EMV, payoff, probabilities, labels, and decision   Question: You...

EMV, payoff, probabilities, labels, and decision

 

Question:

You plan to start your own cafe after graduation. You have to decide to start with a small, medium, or large shop. A consultant's report indicates a .35 probability that demand will be low and a .65 probability that demand will be high.

If you start with a small shop and demand turns out to be low, the payoff will be $96,000; if demand turns out to be high, you can either subcontract and realize the payoff of $96,000 or expand for a payoff of $108,000.

 You can start with a medium-size shop as a hedge: If demand turns out to be low, its payoff is estimated at $54,000; if demand turns out to be high, you could do nothing and realize a payoff of $98,000, or expand and realize a payoff of $120,000.

 If you start with a large shop and demand is low, the payoff will be -$45,000, whereas high demand will result in a payoff of $150,000.