Question

Your company has a customer who is shutting down a production line, and it is your responsibility to dispose of the extrusion machine. The company could keep it in inventory for possible future product and estimates that the reservation value is $250,000. Your dealings on the second-hand market lead you to believe that there is a 0.4 chance a random buyer will pay $300,000, a 0.25 chance the buyer will pay $350,000, a 0.1 chance the buyer will pay 400,000, and a 0.25 chance it will not sell. If you must commit to a posted price, what price maximizes profits?

Answer 1

Answer: $350,000

Explanation:

Commit to the amount with the highest expected value:

Expected value at $300,000:

= (0.4 * 300,000) + (0.6 * 250,000)

= $‭270,000‬

Expected value at $350,000:

= (0.25 * 350,000) + (0.75 * 250,000)

= $275,000

Expected value at $400,000

= (0.1 * 400,000) + (0.9 * 250,000)

= $265,000

Expected value if no sales:

= (0.25 * 0) + (0.75 * 250,000)

= $187,500

Price that maximises profits is $350,000 as it has the highest expected value.