HW 2 Solutions

1. You have mineral rights a piece of land that you believe may have oil underground. There is
only a 10% chance that you will strike oil if you drill, but the payoff is $200,000. It costs
$10,000 to drill. The alternative is not to drill at all, in which case your profit is zero. Before
you drill you might consult a geologist who can assess the promise of the piece of land. She
can tell you whether your prospects are "good" or "poor." But she is not a perfect predictor.
If there is oil, the conditional probability is 0.95 that she will say prospects are good. If no-
oil, the conditional probability is 0. 85 that she will say poor. Draw a decision tree that
includes the "Consult Geologist" alternative. Be careful to calculate the appropriate
probabilities to include in the decision tree. Finally, calculate the EVII for this geologist. If
she charges $7000, what should you do?

“good” = {geologist says the prospects for oil is good”}

“Poor” = {geologist says the prospects for oils is poor}
oil = {There is oil underground}
dry = {There is no oil underground}

P(“good” | oil) = 0.95

P(oil) = 0.1

P(“poor” | dry) = 0.85

P(dry) = 0.9

Using law of total probability:

P(“good”) = P(“good” | oil) P(oil) + P(“good” | dry) P(dry) = 0.95 (0.1) + 0.15 (0.9)= 0.23
P(“poor”) = 1 - P(“good”) = 1 - 0.23 = 0.77.

P ( good |oil ) P( oil) 0.95(0.1)

P(oil | “good”) = = =0.41
P ( good |oil ) P ( oil )+ P ( good |dy ) P (dry ) 0.95 (0.1)+0.15 (0.9)

P(dry | “good”) = 1 - P(oil | “good”) =0.59

P ( poor |oil ) P(oil) 0.05 (0.1)

P(oil | “poor”) = = =0.0065
P ( poor |oil ) P ( oil ) + P ( poor |dy ) P(dry ) 0.05(0.1)+0.85(0.9)

P(dry | “poor”) = 0.9935

 EVII = EMV(Consult Geologist) - EMV(Drill) = $16.56 K - $10 K = $6.56 K.
Geologist charges $7000 and EVII < $7000, hence we don’t opt for consultation with the
geologist.

2. Suppose you are considering two investment options: Option A and Option B. Option A has
a 70% chance of giving a 10% return and a 30% chance of giving a 5% return. Option B has a
50% chance of giving a 15% return and a 50% chance of giving a 0% return. Your utility
function is U(x) = sqrt(x), where x is the return on the investment. What option should you
choose?

U(10%) = sqrt(10%) = 0.3162

U(5%) = sqrt(5%) = 0.2236
EU(A) = (0.7 * U(10%)) + (0.3 * U(5%)) = (0.7 * 0.3162) + (0.3 * 0.2236) = 0.28842

U(15%) = sqrt(15%) = 0.3873

U(0%) = sqrt(0%) = 0
EU(B) = (0.5 * U(15%)) + (0.5 * U(0%)) = (0.5 * 0.3873) + (0.5 * 0) = 0.1937
Since the expected utility of Option A is higher than the expected utility of Option B, we can
conclude that Option A is the preferred option.
3. Suppose the time between consecutive arrivals at a store follows an exponential
distribution with a mean of 5 minutes. What is the probability that the next arrival will occur
within the next 2 minutes?

The exponential distribution, which is given by: f(x) = λ e− λx

where λ is the rate parameter, which is equal to 1/mean.
In this problem, we have λ = 1/5, since the mean time between arrivals is 5 minutes.
We want to find P(X < 2), where X is the time until the next arrival. Using the cumulative
distribution function (CDF) of the exponential distribution, we have:
F(x) = 1 - e− λ x
So, P(X < 2) = F(2) = 1 - e− λ∗2 = 1 - e−2 /5 ≈ 0.3297
Therefore, the probability that the next arrival will occur within the next 2 minutes is
approximately 0.3297.

4. Suppose that the number of defects in a production process follows a Poisson distribution
with a mean of 2 defects per hour. What is the probability that there are more than 4
defects in a 2-hour period?

In this problem, we know that the mean number of defects per hour is 2, so the mean
number of defects in a 2-hour period is 4.
Let X = defects in a 2-hour period. Then, X follows a Poisson distribution with mean 4.
So, the probability of having more than 4 defects in a 2-hour period is:
P(X > 4) = 1 - P(X ≤ 4) = 1 – [P(x=0)+P(x=1)+P(x=2)+P(x=3)+P(x-4)]
40 41 42 43 44
= 1 – e− 4 - e−4 − e−4− e−4− e−4 ≈ 0.371
0! 1! 2! 3! 4!
Therefore, the probability of having more than 4 defects in a 2-hour period is approximately
0.324.

5. Suppose you are waiting for a bus that arrives every 10 minutes on average, and the waiting
time follows an exponential distribution. You have already waited for 5 minutes. What is the
probability that you will have to wait for more than 10 minutes in total?

Using the memoryless property of exponential distribution:

Let X = waiting time for the bus
P(X > 10 | X > 5) = P(X > 5) = e^(-5/10) = e^(-1/2) ≈ 0.6065

6. Suppose a call center receives an average of 10 customer calls per hour, and the number of
calls the call center receives in an hour is Poisson distributed. What is the probability of
receiving exactly 12 calls in an hour?

Let X = the number of calls in an hour

Using the Poisson distribution, we can calculate the probabilities of different numbers of
calls occurring in an hour. For example, the probability of receiving exactly 12 calls in an
hour is:
 12
10 −10
P(X = 12) = e ≈ 0.094
12 !

7. Suppose that a call center receives an average of 2 customer calls per minute, and the
number of calls received per minute follows a Poisson distribution. There are 3 customer
service representatives available to take calls, and each representative can handle at most 1
call per minute. What is the probability that a call is not handled immediately?

The number of calls that each representative receives per minute follows a Poisson
distribution with a mean of 2/3 calls (since there are 3 representatives available to take
calls). The probability of a representative receiving exactly 1 call in a minute is:
P(1 call) = (e^(-2/3) * (2/3)^1) / 1! = e^(-2/3) * 2/3 ≈ 0.34227
Therefore, the probability that all representatives are busy when a call is received is:
P(all representatives are busy) = P(a single representative is busy)^3 ≈ 0.04
Therefore, the probability that a call is not handled immediately is approximately 0.04, or
4%.

8. Suppose that a basketball player has an 80% free-throw shooting average. If the player
takes 10 free-throw shots, what is the probability that the player makes exactly 8 of them?

Use Binomial Distribution

Let X = Number of making a free-throw shot.
P(X = 8) =( )
10 (0.8)8 (1−0.8)2
8
≈ 0.302
Therefore, the probability that the basketball player makes exactly 8 of 10 free-throw shots
is approximately 0.302, or 30.2%.

9. Suppose that a company produces computer chips, and 10% of the chips are defective. The
company ships a batch of 500 chips to a customer. If the customer tests 50 randomly
selected chips from the batch, what is the expected number of defective chips found?

The number of defective chips found in a sample of 50 chips follows a binomial distribution
with parameters n = 50 and p = 0.1.
Let X = the number of defective chips found in the sample.
The expected number of defective chips found in the sample is given by the expected value
of the binomial distribution, which is:
E(X) = n * p
Therefore, the expected number of defective chips found in the sample of 50 chips is:
E(X) = n * p = 50 * 0.1 = 5
The expected number of defective chips found in the sample of 50 chips is 5.

10. A decision maker's assessed risk tolerance is $1210. Assume that this individual's
preferences can be modeled with an exponential utility function.
 Find U($1000), U($800), U($0), and U(-$1250).
 Find the expected utility for an investment that has the following payoff distribution:
P($1000) = 0.33
P($800) = 0.21
P($0) = 0.33
P(-$1250) = 0.13
 Find the exact certainty equivalent for the investment and the risk premium.

using the utility function 1 - e^(-X/R) and R = $1210:

U($1000) = 1 - e^(-$1000/$1210) = 0.562

U($800) = 1 - e^(-$800/$1210) = 0.484
U($0) = 1 - e^(0/$1210) = 1 - 1 = 0
U(-$1250) = 1 - e^(-(-$1250)/$1210) = -1.809

EU = (0.33)*U($1000) + (0.21)*U($800) + (0.33)*U($0) + (0.13)*U(-$1250)

EU = (0.33)(0.562) + (0.21)(0.484) + (0.33)(0) + (0.13)(-1.809) = 0.0519

To find the CE for the investment, we use:

−CE
0.0519=1−e 1210
−CE
e 1210 =1−0.0519
−CE
ln ⁡(e ¿ ¿ )=ln ⁡( 0.9481) ¿
1210
−CE
=−0.0532
1210
CE = $64.49
RP = EMV – CE = 335.5 – 64.49 = $271.01