The CEO of a chemicals firm must decide whether to develop a new process that has been suggested by the research division. His decision tree is shown in Figure 14.20. There are two sources of uncertainty. The production cost is viewed as a continuous random variable, uniformly distributed between $1.75 and $2.25, and the size of the market (units sold) for the product is normally distributed with mean 10,300 units and standard deviation2,200 units.

The firm's CEO is slightly risk-averse. His utility function is given by

U (Z) = 1 –e –Z = 20,000 where Z is the net profit

Should the CEO develop the new process? Answer this question by running a computer simulation, using 10,000 trials. Should the decision maker be concerned about the fact that if he develops the new process, the utility could be less than or greater than the utility for $0? On what basis should he make his decision?

Figure 14.20

Transcribed Image Text:

Market Net Profit Production Size(X) S4 - C)X-S20,000 Develo Do Not Develop Net Profit = S0