Chapter 05S - Decision Theory

Solutions
1. a. Maximax: Expand [$80 is the highest payoff]
b. Maximin: Worst payoffs:
Do Nothing: 50 [best of the worst payoffs]
Expand: 20
Subcontract: 40
c. Laplace: Average Payoff
Do Nothing 55 [indifferent between do nothing
Expand 50 and subcontract]
Subcontract 55
d. Minimax Regret
Low High Worst
Do Nothing 0 20 20
Expand 30 0 30
Subcontract 10 10 10 [best of worst]
2. a. Expected profit
Do Nothing $57 = 50 (.3) + 60 (.7)
Expand 62 [Best] = 20 (.3) + 80 (.7)
Subcontract 61 = 40 (.3) + 70 (.7)
.3
b. $50
$57 .7
Do Nothing $60
$62 .3 $20
Expand
.7
$80
$61 .3
Subcontr. $40
.7
$70

c. EPC: .30(50) + .70(80) = $71

Exp. Profit: 62
EVPI: $9

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3. Equations:
Do Nothing: 50 + 10P Low High
Payoff 80 Payoff
Expand: 20 + 60P
70
Subcontract: 40 + 30P Do Nothing 60
Optimal ranges: 50
Do nothing: 0 to < .50 40 Subcontract

Expand: > .67 to 1.00

Subcontract: > .50 to < .67 20 Expand

4. a. 1) Draw the tree diagram:

0 .50 .67 1.0

Demand Low (.4) $400,000 (1)

Maintain $50,000 (2)

Build Small
2
Demand High (.6) Expand
1 $450,000 (3)
Demand Low (.4) $-10,000 (4)
Build Large

Demand High (.6) $800,000 (5)

2) Analyze decisions from right to left (i.e., work backwards from the end of the tree
towards the root). For instance, begin with decision 2 and choose expansion because it
has a higher present value ($450,000 vs. $50,000).
3) Compute the expected value of the ends of the remaining branches (numbered 1 to 5 in
the diagram), and then determine the expected value for the two initial alternatives.
(1).4 x $400,000 = $160,000
(2)(eliminated) $430,000 (expected value if build small is chosen)
(3).6 x $450,000 = $270,000
(4).4 x –$10,000 = $–4,000
(5).6 x $800,000 = $480,000 $476,000 (expected value if build large is chosen)

4) Since the expected value of building a large plant has the higher expected value, select
the large plant alternative.

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b. Expected payoff under certainty: .4(400,000) + .6 (800,000) = $640,000

Expected payoff under risk: 476,000
Expected value of perfect information: $164,000

Low High
Payoff
800

Build Large

Build Large 450

400 Build Small

-10

1.0 .54 0
P (low)

c.

Low High
Payoff Payoff
800

Build Large

Build Small 450

400

-10

0 .54 1.0
P (high)

400,000 + 50,000 P (H) = 10,000 + 810,000 P (H)

760,000 P (H) = 410,000
P(High) = .54

If P (high) is between 0 and .54, build small.

If P (high) is between .54 and 1.0, build large.
or
If P (low) is between 0 and .46, build large.
If P (low) is between .46 and 1.0, build small.

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Low Demand High Demand Slope Equation

Small 400,000 450,000 50,000 400,000 + 50,000 P (H)
Build
Large 10,000 800,000 810,000 10,000 + 810,000 P (H)

5. EVsubcontract= (.4)(1.0) + (.5)(1.3) + (.1)(1.8) = 1.23

EVexpand = (.4)(1.5) + (.5)(1.6) + (.1)(1.7) = 1.57
EVbuild = (.4)(1.4) + (.5)(1.1) + (.1)(2.4) = 1.35
Since 1.57 > 1.35 > 1.23, Expand.
6. MaxiMax MaxiMin Laplace Minimax
Alternative (a) Max. Payoff (b) Min. Payoff (c) Average (d) Regret
Renew $4,000,000 $500,000* $2,250,000 $4,500,000
Relocate $5,000,000* $100,000 $2,550,000* $3,900,000*
Decision: Relocate Renew Relocate Relocate

7. Alternative Expected Value

a. Renew 500,000(.35) + 4,000,000(.65) = $2,775,000*
Relocate 5,000,000(.35) + 100,000(.65) = $1,815,000
Decision: Renew lease

b.
Approve (.35) E.V.
$500,000
$2,775,000*
Reject (.65)
Renew $4,000,000

Approve (.35)
Relocate $5,000,000
$1,815,000
Reject (.65)
$100,000

c. EVPI = EPC – EMV

= .35(5,000,000) + .65(4,000,000) – 2,775,000 = $1,575,000
Yes, the manager should sign the lease for $24,000 since it is less than the EVPI of
$1,575,000.

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8. a., b. Let P (application is approved) = x. Then P (application rejected) = 1 – x.

From 7(a)
500,000x + 4,000,000(1 – x) = 4,000,000 – 3,500,000x
and 5,000,000x + 100,000(1 – x) = 100,000 + 4,900,000x
The two alternatives are equally good when
4,000,000 – 3,500,000x = 100,000 + 4,900,000x
3,900,000
i.e. when x = = 0.4643
8,400,000

Exp.
Value
5
(millions) Renewal better than 5
Relocation 100,000 + 4,900,000x
4
Renew Relocate 4
For 8(a) and 8(b) the decision
3 should be to renew the 10 year
3 lease.
4,000,000 – 3,500,000x
2 2
Relocate

1 1
.5
x = .4643
P (application approved)

c. D = amount of decrease in $4,000,000 in order that EV= EV

EV– EV= $2,775,000 – $1,815,000 = $960,000
$960,000 = .65D
D = $1,476,923
$4,000,000 – $1,476,923 = $2,523,077
Range is $2,523,077 or more.

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9. $ 42 .2(42)
46.8 .2 Low

.8 High 48 Subcontract
42 + 46.8
2
Expand Greatly
48 .8(48)
Small

53.6 44.4 .2 Low 22 .2(22)

Medium
1 .8 High Do Nothing
50 46 44.4
+
2
Expand 50
Large .8(50)

53.6
.2 Low (20) .2(-20)

.8 High + 53.6

72 .8(72)

a. Decision: Build a large facility.

b. Max (42;22;–20) = $42 million.
Decision: Build a small facility.
c. EPC = 42(.2) + 72(.8) = 8.4 + 57.6 = $66.0
EVPI = EPC – EMV = 66 – 53.6=$12.4
d. Let P(high) = x P(low) = 1 – x
I. Small: 42(1 – x) + 48x => 42 + 6x
II. Medium: 22(1 – x) + 50x => 22 + 28x
III. Large: –20(1 – x) + 72x => –20 + 92x
Value of x where expected value for I and III are the same.
42 + 6x = –20 + 92x => 86x = 62 => x = 0.7209

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72

50
Small
42 48
Medium

22
Large

0 .721 1.0
-20 P (High)
10.

.30 low $90

do nothing
1
.7 high 90
buy 1
subcontract
2 110

buy 2nd
100
.30 low
75
buy 2
2

.70 high 130

EV1 = (.3) (90) + (.7) (110) = 104

EV2 = (.3) (75) + (.7) (130) = 113.5 Since 113.5 > 104
Decision: Buy 2 machines.

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11. 1/3
0
1/3 60
1
1/3
90
50

49 .30 40
.50
4 44
Alternative A 60
.20

49 1/3
(45)
1/3
2 45
1/3 99
Alternative B 40
46 .30
40
.50
5 50

.20 30
1/2
45 40
3
EV1 = (1/3)(0) + (1/3)(60) + (1/3)(90) = 50 1/2
50
EV2 = (1/3)(–45) + (1/3)(45) + (1/3)(99) = 33
EV3 = (1/2)(40) + (1/2)(50) = 45
EV4 = (.3)(50) + (.5)(44) + (.2)(60) = 49
EV5 = (.3)(40) + (.5)(50) + (.2)(45) = 46

Since 49 > 46, choose alternative A.

12. 1) Draw the tree diagram:

Demand Low (.50) $700

Lease $100
Build Small
2
Demand High (.50) Expand
1 $500
Demand Low (.50) $40
Build Large

Demand High (.50) $2,000

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Maximin:
The worst possible payoff for small would occur with expanding under high demand: $500k. The
worst possible payoff for large would be $40k for low demand. Hence, build a small warehouse.

Maximax:
The best possible payoff would occur with a large warehouse ($2,000k), so build a large warehouse.

Laplace:

Assume the probabilities of low and high demand to be .50 each. The expected payoffs would be:

Small .50($700k) + .50($500k) = $600k.

Large .50($40k) + .50($2,000k) = $1,020k.
Hence, build a large warehouse.

Minimax regret:
Small: Large:
Large = $2,000k Small = $700k
Small = $500k Large = $40k
$1,500k $660k
Hence, build a large warehouse.

13. Moderate High Very High Worst Best Average

Reassign 50 60 85 85 50 65
New Staff 60 60 60 60* 60 60 (tie)
Redesign 40 50 90 90 40* 60
a. Maximin: New staff
b. Maximax: Redesign
c. Regret table:

Moderate High Very High Worst

Reassign 10 10 25 25
New Staff 20 10 0 20*
Redesign 0 0 30 30
d. Insufficient reason: (tie) New Staff or Redesign

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14. a. Reassign: .10(50) + .30(60) + .60(85) = $74

New Staff: .10(60) + .30(60) + .60(60) = 60*
Redesign: .10(40) + .30(50) + .60(90) = 73

b.
.10 Moderate
50
c. Opportunity loss table:74
Reassign .30 High
60
.60 Very High
Moderate High Very 85
High EOL
.10 Moderate
Reassign 10 10 25
60 19
New Staff .30 High
60 60 60
New Staff 20 10 0 5*
.60 Very High 60
Redesign 0 0 30 18
.10 Moderate
40
Redesign (.1) (.3)
.30 High (.6)
73 50
.60 Very High 90

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At an expected cost of $60, the director should hire and train 2 additional staff members.
.10 Moderate
15. 50
Reassign .30 High
74 60
.60 Very High
85
.10 Moderate
Hire 2 60
Initially .30 High
60 60
.60 Very High
New Staff 60
60 60 .10 Moderate
40
.30 High (Hire 1) 75
74.5
Hire 1 .60 V. High (Hire 1) 80
Initially
.10 Moderate
40
Redesign .30 High
73 50
.60 Very High
90

Payoff Payoff
16. a.
#1 #2

140
120 B A
100
C B
80
C
A
40

0 1.0
P(#2)

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b. Alternative C is lower than Alternative B for all values of P(#2), so it would never be
appropriate.

c. EVB = 120 – 40P; EVA = 20 + 120P. Solving, P = .625.

Therefore, choose Alternative A if P(#2) is greater than .625.

d. For P(#1), choose Alternative A, if P(#1) is less than .375 (i.e., 1.000 – .625).

17. a. [Refer to the diagram in the previous solution]

b. Alternative B is now the one that is never appropriate.

c. EVA = 20 + 120P; EV= 100 – 60P. Solving, P = .444.

Therefore, choose Alternative A for P(#2) less than .444, and choose Alternative C for
P(#2) greater than .444.

d. In terms of P(#1), choose A for P(#1) greater than .556 and C for P(#1) less than .556.

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18. EV1 = 10 – 12P Payoff for Payoff for

contract 10 no contract
EV2 = 8 – 5P
EV3 = 5 – 0P #1
8 #2
EV4 = 0 + 7P 7
#2 #4
#3 5
5

#4

0 .286 .60 .714 1.0

Payof -2
Payof
.30 .80
f f
#1120 #2
A Profit 110
s
C
D
90 90

60
B

C 40
Costs A

20
10

0 .417 .75 1.0

P (#2)

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19. EVA = 120 – 100P

EVB = 60 – 20P
EVC = 10 + 100P
EVD = 90
Note that in terms of
P(#1), .30 becomes .70, .80
becomes .20, .417
becomes .583, and .75
becomes .25.

Enrichment Model: Advanced Decision Tree Problems

In this section two additional decision tree problems are presented
1. Space engineers have three alternative designs for the configuration of a component for an
unmanned space shuttle. The space vehicle is likely to encounter one of four different
conditions, which have probabilities of occurrence as listed in the following payoff table with
the payoffs for each combination of design and state of nature. Additional data from previous
flights are available but will require additional expenditures to analyze. However, the project
director is confident that analysis of the data will clearly indicate which state of nature will be
encountered. What amount would be justified for the data analysis?
States of Nature
A B C D
Probability: .3 .4 .2 .1
Design 001 20* 10 10 0
002 15 10 0 40
003 10 20 30 30
* In $ hundreds.
2. Demand for movie rentals at a video store on Saturdays during summer months is related to
the weather. If it is raining, or if the chance of rain is greater than 50%, demand tends to
follow one distribution, whereas if it is not raining and the chance of rain does not exceed
50%, demand follows a different distribution. This is important to the video store because the
manager must decide early on Saturday how many employees to schedule for Saturday
afternoon and early evening.
The two distributions are:
P(Rain) > 50% P(Rain)  50%
Demand Probability Demand Probability
Low .10 Low .60
Moderate .20 Moderate .30
High .70 High .10

The regular staff can handle Low demand. Moderate demand requires two additional
employees, and High demand requires another two employees. The payoff table (profits in
$000) is

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Demand

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Moderate High
0 2 3 4
Extra Staff 2 1 4 5
4 0 3 6
a. Construct a tree diagram showing the payoffs for this situation.
b. Determine the number of additional staff needed for a rainy Saturday.
c. Determine the number of staff needed when the chance of rain is 20% for a Saturday.
1.
A B C D
Designs .3 .4 .2 .1 EMV EPC: .3(20) + .4(20) + .2(30) + .1(40) = 24
001 20 10 10 0 12
002 15 10 0 40 12.5
003 10 20 30 30 20 [best] EVPI = 24 – 20 = 4
Low demand
2
2. a. No additional staff Medium demand
1 3
High demand 4
Low demand
1
Two additional staff Medium demand
2 4
High demand 5
Low demand
0
Medium demand
3 3
Four additional staff High demand 6

Low demand (.1)

2
No additional staff Medium demand (.2)
1 3
b. High demand (.7) 4
Low demand (.1)
1
Two additional staff Medium demand (.2)
2 4
High demand (.7) 5
Low demand (.1)
0
Medium demand (.2)
3 3
Four additional staff
High
ma demand (.7) 6
our additional staff
d
EV1 = (.1)(2) + (.2)(3) + (.7)(4) = 3.6 (.2)
EV2 = (.1)(1) + (.2)(4) + (.7)(5) = 4.4
EV3 = (.1)(0) + (.2)(3) + (.7)(6) = 4.8
Since 4.8 > 4.4 > 3.6, hire four additional employees when it is rainy.

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c. Low demand (.6)

2
No additional staff Medium demand (.3)
1 3
High demand (.1) 4
Low demand (.6)
1
Two additional staff Medium demand (.3)
2 4
High demand (.1) 5
Low demand (.6)
0
Medium demand (.3)
3 3
Four additional staff High demand (.1) 6

EV1 = (.6)(2) + (.3)(3) + (.1)(4) = 2.5

EV2 = (.6)(1) + (.3)(4) + (.1)(5) = 2.3
EV3 = (.6)(0) + (.3)(3) + (.1)(6) = 1.5
Since 2.5 > 2.3 > 1.5, hire no additional employees when the probability of rain is 20%.

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