Guatam, who is risk neutral, is considering whether to invest in a new store. Af

Question

Guatam, who is risk neutral, is considering whether to invest in a new store. After investing, he can increase the probability that demand will be high at the new store by advertising at a cost of $60 (thousand). If he makes the investment but does not advertise, he has a 40% probability of making $100 (thousand) from high demand and a 60% probability of losing $100(thousand) from low demand. Should he invest in the new store? Advertising increases the probability of high demand. What is the minimum probability of high demand resulting from advertising such that Guatam decides to invest and advertise? This minimum probability is % Enter your response as a whole number

Explanation / Answer

A risk neutral person is indifferent between a certain outcome and an expected outcome. Gautam can invest and advertise if he receives an expected profit that is same as the advertisment costs. Assume that the probability of high demand is increased by x% and so probability of low demand is reduced by x%.

Expected profit = (40% + x)*(100) + (60% - x)(-100)

= 40 + 100x - 60 + 100x

= 200x - 20

200x - 20 = 60

x* = 80/200 = 40%

Hence probability is increased by 40 so minimum probability of advertising is 80

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