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Exercises 173
why it was rational for the decision maker to opt for the
alternative having the highest expected utility.
(9) The Northern Manufacturing Company (NMC) is considering
extending its operations by opening a manufacturing plant in
an overseas country. Two countries are being considered, Slohemia
and Tundrastan, but resource constraints mean that only one of
these countries can be selected. The decision will largely be based
on the level of sales of NMC’s products which can be achieved over
the next 5 years in the host country. For simplicity, these sales have
been categorized as either high or low.
If Slohemia is selected there is estimated to be a 0.3 probability
that a new government will come into power within the next 5 years
and nationalize all foreign investments. This would lead to losses
with an estimated present value of $10 million being incurred by
NMC. If nationalization does not take place it is thought that there is
a 0.7 probability of high sales being achieved. These would generate
net returns having an estimated present value of $95 million. Low
sales would lead to net returns with a present value of $15 million.
If Tundrastan is selected the chances of achieving high sales
will depend on whether a local company sets up in competition
with NMC. It is estimated that there is an 80% chance of this
happening. However, if there is no competition there is thought to
be a 0.9 probability of high sales occurring. These would generate
net returns with an estimated present value of $90 million. Low
sales would lead to net returns with a present value of $10 million.
If NMC does find itself facing competition in Tundrastan, it would
first have to decide whether to attempt to buy out the competitor.
This would be expensive. Indeed it is estimated that it would
reduce net returns, by $20 million, irrespective of whether it was
successful. The chances of a success are estimated to be only 75%,
but a successful buyout would lead to market conditions identical
to those involving no competition. If a decision was made not to
attempt the buyout, or if the buyout failed, NMC would then have
to decide whether to lower its prices to undercut the competitor.
This would reduce net returns by around $30 million but its effect
would be to increase the chances of high sales from 0.5 to 0.8.
(a) Assuming that the management of NMC wish to maximize
expected net returns, determine the optimal policy which they
should pursue.
(b) Discuss the limitations of the analysis which you applied in
part (a).