1. Slide 1 Chapter 2 Demand, Supply, and Equilibrium Review Total, Average, and Marginal Analysis Finding the Optimum Point Present Value, Discounting & Net Present Value Risk and Expected Value Probability Distributions Standard Deviation & Coefficient of Variation Normal Distributions and using the z-value The Relationship Between Risk & Return Fundamental Economic Concepts ©2008 Thomson * South-Western

2. Slide 2 Demand Curves Individual Demand Curve the greatest quantity of a good demanded at each price the consumers are willing to buy, holding other influences constant $/Q Q /time unit $5 20

3. Slide 3 The Market Demand Curve is the horizontal sum of the individual demand curves. The Demand Function includes all variables that influence the quantity demanded 4 3 7 Sam +Diane = Market Q = f( P, P s, P c, Y, N P E ) - + - ? + + P is price of the good P S is the price of substitute goods P C is the price of complementary goods Y is income, N is population, P E is the expected future price

4. Slide 4 Determinants of the Quantity Demanded i. price, P ii. price of substitute goods, P s iii. price of complementary goods, P c iv. income, Y v. advertising, A vi. advertising by competitors, A c vii. size of population, N, viii. expected future prices, P e xi. adjustment time period, T a x. taxes or subsidies, T/S The list of variables that could likely affect the quantity demand varies for different industries and products. The ones on the left are tend to be significant.

5. Slide 5 Supply Curves Firm Supply Curve - the greatest quantity of a good supplied at each price the firm is profitably able to supply, holding other things constant. $/Q Q/time unit

6. Slide 6 The Market Supply Curve is the horizontal sum of the firm supply curves. The Supply Function includes all variables that influence the quantity supplied 4 3 7 Acme Inc. + Universal Ltd. = Market Q = g( P, P I, RC, T, T/S) + - - + ?

7. Slide 7 Determinants of Supply i.price, P ii.input prices, P I, and sometime shown as W (wages) and R (cost of capital) iii.cost of regulatory compliance, RC iv. technological improvements, T v.taxes or subsidies, T/S Note: Anything that shifts supply can be included and varies for different industries or products.

8. Slide 8 Equilibrium: No Tendency to Change Superimpose demand and supply If No Excess Demand and No Excess Supply... Then no tendency to change at the equilibrium price, P e D S PePe Q P Willing & Able in cross- hatched

9. Slide 9 Dynamics of Supply and Demand If quantity demanded is greater than quantity supplied at a price, prices tend to rise. The larger is the difference between quantity supplied and demanded at a price, the greater is the pressure for prices to change. When the quantity demanded and supplied at a price are equal at a price, prices have no tendency to change.

10. Slide 10 Equilibrium Price Movements Suppose there is an increase in income this year and assume the good is a “normal” good Does Demand or Supply Shift? Suppose wages rose, what then? D S e1e1 P Q P1P1

11. Slide 11 Comparative Statics & the supply-demand model Suppose that demand Shifts to D’ later this fall… We expect prices to rise We expect quantity to rise as well D S e1e1 P Q D’ e2e2

12. Slide 12 Break Decisions Into Smaller Units: How Much to Produce ? Graph of output and profit Possible Rule: »Expand output until profits turn down »But problem of local maxima vs. global maximum quantity B MAX GLOBAL MAX profit A

13. Slide 13 Average Profit = Profit / Q Slope of ray from the origin »Rise / Run »Profit / Q = average profit Maximizing average profit doesn’t maximize total profit MAX C B profits Q PROFITS quantity

14. Slide 14 Marginal Profits =  /  Q  Q 1 is breakeven (zero profit)  maximum marginal profits occur at the inflection point (Q 2 )  Max average profit at Q 3  Max total profit at Q 4 where marginal profit is zero  So the best place to produce is where marginal profits = 0. profits max Q2Q2 marginal profits Q Q average profits average profits Q3Q3 Q4Q4 (Figure 2.5) Q1Q1

15. Slide 15 Present Value »Present value recognizes that a dollar received in the future is worth less than a dollar in hand today. »To compare monies in the future with today, the future dollars must be discounted by a present value interest factor, PVIF=1/(1+i), where i is the interest compensation for postponing receiving cash one period. »For dollars received in n periods, the discount factor is PVIF n =[1/(1+i)] n

16. Slide 16 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 NCF t / ( 1 + r t ) t »where NCF t 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

17. Slide 17 Sources of Positive NPVs 1.Brand preferences for established brands 2.Ownership control over distribution 3.Patent control over products or techniques 4.Exclusive ownership over natural resources 5.Inability of new firms to acquire factors of production 6.Superior access to financial resources 7.Economies of large scale or size from either: a. Capital intensive processes, or b. High start up costs

18. Slide 18 Most decisions involve a gamble Probabilities can be known or unknown, and outcomes can be known or unknown Risk -- exists when: »Possible outcomes and probabilities are known »Examples: Roulette Wheel or Dice »We generally know the probabilities »We generally know the payouts

19. Slide 19 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   p i = 1 States of Nature StrategyRecessionEconomic Boom p =.30 p =.70 Expand Plant - 40 100 Don’t Expand - 10 50

20. Slide 20 Payoff Matrix Payoff Matrix shows payoffs for each state of nature, for each strategy Expected Value = r  =  r i  p i. r =  r i p i = (-40)(.30) + (100)(.70) = 58 if Expand r =  r i p i = (-10)(.30) + (50)(.70) = 32 if Don’t Expand Standard Deviation =  =    (r i - r ) 2. p i - _ _ _

21. Slide 21 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).

22. Slide 22 Coefficients of Variation or Relative Risk Coefficient of Variation (C.V.) =  / r. »C.V. is a measure of risk per dollar of expected return. The discount rate for present values depends on the risk class of the investment. »Look at similar investments Corporate Bonds, or Treasury Bonds Common Domestic Stocks, or Foreign Stocks _

23. Slide 23 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 = 15.510}  = SQRT{(10-15) 2 (.5)+(20-15) 2 (.5)].520} = SQRT{25} = 5 C.V. = 5 / 15 =.333 B: Prob X }R = 30.520}  = SQRT{(20-30) 2 ( (.5)+(40-30) 2 (.5)].540} = SQRT{100} = 10 C.V. = 10 / 30 =.333 A: Prob X }R = 15.510}  = SQRT{(10-15) 2 (.5)+(20-15) 2 (.5)].520} = SQRT{25} = 5 C.V. = 5 / 15 =.333 B: Prob X }R = 30.520}  = SQRT{(20-30) 2 ( (.5)+(40-30) 2 (.5)].540} = SQRT{100} = 10 C.V. = 10 / 30 =.333

24. Slide 24 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

25. Slide 25 Normal Distributions and z-Values z is the number of standard deviations away from the mean z = (r - r )/  68.26% of the time within 1 standard deviation 95.44% of the time within 2 standard deviations 99.74% of the time within 3 standard deviations Problem: income has a mean of $1,000 and a standard deviation of $500. What’s the chance of losing money? _

26. Slide 26 Realized Rates of Returns and Risk 1926-2002 (Table 2.10, page 54) Security TypeArithmetic Mean RORStandard Deviation Large Company Stocks12.7%20.2% Small Company Stocks17.3%33.2% Long-Term Corporate Bonds 6.1%8.6% Long-Term Government Bonds 5.7%9.4% Intermediate-Term Government Bonds 5.5%5.7% US Treasury Bills3.9%3.2% Inflation3.1%4.4%  Which is the riskiest?  Which had the highest return?

27. Slide 27 The Relationship of Risk & Return Typically markets demonstrate that there is a trade-off between risk & return »Everyone likes high returns »Many find risk something that they would like to avoid Therefore, the market sets the premium an investor needs to accept a type of risk. Required Return = Risk-free return + Risk Premium In Table 2.10, if T-bills reflect the risk-free rate, on average that is 3.8%. If large company stocks earn on average 12.3%, then the risk premium for this form of investment would be: 8.5% »12.3% = 3.8% + 8.5% The risk premium for other classes of assets. There would be lower risk premium for bonds and a much higher one for small company stocks.