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# Chapter 15 Bayesian Statistics and Decision Analysis

True/False Questions

## Answer: False Type: Concept Difficulty: Easy

3. In Bayesian statistics, population parameters such as the mean and variance are
assumed to be random variables.

## Answer: True Type: Concept Difficulty: Medium

5. If the prior distribution is normal and the likelihood function is normal, then the
posterior distribution is also normal.

## Answer: True Type: Concept Difficulty: Medium

6. A continuous random variable has a probability density function, f(x), which may be
positive or negative.

## Answer: False Type: Concept Difficulty: Medium

7. The total area under the curve of the probability density function must equal one.

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10. Diffuse priors give much information about the process in question.

## Answer: False Type: Concept Difficulty: Medium

11. In a normal distribution, about 95% of the distribution lies within two standard
deviations of the mean.

## Answer: True Type: Concept Difficulty: Easy

12. In decision analysis, what actually takes place is called the state of nature.

## Answer: True Type: Concept Difficulty: Easy

13. Bayes, the person that Bayesian statistics is name after, was a British clergyman.

## 15. Bayesian statistics is a branch of statistics that uses:

A) non-normal analysis
B) analysis using prior information
C) no hypothesis tests or confidence intervals
D) analysis by computer only
E) none of the above

## 16. The de Finetti game assesses:

A) personal probabilities
B) objective probabilities
C) gambling probabilities
D) game theory
E) none of the above

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## 17. The utility function of a risk-averse person is:

A) concave
B) convex
C) straight line
D) s-shaped
E) none of the above

## Answer: A Type: Concept Difficulty: Medium

18. Suppose that you are sampling from a normal distribution with standard deviation 5.
The population mean is assumed to be a random variable with mean 10 and standard
deviation 3. A sample of size 100 gives a sample mean of 8. The posterior normal
distribution of the population mean has a mean equal to:
A) 0
B) 10
C) 5.389
D) 2.932
E) none of the above

## Answer: E Type: Computation Difficulty: Hard

19. Suppose that you are sampling from a normal distribution with standard deviation 5.
The population mean is assumed to be a random variable with mean 10 and standard
deviation 3. A sample of size 100 gives a sample mean of 8. The posterior normal
distribution of the population mean has a mean equal to:
A) 8.05
B) 8.01
C) 9.95
D) 9.99
E) none of the above

## Answer: A Type: Computation Difficulty: Medium

20. Suppose that you could buy a sure investment that gives 10% interest. You also have
the option of buying an investment that gives 12% return with a 50% chance and an
8% return with a 50% chance. The expected monetary value of the sure investment is:
A) equal to that of the risky investment
B) greater than that of the risky investment
C) lesser than that of the risky investment
D) insufficient information to determine
E) zero

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## Use the following to answer questions 21-24:

A pharmaceutical company develops a new drug for a disease and expects it to have the
following prior probability distribution of success based on laboratory tests. The partially
completed posterior probability distribution of S is given.

S P (S ) P ( X |S ) P ( S ) P ( X |S ) P ( S |X )
.1 0 .0 5 0 .0 1 1 B
.2 0 .0 5 0 .0 8 8 0 .0 0 4 4
.3 0 .1 0 0 .2 0 0 0 .0 2 0
.4 0 .1 5 0 .2 5 1 0 .0 3 7 5
.5 0 .2 5 A 0 .0 5 1 2 5
.6 0 .3 0 0 .1 1 1 0 .0 3 3 3
.7 0 .1 0 0 .0 3 7 0 .0 0 3 6 C
1 .0 0

A random sample of ten patients revealed that four of them benefited from the drug.

## 21. Complete the table by giving the value of A.

A) 0.205
B) 0.377
C) 0.172
D) 0.246
E) none of the above

## 22. The values in the second column come from the:

A) normal table
B) t table
C) chi-square table
D) nonparametric statistical test
E) binomial table

## 23. Complete the table by filling in the value of B.

A) 0.0011
B) 0.00055
C) 0.5
D) 0.022
E) none of the above

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Chapter 15 Bayesian Statistics and Decision Analysis

## 24. Complete the table by filling in the value of C.

A) 0.000502
B) 0.01998
C) 0.0239
D) 0.015075
E) none of the above

## Answer: C Type: Computation Difficulty: Medium

25. Assuming a normal distribution, a sample mean of ten, a sample standard deviation of
two, a sample size of 100, a prior mean of 12 and a prior standard deviation of 5; what
is the posterior mean?
A) 1
B) 50
C) 12
D) 10
E) none of the above

## Use the following to answer questions 26-27:

Stock A gives a 16% return with a probability of 0.4 and 19% return with a probability of 0.6.
Stock B gives a 14% return with a probability of 0.15 and a 21% return with a probability of
0.85.

## 26. Which is the better stock?

A) both A and B are equally good
B) A is better
C) B is better
D) neither is worth investing in
E) insufficient information to determine which is better

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27. Stock C, gives a 22% return with a 0.30 probability, a 15% return with a 0.55
probability, and a 9% return with a 0.15 probability. Which of the three stocks is the
best in terms of its return?
A) A
B) B
C) C
D) B and C are equally good
E) A and C are equally good

## 28. Subjective probabilities are:

A) Bayesian
B) posterior
C) prior
D) personal
E) none of the above

## 29. A high-tech company is considering opening a branch in a third world country. It is

thought that there would be a 0.55 chance that the profits would be \$7.5 million, and a
0.45 chance that the profits will be \$4 million, in the first year. An alternative proposal
ensures a profit of \$5 million, with minimal risk. What should the company do?
A) open the branch
B) definitely not open the branch and take the other alternative proposal
C) investigate the situation further
D) find a third alternative which is completely without risk
E) none of the above

## 30. All the following are elements of a decision analysis, except:

A) actions
B) chance occurrences
C) final outcomes
D) subjective probabilities
E) decision

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## 31. The method used to determine personal probabilities is:

A) prior probabilities
B) de Finetti game
C) Bayesian tests
D) construction of credible sets
E) none of the above

## Answer: B Type: Concept Difficulty: Easy

32. A computer manufacturer believes that her disk drives last an average 10,000 hours of
operation, without failure, with a standard deviation of 600 hours. A random sample of
25 computer drives reveals that the mean continuous operation time without failure is
10,500 hours, with a standard deviation of 250 hours. Compute the posterior mean.
A) 10,000
B) 10,497
C) 10,500
D) 10,406
E) none of the above

## Answer: B Type: Computation Difficulty: Medium

33. A computer manufacturer believes that his disk drives last an average 10,000 hours of
operation, without failure, with a standard deviation of 600 hours. A random sample of
25 computer drives reveals that the mean continuous operation time without failure is
10,500 hours, with a standard deviation of 250 hours. Compute the posterior variance
of the normal distribution of the population mean, m.
A) 2,482.76
B) 49.83
C) 11,703.5
D) 108.18
E) none of the above

## Use the following to answer questions 34-35:

A company is analyzing two investments. In the first investment, A, there is a 0.20 chance that
the investment results in a profit of \$250,000, a 0.35 chance that it results in a profit of
\$500,000, a 0.40 chance that it results in a profit of \$350,000, and a 0.05 chance that it results
in a loss of \$100,000. The second investment, investment B, has a 0.25 chance of a \$550,000
profit, a 0.30 chance of a \$700,000 profit, and a 0.45 chance of a \$100,000 profit.

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## 34. Which investment should the company chose?

A) A and B are equally good
B) B
C) A
D) neither is worth considering
E) insufficient information to determine which one is best investment

## Answer: B Type: Computation Difficulty: Hard

35. A third investment, C, has an 0.30 chance of a \$400,000 profit, an 0.65 chance of a
\$250,000 profit, and an 0.05 chance of an \$150,000 loss. Which of these three
investments is best for the company?
A) A
B) B
C) C
D) B and C are equally good
E) A, B and C are all equally good

A) concave
B) convex
C) symmetric
D) straight line
E) s shaped

## 37. The basis of Bayesian analysis is the use of:

A) nonparametric statistics
B) prior information
C) very subjective probabilities
D) classical statistics
E) the binomial and the normal distributions

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## Use the following to answer questions 38-39:

The gasoline consumption of a car is advertised as 32 mpg, with a standard deviation of 1.5
mpg. A random sample of 30 cars reveals a mean gasoline consumption of 31 mpg with a
standard deviation of 1.1. Assuming normality and the gasoline consumption to be a random
variable,

38. Compute the posterior mean of the normal distribution of the population mean, m.
A) 30.69
B) 31.02
C) 5.57
D) 16.44
E) none of the above

## Answer: B Type: Computation Difficulty: Medium

39. Compute the posterior variance of the normal distribution of the population mean, m.
A) 0.4355
B) 0.1897
C) 0.3389
D) 0.0396
E) none of the above

## Use the following to answer questions 40-42:

A new company is entering the fast food market and the manufacturer expects it to have the
following prior probability distribution of the market share based on experience with similar
products.

M P (M ) P ( X |M ) P (M ) P ( X |M ) P ( M |X )
0 .1 0 .1 0
0 .1 5 0 .2 0
0 .2 0 0 .2 5
0 .2 5 0 .2 5
0 .3 0 0 .1 5
0 .3 5 0 .0 5

A random sample of twenty people revealed that two of them would prefer to go to this
restaurant.

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## 40. How would the probabilities in the P(XM) column be obtained?

A) from normal table
B) by multiplying value of M times value of P(M)
C) from binomial table
D) by dividing the value of P(M) by total of P(M) column
E) none of the above

## 41. What do the values in the P(MX) column stand for?

A) subjective probabilities
B) binomial probabilities
C) posterior probabilities
D) normal probabilities
E) none of the above

## 42. The sum of the values in the last column is always?

A) 1
B) 0
C) 0.95
D) at least 0.5
E) none of the above

## Use the following to answer questions 43-44:

A manager is trying to choose between options A, B & C. The value of each option depends
on the state of nature that occurs well after the choice has been made. The likelihood of the
two possible states of nature and the payoffs for the individual options are in the following
table:

S ta te o f N a tu r e (p r o b a b ility )
I ( .4 ) I I (.6 )
A \$ 1 0 ,0 0 0 \$ 3 0 ,0 0 0
B 4 0 ,0 0 0 5 ,0 0 0
C -2 ,0 0 0 5 0 ,0 0 0

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43. Suppose this manager is so pessimistic that he always chooses the option whose worst-
case scenario is most attractive. In this situation, how much does the manager's
pessimism cost him (in terms of expected value)?
A) If the manager follows his usual approach, in this case he will pass up \$7,200 in
expected monetary value
B) If the manager follows his usual approach, in this case he will pass up \$10,200 in
expected monetary value
C) If the manager follows his usual approach, in this case he will pass up \$10,000 in
expected monetary value
D) If the manager follows his usual approach, in this case he will pass up \$20,000 in
expected monetary value
E) Nothing, because his decision-making approach would, in this case at least, lead to
the optimal choice (in terms of expected monetary value)

## Answer: A Type: Computation Difficulty: Medium

44. In this situation, perfect information would be worth _____________ to this manager.
A) \$ 50,000
B) \$ 46,000
C) \$ 29,200
D) \$ 22,000
E) \$ 16,800

## Use the following to answer questions 45-47:

A fast-food chain's internal process improvement consultant believes that the use of his
techniques will reduce average response time (assume a normal distribution) to 80 seconds,
with a standard deviation of 30 seconds. A local franchise owner has implemented these
techniques and taken a random sample of 20 transactions. The average response time for the
sampled transactions was 95 seconds, with a standard deviation of 10 seconds.

45. The posterior normal distribution for the mean response time after the implementation
of these techniques has a mean equal to:
A) 94.84
B) 94.92
C) 80.08
D) 84.66
E) 90.34

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46. The posterior normal distribution for the mean response time after the implementation
of these techniques has a standard deviation equal to:
A) 6.88
B) 5.57
C) 4.97
D) 3.14
E) 2.23

## Answer: E Type: Computation Difficulty: Hard

47. The 95% HPD credible set for m in this situation is:
A) [77.34, 97.57]
B) [73.74, 95.57]
C) [85.17, 104.66]
D) [90.55, 99.29]
E) [80.51, 109.43]

## Answer: D Type: Computation Difficulty: Hard

48. An occasional casino visitor has decided to switch games. In the past this visitor has
played a game in which he has a 48% of winning \$1 and a 52% chance of losing \$1. If
this visitor switches to a game that offers him only a 45% chance of winning \$1, with
a 55% chance of losing \$1, this visitor is becoming more ____________ since his
utility curve is increasingly _____________.
A) Risk-seeking; concave
B) Risk-avoiding; concave
C) Risk-seeking; convex
D) Risk-avoiding; convex
E) Risk-neutral; linear

## A defendant in a lawsuit is trying to determine whether or not to offer a settlement to a

plaintiff, and if a settlement is offered, how large a settlement to offer. An extensive review of
similar cases leads the defendant to conclude that if the lawsuit goes to trial, the plaintiff has a
probability of winning of 0.6. The typical jury award in such cases is \$1,500,000. The
defendant's legal team estimates that a settlement offer of \$500,000 has a 0.3 probability of
being accepted. If the settlement offer is rejected, the defendant could then choose to offer
\$800,000 which would certainly be accepted or go to trial. A final option under
consideration is to simply offer the plaintiff \$750,000 up front; the defendant's legal team
estimates that such a large initial offer would certainly be accepted.

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49. What is the expected cost to the defendant of taking this lawsuit to trial?
A) \$ 3,000,000
B) \$ 1,500,000
C) \$ 900,000
D) \$ 800,000
E) \$ 750,000

## Answer: C Type: Computation Difficulty: Medium

50. What is the optimal approach for this situation (from the defendant's perspective)?
A) Make an initial offer of \$750,000
B) Make an initial offer of \$500,000, and if this offer is rejected, make a subsequent
settlement offer of \$800,000
C) Make an initial offer of \$500,000, and if this offer is rejected, take the lawsuit to
trial
D) Make no settlement offer and take this lawsuit to trial
E) Either A or C are optimal approaches

## Answer: B Type: Computation Difficulty: Hard

51. Junkets Airline is considering whether or not to expand its trans-Atlantic routes. The
airline is considering three options: a major expansion of four additional jets, a
moderate expansion of two additional jets, or no expansion at all. The expected benefit
of the expansion options depends on the level of European vacation travel. Experience
has shown that three demand patterns are possible low, medium or heavy. Payoffs of
the expansion options under the various demand patterns are shown in the following
table:
D em and
O p tio n Low M o d e ra te H eavy
F o u r J e ts \$ (4 0 0 ,0 0 0 ) \$ 3 0 0 ,0 0 0 \$ 1 ,0 0 0 ,0 0 0
T w o J e ts \$ (2 5 0 ,0 0 0 ) \$ 2 0 0 ,0 0 0 \$ 7 0 0 ,0 0 0
N o E x p a n s io n 0 0 0

If Junkets has estimated the probability of a low demand environment to be 0.55 and
the probability of the heavy demand environment to be 0.20, what choice should
Junkets make if it wants to maximize its expected value?

Answer: The four-jet option offers the highest expected payoff (expected value =
\$55,000). Therefore, if this airline wants to maximize its expected payoff, it should
choose the four-jet option.

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52. The financial success of a ski resort is dependent on the amount of snow that falls
during the winter months. If the snowfall averages more than 40 inches, the resort will
be successful; if the snowfall is between 30 and 40 inches, a moderate return is
expected; and if the snowfall averages less than 30 inches, financial losses will accrue.
Probabilities for each snowfall amount have been developed by a weather service. The
financial return for each snowfall is as follows:

S n o w fa ll L e v e l
> 4 0 in . 3 0 -4 0 in . < 3 0 in .
L ik e lih o o d 40% 20% 40%
R e tu rn \$ 1 ,2 0 0 ,0 0 0 \$ 4 0 0 ,0 0 0 \$ - 4 0 0 ,0 0 0

Suppose a large hotel chain has offered to lease the resort during the winter months
and will pay the hotel's owners a fixed fee of \$450,000. What should the owners do?

Answer: The owners should pass up this fixed fee, since the expected value of not
leasing their resort is \$30,000 larger (\$480,000) than leasing it.

53. A real-estate developer is evaluating options for a tract of land near a major
metropolitan area. The value of the land to the developer depends on: A) how the
developer chooses to develop the land; and B) the pattern of economic development in
an adjacent suburb. The payoffs (in \$1,000,000s) of the various development options
under the possible growth environments are as follows:

G r o w th E n v ir o n m e n t
I II III IV
R e s id e n tia l 1 .8 3 .2 0 .5 0 .5
C o m m e rc ia l 1 .6 3 .1 0 .9 1 .2
In d u s tria l 1 .7 1 .7 1 .8 2 .1

## Economic development experts anticipate that the likelihood of growth environment I

occurring is 25%. They anticipate a 35% chance of growth environment II emerging
and a 30% chance of growth environment III emerging.

## A) Which development option maximizes the developer's expected payoff?

B) What is the expected value of perfect information in this situation?

A) The commercial development option maximizes the developer's expected payoff.
Its expected payoff is \$1.875 million. Both the residential and industrial options have
expected payoffs of \$1.77 million.
B) The expected value of perfect information in this situation is \$0.445 million (\$2.32
million - \$1.875 million)

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Chapter 15 Bayesian Statistics and Decision Analysis

54. The set of conditional probabilities P(xq) for given x, is called ________________.

## 55. In Bayesian statistics, population parameters are assumed to be _______________,

rather than fixed quantities.

## Answer: random Type: Concept Difficulty: Medium

56. The total area under the curve of a continuous function is always _____________.

## Answer: highest-posterior density credible set Type: Concept Difficulty: Easy

59. What percent of the distribution lies within one standard deviation of the mean in a
normal distribution?

## Answer: 68% Type: Concept Difficulty: Easy

60. The final result of the steps in decision analysis is the ______________.

## Answer: decision Type: Concept Difficulty: Easy

61. The method of solving decision trees by working backward from the final outcomes, is
called ________________.

Answer: averaging out and folding back Type: Concept Difficulty: Medium

62. Ordering items on a scale of values which reflects the amount of money it would take
to give them up is called ______________.

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63. The difference between the monetary value of a situation when perfect information is
available and the expected value of the decision situation when no additional
information is available is called the __________________.

## Answer: expected value of perfect information Type: Concept Difficulty: Medium

64. As a manager in a large oil company, you must exercise your company's option on an
oil lease. Your choices are to drill the well, abandon the lease, or collect seismic data
before you decide. Your geologist estimates that with the present data, there is a .6
probability that you will drill a dry hole and lose \$40,000,000, a .2 probability that
drilling will produce a moderately successful well and expect a \$40,000,000 profit,
and a .2 chance of a gusher which will be expected to yield a \$100,000,000 profit. If
you decide to abandon the lease, it will cost the company \$20,000 and collecting the
additional seismic data will cost the company \$1,700,000. The geologists estimate that
if there is a gusher, the test will be correct 70% of the time, there is a .1 probability
that the test will predict moderate production, and a .2 probability that the test will
predict a dry hole. If the well will produce moderate amounts of oil the test will be
correct 60% of the time, there is a .1 probability that the test will predict a gusher, and
a .3 probability that the test will predict a dry hole. If there is no oil to be found, the
test will be correct 60% of the time, predict a gusher 10% of the time, and a .3
probability that the test will predict moderate production. What should the decision
statement be? What should your decision statement be?

Answer: If you abandon, you will lose \$20,000, if you drill you can expect to make
\$4,000,000, and if you collect seismic data you can expect to make \$12,374,800. You
should collect the seismic data and if the seismic test predicts a gusher, drill, otherwise
abandon the lease. Type: Computation Difficulty: Hard