The owner of a small firm has just purchased a personal computer, which she expe

Question

The owner of a small firm has just purchased a personal computer, which she expects will serve her for the next two years. The owner has been told that she "must" buy a surge suppressor to provide protection for her new hardware against possible surges or variations in the electrical current, which have the capacity to damage the computer. The amount of damage to the computer depends on the strength of the surge. It has been estimated that there is a 1% chance of incurring 450 dollar damage, 6% chance of incurring 250 dollar damage, and 13% chance of 50 dollar damage. An inexpensive suppressor, which would provide protection for only one surge, can be purchased. How much should the owner be willing to pay if she makes decisions on the basis of expected value? Expected value-

Explanation / Answer

The owner should be willing to pay an amount equal to the expectation of cost of damage in the first surge.

Let X= amount of damage incurred.

E[X] = 450* P[X=450] + 250* P[X=250] + 50* P[X=50]

= 450*0.01 + 250*0.06 + 50* 0.13 = 26 Dollar

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