Overview
Week 2 Problem Set: End of Chapter 2 Conceptual Questions – C.1 - C.5
Using MS Excel, complete the following problems at the end of each chapter. Using MS Excel, complete the following problems at the end of each chapter. See Learning Material>Readings and Resources
C.1.
Your company needs to make an important decision that involves large monetary consequences. You have listed all of the possible outcomes and the monetary payoffs and costs from all outcomes and all potential decisions. You want to use the EMV criterion, but you realize that this requires probabilities and you see no way to find the required probabilities. What can you do?
C.2.
If your company makes a particular decision in the face of uncertainty, you estimate that it will either gain $10,000, gain $1000, or lose $5000, with probabilities 0.40, 0.30, and 0.30, respectively. You (correctly) calculate the EMV as $2800. However, you distrust the use of this EMV for decision-making purposes. After all, you reason that you will never receive $2800; you will receive $10,000, $1000, or lose $5000. Discuss this reasoning.
C.3.
In the previous question, suppose you have the option of receiving a check for $2700 instead of making the risky decision described. Would you make the risky decision, where you could lose $5000, or would you take the sure $2700? What would influence your decision?
C.4.
In a classic oil-drilling example, you are trying to decide whether to drill for oil on a field that might or might not contain any oil. Before making this decision, you have the option of hiring a geologist to perform some seismic tests and then predict whether there is any oil or not. You assess that if there is actually oil, the geologist will predict there is oil with probability 0.85. You also assess that if there is no oil, the geologist will predict there is no oil with probability 0.90. Why will these two probabilities not appear on the decision tree? Which probabilities will be on the decision tree?
C.5.
Your company has signed a contract with a good customer to ship the customer an order no later than 20 days from now. The contract indicates that the customer will accept the order even if it is late, but instead of paying the full price of $10,000, it will be allowed to pay 10% less, $9000, due to lateness. You estimate that it will take anywhere from 17 to 22 days to ship the order, and each of these is equally likely. You believe you are in good shape, reasoning that the expected days to ship is the average of 17 through 22, or 19.5 days. Because this is less than 20, you will get your full $10,000. What is wrong with your reasoning?
C.6.
You must make one of two decisions, each with possible gains and possible losses. One of these decisions is much riskier than the other, having much larger possible gains but also much larger possible losses, and it has a larger EMV than the safer decision. Because you are risk averse and the monetary values are large relative to your wealth, you base your decision on expected utility, and it indicates that you should make the safer decision. It also indicates that the certainty equivalent for the risky decision is $210,000, whereas its EMV is $540,000. What do these two numbers mean? What do you know about the certainty equivalent of the safer decision?
C.7.
A potentially huge hurricane is forming in the Caribbean, and there is some chance that it might make a direct hit on Hilton Head Island, South Carolina, where you are in charge of emergency preparedness. You have made plans for evacuating everyone from the island, but such an evacuation is obviously costly and upsetting for all involved, so the decision to evacuate shouldn’t be made lightly. Discuss how you would make such a decision. Is EMV a relevant concept in this situation? How would you evaluate the consequences of uncertain outcomes?
C.8.
It seems obvious that if you can purchase information before making an ultimate decision, this information should generally be worth something, but explain exactly why (and when) it is sometimes worth nothing.
C.9.
Insurance companies wouldn’t exist unless customers were willing to pay the price of the insurance and the insurance companies were making a profit. So explain how insurance is a win-win proposition for customers and the company.
C.10.
You often hear about the trade-off between risk and reward. Is this trade-off part of decision making under uncertainty when the decision maker uses the EMV criterion? For example, how does this work in investment decisions?
C.11.
Can you ever use the material in this chapter to help you make your own real-life decisions? Consider the following. You are about to take an important and difficult exam in one of your MBA courses, and you see an opportunity to cheat. Obviously, from an ethical point of view, you shouldn’t cheat, but from a purely monetary point of view, could it also be the wrong decision? To model this, consider the long-term monetary consequences of all possible outcomes.