Question

4. The CEO must determine whether to build a small plant or a large plant for the company. The CEO believes that the profit made will depend on the level of future demand. The payoff table (in $) is as follows: Event High Demand Low Demand Probability 0.65 0.35 Action Small Plant 270 195 Action Large Plant 480 100 a. Build the opportunity loss matrix b. Interpret the number in the opportunity loss matrix for a low demand and a large plant C. Compute the expected opportunity loss (EOL) solution for each action. What is the optimal action?

Answer 1

Maximum profits under high demand = max (270, 480) = 480

Maximum profits under low demand = max (195, 100) = 195

Part (a)

	Probability	Small	Large
High Demand	0.65	210	0
Low Demand	0.35	0	95

Part (b)

If we start a large plant and the demand remains low, we will make a profit of $ 100 however we will lose the opportunity of making $ 195 under the same condition with a small plant. Hence, the opportunity lost under a low demand scenario of a large plant is 195 - 100 = 95

Part (c)

EOL for small plant = 0.65 x 210 + 0.35 x 0 = 136.50

EOL for a large plant = 0.65 x 0 + 0.35 x 95 = 33.25

EOL is lower in case of a large plant. Hence, the optimal decision will be to choose the large plant option.