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An electric utility company builds a new power plant, and management wants to decide whether to build the plant at Site 1 or at Site 2. The cost of building the plant is $10 million at Site 1 and $20 million at Site 2. If the company builds at Site 1, and an earthquake occurs there during construction in the next three years, then the plant construction will have to be terminated (losing an estimated $10 million), due to the earthquake the company will lose another $10 million, and they will have to build the plant at Site 2. Based on experience, the company estimates that there is a 20% chance that an earthquake will occur at Site 1 during the next three years. For $1 million, the company can commission a detailed geological study of Site 1: the result of this study will be either favorable or unfavorable. In the past, similar geological studies have been unfavorable on 95% of the occasions in which an earthquake occurred in the following three years, and favorable on 90% of the occasions in which an earthquake did not occur in the following three years. 3.1 How should the company proceed to minimize its expected cost of constructing the plant

Respuesta :

michell96

To minimize the expected cost of building the plant the best option for this company is to build at site 1

The best way to determine the best option for this company is to carefully analyze and compare the options presented:

  • Site 1:

Cost for building the plant $10 million

However, if an Earthquake occurs in the next 3 years:

Expected loss: $10 million (cost of the plant) + 10 million (cost paid due to earthquake) + $20 million (cost for building a new plant) = $40 million

  • Site 2:

Cost for building the plant $20 million

This means an Earquake in site 1 would make the cost of building in site 1 higher than the cost of building the plant at site 2 ($40 million vs $20 million)

Now, let's analyze the probabilities of an Earthquake

  • 20% chance of earthquakes (company estimation)
  • 95% unfavorable for earthquakes (previous studies)
  • 90% favorable for earthquakes not occurring (previous studies)

These previous studies show the probability of an Earquake not occurring is about 92.5%, which is quite low. Based on this and the comparison of prices for building in site 1 and site 2, the best option is to build at site 1 because it is very likely there is not an earthquake and the cost is only $10 million. Moreover, the company can pay $1 million to double-check this probability, which leads to a total cost of $11 million.

Learn more in: https://brainly.com/question/11651681

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