Slide 1

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

Fundamental Economic Concepts

©2008 Thomson * South-Western

Slide 2

Demand Curves• Individual

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

$/Q

Q /time unit

$5

20

Slide 3

• The Market Demand Curve is the horizontal sum of the individual demand curves.

• The Demand Function includes all variables that influence the quantity demanded

4 3 7

Sam + Diane = Market

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

P is price of the goodPS is the price of substitute goodsPC is the price of complementary goodsY is income, N is population, PE is the expected future price

Slide 4

Determinants of the Quantity DemandedDeterminants of the Quantity Demanded

i. price, P

ii. price of substitute goods, Ps

iii. price of complementary goods, Pc

iv. income, Y

v. advertising, A

vi. advertising by competitors, Ac

vii. size of population, N,

viii. expected future prices, Pe

xi. adjustment time period, Ta

x. 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.

Slide 5

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

Q/time unit

Slide 6

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

• The Supply Function includes all variables that influence the quantity supplied

4 3 7

Acme Inc. + Universal Ltd. = Market

Q = g( P, PI, RC, T, T/S)Q = g( P, PI, RC, T, T/S) + - - + ?

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Determinants of SupplyDeterminants of Supplyi. 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 8

Equilibrium: No Tendency to Change

• Superimpose demand and supply

• If No Excess Demand and No Excess Supply . . .

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

D

S

Pe

Q

P

Willing& Ablein cross-hatched

Slide 9

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 10

Equilibrium Price Movements• 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?D

S

e1

P

Q

P1

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Comparative Statics& the supply-demand model

• Suppose that demand Shifts to D’ later this fall…

• We expect prices to rise

• We expect quantity to rise as well

D

S

e1

P

Q

D’

e2

Slide 12

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

quantity B

MAX

GLOBALMAX

profit

A

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Average Profit = Profit / Q

• Slope of ray from the origin» Rise / Run» Profit / Q = average profit

• Maximizing average profit doesn’t maximize total profit

MAX

C

B

profits

Q

PROFITS

quantity

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Marginal Profits = /Q Q1 is breakeven (zero profit)

maximum marginal profits occur at the inflection point (Q2)

Max average profit at Q3

Max total profit at Q4 where marginal profit is zero

So the best place to produce is where marginal profits = 0.

profits max

Q2

marginalprofits

Q

Q

averageprofits

averageprofits

Q3

Q4

(Figure 2.5)

Q1

Slide 15

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. high expected future net cash flows

2. low initial outlays

3. low rates of discount

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Sources of Positive NPVs1. Brand preferences for

established brands

2. Ownership control over distribution

3. Patent control over products or techniques

4. Exclusive ownership over natural resources

5. Inability of new firms to acquire factors of production

6. Superior access to financial resources

7. Economies of large scale or size from either:a. Capital intensive processes, or

b. High start up costs

Slide 18

• 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

States of NatureStrategy Recession Economic Boom

p = .30 p = .70

Expand Plant - 40 100Don’t Expand - 10 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 Don’t Expand

• Standard Deviation = = (ri - 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

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).

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Coefficients of Variationor 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

_

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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 X } R = 15.5 10 } = SQRT{(10-15)2(.5)+(20-15)2(.5)].5 20 } = SQRT{25} = 5

C.V. = 5 / 15 = .333B: Prob X } R = 30

.5 20 } = SQRT{(20-30)2 ((.5)+(40-30)2(.5)]

.5 40 } = SQRT{100} = 10C.V. = 10 / 30 = .333

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 = .333B: Prob X } R = 30

.5 20 } = SQRT{(20-30)2 ((.5)+(40-30)2(.5)]

.5 40 } = SQRT{100} = 10C.V. = 10 / 30 = .333

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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 25

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 26

Realized Rates of Returns and Risk1926-2002

(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 Bonds

6.1% 8.6%

Long-Term Government Bonds

5.7% 9.4%

Intermediate-Term Government Bonds

5.5% 5.7%

US Treasury Bills 3.9% 3.2%

Inflation 3.1% 4.4%

Which is the riskiest? Which had the highest return?

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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.