TUTORIAL 2 – DECISION THEORY

Question 1

Adam, the president of AAA Manufacturing, is considering whether to build a new manufacturing
plant in Klang Valley. The net profits or losses for various alternatives and market conditions are
summarized in the following table:

Alternative Favourable Market (RM) Unfavourable Market (RM)

Build a large plant 400,000 -300,000
Build a small plant 80,000 -10,000
Don't build 0 0
Probability 0.45 0.55

a) Construct an opportunity loss table. What is the best alternative based on EOL's?
b) What is the most that Adam should pay for perfect information on the market condition?

(Small Plant EOL=149500)

Question 2

Faizal, a house developer, is trying to decide whether to build bungalows or medium-cost

houses or he could also choose not to proceed with the project. Given a favorable market, he
will earn a profit of RM30,000 if he builds bungalows and RM10,000 if he builds medium cost
houses. However, with an unfavorable market, Faizal could loose RM40,000 with the bungalows
and RM20,000 with medium-cost houses. He believes that the probability of a favorable market
is 0.7.

Prior to this decision, Faizal can get additional information from market research analyst at cost
of RM6,000 and the probability that the result will be positive is 0.5. A positive result from the
study will increase the probability of a favorable market to 0.9. Furthermore, a negative result
from the study will decrease the probability of a favorable market to 0.4.

a) Construct a decision tree for this problem.

b) Analyze the decision tree and advise Faizal for the best decision.
c) If the cost to gather additional information is reduced to only RM2,000, what will be your
advice to Faizal?
(Without market research EMV=RM9000, EVSI=2500)

ZAK / NMY @ UiTM Terengganu Page | 1

Question 3

Zarif is opening another branch of his Zarif Deli Kiosk at RnR Tapah in the North-South Expressway.
Zarif can run the kiosk either for 24 hours per day or only 12 hours per day (from 8.00 am to 8.00
pm). He also considers hiring a sales expert to predict the potential demand for the new branch. If
the survey were conducted, the results would show either high demand or low demand for the kiosk.

Zarif has also done some analysis on the potential return of the kiosk operation. If he runs 24 hours
per day, the expected return is RM90,000 if the market is favourable, but he will lose RM45,000 if
the market is unfavourable. If he run for 12 hours, the estimated profit will be RM50,000 in a
favourable market, and RM20.000 loss in an unfavourable market. Currently, he assumes the
probability that the market is favourable is 50%.

The sales expert will charge him RM8,000 for the survey. It is estimated that there is a 0.6 probability
that the survey will indicate high demand. Furthermore, there is a 0.7 probability that the market will
be favourable given a high demand from the survey. However, the sales expert warns him that there
is only 38% chance of favourable market if the survey shows low demand.

a) Construct a decision tree for Zarif. Analyze the tree and determine the best decision for
him.
b) Calculate the worth of the sales expert's advice.

(Hire sales expert EMV=24340, EVSI=9840)

Question 4

Tanko Logistics, a large shipping company, has determined that it must increase its tonnage
capacity in order to maintain its position during the next five years. One possibility is to buy a
50,000-ton ship estimated profit of RM900,000 if demand for service is high and RM200,000 if
the demand is low. A second possibility is to subcontract the increased shipping tonnage to
another company. The subcontract will guarantee an income of RM650,000. The planning
department of the shipping company feels that the likelihood of a high demand for service is
60%.

To assist in the decision, the company is considering hiring a sales expert who predicts that the
probability that demand is high given the expert's prediction is also high is 82%. Additionally, the
probability that demand is low given the expert's prediction is low is 0.67. In any case, the
expert predicts that there is a 55% chance of high demand. The fee for the sales expert's
service is RM25,000.

a) Construct a decision tree for Tanko Logistics. Analyze the tree and determine the
shipping company's best strategy.
b) Calculate the worth of the sales expert's advice.

(Hire sales expert EMV=693200, EVSI=68200)

ZAK / NMY @ UiTM Terengganu Page | 2

Question 5

Ahmad Department Store faces a buying decision for a seasonal product for which demand can
be high, medium or low. Ahmad's customer can order 1, 2 or 3 boxes of the product before the
season begins but cannot reorder later. Profit projections (RM) are shown in the table below.

Alternatives State of nature

High Demand Medium Demand Low Demand
Order 1 box 600 320 -130
Order 2 boxes 480 160 680
Order 3 boxes 160 320 120

If the prior probabilities for the high demand, medium demand and low demand are 0.3, 0.5 and
0.2 respectively, what is the recommended order quantity?
(Order 2 boxes EMV=360)

Question 6

The Bota Minimart must decide how many cases of milk to stock each week in order to meet
demand. The probability distribution of demand during a week is shown below.

Demand (cases) 16 17 18
Probability 0.30 0.40 0.30

Each case costs the Minimart RM10 and sells for RM12. Unsold cases are sold to a local farmer
(who mixes the milk with feed for livestock) for RM2 per case. If there is a shortage, the
Minimart considers the cost of customer good will and lost profit to be RM4 per case.

Construct a payoff table for the above problem and use the Expected Monetary Value criterion
to determine the number of cases the Minimart should stock each week.
(Stock 16 cases EMV=32)

Question 7

Consider the following decision table.

Alternative State-of-nature
X Y Z
1 300 400 600
2 400 500 500
3 200 600 200

Determine the best decision under the following decision criteria:

a) Maximin
b) Hurwicz (α = 0.7)

(Maximin: Alt 2 with maximum payoff RM400, Hurwicz: Alt 1 with maximum CR RM510

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