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

c April 28, 2010 D.M. Tulett

i

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, OpenOfﬁce.org 3 R is a registered trademark of OpenOfﬁce.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 modiﬁed version of the one that appears near the end of Lecture 4.

ii

c April 28, 2010 D.M. Tulett

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 ﬁnal exam. Your professor may require that some of these be done for credit. It would be beneﬁcial, 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 OpenOfﬁce.org 3 OpenOfﬁce 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

c April 28, 2010 D.M. Tulett

iii

Contents

1 Introduction 1.1 The Paradigm of Management Science 1.2 Example – Cellular Phone Plans . . . 1.2.1 Problem Identiﬁcation . . . . 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

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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 Deﬁnition 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 Ofﬁce 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 Coefﬁcients 14.3.2 Changes to the Right-Hand-Side Values . . . . 14.4 Example 2: Minimization . . . . . . . . . . . . . . . . 14.4.1 Changes to the Objective Function Coefﬁcients 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 Coefﬁcients 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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. . . . . . . . .2 Repair Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . 16. 18. 17. . . . . . . . . . . . . . . . . . . . . . . . . . .1 Introduction . . . . . . 18 Utility Theory 1 18.1 Situation Description . .1 Educational Model . . . . . . 17 Markov Chains 3 17. . . . . . . . . .4. 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Obtaining the Data for a Utility Function 18.2 Problem 2 . . . . . 18. . . . . . . . . . . . . . . . c April 28. . . . . . . 16.4. . . . . .2 Formulation . . . . . . . . . 16.4 An Application: Credit Card Analysis 16. . . . 18. . . .3 Analysis . . . . . . . . . . .6. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2. . . . . . . . . . . . . . . . .1 Situation Description 17. . . . . .1 Introduction . . . . . . . . . . . . . . 17. . .5. . . . . . . . . 18. . . . . . . . . 17. . . . . . . . . . . . . . .2. . . .1 Problem 1 . . . . . 18. . . . . . . . .3.1 Gambler’s Ruin . . . . . . . 17.3 Using the Graph with a Payoff Matrix . . . . . . . 16. . . .5. . . . . . . . . . . . . . . . . . . . . . . . . . . 16. . . .6. . . . . . . .2 Formulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Exercise . . . . . . . . . . . . . . . . . . 2010 D. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Introduction . .2 A Simple Decision .3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Extension 1 . . . . . . . . . .4. . . . . .5. . . . . . . .M. . . . .viii 16 Markov Chains 2 16. . . . . . . . . .5.5. . . . . .4 A More Complicated Graph . . . . . . . . 17. . . .5 Exercise . . . . . 16. .3 Repair Problem A . . . . 18. . . . . . . . . . . . . . . . . . . . . . . 17. . . . . . .2 Absorbing States Analysis . . . . . . . . . . . . . . . . .2 Problem 2 . . . . . . . . . . . 18. . . . . . . . .3 Solution by Computer . . . . . . 17. . . .5 Utility Functions . . . . . . . . . . . . . 16. . . . . . 17. .2 Extension 2 . . . . . . . . . . . . . . . . . .5. . . 16. .4 Repair Problem B . . . . . . . . . . . . . . . . . . . . 18. . . . .6 Exercise . . . 17. . . .2 Educational Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Problem 1 . . . .

. . . . . . . 21. 20. . . . . . . . . .3. . . . . . . 20. . 20. . 20. . . . . . . . . . . . . . . . . . . . . . . . . . . . .6. . . . . . . 21. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Pure Strategy . . 21. . . . . . . . . . .1 Example 1 . . . . . . .6 Exercise . . . . .3. . . . . .4. . . . . . . . .2 Three Useful Properties . .3. . 20. . . .2 Problem 2 . . .6. . . . . .4 Prisoner’s Dilemma . . . . . . .1 Introduction . . . . . . . . . 20. . . .2. . . . . . . . . . . . . . . . . . . . . .3. . . . . . . . . . . . .M. . . . . . . . . . . . . . . . 19. . . . . . . . . . . . 19. . . . . . . . . . . . . . . . . . .3 Finding the EVPI . 20 Game Theory 1 20.3. . . . . 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 . . . . . . . . . . . . . . . . . . . . . . . . . 20. . . . . .2. . . . . . . . . .2 Problem 2 . . .5. . . . . . . . . . . . 20. . . . . . . . .1 Problem 1 . . . .4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20. . 19. . . . . . . . . . . . .6. . .c April 28. .5 Exercise . . . . . 21. . . . .1 Problem 1 . . . . . . . .2 Formulation as a Linear Optimization Model 21. . . . . . . . . . . . . . 20.1. . 20. . . . . . 21 Game Theory 2 21. . . . .1 Introduction . . . . . .1 Graphical Solution . . . . . . .1 The EVPI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Using Utility Functions with Decision Trees 19. . . . . .3 DARS Algorithm . . .1 Example 1 . . . . . . . . 20. . . . . . . . . . . . . . . . . 20. . . . . . .4. . . . . . . .3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Jack and Jill Problem . . . . . . . . . . . .1 Situation Description . . . . . . . . . . . . 19. . 21. . . . . . . . . . . . . . . .5 Obtaining the Payoffs . . . .3 Formulation Problem . . . . . .3 General Methodology . . . . . . . . 19. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Dominance . . . . . . . . . . . . . . 21. .3 Problem 3 . . . . . . . . . . . . . . . . . 2010 D. . . 21. . . .2 Solution .3 Exercise . . . 19. . . . . . . . . . .3 Mixed Strategy . . . . . . 20. . . . . . . . . . . . . .1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1. . . . . .2 Example 2 . . . . . . . . .2 Example 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1. . . . . . . . . . . . . . . . .5. . .1 Mixed Strategy Game 20. . . . . . . Tulett 19 Utility Theory 2 19. . . . . . . . . . . . . . . . . . .

23. . . . . . .8 Game Theory . . . . . . . . . . . . . . . . . . .4 Problem 4 . . . . 23.7 Utility Theory . . . . . . . . . . . 2010 D. . . . . . . . . . . . .1 Advanced Problems . . . .5 Problem 5 . . . . . .6 Markov Chains . . . . . . . . . . . . . . . . . . . 23. . . . . . .3. . . . . . . . . . . . . . . . . . 23.3. . . . . . . . . . . . . .2 Uncertainty . . . . . . .x c April 28. . .3 Decision Trees . . .1. . . . . . . . . . . . . . . . . . . 23. . . . . . . . . . . . . . . . .4 Imperfect Information . . . 23. Tulett 21. . 23. . . . . .M. . . . . . . . . . . . . . . . . . . . . . . 23. . . . . 348 21. . . . . . . . . . . .9 Linear Optimization – Applications 349 353 354 356 357 368 375 394 402 411 421 428 . . . . . . . 348 22 Moving Forward 23 Supplement – Extra Problems 23. . . . . . . 23. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Linear Optimization – Introduction . . . . . . . . . . . . . . . . . .1 Introduction . . . . . . . . . . . . . .

As mentioned in the Preface. Because we are working in an academic context.M. Also. We will. Instead. for example. The “problem” is not for us a real-world observation.c April 28. The important thing is always going from a problem description to a model for the problem. the difﬁculty is likely to be the building of the model which the mathematics seeks to solve. Tulett 1 1 Introduction Management Science involves the application of mathematics to management problems. it’s probably not the mathematics. but instead it a written description (a “word” or “story” problem).1 The Paradigm of Management Science A paradigm is a pattern for the general understanding of something. When the fourth phase has been done. . the mathematics that we need is covered in Mathematics for Management Science. 1. A common paradigm for management science is to think of it being composed of four phases: • problem deﬁnition • model building • solution • implementation. the numerical calculations can often be left to a spreadsheet or other software tools. This is part of the paradigm of management science. it is appropriate to ask whether or not it addressed the original problem. which is the focus of this section. We are left with looking at the second and third phases of the paradigm. 2010 D. use such things as Bayesian revision and graphing for linear optimization that are covered in that book. 1. If there’s a difﬁculty with this subject. Also. we cannot implement the solutions.2 Example – Cellular Phone Plans We use this example as a way to illustrate the paradigm. we cannot observe the entire paradigm.

35(90) for a total of $69. especially since she would use the cellphone almost entirely during working hours Monday to Friday.25 anywhere Alison plans to make 240 minutes of local calls and 60 minutes of longdistance calls each month. 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. we can easily solve this problem. and long-distance charges are 35 cents per minute at any time. especially when some cellular phone companies give the phones away in order to attract business.35 long-distance $39 200 $0.35 long-distance $25 200 $0. However. For example if a user of this plan made 160 minutes of local calls. but also because of the convenience that it will provide. Tulett Alison has decided to buy a cellular telephone. 2010 D.20 all calls $0. . and 90 minutes of long-distance calls. with a per-charge premium if extra minutes are used. she is concerned about the monthly operating cost.2. Most plans operate on the user paying a ﬁxed charge to obtain a set number of minutes per month.35 long-distance $45 400 $0.1 Problem Identiﬁcation c April 28. Other plans treat both local and long-distance (within the country) calls the same. For example.35 all calls $0.2 1. the cost would be $25 plus $0. 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 $0.25(160 + 90 − 200) + $0.25 anywhere $109 800 $0. 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. which plan should be bought? By building a spreadsheet model.35 long-distance $69 600 $0.30 anywhere $59 400 $0. partly for safety in case of a breakdown in an isolated area. She’s not concerned about the initial cost of the telephone itself.25 all calls $0.20 all calls $0. Which plan should she buy? Hers is a speciﬁc example.M.00.

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. and the cost of these extra minutes is $0.35y $25 + $0. Overall.25 max{0. However. and the longdistance charge is $0. x + y − 400} $109 + $0. 2010 D. its cost is $0. These four parameters represent. then the user must pay for an extra x + y − 200 minutes. then there is no extra charge.25 max{0. x + y − 200} + $0.35(x + y) + $0. whichever is greater. The cost of the plans (the seven alternatives) can be written terms of x and y.25 max{0. Seeing patterns like this helps when making a . x + y − 400} + $0. but let’s look at the general problem of a person who needs x minutes of local calls and y minutes of long-distance calls each month.c April 28. the number of minutes for the plan. plus the cost of the calls (if any) which exceed the plan’s limit. The number of extra minutes can be represented by the expression max{0. x + y − 200} $59 + $0. The monthly cost is the ﬁxed cost of the plan. The Pay-as-you-go plan is easy. respectively: the ﬁxed cost per month. x + y − 200}.35y For the Basic User Local plan. x + y − 800} Every plan is of the form a + b max{0.2. if x + y > 200. a bit trickier.30 max{0. and d may be 0. We can quickly solve Alison’s problem by hand. the ﬁxed charge is of course $25.35y Continuing to develop cost expressions for each alternative. Hence the number of extra minutes is either 0 or x + y − 200. x + y − 200} + $0. Tulett 1. the per-minute cost when over the limit of the plan.20 max{0. c. the expression for the cost of this plan is: $25 + $0.35y $45 + $0. however. x + y − 200}.35y $69 + $0. x + y − c} + dy where some of parameters a.M. The cost of extra calls is.35(x + y) + $0.25 max{0.35y. x + y − 600} + $0. If x + y ≤ 200. and the per-minute longdistance supplementary charge.35y $39 + $0.25 max{0. b.2 Building the Model 3 Minimizing the total monthly cost should be her objective.20 max{0.

Because this problem is simple.25 $0. and d for alternatives 1 to 7 could go into the range B8:E14.35 max{0. we could put the values for the number of local and long-distance minutes into cells B1 and F1 respectively.4 c April 28. This is why.35 $0. b. Allowing some room for column labels.1 We need to reserve two cells. 2010 D.20 $0. b. because then a formula can be entered once.2.20 $0. .00 $39. c.25 LongDistance Per-Minute Total Monthly Cost 1 2 3 4 5 6 7 0 200 400 600 200 400 800 $0.00 $109.70y.00 $25. and d are put into the next four columns.35 $0.00 $45. 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.M. For example.35(x + y) + $0.00 $59. their values for a. the pay-as-you-go plan (which costs $0. we could solve it using a calculator with speciﬁc values of x and y. Tulett spreadsheet model. 1.25 $0. 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. In one column every alternative is listed. rather than being simpliﬁed to $0.3 Model Solution What we have done so far is make an algebraic model of the problem. for example. and one for y.00 $0. c. would be thought of as 0 + $0. and then be copied for every alternative.35 $0.35x + $0.30 $0.00 $0.35 $0. the values of a. However. and in the sixth column the monthly cost is calculated.35y so that it ﬁts the pattern.00 is assumed that the reader has at least a basic familiarity with spreadsheets. x + y − 0} + $0.35y).00 Per-Minute Charge over the Plan Limit $0. one for x.35 $0.00 $69.

35 $0.35 $0. that alternatives 1 to 7 cost respectively $126.00 $39. whether using a calculator or a spreadsheet. and $109. $66. Tulett 5 In columns B.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 $0.25 $0. the data was entered as a number.00 $69.00).35 $0.00 $126. Cells B8.00 $25.25 LongDistance Per-Minute 1 2 3 4 5 6 7 0 200 400 600 200 400 800 $0. but the cell format was set to currency with two decimal places. so the emphasis should be on giving the recommendation: .30 $0.00 $109.20 $0.00.00 $69.c April 28. C. hence entering 25 produces $25.M.$B$1+$F$1-D8)+E8*$F$1 This is then copied in the range F8:F14. 2010 D.35 $0. In cell F8 we input =B8+C8*MAX(0. but instead a 0 is entered (which the spreadsheet formats as $0. A Local Alternative B 240 Fixed Charge Per Month $0. Alison) might not be familiar with spreadsheets.25 $0. at a cost of $59 per month.00 $0.00 The developer of the model. a blank cell would produce an error message. In the sixth column (F) we calculate the cost of the plans. Doing this we see that with the speciﬁc values of 240 in cell B1 and 60 in cell F1.00 $0. The cheapest plan for Alison is the Regular User Anywhere Plan (alternative 6).00 $45.00 $59. $71.00 $71.00 $66.00 $109.00 $90.00 $59.35 $0. and E. must make the recommendation clear. $59. and the range E12:E14 are not left blank. The customer of the model (in this case. This is because the formulas to be entered in column F need to read a 0. $90. $69.20 $0.

the recommended solution is only optimal for the model. a model cannot capture every nuance. at a constant cost of $59. Now suppose that Alison isn’t sure about her long-distance usage. What we have done here is a primitive form of sensitivity analysis .2. 3 and 6 are tied at $59. however. Sometimes. we seek the alternative with the highest proﬁt. it will quickly become very big.4 Implementation Models only approximate reality.5 Commentary The four phases of the management science paradigm are not totally distinct. things can be left out because they don’t affect the choice. At 80 minutes. at a cost of $59 per month. but some plans do not. plans 2. this one using a spreadsheet. For example. This model only involved cost. In many management science examples. and that it could be anywhere from 40 to 80 minutes. For this reason. so we found the alternative with the minimum cost. 2010 D. in which a parameter of the model is varied to examine the effect (if any) on the recommended solution. Hence alternative 6 is best everywhere from 40 to 80 minutes of long-distance use. Tulett Alison should sign up for the Regular User Anywhere plan. we should go back to Alison to see if she is happy with the recommended plan. the cheapest alternative will still be the cheapest alternative. and is not necessarily best at solving the original problem.6 Recommendation c April 28. When we had completed the algebraic model. rather than exactly 60. . On the other hand. be it 15% or something different. even if it might change the optimal choice. 1. At 40 minutes. 1. Whatever the tax rate. we have ignored taxes. It’s easy to plug the values 40 and 80 into the spreadsheet and see what happens. To complete the paradigm. If we try to capture this in the model. It may be that some plans have extra features like call forwarding. so that we could solve it. plan 6 is still uniquely the best. we saw that it was useful to build another model.2.M.

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 ﬂy. y + 1) are not feasible. these are the combinations for which (x. y) and (x. 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. 1) = (4. and it has a volume capacity of 15 m3 and a mass capacity of 3600 kg.8 m3 and a mass of 530 kg. but both (x + 1. plus one Type 2 box. because (3 + 1. for each of the three ﬁnancial scenarios. 2010 D.) (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. i. and the value of the load. This combination (3. 1). then look at the hints on the next page. Where x and y are of course positive integers (including 0). how many boxes of each type are carried.e. not all the boxes can be put onto the plane. three Type 1 boxes. Tulett 7 1. would be a better solution. and which has two cells reserved for the value of each type of box. One example is (3. and a Type 2 box is worth $250. 1). and (iii) a Type 1 box is worth $300. Work on this on your own and come up with your own method. Obviously. and a Type 2 box is worth $750.M. while a Type 2 box has a volume of 1. We will consider the following three situations: (i) both type of boxes are worth $400 each. A Type 1 box has a volume of 2. and the total mass carried must be ≤ 3600 kg. y) is feasible. 2). (c) Make a spreadsheet in which the alternatives are the combinations from (b). (ii) a Type 1 box is worth $600. 1 + 1) = (3. If you’re stuck after 15 minutes or so. There is only one cargo plane. using a spreadsheet to help with the calculations. There are six Type 1 boxes and eight Type 2 boxes waiting to be loaded. because we would obtain more money by adding the extra box. which is feasible. determine all the feasible combinations (x. Find these combinations. as would the feasible solution (3. .9 cubic metres (m3 ). y). therefore suppose that the objective is to maximize the value of the load. (To be feasible the total volume carried must be ≤ 15m3 .3 Exercise Two types of big boxes are about to be loaded onto a small cargo plane. Therefore. Later in this course we shall see an efﬁcient approach for solving this type of problem. Mathematically. Use the spreadsheet to determine.c April 28. and a mass of 470 kilograms (kg). 1) (and all others like it) is therefore trivially sub-optimal.

(0. y) = (0..333. Using the rules of part (b).6) are feasible. Therefore all combinations (x. We could then determine using trial-anderror if (0. is to start by ﬁxing x = 0.8y ≤ 15 and 530y ≤ 3600. Based on this. then see if (0.3).. The range B4:F4 is then copied to the rows below. and the mass available is 3600 kg. and y ≤ 6.0). it can be seen that y can be at most 5. A faster way.8 m3 and 530 kg.. and so on.. 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. (0. y 0 1 2 3 4 5 6 7 Find the formula for each of the cells C4.1) is feasible. This takes up 2. we see that the search can be limited to just ﬁve combinations.9 = 12. Now suppose that x = 1. Tulett Obviously carrying no boxes is feasible.M. For F4. and (0. Keep repeating this for higher values of x until no more type 1 boxes can be carried. There are three restrictions: we cannot exceed the volume available. Each unit of y (each Type 2 box) takes up 1. There will be a row in which it and all subsequent . y (Mass) F Overall Max. so this is a good starting point. You should ﬁnd a total of 26 feasible combinations. y) = (0. we cannot exceed the mass available.5).9*A4 C Remaining Mass D Max.. (0. D4.9 m3 and 470 kg. (0. (0. therefore y is the largest integer such that both 1. and y must be an integer. even if no type 2 boxes are carried. 2010 D. y (Volume) E Max.. therefore the type 2 boxes can use up to 15 − 2.2) is feasible. Hence y ≤ 8. 0).792. and F4.4).8 Hints c April 28.2).1m3 and up to 3600 − 470 = 3130 kg. you will need the INT function (look at your spreadsheet’s Help menu). and then ﬁnd the largest value for y. however. Hence the most that y can be is 6. and if so.1). E4. This solution is represented as (x. When x = 0 the volume available is of course the full 15 m3 .

this means that the corresponding value of x is infeasible. 2010 D. . Tulett 9 rows contain one or more negative numbers.c April 28.M.

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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 ﬁnd 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 ﬁnd 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 deﬁnitely 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 inﬂuenced by the critics’ reviews. The critics will attend a dress rehearsal the night before the ﬁrst performance, and their opinions will be printed and broadcast in the media the next morning. The theatre company has already decided to price all

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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 deﬁne 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 deﬁne 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

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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

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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 ﬁxed 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 ﬁnd what is often called the “proﬁt”, but we deﬁne a new term payoff , which can mean proﬁt, 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. There’s 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:

c April 28, 2010 D.M. Tulett

$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 sufﬁcient 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 ﬁnal 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 ﬁnal 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 ﬁlled in, and then with the right-hand side ﬁlled 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 ﬁnal row lists the

c April 28, 2010 D.M. Tulett

15

probabilities of the outcomes. The ﬁnal 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 ﬁrst 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

c April 28, 2010 D.M. Tulett

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

B

C

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

E F G Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500

D

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

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

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 deﬁned as: E (X) = ∑ pi xi

i=1 n

(1)

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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 ﬁgure 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 proﬁts/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 ﬁnal 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

Theatre Size Small Medium Large

3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability

Fringe 250 1900 700 −3000 0.20

Expected Value $2300 $5500 $3030

09 0.00 $3030. The syntax is SUMPRODUCT(range1. Tulett Now let us see how to do this using a spreadsheet. we shall look at alternate decision criteria. 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. If we format the range H4:H6 as currency. we could do it this way. .D4:G4) This formula is copied into cells H5 and H6. $2300.range2). However.70 0.00 The formatting of the numbers is a matter of individual preference. On average. 2010 D. In cell H4. For example. In the next section. We must put absolute cell addresses on row 7 (the probabilities).20 # of Seats Rent 100 $600 400 $1800 1200 $5500 Probability E F G Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10200 10200 2500 17500 30500 0. The SUMPRODUCT function ﬁnds the dot product of the numbers in range1 with the numbers in range2. where both ranges are rows (or columns) of equal size. we wish to write a formula which will ﬁnd the “dot product” of the probabilities in D7:G7 with the payoffs in D4:G4. this approach would be very cumbersome if we had say twenty outcomes. we will instead use the spreadsheet SUMPRODUCT function. any of 2300. the best alternative is the one with the highest expected value. we will obtain: A 1 2 3 4 5 6 7 Theatre Size Small Medium Large B C D Fringe 250 1900 700 −3000 0. Therefore.00 $5500. or $2300. hence the formula to be placed in cell H4 is: =SUMPRODUCT(D$7:G$7.00 could be used.18 c April 28.M.01 H Expected Value $2300. 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.

or $10. so we focus on giving the recommendation . if a situation like this were to be repeated many times the proﬁt would average out to $3000. the developer of the model must make the recommendation clear to the customer of the model.M. the proﬁt (before deducting ﬁxed expenses such as costumes and makeup) will be either $700. J. let’s say that the term “expected payoff” can be used.4 Recommendation 19 For the example at hand. or $7700. with an expected payoff of $5500. the customer is the theatre company. 2010 D. In giving a recommendation to the theatre company in real-life. Blow. After studying the three alternatives.200.2. After deducting the $2500 in ﬁxed expenses the company will be left with a proﬁt (loss) of ($1800). A spreadsheet which I used to make the gross proﬁt calculations appears as an appendix to this memo. with an expected payoff of $5500. MS Consulting Company Theatre Rental Thankyou for this opportunity to assist your theatre company. Blow Analyst . in real life more explanation would be required. I conclude that renting a medium-sized theatre would be best. They might not be familiar with payoff matrices or spreadsheets.the spreadsheet itself is just an appendix. the best alternative is clearly to rent a medium-sized theatre.c April 28. In this example. Based on the assumptions which you provided. something along the following lines might be appropriate: To: From: Subject: The Management Committee. Tulett 2. As we said in the introductory section. $3700. For the sake of this course. Amateur Theatre Group J. which I am happy to provide on a pro-bono basis. Hence within this course we would write the recommendation as: Recommendation Rent a medium-sized theatre. $6200. if a situation like this were to be repeated many times the proﬁt would average out to $5500.

01 H Expected Value $2300. [Assume that any computers leftover after the two month period become worthless. By how much worse should this be than the (10.M. State this recommendation clearly. Rather than develop a formula.00 $5500. .20 c April 28. On a per-unit basis. but only 10 are demanded. a 20% chance of demand for twelve. Finally.09 0.] (a) Solve this problem by hand by using a payoff matrix.3 Exercise A computer retailer is about to order some computers from the manufacturer. and then 10 are demanded. Tulett A 1 2 3 4 5 6 7 Theatre Size Small Medium Large B C D Fringe 250 1900 700 −3000 0. Then.] Obviously the recommendation which follows from (a) or (b) must be the same.10) case. a 20% chance for thirteen.00 2. compute the expected values and determine the best policy.70 0.20 # of Seats Rent 100 $600 400 $1800 1200 $5500 Probability E F G Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10200 10200 2500 17500 30500 0. Begin this latter step by determining what happens if 11 computers are ordered. and then continue to ﬁnd the rest of the payoffs on the main diagonal. and ﬁnally a 10% chance that fourteen computers will be demanded. Then. write the payoffs in the bottom left-hand triangle. Next. and 11 are demanded. This will require the development of a formula for the (10. (b) Solve this problem using a spreadsheet.00 $3030. calculate the payoff when 11 are ordered. [Save the spreadsheet ﬁle for later use. and copy this formula to all alternatives.10) situation. Create a formula for the order 10 alternative. Continue in this manner to ﬁnd all the payoffs.11) situation? Both answers should lead to the same payoff for the (11. it is easier to ﬁrst ﬁnd out what happens if 10 computers are ordered. 2010 D.10) situation? By how much worse should this be than the (11. and the retail price is $1950. the wholesale cost is $1500. Over the next two months the retailer believes that there is a 20% chance of demand for ten computers. write the payoffs in the top right-hand triangle (very easy). which is then copied for all situations. a 30% chance of demand for eleven.

it’s priced to clear at $160. then $12. which is the remaining value of something which has not sold at the regular price. It is often used when a company needs to clear inventory quickly. 3. First. Tulett 21 3 3. but when sales drop to nothing. 2010 D.1 Theatre Example with Salvage Value Suppose that ﬁfteen minutes before showtime.40 each. Some people buy it at this price.95. The solution to the model depends on the assumptions made – if the assumptions are unrealistic.99. for this only makes the problem complex.M. Sometimes items for sale pass through multiple price levels. unless stated to the contrary.00.1 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.c April 28. If it’s not sold by the end of March. It could also be called a clearance price . we introduce the concept of a salvage value . the left-over copies are sold to a paper recycling operation for 5 cents each. We will begin by investigating what happens if we make the following assumptions: . we will not make models with more than two price levels. A hardcover book lists for $39. 3. A newspaper has a regular price of 75 cents. and hopefully bargain-hunters and passers-by who see the sign will pay the reduced price to see the play.1. However. netting a revenue of $2 each after taxes.99. 2. A winter coat is priced at $300. Another assumption is that the existence of a clearance price does not affect the regular sales. Also.99. but then the price is progressively lowered to $19. the book is priced to clear at $9.99. The next morning. A sign is placed outside the theatre announcing the price reduction. the theatre company decides to price all unsold seats at $2. 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. then so too will be the “solution”. a videotape of a recent release may be priced as high as $34. For example. here are some examples: 1. and ﬁnally the product is priced to clear at $5.

or heavy demand. Because we have already solved the problem without the salvage revenue.M. These are: small theatre with average. especially a play which has been panned by the critics. a medium-sized theatre with great or heavy demand. 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. One possibility would be to limit demand to say 300 tickets (100 per night) at the discount price. This is clearly not reasonable. All seats not sold at the regular price will sell-out at the reduced price. Doing this would limit the salvage revenue to a maximum of $2(300) = $600. and a large theatre with heavy demand. 250 people pay the regular price. According to the above model. A new assumption about demand is therefore required. the sell-out situations are unchanged. 2. all we need do is ﬁnd what the salvage revenue will be in each of the twelve situations (3 alternatives. but the play only attracts fringe interest.22 c April 28. not that many people would walk by the theatre to obtain tickets. 2010 D. For the non-sellout situations. 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 . First of all. The demand at the regular price is not affected by the existence of the cheaper tickets. Tulett 1. and then ten minutes before showtime 3350 people (spread over three nights) arrive to ﬁll the theatre. great. 4 outcomes) and add it to the previously found payoff in that situation. Clearly.

Using the alternative of renting a large theatre to illustrate. we modify what we did earlier (page 16).MAX(0. and hence the salvage revenue is 2*MIN(300. 500) = 3624 The other way is to note that the previous EV in this row was 3030.M.09 0. we see that while each of the three EVs changes.MAX(0. We added 600 to each of the ﬁrst three columns. or MAX(0. whichever is greater. Doing this.01 Theatre Size Small Medium Large 3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability Expected Value $2320 $6040 $3624 As an aside.3*$B4-D$3). therefore the new EV is: 3030 + (0.200 −2400 3100 18. i. rent a medium-sized theatre.70 0.3*$B4-D$3)) . which is to add these payoffs to those obtained before.70 + 0. 2010 D. The formula in cell D4 is currently: =10*MIN(3*$B4. the optimal alternative remains the same. Hence the number of discount tickets sold is MIN(300.3*$B4-D$3).20(−2400) + 0. we obtain: Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500 2000 2400 2400 2400 1300 6800 10.500 0.100 30.D$3)-$C4 The number of unsold seats is either 0 or 3*$B4-D$3. Tulett 23 If we now believe that this table seems reasonable we can proceed to the next step. the number of discount tickets sold is either 300.01(30. To do these calculations on a spreadsheet.20 + 0.3*$B4-D$3)) They net $2 for each ticket.e.09)600 = 3624 With the assumption that discount tickets sales are limited to 300. 100) + 0.20 0. we note that there are two ways to ﬁnd the new expected values.09(18. one way is to calculate: 0. This is represented as MAX(0.70(3100) + 0. whichever is fewer.c April 28.200 10. By our assumption that we cannot sell more than 300 discount tickets. and then ﬁnding the new expected values.

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 $2320. Tulett Adding this revenue the formula in cell D4 becomes: =10*MIN(3*$B4.D$3)+2*MIN(300. from which the rent is subtracted: =IF(D$3>=3*$B4.00 Medium 400 $1800 1300 6800 10200 10200 $6040. 2010 D. suppose that we believed that up to 1800 (rather than just 300) discount-priced last-minute tickets could be sold. For example. if the demand equals or exceeds the number of seats.20 0.10*3*$B4.24 c April 28.09 0.3*$B4-D$3))-$C4 There may be more than one way to correctly write a formula. All we need do is replace the “300” in the formulas in cell D4 with “1800”. then the revenue is the number of seats multiplied by $10.MAX(0. otherwise the revenue is the demand multiplied by $10. This logic is captured in the following IF statement for cell D4.D$3)+2*MIN(1800.M. it is easy to see what happens if one or more of the assumptions of the model is changed.00 Large 1200 $5500 −2400 3100 18100 30500 $3624.70 0.01 Salvage Model with up to 300 discount-priced last-minute tickets A B C D 1 2 3 4 5 6 7 8 Note that a few words have been added on the spreadsheet to make it clear that we are looking at variation of the basic model in which up to 300 discount-priced last-minute tickets may be sold.3*$B4-D$3))-$C4 This alternate formula is no shorter.00 Probability 0. For example. The modiﬁed formula in cell D4 is: =10*MIN(3*$B4. and then copy this new formula to the range D4:G6.10*D$3+2*MIN(300. plus $2 for each seat not sold at the regular price up to a maximum demand of 300 at the lower price. but it may be easier to understand. Either formula is entered into cell D4 and is then copied into the range D4:G6. When a model has been made using a spreadsheet.MAX(0.3*$B4-D$3))-$C4 .

the uncertainty is the level of demand. a perfect weather forecast is not possible.00 Medium 400 $1800 2600 7000 10200 10200 $6440. using the theatre problem as an example. We recall . 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. Of course. or rainy. then a real forecast can be worth no more than $5. it might be possible to obtain perfect information about the uncertain event.00 to hear a perfect weather forecast. suppose that tomorrow’s weather will be either sunny. For any level of demand.20 0.00 Probability 0.00 Large 1200 $5500 600 6100 18100 20100 $6504.09 0.00. With perfect information we can choose the best alternative with respect to the level of demand. and have the formula in D4 refer to the cell that contains the number. In this case. 3.70 0.e. we are interested in the highest payoff (i. if a person would pay $5.M. Tulett 25 Of course. A decision analysis model will always be mathematically easy to solve. the recommendation for the theatre rental would change from a medium-sized to a large theatre. Having perfect information means that we are told the demand level before having to commit to one of the three theatres. 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.c April 28.01 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.2 Expected Value of Perfect Information Suppose that in situations of decision making under uncertainty. the highest payoff in the column). We are interested in determining the expected value of perfect information (EVPI). 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. Perfect information about this event would imply that today’s forecast for tomorrow is certain to be correct. We now show how to calculate the EVPI. For example. cloudy. 2010 D. a better spreadsheet design would be to place this number in its own cell. For example.

then we would change the recommendation from medium to large. There are now two ways to complete the calculation of the EVPI. then we will choose a large theatre. If the perfect information is that demand will be “fringe”.500 30. and 0. thereby increasing the payoff over what it would have been. Before receiving the perfect information.200 to 17. If we are told that the demand will be “average”. thereby increasing the payoff from 700 to 1900.2.500 0. thereby increasing the payoff from 10. then we will choose a medium-sized theatre for a payoff of $6200.20 0. then we would change the recommendation from medium to small. and a 1% chance of . The probabilities of the perfect information being that these outcomes will occur are 0. Hence there is a 20% chance of increasing the payoff from 700 to 1900. 3. thereby increasing the payoff from 10.500 for “great” and $30. we would have recommended renting a medium-sized theatre. 0.01 Theatre Size Small Medium Large 3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability Expected Value $2300 $5500 $3030 If we are told that the demand will be “fringe”.09 0. 2010 D. no salvage value).200 −3000 2500 17. then we would change the recommendation from medium to large.09 for “great”. If the perfect information is that demand will be “heavy”.500.500. then we will choose a small theatre for a payoff of $1900 (the highest payoff in the “fringe” column). If the perfect information is that demand will be “great”.1 Direct Calculation of the EVPI The new information only has value if it would change the recommendation that we had before. with a payoff of $17.26 c April 28. 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 to 17.500 for “heavy”. then we will still make the same recommendation.500. in the other three outcomes of demand. a 9% chance of increasing the payoff from 10. However. we will change the recommendation.70 0. If we are told that the demand will be “great” or “heavy”.20 for “fringe”.M.e.01 for “heavy”.200 to 30.200 10. Tulett the payoff matrix for the basic model (i. If the perfect information is that demand will be “average”.

If we did not have the perfect information. we would have chosen the medium-sized theatre alternative. If more information were available.01(30.500.09(17. 300) 240 + 0 + 657 + 203 1100 The expected value of perfect information in the theatre example is $1100.20(1200) + 0 + 0.09(17. If the price were say $500. then it might be worthwhile purchasing it. we ﬁrst ﬁnd the expected value with perfect information. You are expected to know how to calculate the EVPI using both of these methods. 2010 D. This is done by calculating the expected payoff using the highest payoff in each column. 500) = 380 + 4340 + 1575 + 305 = 6600 The EV with PI is $6600.01(30.] 3. it would depend on how good the information . the short form is EV with PI .70(6200) + 0. the most that they would pay for it would be $1100.20(1900 − 700) + 0 + 0. 200) 0. 500 − 10.01(20.20(1900) + 0. the EVPI is $1100. The EVPI is the expected amount of the proﬁt increase from not having perfect information to having it. For the theatre example. 200) + 0. EV with PI = 0. Tulett increasing the payoff from 10. The EV with PI is found by calculating the expected payoff based on the best alternative for each outcome.c April 28.2. 500 − 10.200 to 30.2 Indirect Calculation of the EVPI To indirectly calculate the EVPI. the $1100 establishes an upper bound to the value of any information concerning the demand. [Note: We could have written the second term of the ﬁrst line of the EVPI calculation as 0. To avoid confusion with the EVPI. or we could have omitted it altogether.09(7300) + 0. 500) + 0. The EVPI is therefore: EVPI = EV with PI − EV without PI = 6600 − 5500 = 1100 As before.70(6200 − 6200). The EVPI is therefore: EVPI = = = = 27 0.M. which has an expected payoff of $5500. which of course is 0.

$700. we would choose the alternative with the highest expected value.200 2500 17. or $10. $1900. 2010 D. A pessimist would recommend that the small theatre be rented. i. [Note: In this example. all the rows minimums were in the same column. the alternative associated with pessimism is the one which contains the maximum of the row minimums.28 c April 28. the small theatre.e. If a medium-sized theatre is chosen. it would not be worth purchasing no matter how good it is. hence the payoff will be at least $700. we see that the payoff will be at least −$3000. A pessimist would choose the alternative associated with this payoff. or $6200. but this will not be true . 3. the payoff will be either $1900 or $2400. Of these three minimum payoffs. the highest is the $1900 payoff. and −$3000. but there are other criteria as well. Hence. This will remain our preferred decision criterion. They are illustrated using the theatre example: Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10. However. if the price were $2000. While a small theatre company would not try to obtain more information about the demand.M.1 Pessimism If a small theatre is chosen.3 Decision Criteria Up to this point our sole decision criterion has been Expected Value.500 30. Tulett is. For any maximization problem. the payoff will be either $700. For a proﬁt maximization example.09 0.70 0. and they are reviewed here. a company with millions of dollars at risk probably would.200.200 10.20 3. the payoff will be at least $1900. From the four outcomes in the “Large” alternative row.3. For a cost minimization example (in which all the payoffs are costs) we would choose the alternative with the lowest expected value.500 0.01 Theatre Size Small Medium Large 3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability Fringe 250 1900 700 −3000 0.

An optimist would recommend that the large theatre be rented. When optimism is applied to a cost minimization problem. Like pessimism.15. suppose we wish to solve the theatre problem with an exogenously given coefﬁcient of pessimism of 0. For example.85.200 −3000 30.85 = 0. and then seeks the maximum of the maximums. optimism ignore the information about probabilities. and $30. and we have: Small Medium Large Pess.M.200.3. and Large are $2400. Either a coefﬁcient of Pessimism (CoP) or a coefﬁcient of Optimism (CoO) (one is the complement of the other) is chosen. Hence. Pessimism is an extreme form of risk-aversion which ignores all the information about probabilities.2 Optimism An optimist seeks the maximum for each alternative. the row maximums for Small.] For any minimization problem.3.15 Hurwicz 1975 2125 2025 . 3. 1900 2400 700 10. we ﬁnd the minimum of the row minimums.c April 28. the coefﬁcient of optimism is 1 − 0. Tulett 29 in general. The subject of risk-aversion will be studied in more detail later in the course. Medium. Opt.500 0. and then (for maximization) a weighted average of the row minimums and maximums is found. For the purposes of this course the CoP or CoO will be an exogenously given number. $10. For the theatre example. the alternative with the highest weighted average is then chosen.500 respectively.85 0. the alternative associated with pessimism is the one which contains the minimum of the row maximums.500. 3. and the alternative associated with this payoff is to rent a large theatre. 2010 D. The maximum of these three is $30.3 Hurwicz The Hurwicz criterion is a mixture of the criteria of Pessimism and Optimism.

500 + 30.30 c April 28.500 0. for every alternative. For the theatre example with its four outcomes we have: Small Medium Large (1900 + 3(2400))/4 = 2275 (700 + 6200 + 2(10. The ranking for the Laplace criterion is conveniently found by summing. 3.85 Opt. For a cost minimization problem. the pessimism column is based on row maximums. a medium-sized theatre is recommended. Tulett The highest weighted average in the Hurwicz column is 2125. Theatre Size Small Medium Large Fringe 1900 700 −3000 Demand for Tickets Average Great Heavy 2400 2400 2400 6200 10. and the lowest ranking for minimization. the probability that any one of them occurs is 1/n. and the chosen alternative is based on the lowest number in the Hurwicz column. which is associated with the large theatre.500)/4 = 11. the optimism column is based on row minimums.3.200 30. all n payoffs. 2010 D.200))/4 = 6825 (−3000 + 2500 + 17.200 2500 17.875 The highest of these is 11. We choose the highest ranking for maximization. a medium-sized theatre is recommended.875.M. 1900 700 −3000 0. 2400 10. The calculations for the four criteria of Pessimism.500 30. except that for the Laplace equal probabilities are used. The best payoff for each criterion is highlighted. Based on Hurwicz with CoP = 0. and Laplace can all be done on one payoff matrix.85.875 . Hurwicz. from these payoffs the best alternative for each criterion can be seen. and then dividing by n.4 Laplace The Laplace and Expected Value criteria are similar.500 Pess. Based on the Laplace criterion the large theatre is recommended. With n outcomes.200 10.15 Hurwicz 1975 2125 2025 Laplace 2275 6825 11. Optimism.

With hindsight. with hindsight. In every column of the payoff matrix. renting a medium-sized theatre is best for this particular outcome.M. 2010 D. The objective is to minimize the expected opportunity loss. and $2500 for large.3. the best alternative for a given outcome. and indeed one reason for obtaining the regret matrix is that it is sometimes easier to calculate than the payoff matrix. It is also possible to obtain the regret matrix without ﬁrst ﬁnding the payoff matrix. 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 0.300 20. $6200 for medium.01 EOL $4300 $1100 $3570 Therefore. To ﬁnd the opportunity loss for each situation from an already existing payoff matrix. the foregone proﬁt would be $6200 − $2400 = $3800 and if the large theatre alternative were chosen. one property that the regret matrix will always have is that there must be at least one zero in every column . there is no foregone proﬁt. Tulett 3. In a payoff matrix we found the expected value for every alternative.5 The Regret Matrix 31 The regret matrix gives the cost of having not chosen. we work with one column at a time.100 0 7. we subtract each number in the column from the largest number in that column. in a regret matrix we ﬁnd the expected opportunity loss (EOL) for every alternative. It is found in an analogous manner to the EV – by ﬁnding the dot product of the probability row with every payoff row. the recommendation is: . the foregone proﬁt would be $6200 − $2500 = $3700 The foregone proﬁt is also called the opportunity loss . so the best alternative is the one with the lowest number in the EOL column. However. No matter how it is obtained. then the payoff is $2400 for small.20 Demand for Tickets Average Great Heavy 800 2300 4500 3800 15.300 3700 0 0 0.100 28. in the theatre problem if the demand turns out to be “average”.70 0. if the small theatre alternative were chosen. For example. In this case.09 0.c April 28.

32 c April 28. optimism. unlike pessimism. except that now any leftover computers are sold for $1400 each. Hence minimizing EOL. The minimum EOL. and Laplace. Hurwicz. Tulett Rent a medium-sized theatre.M. (b) Re-solve Exercise 2 by hand. 3. 2010 D. Moreover. this is not a coincidence – it is always true. begin by copying the spreadsheet you made before. re-solve Exercise 2. equals the EVPI. For every alternative. (c) Using a spreadsheet. but instead is just a variation on the maximizing expected value approach. (b) and (c) should produce the same result. [To save work. we always obtain the same alternative . We obtained the same alternative using the regret matrix as we did when using the payoff matrix. now using a $1400 salvage value. This is not a coincidence – whether we maximize the expected value or minimize the expected opportunity loss. determine the EVPI both directly and indirectly.] .4 Exercise (a) For the Exercise at the end of Uncertainty 1 (Exercise 2). the data is the same as in part (a). this sum is the EV with PI. For parts (b) to (f). usually one does not not take this approach to ﬁnding it if the payoff matrix has already been found. with an expected opportunity loss of $1100. this time using the $1400 salvage value. which is $1100. EV + 2300 + 5500 + 3030 + EOL = EV with PI 4300 = 6600 1100 = 6600 3570 = 6600 Small Medium Large This property is true for all examples. is not a new decision criterion. the sum of the expected value and the expected opportunity loss is the same. Obviously. While this gives us a third method for ﬁnding the EVPI. 3. 2. Again. Some interesting comparisons can be made with the solution obtained by using a payoff matrix: 1.

2010 D. 33 (e) Which alternative would be picked using: (i) Pessimism.8. (iii) Hurwicz with a coefﬁcient of optimism of 0. Tulett (d) Determine the EVPI both directly and indirectly.M. (iv) Laplace? (f) By hand. .c April 28. without looking at the payoff matrix from part (b). and determine the alternative with the minimum EOL. ﬁnd the regret matrix. (ii) Optimism. Try to ﬁnd the regret matrix just from the data of the problem.

Also. and a price per unit at which all leftover items are sold (s). 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. which is the probability that d or fewer units are demanded. We let F (d ) represent the cumulative probability function. for otherwise any amount of stock could be ordered at no risk to the retailer. 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. The marginal analysis method is not applicable for irregular problems such as the theatre example.M.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. the salvage value must be less than the wholesale price. Also. we can use the recursive formula: F (d ) = F (d − 1) + P(d ) (d ≥ 1) . This new method is called marginal analysis . for otherwise the business could not exist. 2010 D. 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 )).34 c April 28. 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. Tulett 4 4. Let x (an integer) represent the optimal order quantity. for d ≥ 1.

P(13) = 0. in which d goes from 10 to 14 inclusive. 2010 D. the retail price is $1950.M. 20%. 30%.3 0. because the proof is somewhat advanced for an introductory course.1 Computer Example In the computer example.1.3. and 10% respectively. the wholesale price is $1500.7 13 0.9 14 0.0 . Tulett 35 The optimal order quantity is given by the marginal analysis formula . Hence F (10) = F (9) + P(10) = 0 + 0.2 0.2 0. 12.5 0.818 The chance that the demand is for exactly 10.1.2 0.1 1. [You will not be tested on the proof – all that is required is that you know how to use the formula. and 14 units is 20%.2. P(11) = 0. r−w 1950 − 1500 = r−s 1950 − 1400 450 = 550 ≈ 0.c April 28. Hence P(10) = 0. P(12) = 0. and F (d ) is found recursively (for example the two numbers highlighted in blue are summed to ﬁnd the number highlighted in red): d P(d ) F (d ) 10 0. Therefore.] The value of x (the optimal order quantity) is chosen such that: F (x − 1) < r−w ≤ F (x) r−s (2) Another way of saying this is that we want the smallest value of x such that: r−w ≤ F (x) r−s 4.2 We can make a table to ﬁnd F (d ). It is not proved here. P(d ) comes from the given probabilities.2 = 0.2. hence F (d ) = 0 from d = 0 to d = 9 inclusive. and P(14) = 0. 11.2. and the salvage value is $1400. 13. 20%.2 11 12 0. All P(d ) from d = 0 to d = 9 inclusive are 0.

we often just vary one parameter at a time. In terms of the formula we have: F (13 − 1) = 0.9 = F (13) The recommendation is to order 13 computers. with everything else remaining . Even if the critical fraction were say 0.36 c April 28. then at least one other probability must be decreased (by the same absolute amount) so that the probabilities remain summed to one. but changing probabilities is an important exception. the critical fraction 0.9 than it is to 0. and the probability of average interest is 0. The Greek symbol ∆ (pronounced delta) is often used to represent a change to something. If one probability is increased. or ∆c to represent a change in cost. but this fact is irrelevant .2. Suppose that we now wish to see what happens if we vary these two probabilities.2 Sensitivity Analysis The subject of sensitivity analysis (also called what-if analysis ) is a recurring theme throughout the ﬁeld of management science.818 ≤ 0. we can easily ﬁnd it by solving for only the optimal row in the payoff matrix. We can play around with the model quite inexpensively. and this is in the d = 13 column.818 is closer to 0. To keeps things simple. We might use ∆ p (read as “delta p”) to represent a change in probability. 2010 D. we would order 13 (and not 12) computers. Tulett The critical value is about 0. it does not also give us the expected payoff associated with this quantity. If we want this too.7 < 0. 4. In this case. the number just above this in the F (d ) line is 0.1 Theatre Example Included in the original parameters are that the probability of fringe interest is 0. where the context is clear. Note that while the formula gives us the best order quantity. in this situation.7.703. Usually. The whole point to building a model is that it is much cheaper than building what the model represents.7. 4. we can simply use ∆.818. 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.9 (highlighted in yellow). Also.M. we must establish a domain for ∆ p based on the fact that no probability can go below 0 or above 1. ∆ can be either positive or negative.2.

200 2500 17. If we do this.01 Theatre Size Small Medium Large 3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability Expected Value $2300 $5500 $3030 Now.20 0. everything will work out in the end.09 0. we will automatically ensure that neither probability goes above 1. The condition that 0.7 [Note: In general if the two probabilities are a + ∆ p and b − ∆ p.20 + ∆ p.2.7. and the 0. Tulett 37 constant.200 10.2 ≤ ∆ p ≤ 0.70 0. in the probability row.09 0.500 0. Suppose that the ﬁrst is increased by ∆ p.7 − ∆ p We must ensure that neither probability goes below 0. and the other is decreased by ∆ p.70 0. the domain of ∆ p is: −0.20 becomes 0.] When we ﬁrst solved the problem we obtained: Demand for Tickets Fringe Average Great Heavy 250 800 2300 4500 1900 2400 2400 2400 700 6200 10.500 30.2 + ∆ p p(average) = 0. (Doing it the other way around would be ﬁne. Demand for Tickets Average Great Heavy 800 2300 4500 2400 2400 2400 6200 10. 2010 D.7 − ∆ p ≥ 0 will be true provided that ∆ p ≤ 0.) Hence we have: p(fringe) = 0.500 30.200 10.70 becomes 0. The condition that 0.20 +∆ p Expected Value .M.c April 28.01 −∆ p Theatre Size Small Medium Large 3-Night Capacity Rent 300 $600 1200 $1800 3600 $5500 Probability Fringe 250 1900 700 −3000 0. Hence.200 −3000 2500 17.70 − ∆ p. then we must have −a ≤ ∆ p ≤ b.500 0. and we wish to determine the revised Expected Values.2 + ∆ p ≥ 0 will be true provided that ∆ p ≥ −0. the 0.

is to re-compute the entire dot product (“Small” row and the Probability row).] All we need are the columns which contain the ∆ p’s and the original Expected Values.7 + 0.09 + 0. using the “Small” alternative to illustrate. 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: .M.01(2400) 0. EV(small) = = = = (0.7(2400) − 2400∆ p + . [If ∆ p = 0.09(2400) + .2 + ∆ p)1900 + (0.09(2400) + . Tulett The long way to do this. we must obtain the original result.2(1900) + 1900∆ p + 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”.01(2400) 0.2(1900) + (0.38 c April 28.7 − ∆ p)2400 + . 2010 D.

2010 D. By letting both alternatives be considered “best” at the tie. and Small is best for all other values. To ﬁnd the point of indifference.c April 28. we see that for any value of ∆ p.M. there would be no point of indifference.] We know that Medium is preferred at ∆ p = 0 (the current situation). These lines are parallel (because of the −5500) and therefore they never intercept. highlighting with colour the regions for the recommended theatre size. 5500 − 5500∆ p > 3030 − 5500∆ p and hence Medium is better than Large.64. Medium must be best for any ∆ p in the domain < 0.2 ≤ ∆ p ≤ 0. and we have found that we would switch to Small at ∆ p = 0. we have EV(Small) = 2300 − 500∆ p versus EV(Medium) = 5500 − 5500∆ p.7).64 Medium 0.64 This value is within the domain −0. If we compare Small with Medium.64. 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.7. we set the two payoffs equal to each other: EV(Small) 2300 − 500∆ p 5000∆ p ∆p = = = = EV(Medium) 5500 − 5500∆ p 3200 0.70 Small We can also show this information on a number line for ∆ p (where −0. there’s a tie at 0.2 ≤ ∆ p ≤ 0. we can state the regions of preference as: −0.64 ≤ ∆ p ≤ 0. . Since these are the only alternatives (because Large was eliminated).2 ≤ ∆ p ≤ 0. We are indifferent between two alternatives when neither is preferred to the other.64. [Were it not so.

2 A More Complicated Example The preceding example was fairly easy in that we were able to reduce it down to two alternatives.7 − 0. The example presented here provides an illustration of these concepts. Doing it ﬁrst this way gives us a shorter analytical method for this type of problem.M. 2010 D. then we would be quite conﬁdent that our initial choice of Medium is correct. When this happens.3 EV 5.84 p(average) = 0.64 is a very large change for a probability. and the expected values having been calculated: A1 A2 A3 A4 Prob.64 = 0.40 c April 28. Tulett Medium −.64 ∆ p = 0.7 5.0 . Consider an example with four alternatives and three outcomes.2 couldn’t be off the true value by all that much.3 4. These are: p(fringe) = 0. a conceptually easy approach is to make a graph of EV versus ∆ p. and so we only had to ﬁnd a single point of indifference.64 = 0.6 T 0.2 + 0. however.06 4. If we believe that the initial estimate of 0.4 ∆p Small . The point of indifference can also be expressed in terms of the original probabilities.1 5.2 .5 . O1 O2 O3 7 5 4 5 5 6 4 6 3 6 4 6 .2 0 . Usually.2. we cannot eliminate any alternative simply by inspection. for which we begin with all payoffs having been found.2 .

7 + 3(−0.0.5) = 5. and the check on the calculations comes from making sure that the line passes through the original EV at ∆ p = 0. These two points are used to deﬁne the line.7 + 3(0.5 + ∆ p.2 to 4. Now suppose that we wish to vary the probabilities for O2 and O3 . and then ﬁnd the EV at the upper limit for ∆ p. For alternative 2. To do this we ﬁnd the EV at the lower limit for ∆ p. 2010 D.3 5.1 + ∆ p 5. Graphical Solution Each of the EV equations is a straight line.3. In this example.5 ≤ ∆ p ≤ 0.1 5.5) = 3.e. For alternative 3.0 EV at ∆p = 0 5.1 + 0. with a little bit of extra work we can obtain each line with a check on the calculations.M. We will let the probability of O2 be 0. and the probability of O3 be 0.4. the lower and upper limits for ∆ p are at −0. all we need do is ﬁnd the EV for any ∆ p = 0.3 = 5.6. with an expected payoff of 5.6 to 5.4. the EV ranges from 4.0 ∆ p = 0. the EV ranges from 5. For each of these.3 − ∆ p 4.3 respectively.0 to 5 − 2(0. one approach is to draw a graph.7 + 3∆ p 5. The domain for ∆ p is therefore: −0. Tulett 41 Hence the recommendation is to choose alternative A2 . For alternative 1.5) = 4.5) = 6.c April 28.3 − ∆ p.1 + (−0. at ∆ p = 0) gives the two distinct points needed to deﬁne the line. for alternative 4 the EV ranges from 5 − 2(−0.4 A1 A2 A3 A4 .0 5.6 5. the EV ranges from 5.3 − (−0.3 The new expected values are: A1 A2 A3 A4 O2 5 5 6 4 ∆p O3 4 6 3 6 −∆ p EV 5.5 4.8 to 5.3 4.7 5.3 − 0.5 and 0.8 3.3) = 5. However.2 6.0 − 2∆ p Unlike the previous example.4 5.6 4. and this along with the original EV (i. Finally. it is difﬁcult to remove an alternative simply by inspection.3) = 4. In summary we have: ∆ p = −0.3 = 5.

4 on the right vertical axis.0 4. On the centre vertical axis.2 3.5. and the largest is 6. Since the smallest EV is 3.M.5 4. The A1 line goes from 4.5 5. we can save vertical space by having the axis run only between 3 and 6 (rather than starting at 0). we see indeed that the line passes through the point (0.2 0 ∆p . r 6. each time verifying that the point on the centre vertical axis is where it should be.0 5.0 −.5 r 3.5 A r 2 EV r 5. we proceed with drawing the four lines.42 c April 28. Tulett The horizontal axis goes from ∆ p = −0.0 A3 3. The other three lines are drawn with their symbols.0.0 A 1 A r 4 4.5 r 4. It is helpful to draw this graph with three vertical axes: one through the lower limit for ∆ p.1).3.2.4 −. 2010 D. and one through the upper limit for ∆ p. With the axes drawn. Next to this line the A1 symbol is drawn.5 to ∆ p = 0.6 on the left vertical axis to 5. one through 0.0 .0 r 6.5 3.0 r 5.

EV(A4 ) = 5. EV(A1 ) 5.3) = 5.1 At this value for ∆ p.3 − (0. we could draw a number line.] Hence the two lines intercept at (−0. we set the EV equations equal to each other: EV(A4 ) 5.M. A2 and A1 .3) = 5. EV(A2 ) = 5.2) = 5.1 + ∆ p −2∆ p ∆p = = = = EV(A3 ) 4.0 − 2(−0. EV(A1 ) = 5. EV(A2 ) = 5.3 − (−0. highlighting the regions where a particular alternative is best.6.3. which of course gives the absolute rather than just the relative ranking of each alternative. Secondly.5.3 − ∆ p 0.2.0 − 2∆ p −∆ p ∆p = = = = EV(A2 ) 5. the line segments which maximize the expected value. 5. then A1 .1 + (0.c April 28.1 + ∆ p −0. A4 is best.7 + 3∆ p −0.2 At this value for ∆ p.3 − ∆ p −2∆ p ∆p = = = = EV(A1 ) 5.1) = 5.2 0.3. 2010 D. These line segments have been highlighted on the graph.6).3 At this value for ∆ p. we could simply report the regions as follows: . Tulett 43 We want.6. of course. As we move to the right.3 −0.4 0. the best alternative switches to A2 . At ∆ p = −0. and A1 and A3 . Thirdly. we could indicate this information on the graph. To ﬁnd the value of ∆ p at which the A4 and A2 lines intercept. We then ﬁnd the other two interception points: EV(A2 ) 5. Hence we need to ﬁnd where the following pairs of lines intercept: A4 and A2 . There are three ways that we could report these values. As we did in the previous example. and then A3 . [Also.

5 ≤ ∆ p ≤ −0.M.1 + ∆ 5.44 Region for ∆ p −0. the two lines are not parallel). and c + d ∆. with expected payoffs a + b∆.3 − ∆ 4.1 Analytical Solution We can also solve such a problem quickly as follows. where a > c and b = d (i.) These alternatives have the same expected payoff when: c + d ∆ = a + b∆ (d − b)∆ = a − c a−c ∆ = d −b If the critical value (a − c)/(d − b) turns out to be outside of the domain of ∆.7 + 3∆ 5. ﬁrst going back to the table showing the effects of ∆.3 −0. For this example. however.3 ≤ ∆ p ≤ 0. we might only wish to determine the values for ∆ p for which the current solution (i. First.3 c April 28. With many alternatives we ﬁnd the critical value of ∆ for each one (where the comparison alternative is the one optimal at ∆ = 0). A1 A2 A3 A4 O2 5 5 6 4 ∆ O3 4 6 3 6 −∆ EV 5. the current solution remains A2 provided that: −0. we seek the ones whose critical values are immediately on either side of 0.1 0. Instead. If.2 ≤ ∆ p ≤ 0.0 − 2∆ . we do not need to know the best alternatives over the entire domain of ∆ p. then the c + d ∆ alternative is not best for any value of ∆. here are some general comments for any situation. Now we solve the example from before. we are using ∆ rather than ∆ p. Consider two alternatives.2 0. at ∆ p = 0) remains optimal.1 ≤ ∆ p ≤ 0. it is inside the domain.3 ≤ ∆ p ≤ 0.e. (For simplicity. 2010 D. Tulett Best Alternative A4 A2 A1 A3 Sometimes. then we must consider this alternative along with any others.e.

4 0.2 Over the entire domain of ∆ we have: Region for ∆ −0. Below −0. A4 is best. 0. A1 is best.1 + ∆ −0.7 + 3∆ −0.3 − ∆ −4∆ ∆ = = = = = = = = EV(A1 ) 5. A3 . the A1 and A3 lines will intercept: EV(A1 ) 5.1 EV(A3 ) 4. and A4 lines meet the A2 line: EV(A2 ) 5.3 (line A4 ) and 0.1 ≤ ∆ ≤ 0. and −0.6 0.3.3 Best Alternative A4 A2 A1 A3 .15 EV(A2 ) = EV(A4 ) 5. 2010 D.3 to 0.1. Further on.1.2 0.3 Comparing the critical values 0.0 − 2∆ ∆ = −0.2 0.1 0.3 −0. Tulett 45 At ∆ = 0.5 ≤ ∆ ≤ −0.3.1 (line A1 ). Hence we ﬁnd where the A1 . A2 is best.2 ≤ ∆ ≤ 0.3 ≤ ∆ ≤ 0. Hence A2 remains optimal from −0.1. and just above 0.1 + ∆ −2∆ ∆ = = = = EV(A3 ) 4.M.3 − ∆ −2∆ ∆ EV(A2 ) 5.7 + 3∆ −0.15. the ones immediately on either side of 0 are −0.c April 28.3 − ∆ = 5.

determine the number of copies that the vendor should order. ∆ p for the ﬁve alternatives. .3. Any left-over copies at the end of the day are sold to a recycling operation at 5 cents per copy.1 . 4. using expected value as the decision criterion. By using the marginal analysis formula. and from this determine all the regions of ∆ p where one of the alternatives is better than the others. Tulett 4. and are sold for 75 cents each. except that we now allow the probabilities of demand for 10 and demand for 14 computers to vary. Now suppose that the probability of O1 increases by ∆. 2010 D.6 EV (a) Find the best alternative.3 . the regions of ∆ where each alternative is best.3.M. the probability of O3 decreases by 4∆. (b) What is the domain of ∆? (c) Find. O1 O2 O3 8 2 4 9 7 3 70 15 −30 −40 60 20 .46 c April 28.1 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.2 Sensitivity Problem 1 In this problem we use the data of the computer example with salvage value. the probability of O2 increases by 3∆. Make a graph of Expected Value vs. by the analytical method.3.3 4. 4. Newspapers are bought by the vendor at 50 cents each.3 Sensitivity Problem 2 A1 A2 A3 A4 Prob.

constitutes the formulation of the problem. 3. In this introduction we explain the graphical symbols used in the decision tree method. A decision node is drawn as a square. we show how to handle more complex examples. All decision trees have at least two kinds of nodes – decision nodes and event nodes .1 Decision Trees 1 Introduction In the previous three sections. Such problems will be analysed by ﬁrst drawing what is called a decision tree . Either of these complications means that a payoff matrix cannot be used. so do decision trees. the point at which two or more branches meet is called a node . Finally. with the same probabilities). Even when there is only one decision. and an event node is drawn as a circle. there may be multiple decisions to be made. It is drawn as two small squares (posts) joined by a straight . The tree is drawn from left to right. Of course. The recommendation is given. Just as real trees have branches . and a null branch. the alternatives may be followed by different events. by going from left to right. Beginning with this section. and an event node is followed by an outcome branch . both in writing and by highlighting on the tree. Tulett 47 5 5. problems in real-life are not that simple. Also. The problem is then solved by performing a rollback procedure on the tree. a payoff node. along with the deﬁnitions of any symbols or abbreviated forms used on the tree. and an outcome branch by a single line. and each alternative was followed by the same event (same outcomes. Associated with each type of node is a corresponding branch emanating from the right side of the node. On a decision tree. we examined simple situations in which there was only one decision. Some textbooks only use what we have described so far. A cost gate resembles a toll gate on a highway. A decision node is followed by an alternative branch . 2010 D. An alternative branch is represented by a double line. but we ﬁnd that it is useful (whenever the decision criterion is expected value) to use three more symbols – a cost gate.M. 2.c April 28. The rollback procedure is performed from right to left. the recommendation should be stated clearly. The drawing of the tree. The overall procedure involves three phases: 1.

A payoff node is represented by a crossed circle. and a revenue on the latter. (This is why some textbooks avoid these three latter symbols. However. which is represented as a dashed line. the payoff at that point is simply written down – a payoff node is not used. payoff nodes. Tulett 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). whenever expected value is the decision criterion. and null branches. when solving the tree (from right to left). Cost gates can appear on both alternative and null branches. then the number is placed in parentheses.) However. These symbols with their meanings are shown in Figure 1. which is used to keep track of payoffs which occur before the ending branches of the tree. when dealing with utility functions (which we shall study later) that approach must be used . usually representing a cost on the former. The cost associated with the gate is written next to it. A payoff node is followed by a null branch . Indeed. the maker of the decision tree could keep track of all costs and revenues and then subtract/add them to the appropriate ﬁnal payoffs. At the ending branch of the tree (on the extreme right-hand side). using these three extra symbols makes the solution easier to ﬁnd.48 c April 28. we will use an eighth symbol. if it’s a revenue rather than a cost. As an alternative to using cost gates (with the cost or revenue next to the gate).M. This symbol consists of two short parallel lines which are drawn at a right angle to the alternative branch: non-recommended alternative . These seven (or just four) symbols are all that are used when formulating a problem using a decision tree. 2010 D. which is applied at every square to every branch except that of the best alternative at that square.

to illustrate this methodology. These words are emphasized here in red. then the thing on the right must come after (or be at exactly the same time) as the thing on the left. 5. The basic shape of the tree is the same for both approaches. but of course using colour is not required.2 Theatre Problem in Tree Form To illustrate the nature of this approach. We will do it both ways. Hence if something appears to the right of something else.] This problem needs no payoff nodes. Tulett 49 In addition to doing this. so we will start with that. We begin with a square on the left-hand side which represents the theatre rental decision. a decision tree is drawn from left to right. We shall see in the next section that some squares are not part of the optimal solution. Emanating from the right-hand side of the square are three alternative branches (double lines). The tree is not drawn to scale with respect to time. several trees are shown for one problem so that the order in which the material is drawn is made clear. ﬁrst without cost gates to show the equivalence with the payoff matrix approach. hence there is no point in highlighting the best alternative at such a square. However. should the decision maker possibly arrive at that square. and is then solved (“rolled-back”) from right to left. we will begin by formulating the theatre problem as a decision tree.c April 28. it can be done with or without cost gates on the alternative branches. in which one proceeds from left to right. . [The problem description appears in Section 2. recommended as part of the overall solution As has been stated.2. we can highlight the alternatives which are recommended. but the relative position in time must be preserved. 2010 D. and then with cost gates to show how these are used. This highlighting is part of the third phase.1.M. Next to these branches is a word describing the meaning of the alternative. It should be emphasized that in using this method only one tree needs to be drawn.

Coming out of each circle there are four outcome branches (single lines). words are written to describe the meaning of each outcome. Adding all this to the tree we obtain: sm al l la e rg .50 c April 28. 2010 D.M. Tulett 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. These words have been emphasized in blue. Again. there is a circle for the demand for tickets.

c April 28.2.0 hh0 9 h h heav y 0 sm al l la e rg .01 5.2 0 d d e g n i d fr d 0.7 ra@ ve@ a@ 51 @@@ @ @ h hhhh great hh . There are twelve ﬁnal branches.7 @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh .2 0 e g in e @ fr @ g @ 0. Tulett Demand . Writing these numbers onto the tree we obtain: .0 hh0 9 h d h d h d eavy d d d 0. all costs are imbedded in the ﬁnal payoffs.2 0 Theatre e g n i fr Rental 0. 01 d d d d .7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0. 01 .1 Without Cost Gates When cost gates are not used. 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. 2010 D.M.

70 + 0.01)(10.70(6200) + (0.2 0 d d e g n i d fr d 0.0 hh0 9 h d h d h d eavy d d d 0.20(700) + 0.500 30. 01 d d d d . 200) = 140 + 4340 + 1020 = 5500 la e rg . the expected payoff at the circle which ends the “small” alternative branch is: EV(small) = 0.01)(2400) = 380 + 1920 = 2300 Similarly.0 hh0 9 h h heav y 0 sm al l We have ﬁnished the left-to-right formulation of the model. EV(medium) = 0.09 + 0. 2010 D.200 −3000 2500 17.2 0 Theatre e g n i fr Rental 0.2 0 e g in e @ fr @ g @ 0.20(1900) + (0.7 @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh . which proceeds from right to left. 01 .7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .01 . we compute the expected value.0 hh0 9 h h h eavy 0.52 Demand c April 28.M. and we now proceed with the roll-back procedure.500 @@@ @ @ h hhhh great hh .09 + 0. Just as we saw when we did it as a payoff matrix.200 10. At each circle.7 ra@ ve@ a@ 1900 2400 2400 2400 700 6200 10. Tulett .

500) + 0.200 10.7 @ ge@@ 2300 ra@ ve@ a@ @ 1900 2400 2400 2400 700 6200 10. 01 d d d d .20(−3000) + 0. 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).0 hh0 9 h h 3030 heav y 0. At a square the best (highest.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 . This can be done by highlighting the numbers calculated as part of the rollback.2 0 e g n i fr 0.500 30.01(30. Putting these numbers onto the tree we obtain: Demand @@ @ @ hhhh gre at hhh .2 0 Theatre e g n i Rental fr 0.0 .70(2500) + 0. Tulett 53 EV(large) = 0.09(17. 2010 D.0 hh0 9 h h h eavy 0.500 sm al l Moving to the left. this is the $5500 associated with the medium-sized theatre alternative.200 −3000 2500 17. and this number goes next to the square. 01 . 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 1 . for proﬁt maximization) payoff is chosen.c April 28. we come to the square.0 hh0 9 h d d h 5500 h d e d avy d d 0.M. 500) = −600 + 1750 + 1575 + 305 = 3030 Though not essential.7 @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh . Clearly.

the recommendation should be stated clearly: Rent a medium-sized theatre.54 Demand c April 28.7 @ ge@@ ra@ ve@ d a d @ @ @ @ medium @ @ hhhh gre at hhh .500 @@@ @ @ h hhhh great hh . 01 d d d d .7 2300 ra@ ve@ a@ 1900 2400 2400 2400 700 6200 10. 01 .7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .0 hh0 9 h h h eavy 0.0 hh0 9 h d h d 5500 5500 h d eavy d d d 0.2 0 d d e g n i d fr d 0. Highlighting the optimal alternative we have: la e rg . with an expected payoff of $5500.200 −3000 2500 17.200 10.0 hh0 9 h h 3030 he avy 0 sm al l As with any problem.2 0 e g in e @ fr @ g @ 0. 2010 D. Tulett .500 30.01 .M.2 0 Theatre e g n i fr Rental 0.

and $5500 for the large one. $1800 for the medium-sized thatre. Though we are starting with the tree having being drawn in this instance. Recall that this was $600 for the small theatre. The tree with cost gates (but without the ﬁnal payoffs) is: . 2010 D.0 hh0 9 h d h d 5500 5500 h d eavy d d d 0.01 5.0 hh0 9 h h 3030 he avy 0 sm al l la e rg . which is the rent for the theatre.c April 28.500 @@@ @ @ h hhhh great hh .7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .2. 01 d d d d .2 With Cost Gates In the theatre problem there is a cost associated with each alternative.500 30. Tulett Demand .0 hh0 9 h h h eavy 0.2 0 e g in e @ fr @ g @ 0.M.7 2300 ra@ ve@ a@ 55 1900 2400 2400 2400 700 6200 10.200 −3000 2500 17.2 0 d d e g n i d fr d 0.200 10. normally one would begin to draw the tree and put on the cost gates as the alternative branches are drawn. 01 .7 @ ge@@ ra@ ve@ d a d @ @ @ @ medium @ @ hhhh gre at hhh .2 0 Theatre e g n i fr Rental 0.

01 d d d d . 2300. medium.7 d @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh 1800 . average. and large theatres can hold. Tulett . and 4500 respectively. but for this example we must work them out. Adding these payoffs to the tree we obtain: 55 00 .000. over three nights. For some problems.7 ra@ ve@ a@ @@@ @ @ h hhhh great hh . 2010 D. these payoffs are given exogenously in the problem description.M. 01 . 300. Recall that the small. A large theatre has a revenue of $2500 for fringe demand.2 0 e g in e @ fr @ g @ 0.0 hh0 9 h h heav y 0 60 0 sm al l la e rg Now we must determine the ﬁnal payoffs. 800.2 0 d d e g n i d fr d 0. 1200.000 for great demand. A small theatre obtains a revenue of $10(250) = $2500 with fringe demand.01 . and is ﬁlled with heavy demand with a revenue of $10(3600) = $36. but otherwise the theatre is ﬁlled for a revenue of $10(300) = $3000. and 3600 people respectively.56 Demand c April 28. These payoffs are all revenues from ticket sales.2 0 Theatre d e g n i fr Rental 0. The tickets net $10 each.0 hh0 9 h h h eavy 0. great. $8000 for average demand.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh . An advantage of using the cost-gate approach is that it is creates a fair amount of repetition in the ﬁnal payoffs. $10(2300) = $23. and heavy are 250. but otherwise the theatre is ﬁlled for a revenue of $10(1200) = $12. A medium-sized theatre has a revenue of $2500 for fringe demand.0 hh0 9 h d h d h d eavy d d d 0. The demand levels for fringe. $10(800) = $8000 for average demand.000.

01)(12.2 0 Theatre d e g n i fr Rental 0. However.7 @ ge@@ ra@ @ ve@ a d d @ d d @@ @ @ h hhhh great hh .01)(3000) = 500 + 2400 = 2900 EV(medium) = 0.70(8000) + 0.000 36.09 + 0.20(2500) + 0.70(8000) + (0.000 @@@ @ @ h hhhh great hh . 01 d d d d .2 0 e g in e @ fr @ g @ 0. Normally we would not write all the details out.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.000 2500 8000 23.c April 28. 000) = 500 + 5600 + 1200 = 7300 EV(large) = 0. 000) 55 00 .2 0 d d e g n i d fr d 0. the full workings are shown: EV(small) = 0.01 .7 ra@ ve@ a@ 57 2500 3000 3000 3000 2500 8000 12.0 hh0 9 h h h eavy 0.000 12.0 hh0 9 h d h d h d eavy d d d 0.7 d @ ge@@ ra@ ve@ a @ @ @ @ medium @ @ hhhh gre at hhh 1800 . Tulett Demand .09(23. 2010 D.20(2500) + (0. we would simply calculate the numbers and then write them on the tree.M.09 + 0.20(2500) + 0. 000) + 0.70 + 0.01(36. since this is the introductory section for this material. 01 .

000 2500 8000 23. Tulett Putting these numbers onto the tree we have: Demand @@@ @ @ h hhhh great hh .000 60 0 sm al l la e rg We are now interested in ﬁnding the highest net payoff at the square.2 0 d d e g n i d fr d 0.2 0 Theatre d e g n i e @ fr Rental d @ g @ 0. 8530 − 5500 = 3030.7 2900 ra@ ve@ a@ 2500 3000 3000 3000 2500 8000 12. 2010 D. each net payoff being the expected value at the circle minus the cost at the gate.000 36.M.0 hh0 9 h d d h 7300 h d eavy d d d 0.01 .2 0 e g in e @ fr @ g @ 0. 01 . 7300 − 1800 = 5500.7 @ ge@@ ra@ ve@ a d d @ d @ d @ @ @ @ hhhh gre at hhh . We write the 5500 next to the square. 2900 − 600 = 2300.58 = 500 + 5600 + 2070 + 360 = 8530 c April 28. 01 d d d d .0 hh0 9 h h 8530 he avy 0 . The choices are: small. and highlight the best alternative to obtain: 55 00 . The best of these (as we saw before) is medium with an expected payoff of 5500. and large. medium.0 hh0 9 h h h eavy 0.7 ra@ @ ve@ a @ @ @ medium @ @ hhhh gre at hhh 1800 .000 12.

7 2900 ra@ ve@ a@ 59 2500 3000 3000 3000 2500 8000 12.7 d @ ge@@ ra@ ve@ d a d @ @ @ @ medium @ @ hhhh gre at hhh 1800 . 01 d d d d .2 0 Theatre d e g n i fr Rental 0. Tulett Demand .000 @@@ @ @ h hhhh great hh .000 36.000 2500 8000 23. with an expected payoff of $5500.M.01 .c April 28. it is emphasized that the recommendation should be stated clearly: Rent a medium-sized theatre.000 12.2 0 e g in e @ fr @ g @ 0. 55 00 .0 hh0 9 h h h eavy 0.0 hh0 9 h d h d 7300 5500 h d eavy d d d 0. 01 .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.2 0 d d e g n i d fr d 0. 2010 D.

09 d d d d d d d d d d For each outcome. With the other outcomes. but instead is the prediction about the demand. followed by the four outcomes. 2010 D. it’s not clear whether we should choose a theatre which is a size less than the demand (to save on the 0. At the other extreme. so we wouldn’t even consider a small or mediumsized theatre in this situation. if we are told that there will be fringe demand. Tulett 5. not even the large theatre can handle heavy demand. when a small one can easily handle all the demand.7 for the] e g a r e v Demand a gre d d at 0. Technically. e fri ng he [The perfect prediction 0. the event is not the demand per se.3 The Expected Value of Perfect Information To ﬁnd the EVPI using a decision tree. For example. 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. because the prediction is perfect. The tree therefore begins with an event node.60 c April 28. 2 y av 0. However. 01 . it has the same outcomes and probabilities as the demand itself. it makes no sense to pay more rent for a medium-sized or large theatre. we can simplify the choices down to one or two reasonable alternatives. the event must precede the decision.M.

7 for the] ge a r e v Demand a fri 600 3000 gre d d at 0. and with great demand we could consider both a medium-sized and a large theatre. 2010 D.M.000 We now perform the rollback to obtain: he y av 5500 23.000 0.000 .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. Tulett 61 rent). 600 ll @@ a@ sm @ @@@ @ @ @ @ @ @@ h m dium hh hhh hhe h hhh hh hh 2 [The perfect prediction 0. or whether we should rent a theatre which is a size bigger than the demand. we obtain: Theatre Rental small 2500 e ng 0. Hence with average demand we could investigate both a small and a mediumsized theatre. 01 large 5500 36. Adding the reasonable alternatives with their cost gates and ﬁnal payoffs.c April 28.

d d d 1 large 36.500 5500 5. Tulett Theatre Rental small 2500 0.000 0 0. which will boost the town’s population and his business if it goes ahead. Because of this.4 5.7 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 @@@ 12.09 @ 6600 d @ @ @ @ d d fri d d d h large hhh hhh hh hhh hhh h 17.62 c April 28. 2 1900 600 ng e 600 [The perfect ll @@ 3000 a@ sm @ @@ @ @ @ @ @ prediction @ @ @ . we obtain (as we did before): EVPI = EV with PI − EV without PI = 6600 − 5500 = 1100 The expected value of perfect information is $1100.500 Calculating the EVPI by the indirect method.000 @ @ @ 0. There’s a possibility of a smelter being built nearby. he y av d 5500 23.M. 2010 D.000 30.1 Sequential Decision Making Example Bill operates a hardware store doing a reasonable amount of business for its size.4. Bill wonders whether .

after he hears about a proposed smelter. because everyone will be looking for construction work to be done.000. we then hear some information about the smelter.600.000. Alternatively.M. it is an event from Bill’s perspective.500. because he has no control over it. which we write on the tree as 2. he could then make a deal for the expansion. He could do it in July.900. excluding the capital costs of the expansion) if the smelter goes ahead. Adding this event with its two outcomes. he could do it in October. then the $2. A contractor has quoted him a ﬁrm construction cost of $2. No matter which alternative is chosen. Expanding now would cost $2. On the top part of the tree we place the two payoffs.000 for winter work. He can either expand now. but only about $1. making a note that all ﬁnancial information is in millions of dollars. but that would be too late to look for a contractor to get the work done before the onset of winter. The construction costs are .000 (net present value. The initial formulation of the tree is shown in Figure 2. provided that a contract is signed by July. or they have decided to delay construction for an indeﬁnite period. the expansion would generate a proﬁt margin of $5. 2010 D.900. but with a surcharge of $150.600. On the bottom part of the tree.000.4. Bill ﬁgures that relative to the proﬁt that he would make anyway. Either we ﬁnd out that the smelter company is proceeding with its construction. there’s about a 40% chance of the smelter going ahead. At the present time.000 and $1.000 ﬁgures mentioned in the text of the case.000.900.9. On the other hand. we draw the structure for the second decision.2 Solution Bill has two opportunities to expand his store.c April 28. then the construction cost will jump to a total of $4. or wait to hear about the smelter. The tree for this problem will have three parts: a decision about expanding now. an event concerning the smelter.000 if it does not. if the smelter company is going ahead with the project. when the construction cost would be lowest. 5. Tulett 63 or not he should expand the store. and a decision about expanding in October. We begin the tree by considering only the initial decision. The company which would operate the smelter has said that they will know one way or the other by late September.000 price is still available. If he does nothing before October. which are the $5. If the smelter company has then said that they are indeﬁnitely delaying the project. While this is a decision from the point of view of the smelter company. we obtain the partial formulation of the tree shown in Figure 3.000.

64 c April 28. y n in do no be in fo re ob ct O er .M. Possible Early Signing d d sig th 9 d d d d d d d d d d d d d d d d d d Figure 2: Bill’s Hardware Store: Initial Part of the Formulation Ju l g 2. Tulett Note: All ﬁnancial information is in millions of dollars. 2010 D.

c April 28.4¨ ¨ 0 s ¨ d ee ¨ del rr aye d0 rr r . 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 9 n in do no be in g fo Figure 3: Bill’s Hardware Store: Partial Formulation of the Tree re ct O ob er del rr ay r ed 0 r r . Smelter oc ¨ r¨ p¨ Info ¨¨ .6 rr Possible r r Early Signing d d sig th 2.6 r rr r . 2010 D. Tulett 65 Note: All ﬁnancial information is in millions of dollars.M.

then Bill should do nothing.e.000. 000 . $840.000 without the perfect information. i. when the construction cost would be lowest. and the expected payoff at each circle. 000 = $640. The ranking payoff is $200. The recommendation is to wait until October. Note that because all the information comes at the outset. The complete formulation of the tree is shown in Figure 4. The EV with PI calculated on the tree is 0. we rollback the tree.000. or because of the extra cost for construction during the winter. 2010 D.84. that if the expansion is to be done at all it would be best to do it in July. ﬁnding the highest net payoff at each square. then Bill should expand his store. Since we would have obtained $200. If it’s announced that the smelter is indeﬁnitely delayed. The completed tree showing the recommended course of action using highlighting is shown in Figure 6. then the proﬁt margin relative to what he is doing now must be 0. Tulett different from what they were before.M. There are four ﬁnal payoffs. 5.4.3 Finding the EVPI We ﬁnd the EV with PI by using a tree as shown in Figure 7. For these we must see that if Bill does not expand his store. the EVPI is: EVPI = EV with PI − EV without PI = $840. 000 − $200.66 c April 28. the two of these which are 0 are not mentioned explicitly in the case. The rollbacked tree is shown in Figure 5. either because of a price increase caused by all the smelter activity. Proceeding from right to left. If it’s announced that the smelter will proceed.

4¨ ¨ 0 s ¨ d ee ¨ 5.0 del rr aye d0 rr r .6 Contract del rr ay 0.6 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 5.5 it$$ d in d n$ sig $ $ d d October $$$ $ $ d d $$ d d 4 . 2010 D.M.c April 28. Smelter oc ¨ r¨ p¨ Info ¨¨ . Ju ly 9 do no 1.9 + 0 Figure 4: Bill’s Hardware Store: Complete Formulation of the Tree . Tulett 67 Note: All ﬁnancial information is in millions of dollars.6 rr Possible r r Early Signing d d sig n in 2.0 0 1.6 October $ $$ $ $ $ $ r $ $$$ rr r do no thing 2.15 n it $ in r ed 0 sig $$$ rr .

96 r .6 rr Possible r r Early Signing d d d d sig n in 9 Ju l 2. Tulett Note: All ﬁnancial information is in millions of dollars.0 del rr aye d0 rr 2.0 0 1.9 + 0 Figure 5: Bill’s Hardware Store: Rollbacked Tree .6 4.2 d d October $$$ $ $ d d $$ d d 4 . y do no 1.15 n it $ in d r sig 0.M.6 Contract del rr aye 0.68 c April 28. Smelter oc ¨ r¨ p¨ Info ¨¨ .6 October $ $$ $ $ $ $ r $$$ $ rr r do no thing 0 2. ¨ d d s0 ¨¨ do no ed¨ d Smelter oce¨ thi g d Info r 0.2 $$$ rr0.5 it$$ d in d n$ sig $ $ 0.5 n ¨ p d d ¨ d d d ¨¨ d i th be ng fo re ct O ob er Contract 5.4¨ ¨ 0 s ¨ d ee ¨ 5. 2010 D.

6 rr Possible r r Early Signing d d d d sig n in 2.9 + 0 Figure 6: Bill’s Hardware Store: Completed Tree . Smelter oc ¨ r¨ p¨ Info ¨¨ .6 October $ $$ $ $ $ $ r $ $$$ rr r do no thing 0 2.15 n it $ in d r sig 0.2 $$$ rr0.M.4¨ ¨ 0 s ¨ d ee ¨ 5.0 0 1.2 d d October $$$ $ $ d d $$ d d 4 . 2010 D.6 Contract del rr aye 0. Ju ly 9 do no 1.5 it$$ d in d n$ sig $ $ 0.5 n ¨ p d d ¨ d d d ¨¨ d th be in g fo re ct O ob er Contract 5. Tulett 69 Note: All ﬁnancial information is in millions of dollars.0 del rr aye d0 rr 2.6 4. ¨ d d s0 ¨¨ do no Smelter d¨ e e d thi g d c ¨ o Info r 0.96 r .c April 28.

9 rr ed in $ n it$ sig 0.84 $$ r 0.0 $ $ July $ $ $$ 0 1.9 it$$ in n$ sig $$ 5.1 n p¨¨ ¨¨ Contract 2.6 Contract r delay 2. 2010 D. [The perfect prediction $$ $$ for the] .70 c April 28.6 July $$ $ $ rr $ $$$ $ $$ r r r do no thing 0 0 Figure 7: Bill’s Hardware Store: Finding the EV with PI . Tulett Note: All ﬁnancial information is in millions of dollars.M.4 ¨ s0 ¨¨ do no Smelter d¨ e e thi g c ¨ o Info r 2.

5 Exercise Make a decision tree for the situation described in the following case. however. but a failure would be worth nothing. A successful product would be worth $2. Betty Johnson. The research department had come up with something called “ice-wine”. and a further 10% could be made into low-quality wine.000.000.000.600. and provide a recommendation. Also. A mild frost could at least be contained by erecting heaters in the ﬁelds at a cost of $350. the production manager of Niagara Frontier Winery.000. 2010 D. This would cost $400. A severe frost. it would be worth about $3. Case: Niagara Frontier Winery Driving to her ofﬁce in St.000. It could either be sold as grape juice or made into low-quality wine at a value of $1. Alternatively. Tulett 71 5. even an attempt at using heaters would be in vain.c April 28. The one o’clock deadline was fast approaching. As long as she made up her mind by 1 p.m. There was one more complication.000 to pick the crop. would destroy the crop entirely. there was enough time to order that all the crop be picked immediately. but perhaps this could be made into ice-wine.000 harvesting cost would have to be paid. heard a very disturbing weather forecast. This was only the 27th of September. the damage would be minimal. “Environment Canada has issued a severe frost warning for the Niagara Region for later in the week”. Betty made herself a pot of tea and then looked at her watch. about 85% of the crop with mild frost damage could be sold as low-quality wine. which would cost $400. Telephoning the weather ofﬁce for more detailed information. and a 30% chance of a severe frost. Catherines. but from this the $400. and would have a 75% chance of success. about 80% of the crop could still be made into high-quality wine. there was enough time to erect the heaters. none of the crop could be made into high-quality wine. on the other hand.000.M.. If the crop were picked in good condition in three weeks time. If the heaters were not used and a mild frost was experienced. and the grapes would not be ready for harvest for another three weeks. Using heaters. Ontario. . she was told that in three days time there would be a 60% chance of a mild frost.200.

that a claim of technical excellence is not going to amount to much.Sc. and Susan work for a consumer products company. we saw most of the technical operations to handle decision trees.” “John and I have read the report. John has a joint B. Doing this case adds one more technical operation – the use of payoff nodes. it is the formulation – the rollback procedure is very straightforward. but has taken a few management science electives as well. We tested it extensively in the laboratory. Thinking that the others would want to . 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. though. specializing in marketing. If there’s any difﬁculty using trees. They recently held a meeting to discuss what to do about the newly-developed detergent.” “I’ve been thinking about that. “John and Susan. and found that there was virtually no fading of colours even after 100 washes. I fear that when it comes to the typical shopper looking at the prices in the store.M.1. in English literature and art..1 6.” Susan knew that Elizabeth was excited about the new detergent because she had helped develop it.1 Case: New Detergent Marketing Campaign Problem Description Elizabeth. 2010 D. 6. I grant you that the average shopper will be skeptical. and works on all advertising campaigns. I hope that with your help we can bring this product to market. Tulett 6 Decision Trees 2 In the previous section. but we hope that a least some segment of the market will understand the trade-off and therefore buy our product. They come from widely different academic backgrounds. “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. and she has been on a research team which has come up with a new type of detergent. thanks for coming. and M. “but it’s the part where it says that the cost will have to be 20% higher than even full-priced brands that has me worried.” said John. In this section we solve a fairly long case.72 c April 28.A.Comm. Elizabeth has a B. The research team is very pleased with this new product. solving this case illustrates the application of the decision tree methodology to a somewhat complex situation. More importantly. John. The meeting began with Elizabeth welcoming the others.” Susan replied. Susan has a B. in biochemistry.Sc.

and in hindsight we saw that Regina wasn’t a good test-market for that kind of product.c April 28. our market is Canada. There were exceptions. or the probability of success raised. but the chance of success is only one in ten. the start-up costs would be about $800. but that’s not always easy to do. it did well everywhere.M.” John broke in when he heard this idea. “If we try for the whole Canadian market. your numbers are at best estimates. and Susan continued. we should see if this product will be proﬁtable in the Canadian market alone.” Elizabeth and John nodded their heads.” Elizabeth wondered how accurate Susan’s ﬁgures were. whether the product turns out to be a success or not. For example. Perhaps if the start-up costs could be lowered. but a failure would provide only a tenth of that. Chocolate-covered seaweed did well when we tried it in Halifax. For now. After that would come some revenue. “I’m assuming that for now at least. “We did test-marketing when I was at my former employer.” said Susan. Usually. or the revenues raised. Tulett 73 proceed.000.” “You’ve hit on a good point. 2010 D. test-marketing in Alberta is often done in Lethbridge. and it didn’t do well. Pickering [just east of Toronto] would be an expensive place to test-market.” replied Susan. With different numbers this project could go ahead. I’d proceed.” “Sure. John. which is large enough to have its own media outlets. if everything works out here ﬁrst. “and with different numbers the project could be even less viable than it is now. but bombed when we tried to go national – you couldn’t give it away in Toronto. If success or failure were 50/50. Since advertising is expensive. because we’d 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. with nearly ten times as many people. In Ontario. if a product succeeded in the test-market. we test-marketed a new quick-cook rice in Regina. so the best that we could hope for in the States is a licensing agreement several years down the road. A success would bring in about $4. “the test-market should ideally reﬂect the country as a whole. I’m not saying that this new detergent couldn’t do well for us. For the same reason. It did best in cities with large immigrant populations. “Susan. but we don’t have a distribution network there. but when on a hunch we went ahead with a national campaign anyway. the project would make sense.” Susan said.000. On the other hand. it suddenly became a success. though. but doesn’t have . Peterborough is often used as a test-market because we can buy air-time just in Peterborough at a reasonable price. but maybe we should try to test-market this product before launching it into the entire Canadian market. she had come up with some approximate numbers. “The United States is just next door. we concentrate on small geographic areas away from high-priced media buys in large cities.000.

I worry that if we do the test marketing. but only a tenth of that for a failure. there would be some revenues as well. and if we test in three these costs will triple.M. I’d say that there’s about a 12% chance of success in Lethbridge. That brings us to the question of how we should use these two markets. If we test in one of these places and it’s a failure. but if we test in two markets. “Testing in all three is probably not going to ﬂy. about 10% chance of success in Peterborough.” John said. “testmarketing is not a perfect predictor. there’s no guarantee of success elsewhere.” “You’re right. “But if we test in two markets our advertising costs would double. rather than being a perfect predictor for what should be done. After taking all the risk. However. If we just test in one market.” replied Susan. and do it sequentially rather than simultaneously. John’s.” Susan said. but it really doesn’t matter.” Elizabeth suggested. we know from past experience that people in British Columbia are most open to new products. 2010 D. a competitor will buy a litre of it. and then based on what we ﬁnd there. “but a case could be made for testing in two markets. and just 8% in St. then there should be more-or-less a 10% chance of success in any test-market. “Whatever we make in the lab. perhaps $30. a success in a test market would be a good omen for the rest of the country. without having to deal with a negative test result. beginning with one of the two cities. and this ﬁgure generally declines as one heads east. someone else can make too. we would then have to share the market . possibly proceeding to the other?” At this point Elizabeth jumped in.” “We could test in two of these markets. or should we test sequentially. This would take some time. but it should give us a better idea of what to do.74 c April 28. but I have to believe that on average the chance of success has increased from 10% to say 60%. or like the rice. John’s. we might just give them the time that they need. “What does it prove once we get the result from the test market? The detergent could be like the chocolate-covered seaweed. Tulett the high rates that are found in Edmonton and Calgary. As John said. then the chance of success in the rest of Canada certainly becomes less than 10% – I don’t know how much less. and then reverse-engineer it in their own labs. Elizabeth. though I think that this ﬁgure would range from 50% in Lethbridge to 70% in St. This project is tenuous enough as it is. Should we test simultaneously in both. If we believe that there’s one chance in ten of the product being a success in the country. On the other hand. or perhaps even all three of them.000 for a success.” Elizabeth wondered aloud about some of John’s comments. I think that Lethbridge and St. John’s would give us a better sense of the country as a whole than using either of these cities with Peterborough. have it chemically analyzed. of course. While the purpose of the test-marketing is to obtain information.

let’s agree that we will do the testing simultaneously. St. “If we test in both Lethbridge and St. John’s. The three persons seem to agree that other types . This gives us four possibilities for the test results. It would be cheaper to do it that way than to buy air time in every city individually except where we test-marketed.99.000. “Senior management will want to see a business plan. Instead.” From his experience.000 for a total of $35.000 cost of the national campaign?” “I wouldn’t count on that.000.2 Formulation We wish to develop and solve the decision tree to which Susan refers.M. “Here’s a hypothetical one for you. so that will cost money.000 to develop an ad campaign.” “It’s time to wrap this up for this morning. John’s only.1. to discuss it. this would be a new campaign as far as the testmarket is concerned. we should think about what must come ﬁrst.000. “We would probably want to modify the test-market advertising.” said Susan.c April 28.” Susan said.000. It’s too complicated to think of all the decisions and events at once in a long case like this. John’s.” Elizabeth wondered if spending this money now would save some money later should they decide to undertake a national campaign. and based on that I’d put our chances of success in the rest of the country at about 35%. the cost of the national campaign would be $800. If we fail in both places. I’d put the probability at 0. so the national revenues wouldn’t be diminished. but succeed in the other. Peterborough only. and we’ll meet again at 2 p. John. we would have to spend about $15. and the basis for this will be the recommendation which will come from making a decision tree of what we’ve been discussing. can we deduct this amount from the $800. If we fail in one. I would want to boost the advertising expenditures by $50.m. More importantly. and testing simultaneously in both Lethbridge and St. Suppose that we test in Lethbridge and St. I’ll work on this later this morning.” 6.” John replied. Should we succeed in both. Having spent $15. 2010 D. we can forget about proceeding further with this product. John’s. “Before we spend anything on advertising. and both tests turn out to be a success. when we buy national advertising. Tulett 75 with someone else. we obtain economies of scale by making one nation-wide media buy. I’d say that no matter what we do with test-marketing. At the same time.” “Point taken.000 plus two times $10. I’d say that in each the cost to buy air time would be about $10. John had some ﬁgures on test-marketing. so we decide to go national. The three test markets aren’t much different in size. It is more-or-less obvious that the case presents us with at least four alternatives for the test-marketing: Lethbridge only. I’m almost certain that we would have a winner on our hands.

we place $10.M. Because of space limitations all ﬁnancial ﬁgures will be written on the tree in thousands of dollars.000. we should consider doing nothing whatsoever. with its two outcomes: there is a 10% chance of making $4.000 per market tested. The beginning of the tree is shown in Figure 8. on this piece of paper we end with two nodes.000. one for proceeding to national marketing directly. we decide whether we want one or two test markets.000. or St. 2010 D. John’s.000 is written on the tree simply as 4000.000 and $20. one a decision node and one an event node. or another pair of cities) should not be considered. which for many business situations may be best of all. If we proceed with the national campaign with no test marketing. Based on the foregoing. The ﬁrst of these alternatives then requires a decision about the manner of the test marketing. it allows the $15. .000. Peterborough.000 cost of preparing the test-market ad campaign to be by itself on the test market alternative branch. John’s. then we must decide whether it will be in Lethbridge. so we might wish to investigate this course of action. with the advertising costs being handled separately. Because the cost of test marketing is $10. Doing it this way would be correct. but again it makes things conceptually easier if we have two decisions. and ﬁnally a do-nothing alternative. hence the event for the result on one of the test markets comes next. but things become clearer if we ﬁrst have a test-marketing decision which has just two alternatives: test market.000 cost gates (written as 10 and 20) on the test in one market and test in two markets alternative branches respectively. or all three cities. First. going directly to a national campaign without doing any test-marketing was not clearly opposed by Elizabeth. hence for example $4. or do nothing. and do not test market. and if we want two test markets it is understood from the case that these will be in Lethbridge and St. Also. after alternative branches for testing in one or two markets. The manner of the test marketing could be one decision with four alternatives. Aside from the clarity provided by this approach. Tulett of multiple testing (sequential testing. If one test market is chosen. and a 90% chance of making $400. The second has a decision about the national campaign with two alternatives: proceed with the national campaign. we could begin with a square followed by six alternative branches: one for each of the four testing alternatives. and we will therefore leave these options out of the decision tree. Hence. then this alternative is followed by a result event. At the other extreme.76 c April 28. In making the tree it turns out that we already have too much to put on one piece of letter-size paper.

9 Campaign ¨¨ ¨¨ ¨ ¨ ¨ Preparation for Test Marketing rr a r rr ban rr d rr r on rr r rr r r 0. Tulett 77 Note: All ﬁnancial information is in thousands of dollars.1 $ 4000 ss$$ e c Result c u $ s $$ $$ 400 no ne 0 d d d d City d d d d Number ¨ d d ¨ ¨¨ of Test 10 one ¨ ¨ d d ¨ ¨ ¨¨ dMarkets ¨ d ¨ ¨ d d d ¨ ¨¨ m 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 .M. d¨ ¨ ee 800 roc ¨ ¨ ¨ ¨ p National failur ¨ ¨ ¨ e 0.c April 28. 2010 D.

3 e g 88 d ri b h et L Peterborough 0 d 1 . Tulett Figure 9: New Detergent Case: First Continuation . 400 $$ 5 a bando n 0 .7 0 s$ $$ 4000 es Result c c $ u s $ $ 0 $$ National 800 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ f $ a $ ilure $ $ $ 0.4 400 ab andon .78 . d 0 3 J d oh d d n’s d d d d St. 0 City $ Result d ess $ cc su $$$ Peterborough $ $ $ (30) failur d S d e 0.9 d t.92 3 c April 28. 2010 D.3 ab andon 400 $ (30) failu re 0. 0 Result $ s $$ d es cc $ u s $ $$ $$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $$ $ re 0.M. 0 d Result d $ s d es cc $$$ u d s d $ d $ d $ $ (30) failur e 0 0.6 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p $$ $$ $$ Campaign $$ $$ failur $ $ $ $ $ e 0.5 0 s$ $$ 4000 es Result c c $ u s $$ Continued from Figure 8 Lethbridge 2 d 1 . John’s d 8 d 0 .

Peterborough. This is why the payoffs are combined – for example. . The second continuation of the tree is shown in Figure 10.000 from each place) is obtained. Because each of these is followed by more tree structure.000 + $3000 = $33.e. $30. with the test campaign in every city being either a success or a failure. Tulett 79 On Figure 8 two continuations are indicated. then $60. First. $3000 from each place). with only some of the numbers being different. In real life. Since it is implied in the case that a failure in a test market would immediately end the venture. After every null branch comes a decision about the national campaign. with the ﬁgure placed in parenthesis indicating that we have a revenue rather than a cost. Finally. Since the places of these markets have been stated in the case as being Lethbridge and St. every ‘success’ outcome branch is treated differently.000 in revenue by using a payoff node followed by a null branch.000.000 in revenue (i.000 associated with a success. Here is an example where the order does not matter – it can either be the Lethbridge result event followed by the St. If one is a success. we handle the $30. Hence a revenue of $30. On the null branch we place a cost gate. but we note that the cost of a national campaign after one failing test market is now $800. but the other is a failure. and St. or vice versa. if we are successful in both markets.c April 28. The second continuation comes after the alternative of testing in two markets.M. The tree structure of the ﬁrst continuation is shown in Figure 9. John’s as the solitary test market.000 is obtained. John’s result event. if both are failures then the revenue is $6000 (i. There is a payoff of $30. and then a result event if the ‘proceed’ alternative is followed. John’s. 2010 D. The ﬁrst of these occurs at the decision node for choosing between Lethbridge. these results would be announced more-or-less simultaneously.e. After each of these comes a similar structure. all we need do is put a ‘3’ (for $3000) at the end of every outcome branch which represents failure. we next have the result events for these two markets. and a payoff of $3000 associated with a failure. However.000 is indicated as: d d (30) When the tree is rolled-back. The rest of the tree is similar in structure to the ﬁrst continuation. the ‘30’ is added to the number on the right of the null branch to obtain the number at the payoff node.000 = $850. then $30. there is a result event.000 + $50.

400 $$ 65 aband on 0 6 c April 28.92 rr s s e r c c d d su Lethbridge (33) Result d d fa d ilu d re d 0.M. John’s ss ¨ (60) e¨ ¨ Result su cc ¨ ¨ ¨ Continued from r fai Figure 8 r lur rre 12 . John’s ss e¨ Result su ¨ cc ¨ (33) d d ¨ 08 .¨ 0 ¨ $$ National 800 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ failu $$ $ re 0. 0 r 0. 400 $$ 01 aband on 0 .9 rr 2 rr St. d88 d d d ¨ d ¨ r fai r lur rre 0. Tulett Figure 10: New Detergent Case: Second Continuation .65 aband on 0 5 .¨ 0 St. 2010 D.35 0 s$ $$ 4000 s e Result c c su $$ $$$ National 850 roceed$ p$ $$ $ $$ Campaign $$ $ $ f $ a $ ilure $ $ $ 400 0.3$ 0 s$ 4000 $ s e Result c c su $$$ $ $ National 850 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $ $ $ re 0.80 .99 0 s$ $$ 4000 es Result c c $ u s $ $ d d ¨ 08 .

this ﬁgure represents $188. 2010 D.c April 28. At the extreme left. The ranking payoff is $156. The question arises as to how many decimal places we should report. The ﬁgures from the extreme left of the ﬁrst and second continuations are then transferred to the initial part of the tree.M.1. then proceed with the national campaign.40. In words. some would argue that it’s pretentious to report any ﬁgure closer than say the nearest ten dollars.3 Solution and Recommendation 81 We perform the rollback beginning with the ﬁrst continuation. If the test campaign turns out to be a failure. we perform the rollback for the second continuation. My preference is to do things accurately. we obtain the ﬁgure 188. Because the ﬁgures are in thousands of dollars. so at least we aren’t trying to report a fraction of a cent. Even so. . That part of the tree is then rolledback. should that be desirable. It turns out in this example that the ﬁnal answer is unaffected by this ﬁgure anyway.2224. and run this campaign in Peterborough. Tulett 6. If this turns out to be a success.700. then abandon the project. and then round the ﬁnal answer. Next.222. The recommended courses of action have been highlighted on Figures 14 and 15. we can state the recommendation as: Make the ads for a test market campaign.

5 0 s$ $$ 4000 es Result c c $ u s $$ failu re 0. 0 d Result d $ s d es cc $$$ u d s d $ d $ d $ $ 2150 (30) fa 174. Tulett Figure 11: Rollback of the First Continuation .M.70 ilure 0. 0 Result $ s $$ d es cc $ u s $ $ $ $ 1430 (30) $$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $$ $ re 0.82 . 2010 D.24 ri b h et L Peterborough 0 d 1 .76 ilure Continued on Figure 13 Lethbridge 2 d 1 .3 aband on 2120 0 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 .7 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p$ $$ $ $$ Campaign $$ $ $ f $ a $ ilure $ $ $ 2920 400 0 . d t. 90 3 d J d oh d d n’s d d d d St.70 d 181. 3 e g 88 d 174.4 2560 400 aband on 1760 0 . 0 City d $ Result d d ess $ cc su $$$ Peterborough $ $ $ 1790 (30) fa d S 181. John’s d 8 d 0 .92 3 c April 28.

0 r 0.9 . John’s ss ¨ 843 (33) e¨ d Result su ¨ cc ¨ d ¨ d ¨ r fai r lur rre 72.92 rr s 1033. 400 $$ 3964 01 aband on 3164 0 .35 0 s$ $$ 4000 s e Result c c $ su $ $$$ National 850 roceed$ p$ $$ $$ Campaign $$ $$ $ f $ a $ ilure $ $ $ 1660 400 0.96 0. d88 d d d ¨ 08 .9 rr 2 rr 6 $ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $ $ $ re 0. John’s ss ¨ 3224 (60) e¨ ¨ Result su cc ¨ ¨ ¨ Continued on r fai Figure 13 r lur rre 12 .65 aband on 810 0 .2224 dd re d 0.35 0 s$ $$ 4000 s e Result c c $ u s $$ $$ National 850 roceed$ p$ $$ $$ Campaign $$ $$ $ failu $ $ $ re 0. Tulett $$ d d ¨ 08 0. 400 $$ 1660 65 aband on 810 0 Figure 12: Rollback of the Second Continuation 83 .48 s e r c c d d su Lethbridge 843 (33) Result d d fa ilu 188.¨ 0 St.9$ 0 s$ 4000 $ s e Result c c su $$ c April 28. 2010 D.¨ St.M.

2224 .70 rr t r rr Lethbridge r wo rr r rr r Result rr Continued r 20 r Figure 12 on 188. d¨ ¨ ee 800 roc ¨ ¨ ¨ ¨ p National failur ¨ ¨ ¨ 760 e 0.84 c April 28.70 ¨¨ dMarkets ¨ d ¨ ¨ ¨ d d ¨ d ¨ ea ak m Continued on Figure 11 15 Figure 13: Rollback of the Beginning of the Tree ds 171.M.1 $ 4000 ss$$ e c Result c u $ s $$ $$ 400 0 rr a r rr ban rr d rr r on rr r rr r r no ne 0 156. Tulett Note: All ﬁnancial information is in thousands of dollars.70 dd d d d City d d d Number ¨ d d ¨ ¨¨ of Test 10 one ¨ ¨ d d ¨ ¨ 181. 2010 D.9 ¨ Campaign ¨¨ ¨¨ ¨ ¨ Preparation for Test Marketing d d 0.

70 rr t r rr Lethbridge r wo rr r rr r Result rr Continued r 20 r Figure 12 on 188. 2010 D.c April 28. d¨ ¨ ee ¨ 800 roc ¨ ¨ ¨ p National failur ¨ ¨ ¨ 760 e 0. Tulett 85 Note: All ﬁnancial information is in thousands of dollars.1 $ 4000 ss$$ e c Result c u $ s $$ $$ 400 0 rr a r rr ban rr d rr r on rr r rr r r no ne 0 156.2224 Figure 14: Recommendation – Part 1 .70 ¨¨ dMarkets ¨ d ¨ ¨ ¨ d d d ¨ d ¨ Continued on Figure 15 m ea ak 15 ds 171.M.70 dd d d d City d d d Number ¨ d d ¨ ¨¨ of Test 10 one ¨ ¨ d d ¨ ¨ 181.9 ¨ Campaign ¨¨ ¨¨ ¨ ¨ Preparation for Test Marketing d d 0.

400 $$ 2200 5 a bando n 1400 0 .76 ilure Continued from Figure 14 failu re 0. 3 e g 88 d 174.24 ri b h et L Peterborough 0 d 1 .70 t d d .92 3 c April 28.M.7 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p$ $$ $ $$ Campaign $$ $ $ f $ a $ ilure $ $ $ 2920 400 0 . 0 d Result d $ s d es cc $$$ u d s d $ d $ d $ $ 2150 (30) fa 174.9 181.86 . 0 Result $ s $$ d es cc $ u s $ $ $ $ 1430 (30) $$ National 800 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $$ $ re 0.6 0 s$ $$ 4000 es Result c c $ u s $ $$$ National 800 roceed$ p $$ $$ $$ Campaign $$ $$ failur $ $ $ $ $ e 0 .4 2560 400 aband on 1760 0 .3 aband on 2120 0 0.5 0 s$ $$ 4000 es Result c c $ u s $$ failur d S d e 0 . 2010 D. John’s d 8 d 0 . 0 City d $ Result d d ess $ cc su $$$ Peterborough $ $ $ 1790 (30) Lethbridge 2 d 1 .70 181.J 0 3 d oh d d n’s d d d d St. Tulett Figure 15: Recommendation – Part 2 .

but as with any new product the commercial success is risky. Tulett 87 6.M. Because of this. they would abandon the product without even test-marketing it. On some occasions. a followup national campaign at a cost of $500.800. what would be the revised recommendation? . The technical success is clear. otherwise it would be a failure with a revenue of $150. (a) Draw and solve a decision tree for the situation (using payoff nodes where appropriate).2 chance of success (with the same cost.c April 28.000 ﬁgure in the last paragraph were changed to $800. It would cost $600.000.000.000. (b) If the $600.2 Exercise Newlab has come up with a new product in its research lab. at other times they would proceed directly to national marketing.900.000.4) there would be revenues of $40. The test-marketing would cost about $120. If successful (probability 0. but only $175.000 if successful.000 would have a 70% chance of success with a revenue of $1. and would produce a revenue of $1. they would sometimes test-market a product ﬁrst. A national campaign not preceded by a test campaign would have a 45% chance of success. if unsuccessful the revenues would only be $10. and then make a decision about national marketing after the test-market results had come in. Should the test market be unsuccessful.000. 2010 D.000 otherwise. Should the test market be successful.000. a followup national campaign would have only a 0.000. and the same revenues for success and failure). and state the recommendation for Newlab clearly.

Then there are the deadlines for the . Another choice is to buy a non-refundable seat-sale ticket for $800. as there is now. we would choose the alternative with the lowest cost .88 c April 28.1 Airfare Problem Problem Description An ofﬁce manager in St. which would have to be purchased no later than tomorrow. develop and solve a decision tree to analyze the manager’s problem. so if we put all the numbers onto the tree as we did in the previous section we will be rolling back negative numbers. if there’s no announcement on day 5. There is a 100% chance that in ten days time they will know for sure about the meeting one way or the other. only certain points in time are relevant. Instead of dealing with negative numbers. the ﬁnal tree will have all ﬁnancial information being the absolute value of what we would have had if we had not used this approach. We then look at sensitivity analysis in the context of decision trees. Tulett 7 Decision Trees 3 In this section we begin with an example which contains only costs. A full-fare economy return ticket. 7. John’s has been informed that a compulsory companywide meeting might need to be held in Vancouver in ﬁfteen days time. Another option would be to buy a non-refundable ticket for $1300 which must be purchased at least seven days before departure. At the present time. not revenues. 7. If they still are not sure at that point. then there is the possibility of more information on day 5. While there is a ﬁfteen day continuum of time in this problem. Assuming that a non-refundable ticket would be worthless should the meeting not go ahead. To attend a meeting on day 15.2 Formulation This example only mentions costs. then there will be an announcement on day 10. 2010 D. which would cost $3500. could be purchased as late as the day of the trip. If we call today day 0.1 7. There is about a 40% chance that in about ﬁve days from now they will know for sure whether or not the meeting will be held. then there’s still.1. the manager must ﬂy across the country no later than day 14. and rollback the tree as before. there is about a 30% chance that the meeting will go ahead. We will solve this problem using the alternate approach.M.1. except that at each square. we could write costs on the tree as positive numbers. only a 30% chance that the meeting will go ahead.

there are no further branches after the alternative branch to buy a seat-sale ticket for $800. After tomorrow.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. Hence our focus should be on days 1. day 7 for the $1300 ticket. because an $800 ticket is available during this time with the same privileges. 2010 D. and day 14 for the full-fare $3500 ticket. If the few days interest is not important.M. we do not need a cost gate – all we need to do is write 800 to the right of the branch. At the outset. then a few days extra interest is charged. There is no sense in buying a $1300 ticket today or tomorrow. then the ticket could be bought after day 10. and because we are writing costs as positive numbers. or it will not go ahead. Hence the tree begins with two alternatives. Hence the $800 seatsale ticket would be bought on either on days 0 or 1 (or not at all). the ofﬁce manager might as well wait until at least the end of day 5 to possibly obtain more information. 7. The tree so far is: Seat-Sale ¨ Ticket ¨¨ ¨¨ ¨ ¨ ¨ ¨ y¨¨ u b¨ ¨¨ ¨ ¨ ¨ 800 Possible ¨ Announcement 0¨ . and 14. there would be the hassle of returning the ticket should the trip become unnecessary. 5. the manager could buy an $800 ticket. there is no advantage to purchasing it early. It is .c April 28. or he could wait ﬁve days for more information. Because this is a ﬁnal branch. however. While the $3500 ticket can be purchased at any time. Tulett 89 purchase of the various classes of tickets: day 1 for the $800 ticket. The wait ﬁve days option. If the ticket is bought early.6r r After the outcome branch for the announcement being made there is an event with two outcomes: the meeting will go ahead. 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). or no announcement is made. and more importantly. 10. then has an event with two outcomes: an announcement is made.

In words. If there’s no announcement after ﬁve days.90 c April 28. a note has been placed on the ﬁgure to that effect. Because the ﬁnancial information is all costs. then an event occurs giving information about the meeting.1. After the “go ahead” branch. the recommendation is: . to combine the two events into one event with three outcomes: the meeting will go ahead. and one for buying a full-fare ticket for $3500. no action is required. printed in landscape form. after the “will not go ahead” branch.M. The recommended course of action can be followed on the tree. we often use the term ranking proﬁt (or ranking cost in this example) to indicate that the number being presented is a mixture of measures (best at a square. Tulett possible. Doing it this way would shorten the tree. no action needs to be taken. it is obvious that the manager should buy a 7 day advance ticket for $1300.3 Solution To rollback the tree. The entire tree. the rolled-back tree appears in Figure 17. one for buying a 7 day advance ticket. expected value at a circle). we need to choose the lowest cost at each square. but the analyst should also make the recommendation by clearing stating it in words. We will therefore write what is happening as two events. appears in Figure 16. and no announcement. 2010 D. then our choices are to either buy a 7 day advance ticket or wait another ﬁve days. However. it will not go ahead. With this modiﬁcation. the manager must buy a full-fare ticket. so we simply write a payoff of 0 to the right of this branch. In trees with multiple decisions. but it would require computing some joint probabilities – this confuses the formulation process with the solution process. After the “will not go ahead” outcome branch. we could have a square with two alternatives. If the latter is chosen. 7. This is reported along with the best course of action. After the “will go ahead” outcome branch. so we will only draw this alternative. but not advisable.

2010 D. ¨ r do r ¨¨ rr no r ¨ 3 . Tulett ¨ ¨ ¨ ¨ ¨ y ¨ u ¨ b¨ Seat-Sale ¨ ¨ Ticket ¨¨ ¨¨ ¨ ¨ ¨ Possible r ¨ Announcement 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 .4 ¨ rrdo r w 0.7 ill nrr ot g r o arr hea r dr 0 Figure 16: Airfare Problem before Rollback 91 .M.6 r rr notr mrr Note: All ﬁnancial ﬁgures are costs . 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 Day Advance Ticket 800 .3 ad News: The 0¨ e ¨ Meeting ¨ go ah ¨ ¨ will ¨ ¨ ¨¨ buy 1300 c April 28.

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. The chance that we will be told that the meeting will be going ahead is 30%. Although the $786 ﬁgure is the most important one on the tree. Tulett Recommendation Do not buy the $800 seat-sale ticket. then do nothing. If there’s no announcement after ﬁve days.7(0) = $240. We subtract to ﬁnd the EVPI.1. For example. then we would buy the seat-sale ticket for $800. If there’s an announcement that the meeting will go ahead. . otherwise. If there’s an announcement that the meeting is not going ahead. in reverse order because these are costs. then wait for a further announcement. because they give the ranking cost to be incurred for proceeding further down that path.3(800) + 0. the other rolled-back numbers are also important. otherwise we would do nothing. do nothing. hence EC with PI = 0. If the meeting is going ahead.M.4 The EVPI In this example we need to ﬁnd the expected cost with perfect information (EC with PI). but instead wait to see if there’s an announcement in ﬁve days time. The expected cost without information is $786.92 c April 28. if an announcement is not made after ﬁve days. If at the outset we were to receive perfect information that the meeting will be going ahead. 7. The ranking cost is $786. then buy a $1300 7 day advance ticket at that time. then the ranking cost increases from $786 to $1050. 2010 D. then buy a $3500 full-fare ticket.

7 Day Advance Ticket 800 . 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 0.4 ¨ rrdo r w 0. 2010 D. ¨ r do r ¨¨ rr no r ¨ 3 . Tulett ¨ ¨ ¨ ¨ ¨ y ¨ u ¨ b¨ Seat-Sale ¨ ¨ Ticket ¨¨ ¨¨ ¨ ¨ ¨ Possible r ¨ Announcement 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 .7 i 1050 ll nr otr r go ar her r 0 adr Figure 17: Airfare Problem after Rollback 93 .M.3 ad 1300 News: The 0¨ e ¨ Meeting ¨ go ah ¨ ¨ will ¨ ¨ ¨¨ buy 1300 c April 28.6 r rr n 786 otr mrr buy 3500 Note: All ﬁnancial ﬁgures are costs .

we can do so if we wish. If we know that the product would be a failure. 000 − $156.000 to make only $400.000. Making this tree and performing the rollback we have: . 000) + 0. 7. 2010 D. being the prediction about the success or failure of the national campaign.1 The EVPI There are four pieces of uncertainty in the case: the result in each of the three test markets. or any combination of these four things. 300 Though we did not need to draw a tree the ﬁnd the EV with PI. it is the uncertainty about the national campaign which is of primary importance. 700 = $163. and a 90% chance of being told that a failure will occur. 200.10($3. hence the EVPI is: EVPI = EV with PI − EV without PI = $320. If we know that the product would be successful. for a net of $3.2. While it would be possible to compute the EVPI based on knowing perfect information about any of these four things. the ranking payoff is $156. Tulett 7.000.90(0) = $320.000. 000 Without perfect information. and the result of a national campaign. followed by the decision about whether or not to proceed with the national campaign. There is a 10% chance of being told that a success will occur. We begin with the event.000 to make $4. hence the EV with PI is: 0.M. then clearly we would not spend $800.200.000. then clearly we would spend $800.94 c April 28.700.2 New Detergent Case: Some Extensions Here we look at some extensions to the case which was analyzed in the previous section.

the ads can cost up to $171. usually we are only interested in ﬁnding the point(s) at which the recommendation would change.2. The effect of changing the cost of the test market campaigns is a bit trickier.9 r $$ $$ $ $$ 0 aband on 400 0 Hence the EV with PI is $320. At the other extreme. Sometimes ﬁnding the region for which the same recommendation hold also means that the ranking payoff is unchanged as well. and then we shall look at changing probabilities.000 or increased by $156. Changing Costs The effect of changing the cost of making the ads is very easy to analyze.000. From Figure 14.000.700. if the ads cost nothing then the make ads alternative is of course still preferred.700 before making the other alternative better. we will look at changing costs.300. Therefore. Tulett National d $ 4000 Campaign 800 rocee $ p$ $$ $ $ $$ 95 [The perfect $$ $$ $ $$ prediction for the] Result of the aband 1¨ 0. Since the ads currently cost $15. two costs are affected by this change. 7. and the payoff at the square on the right of the make ads alternative branch has a ranking payoff of $171.700 without affecting the current recommendation. At other times the ranking payoff will change as a parameter is changed.700 we see that the EVPI is $163. Suppose that the cost (in thousands of dollars) of a test market campaign is now 10 + . and then subtracting the $156.c April 28. we could say that the cost could be decreased by $15.2 Sensitivity Analysis While we could examine the effect of changing one or more of the parameters by any amount. 2010 D.¨ National on s ¨ 3200 es¨ 0 Campaign c c ¨ su ¨ 320 ¨ ¨ r rr fa r National d$ ee ilur r Campaign 800 proc $ $$ $ $ e rr $ $ $ 0. First.M. we see that not making the ads leads to a payoff of 0. While only one cost is being changed.

Setting the two expressions equal. We now need to ﬁnd the value for ∆ which causes indifference between the two alternatives.700.40.70 − ∆ and 168. consider the probabilities of success and failure in the national campaign.4776 ≤ ∆ ≤ 156.65 − ∆.2224 − 2∆ respectively. the ranking payoff at the square labelled “Number of Test Markets” is either 181. 2010 D. These numbers are currently 0. This critical value of ∆ is where: Ranking Payoff(make ads) 171.70 The current cost of the test market campaign is $10. then the recommended solution is to test in two markets.70 − (10 + ∆) or 188. but if ∆ becomes too high. If ∆ > −3. after two markets have been tested. 477. Changing Probabilities To illustrate the effect of changing probabilities. then the company would be better off doing nothing.70 Hence the recommendation remains unchanged provided that: −3.70 − ∆ = 168.96 c April 28. and where one success and one failure has been obtained.35 ≤ ∆ ≤ 0. whichever is higher.65 for success and failure respectively. hence if the cost per test market is less than $10.000.70 − ∆ − 15 −∆ ∆ = = = = Ranking Payoff(do nothing) 0 −156. These adjustments are shown on the appropriate outcome branches on the righthand side of Figure 18. in absolute terms.M. Now we will let the probability of success be 0.70 156. 000 − $3. We must place the condition that −0.2224 − 2∆ ∆ = −3.35 + ∆.4776 This ﬁgure is in thousands of dollars. Tulett ∆ (where ∆ is ≥ −10). . we solve to ﬁnd ∆: 171. Therefore. the recommendation remains unchanged provided that the cost of the test market campaign remains between $6522.40 and $166. These expressions simplify to 171.65.4776. and hence the probability of failure is 0. then one test market is preferred to two. Hence.60 = $6522.2224 − (20 + 2∆). The cost next to the alternative branch for testing in two markets is therefore 20 + 2∆.35 and 0.

Now let us suppose that ∆ ≥ −0.00534. and this increase is transferred to the appropriate place on Figure 19. For the current recommendation to remain unchanged.88∆ 650.2224 + 650. and then proceeding if at least one of these turns out to be a success.88∆ at the circle on the extreme left. Tulett 97 These changes cascade through the tree.35. the payoffs will also increase by 3600∆. ≥ ≥ ≥ ≥ 188. The 1660 ﬁgure does not need to be recomputed – this is the advantage of dealing with changes to the current probabilities rather than looking at absolute probabilities. with all probabilities being reported to the nearest 5%. If ∆ goes below this ﬁgure. and one failure) is 0. and by 0.08(3600∆) = 288∆ after a failure in Lethbridge. All it would take is an increase to say 36%.88∆ ∆ Hence the recommendation remains unchanged provided that ∆ ≤ 0.225. we increase the payoffs by 4000∆ + 400(−∆) = 3600∆. At the squares immediately to the left. and see what affect this has on the rest of the tree.. This is not much. we must have 171.M. and then the rollback increases the payoffs by 0. This will be the case provided that: 810 + 3600∆ ≥ 0 This condition simpliﬁes to ∆ ≥ −0.4776 0.92(3600∆) = 3312∆ after a success in Lethbridge. but this change would not affect the overall recommendation. we obtain an increase of 0. affecting most of the ranking payoffs. The bottom two payoff nodes also increase by 3600∆.70 171. Finally.88∆ − 20 168. when the current probability of success nationally (after one success.225. provided that the “proceed” alternative remains better than the “abandon” alternative.c April 28. and the recommendation would change to testing in two markets. 2010 D.. .70 3. because this part of the tree is not part of the current recommendation. At the two bottom circles on the right.88(288∆) = 650. then the abandon alternative would be preferred to the proceed alternative.00534.2224 + 650.12(3312∆) + 0.

3$ 0 s 4000 $ s e Result cc su $$$ $ $$ National 850 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ f $ a $ ilure $ $ $ 1660 0.96 0.88∆ d 0. John’s ss ¨ 3224 (60) e¨ ¨ Result su cc ¨ ¨ ¨ Continued on r fai Figure 19 r lur rre 12 .8 d 8 d d d ¨ d ¨ r fai r lur rre 72.2224 dd re + 650.65 − 400 ∆ + 3600∆ aband on 810 0 + 3600∆ 5+∆ . 2010 D.9 rr 2 + 288∆ rr St.3$ 0 s 4000 $ s Result cce $ su $$$ $ $ National 850 roceed$ $ $ p $ $ Campaign $$ $ $$ $ failu $ $ $ re 0.¨ 0 St. John’s ss e¨ Result su ¨ cc ¨ d d ¨ 08 . 400 $$ 1660 65 − ∆ + 3600 ∆ aband on 810 0 + 3600∆ c April 28.225) .¨ 0 ¨ 843 (33) + 3600∆ $$ National 800 roceed$ $ $ p $ $ $ Campaign $$ $ $ $ failu $$ $ re 0.92 1033. 400 $$ 3964 01 aband on 3164 0 5+∆ .M.98 . 0 r 0.48 rr s s e r c + 3312∆ c d d su Lethbridge 843 (33) Result + 3600∆ d d fa ilu 188. Tulett 6 Figure 18: Sensitivity Analysis – Second Continuation (∆ ≥ −0.99 0 s$ $$ 4000 es Result c c $ u s $ $ d d ¨ 08 .

but would be 0%. There is a 10% chance of a severe blight. ﬁnd the limits for which the recommendation from part (a) does not change. a second planting could be undertaken. There is a 60% chance that the weather will be good. A mild blight (20% chance) would partially destroy the crop. he decides to plant potatoes. One thing he could do would be to plant a different crop such as peas which would not be affected by the blight. however. which would destroy the crop. and 95% if the ﬁrst planting had no blight.000 if the weather turns out to be poor.000. After that. or $30. This year.3 Exercise A farmer has been in the habit of always planting potatoes on his farm. and state the recommendation and the ranking payoff. and were ready to harvest in mid-July. If. In previous years. he will have to worry about the blight (but the weather has little effect on the potato crop and can be ignored). and render any attempt at a second planting in late July not worth doing. 2010 D. . 5%. with the probability of a severe blight on the ﬁrst planting being unchanged. NOTE: The crop planted in the Spring will be either peas or potatoes.c April 28. For ∆c both positive and negative. there is concern that a blight might destroy some or all of the potato crop. Tulett 99 7. This planting would yield a crop in October worth $70. with the same costs and revenues as the ﬁrst.2 + ∆ p. doing a bit of both is not an option in this problem. which was ready to harvest in early October. ﬁnd the limits for which the recommendation from part (a) does not change. but the probability of a mild blight on the ﬁrst planting is 0. When drawing the tree. (a) Draw the tree. or no blight would be 15%. 000 + ∆c. After either a mild blight or no blight.M. (b) Now suppose that the cost of planting potatoes is $60. use payoff nodes for intermediate payoffs. 30%. and 55% if the ﬁrst planting had a mild blight. mild. For ∆ p both positive and negative. while having no blight (70% chance) would produce a crop worth $80.000.000. The potato crop would cost $60. the seeds for the potatoes were planted in the spring.000. (c) Now suppose that the cost of planting potatoes is ﬁxed at $60. a second planting took place in late July.000 if the weather turns out to be good.000 to plant. solve it using the rollback procedure. however. making it worth only $35. The peas would have only a single planting at a cost of $40. The probability of a severe.

2010 D. Tulett Note: All ﬁnancial information is in thousands of dollars.70 ¨¨ dMarkets ¨ d ¨ ¨ ¨ d d ¨ d ¨ ea ak m Continued on Figure 15 15 Figure 19: Sensitivity Analysis – Beginning of the Tree ds rr t r Lethbridge r wo 171.88∆ .2224 + 650. d¨ ¨ ee 800 roc ¨ ¨ ¨ ¨ p National failur ¨ ¨ ¨ 760 e 0.100 c April 28.9 ¨ Campaign ¨¨ ¨¨ ¨ ¨ Preparation for Test Marketing d d 0.00534) 188.70 dd d d d City d d d Number ¨ d d ¨ ¨¨ of Test 10 one ¨ ¨ d d ¨ ¨ 181.M.1 $ 4000 ss$$ e c Result c u $ s $$ $$ 400 0 rr a r rr ban rr d rr r on rr r rr r r no ne 0 156.70 rr rr r r Continued on r Result r (if ∆ ≤ rr r 20 r Figure 18 0.

1 Imperfect Information 1 Introduction In this and the next two sections.04 probability of a positive reading. The probability that oil exists at this location is 1%.1 Example – Seismic Testing Problem Description An oil exploration company has identiﬁed a site under which there may be a pocket of oil. We will call the decision about the seismic test the information decision. The purpose of the seismic test is to obtain information which would help us with the major decision. 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.2. or “negative”. and solve it to obtain a recommendation for the oil exploration company. The other decision is whether or not to spend $40. 2010 D. and a 0. Starting with a problem description.c April 28.000. then there is a 60% chance of a positive reading.000. but we also demonstrate a different method. Bayesian revision is performed by making three tables. that of using prior and posterior trees.000 to drill for oil.M. In Mathematics for Management Science. except that not all of the probabilities can be written down immediately. .2 Problem Formulation There are two decisions to be made in this situation. then there’s a 0.2 8.000. We wish to develop a decision tree for this situation. If the oil exists. 8.2. it would be worth $40. That method can be used here too.000. and then transfer these numbers to the decision tree. The result of the test would be one of the following: “positive”. 8.000.000 drilling for oil. we begin to develop the decision tree.000 to do the seismic test.“inconclusive”. Tulett 101 8 8.2 probability of an inconclusive reading. A seismic test is available which would cost $40. The tree is then rolled-back to obtain a recommendation for the situation. If there’s no oil at that location. If there really is oil present. It would cost $3. and a 10% chance of a negative reading. a 30% chance of an inconclusive reading. What we might call the major decision is whether or not to spend $3. We then perform a Bayesian revision to ﬁnd these probabilities.

01.99. Tulett Not just in this situation.000.000. but in all problems of this type. 2010 D. then this becomes an easy problem.0 40 ic 00 te st .000 l 3 0 3 0 3 0 l 3 0. the information decision must precede the major decision .000 0 0 ism se . and if we drill we then have an oil event with two outcomes: oil is present with probability 0. 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 .102 c April 28.0 ic 00 Drilling for Oil te st Oil Event 40. the information decision precedes everything else.000.99 i3 3 r3 3.M. 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. with its two alternatives. This decision. Indeed. and oil is not present with probability 0. Adding these things to the tree we obtain: 01$$ 0. We must choose whether or not to drill at a cost of $3.$ l $$ i o $ $$ no oil .

99 i3 3 r3 3. and will then transfer these numbers to the decision tree. we cannot immediately write the probabilities. When we draw the outcome branches for this situation. Tulett 103 After the alternative to do the seismic test. 2010 D. 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.000 Drilling for Oil 0 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 0 se ism d d d po sit iv e At this point.000.0 ic 00 st te t ga ne d d d d d d d e iv . for we do not know what they are.000 l 3 0 3 0 3 0 l 3 0. with its three outcomes: positive. and negative.$ l $$ i o $ $$ no oil .c April 28. a fair bit of repetition appears in the rest of the tree. We will ﬁnd them later using Bayesian revision. inconclusive. Adding these outcome branches we obtain: 01$$ 0.M. comes the seismic event. After each 40 . d 3 3 3 3 v 3 3 v 3 3 33 v do not dril l Oil Event 40.

104 c April 28. and summing these gives the marginal probabilities of the seismic event. 8. we must do the Bayesian revision. the seismic testing. The probabilities of oil and no oil are not 0. The decision tree with the probabilities absent on the bottom part of the tree is shown in Figure 20.99 as they were before.99 Multiplying the conditional probabilities by the marginal probabilities of the oil event we obtain the joint probabilities.76.7534 Oil oil Event no oil P(seismic result) 0. the words “Drilling for Oil” and “Oil Event” only appear once rather than in all three places.01 0.76 Oil oil Event no oil 0.20) = 0.7524 0.04 0.2.10 0. Tulett of the outcomes of the seismic result event. Note that since one of the three outcomes of the seismic test must occur. are given in the following table.0396 0. In Mathematics for Management Science.20 0. these are now conditional probabilities.99 for the absence of oil. These probabilities.2010 negative 0.1980 0.01 for the existence of oil at that location. If the drilling is done. To reduce the clutter on this part of the tree. Instead. it is followed by the oil event.M.60 0.01 and 0. The second table is: positive 0.3 Bayesian Revision Now. 2010 D. For the other event. This of course is like what we have already drawn at the top of the tree. we ﬁnd P(negative/no oil) as 1 − (0.99 . you might wish to go back and re-read this topic before proceeding further with this discussion.0030 0. Bayesian revision was done using tables.04 + 0. we have probabilities (given in the problem description) which are conditional on whether there is or is not oil in the ground.0010 0.01 0.30 0. and 0. and they must be calculated using Bayesian revision. but there’s one important exception. and the two marginal probabilities. The event for which the marginal probabilities are known is that of the presence of oil. Seismic Event positive inconclusive negative 0. there is the decision about drilling.0060 0.0456 Seismic Event inconclusive 0. These probabilities are 0. If your memory of this topic is fuzzy.

Oil Event 40. 3 d 3 3 3 3 3 v 3 3 v 3 3 33 v 01$$ 0.000 l 3 0 3 0 3 l3 i3 3 r3 3.000.$ $ l i $ o $ $$ no oil .000 d d d d s d eis 40 d d mi Seismic ve d . i 3 r3 3 d 3 3 3 3 3 v 3 3 v 3 3 33 v do not dril l 0 105 0 Figure 20: Seismic Testing – Decision Tree without Revised Probabilities . 2010 D.000.M. Tulett c i ism se Seismic no Testing 40.000 l 3 0 3 0 3 0.0 d 3 3 3 3 v 3 3 v 3 3 3 3 v 0 d ne d gat d ive d d d d d d d 40.0 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 do not dril l 0 $ l $$$$ oi $ $ 0 $n o oil 0.000.000 l 3 0 3 0 3 0 l 3 i 3 r 3.99 il 3 3 r3 3.0 d 3 33 3 3 v 3 3 v 3 3 3 3 v do not dril l c April 28.00 ll 33 3 0 3 0 .000.000 Drilling for Oil 0 Oil Event 0 0 $ l $$$$ i o $ $$ no oil .000 40.

01493. some of the probabilities will be multiplied by large numbers.132 for three places. 2010 D.7534 We read this as P(oil/positive) = 0.00133 0. it does not make sense to reduce the fraction to the lowest common denominator. speciﬁcally the $40. However. However.98507 0.86842.000 ﬁgure. and the differences between these values and the theoretical value are: .0030 divided by 0.13158 for ﬁve places.7534 The concern about accuracy may seem to be misplaced when all the original probabilities in the ﬁrst table are approximations anyway.263.13158.01493 0..000. 0.0456 0. 0. These ﬁgures. The third table using ﬁveplace decimals is: Seismic Event inconclusive 0. If this is done. For example.90. instead of calculating the decimal quantity 3 . The values of these numbers times $40. we could have expressed 0. P(no oil/positive) = 0. even though there are ﬁve-place decimals.2010 as the fraction 201 1 but we need not reduce this fraction to 67 .000. we can use fractions instead. If we wish.13157947. When multiplied by $40.M. and 0. dividing the joint probabilities by the marginal probabilities underneath we obtain the posterior conditional probabilities. as this only adds work. we obtain (to the nearest cent) $5.2010 Oil oil Event no oil P(seismic) positive 0.157.2010 0. 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. are approximations of exact fractions.106 c April 28.86842 0. it makes sense to remove the decimals from the numerator and the denominator.13158 0. Tulett Finally.0456 negative 0.000.99867 0.000.1316 for four places.. If we approximate the decimal we obtain (using rounding) 0. and so on.000. The decimal expansion is 0. Here’s what happens depending on the level of accuracy when we approx60 imate 456 using decimals.

or use ﬁve decimal places (rounded).1316 0. the prior tree consists of the oil event followed by the seismic event.200.10 $842. Since the prior tree contains these events in reverse order..000 $5. called the prior tree and the posterior tree. Before transferring these probabilities to the decision tree.842.263. By the time everything is rolled back. using only three can cause substantial errors.00 $5. We work with two probability trees.157. the posterior tree has the two events in the same order as they appear in the decision tree .. I would recommend that you either do it that way. 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 . we will look at the prior and posterior tree method of performing Bayesian revision. 2010 D. but it’s conceptually easy because it mimics a subset of the decision tree. the error would be diminished.90 $5.13157947. For this reason. I store all probabilities in my calculator’s memory. Equivalently. but it would still be considerable. This method takes a little bit longer to do.10 $16. in that order. so that the nearly exact value is used.000. Tulett Value 0.13158 0. Both the prior and posterior trees contain two events.132 Value × $40. the two events of the decision tree are the seismic event and the oil event. The prior tree (which is done ﬁrst) has the two events of the decision tree in the reverse order of how they appear in the decision tree.10 107 These variations are what would be present at the “Oil Event” node which comes after a “positive” seismic result.c April 28. 0. . At the very least.280.000.000. 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.263. For this example. For student use. use four decimal places (rounded).00 $5.00 Variation – $42.264.M. even if I only write ﬁve decimal places – doing it this way is equivalent to using fractions.

The joint probability at the end of the top “positive” branch equals 0.01(0. the joint probability at the top seismic event node is 1 (the joint probability at the oil event node) multiplied by 0.6 (the conditional probability along the “positive” outcome branch). which is 0. the joint probability at the bottom seismic event node is 0.1 D 0 rr . D 0 D l i oD D D l no l oi ll l 0.001 respectively. Tulett s po ¨¨ ¨ ¨ inconclusive r nega D rr tiv 0.99.9 l9 l .108 c April 28. which is simply 0. Similarly.01(0.006. So far. Similarly.01) = 0.04 0 ¨¨ On this tree we write the joint probabilities at each node and at the ends of the branches. For example. The node on the left begins with a probability of 1.3) = 0. The joint probability at the end of the bottom “positive” branch equals 0. the joint probabilities at the end of the top “inconclusive” and “negative” outcome branches are 0. meaning that it is certain that something will occur.99 (the joint probability .3 D e rr D 0 1 r .01 (the marginal probability along the “oil” outcome branch. For any outcome branch on the tree.01).M.20 rr e r 0.003 and 0. everything is trivial.7 rr6 r .6 0 ¨¨ e ¨ ¨ itiv e ¨¨ tiv si¨ l o p ¨ l ¨ l ¨ inconclusive r nega r tiv 0. 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. 2010 D.01 (the joint probability at the seismic event node) multiplied by 0.

006 + .7524 The sum of the joint probabilities on the extreme right of the tree must sum to 1.7 rr 6 r 0.M.99(0. the joint probabilities at the end of the bottom “inconclusive” and “negative” outcome branches are 0. it is seen that the prior tree is simply a visual way of displaying the information which appears in the ﬁrst table and in part of the second table.9 l9 l 0.3 D tive D 0. 0D r D l i oD D D no 1 ll o lil l 0. As stated earlier.003 0. the posterior tree contains the same events.20 0.99(0.1980 and 0.7524 respectively.0396.1980 + .99 r e rr 0.76) = 0.003 + . Adding the joint probabilities the completed prior tree is: . so it is wise to verify this fact before proceeding to the posterior tree. 2010 D. Similarly.0396 .6 0.001 + .04 (the conditional probability along the “positive” outcome branch).0¨ 0 ¨ e ¨ ¨ itiv neg r rr ativ 0.000 This sum doesn’t have to be written out as it is here. Comparing this approach with the table method. Tulett 109 at the seismic event node) multiplied by 0.006 0 ¨¨ e ¨ v siti ¨ ¨ po ¨ ¨ ¨ inconclusive ¨ r r nega 0.001 s l po ¨¨ l ¨ l ¨ inconclusive ¨ 4 0.0396 + . but you should at least verify that sum is 1 on your calculator.1 1 rr D 0 .01 rr r D r 0. the posterior tree begins . which is 0. For this problem. but in reverse order. √ .1980 0.20) = 0.7524 = 1.c April 28.

We have always placed “oil” above “no oil”.006. which is found on the prior tree (at the top). we have maintained consistency in the vertical ordering of the outcomes. t ga ne d d d d d l d i o d n o oil e iv . except that they are placed in a different order. This consistency will help us when transferring the joint probabilities from the prior tree to the posterior tree. We begin drawing the posterior tree by outlining its shape. prior.110 c April 28. 2010 D. 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. The ﬁrst (top) joint probability on the posterior tree is the joint probability of “positive” and “oil”. and its value is 0. Tulett with the seismic event. and posterior trees. and “positive” above “inconclusive” which in turn is above “negative”. This is numerically the same as the joint probability of “oil” and “positive”. and when transferring marginal and conditional probabilities from the posterior tree to the decision tree. The ﬁnal joint probabilities on the prior and posterior trees are the same. the probabilities need to be computed by transferring the ﬁnal joint probabilities from the prior tree.M. which is followed by the oil event.

Because of the consistent vertical labelling of the outcomes. 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. there will always be a type of pattern to ﬁnd whenever the outcomes have been labelled consistently. remember that for each joint probability the e tiv ga ne d d d d l d oi d no o l i . Tulett 111 The second (from the top) joint probability on the posterior tree is the joint probability of “positive” and “no oil”. we need the joint probability of “inconclusive” and “oil”. which from the prior tree is seen to be 0.0396.M. If there is any doubt.c April 28. This is numerically the same as the joint probability of “no oil” and “positive”. Though the patterns differ from one Bayesian revision to the next. a nice pattern emerges.0396 d d d po sit iv e l i o n o oil inconclusive Going to the third place. which is found on the prior tree (fourth from the top). 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.006 l i o n o oil 0. 2010 D.003. and its value is 0. Placing these values on the posterior tree we have: 0.

taking the numbers we have just computed. so this acts as a check on our calculations. 2010 D. Then.001 d d d d l d oi d no o l i e iv 0. Each of these numbers is written next to its corresponding event node. This is done simply by addition.7534 = 1.0000 This number 1 is written next to the left-hand node.001 and 0.198 to obtain 0.198 0.7524 . we sum them to obtain 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. we add 0.006 0.112 c April 28.0456 + 0. Had we not t ga ne d 0. at the middle node we add 0.0396 0.006 and 0.7524 is 0.201.0456.M. Tulett words on the outcomes of the prior and posterior trees must match up (in reverse order). the next step is to compute the other joint probabilities on the posterior tree.0396 to obtain 0. and at the bottom the sum of 0. Completing the remaining four joint probabilities the posterior tree becomes: l oi no o l i 0. At the top oil event node.7534.201 + 0. It is always true that we should obtain a 1 next to this node.003 and 0.

7534 34 0.198 0.13158 P(oil/positive) = 0. which provides the conditional probabilities. d 75 d l d oi d no o il 0.0456 As stated earlier. producing the same numbers. The probability on every outcome branch is obtained by dividing the ending (right-side) joint probability by the beginning (left-side) joint probability. the conditional probability of oil is computed as 0.201 1d d At this point we have found all the information in the second table of the table method of Bayesian revision.201 0. Doing this much the posterior tree becomes: l oi no o l i 0.e.c April 28.006 45 6 po sit iv e l i o no o l i 0.003 inconclusive 0. For the outcomes on the left-side event. this would have indicated that an error had been made.7524 . we may wish to give the exact value by writing the conditional 60 probability as an unreduced fraction.M.006 ≈ 0. We continue the process of dividing joint probabilities.0456 0. 2010 D.001 d d 0. Tulett 113 obtained a 1. which provides the information found on the third table. We now complete the Bayesian revision on the posterior tree. Starting with the top oil event (which comes after a “positive” seismic outcome). 456 . 0 0.0396 0. i. these are just the ending joint probabilities divided by 1. Writing all six conditional probabilities rounded to ﬁve decimal places the posterior tree becomes: e tiv ga ne d 0.

you should try the tree method of a couple of problems before you make this decision.003 49 01 0. Tulett 3 0.006 15 13 0. there really isn’t much difference in time. 2010 D.201 0.7534 0 34 0.0396 56 e iv 75 0. when doing this in practice all that is needed is a single sheet of paper on which both trees are written.M. When you become used to both methods. This methodology for performing Bayesian revision is entirely optional – if you feel more comfortable using the table method.9 9867 0.114 c April 28. 0 l d oi d no o il . 04 8 0. However.198 d po s iti ve t ga ne d d 0.001 0. This is shown in Figure 21. . then by all means use the table method.9 8507 1d 0.7524 While we have developed the prior and posterior trees slowly to illustrate the process. l i o no o l 0 .201 d 0.8 i 6842 0. d 3 13 d 00 .0456 0. l i o inconclusive n o oil 0.

75 d 34 3 13 d 00 .001 no 1 ll o lil l 0. Tulett po ¨¨ ¨ ¨ inconclusive r nega 0.001 e ¨¨ tiv i¨ s o p l ¨¨ l ¨ inconclusive 0.04 0.M.7524 8 15 13 .99 rr r 0.20 r tive 0.0396 0.7 rr6 r 0.0456 5 4 0 . 0 l oi no o il 0.7524 115 Figure 21: Prior and Posterior Trees for the Oil Drilling Problem .003 0. 0 l oi inconclusive no o 0.006 0 ¨¨ e ¨ ¨ itiv Posterior Tree 0.201 il 0.1980 r nega 0.0396 0 ¨¨ 0.9 9867 0. 0D r D l i oD D D 0.3 D tive D 0.201 eg d at d ive d 0 d .1 1 rr D 0 .01 rr r D r 0.003 c April 28.006 0. 0 e v i sit o p 3 49 01 . 0 l d oi d no o il . 2010 D.6 0.8 6842 6 0.9 l9 l l .7534 0 0.9 n d 8507 1 0.Prior Tree s .198 0.

Using addition.M. 8.e. matching pairs of outcomes) on the right side of the posterior tree. Taking the events from the prior tree in reverse order. and put labels on the outcomes. There are a total of three marginal probabilities. make the posterior tree showing its shape. we can easily see what needs to be transferred where. 4. 2010 D. the difference being that in the decision tree there is a decision between the two events. make the prior tree showing its shape. and verify that they sum to 1.2. to be transferred from the posterior tree to the decision tree. we obtain the decision tree shown in Figure 22. . Transfer the ﬁnal (right side) joint probabilities from the prior tree to the appropriate places (i. the steps involved in making the prior and posterior trees are: 1. Again. 3. we transfer these numbers from the third table. (Alternatively. and verify that the initial (extreme left side) joint probability is 1. With Figures 20 and 21 in hand. and write the marginal and conditional probabilities. To review. if the table method is used. 6. Tulett The main advantage of the table approach is that it can be done on a spreadsheet (though this won’t help you on a test). The events are in the same order. 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.) Doing this. ﬁnd 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. Using multiplication.4 Solution and Recommendation Now we can complete the formulation of the decision tree. 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. 2.116 c April 28. putting labels on the outcomes. and six conditional probabilities. For every outcome branch. it is very easy to see where to transfer the marginal and conditional probabilities onto the decision tree. Taking the events from the decision tree in reverse order. Once the posterior tree has been completed. 5. ﬁnd all the joint probabilities on the prior tree. ﬁnd the other joint probabilities.

99 il 3 3 r3 3.0 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$ .00 ll 33 3 0 3 0 .000.000. i .000.7 d 5 34 d d d d 40.0 0 ism 40 d d i Seismic ve d .201 d ne d gat d ive d 0 d .13 $ 0 $ l i $ o $ $$ no oil .0 d 3 33 3 3 v 3 3 v 3 3 3 3 v do not dril l 40.$ $ l i $ o $ $$ no oil .01 $ 0$ l$ i o $ $$ no oil .000 l 3 0 3 0 3 0. 3 d 3 42 3 3 3 3 v 3 3 v 3 3 3 3 v 40.0 d 0 7 3 3 3 3 v 3 3 v 3 3 3 3 v 0 0. Tulett 0 0 c i ism se Seismic no Testing 58 $ 1$ . 2010 D.000 c April 28.000 do not dril l 0 33 $ 1$ .868 l 3 i 3 r 3.000.000 l 3 0 3 0 3 0.M.000 l 3 0 3 0 3 0 0.000 d d 56 4 d d dse .000 Drilling for Oil 0 Oil Event 01$$ 0.9986 3 r3 3 d 3 7 3 3 3 3 v 3 3 v 3 3 33 v do not dril l 0 117 0 Figure 22: Seismic Testing – Decision Tree with Revised Probabilities .00 $ 0$ l i $ o $ $ 0 $n o oil 0 0.985 l3 i3 3 r3 3.Oil Event 40.

changing at least two numbers (one increasing by ∆. This is because the information is not perfect. 000. 000. and then observing how these changes cascade through the posterior tree. The rolled-back tree with highlighted recommended alternatives is shown in Figure 23. 2010 D. 8.200. but in fact all this information was stored to the accuracy of the calculator. 000 − 3.99(0)] − 0 = 370. so there is a chance that doing the non-obvious thing may be right.5 Commentary In problems of this type.000. and the rolled-back payoffs are shown to the nearest dollar. and another decreasing by ∆). In this case. To consider a change to the probabilities. then drill for oil. You may be wondering why we even considered the “drill” alternative after a “negative” seismic test. Hence.M. Recommendation Do the seismic test. 000 The cost of the seismic test. .2. it is often useful to ﬁnd the EVPI at the outset. Sensitivity analysis can be performed as usual. This sort of analysis can quickly become quite complex. otherwise.118 c April 28. is much less than $370. If the result is “positive”. The ranking payoff is $63. the seismic test cannot be trivially eliminated. do not drill.01(40. the EVPI is: [0. which is $40. The conditional probabilities are shown to ﬁve-place accuracy. then we can eliminate the alternative to seek information. except on the marginal and conditional probabilities which come after the seismic test alternative. we would have to go back to the prior tree. 000) + 0.000. Tulett This tree is then rolled-back to obtain a recommendation. If the cost of obtaining information is higher than the EVPI.

3 d 3 42 3 3 3 3 2.985 l3 i3 3 r3 3.000 do not dril l 0 93 $ 4$ .000.00 $ 0$ l i $ o .M.000 d 56 63.0 0 ism 40 d d i Seismic ve d .000. i . Tulett 0 40.0 i 00 d c te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d 0.000 3 3 v 3 3 v 3 3 3 3 v do not dril l c April 28.000 Drilling for Oil 0 Oil Event 01$$ 0.000 c i ism se Seismic no Testing d d 58 $ 1$ .$ $ l i $ o $ $$ no oil . d 7 $ $ 0 $n d 5 34 o oil 0 0.015 v 3 3 v 3 3 3 3 v 0 40.201 do d n not 103.263.000 l 3 0 3 0 3 0.000.200 dd 4 d dse .0 d 0 7 3 3 3 3 597.868 l 3 i 3 r 3.158 3 3 v 3 3 3 v 0 40.00 ll 33 3 0 3 0 .01 $ 0$ l$ i o $ $$ no oil .9986 3 d r3 3 d 3 7 3 3 d 3 53.263.158 3v 5.000 l 3 0 3 0 3 0. 2010 D.000 l 3 0 3 0 3 0 0.096 v 3 33 3v d d 3 33 v 0 119 0 do not dril l 0 Figure 23: Seismic Testing – Rolled-Back Decision Tree .200 dega 0 dril l t d ive 0 33 $ 1$ d 0 .13 $ 0 $ l i $ o $ $$ 0 no oil .99 il 3 3 r3 3.0 d 3 33 400.000.Oil Event 40.

000.3 Exercise A consumer products company has identiﬁed a potential product which would require $1. since in this case the net proﬁt would be $500.if a product would be a major success.000. while a failure would have a proﬁt contribution of only $500.e. only one new product in twenty became a major success.8.000. there is no reason to suspect that this product would be any different from the rest.7. A minor success would give a proﬁt contribution of $2. a loss of $1. the consumer products company would be told that the proposed product either “looks good” or “looks bad”. .000 contribution to proﬁt.120 c April 28. The fee for the research ﬁrm is $50. they would say “looks bad” with probability 0. Develop a decision tree and solve it to obtain a recommendation for the consumer products company. while three-quarters of them became failures. The research company had established a track record which gave them conﬁdence about saying the following: .300. If it turns out to be a major success. they would say “looks good” with probability 0.000 in start-up costs to launch.000. 2010 D.9.000.000. they would say “looks bad” with probability 0.800. .000. Tulett 8. i. Some of their competitors use an outside independent market research ﬁrm to give them advice about new products.M. there will be a $10.if a product would be a minor success. . In the past.if a product would be a failure.800. in return.000 minus $1. The company is most worried about this third possibility.

c April 28. This necessitates a second revision of the probabilities.” or “looks bad. 9. which gives an upper bound to the expected value of any information.2. and a 10% chance of a “looks bad” result. but rather to the ability to last years of use.” If the inspected desk is of high quality. Wood Finishers can add a second inspection station (which can only inspect a desk which was inspected at the ﬁrst station).M. which is always of high quality. The results of the inspection at this station would be one of the following: “looks good.1 Example – Wood Finishers Problem Description Wood Finishers produces a line of executive-type ofﬁce desks. however. The result of the inspection at the second station is reported as being either “pass” or “fail. Then in Part C we present the concept which is new to this section. We see that the cost of this information is less than the EVPI. This is used when new information is used to revise the probabilities.” If the desk is of high quality there is a 95% chance . so it has been analyzed one paragraph at a time. then there is a 70% chance that the inspection will indicate “looks good. but this would cost $400 for each desk reworked. The example is quite long. Suppose that the company can inspect each desk at a cost of $50 (per desk) before deciding whether or not to rework it. Adding a rework section to the assembly line would guarantee that each desk would be of high quality. A poorly-made desk. and then more new information arrives. A high quality desk nets a proﬁt of $1000. has a net loss of $6000.” “inconclusive. From this we can ﬁnd the EVPI. and a 2% chance of “looks good” result. due to refunds and loss of customer goodwill. 2010 D. In addition to the inspection station mentioned above. Part A can be solved simply by using a payoff matrix. so in Part B we proceed with making a decision tree to analyze this situation. If the inspected desk is of poor quality then there is a 90% chance of a “looks bad” result.2 9.1 Imperfect Information 2 Introduction In this section we look at sequential Bayesian revision. an 8% chance that the inspection will be inconclusive. (High or low quality does not refer to the visible part of the desk.” a 20% chance that the inspection will be inconclusive. 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.) Ninety-six per cent of the production is of high quality. Tulett 121 9 9.

has a net loss of $6000.2. Adding a rework section to the assembly line would guarantee that each desk would be of high quality.04 EV 720 600 Hence. Instead. Rework Decision Alternatives Do not Rework Rework Prob. for an expected proﬁt of $720 per desk. A high quality desk nets a proﬁt of $1000. The EV with PI is: EV with PI = 0. however. If the rework is not done.2 Part A The ﬁrst paragraph of the problem description contains a decision (rework) and an event (quality): Wood Finishers produces a line of executive-type ofﬁce desks. A poorly-made desk.96 0. Tulett of a “pass. We can analyze this situation with a payoff matrix or a decision tree. let us suppose that we only need to consider adding the second station if the result of the ﬁrst test was “inconclusive”.M. We do not know how many desks are being made. but rather to the ability to last years of use. 9. and low quality.” If the desk is of poor quality there is a 97% chance of a “fail.96(1000) + 0.” The cost of this test would be $60 per desk inspected. The rework decision has two alternatives: do not rework. which is always of high quality. For now. (High or low quality does not refer to the visible part of the desk.) Ninety-six per cent of the production is of high quality.122 c April 28. but this would cost $400 for each desk reworked. due to refunds and loss of customer goodwill. then there is an event for which there are two possible outcomes: high quality. we will work out the proﬁt per desk. so we cannot ﬁnd the absolute level of proﬁt.04(600) = 960 + 24 = 984 . 2010 D. Quality Event Outcomes High Low 1000 −6000 600 600 0. we would choose to not rework. and rework.

because the large tree contains three sub-trees which are similar to the one drawn here. 2010 D.M.0 rr $ d $$ $ $ 4 r $$ $ $$ rewor k 600 ¨ 400 1000 As before. . the EVPI is $984 − $720 = $264 per desk. Tulett 123 Hence the EVPI is $984 − $720 = $264 per desk. Using a tree we obtain: 0. we have: Rework Decision $ [The perfect $$ $ $$ prediction for the] rewor Quality of 6 ¨¨ k 9 . Using a tree now helps when drawing the tree for Part B (the second paragraph). Although a payoff matrix is perfectly adequate for solving this part of the problem. it is also possible to use a decision tree.c April 28.04 r3 Rework t 3 o 3 n 3 o 3 3 d3 720 Decision 3 3 3 33 Quality Event 1000 −6000 720 rew ork 400 1000 If we wish to calculate the EV with PI also using a tree. 0 ¨ 1000 the Desk ¨ 1000 h g¨ hi¨ 400 ¨ rk$ o ew $ tr $$ o $ n $ $ 1000 o $ d $ $ $$ 984 r Rework r rr rk$ o low Decision ew $ −6000 r $ t $ o r $ n $ o$ $ 0.96$ $$$ gh i $ h $ $$ k r3 ow l 3 o 3 w 3 e 3 0.

The $50 cost (per desk) of doing the inspection is much less than the EVPI. For now.M. an 8% chance that the inspection will be inconclusive. Tulett 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 inspection decision must precede the inspection event. Hence we must proceed with the analysis to see if it would be worthwhile to do the inspection. Finally. then there is a 70% chance that the inspection will indicate “looks good. This part of the tree is shown in Figure 24.3 Part B c April 28.” a 20% chance that the inspection will be inconclusive. the tree is rolled back to obtain a recommendation. Indeed. but instead merely write the ranking payoff which we calculated to be $720. After every outcome node we have a sub-tree which resembles the tree made in Part A. which is $264 (per desk).” If the inspected desk is of high quality. The completed trees are shown in Figure 26. we do not need to redraw this section.” “inconclusive. These probabilities are transferred to the decision tree shown in Figure 27. We then draw the prior and posterior trees for the Bayesian revision. The ranking payoff is $869. The tree for Part B without the probabilities is shown in Figure 25. as these must be determined using Bayesian revision. we are left with the situation which was analyzed in Part A. and a 2% chance of “looks good” result. which in turn must precede the main (rework) decision.20 per desk. we cannot write the probabilities on the inspection outcomes. the only differences are the probabilities. Based on this. After the “no inspection” alternative.124 9. The rolled-back tree is shown in Figure 28. If the inspected desk is of poor quality then there is a 90% chance of a “looks bad” result. the recommendation is: Recommendation Inspect every desk and rework it if and only if a “looks bad” result is obtained. . which we need to calculate using Bayesian revision. and a 10% chance of a “looks bad” result. The results of the inspection at this station would be one of the following: “looks good. Therefore.2.” or “looks bad. 2010 D.

Information Decision and Event pe io ct n o lo ba d d d d d d d .c April 28. Tulett 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 d oo s in d 50 Figure 24: Desk Making Decision Tree .M. 2010 D.

Tulett Figure 25: Desk Making Decision Tree without Probabilities . 2010 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 c April 28.M.

96 rrk a r rd 0 96 D rr.9 0 D gh hi D inconclusive low 0.M. 0 0.00 2 7 19 6 0.1 0.08 r k sb 0.7 ¨¨ 0 ook Posterior Tree 0.0032 b d 0 l 4 ad 0. 0.1 sg ¨¨0.1952 0.036 0.1952 o d ks l 0.D D r 1 0.Prior Tree od¨¨ o¨ g s .04 rr low a .9 73 0.0032 d hi r loo d 0.272 rd 0 0 rr.0008 0.672 0.9 0 gh hi low 8 0.096 72 l ¨¨ 2 l .7 d ¨ inconclusive 0 gh 0.036 127 Figure 26: Prior and Posterior Trees for the Desk Rework Problem .02 k ¨ o l o d 32 l 7 0.192 od o g s c April 28.192 36 8 .096 ok lo 1 0.2 D sb D 0.672 88 9 . 2010 D. Tulett D igh hD l¨ ¨ ¨ inconclusive r loo 0.0008 ¨ d d l oo ¨ l d 0.6728 1 .132 r 0.016 l lo l d o 39 1 lw 1 0.

1952 d lo doks d ba dd d 0. 0 3 33 pe s in i ct on 720 (from Part A) 1 1000 88 $ 99 . 2010 D.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.$ $ 0 h $ g hi $ $$$ k r ow 0 l 3 o3 w 3 e .M.$ d d d h 50 $ p g o i $ h Inspection o d ec d g $$$ k s d tio Event r ow 0 d 3 o 3 l w 3 e ok .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 $ 0.2727 33 r t 3 3 o 3 3 n 3 o 3 3 d3 3 3 3 3 3 rew ork 400 −6000 1000 c April 28.$ $ 0 h $ hig $ $$$ k r ow 0 l 3 o3 3 w 3 e . Tulett Figure 27: Desk Making Decision Tree with Probabilities . d132 d d d d 1000 rew ork 400 7 72 1000 $ 72 .128 Inspection no Decision 28 7 6 .

$$$ d132 k r ow 0 3 o3 l w 3 e .25 3 3 3 3 d d 3 3 d inconclusive d −6000 0.68 d3 991.Inspection no Decision 3 33 28 7 6 0. Tulett 1000 rew ork d d 869.68 33 Quality Event d d c April 28.2727 33 d r3 t 3 o 3 3 n 3 d −6000 o 3 3 d3 − 909 .$ sp d h 50 d $ g o i $ h Inspection o d ec d g $$$ k s d tio Event r ow 0 d l 3 o 3 k w 3 e o .M.1952 d lo rew 919.$ $ 0 h $ g hi $ $$$ k r ow 0 l 3 o3 w 3 e . pe s in i ct on 720 (from Part A) 1 1000 88 $ 99 .0163 33 r3 dn Rework t d o 3 o 9 l 3 n 3 o 3 d 3 d Decision d 885.0011 33 r t 3 3 o 9 3 n 3 −6000 o 3 3 991.$ h $ g i h $ d 0. 2010 D. 09 3 3 d d 3 33 600 rew ork 400 1000 129 Figure 28: Desk Making – Rolled-Back Decision Tree .20 dok 885.20 d d 4 1 00 36 1000 d in $ 98 $ 0.25 ork s d ba 400 7 1000 72 1000 $ 72 dd $ 0.

2. we cannot write the probabilities on the inspection outcomes. These probabilities are transferred to the decision tree shown in Figure 32. For now. Finally.” If the desk is of high quality there is a 95% chance of a “pass.25. 2010 D. followed by the test event with its two outcomes.” The cost of this test would be $60 per desk inspected. Therefore. we do not need to redraw this section. then we have an alternative branch with a $60 cost gate. If we choose the “no 2nd inspection” alternative.130 9. the tree is rolled back. as these must be determined using Bayesian revision. The completed trees are shown in Figure 31. which is 0. and “fail”. “pass”.98361. On the other hand. Wood Finishers can add a second inspection station (which can only inspect a desk which was inspected at the ﬁrst station). let us suppose that we only need to consider adding the second station if the result of the ﬁrst test was “inconclusive”. The result of the inspection at the second station is reported as being either “pass” or “fail.” If the desk is of poor quality there is a 97% chance of a “fail. The only tricky thing about the Bayesian revision is the determination of the beginning probabilities. The tree for Part C without the probabilities is shown in Figure 30. For now. because they come after the “inconclusive” outcome. After this we can either do or not do the second inspection.4 Part C c April 28.04 that we had originally. we must use the probabilities which are conditional on the ﬁrst test result being “inconclusive”. but instead merely write the ranking payoff which we calculated to be $885. which is 0.96 and 0. After both outcome nodes we have a sub-tree which resembles the tree made in Part A. We will only modify the part of the tree which is affected by this paragraph. This part of the tree is shown in Figure 29. We begin with the “inconclusive” outcome branch.M. However. then we are left with the situation which was analyzed in Part B. Hence we want P(high/inconclusive). Tulett Solving Parts A and B required knowing only what we saw in the previous section. The prior tree begins with the “high” and “low” quality outcomes. 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. which is shown in . but the associated probabilities are not the 0. Instead.01639. We then draw the prior and posterior trees for the Bayesian revision. and P(low/inconclusive). if we choose to do the second test.

M. 2010 D. Tulett 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 d Figure 29: Second Test – Beginning of the Decision Tree 60 tio n fai l .c April 28.

M. increasing the payoff at the outset by: 0.93 Hence the ranking payoff becomes 869. then rework it. The ranking payoff is $874. and rework it if and only if the result of the second inspection is “fail”.25) = 4.52 − 885. Because the payoff after the “inconclusive” branch has increased. 2010 D.20 + 4. Determine if the second inspection would be used in either (or both) of these situations. If the result of the ﬁrst inspection is “looks bad”.93 = 874. then do not rework it.132 c April 28. then do the second inspection. Tulett Figure 33. If a “looks good” result is obtained. and if so restate the recommendation and the revised ranking payoff at the outset of the tree. If an “inconclusive” result is obtained. . The increased payoff will cascade through the tree for Part B.13 Recommendation Inspect every desk.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 ﬁrst test.13 per desk. the overall recommendation is changed.1952(910. 9.

M.25 (from part (b)) tio c e Second nd Inspection o 2 n Decision Quality Event 1000 Rework Decision c April 28. Tulett inconclusive 0.1952 (from part (b)) 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 .p s in n 885. 2010 D.

00049 0.0 l 65 67 55 l 08 ¨¨ 7 .93492 ¨ 5 ¨¨ 0. rr 3 0D D r s sD a pD D D 0. l01 l639 l l ss¨¨ a p ¨ l ¨ 3¨ ¨ 0. Tulett Figure 31: Prior and Posterior Trees for the Second Inspection .9 ¨ Posterior Tree 0. ¨ 0 l ¨¨ gh l i¨ h l l ¨¨ ¨ ¨ r fail r 0.01590 c April 28.04918 l fai 1 ll l l 0.04918 ¨ ¨ low r rr D 2 D 9 rr 0.98361 ¨ gh ¨¨ hi¨ 0.134 Prior Tree ss ¨ pa ¨¨ 0.00049 low 1 ll l 0. 0¨ ¨ r fail D r 1 D 6 0.M.01590 r r low rr 0.93443 47 ¨ 0. 2010 D.01639 rr r7 r rr 0.9 0. rr 0D D r h g D i hD D D 0.93443 9 9 ¨ 9 .06508 0.2 r 443 rr 3 r r 0.0 rr 3 8 D r5 9 .0 ¨ 0.0 D 34 r 005 9 .

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 .M.1952 (from part (b)) 7 1000 94 $ 99 .$ h $ g i h $ $$$ k r ow 0 3 o3 l w 3 e .0 65 08 3 33 7 1000 56 $ 75 $ 0.25 (from part (b)) tio c e Rework Decision 3 33 rew ork 400 c April 28.Second nd Inspection o 2 n Decision Quality Event p s in n 885. 2010 D.$ $ 0 h $ g hi $$ $$ k r l ow 0 3 o3 w 3 e .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. Tulett inconclusive 0.0005 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 .

52 fa 1000 il 0.25 (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 . Tulett Figure 33: Second Test – Rolled-Back Decision Tree .32 −6000 3 inconclusive 0.2443 33 r t 3 3 o3 3 n 3 o 3 3 −710.0005 r3 t3 33 o 3 3 n o 3 3 996.$ $ 0 h $ g hi $ $$$ k r low 0 3 o3 w 3 e .$ $ 0 h $ g$ Rework hi $ $$ Decision k r l ow 0 3 o3 3 w 3 e .33 d3 −6000 33 600 rew ork 400 1000 c April 28.M.136 n 885.1952 (from d 910.32 3 d3 996.0 65 08 3 33 7 1000 56 $ 75 . 2010 D.9 4 04 d cti d o s 4 s d n a4 d p 4 d d d d 4 970.52 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 .

Tulett 137 10 10.1 Imperfect Information 3 Introduction In this section there is only one Bayesian revision to be done.] Solution Here n = 20 and x = 3.M.05 of being defective. Hence P(3.053 (1 − . and the other called “failure” which occurs with probability 1 − p. .1. A very quick overview is provided here.1 Binomial Probability Distribution Consider an event with two outcomes. 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)n−x P(x.05) = 20! . not at least x.418120.05 .000125)(0. The binomial is discussed extensively in Mathematics for Management Science. Example An assembly line has been producing defects at a rate of 5%.. If this event is repeated n times (where each event is identical and independent of the others)...95 (6)17! = (1140)(0. in all problems of this type we mean exactly x.059582. A sample of twenty units is taken from the line. n. 2010 D. What is the probability of ﬁnding three defective units? [Note: Unless indicated to the contrary.) = 0. one called “success” which occurs with probability p.05)20−3 3!(20 − 3)! (20)(19)(18)17! 3 17 = .c April 28. The expected value of this distribution is simply pn. A defect rate of 5% means that a unit chosen from the line at random has probability p = 0. p) = x!(n − x)! This formula is accessed on a spreadsheet using the BINOMDIST function. . but to obtain the probabilities for the prior tree we need to use the formula for the binomial probability distribution.. 20. 10.

they have simply produced all 1000 units and have hoped for the best. the customer receives a refund. If after testing the item cannot be sent to a customer. P(n. then the test is destructive. the test may destroy the item. n.1 Example Problem Description At the outset of each production day. The direct testing cost is two times $10 for the destroyed units plus another $70 for a total of $90. and then stop the production while these units are tested (destructively). and sells for $14. but there is an indirect cost as well: in the time it takes to test the two units.138 c April 28. then P(1. Each unit costs $10 to make. p) = np(1 − p)n−1 . For example if x = 0. This is an example of destructive testing. Defects are independent from one unit to the next. then P(n − 1. 10. Until now. The other ten percent of the time. the defect rate is 20%. 2010 D. . but it costs $600. the defect rate is only 1%. 10. n. the formula simpliﬁes greatly. then the test is non-destructive.M. n. p) = npn−1 (1 − p). and if x = n − 1. a machine which has a capacity to make 1000 units per day is cleaned and made ready for use.2. n. p) = (1 − p)n . and if x = n. then P(0. 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. For 2 ≤ x ≤ n − 2. If x = 1. so provided that it worked during the test it can then be used in the intended manner. the original formula should be used. if after testing an acceptable product it can be sent to a customer. they could have produced another 18 units. Non-Destructive Testing When something is tested. If a unit is defective. For our purposes. plus a $15 gift certiﬁcate 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. Tulett Shortcuts When x is at or near either 0 or n. 30 units could have been produced. and during the time it takes to reset the machine using this special process. On ninety percent of the production days. p) = pn . An example of a non-destructive test is that of testing the voltage of a battery.2 10.2 Destructive vs. The battery is not destroyed by the test.1. Using a special reset process would guarantee that the defect rate will be only 1%.

c April 28. This does not necessarily imply that exactly 10 of the 1000 are defective. The number of defectives in a 1000 unit production run is governed by the binomial probability distribution. Tulett 10. Hence the net revenue is: 1000(0.86 − $0. with a gain of $14 for a good unit and a net loss of $15 for a defective unit.01(1000) = 10. 200 alternate approach is to think of 99% as the non-defective rate. The problem is complicated enough that we should start by ignoring the information decision.20) = $8. then 1000 units are produced. Part A If the special setup is not used.99($14) + 0.01($29)) 1000($14. Once we have determined what to do when no testing is done (Part A).15) = 1000($13. 710 When 20% of the units are defective the net total revenue becomes: 1000($14 − 0.80) = 1000($8. There is a revenue of $14 for each unit. 710 3 An .000. for which the expected number of defectives is pn = . and an information decision (whether or not to destructively test two units). but for each defective unit the $14 is returned to the customer plus there’s a further loss $15 for a total of $29 each.20($29)) = 1000($14.1 probability that defects are produced at a rate of 20%. There is 0. we can then consider whether or not two units should be tested (Part B).2. 2010 D. There is a 0. but rather than any one unit chosen at random has a 1% chance of being defective.00 − $0.2 Solution 139 This problem contains a major decision (whether or not to reset the machine). The production cost would be 1000($10) = $10.01($14 + $15)) = = = = 1000($14 − 0.9 probability that defects are produced at a rate of 1%.71) $13.29) 1000($13.M.00 − 5.01(−$15)) = 1000($13. Hence the net total revenue when 1% of the 1000 units are defective is:3 1000($14 − 0.71) = $13.

.97($13. Associated with this alternative is the number of units made. 710) 1000 = $13.140 c April 28. “yes” means that the special setup is done. which is 1000. Tulett If the special setup is used. producing 970 units gives 97% of the net revenue associated with producing 1000 units: 970 $13. hence we could ﬁnd the net total revenue from the 970 units as: 970($14 − 0. but also on the number of units made. 298. 2010 D. so we draw cost gates on the branches.M.70 The tree has a fair amount of information on it. mak 70 u e nits ye There is a cost associated with each alternative.70 An alternate approach it to recognize that since 970 is 97% of 1000. which is 970. First. The defect rate will be 1%. Each cost is a calculated number. To save space. e Special mak its . which causes the number of units made to be 30 fewer than 1000. we show the decision with its two alternatives. which depends not only on whether the special setup procedure is done. we simply write “no” to mean that the special setup is not done. The cost will be $600 for the setup plus a production cost of 970($10) for a total of $10. so we will build it in stages. 710 = 0. o 3 n3 n 0 u3 3 Setup 0 3 33 03 1 3 3 Decision 33 33 3 33 9 s.300.01($29)) = $13. then 1000 − 30 = 970 units are produced. 298. Similarly.

2010 D. on the top branch the 1% refers to the proportion of the units which are defective.1 0 3 0 1 3 3 3 3 Decision v 3 3 v 3 3 33 v 9 s.00 mak its .9 is the probability that this proportion will occur. the 0. it is important that we not confuse what we have written.000 ake Special = 10 . Tulett 141 ) 0(10 0 0 0 1 e Special = 10.9 and 0. For example.M. and a defect rate of 20%. m $$$ s t i o 0% 0 3 n n 3 2 3 u3 Setup 03 3 . Since sometimes probabilities are written as percentages.1 respectively.c April 28. mak 70 u e nits 600 + ye = 10 970( . which has two outcomes: a defect rate of 1%. . The probabilities of these two outcomes are 0.300 10) We calculate the ending payoffs and show these calculations and the results on the tree: . mak 70 u e nits 600 + Defect Rate Event ye = 10 970( .300 10) We now have the defect rate event. 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.9 $ $ (10) 0$ 0 0 $ % $ 1 10 .

2010 D. mak 70 u e nits 600 + Defect Rate Event ye = 10 970( .000 ake $ Special = 10 .M.1 0 3 0 1 3 3 3 3 Decision v = 8200 3 3 3v 3 33 v 9 s. m $$ s it o 2 0% 0 3 n n 3 3 u 3 Setup 03 1000(14 − 20%(14 + 15)) 3 . Tulett 1000(14 − 1%(14 + 15)) ) 0 $ = 13.000 ake $ Special = 10 .300 10) 97%(13. we have: . 298. m $$ s it o 2 0% 0 3 n n 3 3 u 3 Setup 03 1000(14 − 20%(14 + 15)) . 710 1 9 .159 = 8200 3 3 3v 3 33 v 9 s. 710 $ 1 9 .710) = 13.300 0(10) 97%(13.70 Rolling back the tree we obtain: 1000(14 − 1%(14 + 15)) ) 0 = 13. $ 0$ 0( $ % $ 1 100 .70 If we wish to calculate the EV with PI also using a tree.710) = 13.1 0 33 03 1 3 3 3 Decision v 13.142 c April 28. mak 70 u e 3159 nits 600 + Defect Rate Event ye = 10 97 . 298. 0$$ 0( $ % $ 1 100 .

298. so we proceed with further analysis.87. we hope to ﬁnd that neither unit is defective. hence the EVPI is: EVPI = $3.M.87 − $3.3 00 13. if either (or both) of the two units is defective. mak 70 u e nits 3710 10. m unit 3 8200 3 3 03 33 0 3 0 1 3 3 33 ye 1 0.638. 159. for then it is highly likely that the machine is producing defects at a 1% rate rather than a 20% rate.00 = $479. This is less than the EVPI. 638. then the defect rate is more likely to be 20% rather than 1%.0 no.70 nits 10.4 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 d v 3 3 3v 3 33 v 00 ake s 10.70 . that is to say we must choose between testing or not testing two units. Tulett Special 10. 2010 D. and we will probably want to use the special reset procedure. To make and then test two units would cost 2($10) = $20 plus $70 for a total of $90. mak 70 u e 2998. 9 13. Intuitively. 9 s.c April 28.3 0 0 ye 0.298.70 1% The EV with PI is $3.710 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. make ts i3 3 13. On the other hand.87 dd d 9 s.000 . The analysis presented here quantiﬁes these intuitive ideas.87 Part B We now come to the information decision.

If the testing is not done. Hence we need three outcome branches. Indeed. what we ﬁnd out is whether or not the tested units were defective. then we have the situation which was analyzed in Part A. 90 un its o tw e e e e e e e e . The probabilities on the branches will be found using Bayesian revision. The tree so far is shown in Figure 34.144 Destructive Testing Decision c April 28. 2010 D. we need not ﬁnd this ﬁgure. or both units are defective. If the testing is done. At the end of every outcome branch we have a tree similar to the one found the $90.M. but we cannot quantify this without further analysis. then we have the testing event. Although both units are destroyed by the test. Tulett 3159 (from Part A) no te sti n g 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 e Figure 34: Machine Reset Problem – Beginning of the Decision Tree The tree begins with the decision concerning the testing of the two units. one unit is defective (it does not matter which). There are three possibilities: neither unit is defective. which had a ranking payoff of $3159. because to do so would require more work than is required to solve the original problem.

and the ﬁnal net revenues. the day’s production capacity has been reduced by 2 + 18 = 20 units by the time we reach the major decision. These changes affect the costs on the cost gates. we can easily write the marginal probabilities of the defect rate event. and because during the time of the test eighteen units could have been made. Adding these sub-trees with all costs and revenues (but without the probabilities) we obtain the tree shown in Figure 35. putting the outcomes of the defect rate event ﬁrst.1 o ¨ n l ¨ l ¨ one r two r rr r rr r . So.M. These ﬁnal payoffs are found by pro-rating what the ﬁgure would be if 1000 units were produced and sold. Because two units of the day’s production have already been made (for the test). Before doing these calculations the prior tree is: ¨ ¨¨ ¨ ne ¨¨ no ¨ ¨ one r two 9 . In doing this. if the special setup is used then we would produce 970 − 20 = 950 units during the rest of the day. we create the prior tree. However. Putting the two events from the decision tree in reverse order. and then the outcomes of the testing event (the number of defectives found) second. then we would produce 1000 − 20 = 980 units. the conditional probabilities for the second event need to be calculated.c April 28. if the special setup is not done. Tulett 145 in Part A.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. 2010 D.

80 8036 ye 9 s.100 0(10) $ 13.M. 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.80 0 (1 $$$ % $ 1 980 00 ake $ Special = 98 . mak 50 u e nits 10.50 $$ $ 1% e $$$ k $ a $ . 2010 D.024.435. Tulett Figure 35: Machine Reset Problem – Decision Tree without Probabilities o tw e e e e e e e e 00 13. 710) = 13.1 0 0 13.024. 710) ) $ = 13. mak 50 u e nits 600 + g tin s Destructive te Testing no Decision = 10 95%(13.50 . m $$ 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.80 $$$ % $ 1 e $ ak $$ o. mak 50 u e nits 10.50 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 .3159 (from Part A) 3 33 v Defect Rate Event 146 98%(13. 024.1 e e e c April 28. 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. 435.

and x being 0. If any unit is pulled at random from the production line. Tulett Now we wish to compute the six conditional probabilities.64 0.32 0.2)2 2(. Defect Rate ( p) 1% 20% Number of Defects (x) 0 1 2 0 1 2 Formula (n = 2) (1 − . i. On the bottom branch. To obtain p.0198 0. i. where the defect rate is 20%.e. and therefore a 99% that it is not defective.c April 28. Two units are being tested. 1 (exactly one is defective).04 Putting these six conditional probabilities on the tree we have: .01)(1 − . The number of defects x can range from 0 to n.01) (. 2010 D. in this situation x can be 0 (neither is defective). consider ﬁrst the top branch where the defect rate is 1%. or 2 (both are defective). 1. All six numbers (two values for p times three values for x) are worked out in the following table.9801 0.9801. 147 We need to determine the parameters n and p for the binomial probability distribution.01.2)(1 − .2)2 Probability 0. there is a 1% (or 0.0001 0. we have the binomial probability distribution with n = 2 and p = 0.M. Hence p = 0. therefore n = 2. or 2. For example.01)2 2(.01)2 = 0.2) (.01)2 (1 − .2.01) chance that it is defective.e. the probability of ﬁnding neither unit defective (x = 0) is (1 − . it is simply the defect rate.

1 o ¨ n l ¨ l ¨ one 0. ¨ 0 le ¨¨ ne l 0. .D rr 0 D 0.32 r two r rr 0.0 r4 rr r We then compute the joint probabilities to complete the prior tree.148 c April 28.M. 2010 D.0198 r two 9 .0 r D e 001 t rr aD r t rr ecD fD e d %D 1 D D ne ¨ 01 ¨ 98 . Tulett ¨¨ no ¨ ¨ one 0. and then ﬁnd the posterior tree in the usual manner. 0 ¨ ¨ 2 l 0% l d lefe l ct l rat ¨¨ 64 . These trees are shown in Figure 36.

9 0 1% 20% 0.Prior Tree ne ¨ 0.064 0.004 35 32 .064 0.1 rrr 0.0198 r two 9 .00409 0.032 0.94609 9 0 6 4 .0 0 d 1% d 20% 0. Tulett ¨¨ no ¨ ¨ one 0.3 0 1% one 0.9 rrr 0.00009 20 % 1 ll d lefe l ct l rat ¨¨ 64 .004 149 Figure 36: Prior and Posterior Trees for the Machine Reset Problem .88209 01 ¨ 98 .M.88209 0.04982 do d 0.0 d 04 d 09 d 00 22 d .D 0 D 0. 2010 D.9 0 ne 69 no 57 .1 o ¨ n l ¨ l ¨ one 0.032 0.04982 20% 0.01782 0. 0 ¨ ¨ Posterior Tree 0.6 t d w 4231 1 0.32 r two 0.0 eD t r 001 a rr rD t cD r e f eD d %D 1D D 0.00009 0.0 r4 rr r 0.9 7800 0.0 6765 0.01782 c April 28. e ¨ 0 l ¨¨ ne l 0.

3159 (from Part A) 3 33 v Defect Rate Event 150 98%(13. 0 3 3 8 9 3 3 3 3 Decision v = 8036 3 3 3v ye 7 7 7 9 s. 2010 D. mak 50 u e nits 600 + g tin s Destructive te Testing no Decision 09 no ne 0 .$ $ % $ 1 e $ k a $$ o.024.1 00 13.024. 710) = 13. 024. Tulett Figure 37: Machine Reset Problem – Decision Tree with Probabilities o tw 4 . mak 50 u e nits 10. m nits3 20% 3 n 3 0.80 3 ) 2 3 $ 0 9 0. 3 3 980 983 3 3 3 v 8036 3 3 3v = 10 ye 95%(13.1 0 0 13.50 .50 e e e c April 28.M.50 2200 13.$ $ % $ 1$ e $$ mak ts .80 76 $ 35 $ 0.435.100 0(10) 9 13. 710) 5 = 13. o 0% 0 3 i 3 2 n3 0n 0u 33 64231 . $ (1 1% $$$ 980 Special = 9800.978 0 u 3 3 0 3 3 83 980 3 0 0 9 3 3 v 3 3 v 3 3 33 v ye 8036 9 s. make $$$ 2 ts3 0% 0 3 i3 no un3 3 Setup 06765 98%(8200) .435.04982 d 3 33 v 95 . 435. 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. mak 50 u e nits 10.80 0 $$ 0.00 e e e e e e e e 0 09 9 s.

52 95%(13. 2010 D.435.$ $ % $ 1 $ ke $$ . 0 3 3 980 983 3 3 3 9967.3159 (from Part A) 3 33 v 98%(13.80 0. 710) 5 3 ) 2 93 $$ = 13.$ (10 $ % $ 1 980 00 ake $ Special = 98 .024.978 0 u 3 3 0 3 3 83 980 3 0 0 9 3 3 8154.80 76 $ 35 $ 0. m nits3 20% 3 n 3 0.1 0 0 13.50 09 d c April 28. 0 3 3 83 9 3 3 3 Decision v 13.M. ma its3 2 o 0% 0 3 n n3 0 u 33 64231 . mak 50 u e nits 600 + Defect Rate Event g tin s Destructive te Testing no Decision d d 3270.87 e e 151 Figure 38: Machine Reset Problem – Rolled-Back Decision Tree o tw 4 .50 nits 10.9 46 7 d d d 7 one d 3 33 v 0.00 e e e e e e e e 0 9 s. m $$ s3 o 2 t 0% 0 3 i n 3 n u 3 Setup 3 06765 98%(8200) .100 0(10) 9 13.024. 024.87 dd d dte st 90 d d tw d do d ne 0. 710) = 13.435.070.50 nits 10. mak 50 u e 2924.04982 ye 95 .52 = 8036 3 3 3v ye 7 7 7 9 s.1 0 0 13. 435.82 v 3 3 v 3 3 33 v ye 8036 9 s.80 09 0 $$ 0.50 2200 13. mak 50 u e 2924.44 v 8036 3 3v3 = 10 e 3251.$ % $$ 1 e $ k $ a $ o.50 . Tulett 7 Number of 7 Defective 7 Units 7 u Event 7 d nit d 7 ds d no 3161.

if either (or both) of the units is defective. if it’s lower. It may seem as though up to 1000 units could be tested in theory (though this wouldn’t make any sense when the test is destructive). be it 0. 1. A practical limit can be established by determining the ranking proﬁt when 0.87. To answer this question. then use the special reset procedure. The ranking proﬁt is $3161. the testing of multiple units can be done sequentially rather than simultaneously. . 10. Since only non-defective units would be sent on to a customer. 3. then continue to produce for the rest of the day. making 980 units for sale.3 Recommendation c April 28. and would increase by $28 if neither unit was found to be defective. If neither unit is defective.3 Commentary Though the situation here involved destructive testing. 1. and then proceed with making 950 units for the rest of the day. then keep going on to n + 2. the ﬁnal payoffs would increase by $14 when one defective is found (because this means that the other unit was ﬁne). Sometimes. 2. we would have to begin with a decision about the number of units to be tested. or if three (or possibly more) units were tested.152 10. However. Tulett At the outset of the day. However. If the proﬁt obtained for testing n + 1 units is higher than that for testing n of them. two units should be made and be tested. it’s not hard to change the analysis to handle non-destructive testing. 2 and so on units are tested. then a peak has been obtained and there’s no point in considering testing one more unit.M.2. Perhaps a higher ranking payoff could be obtained if only one unit were tested. In that case. The number of units to be tested (should the test be done at all) was set in the problem description to be two. 2010 D. and so on. we have a situation like that of the previous section.

The test would cost $200.c April 28. but on 1 day in 5 (erratic day) the defect rate is 16%. On 4 days out of 5 (normal day). This procedure costs $14. (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. Assume that if the test is done. that they will reset the machine. and if two or three defective units are found. and takes up 47 units worth of production time. . The test is destructive.M. Tulett 153 10. they could use a special reset procedure. 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. 2010 D.000 and takes up 50 units worth of production time. using it guarantees that there will be no defects.4 Exercise Every day a machine can produce 1000 computer chips. (c) Should they do the test. A good chip is worth $50. As an alternative to producing defects as described above. but a bad one has a net cost of $300. the defect rate is only 2%. The machine has both normal and erratic days.

we begin with an example to illustrate this topic. and at least 30 TPD of Type 2 cement. and production is measured in Tonnes per Day.1 Example – Cement Problem A cement company makes two types of cement.e. and six labour-hours in Departments A. abbreviated as TPD. storage size. and so on. labeled A. and C. ﬁve. Departments B and C are allowed to use up to 500 and 900 labour-hours per day respectively. The physical capacity of the plant. A new labour agreement has increased the length of breaks. and restricts and makes more costly the use of overtime. Each type of cement is made in three departments. which is one person working for one hour. and four labour-hours in Department C. The three departments require workers with very different training and skills. one and a half labour-hours in Department B. is limited to 200 TPD. Work is measured in this company by the labour-hour. B. and $10 per Tonne of Type 2 cement. The company therefore wishes to ﬁnd its best production plan using the new work rules with everyone working a 40 hour week. which they market under registered tradenames. 2010 D. There are also . which is governed by such things as conveyor belt speed.M. The company has contractual sales obligations to produce at least 40 TPD of Type 1 cement.154 c April 28. We then consider variations which lead to a more general understanding of what linear optimization is. The amounts of work per Tonne of Type 2 cement are two. absenteeism. if the time to make the cement is less than the number of labour-hours available). B. and C respectively. Department A has 585 labourhours available each day. To make each Tonne of Type 1 cement requires three labour-hours in Department A. These are the most they can use for the making of cement. 11. 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 proﬁt of $8 per Tonne of Type 1 cement. but for our purposes we will simply call them Type 1 and Type 2. then the workers will be idle for a few minutes at the end of the day. Tulett 11 Linear Optimization 1 In this the ﬁrst of four lectures on the subject of linear optimization . and so on. and factoring in allowances for breaks. If a department has some time leftover (i. so the possibility of transferring employees from one department to another is not something that is factored into the planning process. Based on the current authorized strength in each department. Cement is sold by the Tonne (= 1000 kg).

and gives the objective. these unknowns come from the last sentence of the problem description: the TPD of Type 1 cement that should be made. Everything else. In order to solve the problem.2. or the idle time (if any) in one of the departments. so that the proﬁt is maximized.c April 28. It can then be solved by Excel or a similar package. which appears as the “Problem Description”. The emphasis here is to focus in on the unknowns which are at the heart of the problem. such as the total proﬁt. In this problem. However. 11. one can bypass the algebraic model and go directly to the spreadsheet model. 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. This way of labelling the unknowns is what is required when we consider realistically sized models. Hence we have: . which can have thousands of variables.1 Making a Model Verbal. Models with just two variables can be solved graphically. up to a size limit set by the writers of the software. Algebraic models can be solved by a software package designed for this purpose.2. calling them x1 and x2 . Another option is to transform the algebraic model into a spreadsheet model . With just two unknowns we could label them x and y. we wish to determine the unknowns which will be represented using variables. This model is complete in that the ﬁnal sentence states the essence of the problem. and to skip those things which can easily be determined once the essential unknowns have been determined. 11.2 Deﬁnition of the Variables In beginning to make an algebraic model. Algebraic. so we will not take this route. One such package is LINDO. and the TPD of Type 2 cement that should be made. as we shall later see. Often. we need to transform the verbal model into an algebraic model . to be described later. and so on) which total $1400 per day. for a very simple problem like the cement problem. but of course this is of limited practical use. 2010 D.M. can be determined if we know these two essential things. only the data is provided with a general question of the “what should the company do?” variety.2 11. Indeed. this shortcut will not help us for more complex models. but it is more common to use subscripts. security. Tulett 155 ﬁxed costs (taxes. The company wants to know how much should be produced of each type of cement.

and that x2 be greater than or equal to 0. the minimum sales contract requirements. one Tonne gives a contribution of $8 to the proﬁt. Also present in this and in almost every linear optimization model are non-negativity restrictions on the variables. When writing the algebraic model. Similarly. anticipating that we will use software such as LINDO for these problems.156 c April 28. We write the word maximize in front of the expression.M. we do not write the “ f (x1 . Hence we simplify the objective function to: maximize 8x1 + 10x2 11. Therefore we omit subtracting it for now. the daily proﬁt from the production of Type 1 cement is 8x1 .) Again. we require that x1 be greater than or equal to 0. The word maximize is often abbreviated to simply max. and the limit on labour availability in each of the three departments. Putting these together we have 8x1 + 10x2 . 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 deﬁnitions of the variables be made as clearly as possible. a shorthand such as “x1 = Type 1” is not acceptable. The $1400 in daily ﬁxed costs needs to be subtracted from this expression. For example. Looking at the Type 1 cement alone. because the syntax of the software does not handle this notation. the daily proﬁt from the production of Type 2 cement is 10x2 . but we can easily subtract it at the very end when everything else has been calculated. the limit on total production. but most traditional software (before spreadsheets) is not set up to handle this.3 The Objective Function We now need to write an expression for the proﬁt in terms of the variables. in this example. (A more traditional (but less intuitive) symbol is Z . What we call the objective function is: maximize f (x1 . Since we are producing x1 TPD. because that is the objective in this situation. Since we cannot produce a negative quantity of cement. x2 ) = 8x1 + 10x2 In this document we call refer to the value of the objective function as OFV (for objective function value).2.2. we will indicate this by writing x1 ≥ 0 and . 11.4 The Constraints The objective function is subject to a set of constraints which represent. x2 ) =” (or anything else such as OFV or Z ). 2010 D.

these constraints make the non-negativity restrictions superﬂuous.c April 28. . 2010 D. this short form is only used for the non-negativity restrictions. and factoring in allowances for breaks. Department A has 585 labour-hours available each day. 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.M. Tulett 157 x2 ≥ 0 at the end. From the departmental perspective we have: Based on the current authorized strength in each department.) By convention. the labour-hours to make one Tonne of Type 2. and six labour-hours in Departments A. Note that in this example. the data from the problem description go into the columns. From the product perspective we have: To make each Tonne of Type 1 cement requires three labour-hours in Department A. one for each type of cement. B. it is not used for the other constraints. one for each department. Theoretically. The data for these constraints is written both from a product perspective and a departmental perspective. then the non-negativity restrictions would become the new lower bounds on the variables. and four labour-hours in Department C. (Most software programs assume these restrictions and therefore they do not need to be explicitly entered. This is because the model might later change – should the sales constraints be removed. in other problems some of the data might go into the rows). The third constraint that the total production cannot exceed 200 TPD is represented by x1 + x2 ≤ 200. one and a half labour-hours in Department B. and the number of labour-hours available per day. ﬁve. It may be helpful to put all this data into a table with two rows. or in short form simply x1 . The amounts of work per Tonne of Type 2 cement are two. but we keep them anyway. and three columns for the labour-hours to make one Tonne of Type 1. absenteeism. The ﬁrst three constraints are quite easy. and so on. 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. Departments B and C could use up to 500 and 900 labour-hours per day respectively. and C respectively. x2 ≥ 0. (Be careful about this.

and the non-negativity restrictions written in one line at the end.5 5 4 6 Labour-Hours Available each day 585 500 900 Department A B C In each department.5x1 + 5x2 ≤ 500. Doing this we have: x1 = the number of TPD of Type 1 cement made x2 = the number of TPD of Type 2 cement made .5 Summary The algebraic model needs to be summarized in one place.2. For Department B we must have 1. the words subject to followed by the constraints with their word descriptions. we require that 4x1 + 6x2 ≤ 900. the labour-hours (LH) used cannot exceed the labour-hours available. C Labour 4x1 + 6x2 ≤ 900 11. it becomes easy to write the labour constraints for Departments B and C. For questions of this type on a test or examination in this course. LH used ≤ LH available LH to make Type 1 + LH to make Type 2 ≤ 585 3x1 + 2x2 ≤ 585 Once the pattern has been established.5x1 + 5x2 ≤ 500 Dept. 2010 D. A Labour 3x1 + 2x2 ≤ 585 Dept. the objective function. In summary the labour constraints are: Dept. Tulett Labour-Hours per Tonne of Type 1 Cement of Type 2 Cement 3 2 1. B Labour 1. Let’s look at Department A in particular. This summary consists of: the deﬁnition of the variables.158 c April 28. you may wish to write the constraints directly from the problem description without doing the table as an intermediate step. and for Department C.M. Once you have become used to problems like this. just writing such a summary will sufﬁce.

for each we must determine the direction of the arrow which indicates the inequality. Some of the constraints are easy. x1 ≥ 40.M. The ﬁrst one. From the Total Production constraint x1 + x2 ≤ 200. Setting x1 = 0. The second one. Recall that the convention is that the x1 variable is on the horizontal axis. since all the constraints are inequalities. Though you will no doubt work with lined paper. and the x2 variable is on the vertical axis. C Labour 4x1 non-negativity x1 + + + + .5. When this happens we try to ﬁnd an interception point on either the right-hand side or top boundary of the grid. We now need to plot the boundaries of the six constraints. we shall omit most of the details in solving the Cement Problem. is shown in Figure 39. at which x2 = 200. which is x1 + x2 ≤ 200. here we suppress the printing of the grid lines to make the plotted lines easier to see. 2010 D.c April 28. passes through 200 on both axes. A picture of the grid. the arrow points towards the origin. we obtain x2 = 292. B Labour 1. x2 x2 2x2 5x2 6x2 x2 ≥ 11. . A Labour 3x1 Dept. Tulett 159 maximize subject to 8x1 + 10x2 ≥ ≥ ≤ ≤ ≤ ≤ 40 30 200 585 500 900 0 Type 1 Sales x1 Type 2 Sales Total Production x1 Dept. we can see that a 200 by 200 grid is adequate for solving this problem. Also. is a horizontal line through x2 = 30. x2 ≥ 30. The boundary line of this constraint is given by the equation 3x1 + 2x2 = 585.5x1 Dept. and to do this we must ﬁnd two points for each boundary line. In this situation.3 Graphical Solution Because the methodology of graphing linear optimization models is studied extensively in Mathematics for Management Science. is simply a vertical line through x1 = 40. with word descriptions on the axes. The other three constraints require some calculations. The third constraint. we ﬁnd the value of x1 where the line crosses the top boundary. The Department A Labour constraint is 3x1 + 2x2 ≤ 585. with the arrow pointing upwards. Since the origin is true. which is off the grid. and the arrow points to the right (because the inequality makes the origin false).

M. Tulett 200 Tonnes per Day of Type 2 Cement 150 100 50 0 0 50 100 150 200 Tonnes per Day of Type 1 Cement Figure 39: Cement Problem – Axes .160 c April 28. 2010 D.

This region.200) (0. is shown in Figure 41. We have not drawn arrows to explicitly indicate the two non-negativity restrictions. Tulett Hence we solve 3x1 + 2(200) 3x1 + 400 3x1 x1 = = = = 585 585 185 61. The title of each constraint is written next to its boundary line. For Department B we require that 1.0) (195.0) (200..666.5x1 + 5x2 ≤ 500. For example. Therefore we set x1 = 200 and solve to obtain x2 = 16.M. For Department C we require that 4x1 + 6x2 ≤ 900.. we obtain x1 = 195. Therefore the boundary of the Department A Labour constraint passes through the points (61 2 3 . which is ﬁne.. which is off the grid. but of course these restrictions are present nevertheless.. we obtain x2 = 150. and with word descriptions on the axes. Considering all the constraints and the non-negativity restrictions. we then the ﬁnd the optimal isovalue .200). Setting x1 = 0.. so the arrow for each one points towards the origin. not 100 points to the right. C Labour First Point (40.0) (0. Now setting x2 = 0. which is off the grid.100) lies 100 points above the origin. and solve to obtain x2 = 40. The origin is true for all three labour constaints. a line in which all points have the same objective function value.100) (0.16 3 A picture of this is shown in Figure 40..0). Setting x1 = 0.c April 28.. which is ﬁne. 2010 D. We now ﬁnd a trial isovalue line. Setting x2 = 0 makes x1 = 225. Setting x2 = 0 makes x1 = 333. which is labelled and highlighted. it makes the graph easy to understand. B Labour Dept. Therefore we set x1 = 200 (the right-hand side of the grid).30) (0..40) 2 ) (200. With these titles on the constraints.150) Second Point vertical horizontal (200. 161 2 Hence the line passes through the point (61 3 .200) and (195.666. 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. (0. We must remember not to plot the points for the constraints backwards. This being done. we obtain x2 = 100. In summary.333. we ﬁnd the feasible region. which is on the grid.200) (61 2 3 .

M.BL 50 Type 2 Sales Type 1 Sales 0 0 50 100 150 200 Tonnes per Day of Type 1 Cement Figure 40: Cement Problem – Constraints . 2010 D.162 c April 28. ur od Pr uc tio n La b ou r r abou C . De A bo La t To 150 De 100 Dept al pt. Tulett 200 Tonnes per Day of Type 2 Cement pt.

BL 50 Type 2 Sales Feasible Region Type 1 Sales 0 0 50 100 150 200 Tonnes per Day of Type 1 Cement Figure 41: Cement Problem – Feasible Region . 2010 D. De A bo La t To 150 De 100 Dept al pt. Tulett 163 200 Tonnes per Day of Type 2 Cement pt.c April 28.M. ur od Pr uc tio n La b ou r r abou C .

then x1 = c2 . a quick summary is provided here. In other words. then 8x1 = 200 and hence x1 = 25. and the coefﬁcient of x2 goes on the horizontal axis.M. For the example at hand. this does not help us much here. and we connect these two points with a dashed line. Therefore this particular isovalue line passes through (x1 . x2 ) = (0. because (0. If x2 = 0. we seek to maximize 8x1 + 10x2 . and hence x2 = 20. This procedure is discussed extensively in Mathematics for Management Science.164 c April 28. However. For example. Using the shortcut we obtain a vertical intercept of 8 and a horizontal intercept of 10. and if x2 = 0. 8x1 + 10x2 = 200.0) are in the bottom lefthand corner. the shortcut is that the coefﬁcient of x1 goes on the vertical axis. multiplying each intercept by 10 we obtain a vertical intercept of 80 and a horizontal intercept of 100. 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 points (0. the shortcut may produce intercepts which are off the page. If x1 = 0. For example. Of course. then x2 = c1 . while any non-zero value of v can be used. then 10x2 = 200. These two points deﬁne the isovalue line. 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). However. a line parallel with the trial isovalue line which passes through the optimal solution.0). suppose we have 8x1 + 10x2 in the objective function and wish to try v = 200. 2010 D. the shortcut may produce points that are too close to the origin to be able to draw the connecting line. which is indicated by drawing a dashed line between them. Hence we multiple each of these intercepts by a number greater than 1. Tulett line. in which case we need to multiple each intercept by a number greater than 1. in which case we need to multiply each intercept by a number between 0 and 1.8) and (10.e. so it’s hard to draw the line between them.80) and (100. 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 = 0.0) are what we would have obtained if we had . i. At the other extreme. 20) and (25.

A convenient means of doing this is to use a rolling ruler. the solution expressed in managerial terms . By taking the boundaries of the two binding constraints. and any one of them will sufﬁce. there are an inﬁnite number of trial isovalue lines.c April 28. We now ﬁnd a line parallel with the trial isovalue line. and then solved for the intercepts. The optimal ∗ = 150 and x∗ = 50. This optimal isovalue line is also drawn on the graph (again. 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. and the optimal solution is identiﬁed.M. From the graph we can see that the binding constraints are the ones for (i) Total Production and (ii) Department C Labour. Of course. but a triangle moved along a straightedge will work too. we can obtain the solution exactly: Total Production x1 + x2 = 200 Dept. which just passes through the boundary5 of the feasible region such that the objective function value is maximized. but when there is multiple optimality an entire edge of the feasible region will be optimal. as a dashed line). A picture of this is shown in Figure 42. no part of the optimal isovalue line will appear inside the feasible region. Tulett 165 set 8x1 + 10x2 to a trial value of v = 800. 2010 D. we obtain x2 = 50. In any case. and that the optimal solution appears to be at about x1 = 150 and x2 = 50. 5 Usually ∗ ∗ 8x1 + 10x2 8(150) + 10(50) 1200 + 500 1700 Going back to the original problem. C Labour 4x1 + 6x2 = 900 6x1 + 6x2 = 1200 4x1 + 6x2 = 900 2x1 + 0x2 = x1 = 300 150 By substituting x1 = 150 into x1 + x2 = 200.

2010 D. ur od Pr uc tio n La b ou C 100 Dept r r Optimal Solution . De Op tim 150 A al bo La t To De al pt. Tulett 200 Tonnes per Day of Type 2 Cement pt.M.BL 50 l Type 2 Sales Tr ia abou Feasible Region Type 1 Sales 0 0 50 100 150 200 Tonnes per Day of Type 1 Cement Figure 42: Cement Problem – Optimal Solution .166 c April 28.

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. all the variables may take on fractional values (e. zero. If we require that these three assumptions hold. but these can be removed when it is appropriate to do so. make the model with minimization rather than maximization as the objective. Such a constraint can arise. With a few exceptions. or negative) √ only (we cannot have something like 5 x1 ). no uncertainty is permitted. and that some or all of the variables must be integer.g. Thirdly. you will often see integer optimization and linear optimization referred to as integer programming and linear programming . These three assumptions are common to both linear and integer optimization. 7. The non-negativity restrictions are almost always present. There is no problem in practice solving models with thousands of variables. however. If. 11. however. for a contribution to proﬁt of $1700 per day. We can. In the literature. The number of variables and the number of constraints is theoretically unlimited. then we have a variation called integer optimization. 2010 D. 11. and the constraints can be equalities as well as the more usual ≤ and ≥ inequalities. the net proﬁt is $300 per day. After deducting the $1400 daily ﬁxed costs. for example. but the software to solve the model will come with limitations. we must have a linear objective function and linear constraints. Tulett 167 The cement plant should produce 150 Tonnes per day of Type 1 cement.4.4 11. By linear we mean that in each expression: (1) each variable appear on its own (we cannot have something like 7x1 x2 ) . requiring that some or all of the variables be integer can drastically cut down the size of problem which can be handled. and indeed solving models with millions of variables is sometimes done.M. and (2) every variable is multiplied by a number (which can be positive. if the amount of Type 1 cement production cannot exceed two-thirds of the total amount produced. The number on the right-hand side can be zero (considered below). and 50 Tonnes per day of Type 2 cement. This is not necessarily .2). then we have a linear optimization model.4.1 Extensions General Form To be considered a linear optimization model.c April 28.

which is: x3 = x1 + x2 As a constraint with all variables on the left. x2 x3 2x2 5x2 6x2 x2 − − 2 3 x3 8x1 + 10x2 ≥ ≥ ≤ ≤ ≤ ≤ ≤ 40 30 200 585 500 900 0 0 0 x3 = x3 ≥ x2 . Also. 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. C Labour 4x1 + Proportion x1 Balance non-negativity x1 + x1 . which we write as or equivalently x1 − 2 3 x3 ≤ 0 We need to add this proportion constraint to the existing model. 2010 D. B Labour 1. we need write the relationship between x3 and the other variables.168 c April 28. A Labour 3x1 + Dept.5x1 + Dept. Tulett two-thirds of 200 TPD. 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 .M. 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. . because we do not know that in advance that this constraint will be binding.

If we wish to use a computer to solve this model. 6 If .66667.e.M. In the third line. because of the equality constraint. i. all we need do is make the minor calculation of converting the two-thirds to decimal form. if we wish to solve by using the graphical approach. to avoid the repeating decimal. but we can do it here.c April 28.6 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. we must revert to a model with just two variables. In general. a three-variable model cannot be converted to a two-variable model. Tulett 169 Modelling in this manner is the best form in that no calculations are required for any of the parameters. If a problem on a test asks you to formulate a model without doing any calculations. However. x1 ≤ 3x1 ≤ 2x1 + 2x2 x1 − 2x2 ≤ 0 x1 ≤ 2 3 x3 2 3 (x1 + x2 ) In the second line.75. 2010 D. 0. there would be no need for cross-multiplication. and there’s less likely to be a mistake. 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 crossmultiplied by 3. The advantages of doing no calculations are twofold: the original data are preserved. we used the fact that x3 = x1 + x2 . we would have used the decimal equivalent 0. then the approach used here is what is desired.

B Labour 1. Substituting x1 = 100 and x2 = 0 into x1 − 2x2 ≤ 0 gives us 100 − 2(0) = 100. In Figure 43. What’s new here is that we now must plot a constraint whose right-hand-side value is 0.M. Since at the boundary x1 = 2x2 . a part of the former feasible region has now become infeasible. The binding constraints now are the Department B Labour constraint and the Proportion constraint. C Labour 4x1 Part (b) Proportion x1 non-negativity x1 + + + + − x2 x2 2x2 5x2 6x2 2x2 . and 100 ≤ 0 is false. such as (100. Superimposing this constraint on the existing solution produces an altered feasible region. We must pick a point which is not on the line. therefore the arrow points away from the point (100. a great deal of care must be taken to make sure that the arrow is drawn in the correct direction. the point (200. The boundary of any constraint with a 0 on the right-hand-side will pass through the origin. with the optimal solution occuring at x1 ≈ 125 and x2 ≈ 60. this particular constraint also passes through. the now infeasible part of the former feasible region is shown in light blue. At the boundaries of these constraints we obtain the exact . and especially for one where the right-hand side value is 0.170 c April 28. for example. and if no speciﬁc mention has been made of doing the formulation with no calculations. then you may simply deﬁne two variables and proceed with making the model. 2010 D. Tulett maximize subject to 8x1 + 10x2 ≥ ≥ ≤ ≤ ≤ ≤ ≤ 40 30 200 585 500 900 0 0 Type 1 Sales x1 Type 2 Sales Total Production x1 Dept.5x1 Dept. On any constraint which has a negative number of the left-hand side. and the old and new optimal solutions are shown. x2 ≥ If a problem on a test involves both formulation and graphing.100).0).0). A Labour 3x1 Dept. the new feasible region is shown in gold.

M. 2010 D. Tulett 171 200 Tonnes per Day of Type 2 Cement pt.BL Tr ial 50 Type 2 Sales abou ti por o r P on (b) F. De Op tim 150 A al bo La l ta To De pt.R.c April 28. (b) Feasible Region (a) Optimal Solution (a) Type 1 Sales 0 0 50 100 150 200 Tonnes per Day of Type 1 Cement Figure 43: Cement Problem – Altered Optimal Solution . ur Pr C od uc La b n tio ou 100 Dept r r .

The optimal ∗ = 125 and x∗ = 62.5) 1000 + 625 1625 Going back to the original problem. we obtain x2 = 62.5.5.5x1 + 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. the solution expressed in managerial terms . 2010 D.172 solution: c April 28. 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. B Labour 1. Tulett Dept.M.

1 Garment Problem When solving the following model. A garment factory makes blouses and dresses.5 TPD. for a contribution to proﬁt of $1625 per day. For each model. and 62. Whenever a constraint is added. use algebra to determine the exact solution. use a piece of graph paper with each axis labelled from 0 to 300.5. and draw all lines within the 300 by 300 grid. the cement plant should produce 125 Tonnes per day of Type 1 cement. and both the trial and optimal isovalue lines. By impaired.5 Tonnes per day of Type 2 cement. after adding a seventh constraint. 11. and will increase if the objective is minimization. The Type 1 cement production decreased from 150 to 125 TPD. formulate a linear optimization model for the following problems. clearly indicating the feasible region.5 Exercise Using just two variables. the proﬁt can at best stay the same. and often it will fall.3 Comment The initial model with its six constraints leads to a solution which creates a (daily contribution to) proﬁt of $1700. the net daily proﬁt will be $225. Each blouse gives a proﬁt of $2. otherwise it will be impaired. In general. Then. the proﬁt fell to $1625. only one of the variables did. 11.4. Tulett Recommendation 173 With the added requirement that the level of Type 1 production cannot exceed twothirds of the total production.c April 28. They can sell at most 190 dresses. while each dress gives a proﬁt of $3. Each garment spends time on three machines as follows: . Solve each model graphically. 2010 D. 11. but the Type 2 cement production increased from 50 to 62. we mean that the OFV will decrease if the objective is maximization. Note that while the proﬁt went down. After deducting ﬁxed costs of $1400 per day. adding another constraint (or making an existing one more stringent) can at best keep the OFV the same.M.

2 Baseball Bat Problem A baseball bat company makes two models. 2010 D. and then keep switching back and forth). 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. Up to 600 Tonnes of softrock can be mined each hour. Each of the ﬁve lathes is available for 55 minutes each hour. and independent of this. Each day. The quarry operator wishes to know how many Tonnes of each type of rock they should produce each hour. The company wishes to determine how many sluggers and whackers should be made each day. 11.3 Quarry Problem Background Note: The density of an object is its mass divided by its volume. The conveyor belt can handle up to 110 cubic metres of rock per hour. and one minute of varnishing. and “hardrock” has a density of 8 Tonnes per cubic metre. 11. and volume is mass divided by density. The company makes $10/Tonne for softrock and $14/Tonne for hardrock. the “slugger” and the “whacker”. then switch over to the other type.M. The woodworking shop operates 16 hours/day. .5. the combined production cannot exceed 980 bats. Each slugger requires four minutes of lathework.5. Two types of rock are mined in a quarry. and the varnishing room is available for 50 minutes each hour. Hence mass is density times volume. The crusher can handle up to 1000 Tonnes per hour when crushing softrock. with one room containing ﬁve lathes.174 c April 28. “Softrock” has an density of 5 Tonnes per cubic metre. The mined rock is crushed and then travels on a conveyor belt. and one varnishing room. (To avoid mixing the two types of rock they will crush one type of rock. Each slugger contributes $5 to proﬁt. and each whacker contributes $6. up to 300 Tonnes of hardrock can be mined each hour. or up to 400 Tonnes per hour when crushing hardrock. Each whacker requires ﬁve minutes of lathework and 45 seconds of varnishing.

for which we shall obtain the data from the WWW. we ﬁnd the following: electronic form of this document is linked to the URLs.1. She wants to minimize her daily cost of buying these things.32.gov/fnic/etext/000105. unsweetened. and then look up orange juice. A real diet shouldn’t contain only these two items. and a serving (249 g) of unsweetened orange juice costs about $0. and condiments) costs about $1. or how many grams per day of protein that a 22 year old woman needs. To make a double hamburger (bun. 1 cup (249 g) size. canned.25. Tulett 175 12 Linear Optimization 2 There are two examples presented here. and to restrict the amount of iron from hamburgers to be no more than 90% of her total iron intake. the URLs are http://www. iron.M. and Vitamin C to meet or exceed the recommended amounts for a woman of her age.nal. and then look up a hamburger.usda.1 12. and (2) juice. For this information. regular. two patties of beef.1 Example – Diet Problem Problem Description This example is made to illustrate linear optimization. 12. The ﬁrst is a minimization example.nal. The web 7 can be used to obtain information about the nutrients contained in food and drinks.usda. she wants the protein. To keep the problem simple. Don’t take it as nutritional advice. If you are viewing this in hard copy. how many grams of protein are contained in a double hamburger. we must look elsewhere. We do searches on: (1) hamburger. with double patty and condiments.html 7 The . and then solve graphically.gov/fnic/cgi-bin/nut search. We do not know. The second example looks at a situation in which the variables must take on integer values. 12. for example.c April 28. but she has decided to make sure that she obtains the recommended daily intake of all vitamins and minerals.2 Formulation The problem as stated doesn’t contain enough information. 2010 D. A twenty-two year old student lives on a diet of double hamburgers and orange juice.1.pl and http://www.

and 60 mg of Vitamin C.547 1. one for each of three nutrients.469x2 grams ≥ 46 grams original source is the Food and Nutrition Board .469 1.National Academy of Sciences.656 Looking for dietary requirements. 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.096 85. Each double hamburger costs $1.25x1 + 0.820x1 grams + 1. Now that we have all the data.176 Nutrient Protein (g) Iron (mg) Vitamin C (mg) Double Hamburger (per 215 g sandwich) 31. Davis).M. The purpose of these three constraints is to ensure that the recommended daily intake (RDI) is met. 1998 (University of California.820 5. The amount of protein consumed each day is: total protein = protein from hamburgers + protein from orange juice = 31. To ensure that she obtains at least this amount we use a ≥ constraint: 31. we go to the Table of 1989 RDA and 19971998 RDI 8 (a pdf ﬁle). hence the objective function is: minimize 1.820x1 grams + 1.25. we see that we need to know the amounts consumed each day. 15 mg of Iron. and look up Female 19-24 to ﬁnd a daily need for 46 g of Protein.469 grams/serving of orange juice × x2 servings of orange juice = 31. we can begin the formulation of the model.469x2 grams Her RDI is for 46 grams of protein. and each serving of orange juice costs $0.32.32x2 We begin with the ﬁrst three constraints. Tulett Orange Juice (per 249 g serving) 1. 2010 D.820 grams/hamburger × x1 hamburgers + 1.075 c April 28. 8 The . Looking at the cost information. For any constraint the units must match up on the left-hand and right-hand sides.

plus the amount from orange juice. We obtain units of milligrams on both sides of the inequality.096x2 which we can re-arrange as 5. 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) . we have the non-negativity restrictions.547x1 ≤ 0.c April 28.547x1 + 1. The constraint for the iron requirement is: 5.M.547x1 . which is 5.547x1 + 1.096x2 ≥ 15 The constraint for the Vitamin C requirement is: 1.469x2 ≥ 46 The iron and Vitamin C constraints are in milligrams rather than grams.9x3 ≤ 0 The total iron intake x3 is the amount from hamburgers. Hence we must have: 5. 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 . which is 1. 2010 D. Therefore. but the idea is the same. we can remove the word grams to obtain: 31.096x2 − x3 = 0 Finally. and hence the word milligrams can be dropped from both sides. Tulett 177 With the sameness of the units on both sides.547x1 − 0.820x1 + 1.656x2 ≥ 60 Now we must restrict the iron from hamburgers to be no more than 90% of the total iron consumed.075x1 + 85.096x2 .547x1 + 1. we must have: x3 = 5.9x3 5.

096x2 x2 − 0.656x2 + .5547x1 − 0.547x1 Vitamin C RDI 1.547x1 + 1. After doing some calculations to revise the Iron Proportion constraint.096x2 ) 5.9(5.656x2 − 0.9864x2 .469x2 + 1. If we wish to solve this problem graphically.32x2 ≥ 46 ≥ 15 ≥ 60 ≤ 0 = 0 0 Protein RDI 31.547x1 non-negativity x1 + 1. 5.9864x2 ≤ ≤ ≤ ≤ 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 1.820x1 Iron RDI 5.32x2 ≥ 46 ≥ 15 ≥ 60 ≤ 0 0 minimize subject to Protein RDI 31.9923x1 − 0.547x1 Iron Balance 5.075x1 Iron Proportion 5. the Iron Balance constraint and the third variable are removed.9x3 5.096x2 + 85.9x3 − x3 .820x1 Iron RDI 5.096x2 + 85.25x1 + 0.178 c April 28. Tulett minimize subject to 1.547x1 Vitamin C RDI 1. x2 ≥ .9864x2 0.5547x1 non-negativity x1 + 1.469x2 + 1. then we will have to imbed the ﬁnal constraint into the Iron Proportion constraint.547x1 − 4. 1.M.075x1 Iron Proportion 0. x3 ≥ The model required no calculations. 2010 D.547x1 − 0.547x1 − 0.25x1 + 0.

If the grid from (0. For example. obtaining x1 ≈ 1.687) Because the origin is false for each of the ﬁrst three constraints. we can think of the context from which the model came.469(3) = 46. and we can hope that it will be less than 3 for both of them.0) (2. 2010 D. We try to ﬁnd where the boundary of every constraint intercepts the axes. We now ﬁnd and highlight the feasible region.820x1 + 1.111. are shown in Figure 44. Hence we set x2 = 3. this would imply that x1 = 3.3) (2.2). we can always expand it later. Hence the two points for this constraint are (1. and solve 31. The objective function is to minimize 1.0) Second Point (1. These four constraints. and connect them with a dashed line.7005) (0. Setting x2 = 0 causes x1 to be about 1.e. Doing this for every constraint we obtain: Constraint Protein RDI Iron RDI Vitamin C RDI Iron Proportion First Point (1.820x1 + 1. stopping at the corner where the . we can see that this solution is feasible.0) to (3.1.0). We then move a rolling ruler over to the feasible region. Mathematically.3) turns out to be too small.0. In this example.307.25x1 + 0.704.469x2 = 46 Setting x1 = 0 causes x2 to be off the 3 by 3 grid. so the arrow points toward this point. upwards and to the left.307. all three arrows point away from the origin. The fourth constraint passes through the origin.1. Since we are trying to minimize the cost.3 Graphical Solution 179 To establish a reasonable scale for the graph. each being a double hamburger and a serving of orange juice. but it is clipped by the boundaries of the grid. we use ﬁnd the intercept on the righthand side (x1 = 3) or top (x2 = 3) boundary instead. i.c April 28.32 on the horizontal axis.M. the boundary of the Protein RDI constraint is 31. which is on the grid.0.32x2 . When this yields a point outside the grid.25 on the vertical axis and 0.307.446.6628) (3. along with their arrows and word descriptions. Tulett 12.3) and (1. such as (0. the feasible region is of inﬁnite size.0) (3. so we try the shortcut of plotting 1. By plugging these values into the four constraints. and x2 = 3.446. This point is true with respect to the inequality. Suppose that she eats three meals a day.3) (0. the solution must be less than 3 for one of the two variables.446. so we test a point which is not on the constraint boundary. Plotting the trial isovalue line is quite easy in this situation.

180 c April 28.5 2.0 1.5 1.5 2.0 Figure 44: Diet Problem – Constraints .5 0 0 0.5 1.0 2. Tulett 3.5 Number of Double Hamburgers 3.M.0 1.0 Number of Servings of Orange Juice Protein RDI 2. 2010 D.0 Iro n t por o r P ion Iron R DI Vitamin C RDI 0.

c April 28.438 of a burger.25(2.5 > 1.25(2.5) = −0. However.096x2 = 9.5 > 2.096x2 = Iron Proportion 0. The objective function value is about $1. .48.5. however. Its daily cost is $1.32(1.4 servings of orange juice per day.5) = $3. and in the Iron Proportion constraint we have: 0.369 By substituting this value into either of the original constraints.369). Iron RDI 5. and repeats this cycle. To answer this question we need to consider the context of the problem.438) + $0.5 cents higher than the theoretical optimal solution.605 which is about 12.32(1. for both the hamburgers and the orange juice.864x2 = 10.369) ≈ $3. The orange juice is not a problem.5) − 0.9 g each.9864x2 = 5.438. all we have to do is make 2 servings of 249/1.438.4 double hamburgers per day. This is shown in Figure 45.5) + $0.5547(2. Tulett 181 boundaries of the Iron RDI constraint and the Iron Proportion constraint intercept. since it’s hard to cook 0.1.547x1 + 5. and 1.5547x1 − 0.369 ≈ 181. For example. We are now ready to make a recommendation.5) is a feasible solution. We can see that the optimal solution lies at about 2. She would average 2.5 servings of orange juice over time. This would certainly meet the requirements of the DRI constraints (2.9864(1. and then eats three hamburgers and drinks two servings of orange juice on the next.09285 < 0 Hence (2.96x2 = 15 0 15 0 15 x2 ≈ 1.369 servings of 249 g each.547x1 + 1. we can interpret the DRI for each nutrient as an average to be obtained over a period of time. 2010 D. we ﬁnd the interception point of the boundaries of the Iron RDI and Iron Proportion constraints. we obtain x1 ≈ 2. The question now arises as to whether we should recommend values for the variables which are not integer.5 double hamburgers and 1. suppose that she eats two hamburgers and drinks one serving of orange juice on one day.547x1 − 0x1 + 1. To ﬁnd the exact solution.M. and 1. The hamburgers are more of a problem. because if we want 1.

2010 D.0 Figure 45: Diet Problem – Optimal Solution 0.0 2.5 Feasible Region Optim al 2. Tulett 3.5 1.5 1.0 1.5 Number of Double Hamburgers 3.182 c April 28.M.0 Number of Servings of Orange Juice Protein RDI 2.0 1.0 n Iro Optimal Solution n tio r o p Pro Iron R DI Vitamin C RDI Trial 0 0.5 2.5 0 .

2.2.605. 12. therefore suppose that the objective is to maximize the value of the load. we will formulate and solve this problem using integer optimization. We will consider the following three situations: (i) both type of boxes are worth $400 each. and then eating three hamburgers and drinking two servings of orange juice on the next.1 Problem Description Two types of big boxes are about to be loaded onto a small cargo plane. a near-optimal solution can be implemented by eating two hamburgers and drinking one serving of orange juice on one day. and repeating this cycle. This gives a daily cost of $3.c April 28.M.9 cubic metres (m3 ). we used an enumerative method to ﬁnd all potential solutions. while a Type 2 box has a volume of 1.8 m3 and a mass of 530 kg. Tulett Recommendation 183 Based on a self-imposed diet of double hamburgers and orange juice. not all the boxes can be put onto the plane. 12. A Type 1 box has a volume of 2.2 Formulation We need to determine how many boxes of each type are carried on the plane. Obviously. (ii) a Type 1 box is worth $600. and then evaluated each of these to ﬁnd the optimal ones.2 Example 2 In the ﬁrst lecture. and a Type 2 box is worth $750. so we deﬁne: x1 = the number of Type 1 boxes carried on the plane x2 = the number of Type 2 boxes carried on the plane . and a Type 2 box is worth $250. we presented the following exercise: 12. and considering only the four stated nutritional requirements. and it has a volume capacity of 15 m3 and a mass capacity of 3600 kg. 2010 D. and a mass of 470 kilograms (kg). There are six Type 1 boxes and eight Type 2 boxes waiting to be loaded. Now. There is only one cargo plane. and (iii) a Type 1 box is worth $300. Back then.

M. we have not only the non-negativity restrictions.8x2 ≤ 15 Next.8x2 Mass 470x1 + 530x2 Type 1 x1 Type 2 x2 non-negativity integer x1 x1 .9x1 + 1. 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. but also the requirement that both variables must be integer.184 c April 28. therefore we have two more constraints: Type 1 x1 ≤ 6 and Type 2 x2 ≤ 8 In this example. . 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. 2010 D. ≤ 15 ≤ 3600 ≤ 6 ≤ 8 0 x2 ≥ x2 . 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. Tulett There are three cases of proﬁt data. By now it should be easy to write this constraint: Volume 2.

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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 ﬁll-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.

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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 ﬁrst 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 ﬁrst 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 coefﬁcients were divided by 200. All this is shown in Figure 50. We identify the

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optimal solution for case (ii) as (5,0), i.e. ﬁve 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) Proﬁt 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 Proﬁt $2800 $3000 $4500

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Figure 50: Cargo Plane Problem – Optimal Solution for Parts (i), (ii), (iii)

3 Fruit Buying Problem Jennifer is making a large fruit salad for a party. Tulett 193 12. Vendor 1 is selling bags containing two pineapples and ten bananas for $3 per bag.3 12.c April 28.3. A litre of orange juice contains 6 grams of protein.3. and only the stated requirements.3. of which at least 420 square metres must be executive quality. but no Vitamin C. No more than 95% of the protein consumed should come from beef. A person needs 54 grams of protein per day. and four times the required daily intake of Vitamin C.2 Diet Problem Suppose that a kilogram of beef contains 600 grams of protein. while downtown space rents for $210 per square metre (per annum). Formulate and solve by the graphical method. In suburbia. but at the least cost possible. They wish to know how much space they should rent in each place. She wants to know how many bags she should buy from each vendor to meet (or exceed) the requirements for the punch. only 30% 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. At the downtown location. Based on these two foods alone. Formulate and solve by the graphical method to determine the best integer solution. and 80 grams of fat. . Formulate and solve by the graphical method. while the rest is ordinary quality. She goes to a nearby fruit stand.M. 12. Space is available in suburbia at a rate of $100 per square metre (per annum). 12. where she ﬁnds two vendors selling bags of mixed fruit. while a litre of orange juice costs $2. A kilogram of beef costs $6. except for pineapples and bananas. and the fat should be between 10 and 60 grams per day. we seek the minimum cost daily diet. No more than three quarters of the entire space is to be at either location.1 Exercises Ofﬁce Rental A company needs to rent space for its ofﬁce employees both in the suburbs and downtown. She needs 12 pineapples. She has everything she needs at home. no fat. Vendor 2 is selling bags containing four pineapples and ﬁve bananas for $4 per bag. 2010 D. and 31 bananas. 60% of the space is executive quality.

For a ≥ constraint.1 Linear Optimization 3 Introduction The two-dimensional world of the previous two lectures is useful for providing an understanding of what linear optimization is about. 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 . the surplus is deﬁned as the value of the left-hand side at the point of optimality minus the righthand side value. that of blending gasoline. At one time. learning the basics of how the simplex algorithm works was a core topic of the compulsory management science course. For example. however. we may fortuitously ﬁnd a solution which is integer anyway. but the one most commonly used is called the simplex algorithm. 13. When solving problems using the simplex algorithm in which some or all of the variables must be integer. the study of this subject is not part of this course. the roll-back procedure for decision trees that we saw earlier is a type of algorithm. Real-world applications may involve thousands or even millions of decision variables. There are purpose-built software packages for optimization (such as LINDO. Again.M. an even more complicated algorithm is needed when some or all of the variables must be integer. but we do want to extend what we can do beyond just two variables. We will look at both types of software. but it has very limited usefulness for practical problems. For example. the slack is deﬁned as the right-hand side value minus the value of the left-hand side at the point of optimality. Tulett 13 13. We won’t be doing anything that big. For a model for which the optimal solution has been computed. The size of this problem requires that it be solved using a computer. 2010 D. To do this requires an algorithm. which is a structured sequential approach for solving a problem. The simplex and branch-and-bound algorithms have been incorporated into software for linear and integer optimization.2 Slack and Surplus For a ≤ constraint. the slack or surplus can easily be found by hand. We conclude with an example which illustrates a particular type of problem for which linear optimization is applicable. There are several algorithms for linear optimization.194 c April 28. to be seen here). This algorithm is called the branch-and-bound algorithm. Usually. and spreadsheets can solve optimization problems as well.

The traditional wording of slack and surplus is maintained by LINDO. The Type 1 Sales constraint is x1 ≥ 40 (or 1x1 + 0x2 ≥ 40). this change is within the range in which the optimal solution is not affected. Since the number on the right-hand side is only 40. if the slack or surplus is 0. if the slack or surplus is greater than 0. the right-hand side value can be increased by up to the amount of the surplus (or be decreased indeﬁnitely) without affecting the optimal solution. The optimal values of x1 and x2 are 150 and 50 respectively. i. x2 x2 2x2 5x2 6x2 x2 ≥ We know that the optimal solution is x1 = 150 and x2 = 50. C Labour 4x1 non-negativity x1 + + + + .5x1 Dept. For a ≥ constraint. All that would happen is that the new slack in Department A would be 35 − 30 = 5. Tulett 195 maximize subject to 8x1 + 10x2 ≥ ≥ ≤ ≤ ≤ ≤ 40 30 200 585 500 900 0 Type 1 Sales x1 Type 2 Sales Total Production x1 Dept.c April 28. Let’s calculate the surplus on the Type 1 Sales constraint. Since the slack is 35. . In general. a decrease of 30. and the slack on the Department A Labour constraint. Knowing the slack or surplus gives information for the easiest kind of sensitivity analysis. For a ≤ constraint. 2010 D. hence the value of the left-hand side of the constraint is 1(150) + 0(50) = 150. A Labour 3x1 Dept. At the optimal solution of (150. then the constraint is binding. but Excel uses the single term slack for both senses. the surplus on the Type 1 Sales Constraint is 110.50) the left-hand side value is: 3(150) + 2(50) = 550 By subtracting 550 from 585. the left-hand side value is 150 − 40 = 110 more than it needs to be. The Department A Labour constraint is 3x1 + 2x2 ≤ 585. then the constraint is non-binding. B Labour 1. the right-hand side value can be decreased by up to the amount of the slack (or be increased indeﬁnitely) without affecting the optimal solution.e. For example.M. suppose that the number of labour-hours in Department A were decreased from 585 to 555. we obtain a slack of 35.

We cannot enter a subscripted variable. click on “Downloads”. We are not required to enter the variable deﬁnitions. and What’s Best!. the date of its creation. each is restricted to eight spaces. then open the zip ﬁle. We do not enter the non-negativity restrictions. or anything else that might make the ﬁle easier to understand when viewing it at a later point in time. 2010) a “Solver Suite” CD which contains a version of LINDO API. Anything on the same line which follows an exclamation mark is ignored by LINDO. For the names of the constraints. It is also possible to buy at an educational price ($25 US as of April 28.M.1 LINDO for Linear Optimization To illustrate the use of LINDO for a linear optimization model (no integer variables). and is both part of the name of the company. because they are not needed to solve the problem mathematically. we may wish to enter them as comments in order to make the LINDO printout easier to understand. blank lines may be inserted at will to help improve the appearance of the ﬁle.com they make available “trial versions” of LINDO and other software.3 LINDO LINDO is a registered trademark of LINDO Systems Inc. On their website at lindo. and the name of its ﬁrst software program. we will use the formulation of the cement problem.3. then in the page with the title “Download trial versions of our products” click on “Download Classic LINDO”. the name of the person who made it. a spreadsheet optimizer. hence x1 and x2 are entered as x1 and x2. LINDO is also available as a subset of LINGO 11.) This free version is of course the least powerful version of the software. we enter <= and >= instead. (LINDO API is a different kind of software. Comments could also be made to give the name of the model. Some adjustments have to be made because of the limitations of the keyboard. Tulett 13. 2010 D. but it is nevertheless more than adequate for anything in this course.0 for Windows.. and must be followed by a right parenthesis – this restriction has resulted in making modiﬁcations to the names given in the algebraic model. Also. To obtain the version that is appropriate for this course. There are several shortcuts available (not used here) such as just typing st instead of . LINDO was one of the ﬁrst programs of its type to address the educational as well as the commercial/industrial market. because they are always assumed to be present. LINGO.196 c April 28. However. since there are no ≤ or ≥ symbols on the keyboard. 13. Also. A comment is made by ﬁrst typing an exclamation mark.

This leaves a box called LINDO Solver Status. We could call it cement. Further information is available from the LINDO Help menu. 2010 D.5x1 + 5x2 <= 500 Labour C) 4x1 + 6x2 <= 900 This ﬁle can be saved using a . 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. and release the mouse button under Solve (the ﬁrst line of the menu). for example. the output is always in capitals): . This action causes LINDO to solve the model. and release the mouse button under Reports Window.Prod) x1 + x2 <= 200 Labour A) 3x1 + 2x2 <= 585 Labour B) 1.ltx. and then LINDO asks DO RANGE(SENSITIVITY) ANALYSIS?. We close this box. For now. which should say Optimal under Status. and go to the Window menu. click on No.M. Doing this we obtain the following (whether the input be small or capital letters. 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.ltx extension.c April 28. Tulett 197 subject to. We then go to the Solve menu.M.

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. Tulett LP OPTIMUM FOUND AT STEP 3 OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 1700.000000 REDUCED COST 0. 2010 D.000000 1.PROD) LABOUR A) LABOUR B) LABOUR C) SLACK OR SURPLUS 110. and OFV∗ = 1700. The other information provided by this output is in the column labelled Slack or Surplus.000000 0.000000 NO. ∗ = 150. LINDO would have numbered them as rows 2) to 7). x∗ = 50.M. and we shall not use this information. Other than the substitution of the word minimize for maximize.000000 35.000000 0. there is no . and so on.000000 20.000000 4. Had we not named the constraints. 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.000000 0.000 VALUE 150.000000 0. It Clearly. For a non-binding constraint.000000 0.000000 50. ITERATIONS= The ﬁrst and last lines give us a measure of how much work the computer did to ﬁnd the optimal solution – this is of technical rather than managerial interest.000000 0.000000 3 DUAL PRICES 0.000000 ROW SALES 1) SALES 2) TOT. The 1) which appears after Objective Function Value refers to the fact that LINDO numbers the objective function as row 1. The columns marked Reduced Cost and Dual Prices will be explained in the next lecture.000000 25. and internally calls the ﬁrst constraint row 2.198 c April 28.

c April 28. go to the Report menu and release the mouse on Solution. There is a shortcut in which we could enter gin 2 to declare the ﬁrst two variables found to be integer.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. we write gin x1 followed by gin x2.M. .9x1 + 1. 2. To illustrate. but care must be taken for a model in which some but not all of the variables are required to be integer. In models with many variables. Using the ﬁrst objective function variation. 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 2.3. This shortcut would work well here. we use the gin command. A dialog box will appear with a radio button to indicate that only nonzeros should be reported. 1. and there’s usually one more step to obtain the solution. For an integer variable which can take on values 0. After the model has been entered up to the last constraint.8x2 Mass 470x1 + 530x2 Type 1 x1 Type 2 x2 non-negativity integer x1 x1 . and so on. it is likely that many of them will have optimal values of 0. the model is entered into LINDO as: . 13. To suppress the printing of these variables. ≤ 15 ≤ 3600 ≤ 6 ≤ 8 0 x2 ≥ x2 LINDO has an integer command. 2010 D. but this is used to declare 0 and 1 to be the only possible variables. Tulett 199 special procedure required to handle a minimization model. 3.

M.9x1 Mass) 470x1 + Type 1) x1 <= Type 2) x2 <= end gin x1 gin x2 + 1.000000 -400. OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 2800.8x2 <= 15 530x2 <= 3600 6 8 Solving using the same procedure as before we obtain: LP OPTIMUM FOUND AT STEP 2 OBJECTIVE VALUE = 2813.000 DELETE X1 AT LEVEL 1 ENUMERATION COMPLETE..000000 . Tulett Analyst: D.000000 REDUCED COST -400. BRANCHES= 1 PIVOTS= 12 LAST INTEGER SOLUTION IS THE BEST FOUND RE-INSTALLING BEST SOLUTION.M.000 VALUE 2.99976 AT BRANCH BOUND ON OPTIMUM: 2800. 2010 D.. 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. TWIN= 2600.200 ! Cargo Plane Model c April 28. BND= 2800.000000 5.31396 SET X1 TO <= 2 AT 1. 1 PIVOT 12 12 NEW INTEGER SOLUTION OF 2799.

It begins with some technical information about how the solution was obtained.000000 3.000000 0. it is useful to delete the complete report and ask for the “Solution” under the Reports menu. but then describes the solution as it would for a problem without integer variables.000000 4.000000 0.000000 201 NO. ITERATIONS= 12 BRANCHES= 1 DETERM. so this report is ﬁne as it is.200000 10.M.000000 4.000000 REDUCED COST -400. In this example. and what is worse the optimal solution might not be at the end.000E 0 This example is very small. in a large example the amount of technical material can be enormous. Tulett ROW VOLUME) MASS) TYPE 1) TYPE 2) SLACK OR SURPLUS 0.000E 0 Note that the concept of a “binding constraint” does not apply when integer variables are present. Because of this.000000 0. Again.= 1.000000 0.000000 DUAL PRICES 0.c April 28. Doing this gives: OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 2800. 2010 D.000000 DUAL PRICES 0. no constraint has a slack of 0.200000 10. it .000000 -400.000000 3.000000 5. ITERATIONS= 12 BRANCHES= 1 DETERM. but instead be buried somewhere in the middle.000000 NO.000000 ROW VOLUME) MASS) TYPE 1) TYPE 2) SLACK OR SURPLUS 0. However.000000 0. The reason for this is that the software often cannot tell that it has the optimal solution until more potential solutions have been examined.= 1.000000 0.000 VALUE 2.

there is the numerical information of the problem. To illustrate the second and third types of information. the size of the worksheet will be much larger than the size of the monitor. x3 . Thirdly. On a spreadsheet. Labels are used to help make the model understood to the user and other persons who may look at the spreadsheet. but would have to be deﬁned as an array. 2010 D. However. A spreadsheet may make sense when the data is already in spreadsheet form. We present a brief overview here. Secondly. there is also a column which gives the direction of the inequality of the constraints. there are formulas. but they are simply labels. a row for the coefﬁcients (numbers) of the objective function. First of all. 4. Also. To use a spreadsheet we would input the numbers in one row. and a row for the coefﬁcients of each of the constraints. but then return to LINDO exclusively. 13. or = for an equality constraint. x∗ = 5. and leave space for the variables in another row. 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. entering the model is much slower on a spreadsheet than it is with a dedicated program such as LINDO. Hence we have a row for the variables. the syntax can be found using the Excel Help menu.10 The set of variables is used by the objective function and by every constraint. The objective function can easily be altered to solve parts (ii) and (iii). However.4 Optimization using Spreadsheets Spreadsheets (which are really a multi-purpose mathematical tool) can be used for optimization. The user begins by entering three types of information. such as “Tonnes per Day” and “Total Production”. 10 The .M. there are labels. Tulett ∗ = 2. x4 ). be it <= to mean ≤. for anything but very small models. −6. 3) and a vector of variables (x1 . It should also be noted that the SUM function could do this calculation. This function can also handle more than just a dot product.202 c April 28. 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. making data entry even more difﬁcult. Some of these labels are obvious. the dot product of two rows is made using the SUMPRODUCT function (discussed in Mathematics for Management Science). These may appear to be commands. or >= to mean ≥. The value calculated by the SUMPRODUCT function goes to the right of the left-hand side data. Any cell containing a label has no effect on the calculations. x2 .

and we also use this function to calculate the numerical value of the left-hand side of each constraint. If the solver has not already been installed. The formula for cell A3 is =SUMPRODUCT(B4:C4. As an example. we use the model which we developed for the cement company. but if needed a Solver tutorial is available from Frontline Systems. Inc. and ﬁnally on the extreme right we enter the right-hand side value of the constraint. we can enter the SUMPRODUCT function for the OFV using absolute labels for the range containing the variables. To save work. A Labour Dept. In the spreadsheet which follows. To do this. The overview provided here should be sufﬁcient. These numerical values must obey the relationship of the constraint. and the cells for which the copy command should be used are highlighted in blue. 2010 D.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. the installation in Excel 2007 is accessed as follows: • Click on the “Ofﬁce Button” (top left of the screen). We calculate the OFV by using the SUMPRODUCT function. copy D8 copy D8 copy D8 copy D8 copy D8 >= >= <= <= <= <= RHS 40 30 200 585 500 900 In optimizing a model.5 4 0 1 1 2 5 6 =SUMPR. .c April 28. maximize Tonnes per Day Constraints Type 1 Sales Type 2 Sales Total Production Dept.. which is used in Mathematics for Management Science for nonlinear functions.M.com. 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.. the cells which are reserved for the variables are highlighted in yellow. at solver. we let Excel choose the values of the variables. and then copy the formula to where it is used by the constraints.. Tulett 203 label indicating the direction of the inequality goes to the right of this. we need to use the spreadsheet Solver ..

or ≥) between these two cells. 11 A . =. though it’s not required for any of the models in this document. When the computer tries to solve a poorly scaled model. under “Options”. the optimal cell in Lotus 1-2-3. Tulett • A pop-up box appears. the Solver should be ready to be used. the cell which is to be optimized (called the target cell). For technical reasons. and below click on “Go”.] 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.M. but other brands of software use different names. and the what-if cells in What-If Solver. specifying the relationship (≤. [OpenOfﬁce uses the same terminology as Excel. click on “Add-Ins”. the adjustable cells in Lotus 1-2-3. the constraints. • A new box appears. a range of cells which the computer may vary. click on Solver add-in. 2010 D.g. or ≥) can be entered as a range rather than specifying each one separately. maximization) 3. which is the cell which will contain the OFV) 2. Doing the former invokes the appropriate solution procedure for this type of problem. the user needs to click on “ Assume Linear Model ” and “ Assume Non-Negative ”. On the left. the range of cells reserved for the values of the variables (called the changing cells). In the Solver window. • Under Add-ins. doing the latter enters the non-negativity restrictions.204 c April 28. then Analysis. then Solver). Constraints which are next to one another of the same type (≤. The cell to be optimized is called the solution cell in Quattro Pro. it might be also useful to click on “ Use Automatic Scaling ”. 000x1 + 195. the spreadsheet’s solver is invoked (in Excel 2007 click on Data. Click on “Excel Options” at the bottom of the box. 000x2 ≤ 2.e. i. The user speciﬁes the following: 1. for example if one constraint is 2x1 + 5x2 ≤ 41 while another is 450. =. 000. After entering the model. 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. • After a minute or so. 715.11 model is said to be poorly scaled when the coefﬁcients of one row are very much greater than those of another. the objective (e. and 4.

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.5 13. 29-55. 13. on each constraint. A. 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. and A.c April 28. the objective is maximization.5. the user enters a range under “Constraints” and declares the range to be int. if any. For a model in which some or all of the variables must be integer. Interfaces. A Labour Dept. “Design and Use of the Microsoft Excel Solver”. the target cell is A3. Waren. cell A3 contains the optimal OFV of 1700. and the changing cells are in the range B5:C5. . pp. the values of all the variables.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. C Labour B Cement x1 Type 1 8 150 C Model x2 Type 2 10 50 D E F 1 0 1 3 1. Automatic rescaling helps eliminate such problems. and the slack or surplus (described simply as “slack”). Flystra.M. B Labour Dept. and D10:D13 ≤ F10:F13.1 Blending Problem Problem Description A small gasoline blending operation called Blendex buys gasoline from four nearby reﬁneries. Lasdon. Watson. J. See D. 2010 D. Tulett 205 For this example. These are then blended to make three commercial products: low-octane it may experience numerical problems in ﬁnding the optimal solution. 28:5 September-October 1998. The user can request an “Answer Report” which will give the value of the target cell (the OFV). The constraints are entered as D8:D9 ≥ F8:F9.

Though consumers buy gasoline by the litre. after that time. Each week the Blendex operation can handle up to 500 cubic metres of gasoline in total. leaving a few minutes for Blendex to conﬁrm what they are buying from the four reﬁneries. $600 for high-octane gasoline. The (minimum) octane requirements are 86 for low-octane. The octane rating of a blend of gasolines is approximately the weighted average of the octane ratings of the inputs to the blend. and $700 for propeller-driven aviation fuel.M. and fuel for propeller-driven aircraft. 2010 D. 92 for highoctane. the octane rating of the 20 + 30 = 50 cubic metres is about: 20(80) + 30(100) = 92 20 + 30 It’s Saturday afternoon and the Blendex planning ofﬁce must decide what it wants to receive by truck on Monday morning. They have about 45 minutes to come up with a plan. They are given: the octane rating of the gasoline available. These quotes are valid for one hour. Every week someone from Blendex contacts the four reﬁneries to see what they have to sell. the reﬁneries are free to sell to anyone. and 105 for fuel for propeller-driven aircraft. Tulett gasoline for cars. high-octane gasoline for cars. these companies quote prices and quantities by the cubic metre (equivalent to 1000 litres). or all of what each reﬁnery has to sell. some. Based on all this information. each with a capacity of 260 cubic metres. if 20 cubic metres of 80 octane gasoline is mixed with 30 cubic metres of 100 octane gasoline.206 c April 28. Blendex obtains the wholesale market prices for the three types of gasolines. For example. They have just received the following information: Reﬁnery 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. There are three storage tanks. . Blendex can decide to buy none. and the price per cubic metre. the quantity available in cubic metres. At about the same time each week. so this becomes the upper limit for the production of any one type of gasoline.

In a problem like this. B. B. and the second indicating the output gasoline. For example. high-octane. Keeping this pattern going we have 4(3) = 12 variables with double-letter names. They must also decide how much to make of each product. AP. For example. To determine the octane ratings of the ﬁnal products. BL. A volume balance on the gasoline from each reﬁnery is also needed. AL. and DP represent the number of cubic metres of gasoline from source {A. The objective function is: maximize 570L + 600H + 700P − 350A − 400B − 450C − 600D If we assume that no gasoline is wasted.2 Formulation and Solution 207 We could start naming the variables for this problem as x1 . and Deluxe Gasoline respectively. CH. AH. we need to know how much gasoline comes from each source. where there are both revenues and costs. C. H. 2010 D. Tulett 13. Hence we let A. we can denote this unknown with two letters. and propeller-driven aviation fuel made respectively. or D} used to make output {L.5. CL. and D represent the number of cubic metres of gasoline purchased from A-One Petroleum. so we let L. the total of the amounts of gasoline from the four reﬁneries used to make low-octane gasoline becomes the amount of low-octane gasoline made. Clearly Blendex must decide how much gasoline to buy from each of the four sources. and so on. BP. and L with low-grade gasoline. x2 . BH. H. 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.M. C. CP. or P}. We can summarize this by saying that AL. but instead we will name them so that it will be easy to recall what each variable name means. the ﬁrst letter indication the input gasoline. for the gasoline from the ﬁrst reﬁnery we must have: . Clearly Superior. we subtract the costs from the revenues to make a proﬁt maximization model. Better Grade Fuels. DL. DH. Since A is associated with A-One Petroleum. x3 .c April 28. P represent the number of cubic metres of low-octane. we need to know how much gasoline from A-One Petroleum is used to make low-octane gasoline.

Hence we must have 81AL + 87BL + 98CL + 115DL ≥ 86 AL + BL + CL + DL The denominator is simply L.12 and so on. Tulett ! A.M. Doing this we obtain: ! Blending Model Analyst: D. B. the octane rating of the low-octane gasoline must be at least 86. we need a constraint for each product to ensure that the minimum octane rating is met. C. We require four constraints for the amount available of each input (A ≤ 280. but we can make it so by multiplying both sides by L (doing this also avoids a potential division by 0 problem). 12 As . Better mentioned in Linear Optimization 1. and one more constraint for the total production (L + H + P ≤ 500). For example. To solve this model using LINDO we need the complete algebraic model. and so on).208 c April 28. However with what we have done so far we can develop the algebraic model directly on LINDO. This gives: 81AL + 87BL + 98CL + 115DL ≥ 86L Finally. and D represent the number of cubic metres ! of gasoline purchased from A-One Petroleum. Finally. 2010 D. and there are three constraints for the outputs individually (L ≤ 260). Tulett AL + AH + AP − A = 0 Similar constraints are required for the other three input gasolines. 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.M. hence we have 81AL + 87BL + 98CL + 115DL ≥ 86 L The constraint as it stands is not linear. we write these three constraints using three lines. the shortcut that we used for the non-negativity restrictions is not used for the constraints. to put the constraint into the standard form in which all variables are on the left-hand side.

and DP represent the number ! of cubic metres of gasoline from source {A. BH. or ! D} used to make output {L. DL. Tulett 209 ! Grade Fuels. CP. CL. C) CL + CH + CP .P = 0 ! Balance on the Inputs Bal. H. A) AL + AH + AP . H. 2010 D.C = 0 Bal. P) AP + BP + CP + DP . L) AL + BL + CL + DL .400B .D = 0 . AH. AL. CH. P represent the number of cubic ! metres of low-octane. D) DL + DH + DP . maximize 570L + 600H + 700P .350A . and propeller-driven ! aviation fuel made respectively. Clearly Superior. C.c April 28. or P}.450C . H) AH + BH + CH + DH .L = 0 Bal. high-octane. and Deluxe Gasoline ! respectively. B) BL + BH + BP . ! BP.H = 0 Bal.600D subject to ! Balance on the Products Bal. AP. L. B. BL.M.B = 0 Bal.A = 0 Bal. DH.

000000 REDUCED COST 0.352936 200. 2010 D. Tulett ! 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 .000000 240.000000 0.210 ! Input Availability Input Input Input Input A) B) C) D) A B C D <= <= <= <= 280 400 200 130 c April 28.M.000000 0.23 VALUE 260.000000 192.92H >= 0 Octane P) 81AP + 87BP + 98CP + 115DP .000000 .000000 0.105P >= 0 Solving we obtain (only the non-zero variables and the binding constraints are listed): OBJECTIVE FUNCTION VALUE 1) VARIABLE L P A C 94288.86L >= 0 Octane H) 81AH + 87BH + 98CH + 115DH .

000000 9.000000 0.647057 0.000000 0.000000 211 ROW BAL.000000 0.353.000000 475.352941 NO. and Deluxe Gasoline as follows (all ﬁgures are in cubic metres): . L) BAL.823529 123. Clearly Superior.000000 9 DUAL PRICES 245. but stating that none will be purchased this week. and 107.000000 0.000000 0.000000 0.588242 245. The recommendation could be stated as follows: Recommendation Produce low-grade gasoline and aviation fuel by blending fuel from A-One Petroleum.647 cubic metres respectively.c April 28.000000 0. B) BAL. For their own production crew which must blend the gasolines.529419 -7. H) BAL.000000 0. They send emails to A-One Petroleum.000000 400.000000 600. ITERATIONS= Blendex’s immediate concern is to notify the suppliers of what they want to buy.000000 0.000000 0.588242 350.M. 2010 D.000000 25.352941 -7.000000 0. more information is required. Clearly Superior.000.705882 173.000000 0.647057 183.470589 8.000000 0. Better Grade Fuels is sent an email thanking them for their bid. and Deluxe Gasoline conﬁrming the amounts as 192.000000 0.000000 0.529419 76.000000 0. Tulett D AL CL AP CP DP 107.352941 -7. P) BAL. A) BAL.529411 107. 200. C) BAL.588242 245. D) INPUT C) OUTPUT L) TOTAL) OCTANE L) OCTANE H) OCTANE P) SLACK OR SURPLUS 0.000000 0.

They wish to use a linear optimization model to help determine what they should do.1 Exercise Problem Description A woodworking company buys lumber from which they make tables and chairs.000 The contribution to proﬁt based on this plan is $94.000 Total 192.23. and assembly. When painting tables.824 123. and one person to do the assembly. and sell the ﬁnished products. There are three cutting machines. Tulett Aviation Fuel 8. the shop is available for six hours of productive time.6.M. The painting ﬁrm charges $54 per hour.471 – 260. Each product spends time in three operations: cutting. polishing. The woodworking company sells its products to a wholesaler at $90 per table and $28 per chair.2 Decision Variables We deﬁne (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 . 2010 D.529 76.353 200. while each chair requires 4 board-metres. when painting chairs.529 107.212 Source A-One Petroleum Clearly Superior Deluxe Gasoline Total Low-Grade 183. The times in minutes per unit are: Cutting Table 45 Chair 18 Polishing 12 7 Assembly 15 9 Each day.000 c April 28.647 500.6.6 13. one polisher.288.000 107. they can paint 6 tables per hour. The market requires that at least four chairs be made for every table made.647 240. 13. They then outsource the painting of the tables and chairs. 13. they can paint 20 chairs per hour. They buy the lumber at a cost of $2 per board-metre. Each table requires 30 board-metres of lumber.

6.6. The variable names given above are to be used for the algebraic model. 13. since we can use a computer to solve the model.4 What Needs to be Done Finish this problem by completing the algebraic model. this advantage is not all that important. Tulett 13. which would allow for a graphical solution.g.3 Discussion 213 We are modelling this problem using the four variables as deﬁned above.c April 28. Alternatively. As always. a problem like this could be modelled with just the two product variables. 2010 D. because this preserves the original data of the problem. and then obtain the optimal solution by solving it using either LINDO or a spreadsheet. If you decide to use a spreadsheet. Also.M. so if later a price changes (e. words instead of symbols (e. . We are better off modelling this problem with four variables. if the painting cost goes from $54 to $56 per hour) we can more easily determine the effect of this change. by using four variables we avoid a potential calculation error which could occur when calculating the objective function coefﬁcients of the two-variable version. “Tables Made” instead of “T”) may be used. However.g. report the solution so that a manager can understand it.

For a small model. however. this could be done in seconds on a computer. The explanation which follows is based on the usual situation in which there is a unique nondegenerate optimal solution. However.13 We could.214 c April 28. we can ﬁnd this effect on the computer by re-running the model with these multiple changes. sensitivity analysis in the presence of integer variables is essentially meaningless. there is more output available. 13 The . run an altered model every time a proposed change was made. Earlier in this course we did sensitivity analysis by hand for solutions obtained using a payoff matrix. Also. Sensitivity analysis by hand in the context of linear optimization can be done using either graphical solutions or the ﬁnal iteration of the simplex algorithm. Here in this course. Everything that we are doing here assumes that none of the variables is required to be integer . the variables turn out to be integer without forcing them to be integer). Analyzing the effect of two or more concurrent changes is beyond the scope of this course. However. computer output is still valid for non-usual cases in the sense that within the allowable range the predicted change is correct. Tulett 14 14. Except for problems which are naturally integer (i.1 Linear Optimization 4 Introduction In the previous lecture we saw the terms reduced cost and dual price on the LINDO output. we are looking at predicting the effect of a single change to the model at one time. In what follows.M. we would need to re-run the model if a proposed single change falls outside of the allowable range (deﬁned below) and if we desire the exact change to the OFV. Also. the reported allowable range might understate the true range. which is obtained by answering Yes when prompted with the question “DO RANGE (SENSITIVITY) ANALYSIS?”. 2010 D. for large models. however. which now need to be explained. of course. we shall simply use the LINDO output to give us the data we need to answer some managerial what-if questions.e. 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.

so it is useful to consider separately the variables which have optimal values greater than 0 from those variables whose optimal value is 0. suppose that a variable with an objective function coefﬁcient of 7 has an optimal value of 0. This reduction in cost must be at least the amount given by the reduced cost. If increasing the coefﬁcient to 10 would cause the variable to start increasing from 0.M. then the coefﬁcient would have to fall below 3 in order for the variable to become part of the solution.c April 28.e. when we studied how to optimize a non-linear function subject to an equality constraint. 14. in a maximization model. The reported numbers are the same in magnitude. but are opposite in sign. then the magnitude of the required change in the coefﬁcient is 3. Just as we consider separately the binding and non-binding constraints. The former we call solution variables (or variables in the solution).2 Reduced Cost The term reduced cost was originally developed for minimization models. the Solver in Excel and LINDO treat the reduced cost concept differently. to make the variable part of the solution. Tulett 215 14.2. For example. The idea is that a variable has a value of 0 because the cost is too high.1 New Concepts Solution and Non-Solution Variables When we run anything other than a very small model we are likely to ﬁnd that some (and indeed many) of the variables have an optimal value of 0. For example.2 14. 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. 2010 D. but LINDO would report it as 3. The latter we call non-solution variables (or variables not in the solution). Dual and/or shadow prices provide something similar in the context of linear optimization . However. both the Solver in Excel and LINDO will ﬁnd the same value for the reduced cost associated with each variable. we saw the concept of a Lagrangian multiplier.2. if a variable has an objective function coefﬁcient of 5 and a reduced cost of 2. To make the value greater than 0. 14.3 Dual Price and Shadow Price In Mathematics for Management Science. the objective function coefﬁcient of that variable needs to be reduced. In a minimization model.2. Excel would report the reduced cost to be −3. i.

then you’ll make an extra $3(150) = $450. For changes to the coefﬁcient within the allowable range. and decrease for a minimization model. and the allowable decrease equals the reduced cost. 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 allowable increase equals (theoretically) the reduced cost. 2010 D. There’s nothing profound about this – if instead of selling 150 books at $20 per copy you sell 150 books at $23 per copy. For a variable which is in the solution. and the allowable decrease is inﬁnite. the change in the OFV will equal the change to the coefﬁcient multiplied by the current value of the variable. the allowable increase or decrease may be inﬁnite. for a minimization model they are opposite in sign. and there is no change to the OFV. a nonbinding constraint always has a dual or shadow price of 0. This allowable range could be given as absolute upper and lower limits. For a non-solution variable in a minimization model. the allowable increase is inﬁnite. However. most sellers cannot by themselves raise the price of anything. spreadsheets use shadow prices.2. 14. Tulett (though the sign may be reversed).216 c April 28. we are looking at what happens to the OFV if in the market as a whole the price rises or falls.4 Allowable Range The computer will ﬁnd an allowable range for both objective function coefﬁcients and right-hand side values. there will be an allowable range for changes to its objective function coefﬁcient in which the values of the variables do not change.M. The word allowable has nothing to do with granting permission. but LINDO’s approach is to report both an allowable increase and an allowable decrease compared with the current value. A dual or shadow price can only be non-zero for a binding constraint. Within the allowable range. there is no change to the values of any of the variables. What it gives instead is a range in which changes to the model occur in a predictable manner. the change in the objective function coefﬁcient will change the OFV. Within an allowable range. Sometimes. Of course. . The terms dual price and shadow price mean the same thing for a maximization model. However. Dual prices are used by LINDO. the dual price gives the improvement in the OFV per unit change in the right-hand side value of the constraint. Changes to the Objective Function Coefﬁcients For a non-solution variable in a maximization model. Improvement means increase for a maximization model.

we consider the easier case of a non-binding constraint. the values of the variables will remain the same. For a binding constraint. (If a constraint is made more stringent it could eliminate the feasible . we must have: − allowable decrease ≤ ∆ rhs ≤ allowable increase On LINDO. As was mentioned in the previous lecture. Within the allowable range. all it does is predict the change to the OFV. Suppose that the change (increase or decrease) to the right-hand side value is an amount called ∆ rhs. and therefore also the OFV. Since the allowable decrease is reported as a positive number. where ∆ rhs is in the allowable range. 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. 2010 D. or be decreased indeﬁnitely. and the OFV will remain the same. Tulett 217 Changes to the Right-Hand Side Values First.M. or be increased indeﬁnitely. We denote the change in the OFV as ∆ OFV. the output reports the dual price.c April 28. the effect on the OFV is a predictable one. a change to the right-hand side value will change the values of the variables. the right-hand side value of a non-binding ≤ constraint can be decreased by up to the amount of the slack. 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. we can establish bounds on this number. However. provided that the model remains feasible. The right-hand side value of a non-binding ≥ constraint can be increased by up to the amount of the surplus. 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. within the allowable range.

The chemical company has made the following proﬁt-maximization model: maximize subject to conveyor) shipping) min. and asking for the sensitivity analysis.3 Example 1: Maximization A chemical laboratory can make three types of chemical powders. x2 . 2010 D. if ∆ rhs > allowable increase.218 c April 28.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. we obtain: . Tulett region. The variables x1 . thereby making the model infeasible. then: ∆ OFV ≥ (dual price)(allowable increase) If the ∆ rhs < − allowable decrease. then: ∆ OFV ≥ − (dual price)(allowable increase) If the ∆ rhs < − allowable decrease. 14.) For a maximization model.M. if ∆ rhs > allowable increase. then: ∆ OFV ≤ − (dual price)(− allowable decrease) These concepts are now illustrated using three examples. The ﬁrst two are quite simple. while the third is the more complex blending model which we saw in the previous section. then: ∆ OFV ≤ (dual price)(− allowable decrease) For a minimization model. and x3 represent the number of kilograms per day of the three chemicals.

000000 140.000000 0.000000 11.666664 2.000000 .000000 11.230774 565.590908 INFINITY 56.PROD) MIXING) SLACK OR SURPLUS 0.000000 RIGHTHAND SIDE RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 990.000000 18.000000 ROW CONVEYOR) SHIPPING) MIN.714294 VARIABLE X1 X2 X3 CURRENT COEF 32. Tulett 219 LP OPTIMUM FOUND AT STEP 2 OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 X3 3600.000000 800.000000 2 DUAL PRICES 0.000 VALUE 90.000000 110.000000 ROW CONVEYOR SHIPPING MIN.000000 INFINITY 230. 2010 D.000000 880.PROD MIXING CURRENT RHS 550.000000 360.863636 NO.000000 0.590909 0.000000 25.000000 230.000000 40.363636 0.000000 REDUCED COST 0. ITERATIONS= RANGES IN WHICH THE BASIS IS UNCHANGED: OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 4.000000 140.c April 28.860464 11.000000 0.000000 INFINITY 389.M.000000 3.

139536.860464 = 20. and 40 kg per day of powder 3. (c) increases by $15. and the allowable decrease is 11. they would still make 90 kg per day of powder 1. The slack on the conveyor and mixing constraints is zero. or if it were to fall to 32 − 11. From the OBJ COEFFICIENT RANGES section of the sensitivity report. (b) increases by $9.220 c April 28. 2010 D. hence these are the binding constraints. The price of powder 2: (a) decreases by $18. In other words. and we therefore cannot predict the new value of the OFV exactly. if we wanted to know the new value exactly. 3. the current price of $25 per kg isn’t high enough to justify making any quantity of powder 2. we would obtain the same solution even if the coefﬁcient were to rise from 32 to 32 + 4 = 36. which is currently $32 (don’t confuse this with the value of the variable itself. The solution variables are therefore x1 and x3 . it would fall from $3600 to $2700. which is a solution variable. which is 90 kg). 14. However. 2. We could also state this as ∆ OFV = −$900.1 Changes to the Objective Function Coefﬁcients We consider what happens to the OFV in each of the following situations: 1. we can state that the new OFV will be at least what it would be based on the allowable increase.e. An increase of 4 would cause the proﬁt to increase by $4(90) = $360. Tulett We see that the solution is to produce 90 kg (all units are per day) of chemical 1. i. The price of powder 3: (a) increases by $30. none of chemical 2. Hence a decrease of $10 (which is ≤ 11. Variable x2 is not in the solution.3.860464) would have no effect on the solution. Ordinary logic therefore tells . and 40 kg of chemical 3. A rise of $5 (> 4) is beyond the allowable increase. (b) increases by $5. we see that the allowable increase is 4. The proﬁt obtained using this production plan is $3600.M. The price per kg is the coefﬁcient of this variable. The amount of powder 1 made and sold is represented by variable x1 .860464. the OFV would decrease by $10(90) = $900. i. ∆ OFV ≥ $360. The price of powder 1: (a) decreases by $10. We would have to re-run the model on the computer replacing the 32 with 37. so we would obtain a new solution. (b) decreases by $7. However. hence an increase of 5 would cause an increase of at least this much.e.

M. then ∆ OFV ≤ −$80. Note that the allowable decrease is inﬁnite. (c) increases by 275. (b) decreases by 800. and the OFV would increase. they would still make 90 kg per day of powder 1. In other words. hence a decrease of 7 would cause a decrease of at least this much. However. (c) decreases by 300. and there would be no change to the solution. The rhs of the mixing constraint: (a) decreases by 330. 3. there would be no change to the OFV. If however the price were to rise by $15 per kg.c April 28. because we are not making any powder 2. 2010 D. The current coefﬁcient of this solution variable is $18. but neither of these things could be quantiﬁed without re-running the model. and 40 kg per day of powder 3. (c) increases by 550. The rhs of the shipping constraint: (a) decreases by 100. For a price increase. and the allowable decrease is 2. we would obtain the same solution even if the coefﬁcient were to fall from 18 to 2 = 74 2 18 − 2 = 16. We must be careful with the inequality here. This ﬁgure is seen to be 11. The solution would change. or if it were to rise to 18 + 56 3 3 . Hence an increase of $9 per kg is less than the allowable increase. Hence if the change is say $80 or more downwards. 2. we cannot determine what will happen by logic – we need to look at the allowable increase from the sensitivity report. the magnitude is at least $80.590908. .2 Changes to the Right-Hand-Side Values We consider what happens to the OFV in each of the following situations: 1. We see from the printout that the allowable increase is 56 2 3 . The new OFV will be at most what it would be based on the allowable decrease. so we would obtain a new solution. 14. this would surpass the allowable increase. a decrease in the price of $18 per kg does not change either the solution or the OFV. Hence an increase of $30 2 (which is ≤ 56 3 ) would have no effect on the solution. The rhs of the minimum production constraint: (a) increases by 150.3. A decrease of $7 (> 2) is beyond the allowable decrease. Tulett 221 us that a price decrease is not going to change anything. The amount of powder 3 made and sold is represented by variable x3 . Furthermore. 4. (b) decreases by 600. The right-hand side value (rhs) of the conveyor constraint: (a) decreases by 100. A decrease of 2 in the rhs would cause the proﬁt to decrease by $2(40) = $80. the OFV would increase by $30(40) = $1200. (b) increases by 200. (d) increases by 1200. (b) increases by 110.

2010 D. An increase of 1200 would exceed the allowable increase of 990. To see the effect on the OFV. an allowable decrease of 565.363636. . so the sensitivity analysis is very easy.230774.363636(550) = $200. We see from the sensitivity report that this constraint has an allowable increase of 990 and an allowable decrease of 110.3636 = 3563. then there is no change to the OFV. The minimum production constraint has an allowable increase of 140. It has an allowable increase of 389. A decrease of 600 would be beyond the allowable range.36. the OFV would fall by at least 3. If the proposed change is within the allowable range.363636(−100) = −36.00. and a dual price of 3. though we cannot predict by how much. The rhs of the shipping constraint can be increased indeﬁnitely or be decreased by up to 230. An increase of 275 would be within the allowable range.863636. A decrease of 800 would be beyond the allowable decrease of 110.64. Hence a decrease of 330 is within the allowable range and the OFV will fall by 3. it would decline for a maximization model. i.e.714294.363636(990) = $360. While the new solution is not easily found without re-running the model. The shipping and minimum production constraints are non-binding. the change to the OFV is easy to predict within the allowable range. An increase of 150 would cause the OFV to fall.863636(565.71. so the OFV would increase by at least 0. Tulett Since the conveyor constraint is binding.50. Hence a decrease of 100 is within the allowable range. or we could write ∆ OFV ≤ −$40. we need the dual price for this constraint.363636(110) = $40. or the decrease is 36.) If we want the new OFV this is 3600 − 36. and would cause the OFV to increase by 0. Finally. then the OFV will be impaired.222 c April 28. A decrease of 300 would cause the OFV to decrease. The decrease in the OFV would therefore be at least 0. Hence a decrease of 100 or an increase of 200 would not affect the OFV. the mixing constraint is binding.714294) = 2185.] The OFV will therefore change by: ∆ OFV = (dual price) (∆ rhs) = 0. an increase of 110 would leave it unchanged.M. If the proposed change is beyond this range. and it can be decreased indeﬁnitely. [On Excel for a maximization model we would look at the shadow price. and the OFV would increase by 3.863636(330) = 1275. any change to the rhs will affect the solution. An increase of 550 would be allowable.36 (Note: we can say that the change is −36.36. which is 0.863636(275) = 1062.

4 Example 2: Minimization A company buys food products from some or all of ﬁve suppliers. Tulett 223 14.000000 ROW SLACK OR SURPLUS DUAL PRICES .700000 0.9x4 + 3. The mixture must meet minimum requirements for three nutrients.000000 0.288889 0.4 kg bags.94000 VALUE 4.8 Solving the model on LINDO we obtain: LP OPTIMUM FOUND AT STEP 7 OBJECTIVE FUNCTION VALUE 1) VARIABLE X1 X2 X3 X4 X5 49.5 81. The company has made the following cost minimization model: minimize subject to 3. and then be packed into 14.9 64.3x2 + 5.0 54.c April 28. and are denoted as x1 to x5 . have no more than a speciﬁc amount of fat.M.4 40. 2010 D.1x3 + 2.600000 7. These are mixed together.300000 0.000000 0.000000 1. In this example the objective function coefﬁcients are costs rather than revenues.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 <= = 14.7x1 + 8.000000 1. The variables have been deﬁned as the amount of input of each of the ﬁve suppliers that goes into one bag of mixed product.800000 REDUCED COST 0.

All constraints except the one for Nutrient 3 are binding.900002 64.700000 8. none from supplier 2.800003 14.000000 0.710000 16.657143 1. .900000 3.100000 2.900000 0. The cost of the optimal mixture is $49. 0.800000 3.422222 -5.055555 RANGES IN WHICH THE BASIS IS UNCHANGED: OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 1.706667 0.088889 -0.866667 8.000000 54.311111 0.773334 1. 1.M.000000 7 c April 28.3 kg from supplier 3.000000 1.000000 1.100000 ROW N 1 N 2 N 3 FAT MASS CURRENT RHS 40.828572 2.8 kg from supplier 5.600000 1.288889 0.327273 VARIABLE X1 X2 X3 X4 X5 CURRENT COEF 3. ITERATIONS= 0.000000 0.7 kg from supplier 1.6 kg from supplier 4. and 7.900000 2.500000 81.017391 The optimal solution is for each bag of product to be composed of 4. Tulett -1.720000 1.327273 1. 2010 D.224 N 1) N 2) N 3) FAT) MASS) NO.120000 INFINITY 1.400000 ALLOWABLE DECREASE 1.533333 RIGHTHAND SIDE RANGES ALLOWABLE INCREASE 1.919998 INFINITY 0.127273 0.300000 5.94.

The cost from supplier 2: (a) decreases by $1.6.7) = $5. a 50 cent decrease would cause the OFV to fall by $0. and since x2 is not in the solution.e.30(1.28 or an increase of $50 are both within the allowable range. The current cost for purchases from Supplier 4 is $2.7 kg (per bag of ﬁnished product) from Supplier 1.50(0.1. .3) = $2.464. (b) increases by 85 cents. Tulett 14.05.50 would be within the range.1 Changes to the Objective Function Coefﬁcients 225 We consider what happens to the OFV in each of the following situations: 1.6) = $0.28. a decrease of a dollar would be outside the range.50. Hence a decrease of 50 cents is within the range.50(0.60. 5.288889.90. 3. (b) increases by $5.c April 28.7) = $7.00. a one dollar decrease would cause the OFV to fall by at least $0.3) = $0.6) ≈ $0.50 is outside the allowable range. this has an allowable increase of $1. Since x4 = 0. 4. increases by $1. 0. The cost from supplier 4: (a) decreases by 50 cents. there would be no change to the OFV.3) ≈ $1.50. (c) decreases by $2. Doing a sensitivity analysis on the objective function coefﬁcients is no different for minimization than it is for maximization. The cost from supplier 3: (a) increases by 30 cents. (b) decreases by $1.3. Since x3 = 1.264.50.12.4.828572(1.6) = $0.70 per kg to purchase 4. A decrease by $2 would cause the OFV to fall by $2(1. The coefﬁcient of x2 can be increased indeﬁnitely or be decreased by 1. so the OFV would fall by at least $1.M.657143 and an allowable decrease of 1.828572 and a decrease of 2. Hence a decrease of $1. A decrease of $2. The cost from supplier 5: (a) decreases by $5. The cost [per kg] from supplier 1: (a) increases by $1. 2010 D. there is an allowable increase of 1. An increase of 85 cents would be beyond the range. An increase of $1. 2.773334. and $1.706667 and an allowable decrease of $0.12(4.30) would increase the OFV by 0.50 increase would cause the OFV to rise by $1.90 per kg. and the OFV would increase by $1.50(4.30. and an increase of $1. the OFV would increase by at least 0. The company is currently paying $3. (b) decreases by $2.39.773334(0. an increase of 30 cents (i.50 is within the allowable range. The range for the coefﬁcient of x3 is an increase of 0. (b) increases by $50.077.327273 from its current value of 5.

34.1. it may be helpful to work with the shadow price instead. that this is not the same thing as ﬁnding the absolute value. If Excel is used.5. (b) increases by 300 g.56. improvement for a minimization model refers to a decline in the OFV (if the “improvement” is negative. and by multiplying by −1 we obtain the shadow price. Going to the LINDO printout we ﬁnd the dual prices. because the dual price may already be positive. as opposed to asking about its improvement. For a minimization model the dual price and the shadow price are opposite in sign. The rhs of the Nutrient 3 constraint: (a) increases by 1. The rhs of the Nutrient 2 constraint: (a) increases by 3.8 kg per bag of ﬁnal product.866667(7. which gives the improvement per unit change to the rhs.4.5. 14. (b) decreases by 1.8) = $39. 5.M.5. As stated earlier. The rhs of the fat constraint: (a) decreases by 0. (b) decreases by 15. 4.2 Changes to the Right-Hand-Side Values In doing the sensitivity analysis for minimization using the LINDO output. 14 We consider what happens to the OFV in each of the following situations: 1. (c) increases by 700 g. (c) increases by 0. (c) decreases by 20. The right-hand side value (rhs) of the Nutrient 1 constraint: (a) increases by 1.00(7. 14 Note . then the OFV rises).10 per kg from Supplier 5 and are currently ordering 7.5.226 c April 28.6. 2010 D. then the shadow price gives the change to the OFV per unit change to the right-hand side. The allowable increase is $1. Hence a decrease of $5 would be within the allowable range but an increase of $5 would be outside the range. (b) decreases by 1. The rhs of the mass constraint: (a) decreases by 0. we must be careful when using the dual price. (c) increases by 2.00. (b) increases by 2.533333.0. An increase of $5 would cause the OFV to rise by at least $1. in which case the shadow price is negative. 3.866667 and the allowable decrease is $8. A decrease of $5 would cause the OFV to fall by $5.8.9 kg. Tulett They pay $3. 2. If a question is asking about what happens to the OFV.8) = $14.

and the units are kg (kilograms).127273.e.088889(1. rise in this situation).311111.e. A decrease of 20 would cause an improvement of at least (−$0. i.088889(1.5.5) ≈ −$0.55. Tulett 227 The rhs of the Nutrient 1 constraint is currently 40.311111)3 ≈ −$0.933.088889.633. and a dual price of −5.9) = $4.422222. an allowable decrease of 0. Finally the mass constraint has an allowable increase of 0.264.71.71) = $1. so the improvement to the OFV would be (−1.9 kg is therefore allowable.08889)(−1.6) ≈ $1.8 and an allowable decrease of 1. The Nutrient 3 constraint is non-binding. as would a decrease of 15.5 would have no effect at all. 2010 D. an allowable decrease of 1.9.e.8 is beyond the allowable range.e.667. An increase of 3 would cause an improvement of (−$0.422222(−0.M. A decrease of 15 would cause an improvement of (−$0.311111) (−16. Alternatively. which makes things easy.5 is therefore allowable. A decrease of 1. and the improvement to the OFV would be (−5.742. In other .055555. A decrease of 2.327273. ∆ OFV ≥ 1. i.5 would cause the OFV to improve by −1. The dual price as given by LINDO is −1. i. and would cause the OFV to improve by 1.e.422222(−0.862.e. we can use the shadow price directly: the change to the OFV would be 1. i.311111)(−15) ≈ $4. An increase of 1. the OFV would improve by at least 1. The current rhs value is 14.024. hence an increase of 1. A decrease of 0. A negative improvement for a minimization model is an increase. and a dual price of 1. The fat constraint has an allowable increase of 2.5) ≈ $1. Notice that decreasing the rhs of this ≥ constraint makes the restriction less stringent. The allowable increase is 1.742.711.34) ≈ $0.5) ≈ −$1.4. i.c April 28. while an increase of 2.088889.72. i.e.422222(0.e.633.862.633. the OFV would decrease by $4.024. Hence an increase of 3 would be allowable. but a decrease of 20 would be beyond the allowable range.484.933.e. and the cost decreases as a result.484. the allowable range is −16.6 is allowable. Because such a change would reduce the feasible region. the OFV would increase by about $1.72) = −$1. and the dual price is −$0.1 is beyond the allowable range. A decrease of 1.919998) = $5.711.5 would cause there to be a new solution.34 is allowable.017391. or ∆ OFV ≤ −1.667.055555)(−0. ∆ OFV = −$0. the Excel sensitivity report would state that the shadow price is 1. ∆ OFV = −$1. A decrease of 0. the OFV would improve by at least (−1. it would cause the OFV to be impaired (i.264. This binding constraint has an allowable increase of 1. This improvement being positive for a minimization model means that the OFV would decline by this amount. the OFV would increase by $0.088889)(−1. For the Nutrient 2 constraint. i. An increase of 0. ∆ OFV = $0. the OFV would decrease by at least $5.6.919998 ≤ ∆ rhs ≤ 3. and would cause the OFV to improve by 1. i.

000000 58.055555(0.5.M.655. we will answer Yes when prompted with the “DO RANGE (SENSITIVITY) ANALYSIS?” question.000000 0.000000 .000000 107.327273) = $1.882353 0.000000 0.000000 240. 14. and the improvement to the OFV is (−5.5 14. An increase of 0.882353 0.000000 200.055555)0.352936 0. Now we will show the full report.000000 192.3 ≈ −$1.000000 5.3 kg is allowable.000000 0.823528 8. Tulett words.517. ∆ OFV = $1.000000 0. i.000000 0.23 VALUE 260.1 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.000000 0.000000 0.000000 5. Occasionally a conversion factor is required to analyze something.000000 0.823529 0.647057 192. An increase of 700 g or 0. Also. because it is only the variables whose value is zero which can have positive reduced costs.000000 4.000000 0. 2010 D. we re-state the 300 grams as 0. the OFV would rise by at least 5.5174.228 c April 28. the OFV would fall by $4.352936 0.55. Doing this we obtain: LP OPTIMUM FOUND AT STEP 13 OBJECTIVE FUNCTION VALUE 1) VARIABLE L H P A B C D AL BL CL DL AH BH CH DH 94288.000000 REDUCED COST 0.411765 0.000000 0.000000 0.7 kg exceeds the allowable increase.e.3 kg for consistency with the way the constraint was written.000000 0.

000000 0.705882 4.000000 0.000000 700.411753 11.000000 475.352941 NO.000000 600.M.588242 245.000000 25. B) BAL.000000 260.000000 0.411753 INFINITY 9.352941 -7.000000 -450.529419 -7.000000 0.823532 0.000000 -350. A) BAL.352941 -7.588242 245.000000 5.000000 0. ITERATIONS= RANGES IN WHICH THE BASIS IS UNCHANGED: OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE INFINITY 9.000000 0.000000 229 ROW BAL.882353 0.705882 4. 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 87.647057 400.000000 22.352942 0.c April 28. H) BAL.000000 0.000000 0.000000 0.000000 13 DUAL PRICES 245.000000 0. 2010 D.000000 600.000000 0.176468 98.000000 .588242 350.000000 0.000000 400.000000 0.538434 7. L) BAL.000000 9. C) BAL.000000 173.000000 0.705882 0.000000 141.000000 0.142880 5.000000 20. P) BAL.000000 0.882371 INFINITY INFINITY 25.000000 -400.000000 0.000000 VARIABLE L H P A B C CURRENT COEF 570. Tulett AP BP CP DP 0.

000000 0.000000 0.000018 5.090940 INFINITY 0.000000 400.000022 0.000000 300.705883 107.000018 11.647058 44.499998 0.647057 0.000000 0.000000 0. A BAL.000000 260. Tulett 17.882371 0.000000 0.000000 0.000000 0.695652 2.000000 280.368422 50.000022 5.000000 260.000000 INFINITY 20. with everything else remaining as it is in the .000000 0.000000 0.000000 0.000000 0.000000 300.000009 50.000000 17.000000 c April 28.230 D AL BL CL DL AH BH CH DH AP BP CP DP -600.000000 We will now examine the effect of some changes to the current parameters.352936 87.000000 29.647057 22.000000 0.352942 INFINITY 87.000000 260.000000 0.000000 0. B BAL.608696 192. 2010 D.000000 20.000000 0.999998 760.352942 59.000000 0.000000 0.000011 INFINITY INFINITY INFINITY 0.538433 0.000000 0.000000 400. H BAL.000000 500.000000 RIGHTHAND SIDE RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE 3. L BAL.000000 8.818161 0.000009 10.714256 ROW BAL.000000 5.647058 44.703704 9.000000 0.M.000000 130.000000 0.000018 9.647057 INFINITY 400.000000 0.000000 0. All of these are done one at a time.000000 0.000000 200. C BAL.000000 0.000000 17.000000 1000.705883 INFINITY 22.882371 6.882371 16.382716 0.499998 0.000000 0. 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. P BAL.000000 INFINITY 260.999996 20.000018 INFINITY 16.

the price ($400) and the coefﬁcient (−400) are opposite in sign.882371. then we certainly wouldn’t want to make it and sell it if the market price were to fall. The computer has done more work to come up with the sensitivity report in addition to the solution report. Hence. the allowable increase is 5. C. i. is also a non-solution variable. Also. then the solution would change. especially if the solution report shows a reduced cost of 0. 2010 D. We can tell that the price must change by more than 0 by looking at the variable B row in the sensitivity report. this would not be enough to change the solution because 4 < 4.M. for example. we see that the sensitivity report provides better information. H. if the price were to fall by say $5 per cubic metre (to $395). and the allowable decrease is inﬁnite.411765. 14. we see that its current coefﬁcient is 600. if we look at the variable H row on the sensitivity report. If the price were to rise by say $5 per cubic metre. Note that in this example and for this variable.e. and the allowable decrease is inﬁnite. 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. Tulett current model. BL. for if we do not wish to make and sell high-octane gasoline when the price is $600 per cubic metre. If the price rises by say $4 per cubic metre. we restrict the analysis to those variables which appear in the objective function. variable B has a reported reduced cost of 0. the allowable increase is 4. A. In this case. but that’s not the case here.c April 28. This is seen on the solution report. representing how much is purchased from Better Grade Fuels. The latter piece of information is intuitively obvious. where variable H has a value of 0 and a reduced cost of 4. but we would have to re-run the model with the new price to determine exactly what would happen. so it is wise to check this report. B. Normally. Variable B. . etc. and D.). Non-Solution Variables In the current solution there is no production of highoctane gasoline for cars. the coefﬁcient would rise by 5 (to −395).411765. we would have to re-run the model to determine exactly how. P. There we see that the current coefﬁcient is −400. Curiously.5.411765. We ignore the other twelve variables (AL.882371). L. a reduced cost of 0 for a non-solution variable would indicate that an alternative optimal solution exists.2 Changes to the Objective Function Coefﬁcients 231 For this problem.

Blendex would make more money. this is equivalent to the coefﬁcient decreasing from −350 to −359. If the price were to rise by say $19 per cubic metre (from $570 to $589) the extra proﬁt would be $19(260) = $4940. Tulett Solution Variables For changes to the objective function coefﬁcient of a solution variable.705882 4. They are currently making 260 cubic metres of low-grade gasoline. which is 7. Variables A. and D.M.000000 17. However.368422 11. The effect of a fall in price to say $558 (a drop of 12) is beyond the allowable range. Since C = 300.705882 (allowable decrease). which is ﬁne (the allowable increase is inﬁnite). we can predict that the OFV will decline (because the cost of an input is rising) by at least $7. C.95.705882 9. A. meaning that the OFV would fall by $8(260) = $2080. The new OFV would be $94.e. As another example.13. since A = 192. The change proposed in the question is greater than this amount. C.538434 7. Hence if we are asked “What would happen if the price from A-One Petroleum were to rise by $9 per cubic metre?” (i.000000 -600. However.352936) = $1373. . This would cause the coefﬁcient (which is negative) to rise by 30. because they are quantities which are bought rather than sold.288. the proﬁt for Blendex would rise by $30(200) = $6000. suppose that the price of Clearly Superior were to fall by $30 per cubic metre. P.142880 INFINITY 25.000000 700.000000 -350. a fall in the price of low-octane gasoline would cause the OFV to fall.000000 OBJ COEFFICIENT RANGES ALLOWABLE ALLOWABLE INCREASE DECREASE INFINITY 9. have negative objective function coefﬁcients. Because the coefﬁcient is decreasing we must examine the allowable decrease. so a new solution needs to be obtained by re-running LINDO.53.228. The variables left to examine are L. and D. Extracting just these rows we have: VARIABLE L P A C D CURRENT COEF 570. However.14288(192.352936.538433 From the variable L row. 2010 D. we can say that the OFV would fall by at least $9. we must turn to the sensitivity report. If the price were to fall by $8 per cubic metre.232 c April 28.411753 11.142880.705882(260) = $2523. from $350 to $359).13 + $4940 = $99. we see that an increase in price for low-octane gasoline would not affect the variables. Conversely.000000 -450. we verify that 8 < 9.

000000 22. and the total production. Binding Constraints Any change to the binding constraints will affect the values of the variables.352942 0.000000 0.000000 25.647 cubic metres. and hence a new solution would have to be found using LINDO.M. or be decreased by up to 87. For example.3 Changes to the Right-Hand Side Values 233 It makes no sense to do a sensitivity analysis on the volume balance constraints or the octane constraints. However.000000 173. Non-Binding Constraints All of the non-binding constraints are in this example ≤ constraints.000000 0.000000 260. The octane constraints are binding in this example. without affecting the current solution.000000 20. A change such as reducing the supply from Deluxe Gasoline by 30 cubic metres exceeds the slack. Tulett 14. and the production of H and P. 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. the binding constraints (the ones for which the slack or surplus is 0) are the ones for the amount available of input C. The allowable ranges come from the sensitivity report: . 2010 D. and D. The right-hand side of any of these ≤ constraints can be increased indeﬁnitely.705882 0. all of the volume constraints are binding.000000 9. without affecting the current solution. the supply of gasoline from A-One Petroleum could be increased indeﬁnitely. B. within the allowable range such a change would have a predictable effect on the OFV.000000 0. Because they are equality constraints.c April 28. so we are dealing with a slack on each one. the production of L.000000 0. the context requires that the right-hand side value must be 0.000000 DUAL PRICES 0.000000 0. Besides the volume balance and octane constraints.5. For these.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. or be decreased by the amount of the slack.647057 400.

M.000000 ALLOWABLE DECREASE 44.999998 The total production is currently limited to 500 cubic metres.000000 500.705883 20. from 200 to 214. A decrease from 500 to 475 would cause the OFV to fall by $173.59.24. The $450 per cubic metre that has to be paid to buy the extra gasoline has already been factored into the dual price.5294(10) = $1735. The dual price is 173. the values of the variables change. The allowable decrease is 30. An increase of 35 (> 20) would change the solution. the OFV would go up by at least $173.29. The dual price nets out everything. When evaluating the effect of a right-hand side change.999996 20. see if it’s within the allowable range. Now suppose that we increase the righthand side by say 14 units. and all of this capacity is being utilized. . The allowable increase is 20. and some go down. and if so the improvement to the OFV is simply the dual price multiplied by the change to the right-hand side. An increase in the right-hand side from 500 to 510 would increase the OFV by $173.647058 59.00.234 c April 28.5294(25) = $4338. This may seem a bit more complicated.529419.647058. Tulett ROW INPUT C OUTPUT L TOTAL CURRENT RHS 200. The dual price on this availability constraint is $25. and there are many credits and debits which sum up to the dual price. The dual price of $25 means that the OFV will increase by $25(14) = $350. Actually. 2010 D. As the right-hand side is changed. the allowable decrease is 44. Hence this situation is not more complicated. it’s no more difﬁcult than the previous case.5294(20) = $3470. because increasing the righthand side isn’t free in that we have to buy more @ $450 per cubic metre in order to obtain more.000000 260.705883. The allowance increase is 17.000000 RIGHTHAND SIDE RANGES ALLOWABLE INCREASE 17.000000 29. Some go up. Now let’s take a look at changes to the availability of gasoline from Clearly Superior.

4x2 6x2 5x2 4x2 x2 + + + + . x2 . 2x3 8x3 8x3 3x3 ≤ 64 ≤ 160 ≤ 146 ≥ 72 x3 ≥ 0 (a) Solve using a computer.2 A Minimization Problem A company which makes chocolate bars needs to buy some exotic nuts: walnuts. (iv) The number of units of cutting increases by 10. $27 per blouse.6.M. After deducting all variable costs.00. and indicate which constraints are binding. then give an answer such as “the OFV will increase by at least $90”. and x3 represent respectively the number of skirts. each garment must be inspected. and dresses. the net revenue is $32 per skirt.1 Exercise A Maximization Problem A garment factory can make skirts. chestnuts. In addition. (i) The price of each skirt rises by $5.c April 28. which has been modelled using three . give the predicted change to the objective function value (and the reasoning behind your answer) for the following situations (taken one at a time). and ﬁnishing. (v) The number of units of ﬁnishing increases by 6. (iii) The price of each dress falls from $40 to $27. blouses.6. they will make a constraint to keep at least one inspector busy. and hazelnuts. assembly. and print this solution and the sensitivity report. Since union rules require that at least one inspector be on duty at all times. If the OFV cannot be predicted exactly. (b) State the solution in words. They do not have to buy any of any one type. and dresses to be made each hour. maximize 32x1 + 27x2 + 40x3 subject to Cutting 5x1 Assembly 12x1 Finishing 7x1 Inspection 6x1 non-negativity x1 + + + + . but they do need to satisfy certain combinations of types. (c) By using the information from the sensitivity report (NOT by re-running the model each time). The model has been formulated as: Let x1 . each of which limits the amount of production: cutting. Tulett 235 14. and $40 per dress.6 14. blouses. 2010 D. (ii) There are three fewer units of assembly. 14. There are three operations.

2010 D. (ii) The price of chestnuts falls by $2. and x3 represent respectively the number of kilograms of walnuts. give the predicted change to the objective function value (and the reasoning behind your answer) for the following situations (taken one at a time). x2 + + + + .236 c April 28. (iii) An extra 100 units of capacity becomes available. . (c) By using the information from the sensitivity report (NOT by re-running the model each time). The model has been formulated as: Let x1 . If the OFV cannot be predicted exactly. and hazelnuts to be used each hour in the chocolate bar plant. Also. there is a capacity restriction. (iv) The requirement for combination 1 falls by 25 units. Tulett constraints. and print this solution and the sensitivity report. chestnuts. (v) The requirement for combination 3 increases by 92 units. (b) State the solution in words.70 per kg. then give an answer such as “the OFV will decrease by at least $50”. minimize 2x1 + 7x2 + 4x3 subject to Combination 1 Combination 2 Combination 3 Capacity non-negativity 5x1 2x1 3x1 8x1 x1 + 8x2 + x2 + 4x2 + 9x2 .M. and indicate which constraints are binding.20 per kg. x2 . 6x3 4x3 5x3 4x3 ≥ ≥ ≥ ≤ 230 145 196 252 0 x3 ≥ (a) Solve using a computer. (i) The price of hazelnuts rises by $1.

a good knowledge of matrix algebra as seen in Mathematics for Management Science is required. you should review them. What is seen here can be imbedded into a decision making model. subtraction. To learn about Markov chains. The purpose of having the program is to give them information about how each consumer changes (or doesn’t change) brands from month to month. 52% stayed with brand 2. Decision trees are useful when we have decisions and events. and 3. Matrix operations such as addition. 61% stayed with Brand 3. Thirty-six percent switched to Brand 2. Of the consumers who bought Brand 1 last month. while eighteen percent switched to Brand .c April 28.2. Unlike most of the material in this course. 2.M. meaning that the percentages will add up to 100%. In particular. here referred to simply as Brands 1. but that is a subject for a subsequent optional course. Many textbooks which contain a chapter on Markov chains will discuss the topic of ﬁrst passage time analysis.1 Example: Brand Switching Description of the Situation A supermarket has a points program based on the amount purchased. If the knowledge of these topics is rusty. 15. Among last month’s Brand 3 shoppers. Markov chains are a third approach. multiplication.2 15. and seventeen percent switched to Brand 3. We begin with an example for which modelling as a Markov chain is appropriate. 2010 D. however this subject is omitted in this course. [A small number of shoppers who did not buy in both months are not considered. this is not a chapter about decision making. 47% stayed with this brand. 9% went to Brand 1. Tulett 237 15 15.1 Markov Chains 1 Introduction Whenever we have a managerial problem which requires formulation as a mathematical model. they have studied the three brands of detergent which they sell.] Of those who bought Brand 2 last month. Learning about Markov chains involves formulation and problem solution techniques which can be difﬁcult. and inversion will be used extensively. used for multi-period models which are governed by probabilities which are constant over time. and 39% are purchasing Brand 3 this month. Linear optimization is useful when we have a model which obeys the assumptions of this subject. we look for the type of model which is most appropriate.

A transition from a state to itself is drawn as a loop with an arrowhead entering the state. they would like to be able to predict the long-term market share for each brand of detergent. in many examples of Markov chains there are some impossible tran- . and Brand 3. for example. However. called the state transition probability . labeled as Brand 1. This chain has three brands. This is shown in Figure 53. and then placing each piece of data next to the arrow which represents the transition. The only thing that matters is the present. When we are given. Next to each transition we place the probability of this transition. On the Markov chain. 2010 D. The central idea in Markov chains is that history is irrelevant . switching from one brand to another brand is a transition from one state to another. This is shown in Figure 52.M. Doing this. we obtain the completed state transition diagram. 15. A transition from one state to another is drawn as an line or curve with an arrowhead touching the new state. Brand 2. In this example. For example. the consumer either stays with the same brand. They have been tracking the percentages of consumers who stay or switch for several months.2. This is shown in Figure 51. a statement that 36% of those buying Brand 1 will switch to Brand 2 next month. and 21% switched to Brand 2. There are nine (3 × 3) pieces of data to be extracted from the situation description. if the probabilities of transition between the states are known. and hence three states. called the state of the system. and have found that these numbers are very stable.238 c April 28. staying with the same brand is a transition from one state to itself. Assuming that this stability continues into the future.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. Because of this. it is possible to buy any brand next month no matter what is being purchased this month. Tulett 1. all the arrows needed to be drawn. We sometimes display a Markov chain on what is called a state transition probability diagram (or simply the state transition diagram ). From one month to the next. or switches to another brand. this is the same as saying that a Brand 1 consumer chosen at random has a 0. We begin to make this diagram by making a circle for each state. and if these probabilities do not change over time. A system is a Markov chain if the number of states is ﬁnite. what matters in the brand switching situation described above is what brand the consumer is buying this month.36 probability of switching to Brand 2 next month.

2010 D.c April 28. Tulett 239 Brand 1 Brand 2 Brand 3 Figure 51: Brand Switching: States .M.

Tulett Brand 1 Brand 2 Brand 3 Figure 52: Brand Switching: States with Transitions .M.240 c April 28. 2010 D.

Tulett 241 0.3 9 7 0.1 8 0.1 .52 Brand 3 0.47 0.2 1 0.09 Brand 2 0.M. 2010 D.c April 28.36 Brand 1 0.61 Figure 53: Brand Switching: State Transition Diagram 0.

36 0.61 . By convention. Because these numbers are probabilities.2. For example. the rows and columns match up with the states.21 0. i. the brand switching situation which has three states can be described by a 3 by 3 matrix. we have added the state numbers on the left and at the top. the number in row i and column j is the probability of going in one transition from state i to state j. Tulett sitions.61 For emphasis.M. Obtaining the probabilities either from the original situation description.e.47 0. the clutter on the diagram is greatly reduced. we are better off displaying the data in a matrix.18 0. every number is between 0 and 1 inclusive.17 State 2 0. and the sum of each row must be 1.18 0.242 c April 28.09 0. or from the state transition diagram. Unless indicated to the contrary. This matrix is called the state transition probability matrix (or simply the state transition matrix ). row 1 and column 1 refer to state 1. we do not draw an arrow for a transition with a 0 probability.39 3 0.21 0. but where these are clear they will in future be omitted. For doing calculations based on the state transition probabilities.17 P = 0. i. the state transition matrix is: To State 1 2 3 From 1 0. By omitting such arrows. In this more compact form the state transition probability matrix.52 0.52 0. 15.47 0.09 0. State transition diagrams are useful for providing a conceptual grasp of the situation.e.36 0. and so on. which we denote as P. is simply: 0.3 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.39 0. However. When this happens. they are not suited as a computational tool. 2010 D. the row is the current state and the column is the subsequent state.

what is the probability that he or she will buy Brand 1 two months from now?”. we are asking “If a consumer buys Brand 3 this month. the probability of switching to Brand 1 next month. and then switches to Brand 1 for the subsequent month.21 0. The consumer switches to Brand 2 next month. and then staying with Brand 1 for the subsequent month. for example. The consumer switches to Brand 1 next month.36 0. . 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). 3. (If we wanted to exclude this from happening. which represents the probability of going from state i to state j in one transition.47 0.17 0. On a spreadsheet the information could be displayed as: A 1 2 3 4 5 6 15. We denote the number in row i and column j of this matrix as pi j . and then switches to Brand 1 for the subsequent month. we would be involved with ﬁrst passage time analysis.2.52 0.4 B C E F To State 1 2 3 0. and then stays with Brand 1 for the subsequent month.09 0. Now suppose that we want to know the probability of going from state i to state j in two transitions. 2. Hence.39 0. Tulett 243 However.M.1 .c April 28. Note that we are not precluding the purchase of Brand 1 next month. For example if i = 3 and j = 1. is given by p3. In ﬁnding each joint probability. 2010 D.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. The consumer stays with Brand 3 next month. The probability which we seek is the sum of the joint probabilities of each of the three possibilities. There are three ways for this to happen: 1.1 p1. when using a spreadsheet it is useful to put labels to the left and on top of the space reserved for the transition probabilities. which as stated earlier is not part of this course).18 0.

we can put P2 below it. we ﬁnd the dot product of row i and column j.52 0. we denote the probability of going from state i to state j in k tran(2) (k) sitions as pi j .4846 While ﬁnding P2 by hand is easy enough. say in the range D8:F10. Tulett In general.61 = 0. With P in the range D3:F5.52 0. This is: p2.18(0.1 .0153 + 0.39) 0. For example.47 0.3847 0.09 0.17) + 0.39) + 0. To do this we drag the mouse over the range D8:F10.18 0.2133 To ﬁnd p3.61(0.09(0.1 + p3.3 = (row 2) · (column 3) (2) (2) (2) (2) 0. and in cell D8 we enter the appropriate formula: .39 0.61) = 0.2133 0. doing this operation on a spreadsheet is very fast and avoids a potential calculation error.1 = 0.47 0. we calculated the dot product of row 3 and column 1. we can ﬁnd all the pi j ’s by calculating P times P. 0.1 : p3.21 0.61 0.17 = (0.4560 Since matrix multiplication involves ﬁnding the dot products of all rows and (2) columns.2 p2.1 = p3.1 p1.M.1098 = 0.18) = 0.09 0.36 0. We will denote this product as P2 . 2010 D.39 0.17 0.1593 0.09) + 0.3240 = 0.61 0.3921 0.39 0. In general to ﬁnd pi j .1 + p3.21(0.17 P2 = 0.0189 + 0.21 0.4560 0.3021 0.52(0.47) + 0.2379 = 0.2839 0.39(0. suppose we want the probability that a consumer who is currently buying Brand 2 will buy Brand 3 in two months time.36 0.18 0.09 0. Here we seek p3.244 c April 28.2028 + 0.3 p3.0846 + 0.52 0.

09 0.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. .209183334 0.39 0. or 3 this month.2839 0. one for each column.52 0.18 0.3847 0. For example.17 0.441024731 P9 = 0.440980880 We see that in every column the probabilities are essentially independent of the initial state.349835786 0.36 0.209 probability of buying Brand 1 nine months from now.61 3 0.47 0.M. the fast way to ﬁnd it starting with P would be to ﬁrst obtain P2 .4560 0.3240 0. There are three ways to ﬁnd P4 : (1) P3 P.3021 D F 3 0. 2010 D. Doing this on a spreadsheet we ﬁnd: 0. (2) P2 P2 . matrix multiplication is not commutative.1593 0. 2. and then multiply this by P to obtain P9 . whether the consumer is buying Brand 1. there is about a 0. Tulett 245 =MMULT(D3:F5.c April 28. After many transitions (k of them). In general. then square this to obtain P8 .2133 2 0.441012724 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.349799030 0. Hence we can ﬁnd P3 either as P2 P or as P P2 . Rather than ﬁnding these numbers numerically by ﬁnding Pk for higher and higher values of k. Note that if we wanted something like P9 . but in this context it is commutative.209188246 0.349827600 0.3921 0. then square this to obtain P4 . or (3) PP3 . the nine probabilities in the Pk matrix are reduced to only three distinct probabilities.21 1 0.209147670 0.

these probabilities must sum to 1. Tulett these numbers can be found analytically. There’s clearly no problem in this example. Each of these is an unknown.1 Three State Brand Switching Example The numbers which we seek are the steady-state probabilities of the system being in state 1.1 ). 2. so we can write: x1 + x2 + x3 = 1 Now we need two more equations.3 Determining Steady-State Probabilities Analytically The analytical method of ﬁnding steady-state (also called long-term) probabilities ﬁnds the exact solution in one use of the procedure. we can be at state 1 next month in one of three ways: 1. and we move to state 1 (probability p2. We begin with the three-state brand switching example to illustrate. or Brand 3 many months into the future. state 2. 2010 D. or whether it has many states and we seek a solution using a computer. The analytical method is what we shall use from now on.M. In the context of switching brands. or whether it has three states and we seek a solution by hand. . 15. which after many uses of the procedure ﬁnds successive approximations. We are in state 2 this month (probability x2 ). and we stay in state 1 (probability p1. since even P itself is entirely non-zero. these are the probabilities of the consumer’s purchase being Brand 1.3. We are in state 1 this month (probability x1 ).246 c April 28. After many iterations. The implementation of the analytical method is different depending on whether the chain has just two states. Brand 2. In this document these numbers are represented by the symbols x1 .1 ). Here’s how to obtain another one. for which we shall solve three equations in three unknowns. This is in contrast with the numerical method of the previous section. 15. x2 . the probability of being in state 1 next month is the same as the probability of being in state 1 this month. For any matrix P. One of these three equations is easy to obtain. and x3 . both are x1 . Things will work out properly provided that for some value k all the numbers in the matrix Pk are non-zero. or state 3.

) This system can easily be reduced to two equations in two unknowns by rewriting the third equation as x3 = 1 − x1 − x2 .18x3 x2 = 0.2 x1 + p2. and we move to state 1 (probability p3.36 0.52x2 + 0. Tulett 247 3.52 0.2 x3 x1 + x2 + x3 = 1 There is also an equation which could be written for state 3. 2010 D.18 0. The one equation which cannot be replaced is the one for the sum being 1.1 x2 + p3. this equation could replace either of the state 1 or state 2 equations.1 x1 + p2. the system of equations in numerical form is: x1 = 0.2 x2 + p3. Each of these possibilities has a joint probability.17 P = 0.2 x2 + p3.21(1 − x1 − x2 ) . and the sum of these joint probabilities is: x1 = p1.09x2 + 0.36x1 + 0.c April 28.61 Substituting the relevant pi j ’s.39 0. We are in state 3 this month (probability x3 ).09 0.18(1 − x1 − x2 ) x2 = 0.1 x3 x2 = p1. for which the transition probability matrix is: 0.1 x1 + p2. and then substituting this into the ﬁrst two equations.09x2 + 0.21 0.2 x3 We now have three equations in three unknowns: x1 = p1.1 ).2 x1 + p2.52x2 + 0.21x3 x1 + x2 + x3 = 1 (Note: the numbers in the ﬁrst two rows come from the ﬁrst two columns of P. Now let’s determine the steady-state probabilities for the brand-switching example.1 x2 + p3. This gives: x1 = 0.47 0.M.47x1 + 0.36x1 + 0.1 x3 Doing a similar analysis for state 2 we obtain: x2 = p1.47x1 + 0.

Tulett x1 = 0.21 Multiplying the ﬁrst row by 15.15x1 + 0..34982.31x2 + 0.15x1 + 0. 2010 D. gives: 10. In the context of the brand-switching example.91 Adding we obtain: 0x1 + 50..09(0. when there are more than three states.. + x3 = 1 Solving.0% for Brand 2..M...18 −0..248 Simplifying the right-hand side we obtain: c April 28.61 and therefore x2 = 0.09x2 = 0. you will probably want to use a computer to do part of the calculations..... + 0.44100.09x2 + 0. Hence the steady-state probabilities are: x1 = 0.18 Solving. we obtain x3 = 0. The method shown here is useful for models with three states.70 −10..34982. and the second row by 71.) = 0.35x2 = 2.. 35.29x1 − 0.20917.34982.71x1 + 0.65x1 + 48.69x2 = 0.44100.. and x3 = 0. and 44.99x2 = 14.65x1 + 1.. this means that the market shares of the three brands are about 20.1% for Brand 3.. there is a special formula which should be used instead.. However. . We then substitute this result into one of the two equations in two unknowns to ﬁnd x1 : 0.21 Putting all variables on the left we obtain: 0.18 x2 = 0.. Now we ﬁnd x3 : 0. Conversely. when there are just two states.. We now show how to use these methods.9% for Brand 1.34x2 = 17.20917. x2 = 0..71x1 + 0.20917.. we obtain x1 = 0.34982.

1 x1 + p2.2 p1.1 (1 − x1 ) and therefore Since each row sums to 1. we must have: x1 = p1.1 )x1 = p2. Therefore ( p1.1 (4) p2.1 + p2.2 + p2.41 ≈ 0.1 p2.41 + 0.41 + 0. Tulett 15. Also.1 Therefore: (1 − p1.2 + p2. 2010 D.2 . there is a formula for determining each state’s steady-state probability.1 = p1. 1 − p1.1 x1 + p2. we must have: x1 + x2 = 1 Therefore.66 0.1 )x1 = p2.34 0.41 0.2 where each number is at least 0 and each row must sum to 1.4533 0. x1 = and since x1 + x2 = 1 we obtain x2 = 15.3.34 ≈ 0.34 0.59 p1.3.2 P= p2.34 0. (3) . An arbitrary matrix P is of the form p1.1 .1 .M.1 x2 .2 Two State Markov Chain 249 For a Markov chain with only two states. x2 = 1 − x1 . At steady-state.1 p1.5467 0.1 p1. and substituting this into the other equation we obtain: x1 = p1. It’s easy to derive these formulas.c April 28.3 Example P= Using equations 3 and 4 we obtain x1 = and x2 = 0.2 + p2.

24 0.57x3 + 0.43x3 − 0.06 0.04 0.31x1 + 0.36 1.08 0.04 −0.17x3 + 0.02 0. The fourth equation comes from the fact that all the steady-state probabilities must sum to 1.09 0.25 0. 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).25x1 + 0.08x2 − 0.38 −0.17x3 − 0.32x2 + 0.32x2 + 0.16 P= 0.09 A= −0.17 0.32 0.51 We make four equations in four unknowns.00 1.69x1 − 0. it is easier to understand what is happening if we ﬁrst do things by hand.44x2 + 0.00 = = = = 0 0 0 1 .04x4 −0.3.38x1 − 0. 2010 D. Tulett Although we can automate things right from the outset.08x2 + 0. Doing this we obtain: x1 x2 x3 x1 + x2 + x3 + x4 = = = = 0.36 0. suppose that we wish to determine the steady-state probabilities of the following system: 0.57 0.43 −0.09x4 0.56x2 − 0.32 0.250 15.4 Solution by Computer c April 28.69 −0.24 −0.17 −0.25 0. For example.38x1 + 0.36x4 x1 + x2 + x3 + x4 This is a set of equations of the form Ax = b where 0.44 0.04x4 0.38 0.25x1 + 0.36x4 1 Putting all the variables on the left gives: 0.00 1.24x3 − 0.24x3 + 0.00 1. Three of them come in the same manner as before.56 −0.M.08 −0.31 0.09x4 −0. and then switch to using the computer to ﬁnish the problem.

120231638. the column vector b will always be a string of 0’s ending with a “1”. You might wish to try this method on the second problem of this lecture’s exercise. the transposed matrix is subtracted from an identity matrix of the same size. Doing this we obtain x1 = 0.c April 28.190812702. Fourthly. Secondly. and then multiply (using the MMULT function) this result by b to obtain the column vector x. The process can be expedited by ﬁrst ﬁnding the transpose of P. we ﬁnd the inverse of the overwritten matrix.448344037. x2 = 0. Therefore. Tulett x1 x2 x= x3 x4 and 0 0 b= 0 1 251 We wish to determine x = A−1 b. the ﬁnal row of this subtracted matrix is overwritten with 1’s. . and x4 = 0. the product of A−1 and b is simply the same as the ﬁnal column of A−1 .M. On a spreadsheet we can input the matrix A. 2010 D. Indeed. and the ﬁnal column of the inverse gives the steady-state probabilities. x3 = 0.240611623. Thirdly. invert it (using the MINVERSE function). for any matrix P.

3 (a) If a consumer is currently purchasing from company 2. 2010 D.2 0.4 (a) Draw the state transition diagram (omit the impossible transitions).252 c April 28.7 0.4.e. .8 0.1 Exercise Problem 1 Solve this problem by hand (i. Three companies are ﬁghting for market share.0 1.0 0. 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.1 . Use a spreadsheet to solve parts (b) and (c) of this problem.2 0. what is the probability that it will be in state 4 after ﬁve transitions? (c) Determine by matrix inversion the percentage of time that will be spent in each state after a large number of transitions. 15.0 0.0 0.0 0.7 .3 . Tulett 15.2 0. .1 P = .4 15.0 0.3 0. For each company.2 .4.5 . use a calculator rather than a spreadsheet).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. (b) If the system is currently in state 2.M.6 .2 0.2 Problem 2 A Markov chain has the following state transition probability matrix: 0.0 P= 0.0 0.

and a ‘0’ everywhere else in that row.9x1 = 0. at which point there is probability x1 of eventually ending up in state 1. Such states are called absorbing or trapping states.4 0. all we need do is solve a single equation. In a state transition matrix.4 chance of being absorbed into state 1 after one transition. an absorbing state has a ‘1’ on the main diagonal.c April 28. Therefore: x1 = 0.5 0. there is a 0. P1 = 1 0 0. In matrix P1 .1 To obtain the probability of eventual absorption into state 1 (x1 ).1 Markov Chains 2 Introduction In this lecture we examine what happens when a Markov chain has some states which.M. Another way of saying this is that state i is an absorbing state if and only if pii = 1.1 chance of returning to state 3.4444 x1 = 9 . 2010 D.2 0.4 4 ≈ 0. with no other arrow leaving for any other state. state 1 is absorbing and state 2 is transient. Tulett 253 16 16. If the system starts in state 3.5 0. the non-absorbing states are often called transient states.4 0.1 In matrix P3 . There is a 0. states 1 and 2 are absorbing and state 3 is transient. cannot be left. Clearly.1x1 0. an absorbing state has a loop to itself with probability 1. once entered. 1 0 0 1 0 P3 = 0 0. such a system will eventually end up in state 1.8 We note that a matrix such as the one shown in P2 (which has no 1’s on the main diagonal) contains no absorbing states: 0 0 1 0 0 P2 = 1 0. In a state transition diagram.4 + 0. In a Markov chain in which some of the states are absorbing.

41 0. we present an application for which this type of analysis is needed. and an arbitrary number of transient states.254 c April 28.34 0. the area in grey is a 3 by 2 rectangle in which every number is .12 0.5556 = 9 This approach is simple because of the small size of the system.09 0.13 This matrix can be partitioned into four sub-matrices.12 0.38 0.09 0.05 0. it makes things easier if the absorbing states appear together ﬁrst.16 0. We let m represent the number of absorbing states. 2010 D.41 0.07 0.38 0.16 0. This is presented in the next section. After that.13 We see that the 5 by 5 matrix was partitioned as follows: the area in red is a 3 by 3 identity matrix. 16.05 0. Tulett The probability of eventual absorption into state 2 (x2 ) is x2 = 1 − x1 4 = 1− 9 5 ≈ 0.25 0.07 0.M.34 0. Hence the Markov chain has m + n states. Showing this with four colours we have: 1 0 0 0 0 0 1 0 0 0 0 0 1 0 0 P = 0. splitting the absorbing states from the transient states both horizontally and vertically. Here is an example with three absorbing states and two transient states. and n the number of transient states. the absorbing ones appearing ﬁrst.25 0. but what we need is a general procedure for an arbitrary number of absorbing states.2 Absorbing States Analysis In dealing with Markov chains which contain absorbing states. and the transient states appear together afterwards. 1 0 0 0 0 0 1 0 0 0 0 1 0 0 P = 0 0.

the partition looks like: Im 0m×n Rn×m Qn P = . 0m×n . and the area in yellow is a 2 by 2 square which gives the probabilities of switching between the transient states. a rectangle with m rows and n columns consisting only of 0’s (upper-right). Each of these is a sub-matrix denoted as: Im . 2010 D. a rectangle with n rows and m columns (lower-left). the partition looks like: Im 0m×n P = Rn×m Qn When there are fewer absorbing states than transient states (m < n).c April 28. Tulett 255 0. and a square matrix of order n (lower-right). the area in blue is a 2 by 3 rectangle which gives the probabilities of switching from the transient states to the absorbing states. Rn×m . In general P can be partitioned into: an identity matrix of order m (upper-left). When there are more absorbing states than transient states (m > n). and Qn respectively.M.

. .07 0. m and i = m + 1.07 − 0 1 0. the partition results in four square sub-matrices of the same size: Im 0m×n P = Qn Rn×m It turns out that steady-state behaviour can be determined just by using submatrix Rn×m and sub-matrix Qn .12 0. . This matrix gives the probability of eventual absorption into absorbing state j given that the system begins in transient state i.05 0.41 0. a matrix which has the same size as Qn .16 To ﬁnd F. The formula to ﬁnd this n by m matrix.256 c April 28.09 0. is Fn×m = In − Qn −1 × Rn×m (5) The use of colour in Equation 5 is for emphasis.13 0.87 .05 0.07 −0. the sub-matrix of P which is kitty-corner to Qn . .13 0. here called Fn×m . .34 0. the sub-matrices of P which we need are: Q2 = and R2×3 = 0. . Returning to the numerical example. m + n.09 0. . we ﬁrst perform the subtraction within the parentheses: I2 − Q2 = = 1 0 0.05 0. 2010 D. What we are seeking is a matrix which has the same size and shape as Rn×m . It is not Im . where j = 1. Tulett When the number of absorbing states equals the number of transient states (m = n).M.91 −0.38 0. The identity matrix in this equation is In . .25 0.

then the inverse of A. any matrix which is 3 by 3 or larger will be inverted using a spreadsheet.91 −0. Recall how to ﬁnd 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 = a1.91 0. the inverse is deﬁned.05 0.104 transitions in state 4 and 0.2 If det A = 0. If det A = 0.1 det A The matrix that we wish to invert is: I2 − Q2 = 0.193 transitions before being absorbed somewhere.87) − (−0. then 1 a2. it can be inverted by hand.05)(−0. det(I2 − Q2 ) = 0. If the system starts in the second transient state (state 5 in P). It gives the expected number of transitions spent in each transient state before absorption.7882 1.87 0.1 a2.07 −0.05 0. as we shall now do.87 a1.1 a2.2 − a2.91(0. does not exist. If the system starts in the ﬁrst transient state (state 4 in P).07 0. Tulett 257 Since this is a 2 by 2 matrix.2 A−1 = −a2. For our purposes.15453 This matrix has a special meaning.1 a1. and is given by: (I2 − Q2 )−1 = ≈ 1 0.06344 0.M. 2010 D.1 a1.10378 0.08881 1. .1 a1.2 a2.07) = 0.089 transitions in state 5 for a total of 1.c April 28. written as A−1 . then the system will spend about 1.7882 Since the determinant is not 0.7917 − 0.2 We begin by calculating the determinant.2 −a1.0035 = 0.

155 transitions in state 5 for a total of 1.12 0.25 0.7882 0. Doing it this way we obtain: Fn×m = = = ≈ × Rn×m 0.M.000 for the ﬁrst (state 4) and 0.4336 0.1547 0.38 × 0.3901 0.12 0.3418 0. there is simply some rounding error when the probabilities were reported to the nearest fourth digit.258 c April 28. Using this approach. The latter sum is ﬁne.41 0.05 0. and each row must (theoretically) sum to 1. we postpone the division by the determinant until the end. Tulett then the system will spend about 0.2088 In − Qn −1 0. The number in row i (state m + i) and column j gives the probability of the system eventually being absorbed into state j. .15453 0. we multiply this matrix and R: Fn×m = = ≈ In − Qn × Rn×m 1.06344 1. by summing each row we obtain 1.4117 0.2962 0. Alternate Approach If the inverted matrix is not needed in its own right. 2010 D.7882 0. Finally.218 transitions before being absorbed somewhere.9999 for the second (state 5).38 0. then an alternate approach exists which is numerically easier to do by hand.4117 0. but is simply an intermediate calculation in determining Fn×m .063 transitions in state 4 and 1.1219 0. For example.4949 0.41 0.91 0. By inspection we see that the ﬁrst attribute is true.87 0.4949 0.3 Solution by Computer Whenever the matrix inversion is 3 by 3 or larger.16 0.2335 0. starting in state 5.25 0.1646 16.5% chance of being absorbed into state 2.3245 1 0. hence each number must be between 0 and 1 inclusive.2962 0.34 0.1547 0. An example to illustrate this is given by the following six state Markov chain. we will use a computer to do the calculations.07 1 × 0.2088 −1 All the numbers in Fn×m are probabilities.10378 0.34 0.4336 0.08881 0. there is about a 49.16 0.

c April 28, 2010 D.M. Tulett

259

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 ﬁnd 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

260

c April 28, 2010 D.M. Tulett

Now we ﬁnd (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)ˆ{-1} or something similar. To put the inverse into the range C19:F22, we ﬁrst 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: Fn×m = In − Qn
**

−1

× Rn×m In − Qn

−1

F is a 4 by 2 matrix (it’s 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 Rn×m 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

261

Beginning in State 3 State 4 State 5 State 6

However, in reporting the analysis for a speciﬁc 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 classiﬁes 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 insufﬁcient 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

262

c April 28, 2010 D.M. Tulett

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 doesn’t 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:

c April 28, 2010 D.M. Tulett

263

1 Fully Paid (1) Bad Debt (2)

1

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

264

c April 28, 2010 D.M. Tulett

1 0 P = 0.2 0.05 We now wish to determine: Fn×m = We begin with the subtraction: I2 − Q2 = = Now we ﬁnd the inverse:

0 1 0 0.07

0 0 0.7 0.3

−1

0 0 0.1 0.58

In − Qn

× Rn×m

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 deﬁned, 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: Fn×m = = ≈ In − Qn × Rn×m 4.375 1.04167 0.2 0 × 3.125 3.125 0.05 0.07 0.92708 0.07292 0.78125 0.21875

−1

c April 28, 2010 D.M. Tulett

265

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) Deﬁne 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?

266

c April 28, 2010 D.M. Tulett

(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 ﬁnd 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) Deﬁne 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?

and also leave the casino if his cash reaches the $100 level. and are represented by the arrows between the states. This is a Markov chain in which the states represent his level of cash.1 Gambler’s Ruin A gambler walks into a casino with one of the following amounts of cash: $20. 5. suppose that this cell is A6 (with a label p in cell A5). H6. The state transition diagram is shown in Figure 55. and P is placed in the range C2:H7. He will leave the casino if he runs out of cash. 4. he receives $40 for a net gain of $20. 17. one cell is reserved for the value of p. and the probability of losing is 1 − p. If he loses. 2010 D. and 6). Every time he plays the probability of winning is p. . or $80. and C4. we need to spend some more time on model formulation.c April 28. Tulett 267 17 Markov Chains 3 We have seen all the technical operations about Markov chains suitable for a introductory course in management science. All cells are 0 except: C2 and D3. Note that winning and losing are not states – winning and losing are transitions. he bets $20. Every time he plays a game. Having no cash or $100 in cash are absorbing states (numbered 1 and 2). F6. In this lecture we present a few more formulation examples in increasing order of complexity. However. If he wins. For example. G5. he receives nothing for a net loss of $20. 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. $60. which are 1. These formulas can be seen by pressing Cntl (keeping it held down) and the ˜ (tilde) key. E5. $60. or $80 are the transient states (numbered 3. $40. $40. and D7 in which we place the formula =A6. and having $20. in which we place the formula =1-A6.M. and G7. F4.

268 c April 28. 2010 D.M. Tulett 1 Leaves with $0 (1) 1− p Leaves with $100 (2) p 1 $20 (3) 1− p p p $40 (4) 1− p p $80 (6) 1− p $60 (5) Figure 55: Gambler’s Ruin State Transition Diagram .

47 0 0. then (I4 − Q)−1 . 2010 D.155 0. For example.33. this number is 0.53 0 0 0 D 0 1 0 0 0 0. we can create I4 .c April 28.47 in cell A6.670 0.53 0 G 0 0 0 0.330 0.47 Beginning with $20 with $40 with $60 with $80 Probability of Leaving with $0 $100 0. We will present only the ﬁnal solution here. . then ﬁnd I4 − Q.749 For example. the numbers in the matrix will appear. when p = 0.47 E 0 0 0 0.53 0 0 F 0 0 0. and ﬁnally F. For example.251 0.M.53 H 0 0 0 0 0. 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).47 0 By the method seen in the last lecture. with 0.527 0.47 we obtain: Based on p = 0.845 0.473 0.47 B C 1 0 0. we obtain: A 1 2 3 4 5 6 7 Gambler’s Ruin p 0. Tulett A 1 2 3 4 5 6 7 Gambler’s 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 0 269 If we put a number into cell A6 and then press Cntl (keeping it held down) and the ˜ key.47 0 0.

$7.0%) 0.5.20 (20.37 (57. The value of p will be set by the casino. Here is what happens as a function of p if someone begins with $60.67($0) + 0.286 $11.30 for $60.400 none 0. Tulett The expected net loss from the gambler’s perspective is the amount the gambler has initially minus the expected winnings. The Markov chain “drifts” towards the absorbing state which represents leaving with no money left.50 for $20.) Doing this calculation on the spreadsheet for all levels of initial cash we obtain: $4. In order for them to make money to pay their expenses and taxes.40 0.30 for $80.3%) 0.47. $7.40 0.172 $42.04 (52.35 0. .83 (71.50 0.00 (Without rounding the probabilities from the F matrix the expected loss works out to $7.6%) 0. and $5.7%) p 0.98 (40.270 c April 28. The preceding has been based on the arbitrarily chosen value of p = 0.M.190 $21. Beginning with $40 Probability of leaving Expected with $100 Loss 0.478 $12. they will set p to be less than 0.50 0.360 $23. This is why the game is called gambler’s ruin.45 0.41 (28.39 (71.47 is: $40 − (0.600 none 0.48 (83. 2010 D.45 0.01 for $40.116 $28.065 $33.4%) p 0. They don’t have to make it much less for them to collect the lion’s share of the winnings. Beginning with $60 Probability of leaving Expected with $100 Loss 0. if the gambler enters with $40 the expected loss based on p = 0.30 Things are even more bleak for someone who starts out with only $40. For example.01.5%) 0.3%) 0.35 0.0%) 0.256 $34.33($100)) = $7.5% chance of winning overall.30 Here we see for example that a 30% chance of winning on any one play (which doesn’t sound too bad) translates into only a 6.

2. If the student also passes the exam at the end of Year 2. State 1 . Note that passing or failing each year’s program are not states. they are the transitions between the states. If the student fails the same year twice. We could model this situation as a Markov chain. and 75% for Year 2. then the student graduates. or fails Year 2 having previously failed Year 1.Year 2 (the student is currently enrolled in Year 2) The pass rate is 80% for Year 1. he or she then enters Year 2. If the student passes Year 1. then he or she is required to withdraw. state. Eventually.RTW (the student has been required to withdraw) State 3 .2 Educational Model The ﬁrst part of the Exercise for this lecture is based on the content of this section. The Year 2 pass rate is still 75% for those who have never failed before. Instead. If a student fails either year. This would only be correct if the year could be repeated any number of times. and 40% will end up in the RTW state. 2010 D.1 Extension 1 Now we consider a more realistic (and more complicated) model.c April 28.2 Extension 2 Things are as they were in Extension 1. The new Markov chain is not simply the old one with a loop from State 3 (Year 1) to itself. The Year 1 pass rate is still 80% for ﬁrst-timers. Clearly.Grad. but students are now allowed to fail once. 17. The drawing of the state transition diagram is left as part of the Exercise.Year 1 (the student is currently enrolled in Year 1) State 4 . but is 60% for those who repeated Year 1 and are now doing Year 2 for the ﬁrst time.M. . we expect that 60% of the students will end up in the Grad. the overall success rate is 80%(75%) = 60%. he or she is required to withdraw (RTW). and is 85% for those who are doing Year 2 for the second time. Suppose that a college offers a course over two years. but now the pass rates depend on the history. 17. (the student has graduated from the program) State 2 . The pass rates are the same as before. in which there are two absorbing states and two transient states.2. The same applies for Year 2. Tulett 271 17. with an exam at the end of each year written on a pass/fail basis. we need two “Year 1”-type states: one for ﬁrst-timers. but is 90% for repeaters. and one for repeaters.

M.3. then because the repair is . because having two working components is sufﬁcient. i. 17.2 Formulation In this situation if we try to make the model at the component level it will have nine states. Instead. and each can be working. one waiting for repair. 2010 D. with one being repaired. If the system is in state 1 and both working components fail. we have to try altering the chain. in which two components are working and the third is idle. When one component fails. It can be seen that the machine must be at all times in one of three situations.272 c April 28. and are always successful. and one component idle. At the end of every hour there is probability p that each operating component will cease to operate. two components working and the third is under repair. We can create another state to handle the 60% vs. because each component is identical. If the system is in state 2. This would lead to a model which would be overly complex. In the rare situation where two operating components fail simultaneously. Again. the machine is still considered to be “up”.1 Repair Problem A Situation Description A machine contains three identical components. Under normal operation. Though the machine is under repair. so when it is relevant. The repairs always take an hour. The repairer takes an hour to repair one of the two broken components. or under repair. and then repairs the other one. and the third is in working order but idle. (There’s no room for two repairers to work simultaneously. idle. then the system returns to this state. Tulett The assumption of a Markov chain is that history is irrelevant.3. and if neither working component fails. If neither working component fails. because there are three components. If one fails but the other does not.3 17.e. we will make the model at the level of the machine. the drawing of the diagram is left as part of the Exercise. then the machine is “down” and under repair (State 3). two of the components are working. 17. and a repairer begins to ﬁx the non-functioning component.) We wish to model this situation as a Markov chain. This leaves us with three “Year 2”-type states. To see this we begin with the state of normal operation (State 1). the machine is then “down”. the idle component then starts operating. then the machine is “up” but under repair (State 2). 85% pass rates. This probability does not depend on how long the component has been working.

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.0582 0. In states 1 and 2. For example.e. are transitions between the states. (1 − p)2 for two simultaneous non-failures. If the system is in state 2 and just as one component is repaired either (but not both) of the working components fails. the component being repaired becomes an idle component. 2010 D. we could ﬁnd the steady-state probabilities x1 .0009 P = 0.M. or a function of p. we can create a numerical diagram or matrix. the breakdowns of the components. when p = 0. so we are left with a three-state Markov chain. it must move to state 2 when the state under repair becomes operational. then the system stays in state 2. If the system is in state 2 and both components fail. With three coloured boxes for the components. the joint probabilities are given by the binomial formula with n = 2: p2 for two simultaneous failures. i. if the system is in state 3.03. Finally. We have tracked down all the possibilities. Tulett 273 completed at the next transition the system will move into State 1.0009 0 1 0 By using the method seen two lectures ago. and red to mean waiting for repair. 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. and x3 .9409 0. using green to mean working.c April 28. The state transition diagram is shown in Figure 56. and the third one is waiting for repair. . the system has moved to state 3. 1 (if required).0582 0. one of the other two components is being repaired. and moment that the component is switched on after being repaired. the state transition probability matrix is: 0. yellow to mean under repair.9409 0. x2 . and 2 p(1 − p) for one failing but the other not failing. The probabilities of transition are all either 0 (if impossible). blue to mean idle.

274 c April 28.M. 2010 D. Tulett (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 1 p 2 .

1 = (1 − p)2 . State 4 has one component being repaired. but failing to ﬁx it (probability 1 − q) keeps the system in state 4. This is: p2. Tulett 275 17. and p3.3 = (1 − q). For exiting from states 1. 2010 D. and two components waiting for repair. which are shown on the state transition diagram in Figure 57.1 = (1 − p) × (1 − p) × q . This probability does not depend on how many hours the repairer has been working on the failed component.3 = q. and using the previously deﬁned 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. The probabilities coming out of State 2 are much more difﬁcult to determine.M. stays in state 2 if exactly one working component fails. we have the same thing as in Repair Problem A: p1. but failing to ﬁx 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. then the system moves to state 1 if neither working component fails. we have: p4. For this. In state 2. 3. In state 1. Hence we only need one more state. nothing is being repaired. we have: p3. and p4. these are easy to ﬁnd.c April 28. and will be in state 3 if exactly one operating component fails. What we must do is see what other states might be needed now. From state 1. if the repairer fails to ﬁx the component this hour.3 = p2 (the system cannot go from 1 to 4).2 = q. Things are as they were in problem A. Fixing a component in state 3 (probability q) moves the system to state 2 (as before). From state 3. so the probabilities exiting from state 1 do not depend on q. In state 2.4 = (1 − q). and p1. if the repairer ﬁxes the component this hour. but now the probability of successful repair in an hour is q (rather than 1). and 4. then there will be three bad components. We clearly need the three states that we deﬁned earlier. we need a new state.4 Repair Problem B Now we consider a more complicated repair problem. we want the joint probability of two working components not failing and the other component being successfully repaired.2 = 2 p(1 − p). If both operating components fail. To go from 2 to 1. p1. From state 4. then in the next hour the system will be in state 2 if neither operating component fails. and moves to state 3 if both working components fail.

2010 D.M. Tulett (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) + q p2 q Down & Repair (3) 2p (1 − p) (1 − p2 p2 (1 − q) q) q All Down & Repair (4) 1−q Figure 57: Repair Problem B 1−q .276 c April 28.

0009 0.2 .0582 0.c April 28.75272 0. and the other way is if both working components fail combined with the third component being successfully repaired.8 0 0. 2010 D. There are two ways in which one working component fails and the other does not combined with the third component not being successfully repaired.8 0 0 0 p2 (1 − q) 0 1−q 0. if p = 0. This is: p2.00018 0 0. This happens when both working components fail and the third component is not successfully repaired. then: 0.9409 0.01236 0.8.4 = 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 1−q 0 0 q For example.M.2 0. This is: p2. and the other way is if neither working component fails combined with the third component not being successfully repaired. This is: p2. There are two ways in which one working component fails and the other does not combined with the third component being successfully repaired.03 and q = 0.2 = 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. Tulett = (1 − p)2 q 277 There are three ways of going from State 2 to itself.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 4.23474 P = 0 0.

Only one line can be repaired at a time. then he or she is required to withdraw. If the student passes Year 1. If the student also passes the exam at the end of Year 2.278 c April 28. 17. Tulett 17. If the student fails the same year twice. The Year 2 pass rate is still 75% for those who have never failed before. 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.M.5 17. and 75% for Year 2. On any day on which line A is operating.) . there is probability p that it will go down at the end of the day. The pass rate is 80% for Year 1. but now the pass rates depend on the history. Extension 2 Things are as they were in Extension 1. then the student graduates. Extension 1 The pass rates are the same as before. Suppose that a college offers a course over two years. but is 60% for those who repeated Year 1 and are now doing Year 2 for the ﬁrst time. Normally. but is 90% for repeaters. Model this situation as a Markov chain.1 Exercise Educational Model Draw the state transition diagrams for Extensions 1 and 2 as described for the following problem. he or she is required to withdraw (RTW). The Year 1 pass rate is still 80% for ﬁrst-timers. if both are down. If a student fails either year. (Hint: there are four states. On any day on which line B is operating.2 Repair Problem There are two transmission lines from a generating station to a nearby city. and is 85% for those who are doing Year 2 for the second time. both are operating (“up”).5. but students are now allowed to fail once. 2010 D. they repair line A ﬁrst. he or she then enters Year 2. or fails Year 2 having previously failed Year 1.5. with an exam at the end of each year written on a pass/fail basis.

While some contestants would guess in this situation. or walk away? The expected value criterion (also called expected monetary value or EMV) says that the contestant should guess. If the next question is answered correctly. For example. 2010 D. Tulett 279 18 18.000.000. the contestant will have $125. 000) > 0. Where U (x) means the utility of the amount x. 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. For the individual we need to derive his or her utility function by obtaining a set of data points. However. preferring the $64. Actual human behaviour often tends to shy away from risky situations in favour of a more certain situation.000. What should the contestant do: guess. We are now looking for the best alternative(s) for a particular individual. others would not. 000) + 0. These are most easily represented by a graph.e. walking away) which is $64. Instead of looking for the alternative with the highest expected payoff.000 for sure. Another person may choose to do something quite different. What we want to do in this lecture is to capture this effect in the analysis of competing alternatives.c April 28. 000) + 0.e.5($125. This decision criterion works best when a decision is repeated many times.5U ($125. but can also be given as a mathematical .5($32. our principal decision criterion was that of expected value. otherwise he or she will be left with just $32. The 50/50 lifeline has been used to narrow the correct answer down to two possibilities. At each point of uncertainty the payoffs were weighted by the probabilities to calculate an expected payoff at that point. even when the expected payoff of the former is higher. we are now looking for the alternative with the highest expected utility . 000) i.1 Utility Theory 1 Introduction In all the material which we saw earlier on payoff matrices and decision trees. but each of these two is equally likely in the contestant’s eyes. 500 This is greater than the value of not guessing (i.5U ($32. The expected value associated with guessing is 0.M. this criterion may not be the best in a non-repetitive situation in which a great deal of money is involved. the contestant who chooses to walk away is saying that U ($64. 000) = $78.000. the utility of the sure thing is greater than the expected utility of the gamble.

2 Obtaining the Data for a Utility Function The data for a particular individual’s utility function is obtained by asking him or her a series of simple questions. (ii) prefer the gamble. using expected value as the decision criterion leads to indifference.5($10. 000) = $5000) equals the value of the sure thing. If the answer is (i) (the sure thing).000. to say $4000. Would you (i) prefer the sure thing.5($0) + 0. Tulett function. In this case the third question would be: Now suppose the sure amount is $4000. (ii) prefer the gamble. the interviewer could start out by saying: Suppose that you are given a choice between having $5000 for sure. the question can be repeated. but now the sure amount is only $3000. or (iii) be indifferent between the two alternatives? . the amount of the sure thing can be increased. (ii) prefer the gamble.M.280 c April 28. because the expected value of the gamble (which is 0. Would you (i) prefer the sure thing. If in this situation the decision maker says that he or she prefers the sure thing. Other possibilities are to prefer the gamble ( risk preferring ) or to be indifferent ( risk neutral ). or (iii) be indifferent between the two alternatives? If the person still prefers the sure thing. this is the usual response. For example. or being able to play a game with an equal chance of winning nothing or winning $10. 18. using say $1000. Would you (i) prefer the sure thing. or (iii) be indifferent between the two alternatives? Obviously. 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. However. If the person now prefers the gamble (as most people would). then the interviewer could ask the following as the next question: We have the same situation as before. then that person is said to be risk averse for this situation. the answer to the interviewer’s question has no right or wrong answer. 2010 D.

5(0) + 0. rather than going up and down until the point of indifference is obtained. U ($3440) = 0. at $3500 still prefers the sure thing. 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. 000) = 100 U ($0) = 0 Based on these values we can easily ﬁnd the utility of $3440: U ($3440) = 0. 000) = 0. For example we can deﬁne: U ($10. and then ﬁnally at $3440 he or she is indifferent between the two alternatives. so that we may solve for it. then at $3400 prefers the gamble. 000) This critical amount (in this case. The question posed to the decision-maker could be: What amount of money would make you indifferent between having this amount for sure. 000) = $6720 . As an equation this is: U (CE ) = EU (gamble) It is useful to establish a scale for a graph.c April 28.M. In other words.5($3440) + 0. Also.000? The expected value of the gamble is: 0. 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).5U ($10. Perhaps at $4000 the decision-maker prefers the sure thing. $3440) is called the certainty equivalent of the gamble.5U ($10.5U ($0) + 0.5U ($0) + 0. we could simply ask for the point of indifference. because this is a known point. then at $3450 prefers the sure thing. 2010 D.5($10. Tulett 281 This is repeated going up and down as necessary until we hit the point of indifference. We can do this by now asking a question based on the utility of $3440. or being able to play a game with an equal chance of winning $3440 or winning $10.5(100) = 50 We want all subsequent questions to have only one unknown.

2010 D. Tulett A risk-averse person will be indifferent at an amount less than this ﬁgure. Because each person will draw the curve slightly differently. but we’re not going to use anything that sophisticated. the point of indifference may be at $6420. the numerical values will differ slightly from one person to the next.282 c April 28. 000) = 0. What we want to do now is to draw a curve through these points.5U ($3440) + 0.5(50) + 0.5(0) + 0. For our purposes. There is a whole area of mathematics which is devoted to estimating a function from a set of data points. This is shown in Figure 58.5(100) = 75 Another question that could be asked is: What amount of money would make you indifferent between having this amount for sure.M.5U ($10.5(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 ﬁve points. or being able to play a game with an equal chance of winning nothing or winning $3440? The expected value of the gamble is $1720.5U ($0) + 0. it will sufﬁce to draw a curve by freehand through the known points. suppose that a student with little money chooses a certainty equivalent .5U ($3440) = 0. This decision maker has made this curve already possessing a wealth level. For example. Using the fact that U ($3440) = 50 (which we just calculated) we obtain: U ($6420) = 0. We then calculate: U ($1180) = 0. Often the level of a person’s wealth will affect his or her attitude to risk. For example. for a risk-averse decision-maker the certainty equivalent might be only $1180.

c April 28.000 $5000 $7500 x . Tulett 283 100 75 U (x) 50 25 0 $0 $2500 $10.M. 2010 D.Amount above Current Wealth Figure 58: Data Points for the Utility Function .

this is how we shall treat all examples. we compute the expected utilities.5). 2010 D.45 0. One of six dollar ﬁgures in the table has a known utility: U ($0) = 0. and then go across to the vertical axis. Now. A few days later. When this is complete. to use a utility function on a decision problem it is important that the person’s wealth level does not change between the time that the function was obtained and the function would be used. It’s hard to estimate a number any closer than this (magniﬁcation shows that the utility is about 86. If we work out the expected value for each alternative we obtain $4400 for “Keep Existing Capacity” and $4510 for “Expand Capacity”. which is $5000. the student wins $100. we create the following utility matrix.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. For example. we start at $8000 on the horizontal axis. go up to the curve. We go through the same procedure for all the dollar amounts in the above table.000 in a lottery.30 0. unless indicated to the contrary.284 c April 28. Because of this. Hence a risk-neutral person would choose to expand capacity for a ranking payoff of $4510. and for each alternative. Indeed. Using either 86 or 87 would be ﬁne for our purposes. 18. Now he or she can afford to take a risk. For the other ﬁve.25 Keep Existing Capacity Expand Capacity Prob.000 or nothing. In the caption it is emphasized that this is for dollar amounts beyond the person’s wealth level. This is shown in Figure 60. we must use the graph. . let us see what our risk-averse decision maker would do.M. to ﬁnd the utility of $8000. Tulett of only $3000 for a 50/50 gamble of $10. If we do this carefully we see that the utility of $8000 is about 86 or 87. so now the certainty equivalent of the same gamble may well be closer to the expected value. A possible drawing of the curve is shown in Figure 59.

000 $5000 $7500 x . Tulett 285 100 75 U (x) 50 25 0 $0 $2500 $10.M. 2010 D.Amount above Current Wealth Figure 59: The Utility Function Shown as a Smooth Curve .c April 28.

Tulett 100 U (x) ≈ 87 75 U (x) 50 25 0 $0 $2500 $10.000 $5000 $7500 x .M.286 c April 28.Amount above Current Wealth Figure 60: Finding the Utility of $8000 x = $8000 . 2010 D.

A gamble with a two-thirds chance of winning nothing and a one-third chance of winning $50. the optimal alternative is different than the one recommended when using expected value as the decision criterion.000. using the utility function we would recommend for this particular individual that he or she should keep the current capacity.M. 2010 D.000 or $100. because this risk-averse decision maker is prepared to forego some of the proﬁt to avoid the risk. By drawing a horizontal line through U (x) = 57 until we reach the curve as shown in Figure 61. Recommendation Using expected value as the decision criterion. A gamble with a 90% chance of winning nothing and a 10% chance of winning $100. the probabilities do not have to be equal.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. .c April 28.30 0.9 287 Keep Existing Capacity Expand Capacity Prob.000 has a CE of $25. Also. The best alternative is to “Keep Existing Capacity”. this alternative has a certainty equivalent of about $4200.25 Expected Utility 57. meaning that they can be negative (just like temperature). For one thing. In this example. This ﬁgure is less than the expected value of $4510.000 has a CE of $60.000. we see that the certainty equivalent is at about $4200. 18. we would recommend expanding the capacity for a ranking payoff of $4510. 3. This alternative has an expected utility of 57. and then drawing a vertical down from this point. Suppose that an interview has produced the following information: 1. For this person.000. A gamble with an equal probability of winning either $50.000 has a certainty equivalent (CE) of $25.45 0.0 51. Tulett Demand Low Medium High 35 55 87 0 62 96 0. However. 2. we can create utilities outside of the initial scale.

000 $5000 $7500 x . Tulett 100 75 U (x) U (x) = 57 50 0 $0 $2500 Figure 61: Finding the Certainty Equivalent of U (x) = 57 x ≈ $4200 $10. 2010 D.288 c April 28.M.Amount above Current Wealth 25 .

A gamble with a 0.5U (50) + 0. 5.1U (100) = 0. Knowing this. 2010 D. 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) = 30.5(100) = 65 . for example $100. we will have to return to this equation later.000 has a CE of $80.9(0) + 0. Tulett 289 4. 000. we work through each of the seven equivalencies to determine the rest of the data points. 000.000 and a 11/16 probability of losing $30.4 probability of losing $50.5(30) + 0.000 is written as 100.000 and a 0.9U (0) + 0. 7. we can now go back to the second statement to obtain U (60): U (60) = 0.000 has a CE of 0. 6.55 probability of winning nothing has a CE of −$50.5U (100) Since both U (50) and U (60) are unknowns.000.000 and a 5/7 probability of winning $100.45 probability of losing $70.5U (50) + 0. From the ﬁrst we obtain: U (25) = 0.c April 28.5U (100) = 0.000 has a CE of −$50. A gamble with a 0. A gamble with a 5/16 probability of losing $70.M. Arbitrarily setting U (0) = 0 and U (100) = 100. For convenience we will express all ﬁnancial amounts in thousands of dollars. A gamble with a 2/7 probability of winning $60.6 probability of winning $50.1(100) = 10 From the second statement we obtain: U (60) = 0.000 and a 0.

.6(30) 0.4U (−50) U (−50) The ﬁfth equation gives us U (−70): 0.M. 2010 D.55(0) 0.6U (50) 0.290 c April 28. we can start with the unknown on the left.4U (−50) + 0. From the fourth equivalency we obtain: 0.4U (−50) + 0.45U (−70) + 0.000: 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.45U (−70) U (−70) Next we ﬁnd 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 ﬁnd the utility of a loss of $30. Tulett If we recognize the unknown before writing the equation. and drawing a smooth curve through them.45U (−70) + 0.55U (0) 0. gives us the graph shown in Figure 62. Plotting these nine points.

c April 28. Tulett 291 100 U (x) 50 −100 −50 0 50 100 x in Thousands of Dollars −50 −100 Figure 62: Graph of the Utility Function for the Second Example .M. 2010 D.

M.. 2010 D..59.9536 1703.. For our purposes b > 0 and c > 0.59. b..292 c April 28. an inverse exists in analytical form. For now. let us assume that the functions are based on changes to the decision maker’s current wealth level. and c are given constants.56 9517. x = $680. This is useful for when we have found the expected utility of an alternative. Hence we have CE = $1703. is found as: U (680) = 5(680) + 1000 √ = 4400 = 66. for example. and a. This type of function has special properties which we shall examine in the next lecture.5. A Square Root Function An example of such a function is √ U (x) = 5x + 1000 Since we must have 5x + 1000 ≥ 0.5 18.56.1 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. The utility of an amount in the domain. Tulett 18. but we will use exogenously given utility functions. the domain of this function is x ≥ −200.9536 8517. For this function. 97. and we wish to ﬁnd its certainty equivalent. For example. An Exponential Function A modiﬁed exponential function is one of the form U (x) = a − be−cx where x is the amount of money in dollars. suppose that we have found EU = 97.3324958. √ 5x + 1000 = = 5x + 1000 = 5x = x .

001x 2. or something similar.5.001x 293 [On some calculators. We wish to ﬁnd the recommended alternative and the certainty equivalent for the following functions: . 2010 D.2 A Simple Decision 7 − 3e−.675 Here is a simple decision problem in payoff matrix format: O1 90 110 0.] At x = $5000.02021384 6.6 O2 55 30 0.00673795) 7 − 0. exponents may be handled as 2nd function ln .4 A1 A2 Prob. we proceed as follows: 4.M. 18.356675 356.001x = x = The certainty equivalent is $356.675. the function is: U (x) = 7 − 3e−0.9.9 = 3e−. and c = 0. we obtain: U (5000) = = = = = 7 − 3e− 1000 7 − 3e−5 7 − 3(0.1 0. Tulett For example.97978616 5000 This type of function has an analytical inverse function. so if we have an expected utility of say 4.c April 28.001x = −. and if we want the certainty equivalent.001x = e−. b = 3. where a = 7.001.7 ln(0.001x = ln e−.7) −0.

2(90) + 100 √ 280 = = 16. 2010 D. and U (30). Hence we solve: 3 − 2e− 200 x −2e− 200 x e− 200 x − 200 x x = = = = = 75.733201 . so we recommend the use of alternative 1.619094 The higher EU is in the A1 row. Now we solve situation (ii) where U (x) = U (90) = √ 2x + 100.M. and put these numbers into a utility matrix.. beginning with x = $90.6 O2 1.376286 The certainty equivalent is about $75. Tulett (i) and (ii) We begin (i) ﬁrst ﬁnding U (90): U (90) = = = = = U (x) = 3 − 2e− 200 U (x) = √ 2x + 100 90 x 3 − 2e− 200 3 − 2e−0.637628) 3 − 1.372811 0.275256 1.294 c April 28. 1.627189 −1. A1 A2 Prob. U (110).724744 Similarly.627189 1. we ﬁnd U (55).4 EU 1. and work out the expected utilities on the right.686406 −0.257.627189.278584 0.724744 1..26.480856 1. O1 1. The certainty equivalent is the number CE such that U (CE ) = 1.846100 0.45 3 − 2(0.

793814 150. . U (110).793814 75.836471 250.649111 0.3969. and U (30).836471.M. U (x) √ 2x + 100 2x + 100 2x x = = = = = 15. and put these numbers into a utility matrix.491377 12. O1 16..4 EU 15.40. The certainty equivalent is about $75.c April 28. and work out the expected utilities on the right. 2010 D. We now solve for the certainty equivalent.836471 15. we ﬁnd U (55). As with (i).792771 A1 A2 Prob.733201 17. we recommend alternative 1.. Tulett 295 Similarly. The EU of this optimal alternative is 15.6 O2 14.888544 0.836471 15.

Tulett 18. The payoffs associated with each alternative and outcome are (in thousands of dollars) as follows: Weather Cloudy Sunny 600 800 400 600 0.000. $1. 0.000 proﬁt (prob.296 c April 28.000 loss (prob.25) or $600. $1. 2010 D.85) or a $100.000. (iv) $400. (ii) $700. 0.000 proﬁt (prob. or whether to wait until next year.6. $700.000 loss will have a utility of zero and a $1. which may be rainy. $600. Furthermore. (c) What strategy should the golf course adopt using the expected utility decision rule? (d) What is the certainty equivalent of the optimal strategy? . 1 11 ). they are indifferent in the following four situations.15). 0.000 proﬁt (prob. (iii) $600.75).25 Alternative Expand now Wait a year Probability Rainy −100 100 0. cloudy.M. 0. (a) What is the recommended alternative using the EMV decision rule? (b) Construct the utility curve. 10 11 ) 2 3) or $100.000 for certain.000 proﬁt (prob.000 proﬁt a utility of 100.000 proﬁt (prob. (i) $700.40 0.000 for certain.1 Exercise Problem 1 A golf course is considering whether to expand from 9 holes to 18 holes this coming season.000 for certain.6 18. The payoff for each alternative depends on the weather.000 proﬁt (prob. or $100. 1 3 ).35 The company has decided that a $100.000 for certain.000. or sunny.000 proﬁt (prob.

M.2 (a) If she is risk-neutral. Just prior to making the decision.c April 28. or a new large one (or do nothing). Find the recommended alternative and the certainty equivalent.6. and the certainty equivalent (exclude the current wealth at the end). which may be low. Find the recommended alternative. or high. her wealth level is $200.5 0. Tulett 18. (c) Suppose now that her utility function is U (x) = x 100 x where x is her level of wealth in thousands of dollars. medium. .000. what should she do? (b) Suppose now that her utility function is U (x) = 1 − e− 1000 where x is in thousands of dollars.2 Problem 2 297 An investor is considering whether to expand her business by adding a new small store. The payoff for each alternative depends on the demand. 2010 D. The payoffs associated with each alternative and outcome are (in thousands of dollars) as follows: Demand Medium High 0 0 100 300 180 400 0.3 Alternative Do nothing Small store Large store Probability Low 0 −50 −200 0.

2 Three Useful Properties Here are three properties that may be useful for a decision maker’s utility function: 1. Based on these derivative tests. The ﬁrst property requires that the ﬁrst derivative be positive everywhere. we show how to compute the EVPI when a non-linear utility function is used. which requires that instead of using cost gates and/or payoff nodes. we illustrate the use of utility functions on a decision tree. it can be shown that both square-root type functions and exponential functions obey these two properties.e. this was the basis for being allowed to ignore costs or payoffs which are common to all alternatives. More is preferred to less.M.298 c April 28. that all payoffs and costs be consolidated on the extreme right-hand branches of the tree. 2. We can test a differentiable function for these two properties by taking the ﬁrst and second derivatives. The third property is certainly true when the decision criterion is expected value. The second property (riskaversion) is empirically useful. Tulett 19 19. the relative ranking of the alternatives does not change. However. The decision maker is risk-averse. We shall see that this is now quite complicated. the higher the utility. 19. the higher the payoff. Indeed. i. Thirdly. 2010 D. 3. Several advantages arise because of this third property: 1. the second property requires that the second derivative be negative everywhere. only the exponential utility function possesses all three properties. it turns out that the only type of non-linear utility function for which this is true is the family of exponential utility functions. but of course is not a requirement of all utility functions. It seems reasonable that all utility functions would possess the ﬁrst property. The current wealth level of the decision maker is irrelevant. Then. except when the function is exponential. .1 Utility Theory 2 Introduction We begin this lecture by explaining three properties which may be useful for a utility function to have. If the same amount is added to all payoffs.

6 O2 55 30 0. The EV with PI is 0. 19.4 First. let us recall how to ﬁnd the EVPI when the decision criterion is expected value. then ﬁnd the EV with PI. 2010 D.4($55) = $88.3 Finding the EVPI In this section we show how to calculate the EVPI. O1 90 110 0. O1 90 110 0.724744 1. and the EVPI is therefore $88 − $78 = $10.c April 28. can be ignored.278584 0. 3. Any cost or payoff which is common to all cells of a payoff matrix. With an exponential utility function the approach is more complicated but similar. As an example we will use the payoff matrix seen in the previous lecture: A1 A2 Prob. The different methods will help illustrate the third property described above.6 O2 1. The expected value of perfect information (EVPI) is easier to compute than it is for other non-linear utility functions.4 EV 76 78 A1 A2 Prob. Hence a risk-neutral person would choose alternative 2 with a ranking payoff of $78. or common to all ending branches of a decision tree.6($110) + 0. Tulett 299 2. We compute the EV for each alternative.480856 1. and ﬁnally subtract the EV of the optimal alternative from the EV with PI.M. From the previous lecture we had the utility function: U (x) = 3 − 2e− 200 Using this formula we found: A1 A2 Prob.4 EU 1.846100 0.6 O2 55 30 0. if desired.619094 x . O1 1.627189 1.

7000024 −1.7000024 To ﬁnd the CE of this we solve: 3 − 2e− 200 x −2e− 200 x e− 200 x − 200 x x = = = = = 86. Hence the EVPI is about: EVPI = CE(EU with PI) − CE(optimal alternative) = $86. and from this subtract the CE of the optimal alternative.6499988 −0.16. Tulett We found the CE of 1.e. 1.26 = $10.16 − $75. and we let the symbol f represent the amount of the fee..846100) + 0.6.26.300 c April 28. To ﬁnd the EVPI using the exponential. After paying f to obtain perfect information.627189 to be about $75..4 A1 A2 Prob. other than the exponential) is more complex.4307848 Hence the CE of the EU with PI is about $86. As before. 2010 D.6 0. 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 ﬁnd the EVPI.480856) = 1. we imagine that perfect information is available for a fee. Instead.M. we must ﬁnd the CE of the EU with PI.15695.2999976 0.90 The method for ﬁnding the EVPI for non-linear utility functions in general (i.4(1. The dollar amounts from the original matrix are: O1 O2 90 55 110 30 0. we are told that the outcome will be O1 with probability 0. except for the EU of the optimal alternative. EU with PI = 0.6(1. and we are told that the outcome will be O2 with .

and probability 0. 2010 D.6 320 − 2 f + 0.491377 12. An equation like this one was seen in Chapter 1 of Mathematics for Management Science.4 210 − 2 f = 15. after paying f to hear the perfect information. there is probability 0.M.649111 0. with a gross payoff of $110. In summary. and then squaring both sides again. Instead of doing it this way.792771 We recall the following utility matrix from the preceding lecture: A1 A2 Prob.6 O2 14.4 Hence the EU obtained without perfect information is 15. simplifying. Leaving cell A1 reserved for the value of f .4 210 − 2 f EU 15.6 of obtaining a net payoff of $110 − f . Now we bring in the utility function to ﬁnd 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. It is possible to obtain an analytical solution for this example by squaring both sides.4*SQRT(210-2*A1) .733201 17. we want alternative 1.4 of obtaining a net payoff of $55 − f .6*SQRT(320-2*A1)+0. The EVPI is the amount f such that the decision maker is indifferent between obtaining or not obtaining perfect information. the net dollar payoff is $110 − f . If O2 will occur. and then simplifying again. we put the following into cell B1: =0. for a net payoff of $55 − f . we seek the value of f such that: 0.4. we want alternative 2. Tulett 301 probability 0.888544 0. O1 16.6 320 − 2 f + 0.c April 28. If O1 will occur.836471 15. Such a solution would take a great deal of work.836471. we will obtain a numerical solution using Goal Seek on Excel. Because we must pay f to hear the information.836471 We are left with one equation in one unknown. the expected utility with having paid f to obtain perfect information is: 0. In other words.

When the rollback is complete.000. all payoffs must be imbedded at the end.000 to drill for oil. it would be worth $40. The result of the test would be one of the following: “positive”. The tree without any of the revised probabilities or any of the ﬁnancial information is shown in Figure 63. We will illustrate this procedure using a problem which we saw much earlier in the course in Lecture 8.000. we wish to develop a decision tree for this situation.000. by changing cell A1. The Bayesian . First.836471. the EVPI is $11. setting cell B1 to the value of 15. and this is the EVPI.09. The problem description is repeated here: An oil exploration company has identiﬁed a site under which there may be a pocket of oil. several changes must be made to what we saw earlier. As before. it is useful to ﬁnd the certainty equivalent of the optimal expected utility. and a 10% chance of a negative reading. and a 0. The number which Excel puts into cell A1 is 11.04 probability of a positive reading. If there really is oil present.4 Using Utility Functions with Decision Trees When a decision tree is made for a decision-maker with a non-utility function. All that is different is that we no longer have cost gates as we did before. all costs must be imbedded at the end (on the right). but now we will use the utility function: √ U (x) = 2x + 7 where x is in millions of dollars. To the nearest cent. 19. Secondly. except that we are rolling back the expected utility rather than the expected value. there are no payoff nodes. This is the critical value of f which causes indifference between obtaining or not obtaining perfect information. The probability that oil exists at this location is 1%.“inconclusive”.302 c April 28. We already know what the shape of the tree is. The rollback proceeds as usual. 2010 D.2 probability of an inconclusive reading. then there’s a 0. a 30% chance of an inconclusive reading. there are no cost gates on the tree. or “negative”. and then we ﬁnd the utility of each of these ﬁnal payoffs.000.M.0877. and solve it to obtain a recommendation for the oil exploration company. If the oil exists. If there’s no oil at that location. It would cost $3. A seismic test is available which would cost $40. then there is a 60% chance of a positive reading. Tulett We then use Goal Seek. This means that at each ending branch we must work out the net payoff.

000. Tulett 303 revision is unchanged. 2010 D. hence after “seismic”. The dollar amount to be placed at the end of every ﬁnal branch reﬂects all payoffs and costs on the path between the ﬁrst decision node and the ﬁnal branch. This gives: U (37) = 2(37) + 7 √ = 81 = 9 For −$3. hence the payoff is − $3. 000 − $3. we input −3 into the formula: U (−3) = 2(−3) + 7 √ = 1 = 1 .000: after “seismic”. for a ﬁgure of $37. 000 After “no oil”. For example. Completing this portion of the tree. 000. at the top of the tree after the “no seismic” alternative we have the “drill” alternative followed by the “oil” outcome. 000. These three ﬁgures appear in three places. Since the utility function is based on x being in millions of dollars. and “no oil” the net payoff is −$3.000. 000. the path containing the “do not drill” alternative has neither payoffs nor costs. 040. 000 + $40. Because we will be putting utilities onto the tree. 000. after “seismic” and “do not drill” the net payoff is −$40. 000 + $40.c April 28. and so the net payoff is $0. 000 = $37.000 cost of the seismic test must be imbedded at the end. 000. 000.000. we have the cost of the drilling with no offsetting revenue. “drill” and “oil” the net payoff is: −$40. “drill”.M.000 we input 37 into the formula. The tree with all the ﬁnancial information added to the right of every ﬁnal branch is shown in Figure 65. Putting the revised probabilities on the tree gives us Figure 64. The dollar amounts must be converted to the utility of each of these amounts. 000.000. it appears in Figure 21. we will put a dollar sign in front of all ﬁnancial ﬁgures for emphasis. This gives us: −$3. The $40. 000. 000 Similarly the other two ﬁgures are also reduced by $40. 000 = $36. 960.

Tulett 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 .$ l $$ oi $ $ $n o oil 3 3 3 l l 3 0. 2010 D.304 Oil Event 1 Drilling for Oil do not dril l 0 $$ 0.M.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 c April 28.

Tulett c i ism se Seismic no Testing Oil Event d d 56 4 d s d . 2010 D.7 d 5 34 d d d d do not dril l 33 $ 1$ .01 $ 0$ l$ i o $ $$ no oil 3 3 3 l 0.Oil Event Drilling for Oil do not dril l 01$$ 0.201 d ne d gat d ive d 0 d .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 .99 ill 3 3 r3 d 3 33 3 3 3 3 3 3 3 3 58 $ 1$ .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$ .00 $ 0$ l i $ o $ $ $n o oil 0 3 3 3 l l 3 i .M.985 l3 i3 3 r3 d 0 7 3 3 3 3 3 3 3 3 3 3 c April 28.13 $ 0 $ l i $ o $ $$ no oil 3 3 3 l 0.0 d eis 0 d m d i Seismic ve d i d c te Event d sit Drilling d st o d p d d for Oil d d d inconclusive d 0.$ $ l i $ o $ $$ no oil 3 3 3 0.

306 Oil Event $37.13 $ 0 $ l i $ o $ $$ no oil 3 3 3 l 0.040. Tulett do not dril l 3 −$40.201 d ne d gat d ive d 0 d .000 1$ .000 001$ .000 1 Drilling for Oil −$3.000 −$40.000 c April 28.000 Figure 65: Seismic Testing – Complete Formulation of the Tree .960.868 l3 i3 3 r3 d 42 3 3 −$3.985 ll 3 Drilling i3 3 r3 d st d d 0 7 po 3 3 3 d 3 d for Oil 3 3 3 3 d d 3 3 d inconclusive d −$3.7 d 534 d d d d $36. d eis 0 .960.M.000.960.99 i 3 r3 d 3 3 3 3 3 3 3 3 3 33 Oil Event $0 3 33 ic ism se Seismic no Testing 58 $ $36. $9 $ d 0$ l i $ o m $ d i Seismic ve d $$ i no oil d c te Event t d 3 i 3 3 s 0.040.000 014$ .000 do not dril l 0 $$ 0.000 3 3 3 3 3 $36.000 0.9986 33 r3 d 7 3 3 3 3 3 3 3 3 33 do not dril l −$3. $3 $ 0 $ l i $ o$ $$ n o oil 0 3 3 ll 3 i3 .040.000. 2010 D.$ l $$ oi $ $ $n o oil 3 3 3 l l 3 0.000 do not dril d 6 d l 5 4 d s d 3 0 −$40.

000. None of the other numbers work out exactly. We then rollback the utilities .04. 040.63059 U (−3. to obtain: U (0) = 2(0) + 7 √ = 7 ≈ 2. we obtain Figure 66.e. −3.92 = ≈ 0.M.04) + 7 √ = 6.64575 For $36. and do not drill). U (36.92 ≈ 8.64575 (exactly 7). 000. For there to be any effect caused by doing the seismic test. The corrsponding utility is about 2. Also on this diagram the recommended course of√ action has been highlighted. and −$40.04 respectively.000. Recommendation The investor should do nothing (i. .95917 2(−0.960.c April 28. do not use the seismic. This course of action has a certainty equivalent of $0. 2010 D. Tulett 307 It is just good fortune that we have two perfect squares. the rollback is shown in Figure 67. this would not be sufﬁcient. Putting all the utilities next to the dollar amounts at the end of the branches. we input 36.96) = 2(36. we certainty cause this to be true.04) = U (−0. By using ﬁve places. and −0.96.04) = Note that if we were to use for example only two places after the decimal point. the certainty equivalent is $0.99555 2(−3. These utilities are highlighted.96) < U (37). we input 0. −$3.04) + 7 √ 0. For a payoff of $0.96) + 7 √ = 80. we must have U (36.92 ≈ 2.

000 0 $ l i $ o$ d .64575 $0 c April 28.985 ll 3 Drilling i3 3 r3 d st d d 0 7 po 3 3 3 d 3 d for Oil −$3.000 1$ .63059 l d ive − $40. 2010 D.13 $ 0 $ l i $ o $ 8.001$ 33 d 0 $ $ $36.960.201 do d ne not dril d gat 2.0 −$3.000 .000 3 3 3 3 d d 3 3 d inconclusive d 0. Tulett 58 $ $36.95917 do not dril 2.308 Oil Event $37.040.63059 l −$40.$ l $$ oi $ $ $n o oil 3 3 3 l l 3 0.960.000 3 3 3 3 3 3 33 0.99 i 3 r3 d 3 3 3 3 3 3 3 3 3 33 Oil Event ic ism se Seismic no Testing 2.000 9.63059 d 6 d l 5 4 d s d 3 −$40.000.95917 do not dril 2.000 014$ .000.95917 0.040.000 Figure 66: Seismic Testing – Utilities on the Final Branches .99555 $$ no oil 3 3 3 l 0.000 1.960.M.000 d 0$ l i $ o m $ d i Seismic ve 8.868 il 3 3 r3 d 42 3 33 −$3.0 1 Drilling for Oil do not dril l 0 $$ 0.0 d eis 0 .040.000 3 3 3 d d 3 33 0.9986 3 d r3 d 7 3 33 d 3 3 −$3. $ 9 $ $36.99555 d $$ i no oil d c te Event t d 3 i 3 3 s 0.99555 $$ d 534 n o oil 0 3 3 3 l l i 3 .7 8.

000 0.01659 2.985 l3 i3 3 r3 d 0 7 3 3 3 3 1.$ $ l i $ o $ $$ no oil 3 3 3 0. d 7 $ $$ d 5 34 n o 3 oil 0.64575 d d s d d eis d dm d 56 4 0 0.000 8.000 Figure 67: Seismic Testing – Rolled-Back Decision Tree .960.Oil Event $37.0 −$3.040.63059 l 3 −$40.000 001$ d 0 .9 3 ll 3 i3 33 d r3 9867 d 3 3 d 3 3 0.63059 dega 2.63059 −$40.000 8.64575 $0 d 2.99 ill 3 3 r3 d 3 33 3 3 1.07915 3 3 3 3 3 3 $36.960.868 l 3 i 3 r 3 d 3 42 3 3 3 3 2. Tulett c i ism se Seismic no Testing 58 $ 1$ .99555 −$3. $9 $ 0$ l$ i o $ $$ no oil 3 3 3 l 0.13 $ 0 $ l i $ o $ $$ no oil 3 3 3 l 0.000 014$ .000 1. $3 $ 0$ l i $ o .000. 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 do not dril l 2.040.000 9.99555 −$3.960.95917 Drilling for Oil 2.000.95917 309 2.99555 −$3. 2010 D.08 3 3 3 3 3 3 Oil Event c April 28.95917 0.201 do d n not 2.63059 33 3 3 3 3 2.000 0.64575 do not dril l 01$$ 0.000 8.M.000 0.63059 dril 2.040.0 $36.96986 3 3 3 3 d d 3 3 $36.63059 l t d ive 3 −$40.

99*SQRT(7-2*A1) We then use Goal Seek with cell A1 reserved for f . Since the cost of doing the seismic ($40.64575 We put the following formula into cell B1: =0. Tulett As with any problem using Bayesian revision. and B1 being set equal to 2.167934. Hence we needed to work out the solution on the entire tree.64575.64575 which simpliﬁes to: 0.000) is less than the EVPI.64575.4. 0. .1 The EVPI c April 28. The current EU is 2. since f is in millions of dollars. 0.01) which gives a utility of 2(37 − f ) + 7.934. we need not evaluate the testing alternative. we cannot exclude the possibility that the seismic is worth doing.99) with a utility of 2(0 − f ) + 7. it is possible to ﬁnd the EVPI.99 7 − 2 f = 2. or lead us not to drill if there is no oil (prob.M. and then compare this with the cost of doing the testing. Therefore.99 2(0 − f ) + 7 = 2.01*SQRT(81-2*A1)+0.01 81 − 2 f + 0.310 19. In this example perfect information costing f (in millions of dollars) would lead us to drill if there is oil (prob. 2010 D. the EVPI is $167. hence we wish to solve: 0. If the EVPI < the cost of testing.01 2(37 − f ) + 7 + 0. We ﬁnd the solution to be f = 0.

2 0. and calculate the certainty equivalent. (b) Her utility function. medium.5. or high. 19. x .M. The payoff for each alternative depends on the demand.1 Exercise Problem 1 This is a repetition of the second problem from the previous lecture. 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. Where x is in millions of dollars. where x is in thousands dollars.5). 2010 D. putting all costs and payoffs onto the ends of the ﬁnal branches. her wealth level is $200. (in thousands of dollars). Use Goal Seek to ﬁnd the EVPI numerically. The payoffs associated with each alternative and outcome are.3 where x is her level of wealth in thousands of dollars.c April 28.5 19.5 0. which may be low. or a new large one (or do nothing). except that now the problem is to determine the EVPI for each of the three situations. as follows: Alternative Do nothing Small store Large store Probability (a) She is risk-neutral.2 Problem 2 Reformulate the Niagara Winery problem (ﬁrst seen in Section 5.5. Just prior to making the decision. Betty now uses the utility function: U (x) = 1 − e− 2 Solve to obtain a recommendation for Betty.000. You will need some of the answers from the previous exercise. Tulett 311 19. An investor is considering whether to expand her business by adding a new small store.

e. The players make their moves simultaneously (i. For any combination of moves.e.1 Game Theory 1 Introduction In the material which we saw on making decisions in the presence of uncertainty. and the payoff for each player for each combination of moves. Each player tries to do what is best for himself or herself (i. Also.312 c April 28. This competition is treated like a game. we restrict the competition to two players.M. Both the terms zero-sum game and prisoner’s dilemma are widely used in ﬁnancial and economic publications. one player cannot wait to see what the other player does). in which the gain to one player is equal in absolute value to the loss of the other player. In order to keep the complexity manageable. For a zero-sum game. this is called a constant-sum game . we speak of the payoffs to a player. there was only one decision maker. . we must make some assumptions about their behaviour: 1. 4. there is no cooperation with the other player). At the end of this lecture we will relax the last assumption. 2010 D. only one payoff table needs to be written. We will generically refer to these two persons as Player A and Player B. Unless speciﬁcally indicated to the contrary. Now in this material on game theory . Tulett 20 20. we look at two decision makers in competition with each other. The table is written such that the player on the left (we will call him/her Player A) obtains the payoffs shown. the two players share the same total net payoff. A special case of this is the zero-sum game . a positive number meaning that the player receives something and a negative number meaning that the player loses that amount. 2. Both players know each other’s possible moves. and we refer to each decision maker as a player . The player on top (Player B) obtains the negative of the payoffs shown. Doing this allows us to investigate what is called the prisoner’s dilemma . rather than more than two. 3.

c April 28.e. Tulett 313 20. In this example. We do not need to use (or even see) the table from Player B’s perspective. Player B looks at the table and sees: B1 B2 3 ≤ 7 2 ≤ 5 . Player A will always do better with A1 rather than A2.1 Example 1 In this simple example Player A has two alternatives labelled as A1 and A2. Player A A1 A2 −3 −2 −7 −5 Player B B1 B2 Going back to the original table. no matter what Player B does: A1 A2 3 7 ≥ ≥ 2 5 Therefore. 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. so Player B wants low numbers. and Player B has two alternatives labelled as B1 and B2. 20. then Player A will receive $7 from Player B.2 Pure Strategy Some games are simple in that they lead to each player always choosing the same alternative. but it is simple to ﬁnd. we must remember that the payoffs are to Player A. To look at things from B’s perspective. Player A chooses to play A1. being the negative of the transpose of the original table.2. 2010 D. When this happens each player is said to be following a pure strategy .M. i. and if Player B plays B2. if Player A plays A1. Here are two examples. and a loss of $7 for B. we now determine what each side should do. a gain of $7 for A.

M. In this example: max{min{3. this value is 3. Player B chooses B1. 5}} = = max{3. each player will pursue a pure strategy. and represents a loss of 3 for the player on top. and the optimal solution is to play the corresponding alternatives. and we have therefore a stable solution. We summarize this game as follows: There is a stable solution. Tulett Player B chooses the column with the lower numbers. 2}. we say that this game has a stable solution (also called a saddle-point solution ).e. with Player A choosing A1 and Player B choosing B1. maximin or minimax is the value of the game. 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. However. and the value of the game is $3. i. since this condition rarely holds.314 c April 28. 7} 3 Both maximin = 3 and minimax = 3. Stability is obtained if and only if the maximum of the row minimums (“maximin”) equals the minimum of the column maximums (“minimax”). 2010 D. max{7. Here is an example: . When this condition is true. Here we have a stable solution with Player A choosing A1 and Player B choosing B1. When a game has a stable solution. Because each player has found an alternative which he or she prefers. one could start with a game theory table by seeing if maximin = minimax. the methods to be shown later in this module and the next are of more practical beneﬁt. so maximin = minimax. In this example. In general. 20. The payoff located at the interception of these two alternatives is called the value of the game . 7}. min{2. 2} 3 min{3. It is the payoff to the player on the left. 5}} = = and min{max{3.2.2 Example 2 The number of alternatives for each player need not be equal.

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. Then we ﬁnd the maximum of the row minimums. 2010 D. 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. 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. 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 . so we have a pure strategy: Player A chooses A3. and Player B chooses B2.M. Then we ﬁnd the minimum of the column maximums. and write this number down on the bottom.c April 28. We begin with ﬁnding maximin. we ﬁnd the maximum in that column. we ﬁnd the minimum in that row. and write this number down on the right. In every row. here we repeat the table several times to show each step clearly.

we shall see how some mixed-strategy solutions can be found quite easily. Rather than cover this right away. 20. which is 4. but instead must be played with a mixed strategy in which the players will vary the chosen alternative. we see that the maximum of the row minimums. The next example will illustrate that maximin and minimax are not equal.3 Mixed Strategy Unfortunately. the game does not have a pure strategy. Therefore.M. which is 5.2 Dominance If one alternative is always better than another for one of the players no matter what his or her opponent does.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. Tulett 20.316 c April 28. is not equal to the minimum of the column maximums. 2010 D. 20. then the better alternative is said to dominate over . We must therefore do more work to ﬁnd the solution. and when this happens. 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. very few games are played with a pure strategy. a mixed strategy must be played by each player.3.

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. We can observe dominance when comparing two rows (the higher payoff row dominates). we see that neither dominates the other. it is removed from further consideration. or when comparing two columns (the lower payoff column dominates). The dominated (worse) alternative can be removed from further consideration. we see that: A1 A3 4 6 5 ≥ ≥ ≥ 3 2 4 Hence A1 dominates A3. 2010 D. but we will show each step to help make the method clear. a row such as 2 7 3 would dominate a row such as 1 5 3. and for at least one row the relationship is strictly less than. 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. When we say “higher payoff row”. We put a ‘1’ followed by A1 next to the A3 row to indicate that this is the ﬁrst row or column to be removed. so this comparison ends without even looking at the 1 and the 5. while the dominant (better) alternative stays. and the A3 row is therefore removed from further consideration.M. and the justiﬁcation for doing so is that it is dominated by A1: . 7 ≥ 4. We start looking for dominance among either the rows or the columns.c April 28. We will show this removal by darkening the removed row or column. Tulett 317 the other. and for at least one column the relationship is strictly greater than. hence dominance eliminates lower payoff rows and higher payoff columns. When we say “lower payoff column”. in comparing A1 and A3. but 2 ≥ 6. If we compare A1 with A2. However. and put a number beside it to indicate the order of the removal. We eliminate dominated alternatives. For example. Once a row or column is dominated. 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.

We check the pairs A1 and A2. we now return to the rows. comparing B1 and B3 there is no dominance. A2 neither dominates nor is dominated by A4. because the A3 row has been removed. Having compared all pairs of rows.318 c April 28. Now we compare B2 and B3: B2 6 2 – 3 ≥ ≥ – ≥ B3 5 1 – −2 Note that what lies underneath the A3 row is immaterial. and then A2 and A4. we see that neither dominates the other. we ﬁnd no dominance. For the last of these we ﬁnd that with B2 having been removed. and column 2 is removed. Tulett Player B B1 B2 B3 4 6 5 7 2 1 3 2 4 5 3 −2 Player A A1 A2 A3 A4 1 A1 Comparing A1 with A4.M. Also. Hence column 3 dominates over column 2. Also. then A1 and A4. A2 dominates A4: A2 A4 7 – 1 ≥ – ≥ 5 – −2 . Comparing B1 and B2. we turn our attention to the columns. Player B will choose to remove the higher payoff column (since these are payoffs to Player A). 2010 D. 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 1 A1 Having checked all pairs of columns.

The four expected payoffs are equal and are referred to as the Expected Value (E. If Player B chooses B1. We need to determine p. each player will choose his or her alternatives by using probabilities. This is accomplished by setting the two expressions for the Expected Value equal to one another. E. where it is understood that there is no probability of choosing a dominated alternative. If Player A chooses A1. the expected payoff is 7q + 1(1 − q). Similarly. q and 1 − q are the probabilities that Player B chooses alternatives B1 and B3 respectively. p 4q + 5(1 − q) 1 − p 7q + 1(1 − q) A1 A2 Prob. 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. and solving to obtain p. Hence we have: B1 B3 4 5 7 1 q 1−q 4 p + 7(1 − p) 5 p + 1(1 − p) Prob. the expected payoff is 4q + 5(1 − q). Player A chooses p so that the expected payoff does not depend on what Player B does.V. the expected payoff is 5 p + 1(1 − p). the expected payoff is 4 p + 7(1 − p). If Player B chooses B3.c April 28. We let p be the probability that Player A chooses A1. Since Player A must choose either A1 or A2. and the Expected Value of the game. q.V. the probability that Player A chooses A2 is 1 − p. E.V.M.) of the game. . If Player A chooses A2. 2010 D. 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.

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. 2010 D. but we might want to ﬁnd it again as an arithmetic check. 7q + 1(1 − q) 3q 3q 7q 4 q = ≈ 0.5714 7 The expected value of the game has already been found. using the third of these we obtain: 4 4q + 5(1 − q) = 4( 4 7 ) + 5(1 − 7 ) .320 c April 28. which is accomplished by setting the two expected payoffs equal to each other and solving for q. Tulett 5 p + 1(1 − p) p p 7p 6 p = ≈ 0.429 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.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.M.

in the B1 column. 20. R. Tulett 16 15 + 7 7 31 = 7 ≈ 4. we have |7 − 1| = 6. but we show it here broken into several steps. In the A2 row.3 DARS Algorithm After using dominance to reduce the table to a 2 by 2. The next section gives an easier approach for ﬁnding these things starting from a 2 by 2 table.3. but usually the expected value of the game is expressed in decimal form. 2010 D. B1 4 7 B3 5 1 D R S A1 A2 D R S The ﬁrst thing to do is to ﬁnd the absolute value of four differences. First we add space to the right and on the bottom of the table for the operations D. the recommendation is presented at that point. 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. we put |4 − 7| = 3 into the D row.M. and in the B3 column. Next. In the A1 row. we can combine all the above operations into one easy method. This gives: .429 = 321 In expressing the solution. fractions or decimals can be used for the probabilities. called the DARS Algorithm. and S.c April 28. |4 − 5| = | − 1| = 1 goes into the D column. we put |5 − 1| = 4 into the D row.

the ratios are switched: the R column is switched to obtain the S column. 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 S Finally. i. Filling in the four ratios we in the A1 row.M.e. For example. 1 . The sum is placed where the D column and the D row intercept. 2010 D.322 B1 4 7 3 B3 5 1 4 D 1 6 R c April 28. we add (this is the A of DARS) the numbers in the D column (1 + 6 = 7) and the D row (3 + 4 = 7). the ratio is 1 divided by 7. No matter what the original four numbers may be. Tulett S A1 A2 D R S Next. 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 . 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. and the R row is switched to obtain the S row. the two sums must be the same.

if either of them confesses. The police have caught two men named Murphy and Smith with the goods in their possession. and A2 with probability 1 7 . and B3 with probability 7 . The expected value of the game is 4. Tulett 323 Now in each row and column we have the desired probabilities. The police have put each suspect into a separate interview room. 2010 D. If he confesses. For example. you’re going away for 15 years. Smith is down the hall – if he confesses to the armed robbery. To one suspect they say: “Murphy.1 Situation Description A armed robbery has taken place.c April 28. Player B 3 4 should play B1 with probability 7 . Getting a conviction against both of them for possession of stolen property would be easy. We can obtain the dot product of any one of: the B1 column and the S column. and so on. 20. doing the fourth option yields: 3 3 7( 4 7 ) + 1( 7 ) = 4 + 7 ≈ 4. you know that we got you on the possession charge. and for co-operating. we’ll use your testimony to convict him. the B3 column and the S column.429 Recommendation 6 Player A should play A1 with probability 7 . However. and here’s what we’ll do. and the A2 row and the S row. the A1 row and the S row.4. The latter two operations are like what we did earlier with payoff matrices. for example Player A will play A1 with probability 6 7 . the confession along with other corroborating evidence from the crime scene would be enough to convict the other suspect. so they may be more intuitive. It is important because it has implications for the study of collusion in business.4 Prisoner’s Dilemma Here we present a situation which is not a zero-sum (or constant-sum) game. there are four ways to do this. 20. That alone will get you two years in jail. we’ll not only let you off the armed robbery charge but we’ll knock a year off the possession sentence. . but there’s not enough evidence at the scene of the crime to obtain a conviction for the armed robbery as well. should he not confess himself. as before.M. We now ﬁnd the expected value. If he doesn’t confess.429. Why let him do that to you? Tell us you did it.

4. Here is an example: . The choices for each player are i) do not confess.M. 20. He gives the same offer using exactly the same words. The payoffs are not money but the number of years in jail. By confessing. To consider them as payoffs rather than costs all these numbers are negative. 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.2 Solution Let us assume that both men did indeed commit the armed robbery.5 Obtaining the Payoffs We now return to constant-sum games. 20. 2010 D. This is the dilemma which each man faces: to do what looks best for himself assuming the worse from the other man. and ii) confess. Tulett then we don’t need your testimony. so there is no possibility of a false confession. but for being cooperative. Smith will also confess. but if neither man confesses. The problem from their perspective (not society’s) is that the closed communication prevents them coming up with a solution which is better for them.324 c April 28. we will give you just ﬁve years rather than ﬁfteen. except that the surnames have been switched. so Murphy will confess. Smith has the same table: Murphy Do Not Confess Confess −2 −15 −1 −5 Smith Do Not Confess Confess Therefore. each receives ﬁve years.” Down the hall a police ofﬁcer is speaking to Smith. and we wish to obtain the numbers in the table. or do what is best for both of them. which requires that the other man does likewise. each receives only two years.

then Jill gets all the marbles in their hands. Jack has won the two marbles in Jill’s hand. and then they simultaneously open their hands. 325 In this problem. or ﬁve marbles into his or her hand. if Jack puts three marbles into his hand. suppose that Jack plays three and Jill plays three.c April 28. Jack has lost three marbles to Jill. and if Jill puts two marbles into her hand. . the payoff is the net number of marbles gained or lost. three. then the sum of six is even. In the payoff table from Jack’s perspective. so the payoff is −3. As another example. i. 2010 D. If the total number of marbles is even.M.e. then the sum of ﬁve is odd. Working out all sixteen combinations we obtain: Jill’s # of Marbles 2 3 4 5 −2 3 −2 5 2 −3 4 −3 −4 3 −4 5 2 −5 4 −5 Jack’s # of Marbles 2 3 4 5 The solution of this problem is left as part of the exercise. then Jack gets all the marbles in their hands. so there is a net gain of two marbles. If the total number of marbles is odd. but three of these came from his pocket in the ﬁrst place. so Jill gains three marbles from Jack. so Jack obtains the ﬁve marbles from their hands. Tulett Jack and Jill are playing a game in which each player secretly puts two. four. For example.

and then they simultaneously open their hands. If the total number of marbles is odd. then A wins the sum in dollars from B. three. 20. then Jill gets all the marbles in their hands.6.6. 2010 D. 20. 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.3 Formulation Problem Players A and B are playing a game in which A shows either one or two ﬁngers.6 20.2 Jack and Jill Problem Jack and Jill are playing a game in which each player secretly puts two. and B simultaneously shows none.1 Exercise Mixed Strategy Game Players X and Y are playing a zero-sum game. or ﬁve marbles into his or her hand. If the sum of the number of ﬁngers is even. then Jack gets all the marbles in their hands.6. Write the payoff matrix from A’s perspective. If the sum is odd. four. (Do not solve) . or two ﬁngers. Tulett 20.326 c April 28. The payoff table is seen to be: Jill’s # of Marbles 2 3 4 5 −2 3 −2 5 2 −3 4 −3 −4 3 −4 5 2 −5 4 −5 Jack’s # of Marbles 2 3 4 5 Determine how Jack and Jill should play this game. one. and ﬁnd the expected value of the game. and ﬁnd the expected value of the game.M. then B wins the sum in dollars from A. If the total number of marbles is even.

2010 D.c April 28. after which it can be solved using the DARS algorithm. we further reduce the problem to a 2 by 2.5 2 −3 −4 −1 −2 −2. 21. 21. 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.5 7 4 3 It is easily seen that this example has no pure strategy.5 7 4 3 2 B2 . the table is ﬁrst reduced to two columns. a 4 by 2 and so on.1. To do this we model the problem as a linear optimization model. we need to reduce it using dominance to either a 2 by 3. Using dominance we obtain: B1 B2 B3 B4 B5 A1 −3 3 6 2. 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 2.5 −4 −2 −1 A4 −2 3.M. nevertheless we can still obtain a solution. Starting with any size matrix. Tulett 327 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. the table is ﬁrst reduced using dominance to two rows before proceeding with the graphical solution.5 −4 −2 −1 3. a 2 by 4. or else a 3 by 2. Some problems are not reducible to either two rows or two columns.5 2 1 A4 A2 4 −3 −4 −1 −2 3 A3 A3 5 −2. In the second.1 Graphical Solution We present two examples of zero-sum games. In the ﬁrst. This technique allows us to solve any zero-sum (or constant-sum) game. by using a graphical procedure. For such examples the hand procedure will not work. and so on. Then.1 Example 1 A1 A2 A3 A4 B1 −3 4 5 −2 B2 B3 B4 B5 3 6 2.

5 7 3 Whenever a table is reduced to two rows with three or more columns. We now plot the lines for alternatives B2. 2010 D. Player B wants a low expected value. the problem reduces to: A3 A4 B1 5 −2 B2 B3 B5 −2. The ﬁrst column is that of alternative B1.5) we obtain the line shown in Figure 69. the vertical intercept on the left comes from the bottom number. and the vertical intercept on the right comes from the top number. Plotting and then connecting these two points (0.328 c April 28. then the expected value of the game (denoted as V ) is V = 5 p + (−2)(1 − p). The label B1 is placed next to the line for future reference. At p = 0 we obtain V = −2.5 −4 −1 3. In each case the top number goes on the right. Both Player A and Player B have the same information. and the bottom number (−2) goes on the left. Player A). Expressed another way. because the expected value is from Player A’s perspective. and the probability that Player A will choose A4 is 1 − p. and the vertical axis is the expected value of the game (−4 to 7). p 1− p In the reduced table. Player B wants to be on the bottom of the lines which represent Player B’s alternatives.5 7 3 Prob. There’s really no work to do: the top number (5) goes on the right.M. the payoffs range from −4 to 7. the graph is based on the probability for the player on the left (in this example.−2) and (1.5 −4 −1 3. . The axes are shown in Figure 68. plot these two points. Doing this for all three alternatives we obtain the graph shown in Figure 70. and the bottom number goes on the left. so both are able to draw this graph. and at p = 1 we obtain V = 5. and B5. The probability that Player A will choose A3 is p. If Player B plays B1. B3. For any value of p (chosen by Player A). and then connect them with a straight line. A3 A4 B1 5 −2 B2 B3 B5 −2. Tulett With the dominated rows and column removed. The easiest way to plot it is to evaluate the equation at p = 0 and at p = 1. We also write the alternative name as a label next to the corresponding line. In this example this is represented by three line segments involving alternatives B1. This is an equation of a line. To solve the problem we make a graph for which the horizontal axis is the probability p (0 to 1).

6 .8 .9 7 6 5 4 3 2 1 0 −1 −2 −3 −4 Figure 68: Example 1 – Axes .M.3 .4 .2 . 2010 D.5 .1 .c April 28.7 p . Tulett 329 7 6 Expected Value of 5 the Game 4 3 2 1 0 −1 −2 −3 −4 .

Tulett 7 6 Expected Value of 5 the Game 4 3 2 1 0 −1 −2 −3 −4 .7 p .6 .1 .330 c April 28.5 .4 .8 .9 7 6 5 B1 4 3 2 1 0 −1 −2 −3 −4 Figure 69: Example 1 – Alternative B1 .2 .M. 2010 D.3 .

M.3 .9 7 6 5 Figure 70: Example 1 – Alternatives B1.c April 28.4 .5 . B2.2 .8 .7 p . 2010 D. Tulett 331 7 6 Expected Value of 5 the Game 4 3 2 1 0 −1 −2 −3 −4 . B3. and B5 B3 B1 4 3 B5 2 1 0 −1 −2 −3 −4 B2 .6 .1 .

we can see that optimal solution to this game occurs at p ≈ 0.5 −2 3. Player A is aware of how Player B perceives the situation. We are left with: B1 B2 5 −2. By inspection on the graph.M.42.5 = 13 25 = 26 ≈ 0. The expected value of the game is approximately 1. One way (of four) to calculate the expected value of the game is: V = = 6 7 13 (5) + 13 (−2. but because the game has been reduced to a 2 by 2.5 13 R 7.5 − 13 13 12.5 7 6 7 13 6 13 6 13 7 13 A3 A4 D R S D 7.423. because this point has the highest expected value. and B3 (B5 is not best for any value of p).5 5. This approximate solution is shown in Figure 72.332 c April 28.5 A3 A4 We have an approximate solution for p and V already. we can ﬁnd these things as well as q exactly.5 13 S 11 26 15 26 = = 15 26 11 26 We see that p is 11 26 ≈ 0. Looking at the highlighted line segments. 2010 D.5) 30 17.5 13 5. Player A wants to be at the top. This point is located where alternatives B1 and B2 intercept. These line segments are highlighted in Figure 71. Tulett B2. The graph has allowed us to eliminate two more alternatives because of local dominance. Using the DARS algorithm we obtain: B1 B2 5 −2.962 .5 −2 3.

4 .5 .3 .7 p .8 .9 7 6 5 Figure 71: Example 1 – Player B’s Preferences Highlighted B3 B1 4 3 B5 2 1 0 −1 −2 −3 −4 B2 .M.1 . 2010 D. Tulett 333 7 6 Expected Value of 5 the Game 4 3 2 1 0 −1 −2 −3 −4 .c April 28.2 .6 .

334 c April 28.1 EV ≈ 1 .5 p ≈ 0.2 .6 . 2010 D.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 .3 .42 .M.7 p .4 . Tulett 7 6 Expected Value of 5 the Game 4 3 2 1 0 −1 −2 −3 −4 .8 .

B1 12 18 17 0 3 B4 9 16 16 −2 −6 ≥ ≥ ≥ ≥ ≥ B1 (the higher payoff column) is eliminated. 21. A3. A1.A4. A1.A4.B3.B2. A1. and B2 with probability 13 . so we will take this slowly. and ﬁnally we ﬁnd dominance when comparing B1 and B4. The expected value of the game is 0. A2. Tulett Recommendation 335 15 Player A should play A3 with probability 11 26 . so we move on to the columns: B1.1.A5. and A4. 2010 D. No dominance is found. A3. A2.A4. A2. First we do the row comparisons: A1. 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 . B1.M. and A4 with probability 26 .962.A5.A3.A5.2 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. Player 6 7 B should play B1 with probability 13 .A3.A2.A5.c April 28.

B5. 2010 D.336 c April 28.B5. 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. Finding no dominance in any of these. We have reduced the table down to two columns: A1 A3 A4 A5 B3 B4 2 9 −2 16 12 −2 14 −6 . B2. A1. A1.B4. 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 2 A3 There’s no further row dominance.A5. B3.A2. B3.B5. and so we return to the columns.A3.M. A1. and A2. and B4. Tulett We then continue comparing pairs of columns: B2. It can be seen that both columns B2 and B5 are dominated by B3. we go back to the rows: A1.B4. B2.A3.A4.B3.

The four lines are shown in Figure 74. and 1 − q is therefore the probability that Player B chooses B4.56. Both Player A and Player B have the same information. Player A wants a high expected value. B3 B4 2 9 −2 16 12 −2 14 −6 q 1−q To solve the problem we make a graph for which the horizontal axis is the probability q (0 to 1).2) and label this line A1. This procedure is repeated for alternatives A3. Player B is aware of how Player A perceives the situation. 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 A5 (A1 is not best for any value of q).9) to (1. the payoffs range from −6 to 16. 2010 D. we can see that optimal solution to this game occurs at q ≈ 0.M. Player A wants to be on the top of the lines which represent Player A’s alternatives. the expected value is 2(1) + 9(1 − 1) = 2. This point is located where alternatives A3 and A4 intercept. For any value of q (chosen by Player B). because this point has the lowest expected value (Player B must pay this amount to Player A). and the number on the right side of the table goes on the left side of the graph. The graph has allowed us to eliminate two more alternatives because of local dominance. so both are able to draw this graph. A4. Tulett 337 In the reduced table. A1 A3 A4 A5 Prob. We let q be the probability that Player B chooses B3. and the vertical axis is the expected value of the game (−6 to 16). We are left with: . This approximate solution is shown in Figure 76.c April 28.9. We draw therefore a line from (0. In this example this is represented by three line segments involving alternatives A3. These line segments are highlighted in Figure 75. and A5. Player B wants to be at the bottom. The axes are shown in Figure 73. Looking at the highlighted line segments. the expected value is 2(0) + 9(1 − 0) = 9. The expected value of the game is approximately 5. A4. when q = 1. By inspection on the graph. If Player A chooses A1 the expected payoff is V = 2q + 9(1 − q) When q = 0.

5 .8 .7 q .1 .M.9 16 14 12 10 8 6 4 2 0 −2 −4 −6 Figure 73: Example 2 – Axes .3 .338 c April 28.2 . 2010 D.4 .6 . Tulett 16 14 12 Expected Value of 10 the Game 8 6 4 2 0 −2 −4 −6 .

5 . and A5 A3 A1 10 8 6 4 A4 2 . Tulett 339 16 14 12 Expected Value of 10 the Game 8 6 4 2 0 −2 −4 −6 .3 .2 16 14 12 A5 Figure 74: Example 2 – Alternatives A1. A3.7 q .4 .1 .8 .c April 28. 2010 D.M. A4.6 .9 0 −2 −4 −6 .

2010 D.6 .340 c April 28. Tulett 16 14 12 Expected Value of 10 the Game 8 6 4 2 0 −2 −4 −6 .3 .4 .9 0 −2 −4 −6 .8 .1 .7 q .5 .M.2 16 14 12 A5 Figure 75: Example 2 – Player A’s Preferences Highlighted A3 A1 10 8 6 4 A4 2 .

9 Figure 76: Example 2 – Approximate Optimal Solution for Player B A3 A1 10 8 6 4 A4 2 .7 .c April 28.4 .2 16 14 12 A5 EV ≈ 5.1 .6 .3 . Tulett 341 16 14 12 Expected Value of 10 the Game 8 6 4 2 0 −2 −4 −6 .9 0 −2 −4 −6 .5 .8 q q ≈ 0. 2010 D.56 .M.

5625) + (−2)0. Using the DARS algorithm we obtain: B3 B4 −2 16 12 −2 14 18 0.75 − 0.4375.3 General Methodology To use the graphical solution methodology.5625 0. we can ﬁnd these things as well as p exactly. The expected value of the game is 5.4375 0. 21. or two columns with many rows.5625 (from the B3 column). we seek the apex point at the bottom of the top set of line segments. [It’s just a coincidence that we obtained the same number in the A4 row.4375 = 6.] One way (of four) to calculate the expected value of the game is: V = 12(0. In the two-column situation.5625 = 0.5625.875 Recommendation Player A should play A3 with probability 0. The apex point deﬁnes the choices for the other player.4375 0. and the DARS algorithm can then be applied.1. and A4 with probability 0. .5625.4375 S 0. Player B should play B3 with probability 0. Tulett A3 A4 We have an approximate solution for q and V already.4375. we must reduce by dominance to two rows with many columns.4375 D 18 14 32 R = 0.M. we seek the apex point at top of the bottom set of line segments.342 B3 B4 −2 16 12 −2 c April 28.5625 A3 A4 D R S 18 32 14 32 We see that q is 0. 2010 D.875. and B4 with probability 0.875 = 5.5625 0. but because the game has been reduced to a 2 by 2. In the two-row situation.

Indeed. The probabilities for Player A choosing A1. p1 p2 p3 Player A wants V to be as high as possible. q3 . 2010 D. but V could be less than this amount. 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. B2.M. We deﬁne V = expected value of the game. q2 . 7 and so on. 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 . such that p1 + p2 + p3 = 1. the objective is simply to maximize V. i. The variables are the probabilities and the expected value of the game. and A3 are p1 .c April 28. and p3 respectively. so we must use linear optimization. and q4 respectively. 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. The probabilities for Player B choosing B1.2 Formulation as a Linear Optimization Model A zero-sum game of any size can be solved by linear optimization. The parameters of the model are the numbers in the payoff table. A2. B3. B1 8 6 −4 q1 B2 7 9 −8 q2 B3 B4 −5 1 4 −6 7 5 q3 q4 Prob. A1 A2 A3 Prob. 8. Tulett 343 21. because Player B does not have to choose alternative B1. If Player B chooses B1. p2 . there is no need to try to ﬁrst reduce the size of the model using dominance.e. and B4 are q1 . such that q1 + q2 + q3 + q4 = 1.

sum to 1 non-negativity −V −V −V −V + 8 p1 + 7 p1 − 5 p1 + p1 p1 p1 V is unrestricted + + + − + . Tulett −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. Another related model is obtained by looking at things from the perspective of Player B. we will stress this fact. these are the non-negativity restrictions. The expected value V . but V could be more than this amount. 6 p2 9 p2 4 p2 6 p2 p2 p2 − − + + + . the model is: maximize subject to alternative B1 alternative B2 alternative B3 alternative B4 prob. 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. B3.344 Multiplying by −1 we obtain: alternative B1 c April 28. 2010 D.M. From Player A’s perspective. because Player A does not have to choose alternative A1. sum to 1 Each probability must be greater than 0. however. 4 p3 8 p3 7 p3 5 p3 p3 ≥ ≥ ≥ ≥ = 0 0 0 0 1 V p3 ≥ 0 We will call this Model A. is unrestricted in sign. If Player A chooses A1. and B4 columns we obtain three more similar constraints: alternative B2 alternative B3 alternative B4 The probabilities must sum to 1: prob. who wishes to minimize V . In writing the complete formulation. The alternative A1 constraint is that: V ≥ 8q1 + 7q2 − 5q3 + q4 .

Instead. ≤ ≤ ≤ = 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. the same value of V is obtained for both. sum to 1 non-negativity −V + 8q1 −V + 6q1 −V − 4q1 q1 q1 V is unrestricted + 7q2 + 9q2 − 8q2 + q2 . and then after the end statement we add the command free V. For LINDO. 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: . As one would expect.M. 2010 D. B2) -V + 7p1 + 9p2 . B3) -V + -5p1 + 4p2 + 7p3 >= 0 alt. this means that we cannot use the radio button to declare all variables to be non-negative. by adding a range as a set of ≥ constraints with a right-hand side value of 0. 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. Tulett 345 Subtracting the right hand side from the left. For example. we enter the model as usual.c April 28. The model from Player B’s perspective (called Model B) is: minimize subject to alternative A1 alternative A2 alternative A3 prob. On Excel.4p3 >= 0 alt. and we require that the probabilities sum to 1.8p3 >= 0 alt. the ﬁrst model is entered as max V st alt. we must declare each of the probability variable cells to be non-negative. V is unrestricted. 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. B1) -V + 8p1 + 6p2 . q2 − 5q3 + 4q3 + 7q3 + q3 . q3 + q4 − 6q4 + 5q4 + q4 . As before.

367021 DP A1 0.398936 DP B1 0 DP B2 −0. we can create a graphical solution which is like the one seen earlier. the two models form what are called the primal and the dual. all we need to do is formulate and solve either model.257979 DP B4 −0.175532 p3 0.M.257979 q4 0.346 Model A V 1.422872 Therefore.367021 p1 0.398936 q1 0 q2 0. Tulett Model B V 1. In a theoretical sense. Another thing of note is that if the linear optimization model is applied to a situation where there are just two rows or columns. The values of the probability variables for the other model are simply the absolute values of the dual prices of the ﬁrst model.425532 DP A2 0. which provide alternate ways to solve what is really the same problem.422872 c April 28. .175532 DP A3 0. Also.425532 p2 0. 2010 D. game theory is an important link between probability based payoff matrices and the deterministic ﬁeld of linear optimization.319149 q3 0.319149 DP B3 −0. in which the highlighted line segments are in fact edges of the feasible region.

and state the value of the game.3. The payoffs to player X are: Y1 5 −1 −2 −2 Y2 Y3 Y4 −3 −2 7 8 6. (c) Use the analytic technique to determine the optimal strategy for each player. 21. (b) Plot the remaining alternatives on a graph.5 −2. . (c) Use the analytic technique to determine the optimal strategy for each player.2 Problem 2 Players A and B are playing a zero-sum game.3.c April 28.3 Problem 3 Players X and Y are playing a zero-sum game. (b) Plot the remaining alternatives on a graph.3 21. determine the optimal strategy for each player and the value of the game.1 Exercise Problem 1 For problem 3 from the previous Exercise.M. 21.5 6 5 −4 7 6 −3 Y5 2 7 9 5 X1 X2 X3 X4 (a) Eliminate any dominated alternatives. and state the value of the game. 2010 D. 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.3. Tulett 347 21.

This is a somewhat challenging problem because of the tie in row A3. A1 A2 A3 (a) Solve by linear optimization. 2010 D.348 21.5 Problem 5 There is no dominance here. B1 2 3 −5 0 −2 B2 6 5 −10 5 −6 B3 −9 −1 1 −5 0 A1 A2 A3 A4 A5 21. Tulett Solve the following zero-sum game by linear optimization.4 Problem 4 c April 28.M.3. How is this solution more general than the one found in part (a)? B1 B2 2 14 10 −4 7 7 . (b) Solve by hand using the graphical technique.3.

optimization and others. In Canada. then ask your professor what other courses are available to you. Tulett 349 22 Moving Forward We have come to the end of the content to be covered on the ﬁnal examination for this course. This website. Michael Trick. at telephone call centres. and so on. simulation does not guarantee optimality.org/Resources/. Queueing theory studies the behaviour of queues (waiting lines) that form in banks. has links to all sorts of things: courses from around the world. Other terms are operations (or operational) research.M. references to journals. Trick’s site has a resources section which links to a long list of MS/OR books. Prof. decision analysis/science. and of course what we did cover can be studied in greater depth. The following two may be of particular interest. South-Western Publishing. so it tends to be used only when there are no alternative procedures. 2010 D. Obviously there is more to learn for those who are interested. Using the terms operations research and the management sciences. maintained by Prof. There are many more topics in the ﬁeld of management science than the ones we covered. it needs to be pointed out that the term management science is just one of many for this ﬁeld. The Science of Decision Making: A Problem-Based Approach . free computer programs. Also included are references to many professional societies from around the world. there is the Institute for Operations Research and the Management Sciences (or INFORMS). To search further. If learning about more advanced topics is of interest to you. 1999. many of the cases are set in Canada. one of the few books in this ﬁeld ever to do so. Peter. Here are some books which I have found to be useful (alphabetical by surname): Bell. a very comprehensive site is located at http://www. the professional organization is called the Canadian Operational Research Society (or CORS). Simulation is a methodology which allows the model to contain many real-world characteristics. Denardo.informs. Management Science/Operations Research: A Strategic Perspective. but as the speed of computers continuously increases this is becoming less of an issue. However. Eric V. and so on. and the formulation of more difﬁcult linear and integer optimization models. Bell is at the Ivey School at the University of Western Ontario. non-linear optimization. Other topics include the study of algorithms. Traditionally. For example.c April 28. two mainstream topics not covered here are simulation and queueing theory . In the United States. a major drawback of using simulation was that it was very time consuming. Bell’s book emphasizes the use of cases.

1998. 5th edition. 2010. Duxbury Press. or for covering material that may have been missed earlier. Wiley.. but the emphasis is on the algorithms for solving these type of models.M. This book deals with all aspects of operations research. 9th edition. but at a deeper level. Optimization in Operations Research. Winston.350 c April 28. 2010 D.. Ronald L. Operations Research – Applications and Algorithms. using LINDO to provide solutions. Wayne L. Prentice-Hall. Rardin. 2002. Best of luck with it! . Linus E. 1997. for questions. Schrage. Hillier and Lieberman. The exercises from the ﬁrst twenty-one lectures will prepare you well for the ﬁnal examination. 2004. This book covers the material seen in this e-book (and more). Introduction to Operations Research. Duxbury Press. Schrage’s book gives an extensive overview of the main types of applications for linear and integer optimization. Optimization Modeling with LINDO. This lecture is short because being the last one it is principally used for review. McGrawHill. There are three of fourteen chapters which deal solely with formulation.. Winston’s book gives a comprehensive coverage of operations research. Rardin’s book deals with deterministic problems (no probabilities). Tulett Using Excel. 4th edition.

36.org 3 R . 107 prior tree. 280 preferring. 154 marginal analysis. 215 Solver. 214 shadow price.Index absorbing state. 155 spreadsheet. 253 algebraic model. 107 pure strategy. 155 alternative branch. 167 LINDO R . ii opportunity loss. 101. 31 expected utility. 280 rollback procedure. 137 model. 31 event node. i. i linear optimization. 216 EMV. 195 BINOMDIST function. 31 outcome branch. 21 sensitivity analysis. 137 branch-and-bound algorithm. 312 indifference. 31 risk averse. 279 expected value. 34 Markov chains. 279 EOL. 203 spreadsheet functions BINOMDIST. 216 simplex algorithm. 194 certainty equivalent. 101. 48 posterior tree. 47 binding constraint. 25 game theory. 39 integer optimization. 47 Excel R . 237 model algebraic. 194 solution variables. 47 decision tree. 90 reduced cost. 47 dual price. 4 351 . 349 slack. 34 decision node. 280 neutral. i expected opportunity loss. 47 salvage value. 313 queueing theory. 16 expected value of perfect information. 48 OpenOfﬁce. 349 ranking proﬁt/cost. 215 regret matrix. 194 simulation. 281 cumulative probability function. 155 null branch. 47 payoff matrix. 14 payoff node.

107 prior. 238 state absorbing. 253 trapping. 238 state transition matrix. 253 transition. 253 tree posterior. 314 state.352 SUMPRODUCT. 253 state transition diagram. 194 transient state. Tulett . 238 trapping state. 155 stable solution. 18 spreadsheet model. 279 c April 28. 242 SUMPRODUCT. 18 sunk cost. 107 utility. 2010 D. 253 transient.M. 13 surplus.

There is a Solutions Manual available for all these problems.M. Redlack. which can be thought of as an Appendix to the earlier Linear Optimization – Introduction section. with each section covering more than one lecture. They are reproduced here with his permission. A.R. The follow the order of the lectures.c April 28. . except for the ﬁnal section on Linear Optimization – Applications. 2010 D. Tulett 353 23 Supplement – Extra Problems The problems which follow come from a collection prepared not only by me but by Dr.

” The ofﬁcial started to write down some possibilities and said. The second woman says that the fourth is the Queen.000 1. Tulett 23.000 3.000 1.500 2.000 2.000 500 0 Maintenance Cost (during the year) 100 200 400 600 1. Ignoring inﬂation.000.000 5.000 10. how often should a new car be replaced? 2.M. The third woman says that she is the Queen. You are given the following information (in dollars). A public ofﬁcial at city hall who has never met the Brown family enquires by telephone about the ages of the children. “Your ﬁrst clue. He knows that one is the Queen.500 2. Which one is the Queen? 3.1 Introduction 1. “Only one potential answer is biologically impossible: What’s the second clue?” Mr Brown continued. Mr and Mrs Brown have four children. but the other three are rogues who always lie. 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) 14.354 c April 28. “is that the product of their ages (expressed as integers) is 36. The Queen always tells the truth.500 3.000 7. Suppose that minimizing your average annual cost is your only criterion for deciding how often you should buy a new car.000 3. A knight sees four veiled women.000 3.500 1. The fourth woman says that the ﬁrst is the Queen.” said Mr Brown (not wanting to be too cooperative). The ﬁrst woman says that she is the Queen. and so on.500 2. none of whom was adopted. 2010 D. taxes. “the sum of their ages is equal to number .000 A new car costs $20. but he does not know which one.

What was the lawyer’s argument? 15 We use the syntax of Microsoft Excel everywhere in this book. . a man with a conviction record for theft.” replied Mr Brown. Tulett 355 of councillors on city council. 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.c April 28. and Ralph is released. 2010 D. His lawyer explains to the police that he cannot be found guilty based on the current evidence. What are the ages of the Brown children? 4. On an island with a population of a million people a murder has occurred.” which of course the ofﬁcial knew.15 Someone enters =A1*B1 in cell C1. and who has the rare blood type found at the scene of the crime. (Left-handed males comprise 5% of the population). “I still do not have enough information. The police have arrested Ralph.M. An expert has said that there is a 99% chance that this blood belongs to the murderer. A ‘3’ appears in both cells A1 and B1 of a spreadsheet.000. in addition to the blood of the victim. who does not have an alibi. “what is the third clue?” “The difference in ages between our oldest and our youngest child is an odd number. A criminal conviction requires that there be at least a 95% chance that the accused actually committed the crime. some blood was found which comes from a very rare blood type found in only one person in 10. who is left-handed. and 11 appears. Why? 5. Most important of all.” the ofﬁcial replied.

1 Advanced Problems c April 28. 20% in the third month. 2010 D.1. Each failed thermocouple must be replaced by the end of the month in which it fails. (c) What replacement policy would you recommend to the company? 2. If all the thermocouples are replaced at the same time. if the contestant initially chooses door 2. The host then asks the contestant if he or she wishes to change his or her guess. On a television game show a contestant is told that behind one of three doors there is a new car to be won. 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 doesn’t matter whether the contestant switches or not (iii) the contestant should switch. and the host reveals that the car is not behind door 1. The thermocouples have a maximum life of ﬁve months.000 thermocouples in its production process. the cost is $25 per thermocouple replaced. Past experience has shown that 10% will fail in the ﬁrst month. Tulett 1. (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.M.356 23. Which is right? . For example. The Panther Company uses 1. then the cost is only $14 per thermocouple. the host (who knows where the car is). If only the failed thermocouples are replaced. opens one of the other doors to reveal that the car is not behind it. 30% in the fourth month and the remaining 20% in the ﬁfth month. but often fail earlier. The contestant is invited to guess which door leads to the car. 20% in the second month. After the guess. behind each of the other two doors there is nothing of value.

After the alternative has been chosen.2 Uncertainty 1. 2. A business has four alternatives. Parts (e) to (h) use the probabilities. The conditional payoffs are given in the following matrix. 0.c April 28.3 0. The conditional payoffs are given in the following matrix. This event has three mutually exclusive outcomes. 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.4 0.1 In parts (a) to (d). Tulett 357 23. an event occurs. an event occurs which has four mutually exclusive outcomes. (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. and that the minimum EOL itself is the same as the EVPI found in part (f). (a) Criterion of Optimism (b) Criterion of Pessimism (c) The Hurwicz criterion if the coefﬁcient of optimism is 0. (g) Find the regret matrix. 2010 D. After an alternative has been chosen.2 0. determine which alternative and ranking payoff would be chosen according to the given decision criterion (the probabilities are to be ignored). A business must choose between one of ﬁve alternatives.7. (h) Show that the optimal alternative using minimum EOL is the same as the one found in part (e).M. .

The vendor of the computer offers the purchaser a special deal on replacement boards – they can be purchased (in any quantity) for $200 each.M.358 c April 28.53 In parts (a) to (d). (a) Criterion of Optimism (b) Criterion of Pessimism (c) The Hurwicz criterion if the coefﬁcient of optimism is 0.8. a 15% chance that two boards will fail. Over the life of the computer there is a 55% chance that no boards will fail. determine which alternative and ranking payoff would be chosen according to the given decision criterion (the probabilities are to be ignored). 3. The regular price (which is available anytime) is $500 per board. A computer contains several integrated circuit boards. and a 5% chance that three boards will fail. 0. . The purchaser wishes to minimize the expected cost of the replacement boards.45 0. (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. 2010 D. (h) Show that the optimal alternative using minimum EOL is the same as the one found in part (e). (g) Find the regret matrix. Parts (e) to (h) use the probabilities. provided that they are purchased with the computer. a 25% chance that one board will fail. Tulett O1 O2 O3 A1 32 31 34 A2 45 −8 51 50 30 40 A3 A4 12 35 68 3 12 70 A5 Prob. and that the minimum EOL itself is the same as the EVPI found in part (f).02 0.

where the payoffs represent costs rather than proﬁts. John’s is fogged in. As far as cost is concerned. St. John’s is clear 8 times out of 10. One. the trip only takes 45 minutes.00 per kg. If the weather is ﬁne. According to historical weather records for this time of year. Suppose that reservations are required in advance for either the bus or the plane. The other. However. The company owns a number of roadside fruit stands which sell to tourists in this region. John’s. is sometimes closed because very thick fog. and a 10% chance that the fog will continue for an additional 10 hours. (e) Show that the minimum EOL = EVPI. a 70% chance that the wait will still be 20 hours. there is a signiﬁcant difference in the travel time. Tulett (a) Write a payoff matrix for the problem. whereas the plane trip depends on weather.c April 28. The bus trip takes 4 hours.M. (d) Set up the opportunity loss matrix for the problem. Fres Froot purchases ripe peaches for 60 cents per kilogram (kg) and sells them for $1. John’s is fogged in. 2010 D. 359 4. A friend is a frequent traveller between two airports. and from this deduce the EVPI. (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. it is not possible to reserve both. remembering that the original payoffs are already costs. then one has to wait an average of 20 hours for it to clear. located in the city of St. (b) What is the optimal solution and what is its expected cost? (c) Find the expected cost with perfect information. suppose now there is a 20% chance that the weather will clear early and the wait will only be 6 hours. located in the town of Gander. If St. Peaches which are not sold at the end of the day are . (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. has little problem with adverse weather. there is little difference between travelling by bus or by plane.

Solve parts (a) to (d) using the payoff matrix approach. Greenleaf Groceries buys fresh vegetables at wholesale for $5 per crate.50 proﬁt contribution.000 boxes are enough to prevent any shortage. 6.360 c April 28. A crate which they sell at retail on the same day brings a $1. Tulett given to local farms to use as animal food. 50 kg on 30 days. Each box cost $0.10 0. Demand for the peaches during the last year (120 day tourist season) was 40 kg on 40 days.30 0.40 and sells for $1. Instead of giving it away for animal food. this has been the number prepared before each game. A crate which is not sold on the same day is sold later as animal food . (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.00. Past records indicate that 15.40 What would you recommend to the popcorn stand? 7.000 8. Unsold popcorn is disposed of in industrial garbage bags which cost $0.000 15. (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.000 Probability 0. A popcorn stand is faced with the decision of how many boxes of popcorn to prepare before a hockey game at a local stadium. and until now. 2010 D. they will receive a salvage value of 10 cents per kg. 60 kg on 30 days and 70 kg on 20 days.15 per bag and hold 50 boxes of popcorn.M.000 12.20 0. The following data summarizes the sales history: Demand 5.

250. The owner believes that at the regular price the possible demands are 50. and 300 or more in lots of 100 would cost $13 per disk.3.M. and 0. or 350 disks.c April 28. A new recording of Mozart’s Laudate Dominum is sweeping the world. Orders for the disk must be placed with the distributor in lots of 100. 0. the cost to her would be $17 per disk. Tulett 361 for $1 per crate.05 respectively. 0. 200 disks would cost $15 per disk. They can produce and sell the manual . Until Christmas Day the retail selling price will be $20 per disk. 300.1. Over what range for this value would the solution found in part (a) be valid? 9. 0. 150.1.2. 100. 0. 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. (c) Suppose that the $5 to be received for each leftover disk is negotiable. They have spent a lot of effort preparing a course manual and would like to give themselves a small reward. Assume that she will suffer no loss of goodwill if she happens to be out of stock. 8. with probabilities 0.2. (a) What would you recommend to the owner? (b) Determine the expected value of perfect information. any left over after Christmas will be sold to a discount house for $5 per disk. 0. 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 proﬁt from selling vegetables? (c) Repeat the above using marginal analysis. 2010 D. 200. She must place her entire order now.05. If she orders 100 disks. A couple of enterprising business professors are faced with a dilemma.

In addition. Tulett themselves or have the campus bookstore sell it (in which case they receive nothing). 225.3.10 0. 250) with probabilities (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? . if they sell the manual themselves. Based on the long-run forecast of the winter weather. The skis cost $75.3. The store must order skis in lots of 40 pairs. The Wax n’ Wave Sporting Goods store must place their order for skis in August.00 a pair. and the sale price is $25. 0. Any unsold manuals have no value. (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. then 10 manuals would have be given free of charge to their fellow instructors and to the tutorial assistants of the course.362 c April 28. 2010 D.1.30 0. 0. then they have to be specially printed at a cost of $26 per manual. but if not enough manuals are ordered initially. 175.2. The cost to print the manual is $21. 200.00 a pair and sell for $125. The professors have estimated the possible demands for new manuals to be (150. the estimates of the demand for skis are as follows: Demand 50 75 100 125 Probability 0. but used manuals are available from previous years. There are 250 students registered in the course.1).M. 0. If the bookstore sells the manual. 0. then the free copies come out of the departmental budget instead.00 a pair (any other unsold skis are worthless). Up to 50 pairs of skis not sold during the winter can be sold during the big spring sale for $50.50 0.

Demand is estimated as being between 2 and 5 inclusive with probabilities 0.40 for 4. Any left over after Christmas will be sold to a liquidator for $4000 each. if you take the bus to work then you will walk home.M. and if heavy. – You could drive your car. if it is medium. 2010 D. 30% of the time the trafﬁc is light and 50% of the time it is medium.20 for 3. For this time of year. 12.3 − ∆ p At what value of ∆ p would the store be indifferent between ordering 80 or 120 skis? 363 11. 0. You have three options open to you: – You could ride your bicycle and arrive 20 minutes late.50 each way and a $3. 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. A department store is considering carrying a line of baby grand pianos. and 0. – You could take the bus.00 cost for parking. three pianos would cost $15.25 for 5. what would you do? Justify your answer. It will cost you 30 cents for each minute you are late for work. You stayed up late on Sunday night watching Alien and have overslept on Monday morning.c April 28. (a) What should you do? (b) If you are unable to accurately estimate the probabilities of the trafﬁc levels. If the trafﬁc is light you will arrive 10 minutes late. but if it is medium or heavy you will arrive 15 minutes late.15 for 2. 0. (e. If the trafﬁc is light you will arrive on time. This would involve a cost for gasoline of $0. If you take your bicycle or your car to work then you will return home by the same. They can be ordered from the manufacturer at cost of $6000 for the ﬁrst one and $4800 for each subsequent one.g. 20 minutes late. . 30 minutes late. The selling price until Christmas will be set at $8000.600).00 per trip. It now looks as though you may be late for work.5 + ∆ p P(demand = 100) = 0. which costs $1.

use a payoff matrix to determine how many snorkels the store should order. The snorkels sell for $15 each. What is the expected proﬁt? (b) What is the EVPI? (c) Suppose that the probabilities of demand being 2 or 3 are ﬁxed. 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). but the other two probabilities are ﬁxed. Based on the long-range forecast of summer weather. use a payoff matrix to determine how many pianos should be ordered. Tulett (a) Using expected value as the decision criterion. At what values for the probabilities (if any) would you be indifferent between ordering forty-eight and sixty snorkels? 14.10 (a) Using expected value as the decision criterion.30 0.50 0.364 c April 28. Demand for a particular newspaper at Mrs. the store estimates the demand for snorkels to be: Demand 30 40 50 60 Probability 0.M. What is the expected proﬁt? (b) What is the EVPI? (c) Suppose that the demands for forty or ﬁfty snorkels can vary. The Surf ’n Sun Sports Shop must place their orders for snorkels in January. Reid’s News Depot can range anywhere from 31 to 49 papers per day. and cost $10 each. The store must order snorkels by the dozen.10 0. but the other probabilities can vary. At what values for the probabilities (if any) would the optimal alternative change? 13. 2010 D. according to the following triangular probability distribution: P(D = d ) = 0 if d ≤ 30 P(D = d ) = d − 30 if 30 ≤ d ≤ 40 100 .

4 0. Reid sells the papers for $0.54 Papers that are not sold by the end of the day are sold to a recycling ﬁrm for 5 cents each . 0. and D is a random variable which takes on the values of the number of newspapers demanded. Parts (f).2 In parts (a) to (e). (g) and (h) use the probabilities. Her buying price depends on the quantity ordered: Quantity (per day) 20 – 44 45 or more Buying Price (per paper) $0. 2010 D. Mrs. 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. (b) Obtain a graph of the expected proﬁt as a function of the number of papers ordered.M. Tulett P(D = d ) = 50 − d if 40 ≤ d ≤ 50 100 P(D = d ) = 0 if d ≥ 50 365 where d is an integer. (a) Create a spreadsheet model for this problem.60 $0.c April 28.3 0.80 each. (c) What is the smallest value for her selling price for which she will order 45 newspapers? 15.1 0. an event occurs which has four mutually exclusive outcomes. . A business has four alternatives. She wishes to know how many papers she should order so that her expected proﬁt is maximized. The conditional payoffs are given in the following matrix. determine which alternative and ranking payoff would be chosen according to the given decision criterion (the probabilities are to be ignored). After an alternative has been chosen.

(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.M. What is the expected proﬁt? (b) What is the EVPI? . 0.25 for 2. (a) Using expected value as the decision criterion.7. 2010 D.30 for 4.30 for 3.366 (a) Criterion of Optimism (b) Criterion of Pessimism c April 28. and 0. use a payoff matrix to determine how many computers should be ordered.15 for 5. A computer store is considering carrying a line of new computers. 16. Demand is estimated as being between 2 and 5 inclusive with probabilities 0. 0. 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. Tulett (c) The Hurwicz criterion if the coefﬁcient of optimism is 0. Any left over will be repurchased by the supplier for $2000 each. Any computers which are demanded but not in stock are ordered individually from the supplier with an additional $50 charge for speedy delivery.

ranging from 0 to 18 inclusive.c April 28. The situation is as in problem 14 of the previous section (with no salvage value). the retail selling price r. where r ≥ w ≥ s.3. (a) Determine the optimal number of papers to order when q = 0. (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.M. Tulett (c) Suppose that the probabilities of demand being 2 or 3 are ﬁxed. but the other probabilities can vary. . the wholesale buying price w. 2. but now the probability density function is P(K = k) = 18! qk (1 − q)18−k k!(18 − k)! where K takes on the values of the number of newspapers demanded in excess of 31. Assuming that cumulative density function F (D ≤ d ). prove the marginal analysis formula given in the text. and the salvage value s are given. 2010 D. At what values for the probabilities (if any) would the optimal alternative change? Uncertainty (Advanced Problems) 367 1.

If the development is unsuccessful. then she believes that the proposed piece of land will increase in value to $2.000.000.000. 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. Nova is also considering trying to develop the repellant property itself.400.000. By early April of next year the status of the oil development will be known for sure. after which they will try to isolate and market the relevant ingredient which has the repellant effect. (a) Given that she wishes to maximize her expected proﬁt 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. Alternatively. Tulett 23. then they believe they will still be able to sell the rights for $30.368 c April 28. otherwise they will sell them for $140. A piece of land is available for $2. The option cannot be re-sold and if it is not exercised on or before May 1 it will become worthless on May 2.M.000. that Nova will consider marketing the product itself. Nova estimates that the development would cost $80. If the product is successfully developed. fearing that there is a 30% chance that it will not go ahead.000. then Nova believes there is 20% chance of selling the rights for $230.000. 2010 D. .3 Decision Trees 1.150.000 and has only a 70% chance of being successful.000. she can purchase an option on the land for $32. otherwise the value will fall to $1.000.500. The marketing department estimates that there are three levels of demand. (a) What would you recommend to Nova’s management? Suppose now that if the development turns out to be successful. 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. and an entrepreneur is now considering the development of a housing estate. She is worried about the proposed oil development. A major company in the repellant industry has offered to buy the rights (as they pertain to the repellant) of this product for $50. If the oil development goes ahead. It is now October.000. An offshore oil development has just been announced.

40 and 0.000 of the $75. A competitor also has some knowledge of the product and if Meni Idias is successful in development. When submitting the bid.000 respectively. Unfortunately. $180.000. must decide whether or not to pursue the development of a new product for which its recent research has indicated possibilities.M. a low end bid would give an incremental proﬁt of $200. while a high end bid would give an incremental proﬁt of $400.30.000. the probabilities of high.30. It will cost $200.c April 28. (b) Would this affect your recommendation to Nova’s management? 369 3. If accepted.1. The cost of preparing a proposal for the tender is estimated to be $75. there is a 10% chance that .000. $500.000.5. medium. information about the competition is not available before the point in time at which the $250. ABC Construction Co.3. Assume that if this happens such a discovery will have been made after $30.2 if the competitor does not develop the product.000 has been spent. 0. Tulett The marginal revenues associated with each level of demand are estimated to be $100. 2010 D. Meni Idias Inc. then there is a 20% chance that this competitor will also be successful. 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 they try to develop a proposal. and low demand are 0.000 to complete the research and there is a 75% chance that the research will be successful.000 or $280. If the competitor has also developed the product. 0.000 and $100. (b) Would this affect your recommendation to Meni Idias? 4.6. medium.000. or low the operating payoffs will be $800. the company can either submit a low end bid or a high end bid.000 with probabilities 0. there is a 5% chance that the company will ﬁnd that it is unable to meet the requirements of the tender.000 production setup cost is incurred.000. and 0. The cost for setting up for production is $250.3 and 0. has just learned that a tender for a signiﬁcant project has just been issued. (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. If the demand turns out to be high. whereas they are 0. 0. If the contract is obtained.

370 c April 28.000 cases.000 for this information? 6. However.000 to the cost of the project.00 per case to the production cost. 0. If desired.00 per case shift premium. The demand level will be known after two months. should it occur.000 or 15. if the required demand turns out to be 15.M. A machine shop has received an order for 2. (a) What would you recommend to the management of ABC Construction Co. (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. which would add another $2.? (b) What would be the EVPI for the unforeseen problems? 5. then they will be required to layoff the shift at a cost of $5. Secondly. 2010 D. but there would be no extra cost because of the unrest in this month. The labour unrest. First of all. The Plastic Production Company needs to expand its production capacity for the next year. will begin to be felt at the outset of the sixth month. the additional shift could be started anytime instead of being started immediately. they can use overtime at a cost of $3. The marketing department has determined that the company will need 5. This will entail a ﬁxed cost of $15. 0. The company is considering two options to meet the situation.000 units to be made on one of its automated machines.000 for startup expenses and a $1.5.00 per case. Each unit which is classiﬁed as “defective” .000 and convert to overtime. then there will be a 50% chance that there will be labour unrest if overtime continues for more than six months. Should the company be willing to pay $1.00 per case in addition to the regular cost of $10.000 units. This is a multistation operation and once it is started it runs without interruption.3. Tulett unforeseen problems will add an unexpected $100.2) respectively. they can operate an additional shift. However. if the extra demand turns out to be only 5. 10.000. The machine shop makes $2 proﬁt on each part of acceptable quality.000 cases of additional capacity with probabilities of (0.

then there will be a cost of $1. 2% defectives (30% of the time). however. re-work the welds of the ﬁrst group.c April 28. A trial run can be performed at a cost of $30 to determine the defect rate.M. 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. the defect rate above 2% can be reduced to 2%. it produces either 1% defectives (this happens 50% of the time). then all are checked. is applicable only to the seams which are checked and found to be defective.50 before it is considered “acceptable. would this affect the recommendation given in part (a)? .000 for each defective seam. 30% of the time 10% of the seams will be defective. 50% of the time 5% of the seams will be defective. With a minor adjustment that costs $42. An oil company is considering expanding one of its reﬁneries.) If no rework is done. This would cost an additional $20 per seam checked. (The master welders will always ﬁnd a defective seam. the defect rate can be reduced to 1%. and will never re-work a seam which is not defective. and 18% of the time 20% of the seams will be defective. given that they make their judgement based on expected monetary payoff? 7. then based on past experience. 3% defectives (12% of the time) or 5% defectives the rest of the time. Once the initial work has been completed. 2010 D. with a major adjustment that costs $100. Tulett 371 needs rework at a cost of $3. if necessary. Historical data indicates that if the machine is used without any special preparation. What adjustment policy should the company have. The re-work.” The full order must be acceptable. the company will have the option of using a group of master welders to check and. One phase of the construction requires the welding of a large number of seams. if necessary. plus another $100 per seam re-worked. 2% of the time 1% of the seams will be defective. If any seams are checked. re-worked) by the master welders. (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. The initial work will be done using ordinary welders assisted by apprentices.

and what is the expected cost of the recommendation to the company? 10.30 0. In the selection process for new products. 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. Deﬁning symbols for the costs and probabilities which you think are relevant. which will avoid the associated preparation cost for that suit. The product must go through two stages (a) technical development and (b) commercial development. If the ﬁrst suit is lost.30 0. then the combined cost will be only $25. set up a decision tree and derive a formula for the PVI. Tulett 8.000. then assume that there is no revenue. 2010 D. If a suit is won. The company is presently facing two related lawsuits for invasion of privacy. Let r be the revenue if the product is successful. then the court may decree only a minor penalty of $50.000.000 or a major penalty of $200.40 0.000. Tauker.60 0. 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 year’s time. The probabilities of the outcomes of the second suit depend on the outcome of the ﬁrst suit as follows: First Suit Settled Won Lost Second Suit Minor Major 0. One is scheduled to be heard on July 2 and the other on November 5. if it is a failure.000. then no further costs are incurred for that suit. 9.40 Win 0. but if both are done at the same time.000. one of the criteria which is often used is called the project value index (PVI). If the second lawsuit is lost.20 What would you recommend to Mr. then the company will be required to pay $150.10 0.40 0. Either suit can be settled out of court for $80. This is the ratio of the expected revenue of the project to the expected cost of the project.30 0. Smuth Tauker is the chief counsel for Peek-a-Boo Magazine. The preparation cost for either lawsuit is $15.372 c April 28. Land is being purchased by speculators and the developer needs to make his .M.

(The option would give him the right to buy either property one year from now at the current price. The consultant reports that at the present time. Otherwise. A ballpoint pen manufacturer produces pens with an ink designed to ﬂow freely in sub-zero temperatures.000 Future Value if Town Chosen Not Chosen 800. The manufacturer produces the pens in batches of 1000. The report is due in eleven months (about a month before the expiry of the option) and although the recommendation is usually taken.c April 28.000 to help with his decision. What should the developer do? 11.000 600.000 The government has initiated an independent commission to recommend one of the sites. based on the results of previous commissions. The value of the land is estimated to be as follows: Town A B Present Value 500. As with most government initiatives. In addition. 2010 D. other political factors sometimes cause the recommendation to be rejected. there is a chance that the government will have to divert the funds elsewhere and the college will be postponed indeﬁnitely.) He does not want to commit the resources to buying both pieces of land.M. there is a 15% chance that neither town will be awarded the new college. He can take a one-year option on both locations for $100.000 or purchase one of them outright now.00 each. sometimes the entire batch produced has pens with ink that have turned solid. If a batch has solid-ink pens. Depending on factors in the manufacturing process. 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. This happens about ten percent of the time. After the government has either accepted or rejected the recommended site. The government will make its decision just prior to the expiration of the option. the commission recommendation was followed 80% of the time. and after the option will have expired. .000 1. the pens sell for $3.000 300. then the entire batch is worthless. The developer has hired a real estate consultant at a cost of $20.000. Tulett 373 decision on the land soon.000 1.400.

it produces either 1% defectives (this happens 30% of the time). A trial run can be performed at a cost of $200 to determine the defect rate.M. but either the chemical or the heating process can be applied to the remaining half of the batch. Once started the machine runs without interruption. If performed at this time. With a minor adjustment that costs $100.00. 2010 D. the ink can be heated at a negligible cost. . the test would cost $50. the defect rate can be reduced to 1%. The effects would be the same as before but adding the chemical will cost only $1250.” this guarantees that there will be no problems with the entire batch (the pens will not have solid ink). Use a decision tree to ﬁnd the optimal adjustment policy. 12. If the test result is “positive. Historical data indicates that if the machine is used without any special preparation. Tulett A test can be performed on the raw materials before a batch is produced. Alternatively.000 units to be made on one of its automated machines. with a major adjustment that costs $500. The test can also be done when the batch is half completed. If the test result is positive. there are two alternatives.374 c April 28. but not at sub-zero temperatures.” the solidink problem will affect the entire batch to be produced. which will partially correct the problem.79 each. 2% defectives (45% of the time). A chemical can be added to the raw materials at a cost of $2000 which will completely correct the problem. If the test result is “negative. the defect rate above 2% can be reduced to 2%. The shop makes a proﬁt of $5 on each part of acceptable quality. It would cost only $20. Use a decision tree to determine what the manufacturer should do. or 5% defectives the rest of the time. Pens made with heated ink will work at normal temperatures. Such pens sell for $0. A machine shop has received an order for 4. the pens already produced are not salvageable. Each unit which is classiﬁed as “defective” needs rework at a cost of $9 before it is considered to be “acceptable.00 if performed at this time.” The full order must be acceptable. In this situation.

then there is a 90% chance that the reviewer will .000. In the absence of an external review of the manuscript.” or “looks good. past experience suggests that when the author is unknown there is only a 5% chance that the book would be a major success.” If the inspected car is of high quality. To develop a manuscript into a book would cost $50. (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.” If a customer receives a lemon it will cost Major Motors $10. 2010 D. A publishing company is considering whether or not to publish a manuscript from an unknown author. requiring only $500 in warranty work. then there is an 80% chance that the inspection will indicate “looks good. then it will generate $500. Ninety-seven per cent of the production is of high quality.4 Imperfect Information 1. (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. Adding a re-work section to the assembly line would guarantee that each car would be of high quality. otherwise the inspection will be inconclusive. and a 15% chance that the book would be a minor success. but this would cost $400 per car. If the inspected car is a lemon then there is a 75% chance of a “looks bad” result.” and a 20% chance that the test will be inconclusive. Tulett 375 23. Major Motors produces a line of passenger cars. If the book is published and if it turns out to be a major success.” If the book would be a major success. but the rest are “lemons.M.000 to replace it with a high quality car (this includes the subsequent $500 to be spent on the new car).c April 28. (c) What should the company do now? 2. If the book turns out to be a failure then it will generate no revenue.000.000 in revenue for the company. while a minor success will generate $100. The results of the inspection would be one of the following: “looks bad.” “inconclusive.

000. The payoffs can be summarized as follows: Box Ofﬁce Medium Large 1.376 c April 28. then she would receive a ﬁxed payment. If she signs with the TV network. then there is an 80% chance that he will not recommend.000 0. The movie company. is offering a royalty based on box ofﬁce performance.20 0. (c) If the reviewer demands a fee for his services. and she is now considering whether she should sell the exclusive ﬁlm rights to her novel Murder on Wall Street to a movie company or a TV network.40 0. For $25. the ﬁrm will give either a “looks favourable” or “looks unfavourable” recommendation. She holds the copyright on her works.60 0. then the probability that he will recommend is 60%.100.80 “Looks Unfavourable” 0. TV Network Prob.R.100.000 3.000 1.000 1.3 (a) Based on the above information. J.000 0. If the book would be a failure.80 0. on the other hand.5 0. to whom should Ms Blossom sell the rights? (b) What is the EVPI? She also knows of a market research ﬁrm specializing in movie productions.000. what is the most that the publishing company would be willing to pay? 3.100.20 (c) What would you recommend that Ms Blossom do? (d) What is the EVII? . Tulett recommend that the manuscript be developed as a book. 2010 D. regardless of the ratings. Small 100.M.000 1. The track record of the ﬁrm can be summarized as follows: Actual Outcome Small Medium Large “Looks Favourable” 0.000.2 Alternative Movie Co. Blossom is a proliﬁc author of murder mysteries. If the book would be a minor success.

From past experience.5.00 if you guess incorrectly. what would you recommend to the operator? (b) What is the EVPI? A small marketing research ﬁrm will carry out a quick survey of sports shops to determine recent activity. but you lose $1. (a) What should you do? (b) What is the value of the ﬂip? (c) Suppose you can elect to buy either one or two ﬂips at a cost of $0.000. If the turnout is “heavy.000. You have the opportunity of having an impartial observer ﬂip the coin and tell you if it came up heads or tails. You are asked to guess the type of coin.” then the weekend receipts will be $10. They will report the level of activity as either “low” or “high. It is either two-headed or a normal coin.20 per ﬂip before any ﬂipping takes place? What should you do? . and when the turnout was “heavy” the ﬁrm reported “high” 90% of the time. (a) With only the above information.M. if performed. he estimates that only three or four slopes will be needed at this time. A coin is lying on the table with a head facing up.” “moderate” and “heavy” turnouts to be 0. Tulett 377 4.” then three slopes will give receipts of about $13.” Past experience has shown that when the turnout was “light.000 per slope. If the turnout is “light. At present he estimates the probabilities of having “light. The ﬂip. a ski resort operator must prepare his slopes for the weekend crowd using artiﬁcial snow.000 whereas four slopes will give receipts of $20. when the turnout was “moderate” the ﬁrm reported “high” 60% of the time.4 and 0.000. The cost of the survey is $200.000 whereas four slopes will give $14.20.c April 28.” then three slopes will give receipts of $15. He estimates that it will cost him about $1. (c) What would you recommend to the operator? (d) What is the EVII? 5. 0. 2010 D. Due to recent mild weather.” the ﬁrm reported “low” 85% of the time. would cost you $0. If you guess correctly you win $2.1 respectively.00. If the turnout is “moderate.

Management at Toys. He thinks that he has only a 30% chance of passing the course. A special tutor will cost $100 and will increase his chance of passing to 90%. then 18 of them would fail the pre-test. It costs $10 to take the pretest. They feel that there is a 60% chance that the toy will be successful. and (c) above. the pre-test has been found to be reliable 18 times of the last 20 times it was given. regardless of whether the student passed or failed the pre-test. then the ﬁrm will earn $600. then the chance of passing the ﬁnal exam is still 90%.” For the students who do not subsequently use a tutor. The coin has been placed with its head (or one of its two heads) face up. For example. The result of the pretest is either “pass” or “fail. Some enterprising Management Science graduates have developed a pretest which helps predict how well students will do on the ﬁnal exam. Its past studies show the following results: .000 per report containing data on the owners’ impression of the product.378 c April 28. is known to conduct highly accurate surveys at high cost.000. Solve as per parts (a). The actual mark is not too important if he manages to obtain the pass. What would you recommend that this student do? 8. If the product is successful. He values passing the course to be worth $500. Assume that if a student who takes the pre-test subsequently uses a tutor. A Management Science student feels that things are not going very well. must decide whether the company should produce a new toy. 75% of the interviewed owners had been unimpressed. (Assume that the ﬁnal mark in the course is based only on the ﬁnal exam). Its fee is $40.. Inc. R Inc. but now you know that the coin has been picked at random from a pile of ﬁve coins with two of them being two-headed. Two market survey ﬁrms have submitted bids for interviewing toy store owners. Tulett 6. if 20 students who do not subsequently use a tutor are destined to fail the course.When a product has been unsuccessful. 7.000. 80% of the interviewed owners had been favourably impressed. . Consider the situation as in the previous problem. (b). 2010 D.M. Otherwise an unsuccessful toy will involve a loss of $400.When a product has been successful.. .

However. 2010 D. Inc. You estimate the chance of passing the course without any help to be 60%. 30% of the interviewed owners had a neutral impression and 50% were negative. From past sessions the following results were observed: Actual Result Pass Fail Feeling after session Conﬁdent Confusion Despair 0.10 0. a company whose stock symbol is IAM and whose slogan is “I think. IAM’s earnings are . assuming that at most one survey would be undertaken? What is the EVPI? (b) What are the efﬁciencies of the two surveys? 9.30 0.M. has a lower fee but provides less accurate information.000 for its report on the owners’ impression of the product. The exam preparation session will leave you with a feeling of conﬁdence. Its past studies show the following results: .When a product has been unsuccessful. You would like to pass Management Science. mild confusion or despair.20 0.c April 28.60 0. (a) What would you recommend to the management of Toys. the uncertainty as to what you are missing will give rise to mental anguish costs of about $7.30 0. . How much would you be willing to pay to take the exam prep session? 10.When a product has been successful. but you are not exactly sure if you will! You have the opportunity of doing an Exam Preparation Session before writing the exam. Janet Descartes owns 1000 shares of International Automated Machines. 60% of the interviewed owners had a positive impression and 25% were neutral.” Her mortgage is up for renewal next week and she wishes to sell these shares so that she can pay down her mortgage.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. It wants $20. therefore IAM. Tulett 379 I Inc.

2. (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.60. For a fee. Based on their past predictive ability.000 + 10% of the ticket sales.93 What is the highest fee that Ms Descartes would be willing to pay for such information? 11.M.000 if cloudy. $70.10 0. $15.70 0.25 0.000 to rent the land. Tulett due out in three days time. Assume that after the announcement the price will be either $10.09 0. 0.000 if sunny.3. Assume that this will remain constant until the earnings announcement.05 0. The current price of the stock is $15 per share.15 0. The rock concert promoter will pay $5.02 Earnings Forecast “as expected” “better” 0.000.10 for .1.000 if rainy. held under a tent. or $20 per share with probabilities of 0.30. She must decide whether to sell these shares just prior to or just after the earnings announcement.01 0. will pay the farmer $10. $13.30 0.2 and 0. Ms Descartes will use the following conditional probabilities: Price per Share $10 $13 $15 $17 $20 “worse” 0. 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. The circus.05 0. 0.380 c April 28.30 0. $17. 0. a ﬁnancial 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. Normal proﬁt from the land would be $5. From past experience the farmer estimates that the probabilities are 0. 0. and $20. Ticket sales depend on the weather as follows: $100.90 0.40 0.2 respectively.75 0. 0. 2010 D.

3 0.” or “negative. The chance that a hole drilled on this land will ﬁnd oil is about 1%.1 Predicted Cloud Rain 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.6 0.” “inconclusive.c April 28. (a) What would be your recommendation to the farmer? (b) What is the EVPI? To better predict the weather next summer.000. Actual Sun Cloud Rain Sun 0.M. 2010 D.00 to receive the forecast this far in advance. 12.1 0. The circus and rock concert promoter are responsible for all expenses associated with each respective event.1 0.000.000. only the latter is provided in the “Answers” section at the back of the book. and thirdly they provide the overall recommendation considering the testing information. At a cost of $50. The weather forecasters have provided the farmer with the following summary of their previous “track record” for predicting weather this far in advance. Such a hole would cost $700.2 0. a seismic test could be performed. and if oil is found assume that it has a value of $40.1 0.” In the area in which the land is located there is 70% chance .8 0.000. There is a cost of $200. cloud and rain respectively. The results of a seismic would be either “positive. the national meterological service will provide the farmer with a long range forecast. secondly they give the EVPI. the solutions ﬁrst give the recommended alternative in the absence of the testing information. An oil company owns a plot of land under which there might be a pocket of oil. Tulett 381 sun.

Adding up the costs involved. a 40% chance of a “medium” reading. The test is not perfect. retrieve the gold. A deep-water net from this trawler becomes tangled in a sunken sailing ship which lies on the ocean ﬂoor. If there really isn’t any oil. A trawler is ﬁshing in international waters. In the absence of any other information he believes that there is one chance in eight (0.” or “weak. the captain does some research when he arrives back in port.000 to retrieve the gold if the ship turns out to be the galleon. and a 70% chance of a “weak” reading. Nu Products Inc. then there is a 10% chance of a positive reading.000 if only searching were performed. if applicable. and a 55% chance of a negative reading. the captain ﬁgures that the test will cost about $50. When the probe is not near gold there is a 5% chance of a “strong” reading. He discovers that eight sailing ships have sunk in that vicinity over the past several centuries.200. has recently developed a new product and is in the process of trying to develop a marketing strategy. the success of .M. The depth of the water precludes scuba diving. a 25% chance of a “medium” reading. “strong. and a 10% chance of a “weak” reading. Given that some monitoring equipment needs to be on the trawler. The captain learns from a scientist friend of a procedure which can be used to do underwater testing of the presence of gold. What is your recommendation to the captain? 14. the captain would need to make a special trip to the location.000.000. This test would involve dropping a cable with an electronic probe from the side of the trawler. What should the oil company do? 13. and a 5% chance of a negative reading.125) that he has found the Spanish galleon. Noting the exact latitude and longitude. a 25% chance of an inconclusive reading.” “medium. Unfortunately. he could hire a submarine to search the ship and. They have come up with two marketing strategies – Plan A and Plan B. Tulett of a positive reading if there really is oil present.000 at today’s prices. This would cost $800. However. It will give one of three readings.” When the probe is near gold there is a 50% chance of a “strong” reading. a 35% chance of an inconclusive reading.382 c April 28. There would be an additional charge of $1. One of these eight ships was a Spanish galleon laden with gold worth about $10. He assumes that the other seven ships contain nothing of value. 2010 D.

The survey is 80% reliable. if Plan B will be preferred by the market. if Plan A will be preferred by the market. if employers prefer a graduate from a theory program. Tulett 383 the strategies depends on the market receptiveness. if the market turns out to be receptive to Plan B. there is an 80% chance that the survey will recommend that Plan A be used.e. but the payoff would be only $200. then a graduate of OWU will receive only $34. However. Management estimates that there is a 60% chance that the market would be receptive to Plan B. there is an 80% chance that the survey will recommend that Plan B be used. There is a small survey available which will recommend using either Plan A or Plan B. If the market turns out to be receptive to Plan A.000 whereas a graduate of CBU will receive only $35. but the payoff would be only $300. We will assume that the salaries in later years are independent of the starting salary.000 per prediction and gives only one prediction per customer. In other words. A government study has shown that in two years time (i. If he launches an all out assault on the position with his existing forces. If this occurs. degree. then the payoff would be $500. a graduate of OWU will receive a starting salary of $38. 2010 D. Similarly. then .c April 28. What would you recommend to Nu Products? 15. the futurist charges $1. what should the young man do? 16.M.B.000. A thoughtful young man has decided that it would be advantageous to his career path if he obtained an M.000 if Plan B had been used.000 if Plan A had been used. there is a 60% chance that employers will prefer a graduate from a case program. Assuming that the costs of obtaining the degree and other non-monetary factors are the same at each of the universities. The cost of the survey is $10. upon graduation). and CBU which concentrates on the theoretical approach. otherwise the market would be receptive to Plan A.000.A.000 otherwise. The universities he is considering are: OWU which concentrates on the case approach.000 if Plan B had been used. Before making his ﬁnal decision. General Lemmor has run into some unexpected resistance of unknown strength. a friend informs him that there is a genuine futurist who has a reliability of 95% on his predictions. then the payoff would be $450.500.000 but a graduate of CBU will receive $39. However.

then an all out assault will only sustain about 100 casualties if it is well fortiﬁed and no casualties if it is lightly defended. He thinks that there is about a 30% chance that it is well fortiﬁed.30 0.000 casualties later. At the outset of each working day. or a fee of $3.000 with a probability of 0. If it is well fortiﬁed he will sustain 100 casualties with probability 0.35 0. 2010 D. The daily production capacity is 50 units. What advice would you give General Lemmor? 17.40.70 0. The losses incurred during this attack will indicate to him how well the position is fortiﬁed.000 casualties whereas if it is lightly defended he will sustain only 50 casualties. Unfortunately time is of the essence and waiting for reinforcements will give rise to an estimated 1. The past experience of the investment ﬁrm is as follows: Firm recommends to invest not invest 0.000 if the company does invest.65 Investment Successful Failure The investment ﬁrm has two plans .05 but only 10 casualties otherwise.(i) an upfront charge of $2. Tulett he is sure that he will wipe out the position but the casualties might be excessive.000 with a probability of 0. A company is in a position to invest in a new venture which has only two outcomes . General Lemmor has the option of launching a probing attack. If the position is well fortiﬁed.000 or (ii) no upfront charge but instead a fee of $500 if the company does not invest. Normally. the line will produce defectives according to a Bernoulli process with p = .9. If he waits for reinforcements.384 c April 28.M. an assembly line is set up to produce colour picture tubes. (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. then he will sustain about 2.60 or a loss of $15. The company has the option of consulting an investment ﬁrm which will either recommend or not recommend investing. If is lightly defended then he will sustain 100 casualties with probability 0. but only 10 casualties otherwise.a gain of $25.

or will subtract 20 gold coins from the consolation prize should you guess incorrectly. it will take one year . if any. He has come up with the following proposal.M.one is ﬁlled with 1000 gold coins and the other with 600 gold coins and 400 lead coins. however. Acceptable tubes generate a revenue of $120 each. Tulett 385 0. If a customer receives a defective tube. 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. In front of you are two identical urns . The probability that X will be successful is 30%. this will subtract 500 gold coins from the total number of 1600 should you guess correctly. An inspection station can test up to two picture tubes. defectives are produced according to a Bernoulli process with p = 0. They are now in a race against time to produce the vaccine in large quantities. no revenue is received – instead there is a cost of $40 whenever this happens. then you will receive only 100 gold coins as a consolation prize. 2010 D. Determine the optimal number of tubes to test. you may have one of the Sultan’s attendants take one coin from one of the urns and show it to you. What is your optimal course of action? 20. If you correctly tell the Sultan the contents of one of the urns you will receive both urns. A resetting procedure is available which will guarantee that no defectives will be produced. Resetting the assembly line costs $500 and reduces that day’s capacity by three units.02 (this happens about 85% of the time). 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). and the total expected contribution to proﬁt associated with such a policy.30. If you guess incorrectly. However. It will take two years to develop and try process X. On the other days. since there is a revenue of $120 for each of these regardless of what else happens. If you wish. It is known that either process X or process Y will be successful but not both. Hint: Use a payoff node whenever one or two of the tested tubes are found to be acceptable. Researchers at Chembioco have just discovered a vaccine which retards the AIDS virus.c April 28.

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. For example. however. Because of the shortage of lab space. The recent experience has been that on 40% of the days there is a 1% defect rate. The daily production has averaged 1000 units and each defective unit sent back costs the company $100 in rework and other charges. the IC’s can be reworked before soldering. the machine which produces the IC’s has an “erratic” day and the percentage defectives increases to 30%. 2010 D. and on the remaining days there is a 10% defect rate. Due to a restriction on the amount of lab space available. Sixty-seven integrated circuits are needed per day. What would you recommend to First Rate to improve the quality of its product? 22. 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. the experiment cannot be performed simultaneously with either of the processes. The plant has a capacity to produce seventy per day. On “normal” days. If a defective IC is soldered to any other part. What would your recommend to Chembioco? 21. The production quality for one of the components of the ﬁnal product is quite variable from day to day. Sometimes. if X is tried and is found to be unsuccessful. the two processes cannot be developed simultaneously. guaranteeing . is having some minor production problems. “Erratic” days occur about 12% of the time. It is possible to perform an experiment which will give an indication of the correct process. it results in a $8 charge to rework.386 c April 28. the number of defective integrated circuits produced has a binomial distribution with a percentage defectives of 4%. If desired. An electronics manufacturer is having varying production quality for the integrated circuits which it produces. Unfortunately it destroys the tested unit(s) for a net cost to the company of $50 per unit tested.M. Each of the components can be reworked before putting them into the ﬁnal product at a cost of $4 per unit. First Rate Inc. an additional year must be spent to develop process Y (even though you know that it will be successful). Tulett to develop and try process Y. on 50% of the days there is a 4% defect rate.

000 and −$2.c April 28.50 per IC. What should the manufacturer do? 23.000. medium and low with net payoffs (excluding development costs) of $15. If you wish. 387 There is a destructive test procedure available which will indicate whether or not the IC being tested is defective. For product 1 the effect of this improvement will be to change the probabilities of high and medium demand to be 0. but a bad batch costs $2.000 to develop and has possible demand levels of high.5.4 and 0.000.4 respectively and with payoffs of $7.7 respectively.000. 2010 D.3 and 0.000. Product 1 will cost $10.000.000. Product 2 will cost $5.000 and product 2 will cost $2. The probabilities associated with the product are 0.000. and the test would cost $1 per unit tested. A good batch received by a customer is worth $5.000.M. The cost of the survey is $15.000 to the company. the survey predicted a “go” result 80% of the time and when a loss was incurred. $5. A marketing research company has a survey available which will provide information on the market response.000 to develop and has possible demand levels of good and poor with probabilities 0.000. whereas for product 2 it will change the uncertainty of good and poor demands to be equally likely. In 80% of the batches there are no defects.1 for each demand level respectively. A microcomputer chip production line produces large batches of chips each day.000 and −$5.000 respectively. 0. the survey predicted a “no go” result 70% of the time. 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.000. A company is considering introducing a new product and has two products under consideration. What would you recommend to the company? 24. then the company can improve the product further.000.000. at a cost of $500. If the market response is unfavourable. At any time the batch may be destroyed at the plant.000. Product 1 will cost $10.6 and 0. . In the past for those times that a product made a net proﬁt.000. and the remaining 20% have 30% defectives. To produce an IC in excess of the required 67 would cost $1. Tulett that they will not be defective at a cost of $2 per IC.

One of its machines normally produces only 2% defectives. draw a decision tree and determine your optimal action. 27. If the setup is normal. 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.000. A company is considering implementing a new quality control system. 25. You have the opportunity of having an impartial observer ﬂip the coin up to three times and tell you after each ﬂip if it came up heads or tails. you win $2.20.M. The coin has a head facing up. (a) If a ﬂip comes up tails. and low with marginal proﬁts respectively of $500. Each ﬂip. it will give a “good” reading 60% of the time and a “poor” reading 10% of the time. If you guess incorrectly. if performed. what can you say about the coin? (b) Using the result from part (a).388 c April 28. “inconclusive” or “poor”. $100. ABC Corp has developed but not produced a new product and must decide whether or not to market it.000 . You are asked to guess what kind of coin it is. you lose $1. A coin lying on a table is either a two-headed coin or a fair coin. but occasionally (10% of the time) it produces 8% defectives. what are the probabilities of normal and abnormal setups? 26. (a) What is the probability that the ﬁrst test will give an “inconclusive” reading? (b) If both the ﬁrst and second readings are “inconclusive”. If the setup is abnormal. The possible demands are characterized as high. You will defer the decision about subsequent ﬂips until you know what happens on the current ﬂip. A test can be performed which will give a reading of “good”. would cost $0. medium. it will give an “inconclusive” reading 50% of the time and a “poor” reading 40% of the time. 2010 D. If you guess correctly. Some of the technical aspects of this are covered in the appendix to the chapter.

A and B. If after seeing this ball you then decide to draw another. What would you recommend? 28.000 and gives predictions on the actual demand. A “no go” recommendation was given 30% of the times when the demand was high.00.c April 28. 50% of the times when the demand was medium and 30% of the times when the demand was low. Two surveys.50 Survey B can be used by itself or following survey A. The prize for correctly identifying the type of urn is $10. Tulett 389 and −$300. you may draw one or two balls from the urn.90 0. If you wish. You are invited to play a game in which there is one urn which is either Type I or Type II.” Based on past experience. Survey A will not be done if survey B has already been done.00 0.40. it is only after you have seen the ﬁrst ball. Past experience is given in the following table. It costs $5. It costs $2.000 and will give a recommendation of “go” or “no go. (a) Suppose that you have decided to draw a ball. 2010 D. are available.40 0. A Type I urn contains four red balls and one blue ball.30 0. Survey A costs only $10. The object of the game is to correctly identify the type of urn. 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? . A Type II urn contains one red ball and three blue balls. 000.00 to draw the ﬁrst ball.75 to play the game. If a second ball is drawn.M.10 0.50 0.20 0. and after observing this ball you decide to draw another. a “go” recommendation was given 70% of the times when the demand was high. then the cost to draw it is $0. Survey B costs $50. 50% of the times when the demand was medium and 70% of the times when the demand was low. Predicted Demand High Medium Low Actual demand High Medium Low 0.10 0. Management assesses the probability of high demand to be 20% and medium demand to be 40%.

” If a customer receives a lemon it will cost Pleasure Craft $40. then there is an 80% chance that the inspection will indicate “looks good. but the rest are “lemons. 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 .M. The results of the inspection at this station would be one of the following: “looks bad. Imperfect Information (Advanced) 1. The result of the inspection at the second station is reported as being either “pass” or “fail.” or “looks good.390 c April 28. 2010 D. (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.” If the boat is of high quality there is a 90% chance of a “pass.” (d) Draw and solve the new tree. if at all. (c) What should the company do now? In addition to the inspection station mentioned above.” If the inspected boat is of high quality. and a 1% chance of “looks good” result. Adding a re-work section to the assembly line would guarantee that each boat would be of high quality. 29. a 20% chance that the inspection will be inconclusive.” “inconclusive. and determine how. Life at Chembioco (see the preceding section) is not as simple as it could be. and a 5% chance of a “looks bad” result. Pleasure Craft can add a second inspection station (which can only inspect a boat which was inspected at the ﬁrst station).” a 15% chance that the test will be inconclusive.000 to replace it with a high quality boat (this includes the subsequent $2000 to be spent on the new boat). but this would cost $1500 per boat. requiring only $2000 in warranty work. Ninety-ﬁve per cent of the production is of high quality. Tulett (b) Using the results from part (a). produces a line of power boats. the game should be played. If the inspected boat is a lemon then there is a 79% chance of a “looks bad” result. Pleasure Craft Inc.” If the boat is a lemon there is a 98% chance of a “fail. draw the decision tree.

then the land will have a value of only $10. Tulett 391 the probability of X unchanged. 2. If the formation is present. Initial indications are that there is a 60% chance that the tract has standard oil bearing formations. A more detailed seismic survey can be done at a cost of $500. then the remaining probabilities must be re-scaled to 1.70 0.000. a 35% chance of small reserves and a 50% chance of large reserves. there is an 80% chance of no oil and a 20% chance of small reserves.30 0. It is currently having some problems with one of its high volume items. A full scale drilling program will cost the company 5 million dollars and will completely determine the nature of the reserves.20 0. If the survey is positive. 2010 D. If needed. The seismic result will be either “positive” or “negative. If there are no reserves.10 0. Small reserves are worth 10 million dollars to the company and large reserves are worth 100 million dollars.50 0. then the land is worth $1. Experiment Predicts X Y Z Actual Successful Process X Y Z 0.10 0. A company has the drilling rights for a promising tract of land. These .M. otherwise it is worth only $100. What would you recommend to Chembioco in this case? Note: This is a major problem with a signiﬁcant number of sub-trees.000. Otherwise.30 0.000. Video Shack is a retail chain specializing in electronic equipment. the test can be repeated. What would you recommend that the company do? 3.40 0. If there is no survey. the sale price is $500.000.” If the formation exists. The laboratory test results are incorporated in the following table.000.000. 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).40 If one process has been shown to be unsuccessful. there is a 15% chance of no oil. The land can be sold at any time.c April 28.

and 0. If desired.5. The Plastic Production Company needs to expand its production capacity for the next year.392 c April 28.2 respectively. 20% and 30% with probabilities of 0. 0. However. then there will be a 50% chance that there will be labour unrest after six months which will add another $2.00 per case.00 per case in addition to the regular cost of $10. then they will be required to layoff the shift at a cost of $5. 0.3 and 0.00 per case shift premium.3. Past experience indicates that the possible percentage defectives in a lot are 10%. they can use overtime at a cost of $3. 2010 D. it is replaced by Video Shack at a cost of $20. Tulett items are ordered from the supplier in lots of 100 units and give a proﬁt contribution of $10 per unit. they could choose to do no more testing. What would you recommend to Video Shack? 4. The replacement unit will be known to be non-defective. (For example. First of all.000 cases of increased capacity with probabilities of 0. This problem was ﬁrst seen on page 370. The company is considering two options to meet the situation.) No matter how the testing is done.2 respectively. The marketing department has determined that the company will need 5. or 15. the company could start the second shift in six months time instead of starting it immediately. then test another.000 cases. However. at any time they may choose to test all remaining units.000 for startup expenses and a $1. 10.000 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 . However.5. If Video Shack inspects a unit and ﬁnds it to be defective. the testing costs $4 per unit tested. A maximum of three units could be tested sequentially (test one and see whether it’s defective or acceptable.00 per case.000.000. however.000 and use overtime. if the required demand turns out to be 15. after testing two units. if the demand turns out to be only 5. Secondly. or test all remaining 98 units. Video Shack could non-destructively test some or all of the units. This will entail a ﬁxed cost of $15. when a defective unit is sent to a customer. then it will be replaced by the supplier at no cost.000 units. or test the third unit. and so on). they could operate a second shift.M. A survey which costs $2.

After looking at your cards. the company could monitor the labour situation at a cost of $500. Pile A is given to you. or continue playing by giving $2 to the dealer. After paying the $2. What is the optimal procedure for playing this game? 6. In addition. A correct guess wins a $8 prize. you may guess the number of Kings in pile C. you can either fold. and eleven other cards. Solve the preceding problem where the drawing of the cards must be made simultaneously. 5. A game is played with ﬁfteen cards – the four Kings.M. while piles B and C are placed face down. Find the optimal course of action for the company. Before guessing you may sequentially draw one or more cards from pile B. and C) of ﬁve cards each. of course. an incorrect guess wins nothing. This would have a 95% reliability in predicting labour unrest.c April 28. . If you wish to play you give $1 to the dealer. at a cost of $1. B. Only one guess is permitted at any time in the game. 2010 D.50 per card. The object of the game is to correctly guess how many Kings there are in Pile C. You may draw all ﬁve cards if you wish. Tulett 393 – 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. The cards are shufﬂed and dealt into three piles (A.

000 in utilities. .000 in high-tech companies. (d) She will invest at least $21. and 7 are industrials.M. (b) Solve graphically to obtain a recommendation. machine A is available for 7 hours. Each unit of product 1 contributes $45 to proﬁt. (a) Formulate a linear model which will maximize the daily contribution to proﬁt. 9.394 c April 28. and 8. and 15 minutes on machine B.000. while machine B is available for 7.5 Linear Optimization – Introduction 1.000 in a lottery. . no more than $50. 6. (e) She will invest no more than $60. At least 20 units of product 1 and at least 15 units of product 2 must be produced each day. (f) The amount invested in utilities must be at least half as much as the amount invested in industrials and high-tech combined.000 in utilities. and nor more than $40. . (c) She will invest no more than $20.000 in each security. Let Xi represent the amount of money (in dollars) invested in security (stock) i. (b) She will invest at least $2.5 hours. Write the following constraints mathematically. using summation notation where appropriate: (a) Her total investment must not exceed $100. . Each product must pass through two machines.000 in industrials. at least $18.000 in any security. . while each unit of product 2 contributes $30.000 in industrials. 2010 D. Each unit of the ﬁrst product requires 10 minutes on machine A. A company produces two products. and 10 are high-tech companies. and 6 minutes on machine B. where i = 1. A student has just won $100. and she has decided to invest some or all of it in the stock market. stocks 1 to 4 are utilities. 5. Tulett 23. On a daily basis. Each unit of the second product requires 8 minutes on machine A. She has identiﬁed 10 blue chip stocks. and at least $15.000 in high-tech.000 more than the amount invested in high-tech. (g) The amount invested in industrials must not be over $20. 10. 2.

(b) For each constraint. (c) The company which produces product 2 decides to raise its price to $1. (a) Show the following model graphically. 5. 2010 D. (a) Formulate a model for this problem. 3X2 5X2 3X2 1X2 ≥ 24 ≥ 30 ≥ 12 ≥ 0 0 X2 ≥ (a) Solve using the graphical procedure. $0.20 Protein (% by weight) 20 50 Carbohydrates (% by weight) 25 30 Suppose that a cat needs 80 grams of protein per day. Tulett 395 3. labelling all constraints. and state which constraints (if any) are redundant. and indicating the feasible region: .M. and 75 grams of carbohydrates per day.c April 28.60 $1. Given the following model min subject to (1) (2) (3) (4) 2X1 + 5X2 6X1 3X1 4X1 2X1 X1 + + − − . drawing an isovalue line. Assume that the cat will eat everything that she is given. state whether or not it is binding. The two products have the following characteristics: Product 1 2 Cost per kg. What will the owner do now? 4. (b) Solve this model by using the graphical method. A cat owner buys cat food from two sources and blends them to obtain a minimum cost nutritious diet.80 per kilogram. The owner wishes to determine how much to buy of each product.

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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 proﬁt, 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 proﬁt contribution of $0.24, while each litre of Wholesome Light gives a proﬁt contribution of $0.30. The brewery wishes to know how much of each brand should be produced. (a) Formulate the brewery’s 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)

c April 28, 2010 D.M. Tulett

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 ﬁfth constraint. Draw this constraint on the same graph, and show the new optimal solution. Again, use algebra to ﬁnd 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 ﬁnd 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 ﬁnd 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 difﬁcult. 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 distillery’s 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

400

c April 28, 2010 D.M. Tulett is sold (before tax) for £2.25 per litre. The ﬁxed 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 proﬁt 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 ﬂue 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 university’s 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 ﬁrst passage time from “up” to “down”? (c) What is the expected ﬁrst passage time from “down” to “up”? 2. The manager at a ﬁsh plant has noticed that there seems to be a relationship between one day’s intake of ﬁsh to be processed and the next’s. Eighty percent of the time when today’s catch is good, tomorrow’s is also good. If today’s catch is bad, then there is a sixty percent chance that tomorrow’s catch is also bad. (a) If today’s 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 Tea’s 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 week’s time? ii) in three week’s 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 week’s time? ii) in three week’s time?

403

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?

2010 D. Four companies are ﬁghting for market share. What do you think it is? 7. X. For each company.3 (a) By using matrix inversion within a spreadsheet model. A car can be returned to any of the four facilities. . determine the long-term percentage market share for each company.1 .2 . what would be the longrun distribution of these cars. there will be a major convention at location Y. U-Drive Car Agency maintains four rental facilities at locations W.3 . 100).4 .5 P= .2 . 150. Tulett 6. Historical data have shown that for every 150 cars picked up at each of the locations. 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.1 .3 .404 c April 28. Y and Z.2 .1 . 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. 250.4 . (b) There is a feature of this matrix which causes the result found in (a). What redistribution of cars will be necessary to meet this demand? .M. The demand during that week is estimated to be (100.2 .3 . 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.2 .2 .

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% .” If the candidate passes the ﬁrst exam. and 40% are marginal. Each term. conditional on whether the candidate is about to write the ﬁrst or the second exam. then he must re-sit the same exam at the next sitting of the examinations. what will it be in the long run assuming no change in the number of jobs in region X? 9. or withdraw. then he writes the second at the next sitting of the examinations.c April 28. An Undergraduate Studies Committee is evaluating the performance of students in its program. 2010 D. A examination body for a profession administers two examinations to each candidate. Suppose that on the ﬁrst exam 25% of the students pass. is adjacent to Region Y.000. Each year 10% of X’s workforce population moves to Y and 4% of Y’s moves to X. If the student fails the ﬁrst exam he is no longer a candidate and he must therefore pursue a different career. with a workforce population of 1.M. If the current unemployment rate (percentage of those in the workforce who are seeking work) in X is 8%. The result of each examination is either “pass. If he passes the second exam then he is admitted to the profession. which is usually six months later. 10. A student is said to have withdrawn if s/he changes programs or is required to permanently leave the program due to poor performance.” or “fail. he must repeat the ﬁrst exam at the next sitting. with a workforce population (includes those working and those who are seeking work) of 500.000. fail (must repeat the same term). Tulett 405 8.000. On the second exam 30% pass and 50% are marginal. each student will either pass (and is therefore promoted to the next term).” “marginal. Find the probabilities of eventual success or failure. Region X. If the student obtains a “marginal” on either exam. If the student fails the second exam.

During the year. Renteels can obtain a new car by trading in a one-year old car plus $2. Past statistics indicate that 20% of the new cars and 10% of the one-year old cars meet this fate. advising the customer to make the account active.M. Tulett Given that 200 students enter Term I. Inc. who are happy to learn about forgotten money. and about 45% of the account holders. During each calendar year. is in the car rental business. about 5% of all active accounts are closed. Renteels. What percentage of active accounts end up eventually being transferred to the government? 12.” An active account is one in which there was at least one deposit or withdrawal during the previous year. what is the expected number of students who will eventually be promoted to Term V? 11. bank accounts are classiﬁed as “active” or “inactive.000. close their accounts. otherwise the account is inactive. On January 1 of each year. The other 5% of the time no response is received. At the year-end. about 40% of the accounts are made active. Older cars are sold to the public. 10% of the new cars and 5% of the one-year old cars fall under this category. under a special arrangement with a local dealer. 2010 D. and such accounts are turned over to the government. Also. These wrecks are sold to junkyard dealers only. customers are sometimes involved in accidents and wreck the car completely. Such accounts are handed over to the bank’s legal department. In response to the registered letters. In early January a registered letter is sent to the last known address of each inactive account holder. at the end of the second year. some of the cars may develop a major component failure and would then be taken out of service and returned to the manufacturer. the letter states that any money not spoken for by the end of the year will be turned over to the government. or they can obtain a one-year old car for a two-year old car plus $1000. 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. and 2% of all active accounts become inactive. These trades happen 20% and 10% of the time respectively. Its policy is to use only new or one-year old cars. 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 . or to close the account.406 c April 28. Furthermore.

2010 D. Each month. there is a 20% chance that nothing will be paid on an account.M. As soon as DEF makes a sale. A credit card company classiﬁes its accounts into one of ﬁve categories: fully paid. then there is a 20% chance that it will become available and a 10% chance that it will spoil and have to be discarded. how many will end up being sold? 15. bad debt. and 61-90 days old. and a 20% chance of spoiling.000 bottles. 407 13. Tulett to the public. DEF Co. 31-60 days old. who will pay 95% of the amount of the bill. Wines available for sale have a 40% chance of sale this season. Fine Wines Winery annually offers a selection of ﬁne wines to a number of preferred customers during the Christmas season. There is a 25% chance that just enough is paid to keep the account in the same category. 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. If the account is in the . There are 3500 in this category. has the following current distribution of accounts in their accounts payable ledger. then there is a 20% chance that the account will be paid in full. If the current inventory is 10. (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. 0-30 days old. it will turn the bill over to the collection agency. If a wine is not sufﬁciently aged.c April 28. Should DEF accept the deal? 14. Some of the wines in their collection are not considered to have aged sufﬁciently and are not offered for sale. Accounts which are older than four months are written off as bad debts. If the account is in the 31-60 day category.

Alternatively. Many businesses fail because they are under capitalized. and a 10% chance that it will move to the 0-30 day category. 2010 D. a good year with a minor league team can give rise to a well-paying major league position. Professional baseball players begin their careers in the relatively poorly paid minor leagues. making a spreadsheet model in which the actual values for p and q are only entered once. (d) Repeat (b) using p = 0. and probability 1 − p − q that it will stay the same. Suppose that when a company’s capital reaches 21 units it is in the clear and there is no further risk of bankruptcy. Some other players may be released by the team against their will. A new business starts off with n units of capital.3. Each month. However. and q = 0.408 c April 28. 17. where n is an integer between 0 and 20 inclusive. (a) Model this situation as a Markov chain. .5. conditional on the initial level of capitalization (n). (b) Now suppose that p = 0. How long.4.M. there is probability p that the capital will increase during the month by one unit. then there is a 5% chance that it will be paid in full. while the rest will return to play minor league baseball in the subsequent season. and q = 0. on average. with 20 units of capital? (c) Repeat (b) using p = q = 0.5. When a company’s capital falls to −1 units it declares bankruptcy. This problem examines how the probability of avoiding bankruptcy could be related to the initial level of capitalization. Tulett 61-90 day category. Draw the transition diagram. . Suppose that from season to season a minor league . probability q that it will decrease during the month by one unit.2. Obtain a graph of the probability that a company will avoid bankruptcy. conditional on the initial classiﬁcation of debt? 16. will a company possess between 0 and 20 units of capital inclusive if it starts out with 0 units of capital? . a player may realise that he is not cut out for professional baseball and will therefore resign of his own accord. whenever the company begins the month with between 0 and 20 units of capital inclusive. What is the long term probability of being fully paid. and write the transition probability matrix.

a 5% chance or retiring. Tulett 409 player has a 20% chance of advancing to the major leagues.c April 28. 2010 D. 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. a 10% chance of retiring. 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. 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. 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. (c) If a player reaches the major leagues. and a 2% chance of promotion to coach or manager. The career possibilities for major league players are similar. All other students are required to temporarily leave the program for the duration of two terms. (a) In a particular year. and a 15% chance of being released. even if it is for only one season.M. what is the expected number of consecutive years that he will remain in the major leagues? 18. 80 new players are signed up by minor league teams. a 4% chance of being released. About 5% of the students in terms I to IV are required to permanently leave the program due to poor performance. after which they re-enter the program to repeat the failed term. The Undergraduate studies committee of a business school is evaluating its scholastic standards. . Show how to re-formulate the model so that this question can be answered. Eventually.

as a function of p and q. and so on. the probability that Party P will control all three seats. then Party Q will retain the seat with probability q. (c) If we were to use the matrix found in part (b). denoted as P and Q. Tulett (a) What percentage of students entering term I will ﬁnally graduate? (b) What percentage of students entering term I will be required to permanently leave the program? 19.M. There are two political parties.410 c April 28. 2010 D. However. If one of the three constituencies is represented by a member from Party P. (a) We wish to model the parliament using a single Markov chain. If a constituency is represented by a member from Party Q. What is a simpler way to answer such questions? . All three seats are contested by both parties whenever there is a general election. this would require a lot of algebraic work. or that they will form a government (at least two seats). (b) Derive the transition probability matrix as a function of p and q. it would be possible to derive. Deﬁne the states using the minimum number possible. then Party P will retain the seat with probability p. A tiny island nation has a parliament of just three seats.

a gamble with an equal chance of obtaining −$50. Situation 2.5 where the payoffs are in 1.000 for certain.M. using a smooth curve between the known points.00 0. A farmer has determined that he has three options at the present time.52 0.075 0.2 0. The payoff for each option depends on the weather as follows: Weather Bad Average −10 15 −50 25 −100 40 0.00 .000 for certain? 2. A businessman’s utility function is scaled at U(−$100. or $100.82 1.000) = 100. Using the Certainty Equivalence approach.3 Option Plant 20 Hectares Plant 40 Hectares Plant 80 Hectares Probability Good 25 50 90 0. a management scientist was able to determine the following utility indices: Payoff −100 −40 25 55 75 100 Utility 0. or $400. (a) Draw the utility function. a 50-50 gamble of −$100. and U($1. (b) Which would he prefer.000.27 0.000. 000 or $200. a 60-40 gamble of $200.000.7 Utility Theory 1. 2010 D.000.000 for certain. Tulett 411 23.000.000 or $1. Situation 3.000. or $200.000’s of dollars. 000) = 0. or nothing for certain. a 50-50 gamble of −$100. 000 or $300.000. He is indifferent between the alternatives in the following situations: Situation 1. 000 or $1.c April 28.

000 proﬁt a utility of 100. (b) Construct the utility curve. (c) What is the certainty equivalent of the recommended alternative? (b) What would you recommend to the farmer? 3. they are indifferent in the following three situations. . $10. 2010 D. Situation2.000 loss (prob. (i) $60. determine the certainty equivalent for that individual. (in 1. 0. The payoffs associated with each alternative and outcome are. Furthermore.000. $10.000 for certain and (ii) a lottery: $80. The payoff for each alternative depends on the demand for their product which may be low. 0. The Fresh Milk Dairy is considering enlarging their plant now or waiting until next year.75).412 c April 28.25).4 Alternative Enlarge now Wait Probability Low −10 5 0. (i) $80. (c) What strategy should the dairy adopt using the expected utility decision rule? (d) What is the certainty equivalent of the optimal strategy? 4.000’s of dollars).9).000 for certain and (ii) a lottery: $100. (i) $80. In each situation. $60.000 for certain and (ii) a lottery: $100.3 High 90 70 0. Tulett (a) Construct the utility curve for the range −$100. 2 3 ). 000 to $100.000 proﬁt (prob.M. 0. 3 ). as follows: Demand Moderate 70 50 0.3 The company has decided that a $10.000 proﬁt (prob. moderate or high.000 proﬁt 1 (prob.000 proﬁt (prob. 0. Each person has evaluated a risky venture at a given number of utiles. Situation3. Situation1. (a) Find the recommended alternative using the EMV decision rule. Here we consider ﬁve investors who have the utility functions given in parts (a) to (e).1).000 loss will have a utility of zero and a $100.000 proﬁt (prob.

A manager whose utility function is described in the following table (in units of 1.5 . must choose between contract A and contract B.500 with probability 0. 0.63 utiles x 4x+10000 . The outcomes of the subcontracts are independent.000 with a probability of 0. Sketch the utility function. $40. A 100 40 100 100 B 0 0 40 50 Certain 40 25 50 62.000 dollars).000 with probability 0. Tulett (a) U (x) = (b) U (x) = x x+6000 .6. and (ii) a certain equivalent.000 with probability of 0.c April 28. in the following four situations: Situation 1.85 utiles −x 413 (d) U (x) = 1 − e 2000 .6. Contract A promises a loss of $45. 0. 3. Contract B consists of two subcontracts each of which promises a loss of $22.M.4 and a proﬁt of $80. 0. 0. 2010 D. $0 with equal probability. 4. Your friend can invest in investment 1 which will guarantee a payoff of $50 or in investment 2 which has possible payoffs of $100.52 utiles 5.57 utiles −3x x+1 (e) U (x) = 3 ln( 5000 ). (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. 2. Assume a friend of yours asks your advice on the following decision.4 and a proﬁt of $40.45 utiles (c) U (x) = 1 − e 1000 . 0. (c) Which investment would you recommend if your friend wanted to maximize the expected utility of the investment? 6.

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.650 0.90 1.000 (a) Which contract would you recommend to the manager? (b) What is the certainty equivalent of the chosen contract? 7. 0.375 0.414 Dollar −200 −100 −50 −20 0 24 60 100 200 280 400 c April 28.85 0.45).750 0.925 1. Tulett Utility 0.00 .875 0.65 0.825 0. (b) The manager is given the opportunity to buy a contract which will either give him/her $200.55) or cost him/her $100.575 0.525 0.000 (prob. 2010 D.M. what should the manager be willing to pay for it? Utility 0.925 0.80 0.000 (prob.725 0. 0. What is the contract worth to the manager? (c) If a second identical contract were made available.00 0.000 0.700 0.40 0.

or a “major” theft of $1. She is considering an investment of $50.000.000.000 for certain and (ii) a lottery: a loss of $100. 2010 D.000 with probability of 0. Situation 2. Situation 3.000 loss with probability 0.000 for certain and (ii) a lottery: a $1. the president has determined that he is indifferent between each of the two alternatives presented in the following four situations: Situation 1.000 for certain and (ii) a lottery: a loss of $250.000 .9.000.1 and no loss with probability 0. Storage Inc. (a) Construct and graph the utility function for the company president. If the insurance were purchased. Her current net worth is $100. the company executives believe that the utility rating is the appropriate measure to use in evaluating alternatives. (i) a loss of $20.000 with a probability of 0.000.000 in a venture which will have revenues . 000 to −$20.000. The insurance will fully compensate any loss due to theft.M.000 with probability 0. Tulett 415 8. (b) Given that the company president wishes to maximize his expected utility. (i) do nothing and (ii) a lottery: a $1.000 payoff with probability 0.000. There are three outcomes which can occur in any year: no theft (95% chance). where x is her level of wealth in dollars.9.8 and a loss of $1. Situation 4. is considering the purchase of a theft insurance policy for a local warehouse. The company president has assigned a utility of 100 to $1. In order to determine the utility function. After considering the risk and other related factors.000. She uses the utility function U (x) = 100x . (i) a loss of $250.000 (4% chance).000 and a utility of 0 to $0. Susan Prudent is a businesswoman who carefully considers the risks of any new business venture.2.75.25 and no loss with probability 0.c April 28. a “minor” theft of $100. 000.] 9.000. 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. the premium would be $20. (i) a loss of $20.1 and no loss with probability 0.

0. In the above problem suppose that the $50. For the management course the respective probabilities are 0. A student is confronted with the problem of deciding which of two courses to take.2.A and B.M. C and D respectively. Furthermore she has determined that she is indifferent between the alternatives in the following two situations: .000 with probabilities of 0. Assume that you are faced with the following dilemma. The expression that you will obtain for the maximum amount can be solved either by trial and error or by graphing the expression. If you study for A. 0. 0.30.000 investment is not ﬁxed but is subject to negotiation. B. Tulett of 0. 2010 D.000 dollars.00 for A. If you study B.30 and 0.5 respectively. 12. 0. Your ﬁnal exam is tomorrow and you have only time to study one of two important topics . 55% and 70% respectively for each situation. (a) Should she undertake this venture? (b) What is the EVPI (for her)? 10. explain why they are different. 95% and 65% respectively for each situation. She has decided to take either a statistics course or a management course.50 and 0. (c) Are the results to (a) and (b) different? If they are different. For the statistics course.50.416 c April 28.10.000.10.20. 000 to 100. $80.3. Derive your own utility curve for the range −10. and 0. 35% of the time B is heavily weighted. she estimates the probabilities of each grade as 0. or $200. Otherwise they are equally weighted. then you will receive 85%. then you will receive 50%. (a) Which alternative do you prefer? (b) Evaluate these situations using your utility curve. 13. 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. From past results you know that 40% of the time A is heavily weighted. 0. Derive your own utility curve for ﬁnal grades in a course.] 11.

Alternative 1. what is its certainty equivalent? 15.80 of a D.000? 10. An individual’s utility function for dollar values greater than −100.40 of a C. a C for certain Alternative 2.000.000 is given by U (x) = 100 − where x is in units of $1.000 . Alternative 1. Situation 2.20 of an A and a probability of 0. 2010 D.M. 000 100 + x (b) If the utility of an uncertain situation is 40. (a) What is the utility of −$20.6 of an A and a probability of 0. 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. a B for certain Alternative 2. Which course should she take? 417 14.c April 28. a lottery with a probability of 0. a lottery with a probability of 0. Tulett Situation 1.

which alternative should be chosen? (b) If each alternative costs $20.3 0.2 Investment A1 A2 Probability (a) If each alternative costs $10. 2010 D.000.418 c April 28. which alternative should be chosen? .000’s) O1 O2 O3 O4 20 −30 80 −10 30 90 −40 30 0.1 0.M. Tulett This individual has two investment alternatives which have the following payoffs: Outcome (in $1.000.4 0.

If the redesigns are successful (independent probabilities of 0.000 for the premium model. 2010 D. Re-solve parts (a) and (b). −x .000.000. 3. A major car manufacturer is thinking of redesigning the regular and premium versions of one of its models.6 respectively). some.000. (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. The cost of the redesign will be $2.000 loss for sure or a 20% chance of a 50 million loss and an 80% chance of a 3 million proﬁt. or none on a lottery on which he will either gain the amount wagered with probability 0. $6. The company’s management has determined that it is indifferent in the following situations: Situation 1. Tulett Utility Theory (Advanced) 419 1. 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. 2. An investor has decided that for any amount x.000. $10. Hint: this sort of function is independent of wealth.000. then the regular model would result in an increase in proﬁts of $10. If the utility of x = 0 is 0. and the premium model would result in an increase in proﬁts of $15. then the company would lose $5. and if the utility of x = 300 is 1.M. A man with utility function U (x) = 1 − e 100 has $200 dollars of which he may gamble all. Situation 3.000.000.4. give the function U (x).c April 28.000. Situation 2.000 and $8.000.000. $3.000 for the regular model and $3. If the designs are not successful.000.6 or he will lose the amount wagered with probability 0.000 respectively.000 proﬁt for sure or a 30% chance of a 10 million loss and a 70% chance of a 20 million proﬁt.5 and 0.000 proﬁt for sure or a 15% chance of a 10 million loss and a 85% chance of a 20 million proﬁt.

which do you prefer? (c) Evaluate the four alternatives using utility theory.420 c April 28. which do you prefer? (b) Comparing A3 with A4 .60 serious injury 0. 21. Allais who discussed it in the paper “Le Comporte´ ment de l’Homme Rationnel devant le Risque: Critique des postulats et Axiomes de l’Ecole Am´ ericaine. On average most drivers will have at least two or more accidents of varying degrees of severity. 2010 D.000.95 0.$5.000.” Econometrica.000 for certain. Alternative A4 .000 with probability 0.000.11.10 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.000 proﬁt for sure or a 20% chance of a 20 million loss and an 80% chance of a 20 million proﬁt.30 death 0.000.000.000 loss for sure or a 75% chance of a 30 million proﬁt and a 25% chance of a 20 million loss. $0 otherwise.$1.M.000 with probability 0. 5.01.$1. Tulett Situation 4. serious injury. 16 This . (a) Comparing A1 with A2 . The probabilities of these outcomes can be described as follows: no injury 0.000 with probability 0. We classify the outcomes of an accident as no injury. 1953. Situation 2. Situation 5. Alternative A3 . Alternative A2 . Is your answer to (a) consistent with your answer to (b)? problem is usually named after M.1.000 with probability 0. What would you recommend that the company do? 4. and death. $0 otherwise.04 0.89 and $0 with probability 0. $10. Consider the following set of situations16 : Situation 1. $1.01 0.$5. $3. Alternative A1 .000. vol.1. A well established fact is the beneﬁt one derives from wearing a seatbelt when in an accident.000.

A union is just about to negotiate a contract with company management. The Fast Track and Quick Trip Bus Companies serve the same route between two major cities. both companies are thinking of improving their service by either lowering fares or serving soft drinks en route. The total number of passengers travelling by bus has been fairly stable over the recent years.8 Game Theory 1. What strategy should each side choose? .M. They have estimated the payoffs in millions of dollars. They have identiﬁed four bargaining strategies for themselves and they believe that the company will choose from four strategies as well. What strategies would you recommend for each company? (b) Use the Criterion of Pessimism to ﬁnd the optimal solution. To obtain a larger market share. 2010 D. for their members as a whole over the life of the contract. as a function of the union’s and management’s 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. 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. Is the saddle point the same as in part (a)? 2.c April 28. Tulett 421 23.

Due to the relative unpopularity of big business polluters.5 of winning for each side. 000 + 2. Tulett 3. the environmental group might allocate $3. An environmental group has a $4.000.000. Suppose that each side will allocate its money in $1.000 increments.6 3. The objective for each side is to maximize the expected number of issues won.000. The market share payoffs to ﬁrm 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 ﬁrm? 4. are each considering three advertising plans.000 to ﬁghting for water treatment. 000. Two ﬁrms.000. The payoffs are in terms of market share. For example. Suppose that the probability of winning an issue (in terms of governmental action) is proportional to the amount of money spent by each side.422 c April 28. and the game is zero-sum. A and B.000.000 to ﬁghting against acid rain and $1.000. then there is a probability of 0.000 war chest with which to ﬁght the environmental group. What should each side do? 5. the effectiveness of their advertising is only 80% of the effectiveness of the environmental . 2010 D.000. To combat these campaigns. 000. 000 If neither side spends anything on a particular issue.M. if the environmental group spends $3.000 denying acid rain effects. 000. then the probability that the environmental group wins the issue is 3. 000 = 0. an industry group has put together a $5.000 fund from which to allocate to advertising campaigns on two environmental issues: acid rain and water treatment. The advertising money is inconsequential for both parties.000 ﬁghting against acid rain. For example. and the industry spends $2.

but the union decreases its demand by 50 cents.c April 28. If one of the vendors is closer than the other vendor to a particular hotel. but not $1. In the case of ties (or if neither side moves). The arbitrator has asked each side to submit a new proposal. If both players choose the same item. then the closer vendor will obtain 75% of the customers at that hotel. Tulett 423 group’s advertising. or submit a new offer between $1.25 per hour. if the company increases its offer by 25 cents. (a) Construct the payoff matrix in terms of market share. The hotel situated at the western end of the beach has on average 1000 guests. then no-one wins. How will this affect the recommendations obtained in the previous question? 6. 2010 D. What is the optimal strategy for each player? 8. paper or rock. An arbitrator has been called in. Each side must either re-offer its existing “ﬁnal” offer.75 per hour). then the increase will be $1. Alison . and the eastern hotel has 1500 guests. the hotel at the centre of the beach has 500 guests. Draw the game table from the union’s perspective.M. Rock” as a zero-sum game.00 per hour and $2.00 per hour. Scissors cut paper. while the company has offered an increase of $1. Three hotels have been built to take advantage of a bay with a beautiful sandy beach. and rock breaks scissors. The union has demanded an increase of $2. Two ice cream vendors service the beach. Alison and Wendy enjoy gambling.81 per hour).75 per hour. A union and a company have made their “ﬁnal” contract offers. Formulate the children’s game of “Scissors. then the arbitrator will award an increase of $1. What should each side do? What is the value of the game? 7.625 per hour. The arbitrator will make the ﬁnal wage increase equal to the offer which has moved the most from its current position. Paper. They play a game in which each opponent secretly chooses a coin from one of her piles of British coins. paper entraps rock. Recall that each player chooses scissors. the union could now ask for $1. (For example. (b) Find the optimal strategy for each vendor. whereas if they are equidistant then each vendor will receive 50% of the customers at that hotel. 9.25 per hour inclusive in 25 cent increments (for example.

(c) solve the game and ﬁnd the expected payoff to Player A. 11.424 c April 28.M. . and the expected number of patrons per week at each is given in the following picture. 2010 D. 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. All winnings go into two separate piles. (a) Set up the payoff table for Alison. and 10p coins. Three pubs are located in the downtown area of a large city. Wendy has three piles of 1p. Tulett has three piles of 2p. The following table gives the payoffs to Player A for a zero-sum game. 5p. otherwise Wendy wins Alison’s coin. (The players do not choose from these piles). 5p. If the value of the sum of the values of the two coins is even then Alison wins Wendy’s coin. and 10p coins. (b) use a graph to ﬁnd the alternative which is dominated locally. (b) Which strategies can be removed using dominance? (c) What are the optimal strategies for each player. one for each player. The relative locations of the three pubs. and what is the expected value of the game? 10.

000 Westland Eastland Two competitive hot dog vendors named Jack and Jill are planning to service the area. then they will be imprisoned for jaywalking. resisting arrest for a total of 5 years for each man. and then separate them. . then they will receive lighter sentences of 5 years each. put the following proposal to the men. but lacking sufﬁcient evidence to convict either. convinced that both are guilty. vagrancy.c April 28. At the outset of each day. the ﬁrst will go free and the other will receive the maximum sentence of 10 years. Assuming that the patrons of each pub have similar preferences for hot dogs. (3) If neither confesses. (2) If both confess.500 Northland ¡ ¡ ¡ ¡ ¡ d d d d d d 425 300 metres ¡ ¡ ¡ ¡ ¡ ¡ 400 metres d d d d d d 7. The Prisoner’s Dilemma I. Two men are arrested for armed robbery.M. what would you recommend to Jack? to Jill? 12. (1) If one man confesses but the other does not.500 ¡ ¡ ¡ 500 metres d d 20. Tulett 12. each person will park his or her hot dog stand outside one of the three pubs. 2010 D. 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. The police.

2010 D. 13. The police. and then separate them. Two men are arrested for armed robbery. The rules of the game are that each player chooses from 1 to 5 pennies (hidden from the other player). convinced that both are guilty. The Prisoner’s Dilemma II. Two friends are playing a simple game called “Five Pennies”. (1) If one man confesses but the other does not.426 c April 28. (a) Why is Prisoner’s Dilemma II signiﬁcantly different from Prisoner’s 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). put the following proposal to the men. Two groups (A and B) are in a conﬂict 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? . the ﬁrst will go free and the other will receive the maximum sentence of 10 years. (2) If both confess. 14. 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 they will receive lighter sentences of 5 years each. but lacking sufﬁcient evidence to convict either. 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). then the player with the higher choice pays the difference to the player with the lower choice.M. (b) Is there a pure strategy available for either player? 15. (a) Set up the appropriate payoff matrix for this problem. If the difference between the choices is 2 or fewer. (3) If neither confesses. then both men will go free.

decide to play a version of a “four-ﬁnger” game in which they simultaneously show either 1. otherwise Welf wins the sum from Alf. Alf wins that amount (in dollars) from Welf. What is the optimal strategy for each player and the value of the game? 2. .c April 28. previous problem) but also requires that each player guess the number of ﬁngers which the other player has chosen. and how many to guess. Two players. Alf and Welf. 2010 D. Solve the situation where each player must show either one or two ﬁngers. A “morra” game involves the showing of ﬁngers (cf. then the game is a draw. Hence each player must choose how many ﬁngers to show.M. the single player who guesses correctly wins the sum (in dollars) of the total number of ﬁngers shown. Tulett Game Theory (Advanced) 427 1. Otherwise. 2 or 4 ﬁngers. If neither player guesses correctly or if both players guess correctly. If the sum of the ﬁngers shown is even.

or 650.000 litres/month overall.000 The inputs are blended to produce two outputs. The requirements for employees over the seven day work week are: . thereby enabling the sulphur percentages to be treated as if they were by volume. 2010 D.2 0. you may wish to number the commodities and then use subscripted variables. 2.7 Minimum Thermal Value (kilojoules/litre) 16. Tulett 23.000 litres of any output can be handled. An oil reﬁnery has three types of inputs.428 c April 28.000 17.000 20.63 $0.9 Linear Optimization – Applications Formulate the following problems as linear optimization models.2 0.000. with the following prices and characteristics: Input # 1 2 3 Price per litre $0. A large unionized restaurant is planning its workforce schedule. We can also assume that there are no losses in the blending process.76 $0.91 Maximum % Sulphur (by mass) 1.000 18. We can assume that all three inputs have identical densities.4 1.42 $0. up to 500.60 % Sulphur (by mass) 2.0 Thermal Value (kilojoules/litre) 15. 1.000 litres of any input.000 The reﬁnery has a capacity of 1. and that the characteristics of the outputs are a weighted average (by volume) of the characteristics of the inputs. Where appropriate. Subject to the overall capacity.M. with the following outputs and promised speciﬁcations: Output # 1 2 Price per litre $0.

peas. The state government gives him up to 1.c April 28.04 per cubic metre. $1.M. Columbian.20. and $0. Therefore. nor may any commodity occupy less than 10% of the total area planted.000 cubic metres of water per annum at a cost of $0. In addition. 4. he may purchase up to an additional 300. The net revenue per hectare of each commodity (excluding the cost of purchased water. and onions. The restaurant manager wishes to minimize such wastage. no commodity may occupy more than 50% of the total area planted. the schedule might assign 119 employees on Wednesday). and Nigerian coffee beans can be purchased for $1. Peruvian. Tulett Minimum Number of Employees 110 81 85 118 124 112 120 429 Day Sunday Monday Tuesday Wednesday Thursday Friday Saturday The collective bargaining agreement states that all employees are to work ﬁve 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. 2010 D. (Ignore the fact that the number of employees must be integer.90 per kilogram respectively.000.000 cubic metres of water for irrigation each year. A farmer owns 500 hectares of land in an arid region.) 3. From these sources a company . He grows corn.00. 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.

The domestic wine contains (by volume). the two shifts are consecutive (effectively one seven-hour shift). . and then again at night from 11 p. those who work non-consecutive shifts are paid a $5 per day bonus. and Marseille regions of France are sold at wholesale for 20. the management has stipulated that no one will be asked to work from 7 a. but usually they are not. The foreign wine must be at least 70% Alsace and no more than 5% Marseille. which sell for $1. Burgundy.000 kilograms of premium coffee.m. to 10:59 a.m. Burgundy. 4:00 p. and 10 FF (French francs) per litre respectively. 2010 D. Because of the inconvenience of breaking up the day. Subject to meeting all its requirements for drivers. In some cases. 6. 18. The supply of Alsace. Tulett makes a “regular” and a “premium” blend of coffee.m. City bus drivers work two three and a half-hour shifts per day. and Marseille wines is limited to 15.m. and 21.m. The premium blend contains at least 50% Columbian beans.30 and $1.m. The maximum market demand is for 200.430 c April 28. and at least 20% Peruvian beans. to 3:59 p.000. to 7:29 p.000. 15. and “foreign”. and no more than 15% Nigerian beans.000 litres respectively.m. to 8:59 a. A Parisian company buys these wines and blends them into two types. However. In some cases.m. Wines from the Alsace. no more than 12% Alsace and at least 50% Burgundy wine.60 per kilogram respectively. the two shifts are consecutive (effectively one eight-hour shift). 12:30 p.m.m. The regular blend contains at least 10% (by mass) Columbian beans. to 12:29 p. but usually they are not. The bus company has the following daily requirements: Minimum Number of Drivers Needed 150 80 90 160 70 Time of Day 5:30 a. to 10:59 p. to 2:59 a.M.m.m. which they sell for 25FF and 35FF per litre respectively.000 kilograms of regular coffee and for 130. “domestic”. All bus drivers earn a base rate of $10 per hour. 5. 7.m. the bus company wishes to minimize its daily labour cost (regular and bonus). 9:00 a.m. Food service employees work two four-hour shifts per day. 7:30 p.

to 2:59 a.m. The previous month’s (month 0) production level was 240 units. No shortages are permitted. 11:00 p. to 10:59 a. The company wishes to minimize the sum of production level change costs and inventory holding costs over the six month horizon. the restaurant wishes to minimize its daily labour cost (regular and bonus).m.20 per hour paid for each hour worked from 7 p.M. In addition. To hold a unit in inventory for one month costs $4. Tulett 431 All food service workers earn a base rate of $5 per hour. there is an evening bonus of $1. to 10:59 p. 2010 D. 7:00 p. Subject to meeting all its requirements for workers. 11:00 a.m. A company has ﬁrm 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. 3:00 p.m. to 2:59 a.m. to 6:59 p. The restaurant has the following daily requirements: Minimum Number of Workers Needed 100 230 110 180 80 Time of Day 7 a. 8.m.m.m. There must be no inventory left over at the end of month six. The company starts off (think of this as month 0) with 50 units in inventory.c April 28.m.m.m. 9. to 2:59 p.m. There is no restriction on the level of production in month six. A company which produces a single product has deﬁnite orders for this product over the next four quarters as follows: Quarter Demand 1 350 2 680 3 275 4 590 .

Mills 1 and 3 can only ship 350 tonnes each to any one furniture plant. 10.80 per unit per quarter. 2010 D. each of which can supply any of the three plants. 11.M.20 5. Tulett The company ended the previous year with an inventory of 200 units. Shipping Charges in Dollars per Tonne Lumber Furniture Plant Mill 1 2 3 1 2. It costs $3.40 3. each of which is costly and in short supply: Ingredient 1 2 3 4 Amount on Hand (kgs.60 3. are additional. A furniture manufacturing company has three plants which need 474. The cost of holding inventory from one quarter to the next is $4. at each lumber mill. and 870 tonnes of lumber per week.432 c April 28. No shortages are permitted. Hint: Use doubly-subscripted variables. lumber mills 1 and 2 are limited to 700 tonnes per week (each) to the furniture company.10 2 3. The vaccine consists of four ingredients.50 4. A military hospital in an isolated area needs to make 25 kilograms of a vaccine. The company wishes to minimize the sum of production level change costs and inventory costs over the four quarter planning horizon.) 28 35 52 26 .00 per unit to decrease it. The company wishes to end this year with an inventory of at least 250 units.00 3 1. while mill 3 can supply any demand. 620.) 22 18 20 24 Cost ($/kg. Shipping charges.50 3. which vary according to where the lumber is sent. The price of lumber is $240 per tonne. There are three lumber mills. there is no such restriction on mill 2.50 Because of commitments to other customers. and the ﬁnal quarter production level was 400 units.20 4. and $6.50 per unit to increase the production level from one quarter to the next.

The contracted quantities are: Year 1 2 3 4 Demand Type A Type B 4. We-Make-Um-Well has received a lucrative contract to manufacture two types of industrial components. What is the objective function now? 12. (a) Formulate a cost minimization model. 400 tonnes and 450 tonnes of paper for the next three months. Tulett 433 In order for the vaccine to be effective.000 15.000 4. The contract calls for certain quantities each year for the next four years. 10% of the paper inventory on hand at the end of a month must be discarded. (b) Suppose that because of heavy casualties that as much vaccine as possible is desired. but together must not exceed 25%. The ﬁrm’s storage area will not hold more than 500 tonnes.000 10. There is no prospect of production after that.000 5.M. (iii) Ingredient 4 must not be more than 50% of the total. 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. During the ﬁrst month the price of paper is $6. the following restrictions must be met.500 in the second and third month due to an anticipated strike at the regular supplier.000 per tonne and rises to $7. and that money is of no concern. 2010 D. As a result of humidity and other storage factors.000 .000 20. Precision Printers estimates that it will need 300 tonnes.000 6. (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.c April 28. Formulate the appropriate model for the management of Precision Printers. 13.000 8.

500 to proﬁts each year. The terms of the loan require Buns to repay the amount borrowed plus interest at the end of the ﬁrst year. Each year the rental charge will increase by $2.000 in year 1 and will increase by $5. Tulett Each type of component needs a special machine at a particular stage of the manufacturing. except in the ﬁrst year when it loses $15.000 or leased for two years at $2. Formulate an appropriate model for We-Make-Um-Well’s management.000 will become available at the end of each year for use in the following year. To break a lease would cost $300 per machine. Each of the 100 machines will contribute $3.000 each following year.000. machines which have purchased can be sold at their salvage value. To buy a machine costs $100. Each year of its life the machine loses $10. After two years a more efﬁcient model is due to be available and all machines will be replaced at this time. Machines can be purchased for $5. therefore $350. These machines can be either purchased or leased. Machines can be rented for either a 1-year or 2-year term at rental charges starting in year 1 at $24. Buns has $150. Buns can obtain a loan at the outset of the ﬁrst year for up to $300. except that machines already on hire stay at their original charge until the rental period expires.000 per year.000 at 13% interest per year. The ﬁrm wishes to minimize the present value of the net cost associated with these machines where the company’s discount rate is 20%. one machine will handle 3000 Type A components or 2000 Type B components or any proportional combination of them.800 per year payable at the beginning of each year. Each machine has a two year life and is depreciated linearly to a salvage value of $1. Unused cash earns 10% per year.000 in uncommitted funds that can be used to lease and/or buy machines at the outset of the ﬁrst year.000. Thus any machines on hand at the end of two years will be sold at their depreciated value. Due to recent market forecasts. On an annual basis. 2010 D. In addition. 14. Inventory may be carried over from one year to the next at a cost of $2 per unit.434 c April 28.000. At the end of the four year planning horizon.000 of its value.M. Buns Bakery estimates that it will need an additional 100 donut machines for its various facilities for the next two years. All expenditures are assumed to occur at the beginning of each year. . respectively.000 and $20.

every trainee is either hired as a regular employee the following month or is put on retainer. For January.c April 28. Upon completion of their training. they require 1670. or it can put them on retainer at $75 per person per month.) 15. the right to recall is lost. and high-tech products. Each trainee is paid only $760 per month. Formulate a linear optimization model to determine a minimum cost stafﬁng schedule for the six month period. February. May. April. and another 15% will resign for personal reasons. The state of Kaybeck produces three major types of outputs for the export market: electrical energy. (Hint: Maximize the ending cash position. 1770. Each commodity can be sold on the world market in units worth $50. To produce 1 unit of aluminum requires 1. Anyone on retainer can be re-called at the restaurant’s whim at any time. and 2040 labour hours respectively. Each unit of electrical energy produced requires 0. Such re-called employees do not require any further training. The nonsalary training cost will rise to $690 per trainee in April. 1550. If the restaurant does not pay the $75 retainer fee. This work is performed by employees who have completed a one month training program. 2010 D. it is unrealistic to expect that more than seven trainees can be hired in any month.05 units of high-tech products.2 .1 units of aluminum and 0. the restaurant can hire them as regular employees immediately. Because of local labour conditions. the trainees are all keeners. $90. At the outset of the year. aluminum ingots. their inexperience means that the restaurant receives only a negligible amount of useful productive work from the trainees.M. approximately 10% of the trained employees who worked that month will be ﬁred. Each employee makes $960 per month (or $6 per hour). but costs another $440 in non-salary training expenses. Tulett 435 Formulate the appropriate model for the management of Buns Bakery. The owners of a fast food restaurant must make several stafﬁng decisions over the next several months. Because of this. At the end of each month. Hint: What are the decisions to be made at the beginning of each month? 16. March. and $200 respectively. so ﬁrings and resignations are virtually non-existent. 1830. there are 12 trained employees available and willing for work. Each trained employee works up to 160 hours per month. However. Furthermore. and June. 1980.

These are produced using two parallel production lines. (a) Assume for the moment that energy. (b) Suppose now that there are no import restrictions. J. There is no production capacity limit for high-tech products. and 0. give an argument as to why some some of the variables will be at their upper limits. 1400 and 3000 on line one and 2500.000 units of energy and 350. Tulett units of electrical energy. The state of Kaybeck has a capacity to produce up to 500. but it is unlikely that more than 100. 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. 2010 D.7 units of energy. Aut Co.436 c April 28. 18. From this deduce the values of all the variables. but not necessarily either of the two standard widths. Make the appropriate modiﬁcations to the model given in part (a). Formulate a model which will maximize the dollar value of the trading surplus. aluminum. If more than one product is produced on either line. All paper produced has a thickness of 0.04 units of high-tech products. The single-product capacities of these lines over the planning horizon are 1000. 17. and high-tech products cannot be imported.2 units of aluminum.000 units could be exported.M. (c) For the model given in part (b). $15 worth of imported bauxite ore. then the capacity of that line must . Each unit of high-tech product is produced using 0. has three major products: X.000 units of aluminum.1 mm. 0. and each roll has a length of 1000 metres. Y and Z. Y and Z respectively. The customers all desire rolls of this thickness and this length. W. A paper mill produces rolls of paper in standard widths of 90 cm and 200 cm. Formulate a model which will minimize the amount of paper which needs to be re-cycled. 1600 and 1000 on line two for X. and $120 worth of imported materials.

Y and Z respectively. The lines are such that you may switch from one product to another without any setup cost. neither method of preparation (nor any combination of the two) will improve his mark by more than 60 marks in any course. The proﬁt contributions are 100. 19. Tulett 437 be determined in an appropriate manner. Without doing any preparation. In addition. There are two components (A and B) used in making these products which are in relatively short supply. (b) Use a computer to help give a recommendation to the management of J. and one units of component B respectively. Products X. omitting any constraints which are trivially redundant. 150 and 300 for products X. In addition. he believes that his marks will be 20. He has two methods of preparation: reading his texts and problem solving. There are only 2500 units of component A. .M. each of which is of equal importance to him. A student needs to prepare for three mid-term exams. and 30 in courses 1. W. 2. 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. He has 20 hours available for studying. 2010 D.c April 28. Marketing requires that there be at least twice as many units of product Y as of product X. (a) Formulate this problem. the production of Z must not be less than the combined production of X and Y. (a) Formulate this problem. Y and Z need one. and two. 25. and 3 respectively. one. Aut Co. one. and 3000 units of component B. and two units of component A. Based on his past experience. (b) Use a computer to help decide what the student should do.

Finally. the different truck models vary in terms of the number of deliveries or round trips possible per month.438 c April 28. 2010 D. the company would like to make sure it purchases at least four of the new Econoline tankers to use on short run. (a) Formulate a model for the management of Three Hills.000 10. Due to the size and speed differences of the trucks.000 Monthly Operating Costs (in $) 800 500 200 Depreciation has been included in the monthly operating cost. Based on driver availability and maintenance capability.000 available to ﬁnance the capital costs of the expansion. Three models of gasoline tanker are available. twenty-ﬁve per month for the regular and thirty per month for the Econoline. The maximum number of trips are estimated at twenty per month for the Super.000 Purchase Cost (in $) 150. Tulett 20.M.600.000 75. .000 5. The Three Hills Gas Company supplies its distributors using a ﬂeet of gasoline tankers.000 100. the company does not want more than half of the new models to be Supers. The company estimates that the monthly demand for the new region will be a total of two million litres of gasoline. An added complication is that there is a $150 per month per vehicle ﬂeet charge for insurance which has not been included in the operating costs. The company has $1. (b) Use a computer to help give a recommendation. low demand routes. A new region has been acquired which will require expansion of the existing ﬂeet. In addition. the ﬁrm does not want to add more than twenty new vehicles to the ﬂeet. Truck Model Super Regular Econoline Capacity (litres) 20.

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