Making Decisions With Uncertainty

Student’s Name

Institution
 Chapter 17 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 thinks his 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?

The exceed value of playing should be compared with the current winnings.

Expected Value = (Probability of Correct Guess × Winnings for Correct Guess) +

(Probability of Incorrect Guess × winnings from Incorrect Guess)

Expected Value = (p × $2,000,000) + ((1 - p) × $500,000)

(p × $2,000,000) + ((1 - p) × $500,000) > $1,000,000

Simplifying the equation:

2,000,000p + 500,000 - 500,000p > 1,000,000

1,500,000p > 500,000

p > 500,000 / 1,500,000

p > 1/3

Therefore, the lowest probability of a correct guess that would make playing profitable is 1/3

or approximately 33.33%.
 Chapter 18: Auctions

18-4 Asset Auctions in Sweden

In Sweden, firms that fail to meet their debt obligations are immediately auctioned 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?

Eckbo adnd Thorburn (2009) describe the American Chapter 11 bankruptcy process where

financial claims are renegotiated under legal protection as firms continue to be operate under

the existing management as an inefficient way of dealing with companies that are under

financial distress. They proceed to make a case for the mandatory auction bankruptcy system

applicable in Sweden, where financially distressed firms are sold in open auctions

immediately after filing. However, it is apparent that the managers of those distressed firms

have valuable knowledge and expertise about those firms because of their involvement in

their daily operations. Such familiarity gives them an edge when accurately assessing the true

value of the firms, and which enables them to make an accurate bidding decision.

Furthermore, the current managers are known to have established intricate relationships with

the firm’s partners and stakeholders. Such relationships provide them with insights about the

true value of the firm when participating in bidding wars during auctions.

Chapter 19: 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 keep the car, 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?

According to Hendel and Lizzeri (2002), under adverse selection, leasing contracts impact

equilibrium allocations in ways that match observed behaviour in the auto market. Froeb et

al. (2018) argues that adverse selection arises when one part to a transaction has better

information than the other, and in this case, the customers returning the cars have greater

knowledge of the state of the value of the car after using them for say a two year period. For

the manufacturer to set the residual value at 60% flat rate without thinking about the

percieved value of the cars might be a mistake. Hence, when the manufacturer is selling the

returned cars at auctions, the prices that they fetch will lead to an average of $480 less than

the residual value, which contributes to losses for the manufacturer.

The manufacter can migitate adverse selection problem by imprving the initial screening

process. The manufacter can implement a rigorous screening process to lease cars to

customers meeting specific criteria. In addition, the manufacter can re-adjust their residual

values. They can also improve their marketing process or offer lease to own options for their

cars. Fundamentally, the problem of adverse selection is migitated when the manufacturer

collect more information about the state and perceived value of the cars that have been

returned and their customers preferences and intentions.

 Chapter 20: 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.

When pricing the extended warranty at 2 percent of the product price, there are

considerations related to moral hazard and adverse selection that should be considered. First,

moral hazard. It refers to the potential change in customer behaviour after buying the

extended warranty knowing that they will be shielded from the financial consequences of

product failures. Hence, if the extended warranty is at about 2% of the product price, it may

lead to hazard problem. Customers buying the extended warranty may become less careful

when handling the product since they know that the warranty covers them. It can lead to

increases in the actual rate of failure above the average 2%. When the failure rate increases

considerably, the cost of product replacements under the extended warranty can exceed the

revenue generated from the sale of the warranties.

The problem of adverse selection happens when customers who are more likely to experience

product failure are more inclined to buy the extended warranty. When it is priced at the

average rate of 2% of product price, it can affect customers who are prone to greater risk of

product failure. Customers with greater propensity for product failure can be more willing to

pay for an extended warranty because they believe that it can provide them with greater

value. The adverse selection might lead to a higher chunk of warranty claims and the costs

exceeding the revenue earned from selling the warranties.

Addressing the issues requires a pricing strategy accounting for the problem of adverse

selection and the issue of moral hazard. First, they can adjust the prices based on the risk.

Instead of holding on to a fixed rate, the extended warranty rate can be tiered based on the

perceived risk of product failure. In addition, they ca also incorporate co-payments and

deductibles. This reduces the risk attributed to moral hazards as it dissuades careless

behaviour when handling of the products. Finally, collecting more information and data about

the customers might help in mitigating against the problem of adverse selection.

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?

The availability of lightweight personal locator beacons for hikers can have both positive and

negative effects on the costs incurred by the Forest Service. Contributes to improved

efficiency as they can considerably improves the efficiency of rescue operations and thereby

reducing the time and resources required to locate lost hikers and hence the costs associated

with protracted searches and rescue missions. However, the negative outcome relates to the

higher resources spent towards rescue operations. The ease of use and availability of them

can encourage hikers to seek remoter and more challenging areas of the forests.
References

Eckbo, B. E., & Thorburn, K. S. (2009). Bankruptcy as an auction process: Lessons from

Sweden. Journal of Applied Corporate Finance, 21(3), 38-52.

Froeb, L. M., McCann, B. T., Shor, & Ward, M. R. (2018). Managerial economics : a

problem solving approach (Fifth). Boston: Cengage Learning.

Hendel, I., & Lizzeri, A. (2002). The role of leasing under adverse selection. Journal of

Political Economy, 110(1), 113-143.