Based on Balson et al XXXXXXXXXXAn electric utility company is trying to decide whether to replace its PCB transformer in a generating station with a new and safer transformer. To evaluate this...

Based on Balson et al. (1992). An electric utility company is trying to decide whether to replace its PCB transformer in a generating station with a new and safer transformer. To evaluate this decision, the utility needs information about the likelihood of an incident, such as a fire; the cost of such an incident; and the cost of replacing the unit. Suppose that the total cost of replacement as a present value is $75,000. If the transformer is replaced, there is virtually no chance of a fire. However, if the current transformer is retained, the probability of a fire is assessed to be 0.0025. If a fire occurs, then the cleanup cost could be high ($80 million) or low ($20 million). The probability of a high cleanup cost, given that a fire occurs, is assessed at 0.2.


a.  If the company uses EMV as its decision criterion, should it replace the transformer?


b.  Perform a sensitivity analysis on the key parameters of the problem that are difficult to assess, namely, the probability of a fire, the probability of a high cleanup cost, and the high and low cleanup costs. Does the optimal decision from part a remain optimal for a “wide” range of these parameters?  c.  Do you believe EMV is the correct criterion to use in this type of problem involving environmental accidents?