1

SARAH CHANG’S DILEMMA

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Assumptions
• If research is successful, Sarah will bid with new technology
• If Sarah gets the contract, she delivers it in time and incurs
no additional cost on top of what we have already
accounted for
 3

Strategies/Scenarios

• Sarah does not invest, does not bid Value = $0

• Sarah does not invest, but bids
• Bid successful Value = $830K
• Bid not successful Value = - $20K
• Sarah invests in research
• Engineers do not succeed
Value = - $200K
• Sarah does not bid
• Sarah bids Value = $630K
• Bid successful Value = - $220K
• Bid not successful
• Engineers succeed Value = -$200K
• Sarah does not bid
• Sarah bids Value = $600K
• Bid successful Value = -$250K
• Bid not successful
Further Assumptions
• Chance of engineers succeeding: 0.6
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USING A DECISION TREE

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Strategies/Scenarios
Bid succeeds
$830K

Sarah bids
(with old)
Sarah does not Bid fails -$20K
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail
Sarah bids
(with old)
Sarah invests Bid fails -$220K

Bid succeeds
$600K
Engineers
succeed,
Sarah bids
(with new) Bid fails
-$250K
 7
Decision Tree
Bid succeeds
$830K

Sarah bids
(with old)
Sarah does not Bid fails -$20K
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail
Sarah bids
(with old)
Sarah invests Bid fails -$220K

Bid succeeds
$600K
Engineers
succeed,
Sarah bids
(with new) Bid fails
-$250K
Decision Tree with Probabilities 8

Bid succeeds
$830K
p = 0.1
Sarah bids
(with old)
Sarah does not Bid fails -$20K
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail p = 0.1
p = 0.40
Sarah bids
(with old)
Sarah invests Bid fails p = 0.9 -$220K

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Sarah bids
(with new) Bid fails
-$250K
p = 0.20
 9
Rolling Back

Sarah bids Exp. Return

(with old) $65K
Sarah does not
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers
fail
p = 0.40
Sarah bids Exp. Return
(with old) - $135K
Sarah invests

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Sarah bids
(with new) Bid fails
-$250K
p = 0.20
 10
Rolling Back

Sarah bids
Sarah does not
Exp. Return $65K
invest

Engineers Sarah bids

fail p = 0.40
Exp. Return -$135K

Sarah invests

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Sarah bids
Bid fails
-$250K
p = 0.20
 11
Rolling Back

Sarah does not Sarah bids

invest Exp. Return $65K

Engineers Sarah bids

fail p = 0.40 Exp. Return -$135K

Sarah invests

p = 0.60 Sarah bids

Engineers
Exp. Return
succeed
$430K
 12
Rolling Back

Sarah bids
Sarah does not
Exp. Return $65K
invest

Sarah bids regardless of whether

Sarah invests the engineers succeed
Exp. Return
$204K
 13
Rolling Back

Sarah invests
Exp. Return
$204K
 14

Summary
• Sarah’s immediate decision
“Invest money in Research & Development.”
• Sarah’s strategy
“Invest money in R&D;
bid regardless of the outcome of R&D.”
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Sarah’s Strategy
Bid succeeds
$830K
p = 0.1
Sarah bids
(with old)
Sarah does not Bid fails -$20K
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail p = 0.1
p = 0.40
Sarah bids
(with old)
Sarah invests Bid fails p = 0.9 -$220K

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Sarah bids
(with new) Bid fails
-$250K
p = 0.20
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SENSITIVITY ANALYSIS
 17

What-if Analysis/Sensitivity Analysis

Action: Change a problem parameter.

Question: How much change will be tolerated before the

optimal strategy changes?
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What-if Analysis/Sensitivity Analysis

• How critical is the assumption that the probability of the

engineers’ success is 0.6? How small can it be before our
decision changes?
• Assume everything else to be fixed.
 19
What-if Analysis/Sensitivity Analysis
Bid succeeds
$830K
p = 0.1
Sarah bids
(with old)
Sarah does not Bid fails -$20K
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail p = 0.1
p = 0.40
Sarah bids
(with old)
Sarah invests Bid fails p = 0.9 -$220K

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Sarah bids
How low can this (with new) Bid fails
probability be? -$250K
p = 0.20
 20

What-if Analysis/Sensitivity
Analysis
• Let us say that the probability of the engineers’ success is p.
 21
What-if Analysis/Sensitivity Analysis
Bid succeeds
$830K
p = 0.1
Sarah bids
(with old)
Sarah does not Bid fails
-$20K
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail p = 0.1
1-p Sarah bids
(with old)
Sarah invests Bid fails p = 0.9 -$220K

Bid succeeds
$600K
Engineers p p = 0.80
succeed,
Sarah bids
(with new) Bid fails
-$250K
p = 0.20
 22

Rolling Back

Sarah bids
Sarah does not
Exp. Return $65K
invest

Engineers Sarah bids

fail Exp. Return -$135K
1-p

Sarah invests

Engineers p
succeed, Sarah bids
Sarah bids Exp. Return $430K
(with new)
 23

Rolling Back
Sarah bids
Sarah does not
Exp. Return $65K
invest

Sarah bids regardless of whether

Sarah invests the engineers succeed
Exp. Return
$ [430p-135(1-p)] K
 24

Solving

• Sarah should invest in R&D as long as

430p-135(1-p) ≥ 65
• i.e. p ≥ (135+65)/(430+135) = 0.354.

• So Sarah’s decision is fairly safe.

 25

What-If Analysis

• How high/low could Sarah’s initial investment in R&D be

before her optimal strategy changes?
• Assume everything else to be fixed.

• Assume the cost of R&D really is x (in thousand dollars,

i.e. $x K).
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What-if Analysis/Sensitivity Analysis
Bid succeeds
$830K
p = 0.1
Sarah bids
(with old)
Sarah does not Bid fails
-$20K
invest
Sarah does Sarah does -$xK
not bid $0
not bid
Engineers Bid succeeds $630K
$(830-x)K
fail p = 0.1
p = 0.40
Sarah bids
(with old)
Sarah invests Bid fails p = 0.9 -$220K
-$(x+20)K

Bid succeeds
$(800-x)K
Engineers p = 0.80
p = 0.60
succeed,
Sarah bids
(with new) Bid fails
-$(x+50)K
p = 0.20
 27

Rolling Back
Sarah does not Sarah bids
invest Exp. Return $65K

Sarah bids
Engineers Exp. Return
fail $(65-x)K
p = 0.40

Sarah invests

p = 0.60 Sarah bids

Engineers Exp. Return
succeed $(630-x)K
 28

Rolling Back
Sarah bids
Sarah does not
Exp. Return $65K
invest

Sarah bids regardless of whether

Sarah invests the engineers succeed
Exp. Return
$(404-x)K
 29

Solving
• Sarah should invest in R&D as long as
404-x ≥ 65
• i.e. x ≤ 404 – 65 = 339.

• So Sarah’s decision, once again, is fairly safe.

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When many parameters vary together

• Assume
1. Research cost varies between $100,000 to $300,000
2. P(success in R&D) varies between 0.3 to 0.9
3. P(success in bid with old) varies between 0 to 0.2
4. P(success in bid with new) varies between 0.6 to 1

How would you perform a sensitivity analysis?

Hint: Use simulation. Model the research cost using a normal random
variable and the rest using uniform random variables.
 31

VALUE OF INFORMATION
 32

Value of Perfect Information

• What if Sarah has a source that can tell her whether her bid
will be accepted or not before building the prototype if the
engineers succeed research?
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Value of Perfect Information
Bid succeeds
$830K
p = 0.1
Sarah bids Exp. Return $65K
(with old)
Sarah does not Bid fails -$20K
invest p = 0.9
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers Bid succeeds $630K
fail p = 0.1
p = 0.40
Sarah bids
Exp. Return -$135K
(with old)
Sarah invests Bid fails p = 0.9 -$220K

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Exp. Return $430K
Sarah bids
(with new) Bid fails
-$250K
p = 0.20
 34
Value of Perfect Information

Sarah bids Exp. Return $65K

(with old)
Sarah does not
invest
Sarah does Sarah does -$200K
not bid $0
not bid
Engineers
fail
p = 0.40
Sarah bids
Exp. Return -$135K
(with old)
Sarah invests

Bid succeeds
$600K
Engineersp = 0.60 p = 0.80
succeed,
Sarah bids
(with new) Bid fails
-$250K
p = 0.20
 35
Value of Perfect Information

Sarah bids
Exp. Return $65K
with old
Sarah does not
invest
Sarah does Sarah does
not bid $0 -$200K
not bid
Engineers
fail
p = 0.40
Sarah bids
with old Exp. Return -$135K

Sarah invests
Source tells bid
will fail, Sarah Exp. Return -$135K
bids with old
p = 0.60
Engineers p = 0.20
succeed Source tells bid
will go through,
$600K
Sarah bids with
new p = 0.80
 36

Rolling Back
Sarah does not Sarah bids
invest Exp. Return $65K

Engineers Sarah bids

fail Exp. Return -$135K
p = 0.40

Sarah invests

p = 0.60
Engineers Sarah bids with new if source says yes,
succeed Otherwise she bids with old
Exp. Return $453K
 37

Rolling Back
Sarah bids
Sarah does not
Exp. Return $65K
invest

Sarah bids with old if engineers fail,

Sarah invests Sarah bids with old if engineers succeed but source says no
Sarah bids with new if engineers succeed and source says yes
Exp. Return
$217.8K
 38

Rolling Back

Sarah invests
Exp. Return
$217.8K

Without information: $204K

With information: $217.8K

Expected Value of (perfect) information (EVPI):

$217.8K-$204K = $13800.
The information is worth $13800 to Sarah.
 39

Value of Sample Information

Sarah can hire a research firm before building the prototype to

predict the outcome for a bid, assuming that her engineers
succeed in research.

Of the times the bid is actually successful, the firm could predict it correctly
99% of the time.
Of the times the bid is actually unsuccessful, the firm could predict it correctly
95% of the time.

How much is the research worth to Sarah?

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Partial Tree where Research Firm’s Help

is Relevant
Sarah bids
Exp. Return -$135K
with old
Survey says Bid succeeds
$600K
YES p = ??? p = ???
Sarah bids
with new
Engineers Bid fails p = ???
-$250K
succeed
Sarah bids
Exp. Return -$135K
with old
Survey says Bid succeeds
NO $600K
p = ??? p = ???
Sarah bids
with new
Bid fails p = ???
-$250K
 41

Re-Computing Probabilities

Actual Situation
Success Failure
Success
Firm Says
Failure
80% 20%
 42

Re-Computing Probabilities

Actual Situation
Success Failure
Success 0.9980% 0.0520%
Firm Says
Failure 0.0180% 0.9520%
80% 20%
 43

Re-Computing Probabilities

Actual Situation
Success Failure
Success 79.2% 1%
Firm Says
Failure 0.8% 19%
80% 20%
 44

Re-Computing Probabilities

Actual Situation
Success Failure
Success 79.2% 1% 80.2%
Firm Says
Failure 0.8% 19% 19.8%
80% 20%

Actually succeed if Firm says “success” = 79.2/80.2 = 98.8%

Actually fail if Firm says “success” = 1/80.2 = 1.2%
Actually succeed if Firm says “failure” = 0.8/19.8 = 4%
Actually fail if Firm says “failure” = 19/19.8 = 96%
 45

Tree with Research Firm’s Help

Sarah bids Exp. Return -$135K

with old
Survey says Bid succeeds
YES $600K
p = 0.988
p = 0.802
Sarah bids
with new Exp. Return $590K
Engineers Bid fails p = 0.012
Exp. Return $446.45K -$250K
succeed
Sarah bids
Exp. Return -$135K
with old
Survey says Bid succeeds
NO p = 0.04 $600K
p = 0.198 Sarah bids Exp. Return -$216K
with new
Bid fails p = 0.96
-$250K
 46

Full tree
Sarah does not Sarah bids
invest Exp. Return $65K

Engineers Sarah bids

fail Exp. Return-$135K
p = 0.40

Sarah invests
Exp. Return $213.87K

p = 0.60
Engineers Sarah bids with new if research says
succeed yes, bids with old if research says no

Exp. Return $446.45K

 47

Expected Value of Sample Information

Let EMVno-info be the expected monetary value when information

is not available.

Let EMVinfo be the expected monetary value when information is

available.

Expected Value of information = EMVinfo – EMVno-info

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Value of Information for Sarah

When firm is not hired Sarah’s expected monetary value =

$204K.

When firm is hired, Sarah’s expected monetary value =

$213.87K.

So the information is worth $9870 to Sarah.

(Expected Value of sample information (EVSI).)