Decision Analysis Exercise

1. Susan Solomon has been thinking about starting her own independent gasoline station. Susan’s
problem is to decide how large her station should be. The annual returns will depend on both the
size of her station and a number of marketing factors related to the oil industry and demand for
gasoline. After a careful analysis, Susan developed the following table:

SIZE OF GOOD FAIR POOR

FIRST STATION MARKET ($) MARKET ($) MARKET ($)
Small 500,000 200,000 -100,000
Medium 800,000 300,000 -200,000
Large 1,000,000 300,000 -400,000
Very large 3,000,000 250,000 -1,600,000

a. Develop a decision table for this decision.

b. If Susan is a very optimistic decision maker, what decision should she use and what
alternative is the best?
c. If Susan is very conservative and is a risk avoider, what decision criterion should Susan
use, and what alternative will she select?
d. If Susan decided to use the equally likely criterion, what alternative will she select?
e. What is Susan’s criterion of realism decision if   0.8 ?
f. Develop an opportunity loss table.
g. What is Susan’s minimax regret decision?

2. Mickey Lawson is considering investing some money that he inherited. The following payoff table
gives the profits that would be realized during the next year for each of the three investment
alternatives Mickey is considering:

DECISION STATE OF NATURE

ALTERNATIVE GOOD ECONOMY POOR ECONOMY
Stock Market 80,000 -20,000
Bonds 30,000 -20,000
CDs 30,000 -23,000
Probability 0.50 0.50

What decision would maximize expected profits? What is the maximum amount that should be
paid for a perfect forecast of the economy?

3. Brilliant Color is a small supplier of chemicals and equipment that is used by some photographic
stores to process 35mm films. One product that Brilliant Color supplies is BC-6. John Kubick,
president of Brilliant Color, normally stocks 11, 12 or 13 cases of BC-6 each week. For each case
that John sells he makes a profit of $35. Because BC-6, like many photographic chemicals, has a
short shelf life, if a case is not sold by the end of the week, John must discard it. Since each case
costs John $56, he loses $56 for every case that is not sold by the end of the week. There is a
probability of 0.45 of selling 11 cases, a probability of 0.35 of selling 12 cases, and a probability
 of 0.20 of selling 13 cases. Construct a decision table and the corresponding decision tree for
Brilliant Color.

Using the EMV approach, what is your recommended course of action? If John is able to develop
BC-6 with an ingredient that stabilizes it so it no longer has to be discarded, how would this
change your recommended course of action?

4. Farm Grown, Inc., produces cases of perishable food products. Each case contains an assortment
of vegetables and other farm products. Each case costs $5 and sells for $15. If there are any cases
not sold by the end of the day, they are sold to a large food processing company for $3 a case. The
probability that daily demand will be 100 cases is 0.3, the probability that daily demand will be
200 is 0.4, and the probability that daily demand will be 300 cases is 0.3. Farm Grown has a policy
of always satisfying customer demands. If its own supply of cases is less than the demand, it buys
the necessary vegetables from a competitor. The estimated cost of doing this is $16 per case.

a. Draw a decision table for this problem.

b. What do you recommend?

5. A group of medical professionals is considering the construction of a private clinic. If the medical
demand is high (i.e., there is a favorable market for the clinic), the physician could realize a net
profit of $100,000. If the market is not favorable, they could lose $40,000. Of course, they don’t
have to proceed at all, in which case there is no cost. In the absence of market data, the best the
physicians can guess is that there is a 50-50 chance the clinic will be successful. Construct a
decision tree to help analyze this problem. What should the medical professionals do?

The physicians have been approached by a market research firm that offers to perform a study of
the market at a fee of $5,000. The market researchers claim their experience enables them to use
Bayes’ theorm to make the following statements of probability:

 probability of a favorable market given a favorable study = 0.82

 probability of an unfavorable market given a favorable study = 0.18
 probability of a favorable market given an unfavorable study = 0.11
 probability of an unfavorable market given an unfavorable study = 0.89
 probability of a favorable research study = 0.55
 probability of an unfavorable research study = 0.45

a. Develop a decision tree for this problem.

b. Use the EMV approach to recommend a strategy.
c. What is the expected value of sample information? How much might the physicians be
willing to pay for a market study?

6. A food processor is considering the introduction of a new line of instant lunches. On a national
basis the company estimates a net profit of 50 million pesos if the product is highly successful, a
net profit of 20 million if it is moderately successful, and a loss of 14 million pesos if it is not
 successful. If the company does not introduce the line, its research and development costs totaling
3 million pesos must be written of as a loss. Current estimates place the probability of high
success at 0.10 and probability of moderate success at 0.40.

Prior to introducing it on a national level, the company could test market the line on a regional
basis. The cost of such a test would be one million pesos. Although the test results would be
significant, they would not be conclusive; the reliability of such a test is given by the conditional
probabilities in the table below

Test results will indicate:

Given that a product is: High Success Moderate Success No Success
Highly successful 0.60 0.40 0.00
Moderately successful 0.20 0.60 0.20
Not successful 0.10 0.30 0.60

a. Draw the appropriate decision tree for the problem

b. What should be the processor’s decision?

7. Amy Lloyd is interested in leasing a new Saab and has contracted three automobile dealers for
pricing information. Each dealer has offered Amy a closed-end 36-month lease with no down
payment at the time of signing. Each lease includes a monthly charge and a mileage allowance.
Additional miles receive a surcharge of per-mile basis. The monthly lease cost, the mileage
allowance, and the cost for additional miles follow:

Dealer Monthly Cost Mileage Allowance Cost per Additional Mile

Forno Saab $299 36,000 $0.15
Midtown Motors $310 45,000 $0.20
Hopkins Automotive $325 54,000 $0.15

Amy has decided to choose the lease option that will minimize the total 36-month cost. The
difficulty is that Amy is not sure how many miles she will drive over the next three years. For
purposes of this decision she believes it is reasonable to assume that she will drive 12,000 miles
per year, 15,000 miles per year, or 18,000 miles per year. With this assumption Amy has estimated
her total costs for the three lease options. For example, she figures that the Forno Saab lease will
cost her $10,764 if she drives 12,000 miles per year, $12,114 if she drives 15,000 miles per year,
or $13, 464 if she drives 18,000 miles per year.

a. What is the decision, and what is the chance event?

b. Construct a payoff table for Amy’s problem.
c. If Amy has no idea which of the three mileage assumptions is most appropriate, what is the
recommended decision (leasing option) using the optimistic, conservative, and minimax regret
approaches?
 d. Suppose that the probabilities that Amy drives 12,000, 15,000 and 18,000 miles per year are
0.5, 0.4, and 0.1, respectively. What option should Amy choose using the expected value
approach?

8. A decision maker has been presented the following payoff table showing payoffs for three
alternative decisions A, B, and C, as well as three states of nature X, Y, and Z:

State of Nature
Decision Alternatives X Y Z
A 800 400 -100
B 700 600 200
C 600 500 400

You have learned that the decision maker chose alternative B. According to the criterion of
realism, find a range of alpha values that characterize the level of optimism implied by this
decision maker.

9. A financial advisor has recommended two possible mutual funds for investment: Fund A and Fund
B. The return that will be achieved by each of these depends on whether the economy is good, fair
or poor. A payoff table has been constructed to illustrate this situation:

State of Nature
Investment Good Economy Fair Economy Poor Economy
Fund A $10,000 $2,000 -$5,000
Fund B $6,000 $4,000 0
Probability 0.2 0.3 0.5

a. Draw the decision tree to represent this situation.

b. Which one of the mutual funds should you choose to maximize the expected value?
c. Suppose that there is a question about the return of Fund A in a good economy. It could be
higher or lower than $10,000. What value for this would cause a person to be indifferent
between Fund A and Fund B?

10. Hale’s TV Productions is considering producing a pilot for a comedy series in the hope of selling
it to a major television network. The network may decide to reject the series, but it may also
decide to purchase the rights to the series for either one or two years. At this point in time, Hale
may either produce the pilot and wait for the network’s decision or transfer the rights for the pilot
and series to a competitor for $100,000. Hale’s decision alternatives and profits (in thousands of
dollars) are as follows:
 State of Nature
Decision Alternatives Reject, s1 1 year, s 2 2 Years, s 3
Produce Pilot -100 50 150
Sell to Competitor 100 100 100

The probabilities for the states of nature are P(s1 )  0.20 , P(s2 )  0.30 and P(s3 )  0.50 . For a
consulting fee of $5,000, an agency will review the plans for the comedy series and indicate the
overall chances of a favorable network reaction to the series. Assume that the agency review will
result in a favorable (F) or an unfavorable (U) review and that the following probabilities are
relevant.

P( F )  0.69 P(s1 | F )  0.09 P(s1 | U )  0.45

P(U )  0.31 P(s2 | F )  0.26 P(s2 | U )  0.39

P(s3 | F )  0.65 P(s3 | U )  0.16

a. Construct a decision tree for this problem.

b. What is the recommended decision is the agency opinion is not used? What is the expected
value?
c. What is the expected value of perfect information?
d. What is Hale’s optimal decision strategy assuming the agency’s information is used?
e. What is the expected value of the agency’s information?
f. Is the agency’s information worth the $5,000 fee? What is the maximum that Hale should be
willing to pay for the information?
g. What is the recommended decision?