Questions on Decision Theory

1. A bookseller sells a particular book of tax laws for Rs. 100. It purchases the book for Rs.80 per copy.
Since some of the tax laws change every year, the copies unsold at the end of a year become out-
dated and can be disposed of for Rs.30 each. According to past experience, the annual demand for
this book is between 18 and 23 copies. Assuming that the order for this book can be placed only once
during the year, the problem before the store's manager is to decide how many copies of the book
should be purchased for the next year.

2. The following matrix gives the payoff of different strategies (alternatives) A, B, and C against
conditions (events) W, X, Y and Z. Identify the decision taken under the following approaches:
(i) Pessimistic, (ii) Optimistic, (iii) Equal probability, (iv) Regret, (v) Hurwicz criterion. The decision
maker’s degree of optimism (α) being 0.7.
Events W X Y Z

Alternatives Rs. Rs. Rs. Rs.

A 4000 -100 6000 18000

B 20000 5000 400 0

C 20000 15000 -2000 1000

3.. A newspaper boy has the following probabilities of selling a magazine. Cost of the copy is Rs. 30
and sale price is Rs. 50. He cannot return unsold copies. How many copies can he order?
No of copies sold Probability

10 0.10

11 0.15

12 0.20

13 0.25

14 0.30

Total 1.00

4. Consider the following problem with two decision alternatives (d1 & d2) and two states of nature S1
(Market Receptive) and S2 (Market Unfavorable) with the following payoff table representing profits
( Rs.1000):
States of nature
States of Nature
Decisions s1 s2
d1 20 6
d2 25 3
Assume the probability of the market being receptive is known to be 0.75. Use the expected monetary
value criterion to determine the optimal decision.

5. Technico Ltd has installed a machine costing Rs 4 Lacs and is in the process of deciding on
appropriate number of spare parts required for repairs. The spare parts cost Rs 4000 each but are
available only if they are ordered now. In case, the machine fails and no spares are available, the cost
to the company of mending the part is Rs 18000. The plant has estimated life of 8 years and the
probability distribution of failures during this time, based on experience of similar machines is as
follows.
No. of failures 0 1 2 3 4 5 6+
Probability 0.1 0.2 0.3 0.2 0.1 0.1 0
Ignoring any discounting for time value for money, determine following: a) The optimal number of
units of the spare part on the basis of (i) Minimax principle (ii) Minimin principle (iii) Laplace principle
(iv) Hurwicz principle ( taking α =0.7) and (v) Expected cost principle.
b) Expected number of failures in the 8 year period
c) The regret table and the optimal choice on the basis of expected regret criterion
d) Find EVPI
6. The annual demand for a seasonal product follows the distribution shown below:
Demand(Units) 3000 3500 4000 4500 5000

Probability 0.1 0.2 0.3 0.3 0.1

The manufacturer of this item can produce it by one of the three methods:
a) Using the existing equipment at a cost of ₹ 8 per unit.
b) Buy special equipment for ₹ 22,000 whose salvage value at the end of the year would be ₹
2,000. The variable cost per unit, using this equipment is ₹ 2.
c) Buy special equipment for ₹ 90,000 which would be depreciated on straight line basis over a
period of 4 years. The variable cost using this equipment is ₹ 1.20 per unit.
Which method of production should the manufacturer follow in order to maximize profit assuming
that production must meet all the demand?
7. The manager of American company is considering three options for managing its data processing
operation: continuing with its own staff, hiring an outside vendor to do the managing (referred to as
outsourcing), or using a combination of its own staff and an outside vendor. The cost of the operation
depends on future demand. The annual cost of each option (in thousands of dollars) depends on
demand as follows:
Demand

Staffing Options High Medium Low

Own staff 750 750 720

Outside vendor 960 620 350

Combination 840 740 500

If the demand probabilities are 0.2, 0.5, and 0.3, which decision alternative will minimize the expected
cost of the data processing operation?
8. A food products’ company is contemplating the introduction of a revolutionary new product with
new packaging or replacing the existing product at much higher price (S1). It may even make a
moderate change in the composition of the existing product, with a new packaging at a small increase
in price (S2), or may mall a small change in the composition of the existing product, backing it with the
word ‘New’ and a negligible increase in price (S3). The three possible states of nature or events are:
(i) high increase in sales (N1), (ii) no change in sales (N2) and (iii) decrease in sales (N3). the marketing
department of the company worked out the payoffs in terms of yearly net profits for each of the
strategies of three events (expected sales).
This is represented in the following table:
States of Nature

Strategies N1 N2 N3

S1 700000 300000 150000

S2 500000 450000 0

S3 300000 300000 300000

Which strategy should the concerned executive choose on the basis of (a) Maximin criterion (b)
Maximax criterion (c) Minimax regret criterion (d) Laplace criterion(e) Hurwicz Criteria(α =0.6)?

9. A manufacturer manufactures a product, of which the principal ingredient is a chemical X. At the

moment, the manufacturer spends `1,000 per year on supply of X, but there is a possibility that the
price may soon increase to four times its present figure because of a worldwide shortage of the
chemical. There is another chemical Y, which the manufacturer could use in conjunction with a third
chemical Z, in order to give the same effect as chemical X. Chemicals Y and Z would together cost the
manufacturer `3,000 per year, but their prices are unlikely to rise. What action should the
manufacturer take? Apply the maximin and minimax criteria for decision-making and give two sets of
solutions. If the coefficient of optimism is 0.4, then find the course of action that minimizes the cost.

10. An investor is given the following investment alternatives and percentage rates of return.
States of Nature

Strategies Low Medium High

Regular shares 7 10 15

Risky shares -10 -12 25

Property -12 18 30
Over the past 300 days, 150 days have been medium market conditions and 60 days have had high
market increases. On the basis of these data, state the optimum investment strategy for the
investment.

11. A marketing manager has to decide between advertising his product on a national level and not
advertising it. If he advertises the product and it is successful, his company will gain Rs. 4 lakh but if
he advertises and product fails, the company will lose Rs.4 Lakh. No loss or gain is attached to his not
taking action. He thinks that there is 0.6 probability that the advertising campaign will be successful.
(a) Construct a decision tree to help analyse this problem.
(b) What action the marketing manager should take.

12. A few friends who have just obtained their postgraduate degree in medicine are considering to
start their private clinic. If the medical demand is high indicating a favorable market for the proposed
clinic, the doctors could realize a net profit of Rs. 800000. If the market is not favorable, they could
lose Rs. 200000-preliminary expenses needed to set up the clinic. Of course, the doctors do not have
to proceed at all in which case they have not to incur any expenditure. In the absence of the any
market data, the doctors think that there is a 50-50 chance that their clinic will be successful.
On the basis of the above information, construct a decision tree to facilitate the analysis of this
problem. What should the doctors do?

13. A businessman has two independent investments A and B available to him; but he lacks the capital
to undertake both of them simultaneously. Investment A requires capital of Rs.30000 and investment
B, Rs.50000. Market survey shows : high, medium and low demands with corresponding probabilities
of 0.4, 0.4 and 0.2 respectively in case of investment A and 0.3, 0.4 and 0.3 for investment B. Returns
from investment A are Rs. 75000, Rs.55000 and Rs.35000 and corresponding figures for investment B
are likely to be Rs.100000, Rs.80000 and Rs.70000 for high, medium and low demand respectively.
What decision should the company take? Decide by constructing an appropriate decision tree.

14. A businessman has two independent investments A and B available to him; but he lacks the capital
to undertake both of them simultaneously. He can choose to take A first and then stop, or if A is
successful then take B, or vice versa. The probability of success of A is 0.6, while for B it is 0.4. Both
investments require an initial capital outlay of Rs. 10,000, and both return nothing if the venture is
unsuccessful. Successful competitions of A will return Rs. 20,000 (over cost), and successful
completion of B will return Rs. 24,000 (over cost). Draw the decision tree and determine the best
strategy.
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