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Sample Problem

Pittsburgh Development Corporation (PDC) is deciding on the size of a new luxury condominium complex they are developing. They have three options for the size: 30 units, 60 units, or 90 units. The financial success depends on demand, which could be strong or weak. PDC believes there is an 80% chance of strong demand and 20% chance of weak demand. PDC needs to select the size that will maximize expected profit given the uncertainty in demand.

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Bon Joey Bernesto
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298 views

Sample Problem

Pittsburgh Development Corporation (PDC) is deciding on the size of a new luxury condominium complex they are developing. They have three options for the size: 30 units, 60 units, or 90 units. The financial success depends on demand, which could be strong or weak. PDC believes there is an 80% chance of strong demand and 20% chance of weak demand. PDC needs to select the size that will maximize expected profit given the uncertainty in demand.

Uploaded by

Bon Joey Bernesto
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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SAMPLE PROBLEM:

Pittsburgh Development Corporation (PDC) has purchased land, which will be the site of a new luxury condominium
complex. The location provides a spectacular view of downtown Pittsburgh and the Golden Triangle where the Allegheny
and Monongahela rivers meet to form the Ohio River. PDC plans to price the individual condominium units between
$300,000 and $1,400,000.

PDC has preliminary architectural drawings for three different-sized projects: one with 30 condominiums, one with 60
condominiums, and one with 90 condominiums. The financial success of the project depends upon the size of the
condominium complex and the chance event concerning the demand for the condominiums. The statement of the PDC
decision problem is to select the size of the new luxury condominium project that will lead to the largest profit given the
uncertainty concerning the demand for the condominiums.

PDC has the following three decision alternatives:

d1 = a small complex with 30 condominiums


d2 = a medium complex with 60 condominiums
d3 = a large complex with 90 condominiums

For the PDC problem, the chance event concerning the demand for the condominiums has two states of nature:

s1 = strong demand for the condominiums


s2 = weak demand for the condominiums
DECISION MAKING WITH PROBABILITIES

PDC is optimistic about the potential for the luxury high-rise condominium complex. Suppose that this optimism leads to
an initial subjective probability assessment of 0.8 that demand will be strong (s1) and a corresponding probability of 0.2
that demand will be weak (s2). Thus, P(s1) = 0.8 and P(s2) = 0.2. Using the payoff values in Table 4.1 and equation for
expected values, we compute the expected value for each of the three decision alternatives as follows:
Using Table 4.4;

Using P(s1), P(s2), and the opportunity loss values, we can compute the expected opportunity loss (EOL) for each decision
alternative. With P(s1) = 0.8 and P(s2) = 0.2, the expected opportunity loss for each of the three decision alternatives is:

SENSITIVITY ANALYSIS

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