Chapter 2 (Math)

Decision making rule

1. Maximin Decision Rule:
The decision maker should select the alternative that provides
the best of the worst possible outcomes. Maximize the
minimum possible outcome.
2. Minimax Regret Decision Rule:
This decision rule focuses on the opportunity loss associated
with a decision rather than on its worst possible outcome.
The decision maker should minimize the maximum possible
regret (opportunity loss) associated with a wrong decision after
the fact. Minimize the difference between possible outcomes
and the best outcome for each state of nature.
Ex-1
Requirement -1

Maximin decision rule-

The minimum possible outcome for project A is $ 4000
The minimum possible outcome for project B is $ 0

Therefore, by the maximin decision rule I may choose

project A because it provides best among the worst
possible outcome.
Requirement- 2
Minimax Regret decision rule
Calculation of opportunity loss

Event Project A Project B Maximum

return
Recession $4000-$4000=0 $4000-$0=$4000 $4000

Normal $5000-$5000=0 $5000-$5000=0 $5000

Boom $12000-$6000=$6000 $12000-$12000=0 $12000

Total $6000 $4000

Therefore, by the minimax regret decision rule, I may select

project B because it has less opportunity loss.
Ex 2-
If you have to make a decision between two scenarios, which
one will provide the greater potential payoff?
Scenario 1: Best case provides a 20% probability of making
Tk.200,000, Worst case provides a 15% probability of losing
Tk.20,000 and most likely case provides a 65% probability of
making Tk.75,000
Scenario 2: Best case provides a 15% probability of making
Tk.220,000, Worst case provides a 25% probability of making
Tk.15,000, and most likely case provides a 60% probability of
making Tk.45,000
Which scenario do you choose?
3. Mary is a manager of a gadget factory. Her factory has been
quite successful the past three years. She is wondering whether
or not it is a good idea to expand her factory this year. The cost
to expand her factory is $1.5M. If she does nothing and the
economy stays good and people continue to buy lots of gadgets
she expects $3M in revenue; while only $1M if the economy is
bad.
If she expands the factory, she expects to receive $6M if economy
is good and $2M if economy is bad.
She also assumes that there is a 40% chance of a good economy
and a 60% chance of a bad economy.
Now make a decision.
Ex - 3

Particulars Expand (Ex) Not expand (Nx) Probabilities

Good economy $6M $3M 0.40
Bad economy $2M $1M 0.60

Development cost for Expand= $1.5M

1. Expected Return Value- Where,

E(V) =∑ I X P I= Cash inflow /Return
P= Probabilities
= ( 6 X 0.40 ) + ( 2 X 0.60 )
= 3.6 – Development cost
= 3.6 -1.5
= $ 2.1 M
•
•
COV = 0.98
1.8
= 0.54

4. Variance-
SD = 2.47 = 6.1009

SD = 0.98 = 0.9604
Decision-
Marry may not choose to expand her factory because COV COV
SD SD although E (V) E(V)
5. Maximin decision rule-
The minimum possible outcome for expand is $ 2 M
The minimum possible outcome for not expand is $ 1 M

Therefore, by the maximin decision rule Marry may choose to

expand her factory because it provides best of the worst
possible outcome.
6. Minimax Regret decision rule
Calculation of opportunity loss

Particulars Expand Not Expand Maximum

return
Good Economy

Bad Economy

Total
Therefore, by the minimax regret decision rule, Marry may
select to expand her factory because it has no opportunity loss.
4. Your corporation has been presented with a new product
development proposal. The cost of the development project is BDT
500,000. The probability of successful development is projected to be
70%. If the development is unsuccessful, the project will be
terminated. If it is successful, the manufacturer must then decide
whether to begin manufacturing the product on a new production
line or a modified production line. If the demand for the new product
is high, the incremental revenue for a new production line is BDT
12,00,000, and the incremental revenue for the modified production
line is BDT 8,50,000. If the demand is low, the incremental revenue
for the new production line is BDT 7,00,000, and the incremental
revenue for the modified production line is BDT 720,000. All of these
incremental revenue values are gross figures, i.e., before subtracting
the BDT 5,00,000 development cost, BDT 3,00,000 for the new
production line and BDT 1,00,000 for the modified production line.
The probability of high demand is estimated as 40%, and of low
demand as 60%. Now make a decision.
Solution-

Particulars New production line (MPL ‘00000) Probability

(NPL ‘00000)
High demand 12 8.5 0.40

Low demand 7 7.2 0.60

Development cost for NPL= 5+3= 8

Development cost for MPL = 5+ 1= 6
Answer
E(V)NPL= 1
E(V)MPL= 1.72
SD of NPL= 8.37
SD of MPL= 6.03
COV of NPL = 8.37
COV of MPL = 3.51
SD of NPL = 70.06
SD of MPL = 36.36