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    Decision Analysis Tutorial 1

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    The orange grower faces the risk of his crop being destroyed by an upcoming cold front. He has two options to mitigate the risk: 1. Set up burners in the orchard for $5,000, which could reduce losses to $15,000-$20,000 if temperatures drop. 2. Set up sprinklers for $2,000, which are less effective and could result in $25,000-$30,000 in losses. 3. Do nothing and risk losing his entire $50,000 crop if temperatures drop. The weather forecast gives a 50% chance of temperatures dropping low enough to damage the crop. The grower must decide whether to invest in protection or take

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    Decision Analysis Tutorial 1

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    AAAAA
    388 views24 pages
    The orange grower faces the risk of his crop being destroyed by an upcoming cold front. He has two options to mitigate the risk: 1. Set up burners in the orchard for $5,000, which could reduce losses to $15,000-$20,000 if temperatures drop. 2. Set up sprinklers for $2,000, which are less effective and could result in $25,000-$30,000 in losses. 3. Do nothing and risk losing his entire $50,000 crop if temperatures drop. The weather forecast gives a 50% chance of temperatures dropping low enough to damage the crop. The grower must decide whether to invest in protection or take

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    Decision Analysis Tutorial 1

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    The orange grower faces the risk of his crop being destroyed by an upcoming cold front. He has two options to mitigate the risk: 1. Set up burners in the orchard for $5,000, which could reduce losses to $15,000-$20,000 if temperatures drop. 2. Set up sprinklers for $2,000, which are less effective and could result in $25,000-$30,000 in losses. 3. Do nothing and risk losing his entire $50,000 crop if temperatures drop. The weather forecast gives a 50% chance of temperatures dropping low enough to damage the crop. The grower must decide whether to invest in protection or take

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    388 views24 pages

    Decision Analysis Tutorial 1

    Uploaded by

    AAAAA
    The orange grower faces the risk of his crop being destroyed by an upcoming cold front. He has two options to mitigate the risk: 1. Set up burners in the orchard for $5,000, which could reduce losses to $15,000-$20,000 if temperatures drop. 2. Set up sprinklers for $2,000, which are less effective and could result in $25,000-$30,000 in losses. 3. Do nothing and risk losing his entire $50,000 crop if temperatures drop. The weather forecast gives a 50% chance of temperatures dropping low enough to damage the crop. The grower must decide whether to invest in protection or take

    Copyright:

    © All Rights Reserved
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    of 24

    Decision analysis

    - Tutorial 1-
    #1 (Exercise 3.4 in Clemen, MHD) )
     Before making an unsecured loan to an individual a bank
    orders a report on the applicant's credit history. To justify
    making the loan, the bank must find the applicant's credit
    record to be satisfactory.
     Describe the bank's decision.
     What are the bank's objectives?
     What risk does the bank face?
     What role does the credit report play?
     Draw an influence diagram of this situation.
    (Hint: Your influence diagram should include chance nodes for a credit report and for eventual
    default.)
    Elements of solutions
    #2 (Exercise 3.5 in Clemen, MHD)
     When a movie producer decides whether to produce a
    major motion picture, the main question is how much
    revenue the movie will generate.
     Draw a decision tree of this situ ation, assuming that
    there is only one fundamental objective, to maximize
    revenue.
     What must be included in revenue to be sure that the
    clarity test is passed?
    Elements of solutions
    #3 (Exercise 3.11 in Clemen, MHD)
     Suppose you are planning a party, and your objective is to have an enjoyable
    party for all the guests. An outdoor barbecue would be the best, but only if
    the sun shines; rain would make the barbecue terrible. On the other hand,
    you could plan an indoor party. This would be a good party, not as nice as
    an outdoor barbecue in the sunshine but better than a barbecue in the rain.
    Of course, it is always possible to forego the party altogether!
    a) Construct an influence diagram and a decision tree for this problem.
    b) You will, naturally, consult the weather forecast, which will tell you that
    the weather will be either "sunny" or "rainy." The forecast is not perfect,
    however. If the forecast is "sunny," then sunshine is more likely than rain,
    but there still is a small chance that it will rain. A forecast of "rainy"
    implies that rain is likely, but the sun may still shine.
    i. Now draw an influence diagram for the decision, including the weather
    forecast.
    ii. Now draw a decision tree for this problem. Recall that the events and deci-
    sions in a decision tree should be in chronological order.
    b.
    # 4 (Exercise 3.13 in Clemen, MHD)
     Imagine a manufacturing-plant manager who faces a string of defective products and must
    decide what action to take. The manager's fundamental objectives are to solve this problem
    with as little cost as possible and to avoid letting the production schedule slip.
     A maintenance engineer has been dispatched to do a preliminary inspection on Machine 3,
    which is suspected to be the source of the problem. The preliminary check will provide some
    indication as to whether Machine 3 truly is the culprit, but only a thorough and expensive
    series of tests (not possible at the moment ) will reveal the truth. The manager has two
    alternatives.
     First, a replacement for Machine 3 is available and could be brought in at a certain cost. If
    Machine 3 is the problem, then work can proceed and the production schedule will not fall behind. If
    Machine 3 is not the source of the defects, the problem will still exist, and the workers will have to
    change to another product while the problem is tracked down.
     Second, the workers could be changed immediately to the other product. This action would
    certainly cause the production schedule for the current product to fall behind but would
    avoid the risk (and cost) of unnecessarily replacing Machine 3.
     Without the engineer's report, this problem would be another basic risky decision; the
    manager would have to decide whether to take the chance of replacing Machine 3 based on
    personal knowledge regarding the chance that Machine 3 is the source of the defective
    products. However, the manager is able to wait for the engineer's preliminary report before
    taking action.
    # 4 (Exercise 3.13 in Clemen, MHD), cont
     Draw Influence diagram for
    the man-ager's decision
    problem

     Draw the machine-


    replacement decision as a
    decision tree
    #5 (Exercise 3.12 in Clemen, MHD)
     Imagine that a close friend has been diagnosed with heart disease. The
    physician recommends bypass surgery. The surgery should solve the
    problem. When asked about the risks, the physician replies that a few
    individuals die during the operation, but most recover and the surgery is a
    complete success. Thus, your friend can (most likely) anticipate a longer and
    healthier life after the surgery. Without surgery, your friend will have a
    shorter and gradually deteriorating life. Assuming that your friend's
    objective is to maximize the quality of her life, diagram this decision with
    both an influence diagram and a decision tree.
     Suppose now that your friend obtains a second opinion. The second
    physician suggests that there is a third possible outcome: Complications
    from surgery can develop which will require long and painful treatment. If
    this happens, the eventual outcome can be either a full recovery, partial
    recovery (restricted to a wheelchair until death), or death within a few
    months. How does this change the decision tree and influence diagram that
    you created in part a? Draw the decision tree and influence diagram that
    represent the situation after hearing from both physicians. Given this new
    structure, does surgery look more or less positive than it did in part a?
    # 6 (Exercise 4.8 in Clemen, MHD)
     Solve the decision tree in the following figure.
    Elements of solutions
    #7 (Exercise 4.9 in Clemen, MHD)
     Create risk profiles and cumulative risk profiles for all
    possible strategies for the figure in Exercise 3. Is one
    strategy stochastically dominant? Explain.
    Elements of solutions
    Elements of solutions

    None of the alternatives is stochastically


    dominated (first-order) because the cumulative
    risk-profile lines cross.
    # 8 (Exercise 4.15 in Clemen, MHD)
     A stock market investor has $500 to spend and is considering purchasing an option
    con tract on 1000 shares of Apricot Computer. The shares themselves are currently
    selling for $28.50 per share. Apricot is involved in a lawsuit, the outcome of which
    will be known within a month. If the outcome is in Apricot's favor, analysts expect
    Apricot's stock price to increase by $5 per share. If the outcome is unfavorable,
    then the price is expected to drop by $2.75 per share. The option costs $500, and
    owning the option would allow the investor to purchase 1000 shares of Apricot
    stock for $30 per share. Thus, if the investor buys the option and Apricot prevails in
    the lawsuit, the investor would make an immediate profit. Aside from purchasing the
    option, the investor could (1) do nothing and earn about 8% on his money, or (2)
    purchase $500 worth of Apricot shares.

     a) Construct cumulative risk profiles for the three alternatives, assuming Apricot
    has a 25% chance of winning the lawsuit. Can you draw any conclusions?

     b) If the investor believes that Apricot stands a 25% chance of winning the lawsuit,
    should he purchase the option? What if he believes the chance is only 10%? How
    large does the probability have to be for the option to be worthwhile?
    Solutions

    No immediate conclusions can be drawn. No


    one alternative dominates another.
    # 9 (John Thompson case)
     John Thompson is the founder and president of Thompson Lumber Company, a
    profitable firm located in Portland, Oregon. The problem that John Thompson
    identifies is whether to expand his product line by manufacturing and marketing a
    new product, backyard storage sheds.
     John decides that his alternatives are to construct (1) a large new plant to
    manufacture the storage sheds, (2) a small plant, or (3) no plant at all (i.e., he has
    the option of not developing the new product line).
     Thompson determines that there are only two possible outcomes: the market for
    the storage sheds could be favorable, meaning that there is a high demand for the
    product, or it could be unfavorable, meaning that there is a low demand for the
    sheds.
     Because Thompson wants to maximize his profits, he can use profit to evaluate each
    consequence.
     With a favorable market, he thinks a large facility would result in a net profit of
    $200,000 to his firm. The conditional value if the market is unfavorable would be a
    $180,000 net loss.
     A small plant would result in a net profit of $100,000 in a favorable market, but a
    net loss of $20,000 would occur if the market was unfavorable.
     Finally, doing nothing would result in $0 profit in either market.
    # 9 (John Thompson case)
     Draw influence diagram and decision tree for John
    Thompson problem
     Calculate EMV if John believes that the probability of a
    favorable market is exactly the same as the probability of
    an unfavorable market;
     CRP
     Sensitivity analysis
     EVPI
    # 10 (Exercise 5.9 in Clemen, MHD)
     An orange grower in Florida faces a dilemma. The weather forecast
    is for cold weather, and there is a 50% chance that the temperature
    tonight will be cold enough to freeze and destroy his entire crop,
    which is worth some $50,000. He can take two pos-sible actions to
    try to alleviate his loss if the temperature drops. First, he could set
    burners in the orchard; this would cost $5000, but he could still
    expect to incur dam-age of approximately $15,000 to $20,000.
    Second, he could set up sprinklers to spray the trees. If the
    temperature drops, the water would freeze on the fruit and provide
    some insulation. This method is cheaper ($2000), but less effective.
    With the sprin-klers he could expect to incur as much as $25,000
    to $30,000 of the loss with no pro-tective action.
     Compare the grower's expected values for the three alternatives he
    has, considering the various possible loss scenarios for the burners
    and the sprinklers. Which alternative would you suggest the grower
    take? Why?

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