SAMPLE PROBLEM: Decision Theory

John Thompson is the founder and president of Thompson Lumber

Company, a profitable firm in Portland, Oregon. He is considering
expanding his product line by manufacturing and marketing a new
product, backyard storage sheds. John decides that his alternatives are
to construct:(1) a large new plant to manufacture the storage sheds, (2)
a small plant, (3) or not plant at all (that is, he has the option of not
developing the new product line).

Thompson determines that there are only two possible outcomes:

the market for the storage sheds could be favorable, meaning that there
is a high demand for the product, or it could be unfavorable, meaning
that there is a low demand for the sheds. He has already evaluated the
potential payoffs associated with the various outcomes. With a favorable
market, he thinks a large facility would result in a net profit of $200,000
to his firm. If the market is unfavorable, a net less of $180,000 would be
experienced. A small plant would result in a net profit of $100,000 in a
favorable market, but a net loss of $20,000 would occur if the market is
unfavorable. Finally, doing nothing would result in a $0 profit in either
market.

a. Construct a Decision Table for John Thompson

b. Suppose that John Thompson now believes that the probability of a
favorable market is exactly the same as the probability of an
unfavorable market, which alternative would give the greatest
expected monetary value for the firm?
c. Construct a Decision Tree to show the validity of John's decision
d. Construct an Opportunity Loss Table for John Thompson. Determine
the alternative that would minimize EOL.
e. Assuming that no probability of outcomes is available to John
Thompson, evaluate the situation using the following criteria;
e.1 Laplace Criterion e.3 Criterion of Optimism
e.2 Criterion of Pessimism e.4 Hurwicz Criterion

f. John Thompson has been approached by Scientific Marketing, Inc., a

firm that proposed to help John make the decision about whether or
not to build the plant to produce storage sheds. Scientific Marketing
claims that its technical analysis will tell John with certainty whether
or not the market is favorable for his proposed product. This
information could prevent John from making a very expensive mistake.
Scientific Marketing would charge Thompson $65,000 for the
information. What would you recommend to John? Should he hire the
firm to make the marketing study? What would it be worth?
 Before deciding about building a new plant, John has the option of
conducting his own market survey, at a cost of $10,000. The information
from his survey could help him decide whether to construct a large
plant, a small plant, or not build at all. John realizes that such a market
survey will not provide him with a perfect information, but it may help
him nevertheless. There is a 45% chance that the survey results will
indicate a favorable market for storage sheds. From discussions with
market research specialists at the local university, John knows that
special survey such as his can either be positive (that is, predict a
favorable market) or be negative (predict an unfavorable market). The
experts have told John that, statistically, of all new favorable market
(FM) products, market surveys were positive and predicted success
correctly 70% of the time. Thirty percent of the time the surveys falsely
predicted negative results or an unfavorable market (UM). On the other
hand, when there was actually an unfavorable market for a new product,
80% of the surveys correctly predicted negative results. The surveys
incorrectly predicted positive results the remaining 20% of the time.

g. Construct a decision tree with the probability values using Bayesian

analysis
h. What would you recommend to John at this point? Would the survey
be worthwhile?