EconS 301 – Intermediate Microeconomics Review Session #13 ...

) Assuming that the firm is a risk-neutral decision maker, should the firm build a newplant? What is the expected value associated with the optimal decision?c) Suppose instead of finding out about the contract cancellation after it builds the plant,the firm finds out about cancellation before it builds the plant. Draw a new decisiontree corresponding to this new sequence of decisions and events. Again assuming thatthe firm is a risk-neutral decision maker, should the firm build the new plant?Answers:a & b) The decision tree for this situation is shown below. The chance nodes are circular, andthe decision node is square.Contract is cancelled(probability = 0.45)$0 - $60 million = -$60 millionBuildContract is not cancelled(probability = 0.55)$200 - $60 million = $140 millionDo not buildContract is cancelled(probability = 0.45)Contract is not cancelled(probability = 0.55)$0$100 millionSince the decision maker is risk neutral, we can evaluate payoffs using expected values.The expected value if you build the plant is:(0.45)(-$60 million) + (0.55)($140 million) = $50 millionThe expected value if you do not build the plant:(0.45)($0) + (0.55)($100 million) = $55 million.Not building the plant is the best course of action.c) The answer to question of whether the firm should build the plant is: it depends! Thedecision tree for the revised sequence of decisions and event is shown below.6