03 Jun Question Answer the questions below about decisions under uncertainty and asymmetric information: (A) You are considering opening a new
Question
Answer the questions below about decisions under uncertainty and asymmetric information:
(A) You are considering opening a new store in one of three locations. You have identified three possible outcomes (good, typical, and bad). Each location has different outcome probabilities and operating profits. If the store has sunk costs of $0.5 million and you want to maximize your expected profit (net of sunk costs), which would you choose, if any at all?
Location Probabilities Operating Profits
Good Typical Bad Good Typical Bad
A 20% 40% 40% $1.5 mil $1.0 mil $0.3 mil
B 30% 30% 40% $1.0 mil $0.75 mil $0.4 mil
C 15% 60% 25% $2.0 mil $1.0 mil $0.2 mil
(B) For each example below, explain how both adverse selection and moral hazard affect behavior.
a. Cars getting into accidents when airbags are introduced.
b. Food consumption on “all-you-can-eat” night at a restaurant.
c. Telephone volume with unlimited calling plans.
(C) You sell specialized laptop computers to project management professionals for $1,000 each. Since about 1% of these computers will fail within a year, your one-year warranty for an extra $20 has been very attractive for your firm. Recently, you discovered that some of these computers are being brought to dangerous job sites, causing 3% of them to fail. Customers who use them at dangerous job sites are willing to pay a maximum of $40 for the warranty, while those who don’t are willing to pay a maximum of $20. If you cannot tell how y
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