1000 sq. ft. of warehouse space needed for 1000 units of demand

Current demand = 100,000 units per year

Binomial uncertainty: Demand can go up by 20% with p= 0.5 or down by 20% with 1 p= 0.5

Lease price = $1.00 per sq. ft. per year

Spot market price = $1.20 per sq. ft. per year

Spot prices can go up by 10% with p= 0.5 or down by 10% with 1 p= 0.5

Revenue = $1.22 per unit of demand

Planning time horizon: three years, assuming all costs are incurred at the beginning of the year; k= 0.1 for each of the three years

1. Three warehouse lease optionsGet all warehousing space from the spot market as needed
2. Sign a three-year lease for a fixed amount of warehouse space and get additional requirements from the spot market
3. Sign a flexible lease with a minimum charge that allows variable usage of warehouse space up to a limit with additional requirement from the spot market

Represent the decision tree with defined states in each period as well as the transition probabilities between states in successive periods.