Self Study Problem Set - Solutions

1.
The uncertainty in this problem comes from the salary offer that the student gets. We let Xi be
the random variable that represents the job offer that the students gets in month i, i=1, 2, 3, . Xi
is a normally distributed random variable with mean $100,000 and standard deviation $10,000.
Let R be the students reservation level and let i* be the first month in which the candidate gets a
job offer that exceeds her reservation level. That is, i* is the first month where Xi > R. Then the
students total payoff can be written as:
Total payoff = ( 2000)*(i*-1) + Xi*
Note that
1) In months 1,, i*-1, the candidate incurs a search cost of -$2000. In month i*, the candidate
accepts the job and gets a payoff of Xi*.
2) If i*=1, i.e., the candidate accepts a job offer in the first month itself, then the total payoff is
simply X1.
The following figure shows how the total payoff varies as a function of the reservation level. The
optimal reservation level, R*, is around $105,000.
Total payoff
120000

100000

80000

60000

Total payoff

40000

20000

0
80000

85000

90000

95000

100000

105000

110000

115000

120000

2.
(Note : the simulation results were obtained using a simulation package called Crystal Ball. You
may get slightly different numerical results if you implement the simulation in @Risk)
The demand for trees in a particular year is the uncertain or the random variable in this problem.
Let us call it D. The expected profit of the store is the objective that House store owners want to
maximize. They decide upon the order (call it O) to maximize the expected profit (call it P*).
The problem dictates that each tree is sold at a price of $30 a unit and the store incurs a loss of
$45 on each unsold tree.
First determine the number of trees sold. Notice that, if O > D, then D trees are sold. Similarly if
O < D, then O trees are sold. Thus the number of trees sold is the minimum of O and D. Number
of trees left is zero if O < D and O min (O, D) if O > D. Now that we know number of trees
sold and leftover,
Profit (P*) = 30 * min (O, D) - 45 * (O min (O, D)).
Now we are left with the menial job of creating a spreadsheet and simulating. Please refer to
InventoryPlanning.xls.
1.
a) Cell E18 in the spreadsheet forecasts the profit when we order 180 trees and demand
has the custom distribution. The expected profit turns out to be $3727.
b) Cell E43 in the spreadsheet forecasts the profit when we order 180 trees and demand is
normally distributed with mean 185 and standard deviation 57.22. We choose 10,000
runs and get the following statistics for profit:
Statistic
Trials
Mean
Median
Mode
Standard Deviation
Variance
Skewness
Kurtosis
Coeff. of Variability
Minimum
Maximum
Mean Std. Error

i.
ii.

Forecast
values
10,000
$3,878
$5,400
$5,400
$2,382
$5,675,314
-1.81
6.12
0.6143
($10,501)
$5,400
$24

Clearly, the mean or the expected profit is $3878.

95% confidence interval is ($3878 1.96 x 24, $3878 + 1.96 x 24) = ($3832,
$3925).
[Run the same experiment for 1000 runs. Do you get the same answers?]

iii.

There are various ways of finding this probability. Observe that this is simply
the probability that a normal random variable with mean 185 and standard
deviation 57.22 exceeds 180. However, something that provides better
insights is a closer look at the frequency chart.

Observe that there is one bar at the end which dominates. This bar
corresponds to the cases when D was indeed greater than the O. When D O
=180, 180 trees are sold and hence the profit is 180 x $ 30 = $ 5400. So the
probability that demand exceeds quantity is same as the probability that profit
is equal to $5400. We find this from the frequency chart to be 0.53.
2.
To find out the optimum profit first thing we need to do is to come up with reasonable values
of order. When one considers the custom distribution, it is clear that one would never order
below $100 (one has to forego an opportunity to make a sure shot). Ordering above $300
means we will always end up with a surplus. So we take various values from $100 to $300
with increments of $10 to get the following table and graph.

Expected Profit (in $)

Expected Profit - Trees Ordered

$4,000
$3,500
$3,000
$2,500
$2,000
$1,500

Assumption 1

$1,000
$500
$0
90

140

190

240

290

Trees Ordered

Expected
Trees
leftover
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
280
290
300

Profit
3000
3147.825
3295.65
3443.475
3591.3
3739.125
3735.15
3731.175
3727.2
3723.225
3719.25
3451.275
3183.3
2915.325
2647.35
2379.375
1966.05
1552.725
1139.4
726.075
312.75

It is easy to discern either from the table in that the optimal order quantity is 150.
Working with the second assumption that the demand is normal, it again seems reasonable to
consider order quantities between 100 and 300. We get the following table and graph.
Trees

Expected

leftover
100
110
120
130
140
150
160
170
180
190
200
210
220
230
240
250
260
270
280
290
300

Profit
$2,868
$3,107
$3,324
$3,515
$3,673
$3,792
$3,869
$3,898
$3,878
$3,808
$3,686
$3,514
$3,293
$3,029
$2,728
$2,392
$2,027
$1,639
$1,232
$812
$382

Expected Profit (in $)

Expected Profit - Trees Ordered

$4,000
$3,500
$3,000
$2,500
$2,000
$1,500
$1,000

Assumption 2

$500
$0
90

140

190

240

290

Trees Ordered

From the table one finds out that the expected profit attains the maximum value at 170.
This example is instructive as to how nature of assumptions makes a difference to choices we
make. We get two different order quantities, 170 assuming normal distribution and 150
assuming custom distribution. What distribution closely captures real life phenomenon?
It is also worth noting that the difference in the optimal quantity is not vary large and even if
we work with slightly wrong assumptions one reaches at intelligent enough conclusions.
Even if the real world were to have normally distributed demand (which makes more sense)
and we assumed the custom distribution and decide on 150 we are not very worse off.

3.
The random variables in this case are the returns on each stock. Lets RR, RI, and RT denote the
returns on the Infosys, Reliance and Tatas stock respectively. We know that
RR is normally distributed with mean 30% and standard deviation 55%. Similarly, RI is normal
with mean 25%, standard deviation 40% and RT is normal with mean 20% and standard
deviation 20%. The return R* from a portfolio choice is
R*(R ,I,T) = R* RR + I * RI + T* RT
Now as outlined in the problems statement we enumerate all possible portfolio choices (R ,I,T)
and simulate to get the variance and the mean return for a particular portfolio. Then we plot the
variance on the X-axis and mean return on the Y-axis to get the mean-variance graph given
below.

Mean-Variance Graph
1.32

Expected Return

1.30
1.28
1.26
1.24
1.22
1.20
1.18
0.00

0.05

0.10

0.15

0.20

0.25

0.30

Variance

4.
(a) P(At least 4 years experience) = P(4 years experience) + P(5 or more years
experience) = 15/100 + 35/100 = 50/100.
(b) P(At least 4 years experience | At least 3 years experience) = P(At least 4
years experience)/P(At least 3 years experience) = (50/100)/(80/100) = 50/80.

0.35

5.
Let M be the mileage of a customer.
(a) 130 + 0.2 M = 195 implies M = 325. Bill drove 300 + 325 = 625 miles.
(b) ECR rate is better if and only if M > 625. P(M > 625) = 0.13 + 0.09 + 0.08 =
0.30.
(c) Since DRA is less expensive, that means M <= 625. From the table below, it
follows that E(Cost) = $151.

Miles

Cost

P(Cost)

200
300
400
500
600
Total

130
130
150
170
190

0.07
0.19
0.23
0.14
0.07
0.70

P(Cost | M <=
625)
0.10
0.27
0.33
0.20
0.10
1.00

Cost x P
13
35
49
34
19
151

6.
Let F and E respectively denote the events that the first and second balls drawn are black. Now,
given that the first ball selected is black, there are size remaining black balls and five white balls,
and so P(E|F) = 6/11. As P(F) is clearly 7/12, our desired probability is P(E and F) = P(F)*P(E|F)
= 7/12*6/11 = 42/132.

7.
Let X denote the time it takes Helen to complete a homework assignment. P(Go
to bed in time) = P(X < 4) = P(Z < (4 - 3.5)/1.2) = P(Z < 0.42) = 0.6628.

8.
Let D denote the distance traveled.
(a) Since the mean of D is 150 feet and the net is 30 feet long, he should place the
nearest edge of the net at 150 15 = 135 feet from the cannon. Therefore, the
net will cover a landing between 135 and 165 feet from the cannon, which is
the interval where the given normal distribution has the most area, and hence
the most probability of landing on the net.
(b) P(135 < D < 165) = 0.9332 - 0.0668 = 0.8664.

9.

Once Monday's bid is made, Newtowne's optimal strategy is to accept the bid if
it is a $3,000,000 bid and reject it if the bid is for $2,000,000. If Monday's bid
is rejected, then accept Tuesday's bid, regardless of the amount offered. The
EMV of this strategy is $2,600,000.