REVISION QUESTIONS

STA 3113: DECISION THEORY

Question 1 (See notes)
Distinguish between the following terms as used in Decision Theory;
(i) Prior Probability and Posterior Probability (2 Marks)
(ii) Single-Stage and Multi-Stage decision processes (2 Marks)
(iii)Zero-sum game and Non-zero sum game (2 Marks)

Question 2 (See notes Section 12.1.3 Paragraph 1)

Citing an appropriate example, explain why the aspiration-level criterion does not yield
an optimal decision in the sense of maximizing profit or minimizing cost, but is a means
of determining acceptable courses of action (5 Marks)

Question 3 Find Solution from the notes Section 12.1.4)

Briefly describe the most likely future criterion (4 Marks)

Question 4 (Similar to Qn 1b Revision Partner)

The following pay-off matrix shows the potential profits and losses, in millions of
shillings, which are expected to arise from launching four new products P1, P2, P3 and
P4, in five markets M1, M2, M3, M4 and M5.
Product
P1 P2 P3 P4
M1 15 3 1 7
M2 10 14 5 19
Market M3 0 8 14 10
M4 6 9 20 2
M5 17 2 11 5
Assuming that the products are mutually exclusive, evaluate the best decision using;
i) Laplace criterion (5 Marks)

ii) Hurwicz criterion (5 Marks)

iii) Minimax Regret Criterion (5 Marks)
iv) Maximin Criterion (5 Marks)
Question 5
1. Briefly explain what you understand by the following terms;
(i) Risk aversion factor (See notes for Utility Index Curve) (2 Marks)
(ii) Saddle point (see notes 12.4.1 2nd last Paragraph) (2 Marks)

Question 6 (See notes Section 12.1.1 Expected Value Criterion Paragraph 3)

Explain the drawback that is usually cited against using the expected value criterion in
making decisions (5 Marks)

The Management of Unga Ltd is faced with the decision whether to build a new plant,
expand the existing plant or subcontract some of the operations of the company in
order to meet the increasing demand of the company’s product. To build a new plant
will cost 20 million shillings, expanding the existing plant will cost 10 million shillings
while subcontracting some of the operations of the company will cost 7 million shillings.
The future demand of the company’s products is expected to be high, moderate or low
with probabilities of 0.2, 0.5 and 0.3 respectively. The projected sales revenue under
the various options is given in millions in the table below;
State of Demand
Decision High Moderate Low
Build 70 40 15
Expand 40 30 25
Subcontract 30 20 25
Before making the decision, Unga Ltd may decide to contract a market
consultant to conduct a market survey on the future prospects of the company’s
products. The market survey will cost the company 2 million shillings, and the
outcome of the survey will either be acceptable or unacceptable with
probabilities of 0.4 and 0.6 respectively. If the outcome of the survey is
acceptable, the probabilities of high, moderate or low demand would be 0.7, 0.2
and 0.1, respectively. If the outcome of the survey is unacceptable, the
probabilities of high, moderate or low demand would be 0.1, 0.3 and 0.6
respectively, and Unga ltd will not build a new plant.
Draw a decision tree for this problem, and calculate the expected monetary value
of each decision. Hence, recommend an appropriate decision to Unga ltd
(10
Marks)
Question 7 (See example 12.1-4 Experimental Data in Decisions Under Risk)
Kaluworks Ltd produces aluminium sufurias in lots of fixed sizes. Occasionally,
malfunctions in the production process occur. As a result, bad lots with an unacceptable
number of defectives may be produced. Past experience indicates that the likelihood of
producing a bad lot is 0.04. The Operations manager has been considering this
probability as sufficiently small to warrant a random selection of the lots prior to
delivering to customers. However, he received a complaint recently from one of the
customers that some of the lots of sufurias he received had some defective sufurias. He
has now asked the Quality Control Department to handle the complaint and ensure that
it does not occur again. The Quality Control Department decides to employ a method
whereby they will be sampling some sufurias from lots ready for delivery and test them.
As a first step, they decide to be testing a sample of two items from each lot. Suppose
the defectives in a good lot is 5%, while a bad lot has 16% defective items;
(i) Work out the posterior probabilities and comment on these probabilities.
 (10 Marks)
(ii) Suppose Kaluworks Ltd ships sufurias to two customers, Tuskys Supermarket
and Uchumi Supermarket. The contracts specify that the percentage of
defectives for Tuskys and Uchumi should not exceed 5 and 8, respectively. A
penalty of KShs. 8,000 is incurred per percentage point above the maximum
limit. On the other hand, supplying better quality lots will cost the manufacturer
KShs. 6,400 per percentage point. How should the manufacturer decide where to
deliver an inspected lot? (10 Marks)
Question 8 ( See example 12.4.2 & Qn 7 b Study Text)
a) Distinguish between a pure strategy game and a mixed strategy game (2 Marks)
b) Consider the following game;
B

i) Does this game have a saddle point? (3 Marks)

ii) Determine optimal strategy and the corresponding value of the game
(5
Marks)

Question 9 (To answer this qn, you need to understand example 12.1-1 notes)

a) The JKUAT preventive maintenance policy requires making decisions about when a
machine should be serviced on a regular basis in order to minimize the cost of
sudden breakdown. The time horizon is specified in terms of equal time periods, and
thus, the decision entails determining the optimal number of periods between two
successive maintenances. If preventive maintenance is applied too frequently, the
maintenance cost will increase while the cost of sudden break down will decrease.
Therefore, a compromise between the two cases calls for balancing the costs of
preventive maintenance and sudden breakdown.
The decision situation can be summarized as follows; A machine in a group of n
machines is serviced when it breaks down. At the end of T periods, preventive
maintenance is performed by servicing all n machines. The decision problem is to
determine the optimum T that minimizes the total cost per period of servicing
broken machines and applying preventive maintenance.
Let Pt be the probability that a machine would breakdown in period t, and nt be the
random variable representing the number of broken machines in the same period.
Further, assume c1 is the cost of repairing a broken machine and c2 the preventive
maintenance cost per machine. Suppose c1=1000/= and c2=100/=, and n=50. The
probabilities are tabulated below;

T 1 2 3 4 5
Pt 0.05 0.07 0.10 0.13 0.18
Determine, using the expected value-variance criterion, the optimal number of time
periods after which preventive maintenance should be applied (10 Marks)

The future demand of the company’s products is expected to be high, moderate or

low with probabilities of 0.2, 0.5 and 0.3 respectively. The projected sales revenue
under the various options is given in millions in the table below;
State of Demand
Decision High Moderate Low
Build 70 40 15
Expand 40 30 25
Subcontract 30 20 25
Before making the decision, Unga Ltd may decide to contract a market
consultant to conduct a market survey on the future prospects of the company’s
products. The market survey will cost the company 2 million shillings, and the
outcome of the survey will either be acceptable or unacceptable with
probabilities of 0.4 and 0.6 respectively. If the outcome of the survey is
acceptable, the probabilities of high, moderate or low demand would be 0.7, 0.2
and 0.1, respectively. If the outcome of the survey is unacceptable, the
probabilities of high, moderate or low demand would be 0.1, 0.3 and 0.6
respectively, and Unga ltd will not build a new plant.
Draw a decision tree for this problem, and calculate the expected monetary value
of each decision. Hence, recommend an appropriate decision to Unga ltd
(10
Marks)
Question 10 (Similar to Qn 3 Revision Partner)

Dr. Joel Chelule is considering investing in farm machinery. There are two models
available in the market i.e. Model A and model B. The following details relate to
each of the models;

Model A

The estimated cost is 7, 500, 000/= resulting in an annual profit of 3, 000,

000/= if the demand is high or an annual loss of 950, 000/= if the demand is
low. The probability of a high demand is 0.7 while that of a low demand is 0.3.

Model B

The estimated cost is 4, 750, 000/= resulting in an annual profit of 1, 650,

000/= if the demand is high or 275, 000/= if the demand is low. The probability
of a high demand is 0.9 and that of a low demand is 0.1.

The following are some additional information;

i) Dr. Chelule can commission a survey in the next one year in order to
obtain more information on the viability of the investment. The outcome
of the survey would lead to either undertaking or abandoning the
investment with a probability of 0.6 and 0.4, respectively.

ii) The cost of purchase of each model and the corresponding resultant
profitability remain unchanged to the time of completion of the survey but
the revised probabilities of high or low demand would be 0.8 and 0.2,
respectively, irrespective of the model purchased.

iii) The estimated useful life of both models is 5 years from now with an
estimated present value at disposal of 700, 000/= for model A and 150,
000/= for model B.

iv) All cash flows are given at their present values.

 Using a decision tree diagram, advice Dr. Chelule on the best course of action and
the expected return
Question 11 (Similar to Qn 5 Revision Partner)
Generator Solutions Ltd has produced a new model of diesel generator. The
management of the company has to make a decision whether to test market the
generator or to abandon it. The cost of test marketing the generator is 100 million
shillings. The response from the test marketing could either be positive or negative
with probabilities 0.6 and 0.4, respectively. If the response from test marketing is
positive, the company could either abandon the generator or launch it into the
market. If the company launches the generator into the market, the outcome might
be low, medium or high demand with net pay-offs of 92 million, 200 million and 1,
000, respectively. Low, medium and high demands have probabilities of 0.2, 0.5 and
0.3 respectively.
If the result of the test marketing is negative, the company could either abandon
the generator or launch it into the market at an estimated loss of 600 million
shillings. If the company abandons the generator at any point, the company would
realize a net gain of 50 million shillings from sale of generator as scrap.
a) Draw a decision tree to represent the above information
b) Advice the management of Generator Solutions ltd on the best course of action
Question 12 (Qn 4ii Revision Partner & Pg 260 Study Text)
Outline four limitations of game theory in decision making (4 Marks)
Question 13 (Similar to Qn 10 c Revision Partner)
Two robbery suspects are arrested and separated. The prosecutor has little evidence
and is anxious to obtain a little confession from each of the suspects. The
prosecutor separately confides to each that; “If you confess and your companion
does not, I can assure a reduced 6-month sentence, whereas your companion will
get a 10-year sentence. If both of you confess, each will get a 5-year sentence”.
The suspects know that if they do not confess, they will be tried for a lesser crime
with a maximum of 2 years jail sentence each.
i) Obtain a pay-off matrix if the two suspects cannot communicate (4 Marks)
ii) Suppose they are able to communicate, which strategy would dominate?
 (1 Mark)
Question 14 (Solution from the notes Section 12.1.3 Paragraph 2)
Aspiration Level Criterion is classified as one of the decision – making criteria under
decision making under risk yet there is no probability distribution. Explain why this is
the case.