PRODUCTION, SAVING, AND TIME OPTIMAL INVESTMENT

Production cannot occur without prior saving Downward-sloping demand curve for investment (individual industries)
➢ Because production takes time ➢ More is invested when the opportunity cost of borrowing is lower
• During which goods and services are not Investment demand curve for the entire economy
available from current production ➢ Downward sloping
➢ Production needs capital
➢ Producers can also borrow funds
CONSUMPTION, SAVING, AND TIME OPTIMAL INVESTMENT

Consumers Market economy: specialization and exchange

➢ Have a positive rate of time preference ➢ Purchase capital with borrowed funds
➢ Willing to pay more to consume now Firms buy new capital goods
• Impatience ➢ If they expect this investment to yield a higher return than other
• Uncertainty possible uses of their funds
➢ Interest Expected rate of return on capital
• Reward for postponing consumption ➢ Expected annual earnings divided by capital’s purchase price
Market interest rate
Positive rate of time preference ➢ Opportunity cost of investing in capital
➢ Consumers value present consumption more than future ➢ The marginal cost of investing in capital
consumption Maximize profit
➢ People must be rewarded to postpone consumption ➢ Increase investment as long as expected rate of return > market interest rate
➢ Explained by impatience and uncertainty
Interest rate
➢ Interest per year as a percentage of the amount saved or
borrowed
THE VALUE OF A GOOD IDEA: INTELLECTUAL PROPERTY Enforcing property rights is costly
➢ Diminished incentive to create new products
Intellectual property Pirated videos, music, computer games, software
➢ Intangible assets created by human knowledge and ideas ➢ No royalties to artists
➢ Costly to create ➢ No wages to industry workers
➢ Once created, can be reproduced at low cost ➢ No profits to producers, programmers
Patent ➢ No taxes to government
➢ Establishes property rights to an invention or other technical Between 2000 and 2014,
advances ➢ Music-industry revenue dropped 50%
Copyright Sharing music files: not a victimless crime
➢ Confers property rights to an original expression of an author, ➢ Since 2000, more than one-fourth of music industry workers lost their
artist, composer, or computer programmer jobs
Trademark Most musicians
➢ Establishes property rights in unique commercial marks and ➢ Earn more from touring than from recordings
symbols Economic development across the globe
Intellectual property ➢ Affected by the way society nurtures
➢ Intangible asset that fuels the digital economy • Incentives to create new ideas
• Artistic creations • Inventions

THE MARKET FOR LOANABLE FUNDS MARKET INTEREST RATE

Demanders of loans Loanable funds market

➢ Entrepreneurs borrow to: ➢ Savers (suppliers of loanable funds)
• Start firms ➢ And borrowers (demanders of loanable funds)
• Invest in physical and intellectual capital ➢ Come together to determine
• Increase investment until expected marginal rate of return = • Market interest rate
market interest rate • Quantity of loanable funds exchanged
➢ Households borrow to:
• Increase present consumption
• Invest in human capital
DEMAND FOR LOANABLE FUNDS SUPPLY OF LOANABLE FUNDS
Supply of loanable funds
Demand for loanable funds ➢ Banks and other financial institutions are financial intermediaries
➢ Negative relationship between market interest rate and quantity ➢ Positive relationship between market interest rate and quantity of
of loans demanded savings supplied
➢ Declining marginal rate of return ➢ Other things constant
➢ Other things constant • Expected rate of inflation
• Prices of other resources; Technology • People’s retirement plans
• Expected rate of inflation; Tax laws
• Customs and conventions of the market
 WHY INTEREST RATES DIFFER PRESENT VALUE AND DISCOUNTING
• Prime rate • Present value
➢ Interest rate lenders charge their most trustworthy business ➢ The value today of income to be received in the future
borrowers • Discounting
• Collateral ➢ Converting future dollar amounts into present value
➢ Asset pledged by the borrower Present value of payment one year hence
• Can be sold to pay off the loan in the event the borrower defaults ➢ Amount received one year from now divided by (1 + interest rate)
• Term structure of interest rates ➢ The higher the interest rate
➢ Relationship between the duration of a loan and the interest rate • The more any future payment is discounted
charged • The lower its present value
• Risk Present value, PV, for payments in later years
➢ The more valuable the collateral, the lower the interest rate ➢ Present value of M dollars received t years from now is M divided by
• Duration of the loan (1+ interest rate) t
➢ Interest rate increases with the duration of the loan • Receive M dollars
t
• Administration costs as percent of loan • t years from now PV = M / ( 1 + i )
➢ Decrease as size of the loan increases • Interest rate I
• Tax treatment ➢ PV smaller for higher t
ENTREPRENEURSHIP Present value of an income stream
Entrepreneur ➢ Is the sum of present value of each receipt
➢ Comes up with an idea
➢ Turns that idea into a marketable product
• Obtains the financial capital needed to start or expand the
business
• Brings together the necessary resources to produce and
market the product
➢ Accepts the risk of success or failure
➢ Residual claimant: claims any resulting profit or loss
Entrepreneur Annuity
➢ Must have the authority to hire and fire the manager ➢ A given sum of money received each year for a specified
➢ Drives the economy forward number of years
• New products, improve existing products Present value of an annuity
• New production methods ➢ Perpetuity – if continues indefinitely
• New ways of doing business ➢ Present value of receiving M dollars each year forever is M
Not entrepreneurs divided by the interest rate
➢ Corporate inventors; managers; stockholders ➢ =M /i
CORPORATE FINANCE RETAINED EARNINGS
Corporation is a legal entity Retained Earnings
➢ Owned by stockholders ➢ After-tax corporate profit reinvested in the firm
Liable only to the extent of their investment in the firm ➢ Rather than paid to stockholders as dividends
➢ May own property ➢ Help the firm grow
➢ May earn profit
➢ May sue or be sued
➢ May incur debt
➢ May be found guilty of a crime
CORPORATE STOCK CORPORATE BONDS

Corporations fund investment Corporations acquire funds by

➢ Issue and sell stock ➢ Issuing stock
➢ Retain some of their profits ➢ Retaining earnings
➢ Borrow ➢ Borrowing
Initial public offering, IPO Bond
➢ Initial sale of corporate stock to the public ➢ Certificate reflecting a firm’s promise
Corporate stock • To pay the lender periodic interest
➢ Certificate reflecting part ownership of a Corporation • And to repay the borrowed sum of money on the designated
Corporations pay maturity date
➢ Corporate income taxes on any profit ➢ Less risky to own than are stocks
➢ Dividends to shareholders ➢ Risks
Dividends • Corporate bankruptcy
➢ After-tax corporate profit paid to stockholders • Higher market interest rate
➢ Rather than retained by the firm and reinvested Corporations
➢ Issue more bonds when interest rates are low
• Because their interest payments on those bonds will be low
 SECURITIES EXCHANGE Exchanges
Securities exchange ➢ Enhance the liquidity of securities
➢ Secondary market for securities ➢ Hedge funds
➢ Regulated by SEC, Securities and Exchange Commission •Complex strategies to invest for institutions and for wealthy
New York Stock Exchange clients
➢ Largest securities market in the world ➢ Determine the current market value of the corporation
➢ Trades the securities of about 2,800 major corporations • Share price times the number of shares issued
• Including about 500 non-U.S. companies • The share price reflects the present value of the discounted
stream of expected profit

Major U.S. exchanges Crowdfunding

➢ More than 5,000 corporations ➢ Raising money from many people through an online platform
Network of brokers, over-the-countermarket ➢ Kickstarter
➢ Another 10,000 corporations Economists talk about investing
Publicly traded corporations ➢ Purchases of new capital
➢ Traded on major exchanges and over the Counter • New machines and new buildings
6 million much smaller corporations When the media talk about investing
➢ Not publicly traded ➢ Usually mean buying stocks and bonds
➢ Shares are individually owned by families or just a few stockholders
21 million sole proprietorships
3 million partnerships

The 15,000 publicly traded corporations

➢ Are just a fraction of 1 percent of all businesses
➢ Account for the overwhelming share of employment and sales in the U.S.
Institutional investors
➢ Banks, insurance companies, and mutual funds
➢ Account for most of the trading volume on major exchanges
➢