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CHAPTER 9

DECISION ANALYSIS

SOLUTION TO SOLVED PROBLEMS

9.S1 New Vehicle Introduction

The General Ford Motors Corporation (GFMC) is planning the introduction of a brand new

SUVthe Vector. There are two options for production. One is to build the Vector at the

companys existing plant in Indiana, sharing production time with its line of minivans that are

currently being produced there. If sales of the Vector are just moderate, this will work out well

as there is sufficient capacity to produce both types of vehicles at the same plant. However, if

sales of the Vector are strong, this option would require the operation of a third shift, which

would lead to significantly higher costs.

A second option is to open a new plant in Georgia. This plant would have sufficient

capacity to meet even the largest projections for sales of the Vector. However, if sales are only

moderate, the plant would be underutilized and therefore less efficient.

This is a new design, so sales are hard to predict. However, GFMC predicts that there

would be about a 60% chance of strong sales (annual sales of 100,000), and a 40% chance of

moderate sales (annual sales of 50,000). The average revenue per Vector sold is $30,000.

Production costs per vehicle for the two production options depend upon sales, as indicated in

the table below.

Moderate

Sales

Strong Sales

Shared Plant in Indiana 16 24

Dedicated Plant in Georgia 22 20

The amortized annual cost of plant construction and other associated fixed costs for the

Georgia plant would total $400 million per year (regardless of sales volume). The fixed costs for

adding Vector production to the plant in Indiana would total $200 million per year (regardless

of sales volume).

2

a. Construct a decision tree to determine which production option maximizes the expected annual

profit, considering fixed costs, production costs, and sales revenues.

The decision is whether to share the existing plant in Indiana (with a fixed cost of $2 million) or

build a new dedicated plant in Georgia (with a fixed cost of $4 million). This decision is

represented in the decision tree by a decision node with two branches. For each decision, there

are two outcomes: strong sales (60% probability) or moderate sales (40% probability). This is

represented in the decision tree by event nodes with two branches.

If the Indiana plant is used and sales are strong, the profit would be (100,000 units)($30,000

$24,000) = $600 million $200 million (fixed cost) = $400 million.

If the Indiana plant is used and sales are moderate, the profit would be (50,000 units)($30,000

$16,000) = $700 million $200 million (fixed cost) = $500 million.

If the Georgia plant is used and sales are strong, the profit would be (100,000 units)($30,000

$20,000) = $1000 million $400 million (fixed cost) = $600 million.

If the Georgia plant is used and sales are moderate, the profit would be (50,000 units)($30,000

$22,000) = $400 million $400 million (fixed cost) = $0.

The resulting solved decision tree is shown below. The decision to share the plant in Indiana has

a higher expected profit of $440 million.

3

b. Due to the uncertainty in expected sales for the Vector, GFMC is considering conducting a

marketing survey to determine customer attitudes toward the Vector and better predict the

likelihood of strong sales. The marketing survey would give one of two resultsa positive

attitude or a negative attitude toward the design. GFMC has used this marketing survey for other

vehicles. For vehicles that eventually had strong sales, the marketing survey indicated positive

attitudes toward the design 70% of the time and negative attitudes 30% of the time. For vehicles

that eventually had moderate sales, the marketing survey indicated positive attitudes toward the

design 20% of the time and negative attitudes 80% of the time. Assuming GFMC conducts such a

survey, construct a decision tree to to determine how the company should proceed and what the

expected annual profit would be (ignoring the cost of the survey).

First we must determine an estimate for the probability that the survey will indicate a positive

attitude or negative attitude toward the design. Second, given the survey indicates either a

positive or negative attitude, we must determine the posterior probability that sales will be either

strong or moderate. Both of these calculations can be performed using the template for posterior

probabilities on the CD. These results are shown below.

Template for Posterior Probabilities

Data:

State of Prior

Nature Probability Positive Attitude Negative Attitude

Strong Sales 0.6 0.7 0.3

Moderate Sales 0.4 0.2 0.8

Posterior

Probabilities:

Finding P(Finding) Strong Sales Moderate Sales

Positive Attitude 0.5 0.84 0.16

Negative Attitude 0.5 0.36 0.64

P(State | Finding)

State of Nature

P(Finding | State)

Finding

Thus, there is a 50% chance that the survey will indicate a positive attitude and a 50% chance

that the survey will indicate a negative attitude toward the new car. Given a positive attitude, the

probability of strong sales increases to 84%. Given a negative attitude, the probability of strong

sales sinks to 36%.

4

The revised decision tree is shown below. It begins with an event node with two branches for the

two possible outcomes of the survey. After the survey results are known, there is a decision of

whether to share the plant in Indiana, or open a new plant in Georgia, represented by a pair of

branches. Finally, after the decision is made, there will either be strong or moderate sales. This is

represented by event nodes with two branches, and uses the posterior probabilities given the

results of the survey.

If the survey indicates a positive attitude toward the car, they should open a dedicated plant in

Georgia. If the survey indicates a negative attitude toward the car, they should share the plant in

Indiana. The expected profit is $484 million.

5

c. What is the expected value of the sample information in part b? What does this say about how

large the cost of the marketing survey can be before it would no longer be worthwhile to conduct

the survey?

The expected value of sample information is the expected payoff with the information minus the

expected payoff without the information. With the survey information, the expected payoff is

$484 million. Without the survey information, the expected payoff is $440 million. Thus, the

expected value of sample information in part b is $44 million. This is the most that they should

be willing to pay for the marketing survey before it would no longer be worthwhile to conduct.

6

9.S2 Settle or Go to Trial

Meredith Delgado owns a small firm that has developed software for organizing and playing

music on a computer. Her software contains a number of unique features that she has patented

so her companys future has looked bright.

However, there now has been an ominous development. It appears that a number of her

patented features were copied in similar software developed by MusicMan Software, a huge

software company with annual sales revenue in excess of $1 billion. Meredith is distressed.

MusicMan Software has stolen her ideas and that companys marketing power is likely to enable

it to capture the market and drive Meredith out of business.

In response, Meredith has sued MusicMan Software for patent infringement. With

attorney fees and other expenses, the cost of going to trial (win or lose) is expected to be $1

million. She feels that she has a 60% chance of winning the case, in which case she would

receive $5 million in damages. If she loses the case, she gets nothing. Moreover, if she loses the

case, there is a 50% chance that the judge would also order Meredith to pay for court expenses

and lawyer fees for MusicMan (an additional $1 million cost). Music Man Software has offered

Meredith $1.5 million to settle this case out of court.

7

a. Construct and use a decision tree to determine whether Meredith should go to court or accept

the settlement offer, assuming she wants to maximize her expected payoff.

The decision is whether to go to trial (with a cost of $1 million) or settle (receive a payment of

$1.5 million), represented in the decision tree by a decision node with two branches. If Meredith

goes to trial, she will win (60% probability) or lose (40% probability), represented as an event

node with two branches. If she loses, there is also a 50% chance that she must pay court fees,

represented as an event node with two branches.

If she goes to trial and wins, her net payoff is $5 million $1 million = $4 million.

If she goes to trial and loses, but doesnt pay court fees, her net payoff is $1 million.

If she goes to trial and loses and must pay court fees, her net payoff is 2 million.

If she settles, she receives a net payoff of $1.5 million.

The resulting solved decision tree is shown below. The decision to go to trial has a higher

expected payoff of $1.8 million.

8

b. To implement the equivalent lottery method to determine appropriate utility values for all the

possible payoffs in this problem, what questions would need to be asked of Meredith?

The equivalent lottery method begins by assigning the highest possible payoff ($4 million) a

utility value of 1, and the lowest possible payoff ($2 million) a utility value of 0. What remains

is to determine the appropriate utility value of the remaining two possible payoffs: $1 million

and $1.5 million. For each of these payoffs, the following question should be asked of Meredith:

Given a lottery where you receive $4 million with probability p and $2 million with probability

1p, what would p need to be so that you would be indifferent between this lottery and a sure

payoff of $1 million (or $1.5 million)? Her answer is the appropriate utility value for $1

million (or $1.5 million).

c. Suppose that Merediths attitude toward risk is such that she would be indifferent between doing

nothing and a gamble where she would win $1 million with 50% probability and lose $500

thousand with 50% probability. Use the exponential utility function to re-solve the decision tree

from part a.

The decision tree from part a is re-solved below, using an exponential utility function with RT =

$1 million. When accounting for Merediths risk aversion, it turns out that settling the case and

receiving the sure payoff of $1.5 million becomes the better decision.

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