Mr. Smith wants to buy a car and is deciding between brands A and B. Car A
Question:
Mr. Smith wants to buy a car and is deciding between brands A and B. Car A costs \(\$ 20,000\), and Mr. Smith estimates that at the rate he drives he will sell it after 2 years and buy another of the same type for the same price. The resale price will be either \(\$ 10,000\) or \(\$ 5,000\), each with probability . 5 , at the end of each 2 -year period. Car B costs \(\$ 35,000\) and will be sold after 4 years with an estimated resale price of either \(\$ 12,000\) or \(\$ 8,000\), each with probability . 5 . The yearly maintenance costs of the two cars are constant each year and identical for the two cars. Mr. Smith has an exponential utility function with risk aversion coefficient of about \(a=1 / \$ 1,000 \mathrm{now}\). Real interest is constant at \(5 \%\). Which car should he decide is better from an economic perspective over a 4 -year period, and what is the certainty equivalent of the difference?
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