Sharma, J. (2016) - Operations Research Theory and Applications (Pp. 347-360) PDF

Decision Theory and Decision Trees 347
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salesmen. On the other hand, if the new line is handled by the territory and their experience with other products, the
existing sales force, using the existing facilities, the initial representative estimates the following probabilities for annual
investment would only be Rs 30,000, principally for training his sales of the new product:
present salesmen.
The new product sells for Rs 250. The representative Sales (in units) : 1,000 2,000 3,000 4,000 5,000
normally receives 20 per cent of the sales price on each unit Probability : 0.10 0.15 0.40 0.30 0.05
sold, of which 10 per cent is paid as commission to handle the
new product. The manufacturer offers to pay 60 per cent of the (a) Set up a regret table.
sale price of each unit sold to the representative, if the (b) Find the expected regret of each course of action.
representative sets up a separate sales organization. Otherwise (c) Which course of action would have been best under the
the normal 20 per cent will be paid. In either case the salesman maximin criterion?
gets a 10 per cent commission. Based on the size of the
HINTS AND ANSWERS
1. (i) S2, (ii) S2 or S3, (iii) S3, (iv) S1, (v) S2 Therefore, payoff function corresponding to S1 and S2 would
2. (a) Full, (b) Minimal, (c) Full or partial, (d) Partial be
3. (a) S3; Rs 150 (b) S3; Rs 80 (c) S1; Rs 40 (d) S3; Rs 55 S1 = –1,00,000 + 250 × {(30 – 10)/100} × α = –1,00,000 + 50α
4. Choose A: Rs 120, Choose B: Rs 300, Choose C: Rs 176.6, S2 = –30,000 + 250 × {(20 – 10)/100} × α = – 30,000 + 25α
Choose C: Rs 50 Equating the two, we get – 1,00,000 + 50α = – 30,000 + 25α
5. Let S1 = install new sales facilities or α = 2,800.
Let S2 = continue with existing sales facilities.
11.5 DECISION-MAKING UNDER RISK

In this decision-making environment, decision-maker has sufficient information to assign probability to the
likely occurrence of each outcome (state of nature). Knowing the probability distribution of outcomes
(states of nature), the decision-maker needs to select a course of action resulting a largest expected
(average) payoff value. The expected payoff is the sum of all possible weighted payoffs resulting from
choosing a decision alternative.
The widely used criterion for evaluating decision alternatives (courses of action) under risk is the
Expected Monetary Value (EMV) or Expected Utility.
11.5.1 Expected Monetary Value (EMV)

The expected monetary value (EMV) for a given course of action is obtained by adding payoff values multiplied Expected monetary
by the probabilities associated with each state of nature. Mathematically, EMV is stated as follows: value is obtained by
m adding payoffs for
EMV (Course of action, Sj) = Σ pij pi each course of
i =1 action, multiplied by
where m = number of possible states of nature the probabilities
associated with
p i = probability of occurrence of state of nature, Ni
each state of
pij = payoff associated with state of nature Ni and course of action, Sj nature.
The Procedure
1. Construct a payoff matrix listing all possible courses of action and states of nature. Enter the
conditional payoff values associated with each possible combination of course of action and state of
nature along with the probabilities of the occurrence of each state of nature.
2. Calculate the EMV for each course of action by multiplying the conditional payoffs by the associated
probabilities and adding these weighted values for each course of action.
3. Select the course of action that yields the optimal EMV.
applicable copyright law.
Example 11.5 Mr X flies quite often from town A to town B. He can use the airport bus which costs
Rs 25 but if he takes it, there is a 0.08 chance that he will miss the flight. The stay in a hotel costs
Rs 270 with a 0.96 chance of being on time for the flight. For Rs 350 he can use a taxi which will
make 99 per cent chance of being on time for the flight. If Mr X catches the plane on time, he will
conclude a business transaction that will produce a profit of Rs 10,000, otherwise he will lose it.
Which mode of transport should Mr X use? Answer on the basis of the EMV criterion.
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348 Operations Research: Theory and Applications
Solution Computation of EMV associated with various courses of action is shown in Table 11.3.
Courses of Action
States of Bus Stay in Hotel Taxi
Nature Cost Prob. Expected Cost Prob. Expected Cost Prob. Expected
Value Value Value
Catches 10,000 – 25 0.92 9,177 10,000 – 270 0.96 9,340.80 10,000 – 350 0.99 9,553.50
the flight = 9,975 = 9,730 = 9,650
Miss the flight – 25 0.08 – 2.0 – 270 0.04 – 10.80 – 350 0.01 – 3.50
Expected monetary 9,175 9,330 9,550

Table 11.3 value (EMV)
Since EMV associated with course of action ‘Taxi’ is largest (= Rs 9,550), it is the logical alternative.
Example 11.6 The manager of a flower shop promises its customers delivery within four hours on all
flower orders. All flowers are purchased on the previous day and delivered to Parker by 8.00 am the next
morning. The daily demand for roses is as follows.
Dozens of roses : 70 80 90 100
Probability : 0.1 0.2 0.4 0.3
The manager purchases roses for Rs 10 per dozen and sells them for Rs 30. All unsold roses are donated
to a local hospital. How many dozens of roses should Parker order each evening to maximize its profits?
What is the optimum expected profit? [Delhi Univ., MBA, Dec. 2004]
Solution The quantity of roses to be purchased per day is considered as ‘course of action’ and the
daily demand of the roses is considered as a ‘state of nature’ because demand is uncertain with
known probability. From the data, it is clear that the flower shop must not purchase less than 7 or
more than 10 dozen roses, per day. Also each dozen roses sold within a day yields a profit of Rs (30
– 10) = Rs 20 and otherwise it is a loss of Rs 10. Thus
Marginal profit (MP) = Selling price – Cost = 30 – 10 = Rs 20
Marginal loss (ML) = Loss on unsold roses = Rs 10
Using the information given in the problem, the various conditional profit (payoff) values for each
combination of decision alternatives and state of nature are given by
Conditional profit = MP × Roses sold – ML × Roses not sold
=
RS 20D, if D ≥ S
T 20D − 10(S − D) = 30D − 10S , if D < S
where D = number of roses sold within a day and S = number of roses stocked.
The resulting conditional profit values and corresponding expected payoffs are computed in
Table 11.4.
States of Probability Conditional Profit (Rs) due to Expected Payoff (Rs) due to
Nature Courses of Action Courses of Action
(Demand (Purchase per Day) (Purchase per Day)
per Day)
70 80 90 100 70 80 90 100
(1) (2) (3) (4) (5) (1)×(2) (1)×(3) (1)×(4) (1)×(5)
70 0.1 140 130 120 110 14 13 12 11

80 0.2 140 160 150 140 28 32 30 28
90 0.4 140 160 180 170 56 64 72 68
Table 11.4
100 0.3 140 160 180 200 42 48 54 60
Conditional Profit
Value (Payoffs) Expected monetary value (EMV) 140 157 168 167
Account: ns145102
Since the highest EMV of Rs 168 corresponds to the course of action 90, the flower shop should
purchase nine dozen roses everyday.
Example 11.7 A retailer purchases cherries every morning at Rs 50 a case and sells them for Rs 80 a
case. Any case that remains unsold at the end of the day can be disposed of the next day at a salvage
value of Rs 20 per case (thereafter they have no value). Past sales have ranged from 15 to 18 cases per
day. The following is the record of sales for the past 120 days.
Cases sold : 15 16 17 18
Number of days : 12 24 48 36
Find out how many cases should the retailer purchase per day in order to maximize his profit.
[Delhi Univ., MCom, 2000; Ajmer Univ., MBA, 2003]
Solution Let Ni (i = 1, 2, 3, 4) be the possible states of nature (daily likely demand) and Sj ( j = 1, 2,
3, 4) be all possible courses of action (number of cases of cherries to be purchased).
Marginal profit (MP) = Selling price – Cost = Rs (80 – 50) = Rs 30
Marginal loss (ML) = Loss on unsold cases = Rs (50 – 20) = Rs 30
The conditional profit (payoff) values for each combination of decision alternatives and state of nature
are given by
Conditional profit = MP × Cases sold – ML × Cases unsold
= (80 – 50) (Cases sold) – (50 –20) (Cases unsold)
 30S if S ≥ N
=  (80 – 50) S – 30(N – S) = 60S – 30N if S < N

The resulting conditional profit values and corresponding expected payoffs are computed in Table 11.5.
States of Probability Conditional Profit (Rs) due to Expected Payoff (Rs) due to
(Demand (Purchase per Day) (Purchase per Day)
per Week)
15 16 17 18 15 16 17 18
(1) (2) (3) (4) (5) (1)×(2) (1)×(3) (1)×(4) (1)×(5)
15 0.1 450 420 390 360 45 42 39 36
16 0.2 450 480 450 420 90 96 90 84
17 0.4 450 480 510 480 180 192 204 192
Table 11.5
18 0.3 450 480 510 540 135 144 153 162
Conditional Profit
Expected monetary value (EMV) 450 474 486 474 Value (Payoffs)
Since the highest EMV of Rs 486 corresponds to the course of action 17, the retailer must purchase
17 cases of cherries every morning.
Example 11.8 The probability of demand for hiring cars on any day in a given city is as follows:
No. of cars demanded : 0 1 2 3 4
Probability : 0.1 0.2 0.3 0.2 0.2
Cars have a fixed cost of Rs 90 each day to keep the daily hire charges (variable costs of running)
Rs 200. If the car-hire company owns 4 cars, what is its daily expectation? If the company is about to go
into business and currently has no car, how many cars should it buy?
Solution Given that Rs 90 is the fixed cost and Rs 200 is variable cost. The payoff values with 4 cars
at the disposal of decision-maker are calculated as under:
No. of cars
demanded : 0 1 2 3 4
Payoff : 0 – 90 × 4 200 – 90 × 4 400 – 90 × 4 600 – 90 × 4 800 – 90 × 4
(with 4 cars) = – 360 = – 160 = 40 = 240 = 440
Account: ns145102
Thus, the daily expectation is obtained by multiplying the payoff values with the given corresponding
probabilities of demand:
Daily Expectation = (– 360)(0.1) + (– 160)(0.2) + (40)(0.3) + (240)(0.2) + (440)(0.2) = Rs 80
The conditional payoffs and expected payoffs for each course of action are shown in Tables 11.6 and 11.7.
Demand of Probability Conditional Payoff (Rs) due to Decision to Purchase Cars

Cars (Course of Action)
0 1 2 3 4
0 0.1 0 – 90 – 180 – 270 – 360

1 0.2 0 110 20 – 70 – 160
Table 11.6 2 0.3 0 110 220 130 40
Conditional Payoff 3 0.2 0 110 220 330 240
Values 4 0.2 0 110 220 330 440
Demand of Probability Conditional Payoff (Rs) due to Decision to Purchase Cars

Cars (Course of Action)
0 1 2 3 4
0 0.1 0 –9 – 18 – 27 – 36
1 0.2 0 22 4 – 14 – 32
2 0.3 0 33 66 39 12
Table 11.7 3 0.2 0 22 44 66 48
Expected Payoffs 4 0.2 0 22 44 66 88
and EMV EMV 0 90 140 130 80
Since the EMV of Rs 140 for the course of action 2 is the highest, the company should buy 2 cars.
11.5.2 Expected Opportunity Loss (EOL)

Expected opportunity loss (EOL), also called expected value of regret, is an alternative decision criterion
for decision making under risk. The EOL is defined as the difference between the highest profit (or payoff )
and the actual profit due to choosing a particular course of action in a particular state of nature. Hence,
EOL is the amount of payoff that is lost by not choosing a course of action resulting to the minimum payoff
in a particular state of nature. A course of action resulting to the minimum EOL is preferred. Mathematically,
EOL is stated as follows.
m
EOL (State of nature, Ni ) = Σ lij pi
i =1
where lij = opportunity loss due to state of nature, Ni and course of action, Sj
p i = probability of occurrence of state of nature, Ni
The Procedure
1. Prepare a conditional payoff values matrix for each combination of course of action and state of nature
along with the associated probabilities.
2. For each state of nature calculate the conditional opportunity loss (COL) values by subtracting each
payoff from the maximum payoff.
3. Calculate the EOL for each course of action by multiplying the probability of each state of nature
with the COL value and then adding the values.
4. Select a course of action for which the EOL is minimum.

Example 11.9 A company manufactures goods for a market in which the technology of the product is
changing rapidly. The research and development department has produced a new product that appears to
have potential for commercial exploitation. A further Rs 60,000 is required for development testing.
The company has 100 customers and each customer might purchase, at the most, one unit of the
product. Market research suggests that a selling price of Rs 6,000 for each unit, with total variable costs
of manufacturing and selling estimate as Rs 2,000 for each unit.
Account: ns145102
From previous experience, it has been possible to derive a probability distribution relating to the
proportion of customers who will buy the product as follows:
Proportion of customers : 0.04 0.08 0.12 0.16 0.20
Probability : 0.10 0.10 0.20 0.40 0.20
Determine the expected opportunity losses, given no other information than that stated above, and
state whether or not the company should develop the product.
Solution If p is the proportion of customers who purchase the new product, the company’s conditional
profit is: (6,000 – 2,000) × 100 p – 60,000 = Rs (4,00,000 p – 60,000).
Let Ni (i = 1, 2, . . ., 5) be the possible states of nature, i.e. proportion of the customers who will buy
the new product and S1 (develop the product) and S2 (do not develop the product) be the two courses
of action.
The conditional profit values (payoffs) for each pair of Nis and Sjs are shown in Table 11.8.
Proportion of Conditional Profit = Rs (4,00,000 p – 60,000)

Customers Course of Action
(State of Nature) S1 S2
(Develop) (Do not Develop)
0.04 – 44,000 0
0.08 – 28,000 0
0.12 – 12,000 0 Table 11.8
0.16 4,000 0 Conditional Profit
0.20 20,000 0 Values (Payoffs)
Opportunity loss values are shown in Table 11.9.
Proportion of Probability Conditional Profit (Rs) Opportunity Loss (Rs)

Customers
S1 S2 S1 S2
(State of Nature)
0.04 0.1 – 44,000 0 44,000 0
0.08 0.1 – 28,000 0 28,000 0
0.12 0.2 – 12,000 0 12,000 0 Table 11.9
0.16 0.4 4,000 0 0 4,000 Opportunity Loss
0.20 0.2 20,000 0 0 20,000 Values
Using the given estimates of probabilities associated with each state of nature, the expected
opportunity loss (EOL) for each course of action is given below:
EOL (S1) = 0.1 (44,000) + 0.1 (28,000) + 0.2 (12,000) + 0.4 (0) + 0.2 (0) = Rs 9,600
EOL (S2) = 0.1 (0) + 0.1 (0) + 0.2 (0) + 0.4 (4,000) + 0.2 (20,000) = Rs 5,600
Since the company seeks to minimize the expected opportunity loss, the company should select course Expected value of
of action S2 (do not develop the product) with minimum EOL. perfect information
is an average (or
expected) value of
11.5.3 Expected Value of Perfect Information (EVPI) an additional
information if it were
If decision-makers can get perfect (complete and accurate) information about the occurrence of various of any worth.
states of nature, then choosing a course of action that yields the desired payoff in the presence of any
state of nature is easy.
The EMV or EOL criterion helps the decision-maker to select a particular course of action that optimizes
the expected payoff, without any additional information. Expected value of perfect information (EVPI)
represents the maximum amount of money required to pay for getting additional information about the
occurrence of various states of nature before arriving to a decision. Mathematically, it is stated as:
EVPI = (Expected profit with perfect information)
– (Expected profit without perfect information)
m
= ∑ pi max(
j
pij ) – EMV*
i =1
Account: ns145102
where pij = best payoff when action, Sj is taken in the presence of state of nature, Ni
p i = probability of state of nature, Ni
EMV* = maximum expected monetary value
Example 11.10 A company needs to increase its production beyond its existing capacity. It has
narrowed down on two alternatives in order to increase the production capacity: (a) expansion, at a cost
of Rs 8 million, or (b) modernization at a cost of Rs 5 million. Both approaches would require the same
amount of time for implementation. Management believes that over the required payback period, demand
will either be high or moderate. Since high demand is considered to be somewhat less likely than moderate
demand, the probability of high demand has been set at 0.35. If the demand is high, expansion would gross
an estimated additional Rs 12 million but modernization would only gross an additional Rs 6 million, due
to lower maximum production capability. On the other hand, if the demand is moderate, the comparable
figures would be Rs 7 million for expansion and Rs 5 million for modernization.
EVPI provides an (a) Calculate the conditional profit in relation to various action-and-outcome combinations and states of
instant way to nature.
check whether (b) If the company wishes to maximize its expected monetary value (EMV), should it modernize or expand?
getting any (c) Calculate the EVPI.
additional information
might be worthwhile. (d) Construct the conditional opportunity loss table and also calculate EOL. [Delhi Univ, MBA, 2004]
Solution (a) States of nature: High demand and Moderate demand, and Courses of action: Expand and
Modernize.
Since probability of high demand is estimated at 0.35, the probability of moderate demand must be
(1 – 0.35) = 0.65. The calculations for conditional profit values are shown in Table 11.10.
State of Nature Conditional Profit (million Rs) due to

(Demand) Course of Action
Expand (S1) Modernize (S2)

Table 11.10
Conditional Profit High demand (N1) 12 – 8 = 4 6 – 5 = 1
Table Moderate demand (N2) 7 – 8 = –1 5 – 5 = 0
(b) The payoff table (Table 11.10) can be rewritten as follows along with the given probabilities of states
of nature.
State of Nature Probability Conditional Profit (million Rs)
(Demand) Due to Course of Action
Expand Modernize
Table 11.11 High demand 0.35 4 1

Payoff Table Moderate demand 0.65 –1 0
The calculation of EMV for each course of action S1 and S2 is given below:
EMV(S1) = 0.35(4) + 0.65( – 1) = Rs 0.75 million
EMV(S2) = 0.35(1) + 0.65(0) = Rs 0.35 million
Since EMV (S1) = 0.75 million is maximum, the company must choose course of action S1(expand).
(c) To calculate EVPI, first calculate EPPI by choosing optimal course of action for each state of nature.
Multiply conditional profit associated with each course of action by the given probability to get weighted
profit, and then add these weights as shown in Table 11.12.
State of Nature Probability Optimal Course Profit from Optimal Course of Action
(Demand) of Action (Rs million)

Conditional Profit Weighted Profit
High demand 0.35 S1 4 4 × 0.35 = 1.40

Moderate demand 0.65 S2 0 0 × 0.65 = 0
Table 11.12 EPPI = 1.40
Account: ns145102
If optimal EMV* = Rs 0.75 million corresponding to the course of action S1, then
EVPI = EPPI – EMV(S1) = 1.40 – 0.75 = Rs 0.65 million.
In other words, to get perfect information on demand pattern (high or moderate), company should consider
paying up to Rs 0.65 million.
(d) The opportunity loss values are shown in Table 11.13.
State of Nature Probability Conditional Profit Conditional Opportunity

(Demand) (Rs million) Due to Loss (Rs million) Due to
Course of Action Course of Action
S1 S2 S1 S2
High demand (N1) 0.35 4 1 0 3

Moderate demand (N2) 0.65 –1 0 1 0 Table 11.13
Since probabilities associated with each state of nature, P (N1) = 0.35, and P(N2) = 0.65, the expected
opportunity losses for the two courses of action are:
EOL(S1) = 0.35(0) + 0.65(1) = Re 0.65 million
EOL(S2) = 0.35(3) + 0.65(0) = Rs 1.05 million
Since the expected opportunity loss, EOL (S1) = Re 0.65 million minimum, decision-maker must select
course of action S1, so as to have smallest expected opportunity loss.
Example 11.11 A certain piece of equipment has to be purchased for a construction project at a remote
location. This equipment contains an expensive part that is subject to random failure. Spares of this part
can be purchased at the same time the equipment is purchased. Their unit cost is Rs 1,500 and they have
no scrap value. If the part fails on the job and no spare is available, the part will have to be manufactured
on a special order basis. If this is required, the total cost including down time of the equipment, is estimated
at Rs 9,000 for each such occurrence. Based on previous experience with similar parts, the following
probability estimates of the number of failures expected over the duration of the project are provided below:
Failure : 0 1 2
Probability : 0.80 0.15 0.05
(a) Determine optimal EMV* and optimal number of spares to purchase initially.
(b) Based on opportunity losses, determine the optimal course of action and optimal value of EOL.
(c) Determine the expected profit with perfect information and expected value of perfect information.
Solution (a) Let N1 (no failure), N2 (one failure) and N3 (two failures) be the possible states of nature
(i.e. number of parts failures or number of spares required). Similarly, let S1 (no spare purchased), S2 (one
spare purchased) and S3 (two spares purchased) be the possible courses of action.
The conditional costs for each pair of course of action and state of nature is shown in Table 11.14.
State of Nature Course of Action Purchase Emergency Total Conditional

(Spare Required) (Number of Spare Purchased) Cost (Rs) Cost (Rs) Cost (Rs)
 0 0 0 0 0

N1  0 1 1,500 0 1,500

 0 2 3,000 0 3,000
 1 0 0 9,000 9,000

N2  1 1 1,500 0 1,500

 1 2 3,000 0 3,000
 2 0 0 18,000 18,000

N3  2 1 1,500 9,000 10,500
 Table 11.14
 2 2 3,000 0 3,000
Using the conditional costs and the probabilities of states of nature, the expected monetary value can
be calculated for each of three states of nature as shown in Table 11.15.
Account: ns145102
State of Nature Probability Conditional Cost Due to Weighted Cost Due to

(Space Required) Course of Action Course of Action
S1 S2 S3 S1 S2 S3
N1 0.80 0 1,500 3,000 0.80 (0) 1,200 2,400

= 0
N2 0.15 9,000 1,500 3,000 0.15 (9,000) 225 450
= 1,350
N3 0.05 18,000 10,500 3,000 0.05 (18,000)
Table 11.15
= 900 525 150
Expected
Monetary Value EMV = 2,250 1,950 3,000
Since weighted cost = Rs 1,950 is lowest due to course of action, S2, it should be chosen. If the EMV
is expressed in terms of profit, then EMV* = EMV(S2) = – Rs 1,950. Hence, the optimal number of spares
to be purchased initially should be one.
(b) The calculations for conditional opportunity loss (COL) to determine EOL are shown in Table 11.16.
State of Nature Conditional Cost Due to Conditional Opportunity Loss Due to
(Space Required) Course of Action Course of Action
S1 S2 S3 S1 S2 S3
Table 11.16
Conditional N1 0 1,500 3,000 0 1,500 3,000
Opportunity Loss N2 9,000 1,500 3,000 7,500 0 1,500
(COL) N3 18,000 10,500 3,000 15,000 7,500 0
Since we are dealing with conditional costs rather than conditional profits, the lower value for each
state of nature shall be considered for calculating opportunity losses. The calculations for expected
opportunity loss are shown in Table 11.17.
State of Nature Probability Conditional Opportunity Weighted Opportunity
(Space Required) Loss (Cost) Due to Loss (Cost) Due to
Course of Action Course of Action
S1 S2 S3 S1 S2 S3
N1 0.80 0 1,500 3,000 0.80(0) 1,200 2,400

= 0
N2 0.15 7,500 0 1,500 0.15 (7,500) 0 225
Table 11.17 = 1,125
Expected N3 0.05 15,000 7,500 0 0.05 (15,000) 375 0
Opportunity Loss = 750
(EOL) EMV = 1,875 1,575 2,625
Since minimum, EOL* = EOL(S2) = Rs 1,575, therefore adopt course of action S2 and purchase one spare.
(c) The expected profit with perfect information (EPPI) can be determined by selecting the optimal course
of action for each state of nature, multiplying its conditional values by the corresponding probability and
then adding these products. The EPPI calculations are shown in Table 11.18.
States of Probability Optimal Course Cost of Optimal Course of Action (Rs)

Nature of Action
Conditional Weighted
(Space Cost Opportunity Loss
Required) (Minimum Value)
N1 0.80 S1 0 0.80(0) = 0
N2 0.15 S2 1,500 0.15 (1,500) = 225
N2 0.05 S3 3,000 0.05 (3,000) = 150
Table 11.18 Total = 375
Account: ns145102
Thus expected profit with perfect information is, EPPI = Rs 375. Expected value of perfect information then
is: EVPI = EPPI – EMV* = – 375 – (– 1,950) = Rs 1,575. It may be observed that, EVPI = EOL* = Rs 1,575
Example 11.12 XYZ Company manufactures parts for passenger cars and sells them in lots of 10,000
parts each. The company has a policy of inspecting each lot before it is actually shipped to the retailer.
Five inspection categories, established for quality control, represent the percentage of defective items
contained in each lot. These are given in the following table. The daily inspection chart for past 100
inspections shows the following rating or breakdown inspection: Due to this the management is considering
two possible courses of action:
(i) S1: Shut down the entire plant operations and thoroughly inspect each machine.
Rating Proportion of Frequency

Defective Items
Excellent (A) 0.02 25
Good (B) 0.05 30
Acceptable (C) 0.10 20
Fair (D) 0.15 20
Poor (E) 0.20 5
Total = 100
(ii) S2 : Continue production as it now exists but offer the customer a refund for defective items that
S2 : are discovered and subsequently returned.
The first alternative will cost Rs 600 while the second alternative will cost the company Re 1 for each
defective item that is returned. What is the optimum decision for the company? Find the EVPI.
Solution Calculations of inspection and refund cost are shown in Table 11.19.
Rating Defective Probability Cost Opportunity Loss

Rate Inspect Refund Inspect Refund
A 0.02 0.25 600 200 400 0

B 0.05 0.30 600 500 100 0
C 0.10 0.20 600 1,000 0 400
D 0.15 0.20 600 1,500 0 900
Table 11.19
E 0.20 0.05 600 2,000 0 1,400
Inspection and
1.00 600* 670 EOL = 170* 240 Refund Cost
The cost of refund is calculated as follows:

For lot A : 10,000 × 0.02 × 1.00 = Rs 200
Similarly, the cost of refund for other lots is calculated.
Expected cost of refund is:
200 × 0.25 + 500 × 0.30 + . . . + 2,000 × 0.05 = Rs 670
Expected cost of inspection is:
600 × 0.25 + 600 × 0.30 + . . . + 600 × 0.05 = Rs 600
Since the cost of refund is more than the cost of inspection, the plant should be shut down for
inspection. Also, EVPI = EOL of inspection = Rs 170.
Example 11.13 A toy manufacturer is considering a project of manufacturing a dancing doll with three
different movement designs. The doll will be sold at an average of Rs 10. The first movement design using
‘gears and levels’ will provide the lowest tooling and set up cost of Rs 1,00,000 and Rs 5 per unit of
variable cost. A second design with spring action will have a fixed cost of Rs 1,60,000 and variable cost
of Rs 4 per unit. Yet another design with weights and pulleys will have a fixed cost of Rs 3,00,000
and variable cost Rs 3 per unit. The demand events that can occur for the doll and the probability of their
occurrence is given below:
Account: ns145102
Demand (units) Probability

Light demand 25,000 0.10
Moderate demand 1,00,000 0.70
Heavy demand 1,50,000 0.20
(a) Construct a payoff table for the above project.
(b) Which is the optimum design?
(c) How much can the decision-maker afford to pay in order to obtain perfect information about the demand?
Solution The calculations for EMV are shown in Table 11.20.
Payoff = (Demand × Selling price) – (Fixed cost + Demand × Variable cost)
= Revenue – Total variable cost – Fixed cost
States of Probability Conditional Payoff (Rs) Due to Expected Payoff (Rs) Due to
(Demand) (Choice of Movements)
Gears and Spring Weights Gears and Spring Weights
Levels Action and Pulleys Levels Action and Pulleys
Light 0.10 25,000 – 10,000 – 1,25,000 2,500 – 1,000 – 12,500

Moderate 0.70 4,00,000 4,40,000 4,00,000 2,80,000 3,08,000 2,80,000
Table 11.20 Heavy 0.20 6,50,000 7,40,000 7,50,000 1,30,000 1,48,000 1,50,000
EMV and Payoff
Values EMV 4,12,500 4,55,000 4,17,500
Since EMV is largest for spring action, it is the one that must be selected.
States of Probability Courses of Action

Nature Gears and Spring Weights Maximum Maximum Payoff
(Demand) Levels Action and Pulleys Payoff × Probability
Light 0.10 25,000 – 10,000 – 1,25,000 25,000 2,500

Table 11.21 Moderate 0.70 4,00,000 4,40,000 4,00,000 4,40,000 3,08,000
Expected Payoff
Heavy 0.20 6,50,000 7,40,000 7,50,000 7,50,000 1,50,000
with Perfect
Information Total = 4,60,500
The maximum amount of money that the decision-maker would be willing to pay in order to obtain
perfect information regarding demand for the doll will be
EVPI = Expected payoff with perfect information – Expected payoff under uncertainty (EMV)
= 4,60,500 – 4,55,000 = Rs 5,500
Example 11.14 A TV dealer finds that the cost of holding a TV in stock for a week is Rs. 50. Customers who
cannot obtain new TV sets immediately tend to go to other dealers and he estimates that for every customer
who cannot get immediate delivery he loses an average of Rs. 200. For one particular model of TV the probabilities
of demand of 0, 1, 2, 3, 4 and 5 TV sets in a week are 0.05, 0.10, 0.20, 0.30, 0.20 and 0.15, respectively.
(a) How many televisions per week should the dealer order? Assume that there is no time lag between ordering
and delivery.
(b) Compute EVPI.
(c) The dealer is thinking of spending on a small market survey to obtain additional information regarding the
demand levels. How much should he be willing to spend on such a survey. [Delhi Univ., MBA, 2000]
Solution If D denotes the demand and S the number of televisions stored (ordered), then the conditional
cost values are computed and are shown in Table 15.22.
50S + 200 ( D − S ) , when D ≥ S
Cost function = 
50 D + 50 ( S − D ) , when D < S
Account: ns145102
State of Nature Probability Conditional Cost (Rs.)

(Demand) Course of Action (Stock)
0 1 2 3 4 5
0 0.05 0 50 100 150 200 250
1 0.10 200 50 100 150 200 250
2 0.20 400 250 100 150 200 250
3 0.30 600 450 300 150 200 250
4 0.20 800 650 500 350 200 250
5 0.15 1000 850 700 550 400 250 Table 11.22
Expected Cost
Expected Cost = 590 450 330 250 230 250
State of Nature Probability Minimum Cost Expected Cost for

(Demand) for Perfect Information Perfect Information
(1) (2) (3) = (1) × (2)
0 0.05 0 0
1 0.10 50 5
2 0.20 100 20
3 0.30 150 45
4 0.20 200 40 Table 11.23
Expected Payoff
5 0.15 250 37.5
with perfect
ECPI = 147.5 Information
EVPI = Conditional Cost – ECPI = 230 – 147.5 = Rs. 82.5.

The pay-off for EMV is shown in Table 15.24
State of Nature Probability Conditioinal Payoff

(Demand) Course of Action (Stock)
0 1 2 3 4 5
0 0.05 0 – 50 – 100 – 150 – 200 – 250
1 0.10 0 150 100 50 0 – 50
2 0.20 0 150 300 250 200 150
3 0.30 0 150 300 450 400 350
4 0.20 0 150 300 450 600 550
Table 11.24
5 0.15 0 150 300 450 600 750
Computation of
EMV = 0 140 260 340 360 340 EMV
State of Nature Probability Payoff for Expected Payoff

(Demand) Perfect Information for Perfect Information
(1) (2) (3) = (1) × (2)
0 0.05 0 0
1 0.10 150 15
2 0.20 300 60
3 0.30 450 135
4 0.20 600 120
Table 11.25
5 0.15 750 112.5
Computation of
442.5 EPPI
Account: ns145102
The expected value of perfect information is given by

EVPI = EPPI – EMV* = 442.5 – 360 = Rs. 82.5.
(c) On the basis of the given data, the dealer should not be willing to spend more than Rs. 82.5 for the market
survey.
Example 11.15 XYZ company is considering issuing 1,00,000 shares to raise capital needed for expansion. It
is estimated that if the issues were made now, it would be fully taken up at a price of Rs. 30 per share. However, the
company is facing two crucial situations, both of which may influence the share price in the near future, namely:
(i) A wage dispute with tool room operators which could lead to a strike and have an adverse effect on the
share price.
(ii) The possibility of a substantial contract with a large company overseas which would increase the share
price.
The four possible outcomes and their expected effect on the company’s share prices are:
E1 : No strike and contract obtained–share price rises to Rs. 34.
E2 : Strike and contract obtained–share price stays at Rs. 30.
E3 : No strike and contract lost–share price raises to Rs. 32.
E4 : Strike and contract lost–share price falls to Rs. 16.
Management has identified three possible strategies that the company could adopt, namely
A1 : Issue 1,00,000 shares now
A2 : Issue 1,00,000 shares only after the outcomes of (i) and (ii) are known
A3 : Issue 5,00,000 shares now and 50,000 shares after the outcomes of (i) and (ii) are known.
(a) Determine the maximax solution. What alternative criterion might be used?
(b) It has been estimated that the probability of a strike is 55 per cent and that there is a 65 per cent chance
of getting the contract, these probabilities being independent. Determine the optimum policy for the
company using the criterion of maximizing expected pay-off.
(c) Determine the expected value of perfect information for the company.
Solution The payoff values are shown in Table 11.26
States of Probability Conditional Payoff (Rs. lakh) Conditional Loss (Rs. lakh)
Nature Alternative Strategy Alternative Strategy
A1 A2 A3 A1 A2 A3
E1 (1 – 0.55) × 0.65 = 0.2925 30 34 0.5 × 30 + 0.5 × 34 = 31 4 0 3
E2 0.55 × 0.65 = 0.3575 30 30 0.5 × 30 + 0.5 × 30 = 30 0 0 0
E3 (1 – 0.55)(1 – 0.65) = 0.1575 30 32 0.5 × 30 + 0.5 × 32 = 30.5 2 0 1.5
E4 0.55 × (1 – 0.65) = 0.1925 30 16 0.5 × 30 + 0.5 × 16 = 23 0 14 7
Table 11.26 Expected Values 30 34 31
A strategy with highest minimum (maximin) payoff (i.e. 30) is A1 and a strategy with highest (maximax) pay-
off (i.e. 34) is A2. Since highest pay-off of Rs. 30 lakh is obtained corresponding to strategy A1, the company
should adopt strategy A1.
(c) Calculations for expected value of the perfect information are shown in Table 15.27.
State of Nature Maximum Pay-off Probability Expected Pay-off with

Perfect Information
E1 34 0.2925 9.94
E2 30 0.3575 10.72
E3 32 0.1575 5.04
Table 11.27 E4 16 0.1925 5.78
EVPI
31.48
Hence, expected value of perfect information is : 31.48 – 30 = Rs. 1,48,000.
Account: ns145102
Example 11.16 A vegetable seller buys tomatoes for Rs. 45 a box and sells them for Rs. 80 per box. If the
box is not sold on the first selling day, it is worth Rs. 15 as salvage. The past records indicate that demand is
normally distriubuted, with a mean of 30 boxes daily and a standard deviation of 9 boxes. How many boxes
should he stock?
Solution The probability of selling at least one additional unit (box) to justify the stocking of additional unit
is given by
IL (45 − 15)
p= = = 30 = 0.462
IP + IL (80 − 45) + (45 − 15) 65
where Incremental loss (IL) = Cost price – Salvage price
Incremental profit (IP) = Selling price – Cost price
This implies that the vegetable seller must be 46.2 per cent sure
of selling at least one additional unit before he should pay to
stock an additional unit. The vegetable seller should stock
additional boxes until point A is reached. If more units are stocked,
then the probability will fall below 0.462.
Fig. 11.1
The point A is at 0.1 standard deviation to the right of the mean
x = 30. Since the standard deviation of the distribution of past
demand is 9 boxes, point A can be located as follows:
Point A = Mean + Standard deviation = 30 + 0.1 × 9 = 30.1 31 boxes
Hence, the fruit seller should stock 31 boxes.
Example 11.17 A stall at a certain railway station sells for Rs. 1.50 paise a copy of daily newspaper for
which it pays Rs. 1.20. Unsold papers are returned for a refund of Re. 0.95 a copy. Daily sales and corresponding
probabilities are as follows :
Daily sales : 500 600 700
Probability : 0.5 0.3 0.2
(a) How many copies should it order each day to get maximum expected profit?
(b) If unsold copies cannot be returned and are useless, what should be the optimal order each day? Use
increment analysis.
Solution Given that, Incremental profit (IP) = Rs. (1.50 – 1.20) = Re. 0.30
Incremental loss (IL) = Rs. (1.20 – 0.95) = Re. 0.25
The probability (p) of selling at least one additional copy of the newspaper to justify keeping that additional
copy of newspaper is:
IL 0.25
p= = = 0.45.
IP + IL 0.30 + 0.25
Thus to justify the ordering of an additional copy, there must be at least 0.45 cumulative probability of selling
that copy. Cumulative probabilities are computed below:
Daily sales : 500 600 700
Probability : 0.50 0.30 0.20
Comulative
probability : 1.00 0.50 0.20
Hence, the optimal order size is 600 copies.
(b) If unsold copies are non-refundable, then
IL 1.20 1.20
p= = = = 0.80
IP + IL 0.30 + 1.20 1.50
Hence, optimal order size is, 500 copies.
Example 11.18 The demand pattern of the cakes made in a bakery is as follows:
No. of cakes demanded : 0 1 2 3 4 5
Probability : 0.05 0.10 0.25 0.30 0.20 0.10
If the preparation cost is Rs 30 per unit and selling price is Rs 40 per unit, how many cakes should
the baker bake for maximizing his profit?
Account: ns145102
Solution Given that incremental cost (IC) to prepare a cake is Rs 30 per unit and incremental price (IP)
to sell a cake is Rs 40 per unit. The cumulative probability ( p) of selling at least an additional unit of cake
to justify the stocking of that additional unit of cake is given by
IC 30
p= = = 0.428
IC + IP 30 + 40
The cumulative probabilities of greater than type are computed as shown in Table 11.28.
Demand Probability Cumulative Probability

( No. of Cakes) P (Demand = k) P (Demand ≥ k)
0 0.05 1.00
1 0.10 0.95
2 0.25 0.85
3 0.30 0.60 ←
4 0.20 0.30
Table 11.28 5 0.10 0.10
Since P(demand ≥ k) that exceeds the critical ratio, p = 0.428 is k = 3 units of cake, the optimal decision
is to prepare only 3 cakes.
11.6 POSTERIOR PROBABILITIES AND BAYESIAN ANALYSIS

An initial probability statement to evaluate expected payoff is called a prior probability distribution, but
if the probability statement has been revised due to additional information, then such a probability
Posterior statement is called a posterior probability distribution.
probabilities are In this section we will discuss the method of computing posterior probabilities, given prior probabilities
the revised
probabilities of the
using Bayes’ theorem. The analysis of problems using posterior probabilities with new expected payoffs
states of nature and additional information, is called prior-posterior analysis.
obtained after
conducting a test to Baye’s Theorem Statement
improve the prior
probabilities of Let A1, A2, . . ., An be mutually exclusive and collectively exhaustive outcomes. Their probabilities P(A1),
respective nature. P(A2), . . ., P(An) are known. There is an experimental outcome B for which the conditional probabilities
P(B | A1), P(B | A2), . . ., P(B | An) are also known. Given the information that outcome B has occurred, the
revised conditional probabilities of outcomes Ai, i.e. P(Ai | B), i = 1, 2, . . ., n are determined by using the
following relationship:
P ( Ai and B ) P ( Ai ∩ B ) P ( Ai ) P ( B | Ai )
P ( Ai | B ) = = =
P( B) P( B) P( B)
n
where P( B) = ∑ P( Ai ) P( B | Ai )
i =1
Since each joint probability can be expressed as the product of a known marginal (prior) and conditional
probability, i.e., P ( Ai ∩ B ) = P ( Ai ) × P ( B | Ai )
Example 11.19 A company is considering to introduce a new product to its existing product range. It
has defined two levels of sales as ‘high’ and ‘low’ on which it wants to base its decision and has estimated
Baye’s decision the changes that each market level will occur, together with their costs and consequent profits or losses.
rule uses the prior This information is summarized below:
probabilities to
determine the States of Nature Probability Courses of Action
expected payoff for

each decision Market the Product Do not Market the
alternatives and (Rs ’000) Product (Rs ’000)
then chooses the
one with the largest High sales 0.3 150 0
expected payoff. Low sales 0.7 – 40 0
The company’s marketing manager suggests that a market research survey may be undertaken to
provide further information on which the company should base its decision. Based on the company’s past
Account: ns145102
experience with a certain market research organization, the marketing manager assesses its ability to give
good information in the light of subsequent actual sales achievements. This information is given below:
Market Research Actual Sales

(Survey outcome)
Market ‘high’ Market ‘low’
‘High’ sales forecast 0.5 0.1

Indecisive survey report 0.3 0.4
‘Low’ sales forecast 0.2 0.1
The market research survey costs Rs 20,000, state whether or not there is a case for employing the
market research organization. [Delhi Univ., MBA, 2000]
Solution The expected monetary value (EMV) for each course of action is shown in Table 11.29.
States of Prior Courses of Action Expected Profit (’000 Rs)

Nature Probability
Market Do not Market Market Do not Market
High sales (N1) 0.3 150 0 45 0
Low sales (N2) 0.7 – 40 0 – 28 0
EMV = 17 = 0 Table 11.29
With no additional information, the company should choose course of action ‘market the product’.
However, if the company had the perfect information about the ‘low sales’, then company would not go
ahead with the decision because expected value would be (–) Rs 28,000. Thus, the value of perfect
information is the expected value of low sales.
Let outcomes of the research survey be: high sales (S1), indecisive report (S2) and low sales (S3) and
states of nature be: high market (N1) and low market (N2). The calculations for prior probabilities of forecast
are shown in Table 11.30.
Outcome Sales Prediction

High Market ( N1 ) Low Market ( N2 )
High sales (S1) P(S1 | N1) = 0.5 P(S1 | N2) = 0.1

Indecisive report (S2) P(S2 | N1) = 0.3 P(S2 | N2) = 0.4
Low sales (S3) P(S3 | N1) = 0.2 P(S3 | N2) = 0.5 Table 11.30
With additional information, the company can now revise the prior probabilities of outcomes to get posterior
probabilities. The calculations of the revised probabilities, given the sales forecast are shown in Table 11.31.
States of Nature Prior Conditional Joint Probability

Probability Probability P(Si ∩ Ni) = P(Ni) P(Si | Ni)
P(Ni) P(Si | Ni)
High sales (N1) 0.3 P(S1 | N1) = 0.5 0.15 – –

P(S2 | N1) = 0.3 – 0.09 –
P(S3 | N1) = 0.2 – – 0.06
Low sales (N2) 0.7 P(S1 | N2) = 0.1 0.07 – –

P(S2 | N2) = 0.4 – 0.28 –
Table 11.31
P(S3 | N2) = 0.5 – – 0.35
Revised
Marginal Probability 0.22 0.37 0.41 Probabilities
Account: ns145102
The posterior probabilities of actual sales, given the sales forecast, are:
Outcome Probability States of Nature Posterior Probability

(Si) P(Si) (Ni) P(Ni | Si) = P(Ni ∩ Si)/P(Si)
S1 0.22 N1 0.15/0.22 = 0.681

N2 0.07/0.22 = 0.318
S2 0.37 N1 0.09/0.37 = 0.243

N2 0.28/0.37 = 0.756
S3 0.41 N1 0.06/0.41 = 0.146

N2 0.35/0.41 = 0.853
Given the additional information, the revised probabilities to calculate net expected value with respect
to each outcome are shown in Table 11.32.
Sales Forecast
States of Nature Revised High Indecisive Low
Conditional
Profit (Rs) Prob. EV (Rs) Prob. EV (Rs) Prob. EV (Rs)
High sales 130 0.681 88.53 0.243 31.59 0.146 18.98

Low sales – 60 0.318 –19.08 0.756 – 45.36 0.853 – 51.18
Expected value of sales forecast 69.45 – 13.77 – 32.20

Probability of occurrence 0.22 0.37 0.41
Net expected value
Table 11.32 (Expected value × Probability) 15.279 – 5.095 13.202
CONCEPTUAL QUESTIONS B
1. Given the complete set of outcomes in a certain situation, how 4. Briefly explain ‘expected value of perfect information’ with
is the EMV determined for a specific course of action? Explain examples.
in your own words. 5. Describe a business situation where a decision-maker faces a
2. Explain the difference between expected opportunity loss and decision under uncertainty and where a decision based on
expected value of perfect information. maximizing the expected monetary value cannot be made. How
3. Indicate the difference between decision-making under risk, and do you think the decision-maker should make the required
uncertainty, in statistical decision theory. decision?
SELF PRACTICE PROBLEMS B
1. You are given the following payoffs of three acts A1, A2 and A3
Product Nature of Demand
and the events E1, E2, E3.
Good Moderate Poor
States of Three Acts X 0.70 0.20 0.10

Nature A1 A3 A3 Y 0.50 0.30 0.20
Z 0.40 0.50 0.10
E1 25 – 10 – 125
E2 400 440 400 The estimated profit or loss in rupees under the three states
may be taken as:
E3 650 740 750
Product Good Moderate Poor

The probabilities of the states of nature are 0.1, 0.7 and 0.2,
respectively. Calculate and tabulate the EMV and conclude X 30,000 20,000 10,000
which would prove to be the best course of action. Y 60,000 30,000 20,000
2. The management of a company is faced with the problem of Z 40,000 10,000 – 15,000
choosing one of three products that it wants to manufacture.
The potential demand for each product may turn out to be good, Prepare the expected value table, and advise the management
moderate or poor. The probabilities for each of the states of about the choice of product.
nature were estimated as follows.
Account: ns145102

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Decision Theory and Decision Trees 347

HINTS AND ANSWERS

11.5 DECISION-MAKING UNDER RISK

11.5.1 Expected Monetary Value (EMV)

Expected monetary 9,175 9,330 9,550

70 0.1 140 130 120 110 14 13 12 11

Demand of Probability Conditional Payoff (Rs) due to Decision to Purchase Cars

0 0.1 0 – 90 – 180 – 270 – 360

Demand of Probability Conditional Payoff (Rs) due to Decision to Purchase Cars

11.5.2 Expected Opportunity Loss (EOL)

4. Select a course of action for which the EOL is minimum.

Proportion of Conditional Profit = Rs (4,00,000 p – 60,000)

Opportunity loss values are shown in Table 11.9.

Proportion of Probability Conditional Profit (Rs) Opportunity Loss (Rs)

State of Nature Conditional Profit (million Rs) due to

Expand (S1) Modernize (S2)

Table 11.11 High demand 0.35 4 1

(Demand) of Action (Rs million)

High demand 0.35 S1 4 4 × 0.35 = 1.40

State of Nature Probability Conditional Profit Conditional Opportunity

High demand (N1) 0.35 4 1 0 3

State of Nature Course of Action Purchase Emergency Total Conditional

State of Nature Probability Conditional Cost Due to Weighted Cost Due to

N1 0.80 0 1,500 3,000 0.80 (0) 1,200 2,400

N1 0.80 0 1,500 3,000 0.80(0) 1,200 2,400

States of Probability Optimal Course Cost of Optimal Course of Action (Rs)

Rating Proportion of Frequency

Rating Defective Probability Cost Opportunity Loss

A 0.02 0.25 600 200 400 0

The cost of refund is calculated as follows:

Demand (units) Probability

Light 0.10 25,000 – 10,000 – 1,25,000 2,500 – 1,000 – 12,500

States of Probability Courses of Action

Light 0.10 25,000 – 10,000 – 1,25,000 25,000 2,500

State of Nature Probability Conditional Cost (Rs.)

State of Nature Probability Minimum Cost Expected Cost for

EVPI = Conditional Cost – ECPI = 230 – 147.5 = Rs. 82.5.

State of Nature Probability Conditioinal Payoff

State of Nature Probability Payoff for Expected Payoff

The expected value of perfect information is given by

State of Nature Maximum Pay-off Probability Expected Pay-off with

Hence, expected value of perfect information is : 31.48 – 30 = Rs. 1,48,000.

Demand Probability Cumulative Probability

11.6 POSTERIOR PROBABILITIES AND BAYESIAN ANALYSIS

expected payoff for

Market Research Actual Sales

‘High’ sales forecast 0.5 0.1

States of Prior Courses of Action Expected Profit (’000 Rs)

Outcome Sales Prediction

High sales (S1) P(S1 | N1) = 0.5 P(S1 | N2) = 0.1

States of Nature Prior Conditional Joint Probability

High sales (N1) 0.3 P(S1 | N1) = 0.5 0.15 – –

Low sales (N2) 0.7 P(S1 | N2) = 0.1 0.07 – –

Outcome Probability States of Nature Posterior Probability

S1 0.22 N1 0.15/0.22 = 0.681

S2 0.37 N1 0.09/0.37 = 0.243

S3 0.41 N1 0.06/0.41 = 0.146

High sales 130 0.681 88.53 0.243 31.59 0.146 18.98

Expected value of sales forecast 69.45 – 13.77 – 32.20

SELF PRACTICE PROBLEMS B

States of Three Acts X 0.70 0.20 0.10

Product Good Moderate Poor

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