Company GSW is considering whether to expand its production on a specific produc

Question

Company GSW is considering whether to expand its production on a specific product. There is uncertainties in regarding to future market conditions for the product, which can be categorized into two states: favorable or unfavorable future market. Currently there are three alternatives for the GSW to choose from, to build a large plant, build a small plant or do nothing. The following table gives the corresponding payoff information in this decision making problem. For example,
if GSW build a large plan, and if the future market turns out to be favorable for the product, then GSW can make $250,000 profits, but if the market turns out to be unfavorable, GSW will lose $200,000.

Alternative Favorable Market Unfavorable Market
Construct a large plant 250,000 -200,000
Construct a small plant 125,000 -25,000
Do nothing 0 0


a. If using Maximin criterion, what is the best alternative?
b. If the probability that the future market is favorable equals 0.5, what is the best
strategy?
c. And what is the expected value of perfect information (EVPI) ?

Explanation / Answer

(a) According to Maximin criteria we need to choose the possibility which Maximizes the minimum payoff. the maximum minimum payoff is for when Do nothing strategy which is zero. so the best alternative is to do nothing. (b) if we use laplace criterion Big plant value = 0.5 * 250,000 + 0.5 (-200,0000) = 25,000 small plant value = 0.5 * 125,000 + 0.5 * -25,000 = 50,000 Doing nothing value = 0 So the best strategy will be to build a Small plant (c) for calculating EVPI, we conisder the different choices which maximizes payoff Expected value of information = possiblity of market favourable condition * (maximum payoff) + possiblity of market unfavourable condition * (maximum payoff) Maximum payoff when market is favourable = 250,000 Maximum payoff when market is unfavourable = 0 EVPI = 0.5 * 250000 + 0.5 *0 = $ 125,000

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