MS&E 252 Handout #22

Decision Analysis I November 18
th
. 2004

Page 1 oI 11 HW #7
Homework Assignment #7
Due on Tuesday November 30
th
11:59 pm

Note: this homework is due on a TUESDAY and not on a Thursday (as usual)

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) Finish chapter 6 in the Manuscript.
2) Microrisks for Medical Decision Analvsis

Distinctions
From the class lectures. explain the Iollowing concepts:
• Decision Diagram
• InIormational arrow
• InIluence arrow
• Relevance arrow
• Functional arrow

Probabilistic Questions
Equestrinnovation. Inc. is a company that sells computers that predict the outcome oI
horse races. AIter entering the weight and average speed oI a horse. the computer will
tell you which horse to bet on. At the upcoming Palo Alto Derby. three horses are
scheduled to run: Smarty Jones. Lion Heart. and Imperialism. Prior to the race. you
assign the Iollowing probabilities to each horse Iinishing in Iirst place:

Horse Probability
of 1
st
Place
Smarty Jones 0.5
Lion Heart 0.3
Imperialism 0.2


Equestrinnovation has thoroughly tested their computers. and have Iound that the
probabilities oI each reading oI the computer. given the outcome (1
st
Place). are as
Iollows:



MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 2 oI 11 HW #7
Reading:

Outcome:
~Smarty 1ones¨ ~Lion Heart¨ ~Imperialism¨
Smarty 1ones 0.8 0.1 0.1
Lion Heart 0.1 0.8 0.1
Imperialism 0.1 0.1 0.8

Prior to the race starting. you can place a $10 bet on the winner oI the horse race. The
Iollowing table shows the potential winnings associated with every bet:


Outcome:

Bet:
Smarty 1ones Lion Heart Imperialism
Smarty 1ones $24 $0 $0
Lion Heart $0 $40 $0
Imperialism $0 $0 $60

You always have the option not to place a bet. Use this set-up to answer questions 1-4.

1) Suppose Jamie is risk-neutral. and that the company is oIIering him the use oI their
computer Ior $10 per bet. What should Jamie say to the company?

a) 'Thanks. I`ll accept your oIIer. and place a bet.¨
b) 'No thanks. your oIIer is too expensive; I`ll go ahead and bet without using
your computer.¨
c) 'No thanks; although using your computer at the price you quote would be to
my advantage iI I were to place a bet. I`m still better oII not betting at all.¨
d) 'No thanks; using your computer at the price you quote would not be to my
advantage iI I were to place a bet. I choose not to bet at all.¨

2) Now suppose that Cory is a delta-person with risk odds oI 3 on a deal where he can
win or lose $10. The company oIIers him the use oI their computer Ior $10 per bet.
What should Cory say to the company?

a) 'Thanks. I`ll accept your oIIer. and place a bet.¨
b) 'No thanks. your oIIer is too expensive; I`ll go ahead and bet without using
your computer.¨
c) 'No thanks; although using your computer at the price you quote would be to
my advantage iI I were to place a bet. I`m still better oII not betting at all.¨
d) 'No thanks; using your computer at the price you quote would not be to my
advantage iI I were to place a bet. I choose not to bet at all.¨

MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 3 oI 11 HW #7
Equestrinnovation. Inc. has iust come out with Model II oI their horserace-predicting
computer. They are now able to tune their machine so that its predictions are as accurate
as one wants them to be. The accuracy oI the Model II is controlled by setting a parameter
p which takes values in the interval |0.1|. The accuracy Ior each outcome is given as a
Iunction oI p in the Iollowing chart:
Reading:
Outcome:
~Smarty 1ones¨

~Lion Heart¨ ~Imperialism¨
Smarty 1ones (3 ¹ 2p)/5 (1-p)/5 (1-p)/5
Lion Heart (1-p)/5 (3 ¹ 2p)/5 (1-p)/5
Imperialism (1-p)/5 (1-p)/5 (3 ¹ 2p)/5
Use this set-up Ior questions 3-4.

3) Suppose that Jamie is risk-neutral and the company oIIers the use oI their Model II
machine to him Ior one bet Ior a price oI $5 ¹ 15p. Ior any p he chooses in |0.1|.
What should Jamie say to the company?

a) 'Thanks. I`ll buy it with p ÷ 1. and place a bet.¨
b) 'Thanks. I`ll buy it with p ÷ 0. and place a bet.¨
c) 'No thanks; although using your computer at the price you quote Ior some p
would be to my advantage iI I were to place a bet. I`m still better oII not
betting at all.¨
d) 'No thanks; using your computer at the price you quote Ior any p would not be
to my advantage iI I were to place a bet. I choose not to bet at all.¨

4) Suppose that Cory is a delta-person with risk odds oI 3 on a deal where he can win or
lose $10. The company oIIers him the use oI their Model II computer Ior one bet at a
price oI $5 ¹ 15p. Ior any p that he chooses in |0.1|. What should Cory say to the
company?

a) 'Thanks. I`ll buy it with p ÷ 1. and place a bet.¨
b) 'Thanks. I`ll buy it with p ÷ 0. and place a bet.¨
c) 'No thanks; although using your computer at the price you quote Ior some p
would be to my advantage iI I were to place a bet. I`m still better oII not
betting at all.¨
d) 'No thanks; using your computer at the price you quote Ior any p would not be
to my advantage iI I were to place a bet. I choose not to bet at all.¨


5) Recall Kim`s party decision and consider the Iollowing weather detectors:
• Rain detector A: cost oI $15 and accuracy oI 85°
MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 4 oI 11 HW #7
• Rain detector B: cost oI $0 (it is Iree) and accuracy oI 55°
• Rain detector C: cost oI $2 and accuracy oI 30°
How many oI the above weather detectors are economic?
a) 0
b) 1
c) 2
d) 3

6) How many oI the Iollowing statements must be true?
I. Sensitivity analysis is useIul Ior assessing the robustness oI a decision by
varying parameters relevant to it.
II. Consider an uncertain deal with monetary outcomes and two decision-makers.
Bill and John. who share the same belieIs about that deal. II Bill is risk-neutral
over the range oI monetary outcomes considered. whereas John does not
Iollow the delta property on this same range oI monetary outcomes. Bill and
John cannot have the same certain equivalent Ior the deal.
III. II your PIBP Ior the Clairvoyant`s services on the answer to a probabilistic
question is strictly greater than $0. then you are not 100° sure which answer
is correct.

a) 0
b) 1
c) 2
d) 3

7) Cheryl. who Iollows the Five Rules oI Actional Thought and preIers more money to
less. Iaces the Iollowing decision situation:












Value
I
Value Value
Decision
Value
MS&E 252 Handout #22
Decision Analysis I November 18
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. 2004

Page 5 oI 11 HW #7
In other words. she needs to choose between three alternatives A. B and C. and her
Iuture prospects depend only on her initial decision and on the outcome oI the
distinction oI interest I. Distinction I has two degrees i
0
and i
1
.
Cheryl. who is quite Iamiliar with Decision Analysis. plots her u-value Ior each oI the
three alternatives as a Iunction oI her probability that i
0
will occur:

Sensitivity to {i0 | &}
0
2
4
6
8
10
12
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
{i0 | &}
U
-
V
a
l
u
e
Alternative A
Alternative B
Alternative C

How many oI the Iollowing statements must be true?
I. II Cheryl believes that i
0
will occur with probability 0.7. she should choose
alternative B;
II. Suppose that Cheryl is oIIered a new alternative D. with corresponding
prospects |D. i
0
| and |D. i
1
| such that u(|D. i
1
|) ÷ 2 and u(|D. i
0
|) ÷ 9.
Then. iI ¦i
0
' &} ÷ 2/3. she should be indiIIerent between alternatives A. B
and D. and Ior any other value oI her belieI she should not choose D;
III. II Cheryl is risk-neutral. then the value oI ¦i
0
' &} Ior which her value oI
clairvoyance on I will be highest is ¦i
0
' &} ÷ 2/3.

a) 0
b) 1
c) 2
d) 3

u ÷ 5
u ÷ 4
u ÷ 0
u ÷ 10
u ÷ 8
u ÷ 5
MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 6 oI 11 HW #7
8) Jackie Iaces the exact same decision situation as Cheryl. Like Cheryl. Jackie plots her
u-value Ior each oI the three alternatives as a Iunction oI her probability that i
0
will
occur:
Sensitivity to {i0 | &}
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
{i0 | &}
U
-
V
a
l
u
e
Alternative A
Alternative B
Alternative C

Jackie also states that ¦i
0
' &} ÷ 0.4.
Jackie can perIorm a test that could give her more inIormation on I. Her belieIs are
¦'i
0
¨ ' i
0
. &} ÷ p. and ¦'i
1
¨ ' i
1
. &} ÷ q.
How many oI the Iollowing statements must be true?
I. II p ÷ 0.5 and q ÷ 0.9. the test is both relevant and material;
II. II p ÷ 0.5 and q ÷ 0.9. Jackie should choose alternative B iI the test says
'i
0
¨. and alternative C iI the test says 'i
1
¨;
III. II the test is symmetric and iI p > 0.5. the minimum accuracy p that will
make the test material Ior Jackie is approximately 86° (rounding to the
nearest percent).

a) 0
b) 1
c) 2
d) 3


9) How many oI the Iollowing statements can you conclude about the decision situation
depicted in the decision diagram below?
¦i
0
' & ÷ 0.1}
¦i
0
' & ÷ 0.75}
MS&E 252 Handout #22
Decision Analysis I November 18
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. 2004

Page 7 oI 11 HW #7



I. Uncertainty B is irrelevant to uncertainty E. given &.
II. The outcome oI uncertainty E is known beIore making decision C. but
aIter making decision A.
III. AIter making decision A but beIore making decision C. the value oI
inIormation on uncertainty D must be zero.


a) 0
b) 1
c) 2
d) 3

10) Consider the Iollowing statements about tests and test results:
I. A test must be observable to be useIul.
II. A test may be material but not relevant.
III. A test may be relevant but not economic.
How many oI the above statements are true?
a) 0
b) 1
c) 2
d) 3






A C B Value A C B
E
Value
D
A C B Value A C B
EE
Value
DD
MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 8 oI 11 HW #7

Quantitative Problems
1)
An aircraIt company is considering using a new lightweight Iastener. called the
Superlight. to rivet certain sheet metal parts together. These particular items are not
critical to Ilight saIety. and so the decision oI whether to use them is a Iinancial one.

The weight savings realized by using Superlights instead oI the Basic Iastener has a value
oI $100K to the aircraIt manuIacturer.

The Superlight Iastener has never been used beIore on a production aircraIt. however. and
engineers are wary oI its durability. From what little they know oI the design and initial
lab tests. they have high uncertainty about the number oI Superlight Iasteners that would
need replacement during routine maintenance. They translate this to costs oI $300K with
probability oI 0.3. $120K with probability 0.5. and $75K with probability 0.2. (Label
these possible cases High. Moderate. and Low repair cost. Ior Iuture reIerence.) These
costs include both parts and labor.

The alternative to the Superlight is the Basic Iastener. which. although heavier than the
Superlight. has been used extensively on past aircraIt. Stress engineers Ieel that the Basic
has a 'tried and true¨ perIormance record: they conclude Irom past statistics that the
repair cost associated with Basic Iastener Iailure is $125K.

Within these dollar ranges. assume that the aircraIt company is risk-neutral.

a. What is the certain equivalent Ior the best alternative?

b. What is the value oI clairvoyance on the repair costs Ior the Superlights?

c. What probability oI high repair costs would make the aircraIt company
indiIIerent between the two alternatives? When you vary the probability. keep the
ratio oI the other two probabilities constant.

d. What probability oI high repair costs leads to the highest value oI clairvoyance
on repair costs? Again. when you vary the probability. keep the ratio oI the other
two probabilities constant.

The Test Engineering group could run a batch oI Superlights through a test program to
determine their strength and durability characteristics under simulated Ilight conditions.
Given what the stress group has told him regarding the Superlight. the Test group
manager claims that his test program would be oI value. He says that Ior Superlights with
MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 9 oI 11 HW #7
High repair cost. the test batch will pass his test with a likelihood oI only 30°. II the
Superlights have Moderate repair cost. they will pass the test with a probability oI 80°.
and iI they would be Low in repair cost a 90° probability oI passing is estimated. The
Test group manager cautions that a lot oI time and hardware would be needed to conduct
the test.

e. What is the value oI the Test Engineering group`s test program?

I. Draw the decision diagram Ior the aircraIt company`s decision in part a.

g. Draw the decision diagram Ior the aircraIt company`s decision to buy
clairvoyance.

h. Draw the decision diagram Ior the aircraIt company`s decision to use the Test
Engineering group`s test program.


2)
Recall Kim`s party decision.

What is the minimum 'accuracy¨ that a rain detector would need Ior Kim to be willing to
pay $10 Ior its use in helping her make her party decision? By 'accuracy¨ we mean the
probability that the detector indicates sunshine when it will actually be sunny. which
equals the probability that the detector indicates rain when it will actually be rainy.



3)
Konstantin plans to graduate at the end oI the year and enter the working world. He is
currently evaluating several iob prospects. and his choice has come down to one oI two.
He will either work Ior Clairvoyant Consultants. Inc. (CCI) or Ior the Wizard oI Wall
Street and Company (WWS & Co.).

II he goes to work Ior CCI. Konstantin will start out as a driver Ior their Iamous Field
Action Minivan. He has been promised a starting salary oI $25.000/year. CCI has a Iirm
rule that everyone must start out as a driver in the Bay Area Ior three weeks beIore getting
a permanent assignment.

The position oI driver has long been known to carry a great deal oI prestige at CCI. and
Konstantin Iigures that. starting as a driver. he has a 90° chance oI being promoted to
some better position aIter only three weeks on the iob. UnIortunately. he must sign a one-
year contract with CCI beIore he Iinds out whether or not he will receive the promotion.
MS&E 252 Handout #22
Decision Analysis I November 18
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. 2004

Page 10 oI 11 HW #7
and since CCI is in desperate need oI drivers. there is still that 10° chance that they will
keep him there Ior the rest oI this year.

Despite this. Konstantin suspects that there is a 30° chance oI being promoted to
Associate Clairvoyant. Given that he is promoted. he suspects there is a IiIty-IiIty chance
that he will be sent to either CCI`s San Francisco oIIice or their San Jose oIIice. The San
Francisco oIIice pays its Associate Clairvoyants $42.000/year while the San Jose oIIice
pays its Associate Clairvoyants on a very strange commission schedule. II they bring in a
new client. San Jose`s Associate Clairvoyants are paid $53.000/year. but iI they do not
bring in a new client. they are only paid $32.000/year. Konstantin Iigures there is a 40°
chance that. as an Associate Clairvoyant. he could bring in a new client.

Having listened closely to the rumor mills. Konstantin discovers that CCI is desperately
in need oI people to start up a new oIIice in Osaka. Japan. Being Iluent in Japanese. he
suspects there is a 60° chance that CCI will choose to send him to Japan rather than
keeping him in the Bay Area. But once he gets there. he doesn`t know whether he will be
an Associate Clairvoyant or a Senior Clairvoyant. AIter consulting with Blair`s
probability wheel. Konstantin determines that. iI he is sent to Osaka. there is a 85°
chance that he`ll be made a Senior Clairvoyant. and only a 15° chance that he will be an
Associate Clairvoyant. Japanese Senior Clairvoyants are paid $95.000/year but Associate
Clairvoyants are only paid $35.000/year.

The Wizard oI Wall Street & Company has oIIered Konstantin $60.000/year to work in
New York City. However. there is no chance oI promotion once he is there.

Konstantin decides that he would be equally happy working in any oI these cities. His
only concern is Ior his salary level at the end oI the Iirst year. He doesn`t care about
anything aIter the Iirst yearhe plans to ioin a Tibetan monastery and will relinquish all
worldly possessions at that time.

AIter pondering his predicament Ior several hours in Nuts and Mud. Konstantin comes up
with the Iollowing inIormation: He wishes to Iollow the delta property over all the
prospects in his problem. He considers a deal Ior $100.000 or nothing with equal chances
to be worth about $38.000. He considers that same deal Ior $100.000 or nothing. with a
75° probability oI getting $100.000 to be worth about $64.000.

a. Draw a decision diagram Ior Konstantin`s problem.

b. Find Konstantin`s best decision.

c. How much would WWS need to oIIer Konstantin Ior him to be indiIIerent
between the two oIIers?

d. Konstantin decides that he wasn`t quite sure oI his risk preIerence. What risk
tolerance would make him indiIIerent between the two oIIers?
MS&E 252 Handout #22
Decision Analysis I November 18
th
. 2004

Page 11 oI 11 HW #7

e. Konstantin meets secretly with his Iriend the clairvoyant. who will reveal the
outcome oI any uncertainty Konstantin chooses. Draw Konstantin`s new decision
diagram. How much should Konstantin pay Ior his Iriend`s inIormation?

I. Konstantin`s Iriend has changed his mind; she will not allow Konstantin to
choose which uncertainty she reveals. Konstantin is uncertain which oI his
uncertainties his Iriend will reveal. and assigns equal probabilities to each oI his
Iour uncertainties (Driver/Bay Area/Japan. San Jose/San Francisco. Finding a new
client in San Francisco. Being promoted to Senior Clairvoyant in Japan). Draw his
new decision diagram. and determine his PIBP Ior his Iriend`s services.