Proble

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Practice Problems: Module A, Decision Making

Problem 1:

Bascomb’s Candy is considering the introduction of a new line of products. In order to produce the new line, the bakery is considering either a major or minor renovation of the current plant. The market for the new line of products could be either favorable or unfavorable. Bascomb’s Candy has the option of not developing the new product line at all. Develop the appropriate decision tree.

Problem 2:

With major renovation, at Bascomb’s Candy (See Problem 1 above) the payoff from a favorable market is $100,000, from an unfavorable market [pic]. Minor renovations and favorable market has a payoff of $40,000 and an unfavorable market [pic]. Assuming that a favorable market and an unfavorable market are equally likely, solve the decision tree.

Problem 3:

Jeff Heyl, the owner of Bascomb’s Candy (Problem 1 and 2 above) realizes that he should get more information before making his final decision. He decides to contract with a market research firm to conduct a market survey. How much should Jeff be willing to pay for accurate information (i.e. What is the Expected Value of Perfect Information, EVPI?)?

ANSWERS

Problem 1:

[pic]

Problem 2:

[pic]

Therefore, the appropriate choice under equally likely market conditions is to make the minor modifications [pic]

Problem 3:

With knowledge of when a favorable market will occur, Jeff’s best payoff is major renovation. This happens [pic] the time. [pic]

When unfavorable market exists, Jeff will do nothing, which happens [pic] the time.

[pic]

so Perfect Information [pic]

Therefore EMV is $10,000 vs. $50,000 with Perfect Information

and [pic]