Your firm is considering entering a new market. If you Do Not enter the market (

Question

Your firm is considering entering a new market.

If you Do Not enter the market (“stay out”), you will receive a profit of $1800.

If you enter the market, then your profit will depend upon the strength of the economy. If the economy is “average” you will received a profit of $2000. However, if the economy is strong, you will be able to decide between selling (“Sell”) your company for $2500 or “Staying in”. The probability of an “average” and “strong” economy is 0.8 and 0.2 respectively.

If you “Stay In”, the profit will be either $3000 or a loss of $1000 depending on if demand is strong or weak. The probability of strong and weak demand are 0.4 and 0.6 respectively.

This scenario is modeled as a decision tree below.

Given this tree what do you recommend that your firm do?

Given this tree what is the EMV of your optimal strategy?

.40 $3,000 STRONG DEMAND 4 WEAK DEMAND -$1,000 STAY IN .60 SELL .20 STRONG ECONOMY $2,500 ENTER AVERAGE ECONOMY 80 STAY OUT $2,000 $1,800

Explanation / Answer

If economy is strong, Expected value of staying in = 0.4*3000-0.6*1000=1200

hence, if economy is strong, we should sell the company because EMV of selling = 2500

Now, EMV of entering = 0.8*2000 +0.2*2500=2100

SInce 2100 >1800, one should enter the market.

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