Assume that you have a client that is a paper manufacturer and they have expressed concern that the government will pass a new regulation banning the use of chlorine based technologies within their manufacturing process. If the firm were certain that the regulation would pass they would take proactive remedial action now, at a cost of $400K and introduce a newer, compliant technology. They don’t want to spend the $400K if they don’t have to. If they don’t act now, believing that the government will not change the regulation, and end up being wrong then they will find themselves having to change their manufacturing process from a reactive position and the cost for getting in compliance will be $800K, much greater than the $400K. Currently, the company’s best guess that the government will pass the new regulation is 15%.
As a consultant in this area your first instinct is to see if you can get more information on the likelihood of the government moving forward and making a change. Your client informs you that there are two firms available with expertise in forecasting regulatory policy as it relates to the papermaking industry. Firm A charges $80K for a study and their record is perfect. In the past, whenever Firm A has predicted that the government would introduce a more stringent regulation the prediction always came true and for those times that Firm A predicted that no new regulation would occur, none has occurred. If Firm A were to predict a change then your client would immediately undertake proactive remedial action and if Firm A predicted no change they would maintain the current manufacturing process.
Another firm, Firm B, has a much lower fee, charging only $20K but their predictive performance has not been perfect. In the past, Firm B has predicted government policy for passing new regulations with a ninety percent accuracy (i.e. for those times the government introduced a tougher regulation Firm B correctly predicted it about 90% of the time and missed it about 10% of the time). For those times when there was concern over the government changing the regulation but ended up not doing so, Firm B had correctly predicted no change 80% of the time. Your client has stated that if Firm B is hired and predicts that the government will introduce a new regulation then before taking action they would hire Firm A to do an assessment before proceeding, just to be absolutely sure. However, if your analysis indicates a better plan then feel free to recommend it. So, what to do following outcomes from Firm B are really undetermined at this point.
The client is unsure as to whether they should do nothing or re-mediate now or hire Firm A or B to get better information. Use decision analysis tools (either manual analysis or software is acceptable) to answer:
a) What action should the firm pursue in order to minimize expected loss? (50points)
b) Using your work in a) as a reference point then solve for the value of knowing ahead of time what action the government would take (i.e. by how much can you reduce the expected loss from part a)?
c) What is the breakeven value on the initial guess of the likelihood of a new regulation being introduced in order for your client to be indifferent between hiring Firm B and Firm A? In part a.) you assumed that this value was 15% but I’m asking you to let it be a variable and solve for its breakeven value.