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# MS&E 252

## Decision Analysis I Due 11/13/2014

Homework Assignment #6
Due on November 13th, 11:59 pm

In this assignment you are required to turn in the probabilistic section only. Again the
"Food for 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 full knowledge of all sections on this assignment.

Assigned Reading
1) Course Reader I, Foundations of Decision Analysis, read Chapter 12 and 13.
2) Course Reader I, Foundations of Decision Analysis, Chapter 15. Please do not
read 15.4 (page 19 24) before filling out the 20 questions survey.
3) Speaking of Decisions: Precise Decision Language. By Ron Howard.
Decision Analysis, 2004.

Distinctions
From the class lectures, explain the following concepts:
Prior
Likelihood
Posterior
Pre-posterior
Sensitivity
Specificity
Symmetric test
Relevant test
Material test
Economic test
MS&E 252
Decision Analysis I Due 11/13/2014

Probabilistic Questions
1) Please consider the following statements:

## I. If the Value of Clairvoyance on an uncertainty is zero for a risk-neutral

decision maker, it must be zero for a risk-averse decision maker who
follows the Delta Property.
II. A test which is not relevant can be material.
III. Clairvoyance on an uncertainty with two degrees is equivalent to a test that
has a sensitivity and specificity of 1.

## How many of the statements above are always true?

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

2) Tom follows the Five Rules of Actional Thought and prefers more money to less.
Let VoC(A) and VoC(B) denote Toms Value of Clairvoyance for uncertainty A
and uncertainty B, respectively. Let VoC(A,B) denote Toms Value of
Clairvoyance for both uncertainty A and uncertainty B at the same time.

## I. VoC(A,B) < VoC(A) + VoC(B)

II. VoC(A,B) = VoC(A) + VoC(B)
III. VoC(A,B) > VoC(A) + VoC(B)

## How many of the previous statements could possibly be true?

a) 0
b) 1
c) 2
d) 3
MS&E 252
Decision Analysis I Due 11/13/2014
The trees below are for both Question3 and Question 4.

## Consider the deals A and B below:

0.4 0.1
\$100 \$50

A 0.3 B 0.2
\$200 \$150

0.3 0.7
\$300 \$250

3) Philip has a wealth of \$200 and he does not own the deals mentioned above.
!""""
Philips u-curve is u x = 1 !!
, where x is his total wealth (including his
original wealth and any new gain or loss in the deals) in dollars.

## Which of the following statements are true?

I. Philips PIBP for Deal A is higher than Philips PIBP for deal B.
II. If Philip is given deal B for free, then he should be willing to trade Deal B
for Deal A plus \$30.

a) I only
b) II only
c) Both I and II
d) Neither I nor II

4) (Continued from the previous question) Philip is given Deal B for free. Hanna, a
Delta Person, has a risk tolerance of > 0. Let d be the greatest possible absolute
difference between Hannas and Philips certain equivalents for Deal B. Which
range below contains d?

a) d \$90
b) \$90 < d \$110
c) \$110 < d \$130
d) \$130 < d
MS&E 252
Decision Analysis I Due 11/13/2014
5) Hanako is facing the decision situation shown in the decision tree below. She is a
Delta Person with a risk tolerance () of \$10,000. Please see the variable h in the
tree below. Which of the following ranges contains the value of h such that
Hanako is indifferent between Alternative 1 and Alternative 2?
Value Measure

0.4 Outcome 1
h +\$20,000

## Alternative 1 0.3 Outcome 2

\$15,000

0.3 Outcome 3
\$8,000

0.8 Outcome 1
\$35,000
Alternative 2

0.2 Outcome 2
\$0

a) h \$6,000
b) \$6,000 < h \$8,000
c) \$8,000 < h \$10,000
d) \$10,000 < h
MS&E 252
Decision Analysis I Due 11/13/2014
6) Susan follows the Five Rules of Actional Thought, prefers more money to less,
and is risk neutral.
Susan is facing an investment decision where she could choose one of the three
start-ups to invest in: A, B, or C. Susan thinks the macroeconomic situation,
described by the GDP growth, is an important uncertainty to consider when
thinking about the possible payoffs for these startups. Suppose that GDP growth
has two degrees: Fast and Slow.
Consider the following sensitivity analysis plot for the certain equivalents of
investing in the start-ups A, B, and C with respect to the probability of Fast.

500
450
400
Value Measure (\$)

350
300 A
250
200 B
150 C
100
50
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Probability of Fast

## I. If x > 0.3, the decision maker should never choose alternative C.

II. If x = 0.4, the decision maker is indifferent between alternative A and C,
and prefers alternative B to both alternatives A and C.
III. Let x* be the value of x that maximizes the Value of Clairvoyance on GDP
growth. Then x* should be between 0.2 and 0.3.

a) 0
b) 1
c) 2
d) 3
MS&E 252
Decision Analysis I Due 11/13/2014
7) Farm Corp., a major consumer mobile device designer/manufacturer, is facing a
patent infringement lawsuit filed by Bears Inc., their major competitor. Elena, the
general counsel of Farm Corp, has to help the board of directors decide whether to
settle the case or fight the suit in court. If they go to court, Elena believes, given
the facts of the case, that there is a 0.8 probability that Farm Corp can win the case
in court, in which case there wont be any losses or gains for Farm Corp. In case
they lose the lawsuit in court, Elena estimated that the awarded damage will be
\$100 million. If Farm Corp decides to settle, Elena believes that the amount that
has to be paid to Bears Inc. will be \$15 million.

In Elenas discussion of the strategy with her team, a lawyer mentioned that they
could hire a consultant, Mike, for obtaining information on the result of the case.
Elena believes the following about the information from Mike:

{Mike says win | win, &} = {Mike says lose | lose, &} = 0.8.

The board of directors of Farm Corp. follows the Five Rules of Actional Thought,
prefers more money to less, and agrees with Elenas probability assessments.
Farm Corp is also risk neutral for the range of dollar amounts involved in this
decision situation. Let x denote the maximum amount that Farm Corp. should be
willing to pay for Mikes services. Which of the following ranges contains x?

## a) \$0 million x < \$3 million

b) \$3 million x < \$6 million
c) \$6 million x < \$9 million
d) \$9 million x <\$12 million

8) (Continued from Question 7) Elena now believes that the probability of winning
the lawsuit in court is p, instead of the previous assessment of 0.8. Let VoI(p)
denote Farm Corp.s Value of Information for Mikes information as a function of
p. Which range contains the value of p that maximizes VoI(p)?

a) 0 p < 0.1
b) 0.45 p < 0.55
c) 0.8 p < 0.9
d) 0.9 p 1
MS&E 252
Decision Analysis I Due 11/13/2014
9) (Continued from Question 7 & 8) Now assume that instead of being risk neutral,
Farm Corp. is risk averse with a u-curve of u(y) = ln(500+y), where y is the
prospect value in millions of dollars. Which of the following ranges contains z,
Farm Corps PIPB for Mikes service? Assume now that Farm Corp. believes that
the chance of winning the lawsuit is again 0.8.

## a) \$0 million z < \$3 million

b) \$3 million z < \$6 million
c) \$6 million z < \$9 million
d) \$9 million z <\$12 million

10) How many of the following statements must be true?

## I. A binary test with a Sensitivity and Specificity of 0 is immaterial.

II. For a binary test with fixed specificity, a decision makers PIBP for it is
always strictly increasing with respect to the tests sensitivity.
III. In information gathering, a decision makers posterior probability on an
uncertainty is never the same as the prior.

a) 0
b) 1
c) 2
d) 3
MS&E 252
Decision Analysis I Due 11/13/2014

Quantitative Problems

## 1) Bozos Party Problem

The initial problem set up for this problem is very similar to that of Kim, Jane, and
Mary. Bozos preferences for the prospects in the party problem are given by the
following u-curve: u(x) = (x^2)/10,000. Assume that his initial wealth is zero.

0.4
Sun 100 1
out
0.6
Rain 0 0
0.4
Sun 90 0.81
porch 0.6
Rain 20 0.04
0.4
Sun 40 0.16
in 0.6
Rain 50 0.25

## a) What is Bozos certain equivalent for this deal?

b) What is Bozos certain equivalent for the deal after paying \$15 for
Clairvoyance?
c) What is Bozos certain equivalent for the deal with free clairvoyance?
d) What is Bozos value of clairvoyance? Note that he dose not follow the delta
property.

## Use the following information for the next two questions.

Eduardo, a confused graduate student, has just won the EES&OR weekly Bingo prize
in which he has his choice among three alternatives. Although he follows the five
rules of actional thought, he can't decide which alternative to pick and has asked for
your help. In the first alternative, he is given a jar of balls (jar one), some are red
and the others are white. If Eduardo picks a red ball, he wins \$2500, if he picks a
white ball, he wins \$1000. The second alternative is a similar deal, however if he
picks a red ball from the jar (jar two), he wins \$3000, if 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 of red balls in both jars, what
percentage of red balls must there be for Eduardo to be indifferent between
alternative 1 and alternative 2?
MS&E 252
Decision Analysis I Due 11/13/2014
b) What percentage of red balls must be in jar one for him to be indifferent
between alternative one and alternative three?
c) What percentage of red balls must be in jar two for him to be indifferent
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 of red balls in the jars changes.
Also show the points of indifference that you found in parts a-c.

## 3) Value of Clairvoyance Sensitivity

a) Show on a similar graph how free clairvoyance would be represented.
b) Calculate the certain equivalents for each alternative when the fraction of red
balls is equal to 1/6 and then when the fraction is equal to 5/6. Show these
values on the graph.
c) Determine what Eduardo's best alternative is in each of these two cases and
explain why they might be different.
d) What is Eduardo's value of clairvoyance at these two points?
e) Construct your own graph of the sensitivity of the value of clairvoyance to
probability for Eduardo's decision problem as done in chapter five for 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, just finished taking the Decision Analysis midterm.
She understood the scoring rule from Homework #5, but was perplexed when she
received a - on the exam. On one of the questions she was absolutely certain
that the answer was "b," so she assigned her belief of p = s = 1 to "b."
Unfortunately for Ellen, she marked the wrong box and inadvertently put one for
"c" and a zero for everything else and hence p = 0. Oops. Now Ellen wants
you to help her identify how she should approach next years 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, Im ok after all," which well just denote M and M, respectively.
Let {M | b correct, &} = q.

## This can all be represented as the following deal:

MS&E 252
Decision Analysis I Due 11/13/2014
M 100 + 100 ln((1 -p)/3)
15 15 ln 4
q
b correct

1-q
s 100 + 100 ln p
p 15 15 ln 4
M
1-s

## a, c, or d correct 100 + 100 ln((1 -p)/3)

15 15 ln 4

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 Ellens sensitivity to the probability q.

What is her e-value for q = 1? What about for q = 0.00001?
b) Suppose s = 0.7 and p = 0.7. Compute Ellens sensitivity to the probability q.
What is her e-value for q = 1? What about for q = 0.00001?
c) Now include a decision about p, where p can be one of three possible values
{0.25, 0.7, 1}. Suppose s = 1 as in (a). Compute Ellens sensitivity to the
probability q and represent your results in a graph like the one on page XXX
of the manuscript. Repeat for 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 found
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?

MS&E 252
Decision Analysis I Due 11/13/2014

## Consider the following deal:

A "fair" coin is flipped repeatedly until it comes up tails, and the total number of flips,
n, determines the prize, which equals \$2*n. Thus if the coin comes up tails the first
time, the prize is \$2*1 = \$2, and the deal is terminated. If the coin comes up heads
the first time, it is flipped again. If it comes up tails the second time, the prize is \$2*2
= \$4, and the deal is terminated. If it comes up heads the second time, it is flipped
again, and so on. There are an infinite number of possible outcomes (runs of heads
followed by one tail) possible. The probability of an outcome of n flips P(n) is
1/(2*n).

a) What is your PIBP for the deal? Provide a brief rationale. Suppose you
already own the deal, what is your PISP?
b) Repeat (a) for the following cases: 1) assume you are risk neutral, 2) you are
a delta person with risk odds 9:1, and 3) you are risk preferring. For all cases
assume you prefer more money to less and follow the five rules of actional
thought.
c) Given your results from (a) & (b), which of the three cases best characterizes
your own risk attitude?
d) Suppose you are a risk-neutral, forgetful person who currently owns deal.
You know that once you buy it, each time you see the coin ready to be flipped
you will not remember how many (if any) flips have occurred in the past.
How would this change the PISP you found in (a)? (ie, would it increase or
decrease?) Why? What if you were risk averse? If you owned the deal,
do you really think you could keep accurate count of the flips?
e) Extra section for those of you who have studied probability. You may
recognize that the distribution over the number of flips is just a Geometric
distribution. Using this knowledge, calculate the expected number of flips.
Based on this number, would you now be anxious to change your PIBP?
Why or why not? If you were forgetful, would this number change?