Chapter 5 with Solutions

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Chapter 5
A firm has three investment alternatives. Payoffs are in thousands of dollars.

a) Using the expected value approach, which decision is preferred?

b) For the lottery having a payoff of $100,000 with probability p and $0 with probability (1 - p), two decision makers expressed the following indifference probabilities. Find the most preferred decision for each decision maker using the expected utility approach.

c) Why don’t decision makers A and B select the same decision alternative?

Difference in attitude toward risk. Decision maker A tends to avoid risk, while decision maker B tends to take a risk for the opportunity (Risk taker) of a large payoff. (Can be check by plotting the values).
Q#2. Alexander Industries is considering purchasing an insurance policy for its new office building in St. Louis, Missouri. The policy has an annual cost of $10,000. If Alexander Industries doesn’t purchase the insurance and minor fire damage occurs, a cost of $100,000 is anticipated; the cost if major or total destruction occurs is $200,000. The costs, including the state-of-nature probabilities, are as follows:

a) Using the expected value approach, what decision do you recommend?

b) What lottery would you use to assess utilities? (Note: Because the data are costs, the best payoff is $0.)
Lottery:
p= probability of a $0 Cost and (0 is highest payoff and 200, 000 is the lowest value)
1 - p = probability of a $200,000 Cost c) Assume that you found the following indifference probabilities for the lottery defined in part (b). What decision would you recommend?

Q#3. Two different routes accommodate travel between two cities. Route A normally takes 60 minutes and route B normally takes 45 minutes. If traffic problems are encountered on route A, the travel time increases to 70 minutes; traffic problems on route B increase travel…...

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