Question

Philip Musa can build either a large video rental section or a small one in his Birmingham drugstore. He can also gather additional information or simply do nothing. If he gathers additional​ information, the results could suggest either a favorable or an unfavorable​ market, but it would cost him ​$3, 500 to gather the information. Musa believes that there is a​ 50-50 chance that the information will be favorable. If the rental market is​ favorable, Musa will earn ​$18,000 with a large section or ​$6, 000 with a small. With an unfavorable​ video-rental market,​ however, Musa could lose ​$21, 000 with a large section or ​$16, 000 with a small section. Without gathering additional​ information, Musa estimates that the probability of a favorable rental market is 0.7. A favorable report from the study would increase the probability of a favorable rental market to 0.9. ​Furthermore, an unfavorable report from the additional information would decrease the probability of a favorable rental market to 0.4. Of​ course, Musa could ignore these numbers and do nothing. What is your advice to​ Musa?

The expected payoff is ​$ ___ ​(round your response to the nearest​ dollar).

Answer 1

Decision Tree for Option – 1 (without additional Information)

Decision Tree for Option – 2 (without additional Information favorable report at 50% probability)

Decision Tree for Option – 2 (without additional Information unfavorable report at 50% probability)

Conclusions

1. As EMV for Large section is higher than Small section for both options I at $6300 and II at $4350. Philip Musa should build large electronics section

2. The difference between EMV for large section for option 1 without additional information is $6300 and for large section for option 2 with additional information is $ 4350 is $6300-4350=$1950. But the cost of obtaining additional information is higher at $3000. So Philips Musa should proceed without obtaining additional information

Expected payoff is $1950

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