1.

The Campus Bookstore at East Tennessee State University must decide how many economics textbooks
to order for the next semesters class. The bookstore believes that seven, eight, nine or ten sections of the
course will be offered next semester; each section contains 40 students. The publisher is offering
bookstores a discount if they place their orders early. If the bookstore orders too few texts and runs out,
the publisher will air express additional books at the bookstores expense. If it orders too many texts, the
store can return unsold texts to the publisher for a partial credit. The bookstore is considering ordering
280, 320, 360 or 400 texts in order to get the discount. Taking into account the discounts, air express
expenses, and credits for returned texts, the bookstore manager estimates the following resulting profits.

Number of Introductory Economic Classes Offered

Number of
Textbooks to Order
280
320
360
400
a.
b.

c.

d.

7
$2,800
$2,600
$2,400
$2,200

8
$2,720
$3,200
$3,000
$2,800

9
$2,640
$3,040
$3,600
$3,400

10
$2,480
$2,880
$3,440
$4,000

What is the optimal decision if the bookstore manager uses the maximax criterion?
The manager would order 400 textbooks (the maximum of the maximum decision alternatives).
What is the optimal decision if the bookstore manager uses the maximin criterion?
280 has a minimum of $2,480
320 has a minimum of $2,600
360 has a minimum of $2,400
400 has a minimum of $2,200
The maximum of the decision alternative is 320; the manager would order 320 books.
What is the optimal decision if the bookstore manager uses the minimax regret criterion?
280 has a maximum regret of 1520
320 has a maximum regret of 1120
360 has a maximum regret of 560
400 has a maximum regret of 600
The minimum of these maximum regrets is 560; the manager would order 360 books.
What is the optimal decision if the bookstore manager uses the principle of insufficient reason criterion?
280 has a total of 10,640
320 has a total of 11,720
360 has a total of 12,440
400 has a total of 12,400
The maximum is 12,440; the manager would order 360 books.

2.

a.

Consider the data given in problem 1. Based on conversations with the chair of the economics
department, suppose the bookstore manager believes that the following probabilities hold:
P( 7 classes offered) = .10
P( 8 classes offered) = .30
P( 9 classes offered) = .40
P(10 classes offered) = .20
Using the expected value criterion, determine how many economics books the bookstore manager should
purchase in order to maximize the stores expected profit. Do you think the expected value criterion is
appropriate for this problem?
EV(280) = $2,648
EV(320) = $3,012
EV(360) = $3,268
EV(400) = $3,220

b.

EV(360) has the highest expected payoff; the manager should purchase 360 books.
The expected value criterion only assures us that the decision will be optimal in the long run when the
problem is faced over and over again. In this situation, the bookstore manager is facing the problem only
once and basing an optimal decision solely on expected value may not be optimal.
Based on the probabilities given in part (a), determine the expected value of perfect information and
interpret its meaning.
The expected return with perfect information is .1(2800) + .3(3200) + .4(3600) + .2(4000) = $3,480
The expected value of perfect information is 3480 3268 = 212. This represents the gain in expected
return resulting by knowing the probabilities of how the classes are going to be assigned.

Here are the WINSQB results:

3.

National Foods has developed a new sports beverage it would like to advertise on the Super Bowl
Sunday. Nationals advertising Agency can purchase either one, two or three 30second commercials
advertising the drink. It estimated that the return will be based on Super Bowl viewer ship, which in turn
based on fans perceptions whether the game is dull average, above average , or exiting
Nationals foods ad agency has constructed the following payoff table giving the estimate of the expected
profit (in $100,000) resulting from purchasing one, two, three advertising spots.(Another possible
decision is for National foods is not to advertise at all during the super bowl.) The states of nature
correspond to the game being dull average, above average , or exiting
Number of 30Second
Commercials

Perceived Game
Excitement
Dull

Average

Above Average

Exciting

One

-2

13

Two

-5

12

18

Three

-9

13

22

a) What is the optimal decision if the National Foods advertising manager is optimistic?
b) What is the optimal decision if the National Foods advertising manager is pessimistic?
c) What is the optimal decision if the National Foods advertising manager wishes to minimize the firms
maximum regret?

Number of 30-second
Commercials
Purchased

Perceived Game Excitement

Dull

Average

Above
average

Exciting

Maximum
Payoff

One

-2

13

13

Two

-5

12

18

18

Three

-9

13

22

22

a) Optimal decision if the advertising manager is optimistic

This is a Max-max approach.
The optimal decision is to buy 3 30-second commercials expecting the game to be exciting
b) Optimal decision if the advertising manager is pessimistic
This is a Max-min approach, and the manager wants to choose

The solution with the maximum payoff in the worst-case scenario.

In this case the optimal decision is to buy one 30-second commercial.
The manager could also decide to not buy anything at all if he is pessimistic. However,
This would result in 0 profit which, is not the worst-case scenario!

c) The optimal decision if the advertising manager wishes to minimize the firms maximum
regret.
Regret table
Number of 30-second
Commercials
Purchased

Perceived Game Excitement

Dull

Average

Above
average

Exciting

Maximum
regret

One

Two

Three

The optimal decision is to buy 2 30-second commercials.

Analysis with WinQSB

Payoff Decision for National Foods

Best

Decision

Criterion

Decision

Value

Maximin

One

(Pessimistic Manager)

Maximax

Three $22

($2)

(Optimistic Manager)

Hurwicz (p=0.5)

Two

$6.50

Minimax Regret

Two

$4

Expected Value

Two

$6.80

Equal Likelihood

Two

$7.75

Expected Regret

Two

$1.30

(Minimize maximum regret)

Expected Value without any Information =

$6.80

Expected Value with Perfect Information = $8.10

Expected Value of Perfect Information =

$1.30

As shown above, utilizing the WinQSB application produces the same results as those calculated
mathematically by hand.

4. Consider the data given on problem 3 for National Foods. Based on the past Super Bowl games, suppose
the decision maker believes the following probabilities hold for the states of nature;
P (Dull game) = .20
P(Average Game) = .40
P(Above Average Game) = .30
P(Exciting Game) = .10
a) Using the expected value criterion, determine how many commercials National Foods should purchase.
b) Based on the probabilities given here, determine the expected value of perfect information.
Perceived Game Excitement
Commercials Purchased
One commercial
Two commercial
Three commercial

Dull
$-200,000
$-500,000
$-900,000

Number of 30-Second
Average
Above Average
$300,000
$700,000
$600,000
$1,200,000
$500,000
$1,300,000

Exciting
$1,300,000
$1,800,000
$2,200,000

P(Dull game) = .20

P(Average Game) = .40
P(Above Average Game) = .30
P(Exciting Game) = .10
Expected Return
1 Commercial = .20(-200,000) +.40(300,000) +.30(700,000) +.10(1,300,000) = $420,000
2 Commercial = .20(-500,000) +.40(600,000) +.30(1,200,000) +.10(1,800,000) = $680,000
3 Commercial = .20(-900,000) +.40(500,000) +.30(1,300,000) +.10(2,2000,000) = $630,000
a. Expected Value Criterion -- 2 commercials
Expected Value without any Information = $680,000
Expected Value with Perfect Information = $810,000
Expected Value of Perfect Information =
$130,000

b. EVPI -- $130,000

5. Consider the data given in problems 3 and 4 for National Foods. The firm can hire the noted sports pundit
Jim Worden to give his opinion as to whether or not the Super Bowl game will be interesting. Suppose the
following probabilities hold for Jims predictions:
P(Jim predicts game will be interesting game is dull) = .15
P(Jim predicts game will be interesting game is average = .25
P(Jim predicts game will be interesting game is above average = .50
P(Jim predicts game will be interesting game is exciting = .80
P(Jim predicts game will not be interesting game is actually dull) = .85
P(Jim predicts game will not be interesting game is average) = .75
P(Jim predicts game will not be interesting game is above average) = .50
P(Jim predicts game will not be interesting game is exciting) = .20

a.

Jim predict the game will be interesting, what is the If probability the game will be dull?

States of
Prior
Nature
Probabilities
Si
P(Si)
Dull Game
.20
Average Game .40
Above Average .30
Exciting Game .10
States of
Prior
Nature
Probabilities
Si
P(Si)
Dull Game
.20
Average Game .40
Above Average .30
Exciting Game .10

Conditional
Posterior
Probabilities
Joint Probabilities
Probabilities
P(Interesting|Si)
P(InterestingnSi)
P(Si|Interesting)
.15
.03
.03/.36 = .08
.25
.10
.10/.36 = .28
.50
.15
.15/.36 = .42
.08/.36 = .22
.80
.08
P(Interesting) = .36
Conditional
Posterior
Probabilities
Joint Probabilities
Probabilities
P(Non Interesting|Si)
P(Non InterestingnSi) P(Si|Non Interesting)
.85
.17
.17/.64 = .27
.75
.30
.30/.64 = .47
.50
.15
.15/.64 = .23
.20
.02
.02/.64 = .03
P(Non Interesting) = .64

a) If Jim predicts that the game will be interesting, there is 8.3% probability
that the game will be dull

b)
EV
(one/interesting)
=

.083*(-200,000) + 0.278*300,000 + 0.417*700,000 +

0.222*1,300,000 =
= -(16,600) + 83,400 + 291,900 + 288,600 = $647,300

EV
(two/interesting)
=

.083*(-500,000) + 0.278*600,000 + 0.417*1,200,000 +

0.222*1,800,000 =
= -(41,500) + 166,800 + 500,400 + 399,600 = $1,025,300

EV
.083*(-900,000) + 0.278*500,000 + 0.417*1,300,000 +
(three/interesting) 0.222*2,200,000 =
=
= -(74,700) + 139,000 + 542,100 + 488,400 = $1,094,800
National optimal strategy would be to buy three commercials, if Jim predicts
the game to be interesting

EV (one/not
interesting) =

0.266*(-200,000) + 0.469*300,000 + 0.234*700,000 +

0.031*1,300,000 =
= -(53,200) + 140,700 + 163,800 + 40,300 = $291,600

EV (two/not
interesting) =

.266*(-500,000) + 0.469*600,000 + 0.234*1,200,000 +

0.031*1,800,000 =
= -(133,000) + 281,400 + 280,800 + 55,800 = $485,300

EV
.266*(-900,000) + 0.469*500,000 + 0.234*1,300,000 +
(three/interesting) 0.031*2,200,000 =
=
= -(239,400) + 234,500 + 304,200 + 68,200 = $367,500
National optimal strategy would be to buy two commercials, if Jim predicts the
game to be not interesting
c)
Expected Return with Sample Information (ERSI) = 0.36* $1,094,800 + 0.64*
$485,300 = $394,128 + $310,592 = $704,720
From Problem 6.4 Expected Return Without Additional Information (EREV) =
$680,000 (from buying 2 commercials)
Expected Return with Sample Information (ERSI) = 0.36* $1,094,800 + 0.64*
$485,300 = $394,128 + $310,592 = $704,720
From Problem 6.4 Expected Return Without Additional Information (EREV) =
$680,000 (from buying 2 commercials)
Expected Value of Jim's Information (EVSI) = $704,720 - $680,000 = $24,720
Therefore:
Expected Return with Sample Information (ERSI) = 0.36* $1,094,800 + 0.64*
$485,300 = $394,128 + $310,592 = $704,720
From Problem 6.4 Expected Return Without Additional Information (EREV) =
$680,000 (from buying 2 commercials)
Expected Value of Jim's Information (EVSI) = $704,720 $680,000 = $24,720

Solve using WinQSB

Using the conditional probabilities of Jims predictions, WinQSB calculated the joint probabilities as follows:
Posterior or Revised Probabilities for National Foods

Indicator\State

State1

State2

State3

State4

Indicator1

0.0833

0.2778

0.4167

0.2222

Indicator2

0.2656

0.4688

0.2344

0.0313

The joint probabilities were also calculated by WinQSB:

Joint Probabilities for National Foods

State\Indicator

Indicator1

Indicator2

State1

0.03

0.17

State2

0.1

0.3

State3

0.15

0.15

State4

0.08

0.02

The payoff decision table for National Foods calculated by WinQSB confirms the results obtained above as
illustrated in the table below.
Payoff Decision for National Foods

Criterion
Maximin
Maximax
Hurwicz (p=0.5)
Minimax Regret
Expected Value
Equal Likelihood
Expected Regret

If Outcome =
Interesting
One
Three
Two
Two
Three
Two
Three

Decision
Value
($2)
$22
$6.50
$4
$10.94
$7.75
$0.86

If Outcome =
Not Interesting
One
Three
Two
Two
Two
Two
Two

Expected Value
Expected Value
Expected Value
Expected Value
Expected Value
Efficiency (%)

without any
with Perfect
of Perfect
with Sample
of Sample
of Sample

Information =
Information =
Information =
Information =
Information =
Information =

$6.80
$8.10
$1.30
$7.05
$0.25
19.23%

Decision
Value
($2)
$22
$6.50
$4
$4.86
$7.75
$1.16

6. Steve Greene is considering purchasing fire insurance for his home. According to statistics for Steves
county, Steve estimates the damage from fire to his home in a given year is as follows:
Amount of Damage
0
$10,000
$20,000
$30,000
$50,000
$100,000

Probability
.975
.010
.008
.004
.002
.001

a. If Steve is risk neutral, how much should he be willing to pay for the fire insurance?
The optimal decision for a risk-neutral, decision-maker can be determined using the expected value criterion
on the payoff values.

.975(0) + .010(10,000) + .008(20,000) + .004(30,000) + .002(50,000) + .001(100,000) = 580.

He should be willing to pay $580 for fire insurance.
Suppose Steves utility values are as follows:

Utility

Amount of Loss ($1000s)

100
50
30
20

10

.95

.995

.65

.75

.8

b. What is the expected utility corresponding to fire damage?

Substitute the utility value for the expected value and solve as follows:
.975(1) + .010(.95) + .008(.8) + .004(.75) + .002(.65) + .001(0) = .9952
c. The expected utility of .9952 is approximately = 1, which means he should be willing to spend about
$1,000. Notice that, this approximation is conservative, therefore he is on the safe side.

7. Freda Fitness is expanding her personal training business by opening another gym location. She has three
possible sites from which to choose. Freda has found that her business success follows the trend in the
nutrition industry, which is expanding, stable, or declining. Given each trend, her expected profit/loss in the
first year of operation for each site is shown below:

Site 1
Site 2
Site 3

Expanding
50000
100000
80000

Stable
20000
50000
60000

Decline
0
-40000
10000

a. If Freda is an optimist and wishes to maximize her maximum profit, which site should she choose using the
maximax approach?

MAXIMAX
Site 1
Site 2
Site 3

maximum payoff
50,000
100,000
80,000

maximax value

She should choose site 2.

b. If Freda is a pessimist but wishes to minimize her regret, what site should she choose using the minimax
regret approach?
b. Under the minimax regret approach, Freda determines the maximum regret for each decision alternative by
creating a regret table and then chooses the one which has the minimum maximum regret. The regret table
for this decision is shown below:

Expanding
50,000
0
20,000

Site 1
Site 2
Site 3

MINIMAX REGRET
Site 1
Site 2
Site 3

Stable
40,000
10,000
0

Declining
10,000
50,000
0

maximum regret
50,000
50,000
20,000

minimax regret value

Here, the maximum regret for Site 1 is $50,000; $50,000 for Site 2 and $20,000 for Site 3.
The site with the minimum maximum regret is Site 3 so Freda should select this site.
8. Continuation of problem No. 7, Based on long-term trends in the nutrition industry, Freda projects the
following probabilities for the state of the industry:
Expanding
30%
Stable
50%
Declining
20%
Given these probabilities, what decision should Freda make to maximize her expected profit?
Given probability estimates for the states of nature, an expected value can be calculated for each decision
alternative by multiplying the probability for each state of nature by the associated return and then summing
these products. To maximize expected profit, Freda should choose the decision alternative with the best
expected value. The expected value of each decision alternative is as follows:
Site 1 = .3(50,000) + .5(20,000) + .2(0) =
Site 2 = .3(100,000) + .5(50,000) + .2(-40,000) =
Site 3 = .3(80,000) + .5(60,000) + .2(10,000) =

25,000
47,000
56,000

The site with the highest expected value is Site 3 so Freda should select this site.

9. The CNN wants to market a new series program, whose success probability was estimated to be 0.80.
Suppose a marketing research agency is hired to evaluate the program. The past experience indicates that the
agency has 90% of accuracy in predicting a success and 80% of accuracy in predicting a failure. What is the
probability that the program is successful given a favorable prediction? What is the probability that the
program is a failure given an unfavorable prediction?

Positive

FAVORABLE
Successful
Unsuccessful

prior

conditional

joint

posterior

.80
.20

.90
.20

.72
.04
.76

.72/.76 = .95
.04/.76 = .05

Negative

10

UNFAVORABLE
Successful
Unsuccessful

prior

conditional

joint

posterior

.80
.20

.10
.80

.08
.16
.24

.08/.24 = .33
.16/.24 = .67

10. Buzzy-B Toys must decide the course of action to follow in promoting a new whistling yo-yo. Initially,
management must decide whether to market the yo-yo or to conduct a test marketing program. After test
marketing the yo-yo, management must decide whether to abandon it or nationally distribute it.
A national success will increase profits by $500,000, and a failure will reduce profits by $100,000.
Abandoning the product will not affect profits. The test marketing will cost Buzzy-B a further $10,000.
If no test marketing is conducted, the probability for a national success is judged to be 0.45. The
assumed probability for a favorable test marketing result is 0.50. The conditional probability for national
success given favorable test marketing, is 0.80, for national success given unfavorable test results, it is 0.10.
Construct the decision tree diagram and perform backward induction analysis to determine the optimal course
of action.
Net Payoffs

Success, 0.80

$490,000

Market
Failure, 0.20
-$110,000
Favorable, 0.50

Abandon

Test market

-$10,000
Success, 0.10

Unfavorable, 0.50

$490,000

Market
Failure, 0.90
-$110,000

Abandon
Don't test market
Success, 0.45

-$10,000
$500,000

Market
Failure, 0.55
Abandon

$-100,000
$0
Net Payoffs

11

$370,000
$370,000

Success, 0.80

$490,000

Market
Failure, 0.20
//

Favorable, 0.50
$180,000
Test market
$180,000

Unfavorable, 0.50

//

-$10,000

-$110,000

Abandon
-$50,000
Market
\\

-$10,000
Success, 0.10

Failure, 0.90
-$110,000

Abandon

Don't test market

$170,000
Market

Success, 0.45

-$10,000
$500,000

Failure, 0.55

$170,000
Optimal Strategy:
Test the market
If Favorable, Market
Otherwise, Abandon.

$490,000

Abandon

$-100,000
$0

12