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Decision Analysis (Full)
Decision Analysis (Full)
November 2013
D ECISION A NALYSIS
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The Goferbroke Company owns a tract of land that may contain oil. A
consulting geologist has reported to management that she believes there is
one chance in four of oil. Because of this prospect, another oil company has
offered to purchase the land for $90,000.
However, Goferbroke is considering holding the land in order to drill for oil for
itself, which costs about $100, 000. If oil is found, the resulting expected
revenue will be $800,000, yielding expected profit of $700,000. A loss of
$100,000 will be incurred if the land is dry (no oil).
D ECISION A NALYSIS
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The Goferbroke Company owns a tract of land that may contain oil. A
consulting geologist has reported to management that she believes there is
one chance in four of oil. Because of this prospect, another oil company has
offered to purchase the land for $90,000.
However, Goferbroke is considering holding the land in order to drill for oil for
itself, which costs about $100, 000. If oil is found, the resulting expected
revenue will be $800,000, yielding expected profit of $700,000. A loss of
$100,000 will be incurred if the land is dry (no oil).
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Alternative
Drill for oil
Sell the land
Chance of status
State of Nature
Oil
Dry
$700,000 -$100,000
$90,000
$90,000
25%
75%
D ECISION A NALYSIS
Expected Payoff
$100
$90
Optimal Decision= Drill
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A Gaming Perspective
A rational decision maker as the first mover should choose the alternative
that yields the best payoff.
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A Gaming Perspective
A rational decision maker as the first mover should choose the alternative
that yields the best payoff.
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A Gaming Perspective
A rational decision maker as the first mover should choose the alternative
that yields the best payoff.
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A Gaming Perspective
A rational decision maker as the first mover should choose the alternative
that yields the best payoff.
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0.4(0.25)
1
=
0.4(0.25) + 0.8(0.75)
7
6
1
=
7
7
0.6(0.25)
1
P(State = Oil|Finding = FSS) =
=
0.6(0.25) + 0.2(0.75)
2
1
1
= .
2
2
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Finding=FSS
State of Nature
Oil (1/7)
Dry (6/7)
$700,000
-$100,000
$90,000
$90,000
State of Nature
Oil (1/2)
Dry (1/2)
$700,000
-$100,000
$90,000
$90,000
D ECISION A NALYSIS
Expected Payoff
$14,300
$90,000
Expected Payoff
$300,000
$90,000
Optimal Decision
Sell
Optimal Decision
Drill
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Decision Tree
Using circles to indicate event (chance) nodes, squares to indicate decision
modes and lines to indicate corresponding branches, we can draw a decision
tree for Goferbroke.
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Advance Selling
Consider a firm selling a seasonal product to a consumer market of a fixed
size N over two periods. The first period is an advance selling period and the
second period is the selling season. Consumers willingness-to-pay in the
second period depends on weather conditions. When the whether is good,
the maximum price consumers would like to pay is H. When the weather is
bad, the maximum price consumers would like to pay is L. The firm knows the
probability that the weather is good is q and the probability that the weather is
bad is 1 q. In the first period, the firm has an option to advance sell the
product with a price p1 . The firm can decide whether to advance sell or wait
until the weather conditions are observed. Consumers decide whether to
purchase in the first period or wait until the second period. The production
cost of the product is c per unit. How to model such a dynamic decision
problem? How much should the firm charge in the first period to induce
consumers to advance buy? Should the firm offer advance selling at all?
Z HAN PANG , P H .D. (LANCS)
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Exercise 1
Investment Strategy
Consider three possible scenarios of investment economy: (1) an improving economy, (2) a stable economy,
and (3) a worsening economy. The prior probabilities of the three economies are 0.1, 0.5 and 0.4, respectively.
There are three types of investment strategy: conservative investment that would perform well in an improving
economy and only suffer a small loss in a worsening economy; speculative investment that would perform
extremely well in an improving economy but would do very badly in a worsening economy; and countercyclical
investment that would lose some money in an improving economy but would perform well in a worsening
economy.
Conservative
Speculative
Countercyclical
Prior probability
Improving Economy
$30 million
$40 million
-$10 million
0.1
Stable Economy
$ 5 million
$ 10 million
$ 0 million
0.5
Worsening Economy
-$10 million
-$30 million
$15 million
0.4
What are the optimal investment strategies under the following criteria?
(a) Maxmin payoff criterion
(b) Maximum likelihood criterion
(c) Expected payoff maximization criterion
If the prior probabilities are (0.1, 0.3, 0.6), what are the optimal investment strategies?
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Exercise 2
Inventory Control
Consider a newspaper retailer selling a daily newspaper. Suppose that the demand per day follows a Poisson
distribution with mean 100. The cost per copy is $0.5 and the retail price is $1. Unmet demand is lost and
unsold copies have zero salvage value. How many copies should the retailer order per day to maximize the
expected profit per day? [You can use Excel Spreadsheet to find the optimal solution]
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Reference
Hillier F. S., G. J. Liberman. 2009. Chapter 15 Decision Analysis, Introduction to Operations Research,
9th edition, McGraw Hill press.
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P(A|B) =
P(B|A)P(A)
P(B|A)P(A)
=
P(B)
P(B|A)P(A) + P(B|A)P(
A)
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