The Waco Tire Company (WTC) is considering expanding production to meet possible increases in demand. WTC’s alternatives are to construct a new plant, expand the existing plant, or do nothing in the short run. It will cost them $1 million to build a new facility and $600,000 to expand their existing facility. The market for this particular product may expand, remain stable, or contract. ETC’s marketing department estimates the probabilities of these market outcomes as 0.30, 0.45, and 0.25, respectively. The expected revenue for each alternative is presented in the table below.

Question

 MKT expands
MKT stable
MKT contracts
Build new plant$1,650,000
$1,000,000
$450,000
Expand plant$1,000,000
$850,000
$450,000
Do nothing$0
$0
$0
?
?
What course of action is optimal for WTC? What is the expected profit in that case?

What will be an ideal response?

Answer 1

If they build a new plant, the expected profit is ($650)(0.3) + ($0)(0.45) + (–$550)(0.25) = $57.5 thousand.If they expand the plant, the expected payoff is ($400)(0.3) + ($250)(0.45) + (–150)(0.25) = $195 thousand.If they do nothing, the expected profit is $0.The best course of action with the highest expected value is to expand the existing plant. The expected value of this option is $195,000. This option has the highest expected value.