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

©2008 Thomson * South-Western

Slide 1
 Demand Curves
• Individual
$/Q
Demand Curve
the greatest quantity
of a good demanded
at each price the
$5 consumers are willing
to buy, holding other
influences constant
20 Q /time unit
Slide 2
 Sam + Diane = Market
• The Market
Demand Curve is
the horizontal sum of
the individual
demand curves.
4 3 7

• The Demand
Q = f( P, Ps, Pc, Y, N PE)
Function includes - + - ? + +
all variables that
P is price of the good
influence the PS is the price of substitute goods
quantity demanded PC is the price of complementary goods
Y is income, N is population,
PE is the expected future price Slide 3
 Determinants of the
Quantity Demanded
i. price, P • The list of
ii. price of substitute goods, Ps variables that
iii. price of complementary goods, Pc could likely affect
iv. income, Y the quantity
v. advertising, A demand varies for
vi. advertising by competitors, Ac different industries
vii. size of population, N, and products.
viii. expected future prices, Pe • The ones on the
xi. adjustment time period, Ta left are tend to be
x. taxes or subsidies, T/S significant.

Slide 4
 Supply Curves
• Firm Supply
Curve - the
$/Q greatest quantity
of a good supplied
at each price the
firm is profitably
able to supply,
holding other
things constant.
Q/time unit
Slide 5
• The Market
Acme Inc. + Universal Ltd. = Market
Supply Curve is
the horizontal sum
of the firm supply
curves.

• The Supply 4 3 7
Function includes
all variables that Q = g( P, PI, RC, T, T/S)
influence the + - - + ?
quantity supplied

Slide 6
 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
S
• Superimpose demand P
and supply
Willing
• If No Excess Demand& Able
and No Excess Supplyin .cross-
.
. hatched

• Then no tendency to Pe
change at the equilibrium
price, Pe D

Q
Slide 8
 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.

Slide 9
 Equilibrium Price Movements
• Suppose there is an
P
increase in income this
S
year and assume the
good is a “normal” good
• Does Demand or Supply
P1 e1 Shift?
• Suppose wages rose,
D what then?
Q
Slide 10
 Comparative Statics
& the supply-demand model

P
• Suppose that
S demand Shifts to
e2
D’ later this fall…
D’ • We expect
e1 prices to rise
• We expect
D quantity to rise
as well
Q
Slide 11
 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 12
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 13
 Marginal Profits = /Q
(Figure 2.5)
 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 14
 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 15
 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 16
 Sources of Positive NPVs
1. Brand preferences for
established brands
5. Inability of new firms to
acquire factors of production
2. Ownership control
over distribution 6. Superior access to financial
3. Patent control over resources
products or 7. Economies of large scale or
techniques
size from either:
4. Exclusive ownership
over natural resources
a. Capital intensive processes, or
b. High start up costs

Slide 17
• 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 18
 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 19
 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 20
 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 21
 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
Slide 22
 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 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 Slide 23
 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

Slide 24
 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?
Slide 25
 Realized Rates of Returns and Risk
1926-2002
(Table 2.10, page 54)
Security Type Arithmetic Mean ROR Standard Deviation

Large Company Stocks 12.7% 20.2%

Small Company Stocks 17.3% 33.2%

Long-Term Corporate 6.1% 8.6%

Bonds
Long-Term 5.7% 9.4%
Government Bonds
Intermediate-Term 5.5% 5.7%
Government Bonds
US Treasury Bills 3.9% 3.2%

Inflation 3.1% 4.4%

 Which is the riskiest?  Which had the highest return?

Slide 26
 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.

Slide 27