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27E01000 Decision Making and Choice Behavior

Homework 2

Artur Gayfutdinov

84428

Problems Done: 1, 2 ,3, 4

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27E01000 Decision Making and Choice Behavior

Homework 2

1. The matrix shown in the table illustrates the profits earned by a decision maker for various
combinations of acts chosen and states of nature occurring.
Act Chosen State of Nature
I II III IV
A 20 10 30 0
B 25 15 20 -5
C 30 20 -10 10
D 35 25 0 10

(a) What act should be chosen if the decision maker invokes the following decision
criteria: maximax, maximin, equally likely (= Laplace)?

Maximax:

Act Chosen Maximax State of Nature

I II III IV
A 30 20 10 30 0
B 25 25 15 20 -5
C 30 30 20 -10 10
D 35 35 25 0 10

30, 25, 30, 35; 35 is the largest number in that row, indicating the largest gain, therefore act D
should be chosen if using maximax approach

Maximin:

Act Chosen Maximin State of Nature

I II III IV
A 0 20 10 30 0
B -5 25 15 20 -5
C -10 30 20 -10 10
D 0 35 25 0 10

0, -5, -10, 0; 0 is the largest of minimum values in the table => act A or act D are equally good
(as they have the same minimum value) and should be chosen if maximin decision criteria is
applied

Laplace:
Act Chosen Laplace State of Nature
I II III IV
A (20+10+30)*1/4= 15 20 10 30 0
B (25+15+20-5)*1/4= 13,75 25 15 20 -5
C (30+20-10+10)*1/4= 12,5 30 20 -10 10
D (35+25+10)*1/4= 17,5 35 25 0 10

17,5 is the largest value => act D should be chosen for Laplace decision criteria

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(b) Convert the profit matrix to a regret matrix. What decision should be made if the
criterion is minimax of regret?

Regret Matrix
Act Minimax of Regret State of Nature
Chosen
I II III IV
A 15 35-20=15 25-10=15 30-30=0 10-0=10
B 15 35-25=10 25-15=10 30-20=10 10+5=15
C 40 35-30=5 25-20=5 30+10=40 10-10=0
D 30 35-35=0 25-25=0 30-0=30 10-10=0

15, 15, 40, 30; 15 is the smallest value => act A or B should be chosen as they both have the
minimum values in the maximum regret list

(c) If the decision maker’s coefficient of optimism is 0.5, what act should be chosen?

Act Chosen State of Nature

I II III IV Max Min coefficient of optimism
A 15 15 0 10 15 0 15*0,5=7,5
B 10 10 10 15 15 10 15*0,5+10*0,5=12,5
C 5 5 40 0 40 0 40*0,5=20
D 0 0 30 0 30 0 30*0,5=15

Act C should be chosen, as it has the highest coefficient of optimism.

(d) If the probabilities of I, II, III, and IV are 0.1, 0.2, 0.3, and 0.4, respectively, what act
should be chosen to maximize expected monetary value?
Act Chosen State of Nature
I II III IV
A 20 10 30 0
B 25 15 20 -5
C 30 20 -10 10
D 35 25 0 10
Probability 0,1 0,2 0,3 0,4

EMV(A)=20*0,1+10*0,2+30*0,3=2+2+9=13
EMV(B)=25*0,1+15*0,2+20*0,3-5*0,4=2,5+3+6-2=9,5
EMV(C)=30*0,1+20*0,2-10*0,3+10*0,4=3+4-3+4=8
EMV(D)=35*0,1+25*0,2+10*0,4=3,5+5+4=12,5

EMV(A) has the largest value => Act A should be chosen to maximize expected monetary value

2. An engineering firm in California must make a recommendation concerning the

construction material to be used in a building. Three basic approaches have been
suggested. An important factor in the decision is earthquake activity in the next
few years. Each material has different initial cost, maintenance requirements, and
resistance to earthquake damage. Earthquake activity has been categorized as
very mild, normal, and severe.
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Earthquake activity: Concrete Steel Wood
Very Mild 275000 300000 325000
Normal 300000 315000 325000
Severe 350000 340000 335000

(a) What material would the supreme optimist recommend? Why?

Earthquake activity: Concrete Steel Wood

Very Mild 275000 300000 325000
Normal 300000 315000 325000
Severe 350000 340000 335000
Minimin 275000 300000 325000

The supreme optimist would recommend concrete, as it is the cheapest option and
according to the supreme optimist the earthquake activity will be normal (the least
damaging).

(b) What material would the supreme pessimist recommend? Why?

Earthquake activity: Concrete Steel Wood

Very Mild 275000 300000 325000
Normal 300000 315000 325000
Severe 350000 340000 335000
Maximin 350000 340000 325000
The supreme pessimist would recommend wood, as supreme pessimist believes the
conditions would go by the worst possible scenario, therefore the earthquake activity will
be severe, wood is the cheapest option given the worst possible conditions.

(c) If the probabilities of very mild, normal, and severe are assessed as 0.1, 0.2, and
0.7, respectively, which material should be chosen to minimize expected cost?

Earthquake Concrete Steel Wood Probability

activity:
Very Mild 275000 300000 325000 0,1
Normal 300000 315000 325000 0,2
Severe 350000 340000 335000 0,7

EMV (Concrete) = 275000*0,1 + 300000*0,2 + 350000*0,7 = 332500

EMV (Steel) = 300000*0,1 + 315000*0,2 + 340000*0,7 = 331000
EMV (Wood) = 325000*0,1 + 325000*0,2 + 335000*0,7 = 332000

EMV (steel) has the lowest EMC => Steel should be chosen

3. An automobile manufacturer is considering adding a small compact car to the product

line. The company currently produces only full-size autos which are facing an uncertain
demand as consumer concern for fuel economy increases. If gasoline prices continue to

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increase, the move into the small-car market would be wise; however, the president of the
company feels that profits from full-size cars only would exceed profits from a mixed
product line if gasoline prices stay between 50 c and 80 c per gallon. He assesses the
possible prices and their respective probabilities as follows:
Gasoline Price ($/gal) Probability
0.50􀃭0.60 0.1
0.61􀃭0.80 0.3
0.81􀃭1.10 0.4
1.11􀃭1.50 0.2
The president’s estimate of profits in millions of dollars for the two acts given the price of
gasoline are as follows:
Gasoline Price ($/gal) Produce Both Sizes Produce Only Full Size
0.50􀃭0.60 400 700
0.61􀃭0.80 500 600
0.81􀃭1.10 700 300
1.11􀃭1.50 600 100

Gasoline Price Produce Both Only Full Probability

0,5-0,6 400 700 0,1
0,61-0,8 500 600 0,3
0,81-1,11 700 300 0,4
1,11-1,5 600 100 0,2

(a) If the president wishes to maximize expected monetary value, should he produce only
full-size cars or a mixture of both sizes?
EMV(Both) = 400*0,1+500*0,3+700*0,4+600*0,2=40+150+280+120=590 millions
EMV(Full) = 700*0,1+600*0,3+300*0,4+100*0,2=70+180+120+20=390 millions
EMV(Both)>EMV(Full) => EMV (Both) should be chosen to maximize expected monetary
value

(b) If the president tells you he is indifferent between the two strategies, what may you infer
about his degree of optimism concerning gas prices?

The probability that the gasoline prices stay between 0,5c and 0,8c per gallon =
0,1+0,4=0,4=40%. So, the president sees it rather pessimistically that the prices stay at that
interval, given that he estimates only 40% probability of that happening and 60% probability
that the prices will exceed 0,8c per gallon.

4. A farm implement manufacturer has discontinued a particular tractor engine. Most parts in
the engine are interchangeable with other engine parts with the exception of the
crankshaft. The manufacturer must decide now how many replacement crankshafts to
stock in the inventory before tooling in the machine shop is changed for the new line.
Crankshafts cost the manufacturer $210 to make and are sold for $300. They cannot be
modified to fit another engine. If unsold, their scrap salvage value is $30. Estimates of
demand for replacement crankshafts are as follows:
Demand < 1000 1000 1500 2000 2500 3000 > 3000
Probability 0 0.15 0.3 0.25 0.2 0.1 0

Assume that the cost of turning down a customer who needs a crankshaft when none is
available is zero.

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(a) Construct the profit matrix for the manufacturer’s decision problem.

Demand Profit Probability

<1000 0 0
1000 90000 0,15
1500 135000 0,3
2000 180000 0,25
2500 225000 0,2
3000 270000 0,1
>3000 0 0

(b) How many replacement units should be stocked to maximize expected profits?

Demand Profit Probability Expected Profit

<1000 0 0 0
1000 90000 0,15 13500
1500 135000 0,3 40500
2000 180000 0,25 45000
2500 225000 0,2 45000
3000 270000 0,1 27000
>3000 0 0 0
Either 2000 or 2500 replacement units should be stocked to maximize expected profits. From the
e.p. point of view the result is calculated to be the same, however, the end decision will depend
whether it is an optimist or a pessimist who considers these two options.

(c) Construct the conditional loss (= regret) matrix for this problem.

(d) Show that the expected profits plus the expected losses (= regrets) for any act sum to the
same figure. Interpret this figure in words.

(e) How much should the manufacturer be willing to pay for a perfect forecast of demand for
replacement crankshafts?