Problem Set 8 answers

Problem Set 8 answers - PPS 55 Spring 2008 Problem Set 8...

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PPS 55 Spring 2008 Problem Set 8 – ANSWER KEY 1. The Price of Knowledge You have a decision to make about your summer plans. You could go intern at J.P. Morgan, and earn $3000 for the summer. But a friend is leaning on you to join her in a website development business, which she says will earn $5,000 if it is a success. Of course if the business flops, you earn nothing. She thinks that it is equally likely the business will succeed or fail. A. Set up your decision tree, and assuming risk neutrality, decide what to do. Your EMV of joining your friend’s firm is $2,500, versus $3,000 for sure if you take the internship. If you are risk neutral you should take the internship. EMV = (.5*5,000+.5*0 )= $2,500 $5,000 $0 $3,000 Business succeeds Business fails Intern at J.P. Morgan Join your friend p=.5 p=.5
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B. Now suppose that your roommate, marketing expert extraordinaire, offers to do a feasibility study. It will predict the outcome of the website business with 90% accuracy. (That is, if the study is positive, the business will succeed with a probability of .9; if it’s negative, it will fail with probability of .9). How much are you willing to pay for the study? (Hint: when setting up the “test” branch of the tree, consider the choice that you
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Problem Set 8 answers - PPS 55 Spring 2008 Problem Set 8...

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