Chapter 13

Decision Analysis

Learning Objectives

1. Learn how to describe a problem situation in terms of decisions to be made, chance events and
consequences.

2. Be able to analyze a simple decision analysis problem from both a payoff table and decision tree
point of view.

3. Be able to develop a risk profile and interpret its meaning.

4. Be able to use sensitivity analysis to study how changes in problem inputs affect or alter the
recommended decision.

5. Be able to determine the potential value of additional information.

6. Learn how new information and revised probability values can be used in the decision analysis
approach to problem solving.

7. Understand what a decision strategy is.

8. Learn how to evaluate the contribution and efficiency of additional decision making information.

9. Be able to use a Bayesian approach to computing revised probabilities.

10. Be able to use TreePlan software for decision analysis problems.

11. Understand the following terms:

decision alternatives decision strategy

chance events risk profile
states of nature sensitivity analysis
influence diagram prior probabilities
payoff table posterior probabilities
decision tree expected value of sample information (EVSI)
optimistic approach efficiency of sample information
conservative approach Bayesian revision
minimax regret approach
opportunity loss or regret
expected value approach
expected value of perfect information
(EVPI)

Solutions:

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1. a.

s1
250
d1 s2
100

s3
25

s1
100

d2 s2
100

s3
75

b.
Decision Maximum Profit Minimum Profit
d1 250 25
d2 100 75

Optimistic approach: select d1

Conservative approach: select d2

Regret or opportunity loss table:

s1 s2 s3
d1 0 0 50
d2 150 0 0

Maximum Regret: 50 for d1 and 150 for d2; select d1

2. a.
Decision Maximum Profit Minimum Profit
d1 14 5
d2 11 7
d3 11 9
d4 13 8

Optimistic approach: select d1

Conservative approach: select d3

Regret or Opportunity Loss Table with the Maximum Regret

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 Decision Analysis

s1 s2 s3 s4 Maximum Regret
d1 0 1 1 8 8
d2 3 0 3 6 6
d3 5 0 1 2 5
d4 6 0 0 0 6

Minimax regret approach: select d3

b. The choice of which approach to use is up to the decision maker. Since different approaches can
result in different recommendations, the most appropriate approach should be selected before
analyzing the problem.

c.
Decision Minimum Maximum Cost
Cost
d1 5 14
d2 7 11
d3 9 11
d4 8 13

Optimistic approach: select d1

Conservative approach: select d2 or d3

Regret or Opportunity Loss Table

s1 s2 s3 s4 Maximum Regret
d1 6 0 2 0 6
d2 3 1 0 2 3
d3 1 1 2 6 6
d4 0 1 3 8 8

Minimax regret approach: select d2

3. a. The decision to be made is to choose the best plant size. There are 2 alternatives to choose from: a
small plant or a large plant.

The chance event is the market demand for the new product line. It is viewed as having 3 possible
outcomes (states of nature): low, medium and high.

b. Influence Diagram:

Plant Market
Size Demand

c. Profit

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Chapter 13

Low
150

Small Medium
200

High
200

Low
50

Large Medium
200

High
500

d.
Decision Maximum Profit Minimum Profit Maximum Regret
Small 200 150 300
Large 500 50 100

Optimistic approach: select Large plant

Conservative approach: select Small plant

Minimax regret approach: select Large plant

4. a. The decision faced by Amy is to select the best lease option from three alternatives (Hepburn
Honda, Midtown Motors, and Hopkins Automotive). The chance event is the number of miles
Amy will drive.

b. The payoff for any combination of alternative and chance event is the sum of the total monthly
charges and total additional mileage cost, i.e.,

for the Hepburn Honda lease option:

36000 miles (12000 miles for 3 years): 36($299) + $0.15(36000 - 36000) = $10,764
45000 miles (15000 miles for 3 years): 36($299) + $0.15(45000 - 36000) = $12,114
54000 miles (18000 miles for 3 years): 36($299) + $0.15(54000 - 36000) = $13,464

for the Midtown Motors lease option:

36000 miles (12000 miles for 3 years): 36($310) + $0.20*max(36000 – 45000,0) = $11,160.00
45000 miles (15000 miles for 3 years): 36($310) + $0.20*max(45000 – 45000,0) = $11,160.00
54000 miles (18000 miles for 3 years): 36($310) + $0.20*max(54000 – 45000,0) = $12,960.00

for the Hopkins Automotive lease option:

36000 miles (12000 miles for 3 years): 36($325) + $0.15*max(36000 – 54000, 0) = $11,700
45000 miles (15000 miles for 3 years): 36($325) + $0.15*max(45000 – 54000, 0) = $11,700
54000 miles (18000 miles for 3 years): 36($325) + $0.15*max(54000 – 54000, 0) = $11,700

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 Decision Analysis

So the payoff table for Amy’s problem is:

Actual Miles Driven Annually

Dealer 12000 15000 18000

Hepburn Honda $10,764 $12,114 $13,464

Midtown Motors $11,160 $11,160 $12,960

Hopkins Automotive $11,700 $11,700 $11,700

c. The minimum and maximum payoffs for each of Amy’s three alternatives are:

Dealer Minimum Cost Maximum Cost

Hepburn Honda $10,764 $13,464

Midtown Motors $11,160 $12,960

Hopkins Automotive $11,700 $11,700

Thus:

The optimistic approach results in selection of the Hepburn Automotive lease option (which has
the smallest minimum cost of the three alternatives - $10,764).

The conservative approach results in selection of the Hopkins Automotive lease option (which has
the smallest maximum cost of the three alternatives - $11,700).

To find the lease option to select under the minimax regret approach, we must first construct an
opportunity loss (or regret) table. For each of the three chance events (driving 12000 miles, driving
15000 miles, driving 18000 miles) subtract the minimum payoff from the payoff for each decision
alternative.

The regret table for this problem is

State of Nature (Actual Miles Driven Annually)

Decision Alternative 12000 15000 18000 Maximum Regret

Hepburn Honda $0 $954 $1,764 $1,764

Midtown Motors $396 $0 $1,260 $1,260

Hopkins Automotive $936 $540 $0 $936

The minimax regret approach results in selection of the Hopkins Automotive lease option (which
has the smallest regret of the three alternatives: $936).

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d. We first find the expected value for the payoffs associated with each of Amy’s three alternatives:

EV(Hepburn Honda) = 0.5($10,764) + 0.4($12,114) + 0.1($13,464) = $11,574

EV(Midtown Motors) = 0.5($11,160) + 0.4($11,160) + 0.1($12,960) = $11,340

EV(Hopkins Automotive) = 0.5($11,700) + 0.4($11,700) + 0.1($11,700) = $11,700

The expected value approach results in selection of the Midtown Motors lease option (which has
the minimum expected value of the three alternatives - $11,340).
e. The risk profile for the decision to lease from Midtown Motors is:

Note that although we have three chance outcomes (drive 12000 miles annually, drive 15000 miles
annually, and drive 18000 miles annually), we only have two unique costs on this graph. This is
because for this decision alternative (lease from Midtown Motors) there are only two unique
payoffs associated with the three chance outcomes – the payoff (cost) associated with the Midtown
Motors lease is the same for two of the chance outcomes (whether Amy drives 12000 miles or
15000 miles annually, her payoff is $11,160).

f. We first find the expected value for the payoffs associated with each of Amy’s three alternatives:

EV(Hepburn Honda) = 0.3($10,764) + 0.4($12,114) + 0.3($13,464) = $12,114

EV(Midtown Motors) = 0.3($11,160) + 0.4($11,160) + 0.3($12,960) = $11,700

EV(Hopkins Automotive) = 0.3($11,700) + 0.4($11,700) + 0.3($11,700) = $11,700

The expected value approach results in selection of either the Midtown Motors lease option or the
Hopkins Automotive lease option (both of which have the minimum expected value of the three
alternatives - $11,700).

5. Using the expected value approach yields the following results:

EV(d1) = 0.65(250) + 0.15(100) + 0.20(25) = 182.5

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 Decision Analysis

EV(d2) = 0.65(100) + 0.15(100) + 0.20(75) = 95.0

The optimal decision using the expected value approach is d1.

6. a. EV(C) = 0.2(10) + 0.5(2) + 0.3(-4) = 1.8

EV(F) = 0.2(8) + 0.5(5) + 0.3(-3) = 3.2
EV(M) = 0.2(6) + 0.5(4) + 0.3(-2) = 2.6
EV(P) = 0.2(6) + 0.5(5) + 0.3(-1) = 3.4

Pharmaceuticals recommended 3.4%

b. Using probabilities 0.4, 0.4, 0.2.

EV(C) = 4.0
EV(F) = 4.6
EV(M) = 3.6
EV(P) = 4.2

Financial recommended 4.6%

7. a. EV(own staff) = 0.2(650) + 0.5(650) + 0.3(600) = 635

EV(outside vendor) = 0.2(900) + 0.5(600) + 0.3(300) = 570
EV(combination) = 0.2(800) + 0.5(650) + 0.3(500) = 635

The optimal decision is to hire an outside vendor with an expected annual cost of $570,000.

b. The risk profile in tabular form is shown.

Cost Probability
300 0.3
600 0.5
900 0.2
1.0

A graphical representation of the risk profile is also shown:

0.5
Probability

0.4
0.3
0.2
0.1

300 600 900

Cost

8. a. EV(d1) = p(10) + (1 - p) (1) = 9p + 1

EV(d2) = p(4) + (1 - p) (3) = 1p + 3

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Chapter 13

10

p
0 1

Value of p for
which EVs are equal
9p + 1 = 1p + 3 and hence p = .25

d2 is optimal for p  0.25; d1 is optimal for p  0.25.

b. The best decision is d2 since p = 0.20 < 0.25.

EV(d1) = 0.2(10) + 0.8(1) = 2.8

EV(d2) = 0.2(4) + 0.8(3) = 3.2

c. The best decision in part (b) is d2 with EV(d2) = 3.2. Decision d2 will remain optimal as long as
its expected value is higher than that for d1 (EV(d1) = 2.8).

Let s = payoff for d2 under state of nature s1. Decision d2 will remain optimal provided that

EV(d2) = 0.2(s) + 0.8(3)  2.8

0.2s  2.8 - 2.4
0.2s  0.4
s2

As long as the payoff for s1 is  2, then d2 will be optimal.

9. a. The decision to be made is to choose the type of service to provide. The chance event is the level
of demand for the Myrtle Air service. The consequence is the amount of quarterly profit. There
are two decision alternatives (full price and discount service). There are two outcomes for the
chance event (strong demand and weak demand).

b.
Type of Service Maximum Profit Minimum Profit
Full Price $960 -$490
Discount $670 $320

Optimistic Approach: Full price service

Conservative Approach: Discount service

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 Decision Analysis

Opportunity Loss or Regret Table

High Demand Low Demand Maximum Regret

Full Service 0 810 810
Discount Service 290 0 290

Minimax Regret Approach: Discount service

c. EV(Full) = 0.7(960) + 0.3(-490) = 525

EV (Discount) = 0.7(670) + 0.3(320) = 565

Optimal Decision: Discount service

d. EV(Full) = 0.8(960) + 0.2(-490) = 670

EV (Discount) = 0.8(670) + 0.2(320) = 600

Optimal Decision: Full price service

e. Let p = probability of strong demand

EV(Full) = p(960) + (1- p)(-490) = 1450p - 490

EV (Discount) = p(670) + (1- p)(320) = 350p + 320

EV (Full) = EV(Discount)
1450p - 490 = 350p + 320
1100p = 810
p = 810/1100 = 0.7364

If p = 0.7364, the two decision alternatives provide the same expected value.

For values of p below 0.7364, the discount service is the best choice. For values of p greater than
0.7364, the full price service is the best choice.

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Chapter 13

10. a.
High
1000
0.2

Battle Pacific Medium

2 700
0.5

Low
300
0.3

High
0.3 800
1

With Competition Medium

4 400
0.6 0.4

Low
200
Space Pirates 0.3
3
High
1600
0.5

Without Competition Medium

5 800
0.4 0.3

Low
400
0.2

b. EV(node 2) = 0.2(1000) + 0.5(700) + 0.3(300) = 640

EV(node 4) = 0.3(800) + 0.4(400) + 0.3(200) = 460

EV(node 5) = 0.5(1600) + 0.3(800) + 0.2(400) = 1120

EV(node 3) = 0.6EV(node 4) + 0.4EV(node 5) = 0.6(460) + 0.4(1120) = 724

Space Pirates is recommended. Expected value of $724,000 is $84,000 better than Battle Pacific.

c. Risk Profile for Space Pirates

Outcome:

1600 (0.4)(0.5) = 0.20

800 (0.6)(0.3) + (0.4)(0.3) = 0.30
400 (0.6)(0.4) + (0.4)(0.2) = 0.32
200 (0.6)(0.3) = 0.18

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 Decision Analysis

0.30
Probability
0.20

0.10

200 400 800 1600

Profit ($ thousands)

d. Let p = probability of competition

p=0 EV(node 5) = 1120

p=1 EV(node 4) = 460

1120
Space Pirates
Expected Value

640

460 Battle Pacific

0 1
p

1120 - p(1120 - 460) = 640

660p = 480
p = 480/660 = 0.7273

The probability of competition would have to be greater than 0.7273 before we would change to
the Battle Pacific video game.

11. a. Currently, the large complex decision is optimal with EV(d3) = 0.8(20) + 0.2(-9) = 14.2. In order
for d3 to remain optimal, the expected value of d2 must be less than or equal to 14.2.

Let s = payoff under strong demand

EV(d2) = 0.8(s) + 0.2(5)  14.2

0.8 s + 1  14.2

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Chapter 13

0.8 s  13.2
s  16.5

Thus, if the payoff for the medium complex under strong demand remains less than or equal to
$16.5 million, the large complex remains the best decision.

b. A similar analysis is applicable for d1

EV(d1) = 0.8(s) + 0.2(7)  14.2

0.8 s + 1.4  14.2
0.8 s  12.8
s  16

If the payoff for the small complex under strong demand remains less than or equal to $16 million,
the large complex remains the best decision.

12. a. There is only one decision to be made: whether or not to lengthen the runway. There are only two
decision alternatives. The chance event represents the choices made by Air Express and DRI
concerning whether they locate in Potsdam. Even though these are decisions for Air Express and
DRI, they are chance events for Potsdam.

The payoffs and probabilities for the chance event depend on the decision alternative chosen. If
Potsdam lengthens the runway, there are four outcomes (both, Air Express only, DRI only,
neither). The probabilities and payoffs corresponding to these outcomes are given in the tables of
the problem statement. If Potsdam does not lengthen the runway, Air Express will not locate in
Potsdam so we only need to consider two outcomes: DRI and no DRI. The approximate
probabilities and payoffs for this case are given in the last paragraph of the problem statements.

The consequence is the estimated annual revenue.

b. Runway is Lengthened

New New
Air Express Center DRI Plant Probability Annual Revenue
Yes Yes 0.3 $600,000
Yes No 0.1 $150,000
No Yes 0.4 $250,000
No No 0.2 -$200,000

EV (Runway is Lengthened) = 0.3($600,000) + 0.1($150,000) + 0.4($250,000) - 0.2($200,000)

= $255,000

c. EV (Runway is Not Lengthened) = 0.6($450,000) + 0.4($0) = $270,000

d. The town should not lengthen the runway.

e. EV (Runway is Lengthened) = 0.4(600,000) + 0.1($150,000) + 0.3($250,000) - 0.2(200,000)

= $290,000

The revised probabilities would lead to the decision to lengthen the runway.

13. a. The decision is to choose what type of grapes to plant, the chance event is demand for the wine
and the consequence is the expected annual profit contribution. There are three decision

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 Decision Analysis

alternatives (Chardonnay, Riesling and both). There are four chance outcomes: (W,W); (W,S);
(S,W); and (S,S). For instance, (W,S) denotes the outcomes corresponding to weak demand for
Chardonnay and strong demand for Riesling.

b. In constructing a decision tree, it is only necessary to show two branches when only a single grape
is planted. But, the branch probabilities in these cases are the sum of two probabilities. For
example, the probability that demand for Chardonnay is strong is given by:

P (Strong demand for Chardonnay) = P(S,W) + P(S,S)

= 0.25 + 0.20
= 0.45

Weak for Chardonnay

20
0.55
Plant Chardonnay
2 EV = 42.5

Strong for Chardonnay

70
0.45

Weak for Chardonnay, Weak for Riesling

22
0.05

Weak for Chardonnay, Strong for Riesling

40
0.50
Plant both grapes
1 3 EV = 39.6
Strong for Chardonnay, Weak for Riesling
26
0.25

Strong for Chardonnay, Strong for Riesling

60
0.20
Weak for Riesling
25
0.30
Plant Riesling
4 EV = 39

Strong for Riesling

45
0.70

c. EV (Plant Chardonnay) = 0.55(20) +0.45(70) = 42.5

EV (Plant both grapes) = 0.05(22) + 0.50(40) + 0.25(26) + 0.20(60) = 39.6
EV (Plant Riesling) = 0.30(25) + 0.70(45) = 39.0

Optimal decision: Plant Chardonnay grapes only.

d. This changes the expected value in the case where both grapes are planted and when Riesling only

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Chapter 13

is planted.

EV (Plant both grapes) = 0.05(22) + 0.50(40) +0.05(26) + 0.40(60) = 46.4

EV (Plant Riedling) = 0.10(25) + 0.90(45) = 43.0

We see that the optimal decision is now to plant both grapes. The optimal decision is sensitive to
this change in probabilities.

e. Only the expected value for node 2 in the decision tree needs to be recomputed.

EV (Plant Chardonnay) = 0.55(20) + 0.45(50) = 33.5

This change in the payoffs makes planting Chardonnay only less attractive. It is now best to plant
both types of grapes. The optimal decision is sensitive to a change in the payoff of this magnitude.

14. a. If s1 then d1 ; if s2 then d1 or d2; if s3 then d2

b. EVwPI = .65(250) + .15(100) + .20(75) = 192.5

c. From the solution to Problem 5 we know that EV(d1) = 182.5 and EV(d2) = 95; thus, the
recommended decision is d1. Hence, EVwoPI = 182.5.

d. EVPI = EVwPI - EVwoPI = 192.5 - 182.5 = 10

15. a. EV (Small) = 0.1(400) + 0.6(500) + 0.3(660) = 538

EV (Medium) = 0.1(-250) + 0.6(650) + 0.3(800) = 605

EV (Large) = 0.1(-400) + 0.6(580) + 0.3(990) = 605

Best decision: Build a medium or large-size community center.

Note that using the expected value approach, the Town Council would be indifferent between
building a medium-size community center and a large-size center.

b. Risk profile for medium-size community center:

0.6
Probability

0.4

0.2

0 -400 400 800

Net Cash Flow
Risk profile for large-size community center:

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 Decision Analysis

0.6

Probability
0.4

0.2

-400 0 400 800

Net Cash Flow

Given the mayor's concern about the large loss that would be incurred if demand is not large
enough to support a large-size center, we would recommend the medium-size center. The large-
size center has a probability of 0.1 of losing $400,000. With the medium-size center, the most the
town can loose is $250,000.

c. The Town's optimal decision strategy based on perfect information is as follows:

If the worst-case scenario, build a small-size center

If the base-case scenario, build a medium-size center
If the best-case scenario, build a large-size center

Using the consultant's original probability assessments for each scenario, 0.10, 0.60 and 0.30, the
expected value of a decision strategy that uses perfect information is:

EVwPI = 0.1(400) + 0.6(650) + 0.3(990) = 727

In part (a), the expected value approach showed that EV(Medium) = EV(Large) = 605.
Therefore, EVwoPI = 605 and EVPI = 727 - 605 = 122

The town should seriously consider additional information about the likelihood of the three
scenarios. Since perfect information would be worth $122,000, a good market research study
could possibly make a significant contribution.

d. EV (Small) = 0.2(400) + 0.5(500) + 0.3(660) = 528

EV (Medium) = 0.2(-250) + 0.5(650) + 0.3(800) = 515

EV (Small) = 0.2(-400) + 0.5(580) + 0.3(990) = 507

Best decision: Build a small-size community center.

e. If the promotional campaign is conducted, the probabilities will change to 0.0, 0.6 and 0.4 for the
worst case, base case and best case scenarios respectively.

EV (Small) = 0.0(400) + 0.6(500) + 0.4(660) = 564

EV (Medium) = 0.0(-250) + 0.6(650) + 0.4(800) = 710

EV (Small) = 0.0(-400) + 0.6(580) + 0.4(990) = 744

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Chapter 13

In this case, the recommended decision is to build a large-size community center. Compared to the
analysis in Part (a), the promotional campaign has increased the best expected value by $744,000 -
605,000 = $139,000. Compared to the analysis in part (d), the promotional campaign has increased
the best expected value by $744,000 - 528,000 = $216,000.

Even though the promotional campaign does not increase the expected value by more than its cost
($150,000) when compared to the analysis in part (a), it appears to be a good investment. That is,
it eliminates the risk of a loss, which appears to be a significant factor in the mayor's decision-
making process.

16. a.

Profit
Payoff
s1
100
d1
6
s2
300
F
3
s1
400
d2
7
s2
200
Market
2
Research s1
100
d1
8
s2
300
U
4
s1
400
d2
9
s2
200
1
s1
100
d1
10
s2
300
No Market
5
Research s1
400
d2
11
s2
200
b. EV (node 6) = 0.57(100) + 0.43(300) = 186
EV (node 7) = 0.57(400) + 0.43(200) = 314
EV (node 8) = 0.18(100) + 0.82(300) = 264

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 Decision Analysis

EV (node 9) = 0.18(400) + 0.82(200) = 236

EV (node 10) = 0.40(100) + 0.60(300) = 220
EV (node 11) = 0.40(400) + 0.60(200) = 280
EV (node 3) = Max(186,314) = 314 d2

EV (node 4) = Max(264,236) = 264 d1

EV (node 5) = Max(220,280) = 280 d2

EV (node 2) = 0.56(314) + 0.44(264) = 292

EV (node 1) = Max(292,280) = 292

 Market Research
If Favorable, decision d2
If Unfavorable, decision d1

17. a. EV(node 4) = 0.5(34) + 0.3(20) + 0.2(10) = 25

EV(node 3) = Max(25,20) = 25 Decision: Build

EV(node 2) = 0.5(25) + 0.5(-5) = 10

EV(node 1) = Max(10,0) = 10 Decision: Start R&D

Optimal Strategy:

Start the R&D project

If it is successful, build the facility

Expected value = $10M

b. At node 3, payoff for sell rights would have to be $25M or more. In order to recover the $5M R&D
cost, the selling price would have to be $30M or more.

c.
Possible Profit
$34M (0.5)(0.5) = 0.25
$20M (0.5)(0.3) = 0.15
$10M (0.5)(0.2) = 0.10
-$5M 0.50
1.00

18. a. Outcome 1 ($ in 000s)

Bid -$200
Contract -2000
Market Research -150
High Demand +5000
$2650
Outcome 2 ($ in 000s)

Bid -$200
Contract -2000

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Chapter 13

Market Research -150

Moderate +3000
Demand
$650

b. EV (node 8) = 0.85(2650) + 0.15(650) = 2350

EV (node 5) = Max(2350, 1150) = 2350 Decision: Build
EV (node 9) = 0.225(2650) + 0.775(650) = 1100
EV (node 6) = Max(1100, 1150) = 1150 Decision: Sell
EV (node 10) = 0.6(2800) + 0.4(800)= 2000
EV (node 7) = Max(2000, 1300) = 2000 Decision: Build
EV (node 4) = 0.6 EV(node 5) + 0.4 EV(node 6) = 0.6(2350) + 0.4(1150) = 1870
EV (node 3) = MAX (EV(node 4), EV (node 7)) = Max (1870, 2000) = 2000
Decision: No Market Research
EV (node 2) = 0.8 EV(node 3) + 0.2 (-200) = 0.8(2000) + 0.2(-200) = 1560
EV (node 1) = MAX (EV(node 2), 0) = Max (1560, 0) = 1560
Decision: Bid on Contract
Decision Strategy:

Bid on the Contract

Do not do the Market Research
Build the Complex
Expected Value is $1,560,000

c. Compare Expected Values at nodes 4 and 7.

EV(node 4) = 1870 Includes $150 cost for research

EV (node 7) = 2000

Difference is 2000 - 1870 = $130

Market research cost would have to be lowered $130,000 to $20,000 or less to make undertaking
the research desirable.

d. Shown below is the reduced decision tree showing only the sequence of decisions and chance
events for Dante's optimal decision strategy. If Dante follows this strategy, only 3 outcomes are
possible with payoffs of -200, 800, and 2800. The probabilities for these payoffs are found by
multiplying the probabilities on the branches leading to the payoffs. A tabular presentation of the
risk profile is:

Payoff ($million) Probability

-200 .20
800 (.8)(.4)
= .32
2800 (.8)(.6)
= .48

Reduced Decision Tree Showing Only Branches for Optimal Strategy

13 - 18
 Decision Analysis

Win Contract High Demand

3 2800
0.8 0.6
Build Complex
10
Bid Moderate Demand
2 800
0.4
No Market Research
7
1
Lose Contract
-200
0.2

19. a.

s1
-100
d1 s2
6 50
s3
150
Favorable
3
s1
d2 100
s2
7 100
s3
100
Agency
2
s1
-100
d1 s2
8 50
s3
150
Unfavorable
4
s1
d2 100
s2
9 100
s3
1 100

s1
-100
d1 s2
10 50
s3
150
No Agency
5
s1
d2 100
s2
11 100
s3
100

b. Using node 5,

13 - 19
Chapter 13

EV (node 10) = 0.20(-100) + 0.30(50) + 0.50(150) = 70

EV (node 11) = 100

Decision Sell Expected Value = $100

c. EVwPI = 0.20(100) + 0.30(100) + 0.50(150) = $125

EVPI = $125 - $100 = $25

d. EV (node 6) = 0.09(-100) + 0.26(50) + 0.65(150) = 101.5

EV (node 7) = 100
EV (node 8) = 0.45(-100) + 0.39(50) + 0.16(150) = -1.5
EV (node 9) = 100

EV (node 3) = Max(101.5,100) = 101.5 Produce

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

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

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

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

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

g. No agency; sell the pilot.

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 Decision Analysis

20. a.
Success
750
0.75
Accept
7
Failure
-250
0.25
Favorable
4
0.7

Reject
0

Review
2 Success
750
0.417
Accept
8
Failure
-250
0.583
Unfavorable
5
0.3

Reject
0
1

Success
750
0.65
Accept
6
Failure
-250
Do Not Review 0.35
3

Reject
0

b. EV (node 7) = 0.75(750) + 0.25(-250) = 500

EV (node 8) = 0.417(750) + 0.583(-250) = 167

Decision (node 4)  Accept EV = 500

Decision (node 5)  Accept EV = 167

EV(node 2) = 0.7(500) + 0.3(167) = $400

Note: Regardless of the review outcome F or U, the recommended decision alternative is to accept
the manuscript.

EV(node 3) = .65(750) + .35(-250) = $400

The expected value is $400,000 regardless of review process. The company should accept the
manuscript.

c. The manuscript review cannot alter the decision to accept the manuscript. Do not do the
manuscript review.

d. Perfect Information.

13 - 21
Chapter 13

If s1, accept manuscript $750

If s2, reject manuscript -$250

EVwPI = 0.65(750) + 0.35(0) = 487.5

EVwoPI = 400

EVPI = 487.5 - 400 = 87.5 or $87,500.

A better procedure for assessing the market potential for the textbook may be worthwhile.

21. The decision tree is as shown in the answer to problem 16a. The calculations using the decision
tree in problem 16a with the probabilities and payoffs here are as follows:

a,b. EV (node 6) = 0.18(600) + 0.82(-200) = -56

EV (node 7) = 0
EV (node 8) = 0.89(600) + 0.11(-200) = 512
EV (node 9) = 0
EV (node 10) = 0.50(600) + 0.50(-200) = 200
EV (node 11) = 0

EV (node 3) = Max(-56,0) = 0 d2
EV (node 4) = Max(512,0) = 512 d1
EV (node 5) = Max(200,0) = 200 d1

EV (node 2) = 0.55(0) + 0.45(512) = 230.4

Without the option, the recommended decision is d1 purchase with an expected value of $200,000.

With the option, the best decision strategy is

If high resistance H, d2 do not purchase
If low resistance L, d1 purchase
Expected Value = $230,400

c. EVSI = $230,400 - $200,000 = $30,400. Since the cost is only $10,000, the investor should
purchase the option.

22. a. EV (1 lot) = 0.3(60) + 0.3(60) + 0.4(50) = 56

EV (2 lots) = 0.3(80) + 0.3(80) + 0.4(30) = 60
EV (3 lots) = 0.3 (100) + 0.3(70) + 0.4(10) = 55

Decision: Order 2 lots Expected Value $60,000

b. The following decision tree applies.

13 - 22
 Decision Analysis

s1
60
d1 s2
6 60
s3
50
s1
d2 80
Excellent s2
3 7 80
s3
30
s1
d3 100
s2
8 70
s3
V.P. Prediction 10
2 s1
60
d1 s2
9 60
s3
50
s1
d2 80
Very Good s2
4 10 80
s3
30
s1
d3 100
s2
1 11 70
s3
10
s1
60
d1 s2
12 60
s3
50
s1
d2 80
No V.P. Prediction s2
5 13 80
s3
30
s1
d3 100
s2
14 70
s3
10

Calculations

EV (node 6) = 0.34(60) + 0.32(60) + 0.34(50) = 56.6

EV (node 7) = 0.34(80) + 0.32(80) + 0.34(30) = 63.0
EV (node 8) = 0.34(100) + 0.32(70) + 0.34(10) = 59.8
EV (node 9) = 0.20(60) + 0.26(60) + 0.54(50) = 54.6
EV (node 10) = 0.20(80) + 0.26(80) + 0.54(30) = 53.0
EV (node 11) = 0.20(100) + 0.26(70) + 0.54(10) = 43.6
EV (node 12) = 0.30(60) + 0.30(60) + 0.40(50) = 56.0

13 - 23
Chapter 13

EV (node 13) = 0.30(80) + 0.30(80) + 0.40(30) = 60.0

EV (node 14) = 0.30(100) + 0.30(70) + 0.40(10) = 55.0
EV (node 3) = Max(56.6,63.0,59.8) = 63.0 2 lots
EV (node 4) = Max(54.6,53.0,43.6) = 54.6 1 lot
EV (node 5) = Max(56.0,60.0,55.0) = 60.0 2 lots

EV (node 2) = 0.70(63.0) + 0.30(54.6) = 60.5

EV (node 1) = Max(60.5,60.0) = 60.5 Prediction

Optimal Strategy:
If prediction is excellent, 2 lots
If prediction is very good, 1 lot

c. EVwPI = 0.3(100) + 0.3(80) + 0.4(50) = 74

EVPI = 74 - 60 = 14
EVSI = 60.5 - 60 = 0.5

EVSI 0.5
Efficiency = (100)  (100) 3.6%
EVPI 14

The V.P.’s recommendation is only valued at EVSI = $500. The low efficiency of 3.6% indicates
other information is probably worthwhile. The ability of the consultant to forecast market
conditions should be considered.

23.
State of Nature P(sj) P(I  sj) P(I  sj) P(sj  I)
s1 0.2 0.10 0.020 0.1905
s2 0.5 0.05 0.025 0.2381
s3 0.3 0.20 0.060 0.5714
1.0 P(I) = 0.105 1.0000

24. a. Using Bayes’ Theorem:

13 - 24
 Decision Analysis

s1 0.98 30
d1
7
s2 0.02
0.695C 30
3 s1 0.98 25
d2
8
s2 0.02
45
s1 0.79
30
d1
9
s2 0.21
Weather Check 0.215O 30
2 4 s1 0.79
25
d2
10
s2 0.21
45
s1 0.00
30
d1
11
s2 1.00
0.09R 30
5 s1 0.00
25
d2
12
1 s2 1.00
45
s1 0.85
30
d1
13
s2 0.15
No Weather Check 30
6 s1 0.85
25
d2
14
s2 0.15
45
EV (node 7) = 30
EV (node 8) = 0.98(25) + 0.02(45) = 25.4
EV (node 9) = 30
EV (node 10) = 0.79(25) + 0.21(45) = 29.2
EV (node 11) = 30
EV (node 12) = 0.00(25) + 1.00(45) = 45.0
EV (node 13) = 30
EV (node 14) = 0.85(25) + 0.15(45) = 28.0

EV (node 3) = Min(30,25.4) = 25.4 Expressway

EV (node 4) = Min(30,29.2) = 29.2 Expressway
EV (node 5) = Min(30,45) = 30.0 Queen City
EV (node 6) = Min(30,28) = 28.0 Expressway

EV (node 2) = 0.695(25.4) + 0.215(29.2) + 0.09(30.0) = 26.6

13 - 25
Chapter 13

EV (node 1) = Min(26.6,28) = 26.6 Weather

c. Optimal strategy:

Check the weather, take the expressway unless there is rain. If rain, take Queen City Avenue.

Expected time: 26.6 minutes.

25. a. d1 = Manufacture component s1 = Low demand

d2 = Purchase component s2 = Medium demand
s3 = High demand

s1
-20
.35
d1 s2
2 40
.35
s3
100
.30
1
s1
10
.35
d2 s2
3 45
.35
s3
70
.30

EV(node 2) = (0.35)(-20) + (0.35)(40) + (0.30)(100) = 37

EV(node 3) = (0.35)(10) + (0.35)(45) + (0.30)(70) = 40.25

Recommended decision: d2 (purchase component)

b. Optimal decision strategy with perfect information:

If s1 then d2

If s2 then d2

If s3 then d1

Expected value of this strategy is 0.35(10) + 0.35(45) + 0.30(100) = 49.25

EVPI = 49.25 - 40.25 = 9 or $9,000

c. If F - Favorable

State of Nature P(sj) P(F  sj) P(F  sj) P(sj  F)

s1 0.35 0.10 0.035 0.0986

13 - 26
 Decision Analysis

s2 0.35 0.40 0.140 0.3944

s3 0.30 0.60 0.180 0.5070
P(F) = 0.355

If U - Unfavorable

State of Nature P(sj) P(U  sj) P(U  sj) P(sj  U)

s1 0.35 0.90 0.315 0.4884
s2 0.35 0.60 0.210 0.3256
s3 0.30 0.40 0.120 0.1860
P(U) = 0.645

The probability the report will be favorable is P(F ) = 0.355

d. Assuming the test market study is used, a portion of the decision tree is shown below.

s1
-20
d1 s2
4 40

s3
100
F
2
s1
10

d2 s2
5 45

s3
70
1
s1
-20
d1 s2
6 40

s3
100
U
3
s1
10

d2 s2
7 45

s3
70

Summary of Calculations

Node Expected Value

4 64.51
5 54.23

13 - 27
Chapter 13

6 21.86
7 32.56

Decision strategy:

If F then d1 since EV(node 4) > EV(node 5)

If U then d2 since EV(node 7) > EV(node 6)

EV(node 1) = 0.355(64.51) + 0.645(32.56) = 43.90

e. With no information:

EV(d1) = 0.35(-20) + 0.35(40) + 0.30(100) = 37

EV(d2) = 0.35(10) + 0.35(45) + 0.30(70) = 40.25

Recommended decision: d2

f. Optimal decision strategy with perfect information:

If s1 then d2
If s2 then d2
If s3 then d1

Expected value of this strategy is 0.35(10) + 0.35(45) + 0.30(100) = 49.25

EVPI = 49.25 - 40.25 = 9 or $9,000
Efficiency = (3650 / 9000)100 = 40.6%

26. a. EV(d1) = 10,000

EV(d2) = 0.96(0) + 0.03(100,000) + 0.01(200,000) = 5,000

Using EV approach, we should choose No Insurance (d2).

b. Lottery:
p = probability of a $0 Cost
1 - p = probability of a $200,000 Cost

c.
s1 s2 s3
None Minor Major
Insurance d1 9.9 9.9 9.9
No d2 10.0 6.0 0.0
Insurance

EU(d1) = 9.9

EU(d2) = 0.96(10.0) + 0.03(6.0) + 0.01(0.0) = 9.78

13 - 28
 Decision Analysis

 Using EU approach  Insurance (d1)

d. Use expected utility approach. The EV approach results in a decision that can be very risky since it
means that the decision maker could lose up to $200,000. Most decision makers (particularly those
considering insurance) are risk averse.

27. a. P(Win) = 1/250,000 P(Lose) = 249,999/250,000

EV(d1) = 1/250,000(300,000) + 249,999/250,000(-2) = -0.80

EV(d2) = 0

Therefore, the best decision under the EV approach is d2 - Do not purchase lottery ticket.

b.
s1 s2
Win Lose
Purchase d1 10 0
Do Not Purchase d2 0.00001 0.00001

EU(d1) = 1/250,000(10) + 249,999/250,000(0) = 0.00004

EU(d2 ) = 0.00001

Therefore, the best decision under the EV approach is d1 - purchase lottery ticket.

28. a.

1.0
.9
.8 C
.7
A
Probability

.6 B
.5
.4
.3
.2
.1

-100 -50 0 50 100

Payoff
b. A - Risk avoider
B - Risk taker
C - Risk neutral

13 - 29
Chapter 13

c. Risk avoider A, at $20 payoff p = 0.70

Thus, EV(Lottery) = 0.70(100) + 0.30(-100) = $40

Therefore, will pay 40 - 20 = $20

Risk taker B, at $20 payoff p = 0.45

Thus, EV(Lottery) = 0.45(100) + 0.55(-100) = -$10

Therefore, will pay 20 - (-10) = $30

29. Decision Maker A

EU(d1 ) 0.25(7.0)  0.50(9.0)  0.25(5.0) 7.5 

d
EU(d 2 ) 0.25(9.5)  0.50(10.0)  0.25(0.0) 7.375 1

Decision Maker B

EU(d1 ) 0.25(4.5)  0.50(6.0)  0.25(2.5) 4.75 

d
EU(d 2 ) 0.25(7.0)  0.50(10.0)  0.25(0.0) 6.75  2

Decision Maker C

EU(d1 ) 0.25(6.0)  0.50(7.5)  0.25(4.0) 6.175 

d
EU(d 2 ) 0.25(9.0)  0.50(10.0)  0.25(0.0) 7.25  2

30.
Monetary Payoff, x Utility, U(x)
-200 -1.226
-100 -0.492
0 0.000
100 0.330
200 0.551
300 0.699
400 0.798
500 0.865

31. a. The exponential utility function for this decision maker is .

b. The utility function values and plot of is shown below.

x U(x)
-20000 -1.226
-15000 -0.822
-10000 -0.49

13 - 30
 Decision Analysis

-5000 -0.221
0 0
5000 0.181
10000 0.330
15000 0.451
20000 0.551
25000 0.632
30000 0.699
35000 0.753

1
Utility, U(x)

0.5

0
-30000 -20000 -10000 0 10000 20000 30000 40000
x
-0.5

-1

-1.5

c. The decision maker is risk averse.

d. The plots of the two utility functions appear below. We see that the new utility function
(represented by the dashed curve) is “flatter” than the utility function from part b. This means
that, while the decision maker is still, in general, risk averse, she is willing to accept more risk
than the decision maker in part b. Therefore, the decision maker here is being more risk seeking
(less risk averse) than in part b.

1
Utility, U(x)

0.5

0
-30000 -20000 -10000 0 10000 20000 30000 40000
x
-0.5

-1

-1.5

13 - 31