MBA%20201A%20

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MBA 201A Pre-Midterm Review

• Simon Wakeman

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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

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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

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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

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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 DMs choice of action

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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

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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 lt EV.

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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 As will win the
  World Series (of baseball). Barry and Luther bet
  10 on whether or not the As will win the World
  Series. That is, Barry will pay Luther 10 if the
  As dont win the World Series and in exchange,
  Luther will pay Barry 10 if the As 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.

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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.

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Economic costs (contd)

• 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)

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Economic costs (contd)

• Cost allocation with multiple business lines
• Only allocate variable (avoidable) costs
• Do not allocate true shared overheadsBUT
• 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.

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Remember

• Red pens and blue pens
• The scissors example

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Practice question on economic costs(from 2002
Final Exam, Q3)
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Marginal cost and average cost

MC
AC
Q
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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

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Example on MC AC (from Problem Set 2, Q1)
(Q gt 0).
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Economies of scale and learning by doing