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UNIVERSITY OF CALIFORNIA
HAAS SCHOOL OF BUSINESS
EWMBA 201A—Economic Analysis for Business Decisions
Fall 2009
Felix Várdy
ANSWERS – Problem Set #2
Question 1
(a) See Figure 1.
(b) The expected profit of tomatoes is:
0.5x$10,000 + 0.5x$30,000 = $20,000
The expected profit of cactuses is $18,000.
Since the question told you to assume that Old MacDonald is an expected profit
maximizer (i.e. that she is risk neutral), she should grow tomatoes for an
expected profit of $20,000.
This is the solution to the decision tree in Figure 1.
(c) If Old Mac decided to grow cactuses, she must not be maximizing expected
profits (or she made a mistake).
She probably decided to grow cactuses
because there is lower risk.
In fact, the profit from growing cactuses is known
with certainty.
If this is the reason, then Old Mac is risk averse.
(d) The ratio of expected profits from the two crops is still 10:9 ($14,000 versus
$12,600), but if Old MacDonald was growing cactuses because she was risk
averse, she
might
now grow tomatoes.
The risk involved is smaller since both
expected values are smaller.
Since people tend to be less risk averse over
small gambles than over large ones, Old Mac might be willing to take this
gamble (and grow tomatoes) now that the risk is smaller.
If she were risk
neutral, she would grow tomatoes, since the expected value of growing
tomatoes ($14,000) is greater than the expected value of growing cactuses
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 Fall '07
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