BDS4614, MANAGEMENT DECISION SCIENCE

Tutorial 5
Topic 1: Decision Theory

QUESTION 1

a. Ecohome manufactures and sales furniture. At present, the general manager of Ecohome is forced to
consider purchasing new machines because of the increased demand. The alternatives are shown in the
following table

Alternative Market Condition

Good Fair Poor
MI 150,000 120,000 -30,000
MII 170,000 130,000 -40,000
MIII 200,000 135,000 -60,000
Probabilities 0.35 0.45 0.2

Determine the best alternative, using the following decision criteria:

i. Maximax
ii. Maximin
iii. Hurwicz criterion of realism (α = 0.3)

b. The general manager of Ecohome has been approached by a market research firm that offers to perform
a market study at a fee of RM10, 000. The research firm claims that the researchers are able to make the
following statements of probability based on their experience:

Probability of a Good market given =0.50

favourable study
Probability of a Fair market given =0.35
favourable study
Probability of a Good market given =0.20
unfavourable study
Probability of a Fair market given =0.35
unfavourable study
Probability of a favourable study =0.65

Construct a tree diagram for the problem and use the EMV approach to recommend a strategy.

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QUESTION 2

a. A restaurateur is going to set up a cream tea stall at a local gala. On the morning of the gala, she visits
the wholesale market and has to decide whether to buy a large, medium or small quantity of
strawberries, scones, cream and other materials. Her profit depends on the number of people attending
the gala, and this in turn depends on the weather. The pay-off for different weather conditions is given
below:

Weather Conditions
Alternative-buy Good Average Poor
Large quantity $10000 $4000 -$2000
Medium quantity 7000 6000 2000
Small quantity 4000 1000 4000
Probability 0.3 0.5 0.2

Determine the best decision, using the following decision criteria:

i. Maximax
ii. Maximin
iii. Hurwicz criterion of realism (α = 0.7)
iv. Equally Likely
v. Minimax regret
vi. Expected Monetary Value

b. In a study of scientific research on soft drinks, juices and milk, 65% were fully sponsored by the food
industry, and 35% studies were conducted with no corporated ties. Of those that were fully sponsored
by the food industry, 14% of the participants found the products unfavourable, 23% were neutral, and
63% found the products favourable. Of those that had no industry funding, 38% found the products
unfavourable, 15% were neutral and 47% found the products favourable. If a participant selected at
random found the product favourable, what is the probability that he or she belongs to a group that
participated in a corporate-sponsored study?

QUESTION 3

Hudson Corporation is considering to build a community center to be used for conventions, concerts and
other public events, but considerable controversy surrounds the appropriate size. There are three alternatives
small, medium and large. A regional planning consultant provided demand estimates under three scenarios:
worst case, base case and best case. The pay-off table (in thousands of dollars) are given in the following
table:

Demand Scenario
Center Size Worst Case Base Case Best C ase
Small 400 500 660
Medium -250 650 800
Large -400 580 990
Probability 0.1 0.6 0.3

a. Determine the best decision, using the following decision criteria:

i. Maximax
ii. Maximin

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iii. Hurwicz criterion of realism (α = 0.7)

iv. Equally Likely
v. Minimax regret
vi. Expected Monetary Value

b. Determine how much the firm would be willing to pay to a market research firm to gain better
information about future demand.

QUESTION 4

Andy is considering whether to open a new boutique. He is considering opening his boutique in either town
A or B. The annual returns will depend both on the population size of the town and several marketing
factors. The estimated annual returns are presented in the following table:

Alternatives Annual returns

Good Market Poor Market
Open boutique at town A RM100,000 -RM20,000
Open boutique at town B RM70,000 -RM15,000
Do nothing RM0 RM0

For example, if Andy opens the boutique in town A and the market is good, he will earn a profit of
RM100,000. Determine the best option

a. If Andy is an optimistic decision-maker.

b. Using the criterion of realism (Hurwicz). Use α =0.7 .

Andy believes that there is a 0.4 probability that the market will be good and there is a 0.6 probability that
the market will be poor. Andy is also thinking about conducting a marketing survey. The market survey will
cost him RM5,000. If the survey is conducted, it could be favourable or unfavourable. It is estimated that
there is a 0.55 probability that the survey will be favourable and 0.45 probability that the survey will be
unfavourable. The probability of a good market given a favourable market survey is 0.65 and the probability
of a good market given an unfavourable market survey is 0.25.

c. Draw a decision tree. What will you recommend to Andy?

d. Determine the expected value of perfect information?

QUESTION 5

Morris is considering investing his saving. His financial advisor has recommended him two possible
investments, investment A and investment B. Returns of these investments depend on whether the economy
is good, fair, or poor. The estimated annual returns are presented in the following table:

Alternatives Annual returns

Good Economy Fair Economy Poor Economy
Investment A RM15,000 RM8,000 -RM3,000
Investment B RM12,000 RM6,500 -RM2,000

a. What would you suggest to Morris if he is a pessimistic decision maker?

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b. Morris’s financial advisor told him that there is a 45% chance of a good market, a 30% chance of a fair
market and a 25% chance of a poor market. What is the maximum amount that should be paid for a
perfect forecast of the economy?
c. Morris’s financial advisor has recommended him a new investment, Investment C. If the economy is
good the annual return is RM13,000, if the economy is fair the annual return is RM7,000 and if the
economy is poor the annual return is -RM3,500. Draw a decision tree to represent this situation. What is
the best alternative?

QUESTION 6

Southland Corporation’s decision to produce a new line of recreational products resulted in the need to
construct either small, medium or large plant. The best selection of plant size depends on how the
marketplace reacts to the new product line. To conduct an analysis, marketing management has decided to
view the possible long-run demand as either low, medium or high. The following payoff table is as follows:

Long-Run Demand
Plant size High Medium Low
Small 200,000 150,000 70,000
Medium 260,000 200,000 150,000
Large 300,000 230,000 130,000
Probability 0.2 0.5 0.3

a. Determine the best decision, using the following decision criteria:

i. Maximax
ii. Maximin
iii. Hurwicz criterion of realism (α = 0.7)
iv. Equally Likely
v. Minimax regret
vi. Expected Monetary Value

b. Determine how much the firm would be willing to pay to a market research firm to gain better
information about future market conditions.

QUESTION 7

A local real estate investor is considering three alternative investments: a motel, a restaurant or a theatre.
Profits from the motel or restaurant will be affected by the availability of gasoline and the number of
tourists, profits from the theatre will be relatively stable under any conditions. The following pay-off table
shows the profit or loss that could result from each investment:

Gasoline availability
Investment Shortage Stable supply Surplus
Motel -8,000 15,000 20,000
Restaurant 2,000 8,000 6,000
Theater 6,000 6,000 6,000
Probability 0.2 0.6 0.2

a. Determine the best decision, using the following decision criteria:

i. Maximax
ii. Maximin

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iii. Hurwicz criterion of realism (α = 0.8)

iv. Equally Likely
v. Minimax regret
vi. Expected Monetary Value

b. Determine how much the firm would be willing to pay to a market research firm to gain better
information about future market conditions.

QUESTION 8

Home Supply Co. specializes in manufacturing household gadgets. It is considering building a large,
medium or small shop to produce the components. The table below shows the payoffs for a proposed facility
under three market conditions (strong, fair and poor markets):

Alternative States of Nature

Strong Market Fair Market (RM) Poor Market (RM)
(RM)
Large Shop 850 600 250
Medium Shop 600 500 450
Small Shop 400 400 350
Probability 0.3 0.6 0.1

a. Determine the best decision, using the following decision criteria:

i. Maximax
ii. Maximin
iii. Hurwicz criterion of realism (α = 0.4)
iv. Equally Likely
v. Minimax regret
vi. Expected Monetary Value

b. Determine how much the firm would be willing to pay to a market research firm to gain better
information about future market conditions.

QUESTION 9

Telco specializes in manufacturing modern telecommunication components. Tom, who is responsible for
advising the CEO of Telco on telecommunication manufacturing equipment, has developed the following
table concerning a proposed facility:

Profit (RM)
Strong Market Fair Market Poor Market
Large facility 55,000 11,000 -31,000
Medium-sized 30,000 12,900 -10,000
facility
Small facility 20,000 10,000 -3,200
No facility 0 0 0
Probability 0.25 0.65 0.1

Determine the best decision, using the following decision criteria:

a. Maximax

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b. Maximin
c. Hurwicz criterion of realism (α = 0.6)
d. Equally Likely
e. Minimax regret (develop an opportunity loss table
f. Expected Monetary Value

QUESTION 10

Home Realty, a real estate development firm, is considering several alternative development projects. These
include building and leasing an office park, purchasing a parcel of land and building an office building to
rent, buying and leasing a warehouse, building a mall and building and selling condominiums. The various
development projects and their 5-year financial return (in $1,000,000s) given that interest rates will decline,
remain stable or increase, are shown in the following payoff table:

Alternative Interest Rate

Decline (RM) Stable (RM) Increase (RM)
Office park 0.5 1.7 4.5
Office building 1.5 1.9 2.5
Warehouse 1.7 1.4 1.0
Mall 0.7 2.4 3.6
Condominium 3.2 1.5 0.6

a. Determine the best investment, using the following decision criteria:

i. Maximax
ii. Maximin
iii. Equal Likelihood
iv. Hurwicz criterion of realism (α = 0.3)

b. An economist is hired to assign a probability to each direction interest rates may take over the next five
years. The economist has determined that there is a 0.5 probability that interest rate will decline, 0.4
probability that rates will remain stable, and a 0.1 probability that rates will increase. Using the
expected value, determine the best project.
c. Determine the expected value of perfect information.

QUESTION 11
Etech has developed a new model of laptop and currently considering the number of laptops to be produced.
Under consideration is to produce in large, medium, or small quantities. The market response to the new
model may be good, moderate, or poor. The marketing team has estimated the expected payoff under
various market conditions, and it is presented in the following table:

Quantity Market Response (RM)

Poor Moderate Good
Large -50,000 200,000 300,000
Medium -30,000 175,000 225,000
Small -10,000 150,000 200,000
Probability 0.3 0.4 0.3

a. Determine the best decision, using the following decision criteria

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i. Maximax
ii. Maximin
iii. Criterion of Realism (α =0.7 ¿
iv. Minimax Regret

b. What decision would maximise the expected profit?

c. What is the minimum expected opportunity loss?
d. What is the maximum amount that should be paid for a perfect forecast of the market response to the
laptop?

QUESTION 12

Jimmy is considering getting a mobile internet data plan. He is considering three different plans: A, B, and
C. Jimmy has estimated that there is a 35% chance that he will use 50GB per month, 40% chance that he
will use 75GB per month, and 25% chance that he will use 100GB per month. The payoff (cost in RM) table
for the plan and usage is as follows:

Plan Data Usage per month

50GB 75GB 100GB
A 75 100 130
B 78 90 125
C 80 100 120

a. Determine the best decision, using the following decision criteria:

i. Optimistic
ii. Pessimistic
iii. Equally Likely
iv. Criterion of Realism (α =0.6 ¿
v. Expected Monetary Value
vi. Minimax Regret
b. John can help Jimmy to accurately determine his monthly data usage. However, John would like to get
some return for that. How much should Jimmy pays John?

QUESTION 13
Joshua has decided to lease a car. There are several leasing plans available and all the leases are for 2 years.
The following table has shown the information of all available lease plans.:

KM allowance Cost per excess KM Monthly cost

Plan 1 30,000KM RM0.35 RM300
Plan 2 40,000KM RM0.28 RM360
Plan 3 50,000KM RM0.20 RM420
Joshua has estimated that, during the 2 years of the lease, there is a probability of 0.3 he will drive
30,000KM, a probability of 0.3 he will drive 40,000KM, and a probability of 0.4 he will drive 50,000KM.

a. Develop a payoff table for this problem.

b. Determine the best decision, using the following decision criteria:
i. Optimistic
ii. Pessimistic
iii. Equally Likely
iv. Criterion of Realism (α =0.6 ¿

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v. Expected Monetary Value

vi. Minimax Regret
c. What is the maximum amount that Joshua would willing to pay for perfect information?