Name: Le Duc Thinh

ID: BABAIU14255
QUANTITATIVE METHODS FOR BUSINESS

ASSIGNMENT: DECISION TREE

335: The physicians in Problem 334 have been approached by a market

research firm that offers to perform a study of the market at a fee of $5,000.
The market researchers claim their experience enables them to use Bayes
theorem to make the following statements of probability:
Probability of a favorable market given a favorable study = 0.82
Probability of an unfavorable market given a favorable study = 0.18
Probability of a favorable market given an unfavorable study = 0.11
Probability of an unfavorable market given an unfavorable study = 0.89
Probability of a favorable research study = 0.55
Probability of an unfavorable research study = 0.45
(a) Develop a new decision tree for the medical professionals to reflect the
options now open with the market study.
(b) Use the EMV approach to recommend a strategy.
(c) What is the expected value of sample information? How much might the
physicians be willing to pay for a market study?
(d) Calculate the efficiency of this sample information.

Solution:
(b)

Given favorable survey results, we have:

EMV(node 2) = EMV(construct | positive survey)
= (0.82)*($95,000) + (0.18)*($45,000) = $69,800
The EMV of the situation that the clinic is not constructed in this case is
$5,000. Thus, if the survey results are favorable, they should construct the
clinic.
Given negative survey results, we have:

EMV(node 3) = EMV(construct | negative survey)

= (0.11)*($95,000) + (0.89)*($45,000) = $29,600
The EMV of the situation that the clinic is not constructed in this case is
$5,000. Thus, if the survey results are negative, they should not construct the
clinic.
The expected value of conducting the market survey is:

EMV(node 1) = EMV(conduct survey)

= (0.55)*($69,800) + (0.45)*($5,000) = $36,140
 If the market survey is not conducted, we have:

EMV(node 4) = (0.5)*($100,000) + (0.5)*($40,000) = $30,000

The EMV of the situation that the clinic is not constructed in this case is $0.
Thus, constructing the clinic is the best choice, given that the market survey
is not performed.
Therefore the survey should be used since EMV (conduct survey) > EMV(no

survey). If it is favorable, construct the clinic. If it is unfavorable, dont

construct the clinic.
(c) We have:
EVSI = (EV with sample information + cost) (EV without sample
information)
= ($36,140 + $5,000) $30,000 = $11,140
Thus, the physicians would pay up to $11,140 for the survey.
(d) We have the decision table as following:
STATE OF NATURE
DECISION
FAVORABLE MARKET UNFAVORABLE MARKET
ALTERNATIVE
($) ($)
Construct clinic
Do nothing 100,000 40,000
With perfect 0 0
100,000 0
information 0.5 0.5
Probability

We have:
EMV(construct clinic) = (0.5)*($100,000) + (0.5)*($40,000) = $30,000
EMV(do nothing) = (0.5)*($0) + (0.5)*($0) = $0
Best alternative for favorable and unfavorable market is constructing the
clinic with a payoff of $100,000 and not construct the clinic with a payoff of
$0, respectively. We have:
EV(with perfect information) = (0.5)*($100,000) + (0.5)*($0) = $50,000
EVPI = EV(with perfect information) Maximum EMV(without perfect information)
= $50,000 $30,000 = $20,000
EVSI $ 11,140
Efficiency of sample information = 100 = 100 =
EVPI $ 20,000
55.7%
Thus, the market survey is only 55.7% as efficient as perfect information.
341: A financial advisor has recommended two possible mutual funds for

investment: Fund A
and Fund B. The return that will be achieved by each of these depends on

whether the economy is good, fair, or poor. A payoff table has been

constructed to illustrate this situation:

(a) Draw the decision tree to represent this situation.

(b) Perform the necessary calculations to determine which of the two mutual
funds is better. Which one should you choose to maximize the expected
value?
(c) Suppose there is question about the return of Fund A in a good economy.
It could be higher or lower than $10,000. What value for this would cause a
person to be indifferent between Fund A and Fund B (i.e., the EMVs would be
the same)?
STATE OF NATURE
INVESTMENT GOOD FAIR POOR
ECONOMY ECONOMY ECONOMY
Fund A $10,000 $2,000 $5,000
Fund B $6,000 $4,000 0
Probability 0.2 0.3 0.5

(b) We have:
EMV(fund A) = (0.2)*($10,000) + (0.3)*($2,000) + (0.5)*($5,000) = $100
EMV(fund B) = (0.2)*($6,000) + (0.3)*($4,000) + (0.5)*($0) = $2,400
EMV(no investment) = $0
Hence, investing in fund B is the best choice since it maximizes the expected
value.
(c) Let X (dollars) be the return of fund A in a good economy. We are
indifferent when the EMV of fund A is the same as the EMV of fund B, which is
$2,400. We have:
EMV(fund A) = EMV(fund B)
(0.2)*(X) + (0.3)*($2,000) + (0.5)*($5,000) = $2,400
(0.2)*X = $4,300
=> X = $21,500
Therefore, the return of fund A in a good economy would have to be $21,500
for the two funds to be equally desirable based on the expected values.

342: Jim Sellers is thinking about producing a new type of electric razor for
men. If the market were favorable, he would get a return of $100,000, but if
the market for this new type of razor were unfavorable, he would lose
$60,000. Since Ron Bush is a good friend of Jim Sellers, Jim is considering the
possibility of using Bush Marketing Research to gather additional information
about the market for the razor. Ron has suggested that Jim either use a
survey or a pilot study to test the market. The survey would be a
sophisticated questionnaire administered to a test market. It will cost $5,000.
Another alternative is to run a pilot study. This would involve producing a
limited number of the new razors and trying to sell them in two cities that are
typical of American cities. The pilot study is more accurate but is also more
expensive. It will cost $20,000. Ron Bush has suggested that it would be a
good idea for Jim to conduct either the survey or the pilot before Jim makes
the decision concerning whether to produce the new razor. But Jim is not sure
if the value of the survey or the pilot is worth the cost.
Jim estimates that the probability of a successful market without performing a
survey or pilot study is 0.5. Furthermore, the probability of a favorable survey
result given a favorable market for razors is 0.7, and the probability of a
favorable survey result given an unsuccessful market for razors is 0.2. In
addition, the probability of an unfavorable pilot study given an unfavorable
market is 0.9, and the probability of an unsuccessful pilot study result given a
favorable market for razors is 0.2
(a) Draw the decision tree for this problem without the probability values.
(b) Compute the revised probabilities needed to complete the decision, and
place these values in the decision tree.
(c) What is the best decision for Jim? Use EMV as the decision criterion.

(b) Let FM, UM, FS, US, FP and UP respectively be the favorable market,

unfavorable market, favorable survey, unfavorable survey, favorable pilot

study and unfavorable pilot study. We have:

P(FM) = 0.5 P(UM) = 0.5

P(FS | FM) = 0.7 P(US | FM) = 1 P(FS | FM) = 0.3
P(FS | UM) = 0.2 P(US | UM) = 1 P(FS | UM) = 0.8
P(UP | UM) = 0.9 P(FP | UM) = 1 P(UP | UM) = 0.1
P(UP | FM) = 0.2 P(FP | FM) = 1 P(UP | FM) = 0.8

Now, we can compute the revised probabilities needed to complete the

decision in this situation:
 FS|UM ) P(UM )
P( FSFM ) P( FM )+ P
P(FM | FS) =
P( FSFM ) P( FM )

( 0.7 ) (0.5)
= = 0.78
( 0.7 ) ( 0.5 ) + ( 0.2 ) (0.5)

P(UM | FS) = 1 P(FM | FS)

= 0.22
US |UM ) P(UM )
P(USFM ) P( FM )+P
P(FM | US) =
P(USFM ) P(FM )

( 0.3 ) (0.5)
= = 0.27
( 0.3 ) ( 0.5 ) + ( 0.8 ) (0.5)

P(UM | US) = 1 P(FM | US)

= 0.73
FP |UM ) P(UM )
P( FPFM ) P( FM )+ P
P(FM | FP) =
P( FPFM ) P (FM )

( 0.8 ) (0.5)
= = 0.89
( 0.8 ) ( 0.5 ) + ( 0.1 ) (0.5)

P(UM | FP) = 1 P(FM | FP)

= 0.11
UP |UM ) P(UM )
P(UPFM ) P(FM )+ P
P(FM | UP) =
P(UPFM ) P( FM )

( 0.2 ) (0.5)
= = 0.18
( 0.2 ) ( 0.5 )+ ( 0.9 ) (0.5)

P(UM | UP) = 1 P(FM | UP)

= 0.82
FM |US ) P(US)
P( FM FS) P( FS)+ P
P(FS | FM) =
P( FM FS) P( FS)

 0.78 P(FS)
0.7 =
0.78 P( FS)+ 0.27 (1P ( FS ))

=> P(FS) = 0.45, P(US) = 0.55

FM |UP ) P(UP )
P( FM FP) P( FP)+ P
P(FP | FM) =
P( FM FP) P (FP)

0.89 P( FP)
0.8 =
0.89 P ( FP)+0.18 (1P ( FP ))

=> P(FP) = 0.45, P(UP) = 0.55

(c) *Use survey:

Given favorable survey results, we have:
EMV(node 3) = (0.78)*($95,000) + (0.22)*($65,000) = $59,800
The EMV of the situation that the razor is not produced in this case is
$5,000. Thus, if the survey results are favorable, they should produce the
razor.
Given negative survey results, we have:

EMV(node 4) = (0.27)*($95,000) + (0.73)*($65,000) = $21,800

The EMV of the situation that the razor is not produced in this case is
$5,000. Thus, if the survey results are unfavorable, they should not produce
the razor.
The expected value of conducting the market survey is:

EMV(node 1) = EMV(conduct survey)

= (0.45)*($59,800) + (0.55)*($5,000) = $24,160
*Use pilot study:
Given favorable study results, we have:
EMV(node 5) = (0.89)*($80,000) + (0.11)*($80,000) = $62,400
The EMV of the situation that the razor is not produced in this case is
$20,000. Thus, if the study results are favorable, they should produce the
razor.
If the study results is negative, we have:

EMV(node 6) = (0.18)*($80,000) + (0.82)*($80,000) = $51,200

The EMV of the situation that the razor is not produced in this case is
$20,000. Thus, if the study results are unfavorable, they should not produce
the razor.
The expected value of conducting the market survey is:

EMV(node 2) = EMV(conduct pilot study)

 = (0.45)*($62,400) + (0.55)*($20,000) = $17,080
*Not conduct anything:

EMV(node 7) = (0.5)*($100,000) + (0.5)*($60,000) = $20,000

The EMV of the situation that the razor is not produced in this case is $0.
Thus, producing the razor is the best choice, given that the market survey
and pilot study is not performed.

=> So, since EMV(conduct survey) > EMV(not conduct anything) > EMV(conduct pilot

study), the survey should be used. If it is favorable, produce the razor. If it is

unfavorable, do not produce the razor.