BU275: Practice problems for “Bayesian Updating”

Note: Questions 10 and 11 in the Decision Analysis Practice Problems are also Bayesian updating
problems. Here are a few more:

Q1) Revisit question 4 in the Decision Analysis Practice Problems. Dwight can buy a farmer’s almanac
that will predict whether there will be Heavy Rain or Light Rain this season. In the past, when the
weather was dry, the farmer’s almanac predicted Light Rain 80% of the time and Heavy Rain 20% of the
time. When the weather was moderate, the almanac predicted Light Rain 45% of the time, and Heavy
Rain 55% of the time. When the weather was damp, the almanac predicted Light Rain 30% of the time
and Heavy Rain 70% of the time.

What is the EVSI of the almanac?

Q2) Morgan Manufacturing must decide whether to manufacture a component of its main product at its
own plant, or purchase the component from a supplier. The resulting profit for the year depends on
demand for the product:

States of Nature
Alternatives: Low Demand (l) Medium Demand (m) High Demand (h)
Manufacture (d1) -$20,000 $40,000 $100,000
Purchase (d2) $10,000 $45,000 $70,000

With no other information, the company believes the probability of low demand is 0.2, of medium
demand is 0.3, and of high demand is 0.5.

A market research firm can write a report with three possible outcomes: Positive, Neutral or Negative.
Based on past reports, when demand for a product was low, the report was Negative 70% of the time
and Neutral 30% of the time. When demand for a product was medium, the report was Negative 25% of
the time, Neutral 60% of the time and Positive 15% of the time. When demand for the product was high,
the report was Positive 75% of the time and Neutral 25% of the time.

What are the marginal probabilities of each of the report outcomes?

What are the posterior probabilities of each of the possible states given the report outcomes?

What is the best decision given each report outcome?

Finally, what is the Efficiency of the report?

Q3) A Machine shop owner is considering buying some new equipment: either a Drill Press, Lathe or
Grinder. The profitability this year depends on whether he gets a new contract from a big customer. He
estimates a 40% chance of getting this contract. The payoffs:

Contract No Contract
Drill Press $ 40,000 $ - 8,000
Lathe $ 20,000 $ 4,000
Grinder $ 12,000 $ 10,000

The shop owner is considering hiring a consultant, who will present a Favourable or Unfavourable report
about the possibility of landing the new contract. Based on previous reports, if the report was
Favourable, there is a 70% chance of getting the contract. If the report was Unfavourable, there is an
80% chance of not getting the contract. The owner expects 50% chance of receiving a Favourable report.

What is the best decision given the possible report outcomes?

What is the Efficiency of the report?