The Lubricant is an expensive oil newsletter to which many oil giants subscribe,

Question

The Lubricant is an expensive oil newsletter to which many oil giants subscribe, including Ken Brown. In the last issues, the letter described how the demand for oil products would be extremely high. Apparently, the American consumer will continue to use oil products even if the price of these products doubles. Indeed, one of the articles in the Lubricant states that the chances of a favorable market for oil products was 70%, while the chance of an unfavorable market was only 30%. Ken would like to use these probabilities in determining the best decision. A) What decision model should be used? B) What is the optimal decision? C) Ken believes that the $300,000 figure for the Sub 100 with a favorable market is too high. How much lower would this figure have to be for Ken to change his decision made in part (b)?

Explanation / Answer

decision model should be based on max expected return.

E = P_fav*Val_fav + P_unfav*Val_unfav

the three products/indexes in the table give the following expected returns: 270, 205, 57.9

so the best is product 1 (Sub 100) - assuming the cost is equal (not given in the question).

for the decision to change, Sub 100 expected return should be equal to the next best one, Oiler J.

so 270 should be reduced to 205. This means that the max should be lowered from 300,000 to ~207,140.

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