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Quantitative Methods of Business

Chez Paul is contemplating either opening another restaurant or expanding its existing location. The payoff table for these two decisions is:

s1 s2 s3
New Restaurant -$80K $20K $160K
Expand -$40K $20K $100K

Paul has calculated the indifference probability for the lottery having a payoff of $160K with probability p and -$80K with probability (1-p) as follows:

Amount Indifference Probability (p)
-$40K .4
$20K .7
$100K .9

a. Is Paul a risk avoider, a risk taker, or risk neutral? EXPLAIN.

b. Suppose Paul has defined the utility of -$80K to be 0 and the utility of $160K to be 80. What would be the utility values for -$40K, $20K, and $100K based on the indifference probabilities?

c. Suppose P(s1) = .4, P(s2) = .3, and P(s3) = .3. Which decision should Paul make using the expected utility approach?

d. Compare the result in part c with the decision using the expected value approach.

Solution Summary

The solution covers topics such as payoff tables, indifference probability, risk avoidance, risk taking, risk neutral, utility, expected utility approach and the expected value approach. Attached as Excel.