Ruzanita Mat Rani - FSKM

Topic 2: Decision Theory

Introduction

What is Decision Theory?

is an analytical techniques to identify the optimal decision with several alternatives
and risk or uncertain pattern of future events.

What makes difference between good and bad decision?

i. A good decision is one that is based on logic, considers all available data and possible
alternatives, and applied quantitative approach.

ii. A bad decision is one of that is not based on logic, does not use all available information,
does not consider all alternatives and does not employ appropriate quantitative
techniques.

The Six Steps in Decision Theory

1. Define the problem.

2. List the possible alternatives.

Alternative is a course of action or a strategy that may be chosen by a decision
maker (DM).

3. Identify the possible outcomes or state of nature.

State of nature (SON) is an outcome or occurrence over which the DM has little or no
control.

4. List the payoff or profit of each combination of alternatives and

outcomes.
Payoff or profit is called conditional value.
The easiest way to present these values is by constructing a decision table (payoff
table).
States of nature
Alternatives

Payoffs

5. Select one of the mathematical decision theory models.

6. Apply the model and make your decision.

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Types of Decision Making Environment

The types of decisions people make depend on how much knowledge or information they have
about the situation. Three decision making environments are:

1. Decision making under certainty

DM knows with certainty the consequence of every alternatives or decision choice.

2. Decision making under risk

There are several possible outcomes for each alternative and DM knows the probability of
occurrence of each outcome. The most popular methods of making decision under risk are
EMV, EVPI and EOL.

3. Decision making under uncertainty

There are several possible outcomes for each alternative and DM does not know the
probability of the various outcomes.

Decision Making Under Uncertainty

1. Maximax

The maximax criterion finds the alternative that maximizes the maximum outcome or
consequences for every alternative.
It has been called an optimistic decision criteria.

Step 1 - Locate the maximum outcome within every alternative.

Step 2 Pick that alternative with the maximum number.

Alternatives Favorable market Unfavorable market Maximum in row

Construct a large 200,000 -180,000 200,000*
plant
Construct a small 100,000 - 20,000 100,000
plant
Do nothing 0 0 0

The decision is to construct a large plant.

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2. Maximin

The maximin criterion finds that alternative that maximizes the minimum outcome or
consequence for every alternative.
It has been called a pessimistic decision criteria.

Step 1 Locate the minimum outcome within every alternative.

Step 2 Pick that alternative with the maximum number.

Alternatives Favorable market Unfavorable market Minimum in row

Construct a large 200,000 -180,000 -180,000
plant
Construct a small 100,000 - 20,000 -20,000
plant
Do nothing 0 0 0*

The decision is to do nothing.

3. Equally Likely

The equally likely also called Laplace.

Decision criteria finds the alternative with the highest average outcome.

Step 1 Calculate the average outcome for every alternative, sum of all outcomes divided
by the number of outcomes.
Step 2 Pick the alternative with the maximum number.

Alternatives Favorable market Unfavorable Row average

market
Construct a large 200,000 -180,000 200000 ( 180000 )
plant 10000
2
Construct a small 100,000 - 20,000 100000 ( 20000 )
plant 40000
2
*
Do nothing 0 0 0

The decision is to construct a small plant.

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4. Criterion of realism (Hurwicz criterion)

Often called the weighted average.

The criterion of realism is a compromise between an optimistic and pessimistic decision.

Step 1 Select a coefficient of realism, 0 1 ,

0, the decision maker is pessimistic about the future.
1, the decision maker is optimistic about the future.

Step 2 Calculate the outcome by using the formula below:

Criterion of realism = ( maximum in a row) + (1 - ) (minimum in row)

Alternatives Favorable Unfavorable Criterion of realism

market market ( = 0.8)
Construct a large 200,000 -180,000 (0.8) 200,000 + 0.2 (-180,000)
plant = 124,000*
Construct a small 100,000 - 20,000 (0.8) 100,000 + 0.2 (-20,000)
plant = 76,000
Do nothing 0 0 0

The decision is to construct a large plant.

5. Minimax

Based on opportunity loss table. Minimax finds the alternative that minimizes the
maximum opportunity loss within each alternative.

Step 1 Develop an opportunity loss table.

Step 2 - Find the maximum opportunity loss within each alternative.
Step 3 Pick that alternative with the minimum number

State of nature (RM)

Alternatives Favorable market Unfavorable market
Construct a large plant 200,000 200,000 0 (-180,000)
Construct a small plant 200,000 100,000 0 20,000
Do nothing 200,000 0 00

Alternatives Favorable market Unfavorable market Maximum in row

Construct a large 0 180,000 180,000
plant
Construct a small 100,000 20,000 100,000*
plant
Do nothing 200,000 0 200,000

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The decision is to construct a small plant.

Exercise 2.1

A company is setting the price for one of its products. The marketing department has formulated
three pricing schemes, namely, PSA, PSB, and PSC. The estimated sales volume for three
demand levels of high, medium and low are shown in the table below:

Pricing scheme Levels of demand (RM)

High Medium Low
PSA 18,000 16,000 12,000
PSB 16,000 14,500 10,000
PSC 14,500 14,000 8,000

Determine which pricing scheme should be chosen using the following decision criteria.

a) Optimistic
b) Pessimistic
c) Laplace
d) Hurwicz (a = 0.2)
e) Minimax

Decision Making Under Risk

1. Expected monetary value (EMV)

EMV is the weighted sum of possible payoffs for each alternative.

This is determined by multiplying monetary values by their respective probabilities.

The results are then added to arrive at the EMV.

EMV (alternative I)= (payoff of the first SON) x (prob. of first SON) +
(payoff of the second SON) x (prob. of second SON)+
..+
(payoff of the last SON) x (prob. of last SON)

Example 2.2

The managers problem is whether to expand the product line by manufacturing and marketing
a new product, backyard storage sheds, the alternatives is either to construct a large plant, a
small plant or no plant at all. The manager determines that there are only two possible
outcomes, which are the market storage sheds could be favorable (high demand) or the market
storage sheds could be unfavorable (low demand). The manager thinks that the payoff for each
alternatives and state of nature is as table below.

State of nature (RM)

Alternatives Favorable market Unfavorable market
Construct a large plant 200,000 -180,000
Construct a small plant 100,000 - 20,000
Do nothing 0 0

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The manager believes that the probability of a favorable market is exactly the same as the
probability of an unfavorable market (0.5, 0.5). Which alternatives would be the maximum EMV?

Solution:

State of nature (RM)

Alternatives Favorable market Unfavorable market
Construct a large plant 200,000 -180,000
Construct a small plant 100,000 - 20,000
Do nothing 0 0
Probability 0.5 0.5

EMV (large plant) = (200,000)0.5 + (-180,000)0.5= 10,000

EMV (small plant) = (100,000)0.5 + (-20,000)0.5 = 40,000
EMV (do nothing) = (0)0.5 + (0)0.5 = 0

*The decision that manager should take is construct a small plant.

2. Expected Opportunity loss (EOL)

EOL is the cost of not picking the best solution sometimes called regret.

The amount you would lose by not picking the best alternative. For any SON, this is
the difference between the consequences of any alternative and the best possible
alternative.

The minimum expected opportunity loss is found by constructing an EOL table and
computing for each alternative.

Step 1
- Create the EOL table.
- Subtracting each outcome in the column from the best outcome in the same
column.

Step 2
- EOL is computed by multiplying the probability of each SON times the
appropriate EOL table.

*EVPI = Minimum EOL

Example 2.3

From our previous example (2.2) which alternatives give minimum EOL?

Solution:
Step 1 Create a loss table

State of nature (RM)

Alternatives Favorable market Unfavorable market

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Construct a large plant 200,000 200,000 0 (-180,000)

Construct a small plant 200,000 100,000 0 (- 20,000)
Do nothing 200,000 0 00

State of nature (RM)

Alternatives Favorable market Unfavorable market
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Probability 0.5 0.5

Step 2 Compute EOL

EOL (large plant) = (0)0.5 + (180,000)0.5 = RM 90,000

EOL (small plant) = (100,000)0.5 + (20,000)0.5 = RM 60,000
EOL (do nothing) = (200,000)0.5 + ((0)0.5 = RM 100,000

*The decision that manager should take is construct a small plant.

Exercise 2.2

An investor is to purchase one of three types of real estate. The investor must decide among an
apartment building, an office building and a warehouse. The future states of nature that will
determine how much profit the investor will make are good economic conditions and poor
economic conditions. The profits that will result from each decision in the event of each state of
nature are shown in table below.

Decision State of nature

Good economic Poor economic
Apartment 50,000 30,000
Office 100,000 -40,000
Warehouse 30,000 10,000

Based on several economic forecasts, the investor is able to estimate a 0.60 probability that
good economic conditions will prevail and a 0.40 probability that poor economic conditions will
prevail. Calculate the expected value for each decision and select the best one.

Exercise 2.3

Farah Sufiah, president of FS Manufacturing is considering whether to build more

manufacturing plants in Klang Valley. Her decision is summarized in the following table:

Alternatives Favorable Unfavorable

Market Market
(RM) (RM)
Build a large plant 400,000 -300,000
Build a small plant 80,000 -10,000
Dont build 0 0
Probabilities 0.4 0.6

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Construct an opportunity loss table. What is the best strategy based on EOL?
3. Expected value of perfect information (EVPI)

EPVI is the expected outcome with perfect information minus the expected outcome
without perfect information (maximum EMV).

The average or expected value of information if it were completely accurate. The

increase in EMV that results from having perfect information.

Expected value with perfect information (EVwPI) is the average or expected value of
the decision if you knew what would happen ahead of time. You have perfect knowledge.

EVwPI= (best outcome or consequence for first SON) x (prob. of first SON)
+ (best outcome or consequence for second SON)x (prob. of second
SON)+
..+
(best outcome or consequence for last SON) x (prob. of last SON)

EVPI= EVwPI Maximum EMV

Example 2.4:

From our previous example (2.3), assume that the manager has been approached by the
Scientific Marketing Inc. (SMI), a firm that proposes to help the manager make the decision
about whether to build the plant to produce storage sheds. SMI claims that its technical analysis
will tell the manager with certainty whether the market is favorable for his proposed product.
SMI would charge the manager RM 65,000 for the information. Should the manager hire the firm
to make the marketing study, is it worth RM 65,000?

Solution:

i. EVwPI

State of nature (RM)

Alternatives Favorable market Unfavorable market
Construct a large plant 200,000 -180,000
Construct a small plant 100,000 - 20,000
Do nothing 0 0

EVwPI = (200,000) 0.5 + (0) 0.5 = RM100,000

ii. Maximum EMV = RM40,000

iii. EVPI = EVwPI Maximum EMV

= RM100,000 RM40,000 = RM60,000

*EVPI = minimum EOL = RM60,000

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* The most the manager would be willing to pay for perfect information is RM60,000 so the
manager should not hire SMI to make the marketing study.

Exercise 2.4

The manager of a stores purchasing department must decide on the orders for clothes for the
coming festival month. Two new styles were introduced at the recent show. The payoff for the
various state have been estimated as follows:

Market Acceptance
Alternatives Style A Style B Both
Style A 75 25 80
Style B 35 84 53
Both 54 62 42

The probability for market acceptance of style A, style B and both styles are 0.35, 0.25 and 0.4
respectively.

What is the most the manager should pay for this perfect information?

Problems:

2.1 Perkasa Realty, a real estate development firm, is considering several alternative
development projects. The financial success of these projects depends on interest rate
movement in the next five years. The various development projects and their five-year financial
return (RM millions) given that interest rates will decline, remain stable, or increase are shown in
the following table.

Project Interest rates

Decline Stable Increase
Office building 0.6 1.2 4.5
Mall 1.3 1.9 2.5
Condominiums 3.5 1.5 0.4
Warehouse 1.7 1.5 1.0

Determine the best investment using the following decision criteria.

a) Maximax
b) Maximin
c) Equally likely
d) Hurwicz (=0.4)
e) Minimax

2.2 The manager of a sports shop intends to purchase some cricket bats. He can either
order 50, 100 or 150 cricket bats at RM25 each. He sells each bat for RM40. However, if the
cricket season ends and he still has unsold cricket bats, the manager will sell them at RM15
each.

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Create a payoff table. Determine the number of bats the manager should order according to
maximax and maximin criterion.

2.3 The manager of Excel Overseas Sdn. Bhd. is considering the possibility of opening a
stationery shop at section 11, Shah Alam. His options are to open a large shop, small shop
or no shop at all. The market for a stationery shop can be good, average or bad. The net
profit or loss for the large or small shops for the various market conditions are given below.
Building no shop at all yields no loss or no gain.

Decision State of nature

Good market Average market Bad market
Large shop 250,000 90,000 -120,000
Small shop 150,000 60,000 -80,000
No shop 0 0 0

The manager estimates that the probability of a good market is 0.4, an average market is 0.4
and a bad market is 0.2.

a) Determine the best alternative using EMV.

b) Construct an EOL table. Determine the best alternative using EOL.
c) Calculate the EVPI.

2.4 Osman is considering several alternatives with regard to opening satay restaurants. His
expected payoffs (RM) are shown below:

Alternative State of Nature (RM)

Good Market Fair Market Poor Market
Open 1 restaurant 380,000 70,000 -400,000
Open 2 restaurants 200,000 80,000 -200,000
Do not open any 0 0 0
restaurants

Osman believe that the probability the market will be good, fair or poor are 40%, 30% and 30%
respectively. A market research firm will analyze the market conditions and will provide a perfect
forecast of the future. What is the most that Osman should pay for this information?

2.5 Dr Hassan and wife are both experienced doctors. They are considering the construction
of private clinic. If there is a favorable market for the clinic, they could realize a net profit of
RM100,000. If the market is just able to sustain the clinics operations, they could be earning
RM60,000. If the market is not favorable, they could lose RM40,000. Of course they have the
alternative not to proceed at all, in which case there is no cost. Without any market data, the
best that Dr Hassan and wife could guess is that there is a 50% chance that the clinic will be
successful and a 25% chance that the clinic will be sustainable.

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Using the minimum Expected Opportunity loss criteria, advice Dr Hassan and wife on whether
they should proceed with the construction of the private clinic.

2.6 The manager of an electric shop has to decide how many units of EQUIP STAR have to
be ordered at the beginning of each month. The demand for EQUIP Star is projected to be
either 10, 15 or 20 units per month with the probability of 0.35, 0.40 and 0.25 respectively. Each
unit costs RM200 and selling price RM350 per unit.

a) Construct a payoff table for this problem.

b) Determine the best alternative using Expected Monetary Value criterion?

2.7 Style Sdn. Bhd. Realized that orders for clothing from a particular manufacturer for the
next years festive season must be placed now. The cost per unit for a particular dress is RM20
while the anticipated selling price is RM50. Any goods not sold during the season can be sold
for RM15 to a local discount store. Demand is projected to be either 50, 60 or 70 units. There is
40% chance that demand will be 50 units, a 50% chance that the demand will be 60 units and a
10% chance that demand will be 70 units.

a) Draw the payoff table for Style Sdn. Bhd.

b) How many units should be ordered under Expected Monetary value criterion?
c) What is the Expected Value of Perfect Information.

2.8 The owner of Senireka Construction Company must decide whether to engage his
company in a housing development project, a shopping complex project, or to lease all the
company's equipment to another company. The profit that will result from each alternative will be
determined by whether the material costs remain stable or increase. The profit from each
alternative given the two possibilities for material costs is shown in the following payoff table.

Decision Alternative Material cost

Stable Increase
Housing Project RM70,000 RM30,000
Shopping Complex RM105,000 RM20,000
Leasing RM40,000 RM40,000

a) Determine the best decision using the following decision criteria:

i) Maximax
ii) Maximin
iii) Minimax regret
iv) Hurwicz (a = 0.2)
v) Equal likelihood

b) What is the expected value of perfect information (EVPI) and how it is computed? What
are the differences between EVPI and the expected value of sample information (EVSI)?

c) Suppose the owner of Senireka has estimated the probability of cost remaining stable is
0.3, what is the best decision alternative using the expected value criterion? Calculate the
EVPI?

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2.9 Ever since Majlis Daerah Cheng announced it would build a sports center at either site
A, B or C, land near those sites has been in high demand. Karim is the real estate manager of a
restaurant chain and he plans to construct a new caf near the sports center. He tries to identify
the most suitable plot of land. He has estimated the payoff (RM) in the following table.

Alternative Site selected by Majlis Daerah Cheng

A B C
A 25 -10 -10
B -10 20 -10
C -5 -5 10

a) What is his optimal decision if he uses:

i) Equally likely (Laplace) criterion?
ii) Pessimistic decision criterion?

b) Assume that the following probabilities have been assessed

States of nature Probabilities

Majlis Daerah Cheng will select site A 0.3
Majlis Daerah Cheng will select site B 0.5
Majlis Daerah Cheng will select site C 0.2

i) Find the optimal solution using the expected opportunity loss (EOL) criterion.

ii) A friend of Karim said that he could predict very accurately where Majlis Daerah
Cheng would build the sports center. What is the maximum amount that Karim would be
willing to pay for the information?

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Decision Tree

Any problem that can be presented in a decision table can also be graphically illustrated in a
decision tree.

All decision trees are similar in that they contain decision points or nodes and state of nature
points or nodes:

A decision node from which one of several alternatives may be chosen

A state of nature node out which one state of nature will occur

Five steps of decision tree analysis

1. Define the problem.

2. Draw the decision tree.
3. Assign probabilities to the states of nature.
4. Estimate payoffs for each possible combination of alternatives and the state of nature.
5. Solve the problem by computing expected monetary value (EMV).

A simple decision tree for previous example:

Payoffs

10,000 Favorable market 200,000

(0.5)

1
Construct Unfavorable market
large plant 40,000 (0.5) -180,000
40,000
Favorable market 100,000
Construct
small plant
2 (0.5)
Unfavorable market
(0.5)
-20,000

Do nothing

*The decision that manager should take is construct a small plant.

When a decision situation requires only a single decision, an expected value payoff table will
yield the same result as a decision tree. However, a decision table is usually limited to a
single decision situation. A sequential decision tree illustrates a situation requiring a series of
decisions.

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Example 2.4:

From previous example (2.2), let say the manager has two decisions to make, with the second
decision dependent on the outcome of the first. Before deciding a new plant, Ahmad has the
option of conducting marketing research survey at a cost of RM10,000. The information from
this survey could help the manager decide whether to construct a large plant, a small plant or
not to build at all. The manager recognizes that such a market survey will not provide with
perfect information, but it may help quite a big nevertheless. There is a 45% chance that the
survey results will indicate positive market for storage sheds and 55% that the survey results will
negative. 0.78 is the probability of a favorable market for the sheds given a positive result from
the market survey. 0.22 probability that the market for sheds will be unfavorable given that the
survey results are positive. 0.27 is the probability of a favorable market for the sheds given a
negative result from the market survey. 0.73 probability that the market will be unfavorable given
that the survey results are negative.

State of nature (RM)

Alternatives Favorable market Unfavorable market
Construct a large plant 200,000 -180,000
Construct a small plant 100,000 - 20,000
Do nothing 0 0

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1)

Payoffs

First Decision Point Second Decision Point Favorable market (0.78) 200,000
116,400

2 Unfavorable market (0.22) -180,000

Large plant

Favorable market (0.78) 100,000

Small plant

116,400
73,600

3 Unfavorable market (0.22) -20,000

Survey (0.45)
Result positive

*59,200-10,000 = 49,200 No plant 0

1
Favorable market (0.27)
200,000
Conduct market
survey
-77,400
Unfavorable (0.73)
Large plant 4 -180,000
Survey (0.55)
Result negative Favorable (0.27)
49, 200

100,000
12 ,400

Small plant
12,400
Unfavorable (0.73)
5
Do not conduct -20,000
market survey
No plant

Favorable market (0.50)

200,000

10,000

Unfavorable market (0.50)

6 -180,000
Large plant

Favorable (0.50)
40 ,000

Small plant
100,000
40,000

*The best decision is to conduct 7 Unfavorable (0.50)

market survey. If the survey -20, 000
results favorable construct a
large plant, but if the survey No plant 20
results unfavorable construct a 0
small plant.
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Favorable market (0.78)

Payoffs

2) 190,000

Unfavorable market (0.22)

First Decision Point Second Decision Point
106,400 -190,000
Favorable market (0.78)

2 90,000

Large plant Unfavorable market (0.22)

106 ,400

Small plant 63,600 -30,000

No plant

3
Survey (0.45)
-10,000
Result positive

Favorable market (0.27)

49,200

190,000
1 Unfavorable (0.73)

Favorable (0.27)
Conduct market -190,000
survey -87,400
Survey (0.55)
90,000
Result negative Unfavorable (0.73)
4
49, 200

Large plant
No plant
2, 400

Small plant 2,400 -30,000

5
Do not conduct Favorable market (0.50) -10,000
market survey

200,000

Unfavorable market (0.50)

10,000 -180,000
Favorable (0.50)

6 100,000

Large plant Unfavorable (0.50)

40 ,000

Small plant 40,000

No plant -20,000

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*The best decision is to conduct

market survey. If the survey
results favorable construct a
Exercise 2.4 but if the survey
large plant,
results unfavorable construct a
small plant.
A housing developer is considering three housing projects: Anggerik, Mawar and Dahlia. The
developer has to decide which housing project to launch. The profit from each project depends
on the demand for houses. The payoffs (million ringgit) from each project under high demand
and low demand are given below,

House project High demand Low demand

Anggerik 12 7
Mawar 15 6
Dahlia 10 8

The developer estimates that there is a 50-50 chance of a high demand.

For a fee of RM15000, an economist can be engaged to give an economic outlook. The
economist claims that from past studies, the probability of a high demand for houses given a
good economy is 0.8, and the probability of a low demand given a poor economy is 0.9. The
probability of a good economy is 0.70.

Use a decision tree to determine the best strategy for the developer.

Bayesian Theorem

There are many ways of getting probability data for a problem. The numbers can be
assessed by a manager based on experienced or intuition.

They can be derived from historical data or they can be computed from other available
data using Bayes theorem.

Bayes theorem allows decision makers to revise probability values. The revised
probabilities are called posterior probabilities (the altered prior probability of an event
based on additional information).

Example 2.5:

From previous example (2.4) we made the assumption that the following four posterior
probabilities (the revised probability of past events based on new information) were known:

P(favorable market (FM) survey results positive) = 0.78

P(unfavorable market (UM) survey results positive) = 0.22
P(favorable market (FM) survey results negative) = 0.27
P(unfavorable market (UM) survey results negative) = 0.73

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Recall that without any market survey information, decision maker estimates of a favorable and
unfavorable market are:

P(FM) = 0.50
P (UF) = 0.50

These are referred to as the prior probabilities (probability of single event occurring).

Joint probability is the probability both events will occur.

The general form of Bayes theorem:

P ( B A).P ( A)
P(AB)= P ( B A).P ( A) P ( B A).P ( A)

Where A.B = any two events

A complement of A

Prior
Probability
Bayes Posterior
Process probability
Additional
information
(Conditional
Probability)

Additional information comes from the experts.

For example 2.5:

The experts have told the manager that, statistically of all new products with a FM,
market surveys were positive and predicted success correctly 70% of the time. 30% of the
time the surveys incorrectly predicted negative results.
The experts have told the manager that, statistically of all new products with a UFM,
market surveys were negative and predicted success correctly 80% of the time. 20% of the
time the surveys incorrectly predicted positive results.

Market survey reliability in predicting states of nature

Result of survey Actual state of nature

Favorable market Unfavorable market
Positive P(survey positive FM)=0.70 P(survey positive UM)=0.20
Negative P(survey negative FM)=0.30 P(survey negative UM)=0.80

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Probability revisions given a positive survey

State
of Conditional probability Prior Joint Posterior probability
nature P(survey positive SON) probability probability P (SON survey positive)
(SON)
FM 0.70 x 0.50 = 0.35 0.35 / 0.45 = 0.78
UM 0.20 x 0.50 = 0.10 0.10 / 0.45 = 0.22
= 0.45 = 1.00
P (survey results positive)

Probability revisions given a negative survey

State
of Conditional probability Prior Joint Posterior probability
nature P(survey negative SON) probability probabilit P (SON survey
(SON) y negative)
FM 0.30 x 0.50 = 0.15 0.15 / 0.55 = 0.27
UM 0.80 x 0.50 = 0.40 0.40 / 0.55 = 0.73
= 0.55 = 1.00
P (survey results negative)

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Exercise 2.5

A company faces a decision problem with respect to a new product, M337, developed by one of
its research laboratories. A plant is needed to facilitate the production of M337. The
company is considering either to construct large plant or a small plant. The production
of M337 might be responded with similar product competitors. The companys
marketing department projected that profits (in RM) for M337, based on the plant size
and the presence competition, will be as follows:

Alternatives States of nature

No competition Competition
Large plant 120,000 -25,000
Small plant 95,000 5,000
Probability 0.60 0.40

The marketing department suggested that M337 be test marketed. It is estimated that test
marketing will cost RM10,000. The test market will indicate whether the new product is
successful or unsuccessful. The reliability of the test marketing data is given by the
conditional probabilities shown below.

Test market Actual state of nature

result No competition Competition
Successful 0.7 0.2
Unsuccessful 0.3 0.8

Example:
P(test market indicates product is successful given no competition) = 0.7
P(test market indicates product is unsuccessful given there is competition) = 0.8

a) Find the following probabilities:

i) Probability that there is no competition given the test market indicates the
product is successful.
ii) Probability that there is competition given the test market indicates the product is
unsuccessful.
iii) Probability that the test market indicates the product is successful.

b) Draw the decision tree for the above situation.

c) Analyze the tree and determine the best course of action for the company.

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Expected Value of Sample Information (EVSI)

EVSI is the maximum amount to pay to access sample information.

From example 2.4, the manager realizes that conducting the market research is not free.
The manager would like to know what the actual value of doing a survey is. One way of
measuring the value of market information is to compute the EVSI.

EVSI = expected value of expected value

best decision with of best decision
__
sample information, without sample
assuming no cost to information
gather it

= 59,200 40,000 (see solution ex 2.4 (1))

Or

= (EV with sample information + cost) (EV without sample information)

= (49,200 + 10,000) (40,000) (see solution ex 2.4(2))
= 19 200

The maximum amount is RM19,200 for a market study.

Since the cost to conduct market survey is RM10,000 so the survey is worthwhile.

Problems:

2.10 Ali is considering opening a competing bookstore near the campus and he has begun an
analysis of the situation. There are two possible sites under consideration. One is relatively
small while the other is large. If he opens at site A and demand is high, he will generate a profit
of RM55,000. If demand is low he will lose RM10,000, If he opens at site B and demand is high,
he will generates profit of RM85,000, but he will lose RM30,000 if the demand is low. He also
has the option of not opening either. He believes that there is 50% chance that demand will be
high. Ali can hire an expert to conduct a market research study. The probability of a high
demand given a favorable study is 0.85. The probability of a high demand given an unfavorable
study is 0.1. There is a 60% chance that the study will be favorable. Should Ali conduct the
study? What is the maximum amount Ali will be willing to pay for this study?

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2.11 The director of telecommunication company is going to introduce one of the two models
of mobile phone: Persona Elegant or Persona Compact. The companys profit is determined by
the market conditions and is presented in the payoff table below:

Market Condition (RM)

Model Favorable Stable Unfavorable
Persona Elegant 100,000 80,000 -34,000
Persona Compact 95,000 82,000 -29,000

From his records the probability of a favorable market is estimated at 0.4 and that of
unfavorable market 0.1. At the same time he is considering hiring a market research firm to do a
survey to determine the future market conditions. The result of the survey will indicate either
positive or negative market conditions. It is estimated that there is 0.6 probability that the survey
will be positive. If the survey is positive the probability that the market will be favorable, stable or
unfavorable are 0.72, 0.26 and 0.02, respectively. On the other hand, if the survey is negative,
the probability that the market will be favorable, stable or unfavorable are 0.20, 0.66 and 0.14,
respectively.

Using decision tree analysis, determine:

a) The decision strategy the company should follow.

b) The maximum amount the company should pay the market research firm.

2.12 A firm that manufactures bicycles needs to expand its production facilities. The firm must
decide whether to construct a large plant or a small plant. The market is either good or fair. The
payoff (in RM) for each combination of alternatives and states of nature are given below:

Alternative Market condition

Good Fair

Small plant 600,000 200,000

Large plant 900,000 -100,000
Probability 0.60 0.40

The firm is considering hiring a market research team to conduct a survey on future market
condition. The result of the survey would indicate either positive or negative market condition.
There is 80% chance of a good market given a positive survey, and 70% chance of a fair market
given a negative survey. The chance of a positive survey result is 56%.

a) Construct a decision tree to help the firm choose the best decision.
b) Advise the firm on the optimal decision strategy.
c) How much should the firm pay for the market research?

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2.13 Abdul Rahman is thinking about producing a new product for his company. If the market
were favorable, he would get a return of RM100,000, but if the market were unfavorable he
would lose RM40,000. He estimates that the probability of a favorable market is 0.5. He is also
considering doing a survey to gather additional information about the market. The cost of the
survey is RM4,000. Furthermore, the revised probability for the favorable market given that the
survey result is positive is 0.73. The probability of the favorable market given that the survey is
negative is 0.22. The probability that the survey will result in a positive market is 0.55.

a) Draw a decision tree for this problem.

b) Give the best decision that Abdul Rahman should take.
c) Compute the Expected Value of Sample Information for the problem and explain the
value obtained.

2.14 Ramzi & Co, a house developer, is trying to decide whether to build double-storey
terrace houses or single-storey terrace houses or he could also choose not to proceed with the
project. Given a favorable market, he will earn a profit of RM30,000 if he builds double storey
houses and RM10,000 if he builds single storey houses. However, with an unfavorable market,
Ramzi could lose RM40,000 with the double-storey houses and RM20,000 with single-storey
houses. He believes that the probability of a favorable market is 0.7. Prior to this decision,
Ramzi can get additional information from market research analyst at the cost of RM6,000 and
the probability that the result will be positive is 0.5. A positive result from the study will increase
the probability of a favorable market to 0.9. Furthermore, a negative result from the study will
decrease the probability of a favorable market to 0.4.

a) Construct a decision tree for this problem.

b) Analyze the decision tree and advise Ramzi for the best decision.
c) If the cost to gather additional information is reduced to only RM2,000, what will be your
advised to Ramzi.

2.15 Borneo Manufacturing Company must decide whether it should manufacture component
A or component B. The profit (RM) depends on the demand of the components and is given in
the following table:

State of nature
Alternatives High demand (H) Low demand (L)
Component A 100,000 -20,000
Component B 70,000 10,000
Probability 0.6 0.4

A market research firm offers to perform a study of the market for a fee of RM4,000 and will
report either a favorable market (F) or unfavorable market (U).

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The relevant conditional probabilities are as follows:

P(FH) = 0.88 P(UH) = 0.12 P(FL) = 0.3 P(UL) = 0.7

The company has calculated the following posterior probabilities:

P(HF) = 0.82 P(LF) = 0.18

a) Show that P(HU) = 0.2 and P(LU) = 0.8

b) Draw a decision tree for the above problem.
c) Determine whether the study should be performed.
d) Calculate the Expected Value of Sample Information (EVSI).

2.16 Abu is a farmer. He must determine whether to plant corn or wheat. If he plants corn and
the weather is warm, he earns RM8,000. If he plants corn and the weather is cold, he earns
RM5,000. If he plants wheat and the weather is warm, he earns RM7,000. If he plants wheat
and the weather is cold, he earns RM4,500. In the past, 40% of the years have been cold and
60% have been warm. Before planting, Abu can pay RM600 for an expert weather forecast.

The reliability of the forecast is given by the conditional probabilities below:

Weather forecast predict

Given the actual Cold Warm
weather Cold 0.7 0.3
Warm 0.2 0.8

Example:
P(weather forecast will predict a cold year given the actual weather is warm) = 0.2
P(weather forecast will predict a warm year given the actual weather is cold) = 0.3

a) Draw a decision tree for the above situation.

b) Analyze the tree and determine the best course of action for Abu.
c) State the maximum amount Abu will be willing to pay to the weather forecaster.

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