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MB2101 Decision Making

Review UAS
DT-Basic,Bayes Theorem,Value
of New Information
Tutorial Session

Tuesday, 23 November 2016

Decision Tree Basic


TheCastiengineeringcompanymanufacturesspecializedcomponents
foragriculturalmachinery.Themovingpartsofoneofthese
componentsneedtobeprotectedbyapplyingawaterproofsealtoits
surface.Recentlytwonewtechnologieshavebecomeavailable,whichit
isthoughtcouldreplacetheexistingmethodandyieldcostsavings
whichwouldgiveCastiasignificantadvantageovercompetitors.The
companynowhastodecidewhichtechnology,ifany,itshoulddevelop
(resourceconstraintsmeanthatonlyonetechnologycanbedevelopedat
anyonetime).

Decision Tree Basic


ThefirsttechnologyisapatentedmethodcalledKVGelectrosealing.It
isthoughtthatthereisa0.8probabilitythatthistechnologycould
successfullybeappliedtothesealingprocess.Thecostofdeveloping
thistechnologyisestimatedtobe$8millionandasuccessful
developmentwouldleadtogrosssavings(i.e.savingsbefore
developmentcostshavebeentakenintoaccount)of$19millionwitha
probabilityof0.1,$12millionwithaprobabilityof0.5and$9million
withaprobabilityof0.4.Iftheprocesscouldnotbemadetowork
successfullythenthecompanywouldabandontheprojectandcontinue
withtheexistingmethodofsealing.

Decision Tree Basic


ThesecondtechnologywouldinvolvedippingthecomponentsinasolutionofTCX.
Developingthistechnologywouldcostanestimated$2million,butitisthoughtthat
there is only a 0.65 probability that the process could be designed to meet EC
pollution standards. If pollution standards can be met then the process will lead to
grosssavingsestimatedtobeworth$8million.Ifthestandardscannotbemetthen
thecompanywouldhavethreeoptions.Eitheritcouldabandontheentireproject,or
itcouldattempttomodifythemethodoritcouldswitchitsresourcesinanattempt
todeveloptheKVGelectrosealinginstead.ModifyingtheTCXdippingprocedure
wouldbelikelytocostafurther$2millionanditisthoughtthattherewouldbea
50:50 chance that the modification would succeed. In the event of modification
failingtomeetthepollutionstandardstheentireprojectwouldbeabandoned.
Assuming that Castis objective is to maximize expected net savings (i.e. gross
savings minus development costs) determine the policy that the company should
pursue(forsimplicityyoushouldignoretimepreferencesformoney).

DT

Decision: TCX

DT-Bayes Theorem
We will now consider the application of Bayes theorem to a decision
problem: a process which is sometimes referred to as posterior
analysis.
Problems
A retailer has to decide whether to hold a large or a small stock of a
product for the coming summer season. A payoff table for the
courses of action and outcomes is shown below:
Profits
Decision

Low sales

High
sales

Hold small
stocks

$80,000 $140,000

Hold large
stocks

$20,000 $220,000

DT-Bayes Theorem
Problems (continued)
The following table shows the retailers utilities for the above sums of
money (it can be assumed that money is the only attribute which he is
concerned about):
Profit
Utility

$20,000 $80,000
0

0.5

$140,00 $200,00
0
0
0.8

1.0

The retailer estimates that there is a 0.4 probability that sales will be low
and a 0.6 probability that they will be high. What level of stocks should
he hold?

DT-Bayes Theorem
Before implementing his decision the retailer receives a sales forecast
which suggests that sales will be high. In the past when sales turned
out to be high the forecast had correctly predicted high sales on
75% of occasions. However, in seasons when sales turned out to be
low the forecast had wrongly predicted high sales on 20% of
occasions. The underlying market conditions are thought to be stable
enough for these results to provide an accurate guide to the
reliability of the latest forecast. Should the retailer change his mind
in the light of the forecast?

DT-Bayes Theorem

A decision tree for the retailers problem based on prior probabilities

It can be seen that his expected utility is maximized if he decides to hold a small stock of the commodity

DT-Bayes Theorem

revised prior
probability with
posterior
probability
It can be seen that
holding a large stock
would now lead to
the highest expected
utility, so the retailer
should change his
mind in the light of
the sales forecast

DT-Value of New Information


The managers of Red Valley Auto Products are
considering the national launch of a new carcleaning product. For simplicity, the potential
average sales of the product during its lifetime are
classified as being either high, medium or low and
the net present value of the product under each of
these conditions is estimated to be $80 million,
$15 million and $40 million, respectively. The
companys marketing manager estimates that
there is a 0.3 probability that average sales will be
high, a 0.4 probability that they will be medium
and a 0.3 probability that they will be low. It can be
assumed that the companys objective is to
maximize expected net present value.

DT-Value of New Information


1. On the basis of the marketing
managers prior probabilities,
determine:
(a) Whether the product should be
launched;
(b) The expected value of perfect
information.

$80

h
nc
u
La
$18
1

.3
0
gh
i
H
Medium 0.4
Lo
w
0.
3

Not launch $0

EVWOI: $18
$15

$-40

Conclusion: Product should be launched


Expected Value if launch the product: ((80 x 0.3) + (15 x 0.4) + (0.4 x -40)) = $

h
nc
u
La

8
0
0.3

y
Bu

o
inf

30

$18

0.4

M
L

Not buy info

Not launch
ch
un
a
L

1
5

0.
3

h
nc
u
La

80

gh 1
Hi
Med0
Lo
w
0

15

gh 0
Hi
Med 1
Lo
w
0

Not launch
gh 0
Hi
-40
Med0
Lo
w
1
Not launch

$80
$15

$-40
$80
$15
$-40
$80

$15

$-40

Expected value if buy info = ((80 x 0.3) + (15 x 0.4) + (0


x 0.3))
= 24 + 6 + 0 = 30
EVWI = $30
EVPI = EVWI EVWOI
= 30 18 = 12

DT-Value of New Information


2. The managers have another option. Rather
than going immediately for a full national
launch they could first test market the product
in their Northern sales region. This would
obviously delay the national launch, and this
delay, together with other outlays associated
with the test marketing, would lead to costs
having a net present value of $3 million. The
test marketing would give an indication as to
the likely success of the national launch, and
the reliability of each of the possible indications
which could result are shown by the conditional
probabilities in the table below (e.g. if the

DT-Value of New Information

3. Calculate the expected value of imperfect


information and hence determine whether the
company should test market the product.

p(h)=0.24+0.1+0.03=0.37
p(m)=0.045+0.24+0.09=0.
375
p(l)=0.015+0.05+0.18=0.2
55
gh
Hi

0.3

0.8 x 0.3 = 0.24


0.8

M
L

0.15

0.15 x 0.3 = 0.045

0.0
5

0.05 x 0.3 = 0.015


5
0.2

Medium 0.
4
w

0.6

M
L

Lo
3
0.

0.1

0.3

M
L

Prior probability

0.
15

0.25 x 04 = 0.1

0.6 x 0.4 = 0.24


0.15 x 0.4 = 0.06
0.1 x 0.3 = 0.03
0.3 x 0.3 = 0.09

0.
6

0.6 x 0.3 = 0.18


Conditional
probability

Joint probability

h
nc
u
La
52
.6
9

7
0.3

H
y
Bu

o
inf

23.0
9

0.375

9.
6

Not buy info

0.
2

55

52.6
9

Not launch

6 $80
648
.
h
0
g
Hi
Med 0.2703$15
Lo
w0.
08
11
$-40

$80
0.12
h
g
Hi
h
c
Med 0.64 $15
9.6
un
Lo
La
w 0
.2
4
$-40
Not launch
88 $80
gh 0.05
i
H
ch
-20.01
n
u
Med0.2353
La
Lo
w0.
$15
70
59
Not launch
$-40

EVWOI = $18 (from exercise 2 part 1)


EVWI = $23.09
EVII = EVWI EVWOI
= 23.09 18 = 5.09

Thank You