Fundamental Economic Concepts

Chapter 2
• Demand and Supply Review
• Total, Average, and Marginal Analysis
• Finding the Optimum Point
• Present Value, Discounting & Net Present Value
• Risk and Expected Value
• Probability Distributions
• Standard Deviation & Coefficient of Variation
• Normal Distributions and using the z-value
• The Relationship Between Risk & Return
© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated,
or posted to a publicly accessible website, in whole or in part. Slide 1
 Demand Curves
• Individual
$/Q
Demand Curve
the greatest quantity
of a good demanded
at each price the
$5 consumers are willing
to buy, holding other
influences constant
20 Q /time unit
Slide 2
FIGURE 2.1 Demand and Supply
Determine the Equilibrium Market Price

Slide 3
FIGURE 2.2 The Diamond-Water
Paradox Resolved

Slide 4
Slide 5
 Jenny + Pete + … = Market
• The Market
Demand Curve is
the horizontal sum of
the individual
demand curves.
4 3 7

• The Demand [2.1] A demand function for hybrid cars:

Function includes Q = f( P, Ps, Pc, Y, A, AC N, PE, TA, T/S)
all variables that - + - + + - + + + -
The signs below each variable indicate the
influence the impact the variable has on Q (hybrid cars), as in
quantity demanded the partial impact of price on quantity, ∂Q/∂P <
0. See Variable definitions are on the next slide.
See also Table 2.2. Slide 6
 Determinants of the
Quantity Demanded
i. price, P • The list of
ii. price of substitute goods, Ps variables that
iii. price of complementary goods, Pc could likely affect
iv. income, Y the quantity
v. advertising, A demand varies for
vi. advertising by competitors, Ac
different industries
and products.
vii. size of population, N,
viii. expected future prices, Pe
• The ones on the
left tend to be
xi. adjustment time period, Ta
significant.
x. taxes or subsidies, T/S

Slide 7
Slide 8
Figure 2.3 Shifts in Demand

Slide 9
 Supply Curves
• Firm Supply
Curve - the
$/Q greatest quantity
of a good supplied
at each price the
firm is profitably
able to supply,
holding other
things constant.
Q/time unit
Slide 10
• The Market
Acme Inc. + Universal Ltd. + … = Market
Supply Curve is
the horizontal sum
of the firm supply
curves.

2200 3100 7300

• The Supply
Function includes [2.2] is the supply function:
Q = g( P, PI, PUI, T, EE, F, RC, PE, TA, T/S)
all variables that
+ - - + + - - - + -
influence the The signs below each variable indicate the
quantity supplied impact the variable has on Q (hybrid car
supply), as in the partial impact of price on
quantity, ∂Q/∂P > 0. See Variable
definitions are on the next slide. See also
table 2.3. Slide 11
 Determinants of the Supply Function
i. price, P
ii. input prices, PI, e.g., sheet metal
iii. Price of unused substitute inputs, PUI, such as fiberglass
iv. technological improvements, T
v. entry or exit of other auto sellers, EE
vi. Accidental supply interruptions from fires, floods, etc., F
vii. Costs of regulatory compliance, RC
viii. Expected future changes in price, PE
ix. Adjustment time period, TA
x. taxes or subsidies, T/S

Note: Anything that shifts supply can be included and varies for different industries or
products.

Slide 12
Slide 13
 Equilibrium: No Tendency to Change
• Superimpose demand and supply S
• Then no tendency to change at P
the equilibrium price, Pe
• Gasoline prices vary quite a bit Willing
• Explanations on gas include: & Able
1. Supply disruptions & refinery in cross-
capacity constraints hatched
2. Retail distributors and price
gouging
3. Increases in excise taxes on Pe
gasoline
4. Variation in crude oil prices.
D

Q
Slide 14
FIGURE 2.5 Supply Disruptions and Developing
Country Demand Fuel Crude Oil Price Spikes

Slide 15
Slide 16
 Break Decisions Into Smaller Units:
How Much to Produce ?
• Graph of output and profit
GLOBAL
profit MAX
• Possible Rule: Local
» Expand output until MAX
profits turn down
» But problem of local
maxima vs. global
maximum gets you
to point A not B
A quantity B
Slide 17
Average Profit = Profit / Q
PROFITS
• Slope of ray from the
MAX origin
C » Rise / Run
B
» Profit / Q = average profit
• Maximizing average
profits profit doesn’t
maximize total profit
Q quantity
Slide 18
 Marginal Profits = /Q
• Q1 is breakeven (zero profit)
• maximum marginal profits occur at the
inflection point (Q2)
• Max average profit at Q3
• Max total profit at Q4 where marginal profit
is zero
• So the best place to produce is where marginal
profits = 0.

Slide 19
FIGURE 2.8 Total, Average, and
Marginal Profit Functions

Slide 20
 Present Value
» Present value recognizes that a dollar received in the
future is worth less than a dollar in hand today.
» To compare monies in the future with today, the future
dollars must be discounted by a present value interest
factor, PVIF=1/(1+i), where i is the interest
compensation for postponing receiving cash one
period.
» For dollars received in n periods, the discount factor is
PVIFn =[1/(1+i)]n

Slide 21
 Net Present Value (NPV)
• Most business decisions are long term
» capital budgeting, product assortment, etc.
• Objective: Maximize the present value of profits
• NPV = PV of future returns - Initial Outlay
• NPV = t=0 NCFt / ( 1 + rt )t
» where NCFt is the net cash flow in period t
• NPV Rule: Do all projects that have positive net present values. By doing
this, the manager maximizes shareholder wealth.
• Good projects tend to have:
1. high expected future net cash flows
2. low initial outlays
3. low rates of discount

Slide 22
 Sources of Positive NPVs
1. Brand preferences for 5. Inability of new firms to
established brands acquire factors of production
2. Ownership control 6. Superior access to financial
over distribution
resources
3. Patent control over
7. Economies of large scale or
products or
techniques size from either:
4. Exclusive ownership a. Capital intensive processes,
over natural resources or
b. High start up costs

Slide 23
• Most decisions involve a gamble
• Probabilities can be known or unknown, and
outcomes possibilities can be known or unknown
• Risk -- exists when:
» Possible outcomes and probabilities are known
Examples: Roulette Wheel or Dice
» We generally know the probabilities
» We generally know the payouts
Uncertainty if probabilities and/or payouts are unknown
Slide 24
 Concepts of Risk

• When probabilities are known, we can analyze risk using

probability distributions
» Assign a probability to each state of nature, and be
exhaustive, so thatpi =1
States of Nature
Strategy Recession Economic Boom
p = .30 p = .70

Expand Plant - 40 100

Don’t Expand - 10 50
Slide 25
 Payoff Matrix

• Payoff Matrix shows payoffs for each state of nature,

for each strategy
• Expected Value = r= ri pi
• r_ = ri pi = (-40)(.30) + (100)(.70) = 58 if Expand
• r_ = ri pi = (-10)(.30) + (50)(.70) = 32 if Don’t
Expand
• Standard Deviation = =  (r i - r ) 2. pi
-

Slide 26
Slide 27
 Example of
Finding Standard Deviations
expand = SQRT{ (-40 - 58)2(.3) + (100-58)2(.7)} = SQRT{(-
98)2(.3)+(42)2 (.7)} =
SQRT{ 4116} = 64.16

don’t = SQRT{(-10 - 32)2 (.3)+(50 - 32)2 (.7)} = SQRT{(-42)2

(.3)+(18)2 (.7) } =
SQRT{ 756 } = 27.50

Expanding has a greater standard deviation (64.16), but also has the
higher expected return (58).

Slide 28
Slide 29
FIGURE 2.9 A Sample Illustration of
Areas under the Normal Probability
Distribution Curve

Slide 30
 Coefficients of Variation
or Relative Risk
• Coefficient of Variation (C.V.) = / r. _
» C.V. is a measure of risk per dollar of expected return.
• Project T has a large standard deviation of $20,000 and
expected value of $100,000.
• Project S has a smaller standard deviation of $2,000
and an expected value of $4,000.
• CVT = 20,000/100,000 = .2
• CVS = 2,000/4,000 = .5
» Project T is relatively less risky.

Slide 31
 Projects of Different Sizes:
If double the size, the C.V. is not changed !!!
Coefficient of Variation is good for comparing
projects of different sizes
Example of Two Gambles

A: Prob X } R = 15
.5 10 }  = SQRT{(10-15)2(.5)+(20-15)2(.5)]
.5 20 } = SQRT{25} = 5
C.V. = 5 / 15 = .333
B: Prob X } R = 30
.5 20 }  = SQRT{(20-30)2 ((.5)+(40-30)2(.5)]
.5 40 } = SQRT{100} = 10
C.V. = 10 / 30 = .333
Slide 32
 What Went Wrong at LTCM?
• Long Term Capital Management was a ‘hedge fund’
run by some top-notch finance experts (1993-1998)
• LTCM looked for small pricing deviations between
interest rates and derivatives, such as bond futures.
• They earned 45% returns -- but that may be due to
high risks in their type of arbitrage activity.
• The Russian default in 1998 changed the risk level of
government debt, and LTCM lost $2 billion

Slide 33
Table 2.10 Realized Rates of Returns and Risk

 Which had the highest return? Why? Slide 34