Problem sets for Microeconomics II [110051-0471]

4 Decision making under uncertainty and value of
information
Exercise 4.1. In 1976, the parents of a 7-year-old boy sued a New York hospital for
$3.5 million. The boy was blinded shortly after he was born two weeks prematurely.
His parents claimed that hospital doctors administered excessive oxygen
to the baby and that caused the blindness. The case went to trial, and just as the
jury announced it hat reached the verdict, the lawyers for the two sides arrived
at an out-of-court settlement of $500,000.
a. If you were the parents, how would you decide whether to accept the settlement
or wait for the jury’s decision What probability assessments would
you need to make Would you have accepted the settlement
b. Answer the questions in part a, taking the hospital’s point of view.
Exercise 4.2. A European consortium has spent a considerable amount of time
and money developing a new supersonic aircraft. The aircraft gets high marks on
all performance measures except noise. In fact, because of the noise, the consortium’s
management is concerned that the U.S. government may impose restrictions
at some of the American airports where the aircraft can land. Management
judges a 50-50 chance that there will be some restrictions. Without restrictions,
management estimates its (present discounted) profit at $125 million; with restrictions,
its profit would be only $25 million. Management must decide now,
before knowing the government’s decision, whether to redesign parts of the aircraft
to solve the noise problem. The cost of the redesign program is $25 million.
There is a .6 chance that the redesign program will solve the noise problem (in
which case, full landing rights are a certainty) and a .4 chance it will fail.
a. Using decision tree , determine the consortium’s best course of action, assuming
management is risk neutral.
b. Find the expected value of perfect information about the redesign program.
Calculate separately the expected value of perfect information about the
U.S. government’s decision.
c. Suppose the management of the consortium questions its engineers about the
success or failure of the redesign program prior to committing to it. Management
recognizes that its engineers are likely to be biased in favor of the
program. It judges that if the program truly will succeed, the engineers will
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