Questions on Decision Analysis

Questions on Decision Analysis

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1. One of Philip Mahn’s investments is going to mature, and he wants to determine how to invest the proceeds of $30,000. Philip is considering two new investments: a stock mutual fund and a one-year certificate of deposit (CD). The CD is guaranteed to pay an 8% return. Philip estimates the return on the stock mutual fund as 16%, 9%, or -2%, depending on whether market conditions are good, average, or poor, respectively. Philip estimates the probability of a good, average, and poor market to be 0.1, 0.85, and 0.05, respectively. Construct a payoff matrix. What decision should be made according to the maximax decision rule? What decision should be made according to the maximin decision rule? What decision should be made according to the minimax regret decision rule? What decision should be made according to the EMV decision rule? What decision should be made according to the EOL decision rule? How much should Philip be willing to pay to obtain a market forecast that is 100% accurate?

2. Morley Properties is planning to build a condominium development on St Simons Island, Georgia. The company is trying to decide between building a small, medium, or large development. The payoffs received for each size of development will depend on the market demad for condominiums in the area, which could be low, medium, or high. The payoff matrix for this decision problem is: Market Demand Size of Development Low Med High Small 400 400 400 Medium 200 500 500 Large -400 300 800 (Payoffs in 1,000s) The owner of the company estimates a 21.75% chance that market demand will be low, a 35.5% chance that it will be medium, and a 42.75% chance that it will be high. What decision should be made according to the EMV decision rule? Solve using a decision tree.

3. Bulloch County never has allowed liquor to be sold in restaurants. However, in three months, county residents are scheduled to vote on a referendum to allow liquor to be sold by the drink. Currently, polls indicate a 60% chance that the referendum will be passed by voters. Phil Jackson is a local real estate speculator who is eyeing a closed restaurant building that is scheduled to be sold at a sealed bid auction. Phil estimates that if he bids $ 1.25 million, there is a 25% chance he will obtain the property; if he bids $ 1.45 million, there is a 45% chance he will obtain the property; and if he bids $ 1.85 million, there is an 85% chance he will obtain the property. If he acquires the property and the referendum passes, Phil believes he could then sell the restaurant for $ 2.2 million. However, if the referendum fails, he believes he could sell the property for only $ 1.15 million.

a. Develop a decision tree for this problem.

b. What is the optimal decision according to the EMV criterion