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# Decision Theory

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Do not do D in # 8

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8) A local real estate investor in Orlando is considering thre3e alternative investments: a motel, a restaurant, or a theater. Profits from the motel or restaurant will be affected by the availability of gasoline and the number of tourist; profits from the theater will be relatively stable under any conditions. The following payoff table shown the profit or loss that could result from each investment.
Gasoline Available
Investment Shortage Stable Supply Surplus
Motel \$-8,000 \$15,000 \$20,000
Restaurant 2,000 8,000 6,000
Theater 6,000 6,000 5,000

Determine the best investment using the following decision criteria.
A. Maximax
B. Maximin
C. Minimax regret
D. N/A
E. Equal likelihood

18) The Miramar Company is going to introduce one of these new products: a widget, a hummer, or a nimnot. The market conditions (favorable, stable, or unfavorable) will determine the profit or loss the company realizes, as shown in the following payoff table.
Market Conditions
Product Favorable .2 Stable .7 Unfavorable .1
Widget \$120,000 \$70,000 \$-30,000
Hummer 60,000 40,000 20,000
Nimnot 35,000 30,000 30,000
A. Compute the expected value for each decision tree and select the best one.
B. Develop the opportunity loss table and compute the expected opportunity loss for each product.
C. Determine how much the firm would be willing to pay to a market research firm to gain better information about future market conditions.
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#### Solution Summary

To decide best investment using decision theory.

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## Decision theory

See attached notes to solve for problems in the attachment. Show work.

3-17
Although Ken Brown is the principal owner of Brown Oil, his brother Bob is credited with making the company a financial success. Bob is vice president of finance. Bob attributes his success to his pessimistic attitude about business and the oil industry. Given the information from problem 3-16, it is likely that Bob will arrive at a different decision. What decision criterion should Bob use, and what alternative will he select?

3-19
Mickey Lawson is considering investing some money that he inherited. The following payoff table gives the profits that would be realized during the next year for each of the three investment alternatives Mickey is considering:

STATE OF NATURE

DECISION GOOD POOR
ALTERNATIVE ECONOMY ECONOMY

Stock Market 80,000 - 20,000

Bonds 30,000 20,000

CDs 23,000 23,000

Probability 0.5 0.5

(a) What decision would maximize expected profits?
(b) What is the maximum amount that should be paid for perfect forecast of the economy?

3-23
Today's Electronics specializes in manufacturing modern electronic components. It also builds the equipment that produces the components. Phyllis Weinberger, who is responsible for advertising the president of Today's Electronics on electronic manufacturing equipment, has developed the following table concerning a proposed facility:

PROFIT (\$)
STRONG FAIR POOR
MARKET MARKET MARKET

Large facility 550,000 110,000 - 310,000

Medium-sized facility 300,000 129,000 - 100,000

Small facility 200,000 100,000 - 32,000

No facility 0 0 0

(a) Develop an opportunity loss table.
(b) What is the minimax regret decision?

3-28
A group of medical professionals is considering the construction of a private clinic. If the medical demand is high (i.e., there is a favorable market for the clinic), the physicians could realize a net profit of \$100,000. If the market is not favorable, they could lose \$40,000. Of course, they don't have to proceed at all, in which case there is no cost. In the absence of any market data, the best the physicians can guess is that there is a 50 - 50 chance the clinic will be successful. Construct a decision tree to help analyze this problem. What should the medical professionals do?

3-29
The physicians in Problem 3-28 have been approached by a market research firm that offers to perform a study of the market at a fee of \$5,000. The market researchers claim their experiences enable them to use Bayes' theorem to make the following statements of probability:

probability of a favorable market given
a favorable study = 0.82
probability of an unfavorable market given
a favorable study = 0.18
probability of a favorable market given
an unfavorable study = 0.11
probability of an unfavorable market given
an unfavorable study = 0.89
probability of a favorable research
study = 0.55
probability of an unfavorable research study = 0.45

(a) Develop a new decision tree for the medical professionals to reflect the options now open with the market study.
(b) Use EMV approach to recommend a strategy.
(c) What is the expected value of sample information? How much might the physicians be willing to pay for a market study?

3-32
Bill Holliday is not sure what he should do. He can either build a quadplex (i.e., a building with four apartments), build a duplex, gather information, or simply do nothing. If he gathers additional information, the results could be either favorable or unfavorable, but it would cost him \$3,000 to gather the information. Bill believes that there is a 50-50 chance that the information will be favorable. If the rental market is favorable, Bill will earn \$15,000 with the quadplex or \$5,000 with the duplex. Bill doesn't have the financial resources to do both. With an unfavorable rental market, however, Bill could lose \$20,000 with the quadplex or \$10,000 with the duplex. Without gathering additional information, Bill estimates that the probability of a favorable rental market is 0.7. A favorable report from the study would increase the probability of a favorable rental market to 0.9. Furthermore, an unfavorable report from the additional information would decrease the probability of a favorable rental market to 0.4. Of course, Bill would forget all of these numbers and do nothing. What is your advice to Bill?

3-41
In this chapter a decision tree was developed for John Thompson. After completing the analysis, John was not completely sure that he is indifferent to risk. After going through a number of standard gambles, John was able to assess his utility for money. Here are some of the utility assessments: U( - \$190,000) = 0, U( - \$180,000) = 0.15, U(- \$30,000) = 0.2, U(\$0) = 0.3, U(\$90,000) = 0.5, U(\$100,000) = 0.6, U(\$190,000) = 0.95, and U(\$200,000) = 1.0. If John maximizes his expected utility, does his decision change?

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