P is of the form p1,1 p1,2 P= p2,1 p2,2 where each number is at least 0 and each row must sum to 1. At steady-state, we must have: x1 = p1,1 x1 + p2,1 x2 . Also, we must have: x1 + x2 = 1 Therefore, x2 = 1 x1 , and substituting this into the other equation we obtain: x1 = p1,1 x1 + p2,1 (1 x1 ) and therefore Since each row sums to 1, 1 p1,1 = p1,2 . Therefore ( p1,2 + p2,1 )x1 = p2,1 . x1 = and since x1 + x2 = 1 we obtain x2 = 15.3.3 Example P= Using equations 3 and 4 we obtain x1 = and x2 = 0.41 0.5467 0.41 + 0.34 0.34 0.4533 0.41 + 0.34 0.66 0.34 0.41 0.59 p1,2 p1,2 + p2,1 (4) p2,1 p1,2 + p2,1 Therefore: (1 p1,1 + p2,1 )x1 = p2,1 .
(3)
250 15.3.4 Solution by Computer
Although we can automate things right from the outset, it is easier to understand what is happening if we rst do things by hand, and then switch to using the computer to nish the problem. For example, suppose that we wish to determine the steady-state probabilities of the following system: 0.31 0.25 0.38 0.06 0.08 0.44 0.32 0.16 P= 0.24 0.17 0.57 0.02 0.04 0.09 0.36 0.51 We make four equations in four unknowns. Three of them come in the same manner as before, in which each steady-state probability in written in terms of the pi j s and the other steady-state probabilities (by going down the columns of P) (we call these the x = xP equations). The fourth equation comes from the fact that all the steady-state probabilities must sum to 1. Doing this we obtain: x1 x2 x3 x1 + x2 + x3 + x4 = = = = 0.31x1 + 0.08x2 + 0.24x3 + 0.04x4 0.25x1 + 0.44x2 + 0.17x3 + 0.09x4 0.38x1 + 0.32x2 + 0.57x3 + 0.36x4 1
Putting all the variables on the left gives: 0.69x1 0.08x2 0.24x3 0.04x4 0.25x1 + 0.56x2 0.17x3 0.09x4 0.38x1 0.32x2 + 0.43x3 0.36x4 x1 + x2 + x3 + x4 This is a set of equations of the form Ax = b where 0.69 0.08 0.24 0.04 0.25 0.56 0.17 0.09 A= 0.38 0.32 0.43 0.36 1.00 1.00 1.00 1.00 = = = = 0 0 0 1
c April 28, 2010 D.M. Tulett x1 x2 x= x3 x4 and 0 0 b= 0 1
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We wish to determine x = A1 b. On a spreadsheet we can input the matrix A, invert it (using the MINVERSE function), and then multiply (using the MMULT function) this result by b to obtain the column vector x. Indeed, for any matrix P, the column vector b will always be a string of 0s ending with a 1. Therefore, the product of A1 and b is simply the same as the nal column of A1 . Doing this we obtain x1 = 0.190812702, x2 = 0.240611623, x3 = 0.448344037, and x4 = 0.120231638. The process can be expedited by rst nding the transpose of P. Secondly, the transposed matrix is subtracted from an identity matrix of the same size. Thirdly, the nal row of this subtracted matrix is overwritten with 1s. Fourthly, we nd the inverse of the overwritten matrix, and the nal column of the inverse gives the steady-state probabilities. You might wish to try this method on the second problem of this lectures exercise.
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15.4
15.4.1
Exercise
Problem 1
Solve this problem by hand (i.e. use a calculator rather than a spreadsheet). Three companies are ghting for market share. For each company, the proportion of the customers who switch to another company (or who stay with the same company) each month is given by the following matrix. .2 .7 .1 P = .5 .2 .3 .6 .1 .3 (a) If a consumer is currently purchasing from company 2, what is the probability that he or she will purchase from company 1 in three months time? (b) Analytically determine the long-term percentage market share for each company. 15.4.2 Problem 2
A Markov chain has the following state transition probability matrix: 0.0 1.0 0.0 0.0 0.0 0.3 0.7 0.0 P= 0.0 0.0 0.2 0.8 0.2 0.2 0.2 0.4 (a) Draw the state transition diagram (omit the impossible transitions). Use a spreadsheet to solve parts (b) and (c) of this problem. (b) If the system is currently in state 2, what is the probability that it will be in state 4 after ve transitions? (c) Determine by matrix inversion the percentage of time that will be spent in each state after a large number of transitions.
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16
16.1
Markov Chains 2
Introduction
In this lecture we examine what happens when a Markov chain has some states which, once entered, cannot be left. Such states are called absorbing or trapping states. In a state transition diagram, an absorbing state has a loop to itself with probability 1, with no other arrow leaving for any other state. In a state transition matrix, an absorbing state has a 1 on the main diagonal, and a 0 everywhere else in that row. Another way of saying this is that state i is an absorbing state if and only if pii = 1. In a Markov chain in which some of the states are absorbing, the non-absorbing states are often called transient states. In matrix P1 , state 1 is absorbing and state 2 is transient. Clearly, such a system will eventually end up in state 1. P1 = 1 0 0.2 0.8
We note that a matrix such as the one shown in P2 (which has no 1s on the main diagonal) contains no absorbing states: 0 0 1 0 0 P2 = 1 0.4 0.5 0.1 In matrix P3 , states 1 and 2 are absorbing and state 3 is transient. 1 0 0 1 0 P3 = 0 0.4 0.5 0.1 To obtain the probability of eventual absorption into state 1 (x1 ), all we need do is solve a single equation. If the system starts in state 3, there is a 0.4 chance of being absorbed into state 1 after one transition. There is a 0.1 chance of returning to state 3, at which point there is probability x1 of eventually ending up in state 1. Therefore: x1 = 0.4 + 0.1x1 0.9x1 = 0.4 4 0.4444 x1 = 9
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The probability of eventual absorption into state 2 (x2 ) is x2 = 1 x1 4 = 1 9 5 0.5556 = 9 This approach is simple because of the small size of the system, but what we need is a general procedure for an arbitrary number of absorbing states, and an arbitrary number of transient states. This is presented in the next section. After that, we present an application for which this type of analysis is needed.
16.2
Absorbing States Analysis
In dealing with Markov chains which contain absorbing states, it makes things easier if the absorbing states appear together rst, and the transient states appear together afterwards. We let m represent the number of absorbing states, and n the number of transient states. Hence the Markov chain has m + n states. Here is an example with three absorbing states and two transient states, the absorbing ones appearing rst. 1 0 0 0 0 0 1 0 0 0 0 1 0 0 P = 0 0.12 0.34 0.38 0.09 0.07 0.25 0.41 0.16 0.05 0.13 This matrix can be partitioned into four sub-matrices, splitting the absorbing states from the transient states both horizontally and vertically. Showing this with four colours we have: 1 0 0 0 0 0 1 0 0 0 0 0 1 0 0 P = 0.12 0.34 0.38 0.09 0.07 0.25 0.41 0.16 0.05 0.13 We see that the 5 by 5 matrix was partitioned as follows: the area in red is a 3 by 3 identity matrix; the area in grey is a 3 by 2 rectangle in which every number is
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0; the area in blue is a 2 by 3 rectangle which gives the probabilities of switching from the transient states to the absorbing states; and the area in yellow is a 2 by 2 square which gives the probabilities of switching between the transient states. In general P can be partitioned into: an identity matrix of order m (upper-left); a rectangle with m rows and n columns consisting only of 0s (upper-right); a rectangle with n rows and m columns (lower-left); and a square matrix of order n (lower-right). Each of these is a sub-matrix denoted as: Im ; 0mn ; Rnm ; and Qn respectively. When there are more absorbing states than transient states (m > n), the partition looks like: Im 0mn
P = Rnm
Qn
When there are fewer absorbing states than transient states (m < n), the partition looks like: Im 0mn
Rnm Qn P =
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When the number of absorbing states equals the number of transient states (m = n), the partition results in four square sub-matrices of the same size: Im 0mn P = Qn Rnm It turns out that steady-state behaviour can be determined just by using submatrix Rnm and sub-matrix Qn . What we are seeking is a matrix which has the same size and shape as Rnm . This matrix gives the probability of eventual absorption into absorbing state j given that the system begins in transient state i, where j = 1, . . . , m and i = m + 1, . . . , m + n. The formula to nd this n by m matrix, here called Fnm , is Fnm = In Qn
1
Rnm
(5)
The use of colour in Equation 5 is for emphasis. The identity matrix in this equation is In , a matrix which has the same size as Qn . It is not Im , the sub-matrix of P which is kitty-corner to Qn . Returning to the numerical example, the sub-matrices of P which we need are: Q2 = and R23 = 0.09 0.07 0.05 0.13
0.12 0.34 0.38 0.25 0.41 0.16 To nd F, we rst perform the subtraction within the parentheses: I2 Q2 = = 1 0 0.09 0.07 0 1 0.05 0.13 0.91 0.07 0.05 0.87
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Since this is a 2 by 2 matrix, it can be inverted by hand, as we shall now do. For our purposes, any matrix which is 3 by 3 or larger will be inverted using a spreadsheet. Recall how to nd the inverse of a 2 by 2 matrix A (this is seen in Chapter 3 of Mathematics for Management Science): A= The determinant of this matrix is det A = a1,1 a2,2 a2,1 a1,2 If det A = 0, then the inverse of A, written as A1 , does not exist. If det A = 0, then 1 a2,2 a1,2 A1 = a2,1 a1,1 det A The matrix that we wish to invert is: I2 Q2 = 0.91 0.07 0.05 0.87 a1,1 a1,2 a2,1 a2,2
We begin by calculating the determinant. det(I2 Q2 ) = 0.91(0.87) (0.05)(0.07) = 0.7917 0.0035 = 0.7882 Since the determinant is not 0, the inverse is dened, and is given by: (I2 Q2 )1 = 1 0.7882 1.10378 0.06344 0.87 0.07 0.05 0.91 0.08881 1.15453
This matrix has a special meaning. It gives the expected number of transitions spent in each transient state before absorption. If the system starts in the rst transient state (state 4 in P), then the system will spend about 1.104 transitions in state 4 and 0.089 transitions in state 5 for a total of 1.193 transitions before being absorbed somewhere. If the system starts in the second transient state (state 5 in P),
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then the system will spend about 0.063 transitions in state 4 and 1.155 transitions in state 5 for a total of 1.218 transitions before being absorbed somewhere. Finally, we multiply this matrix and R: Fnm = = In Qn Rnm 1.10378 0.08881 0.12 0.34 0.38 0.06344 1.15453 0.25 0.41 0.16 0.1547 0.4117 0.4336 0.2962 0.4949 0.2088
1
All the numbers in Fnm are probabilities, hence each number must be between 0 and 1 inclusive, and each row must (theoretically) sum to 1. By inspection we see that the rst attribute is true; by summing each row we obtain 1.000 for the rst (state 4) and 0.9999 for the second (state 5). The latter sum is ne; there is simply some rounding error when the probabilities were reported to the nearest fourth digit. The number in row i (state m + i) and column j gives the probability of the system eventually being absorbed into state j. For example, starting in state 5, there is about a 49.5% chance of being absorbed into state 2. Alternate Approach If the inverted matrix is not needed in its own right, but is simply an intermediate calculation in determining Fnm , then an alternate approach exists which is numerically easier to do by hand. Using this approach, we postpone the division by the determinant until the end. Doing it this way we obtain: Fnm = = = Rnm 0.87 0.07 1 0.7882 0.05 0.91 0.1219 0.3245 1 0.7882 0.2335 0.3901 0.1547 0.4117 0.4336 0.2962 0.4949 0.2088 In Qn
1
0.12 0.34 0.38 0.25 0.41 0.16 0.3418 0.1646
16.3
Solution by Computer
Whenever the matrix inversion is 3 by 3 or larger, we will use a computer to do the calculations. An example to illustrate this is given by the following six state Markov chain.
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P =
1 0 0.13 0.07 0.06 0.04
0 1 0.24 0.52 0.32 0.07
0 0 0.32 0.21 0.09 0.18
0 0 0.28 0.08 0.15 0.64
0 0 0.02 0.03 0.26 0.04
0 0 0.01 0.09 0.12 0.03
We can put this onto a spreadsheet, using four colours to highlight the partitioned matrix P. A 1 2 3 4 5 6 7 B C 1 0 0.13 0.07 0.06 0.04 D 0 1 0.24 0.52 0.32 0.07 E 0 0 0.32 0.21 0.09 0.18 F 0 0 0.28 0.08 0.15 0.64 G 0 0 0.02 0.03 0.26 0.04 H 0 0 0.01 0.09 0.12 0.03
Matrix P
Since Q (yellow) is 4 by 4, we need a 4 by 4 identity matrix. This is: A 8 9 10 11 12 B C 1 0 0 0 D 0 1 0 0 E 0 0 1 0 F 0 0 0 1 G H
Matrix I4
We now nd I4 Q. To put this into the range C14:F17, we input =C9-E4 into cell C14, and then copy this formula into the range C14:F17. Doing this we obtain: A 13 14 15 16 17 B C 0.68 0.21 0.09 0.18 D 0.28 0.92 0.15 0.64 E 0.02 0.03 0.74 0.04 F 0.01 0.09 0.12 0.97 G H
Matrix I4 Q
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Now we nd (I4 Q)1 . To write the label, we can use Equation Editor in Word and then paste this into Excel. Alternatively, we can write the label simply as (I4-Q){-1} or something similar. To put the inverse into the range C19:F22, we rst drag the mouse from cell C19 to cell F22 which blackens the range. Secondly we enter =MINVERSE(C14:F17) into cell C19. Thirdly we press Ctrl (keeping it held down) Shift (keeping it held down) and Enter, which produces: A 18 19 20 21 22 B C 1.680313349 0.458271813 0.399523068 0.630650810 D 0.579065465 1.334249642 0.504437482 1.008586654 E 0.073219698 0.073918296 1.394678348 0.119870504 F 0.080108649 0.137665342 0.223459800 1.145838936
Matrix (I4 Q)1
Finally, we are ready to calculate: Fnm = In Qn

1
Rnm In Qn
1
F is a 4 by 2 matrix (its always the same size as R, the blue sub-matrix of P). Hence we reserve a 4 by 2 range for this matrix, say C24:D27. is in the range C19:F22, and Rnm is in the range C4:D7, so in cell C24 we enter the formula =MMULT(C19:F22,C4:D7). We then press Ctrl (keeping it held down) Shift (keeping it held down) and Enter, which produces: A 23 24 25 26 27 B C 0.266572846 0.162914522 0.179867716 0.205611459 D 0.733427154 0.837085478 0.820132284 0.794388541 E F G H
Matrix F
The spreadsheet output produces far more places after the decimal point than we need (and far more than we can justify, given that the initial data is not precise). To present the data to a manager, we might report it in a table, with the spreadsheet output being an appendix to the report. In a generic form the table could resemble:
c April 28, 2010 D.M. Tulett Probability of Absorption into State 1 State 2 0.267 0.733 0.163 0.837 0.180 0.820 0.206 0.794
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Beginning in State 3 State 4 State 5 State 6
However, in reporting the analysis for a specic example, the labels for the states should be replaced by word descriptions in order to make the report easy to understand.
16.4
An Application: Credit Card Analysis
Often once an absorbing state is entered, there are no further transitions, however it is still appropriate to model the situation as if there were perpetual transitions all returning to the same state. Here follows an example of this. 16.4.1 Situation Description
A credit card company classies each account into one of four categories: 1. The account is fully paid. 2. The account last had credit granted within the past one to thirty days. 3. The account last had credit granted within the past thirty-one to sixty days with either no payment or insufcient payment to pay off the account. 4. The account has been written off as bad debt. Of the accounts currently in the 1 30 day category, 20% are paid in full, 70% have debits and credits which cause the account to be in the same category next month, and on the other accounts nothing is paid. Of the accounts currently in the 31 60 day category, 5% are paid in full, enough is paid on 30% of the accounts to upgrade the status to 1 30 day old debt, 58% of the accounts remain in the same category next month, and on the rest nothing is paid. The company expects these patterns to continue into the future. The company wishes to know how long on average their money is lent out before it is either repaid or is written off. The company currently has $108,000,000
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lent out, of which $96,000,000 is in the 1 30 day category. The company wishes to determine how much money they can expect to recover. 16.4.2 Formulation
Each of the four categories is a state of a Markov chain. Once a dollar lent out has been returned, or has become bad debt, it doesnt keep making transitions, but for the sake of doing the Markovian analysis, we treat the fully paid and bad debt situations as absorbing states. The other two states, with debt in either the 1 30 or 31 60 day categories, are transient. From what we saw in the previous section, the analysis is made easier if we put the absorbing states together, and then put the transient states together. The four states are therefore: 1. Fully Paid (absorbing) 2. Bad Debt (absorbing) 3. 1 30 Days (transient) 4. 31 60 Days (transient) We are now almost ready to make the state transition diagram. The percentages become the probabilities. Where it states that on the other accounts nothing is paid, the probability is found by subtracting everything else from 1 to obtain 1 0.2 0.7 = 0.1. In this case, the system moves from the 1 30 Days state to the 31 60 Days state. Where it states that on the rest nothing is paid, the probability is found by subtracting everything else from 1 to obtain 1 0.05 0.30 0.58 = 0.07. In this case, the system moves from the 31 60 Days state to the Bad Debt state. In making the state transition diagram, the words which describe the state are given prominence over the state number. For emphasis, the absorbing states are in red, and the transient states are in yellow. The state transition diagram is shown in Figure 54. 16.4.3 Analysis
While the diagram makes things easy to understand, we need the state transition probability matrix from which the calculations will be made. This matrix is:
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1 Fully Paid (1) Bad Debt (2)
0.
0.2
0.07
05
1 30 Days (3)
0.1 0.3
31 60 Days (4)
0.7
0.58
Figure 54: Credit Card State Transition Diagram
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1 0 P = 0.2 0.05 We now wish to determine: Fnm = We begin with the subtraction: I2 Q2 = = Now we nd the inverse:
0 1 0 0.07
0 0 0.7 0.3
1
0 0 0.1 0.58
In Qn
Rnm
1 0 0.7 0.1 0 1 0.3 0.58 0.3 0.10 0.3 0.42
det(I2 Q2 ) = 0.3(0.42) (0.3)(0.1) = 0.126 0.03 = 0.096 Since the determinant is not 0, the inverse is dened, and is given by: (I2 Q2 )1 = 0.42 0.1 1 0.096 0.3 0.3 4.375 1.04167 3.125 3.125
If an account is currently in the 1 30 Day state, the money is expected to spend 4.375 months in this state, and 1.04167 months in the 31 60 Day state, for a total of 5.41667 months before being absorbed into either the Fully Paid or Bad Debt states. If an account is currently in the 31 60 Day state, the money is expected to spend 3.125 months in each transient state for a total of 6.25 months before being absorbed into either the Fully Paid or Bad Debt states. Finally, we multiply this matrix and R: Fnm = = In Qn Rnm 4.375 1.04167 0.2 0 3.125 3.125 0.05 0.07 0.92708 0.07292 0.78125 0.21875
1
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The interpretation of these numbers is that for each dollar in the 1 30 Day state, we expect that 92.708 cents will be recovered, and 7.292 cents will end up as bad debt. For each dollar in the 31 60 Day state, we expect that only 78.125 cents will be recovered, and 21.875 cents will end up as bad debt. As one would expect, a dollar in the 31 60 Day state has less chance of being recovered than a dollar in the 1 30 Day state. Hence the data could be reported as: Percentage which is Recovered Not Recovered 92.7 7.3 78.1 21.9
Current Status 1 30 Days 31 60 Days
With $108,000,000 currently on loan, of which $96,000,000 is in the 1 30 Day state, there is $12,000,000 in the 31 60 Day state. They should expect to recover: 0.92708($96, 000, 000) + 0.78125($12, 000, 000) $98, 375, 000 Based on the $108,000,000 in credit outstanding, this is a recovery rate of about 91.1% overall.
16.5
16.5.1
Exercise
Problem 1
A chocolatier makes white, light, medium, and dark chocolate. Once a customer buys either white or dark chocolate, he or she continues to buy it forever. Of those who are currently eating light chocolate, 20% will switch to white, 50% will stay with light, and 30% will switch to medium next time. Of those who are currently eating medium chocolate, 15% will switch to light, 60% will stay with medium, and 25% will switch to dark next time. (a) Dene the states and draw the state transition diagram. (b) Write the state transition matrix, and doing the matrix inversion by hand, determine the expected number of transitions before absorption depending on whether the consumer is currently buying light or medium chocolate. (c) What are the probabilities of absorption into white or dark chocolate conditional on whether the consumer is currently buying light or medium chocolate?
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(d) At the outset, light chocolate has 30% of the market, and medium chocolate has the rest. Eventually, what will the market shares be for white and dark chocolate? (Hint: Draw a probability tree.) 16.5.2 Problem 2
A credit-card company categorizes its open accounts as being current, onemonth overdue, two-months overdue, and three-months overdue. They nd that 70% of their current accounts are paid in full. However, only 40% of the onemonth old accounts are paid in full; 20% of the two-month old accounts are paid in full, and only 10% of the three-month old accounts are paid in full. Of the accounts which are not paid in full, half stay in the same category, and the other half are not paid at all. For example, for the one-month accounts, 0.5(1 40%) = 30% of them go into the two-month category in the following month. Accounts which have not been paid for four months are written off as bad debt, and the account is closed. (a) Dene the states and draw the state transition diagram. (b) Using a spreadsheet to perform the necessary matrix inversion, determine the percentage of the debt which is eventually repaid as a function of the age of the account. (c) The company currently has $66 million lent out in current accounts, $35 million in one-month accounts, $7 million in two-month accounts, and $2 million in three-month accounts. What is the expected amount of money that will eventually be paid in full?
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17
Markov Chains 3
We have seen all the technical operations about Markov chains suitable for a introductory course in management science. However, we need to spend some more time on model formulation. In this lecture we present a few more formulation examples in increasing order of complexity.
17.1
Gamblers Ruin
A gambler walks into a casino with one of the following amounts of cash: $20; $40; $60; or $80. Every time he plays a game, he bets $20. If he wins, he receives $40 for a net gain of $20. If he loses, he receives nothing for a net loss of $20. Every time he plays the probability of winning is p, and the probability of losing is 1 p. He will leave the casino if he runs out of cash, and also leave the casino if his cash reaches the $100 level. This is a Markov chain in which the states represent his level of cash. Having no cash or $100 in cash are absorbing states (numbered 1 and 2), and having $20, $40, $60, or $80 are the transient states (numbered 3, 4, 5, and 6). Note that winning and losing are not states winning and losing are transitions, and are represented by the arrows between the states. The state transition diagram is shown in Figure 55. The state transition matrix is: P = 1 0 1 p 0 0 0 0 1 0 0 0 p 0 0 0 1 p 0 0 0 0 p 0 1 p 0 0 0 0 p 0 1 p 0 0 0 0 p 0
In putting this onto a spreadsheet, one cell is reserved for the value of p. For example, suppose that this cell is A6 (with a label p in cell A5), and P is placed in the range C2:H7. All cells are 0 except: C2 and D3, which are 1; F4, G5, H6, and D7 in which we place the formula =A6; and C4, E5, F6, and G7, in which we place the formula =1-A6. These formulas can be seen by pressing Cntl (keeping it held down) and the (tilde) key.
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1 Leaves with $0 (1) 1 p Leaves with $100 (2) p
$20 (3) 1 p p p $40 (4) 1 p p
$80 (6) 1 p
$60 (5)
Figure 55: Gamblers Ruin State Transition Diagram
c April 28, 2010 D.M. Tulett A 1 2 3 4 5 6 7 Gamblers Ruin p B C 1 0 =1-A6 0 0 0 D 0 1 0 0 0 =A6 E 0 0 0 =1-A6 0 0 F 0 0 =A6 0 =1-A6 0 G 0 0 0 =A6 0 =1-A6 H 0 0 0 0 =A6 0
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If we put a number into cell A6 and then press Cntl (keeping it held down) and the key, the numbers in the matrix will appear. For example, with 0.47 in cell A6, we obtain: A 1 2 3 4 5 6 7 Gamblers Ruin p 0.47 B C 1 0 0.53 0 0 0 D 0 1 0 0 0 0.47 E 0 0 0 0.53 0 0 F 0 0 0.47 0 0.53 0 G 0 0 0 0.47 0 0.53 H 0 0 0 0 0.47 0
By the method seen in the last lecture, we can create I4 , then nd I4 Q, then (I4 Q)1 , and nally F. We will present only the nal solution here. For example, when p = 0.47 we obtain: Based on p = 0.47 Beginning with $20 with $40 with $60 with $80 Probability of Leaving with $0 $100 0.845 0.155 0.670 0.330 0.473 0.527 0.251 0.749
For example, for someone entering the casino with $40 the probability of eventually winning a net of $60 to obtain a total of $100 is given by row 2 (state 4) and column 2 (state 2) of the table (the matrix F); this number is 0.33.
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The expected net loss from the gamblers perspective is the amount the gambler has initially minus the expected winnings. For example, if the gambler enters with $40 the expected loss based on p = 0.47 is: $40 (0.67($0) + 0.33($100)) = $7.00 (Without rounding the probabilities from the F matrix the expected loss works out to $7.01.) Doing this calculation on the spreadsheet for all levels of initial cash we obtain: $4.50 for $20; $7.01 for $40; $7.30 for $60; and $5.30 for $80. The preceding has been based on the arbitrarily chosen value of p = 0.47. The value of p will be set by the casino. In order for them to make money to pay their expenses and taxes, they will set p to be less than 0.5. They dont have to make it much less for them to collect the lions share of the winnings. Here is what happens as a function of p if someone begins with $60. Beginning with $60 Probability of leaving Expected with $100 Loss 0.600 none 0.478 $12.20 (20.3%) 0.360 $23.98 (40.0%) 0.256 $34.37 (57.3%) 0.172 $42.83 (71.4%)
p 0.50 0.45 0.40 0.35 0.30
Things are even more bleak for someone who starts out with only $40. Beginning with $40 Probability of leaving Expected with $100 Loss 0.400 none 0.286 $11.41 (28.5%) 0.190 $21.04 (52.6%) 0.116 $28.39 (71.0%) 0.065 $33.48 (83.7%)
p 0.50 0.45 0.40 0.35 0.30
Here we see for example that a 30% chance of winning on any one play (which doesnt sound too bad) translates into only a 6.5% chance of winning overall. This is why the game is called gamblers ruin. The Markov chain drifts towards the absorbing state which represents leaving with no money left.
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17.2
Educational Model
The rst part of the Exercise for this lecture is based on the content of this section. Suppose that a college offers a course over two years, with an exam at the end of each year written on a pass/fail basis. If a student fails either year, he or she is required to withdraw (RTW). If the student passes Year 1, he or she then enters Year 2. If the student also passes the exam at the end of Year 2, then the student graduates. We could model this situation as a Markov chain, in which there are two absorbing states and two transient states. State 1 - Grad. (the student has graduated from the program) State 2 - RTW (the student has been required to withdraw) State 3 - Year 1 (the student is currently enrolled in Year 1) State 4 - Year 2 (the student is currently enrolled in Year 2) The pass rate is 80% for Year 1, and 75% for Year 2. Clearly, the overall success rate is 80%(75%) = 60%. Eventually, we expect that 60% of the students will end up in the Grad. state, and 40% will end up in the RTW state. Note that passing or failing each years program are not states; they are the transitions between the states. 17.2.1 Extension 1
Now we consider a more realistic (and more complicated) model. The pass rates are the same as before, but students are now allowed to fail once. If the student fails the same year twice, or fails Year 2 having previously failed Year 1, then he or she is required to withdraw. The new Markov chain is not simply the old one with a loop from State 3 (Year 1) to itself. This would only be correct if the year could be repeated any number of times. Instead, we need two Year 1-type states: one for rst-timers; and one for repeaters. The same applies for Year 2. The drawing of the state transition diagram is left as part of the Exercise. 17.2.2 Extension 2
Things are as they were in Extension 1, but now the pass rates depend on the history. The Year 1 pass rate is still 80% for rst-timers, but is 90% for repeaters. The Year 2 pass rate is still 75% for those who have never failed before, but is 60% for those who repeated Year 1 and are now doing Year 2 for the rst time, and is 85% for those who are doing Year 2 for the second time.
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The assumption of a Markov chain is that history is irrelevant, so when it is relevant, we have to try altering the chain. We can create another state to handle the 60% vs. 85% pass rates. This leaves us with three Year 2-type states. Again, the drawing of the diagram is left as part of the Exercise.
17.3
17.3.1
Repair Problem A
Situation Description
A machine contains three identical components. Under normal operation, two of the components are working, and the third is in working order but idle. At the end of every hour there is probability p that each operating component will cease to operate. This probability does not depend on how long the component has been working. When one component fails, the idle component then starts operating, and a repairer begins to x the non-functioning component. Though the machine is under repair, the machine is still considered to be up, because having two working components is sufcient. The repairs always take an hour, and are always successful. In the rare situation where two operating components fail simultaneously, the machine is then down. The repairer takes an hour to repair one of the two broken components, and then repairs the other one. (Theres no room for two repairers to work simultaneously.) We wish to model this situation as a Markov chain. 17.3.2 Formulation
In this situation if we try to make the model at the component level it will have nine states, because there are three components, and each can be working, idle, or under repair. This would lead to a model which would be overly complex. Instead, because each component is identical, we will make the model at the level of the machine. It can be seen that the machine must be at all times in one of three situations. To see this we begin with the state of normal operation (State 1), in which two components are working and the third is idle. If neither working component fails, then the system returns to this state. If one fails but the other does not, then the machine is up but under repair (State 2), i.e. two components working and the third is under repair. If the system is in state 1 and both working components fail, then the machine is down and under repair (State 3), with one being repaired, one waiting for repair, and one component idle. If the system is in state 2, and if neither working component fails, then because the repair is
273
completed at the next transition the system will move into State 1. If the system is in state 2 and just as one component is repaired either (but not both) of the working components fails, then the system stays in state 2. If the system is in state 2 and both components fail, the component being repaired becomes an idle component, one of the other two components is being repaired, and the third one is waiting for repair, i.e. the system has moved to state 3. Finally, if the system is in state 3, it must move to state 2 when the state under repair becomes operational. We have tracked down all the possibilities, so we are left with a three-state Markov chain. With three coloured boxes for the components, using green to mean working, blue to mean idle, yellow to mean under repair, and red to mean waiting for repair, the states are (where the boxes can be in any order): State 1 State 2 State 3 Operating Operating Being Repaired Operating Operating Waiting for Repair Idle Being Repaired Idle
In this situation, the breakdowns of the components, and moment that the component is switched on after being repaired, are transitions between the states. The probabilities of transition are all either 0 (if impossible), 1 (if required), or a function of p. In states 1 and 2, the joint probabilities are given by the binomial formula with n = 2: p2 for two simultaneous failures; (1 p)2 for two simultaneous non-failures; and 2 p(1 p) for one failing but the other not failing. The state transition diagram is shown in Figure 56. The equivalent state transition matrix is: (1 p)2 2 p(1 p) p2 P = (1 p)2 2 p(1 p) p2 0 1 0 With a given numerical value for p, we can create a numerical diagram or matrix. For example, when p = 0.03, the state transition probability matrix is: 0.9409 0.0582 0.0009 P = 0.9409 0.0582 0.0009 0 1 0 By using the method seen two lectures ago, we could nd the steady-state probabilities x1 , x2 , and x3 .
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(1 p)2 Normal Operation (1) 2 p(1 p) (1 p)2
2 p(1 p) Up & Repair (2)
Down & Repair (3)
Figure 56: Repair Problem A
p2
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17.4
Repair Problem B
Now we consider a more complicated repair problem. Things are as they were in problem A, but now the probability of successful repair in an hour is q (rather than 1). This probability does not depend on how many hours the repairer has been working on the failed component. We clearly need the three states that we dened earlier. What we must do is see what other states might be needed now. In state 1, nothing is being repaired, so the probabilities exiting from state 1 do not depend on q. In state 2, if the repairer xes the component this hour, then the system moves to state 1 if neither working component fails, stays in state 2 if exactly one working component fails, and moves to state 3 if both working components fail. In state 2, if the repairer fails to x the component this hour, then in the next hour the system will be in state 2 if neither operating component fails, and will be in state 3 if exactly one operating component fails. If both operating components fail, then there will be three bad components. For this, we need a new state. State 4 has one component being repaired, and two components waiting for repair. Fixing a component in state 3 (probability q) moves the system to state 2 (as before), but failing to x it (probability 1 q) keeps the system in state 3. Fixing a component in the new state 4 (probability q) moves the system to state 3, but failing to x it (probability 1 q) keeps the system in state 4. Hence we only need one more state, and using the previously dened colours we have: State 1 State 2 State 3 State 4 Operating Operating Being Repaired Being Repaired Operating Idle Operating Being Repaired Waiting for Repair Idle Waiting for Repair Waiting for Repair
We need to determine the expressions (which depend on p and q) for the state transition probabilities, which are shown on the state transition diagram in Figure 57. For exiting from states 1, 3, and 4, these are easy to nd. From state 1, we have the same thing as in Repair Problem A: p1,1 = (1 p)2 ; p1,2 = 2 p(1 p); and p1,3 = p2 (the system cannot go from 1 to 4). From state 3, we have: p3,2 = q; and p3,3 = (1 q). From state 4, we have: p4,3 = q; and p4,4 = (1 q). The probabilities coming out of State 2 are much more difcult to determine. To go from 2 to 1, we want the joint probability of two working components not failing and the other component being successfully repaired. This is: p2,1 = (1 p) (1 p) q
276
(1 p)2 Normal Operation (1) 2 p(1 p) (1 p)2 q
2 p(1 p)q+ (1 p)2 (1 q) Up & Repair (2)
p2 q
Down & Repair (3)
2p
(1
p) (1
p2
p2 (1 q)
q)
q
All Down & Repair (4)
1q
Figure 57: Repair Problem B
1q
c April 28, 2010 D.M. Tulett = (1 p)2 q
277
There are three ways of going from State 2 to itself. There are two ways in which one working component fails and the other does not combined with the third component being successfully repaired, and the other way is if neither working component fails combined with the third component not being successfully repaired. This is: p2,2 = p(1 p)q + (1 p) pq + (1 p)(1 p)(1 q) = 2 p(1 p)q + (1 p)2 (1 q) There are three ways of going from State 2 to State 3. There are two ways in which one working component fails and the other does not combined with the third component not being successfully repaired, and the other way is if both working components fail combined with the third component being successfully repaired. This is: p2,3 = p(1 p)(1 q) + (1 p) p(1 q) + ppq = 2 p(1 p)(1 q) + p2 q Finally, there is one way to go from State 2 to State 4. This happens when both working components fail and the third component is not successfully repaired. This is: p2,4 = p2 (1 q) The state transition matrix as a function of p and q is: (1 p)2 2 p(1 p) p2 2 2 (1 p) q 2 p(1 p)q + (1 p) (1 q) 2 p(1 p)(1 q) + p2 q P = 0 q 1q 0 0 q For example, if p = 0.03 and q = 0.8, then: 0.9409 0.0582 0.75272 0.23474 P = 0 0.8 0 0 0 p2 (1 q) 0 1q
0.0009 0.01236 0.2 0.8
0 0.00018 0 0.2
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17.5
17.5.1
Exercise
Educational Model
Draw the state transition diagrams for Extensions 1 and 2 as described for the following problem. Suppose that a college offers a course over two years, with an exam at the end of each year written on a pass/fail basis. If a student fails either year, he or she is required to withdraw (RTW). If the student passes Year 1, he or she then enters Year 2. If the student also passes the exam at the end of Year 2, then the student graduates. The pass rate is 80% for Year 1, and 75% for Year 2. Extension 1 The pass rates are the same as before, but students are now allowed to fail once. If the student fails the same year twice, or fails Year 2 having previously failed Year 1, then he or she is required to withdraw. Extension 2 Things are as they were in Extension 1, but now the pass rates depend on the history. The Year 1 pass rate is still 80% for rst-timers, but is 90% for repeaters. The Year 2 pass rate is still 75% for those who have never failed before, but is 60% for those who repeated Year 1 and are now doing Year 2 for the rst time, and is 85% for those who are doing Year 2 for the second time. 17.5.2 Repair Problem
There are two transmission lines from a generating station to a nearby city. Normally, both are operating (up). On any day on which line A is operating, there is probability p that it will go down at the end of the day. On any day on which line B is operating, there is probability q that it will go down at the end of the day. It takes the repair crew a day to repair a broken line. Only one line can be repaired at a time; if both are down, they repair line A rst. Model this situation as a Markov chain. (Hint: there are four states.)
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18
18.1
Utility Theory 1
Introduction
In all the material which we saw earlier on payoff matrices and decision trees, our principal decision criterion was that of expected value. At each point of uncertainty the payoffs were weighted by the probabilities to calculate an expected payoff at that point. This decision criterion works best when a decision is repeated many times. However, this criterion may not be the best in a non-repetitive situation in which a great deal of money is involved. Actual human behaviour often tends to shy away from risky situations in favour of a more certain situation, even when the expected payoff of the former is higher. For example, consider someone who is a contestant on the popular television show Who Wants To Be A Millionaire? Suppose that this person has won (if he or she walks away now) $64,000. If the next question is answered correctly, the contestant will have $125,000, otherwise he or she will be left with just $32,000. The 50/50 lifeline has been used to narrow the correct answer down to two possibilities, but each of these two is equally likely in the contestants eyes. What should the contestant do: guess; or walk away? The expected value criterion (also called expected monetary value or EMV) says that the contestant should guess. The expected value associated with guessing is 0.5($32, 000) + 0.5($125, 000) = $78, 500 This is greater than the value of not guessing (i.e. walking away) which is $64,000. While some contestants would guess in this situation, others would not, preferring the $64,000 for sure. What we want to do in this lecture is to capture this effect in the analysis of competing alternatives. Instead of looking for the alternative with the highest expected payoff, we are now looking for the alternative with the highest expected utility . Where U (x) means the utility of the amount x, the contestant who chooses to walk away is saying that U ($64, 000) > 0.5U ($32, 000) + 0.5U ($125, 000) i.e. the utility of the sure thing is greater than the expected utility of the gamble. We are now looking for the best alternative(s) for a particular individual. Another person may choose to do something quite different. For the individual we need to derive his or her utility function by obtaining a set of data points. These are most easily represented by a graph, but can also be given as a mathematical
280
function. All the work required to make any payoff matrix or decision tree must be done as before, but now every payoff must be converted to the utility of that payoff.
18.2
Obtaining the Data for a Utility Function
The data for a particular individuals utility function is obtained by asking him or her a series of simple questions. For example, the interviewer could start out by saying: Suppose that you are given a choice between having $5000 for sure, or being able to play a game with an equal chance of winning nothing or winning $10,000. Would you (i) prefer the sure thing; (ii) prefer the gamble; or (iii) be indifferent between the two alternatives? Obviously, using expected value as the decision criterion leads to indifference, because the expected value of the gamble (which is 0.5($0) + 0.5($10, 000) = $5000) equals the value of the sure thing. However, the answer to the interviewers question has no right or wrong answer. If in this situation the decision maker says that he or she prefers the sure thing, then that person is said to be risk averse for this situation; this is the usual response. Other possibilities are to prefer the gamble ( risk preferring ) or to be indifferent ( risk neutral ). If the answer is (i) (the sure thing), then the interviewer could ask the following as the next question: We have the same situation as before, but now the sure amount is only $3000. Would you (i) prefer the sure thing; (ii) prefer the gamble; or (iii) be indifferent between the two alternatives? If the person still prefers the sure thing, the question can be repeated, using say $1000. If the person now prefers the gamble (as most people would), the amount of the sure thing can be increased, to say $4000. In this case the third question would be: Now suppose the sure amount is $4000. Would you (i) prefer the sure thing; (ii) prefer the gamble; or (iii) be indifferent between the two alternatives?
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This is repeated going up and down as necessary until we hit the point of indifference. Perhaps at $4000 the decision-maker prefers the sure thing, at $3500 still prefers the sure thing, then at $3400 prefers the gamble, then at $3450 prefers the sure thing, and then nally at $3440 he or she is indifferent between the two alternatives. In other words, U ($3440) = 0.5U ($0) + 0.5U ($10, 000) This critical amount (in this case, $3440) is called the certainty equivalent of the gamble. In general the certainty equivalent (CE) of a gamble is the amount such that the utility of the certainty equivalent equals the expected utility (EU) of the gamble. As an equation this is: U (CE ) = EU (gamble) It is useful to establish a scale for a graph; we can begin the scale by arbitrarily picking two values of the utility function (just as the freezing point and boiling point of water were arbitrarily chosen). For example we can dene: U ($10, 000) = 100 U ($0) = 0 Based on these values we can easily nd the utility of $3440: U ($3440) = 0.5U ($0) + 0.5U ($10, 000) = 0.5(0) + 0.5(100) = 50 We want all subsequent questions to have only one unknown, so that we may solve for it. We can do this by now asking a question based on the utility of $3440, because this is a known point. Also, rather than going up and down until the point of indifference is obtained, we could simply ask for the point of indifference. The question posed to the decision-maker could be: What amount of money would make you indifferent between having this amount for sure, or being able to play a game with an equal chance of winning $3440 or winning $10,000? The expected value of the gamble is: 0.5($3440) + 0.5($10, 000) = $6720
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A risk-averse person will be indifferent at an amount less than this gure. For example, the point of indifference may be at $6420. Using the fact that U ($3440) = 50 (which we just calculated) we obtain: U ($6420) = 0.5U ($3440) + 0.5U ($10, 000) = 0.5(50) + 0.5(100) = 75 Another question that could be asked is: What amount of money would make you indifferent between having this amount for sure, or being able to play a game with an equal chance of winning nothing or winning $3440? The expected value of the gamble is $1720; for a risk-averse decision-maker the certainty equivalent might be only $1180. We then calculate: U ($1180) = 0.5U ($0) + 0.5U ($3440) = 0.5(0) + 0.5(50) = 25 So far we have found the following data points: x U (x) $0 0 $1180 25 $3440 50 $6420 75 $10,000 100
We can plot U (x) as a function of x for these ve points. This is shown in Figure 58. What we want to do now is to draw a curve through these points. There is a whole area of mathematics which is devoted to estimating a function from a set of data points, but were not going to use anything that sophisticated. For our purposes, it will sufce to draw a curve by freehand through the known points. Because each person will draw the curve slightly differently, the numerical values will differ slightly from one person to the next. This decision maker has made this curve already possessing a wealth level. Often the level of a persons wealth will affect his or her attitude to risk. For example, suppose that a student with little money chooses a certainty equivalent
283
100
75 U (x)
50
25
0 $0
$2500
$10,000 $5000 $7500 x - Amount above Current Wealth
Figure 58: Data Points for the Utility Function
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of only $3000 for a 50/50 gamble of $10,000 or nothing. A few days later, the student wins $100,000 in a lottery. Now he or she can afford to take a risk, so now the certainty equivalent of the same gamble may well be closer to the expected value, which is $5000. Because of this, to use a utility function on a decision problem it is important that the persons wealth level does not change between the time that the function was obtained and the function would be used. A possible drawing of the curve is shown in Figure 59. In the caption it is emphasized that this is for dollar amounts beyond the persons wealth level. Indeed, this is how we shall treat all examples, unless indicated to the contrary.
18.3
Using the Graph with a Payoff Matrix
Suppose that the decision maker for whom the graph has been made faces the following situation: Demand Low Medium High $2000 $4000 $8000 $0 $4800 $9400 0.30 0.45 0.25
Keep Existing Capacity Expand Capacity Prob.
If we work out the expected value for each alternative we obtain $4400 for Keep Existing Capacity and $4510 for Expand Capacity. Hence a risk-neutral person would choose to expand capacity for a ranking payoff of $4510. Now, let us see what our risk-averse decision maker would do. One of six dollar gures in the table has a known utility: U ($0) = 0. For the other ve, we must use the graph. For example, to nd the utility of $8000, we start at $8000 on the horizontal axis, go up to the curve, and then go across to the vertical axis. If we do this carefully we see that the utility of $8000 is about 86 or 87. This is shown in Figure 60. Its hard to estimate a number any closer than this (magnication shows that the utility is about 86.5). Using either 86 or 87 would be ne for our purposes. We go through the same procedure for all the dollar amounts in the above table. When this is complete, we create the following utility matrix, and for each alternative, we compute the expected utilities.
285
100
75
U (x)
50
25
0 $0
$2500
Figure 59: The Utility Function Shown as a Smooth Curve
286
100
U (x) 87 75
U (x)
50
25
0 $0
$2500
Figure 60: Finding the Utility of $8000
x = $8000
c April 28, 2010 D.M. Tulett Demand Low Medium High 35 55 87 0 62 96 0.30 0.45 0.25 Expected Utility 57.0 51.9
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Keep Existing Capacity Expand Capacity Prob.
The best alternative is to Keep Existing Capacity. In this example, the optimal alternative is different than the one recommended when using expected value as the decision criterion. This alternative has an expected utility of 57. By drawing a horizontal line through U (x) = 57 until we reach the curve as shown in Figure 61, and then drawing a vertical down from this point, we see that the certainty equivalent is at about $4200. This gure is less than the expected value of $4510, because this risk-averse decision maker is prepared to forego some of the prot to avoid the risk. Recommendation Using expected value as the decision criterion, we would recommend expanding the capacity for a ranking payoff of $4510. However, using the utility function we would recommend for this particular individual that he or she should keep the current capacity. For this person, this alternative has a certainty equivalent of about $4200.
18.4
A More Complicated Graph
The questions which the interviewer poses to the decision maker in order to obtain the points for the graph need not be as straightforward as they are in the example above. For one thing, the probabilities do not have to be equal. Also, we can create utilities outside of the initial scale, meaning that they can be negative (just like temperature). Suppose that an interview has produced the following information: 1. A gamble with a 90% chance of winning nothing and a 10% chance of winning $100,000 has a certainty equivalent (CE) of $25,000. 2. A gamble with an equal probability of winning either $50,000 or $100,000 has a CE of $60,000. 3. A gamble with a two-thirds chance of winning nothing and a one-third chance of winning $50,000 has a CE of $25,000.
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100
75
U (x) U (x) = 57 50
0 $0
$2500
Figure 61: Finding the Certainty Equivalent of U (x) = 57
x $4200 $10,000 $5000 $7500 x - Amount above Current Wealth
25
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4. A gamble with a 0.4 probability of losing $50,000 and a 0.6 probability of winning $50,000 has a CE of 0. 5. A gamble with a 0.45 probability of losing $70,000 and a 0.55 probability of winning nothing has a CE of $50, 000. 6. A gamble with a 2/7 probability of winning $60,000 and a 5/7 probability of winning $100,000 has a CE of $80,000. 7. A gamble with a 5/16 probability of losing $70,000 and a 11/16 probability of losing $30,000 has a CE of $50, 000. For convenience we will express all nancial amounts in thousands of dollars; for example $100,000 is written as 100. Arbitrarily setting U (0) = 0 and U (100) = 100, we work through each of the seven equivalencies to determine the rest of the data points. From the rst we obtain: U (25) = 0.9U (0) + 0.1U (100) = 0.9(0) + 0.1(100) = 10 From the second statement we obtain: U (60) = 0.5U (50) + 0.5U (100) Since both U (50) and U (60) are unknowns, we will have to return to this equation later. From the third statement we obtain a single unknown on the right: U (25) = 10 = 10 =
1 2 3 U (0) + 3 U (50) 2 1 3 (0) + 3 U (50) 1 3 U (50)
From this we obtain U (50) = 30. Knowing this, we can now go back to the second statement to obtain U (60): U (60) = 0.5U (50) + 0.5U (100) = 0.5(30) + 0.5(100) = 65
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If we recognize the unknown before writing the equation, we can start with the unknown on the left. From the fourth equivalency we obtain: 0.4U (50) + 0.6U (50) 0.4U (50) + 0.6(30) 0.4U (50) U (50) The fth equation gives us U (70): 0.45U (70) + 0.55U (0) 0.45U (70) + 0.55(0) 0.45U (70) U (70) Next we nd U (80): U (80) =
2 5 7 U (60) + 7 U (100) 5 2 7 (65) + 7 (100)
= = = =
U (0) 0 18 45 U (50) 45 45 100
= = = =
= = 90
Finally we nd the utility of a loss of $30,000:

5 16 U (70) + 5 16 (100) + 11 16 U (30) 11 16 U (30)
= 500 + 11U (30) = 11U (30) = U (30) =
= U (50) 45 720 220 20
Where x is in thousands of dollars we have obtained the following utility table: x U (x) 70 50 30 0 25 50 60 80 100 100 45 20 0 10 30 65 90 100
To plot these points we need the negative as well as the positive regions for both the horizontal and vertical axes. Plotting these nine points, and drawing a smooth curve through them, gives us the graph shown in Figure 62.
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100

U (x)
50
100
50
50 100 x in Thousands of Dollars
50
100
Figure 62: Graph of the Utility Function for the Second Example
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18.5
18.5.1
Utility Functions
Introduction
It is possible to take the data points from a set of questions about certainty equivalents and from these create a mathematical function. We will not make such transformations ourselves, but we will use exogenously given utility functions. For now, let us assume that the functions are based on changes to the decision makers current wealth level. A Square Root Function An example of such a function is U (x) = 5x + 1000 Since we must have 5x + 1000 0, the domain of this function is x 200. The utility of an amount in the domain, for example, x = $680, is found as: U (680) = 5(680) + 1000 = 4400 = 66.3324958...
For this function, an inverse exists in analytical form. This is useful for when we have found the expected utility of an alternative, and we wish to nd its certainty equivalent. For example, suppose that we have found EU = 97.56. 97.56 9517.9536 8517.9536 1703.59... Hence we have CE = $1703.59. An Exponential Function A modied exponential function is one of the form U (x) = a becx where x is the amount of money in dollars, and a, b, and c are given constants. For our purposes b > 0 and c > 0. This type of function has special properties which we shall examine in the next lecture. 5x + 1000 = = 5x + 1000 = 5x = x
c April 28, 2010 D.M. Tulett For example, where a = 7, b = 3, and c = 0.001, the function is: U (x) = 7 3e0.001x
293
[On some calculators, exponents may be handled as 2nd function ln , or something similar.] At x = $5000, we obtain: U (5000) = = = = = 7 3e 1000 7 3e5 7 3(0.00673795) 7 0.02021384 6.97978616
5000
This type of function has an analytical inverse function, so if we have an expected utility of say 4.9, and if we want the certainty equivalent, we proceed as follows: 4.9 = 3e.001x = e.001x = ln e.001x = .001x = x = The certainty equivalent is $356.675. 18.5.2 A Simple Decision 7 3e.001x 2.1 0.7 ln(0.7) 0.356675 356.675
Here is a simple decision problem in payoff matrix format: O1 90 110 0.6 O2 55 30 0.4
A1 A2 Prob.
We wish to nd the recommended alternative and the certainty equivalent for the following functions:
294
(i) and (ii) We begin (i) rst nding U (90): U (90) = = = = =
U (x) = 3 2e 200 U (x) = 2x + 100

90
3 2e 200 3 2e0.45 3 2(0.637628) 3 1.275256 1.724744
Similarly, we nd U (55), U (110), and U (30), and put these numbers into a utility matrix, and work out the expected utilities on the right. A1 A2 Prob. O1 1.724744 1.846100 0.6 O2 1.480856 1.278584 0.4 EU 1.627189 1.619094
The higher EU is in the A1 row, so we recommend the use of alternative 1. The certainty equivalent is the number CE such that U (CE ) = 1.627189. Hence we solve: 3 2e 200 x 2e 200 x e 200 x 200 x
x
= = = =
= 75.257...
1.627189 1.372811 0.686406 0.376286
The certainty equivalent is about $75.26. Now we solve situation (ii) where U (x) = U (90) = 2x + 100, beginning with x = $90.
2(90) + 100 280 = = 16.733201
295
Similarly, we nd U (55), U (110), and U (30), and put these numbers into a utility matrix, and work out the expected utilities on the right. O1 16.733201 17.888544 0.6 O2 14.491377 12.649111 0.4 EU 15.836471 15.792771
A1 A2 Prob.
As with (i), we recommend alternative 1. The EU of this optimal alternative is 15.836471. We now solve for the certainty equivalent. U (x) 2x + 100 2x + 100 2x x = = = = = 15.836471 15.836471 250.793814 150.793814 75.3969...
The certainty equivalent is about $75.40.
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18.6
18.6.1
Exercise
Problem 1
A golf course is considering whether to expand from 9 holes to 18 holes this coming season, or whether to wait until next year. The payoff for each alternative depends on the weather, which may be rainy, cloudy, or sunny. The payoffs associated with each alternative and outcome are (in thousands of dollars) as follows: Weather Cloudy Sunny 600 800 400 600 0.40 0.25
Alternative Expand now Wait a year Probability
Rainy 100 100 0.35
The company has decided that a $100,000 loss will have a utility of zero and a $1,000,000 prot a utility of 100. Furthermore, they are indifferent in the following four situations. (i) $700,000 for certain; $1,000,000 prot (prob. 0.85) or a $100,000 loss (prob. 0.15). (ii) $700,000 for certain; $1,000,000 prot (prob. 0.25) or $600,000 prot (prob. 0.75). (iii) $600,000 for certain; $700,000 prot (prob.
1 11 ). 10 11 ) 2 3)
or $100,000 prot (prob. or $100,000 prot (prob.
(iv) $400,000 for certain; $600,000 prot (prob.

1 3 ).
(a) What is the recommended alternative using the EMV decision rule? (b) Construct the utility curve. (c) What strategy should the golf course adopt using the expected utility decision rule? (d) What is the certainty equivalent of the optimal strategy?
c April 28, 2010 D.M. Tulett 18.6.2 Problem 2
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An investor is considering whether to expand her business by adding a new small store, or a new large one (or do nothing). The payoff for each alternative depends on the demand, which may be low, medium, or high. The payoffs associated with each alternative and outcome are (in thousands of dollars) as follows: Demand Medium High 0 0 100 300 180 400 0.5 0.3
Alternative Do nothing Small store Large store Probability
Low 0 50 200 0.2
(a) If she is risk-neutral, what should she do? (b) Suppose now that her utility function is U (x) = 1 e 1000 where x is in thousands of dollars. Find the recommended alternative and the certainty equivalent. (c) Suppose now that her utility function is U (x) = x 100
x
where x is her level of wealth in thousands of dollars. Just prior to making the decision, her wealth level is $200,000. Find the recommended alternative, and the certainty equivalent (exclude the current wealth at the end).
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19
19.1
Utility Theory 2
Introduction
We begin this lecture by explaining three properties which may be useful for a utility function to have; only the exponential utility function possesses all three properties. Then, we show how to compute the EVPI when a non-linear utility function is used. We shall see that this is now quite complicated, except when the function is exponential. Thirdly, we illustrate the use of utility functions on a decision tree, which requires that instead of using cost gates and/or payoff nodes, that all payoffs and costs be consolidated on the extreme right-hand branches of the tree.
19.2
Three Useful Properties
Here are three properties that may be useful for a decision makers utility function: 1. More is preferred to less. 2. The decision maker is risk-averse. 3. If the same amount is added to all payoffs, the relative ranking of the alternatives does not change. It seems reasonable that all utility functions would possess the rst property, i.e. the higher the payoff, the higher the utility. The second property (riskaversion) is empirically useful, but of course is not a requirement of all utility functions. We can test a differentiable function for these two properties by taking the rst and second derivatives. The rst property requires that the rst derivative be positive everywhere; the second property requires that the second derivative be negative everywhere. Based on these derivative tests, it can be shown that both square-root type functions and exponential functions obey these two properties. The third property is certainly true when the decision criterion is expected value. Indeed, this was the basis for being allowed to ignore costs or payoffs which are common to all alternatives. However, it turns out that the only type of non-linear utility function for which this is true is the family of exponential utility functions. Several advantages arise because of this third property: 1. The current wealth level of the decision maker is irrelevant.
299
2. The expected value of perfect information (EVPI) is easier to compute than it is for other non-linear utility functions. 3. Any cost or payoff which is common to all cells of a payoff matrix, or common to all ending branches of a decision tree, can be ignored, if desired.
19.3
Finding the EVPI
In this section we show how to calculate the EVPI. The different methods will help illustrate the third property described above. As an example we will use the payoff matrix seen in the previous lecture: A1 A2 Prob. O1 90 110 0.6 O2 55 30 0.4
First, let us recall how to nd the EVPI when the decision criterion is expected value. We compute the EV for each alternative, then nd the EV with PI, and nally subtract the EV of the optimal alternative from the EV with PI. O1 90 110 0.6 O2 55 30 0.4 EV 76 78
A1 A2 Prob.
Hence a risk-neutral person would choose alternative 2 with a ranking payoff of $78. The EV with PI is 0.6($110) + 0.4($55) = $88, and the EVPI is therefore $88 $78 = $10. With an exponential utility function the approach is more complicated but similar. From the previous lecture we had the utility function: U (x) = 3 2e 200 Using this formula we found: A1 A2 Prob. O1 1.724744 1.846100 0.6 O2 1.480856 1.278584 0.4 EU 1.627189 1.619094
x
300
We found the CE of 1.627189 to be about $75.26. To nd the EVPI using the exponential, we must nd the CE of the EU with PI, and from this subtract the CE of the optimal alternative. EU with PI = 0.6(1.846100) + 0.4(1.480856) = 1.7000024 To nd the CE of this we solve: 3 2e 200 x 2e 200 x e 200 x 200 x
x
= = = =
= 86.15695...
1.7000024 1.2999976 0.6499988 0.4307848
Hence the CE of the EU with PI is about $86.16. Hence the EVPI is about: EVPI = CE(EU with PI) CE(optimal alternative) = $86.16 $75.26 = $10.90 The method for nding the EVPI for non-linear utility functions in general (i.e. other than the exponential) is more complex. As before, we will use the utility function U (x) = 2x + 100 to illustrate the method. The utility matrix which we found in the previous lecture is not used to nd the EVPI, except for the EU of the optimal alternative. Instead, we imagine that perfect information is available for a fee, and we let the symbol f represent the amount of the fee. The dollar amounts from the original matrix are: O1 O2 90 55 110 30 0.6 0.4
A1 A2 Prob.
After paying f to obtain perfect information, we are told that the outcome will be O1 with probability 0.6, and we are told that the outcome will be O2 with
301
probability 0.4. If O1 will occur, we want alternative 2, with a gross payoff of $110. Because we must pay f to hear the information, the net dollar payoff is $110 f . If O2 will occur, we want alternative 1, for a net payoff of $55 f . In summary, after paying f to hear the perfect information, there is probability 0.6 of obtaining a net payoff of $110 f , and probability 0.4 of obtaining a net payoff of $55 f . Now we bring in the utility function to nd the utility of each net payoff: U (110 f ) = = 2(110 f ) + 100 320 2 f
U (55 f ) =
2(55 f ) + 100 210 2 f
Therefore, the expected utility with having paid f to obtain perfect information is: 0.6 320 2 f + 0.4 210 2 f EU 15.836471 15.792771
We recall the following utility matrix from the preceding lecture: A1 A2 Prob. O1 16.733201 17.888544 0.6 O2 14.491377 12.649111 0.4
Hence the EU obtained without perfect information is 15.836471. The EVPI is the amount f such that the decision maker is indifferent between obtaining or not obtaining perfect information. In other words, we seek the value of f such that: 0.6 320 2 f + 0.4 210 2 f = 15.836471
We are left with one equation in one unknown. An equation like this one was seen in Chapter 1 of Mathematics for Management Science. It is possible to obtain an analytical solution for this example by squaring both sides, simplifying, and then squaring both sides again, and then simplifying again. Such a solution would take a great deal of work. Instead of doing it this way, we will obtain a numerical solution using Goal Seek on Excel. Leaving cell A1 reserved for the value of f , we put the following into cell B1: =0.6*SQRT(320-2*A1)+0.4*SQRT(210-2*A1)
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We then use Goal Seek, setting cell B1 to the value of 15.836471, by changing cell A1. The number which Excel puts into cell A1 is 11.0877. This is the critical value of f which causes indifference between obtaining or not obtaining perfect information, and this is the EVPI. To the nearest cent, the EVPI is $11.09.
19.4
Using Utility Functions with Decision Trees
When a decision tree is made for a decision-maker with a non-utility function, several changes must be made to what we saw earlier. First, all costs must be imbedded at the end (on the right); there are no cost gates on the tree. Secondly, all payoffs must be imbedded at the end; there are no payoff nodes. This means that at each ending branch we must work out the net payoff, and then we nd the utility of each of these nal payoffs. The rollback proceeds as usual, except that we are rolling back the expected utility rather than the expected value. When the rollback is complete, it is useful to nd the certainty equivalent of the optimal expected utility. We will illustrate this procedure using a problem which we saw much earlier in the course in Lecture 8. The problem description is repeated here: An oil exploration company has identied a site under which there may be a pocket of oil. The probability that oil exists at this location is 1%. It would cost $3,000,000 to drill for oil. If the oil exists, it would be worth $40,000,000. A seismic test is available which would cost $40,000. The result of the test would be one of the following: positive,inconclusive, or negative. If there really is oil present, then there is a 60% chance of a positive reading, a 30% chance of an inconclusive reading, and a 10% chance of a negative reading. If theres no oil at that location, then theres a 0.04 probability of a positive reading, and a 0.2 probability of an inconclusive reading. As before, we wish to develop a decision tree for this situation, and solve it to obtain a recommendation for the oil exploration company, but now we will use the utility function: U (x) = 2x + 7 where x is in millions of dollars. We already know what the shape of the tree is. All that is different is that we no longer have cost gates as we did before. The tree without any of the revised probabilities or any of the nancial information is shown in Figure 63. The Bayesian
303
revision is unchanged; it appears in Figure 21. Putting the revised probabilities on the tree gives us Figure 64. The dollar amount to be placed at the end of every nal branch reects all payoffs and costs on the path between the rst decision node and the nal branch. For example, at the top of the tree after the no seismic alternative we have the drill alternative followed by the oil outcome. This gives us: $3, 000, 000 + $40, 000, 000 = $37, 000, 000 After no oil, we have the cost of the drilling with no offsetting revenue, hence the payoff is $3,000,000. Completing this portion of the tree, the path containing the do not drill alternative has neither payoffs nor costs, and so the net payoff is $0. The $40,000 cost of the seismic test must be imbedded at the end, hence after seismic, drill and oil the net payoff is: $40, 000 $3, 000, 000 + $40, 000, 000 = $36, 960, 000 Similarly the other two gures are also reduced by $40,000: after seismic, drill, and no oil the net payoff is $3, 040, 000; after seismic and do not drill the net payoff is $40, 000. These three gures appear in three places. Because we will be putting utilities onto the tree, we will put a dollar sign in front of all nancial gures for emphasis. The tree with all the nancial information added to the right of every nal branch is shown in Figure 65. The dollar amounts must be converted to the utility of each of these amounts. Since the utility function is based on x being in millions of dollars, for a gure of $37,000,000 we input 37 into the formula. This gives: U (37) = 2(37) + 7 = 81 = 9
For $3, 000, 000, we input 3 into the formula: U (3) = 2(3) + 7 = 1 = 1
304
Oil Event
Drilling for Oil

do not dril l
0 $$ 0.$ l $$ oi $ $ $n o oil 3 3 3 l l 3 0.99 i 3 r3 d 3 3 3 3 3 3 3 3 3 33
Oil Event
$ l $$$$ i o $ $$ no oil 3 3 3 l l3 i3 3 r3 d 3 3 3 3 3 3 3 3 33
ic ism se Seismic no Testing
do not dril d d l d s d d eis d $$$ $ l i $ o m $ d i Seismic ve d $$ i no oil d c te Event t d 3 i 3 3 s ll 3 Drilling i3 3 r3 d st d d po 3 3 3 d 3 d for Oil 3 3 3 3 d d 3 3 d inconclusive d
d ne d gat d ive d d d d d d d
do not dril l $ l $$$$ i o $ $$ no oil 3 3 3 l l 3 i 3 r d 3 3 3 3 3 3 3 3 3 3 33 do not dril l
Figure 63: Seismic Testing Structure of the Tree
Oil Event
Drilling for Oil

do not dril l
01$$ 0.$ $ l i $ o $ $$ no oil 3 3 3 0.99 ill 3 3 r3 d 3 33 3 3 3 3 3 3 3 3 58 $ 1$ .13 $ 0 $ l i $ o $ $$ no oil 3 3 3 l 0.868 l 3 i 3 r 3 d 3 42 3 3 3 3 3 3 3 3 3 3

do not dril l 93 $ 4$ .01 $ 0$ l$ i o $ $$ no oil 3 3 3 l 0.985 l3 i3 3 r3 d 0 7 3 3 3 3 3 3 3 3 3 3
Oil Event
d d 56 4 d s d .0 d eis 0 d m d i Seismic ve d i d c te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d 0.201 d ne d gat d ive d 0 d .7 d 5 34 d d d d
do not dril l 33 $ 1$ .00 $ 0$ l i $ o $ $ $n o oil 0 3 3 3 l l 3 i .9986 3 r3 d 3 7 3 3 3 3 3 3 3 3 33 do not dril l
305
Figure 64: Seismic Testing Tree with Revised Probabilities
306
Oil Event $37,000,000
Drilling for Oil $3,000,000

do not dril l
0 $$ 0.$ l $$ oi $ $ $n o oil 3 3 3 l l 3 0.99 i 3 r3 d 3 3 3 3 3 3 3 3 3 33
Oil Event
$0
3 33
58 $ $36,960,000 1$ .13 $ 0 $ l i $ o $ $$ no oil 3 3 3 l 0.868 l3 i3 3 r3 d 42 3 3 $3,040,000 3 3 3 3 3
$36,960,000
do not dril d 6 d l 5 4 d s d 3 0 $40,000 014$ . d eis 0 . $9 $ d 0$ l i $ o m $ d i Seismic ve d $$ i no oil d c te Event t d 3 i 3 3 s 0.985 ll 3 Drilling i3 3 r3 d st d d 0 7 po 3 3 3 d 3 d for Oil 3 3 3 3 d d 3 3 d inconclusive d
$3,040,000
0.201 d ne d gat d ive d 0 d .7 d 534 d d d d
$36,960,000
do not dril l 3 $40,000 001$ . $3 $ 0 $ l i $ o$ $$ n o oil 0 3 3 ll 3 i3 .9986 33 r3 d 7 3 3 3 3 3 3 3 3 33 do not dril l
$3,040,000
$40,000 Figure 65: Seismic Testing Complete Formulation of the Tree
307
It is just good fortune that we have two perfect squares. None of the other numbers work out exactly. For a payoff of $0, we input 0, to obtain: U (0) = 2(0) + 7 = 7 2.64575
For $36,960,000, $3, 040, 000, and $40, 000, we input 36.96, 3.04, and 0.04 respectively. U (36.96) = 2(36.96) + 7 = 80.92 8.99555 2(3.04) + 7 0.92 = 0.95917 2(0.04) + 7 = 6.92 2.63059
U (3.04) =
U (0.04) =
Note that if we were to use for example only two places after the decimal point, this would not be sufcient. For there to be any effect caused by doing the seismic test, we must have U (36.96) < U (37). By using ve places, we certainty cause this to be true. Putting all the utilities next to the dollar amounts at the end of the branches, we obtain Figure 66. These utilities are highlighted. We then rollback the utilities ; the rollback is shown in Figure 67. Also on this diagram the recommended course of action has been highlighted. The corrsponding utility is about 2.64575 (exactly 7); the certainty equivalent is $0. Recommendation The investor should do nothing (i.e. do not use the seismic, and do not drill). This course of action has a certainty equivalent of $0.
308
Oil Event $37,000,000 9.0 $3,000,000 1.0
Drilling for Oil

do not dril l
0 $$ 0.$ l $$ oi $ $ $n o oil 3 3 3 l l 3 0.99 i 3 r3 d 3 3 3 3 3 3 3 3 3 33
Oil Event
2.64575 $0
58 $ $36,960,000 1$ .13 $ 0 $ l i $ o $ 8.99555 $$ no oil 3 3 3 l 0.868 il 3 3 r3 d 42 3 33 $3,040,000 3 3 3 3 3 3 33 0.95917 do not dril 2.63059 d 6 d l 5 4 d s d 3 $40,000 014$ .0 d eis 0 . $ 9 $ $36,960,000 d 0$ l i $ o m $ d i Seismic ve 8.99555 d $$ i no oil d c te Event t d 3 i 3 3 s 0.985 ll 3 Drilling i3 3 r3 d st d d 0 7 po 3 3 3 d 3 d for Oil $3,040,000 3 3 3 3 d d 3 3 d inconclusive d 0.95917 0.201 do d ne not dril d gat 2.63059 l d ive $40,000 .001$ 33 d 0 $ $ $36,960,000 0 $ l i $ o$ d .7 8.99555 $$ d 534 n o oil 0 3 3 3 l l i 3 .9986 3 d r3 d 7 3 33 d 3 3 $3,040,000 3 3 3 d d 3 33 0.95917 do not dril 2.63059 l $40,000
Figure 66: Seismic Testing Utilities on the Final Branches
Oil Event $37,000,000 9.0 $3,000,000 1.0 $36,960,000 8.99555 $3,040,000 0.95917
Drilling for Oil 2.64575

do not dril l
01$$ 0.$ $ l i $ o $ $$ no oil 3 3 3 0.99 ill 3 3 r3 d 3 33 3 3 1.08 3 3 3 3 3 3
Oil Event
58 $ 1$ .13 $ 0 $ l i $ o $ $$ no oil 3 3 3 l 0.868 l 3 i 3 r 3 d 3 42 3 3 3 3 2.01659 2.63059 33 3 3 3 3
2.64575 $0
d 2.64575 d d s d d eis d dm d
56 4 0 0.
Seismic ve i i d c te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d
do not dril 2.63059 l 3 $40,000 014$ . $9 $ 0$ l$ i o $ $$ no oil 3 3 3 l 0.985 l3 i3 3 r3 d 0 7 3 3 3 3 1.07915 3 3 3 3 3 3
$36,960,000 8.99555 $3,040,000 0.95917
0.201 do d n not 2.63059 dega 2.63059 dril 2.63059 l t d ive 3 $40,000 001$ d 0 . $3 $ 0$ l i $ o . d 7 $ $$ d 5 34 n o 3 oil 0.9 3 ll 3 i3 33 d r3 9867 d 3 3 d 3 3 0.96986 3 3 3 3 d d 3 3
$36,960,000 8.99555 $3,040,000 0.95917 309
2.63059
do not dril l
2.63059 $40,000
Figure 67: Seismic Testing Rolled-Back Decision Tree
310 19.4.1 The EVPI
As with any problem using Bayesian revision, it is possible to nd the EVPI, and then compare this with the cost of doing the testing. If the EVPI < the cost of testing, we need not evaluate the testing alternative. In this example perfect information costing f (in millions of dollars) would lead us to drill if there is oil (prob. 0.01) which gives a utility of 2(37 f ) + 7, or lead us not to drill if there is no oil (prob. 0.99) with a utility of 2(0 f ) + 7. The current EU is 2.64575, hence we wish to solve: 0.01 2(37 f ) + 7 + 0.99 2(0 f ) + 7 = 2.64575 which simplies to: 0.01 81 2 f + 0.99 7 2 f = 2.64575 We put the following formula into cell B1: =0.01*SQRT(81-2*A1)+0.99*SQRT(7-2*A1) We then use Goal Seek with cell A1 reserved for f , and B1 being set equal to 2.64575. We nd the solution to be f = 0.167934. Therefore, since f is in millions of dollars, the EVPI is $167,934. Since the cost of doing the seismic ($40,000) is less than the EVPI, we cannot exclude the possibility that the seismic is worth doing. Hence we needed to work out the solution on the entire tree.
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19.5
19.5.1
Exercise
Problem 1
This is a repetition of the second problem from the previous lecture, except that now the problem is to determine the EVPI for each of the three situations. You will need some of the answers from the previous exercise. An investor is considering whether to expand her business by adding a new small store, or a new large one (or do nothing). The payoff for each alternative depends on the demand, which may be low, medium, or high. The payoffs associated with each alternative and outcome are, (in thousands of dollars), as follows: Alternative Do nothing Small store Large store Probability (a) She is risk-neutral. (b) Her utility function, where x is in thousands dollars, is: U (x) = 1 e 1000 (c) Her utility function is U (x) = x 100
x
Demand Low Medium High 0 0 0 50 100 300 200 180 400 0.2 0.5 0.3
where x is her level of wealth in thousands of dollars. Just prior to making the decision, her wealth level is $200,000. Use Goal Seek to nd the EVPI numerically. 19.5.2 Problem 2
Reformulate the Niagara Winery problem (rst seen in Section 5.5), putting all costs and payoffs onto the ends of the nal branches. Where x is in millions of dollars, Betty now uses the utility function: U (x) = 1 e 2 Solve to obtain a recommendation for Betty, and calculate the certainty equivalent.
x
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20
20.1
Game Theory 1
Introduction
In the material which we saw on making decisions in the presence of uncertainty, there was only one decision maker. Now in this material on game theory , we look at two decision makers in competition with each other. This competition is treated like a game, and we refer to each decision maker as a player . We will generically refer to these two persons as Player A and Player B. In order to keep the complexity manageable, we restrict the competition to two players, rather than more than two. Also, we must make some assumptions about their behaviour: 1. Both players know each others possible moves, and the payoff for each player for each combination of moves. 2. The players make their moves simultaneously (i.e. one player cannot wait to see what the other player does). 3. Each player tries to do what is best for himself or herself (i.e. there is no cooperation with the other player). 4. For any combination of moves, the two players share the same total net payoff; this is called a constant-sum game . A special case of this is the zero-sum game , in which the gain to one player is equal in absolute value to the loss of the other player. At the end of this lecture we will relax the last assumption. Doing this allows us to investigate what is called the prisoners dilemma . Both the terms zero-sum game and prisoners dilemma are widely used in nancial and economic publications. Unless specically indicated to the contrary, we speak of the payoffs to a player, a positive number meaning that the player receives something and a negative number meaning that the player loses that amount. For a zero-sum game, only one payoff table needs to be written. The table is written such that the player on the left (we will call him/her Player A) obtains the payoffs shown. The player on top (Player B) obtains the negative of the payoffs shown.
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20.2
Pure Strategy
Some games are simple in that they lead to each player always choosing the same alternative. When this happens each player is said to be following a pure strategy . Here are two examples. 20.2.1 Example 1
In this simple example Player A has two alternatives labelled as A1 and A2, and Player B has two alternatives labelled as B1 and B2. Suppose that are given the payoffs shown in the following table: Player B B1 B2 3 7 2 5
Player A1 A A2
For example, if Player A plays A1, and if Player B plays B2, then Player A will receive $7 from Player B, i.e. a gain of $7 for A, and a loss of $7 for B. We do not need to use (or even see) the table from Player Bs perspective, but it is simple to nd, being the negative of the transpose of the original table. Player A A1 A2 3 2 7 5
Player B
B1 B2
Going back to the original table, we now determine what each side should do. In this example, Player A will always do better with A1 rather than A2, no matter what Player B does: A1 A2 3 7 2 5
Therefore, Player A chooses to play A1. To look at things from Bs perspective, we must remember that the payoffs are to Player A, so Player B wants low numbers. Player B looks at the table and sees: B1 B2 3 7 2 5
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Player B chooses the column with the lower numbers, i.e. Player B chooses B1. Because each player has found an alternative which he or she prefers, we say that this game has a stable solution (also called a saddle-point solution ). When a game has a stable solution, each player will pursue a pure strategy. Here we have a stable solution with Player A choosing A1 and Player B choosing B1. The payoff located at the interception of these two alternatives is called the value of the game . In this example, this value is 3. It is the payoff to the player on the left, and represents a loss of 3 for the player on top. We summarize this game as follows: There is a stable solution, with Player A choosing A1 and Player B choosing B1, and the value of the game is $3. Right on the table we can highlight the preferred alternatives and the value of the game: Player B B1 B2 3 7 2 5
Player A
A1 A2
There is a simple condition to check to see if a game has a stable solution. Stability is obtained if and only if the maximum of the row minimums (maximin) equals the minimum of the column maximums (minimax). In this example: max{min{3, 7}, min{2, 5}} = = and min{max{3, 2}, max{7, 5}} = = max{3, 2} 3 min{3, 7} 3
Both maximin = 3 and minimax = 3, so maximin = minimax, and we have therefore a stable solution. In general, one could start with a game theory table by seeing if maximin = minimax. When this condition is true, maximin or minimax is the value of the game, and the optimal solution is to play the corresponding alternatives. However, since this condition rarely holds, the methods to be shown later in this module and the next are of more practical benet. 20.2.2 Example 2
The number of alternatives for each player need not be equal. Here is an example:
c April 28, 2010 D.M. Tulett Player B B2 B3 B4 6 8 5 9 1 7 3 9 2
315
Player A
A1 A2 A3
B1 7 6 10
Though all work is done in practice on one table, here we repeat the table several times to show each step clearly. We begin with nding maximin. In every row, we nd the minimum in that row, and write this number down on the right. Then we nd the maximum of the row minimums. Doing this much we have: Player B B1 B2 B3 B4 7 6 8 5 6 9 1 7 10 3 9 2 row minimums 6 9 3 max
A1 Player A A2 A3
Then in every column, we nd the maximum in that column, and write this number down on the bottom. Then we nd the minimum of the column maximums. This yields: B1 7 6 10 10 Player B B2 B3 B4 6 8 5 9 1 7 3 9 2 3 9 2 min row minimums 6 9 3 max
A1 Player A A2 A3 column maximums
Hence we see that both maximin and minimax are 3, so we have a pure strategy: Player A chooses A3; and Player B chooses B2. Highlighting the solution on the table we have: Player B row B1 B2 B3 B4 minimums A1 7 6 8 5 6 Player A A2 6 9 1 7 9 A3 10 3 9 2 3 max column 10 3 9 2 maximums min
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20.3
Mixed Strategy
Unfortunately, very few games are played with a pure strategy, but instead must be played with a mixed strategy in which the players will vary the chosen alternative. The next example will illustrate that maximin and minimax are not equal, and when this happens, a mixed strategy must be played by each player. 20.3.1 Example Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 2
A1 Player A A2 A3 A4
We begin to solve the problem by checking for the existence of a pure strategy: Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 2 7 6 5 min row minimums 4 max 1 2 2
Player A
A1 A2 A3 A4 column maximums
Unfortunately, we see that the maximum of the row minimums, which is 4, is not equal to the minimum of the column maximums, which is 5. Therefore, the game does not have a pure strategy. We must therefore do more work to nd the solution. There is a procedure using linear optimization which we shall see at the end of the next lecture for solving two-player zero-sum games. Rather than cover this right away, we shall see how some mixed-strategy solutions can be found quite easily. 20.3.2 Dominance
If one alternative is always better than another for one of the players no matter what his or her opponent does, then the better alternative is said to dominate over
317
the other. The dominated (worse) alternative can be removed from further consideration, while the dominant (better) alternative stays. We can observe dominance when comparing two rows (the higher payoff row dominates), or when comparing two columns (the lower payoff column dominates). We eliminate dominated alternatives, hence dominance eliminates lower payoff rows and higher payoff columns. When we say higher payoff row, we mean that in each column the higher payoff row has a payoff which is greater than or equal to the payoff in the other row, and for at least one column the relationship is strictly greater than. For example, a row such as 2 7 3 would dominate a row such as 1 5 3. When we say lower payoff column, we mean that in each row the lower payoff column has a payoff which is less than or equal to the payoff in the other column, and for at least one row the relationship is strictly less than. We start looking for dominance among either the rows or the columns. Once a row or column is dominated, it is removed from further consideration. We will show this removal by darkening the removed row or column, and put a number beside it to indicate the order of the removal. At the outset we have for this example: Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 2
Player A
A1 A2 A3 A4
All the work is done on one table, but we will show each step to help make the method clear. If we compare A1 with A2, we see that neither dominates the other; 7 4, but 2 6, so this comparison ends without even looking at the 1 and the 5. However, in comparing A1 and A3, we see that: A1 A3 4 6 5 3 2 4
Hence A1 dominates A3, and the A3 row is therefore removed from further consideration. We put a 1 followed by A1 next to the A3 row to indicate that this is the rst row or column to be removed, and the justication for doing so is that it is dominated by A1:
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c April 28, 2010 D.M. Tulett Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 2
Player A
A1 A2 A3 A4
A1
Comparing A1 with A4, we see that neither dominates the other. Also, A2 neither dominates nor is dominated by A4. Having compared all pairs of rows, we turn our attention to the columns. Comparing B1 and B2, we nd no dominance. Also, comparing B1 and B3 there is no dominance. Now we compare B2 and B3: B2 6 2 3 B3 5 1 2
Note that what lies underneath the A3 row is immaterial, because the A3 row has been removed. Player B will choose to remove the higher payoff column (since these are payoffs to Player A). Hence column 3 dominates over column 2, and column 2 is removed. Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 2 2 B3
A1 Player A A2 A3 A4
A1
Having checked all pairs of columns, we now return to the rows. We check the pairs A1 and A2, then A1 and A4, and then A2 and A4. For the last of these we nd that with B2 having been removed, A2 dominates A4: A2 A4 7 1 5 2
c April 28, 2010 D.M. Tulett We remove A4 leaving us with: Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 2 2 B3
319
Player A
A1 A2 A3 A4
1 3
A1 A2
There is no further dominance. Using dominance we have reduced a 4 by 3 table down to a 2 by 2: A1 A2 B1 4 7 B3 5 1
In a mixed strategy, each player will choose his or her alternatives by using probabilities, where it is understood that there is no probability of choosing a dominated alternative. We let p be the probability that Player A chooses A1. Since Player A must choose either A1 or A2, the probability that Player A chooses A2 is 1 p. If Player B chooses B1, the expected payoff is 4 p + 7(1 p). If Player B chooses B3, the expected payoff is 5 p + 1(1 p). Similarly, q and 1 q are the probabilities that Player B chooses alternatives B1 and B3 respectively. If Player A chooses A1, the expected payoff is 4q + 5(1 q). If Player A chooses A2, the expected payoff is 7q + 1(1 q). The four expected payoffs are equal and are referred to as the Expected Value (E.V.) of the game. Hence we have: B1 B3 4 5 7 1 q 1q 4 p + 7(1 p) 5 p + 1(1 p) Prob. E.V. p 4q + 5(1 q) 1 p 7q + 1(1 q)
A1 A2 Prob. E.V.
We need to determine p, q, and the Expected Value of the game. Player A chooses p so that the expected payoff does not depend on what Player B does. This is accomplished by setting the two expressions for the Expected Value equal to one another, and solving to obtain p.
320
5 p + 1(1 p) p p 7p 6 p = 0.8571 7 Hence the expected value of the game is:

6 4 p + 7(1 p) = 4( 6 7 ) + 7(1 7 ) 24 7 = + 7 7 31 = 7 4.429
4 p + 7(1 p) 6(1 p) 6 6p 6
= = = =
Player B chooses q such that Player A has no advantage to choosing one or the other, which is accomplished by setting the two expected payoffs equal to each other and solving for q. 7q + 1(1 q) 3q 3q 7q 4 q = 0.5714 7 The expected value of the game has already been found, but we might want to nd it again as an arithmetic check. Any one of the four expressions for the expected payoff can be used: p with B1 chosen p with B3 chosen q with A1 chosen q with A2 chosen 4 p + 7(1 p) 5 p + 1(1 p) 4q + 5(1 q) 7q + 1(1 q) 4q + 5(1 q) 4(1 q) 4 4q 4 = = = =
For example, using the third of these we obtain:

4 4q + 5(1 q) = 4( 4 7 ) + 5(1 7 )
c April 28, 2010 D.M. Tulett 16 15 + 7 7 31 = 7 4.429 =
321
In expressing the solution, fractions or decimals can be used for the probabilities, but usually the expected value of the game is expressed in decimal form. The next section gives an easier approach for nding these things starting from a 2 by 2 table; the recommendation is presented at that point. 20.3.3 DARS Algorithm
After using dominance to reduce the table to a 2 by 2, we can combine all the above operations into one easy method, called the DARS Algorithm. The four letters stand for: D A R S Difference (always an absolute value) Add Ratio Switch
The procedure is all done on one table, but we show it here broken into several steps. First we add space to the right and on the bottom of the table for the operations D, R, and S. B1 4 7 B3 5 1 D R S
A1 A2 D R S
The rst thing to do is to nd the absolute value of four differences. In the A1 row, |4 5| = | 1| = 1 goes into the D column. In the A2 row, we have |7 1| = 6. Next, in the B1 column, we put |4 7| = 3 into the D row, and in the B3 column, we put |5 1| = 4 into the D row. This gives:
322 B1 4 7 3 B3 5 1 4 D 1 6 R
c April 28, 2010 D.M. Tulett S
A1 A2 D R S
Next, we add (this is the A of DARS) the numbers in the D column (1 + 6 = 7) and the D row (3 + 4 = 7). No matter what the original four numbers may be, the two sums must be the same. The sum is placed where the D column and the D row intercept. A1 A2 D R S B1 4 7 3 B3 5 1 4 D 1 6 7 R S
The ratio (R of DARS) refers to the fraction obtained by dividing the number in the neighbouring D column or row by the sum we just obtained. For example, 1 . Filling in the four ratios we in the A1 row, the ratio is 1 divided by 7. i.e. 7 obtain: A1 A2 D R S B1 4 7 3
3 7
B3 5 1 4
4 7
D 1 6 7
R
1 7 6 7
Finally, the ratios are switched: the R column is switched to obtain the S column; and the R row is switched to obtain the S row. This gives: A1 A2 D R S B1 4 7 3
3 7 4 7
B3 5 1 4
4 7 3 7
D 1 6 7
R
1 7 6 7
S
6 7 1 7
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Now in each row and column we have the desired probabilities, for example Player A will play A1 with probability 6 7 , and so on. We now nd the expected value; as before, there are four ways to do this. We can obtain the dot product of any one of: the B1 column and the S column; the B3 column and the S column; the A1 row and the S row; and the A2 row and the S row. The latter two operations are like what we did earlier with payoff matrices, so they may be more intuitive. For example, doing the fourth option yields:
3 3 7( 4 7 ) + 1( 7 ) = 4 + 7 4.429
Recommendation
6 Player A should play A1 with probability 7 , and A2 with probability 1 7 . Player B 3 4 should play B1 with probability 7 , and B3 with probability 7 . The expected value of the game is 4.429.
20.4
Prisoners Dilemma
Here we present a situation which is not a zero-sum (or constant-sum) game. It is important because it has implications for the study of collusion in business. 20.4.1 Situation Description
A armed robbery has taken place. The police have caught two men named Murphy and Smith with the goods in their possession. Getting a conviction against both of them for possession of stolen property would be easy, but theres not enough evidence at the scene of the crime to obtain a conviction for the armed robbery as well. However, if either of them confesses, the confession along with other corroborating evidence from the crime scene would be enough to convict the other suspect, should he not confess himself. The police have put each suspect into a separate interview room. To one suspect they say: Murphy, you know that we got you on the possession charge. That alone will get you two years in jail. Smith is down the hall if he confesses to the armed robbery, youre going away for 15 years. Why let him do that to you? Tell us you did it, and heres what well do. If he doesnt confess, well use your testimony to convict him, and for co-operating, well not only let you off the armed robbery charge but well knock a year off the possession sentence. If he confesses,
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then we dont need your testimony, but for being cooperative, we will give you just ve years rather than fteen. Down the hall a police ofcer is speaking to Smith. He gives the same offer using exactly the same words, except that the surnames have been switched. 20.4.2 Solution
Let us assume that both men did indeed commit the armed robbery, so there is no possibility of a false confession. The payoffs are not money but the number of years in jail. To consider them as payoffs rather than costs all these numbers are negative. The choices for each player are i) do not confess; and ii) confess. The game payoff table is: Smith Do Not Confess Confess 2 15 1 5
Murphy
Do Not Confess Confess
We see that confessing dominates not confessing, so Murphy will confess. Smith has the same table: Murphy Do Not Confess Confess 2 15 1 5
Smith
Do Not Confess Confess
Therefore, Smith will also confess. The problem from their perspective (not societys) is that the closed communication prevents them coming up with a solution which is better for them. By confessing, each receives ve years, but if neither man confesses, each receives only two years. This is the dilemma which each man faces: to do what looks best for himself assuming the worse from the other man; or do what is best for both of them, which requires that the other man does likewise.
20.5
Obtaining the Payoffs
We now return to constant-sum games, and we wish to obtain the numbers in the table. Here is an example:
c April 28, 2010 D.M. Tulett Jack and Jill are playing a game in which each player secretly puts two, three, four, or ve marbles into his or her hand, and then they simultaneously open their hands. If the total number of marbles is odd, then Jack gets all the marbles in their hands. If the total number of marbles is even, then Jill gets all the marbles in their hands.
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In this problem, the payoff is the net number of marbles gained or lost. For example, if Jack puts three marbles into his hand, and if Jill puts two marbles into her hand, then the sum of ve is odd, so Jack obtains the ve marbles from their hands, but three of these came from his pocket in the rst place, so there is a net gain of two marbles, i.e. Jack has won the two marbles in Jills hand. As another example, suppose that Jack plays three and Jill plays three, then the sum of six is even, so Jill gains three marbles from Jack. In the payoff table from Jacks perspective, Jack has lost three marbles to Jill, so the payoff is 3. Working out all sixteen combinations we obtain: Jills # of Marbles 2 3 4 5 2 3 2 5 2 3 4 3 4 3 4 5 2 5 4 5
Jacks # of Marbles
2 3 4 5
The solution of this problem is left as part of the exercise.
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20.6
20.6.1
Exercise
Mixed Strategy Game
Players X and Y are playing a zero-sum game. The payoffs to player X are: X1 X2 X3 X4 Y1 Y2 4 2 6 0 3 1 12 1 Y3 Y4 0 1 6 5 7 6 3 4
Determine the optimal strategy for each player, and nd the expected value of the game. 20.6.2 Jack and Jill Problem
Jack and Jill are playing a game in which each player secretly puts two, three, four, or ve marbles into his or her hand, and then they simultaneously open their hands. If the total number of marbles is odd, then Jack gets all the marbles in their hands. If the total number of marbles is even, then Jill gets all the marbles in their hands. The payoff table is seen to be: Jills # of Marbles 2 3 4 5 2 3 2 5 2 3 4 3 4 3 4 5 2 5 4 5
Jacks # of Marbles
2 3 4 5
Determine how Jack and Jill should play this game, and nd the expected value of the game. 20.6.3 Formulation Problem
Players A and B are playing a game in which A shows either one or two ngers, and B simultaneously shows none, one, or two ngers. If the sum of the number of ngers is even, then A wins the sum in dollars from B. If the sum is odd, then B wins the sum in dollars from A. Write the payoff matrix from As perspective. (Do not solve)
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21
Game Theory 2
In the previous lecture we saw that a 2 by 2 mixed-strategy game could be solved by hand using the DARS algorithm. Examples which were larger than a 2 by 2 were solvable provided that through the use of dominance the problem could be reduced to a 2 by 2. In this lecture we shall see that a solution by hand is possible as long as one of the players has (or can be reduced to) only two alternatives. Starting with any size matrix, we need to reduce it using dominance to either a 2 by 3, a 2 by 4, and so on, or else a 3 by 2, a 4 by 2 and so on. Then, by using a graphical procedure, we further reduce the problem to a 2 by 2, after which it can be solved using the DARS algorithm. Some problems are not reducible to either two rows or two columns. For such examples the hand procedure will not work, nevertheless we can still obtain a solution. To do this we model the problem as a linear optimization model. This technique allows us to solve any zero-sum (or constant-sum) game.
21.1
Graphical Solution
We present two examples of zero-sum games. In the rst, the table is rst reduced using dominance to two rows before proceeding with the graphical solution. In the second, the table is rst reduced to two columns. 21.1.1 Example 1 A1 A2 A3 A4 B1 3 4 5 2 B2 B3 B4 B5 3 6 2.5 2 3 4 1 2 2.5 4 2 1 3.5 7 4 3
It is easily seen that this example has no pure strategy. Using dominance we obtain: B1 B2 B3 B4 B5 A1 3 3 6 2.5 2 1 A4 A2 4 3 4 1 2 3 A3 A3 5 2.5 4 2 1 A4 2 3.5 7 4 3 2 B2
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With the dominated rows and column removed, the problem reduces to: A3 A4 B1 5 2 B2 B3 B5 2.5 4 1 3.5 7 3
Whenever a table is reduced to two rows with three or more columns, the graph is based on the probability for the player on the left (in this example, Player A). The probability that Player A will choose A3 is p, and the probability that Player A will choose A4 is 1 p. A3 A4 B1 5 2 B2 B3 B5 2.5 4 1 3.5 7 3 Prob. p 1 p
In the reduced table, the payoffs range from 4 to 7. To solve the problem we make a graph for which the horizontal axis is the probability p (0 to 1), and the vertical axis is the expected value of the game (4 to 7). The axes are shown in Figure 68. The rst column is that of alternative B1. If Player B plays B1, then the expected value of the game (denoted as V ) is V = 5 p + (2)(1 p). This is an equation of a line. The easiest way to plot it is to evaluate the equation at p = 0 and at p = 1, plot these two points, and then connect them with a straight line. At p = 0 we obtain V = 2, and at p = 1 we obtain V = 5. Theres really no work to do: the top number (5) goes on the right, and the bottom number (2) goes on the left. Plotting and then connecting these two points (0,2) and (1,5) we obtain the line shown in Figure 69. The label B1 is placed next to the line for future reference. We now plot the lines for alternatives B2, B3, and B5. In each case the top number goes on the right, and the bottom number goes on the left. Expressed another way, the vertical intercept on the left comes from the bottom number, and the vertical intercept on the right comes from the top number. We also write the alternative name as a label next to the corresponding line. Doing this for all three alternatives we obtain the graph shown in Figure 70. Both Player A and Player B have the same information, so both are able to draw this graph. Player B wants a low expected value, because the expected value is from Player As perspective. For any value of p (chosen by Player A), Player B wants to be on the bottom of the lines which represent Player Bs alternatives. In this example this is represented by three line segments involving alternatives B1,
329
7 6 Expected Value of 5 the Game 4 3 2 1 0 1 2 3 4 .1 .2 .3 .4 .5 .6 .7 p .8 .9
7 6 5 4 3 2 1 0 1 2 3 4
Figure 68: Example 1 Axes
330
7 6 5
B1
4 3 2 1 0 1 2 3 4
Figure 69: Example 1 Alternative B1
331
7 6 5
Figure 70: Example 1 Alternatives B1, B2, B3, and B5
B3
B1
4 3
B5
2 1 0 1 2 3 4
B2
332
B2, and B3 (B5 is not best for any value of p). These line segments are highlighted in Figure 71. Player A is aware of how Player B perceives the situation. Looking at the highlighted line segments, Player A wants to be at the top, because this point has the highest expected value. This point is located where alternatives B1 and B2 intercept. By inspection on the graph, we can see that optimal solution to this game occurs at p 0.42. The expected value of the game is approximately 1. This approximate solution is shown in Figure 72. The graph has allowed us to eliminate two more alternatives because of local dominance. We are left with: B1 B2 5 2.5 2 3.5
A3 A4
We have an approximate solution for p and V already, but because the game has been reduced to a 2 by 2, we can nd these things as well as q exactly. Using the DARS algorithm we obtain: B1 B2 5 2.5 2 3.5 7 6
7 13 6 13 6 13 7 13
A3 A4 D R S
D 7.5 5.5 13
R
7.5 13 5.5 13
S
11 26 15 26
= =
15 26 11 26
We see that p is 11 26 0.423. One way (of four) to calculate the expected value of the game is: V = =
6 7 13 (5) + 13 (2.5)
30 17.5 13 13 12.5 = 13 25 = 26 0.962
333
7 6 5
Figure 71: Example 1 Player Bs Preferences Highlighted
B3
B1
4 3
B5
2 1 0 1 2 3 4
B2
334
7 6 Expected Value of 5 the Game 4 3 2 1 0 1 2 3 4 .1 EV 1 .2 .3 .4 .5 p 0.42 .6 .7 p .8 .9
7 6 5
Figure 72: Example 1 Approximate Optimal Solution for Player A
B3
B1
4 3
B5
2 1 0 1 2 3 4
B2
335
15 Player A should play A3 with probability 11 26 , and A4 with probability 26 . Player 6 7 B should play B1 with probability 13 , and B2 with probability 13 . The expected value of the game is 0.962.
21.1.2
Example 2 A1 A2 A3 A4 A5 B1 12 18 17 0 3 B2 3 5 1 14 17 B3 B4 B5 2 9 4 4 16 7 2 16 3 12 2 13 14 6 15
The elimination of the rows and columns using dominance is a bit tricky for this example, so we will take this slowly. First we do the row comparisons: A1,A2; A1,A3; A1,A4; A1,A5; A2,A3; A2,A4; A2,A5; A3,A4; A3,A5; and A4,A5. No dominance is found, so we move on to the columns: B1,B2; B1,B3, and nally we nd dominance when comparing B1 and B4. B1 12 18 17 0 3 B4 9 16 16 2 6
B1 (the higher payoff column) is eliminated, producing: B1 B2 B3 B4 B5 12 3 2 9 4 18 5 4 16 7 17 1 2 16 3 0 14 12 2 13 3 17 14 6 15 1 B4
A1 A2 A3 A4 A5
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We then continue comparing pairs of columns: B2,B3; B2,B4; B2,B5; B3,B4; B3,B5; and B4,B5. Finding no dominance in any of these, we go back to the rows: A1,A2; A1,A3; A1,A4; A1,A5; and A2,A3. We see that A3 dominates A2 (the eliminated B1 column is ignored): A2 A3 Removing row A2 we obtain: A1 A2 A3 A4 A5 B1 12 18 17 0 3 1 B4 B2 3 5 1 14 17 B3 B4 2 9 4 16 2 16 12 2 14 6 B5 4 7 3 13 15 5 4 16 7 1 2 16 3
A3
Theres no further row dominance, and so we return to the columns. It can be seen that both columns B2 and B5 are dominated by B3. Removing B2 and B5 gives us: A1 A2 A3 A4 A5 B1 12 18 17 0 3 1 B4 B2 3 5 1 14 17 3 B3 B3 B4 2 9 4 16 2 16 12 2 14 6 B5 4 7 2 3 13 15 4 B3
A3
There is no further dominance using this method. We have reduced the table down to two columns: A1 A3 A4 A5 B3 B4 2 9 2 16 12 2 14 6
337
In the reduced table, the payoffs range from 6 to 16. We let q be the probability that Player B chooses B3, and 1 q is therefore the probability that Player B chooses B4. A1 A3 A4 A5 Prob. B3 B4 2 9 2 16 12 2 14 6 q 1q
To solve the problem we make a graph for which the horizontal axis is the probability q (0 to 1), and the vertical axis is the expected value of the game (6 to 16). The axes are shown in Figure 73. If Player A chooses A1 the expected payoff is V = 2q + 9(1 q)
When q = 0, the expected value is 2(0) + 9(1 0) = 9; when q = 1, the expected value is 2(1) + 9(1 1) = 2. We draw therefore a line from (0,9) to (1,2) and label this line A1. The shortcut to this process is this: the number on the left side of the table goes on the right side of the graph, and the number on the right side of the table goes on the left side of the graph. This procedure is repeated for alternatives A3, A4, and A5. The four lines are shown in Figure 74. Both Player A and Player B have the same information, so both are able to draw this graph. Player A wants a high expected value. For any value of q (chosen by Player B), Player A wants to be on the top of the lines which represent Player As alternatives. In this example this is represented by three line segments involving alternatives A3, A4, and A5 (A1 is not best for any value of q). These line segments are highlighted in Figure 75. Player B is aware of how Player A perceives the situation. Looking at the highlighted line segments, Player B wants to be at the bottom, because this point has the lowest expected value (Player B must pay this amount to Player A). This point is located where alternatives A3 and A4 intercept. By inspection on the graph, we can see that optimal solution to this game occurs at q 0.56. The expected value of the game is approximately 5.9. This approximate solution is shown in Figure 76. The graph has allowed us to eliminate two more alternatives because of local dominance. We are left with:
338
16 14 12 Expected Value of 10 the Game 8 6 4 2 0 2 4 6 .1 .2 .3 .4 .5 .6 .7 q .8 .9
16 14 12 10 8 6 4 2 0 2 4 6
Figure 73: Example 2 Axes
339
16 14 12 Expected Value of 10 the Game 8 6 4 2 0 2 4 6 .1 .2
16 14 12
A5
Figure 74: Example 2 Alternatives A1, A3, A4, and A5
A3
A1
10 8 6 4
A4
2 .4 .5 .6 .7 q .8 .9 0 2 4 6
.3
340
16 14 12
A5
Figure 75: Example 2 Player As Preferences Highlighted
A3
A1
10 8 6 4
A4
2 .4 .5 .6 .7 q .8 .9 0 2 4 6
.3
341
16 14 12
A5
EV 5.9
Figure 76: Example 2 Approximate Optimal Solution for Player B
A3
A1
10 8 6 4
A4
2 .4 .5 .6 .7 .8 q q 0.56 .9 0 2 4 6
.3
342 B3 B4 2 16 12 2
A3 A4
We have an approximate solution for q and V already, but because the game has been reduced to a 2 by 2, we can nd these things as well as p exactly. Using the DARS algorithm we obtain: B3 B4 2 16 12 2 14 18 0.4375 0.5625 0.5625 0.4375 D 18 14 32 R = 0.5625 = 0.4375 S 0.4375 0.5625
A3 A4 D R S
18 32 14 32
We see that q is 0.5625 (from the B3 column). [Its just a coincidence that we obtained the same number in the A4 row.] One way (of four) to calculate the expected value of the game is: V = 12(0.5625) + (2)0.4375 = 6.75 0.875 = 5.875 Recommendation Player A should play A3 with probability 0.4375, and A4 with probability 0.5625. Player B should play B3 with probability 0.5625, and B4 with probability 0.4375. The expected value of the game is 5.875. 21.1.3 General Methodology
To use the graphical solution methodology, we must reduce by dominance to two rows with many columns, or two columns with many rows. In the two-row situation, we seek the apex point at top of the bottom set of line segments. In the two-column situation, we seek the apex point at the bottom of the top set of line segments. The apex point denes the choices for the other player, and the DARS algorithm can then be applied.
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21.2
Formulation as a Linear Optimization Model
A zero-sum game of any size can be solved by linear optimization. Indeed, there is no need to try to rst reduce the size of the model using dominance. Here is an example: B1 8 6 4 B2 7 9 8 B3 5 4 7 B4 1 6 5
A1 A2 A3
This table cannot be reduced, so we must use linear optimization. The parameters of the model are the numbers in the payoff table, i.e. 8, 7 and so on. The variables are the probabilities and the expected value of the game. We dene V = expected value of the game. The probabilities for Player A choosing A1, A2, and A3 are p1 , p2 , and p3 respectively, such that p1 + p2 + p3 = 1. The probabilities for Player B choosing B1, B2, B3, and B4 are q1 , q2 , q3 , and q4 respectively, such that q1 + q2 + q3 + q4 = 1. A1 A2 A3 Prob. B1 8 6 4 q1 B2 7 9 8 q2 B3 B4 5 1 4 6 7 5 q3 q4 Prob. p1 p2 p3
Player A wants V to be as high as possible; the objective is simply to maximize V. If Player B chooses B1, then the expected value of the game will be: V = 8 p1 + 6 p2 + (4) p3 Player B will certainly not exceed this amount on the right, but V could be less than this amount, because Player B does not have to choose alternative B1. The alternative B1 constraint is that: V 8 p1 + 6 p2 4 p3 Subtracting the right hand side from the left we obtain: V 8 p1 6 p2 + 4 p3 0
344 Multiplying by 1 we obtain: alternative B1
V + 8 p1 + 6 p2 4 p3 0 V + 7 p1 + 9 p2 8 p3 0 V 5 p1 + 4 p2 + 7 p3 0 V + p1 6 p2 + 5 p3 0 p1 + p2 + p3 = 1
Going down the B2, B3, and B4 columns we obtain three more similar constraints: alternative B2 alternative B3 alternative B4
The probabilities must sum to 1: prob. sum to 1
Each probability must be greater than 0; these are the non-negativity restrictions. The expected value V , however, is unrestricted in sign. In writing the complete formulation, we will stress this fact. From Player As perspective, the model is: maximize subject to alternative B1 alternative B2 alternative B3 alternative B4 prob. sum to 1 non-negativity V V V V + 8 p1 + 7 p1 5 p1 + p1 p1 p1 V is unrestricted + + + + , 6 p2 9 p2 4 p2 6 p2 p2 p2 + + + , 4 p3 8 p3 7 p3 5 p3 p3 = 0 0 0 0 1 V
p3 0
We will call this Model A. Another related model is obtained by looking at things from the perspective of Player B, who wishes to minimize V . If Player A chooses A1, then the expected value of the game will be: V = 8q1 + 7q2 + (5)q3 + q4 Player A will certainly not accept less than this amount on the right, but V could be more than this amount, because Player A does not have to choose alternative A1. The alternative A1 constraint is that: V 8q1 + 7q2 5q3 + q4
345
Subtracting the right hand side from the left, and then multiplying by 1 we obtain: alternative A1 V + 8q1 + 7q2 5q3 + q4 0
We also have similar constraints for alternatives A2 and A3, and we require that the probabilities sum to 1. As before, V is unrestricted. The model from Player Bs perspective (called Model B) is: minimize subject to alternative A1 alternative A2 alternative A3 prob. sum to 1 non-negativity V + 8q1 V + 6q1 V 4q1 q1 q1 V is unrestricted + 7q2 + 9q2 8q2 + q2 , q2 5q3 + 4q3 + 7q3 + q3 , q3 + q4 6q4 + 5q4 + q4 , = 0 0 0 1 V
q4 0
The only thing new as far as linear optimization is concerned is the existence of the unrestricted variable V in both models. On Excel, this means that we cannot use the radio button to declare all variables to be non-negative. Instead, we must declare each of the probability variable cells to be non-negative, by adding a range as a set of constraints with a right-hand side value of 0. For LINDO, we enter the model as usual, and then after the end statement we add the command free V. For example, the rst model is entered as max V st alt. B1) -V + 8p1 + 6p2 - 4p3 >= 0 alt. B2) -V + 7p1 + 9p2 - 8p3 >= 0 alt. B3) -V + -5p1 + 4p2 + 7p3 >= 0 alt. B4) -V + p1 -6p2 + 5p3 >= 0 sum to 1) p1 + p2 + p3 = 1 end free V We can now use LINDO to solve both models. As one would expect, the same value of V is obtained for both. We also see that the dual prices (DP) from one model give us (except for the sign) the values of the variables for the other model:
346 Model A V 1.367021 p1 0.425532 p2 0.175532 p3 0.398936 DP B1 0 DP B2 0.319149 DP B3 0.257979 DP B4 0.422872
c April 28, 2010 D.M. Tulett Model B V 1.367021 DP A1 0.425532 DP A2 0.175532 DP A3 0.398936 q1 0 q2 0.319149 q3 0.257979 q4 0.422872
Therefore, all we need to do is formulate and solve either model. The values of the probability variables for the other model are simply the absolute values of the dual prices of the rst model. In a theoretical sense, game theory is an important link between probability based payoff matrices and the deterministic eld of linear optimization. Also, the two models form what are called the primal and the dual, which provide alternate ways to solve what is really the same problem. Another thing of note is that if the linear optimization model is applied to a situation where there are just two rows or columns, we can create a graphical solution which is like the one seen earlier, in which the highlighted line segments are in fact edges of the feasible region.
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21.3
21.3.1
Exercise
Problem 1
For problem 3 from the previous Exercise, determine the optimal strategy for each player and the value of the game. 21.3.2 Problem 2
Players A and B are playing a zero-sum game. The payoffs to player A are: B1 5 1 4 7 6 B2 0 1 2 4 1 B3 1 2 1 0 1
A1 A2 A3 A4 A5
(a) Eliminate any dominated alternatives. (b) Plot the remaining alternatives on a graph. (c) Use the analytic technique to determine the optimal strategy for each player, and state the value of the game. 21.3.3 Problem 3
Players X and Y are playing a zero-sum game. The payoffs to player X are: Y1 5 1 2 2 Y2 Y3 Y4 3 2 7 8 6.5 2.5 6 5 4 7 6 3 Y5 2 7 9 5
X1 X2 X3 X4
(a) Eliminate any dominated alternatives. (b) Plot the remaining alternatives on a graph. (c) Use the analytic technique to determine the optimal strategy for each player, and state the value of the game.
348 21.3.4 Problem 4
Solve the following zero-sum game by linear optimization. B1 2 3 5 0 2 B2 6 5 10 5 6 B3 9 1 1 5 0
A1 A2 A3 A4 A5 21.3.5 Problem 5
There is no dominance here. This is a somewhat challenging problem because of the tie in row A3. A1 A2 A3 (a) Solve by linear optimization. (b) Solve by hand using the graphical technique. How is this solution more general than the one found in part (a)? B1 B2 2 14 10 4 7 7
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22
Moving Forward
We have come to the end of the content to be covered on the nal examination for this course. Obviously there is more to learn for those who are interested. To search further, it needs to be pointed out that the term management science is just one of many for this eld. Other terms are operations (or operational) research, decision analysis/science, optimization and others. Using the terms operations research and the management sciences, a very comprehensive site is located at http://www.informs.org/Resources/. This website, maintained by Prof. Michael Trick, has links to all sorts of things: courses from around the world; free computer programs; references to journals; and so on. Also included are references to many professional societies from around the world. The following two may be of particular interest. In Canada, the professional organization is called the Canadian Operational Research Society (or CORS). In the United States, there is the Institute for Operations Research and the Management Sciences (or INFORMS). There are many more topics in the eld of management science than the ones we covered, and of course what we did cover can be studied in greater depth. For example, two mainstream topics not covered here are simulation and queueing theory . Simulation is a methodology which allows the model to contain many real-world characteristics. Traditionally, a major drawback of using simulation was that it was very time consuming, but as the speed of computers continuously increases this is becoming less of an issue. However, simulation does not guarantee optimality, so it tends to be used only when there are no alternative procedures. Queueing theory studies the behaviour of queues (waiting lines) that form in banks, at telephone call centres, and so on. Other topics include the study of algorithms, non-linear optimization, and the formulation of more difcult linear and integer optimization models. If learning about more advanced topics is of interest to you, then ask your professor what other courses are available to you. Prof. Tricks site has a resources section which links to a long list of MS/OR books. Here are some books which I have found to be useful (alphabetical by surname): Bell, Peter. Management Science/Operations Research: A Strategic Perspective, South-Western Publishing, 1999. Bells book emphasizes the use of cases, one of the few books in this eld ever to do so. Bell is at the Ivey School at the University of Western Ontario; many of the cases are set in Canada. Denardo, Eric V. The Science of Decision Making: A Problem-Based Approach
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Using Excel, Wiley, 2002. This book covers the material seen in this e-book (and more), but at a deeper level. Hillier and Lieberman, Introduction to Operations Research, 9th edition, McGrawHill, 2010. This book deals with all aspects of operations research. Rardin, Ronald L., Optimization in Operations Research, Prentice-Hall, 1998. Rardins book deals with deterministic problems (no probabilities). There are three of fourteen chapters which deal solely with formulation, but the emphasis is on the algorithms for solving these type of models. Schrage, Linus E., Optimization Modeling with LINDO, 5th edition, Duxbury Press, 1997. Schrages book gives an extensive overview of the main types of applications for linear and integer optimization, using LINDO to provide solutions. Winston, Wayne L., Operations Research Applications and Algorithms, 4th edition, Duxbury Press, 2004. Winstons book gives a comprehensive coverage of operations research. This lecture is short because being the last one it is principally used for review, for questions, or for covering material that may have been missed earlier. The exercises from the rst twenty-one lectures will prepare you well for the nal examination. Best of luck with it!
Index
absorbing state, 253 algebraic model, 155 alternative branch, 47 binding constraint, 195 BINOMDIST function, 137 branch-and-bound algorithm, 194 certainty equivalent, 281 cumulative probability function, 34 decision node, 47 decision tree, 47 dual price, 216 EMV, 279 EOL, 31 event node, 47 Excel R , i expected opportunity loss, 31 expected utility, 279 expected value, 16 expected value of perfect information, 25 game theory, 312 indifference, 39 integer optimization, 167 LINDO R , i linear optimization, 154 marginal analysis, 34 Markov chains, 237 model algebraic, 155 spreadsheet, 155 null branch, 48 OpenOfce.org 3 R , i, ii opportunity loss, 31 outcome branch, 47 payoff matrix, 14 payoff node, 48 posterior tree, 101, 107 prior tree, 101, 107 pure strategy, 313 queueing theory, 349 ranking prot/cost, 90 reduced cost, 215 regret matrix, 31 risk averse, 280 neutral, 280 preferring, 280 rollback procedure, 47 salvage value, 21 sensitivity analysis, 36, 214 shadow price, 216 simplex algorithm, 194 simulation, 349 slack, 194 solution variables, 215 Solver, 203 spreadsheet functions BINOMDIST, 137 model, 4 351
352 SUMPRODUCT, 18 spreadsheet model, 155 stable solution, 314 state, 238 state absorbing, 253 transient, 253 trapping, 253 state transition diagram, 238 state transition matrix, 242 SUMPRODUCT, 18 sunk cost, 13 surplus, 194 transient state, 253 transition, 238 trapping state, 253 tree posterior, 107 prior, 107 utility, 279
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23
Supplement Extra Problems
The problems which follow come from a collection prepared not only by me but by Dr. A.R. Redlack. They are reproduced here with his permission. The follow the order of the lectures, with each section covering more than one lecture, except for the nal section on Linear Optimization Applications, which can be thought of as an Appendix to the earlier Linear Optimization Introduction section. There is a Solutions Manual available for all these problems.
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23.1
Introduction
1. Suppose that minimizing your average annual cost is your only criterion for deciding how often you should buy a new car. You are given the following information (in dollars), based on maintaining the car so that the car is always safe to drive: Year 1 2 3 4 5 6 7 8 9 10 11 Resale Value (end of year) 14,000 10,000 7,000 5,000 3,500 2,500 2,000 1,500 1,000 500 0 Maintenance Cost (during the year) 100 200 400 600 1,000 1,500 2,000 2,500 3,000 3,000 3,000
A new car costs $20,000. Ignoring ination, taxes, and so on, how often should a new car be replaced? 2. A knight sees four veiled women. He knows that one is the Queen, but he does not know which one. The Queen always tells the truth, but the other three are rogues who always lie. The rst woman says that she is the Queen. The second woman says that the fourth is the Queen. The third woman says that she is the Queen. The fourth woman says that the rst is the Queen. Which one is the Queen? 3. Mr and Mrs Brown have four children, none of whom was adopted. A public ofcial at city hall who has never met the Brown family enquires by telephone about the ages of the children. Your rst clue, said Mr Brown (not wanting to be too cooperative), is that the product of their ages (expressed as integers) is 36. The ofcial started to write down some possibilities and said, Only one potential answer is biologically impossible: Whats the second clue? Mr Brown continued, the sum of their ages is equal to number
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of councillors on city council, which of course the ofcial knew. I still do not have enough information, the ofcial replied, what is the third clue? The difference in ages between our oldest and our youngest child is an odd number, replied Mr Brown. What are the ages of the Brown children? 4. A 3 appears in both cells A1 and B1 of a spreadsheet.15 Someone enters =A1*B1 in cell C1, and 11 appears. Why? 5. On an island with a population of a million people a murder has occurred. All ports and airports were immediately sealed by the police so the murderer must be on the island. A violent struggle at the murder scene shows that the attacker was a left-handed male. (Left-handed males comprise 5% of the population). Most important of all, in addition to the blood of the victim, some blood was found which comes from a very rare blood type found in only one person in 10,000. An expert has said that there is a 99% chance that this blood belongs to the murderer. A criminal conviction requires that there be at least a 95% chance that the accused actually committed the crime. The police have arrested Ralph, a man with a conviction record for theft, who does not have an alibi, who is left-handed, and who has the rare blood type found at the scene of the crime. His lawyer explains to the police that he cannot be found guilty based on the current evidence, and Ralph is released. What was the lawyers argument?
15 We
use the syntax of Microsoft Excel everywhere in this book.
356 23.1.1 Advanced Problems
1. The Panther Company uses 1,000 thermocouples in its production process. The thermocouples have a maximum life of ve months, but often fail earlier. Past experience has shown that 10% will fail in the rst month, 20% in the second month, 20% in the third month, 30% in the fourth month and the remaining 20% in the fth month. Each failed thermocouple must be replaced by the end of the month in which it fails. If all the thermocouples are replaced at the same time, then the cost is only $14 per thermocouple. If only the failed thermocouples are replaced, the cost is $25 per thermocouple replaced. (a) What are the alternatives which must be evaluated? (b) What is the cost associated with each alternative? Remember that the replacement thermocouples are also subject to failure. (c) What replacement policy would you recommend to the company? 2. On a television game show a contestant is told that behind one of three doors there is a new car to be won; behind each of the other two doors there is nothing of value. The contestant is invited to guess which door leads to the car. After the guess, the host (who knows where the car is), opens one of the other doors to reveal that the car is not behind it. The host then asks the contestant if he or she wishes to change his or her guess. For example, if the contestant initially chooses door 2, and the host reveals that the car is not behind door 1, should the contestant switch his or her guess to door 3? There are three possible answers to this question: (i) the contestant should stick with his or her initial guess (ii) it doesnt matter whether the contestant switches or not (iii) the contestant should switch. Which is right?
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23.2
Uncertainty
1. A business has four alternatives. After an alternative has been chosen, an event occurs which has four mutually exclusive outcomes. The conditional payoffs are given in the following matrix. O1 O2 O3 O4 A1 8 6 3 12 A2 14 3 10 7 9 3 5 13 A3 A4 4 5 7 6 Prob. 0.3 0.4 0.2 0.1 In parts (a) to (d), determine which alternative and ranking payoff would be chosen according to the given decision criterion (the probabilities are to be ignored). Parts (e) to (h) use the probabilities. (a) Criterion of Optimism (b) Criterion of Pessimism (c) The Hurwicz criterion if the coefcient of optimism is 0.7. (d) Laplace criterion (e) What is the preferred alternative using maximum expected value as the decision criterion? (f) Determine the EVPI by the direct method. (g) Find the regret matrix. (h) Show that the optimal alternative using minimum EOL is the same as the one found in part (e), and that the minimum EOL itself is the same as the EVPI found in part (f). 2. A business must choose between one of ve alternatives. After the alternative has been chosen, an event occurs. This event has three mutually exclusive outcomes. The conditional payoffs are given in the following matrix.
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O1 O2 O3 A1 32 31 34 A2 45 8 51 50 30 40 A3 A4 12 35 68 3 12 70 A5 Prob. 0.45 0.02 0.53 In parts (a) to (d), determine which alternative and ranking payoff would be chosen according to the given decision criterion (the probabilities are to be ignored). Parts (e) to (h) use the probabilities. (a) Criterion of Optimism (b) Criterion of Pessimism (c) The Hurwicz criterion if the coefcient of optimism is 0.8. (d) Laplace criterion (e) What is the preferred alternative using maximum expected value as the decision criterion? (f) Determine the EVPI by the direct method. (g) Find the regret matrix. (h) Show that the optimal alternative using minimum EOL is the same as the one found in part (e), and that the minimum EOL itself is the same as the EVPI found in part (f). 3. A computer contains several integrated circuit boards. Over the life of the computer there is a 55% chance that no boards will fail, a 25% chance that one board will fail, a 15% chance that two boards will fail, and a 5% chance that three boards will fail. The vendor of the computer offers the purchaser a special deal on replacement boards they can be purchased (in any quantity) for $200 each, provided that they are purchased with the computer. The regular price (which is available anytime) is $500 per board. The purchaser wishes to minimize the expected cost of the replacement boards.
c April 28, 2010 D.M. Tulett (a) Write a payoff matrix for the problem, where the payoffs represent costs rather than prots. (b) What is the optimal solution and what is its expected cost? (c) Find the expected cost with perfect information, and from this deduce the EVPI. (d) Set up the opportunity loss matrix for the problem, remembering that the original payoffs are already costs. (e) Show that the minimum EOL = EVPI.
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4. A friend is a frequent traveller between two airports. One, located in the town of Gander, has little problem with adverse weather. The other, located in the city of St. Johns, is sometimes closed because very thick fog. As far as cost is concerned, there is little difference between travelling by bus or by plane. However, there is a signicant difference in the travel time. The bus trip takes 4 hours, whereas the plane trip depends on weather. If the weather is ne, the trip only takes 45 minutes. If St. Johns is fogged in, then one has to wait an average of 20 hours for it to clear. According to historical weather records for this time of year, St. Johns is clear 8 times out of 10. Suppose that reservations are required in advance for either the bus or the plane; it is not possible to reserve both. (a) What would you recommend to your friend? (b) What is the probability of foggy weather that would imply indifference between the two alternatives? For those times that St. Johns is fogged in, suppose now there is a 20% chance that the weather will clear early and the wait will only be 6 hours, a 70% chance that the wait will still be 20 hours, and a 10% chance that the fog will continue for an additional 10 hours. (c) Would this affect your recommendation to your friend? 5. The Fres Froot Company operates in a region of good soil and temperate climate in which there are many fruit farms and vineyards. The company owns a number of roadside fruit stands which sell to tourists in this region. Fres Froot purchases ripe peaches for 60 cents per kilogram (kg) and sells them for $1.00 per kg. Peaches which are not sold at the end of the day are
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c April 28, 2010 D.M. Tulett given to local farms to use as animal food. Demand for the peaches during the last year (120 day tourist season) was 40 kg on 40 days, 50 kg on 30 days, 60 kg on 30 days and 70 kg on 20 days. Solve parts (a) to (d) using the payoff matrix approach. (a) What ordering policy would you recommend to Fres Froot? (b) What is the EVPI? The Fres Froot Company has been contacted by a company which buys low quality fruit and ships it to another region of the country in which the soil is thin and the weather often miserable. Instead of giving it away for animal food, they will receive a salvage value of 10 cents per kg. (c) Will this affect your recommendation to the Fres Froot Company? (d) At what salvage value(s) would you change from one recommendation to Fres Froot to a different one? (e) Solve part (c) using marginal analysis.
6. A popcorn stand is faced with the decision of how many boxes of popcorn to prepare before a hockey game at a local stadium. Each box cost $0.40 and sells for $1.00. Past records indicate that 15,000 boxes are enough to prevent any shortage, and until now, this has been the number prepared before each game. Unsold popcorn is disposed of in industrial garbage bags which cost $0.15 per bag and hold 50 boxes of popcorn. The following data summarizes the sales history: Demand 5,000 8,000 12,000 15,000 Probability 0.10 0.20 0.30 0.40
What would you recommend to the popcorn stand? 7. Greenleaf Groceries buys fresh vegetables at wholesale for $5 per crate. A crate which they sell at retail on the same day brings a $1.50 prot contribution. A crate which is not sold on the same day is sold later as animal food
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for $1 per crate. During the last year the demand for vegetables behaved as follows: Demand (in crates) 10 11 12 13 Number of Days 120 90 75 15
(a) What is the expected daily demand? (b) How many crates should the store order if Greenleaf wants to maximize expected daily prot from selling vegetables? (c) Repeat the above using marginal analysis. 8. The owner of a store which sells mainly compact disks must decide which disks and the number of each to order for the Christmas sales season. A new recording of Mozarts Laudate Dominum is sweeping the world. Orders for the disk must be placed with the distributor in lots of 100. If she orders 100 disks, the cost to her would be $17 per disk; 200 disks would cost $15 per disk, and 300 or more in lots of 100 would cost $13 per disk. Until Christmas Day the retail selling price will be $20 per disk; any left over after Christmas will be sold to a discount house for $5 per disk. The owner believes that at the regular price the possible demands are 50, 100, 150, 200, 250, 300, or 350 disks, with probabilities 0.05, 0.1, 0.2, 0.3, 0.2, 0.1, and 0.05 respectively. She must place her entire order now. Assume that she will suffer no loss of goodwill if she happens to be out of stock. (a) What would you recommend to the owner? (b) Determine the expected value of perfect information. (c) Suppose that the $5 to be received for each leftover disk is negotiable. Over what range for this value would the solution found in part (a) be valid? 9. A couple of enterprising business professors are faced with a dilemma. They have spent a lot of effort preparing a course manual and would like to give themselves a small reward. They can produce and sell the manual
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c April 28, 2010 D.M. Tulett themselves or have the campus bookstore sell it (in which case they receive nothing). There are 250 students registered in the course, but used manuals are available from previous years. The cost to print the manual is $21, and the sale price is $25. Any unsold manuals have no value, but if not enough manuals are ordered initially, then they have to be specially printed at a cost of $26 per manual. The professors have estimated the possible demands for new manuals to be (150, 175, 200, 225, 250) with probabilities (0.2, 0.3, 0.3, 0.1, 0.1). In addition, if they sell the manual themselves, then 10 manuals would have be given free of charge to their fellow instructors and to the tutorial assistants of the course. If the bookstore sells the manual, then the free copies come out of the departmental budget instead. (a) What is the mathematical model for this problem? (b) What would you recommend to the professors? (c) What is the EVPI for this situation? (d) What is the standard deviation of the payoffs for your recommendation?
10. The Wax n Wave Sporting Goods store must place their order for skis in August. The skis cost $75.00 a pair and sell for $125.00 a pair. Up to 50 pairs of skis not sold during the winter can be sold during the big spring sale for $50.00 a pair (any other unsold skis are worthless). The store must order skis in lots of 40 pairs. Based on the long-run forecast of the winter weather, the estimates of the demand for skis are as follows: Demand 50 75 100 125 Probability 0.10 0.50 0.30 0.10
(a) What is the mathematical model for this problem? (b) What would you recommend to the store? (c) What is the EVPI for this situation?
c April 28, 2010 D.M. Tulett (d) What is the standard deviation of the payoffs for your recommendation? (e) Suppose that the above probabilities are changed to P(demand = 75) = 0.5 + p P(demand = 100) = 0.3 p At what value of p would the store be indifferent between ordering 80 or 120 skis?
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11. You stayed up late on Sunday night watching Alien and have overslept on Monday morning. It now looks as though you may be late for work. You have three options open to you: You could ride your bicycle and arrive 20 minutes late. You could drive your car. This would involve a cost for gasoline of $0.50 each way and a $3.00 cost for parking. If the trafc is light you will arrive on time, but if it is medium or heavy you will arrive 15 minutes late. You could take the bus, which costs $1.00 per trip. If the trafc is light you will arrive 10 minutes late; if it is medium, 20 minutes late, and if heavy, 30 minutes late. For this time of year, 30% of the time the trafc is light and 50% of the time it is medium. It will cost you 30 cents for each minute you are late for work. If you take your bicycle or your car to work then you will return home by the same; if you take the bus to work then you will walk home. (a) What should you do? (b) If you are unable to accurately estimate the probabilities of the trafc levels, what would you do? Justify your answer. 12. A department store is considering carrying a line of baby grand pianos. They can be ordered from the manufacturer at cost of $6000 for the rst one and $4800 for each subsequent one. (e.g. three pianos would cost $15,600). The selling price until Christmas will be set at $8000. Any left over after Christmas will be sold to a liquidator for $4000 each. Demand is estimated as being between 2 and 5 inclusive with probabilities 0.15 for 2, 0.20 for 3, 0.40 for 4, and 0.25 for 5.
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c April 28, 2010 D.M. Tulett (a) Using expected value as the decision criterion, use a payoff matrix to determine how many pianos should be ordered. What is the expected prot? (b) What is the EVPI? (c) Suppose that the probabilities of demand being 2 or 3 are xed, but the other probabilities can vary. At what values for the probabilities (if any) would the optimal alternative change?
13. The Surf n Sun Sports Shop must place their orders for snorkels in January. The snorkels sell for $15 each, and cost $10 each. Up to ten snorkels that are not sold in the summer can be sold at $12 each in the Fall clearance sale (any unsold snorkels are worthless). The store must order snorkels by the dozen. Based on the long-range forecast of summer weather, the store estimates the demand for snorkels to be: Demand 30 40 50 60 Probability 0.10 0.50 0.30 0.10
(a) Using expected value as the decision criterion, use a payoff matrix to determine how many snorkels the store should order. What is the expected prot? (b) What is the EVPI? (c) Suppose that the demands for forty or fty snorkels can vary, but the other two probabilities are xed. At what values for the probabilities (if any) would you be indifferent between ordering forty-eight and sixty snorkels? 14. Demand for a particular newspaper at Mrs. Reids News Depot can range anywhere from 31 to 49 papers per day, according to the following triangular probability distribution: P(D = d ) = 0 if d 30 P(D = d ) = d 30 if 30 d 40 100
c April 28, 2010 D.M. Tulett P(D = d ) = 50 d if 40 d 50 100 P(D = d ) = 0 if d 50
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where d is an integer, and D is a random variable which takes on the values of the number of newspapers demanded. Mrs. Reid sells the papers for $0.80 each. Her buying price depends on the quantity ordered: Quantity (per day) 20 44 45 or more Buying Price (per paper) $0.60 $0.54
Papers that are not sold by the end of the day are sold to a recycling rm for 5 cents each . She wishes to know how many papers she should order so that her expected prot is maximized. (a) Create a spreadsheet model for this problem. (b) Obtain a graph of the expected prot as a function of the number of papers ordered. (c) What is the smallest value for her selling price for which she will order 45 newspapers? 15. A business has four alternatives. After an alternative has been chosen, an event occurs which has four mutually exclusive outcomes. The conditional payoffs are given in the following matrix. O1 O2 O3 O4 A1 7 4 5 8 A2 13 9 3 5 8 6 3 A3 11 A4 7 15 4 11 Prob. 0.1 0.3 0.4 0.2 In parts (a) to (e), determine which alternative and ranking payoff would be chosen according to the given decision criterion (the probabilities are to be ignored). Parts (f), (g) and (h) use the probabilities.
366 (a) Criterion of Optimism (b) Criterion of Pessimism
(c) The Hurwicz criterion if the coefcient of optimism is 0.7. (d) Laplace criterion (e) What is the preferred alternative using the regret matrix (ignoring the probabilities and using pessimism)? (f) What is the preferred alternative using the regret matrix (using the probabilities)? (g) What is the preferred alternative using maximum expected value as the decision criterion? (h) Determine the EVPI using the payoff matrix. 16. A computer store is considering carrying a line of new computers. The manufacturer of the new computers is trying to encourage sales and is willing to give quantity discounts according to the following table: Number Ordered 1 2 3 4 5 Price per Item 3000 2700 2700 2400 2400
The selling price will be set at $4000. Any left over will be repurchased by the supplier for $2000 each. Demand is estimated as being between 2 and 5 inclusive with probabilities 0.25 for 2, 0.30 for 3, 0.30 for 4, and 0.15 for 5. Any computers which are demanded but not in stock are ordered individually from the supplier with an additional $50 charge for speedy delivery. (a) Using expected value as the decision criterion, use a payoff matrix to determine how many computers should be ordered. What is the expected prot? (b) What is the EVPI?
c April 28, 2010 D.M. Tulett (c) Suppose that the probabilities of demand being 2 or 3 are xed, but the other probabilities can vary. At what values for the probabilities (if any) would the optimal alternative change? Uncertainty (Advanced Problems)
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1. Assuming that cumulative density function F (D d ), the retail selling price r, the wholesale buying price w, and the salvage value s are given, where r w s, prove the marginal analysis formula given in the text. 2. The situation is as in problem 14 of the previous section (with no salvage value), but now the probability density function is P(K = k) = 18! qk (1 q)18k k!(18 k)!
where K takes on the values of the number of newspapers demanded in excess of 31, ranging from 0 to 18 inclusive. (a) Determine the optimal number of papers to order when q = 0.3. (b) What is the smallest value of q for which she will order 45 newspapers? (c) Obtain a graph of the number of papers ordered as a function of q.
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23.3
Decision Trees
1. It is now October. An offshore oil development has just been announced, and an entrepreneur is now considering the development of a housing estate. A piece of land is available for $2,000,000. Alternatively, she can purchase an option on the land for $32,000. If she buys the option she would then have the right to purchase the land on or before May 1 of next year for $2,150,000. The option cannot be re-sold and if it is not exercised on or before May 1 it will become worthless on May 2. She is worried about the proposed oil development, fearing that there is a 30% chance that it will not go ahead. By early April of next year the status of the oil development will be known for sure. If the oil development goes ahead, then she believes that the proposed piece of land will increase in value to $2,400,000, otherwise the value will fall to $1,500,000. (a) Given that she wishes to maximize her expected prot what should she do? (b) What is the value of the probability of the oil development not going ahead that would make her indifferent between the two alternatives? (c) What is the expected value of perfect information (EVPI)? 2. Nova Beauty Products has learned that an unexpected side-effect of one of its products is that it seems to work as an excellent insect repellant. A major company in the repellant industry has offered to buy the rights (as they pertain to the repellant) of this product for $50,000, after which they will try to isolate and market the relevant ingredient which has the repellant effect. Nova is also considering trying to develop the repellant property itself. Nova estimates that the development would cost $80,000 and has only a 70% chance of being successful. If the product is successfully developed, then Nova believes there is 20% chance of selling the rights for $230,000, otherwise they will sell them for $140,000. If the development is unsuccessful, then they believe they will still be able to sell the rights for $30,000. (a) What would you recommend to Novas management? Suppose now that if the development turns out to be successful, that Nova will consider marketing the product itself. The marketing department estimates that there are three levels of demand.
c April 28, 2010 D.M. Tulett The marginal revenues associated with each level of demand are estimated to be $100,000, $180,000 or $280,000 with probabilities 0.30, 0.40 and 0.30. (b) Would this affect your recommendation to Novas management?
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3. Meni Idias Inc. must decide whether or not to pursue the development of a new product for which its recent research has indicated possibilities. It will cost $200,000 to complete the research and there is a 75% chance that the research will be successful. The cost for setting up for production is $250,000. If the demand turns out to be high, medium, or low the operating payoffs will be $800,000, $500,000 and $100,000 respectively. A competitor also has some knowledge of the product and if Meni Idias is successful in development, then there is a 20% chance that this competitor will also be successful. If the competitor has also developed the product, the probabilities of high, medium, and low demand are 0.1, 0.3 and 0.6, whereas they are 0.5, 0.3, and 0.2 if the competitor does not develop the product. Unfortunately, information about the competition is not available before the point in time at which the $250,000 production setup cost is incurred. (a) What would you recommend that Meni Idias do? Suppose now that Meni Idias can defer the production decision until after it knows whether or not the competition has successfully developed a similar product. (b) Would this affect your recommendation to Meni Idias? 4. ABC Construction Co. has just learned that a tender for a signicant project has just been issued. The cost of preparing a proposal for the tender is estimated to be $75,000. If they try to develop a proposal, there is a 5% chance that the company will nd that it is unable to meet the requirements of the tender. Assume that if this happens such a discovery will have been made after $30,000 of the $75,000 has been spent. When submitting the bid, the company can either submit a low end bid or a high end bid. The low end bid will have an 80% chance of successfully obtaining the contract whereas the high end bid will only have a 40% chance of obtaining the contract. If accepted, a low end bid would give an incremental prot of $200,000, while a high end bid would give an incremental prot of $400,000. If the contract is obtained, there is a 10% chance that
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c April 28, 2010 D.M. Tulett unforeseen problems will add an unexpected $100,000 to the cost of the project. (a) What would you recommend to the management of ABC Construction Co.? (b) What would be the EVPI for the unforeseen problems?
5. The Plastic Production Company needs to expand its production capacity for the next year. The marketing department has determined that the company will need 5,000, 10,000 or 15,000 cases of additional capacity with probabilities of (0.3, 0.5, 0.2) respectively. The demand level will be known after two months. The company is considering two options to meet the situation. First of all, they can use overtime at a cost of $3.00 per case in addition to the regular cost of $10.00 per case. However, if the required demand turns out to be 15,000 units, then there will be a 50% chance that there will be labour unrest if overtime continues for more than six months, which would add another $2.00 per case to the production cost. The labour unrest, should it occur, will begin to be felt at the outset of the sixth month, but there would be no extra cost because of the unrest in this month. Secondly, they can operate an additional shift. This will entail a xed cost of $15,000 for startup expenses and a $1.00 per case shift premium. However, if the extra demand turns out to be only 5,000 cases, then they will be required to layoff the shift at a cost of $5,000 and convert to overtime. If desired, the additional shift could be started anytime instead of being started immediately. (a) What would you recommend to the management of Plastic Production given that they must meet the required demand? (b) Suppose a marketing research company offers to perform a survey which will exactly determine the additional demand. Should the company be willing to pay $1,000 for this information? 6. A machine shop has received an order for 2,000 units to be made on one of its automated machines. This is a multistation operation and once it is started it runs without interruption. The machine shop makes $2 prot on each part of acceptable quality. Each unit which is classied as defective
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needs rework at a cost of $3.50 before it is considered acceptable. The full order must be acceptable. Historical data indicates that if the machine is used without any special preparation, it produces either 1% defectives (this happens 50% of the time), 2% defectives (30% of the time), 3% defectives (12% of the time) or 5% defectives the rest of the time. A trial run can be performed at a cost of $30 to determine the defect rate. With a minor adjustment that costs $42, the defect rate above 2% can be reduced to 2%; with a major adjustment that costs $100, the defect rate can be reduced to 1%. What adjustment policy should the company have, given that they make their judgement based on expected monetary payoff? 7. An oil company is considering expanding one of its reneries. One phase of the construction requires the welding of a large number of seams. The initial work will be done using ordinary welders assisted by apprentices. Once the initial work has been completed, the company will have the option of using a group of master welders to check and, if necessary, re-work the welds of the rst group. This would cost an additional $20 per seam checked, plus another $100 per seam re-worked. If any seams are checked, then all are checked. The re-work, however, is applicable only to the seams which are checked and found to be defective. (The master welders will always nd a defective seam, and will never re-work a seam which is not defective.) If no rework is done, then based on past experience, 2% of the time 1% of the seams will be defective, 50% of the time 5% of the seams will be defective, 30% of the time 10% of the seams will be defective, and 18% of the time 20% of the seams will be defective. If the master welders have checked and re-worked the defective seams then all seams are guaranteed to be non-defective. If a defective seam is not discovered until after the construction work has been completed, then there will be a cost of $1,000 for each defective seam. (a) What would you recommend to the oil company? (b) If the percentage defective amongst all the seams could be reliably estimated after only one tenth of the welds had been checked (and, if necessary, re-worked) by the master welders, would this affect the recommendation given in part (a)?
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8. In the selection process for new products, one of the criteria which is often used is called the project value index (PVI). This is the ratio of the expected revenue of the project to the expected cost of the project. The product must go through two stages (a) technical development and (b) commercial development. Let r be the revenue if the product is successful; if it is a failure, then assume that there is no revenue. Dening symbols for the costs and probabilities which you think are relevant, set up a decision tree and derive a formula for the PVI. 9. Smuth Tauker is the chief counsel for Peek-a-Boo Magazine. The company is presently facing two related lawsuits for invasion of privacy. One is scheduled to be heard on July 2 and the other on November 5. The preparation cost for either lawsuit is $15,000, but if both are done at the same time, then the combined cost will be only $25,000. Either suit can be settled out of court for $80,000, which will avoid the associated preparation cost for that suit. If a suit is won, then no further costs are incurred for that suit. If the rst suit is lost, then the company will be required to pay $150,000. If the second lawsuit is lost, then the court may decree only a minor penalty of $50,000 or a major penalty of $200,000. The probabilities of the outcomes of the second suit depend on the outcome of the rst suit as follows: First Suit Settled Won Lost Second Suit Minor Major 0.30 0.40 0.30 0.10 0.40 0.40
Win 0.30 0.60 0.20
What would you recommend to Mr. Tauker, and what is the expected cost of the recommendation to the company? 10. The government has indicated that it is planning to open up a new college in either town A or town B. The decision will be made in one years time. A large real estate developer is planning to develop a new subdivision in one of these towns and has located land in both communities which is suitable. Land is being purchased by speculators and the developer needs to make his
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decision on the land soon. He can take a one-year option on both locations for $100,000 or purchase one of them outright now. (The option would give him the right to buy either property one year from now at the current price.) He does not want to commit the resources to buying both pieces of land. The value of the land is estimated to be as follows:
Town A B
Present Value 500,000 1,000,000
Future Value if Town Chosen Not Chosen 800,000 300,000 1,400,000 600,000
The government has initiated an independent commission to recommend one of the sites. The report is due in eleven months (about a month before the expiry of the option) and although the recommendation is usually taken, other political factors sometimes cause the recommendation to be rejected. The developer has hired a real estate consultant at a cost of $20,000 to help with his decision. The consultant reports that at the present time, town A has a slight edge over town B with a probability of being recommended by the commission of 60% versus 40% for town B. In addition, based on the results of previous commissions, the commission recommendation was followed 80% of the time. The government will make its decision just prior to the expiration of the option. As with most government initiatives, there is a chance that the government will have to divert the funds elsewhere and the college will be postponed indenitely. After the government has either accepted or rejected the recommended site, and after the option will have expired, there is a 15% chance that neither town will be awarded the new college. What should the developer do? 11. A ballpoint pen manufacturer produces pens with an ink designed to ow freely in sub-zero temperatures. The manufacturer produces the pens in batches of 1000. Depending on factors in the manufacturing process, sometimes the entire batch produced has pens with ink that have turned solid. This happens about ten percent of the time. If a batch has solid-ink pens, then the entire batch is worthless. Otherwise, the pens sell for $3.00 each.
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c April 28, 2010 D.M. Tulett A test can be performed on the raw materials before a batch is produced. If performed at this time, the test would cost $50.00. If the test result is negative, this guarantees that there will be no problems with the entire batch (the pens will not have solid ink). If the test result is positive, the solidink problem will affect the entire batch to be produced. In this situation, there are two alternatives. A chemical can be added to the raw materials at a cost of $2000 which will completely correct the problem. Alternatively, the ink can be heated at a negligible cost, which will partially correct the problem. Pens made with heated ink will work at normal temperatures, but not at sub-zero temperatures. Such pens sell for $0.79 each. The test can also be done when the batch is half completed. It would cost only $20.00 if performed at this time. If the test result is positive, the pens already produced are not salvageable, but either the chemical or the heating process can be applied to the remaining half of the batch. The effects would be the same as before but adding the chemical will cost only $1250. Use a decision tree to determine what the manufacturer should do.
12. A machine shop has received an order for 4,000 units to be made on one of its automated machines. Once started the machine runs without interruption. The shop makes a prot of $5 on each part of acceptable quality. Each unit which is classied as defective needs rework at a cost of $9 before it is considered to be acceptable. The full order must be acceptable. Historical data indicates that if the machine is used without any special preparation, it produces either 1% defectives (this happens 30% of the time), 2% defectives (45% of the time), or 5% defectives the rest of the time. A trial run can be performed at a cost of $200 to determine the defect rate. With a minor adjustment that costs $100, the defect rate above 2% can be reduced to 2%; with a major adjustment that costs $500, the defect rate can be reduced to 1%. Use a decision tree to nd the optimal adjustment policy.
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23.4
Imperfect Information
1. Major Motors produces a line of passenger cars. Ninety-seven per cent of the production is of high quality, requiring only $500 in warranty work, but the rest are lemons. If a customer receives a lemon it will cost Major Motors $10,000 to replace it with a high quality car (this includes the subsequent $500 to be spent on the new car). Adding a re-work section to the assembly line would guarantee that each car would be of high quality, but this would cost $400 per car. (a) Should the company re-work the cars? (b) What is the EVPI? Suppose that the company can inspect each car at a cost of $50 (per car) before deciding whether or not to re-work it. The results of the inspection would be one of the following: looks bad, inconclusive, or looks good. If the inspected car is of high quality, then there is an 80% chance that the inspection will indicate looks good, and a 20% chance that the test will be inconclusive. If the inspected car is a lemon then there is a 75% chance of a looks bad result, otherwise the inspection will be inconclusive. (c) What should the company do now? 2. A publishing company is considering whether or not to publish a manuscript from an unknown author. To develop a manuscript into a book would cost $50,000. In the absence of an external review of the manuscript, past experience suggests that when the author is unknown there is only a 5% chance that the book would be a major success, and a 15% chance that the book would be a minor success. If the book is published and if it turns out to be a major success, then it will generate $500,000 in revenue for the company, while a minor success will generate $100,000. If the book turns out to be a failure then it will generate no revenue. (a) Should the company develop the manuscript into a book? (b) What is the EVPI? The company can send the book to a reviewer who will either recommend or not recommend. If the book would be a major success, then there is a 90% chance that the reviewer will
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c April 28, 2010 D.M. Tulett recommend that the manuscript be developed as a book. If the book would be a minor success, then the probability that he will recommend is 60%. If the book would be a failure, then there is an 80% chance that he will not recommend. (c) If the reviewer demands a fee for his services, what is the most that the publishing company would be willing to pay?
3. J.R. Blossom is a prolic author of murder mysteries. She holds the copyright on her works, and she is now considering whether she should sell the exclusive lm rights to her novel Murder on Wall Street to a movie company or a TV network. If she signs with the TV network, then she would receive a xed payment, regardless of the ratings. The movie company, on the other hand, is offering a royalty based on box ofce performance. The payoffs can be summarized as follows: Box Ofce Medium Large 1,000,000 3,000,000 1,100,000 1,100,000 0.5 0.2
Alternative Movie Co. TV Network Prob.
Small 100,000 1,100,000 0.3
(a) Based on the above information, to whom should Ms Blossom sell the rights? (b) What is the EVPI? She also knows of a market research rm specializing in movie productions. For $25,000, the rm will give either a looks favourable or looks unfavourable recommendation. The track record of the rm can be summarized as follows: Actual Outcome Small Medium Large Looks Favourable 0.20 0.60 0.80 Looks Unfavourable 0.80 0.40 0.20
(c) What would you recommend that Ms Blossom do? (d) What is the EVII?
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4. Due to recent mild weather, a ski resort operator must prepare his slopes for the weekend crowd using articial snow. He estimates that it will cost him about $1,000 per slope. From past experience, he estimates that only three or four slopes will be needed at this time. If the turnout is light, then the weekend receipts will be $10,000. If the turnout is moderate, then three slopes will give receipts of about $13,000 whereas four slopes will give $14,000. If the turnout is heavy, then three slopes will give receipts of $15,000 whereas four slopes will give receipts of $20,000. At present he estimates the probabilities of having light, moderate and heavy turnouts to be 0.5, 0.4 and 0.1 respectively. (a) With only the above information, what would you recommend to the operator? (b) What is the EVPI? A small marketing research rm will carry out a quick survey of sports shops to determine recent activity. They will report the level of activity as either low or high. Past experience has shown that when the turnout was light, the rm reported low 85% of the time, when the turnout was moderate the rm reported high 60% of the time, and when the turnout was heavy the rm reported high 90% of the time. The cost of the survey is $200. (c) What would you recommend to the operator? (d) What is the EVII? 5. A coin is lying on the table with a head facing up. It is either two-headed or a normal coin. You are asked to guess the type of coin. If you guess correctly you win $2.00, but you lose $1.00 if you guess incorrectly. You have the opportunity of having an impartial observer ip the coin and tell you if it came up heads or tails. The ip, if performed, would cost you $0.20. (a) What should you do? (b) What is the value of the ip? (c) Suppose you can elect to buy either one or two ips at a cost of $0.20 per ip before any ipping takes place? What should you do?
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6. Consider the situation as in the previous problem, but now you know that the coin has been picked at random from a pile of ve coins with two of them being two-headed. The coin has been placed with its head (or one of its two heads) face up. Solve as per parts (a), (b), and (c) above. 7. A Management Science student feels that things are not going very well. He thinks that he has only a 30% chance of passing the course. The actual mark is not too important if he manages to obtain the pass. A special tutor will cost $100 and will increase his chance of passing to 90%. He values passing the course to be worth $500. Some enterprising Management Science graduates have developed a pretest which helps predict how well students will do on the nal exam. (Assume that the nal mark in the course is based only on the nal exam). The result of the pretest is either pass or fail. For the students who do not subsequently use a tutor, the pre-test has been found to be reliable 18 times of the last 20 times it was given. For example, if 20 students who do not subsequently use a tutor are destined to fail the course, then 18 of them would fail the pre-test. Assume that if a student who takes the pre-test subsequently uses a tutor, then the chance of passing the nal exam is still 90%, regardless of whether the student passed or failed the pre-test. It costs $10 to take the pretest. What would you recommend that this student do? 8. Management at Toys, Inc., must decide whether the company should produce a new toy. They feel that there is a 60% chance that the toy will be successful. If the product is successful, then the rm will earn $600,000. Otherwise an unsuccessful toy will involve a loss of $400,000. Two market survey rms have submitted bids for interviewing toy store owners. R Inc., is known to conduct highly accurate surveys at high cost. Its fee is $40,000 per report containing data on the owners impression of the product. Its past studies show the following results: - When a product has been successful, 80% of the interviewed owners had been favourably impressed; - When a product has been unsuccessful, 75% of the interviewed owners had been unimpressed.
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I Inc. has a lower fee but provides less accurate information. It wants $20,000 for its report on the owners impression of the product. Its past studies show the following results: - When a product has been successful, 60% of the interviewed owners had a positive impression and 25% were neutral; - When a product has been unsuccessful, 30% of the interviewed owners had a neutral impression and 50% were negative. (a) What would you recommend to the management of Toys, Inc. assuming that at most one survey would be undertaken? What is the EVPI? (b) What are the efciencies of the two surveys? 9. You would like to pass Management Science, but you are not exactly sure if you will! You have the opportunity of doing an Exam Preparation Session before writing the exam. You estimate the chance of passing the course without any help to be 60%. However, the uncertainty as to what you are missing will give rise to mental anguish costs of about $7. The exam preparation session will leave you with a feeling of condence, mild confusion or despair. From past sessions the following results were observed: Actual Result Pass Fail Feeling after session Condent Confusion Despair 0.60 0.30 0.10 0.20 0.30 0.50
It has assessed that the cost associated with failing is $30 (need for alcohol to calm your shattered nerves and ego) and the bonus of passing is $25. How much would you be willing to pay to take the exam prep session? 10. Janet Descartes owns 1000 shares of International Automated Machines, a company whose stock symbol is IAM and whose slogan is I think, therefore IAM. Her mortgage is up for renewal next week and she wishes to sell these shares so that she can pay down her mortgage. IAMs earnings are
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c April 28, 2010 D.M. Tulett due out in three days time. She must decide whether to sell these shares just prior to or just after the earnings announcement. The current price of the stock is $15 per share. Assume that this will remain constant until the earnings announcement. Assume that after the announcement the price will be either $10, $13, $15, $17, or $20 per share with probabilities of 0.1, 0.2, 0.3, 0.2 and 0.2 respectively. (a) What would you recommend to Ms Descartes and what would be the expected payoff? (b) What is the expected value of perfect information? (c) Ms Descartes can obtain some information on IAM. For a fee, a nancial research company will investigate IAM and will provide one of the following three predictions: (1) earnings will be worse than expected (2) earnings will be as expected (3) earnings will be better than expected. Based on their past predictive ability, Ms Descartes will use the following conditional probabilities: Price per Share $10 $13 $15 $17 $20 worse 0.90 0.70 0.30 0.10 0.02 Earnings Forecast as expected better 0.09 0.01 0.25 0.05 0.40 0.30 0.15 0.75 0.05 0.93
What is the highest fee that Ms Descartes would be willing to pay for such information? 11. A farmer who lives not too far from a large city has been approached by a circus and a rock concert promoter with offers to rent land. Normal prot from the land would be $5,000. The circus, held under a tent, will pay the farmer $10,000 to rent the land. The rock concert promoter will pay $5,000 + 10% of the ticket sales. Ticket sales depend on the weather as follows: $100,000 if sunny, $70,000 if cloudy, and $20,000 if rainy. From past experience the farmer estimates that the probabilities are 0.60, 0.30, 0.10 for
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sun, cloud and rain respectively. The circus and rock concert promoter are responsible for all expenses associated with each respective event. (a) What would be your recommendation to the farmer? (b) What is the EVPI? To better predict the weather next summer, the national meterological service will provide the farmer with a long range forecast. There is a cost of $200.00 to receive the forecast this far in advance. The weather forecasters have provided the farmer with the following summary of their previous track record for predicting weather this far in advance. Actual Sun Cloud Rain Sun 0.8 0.3 0.1 Predicted Cloud Rain 0.1 0.1 0.6 0.1 0.2 0.7
(c) What is your recommendation for the farmer now? (d) What is the standard deviation of the payoff for your recommendation? (e) What is the EVII?
For problems 12 to 24 inclusive, the solutions rst give the recommended alternative in the absence of the testing information, secondly they give the EVPI, and thirdly they provide the overall recommendation considering the testing information; only the latter is provided in the Answers section at the back of the book. 12. An oil company owns a plot of land under which there might be a pocket of oil. The chance that a hole drilled on this land will nd oil is about 1%. Such a hole would cost $700,000, and if oil is found assume that it has a value of $40,000,000. At a cost of $50,000, a seismic test could be performed. The results of a seismic would be either positive, inconclusive, or negative. In the area in which the land is located there is 70% chance
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c April 28, 2010 D.M. Tulett of a positive reading if there really is oil present, a 25% chance of an inconclusive reading, and a 5% chance of a negative reading. If there really isnt any oil, then there is a 10% chance of a positive reading, a 35% chance of an inconclusive reading, and a 55% chance of a negative reading. What should the oil company do?
13. A trawler is shing in international waters. A deep-water net from this trawler becomes tangled in a sunken sailing ship which lies on the ocean oor. Noting the exact latitude and longitude, the captain does some research when he arrives back in port. He discovers that eight sailing ships have sunk in that vicinity over the past several centuries. One of these eight ships was a Spanish galleon laden with gold worth about $10,000,000 at todays prices. In the absence of any other information he believes that there is one chance in eight (0.125) that he has found the Spanish galleon. He assumes that the other seven ships contain nothing of value. The depth of the water precludes scuba diving. However, he could hire a submarine to search the ship and, if applicable, retrieve the gold. This would cost $800,000 if only searching were performed. There would be an additional charge of $1,200,000 to retrieve the gold if the ship turns out to be the galleon. The captain learns from a scientist friend of a procedure which can be used to do underwater testing of the presence of gold. This test would involve dropping a cable with an electronic probe from the side of the trawler. Given that some monitoring equipment needs to be on the trawler, the captain would need to make a special trip to the location. Adding up the costs involved, the captain gures that the test will cost about $50,000. The test is not perfect. It will give one of three readings, strong, medium, or weak. When the probe is near gold there is a 50% chance of a strong reading, a 40% chance of a medium reading, and a 10% chance of a weak reading. When the probe is not near gold there is a 5% chance of a strong reading, a 25% chance of a medium reading, and a 70% chance of a weak reading. What is your recommendation to the captain? 14. Nu Products Inc. has recently developed a new product and is in the process of trying to develop a marketing strategy. They have come up with two marketing strategies Plan A and Plan B. Unfortunately, the success of
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the strategies depends on the market receptiveness. Management estimates that there is a 60% chance that the market would be receptive to Plan B, otherwise the market would be receptive to Plan A. If the market turns out to be receptive to Plan A, then the payoff would be $500,000 if Plan A had been used, but the payoff would be only $300,000 if Plan B had been used. Similarly, if the market turns out to be receptive to Plan B, then the payoff would be $450,000 if Plan B had been used, but the payoff would be only $200,000 otherwise. There is a small survey available which will recommend using either Plan A or Plan B. The survey is 80% reliable. In other words, if Plan A will be preferred by the market, there is an 80% chance that the survey will recommend that Plan A be used; if Plan B will be preferred by the market, there is an 80% chance that the survey will recommend that Plan B be used. The cost of the survey is $10,000. What would you recommend to Nu Products? 15. A thoughtful young man has decided that it would be advantageous to his career path if he obtained an M.B.A. degree. The universities he is considering are: OWU which concentrates on the case approach, and CBU which concentrates on the theoretical approach. A government study has shown that in two years time (i.e. upon graduation), there is a 60% chance that employers will prefer a graduate from a case program. If this occurs, a graduate of OWU will receive a starting salary of $38,000 whereas a graduate of CBU will receive only $35,500. However, if employers prefer a graduate from a theory program, then a graduate of OWU will receive only $34,000 but a graduate of CBU will receive $39,000. We will assume that the salaries in later years are independent of the starting salary. Before making his nal decision, a friend informs him that there is a genuine futurist who has a reliability of 95% on his predictions. However, the futurist charges $1,000 per prediction and gives only one prediction per customer. Assuming that the costs of obtaining the degree and other non-monetary factors are the same at each of the universities, what should the young man do? 16. General Lemmor has run into some unexpected resistance of unknown strength. If he launches an all out assault on the position with his existing forces, then
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c April 28, 2010 D.M. Tulett he is sure that he will wipe out the position but the casualties might be excessive. If the position is well fortied, then he will sustain about 2,000 casualties whereas if it is lightly defended he will sustain only 50 casualties. He thinks that there is about a 30% chance that it is well fortied. If he waits for reinforcements, then an all out assault will only sustain about 100 casualties if it is well fortied and no casualties if it is lightly defended. Unfortunately time is of the essence and waiting for reinforcements will give rise to an estimated 1,000 casualties later. General Lemmor has the option of launching a probing attack. The losses incurred during this attack will indicate to him how well the position is fortied. If it is well fortied he will sustain 100 casualties with probability 0.9, but only 10 casualties otherwise. If is lightly defended then he will sustain 100 casualties with probability 0.05 but only 10 casualties otherwise. What advice would you give General Lemmor?
17. A company is in a position to invest in a new venture which has only two outcomes - a gain of $25,000 with a probability of 0.60 or a loss of $15,000 with a probability of 0.40. The company has the option of consulting an investment rm which will either recommend or not recommend investing. The past experience of the investment rm is as follows: Firm recommends to invest not invest 0.70 0.30 0.35 0.65
Investment Successful Failure
The investment rm has two plans - (i) an upfront charge of $2,000 or (ii) no upfront charge but instead a fee of $500 if the company does not invest, or a fee of $3,000 if the company does invest. (a) What would you recommend to the company? (b) What is the expected fee which would be paid if the second plan were to be used? 18. At the outset of each working day, an assembly line is set up to produce colour picture tubes. The daily production capacity is 50 units. Normally, the line will produce defectives according to a Bernoulli process with p =
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0.02 (this happens about 85% of the time). On the other days, however, defectives are produced according to a Bernoulli process with p = 0.30. An inspection station can test up to two picture tubes, at a cost of $55 per tube tested. The test is not destructive (hence any tubes which are tested and are found to be acceptable will be sent to a customer). Acceptable tubes generate a revenue of $120 each. If a customer receives a defective tube, no revenue is received instead there is a cost of $40 whenever this happens. A resetting procedure is available which will guarantee that no defectives will be produced. Resetting the assembly line costs $500 and reduces that days capacity by three units. Hint: Use a payoff node whenever one or two of the tested tubes are found to be acceptable, since there is a revenue of $120 for each of these regardless of what else happens. Determine the optimal number of tubes to test, if any, and the total expected contribution to prot associated with such a policy. 19. The Sultan of Samarkan has decided to give you a bonus for the tremendous job you did using management science techniques to solve his problems. He has come up with the following proposal. In front of you are two identical urns - one is lled with 1000 gold coins and the other with 600 gold coins and 400 lead coins. If you correctly tell the Sultan the contents of one of the urns you will receive both urns. If you guess incorrectly, then you will receive only 100 gold coins as a consolation prize. If you wish, you may have one of the Sultans attendants take one coin from one of the urns and show it to you. However, this will subtract 500 gold coins from the total number of 1600 should you guess correctly, or will subtract 20 gold coins from the consolation prize should you guess incorrectly. What is your optimal course of action? 20. Researchers at Chembioco have just discovered a vaccine which retards the AIDS virus. They are now in a race against time to produce the vaccine in large quantities. It is known that either process X or process Y will be successful but not both. The probability that X will be successful is 30%. It will take two years to develop and try process X; it will take one year
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c April 28, 2010 D.M. Tulett to develop and try process Y. Due to a restriction on the amount of lab space available, the two processes cannot be developed simultaneously. For example, if X is tried and is found to be unsuccessful, an additional year must be spent to develop process Y (even though you know that it will be successful). It is possible to perform an experiment which will give an indication of the correct process. It takes three months to perform and predicts X 80% of the time that X will be successful and predicts Y 90% of the time that Y will be successful. Because of the shortage of lab space, the experiment cannot be performed simultaneously with either of the processes. What would your recommend to Chembioco?
21. First Rate Inc. is having some minor production problems. The production quality for one of the components of the nal product is quite variable from day to day. The recent experience has been that on 40% of the days there is a 1% defect rate, on 50% of the days there is a 4% defect rate, and on the remaining days there is a 10% defect rate. The daily production has averaged 1000 units and each defective unit sent back costs the company $100 in rework and other charges. Each of the components can be reworked before putting them into the nal product at a cost of $4 per unit. This rework will guarantee that the component is reliable. The company has at its disposal a testing procedure which determines the reliability of the component. Unfortunately it destroys the tested unit(s) for a net cost to the company of $50 per unit tested. What would you recommend to First Rate to improve the quality of its product? 22. An electronics manufacturer is having varying production quality for the integrated circuits which it produces. Sixty-seven integrated circuits are needed per day. The plant has a capacity to produce seventy per day. On normal days, the number of defective integrated circuits produced has a binomial distribution with a percentage defectives of 4%. Sometimes, however, the machine which produces the ICs has an erratic day and the percentage defectives increases to 30%. Erratic days occur about 12% of the time. If a defective IC is soldered to any other part, it results in a $8 charge to rework. If desired, the ICs can be reworked before soldering, guaranteeing
c April 28, 2010 D.M. Tulett that they will not be defective at a cost of $2 per IC.
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There is a destructive test procedure available which will indicate whether or not the IC being tested is defective. To produce an IC in excess of the required 67 would cost $1.50 per IC, and the test would cost $1 per unit tested. What should the manufacturer do? 23. A microcomputer chip production line produces large batches of chips each day. In 80% of the batches there are no defects, and the remaining 20% have 30% defectives. A good batch received by a customer is worth $5,000 to the company, but a bad batch costs $2,000. If you wish, you may non-destructively test one or two chips at a cost of $100 per chip tested which will clearly identify the chip as being defective or not. At any time the batch may be destroyed at the plant, at a cost of $500. What would you recommend to the company? 24. A company is considering introducing a new product and has two products under consideration. Product 1 will cost $10,000,000 to develop and has possible demand levels of high, medium and low with net payoffs (excluding development costs) of $15,000,000, $5,000,000 and $5,000,000 respectively. The probabilities associated with the product are 0.5, 0.4 and 0.1 for each demand level respectively. Product 2 will cost $5,000,000 to develop and has possible demand levels of good and poor with probabilities 0.6 and 0.4 respectively and with payoffs of $7,000,000 and $2,000,000. If the market response is unfavourable, then the company can improve the product further. Product 1 will cost $10,000,000 and product 2 will cost $2,000,000. For product 1 the effect of this improvement will be to change the probabilities of high and medium demand to be 0.3 and 0.7 respectively, whereas for product 2 it will change the uncertainty of good and poor demands to be equally likely. A marketing research company has a survey available which will provide information on the market response. In the past for those times that a product made a net prot, the survey predicted a go result 80% of the time and when a loss was incurred, the survey predicted a no go result 70% of the time. The cost of the survey is $15,000.
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c April 28, 2010 D.M. Tulett What would you recommend to the management? What are the expected values of imperfect information? Problems Involving Sequential Bayesian Revision The rest of the problems in this section require that two revisions be done in series. Some of the technical aspects of this are covered in the appendix to the chapter.
25. A company is considering implementing a new quality control system. One of its machines normally produces only 2% defectives, but occasionally (10% of the time) it produces 8% defectives. A test can be performed which will give a reading of good, inconclusive or poor. If the setup is normal, it will give a good reading 60% of the time and a poor reading 10% of the time. If the setup is abnormal, it will give an inconclusive reading 50% of the time and a poor reading 40% of the time. (a) What is the probability that the rst test will give an inconclusive reading? (b) If both the rst and second readings are inconclusive, what are the probabilities of normal and abnormal setups? 26. A coin lying on a table is either a two-headed coin or a fair coin. The coin has a head facing up. You are asked to guess what kind of coin it is. If you guess correctly, you win $2. If you guess incorrectly, you lose $1. You have the opportunity of having an impartial observer ip the coin up to three times and tell you after each ip if it came up heads or tails. Each ip, if performed, would cost $0.20. You will defer the decision about subsequent ips until you know what happens on the current ip. (a) If a ip comes up tails, what can you say about the coin? (b) Using the result from part (a), draw a decision tree and determine your optimal action. 27. ABC Corp has developed but not produced a new product and must decide whether or not to market it. The possible demands are characterized as high, medium, and low with marginal prots respectively of $500,000, $100,000
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and $300, 000. Management assesses the probability of high demand to be 20% and medium demand to be 40%. Two surveys, A and B, are available. Survey A costs only $10,000 and will give a recommendation of go or no go. Based on past experience, a go recommendation was given 70% of the times when the demand was high, 50% of the times when the demand was medium and 30% of the times when the demand was low. A no go recommendation was given 30% of the times when the demand was high, 50% of the times when the demand was medium and 70% of the times when the demand was low. Survey B costs $50,000 and gives predictions on the actual demand. Past experience is given in the following table. Predicted Demand High Medium Low Actual demand High Medium Low 0.90 0.30 0.10 0.10 0.50 0.40 0.00 0.20 0.50
Survey B can be used by itself or following survey A. Survey A will not be done if survey B has already been done. What would you recommend? 28. A Type I urn contains four red balls and one blue ball. A Type II urn contains one red ball and three blue balls. You are invited to play a game in which there is one urn which is either Type I or Type II. The object of the game is to correctly identify the type of urn. It costs $5.75 to play the game. The prize for correctly identifying the type of urn is $10.00. If you wish, you may draw one or two balls from the urn. If a second ball is drawn, it is only after you have seen the rst ball. It costs $2.00 to draw the rst ball. If after seeing this ball you then decide to draw another, then the cost to draw it is $0.40. (a) Suppose that you have decided to draw a ball, and after observing this ball you decide to draw another. Without doing any calculations, what can you conclude about the urn if (i) both balls turn out to be red? (ii) both balls turn out to be blue?
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c April 28, 2010 D.M. Tulett (b) Using the results from part (a), draw the decision tree, and determine how, if at all, the game should be played.
29. Pleasure Craft Inc. produces a line of power boats. Ninety-ve per cent of the production is of high quality, requiring only $2000 in warranty work, but the rest are lemons. If a customer receives a lemon it will cost Pleasure Craft $40,000 to replace it with a high quality boat (this includes the subsequent $2000 to be spent on the new boat). Adding a re-work section to the assembly line would guarantee that each boat would be of high quality, but this would cost $1500 per boat. (a) Should the company re-work the boats? (b) What is the EVPI? Suppose that the company can inspect each boat at a cost of $200 (per boat) before deciding whether or not to re-work it. The results of the inspection at this station would be one of the following: looks bad, inconclusive, or looks good. If the inspected boat is of high quality, then there is an 80% chance that the inspection will indicate looks good, a 15% chance that the test will be inconclusive, and a 5% chance of a looks bad result. If the inspected boat is a lemon then there is a 79% chance of a looks bad result, a 20% chance that the inspection will be inconclusive, and a 1% chance of looks good result. (c) What should the company do now? In addition to the inspection station mentioned above, Pleasure Craft can add a second inspection station (which can only inspect a boat which was inspected at the rst station). The result of the inspection at the second station is reported as being either pass or fail. If the boat is of high quality there is a 90% chance of a pass. If the boat is a lemon there is a 98% chance of a fail. (d) Draw and solve the new tree. Imperfect Information (Advanced) 1. Life at Chembioco (see the preceding section) is not as simple as it could be. A third process which will take 18 months to develop is also available which changes the probability of Y being the correct process to 50% while leaving
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the probability of X unchanged. The laboratory test results are incorporated in the following table. If needed, the test can be repeated. Experiment Predicts X Y Z Actual Successful Process X Y Z 0.70 0.40 0.30 0.20 0.50 0.30 0.10 0.10 0.40
If one process has been shown to be unsuccessful, then the remaining probabilities must be re-scaled to 1. What would you recommend to Chembioco in this case? Note: This is a major problem with a signicant number of sub-trees. 2. A company has the drilling rights for a promising tract of land. Initial indications are that there is a 60% chance that the tract has standard oil bearing formations. If the formation is present, there is a 15% chance of no oil, a 35% chance of small reserves and a 50% chance of large reserves. Otherwise, there is an 80% chance of no oil and a 20% chance of small reserves. Small reserves are worth 10 million dollars to the company and large reserves are worth 100 million dollars. A more detailed seismic survey can be done at a cost of $500,000. The seismic result will be either positive or negative. If the formation exists, then there is an 80% chance that the survey will give a true positive result and a 15% chance it will give a false positive (the formation does not exist but the test is positive). The land can be sold at any time. If there is no survey, the sale price is $500,000. If the survey is positive, then the land is worth $1,000,000; otherwise it is worth only $100,000. A full scale drilling program will cost the company 5 million dollars and will completely determine the nature of the reserves. If there are no reserves, then the land will have a value of only $10,000. What would you recommend that the company do? 3. Video Shack is a retail chain specializing in electronic equipment. It is currently having some problems with one of its high volume items. These
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c April 28, 2010 D.M. Tulett items are ordered from the supplier in lots of 100 units and give a prot contribution of $10 per unit. Past experience indicates that the possible percentage defectives in a lot are 10%, 20% and 30% with probabilities of 0.5, 0.3 and 0.2 respectively. Video Shack could non-destructively test some or all of the units. A maximum of three units could be tested sequentially (test one and see whether its defective or acceptable, then test another, and so on); however, at any time they may choose to test all remaining units. (For example, after testing two units, they could choose to do no more testing, or test the third unit, or test all remaining 98 units.) No matter how the testing is done, the testing costs $4 per unit tested. If Video Shack inspects a unit and nds it to be defective, then it will be replaced by the supplier at no cost. The replacement unit will be known to be non-defective. However, when a defective unit is sent to a customer, it is replaced by Video Shack at a cost of $20. What would you recommend to Video Shack?
4. This problem was rst seen on page 370. The Plastic Production Company needs to expand its production capacity for the next year. The marketing department has determined that the company will need 5,000, 10,000, or 15,000 cases of increased capacity with probabilities of 0.3, 0.5, and 0.2 respectively. The company is considering two options to meet the situation. First of all, they can use overtime at a cost of $3.00 per case in addition to the regular cost of $10.00 per case. However, if the required demand turns out to be 15,000 units, then there will be a 50% chance that there will be labour unrest after six months which will add another $2.00 per case. Secondly, they could operate a second shift. This will entail a xed cost of $15,000 for startup expenses and a $1.00 per case shift premium. However, if the demand turns out to be only 5,000 cases, then they will be required to layoff the shift at a cost of $5,000 and use overtime. If desired, the company could start the second shift in six months time instead of starting it immediately. A survey which costs $2,000 is available which has had the following history: it gave a positive response 80% of the time when the demand subsequently had a large increase
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it gave a positive response 50% of the time when the demand subsequently had a moderate increase it gave a positive response 30% of the time when the demand subsequently had a small increase. In addition, the company could monitor the labour situation at a cost of $500. This would have a 95% reliability in predicting labour unrest. Find the optimal course of action for the company. 5. A game is played with fteen cards the four Kings, and eleven other cards. If you wish to play you give $1 to the dealer. The cards are shufed and dealt into three piles (A, B, and C) of ve cards each. The object of the game is to correctly guess how many Kings there are in Pile C. Pile A is given to you, while piles B and C are placed face down. After looking at your cards, you can either fold, or continue playing by giving $2 to the dealer. After paying the $2, you may guess the number of Kings in pile C. A correct guess wins a $8 prize, an incorrect guess wins nothing. Only one guess is permitted at any time in the game, of course. Before guessing you may sequentially draw one or more cards from pile B, at a cost of $1.50 per card. You may draw all ve cards if you wish. What is the optimal procedure for playing this game? 6. Solve the preceding problem where the drawing of the cards must be made simultaneously.
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23.5
Linear Optimization Introduction
1. A company produces two products. Each product must pass through two machines. Each unit of the rst product requires 10 minutes on machine A, and 6 minutes on machine B. Each unit of the second product requires 8 minutes on machine A, and 15 minutes on machine B. On a daily basis, machine A is available for 7 hours, while machine B is available for 7.5 hours. Each unit of product 1 contributes $45 to prot, while each unit of product 2 contributes $30. At least 20 units of product 1 and at least 15 units of product 2 must be produced each day. (a) Formulate a linear model which will maximize the daily contribution to prot. (b) Solve graphically to obtain a recommendation. 2. A student has just won $100,000 in a lottery, and she has decided to invest some or all of it in the stock market. She has identied 10 blue chip stocks; stocks 1 to 4 are utilities, 5, 6, and 7 are industrials, and 8, 9, and 10 are high-tech companies. Let Xi represent the amount of money (in dollars) invested in security (stock) i, where i = 1, . . . , 10. Write the following constraints mathematically, using summation notation where appropriate: (a) Her total investment must not exceed $100,000. (b) She will invest at least $2,000 in each security. (c) She will invest no more than $20,000 in any security. (d) She will invest at least $21,000 in utilities, at least $18,000 in industrials, and at least $15,000 in high-tech companies. (e) She will invest no more than $60,000 in utilities, no more than $50,000 in industrials, and nor more than $40,000 in high-tech. (f) The amount invested in utilities must be at least half as much as the amount invested in industrials and high-tech combined. (g) The amount invested in industrials must not be over $20,000 more than the amount invested in high-tech.
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3. A cat owner buys cat food from two sources and blends them to obtain a minimum cost nutritious diet. The two products have the following characteristics: Product 1 2 Cost per kg. $0.60 $1.20 Protein (% by weight) 20 50 Carbohydrates (% by weight) 25 30
Suppose that a cat needs 80 grams of protein per day, and 75 grams of carbohydrates per day. The owner wishes to determine how much to buy of each product. Assume that the cat will eat everything that she is given. (a) Formulate a model for this problem. (b) Solve this model by using the graphical method. (c) The company which produces product 2 decides to raise its price to $1.80 per kilogram. What will the owner do now? 4. Given the following model min subject to (1) (2) (3) (4) 2X1 + 5X2 6X1 3X1 4X1 2X1 X1 + + , 3X2 5X2 3X2 1X2 24 30 12 0 0
X2
(a) Solve using the graphical procedure. (b) For each constraint, state whether or not it is binding, and state which constraints (if any) are redundant. 5. (a) Show the following model graphically, labelling all constraints, drawing an isovalue line, and indicating the feasible region:
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min 2X1 subject to (1) X1 (2) 3X1 (3) X1 X1 (b) Solve the model graphically.
+ 2X2 + 3X2 12 + X2 13 X2 3 , X2 0
(c) Find the value of the objective function at each feasible corner point. 6. (a) Show and solve the following model graphically, labelling all constraints, drawing an isovalue line, and indicating the feasible region: min 4X1 subject to (1) 2X1 (2) 14X1 (3) 4X1 (4) X1 + 8X2 + 5X2 + 7X2 + 6X2 X2 , 20 35 60 8 0
X2
(b) Find the value of the objective function at each feasible corner point. (c) What happens to the feasible region and the optimal solution if the constraint 3X1 + 2X2 = 15 is added to the model? (d) Not including the constraint given in part (c), what happens if the constraint 3X1 2X2 = 15 is added to the model? 7. A prepared food shop produces regular and deluxe frozen pizzas. Each regular pizza uses 750 grams of dough mix and 200 grams of toppings, while
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a deluxe pizza uses 600 grams of dough mix and 500 grams of toppings. A new shipment of dough and toppings will arrive next week; until that time they have 75 kilograms of dough and 40.4 kilograms of toppings. They estimate that at most they could sell 70 deluxe and 80 regular pizzas during the next week. Given the above, they wish to maximize the total contribution to prot, which is based on $0.50 for each regular pizza sold, and $0.75 for each deluxe pizza sold. (a) Give the linear optimization model formulation. (b) Solve the model graphically. 8. A brewery has two brands of beer, Dark Horse and Wholesome Light. Each is composed of yeast, hops, barley, and water, but in different proportions. Each week, the brewery receives the following quantities: Yeast Hops Barley Water 51 kgs. 96 kgs. 243 kgs. Unlimited
The two products require the following amounts of inputs per litre of output: Yeast Hops Barley Water Dark Horse 5 grams 8 grams 18 grams 1.1 litre Wholesome Light 3 grams 6 grams 15 grams 1.1 litre
(Some of the water is lost due to evaporation, but this does not concern us.) Each litre of Dark Horse gives a prot contribution of $0.24, while each litre of Wholesome Light gives a prot contribution of $0.30. The brewery wishes to know how much of each brand should be produced. (a) Formulate the brewerys problem as a linear optimization model. (b) Solve the model graphically. Dark Horse consumers are incensed at the solution found in part (b). The manager therefore decrees that neither brand can represent more than 80% of the total production. (c) Add the new constraint(s), and re-solve the problem.
398 9. A problem has been formulated as: max subject to (1) (2) (3) (4)
7X1 + 2.8X2 2X1 X1 2X1 5X1 X1 + + + + , X2 2X2 3X2 2X2 6 4 12 10 0
X2
(a) Solve this problem by the graphical method, labelling each constraint and showing the feasible region and an isovalue line. Use algebra to determine the exact optimal solution for X1 , X2 , and the objective function value. (b) Suppose now that 5X1 2X2 = 0 is added as a fth constraint. Draw this constraint on the same graph, and show the new optimal solution. Again, use algebra to nd the optimal solution exactly. 10. A problem has been formulated as: max subject to (1) (2) (3) (4) 2X1 + 4X1 3X1 3X1 3X1 X1 + + + , X2 2X2 2X2 4X2 4X2 24 27 40 0 0
X2
(a) Solve this problem by the graphical method, labelling each constraint and showing the feasible region and an isovalue line. Use algebra to determine the exact optimal solution for X1 , X2 , and the objective function value. (b) Suppose now that the objective function is changed to min 6X1 2X2 . Show the new optimal solution. Again, use algebra to nd the optimal solution exactly.
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11. Solve the following model graphically. Label all the constraints, indicate the feasible region, the isovalue line, and the optimal solution. Use algebra to nd the exact optimal solution. max 3X1 subject to (1) 2X1 (2) 4X1 (3) X1 X1 + 2X2 + 5X2 10 + 3X2 = 12 + 4X2 4 , X2 0
12. (a) Solve the following model graphically. Label all the constraints, indicate the feasible region, an isovalue line, and the optimal solution. max 3X1 + 4X2 subject to (1) X1 (2) X2 (3) X1 + 2X2 (4) 3X1 + 5X2 X1 ,
8 10 22 15 0
X2
(b) What is the solution to this model if the objective is to minimize rather than to maximize? The next three problems are more difcult. The reader may wish to complete them after studying some of the formulation examples of the Applications chapter. 13. A small distillery in the highlands of Scotland custom blends a barley whisky with an ordinary grain whisky. They have received an order of blended whisky, in an amount not less than 2000 litres, nor more than 3000 litres, but otherwise at the distillerys discretion. The blend must be at least 40% (by volume) barley whisky, and must be no more than two parts barley to one part grain. They can use up to 1250 litres of each type of input whisky per week. They desire to complete the order within one week. The blend
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c April 28, 2010 D.M. Tulett is sold (before tax) for 2.25 per litre. The xed costs of operating the distillery are 2800 per week. In addition, there is a cost of 0.75 per litre of barley whisky, and a cost of 0.45 per litre of ordinary grain whisky. (a) Formulate a prot maximizing linear optimization model for the distillery. (b) Solve the model graphically to give a recommendation to the distillery.
14. An electrical utility has had its nuclear energy program frozen by the government, and has therefore decided to activate a mothballed conventional thermal plant. New pollution laws enacted since the plant last operated mean that a new operating plan will be required. The plant produces electrical energy by burning coal which heats water to produce steam. The steam drives large turbines which generate electrical energy. The coal arrives by rail from two mines. One mine produces high quality anthracite coal, while the other mine produces lower quality bituminous coal. The railcars dump each type of coal into separate bins. From each bin, there is a conveyor belt which takes the coal to a grinding mill. From the mill the coal falls by gravity into separate bins for each type of coal. From these bins coal is fed into the combustion chamber. There are three relevant characteristics of each type of coal with respect to this particular plant. There is the thermal value, which is the amount of useful energy measured in megajoules (MJ) per tonne, secondly the amount of sulphur oxides created in the ue gases, measured in parts per million (PPM), and thirdly the particulate emissions measured in kilograms (kg) of emissions per tonne of coal. They are as follows: Thermal Value (MJ/tonne) 24,000 20,000 Sulphur Oxides (PPM) 1800 3800 Particulate Emissions (kg/tonne) 0.4 1.0
Anthracite Bituminous
Government regulations limit sulphur oxide emissions to 2600 PPM, and particulate emissions to 12.8 kg/hour. The grinding mill can handle up to 18 tonnes per hour of anthracite coal, or up to 24 tonnes per hour of bituminous coal. The conveyor belt can handle up to 20 tonnes of coal (regardless of type) per hour. The storage bins are large enough so as to not constrain the operation of the plant.
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(a) Formulate a linear model for this plant which seeks to maximize the energy output per hour. Hint: The grinding mill is represented by a single constraint, which can handle any combination of the two types of coal. (b) Graph the constraints and show an isovalue line. (c) What is the maximum plant capacity? 15. A student has formulated the following model. min 2X1 + 5X2 3X3 subject to (1) 7X1 + 3X2 (2) 2X1 + 4X2 + X3 9X1 +5X2 2X3 (3) X1 +X3 +1 (4) 3X1 + X2 + 2X3 2 4X X 6X (5) 10X1 + 5X1 1 2 3 X1 0 X2 0 X3 0 While this model is non-linear in its current form, it can be converted to a linear model. Help the student out by rewriting the model in the appropriate format. Hint: Begin by replacing X2 with a variable which cannot be negative.
40 + 2X2 2X3 20 2 28 + X3 3X1 X3 + 8X2
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23.6
Markov Chains
1. A universitys computer is always in one of two states: up (operating) or down (under repair). Transitions from state to state occur every hour and are subject to the following Markovian process: Hour t up down Hour t + 1 up down 0.9 0.1 0.8 0.2
(a) If the computer is currently up, what is the probability that it will be up four hours from now? (b) What is the expected rst passage time from up to down? (c) What is the expected rst passage time from down to up? 2. The manager at a sh plant has noticed that there seems to be a relationship between one days intake of sh to be processed and the nexts. Eighty percent of the time when todays catch is good, tomorrows is also good. If todays catch is bad, then there is a sixty percent chance that tomorrows catch is also bad. (a) If todays catch is good, what is the probability that the catch will be bad eight days from now? (b) In the long run what percentage of the time is the catch good? 3. The NF Tea Company currently has one brand which is in competition with all other brands of tea. Brand loyalty for NF Tea is 90% per week. Only 2% of the consumers of all other brands switch to NF Tea each week. (a) What is NF Teas long run market share at this point in time? (b) If a consumer is currently buying a non-NF brand, what is the probability that her next purchase of NF Tea will occur i) in two weeks time? ii) in three weeks time? NF Tea is considering the introduction of a new brand (called brand B), which will take consumers away from other brands, including their existing brand (brand A). They estimate that each
c April 28, 2010 D.M. Tulett week 3% of those buying non-NF brands will switch to NF brand B, and 5% of those buying brand A will switch to brand B. Of those who try brand B, 70% stick with it, while 20% will switch to non-NF brands, and 10% will switch to NF brand A. There is a 7% chance that a brand A buyer will switch to a non-NF brand, but only a 1% chance that a non-NF buyer will switch to brand A. (c) What is the overall long-term market share of the NF Tea Company now? (d) If a consumer is currently buying a non-NF brand, what is the probability that her next purchase of NF Tea Brand B will occur i) in two weeks time? ii) in three weeks time?
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4. Consumers in a particular region of the country make purchases of gasoline every week and brand loyalty (or lack of it) is described by the following Markovian process: Week t ESSOH URVING SEASHELL Week t + 1 URVING SEASHELL 0.1 0.1 0.7 0.1 0.3 0.5
ESSOH 0.8 0.2 0.2
(a) In the long-run, what will the market shares of the three companies be? (b) How long, on average, does a consumer take to switch from URVING to ESSOH? 5. An investor has purchases 1000 shares of a speculative stock for $25 per share. If the price rises to $28 then s/he will sell and if it falls to $23 s/he will also sell. From past experience with this stock, there is a 20% chance that the stock price will increase by $1 and a 15% chance that it will decrease by $1 from one day to the next. Otherwise, the stock price will remain the same. What is the expected gain for this speculation?
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6. Four companies are ghting for market share. For each company, the proportion of the customers who switch to another company (or who stay with the same company) each month is given by the following matrix. .2 .5 P= .1 .2 .3 .2 .2 .3 .4 .1 .3 .2 .1 .2 .4 .3
(a) By using matrix inversion within a spreadsheet model, determine the long-term percentage market share for each company. (b) There is a feature of this matrix which causes the result found in (a). What do you think it is? 7. U-Drive Car Agency maintains four rental facilities at locations W, X, Y and Z. A car can be returned to any of the four facilities. Historical data have shown that for every 150 cars picked up at each of the locations, the following return patterns have been observed: Picked Up From W X Y Z Returned to W X Y Z 74 30 26 20 30 86 20 14 15 20 90 25 35 15 30 70
(a) If this return pattern were to continue, what would be the longrun distribution of these cars, assuming no redistribution of cars by management? (b) At which location should a new service or repair facility be located? (c) In six months time, there will be a major convention at location Y. The demand during that week is estimated to be (100, 150, 250, 100). What redistribution of cars will be necessary to meet this demand?
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8. Region X, with a workforce population (includes those working and those who are seeking work) of 500,000, is adjacent to Region Y, with a workforce population of 1,000,000. Each year 10% of Xs workforce population moves to Y and 4% of Ys moves to X. If the current unemployment rate (percentage of those in the workforce who are seeking work) in X is 8%, what will it be in the long run assuming no change in the number of jobs in region X? 9. A examination body for a profession administers two examinations to each candidate. The result of each examination is either pass, marginal, or fail. If the candidate passes the rst exam, then he writes the second at the next sitting of the examinations, which is usually six months later. If he passes the second exam then he is admitted to the profession. If the student obtains a marginal on either exam, then he must re-sit the same exam at the next sitting of the examinations. If the student fails the second exam, he must repeat the rst exam at the next sitting. If the student fails the rst exam he is no longer a candidate and he must therefore pursue a different career. Suppose that on the rst exam 25% of the students pass, and 40% are marginal. On the second exam 30% pass and 50% are marginal. Find the probabilities of eventual success or failure, conditional on whether the candidate is about to write the rst or the second exam. 10. An Undergraduate Studies Committee is evaluating the performance of students in its program. Each term, each student will either pass (and is therefore promoted to the next term), fail (must repeat the same term), or withdraw. A student is said to have withdrawn if s/he changes programs or is required to permanently leave the program due to poor performance. The committee has found that the pass and withdrawal rates for each term are as follows: Term I II III IV Pass Rate 80% 85% 85% 90% Withdrawal Rate 10% 8% 6% 4%
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c April 28, 2010 D.M. Tulett Given that 200 students enter Term I, what is the expected number of students who will eventually be promoted to Term V?
11. On January 1 of each year, bank accounts are classied as active or inactive. An active account is one in which there was at least one deposit or withdrawal during the previous year, otherwise the account is inactive. During each calendar year, about 5% of all active accounts are closed, and 2% of all active accounts become inactive. In early January a registered letter is sent to the last known address of each inactive account holder, advising the customer to make the account active, or to close the account. Furthermore, the letter states that any money not spoken for by the end of the year will be turned over to the government. In response to the registered letters, about 40% of the accounts are made active, and about 45% of the account holders, who are happy to learn about forgotten money, close their accounts. About 10% of the registered letters result in a visit to the bank by a relative or friend stating that the account holder has died or has disappeared. Such accounts are handed over to the banks legal department. The other 5% of the time no response is received, and such accounts are turned over to the government. What percentage of active accounts end up eventually being transferred to the government? 12. Renteels, Inc. is in the car rental business. Its policy is to use only new or one-year old cars. Older cars are sold to the public, at the end of the second year. During the year, customers are sometimes involved in accidents and wreck the car completely. These wrecks are sold to junkyard dealers only. Past statistics indicate that 20% of the new cars and 10% of the one-year old cars meet this fate. Also, some of the cars may develop a major component failure and would then be taken out of service and returned to the manufacturer. 10% of the new cars and 5% of the one-year old cars fall under this category. At the year-end, under a special arrangement with a local dealer, Renteels can obtain a new car by trading in a one-year old car plus $2,000, or they can obtain a one-year old car for a two-year old car plus $1000. These trades happen 20% and 10% of the time respectively. Renteels presently has 60 new cars and 40 one-year old cars and wishes to know what percentage of these cars (or their trades) will eventually be sold
c April 28, 2010 D.M. Tulett to the public.
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13. DEF Co. has the following current distribution of accounts in their accounts payable ledger. Age (Months) 1 2 3 4 Number 200 150 75 20 Percentage Paid 60% 40% 30% 20%
The percentage paid column refers to the percentage of the accounts which will be paid by the end of the next month. Accounts which are older than four months are written off as bad debts. (a) What is the expected number of the existing accounts which will be written off as bad debts? (b) A collection agency has offered the following deal. As soon as DEF makes a sale, it will turn the bill over to the collection agency, who will pay 95% of the amount of the bill. Should DEF accept the deal? 14. Fine Wines Winery annually offers a selection of ne wines to a number of preferred customers during the Christmas season. Some of the wines in their collection are not considered to have aged sufciently and are not offered for sale. There are 3500 in this category. If a wine is not sufciently aged, then there is a 20% chance that it will become available and a 10% chance that it will spoil and have to be discarded. Wines available for sale have a 40% chance of sale this season, and a 20% chance of spoiling. If the current inventory is 10,000 bottles, how many will end up being sold? 15. A credit card company classies its accounts into one of ve categories: fully paid, bad debt, 0-30 days old, 31-60 days old, and 61-90 days old. Each month, there is a 20% chance that nothing will be paid on an account. There is a 25% chance that just enough is paid to keep the account in the same category. If the account is in the 31-60 day category, then there is a 20% chance that the account will be paid in full. If the account is in the
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c April 28, 2010 D.M. Tulett 61-90 day category, then there is a 5% chance that it will be paid in full, and a 10% chance that it will move to the 0-30 day category. Draw the transition diagram, and write the transition probability matrix. What is the long term probability of being fully paid, conditional on the initial classication of debt?
16. Many businesses fail because they are under capitalized. This problem examines how the probability of avoiding bankruptcy could be related to the initial level of capitalization. A new business starts off with n units of capital, where n is an integer between 0 and 20 inclusive. Each month, whenever the company begins the month with between 0 and 20 units of capital inclusive, there is probability p that the capital will increase during the month by one unit, probability q that it will decrease during the month by one unit, and probability 1 p q that it will stay the same. Suppose that when a companys capital reaches 21 units it is in the clear and there is no further risk of bankruptcy. When a companys capital falls to 1 units it declares bankruptcy. (a) Model this situation as a Markov chain, making a spreadsheet model in which the actual values for p and q are only entered once. (b) Now suppose that p = 0.2, and q = 0.5. Obtain a graph of the probability that a company will avoid bankruptcy, conditional on the initial level of capitalization (n). How long, on average, will a company possess between 0 and 20 units of capital inclusive if it starts out with 0 units of capital? . . . with 20 units of capital? (c) Repeat (b) using p = q = 0.3. (d) Repeat (b) using p = 0.5, and q = 0.4. 17. Professional baseball players begin their careers in the relatively poorly paid minor leagues. However, a good year with a minor league team can give rise to a well-paying major league position. Alternatively, a player may realise that he is not cut out for professional baseball and will therefore resign of his own accord. Some other players may be released by the team against their will, while the rest will return to play minor league baseball in the subsequent season. Suppose that from season to season a minor league
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player has a 20% chance of advancing to the major leagues, a 10% chance of retiring, and a 15% chance of being released. The career possibilities for major league players are similar, except that they may be demoted to the minor leagues or they may be promoted to coach or manager. Suppose that from season to season a major league player has a 12% chance of being demoted, a 5% chance or retiring, a 4% chance of being released, and a 2% chance of promotion to coach or manager. (a) In a particular year, 80 new players are signed up by minor league teams. Eventually, what is the expected number of these players who will retire? who will be released? who will be promoted to coach or manager? (b) Suppose that we also wished to know the expected number of these players who will reach the major leagues, even if it is for only one season. Show how to re-formulate the model so that this question can be answered. (c) If a player reaches the major leagues, what is the expected number of consecutive years that he will remain in the major leagues? 18. The Undergraduate studies committee of a business school is evaluating its scholastic standards. It has found that the pass rate in its seven terms to be as follows: Term I II III IV V VI VII Pass Rate 70% 70% 75% 85% 90% 95% 99%
In addition, it has been found that about 10% of the students in terms I to III voluntarily withdraw from the program to pursue other degrees or careers. About 5% of the students in terms I to IV are required to permanently leave the program due to poor performance. All other students are required to temporarily leave the program for the duration of two terms, after which they re-enter the program to repeat the failed term.
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c April 28, 2010 D.M. Tulett (a) What percentage of students entering term I will nally graduate? (b) What percentage of students entering term I will be required to permanently leave the program?
19. A tiny island nation has a parliament of just three seats. There are two political parties, denoted as P and Q. All three seats are contested by both parties whenever there is a general election. If one of the three constituencies is represented by a member from Party P, then Party P will retain the seat with probability p. If a constituency is represented by a member from Party Q, then Party Q will retain the seat with probability q. (a) We wish to model the parliament using a single Markov chain. Dene the states using the minimum number possible. (b) Derive the transition probability matrix as a function of p and q. (c) If we were to use the matrix found in part (b), it would be possible to derive, as a function of p and q, the probability that Party P will control all three seats, or that they will form a government (at least two seats), and so on. However, this would require a lot of algebraic work. What is a simpler way to answer such questions?
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23.7
Utility Theory
1. A businessmans utility function is scaled at U($100, 000) = 0, and U($1,000,000) = 100. He is indifferent between the alternatives in the following situations: Situation 1. a 50-50 gamble of $100, 000 or $1,000,000, or $200,000 for certain; Situation 2. a 50-50 gamble of $100, 000 or $200,000, or nothing for certain; Situation 3. a 60-40 gamble of $200,000 or $1,000,000, or $400,000 for certain. (a) Draw the utility function, using a smooth curve between the known points. (b) Which would he prefer, a gamble with an equal chance of obtaining $50, 000 or $300,000, or $100,000 for certain? 2. A farmer has determined that he has three options at the present time. The payoff for each option depends on the weather as follows: Weather Bad Average 10 15 50 25 100 40 0.2 0.3
Option Plant 20 Hectares Plant 40 Hectares Plant 80 Hectares Probability
Good 25 50 90 0.5
where the payoffs are in 1,000s of dollars. Using the Certainty Equivalence approach, a management scientist was able to determine the following utility indices: Payoff 100 40 25 55 75 100 Utility 0.00 0.075 0.27 0.52 0.82 1.00
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c April 28, 2010 D.M. Tulett (a) Construct the utility curve for the range $100, 000 to $100,000. (c) What is the certainty equivalent of the recommended alternative?
(b) What would you recommend to the farmer?
3. The Fresh Milk Dairy is considering enlarging their plant now or waiting until next year. The payoff for each alternative depends on the demand for their product which may be low, moderate or high. The payoffs associated with each alternative and outcome are, (in 1,000s of dollars), as follows: Demand Moderate 70 50 0.4
Alternative Enlarge now Wait Probability
Low 10 5 0.3
High 90 70 0.3
The company has decided that a $10,000 loss will have a utility of zero and a $100,000 prot a utility of 100. Furthermore, they are indifferent in the following three situations. Situation1. (i) $80,000 for certain and (ii) a lottery: $100,000 prot (prob. 0.9); $10,000 loss (prob. 0.1). Situation2. (i) $80,000 for certain and (ii) a lottery: $100,000 prot 1 (prob. 2 3 ); $60,000 prot (prob. 3 ). Situation3. (i) $60,000 for certain and (ii) a lottery: $80,000 prot (prob. 0.75); $10,000 prot (prob. 0.25). (a) Find the recommended alternative using the EMV decision rule. (b) Construct the utility curve. (c) What strategy should the dairy adopt using the expected utility decision rule? (d) What is the certainty equivalent of the optimal strategy? 4. Here we consider ve investors who have the utility functions given in parts (a) to (e). Each person has evaluated a risky venture at a given number of utiles. In each situation, determine the certainty equivalent for that individual.
c April 28, 2010 D.M. Tulett (a) U (x) = (b) U (x) =

x x+6000 , 0.63 utiles x 4x+10000 , 0.85 utiles
x
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(d) U (x) = 1 e 2000 , 0.45 utiles
(c) U (x) = 1 e 1000 , 0.57 utiles

3x
x+1 (e) U (x) = 3 ln( 5000 ), 0.52 utiles
5. Assume a friend of yours asks your advice on the following decision. Your friend can invest in investment 1 which will guarantee a payoff of $50 or in investment 2 which has possible payoffs of $100, $40, $0 with equal probability. (a) Which investment would you recommend if your friend wanted to maximize his expected payoff? (b) You have determined that he is indifferent between (i) equal chances of A or B, and (ii) a certain equivalent, in the following four situations: Situation 1. 2. 3. 4. Sketch the utility function. (c) Which investment would you recommend if your friend wanted to maximize the expected utility of the investment? 6. A manager whose utility function is described in the following table (in units of 1,000 dollars), must choose between contract A and contract B. Contract A promises a loss of $45,000 with probability of 0.4 and a prot of $80,000 with a probability of 0.6. Contract B consists of two subcontracts each of which promises a loss of $22,500 with probability 0.4 and a prot of $40,000 with probability 0.6. The outcomes of the subcontracts are independent. A 100 40 100 100 B 0 0 40 50 Certain 40 25 50 62.5
414 Dollar 200 100 50 20 0 24 60 100 200 280 400
c April 28, 2010 D.M. Tulett Utility 0.000 0.375 0.525 0.650 0.700 0.750 0.825 0.875 0.925 0.925 1.000
(a) Which contract would you recommend to the manager? (b) What is the certainty equivalent of the chosen contract? 7. The following set of utilities has been determined for a manager: Payoff 200 120 50 0 50 70 100 150 400 (a) Construct his/her utility curve. (b) The manager is given the opportunity to buy a contract which will either give him/her $200,000 (prob. 0.55) or cost him/her $100,000 (prob. 0.45). What is the contract worth to the manager? (c) If a second identical contract were made available, what should the manager be willing to pay for it? Utility 0.00 0.40 0.575 0.65 0.725 0.80 0.85 0.90 1.00
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8. Storage Inc. is considering the purchase of a theft insurance policy for a local warehouse. There are three outcomes which can occur in any year: no theft (95% chance), a minor theft of $100,000 (4% chance), or a major theft of $1,000,000. If the insurance were purchased, the premium would be $20,000. The insurance will fully compensate any loss due to theft. After considering the risk and other related factors, the company executives believe that the utility rating is the appropriate measure to use in evaluating alternatives. The company president has assigned a utility of 100 to $1,000,000 and a utility of 0 to $0. In order to determine the utility function, the president has determined that he is indifferent between each of the two alternatives presented in the following four situations: Situation 1. (i) do nothing and (ii) a lottery: a $1,000,000 payoff with probability 0.8 and a loss of $1,000,000 with a probability of 0.2. Situation 2. (i) a loss of $250,000 for certain and (ii) a lottery: a $1,000,000 loss with probability 0.1 and no loss with probability 0.9. Situation 3. (i) a loss of $20,000 for certain and (ii) a lottery: a loss of $250,000 with probability 0.1 and no loss with probability 0.9. Situation 4. (i) a loss of $20,000 for certain and (ii) a lottery: a loss of $100,000 with probability of 0.25 and no loss with probability 0.75. (a) Construct and graph the utility function for the company president. (b) Given that the company president wishes to maximize his expected utility, what would you recommend? (c) What is the maximum amount that the president is willing to pay as an insurance premium in order to avoid the risk of theft? [Assume that his utility function is linear in the interval from $100, 000 to $20, 000.] 9. Susan Prudent is a businesswoman who carefully considers the risks of any new business venture. She uses the utility function U (x) = 100x ,000 , where x is her level of wealth in dollars. Her current net worth is $100,000. She is considering an investment of $50,000 in a venture which will have revenues
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c April 28, 2010 D.M. Tulett of 0, $80,000, or $200,000 with probabilities of 0.2, 0.3, and 0.5 respectively. (a) Should she undertake this venture? (b) What is the EVPI (for her)?
10. In the above problem suppose that the $50,000 investment is not xed but is subject to negotiation. What is the maximum amount that she will pay to invest in this venture? [Hint: At the maximum amount she will be indifferent between the two alternatives. The expression that you will obtain for the maximum amount can be solved either by trial and error or by graphing the expression.] 11. Derive your own utility curve for the range 10, 000 to 100,000 dollars. 12. Derive your own utility curve for nal grades in a course. Assume that you are faced with the following dilemma. Your nal exam is tomorrow and you have only time to study one of two important topics - A and B. From past results you know that 40% of the time A is heavily weighted, 35% of the time B is heavily weighted. Otherwise they are equally weighted. If you study for A, then you will receive 85%, 55% and 70% respectively for each situation. If you study B, then you will receive 50%, 95% and 65% respectively for each situation. (a) Which alternative do you prefer? (b) Evaluate these situations using your utility curve. (c) Are the results to (a) and (b) different? If they are different, explain why they are different. 13. A student is confronted with the problem of deciding which of two courses to take. She has decided to take either a statistics course or a management course. For the statistics course, she estimates the probabilities of each grade as 0.20, 0.30, 0.50 and 0.00 for A, B, C and D respectively. For the management course the respective probabilities are 0.10, 0.50, 0.30 and 0.10. Furthermore she has determined that she is indifferent between the alternatives in the following two situations:
c April 28, 2010 D.M. Tulett Situation 1. Alternative 1. a C for certain Alternative 2. a lottery with a probability of 0.20 of an A and a probability of 0.80 of a D. Situation 2. Alternative 1. a B for certain Alternative 2. a lottery with a probability of 0.6 of an A and a probability of 0.40 of a C. Which course should she take?
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14. An individuals utility function for dollar values greater than 100,000 is given by U (x) = 100 where x is in units of $1,000. (a) What is the utility of $20,000? 10, 000 100 + x
(b) If the utility of an uncertain situation is 40, what is its certainty equivalent? 15. An individual whose present wealth level is $10,000 (but who is able to borrow more) has the following utility function 100
$ $$$
Utility
Wealth in $
100,000
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c April 28, 2010 D.M. Tulett This individual has two investment alternatives which have the following payoffs: Outcome (in $1,000s) O1 O2 O3 O4 20 30 80 10 30 90 40 30 0.1 0.3 0.4 0.2
Investment A1 A2 Probability
(a) If each alternative costs $10,000, which alternative should be chosen? (b) If each alternative costs $20,000, which alternative should be chosen?
c April 28, 2010 D.M. Tulett Utility Theory (Advanced)
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1. A man with utility function U (x) = 1 e 100 has $200 dollars of which he may gamble all, some, or none on a lottery on which he will either gain the amount wagered with probability 0.6 or he will lose the amount wagered with probability 0.4. (a) Over what dollar range is gambling better than not gambling? (b) What gamble will give him the greatest expected utility? (c) Consider the general case of this problem where he has y dollars and the probability of winning the lottery is p. Re-solve parts (a) and (b). 2. An investor has decided that for any amount x, he is indifferent between receiving either x for sure or a lottery which has a 50% chance of receiving $100 less than x and a 50% chance of receiving $200 more than x. If the utility of x = 0 is 0, and if the utility of x = 300 is 1, give the function U (x). Hint: this sort of function is independent of wealth. 3. A major car manufacturer is thinking of redesigning the regular and premium versions of one of its models. The cost of the redesign will be $2,000,000 for the regular model and $3,000,000 for the premium model. If the redesigns are successful (independent probabilities of 0.5 and 0.6 respectively), then the regular model would result in an increase in prots of $10,000,000, and the premium model would result in an increase in prots of $15,000,000. If the designs are not successful, then the company would lose $5,000,000 and $8,000,000 respectively. The companys management has determined that it is indifferent in the following situations: Situation 1. $3,000,000 prot for sure or a 30% chance of a 10 million loss and a 70% chance of a 20 million prot. Situation 2. $10,000,000 loss for sure or a 20% chance of a 50 million loss and an 80% chance of a 3 million prot. Situation 3. $6,000,000 prot for sure or a 15% chance of a 10 million loss and a 85% chance of a 20 million prot.
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c April 28, 2010 D.M. Tulett Situation 4. $3,000,000 prot for sure or a 20% chance of a 20 million loss and an 80% chance of a 20 million prot. Situation 5. $10,000,000 loss for sure or a 75% chance of a 30 million prot and a 25% chance of a 20 million loss. What would you recommend that the company do?
4. A well established fact is the benet one derives from wearing a seatbelt when in an accident. On average most drivers will have at least two or more accidents of varying degrees of severity. We classify the outcomes of an accident as no injury, serious injury, and death. The probabilities of these outcomes can be described as follows: no injury 0.95 0.60 serious injury 0.04 0.30 death 0.01 0.10
using seatbelts no seatbelt
(a) How would you approach this situation using utility theory? (b) Evaluate the behaviour of people who use seatbelts versus those who do not. 5. Consider the following set of situations16 : Situation 1. Alternative A1 - $1,000,000 for certain. Alternative A2 - $5,000,000 with probability 0.1, $1,000,000 with probability 0.89 and $0 with probability 0.01. Situation 2. Alternative A3 - $5,000,000 with probability 0.1, $0 otherwise. Alternative A4 - $1,000,000 with probability 0.11, $0 otherwise. (a) Comparing A1 with A2 , which do you prefer? (b) Comparing A3 with A4 , which do you prefer? (c) Evaluate the four alternatives using utility theory. Is your answer to (a) consistent with your answer to (b)?
problem is usually named after M. Allais who discussed it in the paper Le Comporte ment de lHomme Rationnel devant le Risque: Critique des postulats et Axiomes de lEcole Am ericaine, Econometrica, vol. 21, 1953.
16 This
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23.8
Game Theory
1. The Fast Track and Quick Trip Bus Companies serve the same route between two major cities. The total number of passengers travelling by bus has been fairly stable over the recent years. To obtain a larger market share, both companies are thinking of improving their service by either lowering fares or serving soft drinks en route. The payoffs associated with each option are as follows: Fast Track Do Nothing Lower Fare Soft Drink Do Nothing 0 45 90 Quick Trip Lower Fare 40 0 0
Soft Drinks 100 10 0
(a) Eliminate all dominated alternatives. What strategies would you recommend for each company? (b) Use the Criterion of Pessimism to nd the optimal solution. Is the saddle point the same as in part (a)? 2. A union is just about to negotiate a contract with company management. They have identied four bargaining strategies for themselves and they believe that the company will choose from four strategies as well. They have estimated the payoffs in millions of dollars, for their members as a whole over the life of the contract, as a function of the unions and managements strategies as follows: Union Strategies U1 U2 U3 U4 Company Strategies M1 M2 M3 M4 22 17 21 7 27 15 10 12 42 5 14 7 8 7 13 2
From the management perspective the above payoffs represent costs incurred by the company. What strategy should each side choose?
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3. Two rms, A and B, are each considering three advertising plans. The payoffs are in terms of market share, and the game is zero-sum. The market share payoffs to rm A are: Company A Strategies No Advertising Plan I Plan II Company B Strategies No Plan Plan Advertising I II 0 25 20 5 5 15 5 10 15
What should be the advertising strategy of each rm? 4. An environmental group has a $4,000,000 fund from which to allocate to advertising campaigns on two environmental issues: acid rain and water treatment. To combat these campaigns, an industry group has put together a $5,000,000 war chest with which to ght the environmental group. Suppose that each side will allocate its money in $1,000,000 increments. For example, the environmental group might allocate $3,000,000 to ghting against acid rain and $1,000,000 to ghting for water treatment. Suppose that the probability of winning an issue (in terms of governmental action) is proportional to the amount of money spent by each side. For example, if the environmental group spends $3,000,000 ghting against acid rain, and the industry spends $2,000,000 denying acid rain effects, then the probability that the environmental group wins the issue is 3, 000, 000 = 0.6 3, 000, 000 + 2, 000, 000 If neither side spends anything on a particular issue, then there is a probability of 0.5 of winning for each side. The objective for each side is to maximize the expected number of issues won. The advertising money is inconsequential for both parties. What should each side do? 5. Due to the relative unpopularity of big business polluters, the effectiveness of their advertising is only 80% of the effectiveness of the environmental
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groups advertising. How will this affect the recommendations obtained in the previous question? 6. A union and a company have made their nal contract offers. The union has demanded an increase of $2.25 per hour, while the company has offered an increase of $1.00 per hour. An arbitrator has been called in. The arbitrator has asked each side to submit a new proposal. Each side must either re-offer its existing nal offer, or submit a new offer between $1.00 per hour and $2.25 per hour inclusive in 25 cent increments (for example, the union could now ask for $1.75 per hour, but not $1.81 per hour). The arbitrator will make the nal wage increase equal to the offer which has moved the most from its current position. (For example, if the company increases its offer by 25 cents, but the union decreases its demand by 50 cents, then the increase will be $1.75 per hour). In the case of ties (or if neither side moves), then the arbitrator will award an increase of $1.625 per hour. Draw the game table from the unions perspective. What should each side do? What is the value of the game? 7. Formulate the childrens game of Scissors, Paper, Rock as a zero-sum game. Recall that each player chooses scissors, paper or rock. Scissors cut paper, paper entraps rock, and rock breaks scissors. If both players choose the same item, then no-one wins. What is the optimal strategy for each player? 8. Three hotels have been built to take advantage of a bay with a beautiful sandy beach. The hotel situated at the western end of the beach has on average 1000 guests, the hotel at the centre of the beach has 500 guests, and the eastern hotel has 1500 guests. Two ice cream vendors service the beach. If one of the vendors is closer than the other vendor to a particular hotel, then the closer vendor will obtain 75% of the customers at that hotel, whereas if they are equidistant then each vendor will receive 50% of the customers at that hotel. (a) Construct the payoff matrix in terms of market share. (b) Find the optimal strategy for each vendor. 9. Alison and Wendy enjoy gambling. They play a game in which each opponent secretly chooses a coin from one of her piles of British coins. Alison
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c April 28, 2010 D.M. Tulett has three piles of 2p, 5p, and 10p coins; Wendy has three piles of 1p, 5p, and 10p coins. If the value of the sum of the values of the two coins is even then Alison wins Wendys coin; otherwise Wendy wins Alisons coin. All winnings go into two separate piles, one for each player. (The players do not choose from these piles). (a) Set up the payoff table for Alison. (b) Which strategies can be removed using dominance? (c) What are the optimal strategies for each player, and what is the expected value of the game?
10. The following table gives the payoffs to Player A for a zero-sum game.
A1 A2 A3 A4
B1 1 3 0 0
B2 6 2 2 5
B3 5 2 3 4
B4 0 4 3 1
(a) eliminate the dominated alternatives. (b) use a graph to nd the alternative which is dominated locally. (c) solve the game and nd the expected payoff to Player A.
11. Three pubs are located in the downtown area of a large city. The relative locations of the three pubs, and the expected number of patrons per week at each is given in the following picture.
c April 28, 2010 D.M. Tulett 12,500 Northland

d d d d d d
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300 metres

400 metres
d d d d d d
7,500
500 metres
d d
20,000
Westland
Eastland
Two competitive hot dog vendors named Jack and Jill are planning to service the area. At the outset of each day, each person will park his or her hot dog stand outside one of the three pubs. You are given the following data: (1) if Jack is closer than Jill to a particular pub then he will receive 80% of the business from that pub (2) if Jill is closer than Jack to a particular pub then she will receive 70% of the business from that pub (3) if each person locates at the same pub then Jack will receive 55% of the business from each pub. Assuming that the patrons of each pub have similar preferences for hot dogs, what would you recommend to Jack? to Jill? 12. The Prisoners Dilemma I. Two men are arrested for armed robbery. The police, convinced that both are guilty, but lacking sufcient evidence to convict either, put the following proposal to the men, and then separate them. (1) If one man confesses but the other does not, the rst will go free and the other will receive the maximum sentence of 10 years. (2) If both confess, then they will receive lighter sentences of 5 years each. (3) If neither confesses, then they will be imprisoned for jaywalking, vagrancy, resisting arrest for a total of 5 years for each man.
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c April 28, 2010 D.M. Tulett Draw up a payoff matrix for one of the prisoners and explain why the police are convinced that both men will confess (providing both are guilty).
13. The Prisoners Dilemma II. Two men are arrested for armed robbery. The police, convinced that both are guilty, but lacking sufcient evidence to convict either, put the following proposal to the men, and then separate them. (1) If one man confesses but the other does not, the rst will go free and the other will receive the maximum sentence of 10 years. (2) If both confess, then they will receive lighter sentences of 5 years each. (3) If neither confesses, then both men will go free. (a) Why is Prisoners Dilemma II signicantly different from Prisoners Dilemma I? (b) Draw up a payoff matrix for each of the prisoners and explain why the police are convinced that both men will confess (providing both are guilty). 14. Two friends are playing a simple game called Five Pennies. The rules of the game are that each player chooses from 1 to 5 pennies (hidden from the other player). If the difference between the choices is 2 or fewer, then the player with the lower choice pays the difference to the player with the higher choice, whereas if the difference is 3 or more, then the player with the higher choice pays the difference to the player with the lower choice. (a) Set up the appropriate payoff matrix for this problem. (b) Is there a pure strategy available for either player? 15. Two groups (A and B) are in a conict situation and have a set of alternatives available to them which are given in the following table: B1 12 10 11 6 5 B2 B3 4 8 5 6 6 6 10 12 13 15 B4 15 10 12 8 9
A1 A2 A3 A4 A5
What strategy would you recommend to each group?
c April 28, 2010 D.M. Tulett Game Theory (Advanced)
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1. Two players, Alf and Welf, decide to play a version of a four-nger game in which they simultaneously show either 1, 2 or 4 ngers. If the sum of the ngers shown is even, Alf wins that amount (in dollars) from Welf; otherwise Welf wins the sum from Alf. What is the optimal strategy for each player and the value of the game? 2. A morra game involves the showing of ngers (cf. previous problem) but also requires that each player guess the number of ngers which the other player has chosen. Hence each player must choose how many ngers to show, and how many to guess. If neither player guesses correctly or if both players guess correctly, then the game is a draw. Otherwise, the single player who guesses correctly wins the sum (in dollars) of the total number of ngers shown. Solve the situation where each player must show either one or two ngers.
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23.9
Linear Optimization Applications
Formulate the following problems as linear optimization models. Where appropriate, you may wish to number the commodities and then use subscripted variables. 1. An oil renery has three types of inputs, with the following prices and characteristics: Input # 1 2 3 Price per litre $0.42 $0.76 $0.60 % Sulphur (by mass) 2.2 0.4 1.0 Thermal Value (kilojoules/litre) 15,000 20,000 17,000
The inputs are blended to produce two outputs, with the following outputs and promised specications:
Output # 1 2
Price per litre $0.63 $0.91
Maximum % Sulphur (by mass) 1.2 0.7
Minimum Thermal Value (kilojoules/litre) 16,000 18,000
The renery has a capacity of 1,000,000 litres/month overall. Subject to the overall capacity, up to 500,000 litres of any input, or 650,000 litres of any output can be handled. We can assume that all three inputs have identical densities, thereby enabling the sulphur percentages to be treated as if they were by volume. We can also assume that there are no losses in the blending process, and that the characteristics of the outputs are a weighted average (by volume) of the characteristics of the inputs. 2. A large unionized restaurant is planning its workforce schedule. The requirements for employees over the seven day work week are:
c April 28, 2010 D.M. Tulett Minimum Number of Employees 110 81 85 118 124 112 120
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Day Sunday Monday Tuesday Wednesday Thursday Friday Saturday
The collective bargaining agreement states that all employees are to work ve consecutive days per week with two consecutive days off (Saturday and Sunday are consecutive). Such a schedule might mean that some employees show up for work (for which they are paid) but they are not required (for example, the schedule might assign 119 employees on Wednesday). The restaurant manager wishes to minimize such wastage. (Ignore the fact that the number of employees must be integer.) 3. A farmer owns 500 hectares of land in an arid region. The state government gives him up to 1,000,000 cubic metres of water for irrigation each year. In addition, he may purchase up to an additional 300,000 cubic metres of water per annum at a cost of $0.04 per cubic metre. He grows corn, peas, and onions. The net revenue per hectare of each commodity (excluding the cost of purchased water, if any) and the water requirement in cubic metres per hectare are: Commodity Corn Peas Onions Revenue per Hectare $200 $400 $300 Water Requirement (cubic metres per hectare) 3500 6700 2000
He wishes to diversify his crop in case one commodity suffers an unanticipated fall in price. Therefore, no commodity may occupy more than 50% of the total area planted, nor may any commodity occupy less than 10% of the total area planted. 4. Columbian, Peruvian, and Nigerian coffee beans can be purchased for $1.20, $1.00, and $0.90 per kilogram respectively. From these sources a company
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c April 28, 2010 D.M. Tulett makes a regular and a premium blend of coffee, which sell for $1.30 and $1.60 per kilogram respectively. The regular blend contains at least 10% (by mass) Columbian beans, and at least 20% Peruvian beans. The premium blend contains at least 50% Columbian beans, and no more than 15% Nigerian beans. The maximum market demand is for 200,000 kilograms of regular coffee and for 130,000 kilograms of premium coffee.
5. City bus drivers work two three and a half-hour shifts per day. In some cases, the two shifts are consecutive (effectively one seven-hour shift), but usually they are not. Because of the inconvenience of breaking up the day, those who work non-consecutive shifts are paid a $5 per day bonus. All bus drivers earn a base rate of $10 per hour. The bus company has the following daily requirements: Minimum Number of Drivers Needed 150 80 90 160 70
Time of Day 5:30 a.m. to 8:59 a.m. 9:00 a.m. to 12:29 p.m. 12:30 p.m. to 3:59 p.m. 4:00 p.m. to 7:29 p.m. 7:30 p.m. to 10:59 p.m.
Subject to meeting all its requirements for drivers, the bus company wishes to minimize its daily labour cost (regular and bonus). 6. Wines from the Alsace, Burgundy, and Marseille regions of France are sold at wholesale for 20, 15, and 10 FF (French francs) per litre respectively. A Parisian company buys these wines and blends them into two types, domestic, and foreign, which they sell for 25FF and 35FF per litre respectively. The domestic wine contains (by volume), no more than 12% Alsace and at least 50% Burgundy wine. The foreign wine must be at least 70% Alsace and no more than 5% Marseille. The supply of Alsace, Burgundy, and Marseille wines is limited to 15,000, 18,000, and 21,000 litres respectively. 7. Food service employees work two four-hour shifts per day. In some cases, the two shifts are consecutive (effectively one eight-hour shift), but usually they are not. However, the management has stipulated that no one will be asked to work from 7 a.m. to 10:59 a.m. and then again at night from 11 p.m. to 2:59 a.m.
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All food service workers earn a base rate of $5 per hour. In addition, there is an evening bonus of $1.20 per hour paid for each hour worked from 7 p.m. to 2:59 a.m. The restaurant has the following daily requirements: Minimum Number of Workers Needed 100 230 110 180 80
Time of Day 7 a.m. to 10:59 a.m. 11:00 a.m. to 2:59 p.m. 3:00 p.m. to 6:59 p.m. 7:00 p.m. to 10:59 p.m. 11:00 p.m. to 2:59 a.m.
Subject to meeting all its requirements for workers, the restaurant wishes to minimize its daily labour cost (regular and bonus). 8. A company has rm orders for the following quantities over the next six months: Month Demand 1 200 2 300 3 700 4 500 5 100 6 400
To change the production level from one month to the next costs $2 per unit increased or $5 per unit decreased. To hold a unit in inventory for one month costs $4. No shortages are permitted. The company starts off (think of this as month 0) with 50 units in inventory. There must be no inventory left over at the end of month six. The previous months (month 0) production level was 240 units. There is no restriction on the level of production in month six. The company wishes to minimize the sum of production level change costs and inventory holding costs over the six month horizon. 9. A company which produces a single product has denite orders for this product over the next four quarters as follows: Quarter Demand 1 350 2 680 3 275 4 590
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c April 28, 2010 D.M. Tulett The company ended the previous year with an inventory of 200 units, and the nal quarter production level was 400 units. The company wishes to end this year with an inventory of at least 250 units. It costs $3.50 per unit to increase the production level from one quarter to the next, and $6.00 per unit to decrease it. The cost of holding inventory from one quarter to the next is $4.80 per unit per quarter. No shortages are permitted. The company wishes to minimize the sum of production level change costs and inventory costs over the four quarter planning horizon.
10. A furniture manufacturing company has three plants which need 474, 620, and 870 tonnes of lumber per week. There are three lumber mills, each of which can supply any of the three plants. The price of lumber is $240 per tonne, at each lumber mill. Shipping charges, which vary according to where the lumber is sent, are additional. Shipping Charges in Dollars per Tonne Lumber Furniture Plant Mill 1 2 3 1 2.20 5.50 4.10 2 3.20 4.40 3.00 3 1.50 3.60 3.50 Because of commitments to other customers, lumber mills 1 and 2 are limited to 700 tonnes per week (each) to the furniture company, while mill 3 can supply any demand. Mills 1 and 3 can only ship 350 tonnes each to any one furniture plant; there is no such restriction on mill 2. Hint: Use doubly-subscripted variables. 11. A military hospital in an isolated area needs to make 25 kilograms of a vaccine. The vaccine consists of four ingredients, each of which is costly and in short supply: Ingredient 1 2 3 4 Amount on Hand (kgs.) 22 18 20 24 Cost ($/kg.) 28 35 52 26
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In order for the vaccine to be effective, the following restrictions must be met. (i) Ingredient 1 must be between 45% and 60% of the total mixture (by mass). (ii) Ingredients 2 and 3 must each comprise at least 10% of the mixture, but together must not exceed 25%. (iii) Ingredient 4 must not be more than 50% of the total. (a) Formulate a cost minimization model. (b) Suppose that because of heavy casualties that as much vaccine as possible is desired, and that money is of no concern. What is the objective function now? 12. Precision Printers estimates that it will need 300 tonnes, 400 tonnes and 450 tonnes of paper for the next three months. At present it has 50 tonnes on hand and considers a safety stock of 50 tonnes at the end of the third month to be desirable. The rms storage area will not hold more than 500 tonnes. During the rst month the price of paper is $6,000 per tonne and rises to $7,500 in the second and third month due to an anticipated strike at the regular supplier. As a result of humidity and other storage factors, 10% of the paper inventory on hand at the end of a month must be discarded. Formulate the appropriate model for the management of Precision Printers. 13. We-Make-Um-Well has received a lucrative contract to manufacture two types of industrial components. The contract calls for certain quantities each year for the next four years. There is no prospect of production after that. The contracted quantities are:
Year 1 2 3 4
Demand Type A Type B 4,000 6,000 15,000 20,000 10,000 8,000 5,000 4,000
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c April 28, 2010 D.M. Tulett Each type of component needs a special machine at a particular stage of the manufacturing. On an annual basis, one machine will handle 3000 Type A components or 2000 Type B components or any proportional combination of them. These machines can be either purchased or leased. To buy a machine costs $100,000 in year 1 and will increase by $5,000 each following year. Each year of its life the machine loses $10,000 of its value, except in the rst year when it loses $15,000. At the end of the four year planning horizon, machines which have purchased can be sold at their salvage value. Machines can be rented for either a 1-year or 2-year term at rental charges starting in year 1 at $24,000 and $20,000 per year, respectively. Each year the rental charge will increase by $2,000, except that machines already on hire stay at their original charge until the rental period expires. All expenditures are assumed to occur at the beginning of each year. The rm wishes to minimize the present value of the net cost associated with these machines where the companys discount rate is 20%. Inventory may be carried over from one year to the next at a cost of $2 per unit. Formulate an appropriate model for We-Make-Um-Wells management.
14. Due to recent market forecasts, Buns Bakery estimates that it will need an additional 100 donut machines for its various facilities for the next two years. After two years a more efcient model is due to be available and all machines will be replaced at this time. Thus any machines on hand at the end of two years will be sold at their depreciated value. Each machine has a two year life and is depreciated linearly to a salvage value of $1,000. Machines can be purchased for $5,000 or leased for two years at $2,800 per year payable at the beginning of each year. To break a lease would cost $300 per machine. Buns has $150,000 in uncommitted funds that can be used to lease and/or buy machines at the outset of the rst year. In addition, Buns can obtain a loan at the outset of the rst year for up to $300,000 at 13% interest per year. The terms of the loan require Buns to repay the amount borrowed plus interest at the end of the rst year. Each of the 100 machines will contribute $3,500 to prots each year, therefore $350,000 will become available at the end of each year for use in the following year. Unused cash earns 10% per year.
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Formulate the appropriate model for the management of Buns Bakery. (Hint: Maximize the ending cash position.) 15. The owners of a fast food restaurant must make several stafng decisions over the next several months. For January, February, March, April, May, and June, they require 1670, 1550, 1830, 1980, 1770, and 2040 labour hours respectively. This work is performed by employees who have completed a one month training program. At the outset of the year, there are 12 trained employees available and willing for work. Each trained employee works up to 160 hours per month. At the end of each month, approximately 10% of the trained employees who worked that month will be red, and another 15% will resign for personal reasons. Each employee makes $960 per month (or $6 per hour). Because of local labour conditions, it is unrealistic to expect that more than seven trainees can be hired in any month. Each trainee is paid only $760 per month, but costs another $440 in non-salary training expenses. The nonsalary training cost will rise to $690 per trainee in April. Furthermore, their inexperience means that the restaurant receives only a negligible amount of useful productive work from the trainees. However, the trainees are all keeners, so rings and resignations are virtually non-existent. Upon completion of their training, the restaurant can hire them as regular employees immediately, or it can put them on retainer at $75 per person per month. Anyone on retainer can be re-called at the restaurants whim at any time. Such re-called employees do not require any further training. If the restaurant does not pay the $75 retainer fee, the right to recall is lost. Because of this, every trainee is either hired as a regular employee the following month or is put on retainer. Formulate a linear optimization model to determine a minimum cost stafng schedule for the six month period. Hint: What are the decisions to be made at the beginning of each month? 16. The state of Kaybeck produces three major types of outputs for the export market: electrical energy, aluminum ingots, and high-tech products. Each commodity can be sold on the world market in units worth $50, $90, and $200 respectively. Each unit of electrical energy produced requires 0.1 units of aluminum and 0.05 units of high-tech products. To produce 1 unit of aluminum requires 1.2
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c April 28, 2010 D.M. Tulett units of electrical energy, $15 worth of imported bauxite ore, and 0.04 units of high-tech products. Each unit of high-tech product is produced using 0.7 units of energy, 0.2 units of aluminum, and $120 worth of imported materials. The state of Kaybeck has a capacity to produce up to 500,000 units of energy and 350,000 units of aluminum. There is no production capacity limit for high-tech products, but it is unlikely that more than 100,000 units could be exported. (a) Assume for the moment that energy, aluminum, and high-tech products cannot be imported. Formulate a model which will maximize the dollar value of the trading surplus. (b) Suppose now that there are no import restrictions. Make the appropriate modications to the model given in part (a). (c) For the model given in part (b), give an argument as to why some some of the variables will be at their upper limits. From this deduce the values of all the variables.
17. A paper mill produces rolls of paper in standard widths of 90 cm and 200 cm. All paper produced has a thickness of 0.1 mm, and each roll has a length of 1000 metres. The customers all desire rolls of this thickness and this length, but not necessarily either of the two standard widths. The mill currently has the following non-standard width orders: Width (cm) 95 80 46 21 Number 25 31 23 68
The paper which is leftover on the cut rolls is re-cycled. Formulate a model which will minimize the amount of paper which needs to be re-cycled. 18. J. W. Aut Co. has three major products: X, Y and Z. These are produced using two parallel production lines. The single-product capacities of these lines over the planning horizon are 1000, 1400 and 3000 on line one and 2500, 1600 and 1000 on line two for X, Y and Z respectively. If more than one product is produced on either line, then the capacity of that line must
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be determined in an appropriate manner. The lines are such that you may switch from one product to another without any setup cost. There are two components (A and B) used in making these products which are in relatively short supply. There are only 2500 units of component A, and 3000 units of component B. Products X, Y and Z need one, one, and two units of component A, and two, one, and one units of component B respectively. In addition, the production of Z must not be less than the combined production of X and Y. Marketing requires that there be at least twice as many units of product Y as of product X. The prot contributions are 100, 150 and 300 for products X, Y and Z respectively. (a) Formulate this problem. (b) Use a computer to help give a recommendation to the management of J. W. Aut Co. 19. A student needs to prepare for three mid-term exams, each of which is of equal importance to him. Without doing any preparation, he believes that his marks will be 20, 25, and 30 in courses 1, 2, and 3 respectively. He has two methods of preparation: reading his texts and problem solving. He has 20 hours available for studying. Based on his past experience, the student estimates that one hour of study will improve his marks according to the following table: If devoted to Course 1 Course 2 Course 3 5 marks 7 marks 6 marks 9 marks 4 marks 8 marks
Reading Problems
The student wishes obtain at least 50 on each exam and of course cannot obtain more than 100 in any exam. In addition, neither method of preparation (nor any combination of the two) will improve his mark by more than 60 marks in any course. (a) Formulate this problem, omitting any constraints which are trivially redundant. (b) Use a computer to help decide what the student should do.
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20. The Three Hills Gas Company supplies its distributors using a eet of gasoline tankers. A new region has been acquired which will require expansion of the existing eet. The company has $1,600,000 available to nance the capital costs of the expansion. Three models of gasoline tanker are available. Truck Model Super Regular Econoline Capacity (litres) 20,000 10,000 5,000 Purchase Cost (in $) 150,000 100,000 75,000 Monthly Operating Costs (in $) 800 500 200
Depreciation has been included in the monthly operating cost. The company estimates that the monthly demand for the new region will be a total of two million litres of gasoline. Due to the size and speed differences of the trucks, the different truck models vary in terms of the number of deliveries or round trips possible per month. The maximum number of trips are estimated at twenty per month for the Super, twenty-ve per month for the regular and thirty per month for the Econoline. Based on driver availability and maintenance capability, the rm does not want to add more than twenty new vehicles to the eet. In addition, the company would like to make sure it purchases at least four of the new Econoline tankers to use on short run, low demand routes. Finally, the company does not want more than half of the new models to be Supers. An added complication is that there is a $150 per month per vehicle eet charge for insurance which has not been included in the operating costs. (a) Formulate a model for the management of Three Hills. (b) Use a computer to help give a recommendation.

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Management Science

Lecture Notes Edition April 28, 2010 D.M. Tulett

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Uncertainty 3 34 4.1 Marginal Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 34 4.1.1 Computer Example . . . . . . . . . . . . . . . . . . . . . 35

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The Paradigm of Management Science

Example Cellular Phone Plans

We use this example as a way to illustrate the paradigm.

2 1.2.1 Problem Identication

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c April 28, 2010 D.M. Tulett 1.2.2 Building the Model

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Total Monthly Cost

0 200 400 600 200 400 800

$0.35 $0.35 $0.35 $0.35 $0.00 $0.00 $0.00

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0 200 400 600 200 400 800

$0.35 $0.35 $0.35 $0.35 $0.00 $0.00 $0.00

$126.00 $71.00 $66.00 $90.00 $69.00 $59.00 $109.00

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B Remaining Volume =15-2.9*A4

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14 With average interest the payoff is:

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Theatre Size Small Medium Large

Fringe 250 1900 700 3000 0.20

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A 1 2 3 4 5 6 7 Theatre Size Small Medium Large

# of Seats Rent 100 $600 400 $1800 1200 $5500 Probability

# of Seats Rent 100 $600 400 $1800 1200 $5500 Probability

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Theatre Size Small Medium Large

Fringe 250 1900 700 3000 0.20

Expected Value $2300 $5500 $3030

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A 1 2 3 4 5 6 7 Theatre Size Small Medium Large

D Fringe 250 1900 700 3000 0.20

# of Seats Rent 100 $600 400 $1800 1200 $5500 Probability

H Expected Value $2300.00 $5500.00 $3030.00

c April 28, 2010 D.M. Tulett 2.2.4 Recommendation

To: From: Subject:

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A 1 2 3 4 5 6 7 Theatre Size Small Medium Large

D Fringe 250 1900 700 3000 0.20

# of Seats Rent 100 $600 400 $1800 1200 $5500 Probability

H Expected Value $2300.00 $5500.00 $3030.00

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Small Medium Large

300 1200 3600

2(1200 800) = 800 2(3600 800) 2(3600 2300) = 5600 = 2600

Small Medium Large

300 1200 3600

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Theatre Size Small Medium Large

Expected Value $2320 $6040 $3624

.2 0 e g n i fr 0.7 @ ge@@ 2300 ra@ ve@ a@ @

.2 0 e g in e @ fr @ g @ 0.7 2900 ra@ ve@ a@