Quantitative Methods of Business
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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.
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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.
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