A plant manager wants to know how much he should be willing to pay for perfect market research. Currently there are two states of nature facing his decision to expand or do nothing. Under favorable market conditions the manager would make $100,000 for the large plant and $5,000 for the small plant. Under unfavorable market conditions the large plant would lose $50,000 and the small plant would make $0. If the two states of nature are equally likely, how much should he pay for perfect information?
A) $0
B) $25,000
C) $50,000
D) $100,000
E) unable to determine

Question

Quizplus · Accepted Answer

The expected value of the decision without perfect information is:

Expected value of expanding = (0.5 x $100,000) + (0.5 x -$50,000) = $25,000
Expected value of doing nothing = (0.5 x $5,000) + (0.5 x $0) = $2,500

If the plant manager has perfect information about the market conditions, he can make the decision with certainty and avoid the possibility of a loss. Therefore, he should be willing to pay up to the amount of the difference between the expected values, which is:

$25,000 - $2,500 = $22,500

Therefore, the plant manager should be willing to pay up to $22,500 for perfect information. Since this value is closest to option B, that is the correct answer.

A Plant Manager Wants to Know How Much He Should