OPERATIONS MANAGEMENT & ECONOMETRICS

MANAGERIAL DECISION MAKING (ECMT2630)

ASSIGNMENT 1, 2010

Issued: 26 March 2010

Submit date: Tuesday 13 April 2010 @ 5 pm
Submission –During lectures (not during tutorials) or in room 486, Merewether
Building.
All problems to be submitted for assessment (10%)
Please use appropriate cover sheet.

Question 1:
Gasco must determine whether or not to drill for natural gas in a new site in Western
Australia. It costs 100k dollars to drill for gas, and if gas is found, its value is estimated to
be 600k dollars. At present, Gasco believes that there is a 40% chance that the field
contains gas. Before drilling for gas, Gasco can hire (for a fixed fee of X dollars) a
geologist to obtain more information about the likelihood of the field containing gas.
There is a 45% chance that the geologist will issue a favorable report and a 55% chance
that the geologist will issue an unfavorable report. Given a favorable report, there is a
75% chance that the field contains gas. Given an unfavorable report, there is a 15%
chance that the field contains gas.
1. Describe the decision situation using a decision tree.
2. Determine Gasco’s optimal course of action as a function of the geologists wages,
X dollars. What is the EMV of the decision if X=$15k?

Question 2:
Microtel is competing against several software developing companies for a contract
worth 5M dollars with the Australian Armed Forces. Microtel may offer its product in its
current stage of development or invest in R&D in an attempt to offer a better product. If
the product is offered in its current form, there is a small probability ( p1 ) of winning the

contract. An investment of $1M in R&D will improve their product with a probability
of p2 . If the further investment is successful, the probability of winning the contract
increases and is p3 . On the other hand, if the further development is unsuccessful, the

probability of winning the contract remains p1 .

1. Draw a decision tree describing the problem Microtel is facing.

2. If p2 = 0.7 and p3 = 0.5 , for which value of p1 is Microtel indifferent between
investing in R&D and remaining with the existing product?
3. You have been given the following information: p3 = p2 = 2 p1 , and that the

option of attempting to improve the product by investing in R&D yields on

average $600k more than the option of pursuing the contract with the existing
product. Calculate the probabilities involved in the decision ( p1 , p2 , and p3 ).

Question 3:
Consider the following three portfolios:

Portfolio A Portfolio B Portfolio C

Probability Return Probability Return Probability Return
0.4 6% 0.1 10% 0.1 10%
0.3 8% 0.2 12% 0.1 14%
0.1 12% 0.1 16% 0.2 16%
0.1 14% 0.2 18% 0.2 18%
0.1 18% 0.4 20% 0.4 22%

Which is the preferred portfolio using (i) first-order stochastic dominance and (ii) second
order stochastic dominance?