The following example will illustrate the solution procedure for a decision analysis problem.
Problem Statement
T. Bone Puckett, a corporate raider, has acquired a textile company and is contemplating the future of
one of its major plants, located in South Carolina. Three alternative decisions are being considered :
(1) expand the plant and produce lightweight, durable materials for possible sales to the military, a
market with little foreign competition; (2) maintain the status quo at the plant, continuing production of
textile goods that are subject to heavy foreign competition; or (3) sell the plant now. If one of the first
two alternatives is chosen , the plant will still be sold at the end of a year. The amount of profit that
could be earned by selling the plant in a year depends on foreign market conditions, including the
status of a trade embargo bill in Congress. The following payoff table describes this decision
situation:
[Page 548]
State of Nature
Decision Good Foreign Competitive ConditionsPoor Foreign Competitive Conditions
Expand $ 800,000 $ 500,000
Maintain status quo 1,300,000 150,000
Sell now 320,000 320,000
1. Determine the best decision by using the following decision criteria:
1. Maximax
2. Maximin
3. Minimax regret
4. Hurwicz ( a = .3)
5. Equal likelihood
2. Assume that it is now possible to estimate a probability of .70 that good foreign competitive
conditions will exist and a probability of .30 that poor conditions will exist. Determine the best
decision by using expected value and expected opportunity loss.
3. Compute the expected value of perfect information.
4. Develop a decision tree, with expected values at the probability nodes.
5. T. Bone Puckett has hired a consulting firm to provide a report on future political and market
situations. The report will be positive (P) or negative (N), indicating either a good (g) or poor
(p) future foreign competitive situation. The conditional probability of each report outcome,
given each state of nature, is
P (Pg) = .70
P (Ng) = .30
P (Pp) = .20
P (Np) = .80
Determine the posterior probabilities by using Bayes's rule.
6. Perform a decision tree analysis by using the posterior probability obtained in (e).
Solution
Step 1. (part A): Determine Decisions Without Probabilities
Maximax:
Expand $ 800,000
Status 1,300,000 Maximum
quo
Sell 320,000
Decision: Maintain status quo.
[Page 549]
Maximin:
Expand $ 500,000 Maximum
Status -150,000
quo
Sell 320,000
Decision: Expand.
Minimax
regret:
Expand $500,000 Minimum
Status quo 650,000
Sell 980,000
Decision: Expand.
Hurwicz ( a = .3):
Expand $800,000(.3) + 500,000(.7) = $590,000
Status quo $1,300,000(.3) 150,000(.7) = $285,000
Sell $ 320,000(.3) + 320,000(.7) = $ 320,000
Decision: Expand.
Equal
likelihood:
Expand $800,000(.50) + 500,000(.50) = $650,000
Status quo $1,300,000(.50) 150,000(.50) = $575,000
Sell $320,000(.50) + 320,000(.50) = $320,000
Decision: Expand.
Step 2. (part B): Determine Decisions with EV and EOL
Expected
value:
Expand $800,000(.70) + 500,000(.30) = $710,000
Status quo $1,300,000(.70) 150,000(.30) = $865,000
Sell $320,000(.70) + 320,000(.30) = $320,000
Decision: Maintain status quo.
Expected opportunity loss:
Expand $500,000(.70) + 0(.30) = $350,000
Status $0(.70) + 650,000(.30) = $195,000
quo
Sell $980,000(.70) + 180,000(.30) = $740,000
Decision: Maintain status quo.
Step 3. (part C): Compute EVPI
expected value given perfect information= 1,300,000(.70) + 500,000(.30)
= $1,060,000
[Page 550]
expected value without perfect information= $1,300,000(.70) 150,000(.30)
= $865,000
EVPI= $1,060,000 865,000 = $195,000
Step 4. (part D): Develop a Decision Tree
Step 5. (part E): Determine Posterior Probabilities
[Page 551]
Step 6. (part F): Perform Decision Tree Analysis with Posterior Probabilities
