Question

In Chapter 3, we begin to look at how to use data to make decisions. It...

In Chapter 3, we begin to look at how to use data to make decisions. It is not enough to say, "the answer is $2,100." Rather, what do we do with this information to make good choices?

Your assignment for this discussion section is to learn how to use the Expected Monetary Value (EMV) to help you make decisions.

Here’s your task: You have been asked to decide whether your company should build a new factory in Alabama.

  • If you build it and things go well, you could make a lot of money, but if the economy goes bad, you could lose a lot of money (and maybe your job, too).
  • If you choose not to build it and the economy goes bad, you’ve made the right decision because you haven’t lost any money. On the other hand, if you don’t do anything and the economy does really well, you’ve missed a terrific opportunity to make a profit.

How do you use the EMV to do this? Let me show you...

Here’s your grid:

Outcomes

Good Economy              Bad Economy

Your Choices:

            

o Build the factory o Don’t build the factory

A

B

C

D

Probabilities

P1

P2

1. From the following choices, randomly pick how much money you would make if you chose to build the factory and things went well. (You can’t go wrong with any choice; just pick one.) Put that amount in Box “A.” (value: 5 points)

Box “A” choices

  • $100,000 •           $125,000         •           $105,000
  • $75,000     •           $65,000          •           $90,000 •        $50,000          •           $200,000       •           $45,000

2. From the following menu, pick how much money you would lose if you chose to build and the economy went down. (As with Step 1, you can’t go wrong with any choice; just pick one.J) Put that amount in Box “B.” NOTE: Notice that all of these values in Box B are negative: be sure and put the negative number in your calculations! (value: 5 points)

Box “B” choices

  • -$100,000             •           -$115,000       •           -$75,000
  • -$85,000 •           -$165,000       •           -$45,000
  • -$55,000 •           -$105,000       •           -$110,000
  1. Put zeroes (“0”) in Boxes “C” and “D” because you aren’t doing anything that would let make or lose money. (value: 5 points)
  1. Choose one of the possible combinations of probabilities. (Again, just choose one of these nine choices; you can’t go wrong.) Put the value of P1 (the chance of a good economy) in Box “P1.” Put the value of P2 (the chance of a bad economy) in Box “P2.” (Note how both numbers always add to 100 %.) (value: 5 points)

Choices for Box P1 and Box P2

  • P1 = 75% P2 = 25%           •           P1 = 70% P2 = 30%     •           P1 = 10% P2 = 90%
  • P1 = 55% P2 = 45%           •           P1 = 50% P2 = 50%      •           P1 = 45% P2 = 55%
  • P1 = 66% P2 = 34%           •           P1 = 40% P2 = 60%      •           P1 = 25% P2 = 75%

5. Now that you’ve made your choices and have a complete grid, use your notes to do an EMV with the data you’ve entered. Use the Discussion Board to answer the following:

  • What values did you choose from Box A, Box B, and Boxes P1 and P2? (value: 20 points)
  • What EMV amount do you come up with? (value: 50 points)
  • What is your EMV decision? In other words, do you build, or not? (value: 30 points)
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Choices Good Economy Bad Economy
Build the factory $125,000 - $85,000
Don't build the factory $ 0 $ 0
Probabilities 50% 50%

Part 5: (i) Box A = $ 125,000 Box B = $ 85,000

Box P1 = 0.5 Box P2 = 0.5

Expected Monetary Value (EMVB) = 0.5 x 125000 + 0.5 x (- 85000)

EMVB =  $ 20,000

EMVDB =  $ 0

Clearly, since the building of the factory gives us a higher expected payoff, the decision is to build the factory at 50 percent probabilities of good and bad state of the economy.

$ 20,000 is the contingency reserve that should be maintained in case of bad state of the economy.

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