MGMT20005 ASSIGNMENT 1 985606

Question 1:
a. The main purpose of this offer is to not allow the airlines with greater connectivity to fail for post-crisis
recovery which to maximum the economic benefit. The following payoff table (in million dollars) shows
the economic benefits allocated by the government for each option as follows:
Decision State of Nature, sj
Alternatives, di Light, s1 Medium, s2 Heavy, s3
Option 1, d1 200 350 500
Option 2, d2 650 700 1000
Option 3, d3 500 650 850
Probability 0.3 0.3 0.4

b. Under optimistic approach,

Decision Alternatives, di Maximum Payoff ($’million)
d1 500
d2 1000
d3 850
Max (500, 1000, 850) = 1000, therefore, Option 2 is optimal with highest (maximum) payoff which is the
best possible economic benefit.

c. Under conservative approach,

Decision Alternatives, di Minimum Payoff ($’million)
d1 200
d2 650
d3 500
Min (200, 650, 500) = 650, therefore, Option 2 is optimal with highest (minimum) payoff that is the best
of the worst possible economic benefit.

d. Under opportunity loss approach, regrets (in million dollars) are calculated as follows:
Decision State of Nature, sj
Alternatives, di s1 s2 s3
d1 |650 – 200| = 450 |700 – 350| = 350 |1000 – 500| = 500
d2 |650 – 650| = 0 |700 – 700| = 0 |1000 – 1000| = 0
d3 |650 – 500| = 150 |700 – 650| = 150 |1000 – 850| = 150
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Decision Alternatives, di Maximum regret, Rij ($’million)

d1 500
d2 0
d3 150

Min (500, 0, 150) = 0, hence, Option 2 is optimal with smallest (maximum) regret.

e. EV(d1) = 0.3*200 + 0.3*350 + 0.4*500 = 365

EV(d2) = 0.3*650 + 0.3*700 + 0.4*1000 = 805
EV(d3) = 0.3*500 + 0.3*650 + 0.4*850 = 685

Option 2 is optimal with the highest expected value and EMV = $805 million.
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Question 2:
a. The decision tree given as follows:

EMV(d1) = $17,400

EMV(d2) = $18,500

EMV(d3) = $19,500

By applying the “folding back” approach,

EMV(d1) = 0.3($30,000) + 0.5($15,000) + 0.2($10,000) = $17,400

EMV(d2) = 0.3($30,000) + 0.5($15,000) + 0.2($10,000) = $18,500

EMV(d3) = 0.3($25,000) + 0.5($20,000) + 0.2($10,000) = $19,500

To minimise the cost, with the lowest EMV(d1), d1 is recommended by continuing with its own staff with
increased salaries with EMV = $17,400.

b. EVPI = | EVWPI – EVWOPI |

To minimise the cost, optimal decision with the lowest EV and with perfect information is chosen as
follows:
If s1, then d1.
If s2, then d2.
If s3, then d2 or d3.
EVWPI = 0.3($20,000) + 0.5($15,000) + 0.2($10,000) = $15,500
For EVWOPI, the lowest EV (di) is chosen to minimise the cost:
MGMT20005 ASSIGNMENT 1 985606

EVWOPI = min [EV (di)] = min ($17,400, $18,500, $19,500) = $17,400

EVPI = | EVWPI – EVWOPI | = | $15,500 – $17,400 = $1,900

EVPI = $1,900 which implies that additional information could be worth up to $1,900 for Belvedere Age
Care, hence, Belvedere should attempt to obtain a better estimate of demand.

c. Using Bayes’ Theorem,

The favourable branch probability is computed as follows:

State Prior Conditional Joint Posterior Probabilities
of Probabilities Probabilities Probabilities P(sj | F)
Nature P(sj) P(F | sj) P(F ∩ sj)
s1 0.3 0.5 0.3 x 0.5 = 0.15 0.15 / 0.53 = 0.283
s2 0.5 0.6 0.5 x 0.6 = 0.3 0.3 / 0.53 = 0.566
s3 0.2 0.4 0.2 x 0.4 = 0.08 0.08 / 0.53 = 0.151
Total: P(F) = 0.53 1
The probability that the market survey report will be favourable is 0.53.

d. The unfavourable branch probability is computed as follows:

State Prior Conditional Joint Posterior Probabilities
of Probabilities Probabilities Probabilities P(sj | U)
Nature P(sj) P(U | sj) P(U ∩ sj)
s1 0.3 0.5 0.3 x 0.5 = 0.15 0.15 / 0.47 = 0.319
s2 0.5 0.4 0.5 x 0.4 = 0.2 0.2 / 0.47 = 0.426
s3 0.2 0.6 0.2 x 0.6 = 0.12 0.12 / 0.47 = 0.255
Total: P(U) = 0.47 1
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The new decision tree is shown below: C = Market Survey

N = No market survey
F = Favourable conditions
U = Unfavourable conditions

EMV(d1) = $17,660

EMV(d2) = $18,490

EMV(d3) = $19,905

EMV(d1) = $17,108

EMV(d2) = $18,510

EMV(d3) = $19,045
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Under favourable conditions:

EMV(d1) = 0.283($20,000) + 0.566($18,000) + 0.151($12,000) = $17,660
EMV(d2) = 0.283($30,000) + 0.566($15,000) + 0.151($10,000) = $18,490
EMV(d3) = 0.283($25,000) + 0.566($20,000) + 0.151($10,000) = $19,905

Under unfavourable conditions:

EMV(d1) = 0.319($20,000) + 0.426($18,000) + 0.255($12,000) = $17,108
EMV(d2) = 0.319($30,000) + 0.426($15,000) + 0.255($10,000) = $18,510
EMV(d3) = 0.319($25,000) + 0.426($20,000) + 0.255($10,000) = $19,045

Decision strategy:
If market survey is favourable, with the lowest EMV(d1), then d1, continuing with own staff with
increased salaries, EMV = $17,660, to minimise the cost.
If market survey is unfavourable, with the lowest EMV(d1), then d1, continuing with own staff with
increased salaries, EMV = $17,108, to minimise the cost.

e. EVSI = | EVWSI – EVWOSI |

EVWSI = 0.53($17,660) + 0.47($17,108) = $17,400.56
EVWOSI = $17,400
EVSI = | $17,400.56 – $17,400 | = $0.56
Hence, the expected value of the market research information is $0.56.
MGMT20005 ASSIGNMENT 1 985606

Question 3:
Part 1
Let Utility of $80 = U(80) = 10
Utility of -$50 = U(-50) = 0

U(M) = p*U(80) + (1 – p)*U(-50)

Utility Table:
Decision State of Nature
s1 s2 s3
d1 U(5) U(10) U(20)
= 0.22(10) + (1 – 0.22)(0) = 0.25(10) + (1 – 0.25)(0) = 0.35(10) + (1 – 0.35)(0)
= 2.2 = 2.5 = 3.5
d2 U(-25) U(0) U(50)
= 0.10(10) + (1 – 0.22)(0) = 0.20(10) + (1 – 0.22)(0) = 0.60(10) + (1 – 0.22)(0)
= 1.0 = 2.0 = 6.0
d3 U(-50) = 0 U(-10) U(80) = 10
= 0.18(10) + (1 – 0.22)(0)
= 1.8
Probability 0.3 0.35 0.35

EU(d1) = 0.3(2.2) + 0.35(2.5) + 0.35(3.5) = 2.76

EU(d2) = 0.3(1.0) + 0.35(2.0) + 0.35(6.0) = 3.1
EU(d3) = 0.3(0) + 0.35(1.8) + 0.35(10.0) = 9.8

On the basis of expected value, EV(d3) > EV(d2) > EV(d1), therefore, d3, d2, d1 is ranked in order as
table follows.
Ranking of decision Expected Utility
alternatives
d3 9.8
d2 3.1
d1 2.76
MGMT20005 ASSIGNMENT 1 985606

EV(d1) = 0.3(5) + 0.35(10) + 0.35(20) = 12

EV(d2) = 0.3(-25) + 0.35(0) + 0.35(50) = 10
EV(d3) = 0.3(-50) + 0.35(-10) + 0.35(80) = 9.5

On the basis of expected value, EV(d1) > EV(d2) > EV(d3), therefore, d1, d2, d3 is ranked in order as
table follows.
Ranking of decision Expected Utility
alternatives
d1 12
d2 10
d3 9.5

Part 2
a. Let Utility of -$80,000 = U(-80,000) = 0
Utility of $160,000 = U(160,000) = 10

U(M) = p*U(160,000) + (1 – p)*U(-80,000)

Monetary Value, M Indifference Probability, p U(M) Plot graph

-$80,000 0 0 (-80,000, 0)
-$40,000 0.4 0.4(10) + (1–0.4)(0) = 4 (-40,000, 4)
$20,000 0.7 0.7(10) + (1–0.7)(0) = 7 (20,000, 7)
$100,000 0.9 0.9(10) + (1–0.9)(0) = 9 (100,000, 9)
$160,000 1 10 (160,000, 10)

By calculating the utility for a few monetary values given and plotting those utility values on the
graph shown below, it displays a diminishing marginal utility with a concave graph. Also, the line
segment (blue dashed line) lies below the graph. Therefore, Giada is clearly a risk avoider.
MGMT20005 ASSIGNMENT 1 985606

12
U(M) = p*U(160,000) + (1 – p)*U(-80,000)
10

8
Utility, U (M)

0
-1 0 0 , 0 0 0 -50,000 0 50,000 100,000 150,000 200,0 0 0
Monetary value, M ($)

b. Given Utility of -$80,000 = U(-80,000) = 0

Utility of $160,000 = U(160,000) = 80

U(M) = p*U(160,000) + (1 – p)*U(-80,000)

Monetary Value, M Indifference Probability, p Utility, U(M)
-$40,000 0.4 0.4(80) + (1 – 0.4)(0) = 32
$20,000 0.7 0.7(80) + (1 – 0.7)(0) = 56
$100,000 0.9 0.9(80) + (1 – 0.9)(0) = 72

c.
Option Expected Utility (EU) Expected Value (EV)
New 0.4(0) + 0.3(56) + 0.3(80) = 40.8 0.4(-$80,000) + 0.3($20,000) + 0.3($160,000)
restaurant = $22,000
Expand 0.4(32) + 0.3(56) + 0.3(72) = 51.2 0.4(-$40,000) + 0.3($20,000) + 0.3($100,000)
= $20,000
Under expected utility approach, EU(Expand) > EU(New restaurant), hence, Giada should expand
the existing restaurant, while under expected value approach, EV(New restaurant) > EV(Expand),
Giada should therefore open another restaurant in New South Wales.
MGMT20005 ASSIGNMENT 1 985606

Question 4:
a. The decision tree below shows the logical sequence of the decision problem facing Laugh:
MGMT20005 ASSIGNMENT 1 985606

The decision tree below shows the optimal strategy = Laugh should make Yevon a counteroffer at $0.6 million, by applying the “folding
back” approach:

FALSE

EV(node 3) = 0.3(-$2 million) + 0.5(-$1 million) + 0.2($0)

= -$1.1 million

EV = $0.85 million
EV = $1.1 million
TRUE

TRUE

EV = $1.1 million
EV(node 2) = 0.2(-$6 million) + 0.3(-$1.1 million) + 0.5(-$0.8) FALSE
= -$0.85 million

EV(node 5) = 0.3(-$2 million) + 0.5(-$1 million) + 0.2($0)

= -$1.1 million
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b. Applying the “folding back” approach as shown in question 4(a), EV(Laugh counteroffers) >
EV(Laugh accepts Yevon’s offer), instead of accepting Yevon’s initial offer to settle the
claim for $1 million, Laugh should make Yevon a counteroffer at $0.6 million. Expected
monetary value = -$0.85 million which Laugh will need $0.85 million to cover all identified
risks in the above case.

c. If Laugh decides to make Yevon a counteroffer of $0.6 million:

If Yevon accepts Laugh’s counteroffer, no further action is required, the case is closed.
If Yevon rejects Laugh’s counteroffer and elects to have a jury to decide the settlement
amount, Laugh must go to trial.
If Yevon makes a counteroffer at $0.8 million, Laugh should accept her counteroffer.

d. Optimal strategy: Laugh should make Yevon a counteroffer of $0.6 million as EV(Laugh
counteroffers) > EV(Laugh accepts Yevon’s offer).

To construct a risk profile of the optimal strategy, which is shown below, the probability
of each final payoffs is computed by multiplying the branch probabilities on all paths to the
end of the decision tree.
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Settlement Amount Probability

($million)
0 0.3 x 0.2 = 0.06
-0.6 0.2
-0.8 0.5
-1 0.3 x 0.5 = 0.15
-2 0.3 x 0.3 = 0.09
1.00

(729 words)