You purchase a new smartphone for $650. Suppose that during one year, there is a 0.2 probability that you will drop th
You purchase a new smartphone for $650. Suppose that during one year, there is a 0.2 probability that you will drop the phone, a 0.2 probability you "send it for a swim" (drop it in water), and a 0.6 probability you avoid all accidents. If you drop the phone, you will crack the screen, which must be repaired for $150. If you drop it in water, it will be completely broken and you will have to replace it for the full cost. Assume that forgoing the phone, or using one with a cracked screen, is not an option. a. What is your expected loss from one year of smartphone ownership? b. The sales associate at the store offers to sell you an extended warranty that costs $130. If you damage or destroy your phone accidentally, the store will repair your phone or send you a new one. Assuming you are risk neutral, should you buy the warranty? c. Suppose the warranty costs $130, but in the event of either a cracked screen or broken phone, you must pay a $99 "service fee" before the store repairs your phone or sends you a new one. Assuming you are risk neutral, should you buy the warranty now? (Hint: Start by re-doing part (a) for the expected loss you will suffer if you have the warranty) d. Now let's suppose you are risk neutral, but especially accident prone. Now there is a 0.3 probability you will crack the screen, 0.3 probability you will drown your phone, and 0.4 probability you will avoid all accidents. Should you buy the warranty as described in part (c)? e. Suppose you are not accident-prone. Can you think of any other situation where it might make sense for you to buy the extended warranty?