Summary 535it could have taken a “standard” middle-of-road approach, closely
following accepted safety practices of other firms in the industry.
Consider an oil drilling site that is expected to yield $2 billion in
profit over its economic life, if no unforeseen disasters or spills occur. By
following standard safety practices, BP can limit the risk of a disastrous
spill to a 1 percent probability. The cost of adopting standard safety
practices (in terms of time and money) at the site is $160 million. Instead,
adopting an ultraconservative approach (at a cost of $240 million) would
reduce the disaster risk to .5 percent. Finally, BP’s lax safety approach
costs only $40 million and implies a disaster risk of 3 percent.
a. If a disaster were to occur, the best estimate of the ultimate cost to BP is
$10 billion. This expected-value estimate considers a range of costs—from
the tens of millions if an oil spill is immediately plugged by emergency
measures to as high as $40 billion (BP’s estimated cost of the 2010 spill)
in the worst-case scenario. Of the three operating options, which is most
profitable? Equivalently, which has the lowest net expected cost?
b. How would BP’s operating choice change if, because of wishful
thinking, it (wrongly) believed that its lenient safety policy implied
only a 2 percent disaster risk? Or if it believed that its expected
disaster cost would be $5 billion (instead of $10 billion)?- Firm A is facing a possible lawsuit by legal firm B. Firm B represents the
family of Mr. Smith, who was killed in a motel fire (allegedly caused by
faulty wiring). Firm A was the builder of the motel. Firm A has asked its
legal team to estimate the likely jury award it will be ordered to pay in
court. Expert legal counsel anticipates three possible court outcomes:
awards of $1,000,000, $600,000, or $0, with probabilities .2, .5, and .3,
respectively. In addition to any awards, firm A’s legal expenses associated
with fighting the court case are estimated to be $100,000.
Firm A also has considered the alternative of entering out-of-court
settlement negotiations with firm B. Based on the assessments of its
lawyers, A envisions the other side holding out for one of two settlement
amounts: $900,000 (a high amount) or $400,000 (a more reasonable
amount). Each demand is considered equally likely. If presented with
one of these settlement demands, firm A is free to accept it (in which
case firm B agrees to waive any future right to sue) orreject it and take its
chances in court. The legal cost of pursuing a settlement (whether or
not one is reached) is $50,000.
Determine the settlement or litigation strategy that minimizes firm
A’s expected total cost (any payment plus legal fees). - In 1996, McDonald’s (MD) launched Campaign 55, reducing the prices of
its “flagship” sandwiches with the objective of regaining market share. Before
the launch, suppose MD’s management envisioned two possible outcomes: a
strong customer response or a weak response. Industry experts were not
very optimistic about the campaign. They assessed the probability of a strong
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