The owner of Tastee Cookies needs to decide whether to lease a small, medium, or large new retail outlet. She estimates that monthly profits will vary with demand for her cookies as follows: SIZE OF OUTLET DEMAND LOW HIGH Small $ 1,000 1,000 Medium 500 2,500 Large 0 3,000 If she feels there is a 30 percent chance that demand will be high, what is her expected value of perfect information?

$500

Explanation:

If the demand is low, then the optimal solution is to lease a small outlet. If the demand is high, then the optimal solution is to lease the large outlet. The maximum expected value (under certainty of 70 low /30 high) = ($1,000 x 70%) + ($3,000 x 30%) = $700 + $900 = $1,600

The expected value under uncertainty (medium outlet) = ($500 x 70%) + ($2,500 x 30%) = $350 + $750 = $1,100

so,

the expected payoff under certainty = $1,600

the expected payoff under uncertainty = $1,100

value of perfect information = expected payoff under certainty - expected payoff under uncertainty = $1,600 - $1,100 = $500

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