DECISION ANALYSIS

You company markets Raw Gems and is considering entering a new market. If it sells in this new market, it will have to absorb a $275,000 cost. If it enters the market, the amount of revenue generated by the product will depend on the level of demand as given below.

Level of Demand

Revenue

High

$400,000

Middle

$250,000

Low

$100,000

Obviously, your firm cares about profit (revenue less cost). Further, if it does not enter the market, it will bear no cost and receive no revenue.

After extensive research, you estimate that the probabilities of each level of demand are High (40%), Medium (30%) and Low (30%)

(a) Model the above-described situation as a decision-tree. Using the EMV criterion, solve the tree and lay out a recommendation? What is the EMV of this decision? Show your "tree" and calculations

EMV =

(b) Suppose that you were able to hire a company to estimate the market demand for the project with perfect certainty (i.e., they could tell you with perfect certainty [probability of 100%] if the level of demand would be high, medium or low).

If they company were to give you that information for free, would it change your decision? Explain your answer.

If so, what is the most you would pay for that information? Show your work.

(c) Outline the conditions under which you may use the EMV criterion. In other words, how can we defend EMV as the appropriate decision rule?