Fundamental Economic Concepts
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Demand and supply
Marginal analysis
Net present value
Meaning and measurement of risk
Demand and Supply: A Review
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They simultaneously determine equilibrium market
price.
Demand – potential sales concept; purchase
intentions
Supply – actual production, distribution, and
delivery; supply intentions
Peq – market-equilibrium price; equates the flow
rates of intended purchase and planned sale.
Demand function – a relationship between quantity
demanded and all the determinants of demand.
The demand schedule specifies the relationship between
prices and quantity demanded, holding constant the
influence of all other factors.
Demand function specifies all these other factors that
mgt often consider.
Substitute good – alternative products whose demand
increases when the price of the focal product rises.
Complementary goods – complements in consumption
whose demand decreases when the demand of the focal
product rises.
Equilibrium price – point where your demand and supply
meets.
FACTORS THAT AFFECT EQUILIBRIUM PRICE
1. Intrinsic use value – kagamiton sa product
2. Production costs
3. Input scarcity – shortage of raw materials
Marginal use value – the additional value of the
consumption of one more unit; the greater the
utilization already, the lower the use value remaining.
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Marginal – incremental change
Makuha nimo nga additional value if magpuno ka
ug usa pa ka unit (economies of scale)
Decreases as the rate of consumption increases
Why should something as essential to human life as
water sell for low market prices while something as
frivolous as cosmetic diamonds sell for high market
prices? Diamonds cost more than water.
The diamond-water paradox was restated narrowly.
Why should consumers bid low offer prices for something
as essential as water while bidding high offer prices for
something as frivolous as diamonds? to them diamonds
gives more satisfaction.
Changes in the price (P) of the good or service will result
only in movement along the demand curve, whereas
changes in any of the other demand determinants in the
demand function (PS, PC, Y, A, AC, N, CP, PE, and so on)
shift the demand curve.
The curve shifts to the left if the determinant causes
demand to drop. (buyer’s income drop)
The curve shifts to the right if the determinant causes
demand to increase.
Supply function – a relationship between quantity
supplied and all the determinants of supply.
Marginal utility – the use value/satisfaction obtained
from the last unit consumed; personal.
Utility – subjective human value; satisfaction
Marginal Utility and Incremental Cost
Marginal utility - determines the maximum offer price
consumers are willing to pay for each additional unit of
consumption on the demand side of the market.
Marginal cost – variable cost at the margin that
determines the minimum asking price producers are
willing to accept for each additional unit supplied.
Individual and Market Demand Curves
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The demand schedule (aka demand curve) is the
simplest form of the demand relationship. It is
merely a list of prices and corresponding quantities
of a commodity that would be demanded by some
individual or group of individuals at uniform prices.
The lower the price, the greater the quantity that
will be demanded.
Supply curve – a relationship between price and quantity
supplied, holding other determinants of supply constant.
Marginal Analysis
Marginal analysis - a basis for making various economic
decisions that analyzes the additional (marginal) benefits
derived from a particular decision and compares them
with the additional (marginal) costs incurred.
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Marginal analysis instructs decision makers to
determine the additional (marginal) costs and
additional (marginal) benefits associated with a
proposed action.
Only if the marginal benefits exceed the marginal
costs (that is, if net marginal benefits are positive)
should the action be taken.
Net Present Value Concept
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The NPV of an investment represents the
contribution of that investment to the value of the
firm and, accordingly, to shareholder wealth
maximization.
Used when economic decisions require that costs be
incurred immediately to capture a stream of benefits
over several future time periods.
Present value (PV0) – the value today of a future
amount of money or a series of future payments
evaluated at the appropriate discount rate.
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PV0 = FV1 × (PVIF)
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Present value interest factor:
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Expected Value - The weighted average of the possible
outcomes where the weights are the probabilities of the
respective outcomes.
R = expected value
Rj = outcome from the jth case
N = possible outcomes
Pj = probability of the jth outcome
Standard deviation: An Absolute Measure of Risk
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FV1 – amount received 1 yr in the future
NPV = Present value of future returns
Initial outlay
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Sources of Positive Net Present Value Projects
These reasons include the following barriers to entry and
other factors:
1. Buyer preferences for established brand names
2. Ownership or control of favored distribution systems
(such as exclusive auto dealerships or airline hubs)
3. Patent control of superior product designs or
production techniques
4. Exclusive ownership of superior natural resource
deposits
5. Inability of new firms to acquire necessary factors of
production (management, labor, equipment)
6. Superior access to financial resources at lower costs
(economies of scale in attracting capital)
7. Economies of large-scale production and distribution
arising from a) Capital-intensive production
processes b) High initial start-up costs
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Normal probability distribution
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Meaning and Measurement of Risk
Risk – A decision-making situation in which there is
variability in the possible outcomes, and the probabilities
of these outcomes can be specified by the decision
maker.
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A decision is said to be risk free if the cash flow
outcomes are known with certainty. (treasury bonds)
The more variable these outcomes are, the greater
the risk.
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The ratio of the standard deviation to the expected
value.
suitable for comparing alternatives of differing size.
Standard deviation divided by sample mean (average
of a data set)
The higher the coefficient of variation, the greater
the level of dispersion around the mean. The lower
the value of the coefficient of variation, the more
precise the estimate.
Risk and Required Return
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The relationship between risk and required return on
an investment can be defined as:
Required return = Risk-free return + Risk premium
risk-free rate of return - refers to the return available
on an investment with no risk of default.
This risk premium may arise for any number of
reasons.
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Probability - The percentage chance that a particular
outcome will occur.
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How is probability determined? Objectively/Subjectively
An objective determination is based on past outcomes
of similar events, whereas a subjective determination is
merely an opinion made by an individual about the
likelihood that a given event will occur.
The normal probability distribution is characterized by a
symmetrical, bell-like curve.
A table of the standard normal probability function can be
used to compute the probability of occurrence of any
particular outcome.
Coefficient of Variation: A Relative Measure of Risk
Risk and the NPV Rule
A primary problem facing managers is the difficulty of
evaluating the risk associated with investments and then
translating that risk into a discount rate that reflects an
adequate level of risk compensation.
A statistical measure of the dispersion or variability
of possible outcomes.
Can be used to measure the variability of a decision
alternative.
As such, it gives an indication of the risk involved in
the alternative.
The larger the standard deviation, the more variable
the possible outcomes and the riskier the decision
alternative.
A standard deviation of zero indicates no variability
and thus no risk.
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The borrower firm may default on its contractual
repayment obligations (a default risk premium).
The investor may have little seniority in presenting
claims against a bankrupt borrower (a seniority risk
premium).
The investor may be unable to sell his security interest
(a liquidity risk premium as we saw in the case of
LTCM), or debt repayment may occur early (a maturity
risk premium).
Investors generally are considered to be risk averse; that
is, they expect, on average, to be compensated for any
and all of these risks they assume when making an
investment.
Markets – any place where buyers and sellers meet to
exchange goods and services; voluntary exchange.
Price signals – the info that markets generate to guide
the distribution of resources.
Y axis = price per unit
X axis = quantity of strawberries
Demand
Marginal (additional) analysis
– an analysis of how individuals, businesses, and
governments make decisions; additional benefits and
additional cost.
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time around hatagan na nimo sya ug discount kay kibaw
man ka nga mu less ang marginal utility or satisfaction nga
e hatag sa next time mu consume siya sa mangga.
Price goes up people buy less.
Price goes down people buy more.
Supply
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an increase in price gives producers the incentive to
produce more
Law of Diminishing Marginal Utility
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Price goes down seller produce less.
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Price goes up seller produce more.
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Mismatches
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Surplus – high price; producers want to produce
more but consumers want to buy less.
Shortage – low price; producers want to produce less
but consumers want to buy more.
Hiring a worker?
we use marginal analysis every day; weighing the
cost with the benefit
also used by sellers, if naa kay suki sa manga the next
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Utility means satisfaction, or happiness people get
from consuming a good or service
a.k.a Law of Decreasing Additional Satisfaction
the more you consume anything the less satisfaction
you get
Utils a unit used to quantify satisfaction; they are
completely subjective.
As you consume more you pay less
Supply curve = Marginal COST curve
Why is it upward sloping? coz it reflects the higher price
needed to cover the higher marginal cost of production
Equilibrium price
Demand curve = Marginal BENEFIT curve
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Why is it downward sloping? Coz the lower the price the higher the
demand. At a lower price, purchasers have an extra income to spend
on buying the same good, so they can buy greater of it.
Quantity supplied = Quantity demanded
The price of w/ch the quantity of a product offered is
equal to the quantity of the product in demand
Equilibrium quantity
Diamond-Water Paradox
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Why should consumers bid low offer prices for
something as essential as water while bidding high
offer prices for something as frivolous as diamonds?
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Waters utility diminishes overtime (law of diminishing
utility) because it is plentiful thus people offer low prices.
Diamonds are extremely scarce; thus the additional
satisfaction it gives is high, thus people are willing to pay
higher price (marginal analysis).
Relative scarcity contributes to a product’s value.
the quantity demanded or supplied at the
equilibrium price
Supply curve
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a shift to the left means lesser supply (higher pricelower quantity)
Demand curve
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a shift to the left means lesser demand (lower pricelower quantity)
4 Market Behaviors:
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2.
3.
4.
Supply can decrease
Supply can increase
Demand can decrease
Demand can increase
Limitations of Law of Supply and Demand:
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Does that mean because there is less supply and
high demand price should be made higher?
Should not be applied to human organs
ETHICS
“Payment for organs is likely to lead to human
trafficking and take advantage of the poorest and
most vulnerable groups.”
It is not an absolute law and must be regulated.
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However, doesn’t mean it is limited it is valuable.
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Substitution effect – as prices rise consumers will
replace more expensive items w/ less costly
alternatives.
Elasticity (adaptability) of Demand – how sensitive a
quantity is to a change in price.
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Often price has a huge impact on its demand.
However, demand for gasoline is relatively inelastic.
For instance, if the price of gas goes up, people does not buy
less because they need it and there is less substitute.
Elasticity of Supply – responsiveness of a supply to a
change in price.
– a large change in price results to a small change in quantity.
Relative elastic supply – quantity is sensitive to a change in
price (t-shirts); seller can respond quickly unlike airplanes.
Perfectly inelastic supply – Vincent Van Gogh paintings;
regardless if people want more paintings by van gogh he
cannot make another.
Net Present Value
- is the difference between the present value of cash
inflows and the present value of cash outflows over a
period of time.
- present value of future cash flows minus investment
Future value – How much money will I have 1 year from
now if I invest $$$? = PV x (1+r)n
Present value – how much money do I invest today to
achieve $$$ 1 year from now? = FV/(1+r)n