GBC Leadership Conference

Yesterday was the GBC's inaugural NSITE Leadership conference, hosting such fantastic speakers as Michael Lee Chin, Don Morrison from RIM (my old boss), Robert Deluce from Porter Airlines and a host of other tremendous speakers. Topics ranged from entrepreneurship to social responsibility.

Each speaker had their own individual flair and unique experiences for how they got to be where they are now. They talked about the challenges they faced, the frameworks they relied on and how there is a constant struggle against complacency caused by success.

The event was hosted at the Hyatt on King in Downtown Toronto as the event was too large for our Fleck Atrium. I believe that there were over 300 people in attendance.

Many of the students had a great time and several members of our class were excited and already planning ideas for how they could build on the work done by this year's founding team.

Rotman Ambassador - Recruitment Info Session

Today, I was asked to be one of two students acting as Rotman Ambassadors at an evening info session for about 50 prospective students. Jeff Trapp was giving a presentation and the recruitment team asked me to represent first year students.

It was interesting as we were doing the info session in my classroom, and the notes from our earlier lecture on bonds in finance were still on the board. There were some good questions asked by applicants about what to look for in MBA programs, what life is like at Rotman, and how to put together applications.

It was great to pitch the benefits of the Rotman program to a very intelligent crowd and I would hope that my comments have driven them to take a closer look to see if Rotman is a fit for them.

Spot Rates and Bonds - Supply and Demand of Investment Vehicles

We were discussing Treasury strips for CI (Coupon Interest) and NP (Note Principle) bonds. We discussed ideas such as reconstituting bonds, arbitrage opportunities and pricing.

I had wondered before if when investment vehicles get "abstracted" (either with a derivative, in some form of aggregation etc), if it was possible to get supply and demand curves which differ from the original underlying asset.

Prof. Womack showed us the example of two otherwise identical treasury strips, both maturing in 2 years with the same $100 Face Value, but trading at nearly the same (but marginally different) prices. One was a CI strip with the ask yield at 5.78% with an ask price at $89/08 and the other was an NP strip with an ask yield at 5.79% with an ask price of $89/07.

Although these two investment vehicles have identical risk profiles, payment schedules etc. (for all intents and purposes, they are identical) they are trading at different prices. Prof. Womack described the different as being differences in supply and demand for investors who are interested in reconstituting bonds (for example). However, at the same time, since they are so related, they should trade at near identical values.

Financial Accounting II - Understanding the Story Behind Accounts

In our Financial Accounting class today (we have a new professor, Francesco Bova) and although Franco Wong (no relation) was a great professor, the material in Financial Accounting II is more "practical" building on the foundations in Fin Acc I (where we were learning mechanics of accounting).

We began by discussing cash cycle as composed of days [inventory, receivables, payables]. However, Francesco posed an interesting question: "Is it possible to have a negative cash conversion cycle?" (in the same way I had asked Prof. Franco Wong if it is possible to have a negative LIFO reserve). The answer is 'yes', but with special conditions:

Recall:

Cash Conversion Cycle = Days Inventory + Days Receivables - Days Payables

So for Cash Conversion Cycle to be negative:

• Days Inventory should be smaller
• Days Receivables should be smaller
• Days Payable should be higher

When is this the case? Look at Dell computers:

• JIT Inventory - Extremely low Days Inventory (inventory only used as needed / ordered)
• Visa and cash payments - Extremely low Days Receivable (is paid fairly immediately to Dell. It's A/R for Visa)
• Days Payable - Standard terms to suppliers

Because of these unique relationships, (which also exists in construction where revenue and cash is often recognised earlier and then placed in a treasury bond to gain interest) and is known as stretching payables. This is the act of investing cash which is dormant in a negative cash conversion cycle to make some interest income.

Finance - TVM

So we had our first finance class today where we covered the idea of TVM, PV, FV, NPV and discounting. This is the foundation of all finance concepts and, as our Professor Kent Womack described, aims to answer the question of: "How much is this worth?"

Our class is mildly disadvantaged because of this week because of the GBC Leadership conference happening on Friday which has compressed the week such that we have a finance assignment due less than 24 hours between classes. There are also group presentations every day on market updates and I feel bad for the group that has to present tomorrow: they have less than 24 hours to do their homework (allocated 2-3 hours) plus their presentation (also allocated another 2-3ish hours). It would be nice if they could eat, sleep and (more importantly) do work for other courses.

Our homework assignment is related to bond pricing and although a "different" concept for many people, it is still fairly heavily quant, requires Excel or a financial calculator and our tutorial session will be after the assignment is due, therefore a few of us will be sticking around after classes in the evening so that we can bounce ideas off each other to make sure our numbers add up the way they are supposed to.

Fundamentals of Strategic Management - SBUX

Today we hit Q2 running and had a new class, Fundamentals of Strategic Management with Anita McGahan. Her reputation certainly proceeds her, as she has been described as a protegé of Micheal Porter. You can tell with in minutes of meeting her that she's intense. Many students are intimidated by her, but in our class she was absolutely brilliant. Even some students who weren't considering consulting before are certainly considering it now.

She dived right into describing ROA and benchmarking companies versus the industries they were in versus the economy at large.She showed how a company might "out perform" the general economy, but still be "under performing" their industry. This is an idea which I had recently discussed as an extension of Nick Kerhoulas' idea for CEO compensation, but using derivatives (long / short positions) to mathematically come to the same result for bonuses (compensate CEOs and other top managers based on alpha less beta).

Also, I've previously mentioned that DuPont Analysis is one of my favourite financial frameworks because it is intuitive and Anita cut into it in more detail, specifying (as I had previously) that:

ROE = ROA x FLA

But she emphasized that FLA is a financial strategy whereas ROA is an operational strategy (I got called on this question when I was describing it in my post, but obviously Prof. McGahan described it much better. I made the mistake of saying that Total Asset Turnover, TAT, was "how much you could sell". Anita described it better as "Operational Strategy"). She even confirmed my hunch that FLA = 1 + D/E.

Also, her description of Porter's Five Force's was brilliantly (no surprise) insightful as she explained how three of the forces:

1. Buyer Power
2. Supplier Power
3. Threat of Substitution

were all measures of Value Creation (what value can be yielded by this industry - directly related to Industry Structure in the previous graphic and more specifically by the graphic below).(Also note the graphic immediately above can be recursively applied to describe an entire Value Added chain)

However, the last two of Porter's Five Forces:

1. Rivalry
2. Threat of Entry

were directly related to Value Capture (or more generically, Competitive Position as described in the first graphic above).

When it came to applying the material to the Starbucks case, she used the framework to describe where the most interesting stories were in the case, used math to describe the costs of achieving SBUX's growth goals and showed that against the balance sheet that additional fund raising was necessary to fuel growth. She dipped briefly into finance to describe EPS dilution caused by the payback periods required to cover store openings.

Even in building a potential solution, she lead the class in a discussion which critiqued possibilities such as franchising: why firms in the industry, the majority framed as operating as a sole proprietorship, would under report earnings and be disinterested in becoming a franchise.

Besides being a very technical and framework heavy course, it was certainly enjoyable. I know it sounds weird, but she kept our class in absolute stitches with her jokes about strategy and doing business (as I type this, I am aware of how awkward this appears).

To put it lightly, this promises to be an interesting class. This felt exactly like a case interview for consulting.

International Study Tour - Latin America

Upon returning from my last exam, I checked my Blackberry and found an email from the PSO relating to the Latin America International Study Tour. It was the same procedure as before: Go to the office of the Director of International Programs, Laura Wood, and see if we were selected for the tour.

Well, I am very excited to say that I've also been selected for the Latin America tour where we will be visiting Brazil and Argentina. I had originally thought that my application for the Middle East tour was weak, and as a result made doubly sure that my application for the Latin America did not have the same weaknesses.

I'd be remiss if I didn't acknowledge the help of Jenny Mila, a fellow student in my class who had lived in Argentina. She was patient enough to answer some of my questions and dispel my ignorance about that part of the world. She was helpful in providing guidance so I could look in the right places to find out more about Argentina.

I am using Rotman for as much travel as possible it seems, with my Middle East tour in January and the Latin America tour (visiting Brazil and Argentina) in May.

The India tour (also happening in May) has also just released it's candidates and I'm happy to say a few of my friends are also going to be going for that tour. We are certainly going to swap photos and stories as we embark on our adventurous excursions.

One Eighth MBA

"One eighth! One eighth!"

That was the chant at the Madison pub at about 2 pm today. The end of Q1 exams marks a major milestone for those of us in the MBA program at Rotman. We finished our first set of courses and have had a true taste of MBA life.

There was a strong sense of camaraderie as everyone was in good spirits and raising a glass to the end of Q1. Tonight promises to have more celebrations. While the future promises more hard work with Q2 classes starting again on Monday, at least for this weekend we have earned our first real free time in a while.

Exams and International Study Tour Class

I feel like I'm finally a real Rotman MBA student. I've finally written two exams and submitted a paper, meaning I've officially completed all the work for three of the five courses this quarter. We have two exams over the next two days: Managing People in Organizations and Financial Accounting.

Yesterday, I spent some time helping a few people understand stats (one person who I helped was beaming when she came out of the stats exam and said: "Everything I answered was what Josh and I did yesterday"). And she is a pretty smart person to begin with, so that felt pretty good. A few of the guys I helped were also giving me high fives with thanks which was also nice.

Almost immediately after my stats exam, I had to go to my first Middle East International Study tour class (2 hours every Wednesday on top of the regular courseload). As my classmates in Section 2 will know very well, I have an urge to speak up in classes. It was a little intimidating to do at first, as there were mostly second years in the room (I found one other first year who is going on the tour) because they have all had one year of classes under their belts already and they are all very sharp (selected based on interest, academics and extracurricular involvement). However, I would like to feel that I made some useful contributions to the discussion regarding an international perspective on emerging markets and would like to think that I also got some acknowledgement on my ideas by the professor.

Next up is the MPO exam and as brilliant as I think I am, I won't be helping anyone on this one (there's no math, people are generally confident with the material and the method of study doesn't really lend itself to tutorials).

You Make Me Stronger

Continuing my post from yesterday, I was very happy with all the requests by my colleagues to review the more difficult example questions provided by our profs. They were very helpful in learning the concepts which will help as the professors from both classes promised to provide "cook book breaking" questions on the exam. I feel that by being challenged by my classmates to do the tougher questions, we were all able to get better at reframing problems in different ways with the economics tools we were taught in our classes. We even earned a reputation as the 'help desk' as people were often coming by to ask questions and people would often stop by to listen to how we'd put together solutions.

Our table in the public common area on the second floor of Rotman just outside the primary study stacks was alive with boisterous laughter (unusual for the generally somber mood of exam studying MBAs) as we discovered the mechanics of a particularly challenging problem.

I'm very proud to be a part of this class. Numerous second year students have come by and commented on our performance as a whole. "When it was exam time in our year, there weren't this many people who stayed as late as your class. Every day, until late at night, all the study desks in the library are full."

Everyone agrees that economics is a very interesting class and the only regret is that we didn't have enough time to study the concepts in more detail.

Anyways, to all of us who are carving out our futures over the next week, best of luck to all of you and remember me when you're famous!

Even In The Most Important Week of Your Life - Never Lose Perspective in MBA Competition

Please forgive me as I take a small tangent from the regular topics I usually cover. To my friends in New York from the summer who know me well, this will be a familiar theme.

This week is the most important week of my life. As Prof. Walid Hejazi was so elequent to describe in his session entitled: The ROI on your MBA investment. He talked about how your trajectory in life and what stream you find yourself on in terms of career paths is the primary determinent on your success in life (success deliberatetly defined in the traditional sense of your professional development).

While this session was several months ago, I'm guessing that it was intended to "assist" the students who were still debating if they should do the MBA at Rotman, I still remember some of his key take aways:

- An MBA is a great equalizer, especially for those of us who aren't the "traditional stereotype" of executive management (the "white male 42-longs" - a reference to suit size).

- It signals to the market that we are looking for more challenges by taking the initative to complete a challenging and competitive program.

Having said all that, this brings me to the coming week. As Prof. Hejazi has stated, the MBA is probably an inflection point for all our respective careers. And the grades we get in the coming week based on our exam performance will help determine where we end up with summer internships which will in turn determine where we end up with full-time jobs (granted, I've been told repeatedly that there are still "opportunities to change your trajectory" in second year, you can put yourself on "the right track" if you can put yourself together now.)

So we (my fellow students and I) are not naive about the importance of grades especially since Q1 and Q2 are what determines how we are perceived by the market for summer internships. Everyone wants to do well, and this has led to some competitive behaviour. And if there's one thing we've learned (especially with the "flexible" grading in some of our classes, which shall remain unnamed) it is that EVERYTHING IS RELATIVE. What does that mean?

Unlike undergrad, where a good raw percentage grade is all you needed to succeed: In graduate studies (or particularly in the MBA), it's all about PERCENTILES rather than PERCENTAGES. It doesn't matter that your score is 90/100. It matters that your score is in the top 90 percentile (that you beat 90% of your classmates). The work is difficult and intellectually challenging. And your classmates are BRILLIANT too. There is a very good chance they will score high also. The prestige of the Rotman brand coupled with the effectiveness of the Rotman recruitment machine will ensure this. I imagine this is true of any top tier MBA program.

This has lead to some interesting behaviour. In reading my blog, many people have asked me for help on particular topics which I am more than happy to give (more on this later). But one thing I've noticed is that EVERYTHING here is competitive (there are even lines for the men's washroom between classes).

I think that the healthy competition keeps us sharp. But there are a *small* group of people (and this is where my closest NYC friends will probably nod their heads in agreement) where some people have lost perspective when it comes to competition.

Yes, our grades are important. Yes, our grades are relative. By rational economic theory, there is no benefit (in fact there is a HUGE cost) for skewing the curve to bias the grades up by helping "weaker" students.

But there is a *small* group of people who unconciously (involuntarily, reflexively... You get the idea) frown when they walk by and see me helping out other students. I can understand their logic. By helping the weaker students out, I'm making it more difficult to get that "A+" by boosting the curve.

I once put as my status update on Twitter and Facebook: "If you have become so competitive that you can't help a colleague out, you are lost". We've often been told that having grades is important. But having grades is of no value if no one can work with you.

Never lose perspective. Grades are important as a proxy for performance. But never forget the reasons for why we strive to achieve more. If you are the type of person who has to build a "economically rational model" to describe the motivation to help your peers, then understand that performance is a poor proxy for usefulness and there are more valuable skills than simply being "brilliant". No one works in isolation. And the network we build here at Rotman is arguably much more important that that B+ we are trying to turn into an A.

Everyone here is going to be successful. And as I wrote in one of my recent applications to yet another competitive Rotman opportunity: I modeled myself against [a recent Rotman alum who is wildly successful] who "when you hear his peers speak about him they have a high respect for him not only because of his individual success but also because he played a role in their success."

... Having said that I will be focusing on my studies as exams are coming up and occupying my thoughts for all of next week.

Rotman Awards Ceremony

As I had mentioned before, I have been awarded the Peter Godsoe Scotiabank Entrance Scholarship for Financial Engineering. There was a reception in the Fleck Atrium (open bar and hors d'oeuvres) with a short presentation by the Associate Dean Rick Powers (shown above).

Many of my classmates had won awards also and once again, it was no big surprise who was winning the awards. These were the people who you could tell by their comments in class that they were smart cookies.

There were many second years and students from different programs at Rotman as well as our benefactors and scholarship sponsors.

Finance Industry Day - Group 1's first small victory

First some background:
Because I was very busy yesterday, I didn't get a chance to blog about our little finance prep team. We've split the team into two groups, the "advanced group" (Group 2: people with experience who just want to talk about the markets and current events) and the "beginner group" (Group 1: people with little or no experience).

Yesterday, we also had an intense speaker, CEO of Claymore Investments, Som Seif, give a fantastic talk, describing how correlations between different asset classes are increasing (even between international and geographic regions) because of increased globalization. He also described how asset allocation plays a major role in determining return and managing risk. One of his more poignant points was that weak fund managers who can't justify their performance fees in down markets will be quickly replaced by low cost ETFs (the philosophy that management fees are not necessarily supposed to provide amplification on the upside, but rather a sense of expertise and awareness to protect from the downside).

His talk was fairly technical at points, and I began to wonder about our "Group 1" members in the audience. I asked them after the talk, "Did you feel intimidated? Don't worry, the purpose of the group is that a someday (soon) you can have an intelligent conversation with Som with the same vocabulary and technical proficiency".

For Group 1, I've set a schedule of topics to supplement what we'll be learning in finance class, and began reviewing basics like Time Value of Money (TVM), NPV, IRR etc. It was a whirlwind class, but we took them from zero to being able to have the vocabulary and math to describe when perpetuity formulas fail, to how to select between multiple investment vehicles. We'll even be asking Group 2 members to lecture on topics for the Group 1 team as practice. While I am very happy with the result at the end of yesterday, it is also what happened today which made me smile:

Today was the Rotman Finance Industry day and we had a host of speakers in the afternoon from industry (recruiters and alumni) as well as current students and the CCC. So far there wasn't anything earth shatteringly new (mostly hearing the same message from different people: Finance is hard to get into, this is how you should prepare: read the Vault Guides, read the newspaper, be intense... etc)

My proudest moment was during the presentation from one of the industry speakers when he mentioned that you have to calculate IRR's for different projects as part of your job. Immediately, I saw a few heads turn around and catch eyes with me with a knowing smile on their face. If there was anyone who was living the message of "MBA school is great, but a large component of your success is what you do and who you are" it was those who turned around and knew they were doing the right thing by preparing early. These were the people who, less than 24 hours before, were intimidated by Finance TLAs (Three letter acronyms) were now getting a sense of confidence.

Word has spread also. While Group 2 membership is deliberately limited (not a "snobby thing" but rather a purely logistical issue - I've been helping other people put together their own "Group 2's"), the word has spread and Group 1 has picked up a couple more members.

Again, I don't know if people remember that I had promised in my GBC first year rep speech to help all the Rotman students "reach their maximum potential" and build more equity into the degree (and network) we all paid so much to have the opportunity to earn, but I hope I'm beginning to show active signs outside of the standard "job requirements" that there is a lot I can offer and that we can do together.

International Study Tour - Middle East

I got some good news today from the PSO. I have been selected for the Middle East International Study Tour for course credit with Rotman. I'm very happy with the result. I thought that the interview process was very intense, and as I told my fellow classmates who were applying, I felt like I was competing against a future version of myself (the second years).

The tour promises to be an excellent opportunity for culture exchange as well as to understand global markets. The trip will be preceded by a six week course leading up to the travel itself which will be in the first two weeks of January. This means that I have to have my act together well in advance (because recruitment and interviews will occur immediately).

I am absolutely ecstatic about this and am looking forward to traveling with some very intense students from Rotman. This promises to be an exceptional experience and the preparation begins now.

CEO Compensation - Using Complex Derivatives

In our FIT class, our group presentation project was to look at CEO compensation (with deliberately vague instructions to give the teams flexibility to take the initiative on how to approach the topic: allowing us to think about our thinking). Our group was one of the teams that presented today (and we got generous feedback from our peers), however, it's another group's presentation I wanted to discuss in more detail.

Nick Kerhoulas' team, composed of Amanda, Nik, Mark and Nick K, mentioned in their presentation the unique idea of compensating a CEO with stock options against a benchmark. I thought this was a brilliant (yet generally overlooked) idea and I wanted to explore it further.

First, you will probably notice a trend (and skeptics and critics in the market have always highlighted this) that when a company has done well, it is touted as because of good management (alpha). However, when the company is doing poorly, it is pitched as being because the market (beta) is in recession.

In using Kerhoulas' idea which he presented in class, I think it would be interesting to see if CEO compensation could be restructured to include more complex derivatives rather than just stock options. Although stock options are a form of derivatives, deriving their value based on the underlying stock (in this case the firm's equity), I think Kerhoulas' idea can be adopted with more complex derivatives. My proposal is to use a sort of net neutral strategy similar to the market leader growth strategy I mentioned at the end of this previous post. The assumption here is that you believe your company should outperform competitors.

How would this work? Well rather than compensate your CEO with either pure equity or call options to buy the equity at a given exercise price, the CEO should be compensated with a mix of these options as well as a short position against an industry index. What does this mean?

The short position against the industry index means that if the industry as a whole succeeds because the market rises (beta), the compensation of the CEO goes down (the firm is succeeding because of the industry). However, if the CEO's decision making allows his/her firm to outperform the industry, then (s)he will be compensated based on the performance in excess of what the market is providing (alpha).

Similarly, if a market is in recession (beta), the short position gains value as the market declines, but if the CEO can manage the company to outperform (or 'do less bad' than the market as a whole), (s)he gets compensation accordingly (based on alpha).

How about poorly performing CEOs? If management ability (alpha) ever underperforms the market (beta), the CEO's compensation will always be negative. Now rather than qualitatively make statements against the causes of your firm's performance, you can use the market index as a benchmark to have a context in which to describe management (CEO) performance as suggested by Nick.

I think another interesting result is what happens if this compensation structure is adopted in a system (say, the industry at large) versus in isolation (at one company). I intuitively believe that the game theory grid that would represent this scenario describing a system would resemble the prisoner's dilemma, in that as CEO's are incented to "outperform" the market becomes more competitive and the market index rises (which reduces overall compensation within the system due to all the short positions) because each of its individual components rise. It could even potentially be framed as a zero-sum game (as shown below) if the CEOs are forced to trade stocks with each other to create the required short positions in the market index.

This actually even acts as a natural cap for CEO compensation, but still motivates CEO's to fight over the same pool of compensation. The maximum compensation available will be determined by the increase in the short position of the market (how the market moves as a whole), but CEO's can essentially earn more compensation against their competitors.

Example:
Assume 3 CEO's managing equal companies. Each company's stock is valued at $100.
Market index is composed of one of each stock and the compensation derivative is described as:

• Long three shares of the company's stock
• Short one unit of the market index

Assuming that companies 2 and 3 have stable performance (no change in stock price), but company 1's performs and stock price goes up by $10.

Total compensation would be:

• Long three shares: Increase in value $30
• Short Market: Decrease in value $10
• Total compensation change:+ $20

Now try a new (industry wide / systems based) scenario:

Firm 1's stock: +$50

Firm 2's stock: +$20

Firm 3's stock: -$10

Market index: +$60

CEO 1's compensation: 3*(+$50) - (+$60) = +$90

CEO 2's compensation: 3*(+$20) - (+$60) = $0

CEO 3's compensation: 3*(-$10) - (+$60) = -$30

Note that the sum of the CEO's compensation is $60 (CEO compensation 1 + 2 + 3 which is the Market index). This is because the market index compensates 3 CEO's with 3 shares of each company, and the CEO's each hold three shares of their own company. It's as if each CEO shorts competitors' stocks to the other CEOs respectively. In this way, there is a natural cap on the CEO compensation (which is directly reflected to the value they bring to the market) yet, CEO's are still incented to overperform because they can capture the bonuses of their competitors if they outperform them.

Would this work in practice? Well the only people who would actually adopt this form of compensation are the executives who actually believe they can outperform the market. Once this gains legitimacy as a compensation structure by those who want their performance bonuses to have high credibility, it provides companies with a quantitative answer (and a nearly indisputable answer) to the question: Is your company performing well because of you or the market you are in?

GBC Clubs Elections - Results

The results from the election are in, and there are a few noteworthy points I would like to emphasize. There are four positions available for MCA rep based on section, two were one by members of our little team: Yan Wang and Arash Noori. You may recall that Arash ran for Class rep for his section, but was beat out (in a good race) by Thi. However, I think that his previous campaign gave him good exposure which I'm sure boosted him to win a rep position with one of the most popular (code word for competitive) positions in the school for our level.

Also, oddly, there is only 1 position for each of RFA (Rotman Finance Association) and RAMA (Rotman Asset Management Association), although they are two of the most popular and competitive clubs. Aleksander and Xuan one those positions respectively (each was very clear and determined from the get go, so these results come as no huge surprise, although there was a lot of intense competition).

Also noteworthy, one of my teammates, Poonam, won the position of Healthcare and Biotechnology representative. All the people who won positions are 'Rotman 1st year household names' and the sheer number of applicants speaks to this years intensity and drive. It will be an interesting time to see how and where the newly elected reps carry their positions.

The Irony Of Improving Systems Design

I've been doing some thinking based on systems design (systems defined here in the broadest sense, beyond just computer systems and including ideas like service and administrative systems) and noticed what seems to be an irony when it comes to the quality of system design.

When it comes to system design, most systems are GIGO (Garbage In, Garbage Out), that is to say that if your inputs are all junk, then your outputs will be all junk. Using our integrative thinking model of TAO (Thinking, Action and Outcomes), using poor thinking will result in poor actions and subsequently poor outcomes. From a systems perspective, a designer would therefore design a system to constrict inputs such that 'Garbage' inputs in order to create an implicit or explicit form of rigor in the quality of the system's outputs. This is particularly important in large mission critical systems, where you don't want services to be disrupted by inputs which are inexact.

Fortunately or unfortunately, systems are inherently resistant to change. The natural inertia that results from controlling inputs and processes is originally intended to ensure quality and stability of the resulting outputs. However, over time, static systems will deteriorate, not only in the physical sense, but in the sense that the assumptions about the context in which the system operates will not remain static.

However, innovation is a necessary driver for making system models dynamic. The very input or change necessary to improve the system's processes would most likely be interpreted as 'Garbage' as the system isn't likely defined to accommodate this information. This is because the context shifted away from the original assumptions used to design the system.

This creates a dilemma as it relates to innovation. In order for a system to be dynamic, not to decay due to changes in the context in which the system operates, it requires thinking outside of the system's given parameters (a boundless feedback system). But thinking outside the system's given parameters is almost always framed as extraneous data or 'Garbage'. In order to incorporate a new idea requires flexibility in the system, but that flexibility usually comes at the cost of performance or stability.

The irony is, at the risk of sounding too recursive, that the best possible 'systems' are the ones that optimize the performance of all elements including those outside the system itself. That is to say, the best systems are not ecosystems, but organisms in bigger ecosystems.

GBC First Year Class Reps Lunch

The GBC Class reps for the four first year sections had lunch today with the Program Services Office (PSO) and the Corporate Connections Center (CCC) team to talk about initiatives their departments are doing to improve the program and solicit our help and input.

One thing I've been constantly reiterating is that I feel as if Rotman is a great school, but (and I choose my words very carefully) has not nearly reached it's potential. This is not a slight by any means (as Rotman enjoys a very good reputation), but I feel as if there is so much more we can do to improve our brand, our services to students and there is a long runway for improvement.

It was clear that both the PSO and CCC was acting on feedback of previous students to improve how things worked for us, the new incoming class and we, the current class reps, are working to improve the program for our classes and subsequent classes. But more than that, the PSO and CCC had very unique (described by some as 'revolutionary') methods of changing how MBA programs work and deliver services and value to students. It's exciting to be involved with building Rotman at this very important stage of growth.

Multiple Regression Model - High Correlations like Dividing by Zero

In multiple regression models, statisticians will create formulas which incorporate different factors in order to predict a value. The example used in class is the popular model used by real estate agents to do market valuation of houses. A typical model will incorporate things like number of bed rooms, if there is a basement, square footage, home assessment value etc. However, you can very quickly identify that some of these factors are 'related' (a house with many bed rooms, a basement or high home assessment value will probably have more square footage).

However, we were shown a formula which only used AREA to predict value and one formula that used ASSESSMENT (home tax assessment value). Intuitively, you can tell that they are positively correlated to some degree and this was reflected in the formula.

MARKET1 = X + a AREA + e
MARKET2 = Y + b AREA + c ASSESS + e

Where 'e' is the error.

However, in the two formulas, b was less than a. What does that mean? Some of the 'correlated' value between AREA and ASSESS is encompassed both in 'a' and 'c'.

But what if they are VERY highly correlated (or if you deliberately choose one factor which was a linear construction of another factor for a correlation of 1), you can see that it is impossible to create a 'factor' as the two items will move in perfect harmony. Imagine AREA is perfectly correlated to ASSESS or

ASSESS = d AREA

then

MARKET1 = X + a AREA + e
MARKET2 = Y + b AREA + c ASSESS + e

However, if ASSESS = d AREA (perfectly linearly correlated)
then
MARKET2 = Y + b AREA + cd AREA + e
MARKET2 = Y + (b + cd) AREA + e
Since there are only one 'real' factor, this would mean that:

• MARKET1 = MARKET2, the second model would be identical to the first model.
• 'a' would be expressed as (b + cd)
• X = Y

Another problem is that you can allocate b and d in any proportion you want to create MARKET2 (there is no meaningful way to allocate the weight of the factors b and cd). It's a very awkward solution and reminds me of divide by zero when it comes to math problems, that there is a problem when you take the limit of a factor to asymptotically approach a value. Mathematically, I believe that it would be described by these factors having no orthogonal components which causes a unique case.

Another interesting result is that if 'b' is not significantly different from 'c', it shows that correlation is probably low.

Also, if any of the 'weight' letters (except for 'e') is close to zero, it implies that these prediction factors don't actually have any bearing on model, but high numbers don't necessary imply importance (it really matters what the factor variables are measured in as it has a relative impact on the final prediction).

First GBC Meeting

We had our first GBC meeting this evening. There was an introduction of new members as well as a description of roles and responsibilities. It was very reminiscent of a CFES or MES transition meeting. We discussed operational issues such as the budget for the coming year and already the current council was aware of areas where we could make improvements in our processes and policies.

The current council (the more experienced second years) have made some great improvements to the GBC based on what we've been told, yet are aware that more drastic improvements and changes are necessary.

I would like to be involved with these changes as I think that many of the problems that need to be solved are not entirely unique to rapidly growing organizations and there are smarter people than I who have demonstrated standards and solutions which would cause most of our more egregious problems to disappear.

Having said that, we have very intense group of people (elected from an already highly filtered group) who have been asked to perform and behave in a manner consistent with the expectations of the whole. Certainly an interesting challenge.

Career Leader

Me: "Oh career leader... What should I be? An investment banker or a mangement consultant?"
Career Leader Software: "Uh... I dunno"

After telling the Rotman Career Councellors that I couldn't decide between Investment Banking and Consulting, I was asked by the CCC staff to do the career leader exercise online to help give me an indication of what I wanted to do. They suggested it might help me decide what I want to be. After I finished what were my results? They were (I don't think this is sorted in any particular order - all ranked "Very high"):

• Commercial Banking
• Finance in Corporate Settings
• Investment Banking
• Investment Management (Portfolio Management and Securities Analysis)
• Management Consulting
• Managers in Science/Engineering
• Private Equity Investment (Including Leveraged Buy-Out)
• Strategic Planning and Business Development

So, uh... Thanks for nothing? Perhaps I should just be happy it didn't say "Cop" or "Luchadore"

GBC Clubs Elections

Today marks the beginning of the Rotman Clubs elections (If you are a Rotman student, you can vote here).

I'm proud to say that for the MCA rep, there is (once again) a disproportionate number of people represented from our case prep team (7 of the 21 candidates are from our team). Also, I personally nominated three of the potential RFA rep candidates and they are all strong candidates.

I'm very happy that there seems to be strong interest across all clubs. Our class has strong leaders and it's great to see students finding their niche.

Good luck to all candidates! And may the best candidates win!

Rotman Ambassador!

I recently got the good news that I've been selected for the Rotman Ambassador team! The Rotman Ambassadors are the students who help give insight to the MBA program to potential students. I am very excited for the program for several reasons, the most prominent among them is that I am interested in paying back the helpful advice that was given to me from previous students when I was selecting MBA programs. Another top reason is that I'll be given an opportunity to boost the Rotman brand by playing a part in recruiting our colleagues for next year.

As I had mentioned previously, a significant part of my decision to come to Rotman (rather than, say, other top US schools) was based largely because of my interaction with other students who, whether they held the title Rotman Ambassador or not, were raving about the quality of the program and the students in it.

Speaking of Rotman Students, I know that there are quite a few people applying for the Ambassador program (walking past each other as we were being interviewed, waiting outside the interview room) and I have to say I'm impressed with the caliber and diversity of potential candidates (ranging from people active in clubs, academically gifted, international students, and other interesting and highly sociable people) and am honoured to be selected. It's going to be fun working with this team to promote Rotman!

GBC and PSO - Lazy Dog Sports Night

The GBC and Program Services Office (PSO) hosted a FANTASTIC event this evening, the "Lazy Dog Sports Night". The atrium was filled with students playing fooz ball, air hockey, guitar hero, Wii tennis, ping pong and other 'slack' sports. There was plenty of pizza (many of us managed to cart away a couple of slices away at the end) as well as an open bar. All for the price of $5!

If there was one benefit to writing the econ quiz today, it was being able to go to this event without worrying (Sections 1 and 2 wrote the quiz today, Sections 3 and 4 have to write it tomorrow - hence the majority of them spent tonight studying).

The competition for sports got pretty intense pretty quickly (MBA's being MBA's), but mellowed out just as fast when food and drink arrived. It was a great ice breaker and I'm expecting some great photos to be posted on Facebook soon.

Ye Be Fairly Warned...

We had our econ quiz today and I think the class as a whole did TERRIBLE. Sure there are some who probably scored well, but generally, there were a lot of moans in the class as the professor revealed answers to the questions.

Our professor also prognosticated about our exam, saying that "things will only get harder". While I must admit the quiz was "challenging", the professor was quick to point out that we should have all the tools to deal with the questions as proposed on the exam. After all, we are GRADUATE students now... Not undergrads. There is that expectation that we can put the pieces together. And I think that has a lot of us spooked.

But have faith! After all, these quizzes are of low value. It's the EXAM we should all be worried about. So for those of us who are not happy with our performance on the quiz (I'm guessing that's all of us, who lament the answer we wrote for one question or another) it's 'fair warning' for upcoming exams at the end of the quarter (only a few short weeks away)! Keep your eye on the prize and don't get distracted by the (inevitable) bumps in the road!

Game Theory: To Cheat or Not to Cheat

I had started to do a series on game theory earlier this year, but stopped when I realized there were some huge knowledge gaps in what I knew. However, in economics this morning, we talked about game theory and specifically what would happen in the prisoner's dilemma if:

• the game is played more than once for a finite number of terms (immediately goes to Nash equilibrium)
• the game is played an infinite number of times with a trigger strategy and an interest rate (account for time value of money, TVM)

In the latter, there is a VERY interesting result that appears. Using the same game matrix as in the original prisoner's dilemma matrix:

The assumption is that both firms will collude until one firm cheats (the 'trigger'). There is also an assumption that the TVM is described by a general "interest rate", i. You can actually calculate the NPV for each decision matrix and find i (or more accurately in finance terms, IRR) and how that affects the NPV of each decision.

For example:
Colluding forever has a value to Firm 1 of:
= 10 + 10/(1+i) + 10/(1+i)^2 + 10/(1+i)^3 + ...
= 10 + 10/i
(Note this is EXACTLY the same math lesson I gave at the Analyst Exchange, using perpetuities and sequences and series.)

Similarly
Cheating at any given point has a value to Firm 1 of:
= 15 + 2/(1+i) + 2/(1+i)^2 + 2/(1+i)^3 + ...
= 15 + 2/i

Using basic economic theory regarding alternative choices (or using finance theory as regarding NPV, IRR and investment decisions) you can equate the two formulas to understand how 'cheating' decisions are made. Intuitively, you can see that if i is infinity (or some other astronomically high number), the second term goes away and you are incented to cheat. Another way of saying that is if the TVM is very high (resulting in a high interest rate) you'd rather have the money now (cheat).

However, for lower values of i (low time value of money) you'd prefer to benefit later (co-operate). Let's look at where the firms are indifferent, or:

10 + 10/i = 15 + 2/i

Therefore: i = 1.6 or a monstrous 160%
(probably from a bad choice of numbers, or the heavy penalty related to both parties cheating)

This means that when the interest rate (or more accurately, the discount rate) is 160%, the firms are indifferent towards which strategy they choose. This is a phenominal result because it starts to integrate financial valuation with economics and game theory. You can tell my excitement by the number of backlinks I've provided for this post.

Be Useful: The Only Way to Improve Employability (Job Security)

This weekend, a friend of mine asked me to help him compose an M&A model. As you can tell from the posts, this weekend was particularly busy. However, this friend has been incredibly helpful before. I told him I'd meet up with him tonight so that we could go over the financial statements of the two companies who he was proposing to merge. Personally, I think the fact that he asked me to help was a huge compliment as this person is exceptionally talented and has been inspirational in terms of pushing me to achieve my best.

We went over the financial statements of the two companies and discovered there was a lot of "interesting" (chaotic) things going on in their respective annual reports and financial statements. Because of the unique nature of their businesses, they had complex derivatives structures which would allow them to hedge bets against strategic changes in the market which would adversely affect them. However, this meant that they had "interesting" cash flow statements which required a great deal of scrutiny. This was added, of course, to the natural challenge of building a model to merge two separate companies and creating a new capital structure, modeling their future performance, and determining earnings dilution (accretion).

In the course of this exercise (which took just over an hour), he also taught me about private equity and how some of the management fee structures work, how they are levied, how they offset the management fees of funds (theoretically) as well as reviewing how financial engineering works to gain returns through offsetting leverage applied with cash flow (EBITDA) coming in.

Having said that, I'm looking forward to putting together my finance prep team. I anticipate that we will probably meet sometime next week after the RFA recruitment primer scheduled for Friday. I'll probably be sending out an email to interested parties sometime tonight or early tomorrow (after my Econ quiz).

CIBC Run for the Cure with McKinsey

The MCA organized a very popular event for the Rotman students, a team for the CIBC Run for the Cure in downtown Toronto today. The event started at around 10am at University and Queen.

The event was followed by a nice brunch with two people from McKinsey. One was a recruiter and the other was a former Rotman grad who was currently working there. They gave us a great deal of insight into the world of consulting and what makes McKinsey different (global P&L, on-site time with clients rather than home office analysis). They elaborated on how their model has advantages and differences from some of the other top consulting firms.

The event was a great success as the Rotman MBA audience asked questions and learned more about an industry that has a great deal of appeal, but most new students know little about. I'm also quite happy that those who joined our little management consulting case interview prep team where disproportionately represented (against the Rotman MBA class at large). Of the 30 who appeared (there was great interest, but limited space), of the approximately 10 team members in our case prep group, 6 were at the event.

Advanced Data Manipulation with Excel with Ian Schnoor

I've repeatedly heard from various people at Rotman that Ian Schnoor's courses were quite good. This particular course was offered by the Rotman PACE (Professional and Career Essentials) team. Also, I think that most people don't realize the awesome potential in Microsoft Excel. I would even go so far as to suggest that most people probably classify themselves intermediate / advanced when they are really beginner (a great metaphor for business knowledge and the biases and models we study in FIT).

I was a little skeptical about learning "Advanced" data manipulation techniques in Excel, the same way I was skeptical about the Intermediate Excel Rotman Pre-MBA session. It turns out that each of those was REALLY useful, even for myself who heavily used Excel in my Analyst Wireless Consultant position at RIM.

We reviewed pivot tables, VLOOKUPs, OFFSETS, text parsing functions, advanced filters and other REALLY useful topics in Excel. There are so many scenarios where these tools apply which can easily save you HOURS per project (or days in your life). With time being precious, it's often tough to justify spending a precious Saturday on something that isn't direcly MBA nor socially related, but this was definitely worth it.

Rotman Finance Association - Building My Prep Team

It seems the most popular clubs feel like they can have their kick off meetings late on Friday afternoon and still get pack rooms. Which they did. The two undisputed heavy weight champions in terms of clubs interest are the Management Consulting Association (MCA) and the Rotman Finance Association (RFA), both of which held their kick off meetings on consecutive Friday afternoons. Last week was MCA, this week was RFA (today).

The info session was a good primer for those with little or no background in finance as well as an introduction to the upcoming events. They emphasized some key points (which I've been talking to some of the Club Executives about) in terms of how to prepare for what amount to the most competitive and desired jobs available to MBAs. The RFA Exec made a good point, essentially: "All the skills you need to interview for summer jobs, you won't learn until it's too late. You're on your own." There's just too much going on too fast. It's really up to you to take the initiative. Keep in mind that if you went to Ivey (One year program), you'd be facing the same challenges except you'd be worried about full time rather than internships.

I'm currently in the process of putting together a team of people who are interested in investment banking and high finance. I offering to teach them what I know (learned over the summer and through CFA) in exchange for having serious partners for preparation in the same way we're building a case interview / competition team for consulting. The Analyst Exchange was very good in prepping me to discuss and build valuation, consolidated financial statement modeling, leveraged buy outs, mergers and acquisitions.

My goal is two fold. In terms of what I'm offering to give, I hope my Rotman counterparts and I can improve our odds to boost our recruitment and offer batting average (the other side of the hiring batting average) which I promised as my speech for Rotman 1st Year rep.

More selfishly, I want to find a group of dedicated people who I can potentially draw upon as teammates for investment challenges and (in the future) network contacts.

"10 years from now when we've all reached our potential, I want you to tell your executive assistant to take my call when I'm looking to find partners interested in doing a deal." ~ Josh Wong, 2009

Using Inertia to Offset Loss Aversion and the Status Quo

In our Foundations of Integrative Thinking (FIT) class, we were reading an interesting case about savings programs. Particularly, that countries with a high marginal propensity to consume (MPC) naturally exhibit low savings (low marginal propensity to save, MPS = 1 - MPC). Coupled with hyperbolic discounting (the idea that our myopic views cause us to over value short term events at the expense of long term events) and the stickiness of the status quo, inertia and resistance to change. In finance terms, the maturity premium on our discount rates are underweighted.

Using these tools, the question was asked: "Is it possible to build a program which encourages people to save?" An ingenious solution was the SMarT program (Save More Tomorrow Program), which tried to affect the various levers to obtain the desired result (increased savings).

A simple proposed solution was simply: "Can you make them aware of their situation and ask them to save more?" A logical model assuming 'rational' players, however, loss aversion and myopic views would prevent people from taking the 'medicine' they needed. Often many workers were making 'just enough to get by'.

The next attempt to reduce loss aversion would be to ask them to save more when they receive a promotion. However, myopic views and discounting still have an strong enough negative effect that will prevent significant savings program acceptance.

However, the SMarT program mixes a knowledge of all the concepts listed above in a fairly unique manner. Rather than take any of the traditional and 'logical' methods based on simple models in order to solve the problem, they proposed a different solution:

At a given point T=0 (Now) propose that when an employee gets their next
pay raise, that a they increase their savings at that point.

Key points to note:

• By making the decision now to save later, this discounts the future 'loss' associated with having to save more in the future (and consuming less now).
• By introducing the idea of making the decision in the future also results in inertia working in the benefit of savers by biasing them towards not changing their intended course as it relates to saving (sticking to the program).
• Since the trigger is a pay increase, the loss as described by decreased consumption usually associated with saving is offset by an increase which reduces the loss aversion further.

In reading the results of the article, it was shown that this methodology of getting people to increase their savings was significantly more successful than previous methods. The success of the program is primarily attributed to the methodology which considers not only the logical conclusions, but also how the mind works and precieves the benefits of different solutions based on how they are framed. After all, the goal in each of the programs is the same, a modification of saving behaviour. However, the approach in any 'behavioural problem' is critical to obtaining the desired outcome.

Fixing "Problems" We Don't "Understand"

We were discussing statistics in our class and how to understand numbers you are presented with respect to their distribution. Particularly, we were focusing on prediction metics and describing how a residual value (calculated as actual minus prediction) is defined as biased if the mean value is not equal to zero (or FAR from zero, our heuristic is if the mean is approximately 20% of the standard deviation).

I proposed a solution that we could "correct" the bias (even if we didn't understand it) by making a permanent subtraction from our prediction model by the mean of the residual.

My teammate, Matt Clare, and the professor further refined this model to say it would work IF the residual pattern exhibits constant variability (the variation and volitility isn't changing).

While I am loath to use solutions which insufficently describe the underlying causes, this seems to be one of the FEW examples where math can actually be used to solve a problem without a keen knowledge of what is happening (assuming an intimate knowledge of the mechanics of why patterns occur, rather just a knowledge that they exist and are stable).

For residuals that increase with the size of the actual, I think that considering errors as a fraction of residual over actual (in the same way we normalize variation for residual based on actual size) can understand variation in the same way.

Negative LIFO reserve?

I had previously posted about LIFO reserve and how to approach questions on the CFA exam, but I had a a great question about if it was possible to get negative LIFO reserve. While it is mathematically possible, I suggested that there might be some sort of accounting rule that prevents it (I thought it would look really awkward on financial statements).

When I asked my professor if it was possible, however, he was quick to point out that it was (both in theory and practice). When asked what real world scenario would this actually happen, he brought up the example of computer companies such as Dell and Cisco, whose technology products depreciate in cost (rapidly). It becomes apparent that they would:

1. Prefer FIFO accounting over LIFO
2. Probably have small, just-in-time (JIT) inventory management

Revenue Recognition for Large Projects

I apologize for not really discussing Financial Accounting. At the risk of sounding a bit arrogant, a lot of this material (but certainly not all of it - liability recognition percentages for GAAP (80%) versus IFRS (50%) ) has been covered in the CFA level I (for the question that most people ask, should I do an MBA or CFA, this is part of the answer... I should post more on this sometime and why I decided to do both). Plus, as my colleague Megan so eloquently puts it:

"... it is an important and necessary subject, so I may as well learn to love it
because I can't escape it."

Currently, we are discussing different revenue (and cost and profit) recognition techniques for larger projects who span more than one reporting period. The question is how should we recognize these items in financial statements? There are two methods we are looking at: the percentage of completion method and the completed contract method.

The completed contract method is quite simple, where (intuitively) all the revenues are accounted for once the contract is completed. It is more appropriate in scenarios where the contract involves extremely high risks (and may not be completed).

Another method not yet mentioned is the cost recovery method, where revenues match costs until the last period where gross profits are recognized all at once.

[Case] Same as the case in the percentage of completion post:

Assume a construction project with the following construction cost structure:

Year 1: $5M
Year 2: $15M
Year 3: $10M

The overall contract price is $46M.How much profit should be recognized in each of the given years under different methods?

[Solution]
Case 1 - Completed contract method revenue:
Year 1: $0
Year 2: $0
Year 3: $46M

Profit:
Year 1: $0
Year 2: $0
Year 3: $46M - $30M = $16M

Case 2 - Cost recovery method PROFIT:
Year 1: $0M
Year 2: $0M
Year 3: $16M

(Although I don't know what the cost schedule looks like, the revenue recognition will be such that revenues will match and equal costs, until the last year). Note that while the profit schedules are identical in both methods, the revenue and cost recognition schedules are different in these two methods.

Continuing the class after the break, we discussed COGS and Inventory as an extention of the above concepts. Our professor is starting to do a primer (and enter into) the topic of LIFO versus FIFO, one of my top (most popular) posts. And as mentioned before, there are interesting concerns when it comes to accurately measuring performance versus position. Another major issue we are discussing is accounting for inventory costs when they haven't yet been sold, but their value moves with what happens in the market and LOCOM, the lower of cost or market as an accounting standard for both US GAAP and IFRS.

Stackelberg and First Mover Advantage

We have to be careful here, as first mover response has a very specific definition and I believe there are some inherent assumptions here. Most of us would associate first mover response (used colloquially) as when a company creates a new product and is the first to market. It seems as if the theory we learned to describe Stackelberg (essentially a Cournot model where one firm has the opportunity to move first) has a good description for a very specific definition of "first mover advantage".

Intuitively, you can predict that you can exert a form of control over your competitors ('the market') by making a first move. How this differs from Cournot is that Cournot assumes that both firms move together at the same time, and their decisions are unverifyable by the other company. In Stackelberg, by knowing the response functions of both companies (and understanding that the more one firm creates, the less another firm will be incented to create) and confirming quantities early, it affects what the other company will be able to benefit.

The important factor is that the ambiguity and uncertainty of what the other firm produces is removed. The Cournot model is heavily affected by the anticipation of what the other firm will do, rather than the certainty. The result is that optimal quantities in both models change (as demonstrated by the practical and general solving of the formulas in each case). In the Stackelberg case, rather than having to solve an algebraic equation where Q1 is 'floating' (uncertain and expressed as a formula related to what firm 1 produces), Q2 is simply expressed as a formula where Q1 is a known quantity. In that way, firm 1 can 'force' firm 2 to produce their 'optimal' quantity given that firm 1 has put a stake in the ground by actually creating a certain number of units and making sure firm 2 knows.

Bertrand Equilibrium

Continuing with other different models for firm interaction, our professor introduced the idea of choosing price versus choosing quantity as in the Cournot model, known as the Bertrand model. This focuses more on price competition. A key consideration is that in price competition (for homogeneous products) if firm 1 dropped it's price, it could capture the whole market. However, firm 2 is then incented to undercut the new price to recapture the market and the price cutting continues.

Where does it stop? It starts to move towards perfect competition immediately which is the crux of the model. Bertrand proposed that you could have a model which describes perfect competition with only two firms whereas Cournot required that perfect competition would occur where there were more firms in the market.

This highlights the importance of basing decisions on quatity versus price.

Cournot Duopoly - Oligopoly and Foundations of Game Theory

In all my previous undergrad economics courses, we've always discussed oligopolies with OPEC and oil being great examples. However, in our managerial economics class, we've actually started applying some basic math to the model. It's simply expressed as:

P = a - b(Q1 + Q2)
MR1 = a - bQ2 - 2bQ2
MR2 = a - bQ1 - 2bQ2

An interesting point raise by a student was: "Why do we learn these models if we can't necessarily always apply them quantitatively in real life?" and our professor came up with a brilliant answer: "I would hope that especially with your FIT class, you should be able to understand that models are intended simply as a simplification and can help you understand relationships even if you don't always use hard numbers."

Another interesting new way to think we've been introduced to is the Q1 v Q2 graph (explicity not to be confused with a downward sloping demand curve) and is described as a graph of Firm 1's Best-Response Function. Something which I tripped on just now in class was understanding the x intercept (Q1 m - what firm 1 would produce if Q2 produced nothing, a monoploy like scenario) and y intercept (what quantity Q2 would have to produce to kick Q1 out of the market).

I guessed that the y-intercept was the same as the x-intercept which was wrong, because I made some gross assumptions (cost curves of both companies are the same). Whereas, the truth is that firm 2 would have to have a much better MC curve by completely pushing out firm 1 at Q2m. If the cost curves were the same, there would probably be a more balanced production quantitiy for both.

It turns out the y-intercept is the (a-c1)/b. Superimposing the Q2 response function, the reverse appears, the y-intercept is Q2m and the x-intercept is (a-c2)/b, where c1 and c2 is the marginal cost for the respective firms.

The prof then goes to show how, with perfect knowledge ("collusion", or assuming each firm knows both response functions), the two firms will naturally return to equilibrium, even if they try to push (or start) to produce any quantity outside of equilibrium. It is very similar to decreasing osciliations about the mean until the signal stabilizes.

He also discusses collusion, monopolies and "cheating" in collusion and how profit seeking entities will look to predictibly optimize their profits with respect to their competitor's (the market's) production decisions.

How does this relate to game theory? If you can predict what your competitor (in the duopoly model... or any model with N players where N is greater than 1) you can make the appropriate arrangements to maximize your profitability in the market. Suddenly, your mutual decisions are "forecastable" according to game theory.

You can even start to understand the case where the firms would actually prefer to merge and perform as a monoploy. And this is the reason and primary concern for anti-trust with the DOJ or Competition Bureau.