Question

Your company has placed a bit for a contract with a major air conditioning manufacturer, but the decision will not be made for four months. It cost the manufacturer $10,000 to prepare and submit the bid. The possible states of nature and their probabilities of occurring are as follows: (1) Receive the full contract (30%), (2) Receive a partial contract (20%), or (3) No contract (50%). ideally you would like to be up and running when the contract decision is made, but in order to do that any parts or machinery that will be required for the completion of the contract must be ordered right away. Use the information in this problem and the blank decision tree to answer the questions.

Payoff Table	Possible Outcomes ($1,000)
	Full Contract	Partial Contract	No Contract
Full Retooling	850	400	−350
Partial Retooling	550	350	−150
No Retooling	−300	−150	0
*In the payoff table, a negative number (−) indicates loss.

Use the information in this problem and the blank decision tree on the next page to answer the questions.

Questions		Answers
a.	What should you decide to do?
b.	What is the EMV for this problem?

Decision Tree for Problem 4

  

Answer 1

Decision Tree is as follows:

In the above decision tree, cost of bid ($ 10,000) is not subtracted from the payoffs, because this cost is same for all of the three decision alternatives.

EMV of Full Retooling = 0.3*850+0.2*400+0.5*(-350)

= $ 160 (000)

EMV of Partial Retooling = 0.3*550+0.2*350+0.5*(-150)

= $ 160 (000)

EMV of No Retooling = 0.3*(-300)+0.2*(-150)+0.5*0

= $ -120 (000)

EMV for first two decision alternatives, i.e. Full and Partial Retooling is the highest, i.e. 160 k

Therefore, both these alternatives should be equally preferred.

a)

Full Retooling or Partial Retooling

b)

EMV = 160,000 - 10,000

= $ 150,000 (net of cost of bid)