Imchap 005 S

Chapter 05S - Decision Theory
CHAPTER 05S
DECISION THEORY
Solutions
1.
Given: A contractor must make a decision on capacity for next year. Estimated profits under
each of the two possible states of nature are shown below:
Next Years Demand
Alternative
Low
High
Do nothing
$50
$60
Expand
$20
$80
Subcontract
$40
$70
a. Maximax: Determine best possible payoff for each alternative and choose the alternative
that has the best.
Next Years Demand
Alternative
Low
High
Best Payoff
Do nothing
$50
$60
$60
Expand
$20
$80
$80
Subcontract
$40
$70
$70
Best of the Best
Conclusion: Select Expand alternative with a payoff of $80.
5S-1
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
b. Maximin: Determine the worst possible payoff for each alternative and choose the
alternative that has the best worst.
Next Years Demand
Alternative
Low
High
Worst Payoff
Do nothing
$50
$60
$50
Expand
$20
$80
$20
Subcontract
$40
$70
$40
Best of the Worst
Conclusion: Select Do nothing alternative with a payoff of $50.

c. Laplace: Determine the average payoff for each alternative and choose the alternative with
the best average.
Next Years
Demand
Alternative
Low
High
Average Payoff
Do nothing
$50
$60
$55
Expand
$20
$80
$50
Subcontract
$40
$70
$55
Best
Best
Conclusion: Select Do nothing or Subcontract alternative with an average payoff of $55.
5S-2
d. Minimax Regret: Prepare a table of regrets (opportunity losses)for each column,

subtract every payoff from the best payoff in that column. Identify the worst regret for
each alternative. Select the alternative with the best worst.
Regrets
Alternative
Low
High
Worst
Regret
Do nothing
Expand
Subcontract
$0
$20
$20
($50-$50)
($80-$60)
$30
$0
($50-$20)
($80-$80)
$10
$10
($50-$40)
($80-$70)
$30
$10
Best of
the
Worst
Conclusion: Select Subcontract alternative because it has the best of the worst regrets of
the three alternatives.
2.
Given: P(Low Demand) = .3 and P(High Demand) = .7.

a. Determine the best expected profit of the alternatives from Problem 1
Expected Profit:
Do nothing =
.3($50) + .7($60) = $15 + $42 = $57
Expand =
.3($20) + .7($80) = $6 + $56 = $62
Subcontract =
.3($40) + .7($70) = $12 + $49 = $61
Conclusion: Expand is the best alternative because it has the highest expected value.
b. Decision Tree Analysis to Select an Alternative:

.3
$57
Do Nothing
$62
Expand
$61
Subcontr.
.7
.3
.7
$50
$60
$20
$80
$40
$70
.3
.7
5S-3
Expected Value Calculations:

Do nothing =
.3($50) + .7($60) = $15 + $42 = $57
Expand =
.3($20) + .7($80) = $6 + $56 = $62
Subcontract =
.3($40) + .7($70) = $12 + $49 = $61
Conclusion: Expand is the best alternative because it has the highest expected value
($62).
c. Expected Value of Perfect Information:
Expected value of perfect information (EVPI) = Expected payoff under certainty
Expected payoff under risk
Find the best payoff under each state of nature:
Low Demand: Best Payoff = $50
High Demand: Best Payoff = $80
Expected payoff under certainty (apply the probabilities of each state of nature) =
= (Prob. of Low Demand x Best Payoff) + (Prob. of High Demand x Best Payoff)
= .3($50) + .7($80) = $15 + $56 = $71
Expected payoff under risk = Expected value of the alternative selected = $62
EVPI = $71 - $62 = $9
3.
Plot each alternative relative to P(High Demand). Plot the payoff value for Low Demand on
the left side of the graph and the payoff value for High Demand on the right side of the graph.
Payoff values from Problem 1:
Next Years Demand
Alternative
Low
High
Do nothing
$50
$60
Expand
$20
$80
Subcontract
$40
$70
5S-4
Low Payoff
80
70
60
High Payoff
Do Nothing
50
40
Subcontract
20
Expand
0.50.66671.0
P
P(High)
The graph above shows the range of values of P(High) over which each alternative is optimal.
For low values of P(High), Do Nothing is best because it has the highest expected value.
For intermediate values of P(High), Subcontract is best.
For higher values of P(High), Expand is best.
To find the exact values of the ranges, we must determine where the upper parts of the lines
intersect. For each line, b is the slope of the line and x = P(High). The slope of each line =
Right-hand value Left-hand value.
Equations:
Do Nothing:
Expand:
Subcontract:
50 + 10P (slope = 60 50)

20 + 60P (slope = 80 20)
40 + 30P (slope = 70 40)
Find the intersection between Do Nothing & Subcontract:

50 + 10P = 40 + 30P
10P 30P = 40 50
-20P = -10
P = -10/-20
P = .5000 (this value is shown on the graph above already)
Find the intersection between Subcontract & Expand:
40 + 30P = 20 + 60P
30P 60P = 20 40
-30P = -20
P = -20/-30
5S-5
Optimal ranges:
Do nothing:
Subcontract:
Expand:
4.
P(High) = 0 to < .5000

P(High) > .5000 to < .6667
P(High) > .6667 to 1.00
a. 1) Draw the tree diagram:

Demand Low (.4)
Build Small
$400,000 (1)
$50,000 (2)
Maintain
Demand High (.6)
Expand
Build Large
$450,000 (3)
$-10,000 (4)
Demand Low (.4)
$800,000 (5)
Demand High (.6)
2) Analyze decisions from right to left (i.e., work backwards from the end of the tree
towards the root). For instance, begin with decision 2 and choose expansion because it
has a higher present value ($450,000 vs. $50,000). Draw a double slash through the
Maintain alternative.
3) Determine the product of the chance probabilities and their respective payoffs for the
remaining branches.
Build Small
Demand Low:
Demand High:
.4($400,000) = $160,000
.6($450,000) = $270,000
Build Large
Demand Low:
Demand High:
.4(-$10,000) = -$4,000
.6($800,000) = $480,000
4) Determine the expected value of each initial alternative.

Build Small = $160,000 + $270,000 = $430,000
Build Large = -$4,000 + $480,000 = $476,000
Conclusion: Because the expected value of building a large plant is highest, select the
large plant alternative. Draw a double slash through the Build Small alternative.
b. Expected payoff under certainty:
.4(400,000) + .6(800,000) = $640,000
-Expected payoff under risk:
-476,000
Expected value of perfect information:
$164,000
5S-6
c. Determine the range over which each alternative would be best in terms of the value of
P(Low).
Plot each alternative relative to P(Low). Plot the payoff value for High Demand on the left
side of the graph and the payoff value for Low Demand on the right side of the graph.
Alternative
High Demand
Low Demand
Build Small
$450,000
400,000
Build Large
$800,000
-$10,000
High
Payoff
800,000
Large
450,000
Small
400,000
1.0
P(Low)
-10,000
The graph above shows the range of values of P(Low) over which each alternative is optimal.
For low values of P(Low), Build Large is best because it has the highest expected value. For
high values of P(Low), Build Small is best because it has the highest expected value.
intersect. For each line, b is the slope of the line and x = P(Low). The slope of each line =
Equations:
Build Small:
Build Large:
450,000 50,000P (slope = 400,000 450,000)

800,000 810,000P (slope = -10,000 800,000)
Find the intersection between the two lines:

450,000 50,000P = 800,000 810,000P
-50,000P + 810,000P = 800,000 450,000
760,000P = 350,000
P = 350,000/760,000
P = .4605
Optimal ranges:
Build Large:
Build Small:
P(Low) = 0 to < .4605

P(Low) > .4605 to 1.00
5S-7
Low
Payoff
5.
Analyze the decisions from right to left:

1) Determine which alternative would be selected for each possible second decision.
Subcontract with Medium demand: Select either alternative. Payoff = $1.3.
Subcontract with Large demand: Select Build. Payoff = $1.8. Place a double slash through
Do nothing and Expand.
Expand with Small demand: Select Other use #1. Payoff = $1.5. Place a double slash
through Do nothing and Other use #2.
Expand with Large demand: Select Build. Payoff = $1.7. Place a double slash through Do
nothing and Subcontract.
Build with Small demand: Select Other use #1. Payoff = $1.4. Place a double slash
Build with Medium Demand: Select Other use #1. Payoff = $1.1. Place a double slash
remaining branches.
Subcontract
Small demand:
Medium demand:
Large demand:
.4($1.0) = $0.40
.5($1.3) = $0.65
.1($1.8) = $0.18
Expand
Small demand:
Medium demand:
Large demand:
.4($1.5) = $0.60
.5($1.6) = $0.80
.1($1.7) = $0.17
Build
Small demand:
.4($1.4) = $0.56
Medium Demand: .5($1.1) = $0.55
Large demand:
.1($2.4) = $0.24
Subcontract = $0.40 + $0.65 + $0.18 = $1.23
Expand = $0.60 + $0.80 + $0.17 = $1.57
Build = $0.56 + $0.55 + $0.24 = $1.35
Conclusion: Because the expected value of the Expand alternative is greatest, select it.
Draw a double slash through Subcontract and Build.
5S-8
6.
Given: Management must decide whether to renew the lease for another 10 years or to
relocate near the site of a proposed motel. The net present values of the two alternatives under
each state of nature are given in the table below.
States of Nature
Alternative
Motel Approved
Motel Rejected
Renew
$500,000
$4,000,000
Relocate
$5,000,000
$100,000
a. Maximax: Determine best possible payoff for each alternative and choose the alternative
that has the best.
States of Nature
Alternative
Motel Approved
Motel Rejected
Best Payoff
Renew
$500,000
$4,000,000
$4,000,000
Relocate
$5,000,000
$100,000
$5,000,000
Best of
the Best
Conclusion: Select Relocate alternative with a payoff of $5,000,000.
b. Maximin: Determine the worst possible payoff for each alternative and choose the
States of Nature
Alternative
Motel Approved
Motel Rejected
Worst
Payoff
Renew
$500,000
$4,000,000
$500,000
Relocate
$5,000,000
$100,000
$100,000
Best of
the
Worst
Conclusion: Select Renew alternative with a payoff of $500,000.
5S-9
c. Laplace: Determine the average payoff for each alternative and choose the alternative with
the best average.
States of Nature
Alternative
Motel Approved
Motel Rejected
Average
Payoff
Renew
$500,000
$4,000,000
$2,250,000
Relocate
$5,000,000
$100,000
$2,550,000
Best
Conclusion: Select Relocate alternative with an average payoff of $2,550,000.

d. Minimax Regret: Prepare a table of regrets (opportunity losses)for each column,
Regrets
Alternative
Motel Approved
Motel Rejected
Worst Regret
Renew
$4,500,000
$0
$4,500,000
($5,000,000$500,000)
($4,000,000$4,000,000)
$0
$3,900,000
($5,000,000$5,000,000)
($4,000,000$100,000)
Relocate
$3,900,000
Best of the
Worst
Conclusion: Select Relocate alternative because it has the best of the worst regrets of the
two alternatives.
5S-10
7.
Given: Probability that the motels application will be approved = .35.

The probability that the motel will be rejected = 1.00 - .35 = .65.
Alternative
a. Renew
Expected Value
(.35)500,000 + (.65)4,000,000 = $2,775,000
Relocate
(.35)5,000,000 + (.65)100,000 = $1,815,000
Conclusion:
Renew lease.
b.
Approve (.35)
$500,000
Renew
Relocate
Reject (.65)
Approve (.35)
Reject (.65)
E.V.
$2,775,000
$4,000,000
$5,000,000
$1,815,000
$100,000
Conclusion: Renew lease.

c. Expected value of perfect information (EVPI) = Expected payoff under certainty
Motel Approved: Best Payoff = $5,000,000
Motel Rejected: Best Payoff = $4,000,000
= (Prob. of Motel Approved x Best Payoff) + (Prob. of Motel Rejected x Best Payoff)
= .35($5,000,000) + .65($4,000,000) = $1,750,000 + $2,600,000 = $4,350,000
Expected payoff under risk = Expected value of the alternative selected = $2,775,000
EVPI = $4,350,000 - $2,775,000 = $1,575,000
Conclusion: Yes, the manager should sign the lease for $24,000 because this cost is less
than the EVPI of $1,575,000.
5S-11
8.
a. Determine the range over which each alternative would be best in terms of the value of
P(Approved).
Plot each alternative relative to P(Approved). Plot the payoff value for Rejected on the left
side of the graph and the payoff value for Approved on the right side of the graph.
Alternative
Rejected
Approved
Renew
$4,000,000
$500,000
Relocate
$100,000
$5,000,000
Rejected
Approved
Exp. Value
5
(millions)
4
3
2
1
Renewal better than
5
4 100,000 + 4,900,000x
3
Relocate
Renew
For 8(a) and 8(b) the decision should be to renew
2 the 10-year lease because a. P(Approved) of .35 < .4643 & b. P(Approved) of .45 < .46
1
Relocation
4,000,000 3,500,000x
Relocate
.5
x = .4643
P (Approved)
The graph above shows the range of values of P(Approved) over which each alternative is
optimal. For low values of P(Approved), Renewal is best because it has the highest expected
value. For high values of P(Approved), Relocate is best because it has the highest expected
value.
intersect. For each line, b is the slope of the line and x = P(Approved). The slope of each line
= Right-hand value Left-hand value.
Equations:
Renew:
Relocate:
4,000,000 3,500,000P (slope = 500,000 4,000,000)

100,000 + 4,900,000P (slope =5,000,000 100,000)
Find the intersection between the two lines:

4,000,000 3,500,000P = 100,000 + 4,900,000P
-3,500,000P 4,900,000P = 100,000 4,000,000
-8,400,000P = -3,900,000
P = -3,900,000/-8,400,000
P = .4643
5S-12
Optimal ranges:
Renew:
Relocate:
P(Approved) = 0 to < .4643

P(Approved) > .4643 to 1.00
Conclusion: Still should renew because P = .35 is less than P = .4643.

b. Conclusion: Still should renew because P = .45 is less than P = .4643.
c.
Given:
Renew = .35(500,000) + .65(4,000,000)
Relocate = .35(5,000,000) + .65(100,000) = $1,815,000
Plug in x for 4,000,000 in Renew equation:
Renew = .35(500,000) + .65x
Relocate = .35(5,000,000) + .65(100,000) = $1,815,000
Set the two equations equal and solve for x:
.35(500,000) + .65x = $1,815,000
175,000 + .65x = 1,815,000
.65x = 1,815,000 175,000
.65x = 1,640,000
x = 1,640,000/.65
x = 2,523,077
Original decision at the payoff of $4,000,000 would have to decrease to
less than $2,523,077 for the decision to change from Renew to Relocate.
Conclusion:
The decision to Renew remains the same for the range of x > $2,523,077.
At x = $2,523,077, we would be indifferent between Renew and Relocate.
At x < $2,523,077, the decision would change to Relocate.
5S-13
$ 42 .2(42)
9. a.
46.8
.2 Low
.8 High
48
2
Subcontract
Expand Greatly
Small
53.6
1
Medium
44.4
48
.8(48)
46.8
22 .2(22)
.2 Low
.8 High
42
50
2
Large
Do Nothing
46
Expand
50
53.6
44.4
.8(50)
(20) .2(-20)
.2 Low
.8 High
72
53.6
.8(72)

1) Determine which alternative would be selected for each possible second decision
(marked as 2).
Small with High demand: Select Expand Greatly. Payoff = $48. Place a double dash
through Subcontract.
Medium with High demand: Select Expand. Payoff = $50. Place a double slash
through Do Nothing.
remaining branches.
Small
Low demand:
High demand:
.2($42) = $8.4
.8($48) = $38.4
Medium
Low demand:
Medium demand:
.2($22) = $4.4
.8($50) = $40
Large
Low demand:
.2(-$20) = -$4
Medium Demand: .8($72) = $57.6
5S-14

Small = $8.4 + $38.4 = $46.8
Medium = $4.4 + $40 = $44.4
Large = -$4 + $57.6 = $53.6
Conclusion: Because the expected value of the Large alternative is greatest, select it.
Draw a double slash through Small and Medium.
b. Maximin Alternative: Determine the worst possible payoff for each alternative and choose
the alternative that has the best worst.
Next Years Demand
Alternative
Low
High
Worst Payoff
Small
$42
$48
$42
Medium
$22
$50
$22
Large
-$20
$72
-$20
Best of the Worst
Conclusion: Build Small.

c. Expected value of perfect information (EVPI) = Expected payoff under certainty
Low Demand: Best Payoff = $42
High Demand: Best Payoff = $72
= (Prob. of Low Demand x Best Payoff) + (Prob. of High Demand x Best Payoff)
= .2($42) + .8($72) = $8.4 + $57.6 = $66
Expected payoff under risk = Expected value of the alternative selected in part a =
$53.6
EVPI = $66 - $53.6 = $12.4
5S-15
d. Determine the range over which each alternative would be best in terms of the value of
P(High).
Plot each alternative relative to P(High). Plot the payoff value for Low on the left side of
the graph and the payoff value for High on the right side of the graph.
Next Years Demand
Alternative
Low
High
Small
$42
$48
Medium
$22
$50
Large
-$20
$72
Low
High
72
50
42
48
Small
Medium
22
Large
0.72091.0
-20
P (High)
The graph above shows the range of values of P(High) over which each alternative is optimal.
For low values of P(High), Small is best because it has the highest expected value.
For interemediate and higher values of P(High), Large is best.
intersect. For each line, b is the slope of the line and x = P(High). The slope of each line =
Equations:
Small:
Large:
42 + 6P (slope = 48 42)
-20 + 92P (slope = 72 (-20))
5S-16
Find the intersection between Small & Large:

42 + 6P = -20 + 92P
6P 92P = -20 42
-86P = -62
P = -62/-86
Optimal ranges:
Small:
Large:
P(High) = 0 to < .7209

P(High) > .7209 to 1.00
5S-17
10.
Decision Tree
.30 low
$90
do nothing
90
.7 high
buy 1
subcontract
buy 2nd
.30 low
110
100
75
buy 2
130
.70 high

1) Determine which alternative would be selected for each possible second decision.
Buy 1 with High Demand: Select Subcontract. Payoff = $110. Place a double dash through
Do Nothing and Buy 2nd.
remaining branches.
Buy 1
Low Demand:
High demand:
.30($90) = $27
.70($110) = $77
Buy 2
Low demand:
Medium demand:
.30($75) = $22.5
.70($130) = $91

Buy 1 = $27+ $77 = $104
Buy 2 = $22.5 + $91 = $113.5
Conclusion: Because the expected value of the Buy 2 alternative is greatest, select it.
Draw a double slash through Buy 1.
5S-18
EV1 = (.3) (90) + (.7) (110) = 104 McGraw-Hill Education.
EV2 = (.3) (75) + (.7) (130) = 113.5 Since 113.5 > 104
Decision: Buy 2 machines.
11.
EV=50
Decision Tree
1/3
1/3
1/3
D2a
.30
EV=49
4
Alternative A
.50
44
60
.20
EV=33
1/3
1/3
1/3
D2b
.30
EV=46
5
90
40
D1
Alternative B
0
60
(45)
45
99
40
.50
50
.20
30
1/2
D2c
3
EV=45
1/2
40
50
branches on the right hand side. Because this is a complex problem, we have added labels
to the circles:
EV1 = (1/3)(0) + (1/3)(60) + (1/3)(90) = 50
EV2 = (1/3)(45) + (1/3)(45) + (1/3)(99) = 33
EV3 = (1/2)(40) + (1/2)(50) = 45
2) Determine which alternative would be selected for each possible second decision. We
have labeled these D2a, D2b, and D2c.
D2a: Select upper branch with payoff of 50. Draw a double slash through the lower
branch.
D2b: Select lower branch with payoff of 40. Draw a double slash through the upper
branch.
D2c: Select lower branch with payoff of 45. Draw a double slash through the upper
branch.
5S-19
branches on the left hand side. Because this is a complex problem, we have added labels
to the circles:
EV4 = (.30)(50) + (.50)(44) + (.20)(60) = 49
EV5 = (.30)(40) + (.50)(50) + (.20)(45) = 46
Alternative A = $49 (work is shown in previous step)
Alternative B = $46 (work is shown in previous step)
Conclusion: Because the expected value of Alternative A is greatest, select it for Decision
1 (D1). Draw a double slash through Alternative B.
12.
a.
1) Draw the tree diagram. Because the probabilities are unknown, we would assume that
each state of nature has an equal probability of occurring.
Demand Low (.50)

Build Small
$700
$100
Lease
Demand High (.50)
Expand
Build Large
$500
$40
Demand Low (.50)
$2,000
Demand High (.50)
2) We have to make a choice for the possible second decision before proceeding.
Expand has a higher payoff than Lease ($500 > $100). Select Expand. Draw a double
slash through the Lease branch.
5S-20
b. Use the tree diagram to identify the choice that you would make using each of the four
approaches for decision making under uncertainty.
States of Nature
Alternative
Demand Low
Demand High
Build Small
$700
$500
$40
$2,000
Build Large
1) Maximax: Determine best possible payoff for each alternative and choose the
alternative that has the best.
States of Nature
Alternative
Demand Low
Demand High
Best Payoff
Build Small
$700
$500
$700
Build Large
$40
$2,000
$2,000
Best of the
Best
Conclusion: Select Build Large with a payoff of $2,000.

2) Maximin: Determine the worst possible payoff for each alternative and choose the
States of Nature
Alternative
Demand Low
Demand High
Worst
Payoff
Build Small
$700
$500
$500
Build Large
$40
$2,000
$40
Best of the
Worst
Conclusion: Select Build Small alternative with a payoff of $500.
5S-21
3) Laplace: Determine the average payoff for each alternative and choose the alternative
with the best average.
States of Nature
Alternative
Demand Low
Demand
High
Average
Payoff
Build Small
$700
$500
$600
Build Large
$40
$2,000
$1,020
Best
Conclusion: Select Build Large alternative with an average payoff of $1,020.

4) Minimax Regret: Prepare a table of regrets (opportunity losses)for each column,
Regrets
Alternative
Demand Low
Demand High
Worst
Regret
Build Small
$0
$1,500
$1,500
($700-$700)
($2,000-$500)
$660
$0
($700-$40)
($2,000-$2,000)
Build Large
$660
Best of the
Worst
Conclusion: Select Build Large alternative because it has the best of the worst regrets
of the two alternatives.
5S-22
13.
Given: We have the estimated costs for various alternatives and caseloads shown below.
Caseload
Alternative
Moderate
High
Very High
Reassign
staff
50
60
85
New staff
60
60
60
Redesign
collection
40
50
90
Note: Because this problem uses costs, best is associated with lowest cost.
a. Maximin: Determine the worst possible payoff for each alternative and choose the
Caseload
Alternative
Moderate
High
Very High
Worst
Reassign
staff
50
60
85
85
New staff
60
60
60
60
Redesign
collection
40
50
90
90
Best of
the Worst
Conclusion: Select New staff alternative.
5S-23
b. Maximax: Determine best possible payoff for each alternative and choose the alternative
that has the best.
Caseload
Alternative
Moderate
High
Very High
Best
Reassign
staff
50
60
85
50
New staff
60
60
60
60
Redesign
collection
40
50
90
40
Best of
the Best
Conclusion: Select Redesign collection alternative.

c. Minimax Regret: Prepare a table of regrets (opportunity losses)for each column,
Regret
Alternative
Moderate
High
Very High
Worst
Regret
Reassign
staff
10
10
25
25
(50-40)
(60-50)
(85-60)
20
10
(60-40)
(60-50)
(60-60)
30
(40-40)
(50-50)
(90-60)
New staff
Redesign
collection
20
Best of
the Worst
30
Conclusion: Select New Staff alternative.
5S-24
d. Laplace: Determine the average payoff for each alternative and choose the alternative with
the best average.
Caseload
Alternative
Moderate
High
Very High
Average
Reassign
staff
50
60
85
65
New staff
60
60
60
60
Best (tie)
Redesign
collection
40
50
90
60
Best (tie)
Conclusion: Select either New Staff or Redesign collection alternative.

14.
Given: Probabilities for states of nature are now given as follows: .10 for moderate, .30 for
high, and .60 for very high.
a. Minimum expected cost:
Reassign: .10(50) + .30(60) + .60(85) = $74
New Staff: .10(60) + .30(60) + .60(60) = 60
Redesign:
.10(40) + .30(50) + .60(90) = 73
Conclusion: New Staff alternative will yield the minimum expected cost.
b.
.10 Moderate
50
Conclusion:
New Staff alternative
will yield the minimum expected cost. Draw a double
.30 High
Reassign
60
74
slash through the Reassign and Redesign branches.
.60 Very High
.10 Moderate
60
New Staff
60
.30 High
.60 Very High
.10 Moderate
Redesign
73
.30 High
.60 Very High
85
60
60
60
40
50
90
5S-25
c. Opportunity loss table
Regret
Alternative
Moderate
High
Very High
Reassign
staff
10
10
25
New staff
20
10
Redesign
collection
30
Expected regret for each alternative:

Reassign:
New staff:
Redesign:
.10(10) +.30(10) + .60(25) = 19

.10(20) +.30(10) + .60(0) = 5
.10(0) +.30(0) + .60(30) = 18
Conclusion: The lowest expected regret is 5. Hence, the EVPI = 5.
5S-26
15.
a. Given: Payoffs (profits) are provided in the table below.

Plot each alternative relative to P(1). Plot the payoff value for #2 on the left side of the
graph and the payoff value for #1 on the right side of the graph.
State of Nature
Alternative
#2
#1
20
120
40
60
110
10
90
90
#2
#1
A
110
120
90
90
B
60
40
20
10
1.0
P(#1)
Alternative C is best for the lowest range of P(#1), followed by Alternative D for the
intermediate range, and then Alternative A for the highest range.
Equations:
A: 20 + 100P (slope = 120 20)
B: 40 + 20P (slope = 60 40)
C: 110 100P (slope = 10 110)
D: 90 + 0P (slope = 90 90)
Find the intersection between C & D:
110 100P = 90 + 0P
-100P = 90 - 110
-100P = -20
P = -20/-100
P = .2000
5S-27
Find the intersection between D & A:

90 + 0P = 20 + 100P
90 20 = 100P
70 = 100P
P = 70/100
P =.7000
Optimal ranges:
C:
P(#1) = 0 to < .2000
D:
P(#1) > .2000 to < .7000
A:
P(#1) > .7000 to 1.00
b. Treat the payoffs as costs.
#2
#1
A
110
120
90
90
B
60
40
20
10
1.0
P(#1)
Alternative A is best for the lowest range of P(#1), followed by Alternative B for the
intermediate range, and then Alternative C for the highest range.
Equations:
A: 20 + 100P (slope = 120 20)
B: 40 + 20P (slope = 60 40)
C: 110 100P (slope = 10 110)
D: 90 + 0P (slope = 90 90)
5S-28
Find the intersection between A & B:

20 + 100P = 40 + 20P
100P 20P = 40 20
80P = 20
P = 20/80
P = 0.2500
Find the intersection between B & C:
40 + 20P = 110 100P
20P + 100P = 110 40
120P = 70
P = 70/120
P = .5833
Optimal ranges:
A:
P(#1) = 0 to < .2500
B:
P(#1) > .2500 to < .5833
C:
P(#1) > .5833 to 1.00
5S-29
16.
a. Determine the range over which each alternative would be best in terms of the
value of P(High).
Plot each alternative relative to P(#2). Plot the payoff value for #1 on the left side of the
graph and the payoff value for #2 on the right side of the graph.
State of Nature
Alternative
#1
#2
$20
$140
$120
$80
$100
$40
Payoff
#1
Payoff
#2
140
120
100
C
80
A
40
20
0
P(#2)
1.0
5S-30
b. Alternative C is lower than Alternative B for all values of P(#2), so it would never be
appropriate in terms of maximizing profits.
c. For low and intermediate values of P(#2), Alternative B is best because it has the
highest expected value. For higher values of P(#2), Alternative A is best.
To find the exact values of the ranges, we must determine where the upper parts of the
lines intersect. For each line, b is the slope of the line and x = P(#2). The slope of each
line = Right-hand value Left-hand value.
Equations:
A: 20 +120P (slope = 140 20)
B: 120 40P (slope = 80 120)
Find the intersection between A & B:
20 +120P = 120 40P
120P + 40P = 120 20
160P = 100
P = 100/160
P = .6250
Conclusion: Select Alternative A if P(#2) is greater than .6250.
d. Conclusion: For P(#1), choose Alternative A if P(#1) is less than .3750 (i.e., 1.00 .
6250).
5S-31
17.
a. [Refer to the diagram in the solution for Problem 16]

b. Alternative B is higher than Alternative C for all values of P(#2), so Alternative B
would never be appropriate in terms of minimizing costs.
c. For low values of P(#2), Alternative A is best. For intermediate and higher values of
P(#2), Alternative C is best.
Equations:
A: 20 +120P (slope = 140 20)
C: 100 60P (slope = 40 100)
Find the intersection between A & C:
20 +120P = 100 60P
120P + 60P = 100 20
180P = 80
P = 80/180
P = .4444
Conclusion: Select Alternative A for P(#2) less than .4444 and choose Alternative C
for P(#2) greater than .4444.
d. Conclusion: In terms of P(#1), choose Alternative A for P(#1) greater than .5556 (1.00
- .4444) and choose Alternative C for P(#1) less than .5556.
5S-32
18.
Given: Payoffs are provided in the table below.

Plot each alternative relative to P(No Contract). Plot the payoff value for Receive Contract on
the left side of the graph and the payoff value for No Contract on the right side of the graph.
State of Nature
Alternative
Receive
Contrac
t
No
Contract
#1
10
-2
#2
#3
#4
Payoff for No Contract
Payoff for Contract

10
#1
8
7
#4
#2
5
#3
1.0
P(No Contract)
-2
Alternative 1 is best for the lowest range of P(No Contract), followed by Alternative 2 for the
next range, then Alternative 3 for the range after that, and then Alternative 4 for the highest
range.
Equations:
1: 10 12P (slope = -2 10)
2: 8 5P (slope = 3 8)
3: 5 + 0P (slope = 5 5)
5S-33
4: 0 + 7P (slope = 7 0)
Find the intersection between 1 & 2:
10 12P = 8 5P
-12P (-5P) = 8 10
-7P = -2
P = -2/-7
P = .2857
Find the intersection between 2& 3:
8 5P = 5 + 0P
8 5P = 5
-5P = 5 8
-5P = -3
P = -3/-5
P = .6000
Find the intersection between 3 & 4:
5 + 0P = 0 + 7P
5 = 7P
P = 5/7
P = .7143
Optimal ranges:
#1:
#2:
#3:
#4:
Payoff
#1
120
.30
A
P(No Contract) = 0 to < .2857

P(No Contract) > .2857 to < .6000
P(No Contract) > .6000 to < .7143
P(No Contract) > .7143 to 1.00
Payoff
#2
.80
Profits
110
C
90
90
60
B
C
Costs
40
20
10
0
5S-34
Education. All rights reserved. No reproduction or distribution without the prior written consent of
.417 Copyright
.75 2015 McGraw-Hill
1.0
P (#2)
Enrichment Model: Advanced Decision Tree Problems

In this section two additional decision tree problems are presented
1.
Space engineers have three alternative designs for the configuration of a component for an
unmanned space shuttle. The space vehicle is likely to encounter one of four different
conditions, which have probabilities of occurrence as listed in the following payoff table
(costs in $00) with the payoffs for each combination of design and state of nature. Additional
data from previous flights are available but will require additional expenditures to analyze.
However, the project director is confident that analysis of the data will clearly indicate which
state of nature will be encountered. What amount would be justified for the data analysis?
States of Nature
Design
Probability:
.3
.4
.2
.1
001
20*
10
10
002
15
10
40
003
10
20
30
30
* Costs in $ hundreds.
5S-35
2.
Demand for movie rentals at a video store on Saturdays during summer months is related to
the weather. If it is raining, or if the chance of rain is greater than 50%, demand tends to
follow one distribution, whereas if it is not raining and the chance of rain does not exceed
50%, demand follows a different distribution. This is important to the video store because the
manager must decide early on Saturday how many employees to schedule for Saturday
afternoon and early evening.
The two distributions are:
P(Rain) 50%
P(Rain) > 50%

Demand
Probability
Demand
Probability
Low
.10
Low
.60
Moderate
.20
Moderate
.30
High
.70
High
.10
The regular staff can handle Low demand. Moderate demand requires two additional
employees, and High demand requires another two employees. The payoff table (profits in
$000) is shown below:
Demand
Extra Staff
Moderate
High
0 2
2 1
4 0
a. Construct a tree diagram showing the payoffs for this situation.

b. Determine the number of additional staff needed for a rainy Saturday.
c. Determine the number of staff needed when the chance of rain is 20% for a Saturday.
5S-36
Solution to Problem 1
1.
Design
A
.3
B
.4
C
.2
D
.1
001
20
10
10
Expected
Value
12
002
15
10
40
12.5
003
10
20
30
30
20
Design 001 minimizes the expected cost. Expected payoff under risk = $12 ($1,200).
A: Best (minimum cost) = 10
B: Best (minimum cost) =10
C: Best (minimum cost) = 0
D: Best (minimum cost) = 0
Develop the opportunity loss table:
Design
001
A
10
B
0
C
10
D
0
002
40
003
10
30
30
Expected regret for each alternative:

001: .3(10) + .4(0) + .2(10) + .1(0) = $5
002: .3(5) + .4(0) + .2(0) + .1(40) = $5.5
003: .3(0) + .4(10) + .2(30) + .1(30) = $13
Conclusion: The lowest expected regret = $5 ($500). Hence, the EVPI = $500.
5S-37
Solution to Problem 2
Low demand
2. a.
No additional staff
Medium demand
High demand
Low demand
Two additional staff
Medium demand
High demand
Low demand
Four additional staff
b.
No additional staff
Medium demand
High demand
3
4
1
4
5
0
3
6
Low demand (.1)

Medium demand (.2)
High demand (.7)
Low demand (.1)

Medium demand (.2)
High demand (.7)
Low demand (.1)

our additional staff
Medium demand (.2)

High
ma demand (.7)
d
(.2)
0
3
6
EV1 = (.1)(2) + (.2)(3) + (.7)(4) = 3.6

EV2 = (.1)(1) + (.2)(4) + (.7)(5) = 4.4
EV3 = (.1)(0) + (.2)(3) + (.7)(6) = 4.8
Because 4.8 > 4.4 > 3.6, hire four additional employees when it is rainy.
c.
No additional staff
Low demand (.6)

Medium demand (.3)
High demand (.1)
Low demand (.6)

Medium demand (.3)
High demand (.1)
Low demand (.6)

Medium demand (.3)
High demand (.1)
0
3
6
EV1 = (.6)(2) + (.3)(3) + (.1)(4) = 2.5

EV2 = (.6)(1) + (.3)(4) + (.1)(5) = 2.3
EV3 = (.6)(0) + (.3)(3) + (.1)(6) = 1.5
Because 2.5 > 2.3 > 1.5, hire no additional employees when the probability of rain is 20%.
5S-38
5S-39

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Chapter 05S - Decision Theory

Best of the Best

Conclusion: Select Expand alternative with a payoff of $80.

Chapter 05S - Decision Theory

Best of the Worst

Conclusion: Select Do nothing alternative with a payoff of $50.

Conclusion: Select Do nothing or Subcontract alternative with an average payoff of $55.

Chapter 05S - Decision Theory

d. Minimax Regret: Prepare a table of regrets (opportunity losses)for each column,

Given: P(Low Demand) = .3 and P(High Demand) = .7.

b. Decision Tree Analysis to Select an Alternative:

Chapter 05S - Decision Theory

Expected Value Calculations:

Chapter 05S - Decision Theory

50 + 10P (slope = 60 50)

Find the intersection between Do Nothing & Subcontract:

Chapter 05S - Decision Theory

P(High) = 0 to < .5000

a. 1) Draw the tree diagram:

Demand High (.6)

Demand Low (.4)

Demand High (.6)

4) Determine the expected value of each initial alternative.

Chapter 05S - Decision Theory

450,000 50,000P (slope = 400,000 450,000)

Find the intersection between the two lines:

P(Low) = 0 to < .4605

Chapter 05S - Decision Theory

Analyze the decisions from right to left:

Chapter 05S - Decision Theory

Conclusion: Select Relocate alternative with a payoff of $5,000,000.

Conclusion: Select Renew alternative with a payoff of $500,000.

Chapter 05S - Decision Theory

Conclusion: Select Relocate alternative with an average payoff of $2,550,000.

Chapter 05S - Decision Theory

Given: Probability that the motels application will be approved = .35.

(.35)5,000,000 + (.65)100,000 = $1,815,000

Conclusion: Renew lease.

Chapter 05S - Decision Theory

Renewal better than

4,000,000 3,500,000P (slope = 500,000 4,000,000)

Find the intersection between the two lines:

Chapter 05S - Decision Theory

P(Approved) = 0 to < .4643

Conclusion: Still should renew because P = .35 is less than P = .4643.

Chapter 05S - Decision Theory

Analyze the decisions from right to left:

Chapter 05S - Decision Theory

3) Determine the expected value of each initial alternative.

Best of the Worst

Conclusion: Build Small.

Chapter 05S - Decision Theory

Chapter 05S - Decision Theory

Find the intersection between Small & Large:

P(High) = 0 to < .7209

Chapter 05S - Decision Theory

Analyze the decisions from right to left:

3) Determine the expected value of each initial alternative.

Chapter 05S - Decision Theory

Chapter 05S - Decision Theory

Demand Low (.50)

Demand High (.50)

Demand Low (.50)