An oil company must decide whether or not to drill an oil well in a particular area that they already own. The decision maker (DM) believes that the area could be dry, reasonably good or a bonanza. See data in the table which shows the gross revenues for the oil well that is found. Decision Dry (D) Drill $0 Abandon $0 Probability 0.3 Reasonably good(G) $85 $0 0.3 Bonanza(B) $200 m SO 0.4 Drilling costs 40M. The company can take a series of seismic soundings ( at a cost of 12M) to determine the underlying geological structure. The results will be either "no structure","open structure or "closed structure". The reliability of the testing company is as follows that is, this reflects their historical performance. Note that if the test result is "no structure" the company can sell the land to a developer for 50 m. otherwise (for the other results) it can abandon the drilling idea at no benefit to itself.
An oil company must decide whether or not to drill an oil well in a particular area that they already own. The decision maker (DM) believes that the area could be dry, reasonably good or a bonanza. See data in the table which shows the gross revenues for the oil well that is found. Decision Dry (D) Drill $0 Abandon $0 Probability 0.3 Reasonably good(G) $85 $0 0.3 Bonanza(B) $200 m SO 0.4 Drilling costs 40M. The company can take a series of seismic soundings ( at a cost of 12M) to determine the underlying geological structure. The results will be either "no structure","open structure or "closed structure". The reliability of the testing company is as follows that is, this reflects their historical performance. Note that if the test result is "no structure" the company can sell the land to a developer for 50 m. otherwise (for the other results) it can abandon the drilling idea at no benefit to itself.
Chapter19: Pricing Concepts
Section: Chapter Questions
Problem 6DRQ
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Question
![An oil company must decide whether or not to drill an oil well in a particular area that they already
own. The decision maker (DM) believes that the area could be dry, reasonably good or a bonanza.
See data in the table which shows the gross revenues for the oil well that is found.
Decision
Drill
$0
Abandon
$0
Probability 0.3
Dry (D)
Seismic Results
No structure(N)
Open(0)
Closed (C)
Drilling costs 40M. The company can take a series of seismic soundings (at a cost of 12M) to
determine the underlying geological structure. The results will be either "no structure", "open
structure or "closed structure". The reliability of the testing company is as follows that is, this
reflects their historical performance.
Reasonably
good(G)
$85
$0
0.3
Note that if the test result is "no structure" the company can sell the land to a developer for 50 m.
otherwise (for the other results) it can abandon the drilling idea at no benefit to itself.
Dry(d)
0.7
0.2
Bonanza(B)
0.1
$200 m
SO
0.4
Conditional Probability for a given state of nature
b) Fold back the decision tree
must state this strategy
Reasonably good(g)
0.3
0.3
0.4
Bonanza(b)
0.1
0.4
0,5
That is P (N/D)=0.7;P (O/G)=0.3, P(C/B)=0.5
After you have computed the revised probabilities round to two decimal places
a) Construct the appropriate decision tree to help the oil company make the appropriate
decisions. This tree must be constructed in logical order with labels and net payoffs
It also includes the revised probabilities
to determine the best strategy for the company; you
What is the final expected profit?](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2Fad0ac84e-0550-43a0-af29-56c9639f04a2%2Fc7b86905-f1e5-4b31-b0bc-4c31b69eaa41%2Fop4fngj_processed.png&w=3840&q=75)
Transcribed Image Text:An oil company must decide whether or not to drill an oil well in a particular area that they already
own. The decision maker (DM) believes that the area could be dry, reasonably good or a bonanza.
See data in the table which shows the gross revenues for the oil well that is found.
Decision
Drill
$0
Abandon
$0
Probability 0.3
Dry (D)
Seismic Results
No structure(N)
Open(0)
Closed (C)
Drilling costs 40M. The company can take a series of seismic soundings (at a cost of 12M) to
determine the underlying geological structure. The results will be either "no structure", "open
structure or "closed structure". The reliability of the testing company is as follows that is, this
reflects their historical performance.
Reasonably
good(G)
$85
$0
0.3
Note that if the test result is "no structure" the company can sell the land to a developer for 50 m.
otherwise (for the other results) it can abandon the drilling idea at no benefit to itself.
Dry(d)
0.7
0.2
Bonanza(B)
0.1
$200 m
SO
0.4
Conditional Probability for a given state of nature
b) Fold back the decision tree
must state this strategy
Reasonably good(g)
0.3
0.3
0.4
Bonanza(b)
0.1
0.4
0,5
That is P (N/D)=0.7;P (O/G)=0.3, P(C/B)=0.5
After you have computed the revised probabilities round to two decimal places
a) Construct the appropriate decision tree to help the oil company make the appropriate
decisions. This tree must be constructed in logical order with labels and net payoffs
It also includes the revised probabilities
to determine the best strategy for the company; you
What is the final expected profit?
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