What is the expected utility of drilling

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Reference no: EM132301571

An oil drilling company must decide whether or not to engage in a new drilling venture before regulators pass a law that bans drilling on that site. The cost of drilling is $1 million. The company will learn whether or not there is oil on the site only after drilling has been completed and all drilling costs have been incurred. If there is oil, operating profits are estimated at $4 million. If there is no oil, there will be no future profits. The new regulation is also introduce with probability 0.5 a 50% tax on the operating profits from drilling. Let p denote the likelihood that drilling results in oil and assume the company has the von Neuman Morgenstern utility function.

1. Using p to denote the likelihood that drilling results in oil, draw the decision tree for this problem.

2. The company estimates that p = 0.6. What is the expected utility of drilling? Should the company go ahead and drill?

3. To be on the safe side, the company hires a specialist to come up with a more accurate estimate of p. What is the minimum value of p for which it would be the company’s best response to go ahead and drill?

Reference no: EM132301571

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