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Chapter 17

Background Topics

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Chapter Goals

Better apply key economic concepts. Determine the contribution and regulation of major

financial institutions. Assess the advantages and disadvantages of

alternative forms of business entities. Recognize important concepts of business law.

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Demand and Supply Analysis

The amount of output produced for any commodity is a function of the demand and supply for that item.

In the simplest form, demand comes from the consumer.

For example, consider the demand for a particular type of personal computer.

A plot can demonstrate that demand varies with price; the lower the price, the greater the quantity demanded.

At higher prices consumers will substitute.

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Demand and Supply Analysis, cont.

An example of demand and supply curves are as follows:

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Demand and Supply Analysis, cont.

Supply comes from businesses seeking to make the most money possible.

The amount business will supply is a function of price; in this case, the greater the price, the greater the amount supplied.

This is true because more profits are possible, at least up to the point at which costs per unit rise and ultimately exceed the benefits of higher prices.

Equilibrium is set where quantity demanded is equal to quantity supplied.

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Inflation

Inflation: The increase in price for a given good or service or the growth of overall costs in the economy over time.

Inflation can be caused by any number of factors:– Excess of demand for a good or goods as compared with

the supply.– Increases in the cost of items needed to produce a good.– Lack of competition arising from few producers for that item

and barriers to new companies entering the market.– An excess supply of money in the economy.

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Inflation, cont.

Inflation has been present in our economy from time to time since our country was first established.

It has been omnipresent since World War II, as our government has placed more emphasis on limiting weak economic periods and maintaining high overall employment rates.

However, the rate of inflation has varied, with high rates recorded in the 1950s at the time of the Korean War and the 1970s when oil prices moved up sharply.

Inflation, particularly when it is accelerating, is a problem for our economy and for many households.

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Inflation, cont.

Inflation’s effects include:– Redistribute wealth.

Owners of large amounts of property and borrowers on fixed interest loans benefit. People on fixed incomes lose.

– Change economic behavior and bring about inefficient economic activity.

When inflation is high, consumers may purchase goods today to avoid higher prices tomorrow. Businesses may raise prices in anticipation of higher costs.

– Action by the Federal Reserve to stop the inflationary spiral. Often the resultant moves by the Fed can bring about a recession, which

limits activity relative to the economy’s potential and brings about higher unemployment.

– Increased uncertainty about the future, which can reduce the amount of long-term investment.

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Inflation, cont.

The rate of inflation is measured by:

Average inflation by decade:

Rate of Inflation

Current Price

Price in Previous Period

100

Price in Previous Period

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Inflation, cont.

Real items are figures adjusted for inflation, as follows:

Where n = number of periods

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Inflation, cont.

For example, the following table details the purchasing power of $100,000 at alternative inflation rates over time.

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Inflation, cont.

Disinflation: A period in which inflation is rising but at a rate of increase that is declining.

– Often a period of disinflation not accompanied by recession is positive for many sectors of the economy and for investments.

– The period from 1982 to 2002 was a disinflationary period. Deflation: A period in which the absolute level of prices

declines. – In many areas of the economy its effects are the opposite of

inflation’s impact. – A problem with deflation for our economy can be the reluctance

of consumers to spend money as they expect products to become cheaper in the future.

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The Business Cycle

Business cycle: The periodic ups and downs in total economic activity over time. One traditional pattern:

– Acceleration in consumer demand or other factors results in production that begins to reach capacity.

– Producers strain to put on new units of production and do so at an ever-increasing cost, boosting household income and spending.

– The economy enters into expansion which a period of two-quarter or longer increase in real overall economic output of a country.

– Prices rise to reflect the robust demand and higher costs. – Producer’s profits decline as the marginal cost to produce an

extra unit accelerates and exceeds the marginal revenues from the next unit sold.

– Higher inflation brings about a moderation in demand as the purchasing power of consumers is squeezed.

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The Business Cycle, cont.

– A peak in economic activity followed by a decline occurs. – Business capital expenditures turn down businesses lay off

workers, and real household incomes drop, leading to a further cutback in demand.

– The economy enters a recession (a two-quarter or longer decline in real overall output for the nation).

– The government attempts to influence the economy through outlays and tax cuts. Interest rates decrease as weak business conditions result in a decline in demand for funds and Federal Reserve actions increase the supply.

– The economy reaches a trough and begins to turn up. – Outlays by businesses and consumers enable the economy to

pick up its pace. – The economy continues to progress and establishes normal

growth until the next shock to the system.

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The Business Cycle, cont.

For example:

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Economic Indicators

Economic indicators: Statistics that represent where our economy, or parts of it, has been, is going, or is expected to be headed.

Gross National Product (GNP): Overall U.S. economic activity produced by U.S. businesses.

Gross Domestic Product (GDP): All activity by U.S. or foreign businesses produced solely in the U.S.

Most commonly expressed in real dollars, which is a measure of output in units.

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Economic Indicators, cont.

Average real GDP by decade:

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Economic Indicators, cont.

One common use of indicators is to attempt to forecast where our economy is headed.

The Index of Leading Indicators measures 11 factors such as:– Stock Prices.– Consumer Expectations.– Manufacturers’ New Orders.– Money Supply.– Changes in Selected Prices of Materials.– Initial Unemployment Claims.

Net progress is announced publicly and can influence decisions.

The Index can give false readings and the lead-time to actual changes in the economy can also vary.

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Fiscal Policy

Fiscal policy: The role played by government in attempting to favorably influence the course of economic activity through changes in government receipts and disbursements. Two major tools and increased spending and tax cuts.

Increased spending, through:– public works spending.– spending to improve our educational system. – increases in military programs to improve preparedness.– programs to benefit certain age and income brackets .

With increased spending, the government is relatively assured that the money will result in a change in economic output. But implementation is often delayed.

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Fiscal Policy, cont.

Tax cuts: The government can institute temporary or permanent declines in tax rates.

The expectation is that households will spend it. Advantage: The relatively brief time it takes to

implement the cut. Disadvantage: Uncertainty as to whether the

household will actually spend the money. – If the households are pessimistic about the future, they may

save the money instead. – The tax cut would then have little influence on economic

weakness at that time.

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Monetary Policy

Monetary policy: Government actions intended to influence the amount of money in circulation in the economy. Actions that the Federal Reserve can take to influence economic activity include:

– Open Market Operations: Purchase government bonds from member banks or issue government bonds.

– Changes in the Discount Rate: The discount rate is the interest rate that member banks pay the Federal Reserve for borrowing from it. A change in the discount rate signals Federal Reserve intent.

– Changes in the Reserve Ratio: The reserve ratio is the amount of money the banks have to keep in reserve for each dollar they lend.

– Moral Suasion: The Federal Reserve can signal the market through testimony before Congress, speeches in front of economic groups and well timed interviews.

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Yield Curves

Yield curve: The connection of individual points on a graph representing separate returns for one type of bond over all its maturity dates.

– Each yield curve represents only one type of bond. – The curve presents all yields based on all maturity dates for

that type of bond on the same day. Interest rates can be thought of as another

commodity, with yields established by the interaction of demand by borrowers of money and supply by lenders of capital.

The Federal Reserve has significant influence through tightening or easing the supply of money.

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Yield Curves, cont.

Yield curve for U.S. Treasury Bonds, October 2004:

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Financial Institutions

Financial institutions typically serve as middlemen between those providing funds and individuals and institutions seeking to obtain funds to use for their own purposes. Two main types of middlemen:

– Middleman that serves as intermediary without use of its own capital.

– Middleman that uses its own money in their intermediary function, thereby placing their own capital at risk.

Over recent decades the distinctions between various types of financial institutions have become blurred as individual firms have expanded and offer more than one service.

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Financial Institutions, cont.

Commercial Banks: – The largest depository institutions in the country. Commercial

banks also make loans to businesses and individuals. – Regulated by the Comptroller of the Currency, the Federal

Reserve, state bank regulators, and the Federal Deposit Insurance Company (FDIC).

Savings Banks and Savings and Loans (S & Ls): – Deposits come from money markets, savings accounts, and

certificates of deposit. Lending consists principally of mortgages, home improvement loans, and, in some cases, commercial loans.

– Regulated by the FDIC, the Office of Thrift Supervision (OTS) for federal and by the state agencies for state.

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Financial Institutions, cont.

Credit Unions:– Nonprofit organizations in which all members participate in the

benefits of the operations. – Credit unions can be established by a state or can be federally

chartered. Federal credit unions are supervised by the National Credit Union Administration, which provides guarantees for up to $100,000 for insured credit unions.

Insurance Companies:– Regulated by the states that charter them. For property and life

insurance companies, supervision and examination have been grouped together under the National Association of Insurance Commissioners. States attempt to promote insurance guarantees so that when one company goes out of business others will contribute or even assume the “book of business” of a failed company.

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Financial Institutions, cont.

Brokerage Firms:– Traditionally, a brokerage firm is a middleman offering to

help match buyers and sellers of an asset or service for a commission.

– Full service brokerage companies offer investment management, mortgage-loan, check-writing, and insurance products. It may be more appropriate to call them securities firms rather than brokerage firms.

– The Securities and Exchange Commission (SEC) is the principal regulator of the brokerage industry. It requires registration, adherence to certain practices, and it audits individual firms. The New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) also perform regulatory services.

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Financial Institutions, cont.

Mutual Funds:– Mutual fund organizations are regulated by the SEC. They

require a prospectus that, among other things, provides disclosures of conflicts of interest and guidelines on how performance is to be reported.

Finance Companies:– Provide capital in the form of loans to individuals and businesses.

They offer consumer and business loans and mortgage loans. Unlike banks, they do not take deposits and must therefore borrow monies to finance their loan offerings to others.

– May moderate their exposure to higher risk loans by requiring that the lender provide assets as collateral for the loans.

– Not closely regulated, with one exception being limitations on the maximum rate charged.

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Financial Institutions, cont.

Trust Companies:– Provide trustee services for individuals. As such they act as

fiduciaries that must place clients’ interests first. – They typically take into their possession funds in accordance

with state laws on proper actions. – Sometimes the trust services include investment

management and possibly other activities such as tax return, bookkeeping, and bill-paying services.

– Trust services may be performed for affluent individuals, children, and incapacitated people, among others.

– They offer perpetual operations that outlive the services of any one advisor.

– The services may be provided by a separate company, but are often offered by commercial banks.

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Financial Institutions, cont.

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Types of Business Entities

Individual Proprietorships:– One person runs the operation. – Advantages: Easy to form, less regulated, fewer taxes on

operations.– Disadvantages: Lack of continuity, difficulty borrowing large

sums of money, unlimited liability. Partnerships:

– Two or more persons join their individual efforts in group activities.

– Can offer economic efficiencies.– Advantages: Easy to form, less expensive to operate.– Disadvantages: Lack of continuity, difficulty borrowing large

sums of money, unlimited liability.

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Types of Business Entities, cont.

In a limited partnership structure, partners are segregated into two groups, general and limited partners.

– Limited partners do not have voting rights on decisions and are only liable for partnership losses to the extent of their investment.

– Advantage: The ability to attract into the partnership talented individuals or those with significant resources who wish to limit their risk.

In a family limited partnership, a family maintains operating control and passes on financial ownership in a family business.

The limited liability partnership (LLP) combines the limited liability feature of a corporation with the lower taxation of a partnership.

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Types of Business Entities, cont.

Corporations: A separate organization that is established by the state and is legally separate from the individuals who form it.

– Advantages include limited liability, ease in transferring ownership, the potential for unlimited life, and economic efficiencies.

– Perceived by outside investors as more stable, which can make it easier to raise material sums of both debt and equity capital.

– If publicly traded, it has the advantage of a current independently established market value and the ability for its owners to increase or decrease their ownership through transactions in the open market.

– Disadvantages: More complexity when establishing, more detailed recordkeeping, the possibility of more government taxation.

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Types of Business Entities, cont.

The corporations described above are called C Corporations by the IRS, referring to the way they are taxed.

By Subchapter S Corporation, limited liability, but profits are taxed as if the corporation were a partnership or an individual proprietorship.

– Advantage: The ability to deduct operating losses immediately on each individual’s income tax return and to reinvest in the business without double taxation.

The Limited Liability Corporation (LLC):– Combines the limited liability feature of a corporation with being

taxed as a partnership or an individual proprietorship. It can also be taxed as a corporation.

– It can be somewhat more flexible than a regular corporation and may have less paperwork to do than one.

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Types of Business Entities, cont.

PCs are professional service corporations whose benefit is to allow professionals to incorporate and take advantage of its limited liability feature. Can be sued personally for professional malpractice.

An association is a grouping of individuals or businesses that share a common interest or goal and that generally finance an organization. It is taxed as a separate entity unless the government deems it a nonprofit association, which would then provide it with an exemption from taxes.

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Types of Business Entities, cont.

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Business Law

There are three parts to a valid contract:– An Offer: Must be communicated to the other parties.– An Acceptance: Must be clear and unqualified.– Consideration: Must be lawful and engaged in by competent parties

adhering to the form required by law. A tort : An act of wrongdoing against a person or a business

or their property for which compensation is sought. Negligence: Behavior that could result in loss. Arises from

insufficient care. Four parts to a claim:– A duty was placed upon a person.– The duty was violated.– The violation caused the loss.– The loss resulted in damages.

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Business Law, cont.

A negotiable instrument must be written, signed by the maker, an unconditional promise to pay an exact amount of money, payable on demand or as agreed upon, and paid to a specific person or to anyone presenting the paper.

Professional Liability: A person who is deemed to be a professional has a standard of care that must be upheld with clients.

Fiduciary Liability: A fiduciary is a trusted party who acts as an agent for another person.

– The agent must act with sufficient capability, comply with the terms of duties given, steer clear of conflicts of interest, refrain from revealing personal information, disclose relevant data to the principal, and account for work done and its cost.

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Business Law, cont.

Arbitration is the act of transferring decision making from two or more people who are in conflict to a third party. That third-party decision is generally binding and is very difficult to appeal unless the arbitrator does not follow appropriate procedures.

Mediation is a method of handling disputes in which the mediator attempts to facilitate a resolution; unlike an arbitrator, a mediator acts as an advisor and does not have the power to render a final binding decision.

Arbitration and mediation are two increasingly popular ways of resolving disputes because they are less costly than litigation.

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Chapter Summary

Macroeconomics detailed the centrality of demand and supply for establishing prices. New equilibrium prices are an outgrowth of changes in supply and/or demand.

Fiscal and monetary policy are government’s attempts to maintain strong stable economic conditions.

Financial institutions are intermediaries that serve as middlemen between those providing funds and individuals and institutions seeking to obtain funds for their own use.

The way a business is established, whether in individual proprietorship or a form of partnership or corporation, has important effects on economic, taxation, legal, and life-cycle matters.

Understanding and complying with business legal matters such as contract terms, negligence issues, general and fiduciary liability are key factors in handling household and business matters.