Академический Документы
Профессиональный Документы
Культура Документы
Introduction to
Decision Analysis
18-1 DECISION-MAKING ENVIRONMENTS AND DECISION CRITERIA
18-2 COST OF UNCERTAINTY
18-3 DECISION-TREE ANALYSIS
CHAPTER OUTCOMES
After studying the material in Chapter 18, you should be able to:
18-2
CERTAINTY
Sometimes you will encounter a decision situation in which you can be certain of the outcome for
each alternative. This type of decision environment, in which the results of each alternative are
known before the decision is made, is termed a certainty environment.
Certainty
A decision environment in which the results of selecting each alternative are known before the
decision is made.
TABLE 18-1
Econoprint Company:
Profits and Losses for
Two Alternatives
18-3
ALTERNATIVES
REVENUES AND EXPENSES
Revenues
Sales (1 million $5.00)
Costs
Production (1 million $4.50)
Selling (5% of sales)
Overhead (1% of sales)
Profit
Accept Offer
Reject Offer
$5,000,000
$4,500,000
250,000
$4,050,000
$ 200,000
0
0
0
0
best satisfies the decision criterion. In the Econoprint Company example, the decision criterion was
highest profit. Given that the decision model displayed in Table 18-1 utilized all available information, the best decision was to accept the offer. Because this is a certainty environment, the decision
will result in an outcome of $200,000 profit. Thus, in a certainty environment, the best decision will
always be associated with the best outcome.
UNCERTAINTY
If business decisions were always made in a certainty environment, you would probably not need
the academic training you are now receiving to be successful. How many of us would have chosen
to reject the offer in the Econoprint Company example if Table 18-1 reflected the total decision picture? In reality, the typical business decision-making environment is not one of certainty but, rather,
uncertainty.
Uncertainty
A decision environment in which the decision maker does not know what outcome will occur
when an alternative is selected.
The certainty environment is predicated on the fact that the outcome from each alternative
course of action is known. If we choose alternative A, outcome Y will occur. If alternative B is
selected, outcome Z will occur. This makes choosing between the alternatives straightforward.
However, in most business situations, although we may be able to specify the possible outcomes for each alternative, we will be uncertain about which outcome will occur. Consider the real
estate speculator who is trying to decide whether to purchase land outside of Las Vegas, one of the
fastest growing cities in the country, hoping to resell the land to a developer. If the speculator elects
not to purchase the property, the net change in his financial position will be zero. He knows this for
sure. However, if he chooses to buy the land, what will the outcome be? Will he make $10,000,000,
or $20,000,000, or will he lose $5,000,000? Identifying the possible outcomes is difficult enough,
but knowing for certain what outcome definitely will occur is impossible in a competitive real estate
market. Thus, the speculator must decide whether to buy in an environment of uncertainty.
Eagle Lumber CompanyConsider the Eagle Lumber Company in Glenns Ferry, Wisconsin.
About three weeks ago, the manager received 4,000 board feet of 2-inch-by-6-inch tongue-and-groove
knotty pine, which is used primarily for walls and ceilings. The product is hard to get because the
supplier makes only a limited quantity each month. The wholesale price for the recent shipment was
$360 per 1,000 board feet. Two days after receiving the material, a customer came in and bought the
entire shipment for $450 per 1,000 board feet. However, the customer wanted Eagle Lumber to store
the material for eight weeks.
Two weeks later, another customer arrived and wanted to purchase as much 2-inch-by-6-inch
tongue-and-groove knotty pine as possible for immediate use. The only stock on hand at the lumber
company at the time was the 4,000 board feet, which had already been sold. After seeing the paidfor knotty pine, the new customer asked whether the manager would consider selling him the 4,000
board feet now and replacing the material before the previous customer returned to pick it up in
about seven weeks.
In a certain environment, the decision would be relatively easy. If the lumber could be replaced
at a known price before the first customer returned, the manager could resell the material and both
18-4
customers would be happy. If the lumber could not be replaced before the first customer returned,
the second customer would be turned away. Unfortunately, the decision environment facing Eagles
manager is not one of certainty. For one thing, he does not know whether he will be able to replace
the stock within seven weeks. Furthermore, if he is able to replace the material, he does not know
exactly what the cost will be. Therefore, he is uncertain about what price to charge the second customer. He is also uncertain about whether the first customer will arrive early to take his material. As
you can see, a seemingly simple situation is actually quite complex due to the uncertainties
involved.
The decision-analysis techniques presented in this chapter do not eliminate the uncertainty
associated with a decision, but they do provide a framework for dealing with the uncertainty. These
techniques help you make good decisions under certain conditions, but good decisions dont necessarily result in good outcomes. For instance, suppose after considering all available information that
the best decision is not to sell to the new customer. Then, a week later, the original customer calls to
say he will be six weeks late picking up the material. If the manager had known this, he could have
sold the materials to the new customer and received the additional profit. Thus, the best decision at
the time did not result in a good outcome.
This concept of decision analysis is contrary to how many people view situations. The tendency
is to look at the outcome and, if it is not good, we second-guess our decision. However, if we have
properly used all available information in making the decision, it was a good decision. Decision
makers must realize that in an uncertain environment, in which they dont have total control over the
outcomes of their decisions, bad outcomes will sometimes occur. Decision makers must also continually remind themselves that there is a difference between a good decision and a good outcome.
The goal of decision analysis is to focus on making good decisions, which in the long run should
result in an increased number of good outcomes.
Not all decisions require the use of decision analysis; the complexity of the decision situation
usually determines the usefulness of decision analysis. The more complex the decision, the greater
the potential benefit from decision analysis. Several factors affect the complexity of a decision,
including the number of alternatives available to the decision maker, the number of possible outcomes associated with each alternative, and the general level of uncertainty associated with the
decision. For example, marketing decisions regarding product design, product pricing, and distribution are very complex, and decision-analysis tools can be helpful to the decision maker. Of course,
any decision involving product design or pricing also involves other areas in an organization,
including production and finance.
Another characteristic of situations in which decisions can be aided by decision analysis is that
they often extend to multiple functional areas of an organization. Production decisions, including
process design, aggregate planning, and facilities planning, all lend themselves to decision analysis
because of their complexity and long-term importance to the organization. Such financial decision
areas as capital budgeting, project financing, and pension investing clearly can benefit from the
application of decision analysis.
The types of decisions mentioned here are only a few of those in which decision analysis can be
effectively applied. Throughout the remainder of this chapter, we will present further examples in
which decision analysis can be used to aid business decision making.
DECISION CRITERIA
When you are faced with choices between two or more options in a business situation, you are
required to make a decision. Unless you are willing to flip a coin, draw straws, or use some other
random method, you will need to establish some basis for making the decision. The criteria on
which the decision is to be made needs to be established. Then, ideally, you will perform an analysis of the decision situation and make the best choice by weighing each decision option against
the criteria you have established.
Fisher FabricationFisher Fabrication has been in business for 10 years in eastern Tennessee.
The company was started by two brothers who had worked in the electronics industry in Texas and
California. They wanted to get back to where they grew up, and they saw that many electronics
companies were beginning to subcontract their assembly work, particularly on small-volume items.
They saw an opportunity to get into the subcontracting business and decided to move back home.
They found a dedicated workforce and soon employed 150 people.
18-5
The brothers concentrated on manual assembly of limited-volume items such as special equipment for oil exploration, vehicles, and military contracts. Business had been extremely good until
two years ago, when revenues began to decline slightly. By contacting past customers, the brothers
determined the drop in sales was due to the increasing use companies were making of surfacemounted components, something the Fishers were not able to do by hand.
This finding made the brothers realize their company must invest in a surface-mount machine,
but they were uncertain about the extent of the investment needed. Initial research led them to identify three potential courses of action (alternatives):
A1: A large investment, which would involve purchasing a full-scale surface-mount system, including robotics, thus allowing them to bid on the majority of present manufacturing contracts. This
equipment would give them greater capability.
A2: A medium investment, which would give them the same general capability as alternative A, but
the equipment would operate at a much lower speed. This would prevent them from bidding on
large contracts.
A3: A small investment, which would limit them to bidding on less than half of the potential contracts.
Obviously, the alternative the Fishers should select depended on the future revenues generated
by the new equipment. Consequently, the Fishers identified three potential directions that they
believed the demand for surface-mounted components could take. In decision-analysis terminology,
these three demand levels are referred to as states of nature.
States of Nature
The possible outcomes in a decision situation over which the decision maker has no control.
For the Fishers, the states of nature were:
S1: Rapidly increasing demand due to the capability of the surface-mount equipment
S2: Moderately increasing demand
S3: Slight increase in demand as more businesses added their own surface-mount capability
The Fishers wanted to base their investment decision on yearly profit values, but as we can see,
there were three potential profit levels, due to the three states of nature, for each alternative. The
outcome that is associated with any combination of a particular state of nature and an alternative is
called a payoff.
Payoff
The outcome (profit or loss) for any combination of alternative and state of nature. The payoffs
associated with all possible combinations of alternatives and states of nature constitute a payoff
table.
Because the brothers decision involved three alternatives and three states of nature, they had
nine possible payoffs to consider, as shown in the payoff table (Table 18-2).
In order to decide among the three alternatives, the Fishers had to have some basis for comparison, so they established decision criteria. There are two main categories of decision criteria:
nonprobabilistic and probabilistic. Nonprobabilistic criteria are used when either the probabilities
associated with the possible payoffs are unknown or the decision maker lacks confidence and/or
information with which to assess probabilities for the various payoffs. Probabilistic criteria incorporate the decision makers assessment of the probability of each state of nature occurring.
TABLE 18-2
Fisher Fabrication
Payoff Table
S1 Large Increase
S2 Moderate Increase
S3 Small Increase
$6,000,000
2,500,000
2,000,000
$4,000,000
5,000,000
1,500,000
$2,600,000
1,000,000
1,200,000
Note: These values are the Fishers estimates of the profit associated with each combination of alternative and state of nature.
18-6
TABLE 18-3
Fisher Fabrication:
Opportunity-Loss Table
18-7
S1 Large Increase
A1 Large Investment
A2 Medium Investment
A3 Small Investment
S2 Moderate Increase
0
3,500,000
4,000,000
S3 Small Increase
$1,000,000
0
3,500,000
$3,800,000
2,200,000
0
Note: The values in this table were found by subtracting each column value in Table 18-2 from the largest value in that column.
Observe that all three criteria lead to different decisions; therefore, the brothers would determine which criterion best described their decision-making philosophy and use it to help them
decide on their level of investment.
The maximax, maximin, and minimax regret decision criteria are examples of nonprobabilistic
decision criteria. Nonprobabilistic criteria do not take into account the probability associated with
the outcomes for each alternative; they merely focus on the dollar value of the outcomes. The criticism of nonprobabilistic decision criteria is aimed at their failure to include important information
about the chances of each outcome occurring. Decision analysts argue that if the payoff probabilities are known or can be assessed, a probabilistic decision criterion should be employed.
Expected-Value Criterion
The term expected value is often used in statistics to refer to the long-run average outcome for a
given alternative. In order to determine an expected value, we must have probabilities for each possible outcome. The expected value for a discrete variable is computed as follows.
Expected Value
k
E( x ) =
x i P( x i )
18-1
i =1
where:
xi = The ith outcome of the specified alternative measured in some units, such as dollars
P(xi) = The probability of outcome xi occurring
k = Number of potential outcomes
and:
k
P( x i ) = 1
18-2
0 P(xi) 1
18-3
i =1
TABLE 18-4
Fisher Fabrication
Maximum Regret Table
ALTERNATIVE
A1 Large Investment
A2 Medium Investment
A3 Small Investment
(smallest regret)
18-8
Equation 18-1 shows that the expected value is the sum of the weighted outcomes for a specified
alternative. This means that if the alternative is repeatedly selected, over the long run the average
outcome will equal E(x), the expected value.
Xircom, Inc. Consider the following simple decision situation, which involves Xircom, Inc., a
mobile connectivity leader. Its products provide notebook PC users the ability to access their corporate networks. Recently, its stock has been trading at $36.50 a share. There has been a rumor of
a merger between Xircom and one of its major competitors. The expected-value criterion can be
used to determine whether to invest in Xircom using the following steps.
Step 1:
Step 2:
Step 3:
Step 4:
P(x)
$10
$5
0.50
0.50
1.00
E( x ) =
x i P( x i )
i =1
When applying the expected-value criterion, the best decision is to select the alternative with
the highest average payoff or the lowest average loss. In Example 18-1, the stock purchase example,
the best decision, using the expected-value criterion, is to purchase the stock, because $2.50 > $0.
The advantage of the expected-value criterion is that it takes into account the information contained
in the probabilities.
The disadvantage of the expected-value criterion is that it does not take into account the decision
makers attitude toward risk. For instance, in the first case for the stock purchase example, the expected
value was $2.50. Clearly, on the basis of expected value we buy the stock, because $2.50 > $0. However,
18-9
if we purchase stock under these same conditions, we could lose $5. Depending on how averse we are to
this outcome, we might decide not to participate after all. Expected value is the decision criterion around
which the techniques of decision analysis are built and is the one emphasized throughout this chapter.
18-1: EXERCISES
a. Use the maximax criterion to determine which decision alternative to select.
b. Use the maximin criterion to determine which decision alternative to select.
c. Use the minimax regret criterion to determine which
decision alternative to select.
Skill Development
18.1
18.2
18.3
18.4
18.7
Business Applications
18.8
18.9
Alternatives
A1
A2
A3
S1
S2
S3
150
60
240
80
40
70
20
45
10
18.6
A1
A2
A3
A4
170
30
145
40
S2
45
190
50
80
S3
S4
60
175
120
10
100
65
110
70
18-10
0.20
0.30
0.50
Office
Probability
0.10
0.30
0.40
0.20
1.00
Advanced Applications
18.13 The Special Occasions Company, a nationwide distributor of flowers and greeting cards, has just contracted
with Global Floral to purchase up to 500,000 dozen red
and yellow roses for sale in the week before Valentines
Day. Special Occasions supplies flower shops and other
retail outlets from regional distribution centers throughout the country. The problem now facing the company
Probability
100,000
150,000
200,000
225,000
250,000
0.10
0.40
0.20
0.20
0.10
1.00
$10,000
$3.00 per box
$2.80 per box
$2.50 per box
Demand
500
1,000
2,000
4,000
7,000
Probability
0.15
0.20
0.20
0.30
0.15
1.00
18-11
$150,000
$250,000
$400,000
0
1
2
3
4
5
0.05
0.10
0.15
0.25
0.30
0.15
0
1
2
3
4
5
0.06
0.10
0.20
0.40
0.12
0.12
0
1
2
3
4
5
0.09
0.15
0.25
0.40
0.07
0.04
Haroldsons In the United States, more money is now being spent on take-out and restaurant
food than is spent buying groceries. Many grocery chains, in an effort to keep up with this trend,
have added extensive deli and take-out sections. Haroldsons is a regional chain that has joined the
movement. A popular packaged meal is made up of broiled chicken, potato salad, and a green
salad. However, because of several television news specials about potentially spoiled food,
Haroldsons has a company policy of giving all unsold food to a local homeless shelter at the end
of each day. Although the company doesnt mind giving the food away, it would rather sell all the
18-12
meals it prepares. Therefore, the question that deli managers face each day is how many meals to
make. To answer this question and to compute the cost of uncertainty in this situation, you can use
the following steps.
Step 1:
Step 2:
70
80
90
Step 3:
60
50
0.05
60
0.10
70
0.20
80
0.40
90
0.25
Assign appropriate revenue and cost values and establish the payoff function.
The fixed cost of setting up to cook the meals is $120, variable costs amount to
$1.50 per meal, and the selling price is $3.70 each. With this information, we find
the payoffs associated with different production levels by using the following
equation.
Payoff = $3.70(s) $120 $1.50(p)
where:
s = number of units sold
p = number of units produced
Step 4:
Step 5:
50
60
70
80
90
$10
25
40
55
70
$10
12
3
18
33
$10
12
34
19
4
$10
12
34
56
41
$10
12
34
56
78
Add the probabilities to the payoff table and compute the expected value for each
production decision using Equation 18-1.
18-13
The expected values are computed by summing the payoffs times the probabilities. For
example, the expected payoff for a production level of 80 meals is
E(payoff) = $55(.05) + $18(.10) + $19(.20) + $56(.40) + $56(.25)
= $35.65
Therefore, in the long run, the Deli manager can expect to make $35.65 if she prepares
80 meals of broiled chicken and potato salad. The other expected values are computed
in a similar manner.
Haroldsons Expected Values
DEMAND (STATES OF NATURE)
Step 6:
PRODUCTION
50
p = .05
50
60
70
80
90
$10
25
40
55
70
60
p = .1
$10
12
3
18
33
70
p = .2
80
p = .4
90
p = .25
$10
12
34
19
4
$10
12
34
56
41
$10
12
34
56
78
E(PAYOFF)
$10.00
10.15
26.60
35.65
29.90
18-14
18-2: EXERCISES
Skill Development
18.18 Consider the following payoff table, in which the probabilities associated with each state of nature are in parentheses.
Demand
States of Nature
Alternatives
A1
A2
A3
A4
S1(.2)
S2(.1)
S3(.4)
S4(.3)
170
30
145
40
45
190
50
80
60
175
120
10
100
65
110
70
Alternatives
S1
S2
S3
0.5
145
130
110
0.2
55
65
80
0.3
80
100
120
Probabilities
A1
A2
A3
Business Applications
18.20 Refer to Exercise 18.9 in Section 18-1 concerning the
number of hot dogs that Sal De Carlo should order for
10,000
15,000
20,000
25,000
Probability
0.20
0.25
0.30
0.25
18-15
Bighorn Oil Company Bighorn Oil Company has leased the drilling rights on a large parcel
of land in Wyoming that may or may not contain an oil reserve. A competitor has offered to lease
the land for $200,000 cash in return for drilling rights and all rights to any oil that might be found.
The offer will expire in three days. If Bighorn does not take the deal, it will be faced with the decision of whether to drill for oil on its own. Drilling costs are projected to be $400,000. The company
feels that there are four possible outcomes from drilling:
1. dry hole (no oil or natural gas)
2. natural gas
3. natural gas and some oil
4. oil only
If drilling yields a dry hole, the land will be basically worthless, because it is located in the badlands of Wyoming. If natural gas is discovered, Bighorn will recover only its drilling costs. If natural gas and some oil is discovered, revenue is projected to be $800,000. Finally, if only oil is discovered, revenues will be $1,600,000.
Decision-tree analysis can be used to help make the decision using the following steps.
Step 1: Grow the decision tree.
The decision tree is developed by organizing the decisions and events in chronological
order. In this example, the initial decision to be made is whether to accept the lease.
The tree is started as:
Lease out the land
If the land is leased, no further decisions are required. However, if the land is not leased,
Bighorn faces the decision of whether to drill on the property. The tree then grows to:
Lease out the land
Do not drill
Do not lease the land
Drill
Now, if Bighorn decides to drill, there are four possible events that could occur. These
are shown on the decision tree.
Lease out the land
Do not drill
Do not lease the land
Dry hole
Drill
Natural gas
Gas and oil
Oil only
18-16
Step 2:
When finished, the decision tree should show all the decisions and events.
Assign probabilities to the event outcomes on the tree.
In this example, the only event deals with the production result if Bighorn decides to
drill. The company has subjectively assessed the probability of each of the four possible outcomes as follows:
Outcome
Dry hole
Natural gas
Gas and oil
Oil only
Probability
0.20
0.40
0.30
0.10
Step 3:
End Values
$200,000
$0
0.20 Dry hole
$0
0.40 Natural gas
$400,000
0.30 Gas and oil
$800,000
0.10 Oil only
$1,600,000
Step 4:
$400,000
$0
$400,000
$1,200,000
Fold back the decision tree and compute the expected values for each decision.
We need to compute the expected value for each decision alternative. This is done
starting from the right side of the tree and working back to the left. We first determine
the expected value for the Drill branch as follows:
E[Drill] = $400,000(0.20) + $0(0.40) + $400,000(0.30) + $1,200,000(0.10)
= $160,000
18-17
As we fold back the tree, we block all decision alternatives that do not have the highest
expected value. This is shown in the decision tree as follows.
$200,000
End Values
$200,000
Do not drill
Drill
$400,000
$160,000
$0
0.20 Dry hole
$0
0.40 Natural gas
$400,000
0.30 Gas and oil
$800,000
0.10 Oil only
$1,600,000
$400,000
$0
$400,000
$1,200,000
Note that we always select the decision with the highest expected payoff. In this example, the best decision is to lease the land and accept the $200,000 payment because it
exceeds the $160,000 expected value of the not-lease option.
The value of decision-tree analysis is that a tree helps you to visually structure the decision
problem and to systematically analyze the decision alternatives. Decision-tree analysis also provides a way for you to take into account future decisions when making the most current decision.
The Bighorn example was a very simple one that could have easily been handled without a decision
tree. The following application is a little more complicated, and you should see the advantage of
using decision-tree analysis.
PROBABILITY
0.40
0.60
4. The fixed production costs for the hardcover book will be $700,000 before any copies are printed,
and the cost of printing and binding is $16.00 per copy. The number of copies to be printed can
match any projected demand. The wholesale selling price of the hardcover book will be $24.00.
18-18
5. For paperback publication, the following demand distribution has been assessed:
DEMAND
50,000 copies
1,500,000 copies
PROBABILITY
0.30
0.70
6. The fixed costs for paperback publication are $400,000, the printing and binding costs are
$2.00 per copy, and the wholesale selling price is $8.00 each.
7. The accuracy of the books content will be known only after the book has been published and sold.
8. The editor has assessed the probability that the manuscript will get a favorable review from the
editorial board as 0.80.
The decision in this case is complicated by the many uncertainties involved. In situations such
as these, a decision tree can be used to provide a framework to help make the decision. The following steps are used to develop and apply a decision tree to a decision problem such as the one the
Harris Publishing Company is facing.
Dont Sign
Sign
Contract
Decision
Dont Sign
Unfavorable
Review
Sign
Contract
Favorable
Review
Decision
Event
FIGURE 18-3
Harris Publishing Decision
Tree: Phase 3
Dont Sign
Unfavorable
Review
Hardcover
Sign
Contract
Favorable
Review
Paperback
Decision
Event
Decision
18-19
18-20
FIGURE 18-4
Harris Publishing Decision
Tree: Phase 4
Dont Sign
Unfavorable
Review
100,000 Copies
Hardcover
Sign
Contract
1,000,000
Copies
Favorable
Review
50,000 Copies
Paperback
1,500,000
Copies
Decision
Event
Decision
Event
Figure 18-6 shows the final set of branches, which relate to the possibility of a libel suit. If we
have correctly described the decision problem, this tree is a model of the decision facing the Harris
Publishing Company. After reaching the point at which you think the tree is complete, conferring with
someone who has not been involved in developing the tree can be helpful. A fresh perspective is often
useful in finding oversights and inconsistencies in a decision tree. The decision tree should reflect the
decision problem as accurately as possible before any further analysis is performed using the tree.
18-21
FIGURE 18-5
Harris Publishing Decision
Tree: Phase 5
Dont Sign
Accurate
Unfavorable
Review
100,000 Copies
Not Accurate
Hardcover
Accurate
Sign
Contract
1,000,000
Copies
Not Accurate
Favorable
Review
Accurate
50,000 Copies
Not Accurate
Paperback
Accurate
1,500,000
Copies
Not Accurate
Decision
Event
Decision
Event
Event
4. There is an 0.80 chance that the content of the book will prove accurate.
5. There is a 0.90 chance the publisher will be sued for libel if the book turns out to be inaccurate.
Figure 18-7 shows the decision tree with the probabilities assigned. Remember, probabilities
must be assigned to every event branch. The sum of the probabilities for each event fork must be 1.
18-22
Dont Sign
Accurate
Unfavorable
Review
100,000 Copies
Suit
Not Accurate
Hardcover
No Suit
Accurate
Sign
Contract
Suit
1,000,000
Copies
Not Accurate
No Suit
Favorable
Review
Accurate
50,000 Copies
Suit
Not Accurate
No Suit
Paperback
Accurate
Suit
1,500,000
Copies
Not Accurate
No Suit
Decision
Event
Decision
Event
Event
Event
FIGURE 18-6
Harris Publishing Decision Tree: Phase 6, Final Tree
Next, we assign the cash flows associated with the demand levels for hardcover and paperback. For
example, if the hardcover decision is selected and demand is 100,000 copies, the following cash flow
will occur:
Revenue 100,000 at $24.00 each =
$2,400,000
Expenses 100,000 at $16.00 each = 1,600,000
Net cash flow
=
$ 800,000
This $800,000 cash flow is shown in Figure 18-8. You may be wondering what happened to the
authors royalties. These are to be paid only when the books accuracy has been verified. For purposes of this decision, this is the same as paying the author when the books are sold and having him
return the money if the book proves to be inaccurate.
18-23
Dont Sign
Accurate
Unfavorable
Review
100,000 Copies
0.4
0.2
0.8
Suit
0.2
0.9
Not Accurate
0.1
Hardcover
No Suit
Accurate
0.6
Sign
Contract
0.8
1,000,000
Copies
0.8
Suit
0.2
0.9
Not Accurate
0.1
No Suit
Favorable
Review
Accurate
50,000 Copies
0.3
0.8
Suit
0.2
0.9
Not Accurate
0.1
No Suit
Paperback
Accurate
0.7
0.8
1,500,000
Copies
Suit
0.2
0.9
Not Accurate
0.1
No Suit
Decision
Event
Decision
Event
Event
Event
FIGURE 18-7
Harris Publishing Co.Assigning Probabilities
If the hardcover book sells 1,000,000 copies, the cash flow will be
Revenue 1,000,000 at $24.00 each = $24,000,000
Expenses 1,000,000 at $16.00 each = 16,000,000
Net cash flow
= $ 8,000,000
Likewise, if the paperback option is selected, the cash flow associated with 50,000 copies will be:
Revenue 50,000 at $8.00 each = $400,000
Expenses 50,000 at $2.00 each = 100,000
Net cash flow
= $300,000
18-24
$0
$0
Unfavorable
Review
$0
Accurate
100,000 Copies
$400
$800
0.4
0.2
0.8
0.2
Suit
$0
Not Accurate
Hardcover
$400
0.1
$0
Accurate
0.6
$8,000
1,000,000
Copies
0.8
0.9 $1,800
No Suit
$700
Sign
Contract
$500
$200
0.8 $2,000
0.2
$0
Not Accurate
$0
Suit
0.9 $1,800
0.1
$0
Accurate
50,000 Copies
$300
0.3
0.8
0.2
Suit
Not Accurate
$400
0.9 $1,800
0.1
$0
No Suit
Paperback
Accurate
0.7
$9,000
1,500,000
Copies
0.8 $1,200
0.2
$0
Not Accurate
Event
Decision
Event
Event
$6,900
$2,300
$500
$7,000
Suit
0.9 $1,800
0.1
$0
No Suit
Decision
$5,100
$540
$40
$0
$300
$4,900
No Suit
Favorable
Review
$2,100
$6,400
$8,200
Event
FIGURE 18-8
Harris Publishing Co.Assigning Cash Flows ($ 1,000)
18-25
$0
Unfavorable
Review
Accurate
$400
100,000 Copies
0.4
0.2
0.8
$500
Suit
0.2
0.9
Not Accurate
0.1
Hardcover
No Suit
Accurate
0.6
Sign
Contract
0.8
1,000,000
Copies
0.8
Suit
0.2
0.9
Not Accurate
0.1
Accurate
50,000 Copies
0.3
0.8
0.2
0.9
Not Accurate
0.1
No Suit
Accurate
0.7
0.8
1,500,000
Copies
Event
Decision
Event
Suit
0.2
0.9
Not Accurate
0.1
Event
$6,900
$2,300
$500
$7,000
No Suit
Decision
$5,100
$540
Suit
Paperback
$300
$4,900
No Suit
Favorable
Review
$2,100
$6,400
$8,200
Event
FIGURE 18-9
Harris Publishing Co.Final Decision Tree
to settle (Figure 18-8). The editor agrees this amount is more than adequate to stop the suit. Because
there are no other cash flows to be considered in this decision, the last step is to accumulate the cash
flows from left to right and put the net cash flow for each branch to the right of the each branch in
Figure 18-8. These are called the end values.
18-26
$0
$0
Unfavorable
Review
Accurate
$400
100,000 Copies
0.4
0.2
Hardcover
$3,587.52
Sign
Contract
$784
Suit
0.9
Not Accurate
0.1
$2,100
$1,920
No Suit
Accurate
0.6
0.8
1,000,000
Copies
0.8
$500
0.2
$2,672
$2,672
$3,587.52
0.8
$4,976
$4,900
Suit
0.2
0.9
Not Accurate
0.1
$5,100
$5,280
No Suit
Favorable
Review
Accurate
50,000 Copies
0.3
$4,584.40
0.8
$856
Suit
0.9
Not Accurate
0.1
$2,300
$2,120
No Suit
Accurate
0.7
0.8
1,500,000
Copies
$6,916
Event
Decision
Event
Suit
0.2
0.9
Not Accurate
0.1
Event
$500
$7,000
$6,400
$6,580
No Suit
Decision
$6,900
$540
0.2
$4,584.40
Paperback
$300
$8,200
Event
FIGURE 18-10
Harris Publishing Co.Folding Back the Decision Tree
to the initial decision at the far left. To do this, we must determine the expected value of each decision branch. (Please refer to Figure 18-10 as we discuss the fold-back steps.)
Because the Dont sign contract branch has no following uncertain events, the end value of $0
is the expected value of that decision alternative. This expected value is displayed in a box near the
decision fork.
The process of finding the expected value for the Sign contract branch requires a little more
effort. To begin, we go to each event branch at which Suit and No suit are the possible outcomes. We
compute the expected values of these events by multiplying the end value times the probability of
each outcome. For instance, for the event branch emanating from the Hardcover, 100,000 copies,
not accurate branch, the expected value is
EV = $2,100(0.90) + $300(0.10) = $1,920
This expected value is displayed inside the oval between the two event branches. We use the same
procedure to find expected values for all Suit/No suit event branches, as shown in Figure 18-10.
(Note: All dollar amounts are in thousands.)
18-27
Next, we determine the expected value of the event Accurate/Not accurate in each instance in
the tree where the event appears. To illustrate, we will use the event emanating from the Hardcover,
100,000 copies branch. The expected value is
EV = $500(0.80) + $1,920(0.20) = $784
This value is shown in the oval between the two event branches. Note that in computing the expected
value, we used $1,920, the expected value of the Suit/No suit event. This value was multiplied by the
0.20 probability that the content of the manuscript will not be accurate. The 0.80 chance that the manuscript will be accurate is multiplied by $500, because that is the expected value of the Accurate branch.
The expected value of the Accurate/Not accurate event emanating from the Hardcover,
1,000,000 copies branch is:
EV = $4,900(0.80) + $5,280(0.20) = $4,976
This value is also shown in Figure 18-10, in the oval between the two outcome branches. The same
methodology is used in the lower portion of the tree. This process of moving from right to left is
what we mean by folding back the tree.
We continue by determining the expected values of the demand events. For instance, the
expected value for the demand event emanating from the Hardcover branch is
EV = $784(0.40) + $4,976(0.60) = $2,672
This value is also the expected value of the Hardcover decision branch. This means that the
expected value of the hardcover alternative is $2,672 (actually $2,672,000).
The expected value for the demand event emanating from the Paperback decision branch is
EV = $856(0.30) + $6,916(0.70) = $4,584.4
This value is the expected value of the Paperback decision alternative. Because $4,584.4 > $2,672,
the best decision is to select the paperback option if the editor reaches that decision point. She
would expect a net payoff of $4,584.4 (actually $4,584,400) from the paperback decision. Note that
the hardcover decision branch is blocked, indicating that it is not the best decision.
The final step in the fold-back process is to determine the expected value of the review event.
We again multiply the appropriate cash flows by their probabilities.
EV = $400(0.20) + $4,584.4(0.80) = $3,587.52
Thus, as shown in Figure 18-10, the expected value is $3,587.52, which is the expected value of the
Sign contract branch. This means that if the company signs the publishing contract, its expected
payoff is $3,587.52 (actually $3,587,520). Because this value exceeds the $0 expected payoff for
the Dont sign contract branch, the best decision is to sign the contract. If the editorial review is
favorable, then publish in paperback. (Notice that the Dont sign branch is blocked, indicating that
this alternative wont be selected.)
This example demonstrates the use of a decision tree to help in making a decision under uncertainty. The decision tree provides a framework for analyzing alternatives and dealing with uncertainties. The decision reached is the best decision given the expected-value criterion. However, as
we indicated earlier, the best decision does not always lead to the best outcome. For instance, if the
contract is signed and the book is published in paperback, demand may be only 50,000 copies and,
worse yet, the contents might not be accurate. If this chain of events occurs, a lawsuit will be filed.
Harris Publishing would lose $2,300,000 on the deal. Remember, a bad outcome can occur from
this one-time decision. But then again, an extremely good outcome could occur if the demand for
the book is 1.5 million copies, the book proves inaccurate (no royalties are paid), and no suit is filed.
The payoff under this scenario is $8,200,000. The expected-value criterion takes into consideration
all the possible payoffs and the probabilities of those payoffs occurring.
This example illustrates an important virtue of decision-tree analysis. That is, the tree allows
future decisions that have an influence on the current decision to be systematically considered.
Chronologically, the decision about whether to publish in hardcover or paperback comes after the
initial decision of whether to sign a contract. However, the decision of whether to sign is made only
after the expected profits associated with publishing in hardcover and paperback are determined. In
this case, the editor decided to publish in paperback before her analysis indicated the contract
should be signed. The ability to use projected future events to help make a current decision is a natural part of the fold-back process.
18-28
SENSITIVITY ANALYSIS
In a decision problem such as the one facing Harris Publishing Company, uncertainty in the events is measured by the probabilities assessed for each event outcome. The expected-value criterion utilizes these
probability assessments. But a question that arises when decision analysis is applied is how sensitive is the
decision to the probabilities being assessed. For instance, the company might want to know how much the
probability of a favorable review would have to change to make not signing the contract the best decision.
To answer this question, refer to Figure 18-10. Instead of using 0.80 for the probability of a favorable review, let the probability be p. Then the probability of an unfavorable review is 1 p. We next
solve for p such that the expected value of the Sign contract alternative ($3,587.52) is the same as the
expected value of the Dont sign contract alternative, which in this case is $0.
0 = 4,584.40p + 400(1 p)
0 = 4,584.40p 400 + 400p
400 = 4,984.40p
400/4,984.40 = p
0.08025 = p
Thus, the probability of a favorable report would have to decrease from 0.80 to less than 0.1 in order
for the best decision to be not to sign the contract. This means the decision is quite insensitive to the
probability assessed for a favorable editorial review, and there is probably no need to investigate this
assessment any further.
Another question might be: How sensitive is the decision to publish the softcover book to the
probability assessment associated with the number of hardcover books that might be sold? That is,
how much higher than 0.60 would the probability of selling 1 million copies have to be before the
best decision would be to go with the hardcover books? The approach to answering this question is
essentially the same as before. We let p = the probability of selling 1 million copies and 1 p be the
probability of selling 100,000 copies. We then solve for p such that the expected payoff for hardcover is equal to that for paperback: $4,584.40 (see Figure 18-10). We solve for p as follows:
4,584.40 = 4,976p + 784(1 p)
4,584.40 = 4,976p 784 + 784p
5,368.40 = 5,760p
5,368.40/5,760 = p
0.9320 = p
The probability of selling 1 million books would have to be higher than 0.9320 for the best decision
to be to publish a hardcover book. When this is compared with the current assessment of 0.60, we
see the decision is not very sensitive to this probability assessment. Depending on how much information and thought went into the original probability assessment, there does not appear to be a need
to allocate substantial resources to study the hardcover-demand issue further.
Sensitivity analysis can also investigate how much a cash-flow value would have to change
before the decision would change. The method for determining the sensitivity of a cash-flow item is
the same as for a probability. Let the cash-flow value in question equal x, and then solve for x such
that the decision branches have the same expected payoff.
18-29
When sensitivity analysis indicates that the resulting decision is sensitive to a probability or cashflow value, you will want to spend extra time studying this factor before arriving at the final decision.
18-3: EXERCISES
Business Applications
18.24 Tom and Joe operate a rock quarry that provides local
stone for landscaping. They currently have an offer for
$50,000 to sell the quarry. They are hesitant to sell
because they believe there will be an increase in
demand in the next two years that would improve their
financial situation. If they decide to keep the quarry, the
present buyer would be willing to pay $30,000 in two
years, regardless of the situation. Tom and Joe think
there is a 60% chance of an increase, at which point
they would operate at a profit of $75,000 or sell the
quarry to a new buyer for $60,000. If demand does not
increase, they would operate at a profit of only $10,000.
Use a decision tree to determine what they should do.
18.25 Vegetable Farms is a small, family-operated ranch that
sells produce to local markets. The owners are currently
trying to decide whether they should expand their operation next year. Because this is a fairly new business,
the owners have assessed the following demand levels
and probabilities: high (probability 0.50), medium
(0.30), or low (0.20). The payoffs they expect for each
demand/acreage scenario are listed. Use a decision tree
to help decide whether to expand the farm.
Probability
0.3
0.6
0.1
Sale Price
(in Millions)
$2.5
2.0
1.5
Demand
Acreage
Expanded
Same size
High
$100,000
50,000
Medium
$40,000
40,000
Low
$40,000
30,000
Water Temperature
High
Medium
Low
Probability
0.4
0.4
0.2
Drill Revenue
(in Millions)
$5
3
1
Size
Small
Expansion (2nd year)
Large
Cost
(in Millions)
$2.0
1.5
3.0
High
$2
3
Low
$1
2
Revenue figures do not include the costs of construction. Use a decision tree to determine which size
the resort should develop.
18-30
trated how to use a decision tree in making a decision under uncertainty. In addition, we showed how decision-tree analysis, through
the fold-back process, takes into account future decisions that
affect the current decision.
EQUATIONS
Expected Value
k
E( x ) =
x P( x )
i
18-1
i =1
P( x ) = 1
18-2
0.0 P(xi) 1
18-3
i =1
Key Terms
Certainty, 18-2
Decision Tree, 18-14
Expected-Value Criterion, 18-7
Maximax Criterion, 18-6
CHAPTER EXERCISES
Business Applications
Exercises 18.28 through 18.31 refer to the following
situation.
Hatchman Electronics makes specialized fuel-injection units for automobile engines. The company is currently
completing its five-year strategic plan. A major component
of this plan involves analyzing the following situation.
Hatchman currently makes an injection unit that it sells
to automobile manufacturers for $200. The operating profit
(revenue direct manufacturing costs) for this unit is $90.
The company estimates that the probability is 80% that
demand for this product will continue, at the same price, for
the next five years. But if a competitor introduces a better
unit, the selling price will be dropped to $140 to maintain
the companys market share. Hatchman Electronics is considering trying to develop an improved fuel injector.
Whether or not the product is successful, the development
costs will be amortized by adding $20 to the cost of every
injector sold for the next five years. If the development effort
is successful, the improved unit will still be sold for $200,
but direct manufacturing costs will be reduced to $70. The
research and development department estimates that the
probability of a successful development effort is 60%.
Chapter Exercises
Probability
0
10
20
30
40
50
0.05
0.10
0.25
0.25
0.20
0.15
1.00
Excellent ($70,000,000)
Good ($50,000,000)
Fair ($10,000,000)
Poor ($20,000,000)
Probability
3
4
5
6
7
8
9 or more
0.10
0.30
0.25
0.20
0.10
0.05
0.00
1.00
Success Level
18-31
Probability
0.30
0.30
0.10
0.30
1.00
$120,000
150,000
200,000
230,000
0.10
0.10
0.20
0.20
260,000
290,000
320,000
0.20
0.10
0.10
1.00
The second marketing alternativeto rely on advertising in airline magazines and newspaper insertsis projected to have a monthly cost of $120,000. However, the
marketing director thinks that this approach would not be
as effective for generating added monthly revenue as the
18-32
Probability
0.10
0.10
0.25
0.25
0.20
0.10
1.00
18.46 Assuming President Grimm is risk-neutral for this decision, what alternative would you recommend?
18.47 An initial market survey of the acceptance of simulation
games indicates they are so popular that there is a 70%
chance the Grimm Group will be able to raise the price of
the seminars by enough to maintain its previous margins
without affecting the demand. Incorporate this new information into your previous problem analysis.
Advanced Applications
Exercises 18.48 through 18.51 refer to the Major League
Corporation, which makes sports-related items at a plant in
South Carolina. Before the baseball season, the company was
approached by representatives from the Sports Connection, a
company that supplies baseball items to be sold at major
league parks and at sports souvenir stores. The Sports
Connection has offered to contract to buy 300,000 baseball
hats for $3.00 each. The companys production capacity is
500,000 hats. The problem facing Major League is whether to
accept this offer or to attempt to independently sell all its baseball hats. If the demand for hats is high, the company will be
able to sell hats for much more than $3.00 each, but if demand
is low, the hats will have to be sold for much less than $3.00.
At least two uncertainties exist that will affect the
demand for hats. First, if the league races are tight, the
demand will be high; clear leaders early in the season will
lead to low demand. Second, if the players strike this year,
demand will be reduced. Using available information on
injury levels and team-strength analysis, Major Leagues
executives estimate a 60% probability that the league races
will be tight. In addition, the executives estimate the probability of a strike this year to be 30%. Assuming the two
events, tight races and a player strike, are independent, the
following table shows the possible selling prices for the
companys hats and the associated probabilities.
League Race
Player Strike
Yes
No
Tight
$5.00
p = 0.42
$4.00
p = 0.18
Not Tight
$2.50
p = 0.28
$2.00
p = 0.12
18.48 Assuming Major League will sell its entire output, should
it accept the Sports Connections offer if it wishes to maximize its expected revenue?
18.49 Suppose Major Leagues executives believe the company
will be able to negotiate the following deal with the Sports
Connection: The contract price for hats will be reduced to
$2.70 per hat; Major League will commit to delivering
150,000 hats at this price, with the option of supplying the
remaining 150,000 hats at $2.70 each after it determines
whether the players will strike. This decision must be
made before the status of the league races is known.
This proposal, if made, will require the services of legal
counsel, with a fee estimated to be $25,000. Determine the
decision tree describing this situation.
18.50 Should Major League make the proposal? Base your recommendation on expected values.
18.51 Assume you are the purchasing manager for the Sports
Connection. If you receive the proposed offer, would you
recommend that it be accepted if your only other alternative is to buy 300,000 baseball hats on the open market?
Assume that you have assessed the same probabilities as
Major League regarding league races and player strikes.
Base your conclusions on expected costs.
18.52 New Age Marketing is considering two alternative advertising plans for a client. The first plan uses radio and television
commercials that will cost $100,000. The account executive
estimates a 40% chance that the clients revenues will
increase by $80,000, a 25% chance that revenues will
increase by $110,000, and a 35% chance that revenues will
increase by $120,000 as a result of this advertising approach.
The second plan is to use newspaper and magazine
advertisements, at a cost of $20,000. However, print
media are thought to be less effective than radio and television. The account executive estimates the chances are
20% that this plan will increase revenues by $14,000,
50% that revenues will increase by $30,000, and 30% that
revenues will increase by $40,000.
If the newspaper and magazine option is chosen, New
Age can later take the radio and TV option, but expected revenue will decline by $10,000 from what it would have been
had that been the first choice. The account executive has indicated that it would not be feasible to try the newspaper and
magazine approach after first choosing radio and TV.
Use a decision-tree approach to determine what decision(s) the New Age agency should make.
18.53 The Gregston Corporation has purchased a petroleum lease
tract in the Pacific Ocean that may contain extensive oil
deposits. Drilling a dry hole would be very expensive, so
Gregstons managers are considering conducting a test to
18-33
Revenue
Probability
Small find
Medium find
Large find
$ 2 million
$ 5 million
$10 million
.40
.40
.20
CASE 18A:
Rockstone International
Rockstone International is one of the worlds largest diamond brokers. The firm purchases rough stones and has them cut and polished for sale in the United States and Europe. The diamond business has been very profitable, and from all indications it will
continue to be so. However, R. B. Randall, president and chief
executive officer for Rockstone, has stressed the need for effective
management decisions throughout the organization if the firm is to
remain profitable and competitive.
Normally, R. B. does not involve herself in personnel decisions, but todays situation is not typical. Beth Harkness,
Rockstones personnel manager, is considering whether to hire
Hans Marquis, a world-famous diamond cutter, to replace Omar
Barboa, who broke both his hands in a freak skateboard accident
almost a month ago. If he is hired, Hans Marquis will be paid on a
commission basis at the rate of $5,000 for each stone he cuts successfully. (Because of his professional pride, Hans will accept no
fee if he is unsuccessful in cutting a stone.)
In the past, the decision of whether to hire Hans would have
been simple. If he was available, he would be hired. However, six
months ago, the Liechtenstein Corporation introduced the worlds
first diamond-cutting machine. This machine, which can be leased
for $1,000,000 per year, is guaranteed to cut stones successfully
90% of the time.
PROBABILITY
0.10
0.40
0.30
0.10
0.10
1.00
18-34
CASE 18B:
Hadden Materials and Supplies, Inc.
Mark Hadden and his son, Greg, began Hadden Materials and
Supplies, Inc., in the mid-1980s. Both Mark and Greg had had
successful careers with major U.S. corporations, but after several
years of talking about it they came to the conclusion that they
wanted to work together in their own business. They also
decided that they wanted to be in manufacturing, where they
could take advantage of their previous experience and business
contacts.
From the beginning, Mark has run the production shop and
Greg has concentrated on sales. About two years ago, they got a
contract to make an electronic component for natural gas heaters.
At first they made this part exclusively for one company, but about
six months ago they started making the same component for other
heater manufacturers. The component is produced in large volume
and sells for $30. The variable production cost per unit is $13,
making this a very profitable product for the company.
However, until recently there was no way to determine
whether a component would work properly until it had actually
been installed in the heater unit. Whenever the heater manufacturer
found a defect, Hadden Materials and Supplies would refund the
full $30 plus pay a penalty of $10. Although the company has
made major improvements in its quality control program, this particular component is very difficult to build and to have work properly. As a result, the defect rate has been approximately 25%.
A week ago, the company was approached by a representative
of Tech-Notics, Inc., who said her company had a device for testing components such as the one Hadden makes for gas heaters. By
General References
1. Arrow, K. J., Utilities, Attitudes, Choices: A Review Note.
Econometrica, 26 (1958).
2. Baird, Bruce, F., Managerial Decision Making Under
Uncertainty (New York: Wiley, 1989).
3. Bell, D., Regret in Decision Making Under Uncertainty.
Operations Research, 30 (1982).
4. Berger, P. D., and A. Gerstenfeld. Decision Analysis for
Increased Highway Safety Sloan Management Review
(Spring 1971).
5. Brown, R. V., Do Managers Find Decision Theory
Useful? Harvard Business Review (JanuaryFebruary
1970).
6. Brown, R. V., A. S. Kahr, and C. Peterson, Decision
Analysis for the Manager (New York: Holt, 1974).
7. Bunn, D. W., Applied Decision Analysis (New York:
McGraw-Hill, 1984).
8. Davidson, F., Dimensions of Utility in a Regional Planning
Context. Decision Sciences (January 1974).
9. Farquhar, P., Utility Assessment Methods. Management
Science, 30 (1984).
10. Felson, J., Decision Making Under Uncertainty (New York:
CBS Educational and Professional Publishing, 1979).
18-35
General References
18.5
18.7
18.9
Demand
Purchase
10,000
15,000
20,000
25,000
10,000
15,000
20,000
25,000
8,500
5,250
2,000
(1,250)
8,500
12,750
9,500
6,250
8,500
12,750
17,000
13,750
8,500
12,750
17,000
21,250
2. 10,000;
3. 20,000
Demand
20,000
40,000
60,000
80,000
$2,800,000.00
$1,800,000.00
$ 800,000.00
$ (200,000.00)
$2,600,000.00
$5,800,000.00
$4,800,000.00
$3,800,000.00
$2,400,000.00
$5,600,000.00
$8,800,000.00
$7,800,000.00
$ 2,200,000.00
$ 5,400,000.00
$ 8,600,000.00
$11,800,000.00
0
1
2
3
4
5
100,000
150,000
200,000
225,000
250,000
1,000,000
675,000
350,000
187,500
25,000
1,000,000
1,575,000
1,250,000
1,087,500
925,000
1,000,000
1,575,000
2,150,000
1,987,500
1,825,000
1,000,000
1,575,000
2,150,000
2,437,500
2,275,000
1,000,000
1,575,000
2,150,000
2,437,500
2,725,000
Expected Value
1,000,000
1,485,000
1,610,000
1,582,500
1,465,000
250,000
500,000
350,000
200,000
50,000
250,000
250,000
250,000
500,000
500,000
500,000
750,000
750,000
750,000
600,000 1,000,000 1,000,000
450,000
850,000 1,250,000
500,000
500,000
200,000 1,000,000
(100,000)
700,000
(400,000)
400,000
(700,000)
100,000
500,000
1,000,000
1,500,000
1,200,000
900,000
500,000
1,000,000
1,500,000
2,000,000
1,700,000
500,000
1,000,000
1,500,000
2,000,000
2,500,000
Demand
100,000
150,000
200,000
225,000
250,000
250,000
100,000
(50,000)
(200,000)
(350,000)
18.13
Purchases
maximax: 80,000
100,000
150,000
200,000
225,000
250,000
(150,000)
(300,000)
(450,000)
(600,000)
(750,000)
(300,000)
(600,000)
(900,000)
(1,200,000)
(1,500,000)
b Maximin: 20,000;
Purchases
Purchase
18.11 a
20,000
40,000
60,000
80,000
Larger Buildings
States of Nature (possible successful restaurants)
b 1. 25,000;
Production
0
1
2
3
4
5
18.19 a
Opportunity Loss Table
States of Nature
Probabilities
Alternatives
A1
A2
A3
0.5
S1
0
15
35
0.2
S2
15
10
0
b EVPI = 13.5
18.21 EVPI = $1,140,000
18.23 EVPI = $7,320
18.25 The owners should expand.
18.27 The developer should build the large resort.
0.3
S3
40
20
0
18-36
18.55 x 0.66