# MS&E 252 Handout #8

Decision Analysis I October 17
th
. 2004
Page 1 oI 5 HW #2 Solutions
Homework Assignment #2- Solutions

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MS&E 252 Handout #8
Decision Analysis I October 17
th
. 2004
Page 2 oI 5 HW #2 Solutions
Distinctions
These distinctions were prepared by the teaching team and reIlect our best belieI oI the
meanings oI these terms.

• Decision Basis is the basis on which a decision is made. It includes three key
elements:
• Alternatives are what you can do. You need more than one.
• PreIerences are what you want. You must care about what might happen.
• InIormation is what you know or believe to be true. InIormation links what
you want to what you can do.

• Sunk cost is a past irrevocable allocation oI resources. You could also think oI it
as how you got into a particular situation. We only make decisions about the
Iuture. and normatively speaking. sunk costs are irrelevant to the evaluation oI
Iuture decisions (ignoring taxation) and thereIore should not be considered. From
a descriptive perspective. decision-makers are oIten improperly inIluenced by
sunk costs. E.g.. 'We`ve put \$10M into this venture. We can`t abandon it now!¨

• Personal IndiIIerent Buying Price (PIBP) is the most you would be willing to pay
in return Ior something that you will use and not sell. The PIBP Ior good G Ior
person P is a sum oI money M at which P is indiIIerent between ¦paying M and
getting G} and ¦keeping M and not getting G}. with the important caveat that P
must pretend in assessing M that G cannot be resold (so that this is a use value
rather than an exchange value concept). At any price less than M. P preIers to buy
G. while at any price greater than M. P preIers not to buy G. Note that M is a
Iunction not iust oI the good but oI the speciIic person considering the purchase oI
that good. which accounts Ior the 'personal¨ in the name.

• Personal IndiIIerent Selling Price (PISP) is the least you would be willing to
accept to Iorgo the use oI something that you own and cannot replace. The PISP
Ior good G Ior person P is a sum oI money M at which P is indiIIerent between
¦selling G and getting M} and ¦keeping G and not getting M}. with the important
caveat that P must pretend in assessing M that G cannot be replaced (so that M
represents the loss in value associated with Iorgoing use). PISP÷CE.

• Cycle oI Ownership The PIBP and PISP are equal around a cycle oI ownership. A
cycle oI ownership implies either no passage oI time or no new inIormation and
no change in the state oI wealth. A cycle oI ownership only occurs when the price
paid Ior the item is equal to the PIBP Ior the item. II we pay less there cannot be a
cycle oI ownership because oI our new state oI wealth.

• Market buying and selling price The market price is the price one would have to
pay in the market Ior a particular good. Note that this price is easily observable
only Ior goods Ior which a market actually exists. The market price Ior a unique
MS&E 252 Handout #8
Decision Analysis I October 17
th
. 2004
Page 3 oI 5 HW #2 Solutions
good (e.g.. a particular house) may be quite diIIicult to observe. In a 'well-
behaved¨ market one could deIine market price ÷ market buying price ÷ market
selling price. However. this is rarely the case due to transaction costs and to
diIIerential 'power¨ in the marketplace. For example. I can buy used CD`s Ior \$7
but can only sell them Ior \$5 (unless I expend a great deal oI eIIort looking Ior the
right buyers. in which case I would probably want to attach the value oI my time
to my assessment oI what I made in the deal. likely resulting in a lot less than \$5).

• Value in use How much value an obiect creates Ior you once it is integrated into
your liIe. given that you cannot sell it nor exchange it.

• Value in exchange The value you could obtain by selling or exchanging an obiect
to another person (your preIerences do not come into consideration; a diabetic
could own a candy store).

Probabilistic questions
1) Solution: b
Statements i) and iv) are violations oI the sunk cost principle. When making a
decision. you should compare Iuture possible outcomes and ignore irrelevant
inIormation Irom the past. like an original purchase price. Statement ii) is not a
violation oI the sunk cost principle. since it involves considering the original purchase
price Ior tax purposes. Statement iii) pertains to acquiring historical inIormation. and
has nothing to do with the sunk cost principle.
2) Solution: a
Since we`re talking about selling something in this question. we can say nothing
about your PIBP. PISP is the least you would be willing to accept to Iorgo the use oI
something that you own and cannot replace. In this case. iI you are willing to part
with your ticket Ior \$200. your PISP must be less than or equal to \$200. II your PISP
was greater than \$200. say \$300. then your Iriend must oIIer to pay you at least \$300
Ior you to consider selling. Also in this question. your PISP may be \$200 (b). but
nothing in the question tells us it must be.

3) Solution: b
Statement i) is not proactive because oI the use oI the phrase 'have to¨ instead oI
'choose to¨ or 'have decided to.¨ The speaker has not taken responsibility Ior what
may happen iI he or she Iails to submit his work on time. Statement ii) is proactive
and shows that the speaker accepted the consequences oI his decision. Even iI the
speaker had a bad outcome. his initiative still shows proactivity. Statement iii) is not
proactive. because it abdicates responsibility Ior the speaker`s action. and implies an
outside Iorce as the cause oI the decision.

MS&E 252 Handout #8
Decision Analysis I October 17
th
. 2004
Page 4 oI 5 HW #2 Solutions
4) Solution: c
The decision basis consists oI inIormation. preIerences. and alternatives. Statement i)
corresponds to inIormation about prices. Statement iii) corresponds to personal
preIerences Ior the type oI vacation. Statement iv) corresponds to diIIerent islands as
alternatives. Note that the decision basis is part oI the six elements oI decision quality.

5) Solution: d
Choice a is Ialse because the quality oI a decision does not depend on its outcome.
Choice b is Ialse because there is no such thing as a 'true probability.¨ You should be
able to assign a probability to an uncertainty given your current state oI knowledge.
Finally. Choice c is Ialse because a clairvoyant can only tell us outcomes oI physically
determinable events (e.g. 'The Lakers will win the next two games and lose the third
one.¨) but not the probability oI an uncertainty.

6) Solution: d
PIBP may not be additive; the second shirt may or may not have the same PIBP as the
Iirst one. ThereIore. choice a is Ialse. Choice b is Ialse because value in use equal to
PIBP. which in this case is \$15. Choice c is irrelevant to the discussion because
PIBP`s are prices assigned according to personal preIerence and not necessarily based
on market values. Choice d is the only correct statement because it contains the
deIinition oI PIBP.

7) Solution: a
Selling the car Ior a market price that is above one`s PISP. would not violate any
decision rules by itselI. The price paid two years ago is an example oI sunk cost and
shouldn`t be considered in making the current decision. For the same reason. the
potential loss (which is a simple diIIerence between the price paid and the current
market price) is irrelevant in this case. On the other hand. the Iuture 'value-in-use¨ oI
the car is already included in the PISP. and there is no need to know this value iI the
PISP is known.

8) Solution: c
You should have used your best understanding oI the stock market to assign your
probabilities.

9) Solution: a
Statement i) is Ialse: Thomas` PIBP Ior having the hard drive replaced is not
necessarily the market price Ior replacing the hard drive. A PIBP is a value in use. and
not necessarily a value in exchange (market value). Statements ii) and iii) are Ialse:
the cycle oI ownership has been broken and nothing can be said on the PISP or the
PIBP oI an item aIter the cycle oI ownership has been broken.

MS&E 252 Handout #8
Decision Analysis I October 17
th
. 2004
Page 5 oI 5 HW #2 Solutions
10) Solution: c
The Iact that Paul reiects ProI. Howard`s Iirst oIIer shows that he likes his current
situation (with the regular medallion) at least as much as the situation ProI. Howard is
oIIering (with a double-headed medallion). Let us also note that ProI. Howard is
oIIering him nothing other than \$50 Ior sure. ThereIore. Paul`s Iirst decision tells us
that > 50. Similarly. the Iact that Paul accepts ProI. Howard`s second oIIer shows
that he likes a situation in which he makes \$80 Ior sure (the \$100 Irom the deal the
\$20 he needs to pay ProI. Howard Ior his services) at least as much as his current
situation. which he still values at . ThereIore. his second decision tells us that < 80.

Quantitative Problems

1) Half Moon Bay Race
Charlie`s actions must be consistent in both scenarios. II he would not buy another
number Ior the race in Scenario I then he should not buy a number in Scenario II.
Likewise. iI he did buy another number Ior the race in Scenario I then he should buy a
number in Scenario II. So. both statements I and II show behavior consistent with
decision analysis concepts. while statements III and IV do not. The inconsistency in
statements III and IV is a violation oI the norm to ignore 'sunk cost.¨ Noticing that
both scenarios are the same can see this:
Scenario 1: Charlie has your wealth less \$20 and no number;
Scenario 2: Charlie has your wealth less \$20 and no number;

Descriptively. many people will say they would not run in Scenario I but would in
Scenario II. The reason they give is that in Scenario I they would have paid \$40 Ior the
number and their PIBP Ior a number is greater than \$20 but less than \$40. But both
situations are the same and this "mental accounting" is iust a story you tell yourselI. It
is not possible to determine Charlie`s PIBP at his current state oI wealth.

2) Project Funding
a) The company's PIBP Ior Proiect I is \$100 and \$80 Ior Proiect II. Since you can
obtain them both Ior \$40 you should Iund them both.
b) II you only had \$20 to invest you should invest in Proiect I because you can turn
\$20 into \$100 instead oI \$80 (Proiect II)
c) II you knew Proiect I would cost \$110 Irom the start you should not have invested
in it because the company's PIBP was \$100.