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MS&E 52: Introduction to Decision Making. Final Exam. Summer 2012

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TAKE-HOME FINAL EXAMINATION – MS&E 52, SUMMER 2012

Due Saturday, 18 AUG, 10:00pm (sharp!) in your personal Drop Box on Coursework.

Any late exam, even by a few minutes, will receive at most half credit.

Work on this exam individually. You may use any resources other than consulting another person or previous years’

exams or solutions.

Please affirm that you have complied with the requirements of the Stanford Honor Code by typing your name and Student

ID number in the spaces provided below. The exam will not be graded unless the honor code is affirmed.

Please read the entire exam first. Use the Coursework Forum to ask any questions of clarification. However, posting

answers or anything that could be perceived as a hint to anyone reading the post will be considered a violation of the

honor code. Your questions will be answered until midnight tonight, 15 AUG. After that you will be on your own.

Place all answers in the boxes provided. No credit will be given for answers outside the boxes. Any detailed work or

calculations that you would like to provide for possible additional credit should be placed at the end of the exam.

Your final document should be a Word or PDF file. You may paste diagrams or charts from PowerPoint or Excel, or you

may use the graphic functions available in Word. Please avoid using photos from your phone or camera. Be sure the

document that you submit is readable and clear.

The maximum number of points you can receive on this exam is 400 out of total possible of 440 points. These extra

points give you a 10 % cushion.

Good luck!

Last Name: Ruelas Martinez

First Name: Andres Daniel

In recognition and in the spirit of the Honor Code, I certify that I have neither received nor given unpermitted aid on this

exam and that I have reported, to the best of my ability, all Honor Code violations observed.

Student ID Number: 005848788


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Question 1: Tornado Inc.’s Decision (240 points)

You did a great job in Homework 4 for your client, Tornado Inc., the touch-screen tablet manufacturer. So, they

decided to continue working with you on their production decision. To refresh your memory, Tornado Inc. is

launching its newest product, the tPad, and the CEO must decide how many to produce. They previously had

uncertainty about many of the key profit drivers. But now, after thorough research on production costs and

competitive prices, they no longer have any uncertainty regarding fixed production costs, variable production

costs, or tPad price, as summarized in the following table:

Production

Decision

(millions)

Fixed

Production

Costs

($ millions)

Variable

Production

Costs

($/unit)

tPad Price

($/unit)

12 240 15 150

8 100 20 150

4 60 25 150

However, the uncertainty on tPad market demand is still troubling them, where tPad market demand is the

product of overall market size and Tornado Inc.’s market share. The CEO, after consulting with an expert he

trusts, believes that the probability of tPad market demand being 5 million is 60%, and that the probability of

tPad market demand being 10 million is 40%. Tornado Inc. must pay the variable costs for all of the tPads that

it decides to produce because this decision is made before any market demand is realized. The profit of Tornado

Inc. for each level of production is then calculated using the following formula:

Profit = [Min (Production, Market Demand) * Price] – [(Production * Variable Cost) + Fixed Cost]

Each of the following questions can be answered independently of the others.


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a) Draw a decision diagram for Tornado Inc.’s problem. Include only uncertainties, decisions, values, and

relevance relationships. (Remember that the fixed and variable costs as well as tPad price are no longer

uncertainties; they are now calculations included in the definition of profit.) (40 points)

Production

Profit

Market Demand

Demand

Market Size /

Market Share

Costs

Variable & Fixed

Price

Revenues


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Production

12 million

60%

5 million $330 millions

40%

10 million 1,080 millions

8 million

60%


40%


4 million

60%


40%


b) Draw the decision tree for Tornado Inc.’s decision and evaluate it. (40 points)

Table with Calculations in Appendix

Recommended

production

level and its

expected

value

We recommend to produce 8 million of tPad’s, and its expected value is $670

million

Production

Demand Value


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Demand

40%

High

60%

High 24%

40%

Low 16%

60%

Low

20%

High 12%

80%

Low 48%

Demand

36%

High

66%

High 24%

34%

Low 12%

64%

Low

25%

High 16%

75%

Low 48%

c) Mr. Experto called the CEO and offered to predict the market demand (high or low) for $40 million.

The CEO believes that Mr. Experto’s prediction will correctly predict demand with 60% probability if

demand turns out to be high, and with 80% probability if demand turns out to be low. Should he accept

Mr. Experto’s offer? Why or why not? Be sure to say what decision, if any, switches with this

prediction. Hint: You will need to flip a tree. (40 points)

Accept Mr. Experto’s Offer (circle one) Yes No

Demand

High

60%

High

40%

Low

Low

20%

High

80%

Low

Market Test

Assessment Order

Evaluation Order


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$684.40 Value with the imperfect prediction

$670.00 Value without the imperfect prediction

__________

$12.50 Value of the Imperfect Prediction

So, they shouldn’t accept Mr. Experto’s offer, because the most that the company is willing to pay for a prediction is $12.50, and $40 million it’s out of the bucket.

Also now the best is going for the large production.

Table with Calculations in Appendix

$682.60

High

36%

Large

High

66% $1,080

Low

34% $330

Medium

High

66% $940

Low

34% $490

Small

High

66% $440

Low

34% $440

Low

64%

Large

High

25% $1,080

Low

75% $330

Medium

High

25% $940

Low

75% $490

Small

High

25% $440

Low

75% $440


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d) Later that day, Ms. Wizardette approaches the CEO and offers to guarantee high market demand

(10 million units) for $100 million. If he believes that Ms. Wizardette can deliver on this guarantee with

no unanticipated side effects, should he accept the offer? Why or why not? Be sure to say what

decision, if any, switches with this guarantee. (40 points)

Accept Ms. Wizardette’s Offer? (Circle one) Yes No

Yes, we should accept the deal.

Because, if he guarantee a high market demand, you know that the best would be to produce 12,000,000

million units (Large production); and that gives a profit of $1,080 million.

We know that the value without perfect information is = 670 million, (Given in question 1b), so:

Value with perfect information = $1,080 million

- Value without perfect information = $670 million

______________________________________________

Value of the information = $470 million

Now we know that the value of the information it’s equal to $470 million, and Ms Wizardette it’s only

charging for that information $100 million.

So definitely, the CEO should take that offer, without doubt.

And also, the decision of production changes: Instead of medium (8 million), now they should produce

large (12 million).


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$1080

High

Large High $1,080

Low $330

Medium High $940

Low $490

Small High $440

Low $440

Low

Large High $1,080

Low $330

Medium High $940

Low $490

Small High $440

Low $440


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e) The US government is considering upgrading part of its Information Technology (IT) infrastructure. So,

it approached Tornado Inc. with a proposal for a futures contract whereby the US government would

promise to buy 2 million tPads in the future for a price of $20/unit, regardless of market demand.

Should Tornado Inc. accept this deal? Tornado Inc. counter-proposed a future price of $50/unit. Would

this be a good deal for Tornado Inc.? Why or why not? Would their production decision change?

(40 points) Hint: In this case, the profit is calculated using this revised formula:

Profit = [Min (Production-2, Market Demand) * Price] – [(Production * Variable Cost) + Fixed Cost] + 2 * Future Price

They should be indifferent from this deal, because it’s the same expected value than question 1b,

($670 million); but now it changes that the production has to be Large (12 million), instead of

Medium (8 million). So, there’s no problem if they accept the deal or not.


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If the price goes up to $50 instead of $20, the profit would be greater. So, this is the option that Tornado Inc. should go for, because, they now can get a profit of $730 million, instead of $670 million. They should go for this deal.

And now, the production should be large (12 million), instead of medium (8 million).


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-$30 million

Major Damage

5% -$500 million

Minor Damage

10% -$50 million

No Damage Loss

85% $0 million

f) Tornado Inc. is a multinational corporation and most of its manufacturing is conducted outside the U.S.

Because Tornado Inc.’s main market is in the U.S., the company needs to use international

transportation to ship its products, which involves some risk. Prior to the company shipping $500

million worth of tPads to the U.S., the CEO has the opportunity to buy an insurance policy against

accidental loss. He believes that the probability of major damage occurring is 5% and, if so, Tornado

Inc. would experience a total loss of the $500 million shipment, He also believes that minor damage will

result in a loss of $50 million and is twice as likely to occur as major damage. In all remaining

scenarios, Tornado Inc. would experience no damage loss. If Tornado Inc. purchases insurance and

damage occurs, then the company would be liable for the first $100 million of losses and the insurance

company would reimburse the company for all losses over this deductible amount. What is the most that

the CEO should be willing to pay for insurance on this shipment? Why? (40 points)

Most to pay for Insurance Less than $20 million

Why?

Without Insurance


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-$10 million

Major Damage

5%

-$500 million + $400 million

Minor Damage

10% -$50 million

No Damage Loss

85% $0 million

Value without perfect information $-10 million

Value with perfect information $-30 million

_______________________________________

Value of information: (-10) – (-30) = $20 million

So the most that the CEO should be willing to pay is $20 million. Why? Because the Expected value without the insurance is a loss of $-30 million, and with the insurance is $-10 million.

So the difference is $20 million, but a deal less than that amount would be perfect.

With Insurance


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Question 2: Personal Decision (150 points)

Throughout MS&E 52 you have learned to use several tools for framing, structuring, modeling, and analyzing a

decision situation. Select a personal decision situation that you are currently facing, or will be facing in the near

future. Personal decisions might be, but are not limited to: choosing a college to attend, applying for a job or

switching to a new job, joining a professional athletic team, buying a car, treating a medical problem, or

investing your financial resources. You are free to consider any personal decision situation as long as it does not

fall in the Autopilot Zone or the Routine Zone, and as long as you have not already made the decision. Please

be clear, concise, and incisive; bullet points may work better than essay paragraphs.

a) Briefly describe your decision. State who the decision makers are and who is affected by the decision.

List several aspects for both the upside and the downside of possible courses of action. Describe key

technical complexities and organizational complexities of your decision. (20 points)

My decision is if I’m going to transfer to a different college in Mexico or not. I’m going to enter to College this

September in Mexicali, Mexico (city) and after my first semester I have to decide whether if I’m going to Monterrey,

Mexico to continue my studies, or staying in my city.

Decision Makers: My dad and I

Affected: My family, my girlfriend and I

Organizational Complexities (High)

The school that I’m thinking to transfer is more expensive, and I also will have to pay rent or boarding

In that kind of cases, my dad always have the final word

We have different interests, and we think different about the value of staying or leaving

Mentality to be worried about being away from the family

Technical / Data Complexities (High)

Decide between 2 colleges and 15 different majors (Only in Engineering)

Uncertainty about the scholarship that I could receive

Both schools are very recognized, but my personal opinion is influenced about what my friends said about that

school

Uncertain about the rent of the house, possibility to don’t like the school


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b) List three to five key decisions (over which you have control) and three to five key uncertainties (over

which you do not have control.) (10 points)

Decisions

To choose between Tec de Monterrey or Universidad de Monterrey

The major that I’m going to pick in the Engineering School

To live in a department or in the school

Uncertainties

The price of the school, it’s getting more expensive each year

The security in Monterrey

The scholarship that I’m going to receive

The subjects that I’m going to transfer from my old College


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c) Describe your decision situation with a decision hierarchy. Include three to five entries at each level and

ensure that all of your entries are decisions (commitments to irrevocably allocate valuable resources) --

not goals, wishes, information, or preference statements. (20 points)

GIV

EN

FOCUS

LATER

I will study in an Engineering School My College fund is $20,000 per year I will start college this August I will start the transfer application in

November

What major I’m going to pick? Live in department, in the school? What school I’m going to attend? Study scholarship or sport

scholarship?

Exchange to another university in Europe

Where I’m coming back to my hometown?

Join any group? Partial job while

studying?


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d) Use a strategy table to identify three significantly different yet potentially attractive strategies for your

decision. Ensure that your strategy table is consistent with other steps of your analysis. (30 points)

Strategy

Decisions School Major Scholarship Housing

I don’t want to

leave my

hometown

CETYS

University (my

old college)

Mechanical None Department

This is what I

want?

Tec de

Monterrey Biomedical Sport (Soccer)

School

Trust me, I’m

an Engineer

Universidad de

Monterrey

Management

Sciences &

Engineering

Academics My house in

Mexicali


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e) Draw a decision diagram for your decision. Remember that uncertainties with relevance arrows pointing

to decisions must be known with 100% certainty before that decision is made. Ensure that your decision

diagram is consistent with other steps of your analysis. (30 points)

Which College

attend?

Department

of study

College

Fund

Scholarship

Security

Cost of each

course

Major

University

Costs

Part time job

(internship)

$$$

Real Cost

of College

Housing

Courses

City to Study


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f) Provide concise and insightful answers to the following questions. (30 points)

1) Define the possible outcomes for each of your uncertainties.

2) List a total of four cognitive and/or motivational biases that you are concerned might affect your

subjective judgments about these uncertainties. Explain each.

3) How will you deal with each of these biases?

4) What sources of expertise will you use in making your probability assessments?

5) What probabilities are you currently assigning to each possible outcome for each uncertainty?

1) For my scholarship, I could receive a sports scholarship, academic, or none. In the case of university costs,

they may change each semester, so probably it would be more expensive. The security of a city is very

unpredictable it could be very insecure or secure, so that may change my opinion at the moment of choosing the

city to study. After choosing the major, there is a possibility that they could charge me for courses, or for year,

so the cost of the academic charge is uncertainty. Depending on what focus I want to give to my studies, my

first job should be related with my major, but whether I can get paid, or not for that job.

I already know the department of study (Engineering), and the College Fund that I have for my education, so

this “uncertainties” affect my decision directly.

2) Availability: A lot of friends just started college in both schools, and they are telling me that it’s awesome, and

that I should come with them to continue my studies.

Representativeness: So he is graduated from that school, he should be successful. Or he is successful; he should

be graduated from that school. These statements are so wrong, but are in my head.

Misaligned Incentives: If I get the better grades, and change my school as a reward for my grades, I would be

very happy.

Anchoring: I’m guessing about the quality of my original College in my hometown, despising their quality.

3) For the availability, I would search for reliable information, actual and from the last few years, about the quality

of the school, the teachers and how are they in the field that I want to focus. For representativeness, I should

not generalize every people who graduate from those schools, they might be successful, or they might not. For

the misaligned incentives, it’s a reward for me going to that schools, so, the probabilities that I think that it

would happen, depends on my “state of humor”, so, to deal with that, I have to stop thinking like that, and see it

like a goal, a dream, instead of a reward. And for anchoring, stop guessing about the quality and start looking

for official documents that describe how my school is, ask people who went there and are there, and stop being

nervous about that.

4) I will use for example, for the scholarship; I will compare how many students receive sports scholarships, and

how many receive academy, and what they did to get that scholarship. After that, I will compare their situation

with mine, to see how close I am to receive any kind of scholarship. For the uncertainty of the university cost, I


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will talk to the dean of admissions and financial aid, to see how is increasing the costs each year, and what are

the possibilities that the cost will be out of my budget. For the security, I will check in the news, different

newspapers, webpages, radio, too see the different points of view of each kind of media, and also, contact my

friends and family that I have in Monterrey, to ask for their advice. For the part time job, that’s a big

uncertainty whether I going to get paid or not. For that, I will ask first the companies that I want to do an

internship, to see if they accept students. After that, I will ask if they paid or not (That’s not a relevant situation,

if the company is really good, and I want to do my practice there). To finish, I will look for people that I know

that are working in “x company” that I want to do my internship (depending of my major), and ask how are the

conditions of working, and if my major it’s relevant for the company policy.

5) Scholarship: {70% academic, 25% sports, 5% none}

Security in Monterrey {60% secure, 40% insecure}

Security in Mexicali {80% secure, 20% insecure}

University Cost {80% stay the same, 20% increase}

Part time job {50% paid, 50% not paid}


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g) Who will you involve in making this decision to ensure a high-quality commitment to successful

implementation? Why? (10 points)

Myself and my dad, because it’s a personal choice where I have to decide the best for my future,

but my dad also knows me like his hand. He will help me to choice the best option, eliminate

alternatives that are not useful and encourage me to take the best decision. Why? Because he have

3 High Schools, 1 Middle School, 1 Elementary and 1 kindergarten, so he knows the best options

to study in Mexico, because he have contacts with a lot of universities around the country, and he

knows what universities are better for Engineering, for Med Schools, Law, etc.

So, he will be my adviser. After choosing whether to stay in Mexicali or go to Monterrey, (That’s

my decision), he will help me to choice the best alternative of college, depending of my interests

and the major that I want to get.

So this will be an example of a successful implementation, because, he’s not a wizard, but he has

information that would be very useful to make the best decision (And for free).


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Question 3: Joint Venture Investment (20 points)

An entrepreneur has approached two friends of yours, Muhammad and Owen, to join her in a new venture that

she plans to start. The entrepreneur has patent royalty payments that pay him $10,000 per month and comprise

his total discretionary income. Muhammad is an independent stock-market investor. He has personal assets of

$600,000 in an investment portfolio, a car loan with $40,000 remaining, and a home mortgage with $200,000

remaining. Owen has limited resources; the most he is willing to invest at 3 to 1 odds on doubling or losing his

investment is $20,000.

The three had initially planned to split equally an investment of $100,000 in the venture. In five years, they

expected to have a business that could be sold for $400,000. At first, an equal partnership seemed like the

fairest approach. Very soon however, Owen said that he wanted out because the risk was too great for him.

What advice would you give the joint-venture partners about how they should restructure their deal so that all

partners feel that their investment risk is appropriate for the return they expect? Please fill in the table below

and use the data to support your reasoning.

Entrepreneur Muhammad Owen Joint Venture

Partnership

Risk Tolerance

Venture Investment $100,000

Expected Net Return $400,000


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Question 4: Hurricane Crisis Management Decision (30 points)

Hurricanes cause major damage to coastal cities. The mayor of the city of Palm Beach wants to manage the

city’s response to these crises so that all people are evacuated safely, any property damage is minimal, and

public opinion about these outcomes is generally positive. Uncertainties are as follows:

Lives lost to measure those deaths resulting from a hurricane, with relevance from hurricane

category and timing, evacuation effectiveness, and the city’s decisions.

Property damage to residences, infrastructure, government buildings, and commercial or industrial

facilities as measured by costs to repair and rebuild, with relevance from hurricane category and the

city’s decisions.

Public opinion about the outcomes of lives lost and property damage as measured in polls.

Evacuation effectiveness in ensuring that people remain safe from harm, with relevance from

hurricane category and timing as well as from the city’s decisions.

Hurricane category, as measured on the standard scale from 1 to 5.

Hurricane timing, as measured in time to landfall.

The Palm Beach mayor must decide how to prepare for and respond to natural disasters such as hurricanes.

The mayor can choose a strategy that minimizes costs; one that balances costs and benefits, or one that

follows the Precautionary Principle and spends whatever is available. After consulting experts on this matter,

the Palm Beach mayor came up with the following decision diagram:


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To simplify their decision, the mayor of Palm Beach agreed to use the tornado diagram below to focus

attention on the most critical uncertainties, those that contribute the most to the risk in the decision.

(a) Palm Beach’s mayor is very curious about the tornado diagram. You have been asked to answer the

following questions that the mayor has asked: (20 points)

(1) What do the lengths of the colored bars mean?

(2) What does a bar’s swing represent?

(3) How is the approximate cumulative risk calculated?

(4) The mayor wants the analysis to account for 96% of the risk of the city’s decision. What

uncertainties should the mayor include and why?

1) The possible outcomes that should be between this number, the maximum and the

minimum, also known as the range value.

2) Represent the difference between the minimum and maximum of the bar.

3) First, you take the swing at the power of 2, to avoid negative numbers. Then I divide the

swing of an uncertainty by the sum of all the swings. (Swing2/ΣSwings

2)

4) Lives lost, Property Damage, Hurricane Category, and Hurricane Timing. Because this

uncertainties sum a total of 96% of the risk; so this are the main uncertainties that the major

should take advice.

lives lost 35%

property damage

hurricane category

63%

85%

hurricane timing 96%

evacuation effectiveness 99%

public opinion 100%

Name of the uncertainty Cumulative Risk %

0-1-2-3-4-5-6$ Billion:

5.9

5.3

4.8

3.2

1.7

1

Swing ($ Billion)


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Net

Value

Hurricane Crisis

Management

Strategy

Lives Lost

Property

Damage

Hurricane

Category

Hurricane

Timing

(b) Draw a revised decision diagram that includes the remaining uncertainties (those uncertainties

accounting for 96% of the risks) as well as the decision and net value. (10 points)

Additional Work for Consideration of Credit: Place below, and on subsequent pages as necessary, any

additional work or calculations that you want to provide for consideration of credit on any of the questions in

this exam. Please label each piece of work clearly so that we know to which question your work applies.


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Appendix

Question 1

B)

C)

Documents

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