Question

A large transportation company must buy 100,000 gallons of gas each quarter. The company is concerned about the possibility of conflict with Iran. The company believes that there is 70% chance of a conflict, in which case it believes that the spot price (i.e. the current price) of gasoline will rise to $3.50 per gallon. If there is no conflict, the company believes that the price will fall to $2.50 per gallon. A large transportation company must buy 100,000 gallons of gas each quarter. The company is concerned about the possibility of conflict with Iran. The company believes that there is 70% chance of a conflict, in which case it believes that the spot price (i.e. the current price) of gasoline will rise to $3.50 per gallon. If there is no conflict, the company believes that the price will fall to $2.50 per gallon.

If the company buys gas futures, which lock in the price of gasoline at $3.25 per gallon, what will be the expected cost of buying 100,000 gallons of gas? (Enter an integer) (Note: there is no cost to entering into a gas futures contract except that the company will be obligated to buy 100,000 gallons at $3.25 per gallon if it enters into the contract.)

Suppose Professor Stahnke has a second job working as a consultant trying to forecast the political situation in the Middle East. Assume that based on his research, Professor Stahnke will predict whether or not there will be a conflict with Iran with 100% accuracy. Professor Stahnke is offering his forecasting services for the modest price of $15,000. If the transportation company bought Professor Stahnke's forecast, what will be the expected cost of buying 100,000 gallons of oil next quarter (including the cost of the forecast)?

What is the most the company would be willing to pay Professor Stahnke? (Enter an integer)

Answer 1

The company has 2 options- either get in the contract or not. If the company does not get into the contract, then the cost is

70%*3.5*100000+30%*2.5*100000=320000.

If the company gets into the contract, then the cost is 3.25*100000=325000.

The next step is concerned with Expected Value of Perfect Information (EVPI). This is the value of the information from Professor Stahnke. This is how much the company will be willing be to pay for the information since, the company will only pay if

EVPI>=Cost of the information.

If the company had the information from Professor, then its decision tree would look like this

Since the comapny knows for sure whether there will be war or not, it will choose highlighted options. Since there is a 70% chance of war and 30% of no war, the new cost becomes

.7*325000+.3*250000=302500.

As the cost without the information from the Professor was 320000, the company will pay a maximum of

320000-302500=17500.