Changs decision Dilemma Analysis

Name

Affiliation
 Introduction

Decisions Degree of interdependence Non-strategic Direct consequences of your decision depend only

upon your own behavior, not that of others Strategic Agents actions interact to determine direct

consequences for all Uncertainty Low Linkages between actions and consequences are well understood and

completely specified High Linkages are partially understood and/or incompletely specified

Description of the Case

Framing the Decision: Step I:

Framing the Decision: Step I Changs decision is between two alternatives to continue R&D or to abandon

the project Abandon Continue Perhaps make proposal with inferior technology at an additional cost of

$50,000 Take risk on developing the new technology at an additional cost of $200,000 and reconsider

proposal

Step II:

Step II Abandon Continue Not Proposal $0 Expend $50,000 and perhaps win

Uncertainty in a decision tree:

Uncertainty in a decision tree Chang must assess the probability of success Objective based upon data or

specific knowledge Subjective based upon experience & judgement Suppose the probability of winning the

contract with the old product is only 5% = 0.05 This implies probability of losing is 95% = Random Event

Node: point at which Nature takes an action of her own (one path for each possible outcome)

Step III:

Step III Abandon Continue Not Proposal $0 Win Lose 0.05 0.95 $800,000 -$50,000

Step IV:

Step IV

Step V:

Step V No Prop No Prop

Optimal decision plan:

Optimal decision plan while we built the tree by adding branches the way to solve it is to start at the

end and roll back. Looking forward and working backwards is a key skill in economic decision-making

Example (non-strategic under certainty):

Example (non-strategic under certainty) First, solve a node furthest to the right Decision node: Pick the

best choice Nature node: Calculate the average value Solve next node to the left Continue

Solving at a node with uncertainty:

Expected value:

Solving at a node with uncertainty: Expected value Chang wants to know, is R&D a risk worth taking? Easy

to solve, so long as Chang is risk-neutral; Risk-neutral agents prefer decisions with highest average payoff

Good assumption when agent is a firm, poor for individuals (investors can diversify their own portfolios)

Example: Flip a coin, Heads you get $2.10 Tails you lose $1.00 1000 flips: roughly 500 heads, 500 tails an

average of ? per flip. Expected value: = (Probability of heads)(Payoff if heads) + (Prob of tails)(Payoff if

tails) = x 2.1 + x (-1.00) = x (2.1 1.00) = $ 0.55

Solving the Tree:

Solving the Tree Abandon Continue Not Proposal $0 Win Lose 0.05 0.95 $800,000 -$50,000 ? Expected

value = 0.05 ($800,000) + 0.95 (-$50,000) = - $7,500

Solving the Tree:

Solving the Tree Abandon Continue Not Proposal $0 -$7,500 ? Choose the branch with the best payoff

Solving the Tree:

Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 Not Proposal -$200,000 Win Lose 0.9 0.1 -

$250,000 $600,000 Not Proposal -$200,000 Win Lose 0.05 0.95 -$250,000 $600,000

Solving the Tree:

Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 Not Proposal -$200,000 Win Lose 0.9 0.1 -

$250,000 $600,000 Not Proposal -$200,000 -$207,500

Solving the Tree:

Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 Not Proposal -$200,000 $515,000 -$200,000

Solving the Tree:

Solving the Tree Abandon Continue Succeed Fail 0.5 0.5 $0 $515,000 -$200,000

Solving the Tree:

Solving the Tree Abandon Continue $0 $157,500 Never make proposal if dont have newer technology

Choose to take risk and continue R&D

Decision Tree Analysis

at p1 = 0.352 makes Chang indifferent between abandoning the project and going ahead with it,
its substituted till the EMV are the same for both abadoning and continuing

from the tree diagram EMV with $85,6

knowledge = 00
$4,50
EMV without knowledge = 0
$81,10
benefit = 0

chang decides to use exponential utility

function
by changing the R-value it can be seen that the risk tolerance value of
$560,000,000 and higher chang will prefer to continue
entire worksheet
prob in successful R&D 0.352
prob winning contract
with new tech 0.8
winning contract with old
tech 0.1

$1,000,00
Benefit from winning 0
Cost of R&D $200,000
 cost of proposal(successful
R&D) $50,000
cost of proposal( not
successful R&D) $40,000

cost of production $150,000

$570,000,
Risk Tolerance 000

Thus chang will prefer

to continue.
Conclusion

Decision tree (DT) is one way to represent rules underlying data. It is the most popular tool for exploring

complex data structures. Besides that it has become one of the most flexible, intuitive and powerful data

analytic tools for determining distinct prognostic subgroups with similar outcome within each subgroup

but different outcomes between the subgroups. There was a low tolerance to risk hence chang will prefer to

continue.
 References

Anderson, D. R., Sweeney, D. J., Williams, T. A., Camm, J. D., & Cochran, J. J. (2015). An introduction to

management science: quantitative approaches to decision making . Cengage learning.