Question

Dollar Department Stores has received an offer from Harris Diamonds to purchase Dollar's store on Market Street for $120,000. Dollar has determined probability estimates of the store's future profitability, based on economic outcomes, as: P($80,000) = 0.2, P($100,000) = 0.3, P($120,000) = 0.1, and P($140,000) = 0.4.

part a :

Not considering probabilities, based on each of the following criteria, should Dollar sell the store?

1 a. Optimistic approach (Maximax)

1 b. Conservative approach (Maximin)

Part B:

Now use the given probabilities and based on each of the following criteria, should Dollar sell the store?

B 1. Expected Monetary Value (EMV)

B 2. Expected Opportunity Loss (EOL)

Part C:

Determine the Expected Value of Perfect Information (EVPI).

Part D:

A marketing firm has offered to forecast the market with 100% accuracy at a cost of $10,000. Should the offer be accepted? Why or why not.

Please go into depth and show formulas and how you got to the solution.

Answer 1

(a)

A.1

Maximax (optimistic approach) - take the alternative which gives the maximum of the maximum payoffs.

The best decision is 'Don't sell'

A.2

Maximin (Pessimistic approach) - take the alternative which gives the maximum of the minimum payoffs.

The best decision is 'Sell'.

(b)

B.1

Example calculation: 80*0.2 + 100*0.3 + 120*0.1 + 140*0.4 = 114

Based on the maximum EMV, the best decision is 'Sell'.

B.2

Based on the minimum EOL, the best decision is 'Sell'.

C.

Expected Value of Perfect Information (EVPI) = Expected Value with Perfect Information - max. EMV

= 120*0.2 + 120*0.3 + 120*0.1 + 140*0.4 - 120

= 8 (i.e. $8,000)

Second method: Expected Value of Perfect Information (EVPI) = min. EOL = 8 (i.e. $8,000).

D.

The offer may not be accepted because the EVPI is $8,000 only. Why should someone pay $10,000 for an $8,000 worth information?