Fundamental Economic Concepts Chapter 2

Fundamental Economic Concepts Chapter 2 • • • Demand Supply Review 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 using the z-value The Relationship Between Risk & Return © 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Slide 1

Demand Curves • Individual Demand Curve $/Q $5 20 Q /time unit the greatest quantity of a good demanded at each price the consumers are willing to buy, holding other influences constant Slide 2

• The Market Demand Curve is the horizontal sum of the individual demand curves. Jenny + 4 Pete + … = Market 3 7 • The Demand [2. 1] A demand function for hybrid cars: Function includes Q = f( P, Ps, Pc, Y, A, AC N, PE, TA, T/S) all variables that influence the quantity demanded - + + + - The signs below each variable indicate the impact the variable has on Q (hybrid cars), as in the partial impact of price on quantity, ∂Q/∂P < 0. See Variable definitions are on the next slide. See also Table 2. 2. Slide 3

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

Supply Curves • Firm Supply Curve - the greatest quantity of a good supplied at each price the firm is profitably able to supply, holding other things constant. $/Q Q/time unit Slide 5

• The Market Supply Curve is the horizontal sum of the firm supply curves. • The Supply Function includes all variables that influence the quantity supplied Acme Inc. + Universal Ltd. + … = Market 2200 3100 7300 [2. 2] is the supply function: Q = g( P, PI, PUI, T, EE, F, RC, PE, TA, T/S) + - - + + - - - + - The signs below each variable indicate the impact the variable has on Q (hybrid car supply), as in the partial impact of price on quantity, ∂Q/∂P > 0. See Variable definitions are on the next slide. See also table 2. 3. Slide 6

Determinants of the Supply Function i. iii. iv. v. viii. ix. x. price, P input prices, PI, e. g. , sheet metal Price of unused substitute inputs, PUI, such as fiberglass technological improvements, T entry or exit of other auto sellers, EE Accidental supply interruptions from fires, floods, etc. , F Costs of regulatory compliance, RC Expected future changes in price, PE Adjustment time period, TA taxes or subsidies, T/S Note: Anything that shifts supply can be included and varies for different industries or products. Slide 7

Equilibrium: No Tendency to Change • Superimpose demand supply • Then no tendency to change at the equilibrium price, Pe • Gasoline prices vary quite a bit • Explanations on gas include: 1. 2. 3. 4. Supply disruptions & refinery capacity constraints Retail distributors and price gouging Increases in excise taxes on gasoline Variation in crude oil prices. S P Willing & Able in crosshatched Pe D Q Slide 8

Comparative Statics & the supply-demand model P e 2 S e 1 D Q D’ • Suppose that demand Shifts to D’ next year, for example, an improvement in people’s income • We expect prices to rise • We expect quantity to rise as well Slide 9

Total, Marginal, and Average Profits Table 2. 4 Quantity Total Profits Marginal Profits Average Profits 0 -200 0 ----- 1 -150 50 -150 2 -25 125 -12. 50 3 200 225 66. 67 4 475 275 118. 75 5 775 300 155. 00 6 1075 300 179. 17 7 1325 250 189. 29 8 1475 150 184. 38 9 1500 25 166. 67 Maximum Marginal Profits occurs before Maximum Average Profits. Slide 10

Break Decisions Into Smaller Units: How Much to Produce ? • Graph of output and profit • Possible Rule: » Expand output until profits turn down » But problem of local maxima vs. global maximum gets you to point A not B profit GLOBAL MAX Local MAX A quantity B Slide 11

Average Profit = Profit / Q PROFITS MAX C B » Rise / Run » Profit / Q = average profit • Maximizing average profit doesn’t maximize total profits Q • Slope of ray from the origin quantity Slide 12

Marginal Profits = / Q s Q 1 is breakeven (zero profit) profits s maximum marginal profits occur at the inflection point (Q 2) s Max average profit at Q 3 Q 1 s Max total profit at Q 4 where marginal profit is zero s So the best place to produce is where marginal profits = 0. (Figure 2. 8) max Q 3 Q 4 Q 2 Q average profits marginal profits Q Slide 13

Present Value » Present value recognizes that a dollar received in the future is worth less than a dollar 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 Slide 14

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 - Initial Outlay • NPV = t=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: 1. 2. 3. high expected future net cash flows low initial outlays low rates of discount Slide 15

Sources of Positive NPVs 1. Brand preferences 5. Inability of new firms to for established acquire factors of brands production 2. Ownership control 6. Superior access to over distribution financial resources 3. Patent control over products or 7. Economies of large scale techniques or size from either: 4. Exclusive a. Capital intensive processes, ownership over or natural resources b. High start up costs Slide 16

• Most decisions involve a gamble • Probabilities can be known or unknown, and outcomes possibilities can be known or unknown • Risk -- exists when: » Possible outcomes and probabilities are known Examples: Roulette Wheel or Dice » We generally know the probabilities » We generally know the payouts Uncertainty if probabilities and/or payouts are unknown are Slide 17

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 pi Strategy States of Nature Recession Economic Boom p =. 30 Expand Plant Don’t Expand =1 - 40 - 10 p =. 70 100 50 Slide 18

Payoff Matrix • Payoff Matrix shows payoffs for each state of nature, for each strategy • Expected Value = r = ri pi _ • r = ri pi = (-40)(. 30) + (100)(. 70) = 58 if Expand _ • r = ri pi = (-10)(. 30) + (50)(. 70) = 32 if Don’t Expand • Standard Deviation = = (r i - r ) 2. pi Slide 19

Example of Finding Standard Deviations 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 Expanding has a greater standard deviation (64. 16), but also has the higher expected return (58). Slide 20

Coefficients of Variation or Relative Risk • Coefficient of Variation (C. V. ) = _ / r. » C. V. is a measure of risk per dollar of expected return. • Project T has a large standard deviation of $20, 000 and expected value of $100, 000. Project S has a smaller standard deviation of $2, 000 and an expected value of $4, 000. • CVT = 20, 000/100, 000 =. 2 • CVS = 2, 000/4, 000 =. 5 » Project T is relatively less risky. Slide 21

Projects of Different Sizes: If double the size, the C. V. is not changed!!! Coefficient of Variation is good for comparing projects of different sizes Example of Two Gambles A: Prob. 5. 5 X 10 20 } } } B: Prob. 5. 5 X 20 40 } } } R = 15 = SQRT{(10 -15)2(. 5)+(20 -15)2(. 5)] = SQRT{25} = 5 C. V. = 5 / 15 =. 333 R = 30 = SQRT{(20 -30)2 ((. 5)+(40 -30)2(. 5)] = SQRT{100} = 10 C. V. = 10 / 30 =. 333 Slide 22

What Went Wrong at LTCM? • Long Term Capital Management was a ‘hedge fund’ run by some top-notch finance experts (19931998) • 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 Slide 23

Normal Distributions and z-Values • z is the number of standard deviations away from the mean _ • z = (r - r )/ • 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? Ans: Z = (0 – 1, 0000/500 = -2. Look at table for standard normal , or only 2. 228%. Slide 24

Realized Rates of Returns and Risk Table 2. 10 Security Yield US Treasury Bills 3. 8% US Treasury Bonds (25 years or more) 5. 06% Aaa-rated Corporate Bonds 6. 49% Aa-rated Corporate Bonds 6. 93% A-rated Corporate Bonds 7. 18% Baa-rated Corporate Bonds 7. 80% Diamonds 3. 00% Farmland 6. 50% STOCKS: All US Stocks 10. 10% Biotech Stocks 12. 60% Emerging Market Stocks 16. 00% § Which had the highest return? Why? Slide 25