Scenario 5.9:
Torrid Texts, a risk-neutral new firm that specializes in making college textbooks more interesting by inserting contemporary material wherever possible, is planning for next year's production and must decide how many paper producers to contract with. It knows fairly well what the general demand for textbooks is, but is uncertain how faculty will react to this new material. If faculty react very negatively, the firm expects course orders to be down. The executives at Torrid believe that the likelihood of a positive faculty response is 75%. The table below contains profit information under the different possible outcomes.
Producers Faculty Reaction Expected
Contracted Negative Positive Profit
1 $3 million $30 million $23.25 million
2 $1 million $60 million $45.25 million
-Refer to Scenario 5.9. The value to Torrid Texts of complete information is
A) $0.25 million.
B) $0.5 million.
C) $1 million.
D) $14.75 million.
E) $30 million.

Question

Quizplus · Accepted Answer

The expected profit for contracting with one producer is:
Expected profit = (0.75)*$23.25 million + (0.25)*$30 million = $24.19 million
The expected profit for contracting with two producers is:
Expected profit = (0.75)*$45.25 million + (0.25)*$60 million = $46.19 million
Since the expected profit is higher if Torrid contracts with two producers, they should choose that option. However, if Torrid had complete information about the faculty response, they could have made a better decision. If they knew for sure that the faculty response would be positive, they would choose to contract with only one producer, resulting in a profit of $30 million. If they knew for sure that the faculty response would be negative, they would choose to contract with two producers, resulting in a profit of $1 million. The difference between the expected profit and the best possible profit under complete information is $0.5 million, so the value of complete information is $0.5 million.

Scenario 5.9: Torrid Texts, a Risk-Neutral New Firm That Specializes in Making