2-19

The Lubricant is an expensive oil newsletter to

which many oil giants subscribe, including Ken
Brown (see Problem 3-17 for details). In the last
issue, the letter described how the demand for oil
products would be extremely high. Apparently, the
American consumer will continue to use oil products even if the price of these products doubles.
Indeed, one of the articles in the Lubricant
states that the chances of a favorable market for oil
products was 70%, while the chance of an unfavorable market was only 30%. Ken would like to
use these probabilities in determining the best
decision.
(a) What decision model should be used?
(b) What is the optimal decision?
(c) Ken believes that the $300,000 figure for the Sub
100 with a favorable market is too high. How
much lower would this figure have to be for Ken
to change his decision made in part (b)?

Favorable
Unvaforable
Equipment Market
Market ($)
($)
-
Sub 100
300,000 200,000
-
Oiler J
250,000 100,000
-
Texan
75,000 18,000
Solution:

a). Decision model should be use is the Maximize Expected Monetary Value (EMV) model because
the decision making there are several possible states of nature and probabilities of each state

b) The optimal decision is EMV(Sub100)

EMV(sub100) = (0.7)*(300,000)+(0.3)*(-200,000) = $150,000

EMV(oiler j) = (0.7)*(250,000)+(0.3)*(-100,000) = $145,000

EMV(texan) = (0.7)*(75,000)+(0.3)*(-18,000) $47,000

c) Ken should change his decision when Sub 100’s EMV be equal to the next best
one, Oiler J. Let X be the figure for the Sub 100 with a favorable market,

EMV(sub 100) = $145,000 = (0.7)*X + (0.3)(-$200,000) = (0.7)*X - $60,000

X = $292,857.143 (or $7143 lower)

Hence, the figure for the sub 100 with a favorable market have to be $7142.857 lower for Ken to
change his decision
2-20

Solution:
(a) Using the possible profits and probabilities in the table, we have the expected
profits for each decision are as follows:

EMV(Stock market) = (0.5)*($80,000) + (0.5)*(–$20,000) = $30,000

EMV(Bonds) = (0.5)*($30,000) + (0.5)*($20,000) = $25,000
EMV(CDs) = (0.5)*($23,000) + (0.5)*($23,000) = $23,000
Based on the Maximize Expected Monetary Value model, Mickey Lawson
should invest in stock market because it has the highest EMV to maximize expected
profit.

(b) Best alternative for favorable and unfavorable state of nature is invest in stock
market with a payoff of $80,000 and invest in CDs with a payoff of $23,000,
respectively. The data is:
EV(with prefect information) = (0.5)*($80,000) + (0.5)*($23,000) = $51,500
EVPI = EV(with prefect information) – Maximum EMV(without prefect information)
= $51,500 – $30,000 = $21,500
So, the maximum Mickey Lawson should pay for a perfect forecast of the economy is
$21,500