STATES OF fNATURE
ALTERNATIVES N1: (PROSPERITY) N2: (RECESSION)
(0.6) (0.4)
A1: (BUY NEW) $ 950,000 $ - 200,000
A2: (MODIFY) $ 700,000 $ 300,000
(A) EXPECTED VALUE
EXPECTED VALUE = ∑ (Probability * Corresponding PAYOFF)
EXPECTED VALUE (FOR BUY NEW)
Expected Value = (0.6 * 950,000) + (0.4 * - 200,000)
Expected Value = $ 490,000
EXPECTED VALUE (FOR BUY NEW)
Expected Value = (0.6 * 700,000) + (0.4 * 300,000)
Expected Value = $ 540,000
STATES OF fNATURE
ALTERNATIVES N1: (PROSPERITY) N2: (RECESSION) EMV
(0.6) (0.4)
A1: (BUY NEW) $ 950,000 $ - 200,000 $ 490,000
A2: (MODIFY) $ 700,000 $ 300,000 $ 540,000
MAXIMUM EXPECTED VALUE = $ 540,000
BEST DECISION = A2 (MODIFY)
(B) MAXIMAX CRITERION
STATES OF fNATURE
ALTERNATIVES N1: (PROSPERITY) N2: (RECESSION) MAXIMAX
(0.6) (0.4)
A1: (BUY NEW) $ 950,000 $ - 200,000 $ 950,000
A2: (MODIFY) $ 700,000 $ 300,000 $ 700,000
MAXIMAX DECISION = A1 (BUY NEW)
MAXIMAX VALUE = $ 950,000
(C) MAXIMIN METHOD
STATES OF fNATURE
ALTERNATIVES N1: (PROSPERITY) N2: (RECESSION) MINIMUM
(0.6) (0.4)
A1: (BUY NEW) $ 950,000 $ - 200,000 $ - 200,000
A2: (MODIFY) $ 700,000 $ 300,000 $ 300,000
MAXIMIN DECISION = A2 (MODIFY)
MAXIMIN = $ 300,000
(D) HURWICZ METHOD
Given Coefficient Value (a) = 0.3
EXPECTED VALUE = a * BEST PAYOFF + (1 - a) * WORST PAYOFF
EXPECTED VALUE (FOR BUY NEW)
Expected Value = (0.3 * 950,000) + (0.7 * - 200,000)
Expected Value = $ 145,000
EXPECTED VALUE (FOR MODIFY)
Expected Value = (0.3 * 700,000) + (0.7 * 300,000)
Expected Value = $ 420,000
STATES OF fNATURE
ALTERNATIVES N1: (PROSPERITY) N2: (RECESSION) Expected Value
(0.6) (0.4)
A1: (BUY NEW) $ 950,000 $ - 200,000 $ 145,000
A2: (MODIFY) $ 700,000 $ 300,000 $ 420,000
MAXIMUM EXPECTED VALUE = $ 420,000
BEST DECISION = A2 (MODIFY)
f STATES OF NATURE
ALTERNATIVES WEAK NORMAL STRONG
(0.4) (0.25) (0.35)
DRAGON $ 130,000 $ 75,000 $ 25,000
SCORPION $ 700,000 $ - 170,000 $ - 430,000
LION $ - 290,000 $ - 199,000 $ 550,000
(A) CONSERVATIVE (MAXIMAX) CRITERION
f STATES OF
NATURE
ALTERNATIVES WEAK NORMAL STRONG
(0.4) (0.25) (0.35) MAXIMAX
DRAGON $ 130,000 $ 75,000 $ 25,000 $ 75,000
SCORPION $ 700,000 $ - 170,000 $ - 430,000 $ 700,000
LION $ - 290,000 $ - 199,000 $ 550,000 $ 550,000
CONSERVATIVE (MAXIMAX DECISION) = SCORPION
MAXIMAX VALUE = $ 700,000
(B) MINIMAX REGRET APPROACH
REGRET TABLE:
f STATES OF
NATURE
ALTERNATIVES WEAK NORMAL STRONG
(0.4) (0.25) (0.35) MAXIMAX
DRAGON $ 570,000 $0 $ 525,000 $ 570,000
SCORPION $0 $ 245,000 $ 980,000 $ 980,000
LION $ 990,000 $ 274,000 $0 $ 990,000
MINIMAX REGRET VALUE = $ 570,000
MINIMAX REGRET DECISION = DRAGON
(C) EXPECTED VALUE
EXPECTED VALUE = ∑ (Probability * Corresponding PAYOFF)
EXPECTED VALUE ( FOR DRAGON)
EMV = ($ 130,000 * 0.4) + ($75,000 * 0.25) + (25,000 * 0.35)
EMV = $ 79,500
EXPECTED VALUE ( FOR SCORPION)
EMV = ($ 700,000 * 0.4) + ($ - 170,000 * 0.25) + ($ - 430,000 * 0.35)
EMV = $ 87,000
EXPECTED VALUE ( FOR SCORPION)
EMV = ($ - 290,000 * 0.4) + ($ - 199,000 * 0.25) + ($ 550,000 * 0.35)
EMV = $ 26,750
BASED ON HIGHEST EMV OF $ 87,000, BEST DECISION IS SCORPION.
(D)
Expected Value of Perfect Information = Expected Value with perfect information -
Maximum Expected Monetary Value
EXPECTED VALUE WITH PERFECT INFORMATION = ∑ (Probability * Corresponding
BEST PAYOFF)
EXPECTED VALUE WITH PERFECT INFORMATION = (0.4* $700,000) + (0.25* $75,000)
+ (0.35 * $550,000)
EXPECTED VALUE WITH PERFECT INFORMATION = $ 491,250
Expected Value of Perfect Information = Expected Value with perfect information -
Maximum Expected Monetary Value
Expected Value of Perfect Information = $ 491,250 - $ 87,000
Expected Value of Perfect Information = $ 404,250
Ultra-Smart Research must be willing to pay $ 404,250 for the perfect information
service offered by the marketing firm.
(A) MAXIMIN CRITERION
f STATES OF
NATURE
ALTERNATIVES VERY AVERAGE
FAVORABLE MARKET UNFAVORABLE MINIMUM
MARKET MARKET
BUILD NEW PLANT $ 300,000 $ 210,000 $ - 280,000 $ - 280,000
SUB CONTRACT $ 160,000 $ 100,000 $ - 15,000 $ - 15,000
OVERTIME $ 120,000 $70,000 $ - 8,000 $ - 8,000
DO NOTHING $0 $0 $0 $0
MAXIMIN DECISION = DO NOTHING
MAXIMIN = $ 0
(C) EQUALLY LIKELY DECISION
FORMULA::
EQUALLY LIKELY VALUE FOR AN ALTERNATIVE = AVERAGE OF ALL ITS PAYOFFS
UNDER DIFFERENT STATES OF NATURE
f STATES OF
NATURE
ALTERNATIVES VERY AVERAGE
FAVORABLE MARKET UNFAVORABLE EQUALLY
MARKET MARKET LIKELY VALUE
BUILD NEW PLANT $ 300,000 $ 210,000 $ - 280,000 $ 76,667
SUB CONTRACT $ 160,000 $ 100,000 $ - 15,000 $ 81,667
OVERTIME $ 120,000 $70,000 $ - 8,000 $ 60,667
DO NOTHING $0 $0 $0 $0
EQUALLY LIKELY VALUE = $ 81,667
EQUALLY LIKELY DECISION = SUB CONTRACT
STANDARD DEVIATION (FOR MOTEL)
VARIANCE = [(-8,000 - 12,400)^2 * 0.2] + [(15,000 - 12,400)^2 *0.4] + [(20,000 -
12,400)^2 *0.4)]
VARIANCE = 109,040,000
STANDARD DEVIATION = 10,442.222
STANDARD DEVIATION (FOR RESTAURANT)
VARIANCE = [(6,000 - 2,000)^2 * 0.2] + [(6,000 - 8,000)^2 *0.4] + [(6,000 - 6,000)^2 *0.4)]
VARIANCE = 4,800,000
STANDARD DEVIATION = 2190.89
STANDARD DEVIATION (FOR THEATRE)
VARIANCE = [(6,000 - 5,600 )^2 *0.2] + [(6,000 - 5,600)^2 *0.4] + [(5,000 - 5,600)^2 *0.4)]
VARIANCE = 240,000
STANDARD DEVIATION = 489.898
(A) CONSERVATIVE (MAXIMIN APPROACH)
STATES OFfNATURE
ALTERNATIVE S1 S2 S3 MINIMUM
(0.4) (0.35) (0.25)
A1 50 80 30 30
A2 35 50 40 35
A3 60 30 50 30
MAXIMIN VALUE = 35
MAXIMIN DECISION = ALTERNATIVE A2
(C) BAYE’S DECISION RULE (EMV)
STATES OFfNATURE
ALTERNATIVE S1 S2 S3 EMV
(0.4) (0.35) (0.25)
A1 50 80 30 $ 55.50
A2 35 50 40 $ 41.50
A3 60 30 50 $ 47
EXPECTED PAYOFF = ∑ (Probability * Corresponding PAYOFF)
EMV (FOR ALTERNATIVE 1)
EMV = (0.4 * 50 + 0.35 * 80 + 0.25 * 30)
EMV = $ 55.50
EMV (FOR ALTERNATIVE 2)
EMV = (0.4 * 35 + 0.35 * 50 + 0.25 * 40)
EMV = $ 41.50
EMV (FOR ALTERNATIVE 3)
EMV = (0.4 * 60 + 0.35 * 30 + 0.25 * 50)
EMV = $ 47
BASED ON HIGHEST EMV, BEST DECISION IS ALTERNATIVE A1.
REGRET TABLE:
STATES OFfNATURE
DECISION STRONG DEMAND WEAK DEMAND MAXIMUM
SMALL COMPLEX, d1 12 0 12
MEDIUM COMPLEX, d2 6 2 6
LARGE COMPLEX, d3 0 16 16
MINIMAX VALUE = 6
MINIMAX REGRET APPROACH DECISION = CHOOSE MEDIUM COMPLEX
(D) EMV DECISION
STATES OFfNATURE
DECISION STRONG DEMAND WEAK DEMAND EMV
(0.8) (0.2)
SMALL COMPLEX, d1 8 7 7.8
MEDIUM COMPLEX, d2 14 5 12.6
LARGE COMPLEX, d3 20 -9 14.2
EXPECTED COST = ∑ (Probability * Corresponding Cost)
FOR SMALL COMPLEX
EXPECTED COST = (0.8 * 8) + (0.2 * 7) = 7.8
FOR MEDIUM COMPLEX
EXPECTED COST = (0.8 * 14) + (0.2 * 7) = 12.6
FOR LARGE COMPLEX
EXPECTED COST = (0.8 * 20) + (0.2 * -9) = 14.2
SINCE LARGE COMPLEX HAS THE MAXIMUM EMV, THEREFORE CHOOSE LARGE
COMPLEX.
CASELOAD
DECISION MODERATE HIGH VERY HIGH EXPECTED COST
(0.1) (0.3) (0.6)
REASSIGN STAFF 50 60 85 $ 74,000
NEW STAFF 60 60 60 $ 60,000
REDESIGN 40 50 90 $ 73,000
MINIMUM EXPECTED COST = $ 60,000
DECISION = NEW STAFF
(C) OPPORTUNITY LOSS TABLE
CASELOAD
DECISION MODERATE HIGH VERY HIGH EOL
(0.1) (0.3) (0.6)
REASSIGN STAFF 10 10 25 $ 19,000
NEW STAFF 20 10 0 $ 5,000
REDESIGN 0 0 30 $ 18,000
EXPECTED OPPORTUNITY LOSS = ∑ (Probability * Corresponding Regret Cost)
FOR REASSIGN STAFF
EXPECTED REGRET COST = (0.1 * 10) + (0.3 * 10) + (0.6 * 25)
EXPECTED REGRET COST = $ 19 (IN THOUSANDS)
FOR NEW STAFF
EXPECTED REGRET COST = (0.1 * 20) + (0.3 * 10) + (0.6 * 0)
EXPECTED REGRET COST = $ 5 (IN THOUSANDS)
FOR REDESIGN
EXPECTED REGRET COST = (0.1 * 0) + (0.3 * 0) + (0.6 * 30)
EXPECTED REGRET COST = $ 18 (IN THOUSANDS)
Expected value of perfect information = Minimum Expected Regret Loss
Expected value of perfect information = $ 5000
Expected Value of Perfect Information = Expected Value with perfect information -
Maximum Expected Monetary Value
Expected Value with perfect information = $ 3,450 - $ 2,650
Expected Value with perfect information = $ 800
EVPI is the maximum amount the investor will be willing to pay for additional
information about a decision problem, i.e., if we have perfect information about the
state of nature before the decision is made, how much is this information worth. In
this case, it is $ 800.
(D) Let payoff for stock under good economy X.
EMV (for stock) = 0.2X + (0.3 * 2000) + (0.5 * 5,000)
EMV (for bond) = $ 2,650
AT POINT OF INDIFFERENCE
EMV (for stock) = EMV (for bond)
0.2X + 600 - 2500 = 2,650
0.2X = 4550
X = $ 22,750
Payoff for Stock under good economy = $ 22,750
