Question

Given the payoff table below, decide the size of the storage to be constructed (EMV calculation). What is the expected payoff of this decision? Alternatives Small Storage Medium Storage Large Storage Possible Future Demand P(LOW)=0.10 $8,000 $9,000 -$10,000 Possible Future Possible Future Demand Demand P(MODERATE)=0.30 P(HIGH)=0.60 $10,000 $10,000 $14,000 $15,000 $10,000 $20,000 Build a medium storage, EMV-$14,100 Build a small storage, EMV=$9,800 Build a large storage, EMV-$14,000 Build a medium storage, EMV=$12,667 Build a large storage, EMV=$6,667

Answer 1

Answer: Option A

Explanation: The decision rule for the problem is

Decision Rule: Build a storage facility which has the highest EMV.

Expected EMV = Sum (Probability x Payoff)

For Small Storage,

Expected EMV = (0.10 x 8000) + (0.3 x 10000) + (0.6 x 10000)

= $9800

For Medium Storage,

Expected EMV = (0.10 x 9000) + (0.3 x 14000) + (0.6 x 15000)

= $14100

For Small Storage,

Expected EMV = (0.10 x -10000) + (0.3 x 10000) + (0.6 x 20000)

= $14000

Since the EMV of medium storage is the highest ($14100), medium storage should be constructed.