Homework Assignment 1

DSME 4020B Decision Modelling and Analytics

Assigned Date: 20-1-2022
Due Date: 10-2-2022

Problem 1
The manager of the greeting card section of Mazey’s department store is considering her
order for a particular line of Christmas cards. The cost for each box of cards is $3; each box
will be sold for $6 during the Christmas season. After Christmas, the leftover cards will be
sold for $2 a box. The card section manager believes that all leftover cards can be sold at
that price. The estimated demand during the Christmas season for the line of Christmas
cards, with associated probabilities, is shown as follows.

Demand (boxes) Probability

25 .25
27 .30
29 .35
30 .10

a. If the manager orders x boxes and the demand during Christmas turns out to be d boxes
(where d may be greater or smaller than x), what will the resulting profit be?
b. How many (reasonable) alternatives does Mazey’s have? Develop the payoff table for
this decision situation.
c. Compute the expected value for each alternative, and identify the best decision.
d. Compute the expected value of perfect information.

Problem 2 Explain what utility is and how to use the utility function of a decision maker to
check his or her risk attitude. Do some research yourself on how to obtain a utility function of a
decision maker.

Problem 3 Textbook Chapter 13, problem 3

JR Davidson recently started a practice in Landscape Design and is considering the
purchase of an automated drafting system. JR can purchase a system with three possible
drafting capacities. The payoffs for having any of these systems depend on the demand for
drafting services over the next few years. The costs for each system are shown as follows
along with JR’s assessment of the probabilities that demand will match the capacity of
 each one:

Total Cost Probability

Small system $10,000 0.4

Medium system $14,000 0.3
Large system $20,000 0.3

Working at capacity, each system would generate net cash flow at a yearly rate of 50
percent of its total cost. If a system is chosen that is smaller than demand, it would work
at capacity. If a system is chosen that is larger than demand, revenue from the system
would be limited by demand. For convenience, JR has initially decided to count cash
flow for three years, without discounting. For example, if JR chooses the Medium system
and demand is Small, then the profit is calculated as follows:

Profit = 3(0.5×10,000) - 14,000 = $1,000

a. What is the best decision under the maximax criterion?

b. What is the best decision under the maximin criterion?
c. What is the best decision under the minimax regret criterion?
d. What is the best decision under the expected payoff criterion?
e. Reviewing the analysis, JR decides that the assumption of a 3-year horizon is too
restrictive. Instead, it makes more sense to treat the horizon as uncertain, with the
following probability distribution:

Two years of cash flow has 0.4 probability.

Three years of cash flow has 0.4 probability.
Four years of cash flow has 0.2 probability.

Now, what is the best decision under the expected payoff criterion?

Problem 4 Textbook Chapter 13, problem 8

8. Delta Electric Service is an electrical-utility company serving parts of several states. It is

considering replacing some of its equipment at generating substations and is trying to decide
whether it should replace an older, existing PCB transformer. (PCB is a toxic chemical
formally known as polychlorinated biphenyl.) Although the PCB generator meets all current
regulations, if an incident such as a fire were to occur, and PCB contamination caused harm
either to neighboring businesses or farms, or to the environment, the company would be
liable for damages. Recent court cases have shown that simply meeting regulations does not
relieve a utility of liability if an incident causes harm to others. In addition, courts have been
awarding very large damages to individuals and businesses harmed by incidents involving
hazardous material.

If Delta replaces the PCB transformer, no PCB incidents will occur, and the only cost will be
the cost of the new transformer, estimated to be $85,000. Alternatively, if the company elects
to keep the existing PCB transformer in operation, then, according to their consultants, there is
a 50/50 chance that there will be a high likelihood of an incident or a low likelihood of an
incident. For the case of a high likelihood of an incident, there is also a 0.004 probability that a
fire will occur sometime during the remaining life of the transformer, and a 0.996 probability
that no fire will occur. If a fire occurs, there is a 20 percent chance that it will be severe and the
utility will incur a very high cost, whereas there is an 80 percent chance that it will be minor
and the utility will incur a low cost. The high- and low-cost amounts, including both cleanup
and damages, are estimated to be $100 million and $10 million, respectively, based on results
from other incidents in the industry. For the case of a low likelihood of an incident, there is a
0.001 probability of a fire during the remaining life of the transformer, and a 0.999 probability
of no fire. If a fire does occur, then the same probabilities exist for the severe and minor
outcomes as in the previous case. In both cases, there will be no cost if no fire occurs.

a. Should Delta replace its old transformers?

b. What is the expected cost per transformer, under the optimal replacement strategy?

Problem 5 Textbook Chapter 13, problems 10-11

10. In early 1984, Pennzoil and Getty Oil agreed to the terms of a merger. Before any
formal documents could be signed, however, Texaco offered Getty Oil a substantially
better price,
so Gordon Getty, who controlled most of the Getty stock, reneged on the Pennzoil deal and sold
to Texaco. Naturally, Pennzoil felt as if it had been dealt with unfairly and filed a
lawsuit against Texaco alleging that Texaco had interfered illegally in the Pennzoil-Getty
negotiations. Pennzoil won the case; in late 1985, it was awarded $11.1 billion, the largest
judgment ever in the United States. A Texas appeals court reduced the judgment by $2 billion,
but interest and penalties drove the total back up to $10.3 billion. James Kinnear, Texaco’s
chief executive officer, had said that Texaco would file for bankruptcy if Pennzoil obtained
court permission to secure the judgment by filing liens against Texaco’s assets. Furthermore,
Kinnear had promised to fight the case all the way to the U.S. Supreme Court if necessary,
arguing in part that Pennzoil had not followed the Security and Exchange Commission’s
regulations in its negotiations with Getty. In April 1987, just before Pennzoil began to file the
liens, Texaco offered to pay Pennzoil $2 billion to settle the entire case. Hugh Liedtke,
chairman of Pennzoil, faced the choice of whether to accept the Texaco offer. His advisors
were telling him that a settlement of between $3 and $5 billion would be fair, so one of his
options was to make a counteroffer of $5 billion. If Liedtke were to counteroffer, assume
Texaco would be twice as likely to refuse as accept the $5 billion counteroffer. If Texaco
would refuse, the case would go to court, where the judge would award Pennzoil $10.3 billion,
or reduce the award to $5 billion, or award Pennzoil nothing. The probability that the judge
would award Pennzoil nothing is about 50 percent, while the other outcomes were thought to
be equally likely (25 percent probability).

a. What is the best decision for Liedtke, and what is his expected payoff?
b. What is the expected payoff if Pennzoil counteroffers and Texaco refuses? Why is
the expected payoff to the counteroffer higher than this?
c. Consider the probability that the judge would award Pennzoil nothing. How high would this
probability have to go before the best decision would be to accept the $2 billion offer?
(Assume that the probabilities of the other two outcomes are always equal.)

11. (Continuation of the previous problem) Liedtke’s advisors suggest that Texaco has more
options in the face of Pennzoil’s $5 billion counteroffer than simply to refuse or accept. In
particular, they might counteroffer, probably with an amount near $4 billion. Modify your
analysis to take this new possibility into account. Assume that Pennzoil will either accept or
refuse Texaco’s counteroffer of $4 billion. If it refuses, the case will go to court and the same
outcomes and probabilities apply as in the previous exercise. The probabilities that Texaco
accepts, refuses, or counteroffers can be assumed to be 1/3.

a. Now what is the best decision for Liedtke, and what payoff can he expect to receive from it?
Why does the expected value change in this case?
b. How sensitive is the overall expected value of this decision to the probability that Texaco
counteroffers $4 billion? (Assume the probabilities of Texaco accepting or refusing are equal.)
Construct a graph to relate the expected value of the decision to this probability.
c. How would your results change if you added a possible counteroffer of $3 billion?