University of Toronto
Department of Mechanical and Industrial Engineering
MIE263: Operations Research II
(Winter 2023)
Tutorial 2: Decision Trees and Utility Theory
January 26, 2023
Problem 1: Winston §13.2 #1
Suppose my utility function for asset position x is given by u(x) = ln(x).
a) Am I risk-averse, risk-neutral, or risk-seeking?
1 1
Solution: 𝑈′(𝑥) = 𝑥, 𝑈 ′′ (𝑥) = − 𝑥 2 < 0, so I am risk averse.
b) I now have $20,000 and am considering the following two lotteries:
L1: With probability 1, I lose $1,000.
L2: With probability .9, I gain $0.
With probability .1, I lose $10,000.
Determine which lottery I prefer and the risk premium of L2.
Solution:
𝐸(𝑈 𝑓𝑜𝑟 𝐿1 ) = 𝑙𝑛(19,000) = 9.8521943,
𝐸(𝑈 𝑓𝑜𝑟 𝐿2 ) = 0.1(𝑙𝑛 10,000) + 0.9(𝑙𝑛 20,000) = 9.8341728. Therefore I prefer L1.
𝐸𝑉 𝑓𝑜𝑟 𝐿2 = 0.1(10,000) + 0.9(20,000) = $19,000.
Let 𝑥 = 𝐶𝐸(𝐿2 )
Then 𝑙𝑛 𝑥 = 9.8341728 and 𝑥 = $18,661.
Thus 𝑅𝑃 𝑓𝑜𝑟 𝐿2 = $19,000 − $18,661 = $339.
Problem 2: Tommy, a foodie, is trying to determine which of two restaurants to visit. He has
been reading reviews on Yelp for two Restaurants. If he chooses to eat at Restaurant 1, he
believes he has a 15% chance it will be 4-star quality, 50% chance of being 3-star quality and
35% chance of being 2-star quality. If he chooses Restaurant 2, he believes he has a 60% chance
of being 3-star quality, 30% chance of being 2-star quality and 10% chance of being 1-star
quality. Tommy is also indifferent between:
a) Eating at a 2-star restaurant, and
b) A lottery where there is a 20% chance he will eat at a 4-star restaurant and a 80% chance
he will eat at a 1-star restaurant.
Tommy is also indifferent between:
a) Eating at a 3-star restaurant, and
b) A lottery where there is a 65% chance he will eat at a 4-star restaurant and a 35% chance
he will eat at a 1-star restaurant.
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University of Toronto
Department of Mechanical and Industrial Engineering
MIE263: Operations Research II
(Winter 2023)
Tommy is a foodie and will always choose to eat at a higher-starred restaurant. Which restaurant
should Tommy choose?
Solution:
Let 𝑈(4𝑠𝑡𝑎𝑟) = 1 and 𝑈(1𝑠𝑡𝑎𝑟) = 0. Then 𝑈(2𝑠𝑡𝑎𝑟) = .2, 𝑈(3𝑠𝑡𝑎𝑟) = .65 and
Restaurant 1 has expected utility of: 𝐸𝑈 = 0.15(1) + 0 .5(.65) + 0 .35(.2) = 0.545
Restaurant 2 has expected utility of: 𝐸𝑈 = 0.6(. 65) + 0.3(.2) + 0.1(0) = 0.45
Therefore Restaurant 1 should be chosen.
Problem 3: Winston §13.4 #16
You have just been chosen to appear on Hoosier Millionaire! The rules are as follows: There are
four hidden cards. One says “STOP” and the other three have dollar amounts of $150,000,
$200,000, and $1,000,000. You get to choose a card. If the card says “STOP,” you win no money.
At any time you may quit and keep the largest amount of money that has appeared on any card you
have chosen, or continue. If you continue and choose the stop card, however, you win no money. As
an example, you may first choose the $150,000 card, then the $200,000 card, and then you may
choose to quit and receive $200,000!
a) If your goal is to maximize your expected payoff, what strategy should you follow?
Solution: From decision tree we see that optimal strategy is to keep going until you win
$1,000,000 or get the STOP card.
200
b) My utility function for an increase in cash satisfies u(0) = 0, u($40,000) = 0.25, u($120,000)
= 0.5, u($400,000) = 0.75, and u($1,000,000) = 1. After drawing a curve through these
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University of Toronto
Department of Mechanical and Industrial Engineering
MIE263: Operations Research II
(Winter 2023)
points, determine a strategy that maximizes my expected utility. You might want to use your
own utility function.
Solution: Sketching my utility function, we want to obtain u(200,000) and u(150,000). If we
assume the graph is a piece-wise linear graph, we can take the line segment between 120,000
and 400,000 to find our desired utilities.
Assuming x in units of thousands of dollars:
With points (120, 0.5) and (400, 0.75):
0.75 − 0.5 1
𝑚= =
400 − 120 1120
1
𝑦= 𝑥+𝑏
1120
120
𝑠𝑢𝑏𝑏𝑖𝑛𝑔 𝑖𝑛 (120, 0.5): 0.5 = +𝑏
1120
11
𝑏=
28
𝑇ℎ𝑒𝑛 𝑡ℎ𝑒 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑙𝑖𝑛𝑒 𝑠𝑒𝑔𝑚𝑒𝑛𝑡 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 120 𝑎𝑛𝑑 400 𝑖𝑠:
1 11
𝑦= 𝑥+
1120 28
Subbing in x = 200 and x = 150, we get:
4
𝑢(200,000) = = 0.57
7
59
𝑢(150,000) = = 0.53
112
From decision tree we find optimal strategy is to accept the amount of money on the first card,
and then quit.
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University of Toronto
Department of Mechanical and Industrial Engineering
MIE263: Operations Research II
(Winter 2023)
Decision tree with utility:
0.57
0.53
0.57
0.53
0.523
0.525
0.57
0.57
0.57
0.57
0.523
Page 4 of 5
University of Toronto
Department of Mechanical and Industrial Engineering
MIE263: Operations Research II
(Winter 2023)
Problem 4: Winston §13 Review Problems #2
We have $1,000 to invest. All the money must be placed in one of three investments: gold, stock, or
money market certificates. If $1,000 is placed in an investment, the value of the investment one year
from now depends on the state of the economy (see the table below). Assume that each state of the
economy is equally likely. Suppose that the utility function for the value of the investment (x) one
year from now is given by u(x) = ln(x). Determine which investment we should choose.
Value of $1,000 State 1 State 2 State 3
Money market $1,100 $1,100 $1,100
certificate
Stock $1,000 $1,100 $1,200
Gold $1,600 $300 $1,400
Solution:
𝐸𝑈 𝑓𝑜𝑟 𝑀𝑜𝑛𝑒𝑦 𝑀𝑎𝑟𝑘𝑒𝑡 = 𝑙𝑛 1100 = 7.003
𝑙𝑛 1000 + 𝑙𝑛 1100 + 𝑙𝑛 1200
𝐸𝑈 𝑓𝑜𝑟 𝑆𝑡𝑜𝑐𝑘 = = 7.0003
3
𝑙𝑛 1600 + 𝑙𝑛 300 + 𝑙𝑛 1400
𝐸𝑈 𝑓𝑜𝑟 𝐺𝑜𝑙𝑑 = = 6.775
3
We should choose the money market fund because it has the highest expected utility.
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