Roy Lamb has an option on a particular piece of land, and he must decide whether to drill on the land before the expiration of the option or give up his rights. If he drills, he believes that the cost will be $200,000. If he finds oil, he expects to receive $1 million; if he does not find oil, he expects to receive nothing.
a. Construct a decision tree to represent Lamb's decision.
b. Can you tell whether he should drill on the basis of the available information? Why or why not? Lamb believes that the probability of finding oil if he drills on this piece of land is 0.25, and the probability of not finding oil if he drills there is 0.75.
c. Can you tell whether he should drill on the basis of the available information? Why or why not?
d. Suppose Lamb can be demonstrated to be a risk lover. Should he drill? Why or why not?
e. Suppose Lamb is risk- neutral. Should he drill?