SIE 321 Probabilistic Models in OR Homework 4

Problem 1. Jean Clark is the manager of the Midtown Saveway Grocery Store. She now needs to
replenish her supply of strawberries. Her regular supplier can provide as many cases as
she wants. However, because these strawberries already are very ripe, she will need to sell
them tomorrow and then discard any that remain unsold. Jean estimates that she will be
able to sell 12, 13, 14, 15, 16, or 17 cases tomorrow. She can purchase the strawberries
for $10 per case and sell them for $20 per case. Jean now needs to decide how many cases
to purchase.
Jean has checked the store’s records on daily sales of strawberries. On this basis, she
estimates that the demand probability distribution is
Demand (cases) 12 13 14 15 16 17
Probability 0.12 0.15 0.19 0.1 0.23 0.21

(a) Develop a decision analysis formulation of this problem by identifying the decision
alternatives, the states of nature, and the payoff matrix.
(b) How many cases of strawberries should Jean purchase if she uses the maximin payoff
criterion?
(c) How many cases should be purchased according to the maximum likelihood criterion?
(d) How many cases should be purchased according to the expected payoff decision rule?
(e) What is EVPI in this case?
(f) How many cases should be purchased according to the minimax regret decision rule?
p
(g) If Jean’s utility function is given by u(t) = t, what is her optimal decision?

Problem 2. Warren Buffy is an enormously wealthy investor who has built his fortune through his
legendary investing acumen. He currently has been offered three major investments and
he would like to choose one. The first one is a conservative investment that would perform
very well in an improving economy and only suffer a small loss in a worsening economy.
The second is a speculative investment that would perform extremely well in an improving
economy but would do very badly in a worsening economy. The third is a counter-cyclical
investment that would lose some money in an improving economy but would perform well
in a worsening economy.
Warren believes that there are three possible scenarios over the lives of these potential
investments: (1) an improving economy, (2) a stable economy, and (3) a worsening econ-
omy. He is pessimistic about where the economy is headed, and so has assigned probabil-
ities of 0.67, 0.17, and 0.16, respectively, to these three scenarios. He also estimates that
his profits (in millions of dollars) under these respective scenarios are those given by the
following table:

Improving Stable Worsening

Investment Economy Economy Economy
Conservative −5 10 −30
Speculative 20 10 −30
Counter-cyclical 5 0 15
Probability 0.67 0.17 0.16

1
 Which investment should Warren make under each of the following criteria?

(a) Maximin payoff criterion.

(b) Expected payoff criterion.
(c) What is EVPI in this case?
(d) Minimax regret criteirion.
(e) Warren believes that his preferences may be best represented by a utility function
u(t) = c ln t = 2c ln t 2 , where c = 5.

Problem 3. Dwight Moody is the manager of a large farm with 1,000 acres of arable land. For greater
efficiency, Dwight always devotes the farm to growing one crop at a time. He now needs
to make a decision on which one of four crops to grow during the upcoming growing
season. For each of these crops, Dwight has obtained the estimates of crop yields and
net incomes per bushel under various weather conditions. After referring to historical
meteorological records, Dwight also estimated the probabilities for the weather during
the growing season:

Expected Yield, Bushels per acre

Weather Crop 1 Crop 2 Crop 3 Crop 4 Probability
Dry 40 20 30 20 0.14
Moderate 25 25 40 15 0.38
Wet 40 25 20 35 0.48

Which crop should Dwight grow according to

(a) maximin criterion

(b) expected payoff criterion
(c) minimax regret criterion
(d) what is Dwight’s EVPI in this case?
Solution keys for HW3
Problem 1. (a)

12 13 14 15 16 17
12 120 120 120 120 120 120
13 110 130 130 130 130 130
14 100 120 140 140 140 140
15 90 110 130 150 150 150
16 80 100 120 140 160 160
17 70 90 110 130 150 170
(b) Maximin payoff: $120, order 12 cases.
(c) Max likelihood payoff: $160, order 16 cases.
(d) Maximum expected payoff: $133, order 15 cases.
(e) Minimax regret payoff: $30, order 14 or 15 cases.
(f) Expected utility payoff: 11.491588843119, order 15 cases.

Problem 2. (a) Maximin profit: $0 million, maximin investment: Counter-cyclical

(b) maximum expected profit: $10.3 million, maximum expected profit investment: Spec-
ulative
(c) Minimax regret: $15 millions, minimax regret investment: Counter-cyclical
(d) maximum expected utility: 4.41 × 106 , maximum expected utility investment: Spec-
ulative (since ln t is undefined for t < 0, here we used u(t) = 2c ln(t 2 ))

Problem 3. (a) Maximin payoff: 25 thousand bushels, plant Crop 1

(b) Expected payoff: 34.3 thousand bushels, plant Crop 1
(c) Minimax Regret: 15 thousand bushels, plant Crop 1
(d) EVPI = 5.7