Scenario 5.5:
Engineers at Jalopy Automotive have discovered a safety flaw in their new model car. It would cost $500 per car to fix the flaw, and 10,000 cars have been sold. The company works out the following possible scenarios for what might happen if the car is not fixed, and assigns probabilities to those events:
Scenario Probability Cost
A. No one discovers flaw .15 $0
B. Government fines firm .40 $10 million
(no lawsuits)
C. Resulting lawsuits are lost .30 $12 million
(no government fine)
D. Resulting lawsuits are won .15 $2 million
(no government fine)
-Refer to Scenario 5.5. Jalopy Automotive's executives,
A) if risk-neutral, would fix the flaw because it enables them to have a sure outcome.
B) if risk-neutral, would fix the flaw because the cost of fixing the flaw is less than the expected cost of not fixing it.
C) if risk-loving, would fix the flaw because it enables them to have a sure outcome.
D) if risk-averse, would not fix the flaw because the cost of fixing the flaw is more than the expected cost of not fixing it.
E) would fix the flaw regardless of their risk preference, because of the large probability of high-cost outcomes.

Question

Quizplus · Accepted Answer

If Jalopy Automotive's executives are risk-neutral, they would choose the option that gives them the highest expected monetary value. In this case, the expected cost of not fixing the flaw is (0.15 x $0) + (0.40 x $10 million) + (0.30 x $12 million) + (0.15 x $2 million) = $5.5 million. However, the cost of fixing the flaw is only $500 per car x 10,000 cars = $5 million. Therefore, it is less expensive for the company to fix the flaw than to risk facing fines or lawsuits.

Scenario 5.5: Engineers at Jalopy Automotive Have Discovered a Safety Flaw in Flaw