Question

1. David has just been fired as the university bookstore manager for setting prices too low (only 20 percent above suggested retail). He is considering opening a competing bookstore near the campus, and he has begun an analysis of the situation. There are two possible sites under consideration. One is relatively small, while the other is large. If he opens at the small site and demand is high, he will generate a profit of $60,000, but he will lose $20,000 if demand is low. If he opens at the large site and demand is high, he will generate a profit of $90,000, but he will lose $30,000 if demand is low. He also has the option of not opening at either site. He believes that there is a 40 percent chance that demand will be high.

a. Based on all the above assumptions, is this problem a game theory problem, a decision making under uncertainty problem, or a decision making under risk problem? Why?

b. What should David do? Why?

c. Find the true value of perfect information on whether demand will be high.

d. A market research survey is available. Using decision tree analysis, it is found that one of the tree nodes is able to calculate the expected monetary value with the survey (including the survey cost) and that value is $15,000. Should David use the survey? Why?

Answer 1

a) In this problem, David has complete information about the available alternatives, the outcomes of each alternatives and the probability of outcome for each alternative. Therefore, this problem is a problem of decision making under risk.

b)

Expected Monetary Value (EMV) of opening a store at small site = .4*60000+(1-.4)*-20000 = $ 12,000

EMV of opening a store at large site = .4*90000+(1-.4)*-30000 = $ 18,000

EMV of not opening at either site = $ 0

EMV of opening a store at large site is higher.

Therefore, David should open the store at large site

c) Expected Value with Perfect Information, EVwPI = .4*MAX(60000,90000)+.6*MAX(-20000,-30000) = $ 24,000

EVPI = EVwPI - EVw/oPI

= 24000 - 18000

= $ 6,000

d)

EMV of using the survey is lesser than EMV of opening a store at large site without using survey

Therefore, David should NOT use the survey.