solution

Compute the expected value of perfect information for the Willow Café in Problem S1-12. Explain what this value means and how such information might be obtained.

Problem S1-12

The Willow Café is located in an open-air mall. Its lease expires this year and the restaurant owner has the option of signing a 1-, 2-, 3-, 4-, or 5-year lease. However, the owner is concerned about recent energy price increases (including the price of gasoline), which affect virtually every aspect of the restaurant operation including the price of food items and materials, delivery costs, and its own utilities. The restaurant was very profitable when energy prices were lower, and the owner believes if prices remain at approximately their current level profits will still be satisfactory; however, if prices continue to rise he believes that he might be forced to close. In these latter circumstances a longer term lease could be a financial disaster, but with a shorter term lease the mall landlord could always rent the restaurant’s space out from under it when the lease expires. As such, the restaurant owner’s estimates of future profits must also reflect the possibility that the lease will not be renewable. The following payoff table summarizes the owner’s profit (and loss) estimates for each future state of nature of energy prices (over a five-year period).

Determine the best decision using expected value.