DECISION THEORY EXERCISES

1. A revolutionary new process has been developed for the manufacture of golf balls. These golf
balls are packaged in sets of three, and the manufacturer will sell a package of golf balls to a
sporting goods wholesaler for $1.50. However, in order to become a distributor of these
revolutionary new golf balls, the wholesaler agrees to one of two promotional actions.
(a) Sell the package of golf balls for $2.50, agreeing to refund the entire purchase if one or more
of the golf balls is found to be defective.
(b) Sell the package of golf balls for $2.00, agreeing to refund $0.50 for each golf ball found to
be defective.
(1) Determine the loss table for this problem situation.
(2) The wholesaler has determined the following set of information related to the number
of defectives based upon testing 60 randomly selected test boxes.
Quality of Test States of Nature
Ball θ1: 0 defective θ2: 1 defective θ3: 2 defectives θ4: 3 defectives
Good 11 10 7 3
Bad 4 6 7 12
Total 15 16 14 15
Testing does not cost the wholesaler anything. A priori, wholesaler assumed that the
probabilities associated with states of nature were as follows:
P(θ1: 0 defective) = 0.25 P(θ3: 2 defectives) = 0.20
P(θ2: 1 defective) = 0.30 P(θ4: 3 defectives) = 0.25
(A) What is the optimal Bayes’ action before examining the test ball?
(B) What are the optimal Bayes’ actions given the two measures of quality of test balls?
(C) What is the expected value of the optimal decision with the sample information?
(D) What are the EVSI and EVPI for this problem?
2. A trust officer for a major banking institution is planning the investment of a $1 million family
trust fund for the coming year. The trust officer has identified a portfolio of stocks and another
group of bonds that might be selected for investment. The family trust can be invested in stocks
or bonds exclusively, or a mix of the two. This trust officer prefers to divide the funds in
increments of 10%; that is, the family trust is split into the following alternatives:
(a) 100% stocks and 0% bonds (d) 70% stocks and 30% bonds
(b) 90% stocks and 10% bonds (e) 0% stocks and 100% bonds
(c) 80% stocks and 20% bonds
The trust officer has evaluated the relationship between the yields on the different investments
and the general economic conditions. Her judgment is as follows:
(1) If the next year is characterized by solid growth in the economy, bonds will yield 12% and
stocks 20%;
(2) If the next year is characterized by inflation, bonds will yield 18% and stocks 10%;
(3) If the next year is characterized by stagnation, bonds will yield 12% and stocks 8%.
(A) Constructs the payoff and the opportunity loss table.
(B) Determine the best decision using the maximax, maximin, Laplace, Hurwicz (α = 0.40)
and minimax regret criteria.
 (C) Suppose that a leading economic forecasting firm projects P(solid growth) = 0.40,
P(inflation) = 0.25 and P(stagnation) = 0.35. Use the expected value criterion to select
the appropriate strategy. What is the EVPI for this problem?
3. The Cactus Land Company owns 10,000 acres of land in southeastern Arizona that may contain
valuable uranium deposits. The company is faced with a decision whether to explore
extensively for uranium, to lease the land, or to sell the land. For each of these three
alternatives, three states of nature may exist: θ1, a large uranium deposit; θ2, a small uranium
deposit; θ3, no uranium deposit. The possible profits for the various alternatives and the
various states of nature are shown in the following table:

STATES OF NATURE
Decision Alternative θ1: Large Uranium Deposit θ2: Small Uranium Deposit θ3: No Uranium
Deposit
Explore extensively $10 M $4 M -$0.5 M
Lease land 5M 2M 0.75 M
Sell land 1M 1M 1M

The Cactus Land Company has made (prior) subjective estimates concerning the probabilities of finding
the various sizes of uranium deposits. These estimates are:
P (θ1: Large uranium deposit) = 0.3
P (θ2: Small uranium deposit) = 0.3
P (θ3: No uranium deposit) = 0.4

(a) What decision alternative should the Cactus Land Company choose, assuming that a Bayes’ decision
procedure without data is employed?
(b) The Cactus Land Company can have a geologic study made of its land holdings. This study will cost
$10,000 and will lead to four possible land classifications:
(1) Uranium deposits highly likely
(2) Uranium deposits possible
(3) Uranium deposits unlikely
(4) Uranium deposits virtually impossible
Based on previous studies of a similar nature, the following probability information is obtained:
STATES OF NATURE
Geologic Classification θ1: Large Uranium Deposit θ2: Small Uranium Deposit θ3: No Uranium
Deposit
Uranium deposits highly likely 0.60 0.30 0.10
Uranium deposits possible 0.20 0.50 0.10
Uranium deposits unlikely 0.10 0.10 0.10
Uranium deposits impossible 0.10 0.10 0.70

What are the optimal courses of action, given the various geologic classifications?
(c) What is the expected value of the optimal decision with the sample information?
(d) What is the EVSI for this problem?
(e) What is the EVPI for this problem?
(f) What is the efficiency of information for this problem? Efficiency is the ratio of EVSI to EVPI times
100%.

4. A hosiery company must make a pricing decision regarding its new line of stockings. Two
economists have been hired to develop forecasting equations that relate the quantity
demanded to the price of the stockings. The forecasting equations the economists derive are:
Economist 1: q = 10 - 2p
Economist 2: q = 16 - 4p
where q is the quantity demanded in units of 100,000 and p is the price in dollars. Four prices
are being considered: $0.99, $1.98, $2.75, and $3.50. Assume that one of the economists’
forecasting equations will be correct, but you do not know which one.

a) Construct the payoff and opportunity loss table.

b) Determine the best decision using the maximax, maximin, Laplace, Hurwicz (α = 0.70), and
Savage criteria.
c) If the company believes the forecasting equations have an equal probability of being
correct, which price should be charged according to the expected value criterion? What is
the EVPI?