Making Decisions With Uncertainty

17-2 Game Show Uncertainty

In the final round of a TV game show, contestants have a chance to increase their current winnings of $1 million to $2 million. If they are wrong, their prize is decreased to $500,000. A contestant thinkshis guess will be right 50 percent of the time. Should he play? What is the lowest probability of a correct guess that would make playing profitable?

Auctions

18-4 Asset Auctions in Sweden

In Sweden, firms that fail to meet their debt obligations are immediatelyauctioned off to the highest bidder. (There is no reorganization through Chapter 11 bankruptcy.) The current managers are often the high bidders for the company. Why?

The Problem of Adverse Selection

19-1 Leasing Residuals

In the late 1990s, car leasing was very popular in the United States. A customer would lease a car from the manufacturer for a set term, usually two years, and then have the option of keeping the car. If the customer decided to keepthecar, the customer would pay a price to the manufacturer, the "residual value," computed as 60 percent of the new car price. The manufacturer would then sell the returned cars at auction. In 1999, the manufacturer lost an average of $480 on each returned car (the auction price was, on average, $480 less than the residual value).

A. Why was the manufacturer losing money on this program?

B. What should the manufacturer do to stop losing money?

The Problem of Moral Hazard

20-1 Extended Warranties

Your product fails about 2 percent of the time, on average. Some customers purchase the extended warranty you offer in which you will replace the product if it fails. Would you want to price the extended warranty at 2 percent of the product price? Discuss both moral hazard and adverse selection issues.

20-3 Locator Beacons for Lost Hikers

Lightweight personal locator beacons are now available to hikers that make it easier for the Forest Service's rescue teams to locate those lost or in trouble in the wilderness. How will this affect the costs that the Forest Service incurs?

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