Using a decision tree, determine the consortium’s best course of
action, assuming management is risk neutral.- A firm faces uncertain revenues and uncertain costs. Its revenues may be
$120,000, $160,000, or $175,000, with probabilities .2, .3, and .5,
respectively. Its costs are $150,000 or $170,000 with chances .6 and .4,
respectively. (Revenues and costs are independent.)
a. How many possible profit outcomes exist? Draw a decision tree listing
these profit outcomes at the branch tips. Compute the firm’s
expected profit by folding back the tree. (It does not matter which
uncertainty, demand or cost, is resolved first in the tree.)
b. Without a decision tree, calculate separatelythe firm’s expected
revenue and expected cost. What is the firm’s expected profit? (This
result underscores a great computational convenience of the
expected-value criterion. Expected profit is equal to expected revenue
minus expected cost; that is, expectations can be taken separately.) - Global Studios is thinking of producing a megafilm, Aqua World,which
could be a megahit or a megaflop. Profit is uncertain for two reasons:
(1) the cost of producing the film may be low or high, and (2) the market
reception for the film may be strong or weak. There is a .5 chance of low
costs (C) and a .5 chance of high costs. The probability of strong demand
(D) is .4; the probability of weak demand is .6. The studio’s profits (in
millions of dollars) for the four possible outcomes are shown in the table.
Low C/Strong D Low C/Weak D High C/Strong D High C/Weak D
80 10 0 70a. Should the studio produce the film? Use a decision tree to justify your
answer.
b. The studio is concerned that Kevin Costmore, the film’s director and
star, might let production costs get out of control. Thus, the studio insists
on a clause in the production contract giving it the right to terminate
the project after the first $30 million is spent. By this time, the studio will
know for certainwhether total production costs are going to be low (i.e.,
under control) or high (out of control). How much is this termination
clause worth to the studio vis-à-vis the situation in part (a)?- As noted in the text, top management of BP adopted a “lax” approach to
safety in its aggressive pursuit of oil discovery. Consider two alternative
safety stances it could have adopted. Emulating Exxon Mobil, BP might
have taken an “ultraconservative” approach to safety, implementing
extensive training of personnel, allowing for generous margins of error,
closely monitoring drilling operations, and formulating backup systems
and contingency plans in the event of an emerging drilling problem. Or
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