An oil company has some land that is reported to possibly contain oil. The company classifies such land into four categories by the total number of barrels that are expected to be obtained from the well, i.e. a 500,000 - barrel well, 200,000 - barrel well, 50,000 - barrel well, and a dry well. The company is faced with deciding whether to drill for oil, to unconditionally lease the land or to conditionally lease the land at a rate depending upon oil strike. The cost of drilling the well is $100,000; if it is a producing well and the cost of drilling is $75,000 if it is a dry well. For producing well, the profit per barrel of oil is $1.50, (after deduction of processing and all other costs except drilling costs).
Under the unconditional lease agreement, the company receives $45,000 for the land whereas for the conditional lease agreement the company receives 50 cents for each barrel of oil extracted if it is a 500,000 or 200,000 barrel oil strike and nothing if otherwise.
The probability for striking a 500,000 - barrel well is 0.1, probability for striking a 200,000 - barrel well is 0.15, probability for striking a 50,000 - barrel well is 0.25, and probability for a dry well is 0.5.
Payoff Table
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States of Nature
|
|
Decision
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500K Barrel Well
|
200K Barrel Well
|
50K Barrel Well
|
Dry Well
|
|
Drill
|
650
|
200
|
-25
|
-75
|
|
Unconditional Lease
|
45
|
45
|
45
|
45
|
|
Conditional Lease
|
250
|
100
|
0
|
0
|
|
Probability
|
0.1
|
0.15
|
0.25
|
0.5
|
(a) Determine the optimal action based on the maximin criterion.
(b) Compute the expected monetary value (EMV) for each decision.
(c) Compute the expected value of perfect information (EVPI) and explain the meaning of it in this problem.
(d) Based on the results of (b) or (c), which decision (which option) would you recommend? Why?