1) Ken Brown is the principle owner of Brown Oil, Inc. At the present time, Ken
ID: 387147 • Letter: 1
Question
1) Ken Brown is the principle owner of Brown Oil, Inc. At the present time, Ken is forced to consider purchasing some more equipment for Brown Oil because of competition (Table 1 illustrates these alternatives). The lubricant is an expensive oil newsletter to which many oil giants subscribe, including Ken Brown. In the last issue, the letter described how the demand for the oil products would be extremely high. Apparently, the American consumer will continue to use oil products even if the price of these products doubles. Indeed, one of the articles in the Lubricant states that the chances of a favorable market for oil products was 70%, while the chance of an unfavorable market was only 30%. Ken would like to use these probabilities in determining the best decision.
a) What decision model should be used?
b) What is the optimal decision?
c) Ken believes that the $300,000 figure for the Sub 100 with a favorable market is too high. How much lower would this figure have to be for Ken to change his decision made in part b?
d) Texan Co. proposes a new alternative to Ken that by advertisement for Brown Oil they would increase the chance of a favorable market to 90%; while the cost incurred on Ken’s firm under unfavorable market will be $60,000 in this case. Should Ken change his decision from part c?
Equipment
Favorable
Market
($)
Unfavorable
Market
($)
Sub 100
300,000
-200,000
Oiler J
200,000
-80,000
Texan
150,000
-40,000
Equipment
Favorable
Market
($)
Unfavorable
Market
($)
Sub 100
300,000
-200,000
Oiler J
200,000
-80,000
Texan
150,000
-40,000
Explanation / Answer
a) Decision model under uncertainty is used in this case, because perfect information about future states of nature is not avaiable. So decision has to be made based on the probabilities of occurrence of each state of nature.
b)
Expected Value of Sub100 = 300000*0.7+(-200000)*0.3 = $ 150,000
Expected Value of Oiler J = 200000*0.7+(-80000)*0.3 = $ 116,000
Expected Value of Texan = 150000*0.7+(-40000)*0.3 = $ 93,000
Expected Value (EV) of Sub100 is the maximum. Therefore, optimal decision is to purchase Sub 100
c) In order for Ken to change his decision, this figure has to be as low such that its expected value does not exceed the EV of next best alternative (Oiler J)
Therefore, this figure has to be = (116000-(-200000)*0.3)/0.7 = $ 251,428
d)
In this case the payoffs for Texan Co. alternative change as under
Expected value = 150000*0.9 + (-100000)*0.1 = $ 125,000
Yes, Ken should change his decision from c , because the EV of Texan is higher than Oiler J now (Considering that payoff for favorable market for Sub 100 is 251428 as determined in part c) .
Equipment Favorable Market ($) Unfavorable Market ($) Expected Value 90% 10% Texan 150000 -100000 125000Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.