Assignment 5d: Decision Theory

1. A large steel manufacturing company has three options with regard to production: i) produce commercially, ii)
build a pilot plant, iii) stop producing steel. The management has estimated that their pilot plant, if built, has
0.8 chance of high yield and 0.2 chance of low yield. If the pilot plant does show a high yield, management
assigns a probability of 0.75 that the commercial plant will also have a high yield. If the pilot plant shows a low
yield, there is only 0.1 chance that the commercial plant will show a high yield. Finally, management’s best
assessment of the yield on a commercial-size plant without building a pilot plant first has a 0.6 chance of high
yield. A pilot plant will cost ₹3,00,000. The profits earned under high and low yield conditions are
₹1,20,00,000 and ₹12,00,000 respectively. Find the optimum decision for the company.

2. A client asks an estate agent to sell three properties A, B, and C for him and agrees to pay him 5% commission
on each sale. He specifies certain conditions. The estate agent must sell property A first, and this he must do
within 60 days. If and when A is sold, the agent receives his 5% commission on that sale. He can then either
back out at this stage or nominate and sell one of the remaining two properties within 60 days. If he does not
succeed in selling the nominated property in that period, he is not given the opportunity to sell the other. If he
does, he is given the opportunity to sell the third property on the same conditions. The following table
summarizes the prices, selling costs (incurred by the real estate agent whenever a sale is made) and the
estimated probability of making a sale.

Property Price ( ₹) Selling Costs ( ₹) Probability of sale

A 12,000 400 0.7

B 25,000 225 0.6

C 50,000 450 0.5

Draw an appropriate decision tree and find out the estimate agent’s best strategy.

3. Mr. X is trying to decide whether to travel to Sri Lanka from Delhi to negotiate the sale of a shipment of China
novelties. He holds the novelties in stock and is fairly confident, but by no means sure that if he makes the trip
he will sell the novelties at a price that will give him a profit of ₹30,000. He puts the probability of obtaining
the order at 0.6. If he does not make the trip he will definitely not get the order.
If the novelties are not sold in Sri Lanka, there is an Indian customer who will certainly buy them at a price that
leaves him a profit of ₹15,000 and his offer will be open at least till Mr. X returns from Sri Lanka. Mr. X
estimates the expenses to be of trip to Sri Lanka at ₹2,500. He is, however, concerned that his absence, even for
only three days, may lead to production inefficiencies in the factory. These could cause him to miss the
deadline on another contract, with the consequence that a late penalty of ₹10,000 will be invoked. Mr. X
assesses the probability of missing the deadline under these circumstances at 0.4. Further he believes that in
his absence there will be lower standard of housekeeping in the factory, and the raw material and labor costs
on the other will rise by ₹2,000 above the budgeted figure.
Draw an appropriate decision tree, and help Mr. X decide on the best strategy.

4. An oil company has recently acquired rights to in a certain area to conduct surveys and test drillings to lead to
lifting oil where it is found in commercially exploitable quantities. The area is already considered to have good
potential for finding oil in commercial quantities. At the outset, the company has the choice to conduct further

Assignments | Decision Theory 1|P a g e

 geological tests or to carry out a drilling program immediately. On the known conditions, the company
estimates that there is a 70:30 chance of a further test 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 program or alternatively consider selling its rights to drill in the area.
Thereafter, however, if it carries out the drilling program, the likelihood of final success or failure is considered
dependent on the foregoing stages. Thus:
a. If successful tests have been carried out, the expectation of success in drilling is given as 80:20
b. If the tests indicate failure, then the expectation of success in drilling is 20:80. If no tests have been
carried out the expectation of success in drilling is 55:45. Costs and revenues have been estimated for
all possible outcomes and the net present value of each is as follows

Outcome NPV ( ₹Cr)

Success:
With Prior Tests 100
Without prior tests 120
Failure:
With Prior Tests –50
Without prior tests –40
Sale of Exploitation Rights:
Prior tests show ‘success’ 65
Prior tests show ‘failure’ 15
Without prior tests 45

Draw a decision tree and advise the management on the best course of action.

5. Robin goes to the racetrack. He has the following options:

a. Decline to place any bets at all.
b. Bet on Belle. It costs ₹1,000 to place a bet; He will be paid ₹2,000 if she wins (for a net profit of ₹1,000).
c. Bet on Jeb. It costs ₹1,000 to place a bet; He will be paid ₹11,000 if he wins (for a net profit of ₹10,000).
Robin believes that Belle has probability 0.7 of winning and that Jeb has probability 0.1 of winning.
Someone comes and offers him gambler’s anti-insurance. If he agrees to it,
a. They pay him ₹2,000 up front
b. He must pay them 50% of any winnings (that is, ₹500 if Belle wins, and ₹5,000 if Jeb wins).
Draw a decision tree to help Robin decide on the course of action.

Answers
(1) EMV at Decision Node 1 = max (₹75,96,000, ₹76,80,000, ₹0)
(2) EMV at Decision Node 1 = max (₹1,072.75, ₹0) (3) EMV at Decision Node 1 = max (₹15,500, ₹15,000)
(4) EMV at Decision Node 1 = max (₹53.5 cr, ₹45 cr, ₹48 cr) (5) EMV at Decision Node 1 = max (₹2,050, ₹400, ₹0)

Assignments | Decision Theory 2|P a g e