The Lubricant is an expensive oil newsletter to which many oil giants subscribe,

Question

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 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)?

Explanation / Answer

Part a:

The decision model should be based on maximum expected return. Thus, Ken should use expected monetary value model.

Part b:

For the sub 100 favorable markets is 300,000 and unfavorable market is 200,000.

Thus, the expected monetary value (EMV) = (300,000 × 70%) – (200,000 × 30%)

= 210,000 – 60,000 = 150,000.

Part c:

Let us consider the figure to be X:

Thus,

(70% × X) – (200,000 × 30%) = 150,000

(70% × X) – 60,000 = 150,000

(70% × X) = 60,000 + 150,000

70% × X = 210,000

Therefore, X = 210,000 ÷ 70% = 147,000

Thus, the amount should be lowered by $3,000 (150,000 – 147000).

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