National TeleCom

National TeleCom is a telecommunications equipment niche company specializing in

computer-telephone interfacing for business networks. The company exclusively does
product design and engineering, licensing the manufacture of its products to large
electronics hardware manufacturers. Sometimes a new idea can be developed into an
engineered prototype in a matter of weeks.
The lion’s share of National TeleCom’s revenue comes from royalties paid by the
manufacturers of its designs. Harry Smith, the company’s founder, feels that National
TeleCom is missing tremendous opportunities by not marketing its own products to the
ultimate consumer. He is considering the possibility of vertically integrating downward
with the next product, a high-speed modem designed for home use. Since National
TeleCom does not have the in-house capability to manufacture that product itself, the
actual fabrication would have to be contracted out – possibly to one of the licensees of
its current products. But National TeleCom would do the marketing and distribution
itself.
If successful, the new product would increase the company’s profit by $200,000.
If unsuccessful, the modem’s introduction cost of $100,000 would be lost. Although past
users of its designs are not in the home market, Mr. Smith believes that some of the
marketing research experience with those products is still valid with the new modem. In
particular he has faith in the outside panel of experts used to screen past products. In
evaluating that arrangement for a 6-month trial period, National found that the panel
approved 7 out of 11 products that later proved to be successful; the panel disapproved
5 out of 7 products that were introduced anyway and eventually failed.
A high-tech marketing research firm has proposed, instead, to give a market
prognostication. For similar products, the firm’s batting average has been 90% in
making favorable forecasts for items that later proved to be successful and 95% in
making unfavorable predictions for devices that later failed in the marketplace.
Mr. Smith judges the new modem very positively, assigning it a 40% chance of
becoming a successful new product.

Questions
1. The decision has not yet been made to employ the panel.
2. For the modem events and the panel results, construct probability trees for the
actual and informational chronologies.
a. If the main modem decision had to be made now without any benefit of
testing or marketing research, which act – market or abandon – would
maximize the expected payoff?
b. What is the upper limit on what Mr. Smith should pay for highly reliable
information predicting the success or failure of the modem? In other
words, what is the EVPI (Expected Value of Perfect Information)?
3. The panel will cost $10,000. Using gross payoffs, construct a decision tree
diagram for this experiment, and perform a backward induction analysis to
determine the expected payoff based on this information. Compute the EVSI
(Expected Value of Sample Information) and ENVSI (Expected Net Value of
Sample Information).
4. Suppose that Mr. Smith uses the marketing researcher’s prognostication. As an
alternative to employing a decision tree, he could perform a decision table
analysis to establish the value of using that forecast.
a. One possible strategy would be as follows:

Market the modem if a favorable prediction is obtained (M if F).

Abandon the modem if an unfavorable prediction is obtained (A if U).

b. Ignoring any cost of experimenting, construct National TeleCom’s payoff

table, using as acts the strategies in part (a) and the various joint events
for prognostication and market outcomes – e.g., F and S.
c. Which strategy maximizes National TeleCom’s expected gross payoff with
this experimental information?
d. What marketing researcher will charge $20,000. Determine the EVSI and
ENVSI.
5. What should National TeleCom do to maximize expected payoff?