Chapter 5S Decision Theory Discussion

Problem 1. A manager's staff has compiled the information below which pertains to four
capacity alternatives. Values in the matrix are present value in thousands of dollars.

(A) Assuming a maximax strategy, which alternative would be chosen?

(B) If maximin were used, which alternative would be chosen?
(C) If states of nature are equally likely and an expected value criterion of maximization is used,
which alternative would be chosen?

Problem 2. A manager has developed a payoff table that indicates the profits associated with a set
of alternatives under two possible states of nature. Answer the following questions.

(A) If the manager uses maximin as the decision criterion, which of the alternatives would be
indicated?
(B) If the manager uses minimax regret as the criterion, which alternative would be indicated?
(C) If the manager uses maximax as the criterion, which alternative would be indicated?
(D) If the manager uses Laplace as the criterion, which alternative would be indicated?
(E) Determine the expected value of perfect information if P(S2) = .30

Problem 3. A firm that plans to expand its product line must decide whether to build a
small or a large facility to produce the new products. If it builds a small facility and
demand is low with a probability of 0.4, the net present value after deducting for building
costs will be $ 400,000. If demand is high with a probability of 0.6, the firm can either
maintain the small facility or expand it. Expansion would have a net present value of $
450,000, and maintaining the small facility would have a net present value of $ 50,000. If
it builds a large facility, when the demand is low, the net present value is $-10,000, and
when the demand is high, the net present value is $800,000.
(A) Draw a decision tree.
(B) Determine the course of action that has the highest expected net present value.

1
Answers to Problem 1.
(A) Maximax is A ($50 is the largest value for any alternative).
(B) Maximin is either B or C (Both have the largest minimum values of $30).
(C) A: $35; B: $33.75; C: $31.25; D: $27.50. Hence, choose A.

Answers to Problem 2.

(A) Maximin: Alt. 3

(B) Regret matrix is:

Minmax regret: Alt. 3.

(C) Maximax: Alt. 1
(D) Laplace: Alt. 3
(E) EMV for Alt. 1 is: 10*0.7+2*0.3 = 7.6 , EMV for Alt. 2 is : (-2)*0.7+8*0.3 = 1
EMV for Alt. 3 is : (8)*0.7+5*0.3 = 7.1, EMV under certainty: 10* 0.7 + 8 *0.3 = 9.4
Therefore, Alternative 1 would be selected under risk, with an EVPI = 9.4-7.6 = 1.8.

Answers to Problem 3.
(A) Draw the tree diagram:

Demand Low (.4) $400,000 (1)

Maintain $50,000 (2)

Build Small
2
Demand High (.6) Expand
1 $450,000 (3)
Demand Low (.4) $-10,000 (4)
Build Large

Demand High (.6) $800,000 (5)

(B) If build small is chosen, the expected net present value is $430,000. If build large is chosen,
the expected net present value is $476,000. Therefore, select the large plant alternative.