Scenario 5.8:
Risk-neutral Icarus Airlines must commit now to leasing 1, 2, or 3 new airplanes. It knows with certainty that on the basis of business travel alone, it will need at least 1 airplane. The marketing division says that there is a 50% chance that tourism will be big enough for a second plane only. Otherwise, tourism will be big enough for a third plane. This, plus revenue information, yields the following table:
Planes Tourism Revenue Expected
Leased Light Heavy Profit
2 $90 million $30 million $60 million
3 $10 million $140 million $75 million
-Refer to Scenario 5.8. Given that the two outcomes are equally likely, Icarus Airlines' expected profit under complete information would be
A) $40 million.
B) $90 million.
C) $115 million.
D) $120 million.
E) $125 million.

Question

Quizplus · Accepted Answer

Under complete information, the optimal decision would be to lease three planes since the expected profit (based on the revenue table) is $75 million. However, since there is only a 50% chance that tourism will be big enough for a third plane, we need to calculate the expected profit under incomplete information.

If Icarus Airlines leases one plane, the expected profit would be $30 million. If it leases two planes, the expected profit would be:

(0.5 x $60 million) + (0.5 x $90 million) = $75 million

If it leases three planes, the expected profit would be:

(0.5 x $75 million) + (0.5 x $10 million) = $42.5 million

Therefore, the expected profit with incomplete information is highest for leasing two planes, which is $75 million.

Scenario 5.8: Risk-Neutral Icarus Airlines Must Commit Now to Leasing 1, 2