A contractor is submitting an estimate to a potential customer. The contractor believes that, if he offers to do the work for $200,000, there is a 10% probability that the customer will agree to that price, a 50% probability that a price of $120,000 would eventually be agreed upon, and a 40% probability that the customer will simply refuse the offer and give the work to another contractor. If instead the contractor offers to carry out the work for $100,000, he believes that there is a 30% probability that the customer will accept this price, a 60% probability that the customer will bargain so that a price of $80,000 will eventually be agreed upon, and a 10% probability that the customer will refuse the offer and take the work elsewhere.

Now, suppose that you inquire into the contractor’s attitudes about risk, and you find out:

He is indifferent between: $80k for certain or a 60% chance to win $200k, and a 40% chance to win $0.

He is indifferent between: $120k for certain or a 50% chance to win $200k, and a 50% chance to win $80k.

He is indifferent between: $100k for certain or a 75% chance to win $120k, and a 25% chance to win $80k.

Do the following:

1. Determine what price ($200,000 or $100,000) the contractor should offer, assuming he wishes to maximize Expected Monetary Value.

2. Based on the information above, sketch the contractor’s utility function, assuming that the utility of the worst possible outcome ($0) is 0, and the utility of the best possible outcome ($200k) is 1.

3. Is the contractor risk averse/seeking/neutral? How can we tell (specifically)?

4. Determine what price ($200,000 or $100,000) the contractor should offer, assuming he wishes to maximize Expected Utility.

Answer rating: 100% (QA)

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