Assignment task:
Alexander Industries is considering purchasing an insurance policy for its new office building in St. Louis, Missouri. The policy has an annual cost of $12,000. If Alexander Industries doesn't purchase the insurance and minor fire damage occurs, a cost of $100,000 is anticipated; the cost if major or destruction occurs is $200,000. The costs, including the state-of-nature probabilities, are as follows: Damage Decision Alternatives None, S1 Minor, S2 Major, S3 Purchase insurance, d1 12,000 12,000 12,000 Do not purchase insurance, d2 0 100,000 200,000 Probabilities .95 .04 .01
a. Using the expected value approach, what decision do you recommend?
b. What lottery would you use to assess utilities? (Note: Because the data are costs, the best payoff is $0, and the worst payoff is $200,000).
c. Assume that you found the following indifference probabilities for the lottery defined in part (b). What decision would you recommend? Cost Indifference Probability 12,000 P=.97 100,000 P=.60
d. Do you favor using expected value or expected utility for this decision problem? Why?