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Analytical Methods
Santa Clara University School of Law
Friedland, Steven

Analytical Methods Outline – Spring 2006
Professor David Friedman

Chapter 1: Decision Analysis

– A way of formally setting up a problem in order to make it easier to decide which course to take
o Decision Tree: a diagram of possible decisions and chances of outcomes where a decision point is a square and circle is a chance node and a crossed off line is a decision you wouldn’t choose
o Determine the expected value by multiplying the chance percentage by the payoff…if payoff is 100k and chance is 60% then 60% x 100k = 60k
o Expected value of a chance node:
§ Multiply the percentage chance times the payoff for each possible decisions and add these up
§ Once you’ve determined the value of each chance node you can solve the decision tree and make select the most profitable decision
– Risk Aversion: when a risky situation is worth less than the expected value…the lower the client’s evaluation of the outcome taking the risk into account the more risk averse he is
o This is why people diversify their portfolios and buy insurance
– Sensitivity Analysis: whether the best decision is sensitive to particular changes in data
– Acquire the necessary information and consider alternatives and situations where there might be non-monetary costs and benefits

Chapter 2: Game Theory

Types and Solutions
– Subgame Perfect Equilibrium
o Players will only choose the rational play, use a decision tree
o Assuming no commitment strategy or coalitions
– Bilateral Monopoly
o Non-fixed sum – my apple is worth nothing to me and one dollar to you…we bargain to try to get the best deal, paradox: no matter what you offer I should take it since it is worthless to me
– Strategy Matrix
o Use a diagram to see what the outcome will be for each decision by each player
– Focal Point
o Psychological behavior taken into account in thinking about what the other will do
– Von Neumann Solution
o For any 2 player zero sum game…a pair of strategies, one for A and one for B, instructs each player what to do where the solution is a set of outcomes none of which dominates the other…tradeoffs
– Nash Equilibrium
o Assumes people are rational and will choose their Nash Equilibrium…driving on the right side of the road
o Problem – it assumes no coordinated changes…prisoners escaping and guard with one bullet…they will just stand there until caught but they are better off if more than one charges the guard
– Prisoner’s Dilemma
o Both better off confessing so they have a dominant strategy…both would actually be better off if they each denied
– Schelling point
o People assume a solution is unique but this depends on how parties think…the may bargain and unable to find a solution split 50/50 but a 50% take is different to each party depending on their expectations and this gives incentives to make unrealistic offer favorable to ourselves
Threats, bluffs and commitment strategies
– Commitment Strategy – one strategy is chosen since he is better off no matter what the other player does
– Bluffs and threats: important in bilateral monopoly
Moral Hazard
– After a K is made a party to it may have incentives to act in a way that’s detrimental to the other party
– Insurance is a prime example…owning insurance increases the risk of losses…if I insure my building for fire I won’t take precautions to prevent fires, insurer of course takes this into account in the premium he charges
– Solutions: insurer could require I take certain precautions, insure building only for fires that are not the result of me taking precautions, coinsurance, give an output based incentive like in employment K
Adverse Selection
– Problem of asymmetric information of the parties…Lemons: the existence of lemons in the used car market adversely effects the market b/c mutually beneficial agreements don’t happen b/c they can’t agree due to lack of info
– Solutions: make more information available to the other party, offer a warranty on the car, allow for inspections of the car,

Chapter 3: Contracts

– Objective: enlarge the contractual pie…include terms that add value to the relationship, look for compromises or ways parties can contribute, and try to maximize you part of this larger pie
– Create the right incentives for the parties

rofit margin goes to owner equity
– Matching Principle
o We want to put revenue and associated costs in the same period
§ We don’t want companies to take in huge costs and then say these expenses will pay off 5 years in the future
§ Recognize income when it is earned, not when we get it (accts receivable)
§ We want to defer costs to when they will generate income (depreciation)
o What if you buy identical inputs at different price?
§ FIFO – first in, first out
§ LIFO – last in, first out
o Profits – small company would want to minimize income to minimize taxes…large public company would look to maximize income for shareholder purpose
– Conservative bias? Friedman disagrees…they don’t count intangibles and these can go up and down, overestimate some
– Other Accounting Concepts
o Comparing short-term assets to short-term liabilities…just having more assets than liabilities might not be enough
§ Cash is better, accts rec., and inventory are not as good
§ Rule of thumb, current assets should be at least 1.5 to 2.0 times current liabilities
§ Improving the short-term ratio – borrow more money long-term, increase cash, reduce short-term debts
o Long-term assets and liabilities
§ Look to assets, liabilities, and equity ratios
§ Leverage – good if you are doing well and will have an opportunity to make a lot of money…bad if firm is not doing well / return is less than the interest rate
§ Interest coverage…enough cash to pay interest on debts
§ Degree of leveraging depends on the industry the firm is in
§ Look at the loan rates of the firm (high interest rate means the firm was risky)…compare rates, inventories, etc. to other companies
Profitability=Revenue minus costs