INTRODUCTION: WHAT IS ECONOMICS, ANYWAY?

What is economics? I remember when I took my first economics class back

in the 1970's. The definition the instructor gave was the "allocation of
scarce resources among competing ends." I remember saying, "what did he
say?" I admit, too, that it took me some years to both understand and
appreciate this definition. I sometimes get the strong impression that
college professors write more to other professors than they write to the
readers. Fortunately, most texts today use a somewhat less stilted
definition by stating that economics is the study of how people allocate
their limited resources to try and satisfy their unlimited wants. This
definition is not bad, but I have one that I think is better. Economics
is the study of how people make choices. That sounds simple enough, you
may say, but aren't many disciplines concerned about how people make
choices? Yes, that is true, but what separates economics from other
disciplines are two words: "rational" and "incentive." Economics makes
the assumption, which some view as quite strong, that people gather all
relevant information before making a decision; they use the information
to make the best possible forecast; and while the forecasts will
inevitably have at least some error (no forecast is really perfect), the
error is random. (The last statement may be translated as "you can fool
some of the people some of the time but not all the people all the
time.") These three points make up the economist's notion of rationality.

By incentive, it is implied that everything has a "price," whether

explicitly or implicitly. To make the story short, the tendency on the
part of people is to want to buy something at the lowest possible price,
earn as much income as possible, and when the first two are a problem, to
get a loan at the lowest possible interest rate. In other words,
everybody every day, every minute, every moment must make a choice, and
economics says that people are moved to choose the option the greatest
gain. What better way of gauging the gain than by checking the so-called
"price"?

An elegant and personal favorite way for me to sum up this discussion is

to say that EVERYTHING in life can be expressed in terms of "return to
risk." I like to call this the "finance side of economics." In other
words, everything, and I mean everything, carries some risk (including
coming to class) and people will take on the risk if the return (or
reward) at least compensates for the risk. Who wants to take on risk if
there is no return? In this sense, the risk represents the "price"
effect: everything carries a price. Translated again, you can't get
something for nothing. People may tell you otherwise but they are, in a
word, WRONG!

There are two other unique features about economics. Both follow from the
discussion so far. One is called "opportunity cost," or what you must
give up in order to get something -- call it the "tradeoff" from the
position you have taken. It can be thought of in Shakespearean terms: "To
be or not to be." Whichever position you take, you must bear the
tradeoff. As an illustration, let's say that it is Friday evening, and
all that you have in your pockets, in addition to some loose change, car
keys, and two pages of notes from the class you skipped yesterday, is
$10.00. What will you do? Let's say you decide to buy two slices of
pizza, a small soda, and see a movie. As soon as you do that, you
effectively sacrifice, say, a large (cheese) pizza and a liter of soda.
In other words, to get one thing, you must give up something else. This
is what opportunity cost is all about. Economics claims that rational
people search for choices that have the lowest opportunity costs. In
other words, you can either maximize your gains, as expressed the second
paragraph, or minimize your regrets, as expressed in this paragraph. If
in the end, the higher (lower) the opportunity cost of doing something,
the less (more) likely it is that you will do it.

To express opportunity cost in terms of return to risk, you can say that
the higher the opportunity cost, the higher the risk is, all else equal.
The only way you will take on higher risk is if there is higher return,
which implies compensation for the higher opportunity cost of making a
particular move. To be specific, you could buy stock in New Jersey's own
Honeywell (headquartered in Morristown), with a return to risk of about
1.60. In doing so, however, you might be giving up the opportunity to
invest in Intel, whose return to risk is about double that. So the cost
of investing in Honeywell may well be higher than you realize.

The other feature about economics is its emphasis on a five-letter word

that all of us must face: "change." This is what "marginal analysis." is
all about. No, marginal doesn't mean of "little or slight importance" but
the idea that a change in one thing will cause a change in something
else. In other words, truly no one is an island. For example, if you
lower the price of a car, all else equal, people will become more
interested in buying it. Note how lowering the price of the car is the
same as "changing" the price. In economics, the "change" is more
important than the "average" because change affects the average. Think of
this along the lines of grade point AVERAGE. Increases (decreases) in GPA
are achieved by adding additional grades, which occur when you take
additional courses. The key lies in the CHANGE.

Speaking of GPA and education, economics emphasizes the input-output

relationship: without input, you get no output. For example, study time
is an input. Without it, you can't realistically hope to get any
knowledge, the output. Other resources, as expressed in texts, are
"labor" (i.e., people's talents in producing goods and services, from
automobiles and computers to education and medical care), land (i.e., all
raw materials, raw land, water, and trees), capital (i.e., physical
capital, such as machinery, warehouses, and diesel locomotives), and
entrepreneurship (i.e., a showy word, implying the ability to move from
an idea, something intangible, to output, something tangible; in two
words, "risk taking.") All resources are used as "inputs," which everyone
needs to produce output (whether the output is steel, pizza, or
knowledge). Once again, you can't get something for nothing; no input, no
output. If you can, you don't need this course and I'm out of a job.

In addition, while inputs are needed to produce output, the way the
inputs are used counts for a lot, too. In other words, how efficiently do
we use our inputs? All else equal, the faster you get the right output
with the inputs you are using, the more efficient you are. There are
several kinds of efficiency. The one I just mentioned is called
"technical" efficiency, which is line with minimizing opportunity cost.
There is also one called "allocative" efficiency, or producing what
people want at prices they can afford, as reflected by market behavior.
To sum efficiency up for a whole nation, ask the following question: Is
it possible to make one group better off without making another group
worse off? If so, then the economy is not doing things efficiently.

This introduction would not be complete without mentioning that we will

go over two kinds of economics, micro and macro. Microeconomics is
concerned about the behavior of individuals, such as consumers and
businesses. Questions such as "what will happen when a local bakery
lowers the price of bagels by 15%?"; or what "what will happen to airline
fares with a rise in terrorism?"; or "what is the impact on housing of
higher mortgage rates?" are microeconomic in nature. On the other hand,
macroeconomics is concerned with the "big picture," such as employment,
inflation, money, federal budget deficits, international trade, and
exchange rates. Questions such as "what is worse, unemployment or
inflation?"; or "by how much should the Federal Reserve System increase
M2?"; or "do budget deficits lead to higher interest rates;?" are
macroeconomic issues. Regardless, an entire economic system -- at both
micro and macro levels -- is designed to address three issues: what to
produce, how to produce, and for whom to produce.

MICROECONOMICS

I. DEMAND AND SUPPLY: THE MOTHER OF ECONOMIC TOPICS

This topic is one, I believe, that everyone is, in various degrees,

familiar with: demand and supply. They are a driving force behind market
systems. It is through demand and supply that price and output -- whether
for food, clothing, housing, cars, computers, legal services, wages,
salaries, tuition, books, etc -- are determined. There is probably not
any concept in economics that gets more attention. In fact, the concept
is so pervasive that I am willing to bet (how about dinner for everyone
if I'm wrong?) that at least some of you have already been formally
exposed to demand and supply analysis, in one way or another. The
interaction of demand and supply reflects "market" behavior, or the
bringing together of buyers and sellers. As you may well know, the
worldwide trend in the last decade has been for nations to pursue
market-oriented systems; that is, those that allow for the determination
of price and quantity (bought and thus sold) by the interaction of demand
and supply. However, I'm getting ahead of myself, so let me pause here
and get down to the basics.

To reduce things to the irreducible (at least as far as I'm concerned),

on the demand side, remember four things: demand (i.e., a definition),
the "law" of demand, the demand curve, and shifts in the curve. On the
supply side, remember four things: supply (i.e., definition), the "law"
of supply, the supply curve, and shifts in the curve.

Now, back to two paragraphs ago, bringing together the concepts of demand
and supply allows us to arrive at two things: a market clearing price and
a market clearing quantity. [By "clearing" in this sense, I mean a
situation in which the amount of something demanded (e.g., pizza, soda,
cars, jeans, etc.) just equals the amount of the good or service
supplied.] That is, the interaction of demand and supply leads to an
equilibrium price and quantity. Think of it along the lines of a
restaurant that makes just the right number of "specials of the day" at
the price offered -- neither too much left over nor requests that go
unsatisfied. (Isn't it disappointing when you order the "special" and
you're told that they are out of it?)

A. Demand

Let's now discuss each of the above, beginning with demand. Demand is the
amount of a good or service that people are willing and able to buy at
various prices at a given point in time. By "willing," we really mean
what people "want," "need," or "something that people have a taste for,"
and "able" refers to "income" or "what people can afford." You may want a
Rolls Royce (personally, I would sell it if I ever got one) but if you
can't afford one, then you are NOT part of the market for this car.
Similarly, if you have the income to buy one but you don't care for them,
you are NOT part of the market for this car.

Let's turn to the "law" of demand. (Note: I'm inclined to express "law"
this way because it really isn't a law or an absolute truth.) Stated
simply, the "law" says that the amount of a good or services demanded is
inversely related to its price. Translated, if the price of the good or
service goes down (up), all else equal (there is that phrase again), the
amount bought will increase (drop). To make sense of this, go back to
chapter 1 and just remember "rationality" and "incentives." If there is
something you want (dinner? a date? a new car?), the "law" says that as
the price of it drops (increases), you will be buy more (less) of it,
holding taste and income constant. (PLEASE NOTE: A COMMON ERROR MADE BY,
YES, EVEN ECONOMISTS, IS THAT THE LAW IS A RELATIONSHIP BETWEEN DEMAND
AND PRICE. DEMAND is not the focus here but the AMOUNT demanded, or
QUANTITY DEMANDED. In other words, the focus is on HOW MUCH of something
you will buy, and that is influenced by its price. The relationship is
between PRICE and QUANTITY DEMANDED, NOT demand. DEMAND and QUANTITY
DEMANDED are TWO DIFFERENT concepts.) Is this clear? If not, please see
me right away.

Let's now turn to the demand curve. This is a set of points showing how
the price of a good or service is related to the amount demanded for it.
In other words, the demand curve is really a statement about the "law" of
demand. So, and this is a KEY point, overlooked and, yes, even by
economists, the "law" of demand reflects the movement up and down a given
demand curve, period. In other words, when price changes, the amount
demanded will also change. NOTE the word CHANGE from section one; that
is, marginal analysis. At this stage, the focus is on the fact that price
and quantity move inversely with each other; we really aren't going to
get into the degree to which this holds. That is a topic for chapter
five.

Let's now turn to shifts in the demand curve. There are five things that
can shift it, either right or left: changes in (1) taste, (2) income, (3)
number of buyers, (4) expectations, and (5) prices of related goods and
services. The first three are pretty clean and self-explanatory. If
people's taste or need for a good or service increases, if their incomes
increase, or if the number of buyers of it increases, then the demand
curve shifts to the RIGHT. If any or all decrease, then the demand curve
shifts to the LEFT.

Expectations can be slippery and have to be looked at on a case by case

basis. Nonetheless, when the snow storm of '96 was approaching, people's
expectations of being snowed in were strong, so they rushed to the
supermarkets to get plenty of food. In effect, the demand for food
increased during the days up to the storm, which translates to a shift in
the demand curve for food to the RIGHT. As another example, when a
company reports strong earnings and revenue growth that exceed investors'
EXPECTATIONS, the demand for the company's stock increases (especially if
the company is optimistic about the company's future for upcoming
quarters. The result is a shift to the RIGHT in the demand curve for the
company's stock and an increase in its stock price.

Fifth and finally, let's turn to prices of related goods and services.
There are two categories here: SUBSTITUTES and COMPLEMENTS. While these
categories may seem simple and straightforward, they can be rich and
subtle. As a rule, if the increase (decrease) in the price of good x
(say, Pepsi) leads to an INCREASE (a decrease) in the amount bought of
good z (say, Coke), then these goods are considered substitutes. As a
result, the demand curve for COKE (not Pepsi) shifts to the RIGHT. On the
other hand, if the increase (decrease) in the price of Nathan's hot dogs
(and I dislike hot dogs of ANY kind) leads to a DECREASE (an increase) in
the amount of Coke purchased, then the goods would be considered
COMPLEMENTS and the demand curve for COKE (NOT Nathan's hot dogs) would
shift to the LEFT. The relationships are subtle, so please be careful.

Note the emphasis on "decrease" and "increase." This is all about

"change" and marginal analysis. Remember, too, that as the price of
something increases (in the above example, Pepsi), the cost of what you
must give up increases as well. This is the opportunity cost. In
addition, rising and falling prices provide "signals" and "incentives"
for doing one thing as opposed to something else, as long as one is
"rational."

To sum up the discussion on demand in an equation, we can state the

following:

qd(x) = f(T,I,#buyers,EXP,POGS), where qd(x) is the quantity demanded for

good/service x; T is taste; I is income; #buyers is the number of buyers;
EXP is expectations; and POGS is prices of other goods and services.

B. Supply

Let us now turn to supply, the counterpart to demand. As we mentioned,

with supply we will look at four categories: a definition, the "law" of
supply, the supply curve, and shifts in the supply curve. Supply
represents the amount of a good or service that people are willing and
able to provide at various prices. "Willing" means inputs or resources;
"able" means technology, or a way of doing things. The "law" of supply is
based on incentives and says that as the price of a good or service rises
(falls), the tendency for sellers will be to provide more (less) of it,
ALL ELSE EQUAL. Think of it this way: Do you know anyone who owns a
profit-making business who really enjoys having to lower prices?
Businesses, as a rule, lower prices reluctantly (generally in response to
competition). As with the law of demand, the law of supply is dealing
with a relationship between the AMOUNT of a good or service supplied and
its PRICE, decidedly NOT the relationship between supply and price. This
can be slippery and sensitive, so be careful.

The supply curve is just a picture of the law of supply, or a set of

points that shows the relationship between the price of a good or service
and the AMOUNT of it supplied. Unlike the demand curve, the supply curve
is UPWARD sloping.

Five things can shift the supply curve: changes in (1) input prices, (2)
technology, (3) the number of sellers, (4) expectations and (5) prices of
related goods and services.

If input prices FALL, if technology IMPROVES, if the number of sellers

RISES, if EXPECTATIONS of future performance are RISING, and if the
prices of related goods and services FALLS, then the supply curve for the
good or service in question shifts to the RIGHT. If input prices RISE, if
technology DROPS OFF, if the number of sellers FALLS, if EXPECTATIONS of
strong future performance are DECLINING, and the prices of related goods
and services RISES, then the supply curve shifts LEFT. Here is a quick
illustration. In the early 1980's, IBM dominated the personal computer
market. During the 1980's, however, technological improvements, an
increase in the number of sellers, and an increase in expectations of
greater future performance in personal computers shoved the supply curve
for personal computers to the right in a big way. IBM, however, decided
to give up on this market and concentrate on mainframes, at the time a
more profitable area. In retrospect, this proved to be a huge mistake,
because as the PC market continued to expand, the mainframe market
contracted. The result, expectedly, was that IBM got clobbered, posting
large losses by the early 1990's. Its stock price dropped from over $130
in January of 1989 to $44 by July of 1993. At that time, the shareholders
of "Big Blue" were indeed feeling blue.

As with demand, we can sum up the supply curve with the following
equation:

qs(x) = f(IP,TECH,#sellers,EXP,POGS), where qs(x) is the amount supplied

of good/service x; IP is input prices; TECH is technology; #sellers is
the number of sellers; EXP is expectations; and POGS is the prices of
other goods and services.

Now we can put together both curves. REMEMBER! A MARKET CONSISTS OF BOTH
CURVES, not just one or the other. For instance, whoever heard of a
"scissor"? You need both blades to cut the paper. When both curves are
used, we can now say something about price and quantity of the good or
service in question.

Rule 1. At the intersection of the curves, there is the determination of

a market-clearing price in which QUANTITY demanded equals QUANTITY
supplied, NOT demand equals supply. Where the curves come together is
usually referred to as "equilibrium" price and quantity.

Rule 2. When the demand curve shifts right or left, you can say something
definite about what will happen to both the price and quantity (demanded
and supplied). (Note: When the demand curve shifts, it is moving along
the supply curve, invoking the law of supply.)
Rule 3. When the supply curve shifts right or left, you can say something
definite about what will happen to both the price and quantity (demanded
and supplied). (Note: When the supply curve shifts, it is moving along
the demand curve, invoking the law of demand.)

Rule 4. When the demand and supply curves both shift either to the right
or left you can generally say something definite about quantity but not
about price. The final price will depend on the magnitude of the shifts
in the curves.

Rule 5. When the demand curve shifts in one direction and the supply
curve in the other direction, right or left, you can generally say
something definite about price but not about quantity. The final quantity
will depend on the magnitude of the shifts in the curves.

Rule 6. When the price is set ABOVE the intersection of the curves
(sometimes referred to as a price "floor"), a surplus results; that is,
quantity supplied exceeds quantity demanded (NOT supply exceeds demand).

Rule 7. When the price is set BELOW the intersection of the curves
(sometimes referred to as a price "ceiling"), a shortage results; that
is, quantity demanded exceeds quantity supplied).

II. ELASTICITY: IT IS ALL RELATIVE

It's time to move to a called "elasticity." You may want to think of it

in the following way. Sure, we say that the "law" of demand holds, but to
what degree? For some goods, such as hot dogs, an increase in their price
may bring a large decrease in the amount of hot dogs bought, because
people will substitute other food for hot dogs, such as hamburgers,
tacos, chicken sandwiches, roast beef sandwiches, pizza, salads, and the
like. However, increases in the price of other goods will bring much
smaller decreases in the amount bought. These goods, such as electricity
and insulin, have few, if any, substitutes.

The above illustrations are references to what is called "price"

elasticity of demand. There are other elasticities of demand, such as
"cross" elasticity, which deals with substitutes and complements, and
"income" elasticity, which is concerned, of course, with income. For the
finance people, there is an elasticity that security traders call
"delta," which deals with the relationship between a security's price and
its option's, or derivative's, price.

ANY elasticity is measured as follows: the percentage change in one

variable divided by the percentage change in another variable, as
follows:

Price elasticity of demand:

percentage change in quantity demanded of good/service x divided by the
percentage change in the price of x

Cross elasticity of demand:

percentage change in quantity demanded of good/service x divided by the
percentage change in the price of y
Income elasticity of demand:
percentage change in quantity demanded of good/service x divided by the
percentage change in income

Price elasticity of supply:

percentage change in quantity supplied of good/service x divided by the
percentage change in the price of x

For our purposes, the values each of the elasticities take on have
significance, as follows:

Price elasticity of demand:

greater than 1, "elastic;"
equal to 1, "unitary"
less than 1, "inelastic"

Cross elasticity of demand:

greater than 0, "substitutes"
less than 0, "complements"
equal to 0, "no relationship"

Income elasticity of demand

greater than 0, "normal"
less than 0, "inferior"
greater than 1, "elastic"
less than 1, "inelastic"

Price elasticity of supply:

greater than 1, "elastic"
equal to 1, "unitary"
less than 1, "inelastic"

Of all these elasticities, the big one is price elasticity of demand. It

is used in a wide variety of situations, from assessing the impact of
advertising to measuring the degree of market power in court cases
involving lawsuits of anticompetitive behavior (Note: The U.S. has laws
designed to insure the operation of demand and supply forces. Thus,
collusion among businesses to fix prices, form monopolies, and engage in
deceptive practices is illegal.) Price elasticity of demand also has a
fascinating relationship with (sales) revenue, or the price of an item
multiplied by the number of items bought (note that this is NOT the same
as profit, since costs have not been accounted for). If price elasticity
of demand exceeds 1, a business can raise revenue by lowering prices.
Why? An elasticity greater than 1 implies many substitutes for the good
or service in question. So, lowering prices leads buyers to purchase a
lot more of the good or service because they substitute away from similar
goods or services. As you would guess, just the opposite happens when
such a business raises its prices; in short, it loses lots of customers.
In fact, revenue is at a maximum when price elasticity of demand just
equals 1.

Both price elasticity of demand and price elasticity of supply have

interesting implications for taxation. Ask yourself the following
question: which kinds of goods do governments tax? Thinking about an
answer, you may discover that things like cigarettes and liquor are
usually taxed and at high rates. On the one hand, governments claim that
these kinds of goods are "sins," and therefore the taxes are "sin" taxes
designed to reduce buying of these items. Don't take this logic too far,
because governments know that they can tax these kinds of goods and
generate lots of tax revenue. Why? At least in the short run, there are
few, if any, substitutes for these goods, so people will pay the higher
prices and governments will get their revenue. If governments were to tax
hot dogs, you would avoid them by buying hamburgers, chicken, tacos,
pizza, and salads in their place.

In light of these illustrations and applications, we can now go over the

variables that influence elasticity of demand: (1) the number of
substitutes, (2) the proportion of one's budget that good or service
takes up, and (3) time. In short, the more (fewer) substitutes, the
greater (lesser) the proportion of one's budget the good or service takes
up, and the more (less) time there is, the larger (smaller) price
elasticity of demand will be.

III. UTILITY: DO WE KNOW WHAT WE WANT?

I really don't care for the word "utility" in this context but I guess
we're stuck with it. It means "pleasure," "satisfaction," or "happiness."
Regardless of which term you choose, it serves as the foundation of
demand. In other words, your demand for something is based your
preference for it. The stronger your preference, obviously the stronger
will be your demand for the good or service. In my view, there are
several interesting things about utility. One is concerned with
advertising. Economics assumes that people's preferences are not easily
altered; that are tastes are pretty much fixed, short of some kind of
shock (e.g., a study showing that Spam on white bread reduces the risk of
heart attacks...yeah, right!). Marketing assumes that the tastes are not
fixed and can be altered, usually easily, by the right advertising
strategy. In other words, the goal is to get people to switch to a
particular good or service by trying to change (manipulate?) consumer
tastes (some cynical marketers talk about playing mind games with
people). Not all advertising strategies work well; some are flat out
failures. One that comes to mind is Zima, an advertised substitute for
beer. Obviously, the advertising was never able to move drinkers from
beer to Zima (whatever Zima is, or is that "was"?). Another one is Pepsi
Crystal, a soda that was clear but not of the Seven-Up genre. It lasted
about six months, if that long, on the market. I also remember the
disaster that Coca Cola suffered when it switched from its secret recipe
to a new one. Traditional Coke drinkers were up in arms over that one.
The point is that it is all about trying to change consumer preferences
from one good to another. You can link this to elasticity of demand. In
short, a business wants to see an expanding market for its product along
with a low price elasticity of demand for it. That way, as consumer
preferences for the product grow, consumers will be slow to substitute
away from the product.

However, consumers have their limits. If a business charges too much,

they will substitute away from it, at least to some extent. The point is
that tastes are one thing, but how much one buys will be influenced by
two variables: price and income. Given your preferences, the lower the
price, the more of it you will buy. Does this sound familiar? If people
have more income, they can buy more, too (no kidding!). In fact, we can
take this further. As you get more and more of a particular good or
service, given a certain period of time, additional amounts of the good
or service will add less and less satisfaction. Think of it this way.
Just how many bagels are you going to eat for breakfast? You will
probably have no more than two, given the price charged for bagels. In
fact, in economics we claim that the only way you will take on additional
amounts of a good or service, given a particular time, is if the price is
lowered. Otherwise, more of the good or service is simply not worth it.
This concept of preferences, amounts, bought, and price can be expressed
formally as follows: you will buy more of something as long the benefit
(i.e., the additional satisfaction, pleasure, or happiness) is greater
than the additional cost (i.e., what you have to pay for it). This may be
expressed as follows:

MU(a)/P(a) = MU(b)/P(b) = MU(c)/P(c) = ...

In words, given one's preferences, one is in equilibrium when you buying

the amounts of goods and services that maximize satisfaction across the
entire basket of goods and services.

IV. PRODUCTION AND COSTS: YOU CAN'T GET SOMETHING FOR NOTHING

So far we've been concerned primarily with the consumer and the demand
curve. Yes, I know we have talked about sellers, such as with respect to
the supply curve, the law of supply, the determinants of supply, price
elasticity of supply, and so on; however, behind every supply curve is a
four-letter word: cost. Behind every cost is a ten-letter word:
productivity. These two topics are, in a nutshell, what chapter 8 is all
about. In fact, as you will see, you may assert that there really is no
such thing as a theory of cost, only a theory of production. What does
this mean? Stay tuned.

Keep in mind a simple but profound relationship: you can't get output
without input. For example, if you want to understand something about
business, you have to do some work. In other words, knowledge (output)
depends on ability and study time (inputs). At General Motors, automobile
output depends on four fundamental inputs that we discussed earlier:
labor from the United Auto Workers, capital such as buildings, robots,
and assembly line equipment, land to put the building on and for parking
lots, and entrepreneurship, or the risk taking necessary to design and
build a car. Without any of these inputs, output is, in word, zero. This
relationship between output and inputs is called a "production function."

In textbooks, output is usually referred to as "total product." The

addition to total product, or output, due to, say, the addition of one
more worker is called the "marginal product of labor." (Yes, here's
"marginal analysis" again.) If it were one more machine, it would be the
"marginal product of capital." The marginal side is to be differentiated
from the "average" side. For instance, total product, or output, divided
by the amount of labor is called the "average product of labor." What
does all this have to do with anything? In a word, it's all about
productivity. If a company isn't productive, it won't be able to get as
much as possible out of its inputs. That means waste or, more formally,
inefficiency.

There is an interesting relationship between "marginal" and "average"

that goes like this: as both marginal and average products increase, the
marginal product intersects the average product at the maximum of the
average product. In other words, when the marginal is above the average,
the average rises; when it's below, it falls. Consider something sacred,
like your GPA. If this semester's GPA is above your overall GPA, it pulls
your overall average up. If it is below your overall GPA, it pulls the
overall GPA down. The same is true with productivity. If this year's
labor productivity at General Motors is higher than average productivity
per worker during the past ten years, then the marginal change will pull
the overall average up; if it's below, it will pull it down. Remember
this, too: in the short run, as a company hires more workers, holding
everything else fixed, beyond some point the ADDITION to total product,
or output, will decline. Once again, we have the law of diminishing
returns.

More subtle is the relationship between productivity and cost. At a given

wage rate, as the marginal and average products of labor rise, the
marginal and average costs of labor fall. Thus, simply because someone
gets an increase in pay doesn't necessarily mean that labor costs are
rising. It all has to do with the pay relative to productivity. The vast
majority of people who are highly paid are so compensated because of
their high productivity. When people mention that a corporate CEO isn't
worth a million dollars a year, I always respond that that depends on
productivity. Highly productive people are generally worth every cent
paid to them. The same applies to other inputs, such as capital, land,
and entrepreneurship. To reinforce what we have just said, you're going
to pay more for a highly productive (and efficient) computer, since it
can help you reach decisions faster and more accurately than its
alternatives (e.g., people punching numbers into adding machines.)

The relationship between productivity and cost is nicely summed up as

follows:

cost = input price/productivity.

Thus, the cost per day per worker is the worker's daily pay divided by
the worker's daily productivity. The more (less) productive a worker is,
all else equal, the less (more) costly it is to employ her/him.

To extend all this out logically, output or total product drives total
cost, which can be split into two components: Fixed costs plus variable
costs. Fixed costs are strictly short-term (one year or less) and can't
be changed, such as renting or leasing a building, lawyers fees, contract
costs, etc. Variable costs are costs that can be readily changed, such as
hiring and laying off workers, turning machines on and off, buying and
selling land, and opening and closing factories. And guess what? These
total costs have marginal and average components. The addition to total
costs due to producing more output is called "marginal cost." Total cost
divided by output is called "average cost." Average (total) costs can be
split into two components: average fixed cost and average variable cost.
Remember, too, that we're dealing in the short term. In the long run,
everything is variable.

Expectedly, we can link our marginal and average costs directly to

productivity. In short, the more productive the inputs, all else equal,
the lower will be the marginal and average costs. In fact, you may want
to state that there really is no such thing as a theory of cost, only a
theory of production, because in the end it's all about productivity,
which is linked directly to efficiency, which can come about through an
incentive-based system. Recall at the beginning of the semester: it's all
about incentives.

V. MARKET STRUCTURE: WHO HAS THE BIGGEST (ECONOMIC) MUSCLES?

A. Competition: Who Can Stand the Heat?

This time the discussion is on one of the driving forces behind markets:
competition. In the purest of cases, competition means (1) many buyers
and sellers, none of whom can influence price; (2) businesses in the
market produce a standard good that has no distinctive features from one
seller to the next; and (3) there are no barriers to entry the market,
such as big investment outlays, licenses, special financing, skills, etc.
In other words, in a purely competitive market, anyone can take advantage
of a profitable opportunity, and to do so, the person needs to produce as
much as possible. The best illustration, in my view, for pure competition
is the stock market. In fact, stock market behavior is based on one more
assumption: that information is freely available to everyone. These
competitive characteristics lead to what is referred to in finance as the
"efficient markets hypothesis." In a nutshell, it says that it is
systematically impossible to beat the market's return to risk. In other
words, the only people who get rich quickly from stock investing are the
truly lucky ones, similar to hitting the jackpot in a lottery or at a
casino. We'll have more to say about this later.

Under pure (sometimes called "perfect") competition, the market sets the
prices. You can take them or leave them; you just can't influence them.
Moreover, as we will also see graphically, the short run equilibrium for
such a company is -- guess where? -- where marginal revenue equals
marginal cost. In fact, with pure competition, price and marginal revenue
are equal, because price is taken as set by the market. The seller who
tries to sell above the market price loses customers big time; the seller
sells below the market price finds, unfortunately, that profits will be
significantly reduced and in the long run is forced out of the market.
Much of this is more easily shown with pictures (i.e., graphs). Sometimes
the graphs look a bit complicated, and, in a way, they are; however, they
just amount to putting together the tools we have already used, from
demand and supply to production and costs. Here are some important points
to remember:

1. Prices are set by the market; no seller (nor buyer) has influence over
them.

2. The price of the output = marginal revenue = marginal cost.

3. The shut-down point is when price falls below minimum AVC.

4. The short-run supply curve for the firm is its marginal cost curve
(above minimum AVC).

5. Excess Profits may be earned in the short run but not the long run.

6. In the long run, the output price equals the minimum point on the ATC
curve, which also where the MC curve intersects the ATC curve.

7. The point at which P = MR = minimum ATC = MC is a social ideal in

which both allocative efficiency (i.e., producing what consumers want)
and technical efficiency (i.e., producing at the lowest possible unit
costs). Textbooks usually call this the point at which "marginal social
benefit = marginal social cost." While you probably need to remember this
statement, I prefer saying that "we're doing the very best we can." You
won't find this outcome in any other market structure, least of all
monopolies, like the bookstore on campus.

There are other aspects, such as whether the industry is one of constant,
increasing, or declining costs (these are related to input purchases and
the production function) but the above represent the major points.

B. Monopoly and Its Cousins: What Every Business Owner Dreams About

At the broadest of levels, keep in mind a simple but descriptive

statement: (market) structure determines conduct and performance. Conduct
means the behavior of the business, such as price setting. Performance
implies profits. Put simply, monopoly means a single seller, a lone
producer. Every business dreams of being a monopoly because, as it name
implies, it's the only game in town. Consumers must buy from it;
otherwise, they go empty-handed. Thus, the monopolist is a "price maker"
-- it sets the price -- unlike its competitive counterparts that are
"price takers" -- they are subjected to strong market forces. In short,
monopolists can get away with charging high prices. The punch line, and
its predictable, is that the monopolist can earn extraordinary profits,
even in the long run, something that is just about impossible in a
competitive environment. The best examples of monopolies include utility
companies, such as PSE&G and Consolidated Edison; however, there are
various near-monopolies that have much the same effect, such as Intel
with computer chips, pharmaceutical giants Merck and Pfizer with patents
on drugs, and the international oil cartel OPEC (i.e., the Organization
of Petroleum Exporting Countries). In addition, monopolies exist in
various degrees. Take, for example, airline pricing. On major routes with
many carriers, say between Newark and Florida, fares can be quite
reasonable, reflecting the competition of numerous airlines. However,
where competition doesn't exist, a single airline can easily get away
with doubling or tripling the fare and over a much shorter distance. From
a social standpoint, compared to pure competitors, monopolists charge
higher prices, produce less output and at higher unit costs than their
competitive firms; in short, they are, in general, allocatively and
technically inefficient. As a result, they tend not to do a good job of
allocating resources. So while every business would love to be a
monopoly, every consumer would hate it. To show this convincingly, I need
to use a picture, and I can't quite do it in this space. So stay tuned.

The same conclusion about inefficiency, though to a smaller degree, holds

for two other forms of "impure" (imperfect) competition: oligopoly and
monopolistic competition. Oligopolies involve a few sellers, all of whom
have some influence over price but at the same time, unlike monopolists,
have to watch what the competition is doing. A good illustration of
oligopoly, although not as good as it was twenty years ago, is the U.S.
auto industry, as represented by General Motors, Ford, and Chrysler. For
years, General Motors was the price leader among the three. Every year it
would come out with a set price increase for automobiles, with Ford and
Chrysler following suit within the next two weeks. If the industry were
more competitive, this would never have occurred. In any case, abnormal
profits may be earned in both the short and long runs. This is because
the market, while certainly more competitive, is sufficiently shielded
from competition due to barriers to entry. There aren't any really good
pictures for oligopolies, so we may have to get by without one.

Under monopolistic competition, we have a combination of monopoly and

pure competition. While firms have some influence over price, their
products differ only slightly, actually being somewhat artificial, such
as in packaging, advertising, and location. Good illustrations include
supermarkets, pizza restaurants, and video stores. Also, think of
location, since location -- like curb appeal in the housing market -- can
be "everything." Malls, with their variety of clothing, book, and
specialty stores, represent a good illustration of monopolistic
competition, since one store tends to feed off another store. Abnormal
profits can be earned in the short run but the competitive aspect insures
that such profits are not possible in the long run. Once again, a picture
here may be worth many words, so I'll hold off until I draw one for you.

VI. EPILOGUE

You have just experienced a brief and quick rundown of microeconomics,

and how brief and quick it was! If I had to boil it down to the basics,
remember the roles played by incentives, as represented by price,
opportunity cost, return to risk, and market forces. Remember, too, that
there are two sides to market forces, the demand side -- consumers and
their ability and willingness to buy goods and services -- and the supply
side -- businesses and their willingness and ability to produce goods and
services. Ultimately, the price charged and quantity produced will be
strongly influence by the market structure; that is, whether the industry
in question is competitive or not. The more (less) competitive the
industry, the lower (higher) the price that will be charged, and the more
(less) output there will be.

MACROECONOMICS

It's time for the macro countdown, so let's "face the music and dance."
What is macroeconomics? It is a branch of economics concerned about the
behavior of the "summations of microeconomics." In other words, rather
than looking at how individuals (i.e., people, businesses, and
governments) behave, we will explore how an entire economy behaves, from
bad times (i.e., recession and inflation) to good times (i.e., growth
without inflation). Thus, our topics will include unemployment,
inflation, spending, money, interest rates, exports, and imports. In yet
more other words, rather than examining the market for, say, cars, as we
might do in microeconomics, we look at the sum total of all markets for
all goods and services. Ideally, all microeconomic behavior should sum to
all macroeconomic behavior. But you know what? It doesn't. In fact,
theoretically and empirically, macroeconomics is "looser" -- perhaps
"messier" is a better word -- than microeconomics. There is much more
discussion, debate, and disagreement about macro issues than micro ones.
Some may feel disheartened by this, but I see it as an area ripe for new
ideas (and let's hope ones that are better than supply-side economics!
But more on that later.)

I. UNEMPLOYMENT AND INFLATION: TWO ECONOMIC MISERIES

Let's begin with two of the biggest, if not the biggest, problems facing
macroeconomies worldwide: unemployment and inflation. Generally, it's one
or the other; however, there are times when both rear their ugly heads at
the same time. In fact, as late as 1980, U.S. politicians and policy
makers focused on something called the "misery" index, which was the sum
of the unemployment and inflation rates in the U.S. It was not unheard of
to have an unemployment rate at 8% with an inflation rate of 11% (with
the sum of the two equaling 19%). Regardless, let's begin with
unemployment, defined as those out of work who are looking for a job.
Note that it's not enough to be out of work; you also must be looking for
a job. There are some strict rules that the government uses in deciding
if someone is indeed unemployed. I'll talk about those in class. The
unemployment rate is calculated by taking the number of unemployed and
dividing by the civilian labor force, which consists of the employed
(e.g., working at least one hour a week for pay) plus the unemployed
(e.g., looking for work and available for work). If you're not looking
for work, you're not part of the equation. There is also a natural rate
of unemployment, which sits at around 5.5% in the U.S. This is the rate
of unemployment considered to be a measure of "full" employment. Yes, I
know, how can it be full employment if the unemployment rate is so high?
This is a tough question, but I do have an answer. It lies within the
various types of unemployment: seasonal, frictional, cyclical, and
structural. "Seasonal" is due to the seasons of the year (e.g.,
unemployment in agriculture during the winter months or unemployment at
ski resorts during the summer months). "Frictional" is when one is
between jobs. Having the right skills isn't the problem; it's finding the
right job (with the right pay, of course). "Cyclical" is more serious. It
has to do with the "ups" and "downs" of an economy, especially the
"downs." The more severe the economic downturn, the worse this kind of
unemployment gets. When I lived in Indiana, cyclical unemployment could
be severe in the auto industry, a dominant industry in northern Indiana.
Yet cyclical unemployment is not the worst. This unfortunate
classification is reserved for the "structural" category. When one is
structurally unemployed, one does not have marketable skills (OUCH!).
Keep in mind that this need not mean that one does not have skills. One
may be quite skillful in a particular area, such as in astronomical
physics; however, there may be no demand for what one offers. Structural
unemployment is the primary contributor to the high unemployment rate at
full employment. The lesson here is that specialization has its
tradeoffs, and they can have severe repercussions.

In moving from unemployment to inflation, we need a definition of

inflation: an overall increase in the average level of the prices of all
goods and services in an economy. Inflation is more subtle than
unemployment. Unemployment robs you of your pocketbook; inflation slowly
eats a hole in your pocket. (Its opposite, deflation, represents a
decline in the average level of all prices.) In other words, inflation
eats into the purchasing power of your income. It has a way of fooling
people into believing they are richer than they are. Some would claim
that a reason, at times, for high unemployment is because economies let
inflation get out of hand, and eventually they must "reign in" inflation.
And when they do, unemployment is inevitable because the only way to stop
inflation is to reduce spending, or stepping hard on the economy's brake,
if you please. Inflation has a number of deleterious effects. For one, it
hits people on fixed incomes hard. If you are getting much of your
income, say, from bonds, the purchasing power of your income declines
over time as inflation continues its march. So if you are getting, for
example, $3000 a month from interest on bonds, inflation will "eat away"
at the ability of that $3000 to buy goods and services. To further
clarify, one dollar today buys about $.21 of what it bought in 1970. See
what I mean? Thus, in a span of about a quarter of a century, the $3000
in income has fallen in purchasing power to about $700. I know of no one
who wants to be a member of this "700 club"! To circumvent this problem,
the elderly, because of their political clout -- yes, unlike many of us,
they vote! -- were able to get their social security payments tied
directly to the CPI. I wish I were so fortunate. In turn, that's caused
quite a drain on the social security system.

Besides people on fixed incomes, inflation erodes an exchange rate, or

the value of one currency against another. It's little wonder why
Mexico's peso went from 25 pesos per dollar in 1982 to 2700 pesos per
dollar by 1990 when one notices that inflation jumped from around 7%
there in the late 1970's to over 100% by the mid-1980s. Still yet another
problem with inflation is that it benefits borrowers over lenders. The
lender gets to pay off a loan in cheaper currency, especially when the
inflation is unexpected. And yet another problem is that inflation
distorts decision making. Because inflation clouds the long term, people
tend to make only short-term investment and production decisions, such as
land and precious metal (e.g., gold and silver) speculation, and shun
long-term commitments, such as building plants or setting up savings
plans.

There are three measures of inflation: CPI (Consumer Price Index), PPI
(Producer Price Index) and the GDP price index (usually referred to as
the GDP deflator or implicit price deflator). The CPI is for consumer
prices only; the PPI is for producer prices; and the GDP index is for
goods and services that make up GDP. One of the important functions of a
price index is to serve as a means of seeing if your income is "keeping
up" with the overall rise in prices. If it's not, then you're losing out
-- the purchasing power of your income is dropping and you're getting
poorer. If your income growth is outpacing inflation, good for you --
you're getting richer. How does this work? For example, if you were
earning $40,000 in 1984, how much would your income have had to increase
to have kept pace with the CPI? The answer is about 60%; that is, your
income would have had to increase to $64,000 just to keep from getting
poorer. Many individuals have not been so fortunate, which is what the
discussion over the disappearance of the middle class is all about. How
did I get 60%? The U.S. Department of Commerce tracks the prices of
thousands of different products and services, and for the CPI, those
bought by the "typical" consumer. The department chooses a base year and
sets it equal to 100, and then compares the prices of these typical goods
and services to this base year number. So if the prices of all these
goods and services climb during the year by 8%, the CPI increases to 108.
In equation terms, [(108 - 100)/100]*100. If there is an increase by 3%
in the following year, the index would have increased to 111.24 (i.e.,
108 times 1.03).

There are generally two kinds of inflation, that which originates from
increases in demand (which deals with more spending) and that which
originates from decreases in supply (which deals with higher production
costs). The first is called demand-side (or demand-pull) inflation; the
other is called supply-side (or cost-push) inflation. If spending, for
example, is driving prices higher, the issue is one of demand. If higher
energy prices, for example, are curtailing production, the issue is one
of supply. Of the two, demand-side inflation is more prevalent.

II. MONEY AND THE FEDERAL RESERVE SYSTEM: WHERE THE POWER IS

Now be careful. The vast majority -- and I mean 99.5% of the population
-- technically use money as a synonym for income. In other words, people
say things like "I could sure use more money," or "I got to get some
money." What they really mean is "income," or payment for services
rendered. Money is simply a means of payment for the income. More
precisely, money is anything generally acceptable as a means of payment.
Think of it as a lubricant. It cuts down on the friction of transactions.
Imagine, for a moment, that you have worked all day at a Colonel Sanders
chicken restaurant. Your payment is not in terms of dollars or pounds or
shillings or drachmas or riyals or rupees or francs or deutsche marks or
... but in terms of fried chicken. In fact, for all the hard work you've
done that day, the company gives you not just two buckets of chicken but
six! And to make matters worse, you are a vegetarian. And assume this
happens every day. What are you going to do with all that chicken? How is
chicken going to buy you clothes or pay the rent or purchase gasoline for
your car? In short, you're going to have to find someone who is willing
to trade each of these items for the chicken you have; not an easy task.
What we have just described is what is called "barter," where money
doesn't exist. All exchanges are item for item; there is no "go between,"
the fundamental function of money. Note how clumsy transactions can
become. There has to be a better way, and that "way" is money. Its
fundamental function is to serve as a "medium of exchange" (i.e., the "go
between"). It also serves as a "unit of account" (i.e., measurement),
"store of value," (i.e., savings), and "standard of deferred payments"
(i.e., loans). Money has evolved from coins to paper to checks to cards
and soon to electronic labels over the Internet. Once again, it's
anything that society accepts as payment. What backs up money? Is it
gold? Is it silver? Is it land? To each question, as you probably know,
the answer is "no." What backs up money is a five-letter word, "faith."
Perhaps "confidence" is the better word. Nothing supports it except
people's belief that others will accept it in place a another good or
service.

How do we measure money? In the U.S., we have various measures of money:

M1, M2, and M3. They differ by their degree of liquidity, or the ease
with which an asset can be converted to a medium of exchange. The easier
it can be done, the more liquid the asset is and the closer it is to
being money. M1 contains the most liquid components: currency, checkable
deposits (e.g., NOW accounts, ATS accounts, etc.) and traveler's checks.
M2 contains M1 plus highly liquid and small savings (e.g., passbook
savings, money market funds, and certificates of deposit) plus overnight
Eurodollars plus overnight repurchase agreements. M3 is M2 plus highly
liquid and large savings (e.g., jumbo certificates of deposit) plus term
repurchase agreements and term Eurodollars. There is a fourth, somewhat
obscure category called "L." It contains M3 + U.S. savings bonds, U.S.
Treasury bills, commercial paper, and bankers' acceptances. Note that as
we move from M1 to L we move further from the money market and closer to
the capital market (e.g., stocks and bonds).

Who controls M1, M2, M3, and L? In other words, who is in charge here? Is
it the President? Does Congress have the authority? Is it the Securities
Exchange Commission? Is it the U.S. Treasury Department? It is the
Federal Reserve System, the nation's central bank. Here is, in my view,
where the REAL power is. The impact of the bank (usually referred to as
"the Fed," decidedly NOT the "feds" -- this is not about drug-running) is
felt worldwide, from interest rates and exchange rates to financial and
goods markets (i.e., stocks, bonds, cars, housing, etc.). But what do we
know about the Fed? It's made up of four components: Board of Governors,
Federal Open Market Committee, Federal Advisory Council, and the twelve
regional Federal Reserve Banks. The real power lies with the Board, whose
power extends to the Open Market Committee. These two components make all
the big decisions (i.e., how much to change M1, M2, and M3, how much
change interest rates, whether or not to allow banks to merge, etc.). The
Board is made up of seven members, currently four men and three women.
The Open Market Committee contains these same seven members plus five
members from any of the twelve regional Fed banks. This committee decides
by how much to change M1, M2, and M3. They do this through the purchase
and sale of U.S. Treasury securities. This function is called "open
market operations." The Federal Advisory Council is no more than a
"jawboning" committee; it has no power. It's made up of the presidents
from each of the twelve banks. The committee offers opinions as to the
direction of monetary policy (i.e., determining by how much to change M1,
M2, and M3). The twelve banks are located in the following cities:
Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago,
St. Louis, Kansas City, Minneapolis, Dallas, and San Francisco. Of these,
the big one -- where the greatest assets are and where open market
operations take place -- is in New York.

III. GDP ACCOUNTING

(OR HOW DO WE KNOW WHAT IS HAPPENING, AND DO WE?)

In microeconomics, everything is easily measured, from the number of cars

and liters of soda to the weight of steel and slices of pizza. Such is
not so easy in macroeconomics. How do we come up with an easily
understood and computed estimate across such different categories. In
other words, how do we lump together slices of pizza with the number of
cars? Here is where money does its magic. With money and the market
system, we can impute value to goods and services. This is money's role
as a unit of account. We know that a slice of pizza runs about $1.50, and
1000 slices is $15,000. One new car can cost $23,000. By adding these two
numbers, we arrive at $38,000. Ah, now we have what we want. In fact, the
$35,000 is nothing more nor less than Gross Domestic Product (GDP), the
sum of all final goods and services produced in an economy during any
particular period.
One way of measuring GDP is to sum up all final expenditures, a follows:

GDP = C+I+G+(X-M), where C is consumer spending, I is investment

spending, G is government spending, X is exports, and M is imports.

Consumer spending makes up about 67% of GDP. Investment spending makes up

about 18%. Government spending contributes approximately 17%. Net exports
(i.e., X-M), have typically been negative in recent years.

GDP, in inflation-adjusted terms, is one of the most widely watched

statistics on the health of an economy. I say "adjusted for inflation"
because in every GDP figure there is a price effect and an output effect.
We want the "output" effect because it is the real thing. In fact, you
will find that GDP adjusted for inflation is often called "real GDP." But
GDP isn't the only measure. There are at least three others of interest:
national income, personal income, and disposable personal income.
National income, in real terms, is perhaps our best measure of aggregate
economic activity. It is not weighted down by the excess baggage of
excise taxes and depreciation, both of which are buried in GDP and do not
represent output. Perhaps the better way of looking at national income is
to think of it as the sum of all earned income: wages, salaries, rent,
interest, profits, capital gains, dividends, and royalties. Personal
income is a measure of earned plus unearned income, where unearned income
represents government transfer payments, such as social security income,
unemployment compensation, and welfare payments. The last one, disposable
personal income, is personal income minus taxes. The current U.S. GDP
figure (in 1987 dollars) is approximately $6.2 trillion. For national
income, it is about $5.2 trillion; for personal income, $5.4 trillion;
and for disposable personal income, $4.5 trillion. By keeping our eye on
these statistics, we can gauge the direction of an economy.

If the figures indicate decline, we know the economy is heading into a

recession; if they show large, rapid jumps, we know that inflation may
soon be a problem. It all depends on where the economy is along the
business cycle. If the economy is sunk in a serious recession (sometime
called a "trough" in the business cycle), such as those of 1981-82 and
1973-74, we know that there is a lot of room for an economy to recover.
If, however, an economy is already producing near full capacity
(sometimes called a "peak" in the business cycle), big jumps in spending
signal an overheated economy.

How do we represent these troughs and peaks? Would you believe we use
demand and supply curves? If so, take a bow. We have what are called
aggregate demand and supply curves. They look like the microeconomic
demand and supply curves. They differ by the labeling of the axes, as I
will try to demonstrate in class. They also shift for different reasons
than in microeconomics. The demand curve shifts due to changes in
consumer and business confidence, money (e.g., M1, M2, and M3),
government spending, taxation, and preferences for the home country's
goods and services as opposed to another country's goods and services.
The supply curve shifts for reasons of changing costs, whether for
agriculture, labor, or energy. For example, a jump in consumer confidence
tends to shift the demand curve to the right, while a jump in oil prices
shifts the supply curve to the left.
IV. MORE ON MONEY (YES, SOMETIMES THE GLITTER DOES MEAN GOLD)

How does the amount of money in the economy change? There are two ways
this happens. One is through the banks. In short, a single bank can
affect the quantity supplied of money by the amount of its EXCESS
reserves, whereas the entire SYSTEM of banks can affect the quantity
supplied of money by a MULTIPLE of excess reserves (where excess reserves
are reserves minus required reserves, and where required reserves are
obtained by multiplying the reserve ratio by reserves, and the reserve
ratio represents the percentage of reserves that a bank must keep idle
(i.e., either as vault cash or deposits with the Federal Reserve bank in
its district) -- whew! The key variable is loans. Whenever you deposit
funds, the bank looks for ways of earning income from those funds. Their
bread and butter are loans. Thus, your deposit, although it is payable to
you on demand, has been loaned to someone else, who now has more money
than she had before. As she spends the proceeds, they become other banks'
deposits. And it is no secret what those banks are going to do with the
deposits. This brings us to something called a money multiplier.

The money multiplier is sometimes defined as 1/rr, where rr is the

reserve ratio. We can expand this formula to 1/(rrd+rrs+nec), where "rrd"
is the reserve ratio on checkable deposits, "rrs" is the reserve ratio on
savings deposits, and "nec" includes all other leakages (e.g.,
withdrawing cash from your account). The formula can be interpreted as
follows: For every one dollar change in excess reserves, by how much will
the quantity supplied of money change? If the multiplier were 3, then the
quantity supplied of money would change by $3.00.

How does all this get started? Where is the spark? The "striker" -- if
you please -- is the Fed (or any central bank, for that matter). There
are three tools the Fed works with to change M1, M2, and M3: changes in
the reserve ratio, changes in the discount rate, and changes in open
market operations. The reserve ratio was defined above. The discount rate
is the rate of interest that the Fed charges banks on short-term loans (a
rate not to be confused with the prime rate, the federal funds rate, the
CD rate, the T-bill rate, the commercial paper rate, the call money rate,
the Eurodollar rate, etc.) Open market operations deal with the Fed's
buying and selling of U.S. Treasury bills (often called "T-bills").

Of the three, open market operations are the most widely used. If the Fed
wishes to INCREASE the quantity supplied of money, it can do so three
ways: REDUCE the reserve ratios, REDUCE the discount rate, and BUY U.S.
Treasury bills. If the Fed wishes to REDUCE the quantity supplied of
money, it can INCREASE the reserve ratios, INCREASE the discount rate,
and SELL U.S. Treasury bills. (Of the three, increasing the reserve
ratios is the one that the Fed least uses.)

The above is concerned with the quantity supplied of money. But as we

well know, there has to be a demand side to all this. And guess what --
there is. The quantity demanded for money can be divided into three
fundamental components: transactions, precautionary, and speculation. The
quantity demanded for transactions is DIRECTLY related to REAL income.
The more (less) real income there is, the more (less) money people
demand. The quantity demanded for speculation is INVERSELY related to
interest rates. The HIGHER interest rates rise, the LESS the incentive is
to hold money (and the more the incentive is to hold bonds). The LOWER
interest rates fall, the GREATER the incentive is to hold money (and the
less the incentive is to hold bonds). Note that the speculative demand
for money is referring to speculation in money and capital markets, from
U.S. Treasury bills to bonds and stocks. Altogether, there is a money
market here, which can be easily represented by a picture. I shall show
you this in class, so stay tuned.

V. SCHOOLS OF THOUGHT: SHOULD WE TRY TO DO SOMETHING ABOUT

BUSINESS CYCLES (OR WHY ECONOMISTS CAN'T AGREE)?

A. Keynesian View (Don't Just Stand There; Do Something!)

The above discussion takes us to the following important topic: Can we do

something about business cycles? Should we do something about business
cycles? The Keynesian (pronounced CANESian) position is that we CAN and
SHOULD do something about business cycles. Second, there is the Classical
position that says we CANNOT and that it is NOT worth trying to. From
there, we can take a deeper look into both positions GRAPHICALLY. The two
positions may be distinguished by looking at the supply curve. For
Keynesians, it has a "backwards-L" shape (with the "elbow"), suggesting
that economies can get stuck in recessions for long periods. The
Classical supply curve is vertical -- no elbows -- suggesting that prices
and wages will adjust to any imbalance. (YES, TO CLARIFY, I SHALL SHOW
YOU SOME PICTURES IN CLASS.) For example, if an economy begins to move
into recession, prices and wages will drop in response to the excess
production and excess labor at the macroeconomic level (remember the role
of incentives). The Keynesian counterpoint is that prices and wages won't
drop much; instead, output is cut and labor is laid off. This observation
is what leads to the elbow shape in the Keynesian supply curve. In other
words, prices and wages may be inflexible (or "sticky") downward.

To examine the Keynesian position more closely, remember one thing: it is

spending that drives an economy. To show this, we turn to an unusual
graph based on a 45-degree line. In short, this graph represents a
decomposition (i.e., a dissecting) of aggregate demand into C+I+G+(X-M),
which says that equilibrium income/output (e.g., real national income,
real GDP, etc.) equals the sum of all spending (e.g., consumer spending,
investment spending, government spending, and exports minus imports). In
other words, businesses will produce as long as there is demand for goods
and services, and the demand can arise either from domestic sources
(i.e., C+I+G) or from foreign sources (i.e., X). Only when the spending
line crosses the 45-degree line is there equilibrium (i.e., Y=C+I+G+X-M).
Below the equilibrium point, there is too little production; above the
point there is too much production. In the end, though, the KEY lies in
getting the economy to full employment without inflation, no small task.
As a result, if recession is a problem, get the Fed to INCREASE the
quantity supplied of money. The quantity supplied of money will expand
via the money multiplier, creating excess reserves and leading to a drop
in interest rates. The drop in interest rates leads to an increase in
spending (and as we will see, by a spending multiplier amount), and an
increase in real national income and aggregate demand. The result is an
expanding economy and lower unemployment.

If inflation is the problem, get the Fed to reduce the quantity supplied
of money. The money multiplier effect kicks in, reducing excess reserves
and raising interest rates. The result is less spending, a decrease in
aggregate demand, and lower inflation, and we hope without increases in
unemployment.

From here, the discussion will move to a few equations and multipliers
based on "marginal propensities." To give you a glance at the equations,
we have the following with familiar notation:

C=$400+0.90Y

I=$100+0.05Y

G=$100

X=$50-0.05Y

Y=C+I+G+X-M

0.90 is called the "marginal propensity to consume" (MPC): the addition

to consumer spending due to an addition to income (i.e., how much you
spend every time you get one more dollar of income).

0.05 in the investment equation is called the "marginal propensity to

invest" (MPI): the addition to investment spending by a business due to
an addition to business income

0.05 in the net export equation is called the "marginal propensity to

import" (MPM): the addition to (actually subtraction from) net exports
for each addition to income. This one is "slippery." As income rises,
people buy MORE imports, which reduces net exports (or exports -
imports). Note the negative sign in front of 0.05.

Solving for Y, we get $65000. In other words, Y=C+I+G+X-M=$6500.

Spending multiplier = 1/(1-MPC-MPI+MPM) = 10. Think of a multiplier as

"splash and ripple effects," measuring the change in aggregate output
given a change in spending.

There is also a fiscal side, government spending and taxation (G and T).
According to Keynesian thinking, during a recession, there should be an
increase in G and a reduction in T. If consumers and producers won't
spend more, then maybe the government can. (Once again, spending drives
an economy.) During inflation, you would have exactly the opposite;
namely, reduce G and increase T.

However, government proceeds to finance the spending do not grow on

trees. There are two ways to finance government spending: raise taxes or
sell bonds (just like a corporation sells bonds). Normally, the approach
is to sell bonds; it is quieter and more politically palatable than
raising taxes. Note that the agency of interest here is NOT the Fed but
the U.S. Treasury Department. The money supply does NOT change.

Bond-financed government spending, as opposed to tax-financed spending,

has its own issues. One is something called the "crowding-out" effect. It
can be described as follows. When the federal government sells more
bonds, it competes with all other borrowers (e.g. consumers) for people's
savings. The increased competition, or increase in the DEMAND for money,
pushes up interest rates. The result chokes off private spending. That
is, the increase in government spending eventually leads to a decrease in
private spending via higher interest rates. The decrease may either
partially or fully offset the increase in government spending. If it
fully offsets the increase, then fiscal policy is useless.

The other issue is the public debt, an accumulation of all the deficits.
A deficit occurs when government spending exceeds taxation. Associated
with the debt are a number of issues. First, while the U.S. may not be
"going broke," the debt must be financed, sooner or later, by higher
taxes, which will likely fall on future generations. Second, up until the
last five years, payments on the debt were the fastest growing component
of government spending. Third, you have the potential crowding-out
effect. Yet, the problems may not be intractable when considering that
future generations do benefit from today's government expenditures (e.g.,
highways, parks, etc.). Moreover, most of the debt (80%) is owed to
ourselves. Finally, the measurement of the debt and its impact may be
exaggerated, especially since the federal government doesn't have a
balance sheet (i.e., it doesn't keep a record of its assets).

B. Alternatives: Monetarism and Rational Expectations

(Don't Do Anything; Just Stand There!)

Monetarism, a sub-school of Classical thought and one that believes that

a central bank should just "stand there and do nothing" out of the
ordinary. With Monetarism, there are five propositions and two
conclusions.

Here are the propositions:

1. Money is the dominant influence on economic activity.

2. In the short run, changes in money can influence output and

employment.

3. In the long run, changes in money can influence only the price index.

4. Economies are basically stable.

5. There is no such thing as a Phillips curve (i.e., a tradeoff between

inflation and unemployment).

Here are the conclusions:

1. By itself, fiscal policy doesn't work.

2. The best thing a central bank can do is to increase the quantity of

money by a steady percent (e.g., M2 by 3%) annually and do nothing more.

Remember, too, that Monetarists embrace a "quantity theory of money" that

says that money and prices are proportional to each other; for example, a
10% increase in M2 will drive prices up by 10%.

Third, we have Rational Expectations. It believes in the following two

propositions and two conclusions:

First we have the propositions:

1. People are rational; they gather all relevant information about a

decision and use it intelligently (i.e., they make the best possible
forecasts/predictions from the information). People cannot be
systematically fooled; that is, you can fool some of the people some of
the time but not all the people all the time.

2. Markets clear, which means that prices and wages are flexible up and
down and that all unemployment is voluntary.

Now we have the conclusions:

1. The only policy that works is the one that surprises people.

2. The best thing that can be done is for the central bank to increase
the quantity supplied of money by a steady amount annually, just like the
Monetarists.

All this sounds fine; however, what about some evidence? In the U.S., up
until the last five years, the Fed's record wasn't great. On numerous
occasions in the last 60 years, the Fed has done the wrong thing, either
raising or lowering the quantity of money (e.g., M1) when it should have
done the opposite. Assuming the Fed is comprised of competent individuals
(let's hope!), we must then conclude that the economy is too complex for
the Fed to actively manage. And there may be reasons for this, such as
the observation that money has a variable-lag effect on the economy
(i.e., data lags, recognition lags, implementation lags, and impact lags)
and that the Fed -- or any central bank -- is rarely sure by how much
money should be changed.

VI. ECONOMIC GROWTH (OR ARE WE TOO BIG FOR OUR BRITCHES?)

For the last twenty-five years, the U.S. has had a tough time expanding,
at least by previous standards. As evidence, economic growth -- growth in
real GDP -- averaged about 3.7 percent from 1948-1973. Since then, growth
has expanded at a rate of about 2.3%. To understand the implications,
from 1948 to 1973, the so-called economic pie doubled in size about every
twenty years. Now it takes about 31 years. Now perhaps you see why some
analysts have been worried about the number of "have-nots" in society and
the dwindling size of the middle class. To make matters worse, there has
been stagnation in worker productivity for over twenty years, and we do
not know why. In fact, we are not all that sure what will increase
economic growth back to at least 3%. You may think of this as trying to
find ways to shift the aggregate supply curve permanently to the right,
leading to higher output and lower prices, but what are these ways and
how are they brought about? No doubt the U.S. needs to increase savings
and investment for the future, but how does one do that? What incentives
can be offered to increase them? You probably need to shock people into
saving more, such as eliminating (but gradually) the social security
system, but what politician has the guts to do this? Explaining why
economic growth has slowed and figuring out what to do about it have been
big puzzles for economists and are likely to remain so.

VII. INTERNATIONAL TRADE AND FINANCE:

(YES, THERE IS LIFE OUTSIDE NEW YORK)

We have not forgotten the international side of things. The two topics of
primary interest here are trade and exchange rates. Countries trade,
obviously, so that they will be better off. They have one or more things
that other countries would like to have. The other countries, of course,
have to have something to offer. The U.S., for example, can trade wheat
and corn for imported cars; Saudi Arabia can trade oil for computers; and
Columbia can trade coffee (no, not crack) for medical supplies. But what
explains who will produce and trade what good or service? There are two
concepts here: absolute advantage and comparative advantage. Absolute
advantage refers to trade that occurs because of endowments, such as the
Canadians growing wheat, the Saudis pumping oil, and the Chileans mining
copper. But most trade takes place through comparative advantage, or
trade based on opportunity cost. In simpler words, a country should
specialize in what it can do well and trade for what it cannot. For
example, rather than have New Jersey specialize in car production, leave
that to Michigan, and instead specialize in pharmaceutical products and
use them to trade for cars. As another illustration, the U.S. has a
dominant position in the semiconductor industry. It can use this position
to trade with Japan for automobiles and electronic equipment. In other
words, for a particular country, it is a question of how well it uses the
resources given to it. The better it uses the resources it has to produce
a given product, the more likely it will develop a comparative advantage
in the product. Perhaps you can think of it this way. Many people take
their clothes to have them dry cleaned. No doubt they could do some of
this themselves but their time is better spent doing other things, such
as their full-time job.

Another way to think about it is with group projects. If someone enjoys

working with numbers, let her handle the quantitative side of the
project. If you enjoy writing, then you should concentrate on expressing
the explanations. The two of you can then "trade" the information and put
together a better report than either one of you could have done on your
own as individuals doing both tasks.

How do these various trades express themselves? There are two ways.
First, we have balance of payment statistics, or the record of one
country's transactions with all other countries. Within the balance of
payments, there are two more balances: one on current account and one on
capital account. The one on current account houses the widely watched
figures of a country's balance of trade -- the value of its exports minus
the value of its imports. The capital account is concerned with the value
of financial capital -- stocks, bonds, loans, etc -- that flows between
countries. If a nation runs deficits in both categories, its currency is
a candidate for depreciation; with surpluses, appreciation of the
currency. Obviously, this moves us to the second way that trade expresses
itself: exchange rates: the price of one currency in terms of another
currency. The more country A wants of country B's goods, all else equal,
the more depreciated country A's currency will be relative to country B's
currency. As evidence, in 1985, one U.S. dollar bought about 260 Japanese
yen. By 1995, that same dollar bought about 80 yen, quite a drop indeed,
or a rise if you are a resident of Japan. Granted, there may be other
speculative forces that drove the value of the dollar down (or the value
of the yen up); however, the persistent trade imbalance that the U.S.
incurred with Japan is the main culprit.

So what is a country to do when it runs trade deficits? It can do one of

two things: try to concentrate on doing some things better (a difficult,
long-term solution but probably the right thing to do) or impose import
controls (an easy, politically expedient solution but generally flawed on
economic grounds). Of these two, import controls deserve some attention,
what with GATT and NAFTA serving as feature newspaper articles in recent
years. The typical arguments in favor of import controls are as follows:
protect domestic jobs and protect new and emerging industries. The
arguments against them are as follows: the affected country could
retaliate against the home country's exports, leading to unemployment in
the exporting industries; less competition means higher domestic prices;
and there is no clear evidence as to what constitutes a healthy,
emerging, infant industry (i.e., when do we remove the diapers?)

VIII. EPILOGUE

So there you have a brief and quick version of macroeconomics, and how
brief and quick it was. What can you easily carry with you? This is a
tougher question to answer than it is for microeconomics, but that will
not keep me from giving it a "go," so to speak. Remember that
macroeconomics is really about explaining business cycles -- an economy's
"ups" and "downs" -- and what to do about the consequences, unemployment
and inflation. The one variable that is probably more responsible for how
business cycles manifest themselves is money, as represented by M1, M2,
and M3. If increased too little, an economy slides into recession; if
increased too much, inflation becomes a problem. These effects extend
beyond domestic boundaries, affecting both the country's exchange rate
and its trade position.

FINANCE

I. INTRODUCTION TO FINANCE: READY, SET, GO

In a few words, and to put it simply, finance is all about money

management. But how does one know if one is managing one's money well? Is
it because you're not in debt? Is it because you pay all your bills on
time? Is it because you try to save some income? While answers to these
questions do provide some insight into money management, the answer goes
well beyond these answers. Broadly, managing money well really implies
that you are increasing the value of your assets; that is, you are
increasing your wealth. But to do it properly, you also have to be
cognizant of an inescapable fact of life: return to risk. In short, the
higher the return that you want to earn from your assets, or anyone
else's assets for that matter, the more risk you will have to take.
Returns add to your wealth, and risk represents the chance that the
returns will be less than you expect (even negative!) -- call it
financial disappointment.

To get a broader and deeper perspective on money management, finance can

be broken down into four main categories: (1) time value of money, (2)
capital budgeting, (3) asset pricing and portfolio management, and (4)
options.

Given these four categories, we can pretty much boil down finance to
seven equations, as follows:

(1) Rate of return:

{{[P(t)-P(t-1)]+C(t)}/P(t-1)}*100, where P(t) is the asset's current

price; P(t-1) is the asset's price in the previous period; and C(t) is
the cash payment (if any).

(2) Fixed payment annuity:

PV=C[1-(1+i)^-n]/i, where PV is the present value; C is the periodic

payment; i is the interest rate; and n is the number of periods

(3) Bond price:

PV=C1/(1+i)+C2/(1+i)^2+C3/(1+i)^3+...+CN/(1+i)^n + PR/(1+I)^n, where C1, C2,

etc.
are the periodic payments, i is the interest rate, n is the number of
periods, and PR is the face value of the bond

(4) Portfolio risk (two securities):

Var(rp)=w1^2*Var(r1)^2+w2^2*Var(r2)^2+2w1*w2*Cov(r1,r2), where var(rp) is

the variance of the portfolio; Var(ri) is the variance of securities 1
and 2; and w1 and w2 are the respective percentages, or weights, invested
in each security.

(5) Capital Asset Pricing Model:

E(ri)=rf+[E(rm)-rf]*Beta, where E(ri) is the expected return on security

i; E(rm) is the expected return on the market; rf is the risk-free
return; and Beta is the index of systematic risk.

(6) Market model/Single-index model:

rit=ai+Betai*rmt+eit, where rit is the rate of return over time on

security i; ai is a constant term; Betai is the index of systematic risk
associated with security i; and eit is an error term.

(7) Black-Scholes model (option pricing):

PN(d1)-EX*e^(rf*t)*N(d2);

where d1=[log(P/EX)+rf*t+var(ri)*t/2}/[var(ri)^0.5]*t^0.5;
d2=[log(P/EX)+rf*t-var(ri)*t/2]/[var(ri)^0.5]*t^0.5;

N(d) is the cumulative normal probability density function;

EX is the expiration price of the option;

t is the time to the exercise date;

P is the current price of the security; and

rf is the risk-free rate of return.

While this may seem like a lot, and it is, it is really remarkable that
so much is contained in just a small set of equations. Throughtout this
summary, you will see references to these seven equations.

II. MONEY, NEAR MONIES, THE MONEY MARKET AND THE CAPITAL

MARKET (OR WHO SAID ECONOMICS AND FINANCE ARE NOT RELATED?)

Before moving into each of these areas, some background is in order. Just
what is money (yes, go back to macroeconomics.) Until you know what it
is, you won't know how to manage it, right? Money is anything generally
acceptable for making payments. Yet how often you have to pay for
something will move you to think about places where you can put your
money. After all, if you are going to manage it well, you surely do not
want to keep it under a mattress at home. Not only is your money not
earning any interest (i.e., compensation for postponing your spending),
but also you run a big risk of having the money stolen. In terms of
return to risk, keeping lots of cash at home is just not very wise. So,
what will you do? As it turns out, by looking at the measurements of
money, as set by the Federal Reserve System (yes, go back to
macroeconomics), you have a number of choices, as follows: M1 (currency +
checkable deposits + travelers checks); M2 (M1 + passbook savings +
certificates of deposit + money market deposit accounts + money market
mutual funds + repurchase agreements + Eurodollar deposits); M3 (M2 +
jumbo certificates of deposit + term repurchase agreements).

Looking these categories over, you can already get a sense of how
complicated money management can be, and we have not even begun to talk
about investments in stock, bonds, options, real estate, plant, and
equipment. And, as you would well guess, each of these has its own set of
subcategories. For example, you can take a certificate of deposit
generally from three months to five years. How long should you go?
Certificates of deposit, however, do not earn high rates of return. If
you want more return -- to create more wealth -- you have to think about
incurring more risk, such as found in bonds and stocks, and everyone has
limits on the amount of risk they are willing to take. In short, and as a
rule, the more liquid your investments, the safer they are and the lower
the return you will get; the less liquid your assets,

the more risk they carry and the greater the chance is for a higher
return. Where you choose to be along this return-to-risk line is up to
you.
What we have said so far seems to apply only to individuals. But
businesses face the same issues. For example, a company could be sitting
on, say, $20 million in cash for a four-day period. Is there a way for
the company to earn a return from its cash; that is, can it create
wealth? Indeed it can. By taking out an overnight repurchase agreement
(or "repo") with a bank, it can, in effect, loan the bank money overnight
with the promise that the bank will repurchase the assets (they are U.S.
Treasury Bills) at a higher price. (See more on this below.) This is
pretty simple, though. What about situations in which the Chief Financial
Officer (CFO) of a company is trying to figure out if it will be
worthwhile for the company to build a new plant, a building expected to
last at least the next 25 years? How would the CFO determine if this
investment will create wealth, and create it to the maximum extent
possible? Answering that question requires knowledge of expected cash
flows and risks, a topic reserved for capital budgeting, and that is
putting rather simply.

Before we get ahead of ourselves, let's separate financial markets into

two groups, a money market and a capital market.

Money market contains the most liquid assets, or those whose values are
the most predictable and can be readily converted to cash. For example, a
money market deposit account is very safe and is very easily converted to
cash, but the same cannot be said for real estate (e.g., a house).

The money market encompasses the following major categories: M1, M2, M3,
U.S. Treasury Bills, federal funds, commercial paper, and bankers
acceptances. Let's take a brief look at each of the components. With the
money market, we can sum up the financial instruments as follows: low
risk, low return.

M1: The two most significant components here are cash and checkable
deposits, especially those that pay interest (e.g., negotiable order of
withdrawal (NOW) and automatic transfer system accounts (ATS)). In fact,
in finance cash and cash equivalent assets are the most important assets.
Without them, you're in big trouble, whether as an individual or as a
business.

M2: Here is where things, in my opinion, begin to get more interesting,

especially with certificates of deposit, money market deposit accounts,
and money market mutual funds. These instruments provide, in particular,
small savers with market rates of return, something that was more
difficult to come by 20 years ago than one may think. There is one basic
reason why I think these categories are interesting: they serve as a home
for the investments of very risk-averse investors, or investors who have
a low tolerance for risk. They also represent one of the first places
where stock and bond investors retreat whenever they feel especially
nervous about movements in financial markets. You may want to think of it
along the lines of getting out your boat (in the middle of a lake) when
you sense an approaching thunderstorm. You are not going to get much
return sitting inside, but you also reduce the chance of being struck by
lightening. In other words, it is all return to risk.

In addition, there is a category called "repurchase agreements" that

serves a good source for quick cash for banks needed to meet cash reserve
shortfalls and for corporations and municipalities with idle cash. In
this case, the bank sells U.S. Treasury Bills, which are short-term debt
of the U.S. Treasury Department, usually on an overnight basis, to a
corporation with the stipulation that it will buy them back from the
corporation the very next day but at a higher price. So both parties
gain. The bank gets needed cash and the corporation puts idle money to
work. Remember that finance is all about money management, and this is a
good illustration of what that means for both parties.

There is one more here. It is called "Eurodollars," or dollar-denominated

deposits in bank outside the U.S. (principally in Europe). The idea here
is that if you do not like your return-to-risk prospects in the U.S., you
can always look elsewhere and protect yourself against exchange-rate risk
as well. (Note: Exchange rate risk, in this sense, means having the U.S.
dollar increase in value as you try to convert a foreign currency into
U.S. dollars, something that, I think, you should have touched on in
macroeconomics, right?) In some cases, I have seen where Eurodollar
deposits can several percentage points more than what one might earn on,
say, a certificate of deposit.

M3: This is an extension of M2. From a corporate viewpoint, two

categories are of special interest here: jumbo certificates of deposit
and term repurchase agreements. The "jumbos" often run in denominations
of $1 million (although you can get them for as little as $100,000).
Corporations flush with cash often take out these instruments as part of
cash management. However, since the deposit is only guaranteed up to
$100,000, corporations are very quick not to renew them as soon as the
slightest whiff of financial instability shows up at the bank.

As part of this group, there are negotiable certificates, whose prices

fluctuate just like a U.S. Treasury bill (which is described below) and
generally trade in denominations of $5 million.

Term repurchase agreements are really an extension of the overnight

repurchase agreements described above.

Before moving to near monies, we should take a brief look at federal

funds. Federal funds really have nothing to do with the federal
government. Instead, federal funds refer to overnight loans that banks
give each other. In other words, a cash-rich bank will loan money
overnight to a cash-poor bank (yes, there are cash-poor banks, or banks
that have invested all of their excess reserves) so that, for example,
the cash-poor bank can meet reserve requirements (another term that you
should have learned in macroeconomics ). Here is another case of cash
management.

Now that we have the money supplies and federal funds taken care of,
let's move to what I like to call "near monies. The big one -- and it is
BIG -- is U.S. Treasury Bills (T-bills). U.S. Treasury Bills represent
the deepest part of the money market. The Federal Reserve System (Fed)
deals in trillions of dollars of T-bills annually. Along with bank
certificates of deposit, they are a favorite with investors, especially
big institutional investors. They have three maturity schedules: three
months, six months, and one year. In general, the longer the maturity,
the higher will be the interest rate on these near monies. Speaking of
the Fed, do you know that the Fed uses T-bills in its open market
operations (another term from macroeconomics). In other words, when the
Fed buys T-bills from investors, it is effectively increasing the size of
M1, M2, and M3. When it sells them, it is taking cash out of the economy,
effectively reducing the amounts of money. Additionally, T-bills are a
prime indicator of something called the "term structure of interest,"
which reflects the relation between short- and long-term interest rates.
Yes, indeed there is a relation between the two. As you would guess,
because it is all due to return to risk, the longer the maturity of the
investment, the higher the return investors will demand. So, T-bills
generally pay lower interest rates than longer-term investments. I say
"generally" because occasionally there are exceptions.

The next group is commercial paper. This is a short-term "I-O-U" issued

by major corporations, including banks. It is part of what is referred to
in finance as "working capital," and the management of working capital is
referred to as -- you guessed it -- "working capital management." Do you
know we offer an MBA course in this area? That's just to give you an idea
of its importance and its complexity. Do you know what backs up
commercial paper? Is it FDIC, or any other insurance program? The answer
is "no." It is supported by the corporation's name. For example, do you
really expect Citigroup to declare bankruptcy in the next six months?
Given the near certainty of that event not happening, investors will buy
the company's commercial paper. By the way, I used six months in the
example because that is just about as long as commercial paper is issued.
In fact, its liquidity and short maturity is what allows us to classify
it as a "near money."

The final group among near monies is bankers' acceptances. They can be
viewed as bank drafts (i.e., very similar to a regular check) used in
international trade. They are issued by the company buying the goods in
another country and are payable at some future date. They are guaranteed
(for a fee, of course) by the bank that stamps it "accepted" (from where
the name "bankers acceptances" is derived). The firm issuing the bankers
acceptance must make sure that sufficient funds are in its account to
cover the acceptance. What is the advantage of this arrangement? The
foreign company knows that even if the company buying the goods from it
goes bankrupt, the bank draft will still be paid off. This is a nice
return-to-risk transaction, right?

You may have thought that much of the discussion so far is worth not much
more than a good yawn, so let us turn now to "glitzier" investments,
bonds, stocks, and options. This is the capital market. We can sum it up
as follows: high risk, high return.

What is a bond, anyway? It is liability -- to put a positive spin on it,

it's a promise -- issued by government (local, state, or national) or
business that pays the investor principal plus interest. Note that is
"princiPAL," not principle. There are a number of different kinds of
bonds, so you will have to watch your language: "Treasuries,"
"corporates," "Ginnie Maes," "munis," "zeros," "debentures," and
"convertibles." And these are not all the names. But a snapshot at these
categories will at least get us going. Before further discussion, we need
to distinguish between a note and a bond. A note typically has a maturity
of two-ten years (sounds a bit like a prison term). Bonds have maturities
in excess of ten years.

Treasuries: bonds issued by the U.S. Treasury Department. The bellwether

of this group is the thirty-year Treasury, whose interest rate is very
closely watched, because it is usually a harbinger for kinds of long-term
rates, such as mortgage (i.e., a long-term loan for a home or other
building). The U.S. Treasury bond market is very deep. Although with its
T-note and T-bill (maturities up to one year) companions, constitutes the
largest component of the capital market. The interest rate on these
bonds, by the way, is the lowest interest rate found on any bonds issued
in this country. Why? These bonds are considered to be default-risk free.
What is default risk, you might ask? It is the chance that the bond
issuer will not make timely interest and principal payments, or may even
not make the payments at all. The U.S. Treasury has never defaulted on an
interest or principal payment. Why? More than any other reason, the U.S.
government, or many governments for that matter, can always raise taxes
to raise the necessary funds. Thus, the U.S. government enjoys the lowest
borrowing rate of any entity.

Included in this group are U.S. Savings bonds, which have a par value
range of $50 to $10,000.

Corporates: bonds issued by corporations. This is also referred to in

corporate circles as debt-financing. You can find "debentures" among this
group. Despite the name, it has a simple meaning. Nothing backs it up
except the good name of the company, much like commercial paper. The
phrase sometimes used is "full faith and credit." Also of interest here
are "convertible" bonds, in which the investor receives interest payments
for a while but also has the option of converting the bonds into stock
(i.e., ownership). The terms of conversion (i.e, when the investor is
allowed to convert and how much each bond is worth in terms of stock --
are specified at the time you buy the bond.

Munis (municipal bonds): bonds issued by local governments (e.g., city

and county). The interesting feature of munis is that the interest earned
from them is tax-free at the federal level and tax-free at the state
level in general if the bonds are from a community within the state.
These bonds have what is sometimes called a "clientele effect," in that
they tend to be bought by wealthy individuals in the highest tax
brackets. Can you figure out why? Many munis are sold as zero-coupon
bonds, or "zeros." These bonds are sold at what is called a "deep
discount." To explain, a twenty-year $5000 bond might be sold for $1885.
Implicitly, the interest earned on this bond is about 5%. So each year,
the price of the bond reflects this 5% return. At the end of 20 years,
the bond will have matured to $5000.

Ginnie Maes: a bond issued by the Government National Mortgage

Association. It is really part of a group called "agency bonds," or bonds
issued by a government agency. Included in this group are bonds issued by
the Federal National Mortgage Association (Fannie Mae). These two
agencies deal in mortgage-backed bonds. A mortgage-backed bond is really
an ownership claim on a group of mortgages. The bank, or other financial
company, packages the mortgages together and sells the package as a
financial asset, or bond. The Government National Mortgage Association,
for example, guarantees the interest and principal payments on these
bonds (once again, no default risk). With these bonds, you will often see
or hear the words "pass through," because the lending institution no
longer holds the mortgage, a mortgage that has been passed through to the
holders of the "Ginnie Maes."

Note that both U.S. Treasuries and Ginnie Maes are free of default risk.
The same cannot be said for their corporate and muni counterparts. There
is a long history of defaults in both groups. In fact, back in the
mid-1970's, the Big Apple itself, New York City, bit the dust by
defaulting on a series of municipal bonds. And the corporate world is
loaded with companies in "reorganization" who have suspended debt and
principal payments. On top of this, even countries have defaulted on
debt. Perhaps the most infamous case of this is Mexico in the early
1980's. Other countries were involved, too. Eventually, by about 1990,
agreements were reached that were financed, in part, by "Brady Bonds,"
named after the then-Secretary of Treasury, Nicholas Brady. The big
question is as follows: what can an investor do? The answer is provided
by Moody's Investor Services, the Standard & Poor's Corporation, Duff and
Phelps, and Fitch. Each of these four companies rates the quality of
bonds issued by corporations and municipalities. The issuer pays any one
of these companies a fee to have its bonds rated. The purpose behind the
ratings is to broaden the market for the issuer's bonds. Moody's ratings
are as follows: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C. The first four
categories represent what are called "investment grade" bonds. Anything
below Baa is considered "noninvestment grade," or "junk." Thus, we have
the terms "junk bonds." The bottom line is that the issuer is hoping that
the rating agency will judge its bonds as having the highest probability
of timely interest and principal payment. The more (less) confident that
the rating agency has in the company's ability to make timely payments,
the higher (lower) the bond rating.

Let's now try some stock. Stock is simply a form of ownership in a

corporation. The more (less) shares you own of a company, more (less) of
the company you own. Keeping things simple, there are two forms of stock,
common and preferred. The difference lies in the return to risk (is that
surprising?). Common stock shareholders take the bigger risk. Not only
are they last in line, behind bondholders and preferred stock holders, in
being able to make a claim on a corporation's assets, but they also can
hope for only one thing: that the stock price rises. (NOTE: There is an
important exception here referred to as "shorting" a stock, a case that
we will explore in class.) Unlike with preferred stock, there is no
guarantee of a dividend with common stock. So an investor's fortunes are
tied to the ability of a company to create wealth by producing the right
amount of output at the least possible unit cost. This further implies
selection of the right projects and the right amounts. Once again, it all
comes back to money management and return to risk.

With preferred stock, the investor gets some big dividends, often
dividend yield (i.e., dividend per year divided by the stock price) of
5%-10%. However, preferred stock does not rise like common stock does. So
getting the dividend does carry the price of not enjoying big increases
in the price of the common stock. Once again, I dare say it, it is all
return to risk. I should mention, too, that many companies do not issue
preferred stock and many companies do not pay any dividends, either.

Keep in mind that all the activity you may hear about in stock markets
takes place in what is called the "secondary" market. This is the New
York Stock Exchange, the American Stock Exchange, and the NASDAQ. To
explain, a company issues stock to raise funds. However, issuing stock is
not quite as easy as it sounds. A company first must arrange for the
selling of the stock in the secondary market. If it is the first time a
company has sold stock, it is called an Initial Public Offering (IPO).
This is accomplished with the help of one or more investment banking
firms, such as Merrill Lynch, Morgan Stanley Dean Witter, or Goldman
Sachs, to name just a few. These companies underwrite the stock offering
(i.e., accepting the risk of selling the new issue after acquiring it
from the corporation). Once the stock is sold in the secondary market, it
is open for trade among all investors.

There are a number of measures of overall stock market activity, such as

Dow Jones, the Standard & Poors 500, the Wilshire 5000, and the Russell
2000. They indicate, on average, whether stock prices rose or fell and
how many shares were traded.

Let's now turn to what is likely the most complicated topic among money
and capital markets: options. An option is the right, but not the
obligation, to buy or sell something. Often options are called
derivatives because the options are "derived" from the underlying value
of the stocks. To keep the discussion simple, we will talk about options
on stocks.

Options were created to help investors reduce risk. To understand how

options serve this purpose, we need to take a look at the two most basic
options, puts and calls. A put gives the owner the right to sell
something; the call, to buy something. For example, let us say that you
are holding 100 shares of America Online (AOL). Let us also assume that
you bought it at $20 per share and it is currently selling on the New
York Stock Exchange for $60 per share. To protect your profits in the
event of an unforeseen and large drop in price, say, from $60 to $50, you
could buy one put contract. One put contract is for 100 shares. Let us
also assume that the put contract costs you $300, or $3 for every share
of stock you own, and that the benchmark (called a "striking" price) is
$60. With options, you have a deadline. In this case, assume the deadline
is in one month. If you do not do something by the deadline, you lose
your $300. If you decide to do something, you have two choices: (1) sell
the stock or (2) sell the put. What you do depends on what happens to
AOL's stock price. First, if the price rises, the value of your put
falls. If the price falls, the value of your put rises. Let us assume
that AOL's stock price falls to $50 (Note: Assume that brokerage fees are
0). Because you are holding 100 shares, you have just had a loss in
wealth of $1000. However, the value of your put has now increased to
$1000 [i.e., ($60 - $50) X 100 shares]. Because you paid $300 for the
put, the profit from the put is $700. So while you lost $1000 in wealth
from the $10 drop in the stock price, you gained $700 from the increase
in the price of the put. Thus, your overall loss is $300. Thus, buying
the put has served its purpose: it has reduced risk, or increased the
chance that your actual return will not be less than your expected
return.

What can we say about a call? To understand its role, note that investors
can earn returns on the upside or the downside. Here our focus will be on
the downside. For example, investors can actually put themselves in a
position to "sell high and buy low." This is called "shorting" a stock.
For example, if you were to short AOL's stock, you would first sell it at
$60 and then buy it back when it fell to, say, $50. The difference is
your profit. If this involved 100 shares, your profit would be $1000
(assuming no brokerage fees). The riskiness of shorting, though, can be
high. What do you if AOL's stock price rises? You would incur a loss, and
the higher the stock price goes, the bigger your loss. You can protect
yourself by buying a call. As the price of the stock rises, the value of
the call rises, and as the price of the stock falls, the value of the
call falls.

By the way, the pathbreaking work on valuing options was done by Fisher
Black and Myron Scholes, now called the Black-Scholes options pricing
model [see equation (7) in the opening section].

III. FINANCIAL STATMENT ANALYSIS: YOU HAVE TO READ THE FINE PRINT

While financial statement analysis can be become quite intricate (believe

it or not, there are literally thousands of ways to legally represent an
income statement), I do have a few simple rules that I use to help
determine how financially well-off a company is. I use these rules as one
way (and not the only way, by the way) to screen companies that I think
would make attractive investments. There are six of them:

1. Revenue/sales growth of at least 15% per year

2. Gross margin of at least 40% per year

3. EPS growth of at least 20% per year

4. Cash must be at least three times the total debt

5. Cash/outstanding shares must be at least three

6. Key financial ratios, such as price-earnings, price-book, and price-sales

should be low (reflecting an undervaluation)

[Note: By "growth," I'm really talking about percentage change from year
to year. The percentage change formula, which is also called the rate of
return on an investment, defined alternatively to equation (1) in the
Introduction, as follows:

r = [(ending value - beginning value)/beginning value]*100.

If you were talking about stocks or bonds, you would have to add a cash
payment to the numerator to reflect the payment of dividends (for stock)
or the payment of interest (for bonds).]
To explain, I'm looking for companies in growing markets that can develop
and maintain a dominant position. If successful, these companies will not
only show significant year-over-year increases in revenue, EPS, gross
margins, and solid profit margins, but also generate lots of cash. And in
finance, cash is the "sine qua non." (translated: "cash is your trump
card."). To explain, accounting is based on an accrual method (some
cynics would say a "cruel method"). But simply because sales are booked
doesn't mean they have generated any cash. As a result, as strong as this
may sound, I've little use for accounts receivable ("promises,
promises...I've heard many of them, too many"). Put alternatively, as
many students would tell me: "show me the money." But generating lots of
cash is only part of the story. Finance is really about how well one
manages cash (and other assets as well -- "money management"). In fact, I
need to see some evidence that not only is a company (or anyone, for that
matter) bringing in lots of cash quickly, but I want to see that the cash
is also going out slowly. In short, I want to see an increase over time in the
cash position.

Turning to financial ratios, of the dozens available, only three really

seem to matter for asset pricing. The "P/E" ratio, or price-earnings
ratio, is the price per share of stock divided by the earnings per share
of the company. The idea is that the bigger the P/E is, the more
expensive the stock may be and the smaller the chance that the stock
price will show big gains. As a rule, financial analysts like stocks
whose P/E ratio is less than the growth in earnings per share of the
companies. This can be converted into something called a "PEG" ratio, which
looks at the P/E ratio relative to the expected growth in earnings per share.
The price-to-book value ratio is the price per share of the stock divided by
the book value per share (or the price of the stock as
recorded on the books of the company). Just like with the P/E ratio, we
want a low value, all things considered. The price-to-sales ratio is the ratio
of a company's total market value to its sales. Once again, a low value is
preferred.

IV. THE TIME VALUE OF MONEY

(OR DON=T YOU BELIEVE YOUR TIME IS VALUABLE?)

This is one of the four major topics in finance. So much flows from the
two basic concepts of "present value" and "future value." Present value
(PV) is the value today of receiving an amount of money tomorrow (i.e.,
in the future). Future value (FV) is the value tomorrow (i.e., in the
future) of setting aside an amount of money today. Let's begin with
future value, since it explicitly accounts for the "magic of
compounding," a facet that even impressed no less than "Dr. Relativity"
himself, Al Einstein:

FV = amount*[(1+r)^t]

Note that (1+r) is raised to a power, the number of periods over which
the money is expected to grow, to reflect compounding. It's really very
simple. For example, $100 earning a 10% rate of return per year grows to
$110 after one year. For the second year, we would multiply the 10% by
the $110 (not the $100!) to get $11, which is then added to the $110 to
get $121. The exact same logic continues year after year, earning what is
sometimes called "interest on interest." Moreover, compounding on a
quarterly basis makes money grow faster than compounding on an annual
basis. Compounding on a monthly basis is even better yet, and daily
compounding is just about perfect. The best you can do is on a continuous
basis. In fact, continuous compounding makes use of the number e, which
is 2.7182...This number helps us to develop a simple and effective set of
rules that we can carry with us the rest of our lives. Do you know that
"doubling your money" is a frequent phrase used in financial market
circles? It has become something of a standard. After all, the faster you
can double your money (or earn a 100% return), the faster your wealth
increases. And finance is all about money management and wealth
maximization. To go back to the point, in a world of continuous
compounding, we learn that the natural log of 2 equals approximately
0.70. If one divides 0.70 by the annual rate of return on an investment,
then you can quickly determine how long it takes for your money (and
anything else for that matter) to double. For example, in a world of
continuous compounding, a 14% (or 0.14) increase per year would lead to a
doubling of one's money in five years, or 0.70/0.14. However, rates of
return are usually expressed in terms that are not continuously
compounded. So we have to modify the rule just a bit, as follows:

0%-9% growth: use 72

10%-18% growth: use 75

19%-28% growth: use 78

For example, if your investment is growing by 15% per year, it would take
you about five years, or 0.75/0.15, to double your money. If growing by
26% per year, your investment will double in value in about three years,
or .78/.26.

These rules for doubling your money can be linked to one other rule:
compound as often as possible. Thus, we have two rules to be gleaned from
this summary. You should (1) compound as often as possible because (2)
the higher the growth rate of your investment, the faster your money will
double, per the rules we've laid out.

So far, the discussion has been about future value. What can we say about
present value (PV) ? I assure you we have plenty to say. Do you know that
PV is the backbone for all loans? Do you know that it is the foundation
for asset pricing (e.g., bonds and stocks)? Do you know that it is "the"
way to evaluate plant and equipment projects? Each of these categories
implicitly assumes that the investor (whether individual, bank, or
company) will receive some kind of payment in the future. So PV is a
"natural" for getting a handle on the price the investor should pay for
the asset, whether financial or physical.

PV is simply the other side of the same coin that pertains to FV. Let's
begin our PV discussion with annuities, which are simply payment streams:

PV = C/(1+r) + C/(1+r)^2 + C/(1+r)^3 + ...

This looks a bit more complicated than it is. In words, we are saying
that the longer you have to wait for your money, the more we need to
"discount" its value to account for the fact that you can't get your
hands on the money now. For example, a one-year financial asset that
promises to pay $10,000 one year from now at 6% interest would be priced
as follows:

$9400 = $10000/(1+.06)^1

If this same investment were to be received five years from now, it would
be priced as follows:

$9000 = $10000/(1+.06)^5
If the interest rate were to increase from 6% to 8%, we would now get

$8800 = $10000/(1+.08)^5.

These illustrations lead to two simple rules about the pricing of

financial assets, especially bills, notes, and bonds:

(1) The longer (shorter) the time you must wait for your investment to
mature, the lower (higher) its price (or PV); and (2) the higher (lower)
the interest rate is, the lower (higher) the asset's price (or PV) will
be.

The annuity formula can be expanded into a true workhorse formula for
periodic payments, whether on bonds or loans, as follows:

PV = C{1-[1/(1+r)^t]/r}.

For example, a thirty-year, $100,000 fixed-payment loan, such as a

mortgage, with an annual interest rate of 10% and monthly payments would
be set up as follows:

$100,000 = C[1-(1+(.10/12)^360]/(.10/12)=$877.28

In other words, a lending company, such as a bank, determines that the

present value of receiving 360 monthly payments (i.e., 30 years) of
$877.54 each is $100,000. Note that this means that, over time, the
borrower pays a total of $877.28 x 360, or $315,820.80 on the loan. In
addition, a not-so-well-known fact is that most of the interest on the
loan is paid up front. So it takes a while before the borrower really
begins to take ownership of the property; that is, begins to pay off the
principal. We can determine the interest (IP) and principal (PP)
components of each monthly payment, as follows:

1. IP = PV*interest rate per month

2. PP = C - IP

In our illustration, IP=$833 (or $100,000*0.00833), and when subtracted

from $877.28 leaves $44.28, the amount of the principal that is paid off.
Note that all this takes place in a nonlinear fashion. This means, for
example, that at the 180th payment of a 360 payment loan, well over 50%
of the total interest owed on the loan has already been paid. Paying off
the loan early won't save you as much interest as you might think.

The same formula can also be used to figure out such questions as "how
much do I have to set aside today to get $40,000 per year for twenty
years at an interest rate of 8%? It can also be used, with a little
modification, to determine the price of a bond that promises to pay 60
semiannual payments for thirty years at an interest rate of 9%. The
modification is that the investor will get her principal back, say $5000,
at the end of thirty years. Thus, the formula must have added to it, in
this case, $5000/(1+.09)^30.

There are other illustrations that one can use with variations on this
fixed-payment formula, such as how much an investment will earn if the
investor puts in $2500 per year for ten years at 8%, or the price of a
stock given a dividend growth rate, or the value of a bond that pays
interest forever.

V. DON=T COUNT YOUR CHICKENS YET:

AN INTRODUCTION TO CAPITAL BUDGETING PROJECT EVALUATION

The discussion on PV helps us to understand how to evaluate the worth of

any project, be it starting up a new business, buying new equipment, or
building a new plant. This represents our initial look at capital
budgeting, another major area of finance. Of course, to go back two
sections ago, cash is our trump card, and all projects better generate,
or at least expect to generate, a lot of cash. There are two rubs here:
(1) how long will it take to generate the cash? and (2) how risky is the
project? There are two things to keep in mind. First, the longer it takes
to generate lots of cash, the more doubtful you should tend to be about
the value of the project. Second, the riskier the project is, the more
circumspect you should be about it. Both of these rubs are incorporated
into an equation called "net present value" (NPV), or the PV of a project
minus the initial cost of the investment, as follows:

NPV = [C1/(1+r)^1 + C2/(1+r)^2 + C3/(1+r)^3 + ... + Cn/(1+r)^n] - initial

cost

The r in the equation, when it is not known with certainty, is called the
"cost of capital." Rarely, if ever, is it known with certainty, by the
way. (Little about anything is known with certainty.) In fact, the cost
of capital reflects the risk of the borrower. As a result, the cost of
capital must be estimated, a topic we will take up later, when we come to
the capital asset pricing model. The C's are the expected cash flows.

What we are really looking for is a NPV>0. If NPV<0, the project is not
profitable. (If NPV=0, the textbook approach is to say "yes," and go with
the project. But, realistically, given a world of uncertainty, this
really isn't enough.) For example, a two-year project that has an
up-front cost of $2.35 million and is expected to generate cash flows of
$840,000 in its first year and $2.9 million in the second year, at a cost
of capital of 14%, generates a positive NPV, as follows:

NPV = $840000/(1+.14)^1 + $2900000/(1+.14)^2 - $2350000=$618297.9>0

Thus, we would consider this project to be worthwhile. Note the three

hurdles that every project faces. We can state this in the form of a
rule: The bigger the initial cost, the longer the time we have to wait
for the cash, and the higher the cost of capital, the less likely it is
that the project is worth it. This makes sense, too. In general, anything
in life that requires a big up-front cost, whose benefits you will have
to wait long time for, and that carries a lot of risk is not likely to be
very appealing. For example, education does require some big initial
outlays (e.g., tuition, books, computer, etc.) but it is generally not a
high risk project, nor does one have to wait long for the benefits.
Still, for some people, attending college is a "negative NPV" project.

While NPV takes into consideration the time value of money, incorporates
the cost of capital, can handle a varying cost of capital, and is
consistent with wealth maximization, it is not the method of choice for
project evaluation in the corporate world, even though it should be.
Other criteria include the internal rate of return, the payback rule, and
the profitability index. The internal rate of return (IRR) is a
substitute for NPV, and in some cases a good one. It uses the same
equation as NPV but it focuses instead on estimating r, the (internal)
rate of return. In other words, with IRR, you're trying to find the r
that makes the NPV=0. This r is then compared to the cost of capital. If
r>cost of capital, the project is a "go;" if, less, it is a "no." It's
that simple.

While somewhat more appealing as a criterion than the NPV (i.e., it's
easier to say that your project is earning, say, 19%, well above your
borrowing cost, than to say you have a NPV of $1.2 million from it),
solving for the IRR does carry some pitfalls. First, there is the
possibility for multiple solutions, and when that happens, which r should
one choose? Second, the IRR doesn't handle a changing cost of capital
well. Third,, in instances of uneven cash flows, something all too
common, it is possible for the IRR not to exist.

Another approach is the profitability index (sometimes called the

"benefit-cost" ratio). The index is centered around 1, as follows:

PI = PV/inial cost,

where the PI is the index. If PI>1, the project is considered worthwhile;

otherwise, it's not. This approach leads to exactly the same decisions as
NPV, because a PI>1 means that the PV exceeds the initial cost, just like
the NPV requires. In this respect, the profitability index comes the
closest to the NPV of its alternatives. However, there is one problem
with the index: it doesn't handle mutually exclusive projects very well.
For example, should Ford invest more in Sport Utility Vehicles or the
Taurus? Should a farmer plant wheat or corn?

There is also a method called the "payback rule." This specifies that the
inial cost of the investment should be recoverable within a specified
cutoff period (e.g., two years, three years, etc.) However, the payback
method gives equal weight to all cash flows before the payback date and
no weight at all to subsequent cash flows. In other words, it really does
not properly consider the PV. Also, if a company uses the same cutoff
period for all projects, it will tend to accept too many short-lived ones
(e.g., the purchase of laptop computers) and reject too many long-lived
ones (e.g., building a warehouse). A discounted payback approach is tad
bit better because it at least discounts the cash flows in the same
manner as the NPV rule requires; however, there is still the problem of
an arbitrarily chosen cutoff period and the problem that all cash flows
after the cutoff are ignored.

VI. PORTFOLIO DIVERSIFICATION AND ASSET PRICING:

IT=S ALL RETURN TO RISK

The key to investing lies in choosing the right securities. But which
ones are the right securities? The answer is twofold. First, they are the
securities that have the highest expected return to risk. Second, the
returns on these securities are not strongly correlated with each other.
This second point brings us to the following two-step guideline: select
securities whose returns are not strongly, positively correlated with
each other. Second, put the securities together in such a way so as to
minimize the risk of the portfolio while preserving the rate of return
you hope to obtain. In fact, putting these two points together allows us
to arrive at something called "efficient diversification." By
"efficient," we mean it's optimal; it's the best you can do. This implies
that portfolios can be placed into one of three categories:
underdiversified (too few securities or too many that are strongly,
positively correlated with each other), overdiversified (too many
securities), or efficiently diversified (just the right number and ones
that are not strongly, positively correlated).

To get a better handle on this concept, consider there are two kinds of
risk, diversifiable and undiversifiable. Before we discuss these two
types of risk, just what is risk, anyway? It is the chance that your
investment will have a lower rate of return than you expect it to earn.
Risk, however, is divisible into two categories, diversifiable
(predictable) and undiversifiable (unpredictable). Diversifiable risk is
unique to an individual company, or individual sector, such as a strike
at General Motors, a drug from Merck that has serious side effects, or
contaminated meat at McDonald's restaurants. In other words, the strike
at General Motors does not affect, for instance, Microsoft, Intel,
International Paper, or Coca Cola. The risk is unique to General Motors.

Systematic risk, however, is not diversifiable. This kind of risk affects

all securities in one way or another. Examples of such risk include
recession, inflation, changes in interest rates, and changes in exchange
rates. In other words, changes in these variables, and others like them,
affect ALL securities. Thus, this risk cannot be diversified away, or
reduced to zero.

The key to portfolio diversification is to minimize risk for a given rate

of return (stated alternatively, maximize return for a given risk level.)
This implies that an investor should reduce the unsystematic risk of a
portfolio to zero; only systematic risk should remain. How do we measure
systematic risk? This is where a term called "beta" comes in. Beta is an
index of systematic risk, where the benchmark number is 1. A security
that has a beta that is greater than 1 is considered to be aggressive
(such as the stock of Intel or Dell Computer) ; if less than 1,
"defensive" (such as the stock of Exxon). If it equals 1 (such as the
stock of General Motors), it is considered to move with the overall
market. The "market," in this case, is considered to be a measure of the
overall securities market, such as the Standard & Poor's 500 or the
Wilshire 5000. Beta is measured statistically by examining how a
security's returns are correlated with the overall market. The
statistical tool used to do this is called regression analysis.

All this is fine so far, but how do we know if a security is a good "buy"
or not? In other words, how might we know if we should buy a particular
stock or bond? This is where asset pricing models come in. The best known
asset pricing model is called the "capital asset pricing model." It says
that the only variable we should look at when determining whether or not
a security is worth buying is beta, as the following equation suggests:

expected return = risk-free return + (risk premium)*beta,

where the "risk premium" is the expected return on the market minus the
risk-free return. In other words, it says that the higher the beta, the
more return the investor is expected to get. How much more return is
that? That's determined by the risk premium, which is the reward an
investor gets for bearing more risk. Put succinctly, it's all return to
risk! The risk premium is equal to the market's rate of return minus the
risk-free rate of return. The risk-free rate of return is approximated by
the annual return on a U.S. Treasury bill. [(As a technical note, you
might ask where the beta comes from? It is taken from the market model
(or single-index model), which is equation (6) in the opening section.]

This is not the only asset pricing model, however. Some critics of the
capital asset pricing model claim that the model is too simplistic.
Surely, they claim, an asset's price depends on more than just beta.
Thus, a theory called "arbitrage pricing" was born. Evidence suggests
that the critics have a legitimate point. There have been studies to show
that the arbitrage pricing theory is more realistic than its counterpart,
suggesting that as many as five variables determine an asset's rate of
return. These variables include changes in interest rates, business cycle
activity, energy prices, and in the overall market. However, when it
comes to predicting asset prices, the capital asset pricing model,
relative to its more sophisticated counterpart, seems to do a credible
job. Regardless, undoubtedly there is much more work for researchers to
do here.

One of the big reasons why asset pricing has been so difficult and
controversial has to do with a controversial and powerful hypothesis
called the "efficient markets hypothesis." It says that the prices of all
securities have incorporated in them all relevant information, and any
changes in this information are rapidly incorporated into the prices, so
fast there is really no such thing as a hot tip (from a friend or
financial advisor). This is a powerful statement, for it implies that it
is systematically impossible to "pick winners;" that is, find securities
whose returns to risk are consistently higher than that offered by the
overall market (e.g., the Standard & Poor's 500 or the Wilshire 5000).
There are three forms of the hypothesis: weak, semistrong, and strong.
The weak form says that historical information cannot help you
systematically outperform a broad market index. In short, it's useless.
The semistrong form says that public information (e.g., analysts'
recommendations, earnings per share estimates, P/E and price-book ratios,
etc.) is useless. The strong form says that even insider information
isn't much help, either. So what should an investor do? Collectively, the
three forms of the hypothesis suggest that the best the investor can do
is to buy, for example, a broad-based mutual fund, or one that is tied to
a broad market index, such as the Standard & Poor's 500 or the Wilshire
5000.

VII. ESTIMATING THE COST OF CAPITAL (YES, RISK IS EVERYWHERE)

The capital asset pricing model, under certain conditions, has the
potential to help a financial manager determine a company's cost of
capital. Recall that the cost of capital, the "r" in the denominator of
the NPV equation, is crucial to determining the profitability of an
investment project. For example, underestimating the cost of capital
might lead to pursuing projects that, in the end, are really not
profitable, or not as profitable as some that could have been chosen. On
the other hand, overestimating the cost of capital might lead to the
rejection of projects that are really worthwhile. Either way, you have
poor financial management, which ends with a declining stock price
because the company is not adding value properly.

Using the capital asset pricing model, we find that the key to estimating
the cost of capital lies with a company's beta. Once we know its beta,
all we need are estimates for the risk-free return and the market's
return. For example, the beta for Microsoft is approximately 1.25. If we
assume that the risk-free return on a one-year U.S. Treasury bill is 6%
and the market's expected return is 12%, then Microsoft's cost of capital
is as follows:

cost of capital = 6% + (12%-6%)*1.25 = 13.5%

This implies that projects that do not have expected rates of return that
exceed 13.5% would not be profitable for Microsoft, and therefore should
be rejected. Note how one can combine the NPV and the IRR rules with the
estimated cost of capital to determine whether or not a project is
worthwhile.

This approach assumes that the project is solely financed through stock
or cash. What do we do if bonds are involved as well, a realistic
situation for many companies? What we need is something called a
"weighted average cost of capital." For example, if Microsoft's project
was 20% debt financed -- a "leveraged" position, as it is sometimes
called -- with the bonds paying 8.8% interest, and 80% equity financed,
then its cost of capital would be

cost of capital = .20*8.8% + .80*13.5% = 12.56%

Note that this is lower than the 13.5% found above. So an obvious
question to ask is why don't companies finance all projects exclusively
by debt (i.e., bonds)? Keep in mind that bonds pay interest, and any cash
generated by the company must first go to paying off the bondholders'
interest and principal. What does the company do if the interest and
principal payments are beginning to drain off most, if not all, of the
company's cash? That's the rub. Too much debt can lead to financial
distress for a company. So there is indeed a limit to how much
debt-financed a company should be.

It seems as though there should be an optimal debt-equity financial

strategy for every company. By "optimal," we mean one that will maximize
shareholder value. Is there? There is a theorem called the
Modigliani-Miller theorem of corporate finance. In its pure form, it says
that, in a world of no taxes and efficient capital markets that a company
should be indifferent between equity financing and debt financing. In
other words, it doesn't matter how a project is financed. One method of
financing (equity) is as good as another (debt). In other words, the
value of a company is not affected by its choice of capital structure.
What Modigliani and Miller were really getting at is that firm value is
determined by the real assets, not by how much debt and equity a firm has
issued. This does make sense, doesn't it? And this holds whether the debt
is risky or not. In other words, it doesn't really matter to shareholders
how a firm finances its projects. It's all one big yawn to them. A pie is
a pie, and how it is sliced makes no difference to a company's value. If
more is sliced for bondholders, it means less is sliced for stockholders.
But the company's value is not affected because the size of the pie
hasn't changed.

Wait a minute, you might say! First, the more debt a company issues, the
more risky its balance sheet, as you state above. So why wouldn't
stockholders care? They do in the sense that they will demand a higher
return for the given level of risk, but in terms of the well known adage
of finance "it's all return to risk," nothing changes. More specifically,
the return on equity should increase just enough to keep the weighted
average cost of capital constant.

All this rests on the assumption of perfect markets (similar to perfect

competition in microeconomics). The notion of perfect markets is also
seen in the discussion of the efficient markets hypothesis, which we
talked about in the section on diversification and asset pricing (i.e.,
the prices of securities reflect all relevant information and rapidly
incorporate new information). While there is evidence to suggest that
financial markets are not absolutely efficient (i.e., there are "holes"
in the hypothesis), trying to find them and exploit them is no easy task
(as I can tell you from experience).

If you now believe that capital structure does not really matter, you're
going to have to look elsewhere for a logical reason why, however. After
all, financial managers do worry about debt structure. If they didn't,
why would a company bother with paying Moody's and Standard & Poor's to
rate their debt? The answer lies in the stuff we've left out to date:
taxes and the costs of financial distress.

With taxes, to keep matters very simple, the government enters the
picture to claim its share of the pie. If this is reasonable, then
anything the firm can do to reduce the government's share is bound to
give the stockholders a bigger share. But, once again, we encounter the
argument that because interest on debt is tax deductible and dividends
are not, a company ought to be 100% debt financed. What we find is that
there seems to be a moderate tax advantage of debt over equity,
especially if the firm's objective is broadened to include limiting the
personal taxes paid by bondholders and stockholders. This amounts to
estimating the PV of a tax shield.

With financial distress, we have two forms of costs, bankruptcy and

potential conflicts of interest between stockholders and bondholders. If
a company does go "belly up," stockholders have the right of limited
liability: they can just walk away. This is indeed a valuable right. It
is the creditors who are stuck. Yet stockholders can be affected, too, if
a company begins to experience financial distress. If a company has
issued too much debt, for example, the probability of default increases,
thus increasing the PV of financial distress. The result is a reduction
in the stock price and ultimately the company's value. The stockholders
will, no doubt, feel this impact.
While we could easily and (much more) rigorously extend these arguments,
the point is that in a world of taxes and financial distress, capital
structure matters to some degree. How much, though, is a controversial
question, because many firms thrive without issuing a single dollar of
debt.

VIII. DIVIDEND POLICY (GIVE ME CAPITAL GAINS, PLEASE!)

Why do companies pay dividends? At first blush, this seems like an easy
question to answer. Isn't it to provide stockholders with a steady stream
of income? But there may be much more to that answer than one might
think. For example, given the previous discussion on capital structure
(Modigliani-Miller), a good project is a good project is a good project,
no matter who undertakes it or how it is to be financed. If dividend
policy does not affect value, then this statement still holds. But what
if it does? For example, if investors really do prefer companies with
high dividend payout records, then companies might be a bit reluctant to
finance any project with retained earnings. So let's define a company's
dividend policy as one of determining the trade-off between (1) retaining
earnings for future investments and (2) paying out cash to stockholders
and issuing new shares/debt. Before proceeding, we should point out that
dividends can be issued in a number of forms, from cash to stock, from
one-time to extra to regular. There is also a share buyback program that
companies have increasingly used.

The pattern in dividend payout determinations is fourfold:

1. Companies have long-term dividend payout goals

2. Managers prefer to focus on how much dividends are changing (i.e.,

increasing or decreasing)

3. Changes in dividends tend to be permanent, reflecting long-term

earnings growth patterns.

4. Companies are very reluctant to reduce dividends.

What do dividends tell us? In other words, what is the information

content of them? Probably the best way of looking at higher dividend
payouts is to suggest that they are a sign of higher future earnings,
which would cause a firm's stock price to rise. If true, then dividend
cuts would be a sign of exactly the opposite, which would cause a stock
price to decline. This makes sense, but is it true?

If you believe (as I do, by the way) that markets are at least relatively
efficient, a dividend is a pretty expensive way for a company to signal
future earnings growth. In fact, in a world of very efficient markets,
it's downright redundant. However, if you believe there are market
imperfections, there may well be a place for dividend payments. For
example, there is a clientele for high dividends. They prefer a regular
dividend payment to liquidating pieces of their investment portfolios.
You might argue, too, that it prevents investors from having to sell
shares at temporarily reduced share prices. Yet dividends are taxed more
heavily than capital gains, so why should a company pay any cash
dividends at all? Also, isn't a company that's paying cash dividends
essentially liquidating itself (i.e., paying off the shareholders)? The
answers to these questions aren't very favorable to dividend-paying
advocates. And can't we find a lot of high-growth companies (that have
enjoyed significant growth in their stock prices) that pay no cash
dividends at all? The answer is decidedly "yes." In fact, Microsoft
hasn't paid one penny in cash dividends in its history. So what's the
verdict? There may be a middle-of-the-road position. This maintains that
dividend policy doesn't affect a company's value. Moreover, if companies
could increase their stock price by issuing more dividends, why haven't
they already done so? This middle-of-the-road approach also argues that
there are enough of both high-dividend paying companies and low-dividend
paying companies to satisfy the investment clientele (i.e., those
investors who prefer one or the other). Thus, there is, at this time, no
inherent tendency for companies to radically change their current
policies. All things considered, a prudent course of action for any
company is to adopt a low dividend payout target, especially one that
keeps the company from having to issue new shares to maintain the
dividend . In short, why pay cash to stockholders if it also requires
issuing new shares to get the cash back? In other words, why spin your
financial wheels if you're not going to go anywhere?