Decision Theory

Chapter 5 Supplement

State whether the following questions are True or False

1. Among decision environments, risk implies that certain parameters have

probabilistic outcomes.  True
2. Among decision environments, uncertainty implies that states of nature have wide
ranging probabilities associated with them. False
3. In decision theory, states of nature refer to possible future conditions.  True
4. The maximax approach is a pessimistic strategy. False
5. The expected value approach applies to decision-making under uncertainty.  False
6. Decision Making is the process of selecting one alternative managerial action
from among several under specific decision making environment. True
7. The Laplace criterion treats states of nature as being equally likely.  True
8. The expected monetary value approach is most appropriate when the decision-
maker is risk-neutral.  True
9. An advantage of decision trees compared to payoff tables is that they permit us to
analyze situations involving sequential decisions. True
10. The EVPI indicates an upper limit on the amount a decision-maker should be
willing to spend to obtain additional information.  True

Choose the correct answer:

1. Which of the following characterizes decision-making under uncertainty? 

a. Decision-makers must rely on probabilities in assessing outcomes.
b. The likelihood of possible future events is unknown.
c. Relevant parameters have known values.
d. Certain parameters have probabilistic outcomes.
e. none of the above
2. Which of the following is not an approach for decision-making under
uncertainty? 
a. Decision trees
b. Maximin
c. Maximax
d. Minimax regret
e. Laplace

3. Determining the worst payoff for each alternative and choosing the alternative
with the "best worst" is the approach called: 
a. Minimin
b. Maximin
c. Maximax
d. Minimax regret
e. Laplace

4. Determining the average payoff for each alternative and choosing the alternative
with the highest average is the approach called: 
a. Minimin
b. Maximin
c. Maximax
d. Minimax regret
e. Laplace

5. The term opportunity loss or regret is most closely associated with: 

a. Minimax regret
b. Maximax
c. Maximin
d. Expected monetary value
e. Laplace

6. The expected monetary value criterion (EMV) is the decision-making approach

used with the decision environment of: 
a. certainty
b. risk
c. uncertainty
d.  all of the above
e. none of the above
7. The method of financial analysis which results in an equivalent interest rate is: 
A. payback
B. net present value
C. internal rate of return
D. queuing
E. cost-volume

8. The method of financial analysis which focuses on the length of time it takes to
recover the initial cost of an investment is: 
A. payback
B. net present value
C. internal rate of return
D. queuing
E. cost-volume

9. A decision tree is: 

A. an algebraic representation of alternatives
B. a behavioral representation of alternatives
C. a matrix representation of alternatives
D. a schematic representation of alternatives
E. limited to a maximum of 12 branches
 Problem (1)

Use the following payoff table to

1. Determine the alternative that will be chosen under each of the following criteria:

a. Alternativ Low Med High a. Maximin b. Maximac. Laplace Minimax

Maximin e x
b.
A $ 50 $ 60 $ 80 50 80 63.3
Maximax
B $ 20 $ 80 $ 100 20 100 66.6
C $ 40 $ 70 $ 110 40 110 73.3
c. Laplace

d. Minimax regret

The numbers represent profits

2. See the previous problem; P (low)=0.2, P(Moderate)=0.5, P(High)=0.3. which

alternative will yield the maximum expected value

3. Construct a decision tree for this problem

4. Determine the expected value of perfect information using 2 methods

Problem (2)

A manager has developed the following payoff table that indicates the profits associated
with a set of alternatives under two possible states of nature.

(A) If the manager uses maximin as the decision criterion, which of the alternatives
would be indicated?
(B) If the manager uses minimax regret as the criterion, which alternative would be
indicated?
(C) Determine the expected value of perfect information if P(S2) = .40.
(D) Determine the range of P(S2) for which each alternative would be optimal. 
Problem (3)
The director of social services of a county has learned that the state has mandated
additional information requirements. This will place an additional burden on the agency.
The director has identified three acceptable alternatives to handle the increased workload.
One alternative is to reassign present staff members, the second is to hire and train two
new workers, and the third is to redesign current practice so that workers can readily
collect the information with little additional effort. An unknown factor is the caseload for
the coming year when the new data will be collected on a trial basis. The estimated costs
for various options and caseloads are shown in the following table:

Caseload
Alternatives
Moderate High Very high
Reassign Present Staff 60* 70 95
Hire And Train Two New Workers 70 70 70
Redesign Current Practice 50 60 100
*Costs in $ thousands.

Assume that past experience has shown the probabilities of various caseloads to
be unreliable.

1. What decision would be appropriate under uncertainty, using each of the

following criteria?
A. Maximin.
B. Maximax.
C. Laplace.
D. Minimax regret.

2. If the probabilities of the caseload are 15% for moderate, 35% for high and 50%
for very high. Which alternative will yield the maximum expected monetary
value?

3. Draw the Decision Tree for this problem

Problem (4)
A manager has compiled estimated profits for various capacity alternatives but is
reluctant to assign probabilities to the states of nature. The payoff table is as follows:
State of Nature
#1 #2
A 20* 140
Alternatives B 120 80
C 100 40
*Profit in thousands

a. Plot the expected-value lines on a graph.

b. Is there any alternative that would never be appropriate in terms of maximizing
expected profit?
c. For what range of P(2) would alternative A be the best choice if the goal is to
maximize expected profit?
d. For what range of P(1) would alternative A be the best choice if the goal is to
maximize expected profit?

a. Payoff Payoff
#1 #2

140
120 B A
100
C B
80
C
A
40

0 1.0
P(#2)

b. Alternative C is lower than Alternative B for all values of P(#2), so it would never be
appropriate.
c. EVB = 120 – 40P; EVA = 20 + 120P. Solving, P = .625.
Therefore, choose Alternative A if P(#2) is greater than .625.
d. For P(#1), choose Alternative A, if P(#1) is less than .375 (i.e., 1.000 – .625).
Problem (5)
Repeat all parts of problem 4, assuming the values in the payoff table are estimated costs
and the goal is to minimize expected costs.
a. [Refer to the diagram in the previous solution]
b. Alternative B is now the one that is never appropriate.
c. EVA = 20 + 120P; EV= 100 – 60P. Solving, P = .444.
Therefore, choose Alternative A for P(#2) less than .444, and choose Alternative C for
P(#2) greater than .444.
d. In terms of P(#1), choose A for P(#1) greater than .556 and C for P(#1) less than .556.