Economics 1301

Economics 1301

Basic Issues in Economics

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Administrative Detail

• Jim Holcomb• BUSN 240• 747-7787• [email protected]• Office Hours

– 1:30 – 3:00 PM M-R

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Economics

• The study of how people use their limited resources to try to satisfy their unlimited desire

• Huh?

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Human Misery

• 2/3 of the world’s population faces near starvation on a daily basis

• 1 in 10 infants die before their 1st birthday in Ethiopia, Pakistan, Tanzania versus less than 1 in 100 in US

• Why?

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Our Limited Means

• The most important concept in economics - ScarcityScarcity– Scarcity means that there isn’t enough of

anything to satisfy the wants of everyone.• Resources are scarce

– Resources are the ingredients of the process of producing goods and services

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Resources

• Land– Raw Materials

• Labor Resources– People

• Capital Resources– manufactured resources

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Scarcity Forces ChoicesChoices

• There just isn’t enough money or time to do everything

• Alternatives must be considered

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Choice Implies CostCost

• Choice implies a tradeoff or sacrifice• Cost is the sacrifice made to acquire

something• The Opportunity Cost of a choice is the best

alternative given up after the choice is made

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Opportunity Cost

• TANSTAAFL– 2nd most important

idea in economics• The cost of NOT

selecting the next best alternative

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Opportunity Cost

• The cost of NOT selecting the next best alternative– Dollar Cost– Time Cost– External Cost

• OC places the value on resources– Price represents the OC

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Choice Also Implies Competition

• When desires exceed resources, desires must compete for what is available

• Competition is a contest for command over scare resources

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Net Advantage

• People choose their actions on the basis of expected benefits and expected costs to themselves (Net advantage)– Their choices alter the net advantage of

everyone else• Events are the result of choices.• The emphasis in on choice. People choose.

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Social Cooperation

• Motives for behavior– Self-Interest (not

selfishness)– prefer more to less

• A process of continual adjustment to changing net advantage

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Choices Represented by a Model

• Model (also called a theory)– simplification of

reality– observable behavior– assumptions– implications

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Production Possibilities

• Combinations of things that can be produced with the economy’s resources

• Choices• Opportunity Cost• Preferences• Rules

bread

Milk

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Economic Systems

• Framework in which economic decisions are made– Who produces how much for whom?

• Pure Market Economy• Pure Command Economy• Mixed Economy

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Market Economy

• Private ownership of resources– private property rights

• Decentralized decision-making

• Choices are left to private resource owners

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Resource Allocation in a Market-Based Economy

• Buyers and sellers voluntarily agree to exchange goods and services

• But, the game does have rules– Market structure

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Markets & Structure

• Sellers’ side (Supply)• Buyers’ side

(Demand)

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Market Structure: Sellers

• Number of firms in a market– Competitive– Monopoly– In-between

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Competitive Market

• Many buyers and sellers– no one can control the price

• Identical products• Price free to adjust• No discrimination by buyers or sellers• Very easy entry and exit from market

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Monopoly

• Single seller• No close substitute• Protective barriers to entry

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Imperfect Competition

• Relatively few firms• Similar products• relatively easy entry and exit

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Markets: Demand

• Quantities of a product that consumers are willing to purchase at various prices,

• Other things equal.– Income– preferences– prices of other goods– expectations about future prices

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Law of Demand

• Given a choice, would you rather pay $10 or 50¢ for a Coke?

• Other things equal, the higher the price of a good the lower is the quantity demanded

• The Case of the Confused Clerk

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Demand Curve

Price

Quantity

D

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A Technical (but important) Distinction

• Change in Quantity Demanded– Movement Along a Demand Curve– Caused by change in price

• Change in Demand– Shift of Whole Demand Curve– Caused by anything other than price

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Change in Quantity Demanded

• Caused by a change in the price of good

• Shown by movement along a demand curve

P

Q

D

A

B

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Change in Demand

• Caused by change in anything other than the price of the good

• Shown by shift of demand curve

P

Q

D1

D2

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Things Other Than Price?

• Change in Income• Change in Prices of Related Goods• Change in Tastes• Change in Expectation• Change in Numbers of Consumers

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Markets: Supply

• Quantity of a Product that Sellers are Willing to Sell at Various Prices, Other Things Equal

• Other Things?– Cost of Production– Sellers’ Expectations– Number of Sellers

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Supply Curve

SP

Q

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Law of Supply

• The higher the price of a product, the larger will be the quantity supplied, other things being equal.

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That Same Technical Distinction

• Change in Quantity Supplied– Caused by a change in price of this good– Movement along a supply curve

• Change in Supply– Caused by anything other than price– Shift of a supply curve

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Change in Quantity Supplied

S

• Caused by change in price of this good

• Shown by movement along supply curve

P

Q

A

B

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Change in Supply

P

Q

S1

S2

• Caused by change in anything other than price– Usually cost

• Shown by shift in Supply Curve

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Economic Costs

• Long run v. Short run• Fixed v. Variable• Total, Average, and Marginal Costs

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Market = Supply & Demand

S

D

$

Q

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Competitive Equilibrium & Social Well-Being

• Equilibrium– No one wants to change anything– Quantity Demanded equals the Quantity

Supplied

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Equilibrium: The Saga Continues

• Everyone is completely happy (in economic sense)– Resource Owners– Owners of Firms– Consumers

• Intentions of buyers and seller coincide

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Economic Nirvana

• At equilibrium, consumers feel that firms are using precisely the right number of resources in production of this good.

• Scarce resource are being used correctly, from society’s point-of-view.

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But How Does (or can) This Happen?

• Consider what happens if price is above the “true but unknown” equilibrium

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Answer--Price Above Equilibrium

• Consumers decrease quantity demanded “Not worth it”

• Firms see unintended inventory accumulation “stuff not selling”

• Firms put stuff on SALE!!– WHY?

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Price “Below” Equilibrium

• Consumers rush to buy “BARGAIN”• Stores sell out and order more• New stuff arrives at higher price• Buyers decrease quantity demanded

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Equilibrating Process

• Resources move from low-valued uses to higher-valued uses as if guided by some “invisible hand.”

• When left alone, market forces tend to ensure social economic well-being.– Always?

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Always?

• Supply and Demand in “free” economies sometimes are not “free”

• Monopoly• Regulation• Government Intervention

THE STOCK MARKET

This material is not is the text. Use the WSJ for much of the references

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Stocks

• Stocks are pieces of corporate pie.

• When you buy stocks, or shares, you own a slice of the company

• A corporation’s stockholders all have equity in the company.– Why do they buy

stock?

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Common Stock

• Ownership shares• Sold initially by company then traded

among investors• Investors buy the shares expecting

dividends• AND, hope the price of the stock will go up

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Why common stock?

• Corporations trade ownership and control to investors whose motive is dividends and profits

• In return, they get investment money to build or expand their business

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Risky?

• Stock prices fall when company does not do well

• Why? How?• Entire investment could be lost• But, not more than that. Shareholders are

not responsible for corporate debt.

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Classes of Stock

• Firms may sell different classes of stock• Classes?

– Preferred– In a specific subsidiary– specific investment purposes– restrictions on ownership and trading

• Blue Chip Stocks– Stocks of largest, consistently profitable

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Stocks and Ownership

• Stockholders have the right to vote on major policy issues at stockholders meetings.– Generally the more stock you own the more

votes– But some companies issue different classes of

stock with different voting rights

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Voting

• Corporations have annual shareholder meetings for voting– In person, or– by proxy

• Securities and Exchange Commission (SEC) monitors publicly traded corporations

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The Value of a Share

• Can change at any moment– market conditions– investor perceptions– phase of the moon, etc.

• Supply and Demand

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The Value of Stock

0

50

100

150

200

250

300

IBMStockPrice

• Aug 1982, IBM major player in PC, stock price rises 75% in one year

• After 1987 Crash price falls from $100 to $41 in less than 1 year

• 2000 - $109

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Making Money with Stock

• Capital Gains– Buy low, sell high

• minus taxes and commissions of course– Timing is everything

• earnings, competitiveness, economy, etc

• Dividends– portion of corporate profit paid out to investors

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Making Money with Stocks

• Dividends (continued)– Paid as dollar amount per share– Amount fixed by BOD– Usually only large, mature corporations pay

dividends– Newer firms need to retain and reinvest their

earnings

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Dividend Yield

• Percentage of purchase price returned in dividends each year– Income Stocks

• stocks that regularly pay dividends– Growth Stocks

• Stocks that pay little or no dividend but instead reinvest their profit

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Stock Certificates

• Before the electronic age, companies prepared elaborate and ornate certificates of ownership called securities

• Today, the certificates have all but disappeared and only electronic records identify owners

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From Private To Public Ownership

• An entrepreneur has an idea for a product and borrows enough money to launch the business

• As the company grows, the entrepreneur can get funds for expansion in the private equity market

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Private Equity Market

• Sophisticated investors have assembled pools of money called venture capital that they are willing to risk in a new business in exchange for a role in how the company runs and a share of the profits

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Going Public

• If the firm continues to grow and needs more money than venture capitalists can provide, it decides to go public– The first time a company sells stock is called

going public– After that it can sell additional stock to raise

money

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Initial Public Offering (IPO)

• Company goes to investment bankers who buy the stock for resale to the public and large investors

• They also prepare prospectus, a detailed analysis of company’s financial history

• They publicize sale with ad called tombstone

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Investment Bankers

• The day before the actual sale the underwriters price the issue.

• Note that the company only gets money when the stocks are issued.

• Subsequent trading means profit or loss for the shareholder, but nothing for the firm.

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Stock Buyers

• Individual Investors– About 51 million Americans own stocks– However, proportion of total stock held by

individuals is dropping• Institutional Investors

– Mutual Funds– Insurance Companies– Banks

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Institutional Investors

• Majority of stocks held by institutions– An institutional trade is in blocks of 10,000 or

more shares• Program Trading

– Trading by formula monitored by computers on automatic

– Large trades can and do influence the market (S&D, again)

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Buying Stocks

• Buy or sell through stockbroker at a brokerage house that is a member of a stock exchange

• Stocks generally sold in round lots of 100 shares– Odd lots less than 100 shares, can be even 1

share

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Broker

• Place order to buy with broker– Broker charges a commission– Types of order

• Market Order -- buy now at current price• Limit Order -- buy when price falls to certain price

• Likewise, orders to sell placed with broker

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Buying on Margin

• Set up margin account with broker.• Then can borrow up to 50% of the price of

stock from broker on the account• Pay interest on the borrowed portion but

don’t repay principal until stock sold• Sounds good but if stock price falls

– The “Dreaded” margin call

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Reading Stock Tables

• High and Low Price• Per Cent Yield (Dividend)• Price/Earnings Ratio (P/E)

– Relationship between price of stock and company’s earnings the past 4 quarters

– A P/E of, say, 14 means its price is 14 times its earnings per share (EPS)

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Stock Tables

• Volume– multiply number by 100 (unless you see a z)

• Cash Dividends (Div)– estimated yearly dividend per share

• In WSJ, companies are listed by name then trading symbol

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Still More Stock Tables

• Daily High, Low, and Close• Net Change from previous close

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Some Advanced Stuff

• Selling Short– Selling something you don’t own yet.– Borrow shares from broker and sell them, wait

for price to fall and buy shares to return to broker plus commission and interest.

– Investors do this when expect prices to fall

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Some Stock Information

• Book Value– Difference between company’s assets and

liabilities--low is generally bad• Earnings Per Share (EPS)

– Divide number of shares into profit--going up is better

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Stock Info

• Return on Equity (ROE)– Divide EPS by Book Value

• Payout Ratio– Percentage of net earning company uses to pay

dividend--25%-50% is normal--higher means firm is struggling to meet obligations

• Get information from annual reports

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The Actual Stock Market

• NYSE & AMEX -- Wall Street– five regional exchanges also

• Role of SEC– See investors are fully informed about

securities offered for sale– Prevent misrepresentations and fraud– Monitor insider trading

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Seat on the Exchange

• Memberships on exchange– 1,366 on NYSE and 661 on AMEX

• The exchanges are actual marketplaces, i.e. malls for stock

• They do not set prices. Supply and Demand set prices

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NASDAQ

• National Association of Security Dealers Automated Quotation system

• An electronic market• Stocks sold over-the-counter (OTC) and not

listed on exchange• Usually smaller, emerging companies

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Market Indices

• Average of market as a whole– Dow Jones Industrial Average (DJIA) a.k.a. the

Dow -- the oldest and most famous• “The market up 15 points today”--they mean the

Dow went up 15 points • 30 component stocks• about 25% of the total value of all stocks listed on

NYSE• firms picked by editors of WSJ

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Other Indices

• NYSE Composite Index– all NYSE stocks

• S&P 500• NASDAQ Composite

• Russell 2000– 2000 small companies

• Wilshire 5000– all stocks traded

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What Makes Market Go Up?

• Ample money supply• Tax cuts• Low interest rates• Political stability• High employment

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What Makes Market Go Down?

• Tight money• Increased taxes• High interest rates offering better return in

less risky investments• Political unrest• International conflicts• Upcoming elections

Mutual Funds

Also not in the text

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Mutual Fund

• Generally safer to own variety of stocks and bonds than to gamble on success of a few (form a portfolio)

• But, it is hard and expensive• So, a collection of stocks, bonds, or other

securities owned by a group of investors and managed by a professional investment company

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Operating a Fund

• Funds are created by investment companies– They decide on an investment concept

• What is their objective?– Growth, income, specific industries

– Issue a prospectus– Sell shares

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How Funds Work

• A large number of people with money to invest buy shares in a mutual fund

• Their pooled money has more buying power• The fund manager invests money in

collection of securities• Successful investment adds value to the fund

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Fund Operation

• Investors receive distribution of earnings– Income Distributions

• money fund earns on its investments– Capital Gain Distributions

• Profit from selling investments

• Or, they can reinvest the money in the fund

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Types of Funds

• Open-end funds– Fund sells as many shares as investors want– Most mutual funds are open-ended

• Closed-end funds– Funds sells shares only once and offers only a

fixed number of shares– The shares often are traded on an exchange

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Mutual Funds Market

• Funds diversify holdings in investments that correspond to their type fund– A typical stock fund may own stock in 100 or

more firms• Some funds are extremely focused

– precious metal funds– sector funds– high yield bond funds

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Fund Types

• Stock or Equity Funds• Bond Funds• Money Market Funds• The first mutual fund was founded in 1924

by The Massachusetts Investors Trust (its still around, today called State Street Research)

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Stock Funds

• Buy shares of stock in various companies– Blue chips for income– Growth stocks for future gains– Value stocks for stability– Cyclical stocks to take advantage of economic

booms• Some funds stress income, others growth,

and others a combination

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Bond Funds

• Two main categories– Taxable

• corporate and U.S. government bonds– Tax-free

• state and municipal bond distributions are federal tax free

• But, what is a bond?

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Bonds

• Bonds are loans investors make to corporations and governments.

• The borrower promises to repay the loan at a specific time and to make annual interest payments over the life (term) of the loan

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Bonds

• Bonds are originally sold at par (usually in units of $1,000) with a specified and fixed interest rate

• Investor like bonds for the steady income• Bonds can be traded in exchanges (the

secondary market)

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Secondary Bond Market

• At a bond’s resale, the current rate of interest may not be the same as the interest rate on the bond.– If rates have gone down, the bond is worth

more than its face value, and the bond is sold at a premium

– If rates are up, the bond is worth less and is sold at a discount

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Bond Vocabulary

• Asset-backed• Mortgaged-backed

– self-amortizing• Agency

• Floating-rate• Convertible• Zero-coupon• Callable• Junk• Savings

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Bond Funds, again

• Many different types of funds– Investment-grade corporate– junk bonds

• Chief advantage is steady income• And bonds are usually high face value and

out of reach of individual investors

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Money Market Funds

• Much like savings account– Put dollar in, get dollar back, plus interest

• Invest in very short-term high grade securities

• Often, checks can be written against account

• Very little risk

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The Risk Factor

• Volatility– how much can return change in short term

• Predictability– of overall returns

• Investment Objective– The Risk/Return Tradeoff

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Special Purpose Funds

• Index Funds– track the market indices

• Tax-Free Funds• Sector Funds• Green Funds

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Operating a Mutual Fund

• A fund has two businesses– Making an investment profit– providing services to its clients

• trading $150 million per day• handling 15,000 pieces of mail per day• Charge management fee and/or commission or load

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Fund Quotations

• Net Asset Value (NAV)– price of one share in

fund• Load

– front-end– back-end

• 12b-1 fee– management,

marketing, and distribution fees

• Investment Objective