Lecture 9 – Applications of

Simulation Models
Decision Models and Optimization
Sumit Kunnumkal
Indian School of Business

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© Kunnumkal
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Outline
 Applications
 Bidding for a lemon
 Gambling: random walk

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Bidding for a lemon
 Suppose you are interested in buying a used car, and do
I have just the car for you! You will make me a single
take-it-or-leave-it offer, and there will be no re-
negotiation over the price of the car. Since I have used
and maintained the car for some time now, I know its
true value. You, however, do not know the true value of
the car, and you think it is normally distributed with a
mean of $500 and a standard deviation of $150. You will
make me an offer and I will accept it if it is higher than
the value of the car to me.

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Adapted from Professor Deshmukh's (Kellogg) lecture notes
Bidding for a lemon
 Suppose you are interested in buying a used car, and do
I have just the car for you! You will make me a single
take-it-or-leave-it offer, and there will be no re-
negotiation over the price of the car. Since I have used
and maintained the car for some time now, I know its
true value. You, however, do not know the true value of
the car, and you think it is normally distributed with a
mean of $500 and a standard deviation of $150. You will
make me an offer and I will accept it if it is higher than
the value of the car to me.
 From your perspective, what is the expected value of the car?
 Now fix the size of the offer you would like to make me, say
$400. What are the chances that I will accept it? If I do accept it,
what do you think is the true value of the car?
 If you were to make an offer of $400, what is the expected value
of the car to you net of what you will pay me?
 What offer should you make me? 4

Adapted from Professor Deshmukh's (Kellogg) lecture notes

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Bidding for a lemon
 Problem formulation
 Random variable (from the bidder’s perspective)
 T : random variable which denotes the true value of the car
 T is normal N(500, 1502)
 E(T) = $500
 Fix the size of the offer at $400
 What are the chances that I accept it?
 Prob(Accept offer of $400) = P(T · 400) = 0.2525
 What is the expected value of the car given that the offer has
been accepted?
 What is the expected surplus?

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Bidding for a lemon
 Expected value of car given that the offer of $400 is accepted can
be obtained analytically but…
 The distribution of T conditional on the offer of $400 being accepted
is NOT normal!
 Evaluate expectations using simulation

Prior Conditional distribution

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Bidding for a lemon
 Fix the size of the offer at $400 (Simulation approach)
 What is the input random variable? What do we simulate?

 What do we measure at the end of the simulation?

@Risk implementation:
Generate a sample of the True Value and pick those values which are
smaller than 400. Discard the values greater than 400.
Y (output) = IF True Value < Bid THEN True Value ELSE “Failed
Bid”

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Bidding for a lemon: Simulation
output
Expected value of the car given bid of $400 accepted

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Bidding for a lemon: Simulation
output
Expected surplus for a bid of $400. Sample mean = -23.73,
Sample std. dev. = 57.39, number of iterations = 1000

Surplus
-500.0 0.0
95.0% 5.0%
80%

70%

60%

50%

40%

30%

20%

10%

0%
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QC Bidding for a lemon: 95% CI
(2min)
Expected surplus for a bid of $400. Sample mean = -23.73,
Sample std. dev. = 57.39, number of iterations = 1000

Surplus
-500.0 0.0
What is a 95% CI for the
95.0% 5.0% expected surplus ?
80%

70% (a) [-20, -27]

60%
(b) [-500, 0]
(c) Cannot apply CI formula
50%
because distribution is
40% not normal
30%

20%

10%

0%
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Bidding for a lemon
 Fix the size of the offer at $400 (Simulation approach)

Simulation results (1000 trials)

Expected value given offer of $400 306.2
accepted

Expected consumer surplus -23.7

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Bidding for a lemon
 Suppose that your prior distribution on the value of the car is a
uniform distribution instead
 In particular, suppose that T~U[0,1000]
 Now, if your offer of $400 has been accepted, then the condtional
distribution of T is again uniform on [0,400]
 Can evaluate expectations analytically

f(t)
1/400
1/1000

f(t)

0 t 1000 0 t 400 1000

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Prior Conditional distribution

Bidding for a lemon
 Fix the size of the offer at $400 (Analytic approach, T~U[0,1000])
 What are the chances that I accept it?
 Prob(Accept offer of $400) = P(T< 400) = 400/1000 = 0.4
 If I do accept it, what do you think is the true value of the car?
 E(T | Accept offer of $400) = E(T | T< 400) = $200
 What is the expected value of the car to you net of what you will pay me?
 Let S be the random variable that denotes value of the car net of what you will pay me
 S = T – 400 if T< 400
0 if T> 400

 E(S) = E(T – 400 | T< 400) * Prob(T< 400) + 0* Prob(T > 400)= (200 – 400)*0.4 = -$80

1/400

f(t)

0 t 400 1000 15
Bidding for a lemon
 Fix the size of the offer at $400 (Simulation approach, T~U[0,1000])

Simulation results (1000 trials)

Expected value given offer of $400 193.7
accepted
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Expected consumer surplus -86.8

 Gambling: random walk
 A roulette wheel is divided into 38 slots: 18 black, 18 red and two
green. If we bet $1 on red, we will win an extra $1 if the randomly
tossed ball lands in a red slot; otherwise we lose the dollar that we bet.
A gambler regularly visits the casino. Each day he plays 100 games on
the roulette wheel.

 A company offers the gambler insurance that would limit the losses at
the end of a day to $10. How much should the gambler be willing to
pay for it?

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Adapted from Professor Deshmukh's (Kellogg) lecture notes
 Gambling: random walk
 The gambler plays 100 games in a day. Without the
insurance policy:
 How many games will he win on average?
 How much can he expect to have (in net) at the end of the day?
 What about the standard deviation of the net winnings at the end of
the day?
 What are the chances that he will not make any money at the end
of the day? What are the chances that he will lose more than ten
dollars at the end of the day?
 Suppose he purchases the insurance policy. What would his net
winnings be at the end of the end? How much should he be willing
to pay for the insurance policy?

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Adapted from Professor Deshmukh's (Kellogg) lecture notes
Gambling: random walk
 Optimal strategy is to either bet on red or black.

 How often will the gambler win in a day?

 Probability of winning on any play = Probability that ball lands in
a red slot = 18/38 = 0.474
 On average, the gambler should win around 47 games out of the
100

 How much can he expect to have (in net) at the end of

the day?

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Gambling: random walk
 Variance of net winnings at the end of the day

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Gambling: random walk
 Variance of net winnings at the end of the day
 Xi: random variable which denotes the outcome on the ith play

 Xi = 1 with probability 18/38 and Xi = -1 with probability 20/38

 What is the expected value and variance of Xi?

 W: random variable which denotes the total winnings at the end

of the day

 How is W related to the Xi’s?

 V(W) =
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Gambling: random walk
 What are the chances that he will not make any money
at the end of the day?
 Probability of not making any money at the end of the day =
Prob(W <= 0) =

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QC: Gambling – Prob (W = 0)
(1min)
 Which Excel function gives the probability that the net
winnings at the end of the day is 0 (Prob(W=0))?
 (a) NORM.DIST(50, -5.3, 10, 0)
 (b) VEGAS.DIST(0, -5.3, 0)
 (c) POISSON.DIST(50, 47.4, 0)
 (d) BINOM.DIST(50, 100, 18/38, 0)
 (e) RANDBETWEEN(-100, 100)

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