Question

3. Dave, a risk neutral concert promoter, schedules an outdoor concert for tomorrow. How much money he makes depends on the weather. Ifit does not rain, his profit (value from the concert) is $15000. If it rains, he'll have to cancel the concert and he'll lose $5000, which he has to pay the band (his profit will be -$5000). Although Dave does not know what the weather will be with certainty, he knows that the weather department forecasts a 50% chance of rain. (a) What is Dave's expected profit from the concert? (b) Suppose Dave can purchase information from the local fortune teller in time so that he can book the band only if needed. The fortune teller can predict the weather with 100% accuracy That is, if she says it will rain, it will rain with certainty. How much is Dave willing to pay for the fortuneteller's information? (c) Now suppose the fortuneteller can only predict the weather with 90% accuracy. That is, if she says it will rain, there is a 90% of rain, and if she says it will not rain, there is a 90% chance that it will not rain. If the fortuneteller demands $1000 for the information, will Dave buy the information?

Answer 1