Question

A contractor is submitting an estimate to a potential customer. The contractor believes that, if he offers to do the work for $200,000, there is a 10% probability that the customer will agree to that price, a 50% probability that a price of $120,000 would eventually be agreed upon, and a 40% probability that the customer will simply refuse the offer and give the work to another contractor. If instead the contractor offers to carry out the work for $100,000, he believes that there is a 30% probability that the customer will accept this price, a 60% probability that the customer will bargain so that a price of $80,000 will eventually be agreed upon, and a 10% probability that the customer will refuse the offer and take the work elsewhere.
Now, suppose that you inquire into the contractor’s attitudes about risk, and you find out:
He is indifferent between: $80k for certain or a 60% chance to win $200k, and a40% chance to win $0.
He is indifferent between: $120k for certain or a 50% chance to win $200k, and a 50% chance to win $80k.
He is indifferent between: $100k for certain or a 75% chance to win $120k, and a 25% chance to win $80k.

Determine what price ($200,000 or $100,000) the contractor should offer, assuming he wishes to maximize Expected Utility.

Answer 1

The contractor should offer $200000.

For the contract price of $2,00,000 he will be able to achieve his expected utility.