2021-04-13

Decision Making Under Risk-

Bayesian Updating

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Prior and Posterior Probabilities

Consider the situation wherein, historically, experimental tests

have been conducted and engineering designs have been
implemented (facilities constructed).

For example, a material sample has been tested for ultimate tensile
strength, a manufacturing process has been selected and the
product has been built.

The result is a paired observation of actual material strength θi, as

demonstrated by performance of the product and predicted
material strength zj, as indicated by the experimental result.

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Problem 1: Calculator material redesign

An industrial engineer must decide between PVC and HDPE plastic material
for the base of an electronic calculator manufacture.
The material strength of the final product is not known for certain, but could
be low (θ1), medium (θ2), or high (θ3). PVC for the calculator have a total cost
of $150,000 while HDPE cost $250,000. The HDPE are considered “safe” in
that if the actual strength turns out to be low, no damage will result to the
calculator. The PVC are less expensive but would result in some calculator
damage if the material strength is low or medium (damage cost $100,000 and
$50,000, respectively), and they would have to be replaced with HDPE
(under difficult manufacturing conditions) if the material strength is low
(replacement cost $1,000,000). Data are provided in tables.
For $10,000 experimental studies and a triaxial strength test can be
conducted. Assume that the joint, prior, and posterior probabilities given in
table 1 and 2 apply to this experiment.

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Table 1: Joint and marginal probabilities for material strength

Experimental Results
Marginal Probability of
State of Nature z1
z1 (low) z3 (high) the State of Nature
(medium)
θ1 (low) 0.24 0.05 0.01 0.30
θ2 (medium) 0.15 0.20 0.05 0.40
θ3 (high) 0.05 0.15 0.10 0.30
Marginal
Probability of the 0.44 0.40 0.16 1.0
experimental results

Table 2: Posterior probabilities for material strength

Pθ1|z1 = 0.545 Pθ1|z2 = 0.125 Pθ1|z3 = 0.063
Pθ2|z1 = 0.341 Pθ2|z2 = 0.500 Pθ2|z3 = 0.313
Pθ3|z1 = 0.114 Pθ3|z2 = 0.375 Pθ3|z3 = 0.625
Sum: 1.0 Sum: 1.0 Sum: 1.0

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(a) Draw the complete decision tree.

(b) Determine the optimal strategy and cost.
(c) Calculate the expected monetary value of information
(EMVI) and the benefit-cost ration for the experiment.

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Problem 2: Paint production

Regina Reddy Mikks produces both interior paint and exterior paint from
raw materials M1, and M2. The probabilities that the demand of these
paints will go up, stay the same, or go down are 0.25, 0.30, and 0.45,
respectively. If the demand go up, the interior paint will net $30,000
and the exterior paint will net $10,000. If the demand remain
unchanged, Regina Reddy Mikks will (barely) break even. But if the
prices go down, the interior paint and exterior paint will sustain
losses of $35,000 and $5,000, respectively.

(a) Represent Regina Reddy Mikks problem as a decision tree.

(b) Which flatwork should Regina Reddy Mikks manufacture?

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Problem 2: Paint production (cont.)

Consider the Regina Reddy Mikks has the additional option of renting the
manufacturing site, in which case it is guaranteed a payoff of $7500. The Regina
Reddy Mikks has also secured additional information from a market analyst regarding
the degree of stability of future paint demand. The analyst’s assessment of
"favorable“ and "unfavorable" is further quantified by the following conditional
probabilities:

a1 a2
s1 0.85 0.15
P{aj|si} = s2 0.5 0.5
s3 0.15 0.85

The symbols a1 and a2 represent the "favorable" and "unfavorable" assessment by

the analyst, and s1, s2, and s3 represent, respectively, the up, same, and down change
in demand.
(a) Draw the associated decision tree.
(b) Specify the optimal decision for the problem.

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