6634 CH08 UG 8/23/02 2:20 PM Page 61
8
C H A P T E R
Decision Theory
SOLUTIONS TO DISCUSSION QUESTIONS
AND PROBLEMS
8-1. The purpose of this question is to make students use a per-
sonal experience to distinguish between good and bad decisions. A
good decision is based on logic and all of the available informa-
tion. A bad decision is one that is not based on logic and the avail-
able information. It is possible for an unfortunate or undesirable
outcome to occur after a good decision has been made. It is also
possible to have a favorable or desirable outcome occur after a bad
decision.
8-2. The decision-making process includes the following steps:
(1) define the problem, (2) list the alternatives, (3) identify the
possible outcomes, (4) evaluate the consequences, and (5) select
an evaluation criterion and make the appropriate decision. The
first four steps or procedures are common for all decision-making
problems. Step 5, however, depends on the decision-making
model used.
8-3. An alternative is a course of action over which we have
complete control. A state of nature is an event or occurrence in
which we have no control. An example of an alternative is decid-
ing whether or not to take an umbrella to school or work on a par-
ticular day. An example of a state of nature is whether or not it
will rain on a particular day.
8-4. The basic differences between decision-making models
under certainty, risk, and uncertainty depend on the amount of
chance or risk that is involved in the decision. A decision-making
model under certainty assumes that we know with complete confi-
dence the future outcomes. Decision-making-under-risk models
assume that we do not know the outcomes for a particular decision
but that we do know the probability of occurrence of those out-
comes. With decision making under uncertainty, it is assumed that
we do not know the outcomes that will occur, and furthermore, we
do not know the probabilities that these outcomes will occur.
8-5. EMV is the expected monetary value. This is the expected
return that we would realize if the decision were repeated an infi-
nite number of times. EVwPI is the expected value with perfect in-
formation. This is the return or value of making the same decision
an infinite number of times when we have perfect or complete in-
formation. EVPI is the expected value of perfect information. This
is simply the difference between EMV and EVwPI. It is the
amount that we would be willing to pay for perfect information.
8-6. A decision tree is preferred to a decision table when a
number of sequential decisions are to be made. A sequential deci-
sion situation is one in which the outcome of one decision be-
comes an important factor in making future decisions. For exam-
ple, if a decision maker is considering the possibility of acquiring
additional information and a decision of whether or not to build a
new plant, the decision to acquire the new information is made
first. Then, based on the results of the new information (if it is
gathered), the decision to build the plant is made. Therefore, these
decisions are sequential. One is made before the other.
8-7. A prior probability is one that exists before additional in-
formation is gathered. A posterior probability is one that can be
computed based on prior probabilities and additional information.
8-8. The purpose of Bayesian analysis is to determine posterior
probabilities based on prior probabilities and new information.
Bayesian analysis can be used in the decision-making process
whenever additional information is gathered. This information can
then be combined with prior probabilities in arriving at posterior
probabilities. Once these posterior probabilities are computed,
they can be used in the decision-making process as any other prob-
ability value.
8-9. The overall purpose of utility theory is to incorporate a de-
cision maker’s preference for risk in the decision-making process.
8-10. A utility function can be assessed in a number of different
ways. A common way is to use a standard gamble. With a stan-
dard gamble, the best outcome is assigned a utility of 1, and the
worst outcome is assigned a utility of 0. Then, intermediate out-
comes are selected and the decision maker is given a choice
between having the intermediate outcome for sure and a gamble
involving the best and worst outcomes. The probability that makes
the decision maker indifferent between having the intermediate
outcome for sure and a gamble involving the best and worst out-
comes is determined. This probability then becomes the utility of
the intermediate value. This process is continued until utility val-
ues for all economic consequences are determined. These utility
values are then placed on a utility curve.
8-11. When a utility curve is to be used in the decision-making
process, utility values from the utility curve replace all monetary
values at the terminal branches in a decision tree or in the body of
a decision table. Then, expected utilities are determined in the
same way as expected monetary values. The alternative with the
highest expected utility is selected as the best decision.
61
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62 CHAPTER 8 DECISION THEORY

8-12. A risk seeker is a decision maker who enjoys and seeks out Using minimum EOL, the best strategy is the small plant.
risk. A risk avoider is a decision maker who avoids risk even if c. EVPI  min EOL  $134,000. See file P8-16.XLS
the economic payoff is higher. The utility curve for a risk seeker
8-17. a. Decision under uncertainty.
increases at an increasing rate. The utility curve for a risk avoider
b.
increases at a decreasing rate.
8-13. a. Decision making under uncertainty.
Population Population Row
b. Maximax criterion. Same Grows Average
c. Sub 100; $300,000
See file P8-13&14.XLS. Large wing 85,000 150,000 32,500
Small wing 45,000 60,000 7,500
Row Row No wing 0 0 0
Equipment Favorable Unfavorable Maximum Minimum
Sub 100 300,000 200,000 300,000 200,000 c. Best alternative: large wing.
Oiler J 250,000 100,000 250,000 100,000 8-18. a.
Texan 75,000 18,000 75,000 18,000
Weighted
a a
Population Population Average with
maximax maximin
Same Grows   0.75
8-14. Maximin criterion: best alternative: Texan (see table).
Large wing 85,000 150,000 91,250
$18,000. See file P8-13&14.XLS.
Small wing 45,000 60,000 33,750
8-15. a. Decision making under risk—maximize expected No wing 0 0 0
monetary value. See file P8-15.XLS.
b. EMV (Sub 100)  0.7  300,000  0.3 b. Best decision: large wing.
c. No.
 (200,000)  150,000
8-19. Profit from each case sold is $(95  45)  $50. Loss from
EMV (Oiler J)  0.7  250,000  0.3
each case not sold is $45.
 (100,000)
 145,000 Demand
EMV (Texan)  0.7  75,000  0.3 Manu- (Cases)
facture
 (218,000) (Cases) 6 7 8 9 EMV
 47,100
6 300 300 300 300 300
Optimal decision: Sub 100. 7 255 350 350 350 340.5
8-16. a., b. 8 210 305 400 400 352.5
9 165 260 355 450 317
Favorable Unfavorable
Market Market EOL Probabilities 0.1 0.3 0.5 0.1

Large plant (400,000  400,000) 0  (300,000) 180,000 John should manufacture 8 cases of cheese spread. See file
0  300,000
P8-19.XLS for the Excel solution of this problem.
Small plant (400,000  80,000) 0  (10,000) 134,000
 320,000  10,000
Don’t build (400,000  0) (0  0)  0 160,000
 400,000
Probabilities 0.4 0.6
6634 CH08 UG 8/23/02 2:20 PM Page 63

CHAPTER 8 DECISION THEORY 63

8-20. The Excel setup and solution of the problem is given in

file P8-20.XLS.

Market
Size of
First Good Fair Poor Row Row Row Weight
Station Market Market Market Minimum Maximum Average Average
Small 50,000 20,000 10,000 10,000 50,000 20,000 38,000
Medium 80,000 30,000 20,000 20,000 80,000 30,000 60,000
Large 100,000 30,000 40,000 40,000 100,000 30,000 72,000
Very large 300,000 25,000 160,000 160,000 300,000 55,000 208,000
a a a a
maximin maximax equally realism
likely (  0.80)

a. Maximax decision: very large station. 8-22. EMV for node 1  (0.5) ($100,000)  (0.5) ($40,000) 
b. Maximin decision: small station. $30,000
c. Equally likely decision: very large station.
d. Realism decision: very large station. PAYOFF
e. Favorable Market (0.5)
$100,000
Opportunity ct 1
tru _$40,000
Loss Table o ns ic
C lin $ 30,000 Unfavorable Market (0.5)
C
Market
Market Row $30,000
Size Good Fair Poor Maximum Do
No
thi
Small 250,000 10,000 0 250,000 ng
$0
Medium 220,000 0 10,000 220,000 EMV for no clinic is $0
Large 200,000 0 30,000 200,000
Very large 0 5,000 150,000 150,000 Choose highest EMV; therefore, construct clinic.
a Note: Slash lines // on the tree indicate branches that are dropped
minimax
from consideration.
f. Minimax decision: very large station.
8-21. a.

No Mild Severe Expected

Congestion Congestion Congestion Time
Tennessee 15 30 45 25
Back roads 20 25 35 24.17
Expressway 30 30 30 30
(30 days)/ (20 days)/ (10 days)/
Probabilities
(60 days)  1/2 (60 days)  1/3 (60 days)  1/6

b. Back roads (minimum expected time used).

c. Expected time with perfect information:
15  1/2  25  1/3  30  1/6 = 20.83 minutes
Time saved is 24.1720.83  3.34 minutes.
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64 CHAPTER 8 DECISION THEORY

8-23. a. Note: The Cost of the market study has been included in the payoffs.

PAYOFF
Favorable Market (0.82)
$ 95,000
CONSTRUCT 2 Unfavorable Market (0.18)
$ _45,000
$ 69,800

5)
v ey (0.5
r $69,800
Su ble
r a
vo _5,000
Fa DO NOT CONSTRUCT
$

1
t Favorable Market (0.11)
uc vey $36,140 $ 95,000
nd ur CONSTRUCT 3
Co et S Unfavorable Market (0.89)
Ne

$ _45,000
Su tive

k
ar
ga

rv (0

M $ 29,600
ey .4
)5

_$5,000
$36,140

_5,000
$
DO NOT CONSTRUCT
Do
No
tC
on
du

Favorable Market (0.5)

ct

$ 100,000
Su

CONSTRUCT CLINIC
rv

4 Unfavorable Market (0.5)

ey

$ _40,000
$ 30,000

$30,000

DO NOT CONSTRUCT $ 0
Indicates branch dropped from consideration

b. EMV(node 2)  (0.82)($95,000)  (0.18)($45,000) EMV(no survey)  (0.5)($100,000)

 77,900  8,100  $69,800  (0.5)($40,000)  $30,000
EMV(node 3)  (0.11)($95,000)  (0.89)($45,000) The survey should be taken.
 10,450  $40,050  $29,600 c. EVSI  ($36,140  $5,000)  $30,000  $11,140.
EMV(node 4)  $30,000 Thus, the physicians would pay up to $11,140 more for the
survey.
EMV(node 1)  (0.55)($69,800)  (0.45)($5,000)
Note: Since EVSI uses the expected value of the best decision with
 38,390  2,250  $36,140 sample information assuming no cost to gather it, $5,000 had to be
added back to $36,140. File P8-23.XLS shows the solution of this
problem using TreePlan.
6634 CH08 UG 8/23/02 2:20 PM Page 65

CHAPTER 8 DECISION THEORY 65

8-24. See the figure for Problem 8-24.

Market Favorable

p 7 Market Unfavorable
Sho
all Market Favorable
Sm
Large
6 Market Unfavorable
Shop

y
S tud
ct No Shop
ndu
t Co
No
Do Market Favorable

p 3 Market Unfavorable
Sho
all Market Favorable
Sm
Large
Co

2 Market Unfavorable
nd

y Shop
tud
uc

eS
t
St

bl
ud

ra
vo
y

Fa No Shop

1
Un Market Favorable
fav
ora
ble 5
St h op Market Unfavorable
ud ll S
y ma Market Favorable
S
Large
4 Market Unfavorable
Shop

No Shop

Figure for Problem 8-24

8-25. EMV(node 2)  (0.9)(55,000)  (0.1)($45,000) EMV(node 1)  (0.6)(45,000)  (0.4)(5,000)

 49,500  4,500  $45,000  27,000  2,000  $25,000
EMV(node 3)  (0.9)(25,000)  (0.1)(15,000) Since EMV(market survey)  EMV(no survey), Jerry should con-
 22,500  1,500  $21,000 duct the survey.
EMV(node 4)  (0.12)(55,000)  (0.88)(45,000) Since EMV(large shop  favorable survey)  EMV(small shop 
favorable survey), and EMV(no shop  favorable survey), Jerry
 6,600  39,600  $33,000
should build a large shop if the survey is favorable. If the survey is
EMV(node 5)  (0.12)(25,000)  (0.88)(15,000) unfavorable, Jerry should build nothing since EMV(no shop  un-
 3,000  13,200  $10,200 favorable survey)  EMV(large shop  unfavorable survey)
EMV(node 6)  (0.5)(60,000)  (0.5)(40,000) and EMV(small shop  unfavorable survey). (See figure for
problem 8-25 on the next page).
 30,000  20,000  $10,000
EMV(node 7)  (0.5)(30,000)  (0.5)(10,000)
 15,000  5,000  $10,000
6634 CH08 UG 8/23/02 2:20 PM Page 66

66 CHAPTER 8 DECISION THEORY

Payoff
$45,000 Favorable Market (0.9)
Large Shop $55,000
2 Unfavorable Market (0.1)
$45,000 –$45,000
No Shop
ey le –$5,000

)
.6
rv rab
(0 $21,000 Favorable Market (0.9)
Su avo

Small Shop $25,000

F

3 Unfavorable Market (0.1)

$25,000 –$15,000
1
–$33,000 Favorable Market (0.12)
r v et

$55,000
Su ark
ey

Large Shop
U ur v
nf e
M

4
av y

Unfavorable Market (0.88)

or (0.

–$5,000 –$45,000
ab 4)
le

No Shop
–$5,000
–$10,200 Favorable Market (0.12)
Small Shop $25,000
N
o

5 Unfavorable Market (0.88)

Su

–$15,000
r
ve
y

$10,000 Favorable Market (0.5)

Large Shop $60,000
Indicates 6 Unfavorable Market (0.5)
branch is $10,000 –$40,000
not chosen No Shop
$0
Figure for Problem 8-25 Favorable Market (0.5)
$10,000
Small Shop $30,000
7 Unfavorable Market (0.5)
–$10,000

8-26. S1: favorable research 8-27. a.

S2: unfavorable research Payoff
Repair Cost = (No. Defective per Batch) × Repair Cost per Unit
S3: store successful
S4: store unsuccessful
1% Defective (0.7)
P(S3)  P(S4)  0.5 –$87.00 = (0.01 × 10,000) × (–$0.50) – $37

P(S1  S3)  0.8  P(S2  S3)  0.2 3% Defective (0.2)

1 –$187.00 = (0.03 × 10,000) × (–$0.50) – $37
P(S2  S4)  0.7  P(S1  S4)  0.3
A
m

–127
fro

5% Defective (0.1)
P( S1 | S3 )P( S3 ) –$287.00 = (0.05 × 10,000) × (–$0.50) – $37
y

P( S3 | S1 ) =
Bu

a. P( S1 | S3 )P( S3 ) + P( S1 | S4 )P( S4 )
0.8 × 0.5
Bu

= = 0.73
y

1% Defective (0.3)
fro

0.8 × 0.5 + 0.3 × 0.5 –$50.00

m
B

3% Defective (0.4)
2 –$150.00

P( S2 | S4 )P( S4 ) –150
b. P( S4 | S2 ) = 5% Defective (0.3)
–$250.00
P( S2 | S4 )P( S4 ) + P( S2 | S3 )P( S3 )
EMV(node 1)  (0.7)  (87)  (0.2)(187)
0.7  0.5
  0.78  (0.1)(250)
0.7  0.5  0.2  0.5
 $127
Therefore, P(S3  S2)  0.22
6634 CH08 UG 8/23/02 2:20 PM Page 67

CHAPTER 8 DECISION THEORY 67

EMV(node 2)  (0.3)(50)  (0.4)(150)

 (0.3)(250)
 15  60  75  150
b. Kuality Komponents should use supplier A (the highest
EMV).
c. (127  37)  (150)  $60 less than does supplier A.
8-28. a.
Payoff
Favorable Market
Produce $95,000
3
Survey Razor Unfavorable Market
–$65,000
Favorable Do Not Produce Razor
–$5,000

1 Favorable Market
Produce $95,000
4
Survey Razor Unfavorable Market
–$65,000
Unfavorable Do Not Produce Razor
ey

–$5,000
urv
tS

Favorable Market
uc

Produce $80,000
nd

5
Co

Study Razor Unfavorable Market

–$80,000
Favorable Do Not Produce Razor
Conduct –$20,000
Pilot
2 Favorable Market
Study $80,000
Produce
6
Study Razor Unfavorable Market
–$80,000
Ne
ith

Unfavorable Do Not Produce Razor

–$20,000
er
Te
s
t

Favorable Market
Produce $100,000
7
Razor Unfavorable Market
–$60,000
Do Not Produce Razor
$0
Figure for Problem 8-28a

b. S1: survey favorable (0.78)

S2: survey unfavorable 3
(0.45) (0.22)
S3: study favorable
S4: study unfavorable
(0.27)
S5: market favorable 1
S6: market unfavorable 4
(0.55) (0.73)
(0.7  0.5) 0.35
P( S5 | S1 )    0.78
(0.7  0.5)  (0.2  0.5) 0.45 (0.89)
P(S6  S1)  1.00  0.78  0.22 5
(0.45) (0.11)
(0.3  0.5) 0.15
P( S5 | S2 )    0.27
(0.3  0.5)  (0.8  0.5) 0.55
(0.18)
2
P(S6  S2)  1.00  0.27  0.73
6
(0.8  0.5) 0.4 (0.55) (0.82)
P( S5 | S3 )    0.89
(0.8  0.5)  (0.1 0.5) 0.45
P(S6  S3)  1.00  0.89  0.11 (0.5)
(0.2  0.5) 0.1 7
P( S5 | S4 )    0.18 (0.5)
(0.2  0.5)  (0.9  0.5) 0.55
Figure for Problem 8-28b
P(S6  S4)  1.00  0.18  0.82
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68 CHAPTER 8 DECISION THEORY

c. See file P8-28.XLS for the TreePlan solution of this problem. appropriate probabilities times the economic consequences for a
The calculations are as follows: small, medium, or a large facility. That alternative that maximizes
the expected monetary value will be chosen. The results follow.
EMV (node 3)  (95,000)(0.78)
 (65,000)(0.22)  $59,800 No survey (analysis values in hundreds of thousands of dollars):
EMV (node 4)  (95,000)(0.27) FACILITY
 (65,000)(0.73) Probability Demand Small Medium Large
 $21,800 0.15 Low 500 200 200
EMV (node 5)  (80,000)(0.89) 0.4 Medium 500 700 400
0.45 High 500 800 1,000
 (80,000)(0.11)
EMV 500 670 580
 $62,400
EMV (node 6)  (80,000)(0.18) As seen from the analysis above, the expected monetary val-
 (80,000)(0.82) ues for the small, medium, and large facilities are $500,000,
$670,000, and $580,000. The medium facility, with an expected
 $51,200
monetary value of $670,000, is selected because it represents the
EMV (node 7)  (100,000)(0.5) highest expected monetary value.
 (60,000)(0.5) We are still not done with solving the problem. We also have
 $20,000 to look at the situation of performing the survey. The most difficult
part of this problem is the computation of the revised probabilities
EMV (conduct survey)  (59,800)(0.45) using Bayes’ law. For each alternative facility, three revised proba-
 (5,000)(0.55) bilities must be computed, representing low, medium, and high
 $24,160 demand for a facility. These probabilities can be computed using
tables. One table is used to compute the probabilities for low sur-
EMV (conduct pilot survey)  (62,400)(0.45)
vey results, another table is used for medium survey results, and a
 (20,000)(0.55) final table is used for high survey results. These tables are shown
 $17,080 below.
EMV (neither test)  20,000
For low survey results—A1:
Therefore, the best decision is to conduct the survey and follow
the outcome. State of
Nature P(Bi) P(Ai  Bj) P(Bj and Ai) P(Bj  Ai)
8-29. Bob has two major decisions to make. First, he must decide
B1 0.150 0.700 0.105 0.339
whether or not to conduct the survey. After this decision, he must de-
B2 0.400 0.400 0.160 0.516
cide whether to develop a small, medium, or large waste disposal fa-
B3 0.450 0.100 0.045 0.145
cility. Of course, Bob always has the option of not building any facil-
ity, with an expected monetary value of 0. To solve this problem, we P(A1)  0.310
will look at a decision tree in the figure for Problem 8-29 (shown on For medium survey results—A2:
the next page) involving no survey and then another decision tree in-
State of
volving the use of a survey. The decision branches that represent the
Nature P(Bi) P(Ai  Bj) P(Bj and Ai) P(Bj  Ai)
highest expected monetary value will be the chosen plan of action.
If no survey is to be conducted, the decision tree is fairly B1 0.150 0.200 0.030 0.082
straightforward. There are three main decisions, which are building B2 0.400 0.500 0.200 0.548
a small, medium, or large facility. Extending from these decision B3 0.450 0.300 0.135 0.370
branches are three possible demands, representing the possible P(A2)  0.365
states of nature. The demand for this type of facility could be either For high survey results—A3:
low, medium, or high. It was given in the problem that the proba- State of
bility for a low demand is 0.15. The probabilities for a medium and Nature P(Bi) P(Ai  Bj) P(Bj and Ai) P(Bj  Ai)
a high demand are 0.40 and 0.45, respectively. The problem also
B1 0.150 0.100 0.015 0.046
gave monetary consequences for building a small, medium, or
B2 0.400 0.100 0.040 0.123
large facility when the demand could be low, medium, or high for B3 0.450 0.600 0.270 0.831
the facility. These data are reflected in a decision tree on the next
page. Using the data in the decision tree, we can multiply the P(A3)  0.325
6634 CH08 UG 8/23/02 2:20 PM Page 69

CHAPTER 8 DECISION THEORY 69

Decision Tree—Survey
high survey results are 0.365 and 0.325, respectively. These prob-
L abilities can then be used along with the conditional probabilities
450,000
in selecting the best decision. This can be done by determining the
Small M 450,000 expected monetary value for the small, medium, and large facility
when the survey results are low, medium, and high.
H 450,000
Decision Tree—No survey
L 150,000 (0.15) $500,000
Medium M 650,000 (0.40) $500,000
H 750,000 00 (0.45)
0,0 $500,000
L $50
–250,000 all (0.15) $200,000
Sm
Large M 350,000
)

Medium $670,000 (0.40)

.310

$700,000
0

H
ey (0
Low $495,00

950,000 La (0.45)
rge $800,000
L $5
80
surv

450,000 ,00 (0.15)

0 –$200,000
Small M 450,000 (0.40) $400,000
H 450,000 (0.45) $1,000,000
L 150,000 Figure for Problem 8-29
$646,000 Medium M 650,000 The analysis is shown below.
Medium
survey H 750,000 Survey results are low:
(0.365)
L FACILITY
–250,000
Probability Demand Small Medium Large
High

Large M 350,000
0.339 Low 450,000 150,000 250,000
$821 y (0.325
surv

H 0.516 Medium 450,000 650,000 350,000

950,000
0.145 High 450,000 750,000 950,000
,000
e

L 450,000 EMV 450,000 495,000 233,600

Small M 450,000 Maximum EMV  $495,000
)

H 450,000 Survey results are medium:

L 150,000 FACILITY
Probability Demand Small Medium Large
Medium M 650,000
0.082 Low 450,000 150,000 250,000
H 0.548 Medium 450,000 650,000 350,000
750,000
0.378 High 450,000 750,000 950,000
L –250,000
EMV 450,000 646,000 522,800
Large M 350,000
Maximum EMV  $646,000
H 950,000 Survey results are high:
Figure for Problem 8-29 FACILITY
Probability Demand Small Medium Large
The right-hand sides of these tables contain the needed condi-
0.046 Low 450,000 150,000 250,000
tional probabilities that are required in the analysis. You should
0.123 Medium 450,000 650,000 350,000
note that these tables also compute the probability of the various 0.831 High 450,000 750,000 950,000
states of nature occurring. The probability of low survey results,
for example, is seen at the bottom of the first table to be 0.310. In a EMV 450,000 710,100 821,000
similar fashion, the probabilities for medium survey results and
Maximum EMV  $821,000
6634 CH08 UG 8/23/02 2:20 PM Page 70

70 CHAPTER 8 DECISION THEORY

If the survey results are low, the best decision is to build the
medium facility with an expected return of $495,000. If the survey
results are medium, the best decision is also to build the medium
plant with an expected return of $646,000. On the other hand, if the
survey results are high, the best decision is to build the large facility
with an expected monetary value of $821,000. Now, we can take
these results and multiply them times the probability of having low
survey results, medium survey results, and high survey results to get
the expected value of taking the survey and selecting the appropriate
decision. The results of these computations are shown below.
Final analysis:
Probability Demand
0.31 Low 495,000
0.365 Medium 646,000
0.325 High 821,000
EMV  $656,065
As you can see from the analysis, the expected monetary value is
approximately $656,000. This is the expected monetary value for
conducting the survey and taking the appropriate action. Because
the expected monetary value for not conducting the survey is
greater, the decision is not to conduct the survey and to build the
medium-sized facility. The expected value from doing this, shown
in an earlier table, is $670,000. The solution of this problem using
TreePlan is shown in file P8-29.XLS.
8-30. EU(node 3)  (0.95)(0.78)  (0.5)(0.22)  0.85
EU(node 4)  (0.95)(0.27)  (0.5)(0.73)  0.62
EU(node 5)  (0.9)(0.89)  (0)(0.11)  0.80
EU(node 6)  (0.9)(0.18)  (0)(0.82)  0.16
EU(node 7)  (1)(0.5)  (0.55)(0.5)  0.78
EU(conduct survey)  (0.85)(0.45)
 (0.8)(0.55)  0.823
EU(conduct pilot study)  (0.80)(0.45)
 (0.7)(0.55)  0.745
EU(neither test)  0.81
Thus, the best decision is to conduct a survey and follow its out-
come. Jim is a risk avoider. (See figure for Problem 8-30.).
8-31.
EU(node 2)  (0.82)(0.99)  (0.18)(0)  0.8118
EU(node 3)  (0.11)(0.99)  (0.89)(0)  0.1089
EU(node 4)  (0.5)(1)  (0.5)(0.1)  0.55
EU(conduct survey)  (0.55)(0.8118)  (0.45)(0.7)
 0.76149
EU (do not conduct survey)  0.9
Therefore, the medical professionals should not conduct the sur-
vey and should not construct the clinic. They are risk avoiders.
(See figure for Problem 8-31 on the next page).

Utility
0.85 Market Favorable (0.78)
Produce 0.95
3 Market Unfavorable (0.22)
Survey Razor 0.5
Favorable Do Not Produce Razor
0.82 (0.45) 0.8

1 0.62 Market Favorable (0.27)

Produce 0.95
4 Market Unfavorable (0.73)
Survey Razor 0.5
Unfavorable
y

Do Not Produce Razor

rve

(0.55) 0.8
Su
uct

0.80 Market Favorable (0.89)

0.9
nd

Produce
Co

5 Market Unfavorable (0.11)

Study Razor 0
Favorable Do Not Produce Razor
Conduct 0.70 (0.45) 0.7
Pilot
2 0.16 Market Favorable (0.18)
Study Produce 0.9
6 Market Unfavorable (0.82)
Study Razor 0
Ne

Unfavorable Do Not Produce Razor

ith

(0.55) 0.7
er
Te
st

0.78 Market Favorable (0.5)

Produce 1
7 Market Unfavorable (0.5)
Razor 0.55
Do Not Produce Razor
0.81
Figure for Problem 8-30
6634 CH08 UG 8/23/02 2:20 PM Page 71

CHAPTER 8 DECISION THEORY 71

Payoff Utility
U = 0.8118 Favorable Market (0.82)
Construct $95,000 0.99
2 Unfavorable Market (0.18)
Survey Clinic –$45,000 0
Favorable Do Not Construct Clinic
U = 0.76 (0.55) –$5,000 0.7
t
uc 1 U = 0.1089 Favorable Market (0.11)
o nd ket Construct $95,000 0.99
C ar ey 3
M rv Unfavorable Market (0.89)
Survey Clinic
Su –$45,000 0
Unfavorable Do Not Construct Clinic
D

(0.45) –$5,000 0.7

o
N urv
ot

U = 0.55 Favorable Market (0.5)

C ey
S

$100,000 1.0
on

Construct
du

4
ct

Clinic Unfavorable Market (0.5)

–$40,000 0.1
Do Not Construct Clinic
$0 0.9
Figure for Problem 8-31

8-32. a. Expected travel time on Broad Street  40  0.5 

15  0.5, or 27.5 minutes. Broad Street has a lower expected
EU(large plant  survey favorable)  (0.78)(0.95)
travel time.
 (0.22)(0) b. Expected utility on Broad Street  0.2  0.5  0.9 
 0.741 0.5  0.55. Therefore, the expressway maximizes utility.
EU(small plant  survey favorable)  c.
(0.78)(0.5)  (0.22)(0.10)  0.39  0.022 1.0
 0.412
0.8
EU(no plant  survey favorable)  0.2
0.6
EU(large plant  survey negative) 
Utility

(0.27)(0.95)  (0.73)(0)  0.2565 0.4

EU(small plant  survey negative) 
0.2
(0.27)(0.5)  (0.73)(0.10)  0.135  0.073
 0.208 0
0 10 20 30 40
EU(no plant  survey negative)  0.2 Time (minutes)
EU(large plant  no survey)  (0.5)(1)  (0.5)(0.05)
Lynn is a risk avoider.
 0.5  0.025  0.525
8-34.
EU(small plant  no survey)  (0.5)(0.6)  (0.5)(0.15)
Restaurant Utility
 0.3  0.075  0.375
Old Tavern 1
EU(no plant  no survey)  0.3 Big Burger 0
Ralph’s Diner 0.5  0.5  0  0.5  1
EU(conduct survey)  (0.45)(0.741) 
Vacation Inn 0.75  0.5  0.5  0.5  1
(0.55)(0.2565)  0.33345  0.1411
 0.4745 8-35.
EU(no survey)  0.525 Expected Utility
John’s decision would change—he would not conduct the survey See 3 of Accepting Bet
0 = 0 × 0.2 + 1 × 0.8
and build the large plant. Accept VW’S (0.2)
= 0.8 > 0.75
Bet Do Not See
8-33. 1
3 VW’S (0.8)
Expressway 30 Minutes, Do Not
0.75
U = 0.7 Accept Bet
Congestion (0.5) 40 Minutes, Jack should accept his kids’ bet.
Broad U = 0.2
1
Street No 15 Minutes,
Congestion (0.5) U = 0.9
6634 CH08 UG 8/23/02 2:20 PM Page 72

72 CHAPTER 8 DECISION THEORY

8-36. Given the new probability values, Sue’s best decision is to

Utility build the retail store without getting additional information.
Eat at Big The EMV for this decision is $28,000.
0
Bet Burger (X )
d. Yes. With the higher cost of information, Sue’s decision
Eat at Old would change. She should no longer get the additional infor-
1
Tavern (1 – X ) mation, and build the retail store straightaway. The EMV for
Do Not Bet Eat at this decision is $28,000 (see sheet #4 in file P8-37.XLS).
0.75
Vacation Inn e. The expected utility can be computed by replacing all
Let X  probability at indifference, where payoff values at the end of the decision tree by the utility val-
ues (see column S in sheet #5 in file P8-37.XLS). The ex-
EU(bet)  EU(no bet) pected utility is 0.62 corresponding to a decision of building
(X)(0)  (1  X)(1)  0.75 the retail store without getting additional information. The
0  1  X  0.75 utility values represent a risk seeker.
X  0.25 f. In this case too, the expected utility can be computed by
replacing all payoff values at the end of the decision tree by
8-37.
the utility values (see column S in sheet #6 in file P8-
a. Sue can use decision tree analysis to find the best solu- 37.XLS). The expected utility is 0.80, and again corresponds
tion. The decision tree is drawn in sheet #1 in file P8-37.XLS to a decision of building the retail store without getting addi-
using TreePlan. In this case, the best decision is to get infor- tional information. The utility values represent a risk avoider.
mation. If the information is favorable, she should build the
retail store. If the information is not favorable, she should not
build the store. The EMV for this decision is $29,200.
b. The suggested change is reflected in the appropriate SOLUTION TO SKI RIGHT CASE
branches of the decision tree (see sheet #2 in file P8-37.XLS). 1. Bob can solve this case using decision analysis. The results
The decision stays the same but the EMV increases to are as follows. As you can see, the best decision is to have
$37,400. Leadville Barts make the helmets and have Progressive Products
c. The suggested change is reflected in the appropriate do the rest with an expected value of $2,600. The final option of
branches of the decision tree (see sheet #3 in file P8-37.XLS). not using Progressive, however, was very close with an expected
value of $2,500.

Solution to Ski Right Case (See file P8-Ski.XLS)

Poor ($) Average ($) Good ($) Excellent ($) EMV

Probabilities 0.1 0.3 0.4 0.2

Option 1—PP 5,000 2,000 2,000 5,000 700
Option 2—LB and PP 10,000 4,000 6,000 12,000 2600
Option 3—TR and PP 15,000 10,000 7,000 13,000 900
Option 4—CC and PP 30,000 20,000 10,000 30,000 1000
Option 5—LB, CC, and TR 60,000 35,000 20,000 55,000 2500

The maximum expected monetary value is 2,600 given by Option

2  LB and PP.
2 and 3. The opportunity loss and the expected value of perfect
information is presented below. The EVPI is $15,300.

Perfect Information
Poor Market Average Good Excellent

Probabilities 0.1 0.3 0.4 0.2

Perfect Information 5,000 2,000 20,000 55,000

Perfect* probability 500 600 8,000 11,000
The expected value with perfect information  17,900
The expected monetary value  2,600
The expected value of perfect information  15,300
6634 CH08 UG 8/23/02 2:20 PM Page 73

CHAPTER 8 DECISION THEORY 73

Regret or Opportunity Loss

Poor Market Average Good Excellent EOL

Probabilities 0.1 0.3 0.4 0.2

Option 1—PP 0 0 18,000 50,000 17,200

Option 2—LB and PP 5,000 2,000 14,000 43,000 15,300
Option 3—TR and PP 10,000 8,000 13,000 42,000 17,000
Option 4—CC and PP 25,000 18,000 10,000 25,000 16,900
Option 5—LB, CC, and TR 55,000 33,000 0 0 15,400
The minimum EOL is $15,300, and corresponds to option 2-LB and PP.

4. There are a number of options that Bob did not consider. See Table A
if you can list one or more of these options. State of Probability of
Nature Occurrence
SOLUTION TO THE BLAKE ELECTRONICS CASE S1 (fav.) 0.6
S2 (unfav.) 0.4
1. By employing basic decision theory, Steve’s problem is
solved quite easily. He needs no additional information for its so-
The values in Table A were given by Blake Electronics’ own
lution. In fact, Iverstine and Kinard’s figures are more suitable for
research staff. Given that the product line is introduced, it has a
manipulation than are MAIs.
60% chance of success and a 40% chance of failure.
2. Steve’s problem involves three decisions. First, should he MAI predicted favorable outcomes 50 out of 100 (50%)
contract the services of an outside research agency? Second, times (35  15  50). Given that the actual outcome was success-
should he employ MAI or Iverstine and Kinard, if a survey is war- ful, MAI predicted that outcome 35 times out of 50 (70%), which
ranted? Third, in any case, should the new product line be intro- means that MAI was wrong 30% of the time (100%  70%) it
duced? predicted a favorable outcome. Similarly, 30 out of 50 times
By using the probabilities stated in the case, some expected (60%) MAI correctly predicted an unfavorable outcome. It follows
values can be derived. Then these expected values can be com- that 40% of the time, the firm was incorrect in predicting an unfa-
pared and a decision can be made. This is the basis of decision vorable outcome. See Table B.
theory that will be used to reach a conclusion.
To facilitate the solving of this problem, several variables Table B
will be defined here. MAIs Conditional Probabilities P(Si  Ik)
Si  states of nature STATE OF NATURE
where i  1 connotes a favorable outcome from the introduc- Survey Predictions S1 S2
tion of the product line, and i  2 connotes an unfavor- I1 0.70 0.40
able outcome. I2 0.30 0.60
Aj  decisions
It was given in the case that 90% of the time I&K made a cor-
where j  1 means survey will be done
rect favorable prediction; and 80% of the time the firm made a
j  2 means no survey will be undertaken correct unfavorable prediction. The other two probabilities follow
j  3 means MAI will be employed logically. See Table C.
j  4 means Iverstine and Kinard (I&K) will be
Table C
employed
I&K Conditional Probabilities P(Ik  Si)
j  5 means product will be introduced
STATE OF NATURE
j  6 means product will not be introduced
Survey Predictions S1 S2
Ik  survey predictions
I3 0.90 0.20
where k  1 means MAI predicts a favorable outcome I4 0.10 0.80
k  2 means MAI predicts an unfavorable outcome
k  3 means I&K predicts a favorable outcome For simplicity, the entire problem is drawn in decision tree
form. Using the decision tree, expected values will be found and
k  4 means I&K predicts an unfavorable outcome compared working from right to left.
P(Ik  Si)  conditional probability; probability of Ik given Si First, assuming that no survey is done (A2), the expected
P(Si  Ik)  probability of Si given Ik value of introducing the product line (expected return) can be de-
The following tables give the probabilities of a pertinent termined. The case says that sales can be increased by $2 million.
nature. However, the cost of developing the product ($500,000) must be
6634 CH08 UG 8/23/02 2:20 PM Page 74

74 CHAPTER 8 DECISION THEORY

subtracted from that figure to arrive at a figure for total benefit for The problem, however, is still not solved. Two decisions re-
a favorable outcome. That figure is $1,500,000. If the product is main: (1) Will a survey help? If so, (2) Who should do the survey?
introduced and an unfavorable outcome materializes, the cost of An evaluation of expected returns is necessary here, too. With the
developing the product becomes a loss ($500,000). Table D surveys, the decision to not introduce the product line still has an
computes the expected return for introducing the product and for expected return of 0 [E(A6)  0]. (See the decision tree.) An eval-
not introducing it. uation of expected returns is necessary and requires Bayes’ law.
P( Ik | Si ) P( Si )
Table D P( Si | Ik ) 
P( Ik )
Payoff Table (Profit)
Prior State of Don’t where P(Ik)  P(Ik  S1)P(S1)  P(Ik  S2)P(S2).
Probabilities Nature Introduce Introduce The additional probabilities needed are computed below:
0.6 S1 $1,500,000 0 P(S1  I1)  .7, given in problem
0.4 S2 500,000 0 P(S2  I1)  .3, given in problem
EXPECTED P(S1  I2)  .4, given in problem
PROFIT $ 700,000 0
P(S2  I2)  .6, given in problem

E(P)  0.6(1,500,000)  (0.4)(500,000) (0.9)(0.6) 0.54

P( S1 | I3 )    0.87
 900,000  (200,000)  $700,000 (0.9)(0.6)  (0.2)(0.4) 0.62
The expected return for introducing the product is greater than (0.2)(0.4) 0.08
for not introducing it. Therefore, the product should be introduced P( S2 | I3 )    0.13
(0.9)(0.6)  (0.2)(0.4) 0.62
if no survey is done. (See decision tree for pictorial explanation.)

Figure for Blake Electronic Case S1 (.7) ($1.5 million)

A5 $0.9
mil
$0.9 mil
I1 (0.5) S2 (.3) (–$0.5 million)
A6
$0.6
mil S1 (.4) ($1.5 million)
A5 $0.3
A3
)*

I2 (0.5) mil
00

$0.3 mil
,0

S2 (.6) (–$0.5 million)

00

A6
$1
(–

$596,400
S1 ($1.5 million)
$1.24
(–

A5
$3

mil
00

A4 I3 (0.62) $1.24 mil S2 (–$0.5 million)

,0
0
0)

A1 A6
*

$0.7688
mil S1 ($1.5 million)
A5 –$0.18
I4 (0.38) mil
$0
S2 (–$0.5 million)
$700,000 A6
0.6($1.5 mil)
S1

$700,000
A2
A5 S2
0.4(–$0.5 mil)

decisions to be made
$700,000 probabilities encountered
A6 decision not chosen

* cost of survey
6634 CH08 UG 8/23/02 2:20 PM Page 75

CHAPTER 8 DECISION THEORY 75

( 0.1)( 0.6 ) 0.06 Maximax

P( S1 | I4 ) = = = 0.16
( 0.1)( 0.6 ) + ( 0.8)( 0.4 ) 0.38 Alternative Maximax Payoff
1 0
( 0.8)( 0.4 ) 0.32 2 25,273
P( S2 | I4 ) = = = 0.84
( 0.1)( 0.6 ) + ( 0.8)( 0.4 ) 0.38 3 90,000
4 210,000 k best
The expected value can be found on the decision tree.
After an expected return is calculated for each firm, the cost Hurwicz a coefficient: 0.110
of the study must be subtracted.
Hurwicz
E(MAI) $696,400
Alternative Hurwicz Payoff
Cost of survey 100,000
1 0.00 k best
Actual return $596,400 2 6,119.97
3 3,450.00
E(I&K) 768,800 4 3,600.00
Cost 300,000
Return 468,800 Minimax
Since the MAI survey reaps a greater expected profit, its return Alternative Maximum Regret
is compared with that calculated assuming no survey is undertaken
1 210,000
($700,000). Since $700,000 is greater than $596,400, no survey
2 184,727
should be undertaken and the product line should be introduced. 3 120,000
4 30,000 k best
SOLUTIONS TO INTERNET CASES
a. Sue Pansky is a risk avoider and should use the maximin
Starting Right decision approach. She should do nothing and not make an
This is a decision-making-under-uncertainty case. There are two investment in Starting Right.
events: a favorable market (event 1) and an unfavorable market b. Ray Cahn should use a coefficient of realism of 0.11.
(event 2). There are four alternatives, which include do nothing The best decision is to do nothing.
(alternative 1), invest in corporate bonds (alternative 2), invest in c. Lila Battle should eliminate alternative 1 of doing noth-
preferred stock (alternative 3), and invest in common stock (alter- ing and apply the maximin criterion. The result is to invest in
native 4). The decision table is presented below. Note that for the corporate bonds.
alternative 2, the return in a good market is $30,000  (1  0.13)5 d. George Yates should use the equally likely decision cri-
 the initial investment of $30,000  $25,273. The return in a terion. The best decision for George is to invest in common
good market is (4  $30,000)  $30,000  $90,000 for alterna- stock.
tive 3, and (8  $30,000)  $30,000  $210,000 for alternative 4. e. Pete Metarko is a risk seeker. He should invest in com-
mon stock.
Event 1 Event 2 f. Julia Day can eliminate the preferred stock alternative
Alternative 1 0 0 and still offer alternatives to risk seekers (common stock)
Alternative 2 25,273 10,000 and risk avoiders (doing nothing or investing in corporate
Alternative 3 90,000 15,000 bonds).
Alternative 4 210,000 30,000
Drink-at-Home, Inc.
Solutions: (See file P8-Starting.XLS) Abbreviations and values used in the following decision trees:
Laplace Normal—proceed with research and development at a normal
pace
Alternative Expected Value
6 Month—Adopt the 6-month program: if a competitor’s product
1 0.0
is available at the end of 6 months, then copy; otherwise
2 7,636.5
proceed with research and development.
3 37,500.0
4 90,000.0 k best 8 Month—Adopt the 6-month program: proceed for 8 months; if
no competition at 8 months, proceed; otherwise stop
development
Maximin Success or failure of development effort:
Alternative Expected Value
Ok—Development effort ultimately a success
No—Development effort ultimately a failure
1 0 k best
2 10,000 Column:
3 15,000 S—Sales revenue
4 30,000 R—research and development expenditures
6634 CH08 UG 8/23/02 2:20 PM Page 76

76 CHAPTER 8 DECISION THEORY

E—Equipment costs
I—Introduction to market costs
Market size and Revenues:
Without With
Competition Competition
S—Substantial (P  .1) $800,000 $400,000
M—Moderate (P  .6) $600,000 $300,000
L—Low (P  .3) $500,000 $250,000
Competition:
C6—Competition at end of 6 months (P  .5)
No C6—No competition at end of 6 months (P  .5)
C8—Competition at end of 8 months (P  .6)
No C8—No competition at end of 8 months (P  .4)
C12—Competition at end of 12 months (P  .8)
No C12—No competition at end of 12 months (P  .2)

Mkt S R E I

S (.1)
400 – 100 – 100 – 150 = 50
C12 (.8) M (.6)
300 – 100 – 100 – 150 = –50
L (.3)
Ok (.9) 250 – 100 – 100 – 150 = –100
S (.1)
800 – 100 – 100 – 150 = 450
Normal No C12 (.2) M (.6)
600 – 100 – 100 – 150 = 250
L (.3)
500 – 100 – 100 – 150 = 150
No (.1) (Stop)
– 100 = –100
C8 (.6)
– 80 = –80
S (.1)
400 – 140 – 100 – 150 = 10
8 Month Ok (.9) M (.6)
300 – 140 – 100 – 150 = –90
L (.3)
No C8 (.4) 250 – 140 – 100 – 150 = –140
S (.1)
800 – 140 – 100 – 150 = 410
No (.1) M (.6)
600 – 140 – 100 – 150 = 210
6 Mo

L (.3)
500 – 140 – 100 – 150 = 110
S (.1)
nth

400 – 90 – 100 – 150 = 60

C6 (.5) M (.6)
300 – 90 – 100 – 150 = –40
L (.3)
250 – 90 – 100 – 150 = –90
S (.1)
400 – 100 – 100 – 150 = 50
C12 (.8) M (.6)
300 – 100 – 100 – 150 = –50
L (.3)
Ok (.9) 250 – 100 – 100 – 150 = –100
S (.1)
800 – 100 – 100 – 150 = 450
No C6 (.5) No C12 (.2) M (.6)
600 – 100 – 100 – 150 = 250
L (.3)
500 – 100 – 100 – 150 = 150
No (.1)
– 100 = –100
6634 CH08 UG 8/23/02 2:20 PM Page 77

CHAPTER 8 DECISION THEORY 77

Drink-at-Home, Inc. Case (continued) Mkt

S (.1)
50
C12 (.8) M (.6)
–50
L (.3)
Ok (.9) –100
S (.1)
450
Normal No C12 (.2) M (.6)
250
L (.3)
150
No (.1) (Stop)
–100
C8 (.6)
–80
S (.1)
10
8 Month Ok (.9) M (.6)
–90
L (.3)
No C8 (.4) –140
S (.1)
410
No (.1) M (.6)
210
6 Mo

L (.3)
110
S (.1)
nth

60
C6 (.5) M (.6)
–40
L (.3)
–90
S (.1)
50
C12 (.8) M (.6)
–50
L (.3)
Ok (.9) –100
S (.1)
450
No C6 (.5) No C12 (.2) M (.6)
250
L (.3)
150
No (.1)
–100

Mkt

S (.1)
50
C12 (.8) M (.6)
–50
–55 L (.3)
Ok (.9) –100
(4) S (.1)
450
Normal –6.4 240 M (.6)
250
No C12 (.2) L (.3)
150
No (.1) (Stop)
–100
C8 (.6)
–80
S (.1)
10
8 Month –74.2 Ok (.9) M (.6)
(–74.2) –90
–95 L (.3)
No C8 (.4) –140
S (.1)
410
No (.1) M (.6)
210
6 Mo

200 L (.3)
110
S (.1)
nth

60
C6 (.5) M (.6)
–40
–45 L (.3)
–90
S (.1)
50
C12 (.8) M (.6)
–50
–55 L ( .3)
Ok (.9) –100
S (.1)
450
No C6 (.5) 240 M (.6)
(19.3) 250
No C12 (.2) L (.3)
150
No (.1)
–100
The optimal program is to adopt the 6-month program.
6634 CH08 UG 8/23/02 2:20 PM Page 78

78 CHAPTER 8 DECISION THEORY

Ruth Jones’ Heart By-Pass Operation

Prob. Years Expected Rate

One Year .50 1 .50

Two Years .20 2 .40

a ss Five Years .20 5 1.00

-p
By er
y
Eight Years .10 8 .80
No rg
Su 2.7 years

0 Years .05 0 0.0

Su
rg
er One Year .45 1 .45
y
Five Years .20 5 1.00

Ten Years .13 10 1.30

Fifteen Years .08 15 1.20

Twenty Years .05 20 1.00

Twenty-five
Years .04 25 1.00
5.95 years

Expected survival rate with surgery (5.95 years) exceeds the non-
surgical survival rate of 2.70 years. Surgery is favorable.

Toledo Leather Company

1. Machine 1 Machine 2
(Semiautomated) (Automated)

Capacity  5 days/wk  50 wks/yr Capacity  5 days/wk  50 wks/yr

 1   1 
 640  (640)140, 000 / yr. .  800  (800)150, 000 units/ yr.
 8   4 
Sales price  $6/unit. Sales price  $6/unit.
T.C./case  $1.50 (material) T.C./case  $1.50
 $2.50(v.c.)  $4(no overtime used)  $1.75(v.c.)  $3.25(no overtime used)
T.C./case (with overtime)  $1.50 T.C./case (with overtime)  $1.50
 $2.50  $1.20  $5.20  $1.75  $0.90  $4.15
Cost of machine  $250,000 Cost of machine  $350,000
Cost to modify  $15,000 Cost to modify  $20,000

Volume Profit Volume Profit

120k ($6  4)(120k)  $240k 120k ($6  3.25)(120k)  $330k

130k ($6  4)(130k)  $260k 130k ($6  3.25)(130k)  $357k
140k (capacity) ($6  4)(140k)  $280k 140k ($6  3.25)(140k)  $385k
150k (capacity) $280k  (80¢/overtime unit) 150k (capacity) ($6  3.25)(150k)  $412.5k
(10k)  $288k
150k (modify) ($6  4)(150k)  $15k  $280k 160k (overtime) $412.5k  (6  4.15)(20k)  $431k
160k (overtime) $280k  (80¢/unit)(20k)  $296k 160k (modify) ($6  3.25)(160k)  $20k  $420k
160k (modify) ($6  4)(160k)  $15k  $305k
6634 CH08 UG 8/23/02 2:20 PM Page 79

CHAPTER 8 DECISION THEORY 79

2. Payoff Matrix

States of Nature—Payoff in $1,000s

Alternative $120k $130k $140k $150k (OT) $160k (OT)
Machine 1 240 260.0 280 288.0 296
Machine 2 330 357.5 385 412.5 431

(a) Maximax: $296k  $250k  $46k

$431k  $350k  $81k k maximax (Machine 2)
(b) Maximin: $240k  $250k  $10k k maximin (Machine 1)
$330k  $350k  $20k
(c) Equally likely: Machine 1  $272.8k  $250k  $22.8k
Machine 2  $383.2k  $350k  $33.2k k (Machine 2)

Volume = 120,000 (0.15)

$240k
V = 130,000 (0.25)
$260k
(Machine 1)
Semiautomated V = 140,000 (0.40)
$271,450 $280k
$250,000
cost V = 150,000 (0.15) Overtime
$21.450 $288k
Modify
$285k
V = 160,000 (0.5) Overtime
$296k
$26.300
Modify
$305k
Volume = 120,000 (0.15)
$330k

$26.300 V = 130,000 (0.25)

$357.5k
(Machine 2)
Automated V = 140,000 (0.40)
$376,300 $385k
$350,000
cost V = 150,000 (0.15)
$412.5k
V = 160,000 (0.05) Overtime
$431k
Modify
$420k