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Solutions To Discussion Questions and Problems
Solutions To Discussion Questions and Problems
3-1. The purpose of this question is to make students use a personal experience to distinguish
between good and bad decisions. A good decision is based on logic and all of the available
information. A bad decision is one that is not based on logic and the available information. It is
possible for an unfortunate or undesirable outcome to occur after a good decision has been made.
It is also possible to have a favorable or desirable outcome occur after a bad decision.
3-2. The decision-making process includes the following steps: (1) define the problem, (2) list
the alternatives, (3) identify the possible outcomes, (4) evaluate the consequences, (5) select an
evaluation criterion, and (6) make the appropriate decision. The first four steps or procedures are
common for all decision-making problems. Steps 5 and 6, however, depend on the decision-
making model.
3-3. An alternative is a course of action over which we have complete control. A state of nature
is an event or occurrence in which we have no control. An example of an alternative is deciding
whether or not to take an umbrella to school or work on a particular day. An example of a state
of nature is whether or not it will rain on a particular day.
3-4. The basic differences between decision-making models under certainty, risk, and
uncertainty depend on the amount of chance or risk that is involved in the decision. A decision-
making model under certainty assumes that we know with complete confidence the future
outcomes. Decision-making-under-risk models assume that we do not know the outcomes for a
particular decision but that we do know the probability of occurrence of those outcomes. With
decision making under uncertainty, it is assumed that we do not know the outcomes that will
occur, and furthermore, we do not know the probabilities that these outcomes will occur.
3-5. The techniques discussed in this chapter used to solve decision problems under uncertainty
include maximax, maximin, equally likely, coefficient of realism, and minimax regret. The
maximax decision-making criterion is an optimistic decision-making criterion, while the
maximin is a pessimistic decision-making criterion.
3-6. For a given state of nature, opportunity loss is the difference between the payoff for a
decision and the best possible payoff for that state of nature. It indicates how much better the
payoff could have been for that state of nature. The minimax regret and the minimum expected
opportunity loss are the criteria used with this.
3-7. Alternatives, states of nature, probabilities for all states of nature and all monetary
outcomes (payoffs) are placed on the decision tree. In addition, intermediate results, such as
EMVs for middle branches, can be placed on the decision tree.
3-8. Using the EMV criterion with a decision tree involves starting at the terminal branches of
the tree and working toward the origin, computing expected monetary values and selecting the
best alternatives. The EMVs are found by multiplying the probabilities of the states of nature by
the economic consequences and summing the results for each alternative. At each decision point,
the best alternative is selected.
3-9. A prior probability is one that exists before additional information is gathered. A posterior
probability is one that can be computed using Bayes’ Theorem based on prior probabilities and
additional information.
3-10. The purpose of Bayesian analysis is to determine posterior probabilities based on prior
probabilities and new information. Bayesian analysis can be used in the decision-making process
whenever additional information is gathered. This information can then be combined with prior
probabilities in arriving at posterior probabilities. Once these posterior probabilities are
computed, they can be used in the decision-making process as any other probability value.
3-11. The expected value of sample information (EVSI) is the increase in expected value that
results from having sample information. It is computed as follows:
EVSI = (expected value with sample information)
+ (cost of information) – (expected value without
sample information)
3-12. The expect value of sample information (EVSI) and the expected value of perfect
information (EVPI) are calculated. The ratio EVSI/EVPI is calculated and multiplied by 100%
to get the efficiency of sample information.
3-13. The overall purpose of utility theory is to incorporate a decision maker’s preference for
risk in the decision-making process.
3-14. A utility function can be assessed in a number of different ways. A common way is to use
a standard gamble. With a standard gamble, the best outcome is assigned a utility of 1, and the
worst outcome is assigned a utility of 0. Then, intermediate outcomes are selected and the
decision maker is given a choice between having the intermediate outcome for sure and a gamble
involving the best and worst outcomes. The probability that makes the decision maker indifferent
between having the intermediate outcome for sure and a gamble involving the best and worst
outcomes is determined. This probability then becomes the utility of the intermediate value. This
process is continued until utility values for all economic consequences are determined. These
utility values are then placed on a utility curve.
3-15. When a utility curve is to be used in the decision-making process, utility values from the
utility curve replace all monetary values at the terminal branches in a decision tree or in the body
of a decision table. Then, expected utilities are determined in the same way as expected
monetary values. The alternative with the highest expected utility is selected as the best decision.
3-16. A risk seeker is a decision maker who enjoys and seeks out risk. A risk avoider is a
decision maker who avoids risk even if the potential economic payoff is higher. The utility curve
for a risk seeker increases at an increasing rate. The utility curve for a risk avoider increases at a
decreasing rate.
3-17. a. Decision making under uncertainty.
b. Maximax criterion.
c. Sub 100 because the maximum payoff for this is $300,000.
Row Row
Equipment Favorable Unfavorable Maximum Minimum
Sub 100 300,000 –200,000 300,000 –200,000
Oiler J 250,000 –100,000 250,000 –100,000
Texan 75,000 –18,000 75,000 –18,000
3-18. Using the maximin criterion, the best alternative is the Texan (see table above) because the
worst payoff for this ($–18,000) is better than the worst payoffs for the other decisions.
3-19. a. Decision making under risk—maximize expected monetary value.
b. EMV (Sub 100) = 0.7(300,000) + 0.3(–200,000)
= 150,000
EMV (Oiler J) = 0.7(250,000) + 0.3(–100,000)
= 145,000
EMV (Texan) = 0.7(75,000) + 0.3(–18,000)
= 47,100
Optimal decision: Sub 100.
c. Ken would change decision if EMV(Sub 100) is less than the next best EMV, which is
$145,000. Let X = payoff for Sub 100 in favorable market.
(0.7)(X) + (0.3)(–200,000) 145,000
0.7X 145,000 + 60,000 = 205,000
X (205,000)/0.7 = 292,857.14
The decision would change if this payoff were less than 292,857.14, so it would have to decrease
by about $7,143.
3-20. a. The expected value (EV) is computed for each alternative.
EV(stock market) = 0.5(80,000) + 0.5(–20,000) = 30,000
EV(Bonds) = 0.5(30,000) + 0.5(20,000) = 25,000
EV(CDs) = 0.5(23,000) + 0.5(23,000) = 23,000
Therefore, he should invest in the stock market.
b. EVPI = EV(with perfect information)
– (Maximum EV without P, I)
= [0.5(80,000) + 0.5(23,000)] – 30,000
= 51,500 – 30,000 = 21,500
Thus, the most that should be paid is $21,500.
3-21. The opportunity loss table is
Alternative Good Economy Poor Economy
Stock Market 0 43,000
Bonds 50,000 3,000
CDs 57,000 0
b. Stock 11 cases.
c. If no loss is involved in excess stock, the recommended course of action is to stock 13
cases and to replenish stock to this level each week. This follows from the following
decision table.
Stock Demand
(Cases) (Cases) 11 12 13 EMV
11 385 385 385 385
12 385 420 420 404.25
13 385 420 455 411.25
3-26.
Manufacture Demand
(Cases) (Cases) 6 7 8 9 EMV
6 300 300 300 300 300
7 255 350 350 350 340.5
8 210 305 400 400 352.5
9 165 260 355 450 317
Probabilities 0.1 0.3 0.5 0.1
MARKET MINIMAX
Decision Good Fair Poor Row
Alternatives Market Market Market Maximum
Small 250 10 0 250
Medium 220 0 10 220
Large 200 0 30 200
Very Large 0 5 150 150
3-29. Note this problem is based on costs, so the minimum values are the best.
a. For a 3-year lease, there are 36 months of payments.
Option 1 total monthly payments: 36($330) = $11,880
Option 2 total monthly payments: 36($380) = $13,680
Option 3 total monthly payments: 36($430) = $15,480
Excess mileage costs based on 36,000 mileage allowance for Option 1, 45,000 for Option 2, and
54,000 for option 3.
Option 1 excess mileage cost if 45,000 miles are driven = (45000 – 36000)(0.35) = 3150
Option 1 excess mileage cost if 54,000 miles are driven = (54000 – 36000)(0.35) = 6300
Option 2 excess mileage cost if 54,000 miles are driven = (54000 – 45000)(0.25) = 2250
The total cost for each option in each state of nature is obtained by adding the total monthly
payment cost to the excess mileage cost.
Total cost table
Lease option 36000 miles driven 45000 miles driven 54000 miles driven
Option 1 11,880 15030 18180
Option 2 13,680 13680 15930
Option 3 15,480 15480 15480
b. Optimistic decision: Option 1 because the best (minimum) payoff (cost) for this is 11,800
which is better (lower) than the best payoff for each of the others.
c. Pessimistic decision: Option 3 because the worst (maximum) payoff (cost) for this is 15,480 is
better (lower) than the worst payoff for each of the others.
d. Select Option 2.
EMV(Option 1) = 11,880(0.4) + 15,030(0.3) + 18,180(0.3) = 14,715
EMV(Option 2) = 13,680(0.4) + 13,680(0.3) + 15,930(0.3) = 14,355
EMV(Option 3) = 15,480(0.4) + 15,480 (0.3) + 15,480(0.3) = 15,480
(e) EVPI for a minimization problem = (Best EMV without PI) - (EV with PI)
EV with PI = 11,880(0.4) + 13,680(0.3) + 15,480(0.3) = 13,500
EVPI = 14,355 – 13,500 = 855
3-30. Note that this is a minimization problem, so the opportunity loss is based on the lowest
(best) cost in each state of nature.
Opportunity loss table
Lease option 36000 miles driven 45000 miles driven 54000 miles driven
Option 1 11880 – 11880 = 0 15030 - 13680 = 1350 18180 - 15480 = 2700
Option 2 13680 – 11880 = 1800 13680 - 13680 = 0 15930 - 15480 = 450
Option 3 15480 – 11880 = 3600 15480 - 13680 = 1800 15480 - 15480 = 0
The maximum regrets are 2700 for option 1, 1800 for option 2, and 3600 for option 3. Option 2
is selected because 1800 is lower than the other maximums.
EOL(option 1) = 0(0.4) + 1350(0.3) + 2700(0.3) = 1215
EOL(option 2) = 1800(0.4) + 0(0.3) + 450(0.3) = 855
EOL(option 3) = 3600(0.4) + 1800(0.3) + 0(0.3) = 1980
Option 2 has the lowest EOL, so this alternative is selected based on the EOL criterion.
3-31. a. P(red) = 18/38; P(not red) = 20/38
b. EMV = Expected win = 10(18/38) + (-10)(20/38) = -0.526
c. P(red) = 18/37; P(not red) = 19/37
EMV = Expected win = 10(18/37) + (-10)(19/37) = -0.270
d. The enjoyment of playing the game and possibly winning adds utility to the game. A person
would play this game because the expected utility of playing the game is positive even though
the expected monetary value is negative.
3-32. A $10 bet on number 7 would pay 35($10) = 350 if the number 7 is the winner.
P(number 7) = 1/38; P(not seven) = 37/38
EMV = Expected win = 350(1/38) + (-10)(37/38) = -0.526
3-33. Payoff table with cost of $50,000 in legal fees deducted if suit goes to court and $10,000 in
legal fees if settle.
Win big Win small Lose EMV
Go to court 250000 0 -50000 85000
Settle 65000 65000 65000 65000
Prob. 0.4 0.3 0.3
Decision based on EMV: Go to court
3-34. EMV for node 1 = 0.5(100,000) + 0.5(–40,000) = $30,000. Choose the highest EMV,
therefore construct the clinic.
3-35. a.
b. EMV(node 2) = (0.82)($95,000) + (0.18)(–$45,000)
= 77,900 – 8,100 = $69,800
EMV(node 3) = (0.11)($95,000) + (0.89)(–$45,000)
= 10,450 – $40,050 = –$29,600
EMV(node 4) = $30,000
EMV(node 1) = (0.55)($69,800) + (0.45)(–$5,000)
= 38,390 – 2,250 = $36,140
The EMV for using the survey = $36,140.
EMV(no survey) = (0.5)($100,000) + (0.5)(–$40,000)
= $30,000
The survey should be used.
c. EVSI = ($36,140 + $5,000) – $30,000 = $11,140.
Thus, the physicians would pay up to $11,140 for the survey.
3-36.
3-37.
a. EMV(node 2) = (0.9)(55,000) + (0.1)(–$45,000)
= 49,500 – 4,500 = $45,000
EMV(node 3) = (0.9)(25,000) + (0.1)(–15,000)
= 22,500 – 1,500 = $21,000
EMV(node 4) = (0.12)(55,000) + (0.88)(–45,000)
= 6,600 – 39,600 = –$33,000
EMV(node 5) = (0.12)(25,000) + (0.88)(–15,000)
= 3,000 – 13,200 = –$10,200
EMV(node 6) = (0.5)(60,000) + (0.5)(–40,000)
= 30,000 – 20,000 = $10,000
EMV(node 7) = (0.5)(30,000) + (0.5)(–10,000)
= 15,000 – 5,000 = $10,000
EMV(node 1) = (0.6)(45,000) + (0.4)(–5,000)
= 27,000 – 2,000 = $25,000
Since EMV(market survey) > EMV(no survey), Jerry should conduct the survey. Since EMV(large
shop | favorable survey) is larger than both EMV(small shop | favorable survey) and EMV(no shop
| favorable survey), Jerry should build a large shop if the survey is favorable. If the survey is
unfavorable, Jerry should build nothing since EMV(no shop | unfavorable survey) is larger than
both EMV(large shop | unfavorable survey) and EMV(small shop | unfavorable survey).
change his decision. Jerry’s decision is not very sensitive to this probability value.
3-38.
A1: gather more information
A2: do not gather more information
A3: build quadplex
A4: build duplex
A5: do nothing
EMV(node 2) = 0.9(12,000) + 0.1(–23,000) = 8,500
EMV(node 3) = 0.9(2,000) + 0.1(–13,000) = 500
EMV(get information and then do nothing) = –3,000
EMV(node 4) = 0.4(12,000) + 0.6(–23,000) = –9,000
EMV(node 5) = 0.4(2,000) + 0.6(–13,000) = –7,000
EMV(get information and then do nothing) = –3,000
EMV(node 1) = 0.5(8,500) + 0.5(-3,000) = 2,750
EMV(build quadplex) = 0.7(15,000) + 0.3(–20,000) = 4,500
EMV(build duplex) = 0.7(5,000) + 0.3(–10,000) = 500
EMV(do nothing) = 0
Decisions: do not gather information; build quadplex.
3-39. I1: favorable research or information
I2: unfavorable research
S1: store successful
S2: store unsuccessful
P(S1) = 0.5; P(S2) = 0.5
P(I1 | S1) = 0.8; P(I2 | S1) = 0.2
P(I1 | S2) = 0.3; P(I2 | S2) = 0.7
a. P(successful store | favorable research) = P(S1 | I1)
P I1 S1 P S1
P S1 I1
P I1 S1 P S1 P I1 S 2 P S 2
0.8 0.5
P S1 I1 0.73
0.8 0.5 0.3 0.5
b. P(successful store | unfavorable research) = P(S1 | I2)
P I 2 S1 P S1
P S1 I 2
P I 2 S1 P S1 P I 2 S 2 P S 2
0.2 0.5
P S1 I 2 0.22
0.2 0.5 0.7 0.5
c. Now P(S1) = 0.6 and P(S2) = 0.4
0.8 0.6
P S1 I1 0.8
0.8 0.6 0.3 0.4
0.2 0.6
P S1 I 2 0.3
0.2 0.6 0.7 0.4
3-40. I1: favorable survey or information
I2: unfavorable survey
S1: facility successful
S2: facility unsuccessful
P(S1) = 0.3; P(S2) = 0.7
P(I1 | S1) = 0.8; P(I2 | S1) = 0.2
P(I1 | S2) = 0.3; P(I2 | S2) = 0.7
P(successful facility | favorable survey) = P(S1 | I1)
P I1 S1 P S1
P S1 I1
P I1 S1 P S1 P I1 S 2 P S 2
0.8 0.3
P S1 I1 0.533
0.8 0.3 0.3 0.7
P(successful facility | unfavorable survey) = P(S1 | I2)
P I 2 S1 P S1
P S1 I 2
P I 2 S1 P S1 P I 2 S 2 P S 2
0.2 0.3
P S1 I 2 0.109
0.2 0.3 0.7 0.7
3-41. a.
3-49. Selling price = $20 per gallon; manufacturing cost = $12 per gallon; salvage value = $13;
handling costs = $1 per gallon; and advertising costs = $3 per gallon. From this information, we
get:
marginal profit = selling price minus the manufacturing, handling, and advertising costs
marginal profit = $20 – $12 – $1 – $3 = $4 per gallon
If more is produced than is needed, a marginal loss is incurred.
marginal loss = $13 – $12 – $1 – $3 = $3 per gallon
In addition, there is also a shortage cost. Coren has agreed to fulfill any demand that cannot be
met internally. This requires that Coren purchase chemicals from an outside company. Because
the cost of obtaining the chemical from the outside company is $25 and the price charged by
Coren is $20, this results in
shortage cost = $5 per gallon
In other words, Coren will lose $5 for every gallon that is sold that has to be purchased from an
outside company due to a shortage.
a. A decision tree is provided:
b. The computations are shown in the following table. These numbers are entered into the tree
above. The best decision is to stock 1,500 gallons.
Table for Problem 3-49
Demand
Stock 500 1,000 1,500 2,000 EMV
500 2,000 –500 –3,000 –5,500 –$1,500
1,000 500 4,000 1,500 –1,000 $1,800
1,500 –1,000 2,500 6,000 3,500 $3,300
2,000 –2,500 1,000 4,500 8,000 $2,400
Maximum 2,000 4,000 6,000 8,000 $4,800 = EVwPI
Probabilities 0.2 0.3 0.4 0.1
When survey results are low, the probabilities are P(L) = 0.339; P(M) = 0.516; and P(H) =
0.145. This results in EMV(Small) = 450,000; EMV(Medium) = 495,000; and EMV(Large) =
233,600.
When survey results are medium, the probabilities are P(L) = 0.082; P(M) = 0.548; and P(H)
= 0.370. This results in EMV (Small) = 450,000; EMV(Medium) = 646,000; and EMV(Large) =
522,800.
When survey results are high, the probabilities are P(L) = 0.046; P(M) = 0.123; and P(H) =
0.831. This results in EMV(Small) = 450,000; EMV(Medium) = 710,100; and EMV(Large) =
821,000.
If the survey results are low, the best decision is to build the medium facility with an
expected return of $495,000. If the survey results are medium, the best decision is also to build
the medium plant with an expected return of $646,000. On the other hand, if the survey results
are high, the best decision is to build the large facility with an expected monetary value of
$821,000. The expected value of using the survey is computed as follows:
EMV(with Survey) = 0.310(495,000) + 0.365(646,000)
+ 0.325(821,000) = 656,065
Because the expected monetary value for not conducting the survey is greater (670,000), the
decision is not to conduct the survey and to build the medium-sized facility.
3-51. a.
3-53. a. The decision table for Chris Dunphy along with the expected profits or expected
monetary values (EMVs) for each alternative are shown on the next page.
Table for Problem 3-53a
Return in $1,000
NO. OF WATCHES
EVENT 1 EVENT 2 EVENT 3 EVENT 4 EVENT 5
Probability 0.10 0.20 0.50 0.10 0.10 Expected
Profit
100,000 100 110 120 135 140 119.5
150,000 90 120 140 155 170 135.5
200,000 85 110 135 160 175 131.5
250,000 80 120 155 170 180 144.5
300,000 65 100 155 180 195 141.5
350,000 50 100 160 190 210 145
400,000 45 95 170 200 230 151.5
450,000 30 90 165 230 245 151
500,000 20 85 160 270 295 155.5
b. For this decision problem, Alternative 9, stocking 500,000, gives the highest expected
profit of $155,500.
c. The expected value with perfect information is $175,500, and the expected value of perfect
information (EVPI) is $20,000.
d. The new probability estimates will give more emphasis to event 2 and less to event 5. The
overall impact is shown below. As you can see, stocking 400,000 watches is now the best
decision with an expected value of $140,700.
Return in $1,000:
NO. OF WATCHES
EVENT 1 EVENT 2 EVENT 3 EVENT 4 EVENT 5
Probability 0.100 0.280 0.500 0.100 0.020 Expected Profit
100,000 100 110 120 135 140 117.1
150,000 90 120 140 155 170 131.5
200,000 85 110 135 160 175 126.3
250,000 80 120 155 170 180 139.7
300,000 65 100 155 180 195 133.9
350,000 50 100 160 190 210 136.2
400,000 45 95 170 200 230 140.7
450,000 30 90 165 230 245 138.6
500,000 20 85 160 270 295 138.7
3-57. a. EMV can be used to determine the best strategy to minimize costs. The QM for
Windows solution is provided. The best decision is to go with the partial service
(maintenance) agreement.
Solution to 3-57a
Probabilities 0.2 0.8
Maint. No Maint. Expected Row Row
Cost ($) Cost ($) Value Minimum Maximum
($) ($) ($)
No Service Agreement 3,000 0 600 0 3,000
Partial Service Agreement 1,500 300 540 0 1,500
Complete Service 500 500 500 500 500
Agreement
Column best 500 0 500
The minimum expected monetary value is $500 given by Complete Service Agreement
b. The new probability estimates dramatically change Sim’s expected values (costs). The
best decision given this new information is to still go with the complete service or
maintenance policy with an expected cost of $500. The results are shown in the table.
Solution to 3-57b
Probabilities 0.8 0.2
Does Not Expected
Needs Repair Need Repair Value
($) ($) ($)
No Service Agreement 3,000 0 2,400
Partial Service Agreement 1,500 300 1,260
Complete Service 500 500 500
Agreement
Column best 500
3-58. We can use QM for Windows to solve this decision making under uncertainty problem.
We have shown probability values for the equally likely calculations. As you can see, the
maximax decision is Option 4 based on the $30,000, and the maximin decision is Option 1 based
on the 5,000. As seen in the table, the equally likely decision is Option 3 because the average
value for this is $5750.
Solution to 3-58
Prob. 0.25 0.25 0.25 0.25
Judge Trial Court Arbitration Equally Row Row
Likely Min. Max.
Option 1 5,000 5,000 5,000 5,000 5,000 5,000 5,000
Option 2 10,000 5,000 2,000 0 4,250 0 10,000
Option 3 20,000 7,000 1,000 –5,000 5,750 –5,000 20,000
Option 4 30,000 15,000 –10,000 –20,000 3,750 –20,000 30,000
Column best 5,750 5,000 30,000