Grand Canyon ECN601 Module 2 problems

3-17

Kenneth Brown is the
principal owner of Brown Oil, Inc. After quitting his university teaching job,
Ken has been able to increase his annual salary by a factor of over 100. At the
present time, Ken is forced to consider purchasing some more equipment for
Brown Oil because of competition. His alternatives are shown in the following
table:

FAVORABLE UNFAVORABLE
MARKET MARKET
EQUIPMENT ($) ($)___
Sub 100 300,000 – 200,000
Oiler J 250,000 – 100,000
Texan 75,000 – 18,000

For example, if Ken purchases a Sub 100 and if
there is a favorable market, he will realize a profit of $300,000. On the other
hand, if the market is unfavorable, Ken will suffer a loss of $200,000.
But Ken has always been a very optimistic decision
maker.
(a) What type of decision is Ken facing?
(b) What decision criterion should he use?
(c) What alternative is best?

Problem 3-19
The Lubricant is an expensive oil newsletter to which many oil
giants subscribe, including Ken Brown (see Problem 3-17 for details). In the
last issue, the letter described how the demand for oil products would be
extremely high. Apparently, the American consumer will continue to use oil
products even if the price of these products doubles. Indeed, one of the
articles in the Lubricant states that the chances of a favorable market for oil
products was 70%, while the chance of an unfavorable market was only 30%. Ken
would like to use these probabilities in determining the best decision.
a.) What decision model should be used?
b.) What is the optimal decision?
c.) Ken believes that the $300,000 figure for the
Sub 100 with a favorable market is too high. How much lower would this figure
have to be for Ken to change his decision made in part (b)?
EQUIPMENT FAVORITE MARKET UNFAVORABLE MARKET
Sub 100 300,000 -200,000
Oiler J 250,000 -100,000
Texan 75,000 -18,000

Problem 3-22
Allen Young has always been proud of his personal investment
strategies and has done very well over the past several years. He invests
primarily in the stock market. Over the past several months, however, Allen has
become very concerned about the stock market as a good investment. In some
cases it would have been better for Allen to have his money in a bank than in
the market. During the next year, Allen must decide whether to invest $10,000
in the stock market or in a certificate of deposit (CD) at an interest rate of
9%. If the market is good, Allen believes that he could get a 14% return on his
money. With a fair market, he expects to get an 8% return. If the market is
bad, he will most likely get no return at all-in other words, the return would
be 0%. Allen estimates that the probability of a good market is 0.4, the
probability of a fair market is 0.4, and the probability of a bad market is
0.2, and he wishes to maximize his long-run average return.
(a) Develop a decision table for this problem.
(b) What is the best decision?

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