THE HONG KONG POLYTECHNIC UNIVERSITY

DEPARTMENT OF APPLIED MATHEMATICS

Assignment One

Submit solutions to questions 1, 2, 3, 4 by 17 March, 2025.

1. A food canning company has the option to agree at a price at the beginning of the
season for the peas that it will need for the year. If the season turns out well there will be
a glut and the price will be drop. Conversely a poor season will mean that the price will
be higher than that offered at the beginning. There will always be sufficient peas for the
company’s need and the company will always buy. Expressing the season as good,
average or poor the problem can be summarized in terms of price paid (dollars in
thousand per ton) as the table below.

Season
Good Average Poor

Agree price now 20 20 20

Wait 13 22 28

Find the maximin and minimax regret optimal act respectively.

Now the price matrix has been changed to the following:

Season
Good Average Poor

Agree price now 20 20 20

Wait 13 22 28

Alternative 11 21 31

Find the minimax regret optimal act. Comment on the result.

Hint: Apply the method to the negative of price matrix as the problem is now a
minimization one.

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2. During the summer, Carter plans to swim every day. On sunny summer days, he goes
to an outdoor pool, where he may swim for no charge. On rainy days, he must go to an
indoor pool. At the beginning of the summer, he has the option of purchasing a $15
season pass to the indoor pool, which allows him use for the entire summer. If he doesn’t
buy the season pass, he must pay $1 each time he goes there. Past weather records
indicate that there is a 60% chance that the summer will be sunny (in which case there is
an average of 6 rainy days during the summer) and a 40% chance the summer will be
rainy (an average of 30 rainy days during the summer).

Before the summer begins, Carter has the option of purchasing a long-range weather
forecast for $1. The forecast predicts a sunny summer 80% of the time and a rainy
summer 20% of the time. If the forecast predicts a sunny summer, there is a 70% chance
that the summer will actually be sunny. If the forecast predicts a rainy summer, there is
an 80% chance that the summer will actually be rainy. Assuming that Carter’s goal is to
minimize his total expected cost for the summer, what should he do? Also find EVSI and
EVPI.

3. A property owner has three properties which she wishes to sell at the prices shown in
the second column of Table 1. She goes to Mr. L. K. Jones, a real estate broker, and
addresses him as follows: “Jones, I’m offering you only property A as of now, and if you
don’t sell it within a month I’ll take all my business, including A, elsewhere. However, if
you do sell A within a month, you can have your choice of B or C; if you sell that
property within a month of the time it’s put in your hands, you can have a month to sell
the last one”.

TABLE 1
Property Price Advertising cost Probability of sale
A $25000 $800 0.7
B $50000 $200 0.6
C $100000 $400 0.5

Jones inspects the properties, decides on the amount he would spend advertising each one
if it were put in his hands (figures in the third column of Table 1), and assesses his
chances of selling each if he tries (figures in the last column of the table); he believes that
success in selling any one property would not affect his chances of selling any other. His
commission is 4% of the gross.

Jones next informs his consultant on decision theory that his financial position is that:
1) He would be indifferent between getting $1500 outright and taking a 50-50 chance at
+$6000 or -$1000.
2) He would be indifferent between not betting and betting on a 50-50 chance at +$1500
and -$1000.
3) He would be indifferent between getting $3200 for certain or taking a 50-50 chance at
+$6000 or +$1500.

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Given these data:
a. If you were Jone’s consultant, how would you advise him?
b. What is the client’s proposition worth to Jones (approximately)?

Hint: Replace monetary values by utility values in the decision tree.

4. Let u be a utility function for (incremental) amounts of money x and suppose that u is
chosen such that u(100)=0 and u(300)=1. Show that

i. if 100~{(.5:-25),(.5:300)}, then u(-25)=-1.

Plot these six points on a graph where the horizontal axis is labelled x and the vertical
axis u. Fit a piecewise linear function through these points, and assume for the
remainder of this exercise that this utility function is your own. From the graph, you
will be able to answer the following questions:

a. What is the CE of a lottery that gives a .5 chance at $300 and a .5 chance at $600.
b. What is the CE for a lottery that gives a .75 chance at $400 and a .25 chance at
-$200.
c. You are offered a compound lottery with a canonical chance at the lottery l of part
(b) as one prize and a complementary chance at no net gain. What would your
chance of winning lottery l have to be before you would accept this offer?
d. Given that the CE of a lottery is $325, and the lottery gives a p chance at $500 and
a (1-p) chance at $300, find p.
e. What is the CE of a lottery that offers a .375 chance at $500, a .125 chance at $600,
and a .5 chance at $0?
f. You are offered the lottery of part (e) for $200; would you buy it? If you were an
EMV’er would your choice change?
g. Consider the lottery

l={(.2:$0),(.5:$150),(.3:$600)}

For how much would you just be willing to sell this lottery if you owned it?
h. For how much would you just be willing to buy the lottery of part (g) if you did not
own it?