Modelling for Decisions

PGPX 2024 – 25
Session 7
Sarah Chang’s Dilemma
A model for the problem
How do you represent a solution to the problem at hand?

What is your “bag” of possible solutions?

Given a solution, how do you measure its “goodness”?

What do you mean by the “best” solution?

A model for the problem
How do you represent a solution to the problem at hand?

A. Should Sarah invest in R&D? Yes/No

(Assumption: If she does not, then the new technology is not developed.)

B. Should Sarah bid if she only has the old technology? Yes/No

C. Should Sarah bid if she has the new as well as the old technology? Yes/No
A model for the problem
What is your “bag” of possible solutions? A B C

A. Should Sarah invest in R&D? Invest,

Yes bidYes
no matter
Yes what
Yes Yes No

Sarah’s options
B. Should Sarah bid with if she only has the Yes bidNo
Invest, Yes have the new technology
only if you
old technology?
Yes No No
C. Should Sarah bid if she has the new technology No invest,
Don’t Yes bid with
Yes the old technology
as well? No Yes No
No invest,
Don’t No don’tYes
bid
No No No
A model for the problem

Given an option, how does Sarah measure its “goodness”?

The goodness is measured by the expected profit from the option.
What do you mean by the “best” option?
The option that has the largest expected profit is the best. This means that we are assuming
that Sarah is risk neutral.

Our Guesses (these will vary from decision maker to decision maker)
Probability of engineers succeeding: 0.6
Probability of winning the bid with old tech: 0.05
Probability of winning the bid with new tech: 0.80
Now
And decision
The the
probabilities
adddecision
a decision
maker’s
for maker
process uncertain
payoffs
events
Win bid
+800K
Bid with 0.05
Decision node: the decision old tech 0.95
Don’t
maker is in control invest
–50K
Lose bid
Don’t bid 0K
Chance node: the decision Win bid
maker is NOT in control +600K
0.8
Bid with
Engg. new tech 0.2
succeeds Lose bid
–250K
0.6 –200K
Invest Don’t bid
Win bid
+600K
Bid with 0.05
0.4
Engg. old tech 0.95
–250K
fails Lose bid … and you have a
Don’t bid
–200K decision tree
time
 Solving the decision tree
Win bid
+800K
Bid with 0.05
old tech –7.5K
Don’t 0.95
invest 0K (Don’t bid) –50K
Lose bid
Don’t bid 0K
Win bid
Solution: +600K
0.8
Bid with
Expected profit: +178K (Invest and bid only if engineers
430Ksucceed)
Engg. new tech 0.2
succeeds +430K (Bid with –250K
new tech)
Lose bid
0.6 –200K
Invest Don’t bid
Win bid
+178K (Bid only if engineers succeed)+600K
Invest, bid no matter what Bid with 0.05
0.4 –207.5K
Invest, bid only if you have the new technology Engg. old tech 0.95
Don’t invest, bid with the old technology fails
–200K (Don’t bid) –250K
Lose bid
Don’t invest, don’t bid Don’t bid
–200K
What should Sarah do?
Win bid
+800K Investment: between $200K and $400K
Bid with 0.05 Expected profits (after 6 months): $178K
old tech 0.95 What is the ROI?
Don’t
invest
–50K
Lose bid
Don’t bid 0K
Win bid
 +600K Question:
0.8
Bid with What should Sarah do?
Engg. new tech 0.2
succeeds Lose bid
–250K Profits +600 with probability 0.48
0.6 –200K –200 with probability 0.40
 Don’t bid
Invest Win bid –250 with probability 0.12
+600K
Bid with 0.05
0.4
Engg. old tech 0.95
fails –250K
Lose bid
 –200K
Don’t bid