Question 1: Why maximization of the expected value not a valid criterion in decision making subject to risk? Under what conditions would that criterion be valid?
Question 2: How does the adverse selection problem arise in the credit-card market? How do credit-card companies reduce the adverse selection problem that they face? To what complaint does this give rise?
Question 3: A software company has to decide which of two advertising strategies to adopt. TV commercial or newspaper ads. The marketing department has estimated that sales and their probability under each alternative plan are as given in the table below:
Strategy A Strategy B
(TV Commercials) (Newspaper Ads)
Sales Probability Sales Probability
$8,000 0.2 $8,000 0.3
10,000 0.3 12,000 0.4
12,000 0.3 16,000 0.3
14,000 0.2
The firm profit is 50 percent of sales. (a) Calculate the expected profit under each promotion strategy. (b) Calculate the standard deviation of the distribution of profits for each promotion strategy. (c) Which of the two promotion strategies is more risky? (d) Which promotion strategy should the firm choose?
Question 4: Given the following payoff matrix for investment projects A, B and C, determine the best investment project for the firm according to (a) the maximin criterion and (b) the minimax regret criterion.
State of Nature
Project Recession Normal Boom
A $50 $75 $85
B 40 80 100
C 30 70 70