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MGMT20005 Business Decision Analysis

Tutorial 2: Decision making with probabilities

Case Problem 1

The Newox Company is considering whether or not to drill for natural gas on its own land. If they drill, their initial expenditure will be $40,000 for drilling costs. Then depending on whether gas is found, there are two possible outcomes:

• If they strike gas, they must spend an additional $30,000 to cap the well and provide the necessary hardware and control equipment. (This $30,000 cost is not a decision; it is associated with the event "strike gas.")

• If they decide to drill but no gas is found, there are no other subsequent alternatives, so their outcome value is $-40,000.

If they drill and find gas, there are two alternative decisions. Newox could sell to West Gas, which has made a standing offer of $200,000 to purchase all rights to the gas well's production (assuming that Newox has actually found gas). Alternatively, if gas is found, Newox can decide to keep the well instead of selling to West Gas; in this case Newox manages the gas production and takes its chances by selling the gas on the open market.

At the current price of natural gas, if gas is found it would have a value of $150,000 on the open market. However, there is a possibility that the price of gas will rise to double its current value, in which case a successful well will be worth $300,000.

The company's engineers feel that the chance of finding gas is 30%; their staff economist thinks there is a 60% chance that the price of gas will double.

Draw the decision tree and determine whether Newox should drill and whether to sell West Gas.

Case Problem 2

Mary has decided to participate in a general knowledge game show. She will be asked a number of questions in a sequential order of question topics as listed below. Each correct answer will award her a sum of money. If she answers a question incorrectly she will lose all of her accumulated money and be asked to leave the show. She can also choose to leave the game with her accumulated earnings prior to any question.

Her chances and possible prizes are given in the table below:

What is her optimal policy based on the EMV? On average how much is she expected to win?