PS2ANS09

# PS2ANS09 - UNIVERSITY OF CALIFORNIA HAAS SCHOOL OF BUSINESS...

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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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PS2ANS09 - UNIVERSITY OF CALIFORNIA HAAS SCHOOL OF BUSINESS...

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