Question

1. The director of the Springfield Natural History Museum is considering renovating the museum to make it less susceptible to earthquake damage. The director believes that there is a 15% chance that the museum will experience an earthquake, and that such an earthquake would cause $20 million in damage to the museum if it is not renovated. If the museum is renovated, an earthquake would cause no damage. Renovating the museum would cost $2.5 million and would have no benefits other than providing earthquake protection. [Note: Remember that the monetary amounts discussed here are losses, not gains, so smaller amounts are better than larger amounts.]
   1. [2 points] What is the expected value of the loss from earthquake damage if the museum is not renovated?

2. [4 points] What can we say about whether or not the museum director should renovate the museum if they are risk-averse? If they are risk-loving?

Answer 1

If directors are risk averse then director should get the museum renovated as the expected value of museum not getting renovated is negative and therefore will result in loss based on risk neutral basis.

However if the director is risk seeking/loving then he may go ahead without getting the museum renovated as risk lovers have greater acceptance of risk taking capacity.

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