Sally to sally forth

Sarah had asked Sally Chen to look into the issue of investing $200000 in research and development
for developing the new timer device (see Sarah Chang’s Dilemma for context). Sally submitted her
report. It said

Re: Investing in research and development for developing the timer device

Decision options considered:

A. Do nothing
B. Don’t invest, bid for the contract
C. Invest $200,000 in research and development, bid only if you have the new technology
D. Invest in research and development, bid with the best technology you have.

Assumptions:
 Risk-neutrality
 Chance of
(a) engineers developing the proposed new technology in time if $200,000 is not invested: 0%
(b) engineers developing the proposed new technology in time if $200,000 is invested: 60%
(c) winning the bid by bidding with the existing technology: 5%
(d) winning the bid by bidding with the proposed new technology: 80%.

Expected payoffs:
Decision option A: $0
Decision option B: ($7500)
Decision option C: $178000
Decision option D: $175000

Proposed decision:
Choose option C: Invest $200000 in research and development, and bid for the contract only if the
engineers develop the new technology. (Note: With this option you still have a 52% chance of
losing money.)

Sarah realized that she had not told Sally anything about the chances of different events happening.
She noted that the chances that Sally had assumed matched her estimates quite well.

She called Sally in and thanked her for the analysis. “Great work, but I need some more help about
this” she said. “I can’t get a feel for the situation from only the expected values. Could you give me a
bunch of different scenarios that may arise if we go forward, and what payoffs I may expect under
those scenarios?

“I have also been looking at the chance values that you have worked with. Although I agree with
most of them, I am not very comfortable with these values being single numbers. I feel more
comfortable to think of them as ranges. For example, I feel that if I do not invest in research and
development, the engineers have a 2 to 5% chance of still coming up with the new technology. Of
course if I invest the money, this chance jumps to between 50 and 60%.

“If I bid with the proposed new technology, I put my chance of winning the bid at between 75 and
90%. The chance of winning the bid with existing technology between 5 and 7%. You see, we have
around 25 competitors who have the technology that we currently have. Of these there are 10
serious competitors each of whom has a 75% chance of bidding for this contract. Each of the other
15 have a 50% chance of bidding. So with existing technology, our chance of winning the bid is
actually the reciprocal of the number of bidders. With this, could you construct scenarios for me so
that I can make an informed decision?”

Sally knew that this job was going to be a little more difficult and was wondering where to start. She
knew that evaluating the best case scenario and the worst case scenario would not be very helpful.
She also knew that different scenarios had different chances of coming up, and just a complete
listing of all scenarios would also not be helpful.

She felt that it would help Sarah if she could provide a kind of probability distribution of all the
possible payoffs for each of the strategies and some kind of distribution of the relative ranks of the
strategies. But replacing each of the probability values with ranges was a challenge. She had not
seen decision trees with probabilities as ranges.

She thought that the best option would be to design and run a simulation. She made herself a cup of
coffee and opened up a spreadsheet software on her laptop.