Solved problems in decision theory

Exercise 7

Exercise 8

An avionics company is investigating the possibility of manufacturing and marketing a new

microprocessor with almost natural intelligence for the airplanes of the future. The project requires the
purchase of a sophisticated supercomputing center, or the hiring of more engineers, obviously the
company reserves the option of not developing the product. The new product may have a favorable or
unfavorable reception in the market, with a favorable reception in the market the estimated sales would
reach 50,000 microprocessors, on the contrary, if the market reception was not favorable the estimated
sales would be 20,000 microprocessors. The sales price of the microprocessors is 200 euros each unit.
The cost of the supercomputing center is
2,000,000 euros, while the cost of hiring and training new engineers amounts to 1,000,000 euros. The
expected manufacturing cost is 40 euros each unit if manufactured without the help of the
supercomputing center, and 10 euros if it is manufactured with said help. The probability that the new
microprocessor will receive a favorable reception by the market is 50%.
1. Suggest the decision that the company's management should make based on the application of the
expected value criterion.
2. Determine for what favorable market probability range you should purchase the supercomputing
center.
3. Favorable sales have been defined as those that reach 50,000 units. This number is probably too
optimistic, find the value at which you would change your decision and hire more engineers.
Solution on page 49
 Solved problems in decision theory

Troubleshooting

Exercise 8

An avionics company is investigating the possibility of manufacturing and marketing a new

microprocessor with almost natural intelligence for the airplanes of the future. The project requires the
purchase of a sophisticated supercomputing center, or the hiring of more engineers, obviously the
company reserves the option of not developing the product. The new product may have a favorable or
unfavorable reception in the market, with a favorable reception in the market the estimated sales would
reach 50,000 microprocessors, on the contrary, if the market reception was not favorable the estimated
sales would be 20,000 microprocessors. The sales price of the microprocessors is 200 euros each unit. The
cost of the supercomputing center is
2,000,000 euros, while the cost of hiring and training new engineers amounts to 1,000,000 euros. The
expected manufacturing cost is 40 euros each unit if manufactured without the help of the
supercomputing center, and 10 euros if it is manufactured with said help. The probability that the new
microprocessor will receive a favorable reception by the market is 50%.
1. Suggest the decision that the company's management should make based on the application of the
expected value criterion.
2. Determine for what favorable market probability range you should purchase the supercomputing
center.
3. Favorable sales have been defined as those that reach 50,000 units. This number is probably too
optimistic, find the value at which you would change your decision and hire more engineers.
Solution:

1. Suggest the decision that the company's management should make based on the application of the
expected value criterion
Step 1 - List the different decision alternatives.

Buy supercomputing center.

Hire more engineers.

Do not develop the new product.

Step 2 - List for each of the decision alternatives, the states of nature associated with it.
 Solved problems in decision theory

Alternatives States of nature

Buy Favorable market
supercomputing Unfavorable market
Do not develop the new
product
Favorable market
Hire more engineers
Unfavorable market
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Step 3 – Make the decision tree

explicit.

Step 4 - Assign the a priori probabilities of each of the states of nature.

 Solved problems in decision theory

Step 5 - Calculate the benefit of each of the branches of the

tree.

Income:

In the case of a favorable market:

50,000 microprocessors x 200 euros/microprocessor = 10,000,000 euros.

In case of unfavorable market:

20,000 microprocessors x 200 euros/microprocessor = 4,000,000 euros.

Manufacturing costs:

Purchase of the supercomputing center and the favorable market:

50,000 microprocessors x 10 euros/microprocessor = 500,000 euros.

Purchase of the supercomputing center and unfavorable market:

20,000 microprocessors x 10 euros/microprocessor = 200,000 euros.

 Solved problems in decision theory

Hire more engineers and the market is favorable:

50,000 microprocessors x 40 euros/microprocessor = 2,000,000 euros.

Hire more engineers and the unfavorable market:

20,000 microprocessors x 40 euros/microprocessor = 800,000 euros.

Fixed costs:

Purchase of the supercomputing center = 2,000,000 euros.

Hiring and training new engineers = 1,000,000 euros.

The profit of each branch is obtained by subtracting expenses from income:

Profit if you buy the supercomputing center and the market is favorable:

10,000,000 – 500.00 – 2,000,000 = 7,500,000 euros.

Profit if you buy the supercomputing center and the market is unfavorable:

4,000,000 – 200,000 – 2,000,000 = 1,800,000 euros.

Benefit if you hire more engineers and the market is favorable:

10,000,000 – 2,000,000 – 1,000,000 = 7,000,000 euros.

Benefit if you hire more engineers and the market is unfavorable:

4,000,000 – 800,000 – 1,000,000 = 2,200,000 euros.

Step 6 – Solve the decision tree from right to left. Since the final stage is probabilistic, the mathematical
expectation criterion must be applied in order to determine the expected benefit of each decision
alternative.

(7,500,000 x 0.5) + (1,800,000 x 0.5) = 4,650,000 euros.

(7,000,000 x 0.5) + (2,200,000 x 0.5) = 4,600,000 euros.

 Solved problems in decision theory

Place the results in the decision tree above the corresponding node.

Solve the previous stage. Since this first stage is deterministic and the values you have calculated are
benefits, you must choose the alternative whose benefit is greater and place the result above the
corresponding node.
Based on the expected value criterion, the decision that the company's management must make is to
buy the supercomputing center, expecting to obtain a profit of 4,650,000 euros.

2. Determine for what range of favorable market probabilities you should purchase the
supercomputing center
The decision tree is the same as the previous section, in this case p being the a priori probability that
the market demand is favorable and (1 – p) the a priori probability that the demand is unfavorable.
 Solved problems in decision theory

Then solve the decision tree. Since the final stage is probabilistic, the mathematical expectation
criterion must be applied in order to determine the expected benefit of each decision alternative.

(7,500,000 xp) + (1,800,000 x (1 - p))

(7,000,000 xp) + (2,200,000 x (1 - p))

It is interesting to buy the supercomputing center as long as the expected benefit of buying said center
is greater than that of hiring more engineers and that of not developing the new product:

(7,500,000 xp) + (1,800,000 x (1 - p)) > (7,000,000 xp) + (2,200,000 x (1 - p))  p > 0.444
(7,500,000 xp) + (1,800 .000 x (1 - p)) > 0  p > 0

It is interesting to buy the supercomputing center as long as the a priori probability of a favorable
market is greater than 44.44%.

3. Favorable sales have been defined as those that reach 50,000 units. This figure is probably too
optimistic, find the value by which you would change your decision and hire more engineers
The decision tree as well as the a priori probabilities of each of the states of nature are the same as in
the first section of this exercise. Defining VE as favorable sales, the benefits in this case are:
 Solved problems in decision theory

Income:

Favorable market:

VE microprocessors x 200 euros/microprocessor = 200 VE euros

Unfavorable market:

20,000 microprocessors x 200 euros/microprocessor = 4,000,000 euros

Manufacturing costs:

Purchase of the supercomputing center and favorable market:

VE microprocessors x 10 euros/microprocessor = 10 VE euros

Purchase of the supercomputing center and unfavorable market:

20,000 microprocessors x 10 euros/microprocessor = 200,000 euros

Hire engineers and favorable market:

VE microprocessors x 40 euros/microprocessor = 40 VE euros

Hiring engineers and unfavorable market:

20,000 microprocessors x 40 euros/microprocessor = 800,000 euros

Fixed costs:

Purchase of the supercomputing center = 2,000,000 euros

Hiring and training new engineers = 1,000,000 euros

Benefit of each branch of the tree:

Profit if you buy the supercomputing center and the market is favorable:
200 VE – 10 VE – 2,000,000 = 190 VE – 2,000,000 euros
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Profit if you buy the supercomputing center and the market is unfavorable:

4,000,000 – 200,000 – 2,000,000 = 1,800,000 euros

Benefit if you hire more engineers and the market is favorable:

200 VE – 40 VE – 1,000,000 = 160 VE – 1,000,000 euros

Benefit if you hire more engineers and the market is unfavorable:

4,000,000 – 800,000 – 1,000,000 = 2,200,000 euros

Then solve the decision tree. Since the final stage is probabilistic, the mathematical expectation
criterion must be applied in order to determine the expected benefit of each decision alternative.

((190 VE - 2,000,000) x 0.5) + (1,800,000 x 0.5) = 95 VE -

100,000 ((160 VE - 1,000,000) x 0.5) + (2,200,000 x 0 .5) =

80 VE + 600,000

I would hire more engineers

when:

80 VE + 600,000 > 95 VE - 100,000  VE <

46,666.66

I would hire more engineers when favorable sales are less than 46,666.66 microprocessors