A real estate agent is considering renting an apartment Two

. A real estate agent is considering renting an apartment. Two potential tenants are available. One is an old-age pensioner who will take care of the apartment, but who can only afford a low rental. The other is a group of university students, who are prepared to pay more for a ‘group house’ rental. It is costly for the agent to continuously monitor the behaviour of the tenants (especially the students), and how well they care for the apartment. With this in mind, she wants to offer the two tenants contracts so that, whichever one is successful, the tenant takes care of the apartment. The following facts are pertinent:

The agent remembers when she was a student in a group house. A party got out of hand, causing $3000 damage, but the students thought it was $5000 worth of fun, and left the state before the owner could recoup the costs. She assumes it is possible that young students may behave in a similar way.

If she lets the apartment to the pensioner, there is no risk of property damage, and the annual rental (the reservation price for the pensioner) is $5000.

If she lets the apartment to the students, the annual rental is $7000

An option open to the agent is to require the students to post a bond, which is fully refundable if there is no party and therefore no damage (ignore any interest on the bond).

Question: Complete the decision tree below, showing the two sets of payoffs if the students rent the apartment, including the value of a non-refundable bond sufficient to induce good behaviour by the students. Explain your reasoning. The entries for the pensioner have been completed – the agent’s return is equal to the pensioner’s reservation price.   

Solution

Note: Decision tree is not visible in the question.

Here We are assuming 10Months rental as an non refundable deposit in case of damage to induce good behaviour among student tenats. Main reason behind this is even if studnets party and there is a damage to property , $5833 would be sufficient to recoup the costs. Also 10Months rental is sufficiently high price to deterr the students from partying carelessly. So they would take care of property with utmost sincerity.