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**Decision Analysis I November 12
**

th

. 2004

Page 1 oI 9 HW #5

Homework Assignment #6

Due on Thursday November 18

th

. 11:59 pm

In this assignment you are required to turn in the probabilistic section only. Again the

"Food Ior thought" section is optional but will help you think in depth about the concepts

covered and will help with your grade on participation. As mentioned in the course guide.

we will expect Iull knowledge oI all sections on this assignment.

Assigned Reading

1) Decision analvsis manuscript. read Chapter 5 and start Chapter 6.

2) Probabilitv Encoding in Decision Analvsis. Collection oI readings. The material

in this article will be relevant to Iuture lectures by ProIessor Howard on

probability encoding.

3) Speaking of Decisions. Precise Decision Language. By Ron Howard.

Forthcoming in Decision Analysis

Distinctions

From the class lectures. explain the Iollowing concepts:

• Prior

• Likelihood

• Posterior

• Preposterior

• Sensitivity

• SpeciIicity

• Symmetric test

• Relevant test

• Material test

• Economic test

Probabilistic questions

1) For Mary. Kim`s Iriend. plot the sensitivity oI the Value oI Clairvoyance to the

probability p oI sunshine. How many oI the Iollowing statements are true?

I. Mary should always be willing to pay at least as much as Kim Ior

clairvoyance.

II. The diIIerence between the Value oI the deal with Free Clairvoyance and

the Value oI the deal with No Clairvoyance is greatest when p is around

0.87.

III. Mary`s Value oI Clairvoyance sensitivity curve has the same switch points

as Jane`s. (By 'switch points¨ we mean values oI p at which the decision

changes.)

MS&E 252 Handout #18

Decision Analysis I November 12

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. 2004

Page 2 oI 9 HW #5

a) 0

b) 1

c) 2

d) 3

2) Raymond is a manager at Pharmatech Corp. and would like to invest $4.5 million in a

new migraine drug. He believes that the drug will be a success with a probability oI

0.6. in which case the revenue will be $6.5 million. II the drug is not successIul. the

revenue will be $1.5 million. Raymond decides to consult his migraine drug expert

Dr. Headache on the matter. Raymond believes that iI the drug is to be successIul. Dr.

Headache will have predicted it with 80° probability. and iI the drug is to be

unsuccessIul Dr. Headache will have predicted it with 60° probability. Assuming

that Raymond is risk-neutral Ior this dollar range and that Dr. Headache charges

$750.000 Ior his services. how many oI the Iollowing must be true?

I. Dr. Headache`s inIormation is relevant and material.

II. Hiring Dr. Headache is economic.

III. II we assume instead that Raymond is not risk-neutral but has risk odds oI

0.5. we can calculate Raymond`s certain equivalent Ior Dr. Headache`s

services by subtracting the value with no inIormation Irom the value with

Iree inIormation.

a) 0

b) 1

c) 2

d) 3

3) Mr. Bob T. Driller has iust been elected to be the CEO oI a Iamily-run oil company in

his native Texas that Iocuses solely on exploration and sells out any successIul Iield it

Iinds to other operators. That is. iI his company discovers oil in a particular Iield. it

sells the oil to a larger company. Mr. Driller is presently evaluating a potential drilling

site.

II Mr. Driller decides to drill. he will drill only one well; he believes these are the

representative outcomes oI the drilling:

The well turns out to be dry. in which case he abandons the site. and the value oI

the site is $0.

The well proves a small amount oI oil. in which case. Mr. Driller can sell the site

Ior $25 million.

The well proves a large amount oI oil. in which case. Mr. Driller can sell the site

Ior $60 million.

In the range oI dollar values above. Mr. Driller has a u-curve that can be expressed as:

u(x) ÷ 56x-300

MS&E 252 Handout #18

Decision Analysis I November 12

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. 2004

Page 3 oI 9 HW #5

It costs $10 million dollars to drill a well. Mr. Driller has asked the company

geologist. Mr. John T. Stone. to assess the probabilities oI each possibility. Mr. Stone

Iinds it easier to condition the outcome Irom the drilling on the chance that a certain

geological structure. called a dome. is present in the Iield under study. Stone believes

that there is a 0.7 chance that a dome is present. Stone then assesses the probability

Ior each oI the three outcomes oI the drilling conditioned on the presence oI a dome

and he comes up with the Iollowing:

¦well turns out to be a dry hole ' dome. &} ÷ 0.5

¦well proves small amount oI oil ' dome. &} ÷ 0.3

¦well turns out to be a dry hole ' no dome. &} ÷ 0.7

¦well proves small amount oI oil ' no dome. &} ÷ 0.25

What is Bob T. Driller`s certain equivalent Ior this drilling site?

a) Strictly less than $5.25 million

b) At least $5.25 million. but strictly less than $5.5 million

c) At least $5.5 million. but strictly less than $6.25 million

d) At least $6.25 million

4) ReIer to the inIormation covered in the previous question. Mr. Bob T. Driller asks his

geologist. Mr. Stone. about the value oI inIormation on the presence oI the dome.

According to the assessments Irom Mr. Driller and Mr. Stone. what is the value oI

inIormation on the presence oI the dome?

a) Less than $0.2 million

b) At least $0.2 million. but less than $0.4 million

c) At least $0.4 million. but less than $0.5 million

d) At least $0.5 million

5) Janice is a movie producer who must decide whether to produce a new children`s

movie. She currently has $600.000 in her bank account. and her u-curve as a Iunction

oI her total wealth is described by the equation u(x) ÷ 1 ¹ ln(x). She draws the

Iollowing decision tree to help her think about her investment decision:

MS&E 252 Handout #18

Decision Analysis I November 12

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. 2004

Page 4 oI 9 HW #5

Prospect (Total Wealth)

Hit

$1,200,000 15.00

Invest 0.4

14.4725509

Flop

$500,000 14.12

1 0.6

14.47

$709,667

Don't Invest

$600,000 14.30

Let us denote by c the most Janice should be willing to pay Ior inIormation on the 'hit

/ Ilop¨ uncertainty. In what range does c lie?

a) c ÷ $0

b) $0 · c < $80.000

c) c ~ $80.000

d) You need more inIormation to answer this question.

6) Here is Alex`s u-Iunction:

≤ < +

≤ ≤

=

200 $ 100 $ 100

100 $ 0 $ 2

) (

x x

x x

x u

In this equation. x denotes a monetary prospect. Please note that Alex`s u-Iunction

does not depend on his initial wealth.

How would you characterize Alex`s risk attitudes toward the Iollowing deals.

when 1 0 < < p ?

Hint: Remember the deIinitions oI risk-neutral. risk-averse and risk-seeking.

a) He is risk-neutral Ior all three deals.

b) He is risk-neutral Ior Deals A and C. but is risk-averse Ior Deal B.

c) He is risk-neutral Ior Deals A and C. but is risk-seeking Ior Deal B.

d) He is risk-neutral Ior Deal C. but is risk-averse Ior Deals A and B.

p

$25

$75 $125

$75

$175

$125

Deal A Deal B Deal C

p p

p − 1 p − 1 p − 1

MS&E 252 Handout #18

Decision Analysis I November 12

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. 2004

Page 5 oI 9 HW #5

7) Consider the Iollowing Iour statements:

I. Everyone who is risk-neutral satisIies the delta property. but everyone who

satisIies the delta property is not necessarily risk-neutral.

II. Risk-seeking behavior is not compatible with the Five Rules oI Actional

Thought.

III. A risk-neutral person does not need to take into account their initial wealth

when valuing an uncertain deal.

IV. Someone who does not need to take into account their initial wealth when

valuing an uncertain deal must satisIy the delta property.

How many oI the above statements are true?

a) 0

b) 1

c) 2

d) 3 or 4

8) Remember Alicia`s problem in homework 5 (questions 9 and 10). We have seen that

it is optimal Ior Alicia to buy the option even iI she has no clairvoyance (c.I. the

solutions oI HW5 Ior detailed explanations). But beIore buying the option. Alicia

learns that Eric. a noted Iinancial advisor. provides his advisory services about the

evolution oI the stock price. Alicia believes that iI the stock price goes up. Eric will

have predicted such an increase with 75° probability. and that iI the stock price goes

down. Eric will have predicted such a decrease with probability 65°.

Which oI the Iollowing statements must be true about the maximum amount (A) that

Alicia should be willing to pay Ior Eric`s services?

a) A ≤ $0

b) $0 · A ≤ $1.50

c) $1.50 · A ≤ $3

d) $3 · A

9) Alicia learns that Josh. a less reputed Iinancial advisor. is proposing his services.

Alicia believes that iI the stock price goes up. Josh will have predicted such an

increase with 25° probability. and that iI the stock price goes down. Josh will have

predicted such a decrease with probability 20°.

II B is the maximum amount (B) that Alicia should be willing to pay Ior Josh`s

services. which oI the Iollowing statements should be true?

a) B ≤ $0

b) $0 · B ≤ $1.50

c) $1.50 · B ≤ $3

MS&E 252 Handout #18

Decision Analysis I November 12

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. 2004

Page 6 oI 9 HW #5

d) $3 · B

10) Betty. a risk-neutral decision maker. has the same belieIs as Alicia. How many oI the

Iollowing statements must be true?

I. The value oI Eric`s inIormation is higher Ior Betty than it is Ior

Alicia.

II. The value oI the deal with Iree Eric`s inIormation is higher Ior

Betty than Ior Alicia.

III. For Betty. the value oI Eric`s inIormation is higher than the value

oI Josh`s inIormation.

a) 0

b) 1

c) 2

d) 3

Quantitative Problems

1) Bozo`s Party Problem

The initial problem set up Ior this problem is very similar to that oI Kim. Jane. and Mary.

Bozo`s preIerences Ior the prospects in the party problem are given by the Iollowing u-

curve: u(x) ÷ (x`2)/10.000. Assume that his initial wealth is zero.

a) What is Bozo`s certain equivalent Ior this deal?

b) What is Bozo`s certain equivalent Ior the deal aIter paying $15 Ior Clairvoyance?

c) What is Bozo`s certain equivalent Ior the deal with Iree clairvoyance?

Sun 100 1

Rain 0 0

0.4

0.6

Sun 40 0.16

Rain 50 0.25

0.4

0.6

Sun 90 0.81

Rain 20 0.04

0.4

0.6

Prospect ($) u(x)

out

porch

in

MS&E 252 Handout #18

Decision Analysis I November 12

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. 2004

Page 7 oI 9 HW #5

d) What is Bozo`s value oI clairvoyance? Note that he dose not Iollow the delta

property.

Use the following information for the next two questions.

Eduardo. a conIused graduate student. has iust won the EES&OR weekly Bingo prize in

which he has his choice among three alternatives. Although he Iollows the Iive rules oI

actional thought. he can't decide which alternative to pick and has asked Ior your help. In

the Iirst alternative. he is given a iar oI balls (iar one). some are red and the others are

white. II Eduardo picks a red ball. he wins $2500. iI he picks a white ball. he wins

$1000. The second alternative is a similar deal. however iI he picks a red ball Irom the

iar (iar two). he wins $3000. iI not. he wins nothing. The third alternative is a sure

$1500. Assume he is risk neutral.

2) Sensitivity to probability

a) Assuming there will be the same ratio oI red balls in both iars. what percentage oI red

balls must there be Ior Eduardo to be indiIIerent between alternative 1 and alternative

2?

b) What percentage oI red balls must be in iar one Ior him to be indiIIerent between

alternative one and alternative three?

c) What percentage oI red balls must be in iar two Ior him to be indiIIerent between

alternative two and alternative three?

d) Draw a sensitivity to probability graph and explain what the values. axes. and lines

represent. Show where Eduardo's best alternative is represented on the graph and

how it changes as the number oI red balls in the iars changes. Also show the points oI

indiIIerence that you Iound in parts a-c.

3) Value oI Clairvoyance Sensitivity

a) Show on a similar graph how Iree clairvoyance would be represented.

b) Calculate the certain equivalents Ior each alternative when the Iraction oI red balls is

equal to 1/6 and then when the Iraction is equal to 5/6. Show these values on the

graph.

c) Determine what Eduardo's best alternative is in each oI these two cases and explain

why they might be diIIerent.

d) What is Eduardo's value oI clairvoyance at these two points?

e) Construct your own graph oI the sensitivity oI the value oI clairvoyance to probability

Ior Eduardo's decision problem as done in chapter Iive Ior the party problem. Be sure

to label the axes and include the values that would be important to Eduardo in making

his decision.

4)

Ellen. a risk-neutral test taker. iust Iinished taking the Decision Analysis midterm. She

understood the scoring rule Irom Homework #5. but was perplexed when she received a -

∞ on the exam. On one oI the questions she was absolutely certain that the answer was

MS&E 252 Handout #18

Decision Analysis I November 12

th

. 2004

Page 8 oI 9 HW #5

"b." so she assigned her belieI oI p ÷ s ÷ 1 to "b." UnIortunately Ior Ellen. she marked

the wrong box and inadvertently put one Ior "c" and a zero Ior everything else and hence

p ÷ 0. Oops. Now Ellen wants you to help her identiIy how she should approach next

year`s midterm.

Suppose that during the exam she believes that ¦b correct ' &} ÷ s and ¦a correct ' &} ÷

¦c correct ' &} ÷ ¦d correct ' &} ÷ (1-s)/3. She would like to add another distinction.

named "oops. I made a mistake" with two degrees "ouch that hurt" and "whew. I`m ok

aIter all." which we`ll iust denote M and M`. respectively. Let ¦M ' b correct. &} ÷ q.

This can all be represented as the Iollowing deal:

For simplicity. assume that she equally distributes the probability weights among the

other choices (a. c and d.)

a) Given that s ÷ 1 and p ÷ 1. Compute Ellen`s sensitivity to the probability q.

What is her e-value Ior q ÷ 1? What about Ior q ÷ 0.00001?

b) Suppose s ÷ 0.7 and p ÷ 0.7. Compute Ellen`s sensitivity to the probability q.

What is her e-value Ior q ÷ 1? What about Ior q ÷ 0.00001?

c) Now include a decision about p. where p can be one oI three possible values

¦0.25. 0.7. 1}. Suppose s ÷ 1 as in (a). Compute Ellen`s sensitivity to the

probability q and represent your results in a graph like the one on page XXX oI

the manuscript. Repeat Ior the case when s ÷ 0.7.

d) Suppose Ellen is really a delta person with risk odds r ÷ 2. Repeat part (c). How

do your results change? Do the results make sense given her new Iound attitude

toward risk?

e) Suppose Ellen is a delta person with risk odds r ÷ 1/2. Repeat part (c) again.

How do your results change? Do they make sense given this attitude toward risk?

a, c, oi d coiiecl

l coiiecl

1OO + 1OO In p

15 15 In 4

1OO + 1OO In((1-p)/3)

15 15 In 4

M

M´

1OO + 1OO In((1-p)/3)

15 15 In 4

p

MS&E 252 Handout #18

Decision Analysis I November 12

th

. 2004

Page 9 oI 9 HW #5

Iood for 1hought

Consider the Iollowing deal:

A "Iair" coin is Ilipped repeatedly until it comes up tails. and the total number oI Ilips. n.

determines the prize. which equals $2*n. Thus iI the coin comes up tails the Iirst time.

the prize is $2*1 ÷ $2. and the deal is terminated. II the coin comes up heads the Iirst

time. it is Ilipped again. II it comes up tails the second time. the prize is $2*2 ÷ $4. and

the deal is terminated. II it comes up heads the second time. it is Ilipped again. and so on.

There are an inIinite number oI possible outcomes (runs oI heads Iollowed by one tail)

possible. The probability oI an outcome oI n Ilips P(n) is 1/(2*n).

a) What is your PIBP Ior the deal? Provide a brieI rationale. Suppose you already

own the deal. what is your PISP?

b) Repeat (a) Ior the Iollowing cases: 1) assume you are risk neutral. 2) you are a

delta person with risk odds 9:1. and 3) you are risk preIerring. For all cases

assume you preIer more money to less and Iollow the Iive rules oI actional

thought.

c) Given your results Irom (a) & (b). which oI the three cases best characterizes your

own risk attitude?

d) Suppose you are a risk-neutral. IorgetIul person who currently owns deal. You

know that once you buy it. each time you see the coin ready to be Ilipped you will

not remember how many (iI any) Ilips have occurred in the past. How would this

change the PISP you Iound in (a)? (ie. would it increase or decrease?) Why?

What iI you were risk averse? II you owned the deal. do you really think you

could keep accurate count oI the Ilips?

e) Extra section Ior those oI you who have studied probability. You may recognize

that the distribution over the number oI Ilips is iust a Geometric distribution.

Using this knowledge. calculate the expected number oI Ilips. Based on this

number. would you now be anxious to change your PIBP? Why or why not? II

you were IorgetIul. would this number change?

- ProblemSession7
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- ProblemSession6
- Midterm
- ProblemSession2
- HO10-PracticeMidterm
- HO28-HW7Solutions
- HO29-OtherDAClasses
- MidtermSolutions
- HO26-PracticeFinal1Sol
- HO8-HW2Solutions
- HO25-PracticeFinal1
- HO19-HW5Solutions
- HO2-HW1
- HO12-HW3Solutions
- HO5-HW2 v2
- HO17-CaseInstructions
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- HO26b-PF1Sols Erratum
- Final Instructions Part2
- HO27-PracticeFinal2WS

MS&E 252

MS&E 252

- HO28-HW7Solutions
- HO16-HW4Solutions
- HO23-HW6Solutions
- HO22-HW7
- HO19-HW5Solutions
- HO8-HW2Solutions
- HO5-HW2 v2
- HO13-HW4
- HO10-PracticeMidterm
- HO7-HW3
- HO15-HW5
- MidtermSolutions
- HO17-CaseInstructions
- HO12-HW3Solutions
- ProblemSession3
- HO26-PracticeFinal1Sol
- HO25-PracticeFinal1
- ProblemSession8
- HO9-MidtermLogistics
- HO29-OtherDAClasses
- HO27-PracticeFinal2WS
- HO20-Decision Diagrams
- ProblemSession4
- Midterm
- ProblemSession5
- ProblemSession7
- ProblemSession1
- Final instructions Part1
- ProblemSession2
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