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SOLUTIONS TO PRACTICE EXERCISES

Chapter 3: Decision Analysis
Question 1
a) Maximax
The decision is selected that will result in the maximum of the maximum payoffs.
This is how this criterion derives its name--the maximum of the maxima.
The maximax criterion is very optimistic. The decision maker assumes that the
most favorable state of nature for each decision alternative will occur. Thus, for this
example, the company would optimistically assume that good competitive
conditions will prevail in the future, resulting in the following maximum payoffs and
decisions:

Decision: Maintain status quo

b) Maximin
The maximin criterion is pessimistic. With the maximin criterion, the decision
maker selects the decision that will reflect the maximum of the minimum payoffs.
For each decision alternative, the decision maker assumes that the minimum payoff
will occur; of these, the maximum is selected as follows:

Decision: Expand
c) Hurwicz
A compromise between the maximax and maximin criteria. The decision maker is
neither totally optimistic (as the maximax criterion assumes) nor totally pessimistic
(as the maximin criterion assumes). With the Hurwicz criterion, the decision
payoffs are weighted by a coefficient of optimism, a measure of the decision
maker's optimism. The coefficient of optimism, defined as , is between 0 and 1
(i.e., 0 < < 1.0). If = 1.0, then the decision maker is completely optimistic, and
if a = 0, the decision maker is completely pessimistic. (Given this definition, 1 - is
the coefficient of pessimism.) For each decision alternative, the maximum payoff is
multiplied by and the minimum payoff is multiplied by 1 - . For our investment
example, if equals 0.3 (i.e., the company is slightly optimistic) and 1 - = 0.7, the
following decision will result:

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Decision: Expand
d) Equal Likely
The equal likelihood (or Laplace) criterion weights each state of nature equally,
thus assuming that the states of nature are equally likely to occur. Since there are
two states of nature in our example, we assign a weight of 0.50 to each one. Next,
we multiply these weights by each payoff for each decision and select the
alternative with the maximum of these weighted values. (You may also compute the
row averages and select the maximum average)

Decision: Expand
e) Minimax Regret
The decision maker attempts to avoid regret by selecting the decision alternative
that minimizes the maximum regret. A decision maker first selects the maximum
payoff under each state of nature; then all other payoffs under the respective states
of nature are subtracted from these amounts, as follows:
Good Competitive
Poor Competitive
$1,300,000 $800,000 = $500,000
$500,000 $500,000 = 0
$1,300,000 $1,300,000 = $0
$500,000 ($150,000) = $650,000
$1,300,000 $320,000 = $980,000
$500,000 $320,000 = $180,000
These values represent the regret for each decision that would be experienced by
the decision maker if a decision were made that resulted in less than the maximum
payoff. The maximum regret for each decision must be determined, and the
decision corresponding to the minimum of these regret values is selected as follows:

Decision: Expand
The decision to expand the plant was designated most often by four of the five
decision criteria. The decision to sell was never indicated by any criterion. This is
because the payoffs for expansion, under either set of future economic conditions,
are always better than the payoffs for selling. Given any situation with these two
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alternatives, the decision to expand will always be made over the decision to sell.
The sell decision alternative could have been eliminated from consideration under
each of our criteria. The alternative of selling is said to be dominated by the
alternative of expanding. In general, dominated decision alternatives can be
removed from the payoff table and not considered when the various decisionmaking criteria are applied, which reduces the complexity of the decision analysis.
Question 2
a) Payoff Table (profit measured in $ million)
State of Nature
Alternatives
Low Demand
High Demand
Gradual introduction
1
4
Concentrated
-5
10
introduction
b) First you find the maximum profit for each action. For a gradual introduction to
the market, the maximum profit is $4 million. For a concentrated introduction to
the market, the maximum profit is $10 million. Because the maximum of the
maximum profits is $10 million, you choose the action that involves a
concentrated introduction to the market.
State of Nature
Maximum in a
Low
High
Alternatives
Row ($ million)
Demand
Demand
Gradual introduction
1
4
4
Concentrated
-5
10
10 (Maximax)
introduction
Decision: Concentrated Introduction
c) First, you find the minimum profit for each action. For a gradual introduction to
the market, the minimum profit is $1 million. For a concentrated introduction to
the market, the minimum profit is million. Because the maximum of the
minimum profits is $1 million, you choose the action that involves a gradual
introduction to the market.
Alternatives

State of Nature
Low Demand High Demand
1
4
-5
10

Minimum in a Row
($ million)
1 (Maximin)
-5

Gradual introduction
Concentrated
introduction
Decision: Gradual Introduction
d) The coefficient of realism (optimism) is 80%, so = 0.8. The weighted average
is computed as follows: = (best in row) + (1 )(worst in row). Based on the
following table, the best decision is choose the action that involves concentrated
introduction to the market.
Alternatives
State of Nature
Realism / Hurwicz
Low Demand High Demand

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Gradual introduction
1
Concentrated
-5
introduction
Decision: Concentrated Introduction

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4
10

( = 0.8)
4(0.8)+1(0.2) = 3.4
10(0.8) + (-5)(0.2) =
7

Question 3
The expected monetary values for each decision alternative are computed as
follows.

The decision according to this criterion is to maintain the status quo, since it has
the highest expected value.
Question 4
The problem is one of decision making under uncertainty. Before answering the
specific questions, a decision table should be developed showing the alternatives,
states of nature, and related consequences.
State of Nature
Alternative
Favorable ($)
Unfavorable ($)
Strategy 1
10,000
8,000
Strategy 2
8,000
4,000
Strategy 3
0
0
a) Since Cal is a risk taker, he should use the maximax decision criteria. This
approach selects the row that has the highest or maximum value. The $10,000
value, which is the maximum value from the table, is in row 1. Thus, Cals
decision is to select strategy 1, which is an optimistic decision approach.
b) Becky should use the maximin decision criteria because she wants to avoid risk.
The minimum or worst outcome for each row, or strategy, is identified. These
outcomes are $8,000 for strategy 1, $4,000 for strategy 2, and $0 for strategy
3. The maximum of these values is selected. Thus, Becky would select strategy
3, which reflects a pessimistic decision approach.
c) If Cal and Becky are indifferent to risk, they could use the equally likely
approach. This approach selects the alternative that maximizes the row
averages. The row average for strategy 1 is ($1,000)(0.5)+ ($8,000)(0.5) =
$1,000. The row average for strategy 2 is ($8,000)(0.5)+ ($4,000)(0.5) =
$2,000, and the row average for strategy 3 is $0. Thus, using the equally likely
approach, the decision is to select strategy 2, which maximizes the row
averages.
Question 5
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Since the decision-making environment is risk (probabilities are known), it is

appropriate to use the EMV criterion. The problem can be solved by developing a
payoff table that contains all alternatives, states of nature (market), and probability
values. The EMV for each alternative is also computed, as in the following table:
State of Nature
Alternative
EMV ($)
Good
Average
Bad
Small shop
75,000
25,000
15,500
40,000
Medium-sized shop
100,000
35,000
19,500
60,000
No shop
0
0
0
0
Probabilities
0.20
0.50
0.30
EMV (small shop) = (0.2)(75,000) + (0.5)(25,000) + (0.3)(40,000) = $15,500
EMV (medium shop)
= (0.2)(100,000) + (0.5)(35,000) + (0.3)(60,000) =
$19,500
EMV (no shop)
= (0.2)(0) + (0.5)(0) + (0.3)(0) = $0
As can be seen, the best decision is to build the medium-sized shop. The EMV for
this alternative is $19,500.
a) EVwPI = (0.2)(100,000) + (0.5)(35,000) = (0.3)(0) = $37,500
EVPI = EVwPI Maximum EMV = $37,500 - $19,500 = $18,000
b) Opportunity Lost Table
Alternative
Small shop
Medium-sized
shop
No shop
Probabilities

State of Nature
Good
Average
Bad
25,000
0

10,000
0

40,000
60,000

100,000
0.20

35,000
0.50

0
0.30

Minimax
Regret
Maximum in row
40,000
60,000

22,000
18,000

37,500

EOL
($)

The best payoff in a good market is 100,000, so the opportunity losses in the first
column indicate how much worse each payoff is than 100,000. The best payoff in an
average market is 35,000, so the opportunity losses in the second column indicate
how much worse each payoff is than 35,000. The best payoff in a bad market is 0,
so the opportunity losses in the third column indicate how much worse each payoff
is than 0.
The minimax regret criterion considers the maximum regret for each decision, and
the decision corresponding to the minimum of these is selected. The decision would
be to build a small shop since the maximum regret for this is 40,000, while the
maximum regret for each of the other two alternatives is higher as shown in the
opportunity loss table.

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The decision based on the EOL criterion would be to build the medium-sized shop.
Note that the minimum EOL ($18,000) is the same as the EVPI computed in part b.
The calculations are:
EOL (small shop) = (0.2)(25,000) + (0.5)(10,000) + (0.3)( 40,000) = $22,00
EOL (medium shop) = (0.2)(0) + (0.5)(0) + (0.3)(60,000) = $18,000
EOL (no shop)
= (0.2)(100,000) + (0.5)(35,000) + (0.3)(0) = $37,500
Question 6
a)
Stock

Demand

(Cases)

(Cases)

11

12

13

EMV ($)

11

385

385

385

385

12

329

420

420

379.05

13

273

364

455

341.25

Probabilities

0.45

0.35

0.20

Example (how to calculate profits at demand of 11 cases):Profits at stock 11 cases = $35*11 cases = $385
(at stock 11 cases)
Profits at stock 12 cases = $35*11 cases = $385 $56 = $329 (unsold 1 case)
Profits at stock 13 cases = $35*11 cases = $385 $56(2 cases) = $273 (unsold 2
cases)
EMV(stock 11 cases) = (0.45)(385)+(0.35)(385)+(0.20)(385) = $385
EMV(stock 12 cases) = (0.45)(329)+(0.35)(420)+(0.20)(420) = $379.05
EMV(stock 13 cases) = (0.45)(273)+(0.35)(364)+(0.20)(455) = $341.25
b) Stock 11 cases.
c) If no loss is involved in excess stock, the recommended course of action is to
stock 13 cases and to replenish stock to this level each week. This follows from the
following decision table.
Stock

Demand

(Cases)

(Cases)

11

12

13

EMV ($)

11

385

385

385

385

12

385

420

420

404.25

13

385

420

455

411.25

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