Answers to Homework Chapter 3

BSBN2120, J. Wang
Page 103 3-17. (a) The type of the decision making is decision making under uncertainty, because the probability of each state of nature is not known. (b) Since he is a very optimistic decision maker, Ken should use Maximax as his decision criterion. (c) The row maximums: States of Nature Favorable Unfavorable Row Market Market Maximums Sub 100 $300,000 -$200,000 $300,000 Decision Alternatives Oiler J Texan $250,000 $ 75,000 -$100,000 -$ 18,000 $250,000 $ 75,000

The maximum of the row maximums is $300,000 that is associated with Sub 100. Therefore, the decision with the Maximax criterion is Sub 100. 3-18. Since Bob enjoys his pessimistic attitude about business and oil industry, he should use Maximin as the decision criterion. The row minimums: States of Nature Favorable Unfavorable Row Market Market Minimums Sub 100 $300,000 -$200,000 -$200,000 Decision Alternatives Oiler J Texan $250,000 $ 75,000 -$100,000 -$ 18,000 -$100,000 -$ 18,000

The maximum of the row minimums is -$18,000 that is associated with Texan. Therefore, the decision with the Maximin criterion is Texan. 3-19.

(a) Since the probability for each state of nature is given, the decision making model is decision making under risk, and EMV (expected monetary value) is used as the criterion. (b) The EMV for each decision alternative: State of Nature Favorable Market Probability Alternatives Sub 100 Oiler J Texan 0.7 $300,000 $250,000 $ 75,000 Unfavorable Market 0.3 -$200,000 -$100,000 -$ 18,000 EMV 300,0000.7 + (-200,000)0.3 = 150,000 250,0000.7 + (-100,000)0.3 = 145,000 75,0000.7 + (-18,000)0.3 = 47,100

The highest EMV is $150,000 that is associated with Sub 100. Therefore, the optimal decision is Sub 100. 3-22 (a) Payoff (net gain) Table and EMVs: Investment Alternatives Stock market CD
Probability

Good $1,400 $900 0.4

Market Condition Fair $800 $900 0.4

Poor $0 $900 0.2

EMV 880 900

(b) Since 900>880, the best decision is to deposit the money in CD with expected gain of $900. 3-23 (a) The column maximums: Investment Alternatives Good Stock market $1,400 Bank deposit $900 Probability 0.4 Column Max $1,400

Market Condition Fair $800 $900 0.4 $900

Poor $0 $900 0.2 $900

EMV 880 900 $1,100

The expected value with perfect information, EVwPI, is: EVwPI = $1,400*0.4 + $900*0.4 + 900*0.2 = $1,100. The best expected value without the information, EVw/oPI, from the newsletter is $900 as we have calculated in 3-21 (b). That is, EVw/oPI = 900.

Therefore, the expected value of perfect information, EVPI, is EVPI = EVwPI - EVw/oPI = $1,100 - $900 = $200. So, Allen would be willing to pay at most $200 for the newsletter. (b) Yes, the annual return rate change would change the amount Allen is willing to pay. The expected value with perfect information is now changing to: EVwPI = $1,100*0.4 + $900*0.4 + 900*0.2 = $980. EMV for alternative stock market is: 1,100*0.4+800*0.4+0*0.2=$760. EMV for alternative bank deposit is 900*0.4+900*0.4+900*0.2=$900. The max EMV=$900, which is also Vw/oPI. The expected value of perfect information is : EVPI = EVwPI - EVw/oPI = $980 - $900 = $80. So, Allen would be willing to pay at most $80 for a newsletter. 3-24. (a) The given payoff (profit) table, and column maximums.
States of Nature
Decision Alternatives

Large facility Medium facility Small facility No facility

Column maximum

Strong market 550,000 300,000 200,000 0 550,000

Fair market 110,000 129,000 100,000 0 129,000

Poor market -310,000 -100,000 -32,000 0 0

The opportunity loss table of the above payoff table:

States of Nature
Decision Alternatives

Large facility Medium facility Small facility No facility

Strong market 0 250,000 350,000 550,000

Fair market 19,000 0 29,000 129,000

Poor market 310,000 100,000 32,000 0

(b) The row maximums of the above opportunity loss table:

States of Nature
Decision Alternatives

Large facility Medium facility Small facility No facility

Strong market 0 250,000 350,000 550,000

Fair market 19,000 0 29,000 129,000

Poor market 310,000 100,000 32,000 0

Row Maximum 310,000 250,000 350,000 550,000

The minimum of the row maximums is 250,000. So, the minimax regret decision is Medium facility. 3

3-25. Decision: How many cases of BC-6 to order and stock every week. Decision alternatives: Stocking 11 cases, 12 cases, or 13 cases. States of nature: Weekly demand of 11 cases, 12 cases, or 13 cases. Given: Net Profit = $35/case; Cost = $56/case. So, revenue from selling a case is: $35+$56=$91/case sold. Note: There is no penalty cost in terms of ($ out of pocket) for shortage, though there is opportunity cost of shortage due to lost sales. Payoff is in terms of net profit: Profit = $in - $out = Revenue Cost, that is, Profit = $91*(number of cases sold) - $56*(number of cases ordered/stocked). (a) Payoff Table: 11 cases Prob=0.45 91*11-56*11 =385 91*11-56*12 =329 91*11-56*13 =273 Weekly Demand 12 cases Prob=0.35 91*11-56*11 =385 91*12-56*12 =420 91*12-56*13 =364 13 cases Prob=0.2 91*11-56*11 =385 91*12-56*12 =420 91*13-56*13 =455

to order

11 cases 12 cases 13 cases

(b) EMV for each decision alternative: Weekly Demand 11 cases 12 cases 13 cases Prob=0.45 Prob=0.35 Prob=0.2 to order 11 cases 12 cases 13 cases 385 329 273 385 420 364 385 420 455

EMV
385*0.45+385*0.35+385*0.3=

385*
329*0.45+420*0.35+420*0.2=

379.05
273*0.45+364*0.35+455*0.2=

341.25 The maximum EMV is 385 that is associated with 11 cases. So, the best decision is stocking 11 cases. (c) If the unsold cases can be sold later, then the new payoff table would be: Weekly Demand (States of Nature) 11 cases 12 cases 13 cases Decision Alternatives Prob=0.45 Prob=0.35 Prob=0.2 11 cases 385 385 385 12 cases 420 420 420 13 cases 455 455 455 So, stocking 13 cases is the best alternative.
to order

EMV 385 420 455

Or, without needing to generate the above payoff table, it is pretty obvious that stocking 13 cases that is the largest possible weekly demand is the best decision, since there is no penalty of overstocking but there is penalty of under-stocking of losing sales.

3-28. (a) Payoff table Size of 1st Station

Decision alternatives

Small Medium Large Very large

States of Nuture Good Fair Poor Market Market Market $50,000 $20,000 $10,000 $80,000 $30,000 $20,000 $100,000 $30,000 $40,000 $300,000 $25,000 $160,000

(b) Maximax Row maximums: Good Size of 1st Station Market Small $50,000 Medium $80,000 Large $100,000 Very large $300,000 Fair Poor Market Market $20,000 $10,000 $30,000 $20,000 $30,000 $40,000 $25,000 $160,000 Row Maximums $50,000 $80,000 $100,000 $300,000

The maximum of the four row maximums is $300,000, and the decision is therefore Very Large. (c) Maximin Row minimums: Size of 1st Station Small Medium Large Very large Good Market $50,000 $80,000 $100,000 $300,000 Fair Poor Market Market $20,000 $10,000 $30,000 $20,000 $30,000 $40,000 $25,000 $160,000 Row Minimums $10,000 $20,000 $40,000 $160,000

The maximum of the four row minimums is $10,000, and the decision is therefore Small. (d) Equally Likely Size of 1st Station Small Medium Good Market $50,000 $80,000 Fair Market $20,000 $30,000 Poor Market $10,000 $20,000 Averages $20,000 $30,000

Large $100,000 $30,000 $40,000 Very large $300,000 $25,000 $160,000 For example, for alternative Small: Average = ($50,000 + $20,000 + (-$10,000)) / 3 = $60,000 / 3 = $20,000. Large. (e) Realism (Hurwicz), =0.8

$30,000 $55,000

The maximum of row averages is $55,000, and the decision is therefore Very

Good Fair Poor Hurwicz Market Market Market Values Small $50,000 $20,000 $10,000 $38,000 Medium $80,000 $30,000 $20,000 $60,000 Large $100,000 $30,000 $40,000 $72,000 Very large $300,000 $25,000 $160,000 $208,000 For example, for the row of alternative Small: Hurvicz value = (row maximum) + (row minimum) (1-) = $50,000 0.8 + (-$10,000) (1-0.8) = $50,000 0.8 + (-$10,000) 0.2 = $40,000 - $2,000 = $38,000. Size of 1st Station The maximum of the row Hurwicz values is $208,000, and the decision is therefore Very Large. (f) and (g). The column maximums: Size of 1st Station Small Medium Large Very large Column Maximum Good Market $50,000 $80,000 $100,000 $300,000 $300,000 Fair Market $20,000 $30,000 $30,000 $25,000 $30,000 Poor Market $10,000 $20,000 $40,000 $160,000 $10,000

The Opportunity Loss (Regret) Table and the row maximum are: Good Fair Poor Row Size of 1st Station Market Market Market Maximums Small $250,000 $10,000 $0 $250,000 Medium $220,000 $0 $10,000 $220,000

Large $200,000 $0 $30,000 $200,000 Very large $0 $5,000 $150,000 $150,000 For examples, the opportunity cost for alternative Small in Good market is $300,000 $50,000 = $250,000; the opportunity cost for alternative Medium in Good market is $300,000 $80,000 = $220,000; the opportunity cost for alternative Very large in Poor market is ($10,000) ($160,000) = $150,000; The minimum of row maximums in the opportunity loss table is $150,000, and the decision therefore is Very Large.