Fundamental Economic Concepts

CHAPTER 2
FUNDAMENTAL
ECONOMIC
CONCEPTS
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whole or in part.
• 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
whole or in part. 2
DEMAND CURVES
• Individual
Demand Curve
$/Q the greatest quantity
of a good demanded
at each price the
consumers are
$5 willing to buy,
holding other
influences constant
20 Q /time unit
whole or in part. 3
FIGURE 2.1 DEMAND AND SUPPLY DETERMINE THE
EQUILIBRIUM MARKET PRICE
whole or in part. 4
THE DIAMOND-WATER PARADOX AND THE
MARGINAL REVOLUTION
• Equilibrium price is related to intrinsic value,
production costs, and input scarcity.
• Marginal use value–the additional value of
the consumption of one more unit
• Marginal utility–the use value obtained from
the last unit consumed
• The resolution of the paradox hinges on
distinguishing marginal utility from total
utility.
whole or in part. 5
FIGURE 2.2 THE DIAMOND-WATER PARADOX
RESOLVED
whole or in part. 6
whole or in part. 7
DEMAND FUNCTION
• The Demand Function includes all variables
that influence the quantity demanded.
[2.1] A demand function for hybrid cars:

Q = f( P, Ps, Pc, Y, A, AC N, PE, TA, T/S)
- + - + + - + + + -
The signs below each variable indicate the

impact the variable has on Q (hybrid
cars), as in the partial impact of price on
quantity, ∂Q/∂P < 0. See variable
definitions on the next slide.
See also Table 2.2.
whole or in part. 8
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
demanded varies
v. advertising, A for different
vi. advertising by competitors, Ac industries and
vii. size of population, N, products.
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
whole or in part. 9
whole or in part. 10
FIGURE 2.3 SHIFTS IN DEMAND
SUPPLY CURVES
• Supply Curve - the
greatest quantity
$/Q
of a good supplied
at each price the
firm is profitably
able to supply,
holding other
things constant.
Q/time unit
SUPPLY FUNCTION
The Supply Function includes all variables that
influence the quantity supplied.
[2.2] is the supply function:
Q = g( P, PI, PUI, T, EE, F, RC, PE, TA, T/S)

+ - - + + - - - + -
The signs below each variable indicate the
impact the variable has on Q (hybrid car
supply), as in the partial impact of price
on quantity, ∂Q/∂P > 0. See variable
definitions on the next slide. See also
table 2.3.
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.
EQUILIBRIUM MARKET PRICE OF GASOLINE
• Gasoline prices vary quite a bit.
• Explanations for the spike in equilibrium price
of gasoline include:
1. Supply disruptions & refinery capacity
constraints
2. Retail distributors and price gouging
3. Increases in excise taxes on gasoline
4. Variation in crude oil prices.
FIGURE 2.5 SUPPLY DISRUPTIONS AND DEVELOPING
COUNTRY DEMAND FUEL CRUDE OIL PRICE SPIKES
MARGINAL ANALYSIS
Marginal analysis is the basis for

economic decision making that
analyzes marginal benefits derived
from a particular decision and
compares them with the marginal
costs incurred.
AVERAGE PROFIT = PROFIT / Q
• Average profit increases as long as
marginal profit exceeds average
profit.
• Maximizing average profit doesn’t

maximize total profit.
FIGURE 2.9 TOTAL, AVERAGE, AND MARGINAL PROFIT
FUNCTIONS
MARGINAL PROFIT = ΔPROFIT/ΔQ
• 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.
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
NET PRESENT VALUE (NPV)
• Most business decisions are long term.
• Objective: Maximize the present value of
future profits
• The NPV of investment represents its
contribution to the value of the firm
shareholder wealth maximization.
• NPV = PV of future returns - Initial Outlay
• The NPV rule can be generalized to cover
returns received over any number of future
time periods.
SOURCES OF POSITIVE NPVS
1. Brand preferences 5. Inability of new firms to
for established acquire factors of production
brands 6. Superior access to financial
2. Ownership control resources
over distribution 7. Economies of large scale or
3. Patent control over size from either:
products or a. Capital intensive
techniques processes, or
4. Exclusive b. High start up costs
ownership over
natural resources
RISK
• Most decisions involve a gamble.
• Probabilities can be known or unknown, and outcome
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
CONCEPTS OF RISK
• When probabilities are known, we can

analyze risk using probability
distributions.
EXPECTED VALUE

_ n
 rjpj
• Expected Value = r= j=1
• r = expected value
rj = outcome of the jth case
n = possible outcomes
pj = probability that the jth outcome will occur
_
Standard Deviation = =
n
j=1
FIGURE 2.9 A SAMPLE ILLUSTRATION OF AREAS UNDER
THE NORMAL PROBABILITY DISTRIBUTION CURVE
COEFFICIENT OF VARIATION
OR RELATIVE RISK
_
• Coefficient of Variation (C.V.) = / r
• C.V. is a relative measure of risk, and is good for
comparing projects of different sizes
• 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.
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.
TABLE 2.10 REALIZED RATES OF RETURNS AND RISK
 Which had the highest return? Why?


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CHAPTER 2

[2.1] A demand function for hybrid cars:

The signs below each variable indicate the

Q = g( P, PI, PUI, T, EE, F, RC, PE, TA, T/S)

Marginal analysis is the basis for

• Maximizing average profit doesn’t

• When probabilities are known, we can

 Which had the highest return? Why?

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