Fairco, a family business, is considering making an investment in its manufacturing operation. Three decisions are under consideration: (1) a large investment; (2) a medium investment; and (3) a small investment. The business believes that there are three possible future outcomes for its product: (1) increasing demand; (2) stable demand; and (3) decreasing demand. The business believes that the probability for increasing, stable and decreasing product demand are 0.4, 0.5, and 0.1, respectively. The following payoff table describes the decision situation. If the expected value criterion is used, then the best decision would be to
A) make the large investment.
B) make the medium investment.
C) make the small investment.
D) choose the stable demand.

Question

Fairco, a family business, is considering making an investment in its manufacturing operation. Three decisions are under consideration: (1) a large investment; (2) a medium investment; and (3) a small investment. The business believes that there are three possible future outcomes for its product: (1) increasing demand; (2) stable demand; and (3) decreasing demand. The business believes that the probability for increasing, stable and decreasing product demand are 0.4, 0.5, and 0.1, respectively. The following payoff table describes the decision situation.  If the expected value criterion is used, then the best decision would be to
A) make the large investment. 
B) make the medium investment. 
C) make the small investment. 
D) choose the stable demand.

Quizplus · Accepted Answer

Using the expected value criterion, we need to calculate the expected payoffs for each decision. 
For the large investment, the expected payoff is:
(0.4 x 50) + (0.5 x 20) + (0.1 x 0) = 20 + 10 + 0 = 30 
For the medium investment, the expected payoff is:
(0.4 x 35) + (0.5 x 25) + (0.1 x 10) = 14 + 12.5 + 1 = 27.5 
For the small investment, the expected payoff is:
(0.4 x 20) + (0.5 x 15) + (0.1 x 5) = 8 + 7.5 + 0.5 = 16 
Therefore, the best decision is to make the large investment, as it has the highest expected payoff.

Fairco, a Family Business, Is Considering Making an Investment in Its