Chez Paul is contemplating either opening another restaurant or expanding its existing location.The payoff table for these two decisions is: $\begin{array} { l | c c c } & &{ \text { State of Nature } } \\\text { Decision } & s _ { 1 } & s _ { 2 } & s _ { 3 } \\\hline \text { New Restaurant } & - \$ 80,000 & \$ 20,000 & \$ 160,000 \\\text { Expand } & - \$ 40,000 & \$ 20,000 & \$ 100,000\end{array}$ Paul has calculated the indifference probability for the lottery having a payoff of $160,000 with probability p and $80,000 with probability (1p)as follows: $\begin{array} { r c } \text { Amount } & \text { Indifference Probability } ( p ) \\\hline - \$ 40,000 & .4 \\\$ 20,000 & 7 \\\$ 100,000 & .9\end{array}$
a.Is Paul a risk avoider, a risk taker, or risk neutral?
b.Suppose Paul has defined the utility of $80,000 to be 0 and the utility of $160,000 to be 80. What would be the utility values for $40,000, $20,000, and $100,000 based on the indifference probabilities?
c.Suppose P(s₁) = .4, P(s₂) = .3, and P(s₃) = .3. Which decision should Paul make? Compare with the decision using the expected value approach.

Question

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

\begin{array} { l | c c c } & &{ \text { State of Nature } } \\\text { Decision } & s _ { 1 } & s _ { 2 } & s _ { 3 } \\\hline \text { New Restaurant } & - \$ 80,000 & \$ 20,000 & \$ 160,000 \\\text { Expand } & - \$ 40,000 & \$ 20,000 & \$ 100,000\end{array}

Paul has calculated the indifference probability for the lottery having a payoff of $160,000 with probability p and $80,000 with probability (1p)as follows:

\begin{array} { r c } \text { Amount } & \text { Indifference Probability } ( p ) \\\hline - \$ 40,000 & .4 \\\$ 20,000 & 7 \\\$ 100,000 & .9\end{array}

a.Is Paul a risk avoider, a risk taker, or risk neutral?
b.Suppose Paul has defined the utility of $80,000 to be 0 and the utility of $160,000 to be 80. What would be the utility values for $40,000, $20,000, and $100,000 based on the indifference probabilities?
c.Suppose P(s₁) = .4, P(s₂) = .3, and P(s₃) = .3. Which decision should Paul make? Compare with the decision using the expected value approach.

Quizplus · Accepted Answer

The Answer of Chez Paul is contemplating either opening another restaurant or expanding its existing location.The payoff table for these two decisions is: $$\begin{array} { l | c c c } & &{ \text { State of Nature } } \ \text { Decision } & s _ { 1 } & s _ { 2 } & s _ { 3 } \ \hline \text { New Restaurant } & - \$ 80,000 & \$ 20,000 & \$ 160,000 \ \text { Expand } & - \$ 40,000 & \$ 20,000 & \$ 100,000 \end{array}$$ Paul has calculated the indifference probability for the lottery having a payoff of $160,000 with probability p and  $80,000 with probability (1  p)as follows: $$\begin{array} { r c } \text { Amount } & \text { Indifference Probability } ( p ) \ \hline - \$ 40,000 & .4 \ \$ 20,000 & 7 \ \$ 100,000 & .9 \end{array}$$ a.Is Paul a risk avoider, a risk taker, or risk neutral? b.Suppose Paul has defined the utility of  $80,000 to be 0 and the utility of $160,000 to be 80. What would be the utility values for  $40,000, $20,000, and $100,000 based on the indifference probabilities? c.Suppose P(s₁) = .4, P(s₂) = .3, and P(s₃) = .3. Which decision should Paul make? Compare with the decision using the expected value approach.

Chez Paul Is Contemplating Either Opening Another Restaurant or Expanding