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You are on page 1of 11

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:

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.

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.

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

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

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.

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.

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

$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

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?

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.

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?

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

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

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.

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.

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.

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

15 15 ln 4

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

the other choices (a, c and d.)

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

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?

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