Chapter 2

Fundamental Economic Concepts

» Demand and Supply
• Diamond Water Paradox
» Total, Average, and Marginal Analysis
» Finding the Optimum Point
» Present Value, Discounting & Net Present Value
» Risk and Expected Value
» Probability Distributions
» The Relationship Between Risk & Return
Slide 1
 Demand and Supply Determine the Market
Equilibrium Price

• Intrinsic Value placed by demanders

• Variable costs incurred by the suppliers

Slide 2
 Demand and Supply Determine the Market
Equilibrium Price

• Intrinsic Value placed by demanders

• Variable costs incurred by the suppliers
• Scarcity

Slide 3
Intrinsic Value and Supplier’s
Costs

A B C D
Which is the Diamond???

Slide 4
 Intrinsic Value and Supplier’s
Costs

Which is the Diamond???

B

Slide 5
Scarcity

Slide 6
Diamond-Water Paradox

Slide 7
Demand Function

Slide 8
Shifts in Demand

Slide 9
Supply Function

Slide 10
Equilibrium Market Price of
Gasoline

Slide 11
Equilibrium Market Price of
Gasoline

Slide 12
Watch video on crude oil

Slide 13
• Marginal Analysis
• Net Present Value
• Risk Analysis

Slide 14
 How to Maximize Profits
• Decision Making Isn’t Free
» Max Profit { A, B}, but suppose that we don’t know
the Profit {A} or the Profit {B}
» Should we hire a consultant for $1,000?
• Should we market an Amoretto Flavored
chewing gum for adults?
» It is a complex combination of marketing,
production, and financial issues

Slide 15
Marginal Analysis

Slide 16
 Break Decisions Into Smaller Units:
How Much to Produce ?
• Graph of output profit
GLOBAL
and profit MAX
• Possible Rule:
MAX
» Expand output until
profits turn down
» But problem of
local maxima vs.
global maximum
A quantity B
Slide 17
 Average Profit = Profit / Q
PROFITS
• Slope of ray from the
MAX origin
C » Rise / Run
B
» Profit / Q = average profit
• Maximizing average
profits profit doesn’t
maximize total profit
Q quantity
Slide 18
 Marginal Profits = /Q
(Figure 2.1)
 Q1 is breakeven (zero profit)
profits max
 maximum marginal profits Q4
occur at the inflection point Q3
(Q2) Q2
 Max average profit at Q3 Q1
Q
 Max total profit at Q4 where
marginal profit is zero
average
 So the best place to produce
profits
is where marginal profits = 0. marginal
profits
Q
Slide 19
 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 20
 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. high expected future net cash flows
2. low initial outlays
3. low rates of discount

Slide 21
 Present Value of Money
• Future Value: • Present Value (PV)
= Initial Value x (1+R)t PV = FV x 1
(1+R)t
• (1+R)t is the FVIF • 1/(1+R)t is the Present
Value Interest Factor
• The initial value is the (PVIF) or also called the
value today or the discount factor
Present Value • The process of
determining Present Value
is also known as
“discounting”. The
interest is also known as
the discount rate or the
required rate of return.
Slide 22
 Present Value of Money – Example
1
Your father told you that he will entrust you with the
funds for your MBA. He gave you two options: (1)
Receive the money now in the amount of P400,000 or
(2) receive P600,000 five years from now. The
available investment opportunities to you provide a
10% rate of return. Which would you prefer?

- To address this, you can either compute for the

Future Value of the 400,000 or the Present Value of
the 600,000

Slide 23
Present Value of Money - Example
Present Value = Future Value / (1+R)t
= 600,000 / (1.10)5
= P 372,552.79
P 372,552.79 < P 400,000
*Thus, you should choose to get the money today
instead of waiting 5 years. Getting it now will give
you the opportunity to grow it at the rate of 10% per
year. The expected future value in 5 years will be
greater than P600,000. To check:
Future Value = Present Value x (1+R)t
= 400,000 x (1.10)5
= P 644,204
P 644,204 > P 600,000
Slide 24
 Present Value of Money
• A present value using the PVIF (Present
Value Interest Factors) can also be
developed and used. The PVIF will then be
multiplied to the Future Value.
• Alternatively, you can use the FVIF table
by dividing the Future Value with the FVIF.

Slide 25
 Net Present Value (NPV)
NPV = -IO + sum(CFt/(1+R)t) + (SVt/(1+R)t)
Where:
IO = Initial Outlay
CFt = Cash Flow in period t
SVn = salvage value
R = required rate of return/discount rate
t = lifetime of the project /number of periods/years

Slide 26
 Basic Application of Time Value of
Money – Example 1
• A project requires an initial outlay of P100,000. The
inflows associated with the project are P60,000 on year
1, P50,000 on year 2 and P50,000 on year 3. The
discount rate or expected rate of return is 11%. There is
no salvage value.
NPV = -100,000 + 60,000/1.11 + 50,000/1.112 +
50,000/1.113
= -100,000 + 54,054.05 + 40, 581.12 + 36,560.40
= 31, 195.57
*Since the NPV is positive, the project should be accepted.

Slide 27
Basic Application of Time Value of
Money – Example 2
Macro Inc., opened a new factory. The
construction cost is 20 million pesos. Macro Inc
intends to leave the factory open for 3 years.
During the 3 years of operation, Cash inflow are
expected to be 3 million pesos on year 1, 4
million pesos on year 2, and 7 million pesos on
year 3. At the end of the 3rd year, Macro Inc
expects to sell the factory for 15 million pesos.
Macro Inc. has a required rate of return of 15%.

Slide 28
Basic Application of Time Value of
Money – Example 2
NPV = -IO + sum(CFt/(1+R)t) + (SVt/(1+R)t)

NPV = -20MM + 3MM/1.15 + 4MM/1.152

+ 7MM/1.153 + 15MM/1.153
= 98,267
The NPV is positive thus the project will get
a green light.
Slide 29
Basic Application of Time Value of
Money – Example 2
  Year 0 Year 1 Year 2 Year 3 Total

Initial Outlay (20,000,000)        

Discount Rate/Required Rate of

Return 15%        

Cash Inflows   3,000,000 4,000,000 7,000,000  

Salvage Value       15,000,000  

PV of Cash Flows   2,608,696 3,024,575 14,465,357 20,098,627

NPV         98,627

Slide 30
 Exercise D - NPV
Your barkada is planning to set up a food stall inside your
village. You plan to sell fish balls, squid balls, soft drinks,
etc. You will be needing P50,000 capital. Your estimate of
the earnings for the next four years are:
Yr 1: 20,000
Yr 2: 25,000
Yr 3: 25,000
Yr 4: 30,000
At the end of the 4th year, you plan to sell your equipment
at P10,000. Your required rate of return is 10%. Will you
pursue this business?

Slide 31
 Sources of Positive NPVs
• Brand identify and • Difficulty for others to
loyalty acquire factors of
• Control over production
distribution • Superior financial
resources
• Patents or legal
barriers to entry • Economies of large scale
or size
• Superior materials
• Superior management

Slide 32
• 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

Slide 33
 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 =1
States of Nature
Strategy Recession Economic Boom
p = .30 p = .70

Expand Plant - 40 100

Don’t Expand - 10 50
Slide 34