A small biotechnology company has developed a burn treatment that has commercial potential. The company has to decide whether to produce the new compound itself or sell the rights to the compound to a large drug company. The payoffs from each of these courses of action depend on whether the treatment is approved by the Food and Drug Administration (FDA), the regulatory body in the United States that approves all new drug treatments. (The FDA bases its decision on the outcome of tests of the drug's effectiveness on human subjects.) The company must make its decision before the FDA decides. Here are the payoffs the drug company can expect to get under the two options it faces:
a) Draw a decision tree showing the decisions that the company can make and the payoffs from following those decisions. Carefully distinguish between chance nodes and decision nodes in the tree.
b) Assuming that the biotechnology company acts as a risk-neutral decision maker, what action should it choose? What is the expected payoff associated with this action?