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Fundamental Economic Concepts

Fundamental Economic Concepts. Demand, Supply, and Equilibrium Total, Average, and Marginal Analysis Finding the Optimum Point Present Value, Discounting & Net Present Value Risk and Expected Value Probability Distributions Standard Deviation & Coefficient of Variation

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Fundamental Economic Concepts

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  1. Fundamental Economic Concepts • Demand, Supply, and Equilibrium • Total, Average, and Marginal Analysis • Finding the Optimum Point • Present Value, Discounting & Net Present Value • Risk and Expected Value • Probability Distributions • Standard Deviation & Coefficient of Variation • Normal Distributions and the Standard Unit • Relationship Between Risk & Return

  2. A demand curve shows the greatest quantity of a good demanded at each price the consumers are willing to buy, holding other influences constant (ceteris paribus). Demand Curves PRICE/Q $5 20 Quantity / time unit

  3. Sam + Diane = Market • The market demandcurve is the horizontal SUM of the individual demand curves. • The demand function includes all variables that influence demand. 4 3 7 Q = f( P, Ps, Pc,I, N, Pe) - + - ? + + P is price of the good PS is the price of substitute goods PC is the price of complementary goods I is income, N is population, Pe is the expected future price

  4. i. price, P ii. price of substitute goods, Ps iii. price of complementary goods, Pc iv. income, I v. advertising, A vi. advertising by competitors, Ac vii. size of population, N, viii. expected future prices, Pe xi. adjustment time period, Ta x. taxes or subsidies, T/S The list of variables that could likely affect demand varies for different industries and products. The ones on the left tend to be significant. Determinants of Demand

  5. Supply Curves PRICE/Q • A firm’s supply curve is the greatest quantity of a good supplied at each price by the firm, holding other things constant. Quantity / time unit

  6. Acme Inc. + Universal Ltd. = Market • The market supply curve is the horizontal sum of the firm supply curves. • The supply function includes all variables that influence supply. 4 3 7 Q = g( P, PI, RC, Tech,T/S) + - - + ?

  7. Determinants of Supply i. price, P ii. input prices, PI (sometime shown as w (wages) and r (cost of capital) iii. cost of regulatory compliance, RC iv. expected future price, PE v. technological improvements, Tech vi. taxes or subsidies, T/S Note: Anything that shifts supply can be included and varies for different industries or products.

  8. Dynamics of Supply and Demand • If quantity demanded is greater than quantity supplied at a price (excess demand), prices tend to rise. • The larger is the difference between quantity supplied and demanded at a price, the greater is the pressure for prices to change. • When the quantity demanded and supplied at a price are equal at a price, prices have no tendency to change.

  9. Equilibrium: No Tendency to Change S P • Superimpose demand and supply • If no excess demand and no excess supply, then there is no tendency to change at the equilibrium price, Pe. Willing & Able in cross- hatched Pe D Q

  10. Equilibrium Price Movements P • Suppose there is an increase in income this year and assume the good is a “normal” good • Does Demand or Supply Shift? • Suppose wages rose, what then? S P1 E1 D Q

  11. Comparative Statics& the supply-demand model P • Suppose that demand shifts to D’ • We expect prices to rise • We expect quantity to rise as well S E2 D’ E1 D Q

  12. Break Decisions Into Smaller Units: How Much to Produce ? profit • Graph of output and profit • Possible Rule: • Expand output until profits turn down • But problem of local maxima vs. global maximum Global MAX Local MAX A quantity B

  13. Average Profit = Profit () / Q PROFITS • Slope of ray from the origin • Rise / Run • Profit / Q = average profit • Maximizing average profit doesn’t maximize total profit ! MAX C B profits quantity Q

  14. Marginal Profits = /Q max profits • Q1 is breakeven (zero profit) • Maximum marginal profits occur at the inflection point (Q2) • Max average profit at Q3 • Max total profit at Q4 where marginal profit is zero • So the best place to produce is where marginal profits = 0. Q4 Q3 Q2 Q1 Q average profits marginal profits Q

  15. Present Value • Present value recognizes that money received in the future is worth less than money in hand today. • To compare monies in the future with today, the future dollars must be discounted by a present value interest factor, PVIF=1/(1+i), where i is the interest compensation for postponing receiving cash one period. • For dollars received in n periods, the discount factor is PVIFn =[1/(1+i)]n

  16. Net Present Value (NPV) • Most business decisions are long term. • capital budgeting, product assortment, etc. • Objective: Maximize the present value of profits • NPV = PV of future returns less initial outlay • NPV = Σt=0 NCFt / ( 1 + rt )t where NCFt is the net cash flow in period t • NPV Rule: Do all projects that have positive net present values. By doing this, the manager maximizes shareholder wealth. • Good projects tend to have: • high expected future net cash flows • low initial outlays • low rates of discount

  17. Sources of Positive NPVs • Brand preferences for established brands • Ownership control over distribution • Patent control over products or techniques • Exclusive ownership over natural resources • Inability of new firms to acquire factors of production • Superior access to financial resources • Economies of large scale or size from either: - Capital intensive processes, or - High start up costs

  18. Risk • Most decisions involve a gamble. • Probabilities and outcomes can be known or unknown. • We speak of risk when possible outcomes and probabilities are known. • Example is a roulette wheel or dice • We generally know the probabilities • We generally know the payouts

  19. Concepts of Risk • When probabilities are known, we can analyze risk using probability distributions • Assign a probability to each state of nature, and be exhaustive, so that Σpi = 1 States of Nature StrategyRecessionEconomic Boom p = .30p = .70 Expand Plant- 40 100 Don’t Expand - 10 50

  20. Payoff Matrix • Payoff Matrix shows payoffs for each state of nature, for each strategy • Expected value = r = Σ ri pi • r = Σ ri pi = (-40)(.30) + (100)(.70) = 58 if expand • r = Σ ri pi = (-10)(.30) + (50)(.70) = 32 if don’t expand • Standard deviation = =  (ri - r ) 2. pi

  21. expand = SQRT{ (-40 - 58)2(.3) + (100-58)2(.7)} = SQRT{(-98)2(.3)+(42)2 (.7)} = SQRT{ 4116} =64.16 don’t = SQRT{(-10 - 32)2 (.3)+(50 - 32)2 (.7)} = SQRT{(-42)2 (.3)+(18)2 (.7) } = SQRT{ 756 } = 27.50 In this example, expanding has a greater standard deviation (64.16) but also has the higher expected return (58). Example of Finding Standard Deviations

  22. Coefficients of Variation or Relative Risk _ • Coefficient of variation (C.V.) = / r. • C.V. is a measure of risk per dollar of expected return. • The discount rate for present values depends on the risk class of the investment. • Look at similar investments • Corporate Bonds, or Treasury Bonds • Common Domestic Stocks, or Foreign Stocks

  23. Projects of Different Sizes: • Coefficient of variation is a good measure for comparing projects of different sizes. • In the example below, even if size is doubled, C.V. is unchanged. Example of Two Gambles A: Prob X } R = 15 .5 10 } = SQRT{(10-15)2(.5)+(20-15)2(.5)] .5 20 } = SQRT{25} = 5 C.V. = 5 / 15 = .333 B: Prob X } R = 30 .5 20 }  = SQRT{(20-30)2 ((.5)+(40-30)2(.5)] .5 40 } = SQRT{100} = 10 C.V. = 10 / 30 = .333

  24. What Went Wrong at LTCM? • Long Term Capital Management was a ‘hedge fund’ run by some top-notch finance experts (1993-1998) • LTCM looked for small pricing deviations between interest rates and derivatives, such as bond futures. • They earned 45% returns, but that may be due to high risks in their type of arbitrage activity. • The Russian default in 1998 changed the risk level of government debt, and LTCM lost $2 billion

  25. Normal Distributions and z-Values • z is the number of standard deviations away from the mean • z = (r - r )/σ • 68.26% of the time within 1 standard deviation • 95.44% of the time within 2 standard deviations • 99.74% of the time within 3 standard deviations Problem: income has a mean of $1,000 and a standard deviation of $500. What’s the chance of losing money? _

  26. Realized Rates of Returns and Risk (1926-2002)

  27. The Relationship of Risk & Return • Typically markets demonstrate that there is a trade-off between risk & return. • Everyone likes high returns • Many find risk something that they would like to avoid • Therefore, the market sets the premium an investor needs to accept a type of risk. • Required Return = Risk-free return + Risk Premium • In Table 2.10, if T-bills reflect the risk-free rate, on average that is 3.9%. • If large company stocks earn on average 12.7%, then the risk premium for this form of investment would be: 8.8% • 12.7% = 3.9% + 8.8% • The risk premium for other classes of assets. There would be lower risk premium for bonds and a much higher one for small company stocks.

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