1. Slide 1 Economic Analysis and Public Policy Lecture 1 © 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.

2. Slide 2 Part 1 Introduction & Goals of the Firm » The Decision-Making Model » The Role of Profits » The Principal-Agent Problem

3. Slide 3 Economics … … is the study of how individuals and societies choose to use the scarce resources that nature and previous generations have provided. The key word in this definition is choose. Economics is a behavioral, or social, science. In large measure it is the study of how people make choices. The choices that people make, when added up, translate into societal choices.

4. Slide 4 Micro/Macro Economics microeconomics The branch of economics that examines the functioning of individual industries and the behavior of individual decision-making units—that is, business firms and households. macroeconomics The branch of economics that examines the economic behavior of aggregates— income, employment, output, and so on—on a national scale.

5. Slide 5 5 of 34 Three basic questions must be answered in order to understand an economic system: What gets produced? How is it produced? Who gets what is produced?

6. Slide 6 6 of 34 capital Things that are themselves produced and that are then used in the production of other goods and services. factors of production (or factors) The inputs into the process of production. Another word for resources.

7. Slide 7 7 of 34 production The process that transforms scarce resources into useful goods and services. inputs or resources Anything provided by nature or previous generations that can be used directly or indirectly to satisfy human wants. outputs Usable products. opportunity costs The best alternative that we give up, or forgo, when we make a choice or decision.

8. Slide 8 8 of 34 Weighing Present and Expected Future Costs and Benefits We trade off present and future benefits in small ways all the time.

9. Slide 9 9 of 34 Capital Goods and Consumer Goods consumer goods Goods produced for present consumption. investment The process of using resources to produce new capital. Because resources are scarce, the opportunity cost of every investment in capital is forgone present consumption.

10. Slide 10 What is Managerial Economics? The application of microeconomics to problems faced by decision makers in the private, public, and not-for-profit sectors. »Even questions of how best to abate nitrous oxide by coal-fired Power Plants involves economic issues of finding efficient, least cost solutions. Managerial economics deals with microeconomic reasoning on real world problems such as pricing decisions, selecting the best strategy in different competitive environments, and making efficient choices.

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12. Slide 12 Responsibility of Management Managers solve problems before they become a crisis Managers select strategies to try to assure the success of the firm Managers create an organizational culture attune to the mission of the organization Senior management establish a vision for the firm Managers motivate and promote teamwork Managers promote the profitability of the firm And many managers see it in their long-run interest to promote sustainability of their enterprise in their environment. »Managers who fail at these responsibilities are reviled, be they be mangers of BP, Enron, or Bernie Madoff

13. Slide 13 To Expand Capacity or Not? An example of a simplified decision problem Should Honda or Toyota expand its capacity in North America? In part, it must consider current and future demand and what other firms are likely to do. Capacity for making cars is a long term project, so these firms should think in terms of the present value (PV) of future profits. Objective Function: »Max PV of profits {S1(New), S2(Used)} »where S1(New) is expand capacity with new facilities and S2(Used) to purchase used facilities from GM. Decision Rule: »Choose S1 if PV {Profits of S1 } > PV { Profits of S2 } »Choose S2 if PV { Profits of S1 } < PV { Profits of S2 } »If equal profits, then flip a coin »If negative profits for both, then don’t expand at all

14. Slide 14 The Role of Profits Economic Profit is the difference between total revenues and total economic cost (Economic cost includes the “normal” rate of return on capital contributions by the firm’s partners). We’d expect high profit areas to attract investment We’d expect low profit areas to lose investment »Shouldn’t then all industries earn the same profit eventually?

15. Slide 15 Theories of Why Profit Varies Across Industries 1.RISK-BEARING Theory of Profit 2.TEMPORARY DISQUILIBRIUM Theory of Profit 3.MONOPOLY Theory of Profit 4.INNOVATION Theory of Profit 5.MANAGERIAL EFFICIENCY Theory of Profit

16. Slide 16 Agency Problems Modern corporations allow firm managers to have no participation (or only limited ownership participation) in the profitability of the firm. Shareholders are principals, managers are agents. Two common problems : (1) often hard to observe managerial effort and (2) random disturbances in team performance (luck versus effort?)

17. Slide 17 The Principal-Agent Problem »Shareholders (principals) want profit »Managers (agents) want leisure & security »Divergent objectives between these groups are called agency problems.

18. Slide 18 Agency Costs 1.Extending grants of stock or deferred stock options It helps to make workers act more like owners of firm to try to raise the price of the stock, but is a cost 2.Bonuses or other compensation can be an incentive, but clearly is also a “cost” of solving agency problems 3.Internal audits and accounting oversight boards to monitor the firm 4.Bonding expenditures and fraud liability insurance 5.Costs of complex internal approval processes to avoid adverse managerial discretion

19. Slide 19 © 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. Part 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 Fundamental Economic Concepts

20. Slide 20 20 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS quantity demanded The amount (number of units) of a product that a household would buy in a given period if it could buy all it wanted at the current market price.

21. Slide 21 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 tend to be significant.

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23. Slide 23 23 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS The most important relationship in individual markets is that between market price and quantity demanded. CHANGES IN QUANTITY DEMANDED VERSUS CHANGES IN DEMAND Changes in the price of a product affect the quantity demanded per period. Changes in any other factor, such as income or preferences, affect demand. Thus, we say that an increase in the price of Coca-Cola is likely to cause a decrease in the quantity of Coca-Cola demanded. However, we say that an increase in income is likely to cause an increase in the demand for most goods.

24. Slide 24 24 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS PRICE AND QUANTITY DEMANDED: THE LAW OF DEMAND demand schedule A table showing how much of a given product a household would be willing to buy at different prices. Anna ’ s Demand Schedule forr Telephone Calls PRICE (PER CALL) QUANTITY DEMANDED (CALLS PER MONTH) $ 030.5025 3.507 7.003 10.001 15.000

25. Slide 25 25 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS demand curve A graph illustrating how much of a given product a household would be willing to buy at different prices.

26. Slide 26 26 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS law of demand The negative relationship between price and quantity demanded: As price rises, quantity demanded decreases. As price falls, quantity demanded increases. Demand Curves Slope Downward It is reasonable to expect quantity demanded to fall when price rises, ceteris paribus, and to expect quantity demanded to rise when price falls, ceteris paribus. Demand curves have a negative slope.

27. Slide 27 27 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS Other Properties of Demand Curves As long as households have limited incomes and wealth, all demand curves will intersect the price axis. For any commodity, there is always a price above which a household will not, or cannot, pay. Even if the good or service is very important, all households are ultimately constrained, or limited, by income and wealth. That demand curves intersect the quantity axis is a matter of common sense. Demand in a given period of time is limited, if only by time, even at a zero price. Two additional things are notable about Anna’s demand curve.

28. Slide 28 28 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS To summarize what we know about the shape of demand curves: 1.They have a negative slope. An increase in price is likely to lead to a decrease in quantity demanded, and a decrease in price is likely to lead to an increase in quantity demanded. 2.They intersect the quantity (X-) axis, a result of time limitations and diminishing marginal utility. 3.They intersect the price (Y-) axis, a result of limited incomes and wealth.

29. Slide 29 29 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS OTHER DETERMINANTS OF HOUSEHOLD DEMAND income The sum of all a household’s wages, salaries, profits, interest payments, rents, and other forms of earnings in a given period of time. It is a flow measure. Income and Wealth wealth or net worth The total value of what a household owns minus what it owes. It is a stock measure.

30. Slide 30 30 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS normal goods Goods for which demand goes up when income is higher and for which demand goes down when income is lower. inferior goods Goods for which demand tends to fall when income rises.

31. Slide 31 31 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS Prices of Other Goods and Services substitutes Goods that can serve as replacements for one another: when the price of one increases, demand for the other goes up. perfect substitutes Identical products. complements, complementary goods Goods that “go together”: a decrease in the price of one results in an increase in demand for the other, and vice versa.

32. Slide 32 32 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS Tastes and Preferences Expectations

33. Slide 33 33 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS SHIFT OF DEMAND VERSUS MOVEMENT ALONG A DEMAND CURVE Shift of Anna ’ s Demand Schedule Due to increase in Income SCHEDULE D 0 SCHEDULE D 1 Price (Per Call) Quantity Demanded (Calls Per Month at an Income of $300 Per Month) Quantity Demanded (Calls Per Month at an Income of $600 Per Month) $ 03035.502533 3.50718 7.00312 10.0017 15.0002 20.0000

34. Slide 34 34 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS shift of a demand curve The change that takes place in a demand curve corresponding to a new relationship between quantity demanded of a good and price of that good. The shift is brought about by a change in the original conditions. movement along a demand curve The change in quantity demanded brought about by a change in price. Change in price of a good or service leads to Change in quantity demanded (movement along the demand curve). Change in income, preferences, or prices of other goods or services leads to Change in demand (shift of the demand curve).

35. Slide 35 35 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS

36. Slide 36 36 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS FROM HOUSEHOLD DEMAND TO MARKET DEMAND market demand The sum of all the quantities of a good or service demanded per period by all the households buying in the market for that good or service.

37. Slide 37 37 of 46 DEMAND IN PRODUCT/OUTPUT MARKETS

38. Slide 38 38 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS profit The difference between revenues and costs. Successful firms make profits because they are able to sell their products for more than it costs to produce them.

39. Slide 39 39 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS PRICE AND QUANTITY SUPPLIED: THE LAW OF SUPPLY quantity supplied The amount of a particular product that a firm would be willing and able to offer for sale at a particular price during a given time period.

40. Slide 40 40 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS Clarence Brown ’ s Supply Schedule for Soybeans PRICE (PER BUSHEL) QUANTITY SUPPLIED (BUSHELS PER MONTH) $1.500 1.7510,000 2.2520,000 3.0030,000 4.0045,000 5.0045,000 supply schedule A table showing how much of a product firms will sell at different prices.

41. Slide 41 41 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS law of supply The positive relationship between price and quantity of a good supplied: An increase in market price will lead to an increase in quantity supplied, and a decrease in market price will lead to a decrease in quantity supplied.

42. Slide 42 42 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS supply curve A graph illustrating how much of a product a firm will sell at different prices.

43. Slide 43 43 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS OTHER DETERMINANTS OF SUPPLY The Cost of Production Regardless of the price that a firm can command for its product, revenue must exceed the cost of producing the output for the firm to make a profit.

44. Slide 44 44 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS The Prices of Related Products A soybean farm is a producer that supplies soybeans to the market. Assuming that its objective is to maximize profits, a firm’s decision about what quantity of output, or product, to supply depends on 1.The price of the good or service 2.The cost of producing the product, which in turn depends on ■The price of required inputs (labor, capital, and land) ■The technologies that can be used to produce the product 3.The prices of related products

45. Slide 45 i.price, P ii.input prices, P I, e.g., sheet metal iii.Price of unused substitute inputs, P UI, 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, T A x.taxes or subsidies, T/S Note: Anything that shifts supply can be included and varies for different industries or products. Determinants of the Supply Function

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47. Slide 47 47 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS SHIFT OF SUPPLY VERSUS MOVEMENT ALONG A SUPPLY CURVE movement along a supply curve The change in quantity supplied brought about by a change in price. shift of a supply curve The change that takes place in a supply curve corresponding to a new relationship between quantity supplied of a good and the price of that good. The shift is brought about by a change in the original conditions.

48. Slide 48 48 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS TABLE 3.4 Shift of Supply Schedule for Soybeans Following Development of a New Disease-Resistant Seed Strain SCHEDULE S 0 SCHEDULE S 1 Price (Per Bushel) Quantity Supplied (Bushels Per Year Using Old Seed) Quantity Supplied (Bushels Per Year Using New Seed) $1.5005,000 1.7510,00023,000 2.2520,00033,000 3.0030,00040,000 4.0045,00054,000 5.0045,00054,000

49. Slide 49 49 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS Change in price of a good or service leads to Change in quantity supplied (movement along a supply curve). Change in income, preferences, or prices of other goods or services leads to Change in supply (shift of a supply curve). As with demand, it is very important to distinguish between movements along supply curves (changes in quantity supplied) and shifts in supply curves (changes in supply):

50. Slide 50 50 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS FROM INDIVIDUAL SUPPLY TO MARKET SUPPLY market supply The sum of all that is supplied each period by all producers of a single product.

51. Slide 51 51 of 46 SUPPLY IN PRODUCT/OUTPUT MARKETS

52. Slide 52 52 of 46 MARKET EQUILIBRIUM equilibrium The condition that exists when quantity supplied and quantity demanded are equal. At equilibrium, there is no tendency for price to change.

53. Slide 53 53 of 46 MARKET EQUILIBRIUM EXCESS DEMAND excess demand or shortage The condition that exists when quantity demanded exceeds quantity supplied at the current price.

54. Slide 54 54 of 46 MARKET EQUILIBRIUM When quantity demanded exceeds quantity supplied, price tends to rise. When the price in a market rises, quantity demanded falls and quantity supplied rises until an equilibrium is reached at which quantity demanded and quantity supplied are equal.

55. Slide 55 55 of 46 MARKET EQUILIBRIUM EXCESS SUPPLY excess supply or surplus The condition that exists when quantity supplied exceeds quantity demanded at the current price.

56. Slide 56 56 of 46 MARKET EQUILIBRIUM When quantity supplied exceeds quantity demanded at the current price, the price tends to fall. When price falls, quantity supplied is likely to decrease and quantity demanded is likely to increase until an equilibrium price is reached where quantity supplied and quantity demanded are equal.

57. Slide 57 57 of 46 MARKET EQUILIBRIUM CHANGES IN EQUILIBRIUM When supply and demand curves shift, the equilibrium price and quantity change.

58. Slide 58 58 of 46 MARKET EQUILIBRIUM

59. Slide 59 59 of 46 DEMAND AND SUPPLY IN PRODUCT MARKETS: A REVIEW 1.A demand curve shows how much of a product a household would buy if it could buy all it wanted at the given price. A supply curve shows how much of a product a firm would supply if it could sell all it wanted at the given price. 2.Quantity demanded and quantity supplied are always per time period—that is, per day, per month, or per year. 3.The demand for a good is determined by price, household income and wealth, prices of other goods and services, tastes and preferences, and expectations. 4.The supply of a good is determined by price, costs of production, and prices of related products. Costs of production are determined by available technologies of production and input prices. 5.Be careful to distinguish between movements along supply and demand curves and shifts of these curves. When the price of a good changes, the quantity of that good demanded or supplied changes—that is, a movement occurs along the curve. When any other factor changes, the curve shifts, or changes position. 6.Market equilibrium exists only when quantity supplied equals quantity demanded at the current price. Here are some important points to remember about the mechanics of supply and demand in product markets:

60. Slide 60 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 gets you to point A not B quantity B Local MAX GLOBAL MAX profit A

61. Slide 61 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

62. Slide 62 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.

63. Slide 63 Total, Average, and Marginal Profit Functions

64. Slide 64 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

65. Slide 65 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

66. Slide 66 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

67. Slide 67 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

68. Slide 68 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

69. Slide 69 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 _ _ -

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71. Slide 71 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).

72. Slide 72

73. Slide 73 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. CV T = 20,000/100,000 =.2 CV S = 2,000/4,000 =.5 »Project T is relatively less risky. _

74. Slide 74 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

75. Slide 75 Chap 3-75 Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 3-75 The empirical rule approximates the variation of data in a bell-shaped distribution Approximately 68% of the data in a bell shaped distribution is within ± one standard deviation of the mean or The Empirical Rule 68%

76. Slide 76 Chap 3-76 Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 3-76 Approximately 95% of the data in a bell-shaped distribution lies within ± two standard deviations of the mean, or µ ± 2σ Approximately 99.7% of the data in a bell-shaped distribution lies within ± three standard deviations of the mean, or µ ± 3σ The Empirical Rule 99.7% 95%

77. Slide 77 A Sample Illustration of Areas under the Normal Probability Distribution Curve

78. Slide 78 Chap 3-78 Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 3-78 Using the Empirical Rule  Suppose that the variable Math SAT scores is bell- shaped with a mean of 500 and a standard deviation of 90. Then,  68% of all test takers scored between 410 and 590 (500 ± 90).  95% of all test takers scored between 320 and 680 (500 ± 180).  99.7% of all test takers scored between 230 and 770 (500 ± 270).

79. Slide 79 Chap 3-79 Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 3-79 Locating Extreme Outliers: Z-Score  To compute the Z-score of a data value, subtract the mean and divide by the standard deviation.  The Z-score is the number of standard deviations a data value is from the mean.  A data value is considered an extreme outlier if its Z-score is less than -3.0 or greater than +3.0.  The larger the absolute value of the Z-score, the farther the data value is from the mean.

80. Slide 80 Chap 3-80 Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 3-80 Locating Extreme Outliers: Z-Score where X represents the data value X is the sample mean S is the sample standard deviation

81. Slide 81 Chap 3-81 Copyright ©2012 Pearson Education, Inc. publishing as Prentice Hall Chap 3-81 Locating Extreme Outliers: Z-Score  Suppose the mean math SAT score is 490, with a standard deviation of 100.  Compute the Z-score for a test score of 620. A score of 620 is 1.3 standard deviations above the mean and would not be considered an outlier.