A new product has the following profit projections and associated probabilities:

Question

A new product has the following profit projections and associated probabilities: Profit Probability

$150,000 .10

$100,000 .25

$ 50,000 .20

0 .15

-$50,000 .20

-$100,000 .10

a. Use the expected value approach to decide whether to market the new product.

b. Because of the high dollar values involved, especially the possibility of a $100,000 loss, the marketing vice president has expressed some concern about the use of the expected value approach. As a consequence, if a utility analysis is performed, what is the appropriate lottery?

c. Assume that the following indifference probabilities are assigned. Do the utilities reflect the behavior of a risk taker or a risk avoider? Profit Indifference Probability $100,000 .95 $ 50,000 .70 0 .50 -$50,000 .25

d. Use expected utility to make a recommended decision.

e. Should decision maker feel comfortable with the final decision recommended by the analysis?

Explanation / Answer

Calculate expected value of profit using expected value of approach:

Expected value of Profit = $150,000 * 0.10 + $100,000 * 0.25 + $ 50,000 * 0.20 + $ 0 * 0.10 + ($50,000)*0.20 + ($100,000)*0.10

= $ 15,000 + $25,000 + $10,000 + 0 - 10,000 - 10,000

= $ 30,000

We should market the product as expected value of profit is relatively large.

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