SHORT ANSWER 91. What is meant by the expected payoff with perfect information (EPPI)?

ANS: The EPPI is the maximum price that a decision maker should be willing to pay for perfect information if it were available. We compute the EPPI by multiplying the probability of each state of nature by the largest payoff associated with that state of nature, and then summing the products. PTS: 1 REF: SECTION 22.2

Construction Company For a construction company, a payoff table, the prior probabilities for three states of nature, and the likelihood probabilities are shown below: Payoff Table: State of Nature s1 s2 s3 a1 80 60 200 Alternative a2 120 130 140 a3 90 170 100

Prior Probabilities: P(s1) = 0.4, P(s2) = 0.5, and P(s3) = 0.1. Likelihood Probabilities: s1 s2 s3 I1 0.5 0.2 0.1 I2 0.3 0.6 0.2 I3 0.2 0.2 0.7

92. {Construction Company Narrative} What is the expected payoff with perfect information? ANS: EPPI = (0.4)(120) + (0.5)(170) + (0.1)(200) = 153 PTS: 1 REF: SECTION 22.2

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93. {Construction Company Narrative} What is the expected value of perfect information? ANS: EVPI = EPPI EMV* = 153 131 = 22, or EVPI = EOL* = 22 PTS: 1 REF: SECTION 22.2

94. {Construction Company Narrative} Use the prior and likelihood probabilities to calculate the posterior probabilities for the experimental outcome I1. ANS: State of nature sj s1 s2 s3 PTS: 1 Prior Prob. P(sj) 0.4 0.5 0.1 Likelihood Prob. P(I1 / sj) 0.5 0.2 0.1 Joint Prob. P(sj and I1) 0.2 0.1 0.01 P(I1) = 0.31 Posterior Prob. P(sj / I1) 0.645 0.323 0.032

REF: SECTION 22.2

95. {Construction Company Narrative} Use the posterior probabilities for I1 in the previous question to recalculate the expected monetary value of each act, then determine the optimal act and the EMV*. ANS: EMV (a1) = (0.645)(80) + (0.323)(60) + (0.032)(200) = 77.38 EMV (a2) = (0.645)(120) + (0.323)(130) + (0.032)(140) = 123.87 EMV (a3) = (0.645)(90) + (0.323)(170) + (0.032)(100) = 116.16 The optimal act is a2. Hence, EMV* = 123.87. PTS: 1 REF: SECTION 22.2

96. {Construction Company Narrative} Use the prior and likelihood probabilities to calculate the posterior probabilities for the experimental outcome I2. ANS: State of nature sj s1 s2 s3 Prior Prob. P(sj) 0.4 0.5 0.1 Likelihood Prob. P(I2 / sj) 0.3 0.6 0.2 Joint Prob. P(sj and I2) 0.12 0.30 0.02 P(I2) = 0.44 Posterior Prob. P(sj / I2) 0.273 0.682 0.045

PTS: 1

REF: SECTION 22.2

97. {Construction Company Narrative} Use the posterior probabilities for I2 in the previous question to recalculate the expected monetary value of each act, then determine the optimal act and the EMV*. ANS: EMV (a1) = (0.273)(80) + (0.682)(60) + (0.045)(200) = 71.76 EMV (a2) = (0.273)(120) + (0.682)(130) + (0.045)(140) = 127.72
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EMV (a3) = (0.273)(90) + (0.682)(170) + (0.045)(100) = 145.01 The optimal act is a3. Hence, EMV* = 145.01. PTS: 1 REF: SECTION 22.2

98. {Construction Company Narrative} Use the prior and likelihood probabilities to calculate the posterior probabilities for the experimental outcome I3. ANS: State of nature sj s1 s2 s3 PTS: 1 Prior Prob. P(sj) 0.4 0.5 0.1 Likelihood Prob. P(I3 / sj) 0.2 0.2 0.7 Joint Prob. P(sj and I3) 0.08 0.10 0.07 P(I3) = 0.25 Posterior Prob. P(sj / I3) 0.32 0.40 0.28

REF: SECTION 22.2

99. {Construction Company Narrative} Use the posterior probabilities for I3 in the previous question to recalculate the expected monetary value of each act, then determine the optimal act and the EMV*. ANS: EMV (a1) = (0.32)(80) + (0.40)(60) + (0.28)(200) = 105.6 EMV (a2) = (0.32)(120) + (0.40)(130) + (0.28)(140) = 129.6 EMV (a3) = (0.32)(90) + (0.40)(170) + (0.28)(100) = 124.8 The optimal act is a2. Hence, EMV* = 129.6. PTS: 1 REF: SECTION 22.2

100. {Construction Company Narrative} Use your answers to the previous questions to calculate the expected monetary value with additional information. ANS: The expected monetary value with additional information is the weighted average of the expected monetary values, where the weights are P(I1), P(I2), and P(I3). Thus, EMV' = (0.31)(123.87) + (0.44)(145.01) + (0.25)(129.6) = 134.604 PTS: 1 REF: SECTION 22.2

101. {Construction Company Narrative} Calculate the expected value of sample information. ANS: EVSI = EMV' (EMV*) = 134.604 131 = 3.604 PTS: 1 REF: SECTION 22.2

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102. What is meant by the expected value of perfect information (EVPI)? ANS: The EVPI is the difference between the expected payoff with perfect information (EPPI) and the expected monetary value for the best decision (EMV*). PTS: 1 REF: SECTION 22.2

103. A company must decide whether or not to change its packaging to a more environmentally safe material. The impact of the decision on profits depends on which of the following three possible scenarios develops in the future. Scenario 1: The media does not focus heavily on concerns about packaging and no new laws requiring changes in packaging are passed. Under this scenario, the company will make $35 million if they change their packaging now, but will make $75 million if they do not change their packaging now. Scenario 2: The media does focus heavily on concerns about packaging and no new laws requiring changes in packaging are passed. Under this scenario, the company will make $50 million if they change their packaging now, but will make $55 million if they do not change their packaging now. Scenario 3: The media does focus heavily on concerns about packaging and new laws requiring changes in packaging are passed. Under this scenario, the company will make $60 million if they change their packaging now, but will make only $15 million if they do not change their packaging now. The prior probabilities of the three scenarios are 0.3, 0.5, and 0.2, respectively. What is the most the company should be willing to pay for a research study designed to reduce its uncertainty about media and legal developments concerning packaging? ANS: The value we need to determine is the expected value of perfect information (EVPI). First, we need to calculate the expected payoff with perfect information as follows: EPPI = (0.3)(75) + (0.5)(55) + (0.2)(60) = $62 million. Then, EVPI = EPPI (EMV*) = $62 $53 = $9 million. The most the company should be willing to pay for a research study designed to reduce its uncertainty about media and legal developments concerning packaging is $9 million. PTS: 1 Clothing Store A payoff table for a clothing store is shown below. State of Nature s1 s2 s3 a1 25 12 13 Alternative a2 a3 8 3 8 6 8 13 REF: SECTION 22.2

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The following prior probabilities are assigned to the states of nature: P(s1) = 0.2, P(s2) = 0.6, and P(s3) = 0.2. 104. {Clothing Store Narrative} What is the expected payoff with perfect information? ANS: EPPI = (0.2)(25) + (0.6)(12) + (0.2)(13) = 14.8 PTS: 1 REF: SECTION 22.2

105. {Clothing Store Narrative} What is the expected value of perfect information? ANS: EVPI = EPPI EMV* = 14.8 9.6 = 5.2, or EVPI = EOL* = 5.2. PTS: 1 Electric Company A payoff table for an electric company is shown below: State of Nature s1 s2 a1 7 2 Alternative a2 a3 0 4 4 3 a4 6 5 REF: SECTION 22.2

The following prior probabilities are assigned to the states of nature: P(s1) = 0.3, P(s2) = 0.7. 106. {Electric Company Narrative} What is the expected payoff with perfect information? ANS: EPPI = (0.3)(7) + (0.7)(5) = 5.6 PTS: 1 REF: SECTION 22.2

107. {Electric Company Narrative} What is the expected value of perfect information? ANS: EVPI = EPPI EMV* = 5.6 5.3 = 0.3, or EVPI = EOL* = 0.3. PTS: 1 REF: SECTION 22.2

Sporting-Goods Store For a sporting-goods store, a payoff table, the prior probabilities for two states of nature, and the likelihood probabilities are shown below:

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Payoff Table: State of Nature s1 s2 Prior Probabilities: P(s1) = 0.4, and P(s2) = 0.6. a1 20 32 Alternative a2 a3 28 33 29 25 Likelihood Probabilities: s1 s1 I1 0.95 0.08 I2 0.05 0.92

108. {Sporting-Goods Store Narrative} What is the expected payoff with perfect information? ANS: EPPI = (0.4)(33) + (0.6)(32) = 32.4 PTS: 1 REF: SECTION 22.2

109. {Sporting-Goods Store Narrative} What is the expected value of perfect information? ANS: EVPI = EPPI EMV* = 32.4 28.6 = 3.8, or EVPI = EOL* = 3.8 PTS: 1 REF: SECTION 22.2

110. {Sporting-Goods Store Narrative} Use the prior and likelihood probabilities to calculate the posterior probabilities for the experimental outcome I1. ANS: State of nature sj s1 s2 PTS: 1 Prior Prob. P(sj) 0.4 0.6 Likelihood Prob. P(I1 / sj) 0.95 0.08 Joint Prob. P(sj and I1) 0.380 0.048 P(I1) = 0.428 Posterior Prob. P(sj / I1) 0.888 0.112

REF: SECTION 22.2

111. {Sporting-Goods Store Narrative} Use the posterior probabilities for I1 in the previous question to recalculate the expected monetary value of each act, then determine the optimal act and the EMV*. ANS: EMV (a1) = (0.888)(20) + (0.112)(32) = 21.344 EMV (a2) = (0.888)(28) + (0.112)(29) = 28.112 EMV (a3) = (0.888)(33) + (0.112)(25) = 32.104 The optimal act is a3. Hence, EMV* = 32.104. PTS: 1 REF: SECTION 22.2

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112. {Sporting-Goods Store Narrative} Use the prior and likelihood probabilities to calculate the posterior probabilities for the experimental outcome I2. ANS: State of nature sj s1 s2 Prior Prob. P(sj) 0.4 0.6 Likelihood Prob. P(I2 / sj) 0.05 0.92 Joint Prob. P(sj and I2) 0.020 0.552 P(I2) = 0.572 Posterior Prob. P(sj / I2) 0.035 0.965

PTS: 1

REF: SECTION 22.2

113. {Sporting-Goods Store Narrative} Use the posterior probabilities for I2 in the previous questions to recalculate the expected monetary value of each act, then determine the optimal act and the EMV*. ANS: EMV (a1) = (0.035)(20) + (0.965)(32) = 31.580 EMV (a2) = (0.035)(28) + (0.965)(29) = 28.965 EMV (a3) = (0.035)(33) + (0.965)(25) = 25.280 The optimal act is a1. Hence, EMV* = 31.580. PTS: 1 REF: SECTION 22.2

114. {Sporting-Goods Store Narrative} Use your answers to the previous questions to calculate the expected monetary value with additional information. ANS: The expected monetary value with additional information is the weighted average of the expected monetary values, where the weights are P(I1) and P(I2). Thus, EMV' = (0.428)(32.104) + (0.572)(31.580) = 31.804 PTS: 1 REF: SECTION 22.2

115. {Sporting-Goods Store Narrative} Calculate the expected value of sample information. ANS: EVSI = EMV' (EMV*) = 31.804 28.6 = 3.204 PTS: 1 REF: SECTION 22.2

Refrigerator Designs Three different designs are being considered for a new refrigerator, and profits will depend on the combination of the refrigerator design and market condition. The following payoff table summarizes the decision situation, with amounts in millions of dollars.

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State of Nature (Market condition) s1 s2 s3

a1 $30 $19 $11

Alternative (Design) a2 $20 $21 $23

a3 $10 $15 $45

Assume that the following probabilities are assigned to the three market conditions: P(s1) = 0.1, P(s2) = 0.6, and P(s3) = 0.3. 116. {Refrigerator Designs Narrative} Determine the expected payoff that would be realized if perfect information were available. ANS: The expected payoff value with perfect information is the sum of the best payoff value for each state, weighted by the probability associated with the respective state. This is, EPPI = (0.1)(30) + (0.6)(21) + (0.3)(45) = $29.1 million. PTS: 1 REF: SECTION 22.2

117. {Refrigerator Designs Narrative} What is the most the firm would be willing to pay for a research study designed to reduce its uncertainty about market conditions? ANS: The value we need to determine is the expected value of perfect information (EVPI). EVPI = EPPI EMV* = 29.1 23.5 = $5.6 million, or EVPI = EOL* = $5.6 million. The most the firm would be willing to pay for a research study designed to reduce its uncertainty about market conditions is $5.6 million. PTS: 1 REF: SECTION 22.2

Photography Business A high school student, who started doing photography as a hobby, is considering going into the photography business. The anticipated payoff table is: Alternative State of Nature Poor Fair Super Start new business $12,000 $10,000 $15,000 Do Not Start new business 0 0 0

The following prior probabilities are assigned to the states of nature: P(poor) = 0.4, P(fair) = 0.4, and P(super) = 0.2.

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118. {Photography Business Narrative} What is the expected payoff with perfect information? ANS: EPPI = (0.4)(0) + (0.4)(10,000) + (0.2)(15,000) = $7,000 PTS: 1 REF: SECTION 22.2

119. {Photography Business Narrative} What is the expected value of perfect information? What does it mean? ANS: EVPI = EPPI EMV* = $7,000 $2,200 = $4,800, or EVPI = EOL* = $4,800. This means that, if perfect information were available, the student should be willing to pay up to $4,800 to acquire it. PTS: 1 Grocery Store The following table displays the payoffs (in thousands of dollars) for five different decision alternatives under three possible states of nature for a new grocery store: Alternative (Decision) a3 $35 $55 $35 REF: SECTION 22.2

State of Nature s1 s2 s3

a1 $100 $70 $30

a2 $80 $75 $0

a4 $20 $50 $55

a5 $0 $15 $60

The prior probabilities of the states of nature are: P(s1) = 0.2, P(s2) = 0.3, and P(s3) = 0.5. 120. {Grocery Store Narrative} Calculate the expected payoff with perfect information. ANS: EPPI = (0.2)(100) + (0.3)(75) + (0.5)(60) = $72.5 thousand PTS: 1 REF: SECTION 22.2

121. {Grocery Store Narrative} Calculate the expected value of perfect information. ANS: EVPI = EPPI EMV* = 72.5 46.5 = $26 thousand PTS: 1 REF: SECTION 22.2

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