Fundamental Economic Concepts

Chapter 2
Demand, Supply, and Equilibrium 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
Slide 1

2008 Thomson * South-Western

Demand Curves
$/Q

Individual Demand Curve

the greatest quantity of a good demanded at each price the consumers are willing to buy, holding other influences constant
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$5

20 Q /time unit

Sam

Diane

Market

The Market Demand Curve is

the horizontal sum of the individual demand curves.
4 3 7

The Demand Function includes

all variables that influence the quantity demanded

Q = f( P, Ps, Pc, Y, N PE)

+ ? + +
P is price of the good PS is the price of substitute goods PC is the price of complementary goods Y is income, N is population, PE is the expected future price

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Determinants of the Quantity Demanded

i. price, P

ii. iii. iv. v. vi. vii. viii. xi. x.

price of substitute goods, Ps price of complementary goods, Pc income, Y advertising, A advertising by competitors, Ac size of population, N, expected future prices, Pe adjustment time period, Ta taxes or subsidies, T/S

The list of variables that could likely affect the quantity demand varies for different industries and products. The ones on the left are tend to be significant.

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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/time unit
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$/Q

 The Market Supply Curve is the horizontal sum of the firm supply curves.

Acme Inc. + Universal Ltd. = Market

The Supply Function includes Q = g( P, P , RC, T, T/S) I all variables that + + ? influence the quantity supplied

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Determinants of Supply
i. price, P ii. input prices, PI, and sometime shown as W (wages) and R (cost of capital) iii. cost of regulatory compliance, RC iv. technological improvements, T v. 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 and supply Willing & Able If No Excess in crossDemand and No hatched Excess Supply . . . Pe Then no tendency to change at the equilibrium price, Pe
P S

D Q
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Dynamics of Supply and Demand

If quantity demanded is greater than quantity supplied at a price, 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.
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Equilibrium Price Movements

P S

P1

e1
D
Q

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?
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Comparative Statics
& the supply-demand model
P

e2 e1

D
D
Q

Suppose that demand Shifts to D later this fall We expect prices to rise We expect quantity to rise as well
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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
profit GLOBAL MAX MAX

quantity B
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Average Profit = Profit / Q

PROFITS

MAX
C B

Slope of ray from the origin

Rise / Run Profit / Q = average profit

profits

Maximizing average profit doesnt maximize total profit

quantity
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Marginal Profits = /Q
Q1 is breakeven (zero profit) profits maximum marginal profits occur at the inflection point (Q2) Max average profit at Q3 Q1 Max total profit at Q4 where marginal profit is zero So the best place to produce is where marginal profits = 0.
(Figure 2.5) max

Q3
Q2

Q4

Q average profits
marginal profits

Q
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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
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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

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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
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 Most decisions involve a gamble Probabilities can be known or unknown, and outcomes 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
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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 thatpi

=1
p = .70

Strategy

States of Nature Recession Economic Boom

p = .30

Expand Plant Dont Expand

- 40 - 10

100 50
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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 Dont

Expand

Standard Deviation = =

(r

_
i

- r ) 2. pi
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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 dont = 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).
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Coefficients of Variation or Relative Risk

Coefficient of Variation (C.V.) =
C.V. is a measure of risk per dollar of expected return.

/ r.

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
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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 Prob .5 .5 X 10 20 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 23

B:

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
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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. Whats the chance of losing money?
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Realized Rates of Returns and Risk

1926-2002 (Table 2.10, page 54) Security Type Arithmetic Mean ROR Standard Deviation

Large Company Stocks

Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds Intermediate-Term Government Bonds US Treasury Bills

12.7%
17.3% 6.1% 5.7% 5.5% 3.9%

20.2%
33.2% 8.6% 9.4% 5.7% 3.2%

Inflation

3.1%

4.4%
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Which is the riskiest?

Which had the highest return?

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 3.8%. If large company stocks earn on average 12.3%, then the risk premium for this form of investment would be: 8.5%
12.3% = 3.8% + 8.5%

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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