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(Semester I : 2009-2010)


November 2009 Time allowed: 2 Hours


1. This examination paper contains FOUR (4) questions and comprises FIVE (5)
printed pages (including this cover page).

2. This is an OPEN BOOK examination.

3. Answer ALL questions. The total score for this paper is 100 marks.

4. Scientific calculators can be used.

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Question 1 (25 marks)

(a) Bruce indicated that his personal indifferent buying price B for the following one-off
coin-tossing game is $40.
0.5 $100

0.5 Tails

After Bruce has purchased the game but before playing it, he met Eric who offered to
insure him against the bad outcome of the game. That is, if the outcome is Tails,
Eric will pay Bruce $100. Bruce is willing to pay Eric up to a maximum of $55 for the
insurance against the bad outcome.

State with proofs or justifications whether each of the following statements is True or

i. Ben is Risk Neutral. (3 marks)

ii. Ben satisfies the Delta Property. (4 marks)

iii. Ben would not sell the game for $42.50. (4 marks)

(b) Consider the following influence diagram which represents a decision problem:




i. Convert the influence diagram into a Decision Network. Explain why the
additional arcs are necessary. (4 marks)

ii. From the decision network in part (i), draw an equivalent decision tree in
generic (compact) form. (4 marks)

iii. Can chance node B be omitted from the decision tree? Explain. (3 marks)

iv. Can chance node H be omitted from the decision tree? Explain (3 marks)
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Question 2 (25 marks)

(a) Which of the following four utility functions (if any) represent the same risk
preferenc? Explain or justify your answers.

u1 ( w) = 1 2 w / 100
u2 ( w) = 2 4 w / 50
u3 ( w) = 2 + ( 12 )
w / 100

u4 ( w) = 1 ( 14 )
w / 50

(8 marks)

(b) Richard prefers more money to less. We know that he is risk averse but not his exact
utility function. Richard faces the following decision situation:

Good Job

0.9 0.3
Go Graduate Bad Job
School $30,000

Dont Graduate

0.6 $80,000
Take Sales Job

0.4 Fail

Keep Current Job


For each of the following statements, indicate with justifications, if it is True or False:

i. Richard should choose Go Graduate School if he is risk neutral. (4 marks)

ii. Richard should prefer Keep Current Job to Take Sales Job. (5 marks)

iii. Richard should prefer Go Graduate School to Take Sales Job. (5 marks)

iv. Richards optimal decision depends on his actual utility function. (3 marks)
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Question 3 (25 marks)

Mr. Bigs current wealth is somewhere between $80 million and $130 million. He has the
following wealth utility function, where w is wealth in millions of dollar:

w if w < 100
u ( w) = 1
2 w + 50 if w 100

(a) When Mr. Big was offered a risky investment that has an 2/3 chance of receiving $60
million and 1/3 chance of losing $30 million, he indicated that he was willing to pay up
to $20 million upfront (in addition to the potential outcomes) for the investment. What is
Mr. Bigs current wealth? (8 marks)

(b) A couple of months later, Mr. Big reported that he has $90 million in wealth and, in
addition he is invested in a risky oil-drilling venture that can win him another $90
million if it is successful but if it fails he will lose $20 million. Mr. Big believes that
there is a 50% chance that the oil-drilling venture will be successful. What is the
minimum amount for which Mr. Big would sell his oil-drilling venture to another
investor? (8 marks)

(c) Mr. Small is a risk neutral investor with a current wealth of $45 million. He also
believes that the oil-drilling venture has a 50% chance of success. What is the
maximum amount Mr. Small would pay to buy the oil-drilling venture? (6 marks)

(d) If the sale of the oil-drilling venture between Mr. Big and Mr. Small is done through a
middle man, how much money can the middle man make for brokering the deal between
Mr. Big and Mr. Small? (3 marks)
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Question 4 (25 marks)

RST Company is developing a product which it plans to begin marketing next year. As part of
the design process, the company has to select vendors for the various components. For the most
critical component, RST received bids from three potential manufactures. In selecting its
vendors, RST considers three attributes denoted by the vector (C, D, Q), where

Attribute C represents the cost in $ per unit.

Attribute D represents on-time delivery which is characterized by a tardiness score giving the
number of days a shipment is late past the promised delivery date multiplied by the size of the
shipment averaged over all shipment quantities in a year. For example, if in a year, 10,000 units
were delivered of which 2,000 units were delivered 10 days late and another 1,000 units arrived
15 days late, then the tardiness score is (210 + 115)/10 = 3.5.

Attribute Q represents product quality which is characterized by the percentage of rejects after

RST wishes to minimize each of the three attributes.

Manufacturer A submitted a bid of $5 per unit. Based on previous experience with the
company, RSTs procurement manager predicts that manufacturer A will definitely have a
tardiness score of 5, and a quality score of 5.

Manufacturer B has a reputation of being a high cost high quality manufacturer but has a
spotty record as far as on-time delivery is concerned. It submitted a bid of $7 per unit and
assured RST that it has recently replaced its third party logistic service provider to improve its
delivery records. Based on this information, RST procurement manager concludes that
manufacturer B has probability Pb of achieving attribute scores (7, 2, 2), and probability
(1 - Pb) of achieving attribute scores (7, 7, 2).

Manufacturer C submits the most competitive price of $3 per unit but it is a start-up. RST
procurement manager concludes that manufacturer C has probability Pc of achieving attribute
scores (3, 1, 1) and probability (1 - Pc) of achieving attribute scores (3, 8, 8).

(a) Draw a fully labeled decision tree representing RSTs decision problem. (3 marks)

(b) By considering only ONE attribute at a time, and assuming that Pb = 0, find how the
best vendor for each case depends on the value of Pc. (12 marks)

(c) For what range of values of Pc will there be NO CONFLICT among the three attributes,
and which is the best vendor for that range? (4 marks)

(d) Suppose that RSTs multiple attribute utility function is u (C , D, Q) = (C + k 2 D + k3Q) ,

and it is indifferent between manufacturers A and B for Pb = 0.2, and between
manufacturers A and C for Pc = 8/21. What are the values of k2 and k3? (6 marks)