Topics: Decision theory, Expected value, Firm Pages: 2 (514 words) Published: February 26, 2013
Econ 173 Assignment 2

1. Your firm is deciding whether to pursue a \$200 R&D project to develop a new drug. You estimate there is a 40% chance of successfully creating the drug, which will generate revenue of \$550. Your competitor has just announced that it is spending 150 to pursue development of a similar drug using a different technology. You estimate that there is a 30% chance your competitor will succeed. If both firms succeed, they will each obtain revenue of 275.

a. Should your firm undertake the 200 R&D effort? Use a decision tree.

b. Now suppose it is possible for your firm to wait until after the result of your competitor’s R&D effort (success or failure) is known. Is it advantageous for your firm to wait? Use a decision tree.

c. Now suppose that the two firms can form a joint venture to pursue either or both projects. What is the expected profit of pursuing both programs? Alternatively, could the joint venture profitably pursue a single program?

2. A studio is considering making a film. Profit is uncertain for two reasons: the cost of producing the film may be low or high and demand for the film may be low or high. Assume that costs have no impact on demand; the two realizations are independent random draws. There is a .5 probability costs will be 140 and a .5 probability costs will be 60. There is a .4 probability that revenues will be 140 and a .6 probability that revenues will be 80. The studio’s profits depend on the outcomes as follows:

Low Cost/High Demand:140 – 60 = 80
Low Cost/Low Demand: 80 – 60 = 20
High Cost/High Demand: 140 – 140 = 0
High Cost/Low Demand:80 – 140 = – 60

a. Should the studio produce the film? Draw the decision tree and use it to justify your answer.

b. The studio is concerned that the director might let production costs get out of control. Thus, the studio wants a termination clause that gives it the right to terminate the project after the first 30 is spent. Assume that by this time, the...