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Decision Analysis
Decision Analysis
PDecision Theory and Decision Trees
Rs (35 — 15)
whet Phe numberof programs prin and Dis the | 13. Magna of (MP
demand for programmes.
(b) largest expected profit ~ Rs 2,260 accrues for P = 30,000
copies per gam |
(©) In case of perfect forecast, the expected profit is
10% 0.1 +2,000 0.44 3,100 0.3 +4,200%0.2=Rs2,660. | vensens
VPI = Re 2560 — Bs 2.260 = Rs 400 | he ae
0. Cost function ={(P—S) 5 DSS | Max. EMV is correspond
|200(s-D) ; Des = aan
where D = monthly demand (or sales); § = umber of units
purchased
(a) EMV(S,)=Rs 600; EMV(S)
EMV (S,) = Rs 1,037.5;
EMV (S,) = Rs 10125.
the expected cast of Rs 46 is minimum for course of
action 4, the optimum slock to minimize the cost is 4 units per
sooth,
purchase 60 garments
500(D-S) ; D2
Ae 14, (@) Fist altemative, Rs 20,000
200(S-D) } D Rs mae
On the positive side of the curve, it eventually bend away from the straight line, This indicates that
increasing, units of money are resulting in smaller additional gains in utility.Decision Theory and Decision Trees
11.8.3 Construction of Utility Curves
Suppose, there is a project that would payoff with Rs 1000 or (~) Rs 1000. Then what probability of success
would make the decision-maker just about indifferent as to whether to undertake the project or not?
Suppose he says that he would require an 80 per cent probability of success to make him indifferent about
undertaking the project. Suppose utility of Rs 1000 is 10 for an individual. Then
U Red) = (0.80) U(Rs 1000) + (0.20) U(- Rs 1000)
0 = 0.80 (10) + (0.20) U( Rs 10) or U(- Rs 10) = —40
The utility curve will have three points:
UG 1000)=10; U@)=0 and U¢-1000)=—40
Other points on the curve can be obtained by interacting with decision-maker to know his/her utility values
to a payoff
Example 11.27 A manager must choose between two investments A and B that are calculated to yield
net profits of Rs 1,200 and Rs 1,600, respectively with probabilities subjectively estimated at 0.75 and 0.60.
Assume, the manager's utility function reveals that utilities for Rs 1,200 and Rs 1,600 are 45 and 50 utils,
respectively. What is the best choice on the basis of the expected utility value (EUV)?
Solution The expected utility value is expressed as:
Buv= © Usp,
where U, = utility value of state of nature {
, = probability value of state of nature i
‘Then BUV (A) = pyll, = 0.75 * 45 = 33.75 utils and EUV (B) = pyU, = 0.60 * 5
30 utils
Since EUV(A) > BUV(B), therefore, the best choice is investment A.
Example 11.28 A businessman is thinking whether to invest in bonds with an assured return or in a new
venture that is likely ¢o fetch him Rs. 20,000 or nothing with equal probabilities, The businessman says he
would prefer an assured return in itis Rs. 10,000 or more, would be indifferent to the two alternatives if the
assured return is Rs. 8,000 and would opt for the risky alternative if this amount is less than Rs. 6,000.
The businessman had purchased a minicomputer last year which is lying with him unused at present. The
‘minicomputer can fetch him a profit of Rs, 8,000 by way of consultancy. He says that he would not like to sell
the computer but would be indifferent to an offer of Rs. 3,000.
Recently a Govt agency invited bid offers for a contract worth a profit of Rs. 8,000. Bidding expenses are
reimbursable ifthe contract materializes and not otherwise. There is an equal chance of winning or losing the
bid. AfRer thinking over the possibilities, the businessman says that he would be indifferent to submitting the
bid ata bidding expense of Rs. 2,000. Construct the businessman's utility curve by using the CME technique,
Solution Let arbitrary utility values of 100 and 0 be assigned to the most favourable and least favourable
outcomes, i.
Usp oq0 = 100 utiles, Uy = 0 utile
0.5 x 100+0.5 x 0
‘The businessman is indifferent between his utilities for Rs. 3,000 and of a chance of Rs. 8,000 or nothing. Thus,
Us.900 = 0-5 Us.oo9 + 0.5 Uy = 0.5 * 50 +05 x 0 = 25 utiles.
The decision to enter the bid at an expense of Rs. 2,000 may get him either gain of Rs 8,000 or lose
(bidding expenses of) Rs. 2,000 with equal probability. Since he is indifferent to submitting the bid,
Uy = 0.5 Ugcen + 0-5 U_.090
0=0.5*50+0.5U,
Given that Us.000 = 05 Uro.ogo + 05 U, 5 utiles.
OF U2999%~50 utiles.Operations Research: Theory and Applications
Following in the summary of points for the
Utiles
businessman's utility curve
Amount (Rs) uty utes)
20,000 100
8,000 50
3,000 25
0 0
2,000 50 7
Fig. 11.10 =e — 5,000 5,000. 10,000 15,000 20,000
Ublty Curve The utility curve is plotted in Fig. 11.10. This curve
ay reflect a reasonable estimate of the businessman's 50
behaviour when faced with risky ventures.
Example 11.29 Mr XX has an after-tax annual of Rs. 90,000 and is considering to buy accident insurance
for his car. The probability of accident during the year is 0.1 (assume that at most one accident will occur), in
which case the damage to the car will be Rs. 11,600. With autility function of U(x) = v/x , what is the insurance
premium he will be willing to pay?
Solution Let A represent the venture when Mr XX does not by the accident insurance for his car. Then, in
‘case of accident he would spend Rs. 1,600 on damages and will be left with Rs, 78,400. In case of no accident
he retains Rs. 90,000. Then we have
Ug = Ure.00
Since UX) = U,= VF Ursaan
U =280*0.1 +300 *0.9=798 ils,
So the amount Rs. x which will give the same utility of the venture: A= (298)?
U)= vx or X=(U@F]
x 0.1 + Usg
78,400,
go 0.9.
280 utiles, and Usa ogg "90,000 = 300 utiles. Thus,
Rs. 88,804. [Because
Thus Mr XX will be indifferent to an amount of Rs. 88,804 with certainty and the venture A. The amount he will
be willing to pay as car premium would be 90,000—88,804 = Rs. 1,196.
SELF PRACTICE PROBLEMS C
Raman Industries Lid. has a new product that they expect has
great potential. At the moment they have two courses of action
open to them: To test market (S,) and to drop product (S;).
TE they tos tit wil cost them iS 50,000. The response could
be either positive or negative, with probabities 0.70 and 0.30,
respectively. I it i positive, they could oithor market it with ful
effort or drop the product. If they market with full scale, then the
result ight be low, medium, or high demand and the respective
het payots would be — Rs 1,00,000, Rs 1,00,000 or As
5,00,000. These outcomes have probabilities of 0.25, 0.55 and
(0.20, respectively. i the rooutt of the tost markotng fs negative
they would secide to drop the product. I, at ary point, they drop
the product there is a net gain of Rs 25,000 from the sale of
scrap. All financial values have been discounted to the present.
Draw a decision tree for the problem and indicate the most
preferred. decision,
‘A manufacturing company has just developed a new produc.
‘On the basis of past experience, a product such as this woud
either be successful, with an expected gross relun of AS
1,00,000, oF unsuccesslul, with an expected gross retum of Ris
20,000. Similar products manutacturad by the company have a
record of being suocesstul about 50 per cent of the time. The
production and marketing costs of the new product are expected
to be Ris 50,000.
The company is considering whether to market this new
product or to drop ft. Before making its decision, a test marketing
blot can be conducted at a cost of Rs 10,000. Based on past
‘experience, test marketing results have been favourable about
70 per cent of the me, Furthermore, products favourably tested
have been suocesstul 60 per cont of the time. However, when
the test marketing result has been unfavourable, the product
has only been successiul 30 per cent ofthe time. What course
of action should the company pursue?
3. XYZ Company manulactures guaranteed tennis balls. At present,
‘approximately 10 por cent of the tennis balls are defecive. A
‘fective ball leaving the factory cosis the company Fee 0.50 to
honour its quarantee. Assume that all detective bali are returned.
‘At a cost of Re 0.10 per ball, the company can conduct a test
that always correctly Identlies both good and bad tennis ball.
(a) Draw a decision tree and determine the optimal course of
sclion and its expected cost
(&) At what fest cost should the company be inferent o testing?
4, The Ore Mining Company is attempting to decide whether or not
1 cartain pigce of land should be purchased. The land costs RS
300,000. I there are commercial ore deposits on the land, the
estimated value of property is Fs §,00,000. If no ore deposits
exist, however, the property value is estimated at Rs 2,00,000.
Before purchasing the land, the property can be cored at a cost
‘of Re 20,000. The coring wil indicate if conditions are favourable
‘oF unfavourable for oe mining. I the coring repot is favourabie
the probabilty of recoverable ore deposits on tho land is 08.
However, i the coring tenor le Unlavourable then probability Is
‘only 0.2. Prior to obining any coring information, the management
‘estates that the odds of ore being present on the land is 50-50. Management has also received coring reports on pieces of
'acd similar to the ore in question and found that 60 per cent of
the coring reports were favourable. |
Construct a decision tree and determine whether the company
should purchase the tand, decine to purchase i, or take
coring test before making iis decision. Specily tho. optimal
course of action and EMV.
XYZ company, dealing with a newly invented telephone device,
's faced with the problem of selecting out of ‘he following
avaliable courses of action
(i) manufacture the device tse or
(i) be paid on a royalty basis by another manulacturer; or
(i) sel the rights for ts invention for e fump sum.
The profit (in ‘0008 Fs) that can be expected in each case and
the probabilties associated with the level of sales are shown a
the following table:
Provabilty Manufacture Royaties Soll Ar
Outcome
‘tsar Fights
High sales 01 78 as 15
Medium sales og 25 2% 45
Low sales 06 -10 108
Represent the company’s problem in the form of @ decision tree.
Further redraw the decision tree by inducing the following
Aadaitonal information
(@) It manufactures tse, and the sales are medium or high,
{hen the company has the opportunity of developing a new
version of is telephone;
From past experience the company estimates that there is
2 50 per cent chance of successt development
The cost of development is As 18 and relums alter
‘eduction of development cost are As 80 and Re 10 for
high ancl medium sales, respectively
‘An automobile owner faces the decision as to which deductible
amount of comprehensive insurance coverage to select
Comprehensive coverage includes losses due to fre, vehicle
thet, vandaliom and natural calamites. The possible choices are
2210 deductible coverage for Rs 60 per year or Rs 50 deductible
overage for Rs 45 per yoar. (The owner pays tho fist As 0
of any loss of at least Ais 500.) Considering accidents covered
by the comprehensive portion of the policy some of te owners |
tity values are given below.
‘Amount (Fs) > 95 60
Unity 02 04
(@) Sketch the owner's utlity curve.
avoider, an EMV'er of a risk taker?
(©) On the basis of the utity curve drawn in part (a), should
the owner take the zero deductibie or the Rs 50 dedvetile
‘comprehensive coverage? |
Suppose a company has several independent investment
pportunities each of which has an equal chance of galning Fs
100,000 or losing Fs 60,000. What is the probabiliy that the
company will lose money’ on twa such investments? On three
Such Investments? On four such investments?
a company has a number of independent investment
‘©pportuntias, in each of which the tnancial risk ig relatvely sl
‘compared to its overall asset postion, why should the company
try to maximize EMV, rather than expected uty?
An oil ring company is considering the purchase of mineral |
Fights on @ property of Re 100 lakh. The price inchides tess 10
indicate vhether the property has type A geological formation or
‘ype B geological formation. The company wil be unable 10 fel
{he type of geological formation unt the purchase i made. i's
known, however, that 40 per cent of the land in tis area as
"ype A formation and 60 per cent type B formation. # the. |
o)
()
-50 -45 0
045 047 08
Is the owner @ risk
it
Decision Theory and Decision Trees
‘company decides to chill on the land it will cost Rls 200 lakh. tt
the company does dill may hit an of wel, gas wel ot diy
hole Dring experience indeates thal the probably of sling
an ol well is 0.4 on type A and 0.1 on type B. formato:
Probabilly of hiting gas is 0.2 on type A’and 0. on type &
formation. The estimated discounted cash valve from on Chee
is Rs 1,000 lakh and from a gas well is Fs 500 lakh Tris
includes everything except cost of mineral rights and cost ay
‘ling. Use the decision-tiee approach and recommend whether
the company shoukt purchase the mineral rights?
The Sensual Cosmetic Co. has developed a new pertume which
management feels has a tremendous polenial. I not only
interacts with tho wearer's body chemistry 10 create a unique
tragrance but is algo espacialy long lasing, A total of is 10 tek
has already been spent on iis dovelopment. Two. marketing
Plans have’ been «devised:
(8) The fist plan folows the company’s usual poly of giving
smal samples of the new products when othar items in the
company’s product lines are. purchased and placing
‘advertisements in women's. magazines, ‘The plant would
Cost Rs 5 lakh and t's boleved that i might result ina high
‘moderate or low market response with probabiliy of 02,
2.5 and 0.3, respectively. The ‘net profit excluding
development and promotion costs in those cages would bo
FRo 20 lekh, Fis 10 lakh and As 1 lakh, respectively. it
lator appears that the market response is going to bo low
it would be possile to launch a TV advt. campaign, This
would cost another As 7.5 lakh. t would change the market
esponso to high or moderate as previously described but
with probability of 05 each
‘The second marketing plan is much more aggressive than
the first. The emphasis would be heavily upon TV.
‘advertising, The total cost ofthis plan would be Re 16 lak
bat the market response woul be elther excellent or good,
with probabilties of 0.4 and 0.6, respectively. The ‘ott
{excluding development and promotion costs would be Rs
30 lakh and Rs 25 lakh for the two outoomes
Advise on the sequence of strategy to bo followed by the
‘company
The investment staff of TNC Bank is considering four investmont
Proposals for @ client shares, bonds, real estate and saving
Certificates. Those investments will be held for one year, The
pest deta regarding the four proposals are given below:
‘Shares: Thore Is @ 25 per cent chance that shares will decine
‘8 10 per cent, @ 30 per cont chance that they will remain stable
and a 45 per cent chance that they will increase in value by 15.
Ber cent. Also the shares under consideration do not pay any
dividends.
Bonds: These bonds stand a 40 per cent chance of increase
In value by § per cent and 60 per cent chance of 1emaining
stable and yield 12 per cont
eal Estate: This proposal has @20 percent chance of increasing
30 per cent in value, a 25 per cent chance of increasing 20 pet
Cent in value, a 40 per cent chance of increasing 10 per cent in
value, a 10 per cent chance of remaining stable and a 6 per cent
chance of losing § per cont ots value
Savings Certlcates: Those coriicates yield 8.6 per cent with
certainty
Use a decision tree to structure the altematives to the investment
stall, and using the expected value orilerion, choose the
ltemative with the highest expected value
‘A company has developed a new product in its R&D laboratory,
The company has the option of setting up production faci to
‘market this product straighiaway. tthe product is success,
‘then over tho thrae years expected product life, the returns wil
bbe Rs 120 lakh with @ probabilly of 0.70. tthe market does not
respond favourably, then the reluins wil be only Fs 15 lakh, wih
2 probabilty of 0.30
©)Operations Research: Theory and Applications
“The company is considering whether il should tast market this
product by building a smal pilot plant. The chance that the test
‘market wil yield favourable response Is 0.60. i the test market
es a favourable response, then the chance of successtul
total market improves to 0.5.
If the test market give @ poor response, then the chance of
success in the total market i ony 0.90
[As beloce, the retums from a successful market would be As
120 lakh and from an unsuecessiul market only Rs 15 lakh. The.
instalation cost to producion is Rs 40 lakh and tho cost of test.
rmarkating tho plot plant Is AS 5 lakh. Using decision-tree
analysis, draw a decision tree diagram, camry out necessary
analysis to determine the optimal decisions
{Doni Univ, MBA, 2002)
HINTS AND ANSWERS
1, The company should test matket rather than drop the product.
test matket +
product otherwise drop the product
sult is positive, the company should market the
2. ‘Test market should be followed; EMV = Rs 13,800
3. (a) Do not test, Re 0.05: (b) Re 0.05
4, Test: If favourable ~ putchase; If not ~ do not purchas
64,000
Decision Point Outcome
(Drill il well
Dry hole
Gas
(Do not drill
D, ~—@) Drill Oil welt
Dry hole
Gas
(ii) Do not drill
D, Gi) Type A formation
(i) Type B formation
The company should purchase the mineral right
9. Aggressive Plan,
Probably
ou
06
03
04
04
02
04
06
Royalties; IMV = Rs 15.5
If p is the probability of high sale, then
()) manufacture itself when p > 0.24
(i) paid on royalty basis when 0.07
1aC+ (a) EOL (e) emv (6) p= IGKIC + 1) (d) p= uc + 1p) | (6) Hurwice (@), Maximex Rooke wT 2 8F 47 BF 6r 7T BF O9F WF 11. a course of action or strategy 12. risk 13. highest 14. optimism 15. EOL exterion 16. risk 17. minimum 18. weighted average 19, states of nature 20. posterior probablites 21. (8) 22. (a) 23.) 24. (bY 25. (6) 28. (a) 27. ()—28. (6). (a) 90. (0) | Sta) 92) B®) 3H (e) 35. (0) CASE STUDY Case 11.1: Oil India Corporation The corporation has recently got feaschold drilling rights on a large area in the westem part ofthe country. No seismic coverage is available and to condvet a detailed survey Rs 3 milion is required, If ol is struck, a large reserve may result in a net profit of Rs 30 million, whereas a smaller marginal reserve may result in a net profit of Rs 18 milion The cost of driling a wildcast well is Rs 7 million Scismie is thought to be quite reliable in this area. Uncertainty pertains to whether or nota structure exists, The company assesses a probability that the test producing good, fair or bad result is 0.40, 0.30 and 0.30, respectively, (On the basis of past drilling records and experiences indicating the probabilities of striking oil in large reserve, smaller ‘marginal reserve or dry hole, even in the presence of good, fair and bad reading of seismic study are as under Good 030 025 Pair 030 040 od 0.10 070 Exploratory group has suggested two possible exploration strategies: (@)_ Drill at once on the basis of present geologic interpolation and extrapolation (b) Conduct a seismic study and defer drilling till seismic data is reviewed ‘AS a-member of strategic group of the company evaluate the two strategies suggested by the exploratory group. Case 11. Moola Farms Mr. Moola, the owner of Moola Farms is attempting to decide which of three erops he should plant on his 100 acre farm, The profit from each erop is strongly dependent onthe rainfall doring the growing season. He has categorized the amount of the rainfall as substantial, moverate oF light. He estimates his profit for each crop as shown in the table below: ‘Substantial 7,000 2,500 4,000 Moderate 3.500 3,500 4,000 1,000 4,000, 3,000 Based on the weather in previous seasons and the current projection for the coining season, he estimates the probability of substantial rainfall as 0:2, that of moderate rainfall as 0.3, and that of light rainfall as 0Decision Theory and Decision Trees Services of forecasters could be employed to provide a Uetled survey of eurent rain all prospects as shown in the tabe Moderate 030 0.60, 0.10, 010 020 070, You in the capacity of Block Advisor to farmers are expected to suggest (a) Which crop should Mr. Moola plant based on existing data (6) Whether it would be economical for the farmer to hie the services ofa forecaster. If yes, then how will the result affects the decision process Case 11. Matrix India Matrix India, a company in FMCG sector is planning to launch a new product that can be initially introduced in ‘Westem India or in the whole country. If the product is introduced only in Western India, the investment outlay will be Rs 12 million. After two years, company can evaluate the project to determine whcther ic should cover the whole country: For such an expansion it will have to incur an addtional investment of Rs 10 million. To introduce the product in the whole country right inthe beginning would involve an outlay of Rs 20 milion. The product, in any ease, will hhave a life of 5 years, after which the plant will have ze10 net val. If the product is introduced only in Westem India, demand would be high or low with the probabilities of 0.8 ‘and 0.2, respectively and annual cash inflow of Rs 4 million and Rs 2.5 million, respectively. If the product is introduced in the whole country, right atthe beginning the demand would be high ot low with the probabilities of 0.6 and 0.4, respectively and annual cash inflows of Rs 8 million and Rs 5 milion, respectively, Based on the observed demand in Wester Indi, ifthe product is introduced in the entire country the following Probabilities would exist for high and low demand on an all Indie bass, High demand 0.90 ‘Low demand 040, ‘The hurdle rate applicable to this project is 12 percent. Advise Matrix India on the investment policy it should follow. Support your advice with appropri e reasoning.