Example 1

An airline company is offering three types of fare for its new destination, namely, first class,
business class and economy class. The estimated sales for three state of markets’ demand of
high, medium and low is shown in the following table.

Markets’ demand
Types of fare High Medium Low
First class RM20,000 RM18,000 RM12,000
Business class RM25,000 RM15,000 RM10,000
Economy class RM26,000 RM17,000 RM8,000

a) Determine the fare types which will maximize the company’s profit using the following
decision criterion;
i) maximax
ii) equally likely (Laplace)
iii) develop an opportunity loss table.
iv) what is the minimax decision?

b) The R&D department can predict very well the situation of the markets’ demand. They
predict that the probability of high demand is 0.35, the probability of medium demand
is 0.35, and the probability of low demand is 0.3. Determine the most that the marketing
department would be willing to pay for this information?

Solution 1
a) i) Take the maximum value in every row for every alternative;
First class RM20,000
Business class RM25,000
Economy class RM26,000

Then, choose the highest value. In this case the highest value is RM26, 000, thus
the marketing department should choose the economy class.
ii)
Markets’ demand EMV
 Fare policy High Medium Low Equally
Likely
First class RM20,000 RM18,000 RM12,000 RM 50 3 K
Business class RM25,000 RM15,000 RM10,000 RM 50 3 K
Economy RM26,000 RM17,000 RM8,000 RM 51 3 K
class

The decision for the airline company is to choose the economy class.

iii) EOL table

Markets’ demand
Fare policy High Medium Low
First class RM6,000 RM0 RM0
Business class RM1,000 RM3,000 RM2,000
Economy class RM0 RM1,000 RM4,000

iv) Take the maximum value in every row for every alternative;

First class RM6,000

Business class RM3,000
Economy class RM4,000

Then, choose the lowest value. Thus by minimax, the airline company should
choose the business class fare policy.

b) EMV(1st class) = 0.35(20K) + 0.35(18K) + 0.3(12K) = RM16,900

EMV(Bus class) = 0.35(25K) + 0.35(15K) + 0.3(10K) = RM17,000
EMV(Eco class) = 0.35(26K) + 0.35(17K) + 0.3(8K) = RM17,450

EVPI = EVPwI - maximumEMV

= 0.35(26,000) + 0.35(18,000) + 0.3(12,000) - 17,450
= RM1, 550
 The most that the marketing dept. would be willing to pay for the information is RM1,
550.

Example 2
A real estate developer has just purchased a prime land from the state government. He has to
decide a plan for developing the land. After careful consideration, the developer has ruled out
“do nothing” and is left with the alternative to developed the land into a residential area. But
he has to first determine the size of the residential area to be developed. The financial success
of the project will depend heavily on the decision that he makes regarding the size of the
project. Thus, the alternatives that are being considered are medium-sized project (M), and
large-sized project (L). A key factor in selecting one of these decision alternatives involves the
management’s assessment of the demand of the houses being built. He believes that market
acceptance will be one of these possibilities: high acceptance of the project and hence a good
demand for the houses or low acceptance of the project and hence a poor demand for the houses.
The following payoff table shows the profit in RM Million for the development project.

STATE OF NATURE
Profit (RM million)
Alternatives High Acceptance (H) Low acceptance (L)
Medium-sized (M) 14 5
Large-sized, (L) 20 -9

a) If the manager of the real estate company estimates that the probability of low
acceptance is 0.5 and the probability of high acceptance is 0.5, what would be the
recommended decision that they should undertake?

b) If the manager requested to do a market research study that would better indicate
whether acceptance will be low or high, it will cost them RM200,000. If this research
is conducted, the outcome will either be positive or negative and the following
probabilities applies:
 P (Survey +ve) = 0.56 P (High/Survey +ve) = 0.77
P (High/Survey –ve) = 0.18

i) Construct a decision tree

ii) What is the optimal decision strategy? Explain.
iii) What is the expected value of sample information?

Solution 2

a) EMV (M) = 0.5(14) + 0.5(5) = RM9.5 million

EMV (L) = 0.5(20) + 0.5(-9) = RM5.5 million
Thus the real estate developer should choose a medium sized project

b) i)
 ii) The optimal strategy is the real estate developer should conduct a survey since
the EMV is higher than the EMV for not conducting a survey. If the survey
result is positive, he should choose a large-sized project but if the survey result
is negative, he should construct a medium-sized project.

iii) EVSI = RM20,014,240 + RM200,000 – RM9,500,000

= RM10,714,240

Example 3
Daily demand for loaves of bread at a grocery store is given by the following probability
distributions:
Demand for loaves of bread 100 150 200 250 300
 Probability 0.20 0.25 0.30 0.15 0.10

If the loaf is not sold on the same day, it can be disposed of at 15 cents at the end of the day.
Otherwise, the price of a fresh loaf is 49 cents. The cost per loaf to the store is 25 cents.
Assuming that the stock level is restricted to one of the demand levels, how many loaves should
be stocked daily?

Solution 3
If demand = supply; the profit per unit = RM0.24
If demand > supply; the profit per unit = RM0
If demand < supply; the profit per unit = -RM0.10

Demand 100 150 200 250 300

EMV
Supply
100 100(0.24) 100(0.24) 100(0.24) 100(0.24) 100(0.24) 24
= 24 +50(0) +100(0) +150(0) +200(0)
= 24 = 24 = 24 = 24
150 100(0.24) 150(0.24) 150(0.24) 150(0.24) 150(0.24) 32.6
-50(0.10) =36 =36 =36 =36
=19
200 100(0.24)- 150(0.24)- 200(0.24) 200(0.24) 200(0.24) 36.95
100(0.10) 50(0.10) =48 =48 =48
=14 =31
250 100(0.24)- 150(0.24)- 200(0.24)- 250(0.24) 250(0.24) 36.2
150(0.10) 100(0.10) 50(0.10) =60 =60
=9 =26 =43
300 100(0.24)- 150(0.24)- 200(0.24)- 250(0.24)- 300(0.24) 32.9
200(0.1) 150(0.1) 100(0.1) 50(0.1) =72
=4 =21 =38 =55
Prob. 0.2 0.25 0.3 0.15 0.1

Decision; Stock 200 loaves of bread.