Let \(t=\) the amount of sales tax a retailer owes the government for a certain
period. The article "Statistical Sampling in Tax Audits" (Statistics and the
Law, 2008: \(320-343\) ) proposes modeling the uncertainty in \(t\) by regarding
it as a normally distributed random variable with mean value \(\mu\) and
standard deviation \(\sigma\) (in the article, these two parameters are
estimated from the results of a tax audit involving \(n\) sampled transactions).
If \(a\) represents the amount the retailer is assessed, then an under-
assessment results if \(t>a\) and an over-assessment results if \(a>t\). The
proposed penalty (i.e., loss) function for over- or under-assessment is
\(\mathrm{L}(a, t)=t-a\) if \(t>a\) and \(=k(a-t)\) if \(t \leq a(k>1\) is suggested
to incorporate the idea that over-assessment is more serious than under-
assessment).
a. Show that \(a^{*}=\mu+\sigma \Phi^{-1}(1 /(k+1))\) is the value of \(a\) that
minimizes the expected loss, where \(\Phi^{-1}\) is the inverse function of the
standard normal cdf.
b. If \(k=2\) (suggested in the article), \(\mu=\$ 100,000\), and \(\sigma=\$
10,000\), what is the optimal value of \(a\), and what is the resulting
probability of over-assessment?