HO CHI MINH UNIVERSITY OF TECHNOLOGY

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Quantitative methods
Assignment 0 decision analysis

Student : Cao Thị Thanh Huyền

Class : CC01
Student's ID : 1952734
Lecturer : Phạm Quốc Trung

Hồ Chí Minh – 2021

Problem 1: Maria Rojas is considering the possibility of opening a small dress
shop on Fairbanks Avenue, a few blocks from the university. She has located a
good mall that attracts students. Her options are to open a small shop, a medium-
sized shop, or no shop at all. The market for a dress shop can be good, average, or
bad. The probabilities for these three possibilities are 0.2 for a good market, 0.5 for
an average market, and 0.3 for a bad market. The net profit or loss for the medium-
sized and small shops for the various market conditions are given in the following
table. Building no shop at all yields no loss and no gain.

Alternative State of Nature

Good Market Average Market Bad Market
($) ($) ($)
Small shop 75,000 25,000 -40,000
Medium-sized shop 100,000 35,000 -60,000
No shop 0 0 0
a. What do you recommend?
b. Calculate the EVPI.
c. Develop the opportunity loss table for this situation. What decisions would be
made using the minimax regret criterion and the minimum EOL criterion?

Solution:
Since the decision-making environment is risk (probabilities are known), it is
appropriate to use the EMV criterion. The problem can be solved by developing a payoff
table that contains all alter-natives, states of nature, and probability values. The EMV for
each alternative is also computed,as in the following table:
ALTERNATIVE STATE OF NATURE
Good Average Bad Market EMV
Market Market ($) ($)
($) ($)
Small shop 75,000 25,000 -40,000 15,500
Medium-sized shop 100,000 35,000 -60,000 19,500
No shop 0 0 0 0
Probabilities 0.20 0.50 0.30
EMV(small shop)= (0.2)($75,000)+ (0.5)($25,000)+ (0.3)(-$40,000)=$15,500
EMV ( medium shop)= (0.2)($100,000)+ (0.5)($35,000)+(0.3)(-$60,000)= $19,500
EMV ( no shop)= (0.2)($0)+ (0.5)($0) + (0.3)($0)= $0
As can be seen, the best decision is to build the medium-sized shop. The EMV
for this alternative is $19,500.
b. EVwPI = (0.2)$100,000 + (0.5) $35,000 + (0.3)$0 = $37,500
EVPI= $37,500 - $19,500 = $18,000
c. The opporyunity loss table:

ALTERNATIVE STATE OF NATURE

Good Average Bad MAXIMUM EOL
Market Market Market ($) ($)
($) ($) ($)
Small shop 25,000 10,000 40,000 40,000 22,000
Medium-sized 0 0 60,000 60,000 18,000
shop
No shop 100,000 35,000 0 100,000 37,500
Probabilities 0.20 0.50 0.30

The best payoff in a good market is 100,000, so the opportunity losses in the
first column indicate how much worse each payoff is than 100,000. The best
payoff in an average market is 35,000, so the opportunity losses in the second
column indicate how much worse each payoff is than 35,000. The best payoff in a
bad market is 0, so the opportunity losses in the third column indicate how much
worse each payoff is than 0.
The minimax regret criterion considers the maximum regret for each decision,
and the decision corresponding to the minimum of these is selected. The decision
would be to build a small shop since the maximum regret for this is 40,000, while
the maximum regret for each of the other two alternatives is higher as shown in the
opportunity loss table.
The decision based on the EOL criterion would be to build the medium shop.
Note that the minimum EOL ($18,000) is the same as the EVPI computed in part b.
The calculations are:
EOL (small) = (0.2)25,000 + (0.5)10,000 + (0.3)40,000= 22,000
EOL ( medium)= (0.2)0+ (0.5)0 + (0.3)60,000 = 18,000
EOL ( no shop)= (0.2) 100,000 + (0.5) 35,000 + (0.3)0= 37,500
Problem 2: Cal Bender and Becky Addison have known each other since high
school. Two years ago they entered the same university and today they are taking
undergraduate courses in the business school. Both hope to graduate with degrees
in finance. In an attempt to make extra money and to use some of the knowledge
gained from their business courses, Cal and Becky have decided to look into the
possibility of starting a small company that would provide word processing
services to students who needed term papers or other reports prepared in a
professional manner. Using a systems approach, Cal and Becky have identified
three strategies. Strategy 1 is to invest in a fairly expensive microcomputer system
with a highquality laser printer. In a favorable market, they should be able to
obtain a net profit of $ 10,000 over the next two years. If the market is unfavorable,
they can lose $ 8,000. Strategy 2 is to purchase a less expensive system. With a
favorable market, they could get a return during the next two years of $ 8,000.
With an unfavorable market, they would incur a loss of $ 4,000. Their final
strategy, strategy 3, is to do nothing. Cal is basically a risk taker, whereas Becky
tries to avoid risk. a. What type of decision procedure should Cal use? What would
Cal’s decision be? b. What type of decision maker is Becky? What decision would
Becky make? c. If Cal and Becky were indifferent to risk, what type of decision
approach should they use? What would you recommend if this were the case?
Solution:
The problem is one of decision making under uncertainty. Before answering the
specific questions, a decision table should be developed showing the alternatives,
states of nature, and related consequences.
ALTERNATIVE FAVORABLE UNFAVORABLE
MARKET($) MARKET($)
Strategy 1 10,000 -8,000
Strategy 2 8,000 -4,000
Strategy 3 0 0

a. Since Cal is a risk taker, he should use the maximax decision criteria. This
approach selects the row that has the highest or maximum value. The $10,000
value, which is the maximum value from the table, is in row 1. Thus, Cal’s
decision is to select strategy 1, which is an optimistic decision approach.
b. Becky should use the maximin decision criteria because she wants to avoid
risk. The minimum or worst outcome for each row, or strategy, is identified. These
outcomes are –$8,000 for strategy 1, –$4,000 for strategy 2, and $0 for strategy 3.
The maximum of these values is selected. Thus, Becky would select strategy 3,
which reflects a pessimistic decision approach.
c. If Cal and Becky are indifferent to risk, they could use the equally likely
approach. This approach selects the alternative that maximizes the row averages.
The row average for strategy 1 is $1000[ $1000 = ($10,000 - $8,000)/ 2].
-> The row average for strategy 2 is $2,000, and the row average for strategy 3 is
$0. Thus, using the equally likely approach, the decision is to select strategy 2,
which maximizes the row averages.

Problem 3: Monica Britt has enjoyed sailing small boats since she was 7 years old,
when her mother started sailing with her. Today, Monica is considering the
possibility of starting a company to produce small sailboats for the recreational
market. Unlike other mass-produced sailboats, however, these boats will be made
specifically for children between the ages of 10 and 15. The boats will be of the
highest quality and extremely stable, and the sail size will be reduced to prevent
problems of capsizing. Her basic decision is whether to build a large
manufacturing facility, a small manufacturing facility, or no facility at all. With a
favorable market, Monica can expect to make $ 90,000 from the large facility or $
60,000 from the smaller facility. If the market is unfavorable, however, Monica
estimates that she would lose $ 30,000 with a large facility, and she would lose
only $ 20,000 with the small facility. Because of the expense involved in
developing the initial molds and acquiring the necessary equipment to produce
fiberglass sailboats for young children, Monica has decided to conduct a pilot
study to make sure that the market for the sailboats will be adequate. She estimates
that the pilot study will cost her $ 10,000. Furthermore, the pilot study can be
either favorable or unfavorable. Monica estimates that the probability of a
favorable market given a favorable pilot study is 0.8. The probability of an
unfavorable market given an unfavorable pilot study result is estimated to be 0.9.
Monica feels that there is a 0.65 chance that the pilot study will be favorable. Of
course, Monica could bypass the pilot study and simply make the decision as to
whether to build a large plant, small plant, or no facility at all. Without doing any
testing in a pilot study, she estimates that the probability of a favorable market is
0.6. What do you recommend? Compute the EVSI.
Solution:
Before Monica starts to solve this problem, she should develop a decision
tree that shows all alternatives, states of nature, probability values, and economic
consequences. This decision tree is
 (0,6) Market favorable $60000
2
(0.4) Market unfavorable $20,000
Small Facilities

Large (0.6) Market favorable $90,000

B Facilities
3 (0.4) Market unfavorable $30,000
Do not Conduct Study

No facilities $0

(0.8) market favorable $50,000

4 (0.2) market unfavorable $30,000

A Small Facilities

(0.65) Favorable study

C Large (0.8) market favorable $80,000
5
facilities (0.2) Market unfavorable -$40,000
1 No facility -$10,000

(0.35)
Unfavorable study
Conduct study (0.1) Market Favorable $50,000
Small facility
6 (0.9) Market Unfavorable $30,000
D

Large facility (0.1) Market Favorable $80,000

7 (0.9) Market Unfavorable -$40,000

No facility -$10,000
 EMV( node 2) = 60,000(0.6) + (-20,000)0.4= 28,000
EMV( node 3) = 90,000(0.6) + (-30,000)0.4 = 42,000
EMV( node 4) = 50,000(0.8) + (-30,000)0.2= 34,000
EMV( node 5) = 80,000(0.8) +( -40,000)0.2 = 56,000
EMV( node 6) = 50,000(0.1) + (-30,000) 0.9= -22,000
EMV ( node 7)= 80,000(0.1) + (-40,000) 0.9= -28,000
EMV(node 1)= 56,000(0.65) + (-10,000)0.35 = 32,900
At each of the square nodes with the letters, the decision would be:
Node B: Choose large facility since the EMV = $42,000
Node C: Choose large facility since the EMV= $ 56,000
Node D: Choose no facility simce the EMV= -$10,000
Node A: Choose Do Not Conduct Study since the EMV ($42,000) for this
is higher than EMV (node 1), which is $32,900.
Based on the EMV criterion, Monica would select Do Not Conduct Study and
then select Large Facility. The EMV of this decision is $42,000. Choosing to
conduct the study would result in an EMV of only $32,900. Thus, the expected
value of sample information is
EVSI= $32,900 +$10,000 - $42,000 = $900

Problem 4: Developing a small driving range for golfers of all abilities has long
been a desire of John Jenkins. John, however, believes that the chance of a
successful driving range is only about 40%. A friend of John’s has suggested that
he conduct a survey in the community to get a better feeling of the demand for
such a facility. There is a 0.9 probability that the research will be favorable if the
driving range facility will be successful. Furthermore, it is estimated that there is a
0.8 probability that the marketing research will be unfavorable if indeed the facility
will be unsuccessful. Let help John to determine the probability of a successful
driving range given a favorable result from the marketing survey
Solution:

This problem requires the use of Bayes’ theorem. Before we start to solve the
problem, we will define the following terms:
P(SF) = probability of successful driving range facility
P(UF) = probability of unsuccessful driving range facility
P(RF | SF) = probability that the research will be favorable given a successful
driving range facility
 P(RU | SF) = probability that the research will be unfavorable given a successful
driving range facility
P(RU | UF) = probability that the research will be unfavorable given an
unsuccessful driving range facility
P(RF | UF) = probability that the research will be favorable given an
unsuccessful driving range facility
Now, we can summarize what we know:
P(SF) = 0.4
P(RF|SF) =0.9
P(RU| UF) = 0.8
From this information we can compute three additional probabilities that we need
to solve the problem:

P(UF) = 1 - P(SF) = 1 -0.4 = 0.6

P (RU| SF) = 1- P(RF| SF) = 1- 0.9= 0.1
P(RF| UF) = 1 - P( RU| UF)= 1- 0.8 = 0.2
Now we can put these values into Bayes' theorem to compute the desired
probability :

P(SF| RF)=

= 0.75

In addition to using formulas to solve John’s problem, it is possible to perform all

calculations in a table:

Revised Probabilities Given a Favorable Research Result

 State of nature Conditional Prior Joint Posterior
probability probability probability probability
Favorable 0.9 * 0.4 = 0.36 0.36/0.48= 0.75
market
Unfavorable 0.2 * 0.6 = 0.12 0.12/0.48 =0.25
market

-> From the table, the results are the same. The probability successful
driving range given a favorable research result is 0.36/0.48, or 0.75.