Homework 1

RSM 1110 (0101-0105)

Foundations 2016

1. A building supply store is considering expanding its capacity to meet a

growing demand for its products. The alternatives are to build a new store
at a site nearby or expand the old one. Here is the regional economic
outlook: a 20% chance that the economy will remain unchanged (stable),
a 50% probability of an upturn, and a 30% chance of an economic
downturn. The following estimates of the payoffs are given below:

Build new
store
Expand old
store

Market upturn
(millions)
5.0

Stable market
(millions)
0.5

Market downturn
(millions)
-1

2.4

1.0

-0.5

Assume the goal is to maximize expected value.

a)

What should the company do to maximize expected value if they

have to choose before market conditions are realized?
b) What is the expected value?
c) Alternatively, they could choose to wait. If they wait, they will know
the market conditions perfectly before making the decision, and be
able to make a choice based on those conditions, including the
opportunity to simply do nothing and neither gain nor lose. Waiting,
however, reduces by 10 percent any positive returns that they could
make.
Depict this with a decision tree. What is their payoff if they wait?
Should they wait or go ahead (by not waiting, they get the payoff in
(b))?
2. A collection of multi-national firms are made up of exactly two
subsidiaries. Half of the firms subsidiaries are Canadian and half are
located in the US. The probability that the second subsidiary is Canadian

or from the US is independent of the first subsidiary; that is, the

probability of any given subsidiary being Canadian is .5 regardless of the
location of the other subsidiary in the multi-national.
a) What is the probability that a firm has two Canadian subsidiaries, given
that it has at least one? Justify your answer either using the formulas
for probability we learned in class, or a probability table.
Each subsidiary has a logo. Half of all Canadian subsidiaries have a logo
that includes a maple leaf; none of the American subsidiaries do. If a
multi-national has two Canadian subsidiaries, the probability of each
subsidiarys logo having a maple leaf is independent of whether the other
Canadian subsidiary in the multi-national has a maple leaf in the logo.
b) What is the probability that a subsidiary is Canadian, given that it has a
maple leaf in its logo? Justify your answer with either using the
formulas for probability we learned in class, or a probability table.
c) What is the probability that a firm has two Canadian subsidiaries, given
that it has at least one subsidiary with a logo with a maple leaf? Justify
your answer either using the formulas for probability we learned in
class, or a probability table.

3. Consider the test market problem in class 2, but in the simple case where
no test can be run. Recall that in class we showed that launching
generated a negative payoff and therefore was not worth doing without
the test. Maintain all numbers from class, but let the decision maker be
possibly risk averse or risk loving. In particular, let the payoff for zero be
zero utils (i.e. happy points, u(0)=0), the payoff for -5 be -5 utils (i.e. u(5)=-5), and the payoff to 10 be x, i.e. u(10)=x.
a. For what values of x would you describe the decision maker as risk
averse? (Hint: consider a lottery between losing 5 million and gaining
10 million that has the same expected value as getting zero for sure,
i.e. zero.)
b. For what values of x should the decision maker who maximizes
expected utility (i.e. expected happy points) launch the product (even
without any possibility of a test, unlike class where a test market
exists)? For these values is the decision maker risk averse or risk
loving?