Grant proposal to OSHA

The Occupational Safety and Health Administration (OSHA) has recently announced that it will award an $85,000 research
grant to the person or company submitting the best proposal for using wireless communications technology to enhance safety in
the coal-mining industry. Steve Hinton, the owner of COM-TECH, a small communications research firm located just outside of
Raleigh, North Carolina, is considering whether or not to apply for this grant. Steve estimates that he would spend approximately
$5,000 preparing his grant proposal and that he has about a 50-50 chance of actually receiving the grant. If he is awarded the grant,
he then would need to decide whether to use microwave, cellular or infrared communications technology. He has some experience
in all three areas, but would need to acquire some new equipment depending on which technology is used. The cost of the
equipment needed for each technology is summarized as:
Technology Equipment Cost
Microwave $4,000
Cellular $5,000
Infrared $4,000

In addition to the equipment costs, Steve knows that he will spend money in research and development (R&D) to carry out
research proposal, but he does not know exactly what the R&D costs will be. For simplicity, Steve estimates the following best-
case and worst-case R&D costs associated with using each technology, and he assigns probabilities to each outcome based on his
degree of expertise in each area.

Possible R&D Costs

Best Case Worst Case
Cost Prob. Cost Prob.
Microwave $30,000 0.4 $60,000 0.6
Cellular $40,000 0.8 $70,000 0.2
Infrared $40,000 0.9 $80,000 0.1

Steve needs to synthesize all the factors in this problem to decide whether or not to submit a grant proposal to OSHA.

Lawsuit Defense Strategy

John Campbell, an employee of Manhattan Construction Company, claims to have injured his back as a result of a fall while
repairing the roof at one of the Eastview apartment buildings. He filed a lawsuit against Doug Reynolds, the owner of Eastview
Apartments, asking for damages of $1,500,000. John claims that the roof had rotten sections and that his fall could have been
prevented if Mr. Reynolds had told Manhattan Construction about the problem. Mr. Reynolds notified his insurance company,
Allied Insurance, of the lawsuit. Allied must defend Mr. Reynolds and decide what action to take regarding the lawsuit.
Some depositions and a series of discussions took place between both sides. As a result, John Campbell offered to accept a
settlement of $750,000. Thus, one option is for Allied to pay John $750,000 to settle the claim. Allied is also considering making
John a counteroffer of $400,000 in the hope that he will accept a lesser amount to avoid the time and cost of going to trial. Allied’s
preliminary investigation shows that John’s case is strong; Allied is concerned that John may reject their counteroffer and request
a jury trial. Allied’s lawyers spent some time exploring John’s likely reaction if they make a counteroffer of $400,000.
The lawyers concluded that it is adequate to consider three possible outcomes to represent John’s possible reaction to a
counteroffer of $400,000: (1) John will accept the counteroffer and the case will be closed; (2) John will reject the counteroffer
and elect to have a jury decide the settlement amount; or (3) John will make a counteroffer to Allied of $600,000. If John does
make a counteroffer, Allied decided that they will not make additional counteroffers. They will either accept John’s counteroffer of
$600,000 or go to trial.
If the case goes to a jury trial, Allied considers three outcomes possible: (1) the jury may reject John’s claim and Allied will not
be required to pay any damages; (2) the jury will find in favor of John and award him $750,000 in damages; or (3) the jury will
conclude that John has a strong case and award him the full amount of $1,500,000.
Key considerations as Allied develops its strategy for disposing of the case are the probabilities associated with John’s response
to an Allied counteroffer of $400,000 and the probabilities associated with the three possible trial outcomes. Allied’s lawyers
believe the probability that John will accept a counteroffer of $400,000 is 0.10, the probability that John will reject a counteroffer
of $400,000 is 0.40, and the probability that John will, himself, make a counteroffer to Allied of $600,000 is 0.50. If the case goes
to court, they believe that the probability the jury will award John damages of $1,500,000 is 0.30, the probability that the jury will
award John damages of $750,000 is 0.50, and the probability that the jury will award John nothing is 0.20.

Perform a decision tree analysis of the problem facing Allied Insurance.

Finding Gas
A local energy provider offers a landowner $180,000 for the exploration rights to natural gas on a certain site and the option for
future development. This option, if exercised, is worth an additional $1,800,000 to the landowner, but this will occur if natural gas
is discovered during the exploration phase. The landowner, believing that the energy company’s interest in the site is a good
indication that gas is present, is tempted to develop the field herself. To do so, she must contract with local experts in natural gas
exploration and development. The initial cost for such a contract is $300,000, which is lost forever if no gas is found on the site. If
gas is discovered, however, the landowner expects to earn a net profit of $6,000,000. Finally, the landowner estimates the
probability of finding gas on this site to be 60%.
a. Create a decision tree for this problem to find an optimal strategy maximizing the expected profit.
b. Determine the probability of finding gas on the site which makes the possible choices indifferent.

Nuclear Power Plant

A nuclear power company is deciding whether to build a nuclear power plant at Diablo Canyon or at Roy Rogers City. The cost
of building the power plant is $10 million at Diablo and $20 million at Roy Rogers City. If the company builds at Diablo, however,
and an earthquake occurs at Diablo during the next 5 years, construction will be terminated and the company will lose the cost of
building $10 million (and will still have to build a power plant at Roy Rogers City). Without further expert information the
company believes there is a 20% chance that an earthquake will occur at Diablo during the next 5 years.
Create a decision tree for this problem to find an optimal decision maximizing the expected utility.

For $1 million, a geologist can be hired to analyze the fault structure at Diablo Canyon. She will predict either that an
earthquake will occur or that an earthquake will not occur. The geologist’s past record indicates that she will predict an earthquake
on 95% of the occasions for which an earthquake will occur and no earthquake on 90% of the occasions for which an earthquake
will not occur. The power company wants to know whether it is profitable to hire the geologist and how valuable it is.

Marketing a New Product at Acme

The Acme Company is trying to decide whether to market a new product. As in many new-product situations, there is
considerable uncertainty about whether the new product will eventually “catch on.” Acme believes that it might be wise to
introduce the product in a regional test market before introducing it nationally. Therefore, the company’s first decision is whether
to conduct the test market.
Acme estimates that the net cost of the test market is $100,000. We assume this is mostly fixed costs, so that the same cost is
incurred regardless of the test market results. If Acme decides to conduct the test market, it must then wait for the results. Based
on the results of the test market, it can then decide whether to market the product nationally, in which case it will incur a fixed cost
of $7 million. On the other hand, if the original decision is not to run a test market, then the final decision – whether to market the
product nationally – can be made without further delay. Acme’s unit margin, the difference between its selling price and its unit
variable cost, is $18. We assume this is relevant only for the national market.
Acme classifies the results in either the test market or the national market as great, fair, or awful. Each of these results in the
national market is accompanied by a forecast of total units sold. These sales volume (in 1000s of units) are 600 (great), 300 (fair),
and 90 (awful). In the absence of any test market information, Acme estimates that probabilities of the three national market
outcomes are 0.45, 0.35, and 0.20, respectively.
In addition, Acme has the following historical data from products that were introduced into both test markets and national
markets.

„ Of the products that eventually did great in the national market, 64% did great in the test market, 26% did fair in the test
market, and 10% did awful in the test market.
„ Of the products that eventually did fair in the national market, 18% did great in the test market, 57% did fair in the test
market, and 25% did awful in the test market.
„ Of the products that eventually did awful in the national market, 9% did great in the test market, 48% did fair in the test
market, and 43% did awful in the test market.

The company wants to use a decision tree approach to find the best strategy. It also wants to find the expected value of the
information provided by the test market.