1 MBA 201A – Pre-Midterm Review Simon Wakeman

2 Introduction Test strategy Decision trees –Step-by-step approach –Calculating the value of information and options –Detecting risk aversion Costs –Economic costs –Deriving MC and AC functions –Economies of scale and scope, and learning by doing –Short-run and long-run costs

3 Test strategy No blue books. No laptops. No communication devices. No books. No notes. No personal assistants or trainers. Calculators can be used. Do not just memorize and apply formulae –Try to understand the intuition between the concepts and apply that to the questions –Use your common sense and outside knowledge, but not firm or industry-specific expertise Do not be confused by incomplete or ambiguous questions –Ascertain the key facts from the problem –If necessary, make assumptions about missing facts and state them clearly Do not get tripped up by complicated calculations –It is often easier to work with fractions than decimals. –If you decimals, round up answers and move on

4 Step-by-step approach to drawing decision trees Isolate the key facts Work out the sequence of decisions Determine whether decision or chance node Sketch branches Write in probabilities and costs Calculate terminal node values (payoffs) Calculate EVs at nodes, working backwards –if decision node, the highest value of the branches –if risk node, the probability weighted value of the branches Determine the optimal course of action

5 The value of information Obtaining information or sometimes just delaying allows decision maker (DM) to make decision after the random event is realized  swaps order of decision and event nodes Value of information/delay is difference between EVs in these two cases Information has value only if it has the potential to affect DM’s choice of action

6 Practice question on value of information (from Problem Set 1, Q4) Q: What would Sudipto pay for a test that accurately predicted whether he would be baffled at B School? Knowing whether he would be baffled affects whether Sudipto goes to B School or tries the start-up  Value of information is difference in expected outcome of those two choices (i.e., $3,000) N.B. Order of decision and event node reversed in bottom half of the decision tree

7 Risk aversion The Certainty Equivalent (CE) value of a gamble is the minimum certain monetary amount (i.e., with no risk attached) that the DM would accept in exchange for a gamble. A decision maker is risk averse if her certainty equivalent value is less than the expected monetary value of the gamble. Risk aversion means CE < EV.

8 Practice question on risk aversion (from 2002 Final Exam, Q2) What, if anything, can you say about the attitude towards risk exhibited by the following people: Alicia, Barry, Luther, Carlos? For each, is their behavior consistent with risk aversion only? With risk neutrality only? With risk seeking only? With all three? With two of three (which two)? (a) [5] Alicia wants to play a lottery which costs $5 to play, and pays off $100 with 10% probability, or nothing with 90% probability. (b) [5] Barry and Luther agree that there is a 60% chance that the Oakland A’s will win the World Series (of baseball). Barry and Luther bet $10 on whether or not the A’s will win the World Series. That is, Barry will pay Luther $10 if the A’s don’t win the World Series and in exchange, Luther will pay Barry $10 if the A’s do win the World Series. (c) [5] Carlos thinks that there is a 50% chance that the CEO of Bunko, Inc. will be convicted of fraud this afternoon, and a 50% chance that the CEO will not be convicted. In the event that the CEO is convicted, Carlos thinks there is a 40% chance that the CEO will be sentenced to serve time in prison. Carlos is not willing to pay $1 now in exchange for $15 in the event that the CEO is both found guilty and sentenced to serve time in prison.

9 Economic costs To make proper decisions, costs need to be considered from the opportunity-cost perspective. –Opportunity cost: Value of best alternative action  Cost = Expense – Sunk Expenditures + Imputed Costs –Sunk expenditure: An expense that has been incurred or to which the decision maker is committed, and which cannot be recovered, (e.g., lease on a building that cannot be broken) A sunk expenditure is not a cost because it is (or was) incurred under the relevant alternatives. –Imputed cost: The value of a factor/resource (e.g., labor) when used in its next best alternative use (e.g., salary that you would earned if not in MBA program) An imputed cost is a cost even though it might not be accounted for by standard expense accounting.

10 Economic costs (cont’d) Cost is the value of the best forgone alternative –Determine what is the next best alternative action –Count, as costs, all expenses incurred in the considered action that would not be incurred in the next best alternative action AND –The value of factors/resources in their next best alternative use that are not counted as expenses (Imputed Costs) –N.B. Ignore expenditures that would be incurred in both the considered action and the next best alternative (i.e., ignore Sunk Expenditures)

11 Economic costs (cont’d) Cost allocation with multiple business lines –Only allocate variable (avoidable) costs –Do not allocate true shared overheads BUT –Check that direct overhead costs (e.g., packaging & shipping) are truly overheads and count any that vary with production  To determine economic cost, work out which costs are avoidable if stop producing only that business line. Remember the principle of cost causation.

12 Remember Red pens and blue pens The scissors example

13 Practice question on economic costs (from 2002 Final Exam, Q3)

14 Marginal cost and average cost Q $ MC AC

15 Graphical Relations MC intersects the AC curve from below at the minimum of AC The rectangle with lower left corner (0,0) and upper right corner (x, AC(x)) has an area equal to C(x) C(x) is the area under the MC schedule from 0 to x units

16 Example on MC & AC (from Problem Set 2, Q1) (Q > 0).

17 Economies of scale and learning by doing