DECISION THEOTY

SAMPLE PROBLEMS
1. A newsstand receives its weekly order of an Interiors magazine every Monday
and cannot re-order during the week.Each order copy costs Rs. 150/- and sells for Rs.
250/-. Unsold copies can be returned to the publisher the following week for Rs. 50/-
each. When the newsstand runs out of copies and cannot supply a customer wanting a
copy, it estimates its loss of goodwill as Rs. 200/- in future profits as the customer
will take his business elsewhere for a couple of weeks on an average.
a) Determine the optimal decision using various criteria for decision- making under
uncertainty.
b) If demand has been remarkably constant, ranging between 7 and 10 copies as
shown below:
Demand (copies): 7 8 9 10
Fraction of time: 0.3 0.4 0.2 0.1
Determine the optimal decision using criteria for decision making under uncertainty
and risk. What is EVPI?

2. XYZ co. has installed a machine costing Rs. 4 lakhs and is in the process of
deciding on an appropriate number of a certain spare part to order. The spare part
costs Rs. 4000 each, but spare parts are available only if ordered now. If the machine
breaks down and no spare is available, the cost to the company will be Rs. 18,000/- to
procure the spare and get it running. The plant has a life of 8 years and the probability
distribution of failures during this period is as below:
No. of breakdowns 0 1 2 3 4 5 >=6
Probability 0.1 0.2 0.3 0.2 0.1 0.1 0
a) Determine the optimal decision using various criteria for decision- making under
uncertainty.
b) Determine the optimal decision using criteria for decision making under risk. What
is EVPI?

3. In 1995, Digital Equipment Corporation arranged to get the Cunard Lines ship
Queen Elizabeth 2 (QE2) for use as a floating hotel for the company’s annual
convention. The meeting took place in September and lasted nine days. In agreeing to
lease the QE2, Cunard had to make a decision. If the cruise ship were leased to
Digital, Cunard would get a flat fee and an additional percentage of profits from the
gala convention, which could attract as many as 50,000 people. Cunard analysts
therefore estimated that if the ship were leased, there would be a 0.50 probability that
the company would make $700,000 for the nine days; a 0.30 probability that profits
from the venture would be about $800,000; a 0.15 probability that profits would be
about $900,000; and a 0.05 probability that profits would be as high as $1 million. If
the ship were not leased to Digital, the vessel would be used for its usual Atlantic
crossing voyage, also lasting nine days. If this happened, there would be a 0.90
probability that profits would be $750,000 and a 0.10 probability that profits would
be about $780,000. The tighter distribution of profits on the voyage was due to the
fact that Cunard analysts knew much about the company’s usual business of Atlantic
crossings but knew relatively little about the proposed venture.
 Cunard had one additional option. If the ship were leased to Digital, and it became
clear within the first few days of the convention that Cunard’s profits from the
venture were going to be in the range of only $700,000, the steamship company could
choose to promote the convention on its own by offering participants discounts on
QE2 cruises. The company’s analysts believed that if this action were chosen, there
would be a 0.60 probability that profits would increase to about $740,000 and a 0.40
probability that the promotion would fail, lowering profits to $680,000 due to the cost
of the promotional campaign and the discounts offered. What should Cunard have
done?

4. Commodity futures provide an opportunity for buyers and suppliers of

commodities such as wheat to arrange in advance sales of a commodity, with delivery
and payment taking place at a specified time in the future. The price is decided at the
time the order is placed, and the buyer is asked to deposit an amount less than the
value of the order, but enough to protect the seller from loss in case the buyer should
decide not to meet the obligation.
An investor is considering investing $15,000 in wheat futures and believes that there
is a 0.10 probability that he will lose $5,000 by the expiration of the contract, a 0.20
probability that he will make $2,000, a 0.25 probability that he will make $3,000 a
0.15 probability he will make $4,000, a 0.15 probability he will make $5,000, a 0.10
probability he will make $6,000, and a 0.05 probability that he will make $7,000. If
the investor should find out that he is going to lose $5,000, he can pull out of his
contract, losing $3,500 for certain and an additional $3,000 with probability 0.20 (the
latter amount deposited with a brokerage firm as a guarantee).
Suppose that the investor is considering another investment as an alternative to
wheat. He is considering investing his $15,000 in a limited partnership for the same
duration of time as the futures contract. This alternative has a 0.50 chance of earning
$5,000 and a 0.50 chance of earning nothing. Draw the decision tree for this problem,
and solve it. What should the investor do?

5. The Oil India Corporation is considering whether to go for an offshore drilling

contract to be awarded in Bombay High. If they bid, value would be Rs. 600 million
with a 65% chance of gaining the contract. The Corporation may set up a new drilling
operation or move already existing operation, which has proved successful, to new
site. The probability of success and expected returns are as follows:

Outcome New Drilling Operation Existing Operation

Probability Expected Revenue Probability Expected Revenue
(Rs million) (Rs million)

Success 0.75 800 0.85 700

Failure 0.25 200 0.15 350
 If the Corporation does not bid or lose the contract, they can use Rs 600 million to
modernize their operations. This would result in a return of either 5% or 8% on the
sum invested with probabilities 0.45 and 0.55, respectively.
(a) Construct a decision tree for the problem showing clearly the courses of action.
(b) By applying an appropriate decision criterion recommend whether or not the
corporation should bid the contract.

6. An oil company has recently acquired rights in a certain area to conduct surveys
and test drillings to lead to lifting oil if it is found in commercially exploitable
quantities.
The area is considered to have good potential for finding oil in commercial quantities.
At the outset, the company has the choice to conduct further geological tests or to
carry out a drilling programme immediately. On the known conditions, the company
estimates that there is a 70:30 chance of further tests showing a ‘success’.
Whether the tests show the possibility of ultimate success or not or even if no tests are
undertaken at all, the company could still pursue its drilling programme or
alternatively consider selling its rights to drill in the area. Thereafter, however, if it
carries out the drilling programme, the likelihood of final success or failure is
considered dependent on the foregoing stages. Thus:
 If ‘successful’ tests have been carried out, the expectation of success in drilling is
given as 80:20
 If the tests indicate ‘failure’, then the expectation of success in drilling is given as
20:80
 If no tests have been carried out at all the expectation of success in drilling is given
as 55:45
Costs and revenues have been estimated for all possible outcomes and the net present
value of each is as follows:
Outcome Net Present Value (Rs Million)
Success:
With prior tests 100
Without prior tests 120
Failure:
With prior tests -50
Without prior tests -40
Sales of exploitation rights:
Prior tests show ‘success’ 65
Prior tests show ‘failure’ 15
Without prior tests 45
(a) Draw up a decision (probability) tree diagram to represent the above information;
and
(b) Evaluate the tree in order to advise the management of the company on its best
course of action.

7. Insurance companies need to invest large amounts of money in opportunities that

provide high yields and are long-term. One type of investment that has recently
attracted some insurance companies is real estate.
 Aetna Life and Casualty Company is considering an investment in real estate in
central Florida. The investment is for a period of 10 years, and company analysts
believe that the investment will lead to returns that depend on future levels of
economic activity in the area. In particular, the analysts believe that the invested
amount would bring the profits listed in Table below depending on the listed levels of
economic activity ant their given (prior) probability.

Profit from investment Level of economic activity Probability

$3m Low .20
$6m Medium .50
$ 12 m High .30

The alternative to this investment plan-one that the company has used in the past-is a
particular investment that has a 0.5 probability of yielding a profit of $4 million and a
0.5 probability of yielding $7million over the period in question.
The company may also seek some expert advice on economic conditions in central
Florida. For an amount that would be equivalent to$100,000 ten years from now
(when invested at a risk-free rate), the company could hire an economic consulting
firm to study the future economic prospects in central Florida. From past dealings
with the consulting firm, Aetna analysts believe that the reliability of the consulting
firm’s conclusions is as listed in Table below.
Consultant’s conclusion
True future state of economy High Medium Low
Low 0.05 0.05 0.90
Medium 0.15 0.80 0.05
High 0.85 0.10 0.05

The table lists as columns the three conclusions the consultants may reach about the
future of the area’s economy. The rows of the table correspond to the true level of the
economy 10 years in the future, and the table entries are conditional probabilities. For
example, if the future level of the economy is going to be high, then the consultant’s
statement will be “high” with probability 0.85 What should Aetna do?

8. Many airlines flying overseas have recently considered changing the kinds of
goods they sell at their in-flight duty-free services. Swissair, for example, is
considering selling Swiss watches instead of the usual liquor and cigarettes. A
Swissair executive believes that there is a 0.60 chance that passengers would prefer
theses goods to the usual items and that revenues from in- flight sales would increase
by $40,000 over a period of several months. She believes there is a 0.40 chance that
revenues would decrease by $20,000, which would happen should people not buy the
watches and instead desire the usual items. Testing the new idea on actual flights
would cost $6,000, and the results would have a 0.85 probability of correctly
detecting the state of nature. What should Swissair do?