Question

The Americo Oil Company is considering making a bid for a shale oil development contract to be awarded by the federal government. The company estimates that it has a 70% chance of winning the contract with this bid. If the firm wins the contract, it can choose one of three methods for getting the oil fro the sale. It can develop a new method for oil extraction, use an existing (inefficient) process, or subcontract the processing to a number of smaller companies once the shale has been excavated. The results from these alternatives are given as follows.

Develop new process
Outcomes	Probability		Profit ($ millions)
Great Success	.30		600
Moderate Success	.60		300
Failure	.10		-200
Use present process
Outcomes	Probability		Profit ($ millions)
Great Success	.50		300
Moderate Success	.30		150
Failure	.20		-40

Subcontract
Outcomes	Probability		Profit ($ millions)
Moderate Success	1.00		350

The cost of preparing the contract proposal is $2 million. If the company does not make a bid, it will invest in an alternative venture with a guaranteed profit of $30 million.

1. Construct a decision tree for this situation.
2. What decision should the company make?
3. What profit should they expect?
4. Will they really make the profit you predicted in part C?

Hint: It is much easier to work this problem if, when you’re solving the tree, you consider the $2 million at the very end. That is, solve the tree and then subtract the 2 million.

Answer 1