PROBLEM SET 2

Problem 1. Anuj, a shopkeeper sells Chinese electronic items. He is planning to stock some
Chinese e-readers for the Christmas-New Year week (called the holiday week). He is
confident that his sales will be no more than 25 e-readers. The purchase price of the
e-reader model is Rs.10,000 per piece and it sells for Rs.15,000 per piece during the
holiday week. If he is not able to sell e-readers during the holiday week then he will
be able to sell all the remaining e-readers at a markdown price of Rs.7,000. In case,
he does not have an e-reader in stock when a customer comes to him and asks for it
during the holiday week, then in addition to the loss of earning, he has a goodwill
loss that he values at Rs.3,000.
a. How many e-readers should he stock if his strategy is to minimize maximum regret
(i.e. minimax regret)?
b. What was the value of the maximum regret for this strategy?
c. How many e-readers should he stock if he uses a maximax payoff strategy?
d. What was the value of the maximum regret for this strategy?
e. How many e-readers should he stock if he uses a maximin payoff strategy?
f. What was the value of the maximum regret for this strategy?
Let the probability of discrete demand being equal to x, be given as
P (demand = x) = (x − 25)2 /1625.
g. If Anuj decides to maximize expected monetary value how many e-readers should
he stock?
h. If Anuj decides to maximize expected monetary value, what is the expected num-
ber of e-readers that he will have to sell for a markdown price?

Problem 2. ABC Company is in the business of manufacturing widgets. The market size of
widgets is 1000 widgets. The market share of a company is assessed by a probability
distribution given below:
Market Share 10% 20% 40%
Probability 0.3 0.3 0.4
The company can make widgets by one of the two processes A and B. Process A
involves a fixed cost of Rs.10,000 and a variable cost of Rs.40 per widget produced.
Process B involves a fixed cost of Rs.16,000 and a variable cost of Rs.20 per widget
produced.
a. Which of the two processes is the better choice for the company if it wants to
minimize expected manufacturing cost?
b. For what probability values will the choice that you suggest in part (a) remain
the better choice?

Problem 3. A manufacturer must produce and deliver 1000 batches of a particular chemical to
a customer. The profit from each batch is Rs.50. The manufacturing process of
the chemical is not under perfect control. There is a 80% chance that 100 of the
1000 batches are substandard, and a 20% chance that 300 of the 1000 batches are
substandard. If the manufacturer sends a substandard batch to the customer then the
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customer demands a replacement for the substandard batch. The cost of replacing a
substandard batch with a perfect batch is Rs.400.
The manufacturer has three options for corrective action available to him.
Option 1: She could distill all the batches of the chemical at a cost of Rs.40 per batch,
and thus have no substandard batches sent to the customer.
Option 2: She could use a chemical reagent to test the quality of each batch at a cost
of Rs.20 per batch, and distill only those batches that are classified by the
test as substandard at the cost of Rs.100 per batch. However this test is
inaccurate. While “good” batches never get classified as substandard by
the test, 5% of substandard batches get classified as “good” and are not
distilled. These batches when sent to a customer have to be replaced at a
cost of Rs.400 per batch replaced.
Option 3: She could use a specific gravity test which costs Rs.9 per batch, and distill
only those batches that are classified by the test as substandard at the cost
of Rs.100 per batch. This test is also not accurate. 10% of the substandard
batches get classified as “good” and have to be replaced later (at a cost of
Rs.400 per batch). 10% of the good batches get classified as “substandard”
by the test.
a. Draw the payoff table for the manufacturer.
b. If the manufacturer made decisions using the expected value criterion, which of
the options should she choose? What is the expected contribution to profits for
this decision?
c. What is the expected regret if the manufacturer chose Option 3?

Problem 4. Rehman is an independent trucker in Ahmedabad whose truck carries load from one
location to another location for a fee. At times he returns empty on the way back.
At other times he is able to find some business while returning. He has found a
deal to take a load from Ahmedabad to Mumbai, with a return load included, for a
total profit of Rs.32000. Another deal would give him a load to Ajmer for a profit of
Rs.25000. Rehman thinks that there is a 40% chance of finding an Rs.20000 return
load from Ajmer, and another 60% chance he must return back with no revenue for
the return journey. Assume that there are no other options available to Rehman.
a. Which of the two deals should he take up?
b. What is the expected profit from his decision?
c. For what value of the probability of finding a return load from Ajmer will he be
indifferent between the two deals?
Sometimes in the past Rehman has called the Trucking Load Information Company
(TLIC) in Ajmer to get information. TLIC charges him for any information that they
provide.
d. If TLIC gave out perfect information, what would be the expected value of that
information?
e. Whenever TLIC provides the information that loads are available, 80% of the
time he has ended up with a return load. Whenever TLIC says that loads are
not available 70% of the time he has ended up with no return load. What is the
expected value of this imperfect information?

Problem 5. There is 60% chance that there are oil-bearing rocks under a piece of land. With
current technology, if a region contains oil-bearing rocks, there is 80% chance that
if an oil and gas company drills a well in that region, they will hit oil. It requires
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1 million dollars to drill a well, and the revenue earned from the oil extracted is 3
million dollars. The oil and gas company wants to maximize profits, and follows the
expected value criterion to decide whether to drill a well in that piece of land.
a. Should the company drill a well in that piece of land? What is the expected profit
from their best decision?
b. What is the expected value of perfect information about the presence of oil-bearing
rocks under the land?
The company has the option of drilling zero, one, or two wells in that piece of land. If
they decide to drill wells, their decision to drill a second well depends on the outcome
of their drilling the first well.
c. Assume that the company drills a well and the well that they drill hits oil. How
does this fact revise the chance of the presence of oil-bearing rocks under that
piece of land? How does it affect the chance of the company hitting oil under that
piece of land?
d. Assume that the company drills a well and the well that they drill does not hit
oil. How does this fact revise the chance of the presence of oil-bearing rocks under
that piece of land? How does it affect the chance of the company hitting oil under
that piece of land?
e. Under this policy of deciding on drilling the second well depending on the result
of drilling the first well, what is their expected profit?

Problem 6. The AlphaBeta Company (ABC) produces a special widget for a limited market.
The total demand for these widgets in the market is 1000 units. Historically, ABC
has cornered 20% of the market with probability 0.7 and 40% of the market with
probability 0.3. ABC produces widgets to order, i.e., they produce exactly as many
widgets as their customers want from them. ABC can use one of two processes to
manufacture widgets. Process I has a fixed cost of Rs.90,000 and a variable cost of
Rs.300 per widget manufactured. Process II has a fixed cost of Rs.140,000 and a
variable cost of Rs.150 per widget manufactured. Naturally, ABC wants to minimize
the cost of producing widgets.
a. Which of the processes should they use to produce the widgets to minimize ex-
pected manufacturing cost? What is the expected manufacturing cost that they
incur for producing the widgets as per their preferred process?
b. If ABC decided to minimize maximum regret which of the two processes should
they use?
In order to ascertain whether their market share during the next month is 20% or
40%, they plan to do a market survey, questioning 25 potential customers whether
or not they would buy ABC’s widget. The answers from the customers are assumed
to be YES/NO, and truthful. Also assume that ABC’s market share is either 20% or
40%.
c. Which process would ABC prefer if five among the 25 answered YES to the
survey?
d. What is the minimum number of people x such that your answer to part (c) would
change if x among the 25 people surveyed said YES to the survey?
e. What is the expected value of the information provided by the survey?

Problem 7. Universal Publishers (UP) has received a manuscript for a new textbook for possible
publication. In the experience of the editor of UP, similar manuscripts have a 65%
probability of being successful. If UP decide to publish the book and the book is
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successful they make a profit of Rs.75 lakhs. However if the book is unsuccessful then
they suffer a loss of Rs.25 lakhs.
a. What would be the expected value of perfect information about whether or not
the book will be successful?
Before deciding to accept or reject the manuscript, the editor can send the manuscript
to a review process. The review may provide either a favourable evaluation or an
unfavourable evaluation. Past data has shown that if the review is favourable, the
book has been successful 75% of the time. However, even when the review has been
unfavourable, the book has been successful 15% of the time.
b. Based on the editor’s guess that manuscripts have a 65% probability of being
successful, what is the probability that the review will be favourable?
c. Suppose UP sends the manuscript for review, and the review is favourable. If UP
then decide to publish the book, what will be the expected value of the profit that
they make?
d. What is the expected value of the information provided by the review?