After retiring as a physician, Bob Guthrie became an avid downhill skier on the steep slopes of the Utah Rocky Mountains. As an amateur inventor, Bob was always looking for something new. With the recent deaths of several celebrity skiers, Bob knew he could use his creative mind to make skiing safer and his bank account larger. He knew that many deaths on the slopes were caused by head injuries. Although ski helmets have been on the market for some time, most skiers considered them boring and basically ugly. As a physician, Bob knew that some type of new ski helmet was the answer.
Bob’s biggest challenge was to invent a helmet that was attractive, safe, and fun to wear. Multiple colors, using the latest fashion designs, would be a must. After years of skiing, Bob knew that many skiers believed that how you looked on the slopes was more important than how you skied. His helmets would have to look good and fit in with current fashion trends. But attractive helmets were not enough. Bob had to make the helmets fun and useful. The name of the new ski helmet, Ski Right, was sure to be a winner. If Bob could come up with a good idea, he believed that there was a 20% chance that the market for the Ski Right helmet would be excellent. The chance of a good market should be 40%. Bob also knew that the market for his helmet could be only average (30% chance) or even poor (10% chance).
The idea of how to make ski helmets fun and useful came to Bob on a gondola ride to the top of a mountain. A busy executive on the gondola ride was on his cell phone, trying to complete a complicated merger. When the executive got off the gondola, he dropped the phone, and it was crushed by the gondola mechanism. Bob decided that his new ski helmet would have a built-in cell phone and an AM/FM stereo radio. All the electronics could be operated by a control pad worn on a skier’s arm or leg.
Bob decided to try a small pilot project for Ski Right. He enjoyed being retired and didn’t want a failure to cause him to go back to work. After some research, Bob found Progressive Products (PP). The company was willing to be a partner in developing the Ski Right and sharing any profits. If the market was excellent, Bob would net $5,000. With a good market, Bob would net $2,000. An average market would result in a loss of $2,000, and a poor market would mean Bob would be out $5,000. Another option for Bob was to have Leadville Barts (LB) make the helmet. The company had extensive experience in making bicycle helmets. PP would then take the helmets made by LB and do the rest. Bob had a greater risk. He estimated that he could lose $10,000 in a poor market or $4,000 in an average market. A good market for Ski Right would result in a $6,000 profit for Bob, and an excellent market would mean a $12,000 profit.
A third option for Bob was to use TalRad (TR), a radio company in Tallahassee, Florida. TR had extensive experience in making military radios. LB could make the helmets, and PP could do the rest. Again, Bob would be taking on greater risk. A poor market would mean a $15,000 loss, and an average market would mean a $10,000 loss. A good market would result in a net profit of $7,000 for Bob. An excellent market would return $13,000. Bob could also have Celestial Cellular (CC) develop the cell phones. Thus, another option was to have CC make the phones and have PP do the rest of the production and distribution. Because the cell phone was the most expensive component of the helmet, Bob could lose $30,000 in a poor market. He could lose $20,000 in an average market. If the market was good or excellent, Bob would see a net profit of $10,000 or $30,000, respectively.
Bob’s final option was to forget about PP entirely. He could use LB to make the helmets, CC to make the phones, and TR to make the AM/FM stereo radios. Bob could then hire some friends to assemble everything and market the finished Ski Right helmets. With this final alternative, Bob could realize a net profit of $55,000 in an excellent market. Even if the market were just good, Bob would net $20,000. An average market, however, would mean a loss of $35,000. If the market was poor, Bob would lose $60,000.
1. What do you recommend?
2. What is the opportunity loss for this problem?
3. Compute the expected value of perfect information.
4. Was Bob completely logical in how he approached this decision problem?