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Decision analysis

- Tutorial 1-
#1 (Exercise 3.4 in Clemen, MHD) )
 Before making an unsecured loan to an individual a bank
orders a report on the applicant's credit history. To justify
making the loan, the bank must find the applicant's credit
record to be satisfactory.
 Describe the bank's decision.
 What are the bank's objectives?
 What risk does the bank face?
 What role does the credit report play?
 Draw an influence diagram of this situation.
(Hint: Your influence diagram should include chance nodes for a credit report and for eventual
default.)
Elements of solutions
#2 (Exercise 3.5 in Clemen, MHD)
 When a movie producer decides whether to produce a
major motion picture, the main question is how much
revenue the movie will generate.
 Draw a decision tree of this situ ation, assuming that
there is only one fundamental objective, to maximize
revenue.
 What must be included in revenue to be sure that the
clarity test is passed?
Elements of solutions
#3 (Exercise 3.11 in Clemen, MHD)
 Suppose you are planning a party, and your objective is to have an enjoyable
party for all the guests. An outdoor barbecue would be the best, but only if
the sun shines; rain would make the barbecue terrible. On the other hand,
you could plan an indoor party. This would be a good party, not as nice as
an outdoor barbecue in the sunshine but better than a barbecue in the rain.
Of course, it is always possible to forego the party altogether!
a) Construct an influence diagram and a decision tree for this problem.
b) You will, naturally, consult the weather forecast, which will tell you that
the weather will be either "sunny" or "rainy." The forecast is not perfect,
however. If the forecast is "sunny," then sunshine is more likely than rain,
but there still is a small chance that it will rain. A forecast of "rainy"
implies that rain is likely, but the sun may still shine.
i. Now draw an influence diagram for the decision, including the weather
forecast.
ii. Now draw a decision tree for this problem. Recall that the events and deci-
sions in a decision tree should be in chronological order.
b.
# 4 (Exercise 3.13 in Clemen, MHD)
 Imagine a manufacturing-plant manager who faces a string of defective products and must
decide what action to take. The manager's fundamental objectives are to solve this problem
with as little cost as possible and to avoid letting the production schedule slip.
 A maintenance engineer has been dispatched to do a preliminary inspection on Machine 3,
which is suspected to be the source of the problem. The preliminary check will provide some
indication as to whether Machine 3 truly is the culprit, but only a thorough and expensive
series of tests (not possible at the moment ) will reveal the truth. The manager has two
alternatives.
 First, a replacement for Machine 3 is available and could be brought in at a certain cost. If
Machine 3 is the problem, then work can proceed and the production schedule will not fall behind. If
Machine 3 is not the source of the defects, the problem will still exist, and the workers will have to
change to another product while the problem is tracked down.
 Second, the workers could be changed immediately to the other product. This action would
certainly cause the production schedule for the current product to fall behind but would
avoid the risk (and cost) of unnecessarily replacing Machine 3.
 Without the engineer's report, this problem would be another basic risky decision; the
manager would have to decide whether to take the chance of replacing Machine 3 based on
personal knowledge regarding the chance that Machine 3 is the source of the defective
products. However, the manager is able to wait for the engineer's preliminary report before
taking action.
# 4 (Exercise 3.13 in Clemen, MHD), cont
 Draw Influence diagram for
the man-ager's decision
problem

 Draw the machine-


replacement decision as a
decision tree
#5 (Exercise 3.12 in Clemen, MHD)
 Imagine that a close friend has been diagnosed with heart disease. The
physician recommends bypass surgery. The surgery should solve the
problem. When asked about the risks, the physician replies that a few
individuals die during the operation, but most recover and the surgery is a
complete success. Thus, your friend can (most likely) anticipate a longer and
healthier life after the surgery. Without surgery, your friend will have a
shorter and gradually deteriorating life. Assuming that your friend's
objective is to maximize the quality of her life, diagram this decision with
both an influence diagram and a decision tree.
 Suppose now that your friend obtains a second opinion. The second
physician suggests that there is a third possible outcome: Complications
from surgery can develop which will require long and painful treatment. If
this happens, the eventual outcome can be either a full recovery, partial
recovery (restricted to a wheelchair until death), or death within a few
months. How does this change the decision tree and influence diagram that
you created in part a? Draw the decision tree and influence diagram that
represent the situation after hearing from both physicians. Given this new
structure, does surgery look more or less positive than it did in part a?
# 6 (Exercise 4.8 in Clemen, MHD)
 Solve the decision tree in the following figure.
Elements of solutions
#7 (Exercise 4.9 in Clemen, MHD)
 Create risk profiles and cumulative risk profiles for all
possible strategies for the figure in Exercise 3. Is one
strategy stochastically dominant? Explain.
Elements of solutions
Elements of solutions

None of the alternatives is stochastically


dominated (first-order) because the cumulative
risk-profile lines cross.
# 8 (Exercise 4.15 in Clemen, MHD)
 A stock market investor has $500 to spend and is considering purchasing an option
con tract on 1000 shares of Apricot Computer. The shares themselves are currently
selling for $28.50 per share. Apricot is involved in a lawsuit, the outcome of which
will be known within a month. If the outcome is in Apricot's favor, analysts expect
Apricot's stock price to increase by $5 per share. If the outcome is unfavorable,
then the price is expected to drop by $2.75 per share. The option costs $500, and
owning the option would allow the investor to purchase 1000 shares of Apricot
stock for $30 per share. Thus, if the investor buys the option and Apricot prevails in
the lawsuit, the investor would make an immediate profit. Aside from purchasing the
option, the investor could (1) do nothing and earn about 8% on his money, or (2)
purchase $500 worth of Apricot shares.

 a) Construct cumulative risk profiles for the three alternatives, assuming Apricot
has a 25% chance of winning the lawsuit. Can you draw any conclusions?

 b) If the investor believes that Apricot stands a 25% chance of winning the lawsuit,
should he purchase the option? What if he believes the chance is only 10%? How
large does the probability have to be for the option to be worthwhile?
Solutions

No immediate conclusions can be drawn. No


one alternative dominates another.
# 9 (John Thompson case)
 John Thompson is the founder and president of Thompson Lumber Company, a
profitable firm located in Portland, Oregon. The problem that John Thompson
identifies is whether to expand his product line by manufacturing and marketing a
new product, backyard storage sheds.
 John decides that his alternatives are to construct (1) a large new plant to
manufacture the storage sheds, (2) a small plant, or (3) no plant at all (i.e., he has
the option of not developing the new product line).
 Thompson determines that there are only two possible outcomes: the market for
the storage sheds could be favorable, meaning that there is a high demand for the
product, or it could be unfavorable, meaning that there is a low demand for the
sheds.
 Because Thompson wants to maximize his profits, he can use profit to evaluate each
consequence.
 With a favorable market, he thinks a large facility would result in a net profit of
$200,000 to his firm. The conditional value if the market is unfavorable would be a
$180,000 net loss.
 A small plant would result in a net profit of $100,000 in a favorable market, but a
net loss of $20,000 would occur if the market was unfavorable.
 Finally, doing nothing would result in $0 profit in either market.
# 9 (John Thompson case)
 Draw influence diagram and decision tree for John
Thompson problem
 Calculate EMV if John believes that the probability of a
favorable market is exactly the same as the probability of
an unfavorable market;
 CRP
 Sensitivity analysis
 EVPI
# 10 (Exercise 5.9 in Clemen, MHD)
 An orange grower in Florida faces a dilemma. The weather forecast
is for cold weather, and there is a 50% chance that the temperature
tonight will be cold enough to freeze and destroy his entire crop,
which is worth some $50,000. He can take two pos-sible actions to
try to alleviate his loss if the temperature drops. First, he could set
burners in the orchard; this would cost $5000, but he could still
expect to incur dam-age of approximately $15,000 to $20,000.
Second, he could set up sprinklers to spray the trees. If the
temperature drops, the water would freeze on the fruit and provide
some insulation. This method is cheaper ($2000), but less effective.
With the sprin-klers he could expect to incur as much as $25,000
to $30,000 of the loss with no pro-tective action.
 Compare the grower's expected values for the three alternatives he
has, considering the various possible loss scenarios for the burners
and the sprinklers. Which alternative would you suggest the grower
take? Why?

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