Supplementary Chapter E — Decision Analysis

TRUE/FALSE

1. Making decisions in an emergency room of a hospital is an example of a decision analysis situation.

ANS: F PTS: 1

2. Decision analysis situations often have multiple objectives.

ANS: T PTS: 1

3. Risk is a form of uncertainty associated with an unexpected good or undesirable outcome.

ANS: F PTS: 1

4. A numerical value associated with a decision coupled with some event is called a decision tree.

ANS: F PTS: 1

5. For decisions repeated over-and-over again, managers can choose those based upon the expected pay-
off that might occur.

ANS: T PTS: 1

6. An aggressive or risk-taking approach to one-time decisions without probabilities is called maximin.

ANS: F PTS: 1

7. With some modification, the decision rules for one-time decisions without event probabilities can be
applied to situations where the payoff is cost.

ANS: T PTS: 1

8. The expected value of perfect information represents the maximum amount a company should be will-
ing to pay for any information about events, no matter how good it is.

ANS: T PTS: 1

9. The expected value concept weighs each payoff for an alternative in proportion to the likelihood that
the payoff will occur.

ANS: T PTS: 1

10. Managers don't often have the information necessary to find optimal solutions to business problems.

ANS: T PTS: 1

11. The expected value of a decision alternative cannot be negative.

ANS: F PTS: 1

OM3 Test Bank Supplementary Chapter E 1

12. The minimax regret approach is neither aggressive nor conservative.

ANS: T PTS: 1

MULTIPLE CHOICE

1. All of the following are characteristics of management decisions for which decision analysis tech-
niques apply except
a. They must be important

b. They are probably unique

c. They are usually deterministic

d. They are complex

ANS: C PTS: 1

2. Uncertainty refers to not knowing what will happen in the future. Which of the following least applies
to uncertainty?
a. Usually does not involve a sequence of decisions

b. Little or no data available

c. Some data is very expensive

d. Some data is time-consuming to obtain

ANS: A PTS: 1

3. ____ represent a future outcome that can occur after a decision is made that are not under the control
of the decision-maker.
a. Decision alternatives

b. Events

c. Payoffs

d. Probabilities

ANS: B PTS: 1

4. A conservative or risk-averse approach to one-time decisions without event probabilities is ____.

a. Maximax

b. Maximin

c. Minimax regrets

d. Expected value

ANS: B PTS: 1
5. Opportunity loss or ill-feeling that people often have after making a nonoptimal decision is best related
to
a. Maximax

b. Maximin

c. Minimax regrets

d. Expected value

ANS: C PTS: 1

6. Which of the following is best related to the expected value approach?

a. Best used for one-time decisions

b. Since there are many states of nature, the individual probabilities, when added, can be
greater than 1.0

c. It is an average

d. Probabilities are not appropriate

ANS: C PTS: 1

7. Regarding the concept of the expected value of perfect information,

a. Expected value of perfect information means knowing in advance what state of nature will
occur

b. Perfect information is easy to obtain

c. Expected value of perfect information is calculated by adding the expected payoff under
perfect information to the expected payoff of the optimal decision without perfect inform-
ation

d. It can be calculated without the use of probabilities

ANS: A PTS: 1

8. Considering decision trees, which of the following statements is not correct?

a. A decision tree is a graphical schematic of the logical order with which decisions are made
when events occur

b. Decision trees are useful for more complex business decisions

c. Working forward through the decision tree, the expected monetary value of each event
node is computed by first weighting possible payoffs by their changes of occurrence

d. Expected value calculations can be made directly on the tree to arrive at the best decision

ANS: C PTS: 1

9. The expected value criteria is a good tool if

a. The decision will be made only one time

OM3 Test Bank Supplementary Chapter E 3

 b. The decision will be made over-and-over again

c. The decision will be made under conditions of certainty

d. The decision has to be made quickly

ANS: B PTS: 1

10. A model that starts with the future-most point and moves toward the current time period is called a
____.
a. Payoff table

b. Maximax decision

c. Decision tree

d. Satisficing

ANS: C PTS: 1

11. Which of the following is not a similarity between a decision matrix and a decision tree?
a. Time

b. States of nature

c. Alternatives

d. Probabilities

ANS: A PTS: 1

12. Elements common to decision-making in all models do not include

a. Criteria

b. Knowledge about states of nature

c. Measures of benefit (profit or loss) to the decision-maker

d. Expected Value (EV)

ANS: D PTS: 1

13. The decision criterion, for a one-time decision without event probabilities, that is neither aggressive
nor conservative is
a. maximax

b. maximin

c. minimax regret

d. expected value

ANS: C PTS: 1
 SHORT ANSWER

1. Discuss the five characteristics of management decisions when decision analysis techniques should be
utilized.

ANS:
• They must be important

• They are probably unique

• They allow some time for study

• They are complex

• They involve uncertainty and risk

PTS: 1

2. Define the four major elements of a decision problem.

ANS:
• Decision alternatives represent the choices that a decision-maker can make.

• Events represent the future outcomes that can occur after a decision is made that are not
under the control of the decision-maker.

• A payoff is the numerical value associated with a decision, coupled with some event.

• In many decision problems, the probabilities of events can be estimated, either from his-
torical data or managerial judgment.

PTS: 1

3. Differentiate between uncertainty and risk.

ANS:
Uncertainty refers to not knowing what will happen in the future. Risk is the uncertainty associated
with an undesirable outcome, such as financial loss.

PTS: 1

4. Describe how the following criteria are applied to a decision problem in which the object is maximiza-
tion.
a. Maximax

b. Maximin

c. Minimax regrets

ANS:
a. For maximax, choose the decision with the largest payoff.

b. For maximin, choose the decision that maximizes the minimum payoff.

OM3 Test Bank Supplementary Chapter E 5

 c. For minimax regrets, compute the opportunity losses as the difference between the best
(largest) payoff and any other payoff for each event. Then minimize the maximum op-
portunity loss.

PTS: 1

5. Describe how the following criteria are applied to a decision problem in which the objective is minim-
ization.
a. Maximax

b. Maximin

c. Minimax regrets

ANS:
a. For maximax, choose the decision with the smallest payoff.

b. For maximin, choose the decision that minimizes the largest payoff.

c. For minimax regrets, compute the opportunity losses as the difference between the best
(smallest) payoff and any other payoff for each event. Then, minimize the maximum op-
portunity loss.

PTS: 1

6. In what type of situation would the expected monetary value criterion be useful? In what type situation
would it not be useful?

ANS:
Expected values are appropriate when repeated decisions are made. If the decision is a one-time de-
cision, then expected values are not appropriate.

PTS: 1

7. Explain the Expected Value of Perfect Information (EVPI) and how it helps a decision-maker.

ANS:
Perfect information means knowing in advance what state of nature will occur. Although perfect in-
formation is unattainable in practice, it is worth knowing how much the value of our decisions could
improve if such information was available. This is called the Expected Value of Perfect Information
(EVPI). EVPI is the difference between the expected payoff under perfect information and the expec-
ted payoff of the optimal decision without perfect information.

PTS: 1

8. Explain the structure and purpose of a decision tree.

ANS:
A decision tree is a schematic graphic of the logical order with which decisions are made and events
occur. Decision trees can be of substantial benefit in helping decision-makers to logically determine
what decisions need to be made and how to react to external forces such as competitor strategies or
economic changes beyond their control.

PTS: 1

OM3 Test Bank Supplementary Chapter E 7

 PROBLEM

1. A company is expanding its production capacity. The decision will depend upon whether the increase
in demand is low, medium or high. The company's choices for expansion are small, medium, large or
very large. The following table provides an estimate of profits over the next two years.

Demand Values

Decision Low (S1) Medium (S2) High (S3)

Small Expansion (d1) $5,000 $10,000 $10,000

Medium Expansion (d2) $2,000 $12,000 $14,000

Large Expansion (d3) −0− $6,000 $13,000

Very Large Expansion (d4) −$5,000 $8,000 $20,000

a. Which decision variable would be picked using maximax?

b. Which decision variable would be picked using maximin?
c. Which decision variable would be picked using minimax regrets criteria?
d. Suppose the decision-maker assigns the probability of low-demand as 0.2, medium-demand as 0.5
and high-demand as 0.3. Which decision variable would be picked using the expected value cri-
terion?

ANS:
a. d4
b. d1
c. d3
d. d2

PTS: 1

2. The following table shows cost payoffs for four decision variables and four states of nature.

S1 S2 S3 S4

d1 16 8 15 4

d2 12 12 10 6

d3 10 12 16 10

d4 9 14 20 12

a. Which decision variable would be selected using minimin criteria?

b. Remembering that the data represents cost, which decision variable would be selected using min-
imax?
c. Remembering that the data represents cost, which decision variable would be selected using min-
imax-regrets criteria.
d. Suppose the decision-maker assigns the probability for S1 = 0.10; S2 = 0.25; S3 = 0.45; and S4 =
 0.20, which decision variable would be picked using the expected value criterion?

ANS:
a. d1
b. d2
c. d2
d. d2

PTS: 1

3. In the following profit table, di represents decision variables and Si represents states of nature.

S1 S2 S3 S4

d1 15.00 15.00 15.00 15.00

d2 −10.00 − 5.00 25.00 25.00

d3 −35.00 0 40.00 60.00

d4 −60.00 −20.00 50.00 90.00

a. If management assigns probabilities as follows: S1 = 0.15; S2 = 0.25; S3 = 0.40; and S4 = 0.20, de-
termine the expected value for d2.
b. Determine the expected value for d3.
c. Assuming the largest expected value for a decision variable is 24.00, determine the value of per-
fect information.

ANS:
a. 12.25
b. 22.75
c. 20.00

PTS: 1

4. Jumbo James sells hotdogs out of a cart for $3.00 each. His cost to purchase and prepare the hotdog is
$1.15 each. He operates the small business with very few capital assets and has no place to store un-
sold hotdogs. For this reason, every evening he sells the unsold hotdogs to a local homeless shelter for
$0.50 each. Jumbo James will choose one of the following options as a standard stocking plan: d 1 =
100; d2 = 150; or d3 = 200 hot dogs. On any weekday, the demand for hot dogs and the probability of
selling them is estimated as follows:

Demand Per Day Probability

100 0.50

200 0.30

300 0.20

a. Determine the expected value if Jumbo James stocks 200 hot dogs every day.

OM3 Test Bank Supplementary Chapter E 9

 b. Determine the expected value if Jumbo James decides to stock 150 hot dogs every day.

ANS:
a. $227.50
b. $222.50

PTS: 1

5. Given the following table, calculate the expected value of perfect information.

Low Medium High Expected

Demand Demand Demand Value

Small d1 $400 $400 $400 $400

Medium d2 $100 $600 $600 $500

Large d3 −$300 $300 $900 $450

Probability 0.20 0.35 0.45

ANS:
$195

PTS: 1

6. A decision-maker has decided to expand her operations and become more efficient. Decision variable
d1 is to do nothing; d2 is a moderate expansion; and d3 is a major expansion.
 a. Determine the expected value of d2 if the states of nature are S1 = 0.25; S2 = 0.60; and S3 = 0.15.
b. Determine the expected value for d3 if the states of nature are S1 = 0.25; S2 = 0.60; and S3 = 0.15.

ANS:
a. $12,200
b. $9,200

PTS: 1

7. A regional fast-food restaurant is considering an expansion program. The major factor influencing the
success of such a program is the future level of interest rates. It is estimated that there is a 20 percent
chance that interest rates will increase by 2 percentage points, a 50 percent chance that they will re-
main the same, and a 30 percent chance that they will decrease by 2 percentage points. The alternatives
they are considering and possible payoffs are shown in the following table:

Rates Up Rates Rates Down

2 Percent Unchanged 2 Percent

Build 50 new places -$200,000 $50,000 $150,000

Build 25 new places -$115,000 $26,000 $ 80,000

Do nothing -$ 70,000 0 $ 5,000

OM3 Test Bank Supplementary Chapter E 11

 a. Using decision tree analysis, what is the expected value for building 50 new restaurants?
b. Using decision tree analysis, what is the expected value for building 25 new restaurants?
c. What is the action and corresponding EV for this overall decision tree problem?

ANS:
a. EV (A--50 restaurants) = .2(-200,000) + .5(50,000) + .3(150,000) = $30,000

b. EV (B--25 restaurants) = .2(-115,000) + .5(26,000) + .3(80,000) = $14,000

c. EV (C--do nothing) = .2(-70,000) + .5(0) + .3(5,000) = -$12,500

Decision 1 --choose between build 50, build 25, or do nothing
The company should build 50 restaurants; EV of $30,000

PTS: 1

8. A Pacific Northwest lumber company is considering the expansion of one of its mills. The question is
whether to do it now, or wait for one year and re-consider. If they expand now, the major factors of
importance are the state of the economy and the level of interest rates. The combination of these two
factors results in five possible situations. If they do not expand now, only the state of the economy is
important and three conditions characterize the possibilities. The following table summarizes the situ-
ation:

Expand Probabilities Revenues

very favorable .2 $80,000

favorable .2 $60,000

neutral .1 $20,000

unfavorable .3 -$20,000
 very unfavorable .2 -$30,000

Don't expand

expansion .2 $50,000

steady .5 $30,000

contraction .3 $10,000

a. Using decision tree analysis, what is the expected value for expanding?
b. Using decision tree analysis, what is the expected value for not expanding?
c. Based on expected value, what should the company’s decision(s) be?

ANS:
a. EV (A--Expand) = .2(80,000) + .2(60,000) + .1(20,000) +
.3(-20,000) + .2(-30,000) = $18,000

b. EV (B--Don't expand) = .2(50,000) + .5(30,000) + .3(10,000) = $28,000

c. Decision 1 -- choose between expand or don't expand

The company should not expand; EV of $28,000

PTS: 1

9. A major retail clothing store is considering whether to open a new store on the other side of town or
wait one year and then open the store. In the meantime, they have paid $10,000 for a one year option
on a building. If they open the store now it will cost $140,000 to refurbish it, but it will cost $160,000
if they wait one year. They expect sales to depend on the economy in the area at the time they open the
store. If they go ahead now, there is a 50% chance the economy will go up, 30% it will stay the same,
and 20% it will go down. They then expect the following returns: if the economy goes up $200,000;
stays the same $160,000; and goes down -$20,000.

If they wait one year, they can either open the store then or not open the store and let the option expire.
If the option expires, they will lose the $10,000. One year from now they expect there is a 40% chance
the economy will go up, 30% stay the same, and 30% go down. The returns they expect to get would
then be: if the economy goes up $180,000; stays the same $160,000; and goes down -$30,000.

OM3 Test Bank Supplementary Chapter E 13

 a. Using decision tree analysis, what is the expected value of opening the store now?
b. Using decision tree analysis, what is the expected value of waiting one year to open the store?
c. What should the company do and what is the expected value of that decision?

ANS:
a. EV (A--open now) = .5(200,000) + .3(160,000) + .2(-20,000) − 140,000 = $4,000

b. EV (B--open in one year) = .4(180,000) + .3(160,000) + . 3 (-30, 000) − 160, 000 = -$49,000

c. Decision 2--choose between open in one year or don't open and lose option;
Choose to not open
EV of -$10,000
Decision 1--choose between open store now or wait one year and lose option
The company should open the store now; EV of $4,000

PTS: 1

10. A chemical company is trying to decide whether to build a pilot plant now for a new chemical process
or to build the full plant now. If they build a pilot plant now, they could expand it later to a full plant or
license the plant to another company. It would cost them $2 million to build the pilot plant and another
$2 million later to expand it. If they build the full plant now it would cost $3.5 million to construct.
The returns they expect to get from the full production plant depend upon the market.

They estimate there is a 60% chance the market will be robust, a 30% chance it will remain stable, and
a 10% chance it will become stagnate. The returns are estimated to be $5 million if it is robust, $3 mil-
lion if it is stable, and $1 million if it is stagnate.

Before they expand the pilot plant, they plan to conduct a comprehensive study. Based on past experi-
ence, they expect the study to report a 60% chance of favorable outcome for expansion and a 40% un-
favorable chance. In either case they will have to decide whether to expand to a full plant or license the
pilot plant. If the report is favorable and they license it, they expect to get $3 million. However, if the
report is unfavorable and they license it, they will only get $1 million.

a. Using decision tree analysis, what is the expected value for building the full plant now?
b. Using decision tree analysis, what is the value of the decision on expanding the pilot plant assum-
 ing the report is favorable?
c. What should the company do and what is the expected value of that decision?

ANS:
a. EV (A--build full plant) = .6(5 mil) + .3(3 mil) + .1(1 mil) − 3.5 mil = $.5 million

b. Decision 3 (report favorable) -- choose between build full plant or license

EV (C--build full plant) = 4 mil − 2 mil = $2 million
License plant return = $3 million
Choose to license plant; EV of $3 million

c. Decision 2 (report unfavorable) -- choose between build full plant or license

EV (B--build full plant) = $2 million
License plant return = $1 million
Choose to build full plant; EV of $2 million
EV (D--report) = .6(3 mil) + .4(2 mil) − 2 mil = $.6 million
Decision 1 --choose between build full plant now or build pilot plant
Company should build pilot plant; EV of $600,000

PTS: 1

11. A paint company has three sources for buying bright red pigment for their paints: Vietnam, Taiwan, or
Thailand. Unfortunately, the pigment is made from a bush whose annual growth is heavily dependent
upon the amount of rainfall during the growing season. The tables below show probabilities and prices
for wet, dry and normal growing seasons:

Probabilities

Wet Dry Normal

Vietnam .5 .2 .3

Taiwan .6 .3 .1

Thailand .4 .4 .2

OM3 Test Bank Supplementary Chapter E 15

 Price/Pound ($)

Wet Dry Normal

Vietnam .95 1.10 1.00

Taiwan .85 1.20 .98

Thailand .90 1.15 1.05

a. Using decision tree analysis, what is the expected value (price) for Thailand?
b. What country should the company select and what is the expected value (price) associated with it?

ANS:
a. EV (Thailand) = .4(.90) + .4(1.15) + .2(l.05) = $1.03

b. EV (Vietnam) = .5(.95) + .2(l.10) + .3(1.00) = $.995

EV (Taiwan) = .6(.85) + .3(l.20) + .1(.98) = $.968
Select Taiwan since it has the lowest EV

PTS: 1