Problem:
Consider an oil-wildcatting problem. You have mineral rights on a piece of land that you believe may have oil underground. There is only a 10% chance that you will strike oil if you drill, but the payoff is $200,000. It costs $10,000 to drill. The alternative is not to drill at all, in which case your profit is zero.
- Draw a decision tree to represent your problem. Should you drill?
- Using the decision tree, calculate EVPI.
- Before you drill, you might consult a geologist who can assess the promise of the piece of land. She can tell you whether your prospects are "good" or "poor." But she is not a perfect predictor. If there is oil, the conditional probability is 0.95 that she will say prospects are good. If there is no oil, the conditional probability is 0.85 that she will say poor. Draw a decision tree that includes the "Consult Geologist" alternative. Be careful to calculate the appropriate probabilities to include in the decision tree. Finally, calculate the EVII for the geologist. If she charges $7,000, what should you do?