2 economic foundations of fm

Economic Foundation of Financial ManagementACC08

Topical ObjectivesTopical Objectives

bull Review relevant microeconomic concepts

bull Review relevant macroeconomic concepts and

bull Identify the Green regulations affecting doing business

Microeconomics ElasticityMicroeconomics Elasticity

bull a concept related to the equilibrium between demand and supply

bull measures the dependency between demand and supply and the impact of changes in either on the equilibrium price level

Microeconomics Price Elasticity of Microeconomics Price Elasticity of DemandDemand

bull Price elasticity of demand is calculated as


bull Perfect Elasticity

bull Elastic


bull Unit Elasticity

bull Inelastic


bull Perfectly Inelastic Elasticity

Microeconomics Price Elasticity of Microeconomics Price Elasticity of Demand - ExamplesDemand - Examples

bull For each sample determine elasticity as Perfectly Elastic Elastic Unit Elasticity Inelastic Perfectly inelastic

Microeconomics Price Elasticity of Microeconomics Price Elasticity of Demand ndash Example 1Demand ndash Example 1

bull Rich Asians buy into upwardly mobile Manilas luxury condominiums

bull Yield-hungry investors from Malaysia to Japan now buy Philippine condominium space in bulk rotating money from favorites Hong Kong and Singapore as the authorities there have acted to cool real estate prices property managers and consultants said

bull There has never been this strong foreign interest in the Philippines said David Young Philippines managing director with consultancy and brokerage Colliers International


bull Rich Asians buy into upwardly mobile Manilas luxury condominiums (continuation)

bull Typically 40 of space in newer condominiums is owned by foreigners the maximum they are allowed Foreigners cannot own land in the Philippines but they are allowed to hold condominium titles as long as 60 of the developments total floor area is owned by Filipinos

bull Asians usually buy apartments worth as much as $550000 per unit CPG managing director Robbie Antonio said



bull Brokers also noted rising interest in office space on bets that commercial leasing prices will skyrocket as more foreign firms outsource in the country

bull The action remains concentrated in Manila brokers said although it is slowly spilling over into new wave cities in central and southern Philippines which host business process outsourcing firms

bull Top property developers use globally-known luxury brands to attract overseas demand



bull Other than Armani CPG has tapped Versace and American socialite Paris Hilton to design interiors Brand associations have attracted interest from foreign nationals Antonio said

bull For their part Megaworlds Go said the company is offering in-house brokerage services to help in leasing apartments

Microeconomics Price Elasticity of Microeconomics Price Elasticity of Demand ndash Example Demand ndash Example

bull The surge in overseas pre-sales also keeps top property firms awash with cash to fund projects and fatten their land bank

bull Jones Langs Leechiu said top developers brush off private equity and sovereign wealth funds seeking discounts as they foresee sustained strong demand from retail buyers

bull If they ask for too much discount we wont agree We dont need the money Go said

Reuters (2014 July 3) Rich Asians buy into upwardly mobile Manilas luxury condominiums Retrieved July 6 2014 from Yahoo Finance httpsfinanceyahoocomnewsrich-asians-buy-upwardly-mobile-052903760html_ylt=AwrSbmsDSLlTHVIATCRXNyoA_ylu=X3oDMTEzbm5lbnJjBHNlYwNzcgRwb3MDMQRjb2xvA2dxMQR2dGlkA1ZJUDQ3M18x

Microeconomics Price Elasticity of Microeconomics Price Elasticity of Demand ndash ExamplesDemand ndash Examples

Microeconomics Expenditures and Price Microeconomics Expenditures and Price ElasticityElasticity

Microeconomics Factors influencing Microeconomics Factors influencing elasticityelasticity

bull Close substitutes increase elasticity

bull Luxuries tend to be more elastic than necessities

bull Elasticity increases when the proportion of income spent on a product is high

bull Elasticity increases over time

Microeconomics Cross elasticity of Microeconomics Cross elasticity of DemandDemand

measures the responsiveness of the quantity demanded of one product to the change in price of another product

If Cross Elasticity Is

The Products Are

Positive Substitutes

Negative Complements

Microeconomics Income elasticity of Microeconomics Income elasticity of DemandDemand

measures the responsiveness of the demand for a product to changes in income

If Income Elasticity Is

Positive and greater than 10

Positive and less than 10

Negative

The Product IsNormal and income elastic

Normal and income inelastic

Inferior

As Income Rises

The amount of income spent and of income spent on the product rise

The amount of income spent rises but the of income spent on the product falls

The amount of income spent and of income spent on the product fall

Microeconomics Price elasticity of Microeconomics Price elasticity of SupplySupply

measures the responsiveness of the quantity supplied of a product to a change in its price

More Elastic Supply

Product is easy to produce with many different common types of resources

Less Elastic Supply

Product is hard to produce and requires very specific scarce resources

Microeconomics Examples of factors Microeconomics Examples of factors affecting increase (decrease) demand for affecting increase (decrease) demand for goodsgoods

Microeconomics Examples of factors Microeconomics Examples of factors affecting increase (decrease) supply for affecting increase (decrease) supply for goodsgoods

Microeconomics Example of factors Microeconomics Example of factors affecting increase (decrease) supply for affecting increase (decrease) supply for goodsgoods

bull Discussion Questions bull Predict what may happen to the usage by the riding

public of the MRT Of the Bus bull Do you think the MRTLRT fare hike is good

bull MRT LRT fares may go up in AugustmdashAbayabull By Miguel R Camus |Philippine Daily Inquirer 1226

am | Friday June 21st 2013 bull Read more httpbusinessinquirernet128269mrt-lrt-fares-may-go-up-in-

august-abayaixzz36mF0nFX7


bull Read more httpbusinessinquirernet128269mrt-lrt-fares-may-go-up-in-august-abayaixzz36mF0nFX7

bull This means fares which were last adjusted in the early 2000s will increase by P5 in 2013 while the second P5 increase will kick in next year

bull The announcement of the fare increases comes amid severe criticism of the LRT-MRT operationsmdashcoaches with passengers woefully packed like sardines most times of the day and long queues to the stations during rush hours



bull For example MRT 3 was designed to serve 350000 passengers per day but some 600000 people cram the system daily

bull A 13-kilometer stretch of the line on north Edsamdashfrom Muntildeoz to Trinomamdashhas yet to be connected three years into the Aquino administration

bull Critics say that no mass transportation system anywhere in the world makes money quite apart from Hong Kong



bull Even with the fare increase the LRT lines and MRT 3 come out ldquocheaperrdquo than rates charged by bus operators which are pegged at P40 per passenger Abaya said

bull The current fare at MRT which runs through Edsa Metro Manilarsquos main highway is pegged at a maximum of P15 per passenger For LRT 1 passengers are charged up to P20 each for a single journey for LRT 2 the rate is pegged at P15



bull Unlike other agencies under the DOTC the LRTA is unique as it does not have a regulating body when it comes to setting fares

bull For the MRT 3 alone Abaya said the government was spending P60 to transport one passenger from end to end well above the current ticket price This translates to about P7 billion to P9 billion in subsidies every year



bull To address overcrowding the DOTC is evaluating a proposal by a Chinese manufacturer as part of its plan to acquire 48 new train cars to expand MRT 3rsquos capacity

bull ldquoComplete delivery will happen on May 2016rdquo he said

bull MRT 3 currently has a fleet of 73 train cars serving passengers at 3-minute intervals The DOTC said the addition of new cars will cut the waiting time to 25-minute intervals

Marginal Benefit vs Marginal CostMarginal Benefit vs Marginal Costbull Marginal Benefit ndash Benefit that an individual gets from consuming an

additional unit of good or service However each additional unit consumed results in smaller marginal benefit and results in diminishing returns

The demand curve represents the marginal benefit curve of the product to consumers

bull Marginal Cost ndash Cost of producing an additional unit of output also referred to as opportunity cost

The supply curve represents the marginal cost curve of the producers

Marginal Benefit vs Marginal Cost ndash Marginal Benefit vs Marginal Cost ndash Example 1Example 1

bull Read more httpnewsinfoinquirernet617323sc-ruling-on-dap-checks-balances-democracy-workixzz36mhRVdfo Follow us inquirerdotnet on Twitter | inquirerdotnet on Facebook

bull The Supreme Court last Tuesday struck down the DAP including a circular allowing the release of savings from the executive department to agencies and projects outside the national budget approved by Congress

bull The executive department pooled savings under the DAP a stimulus program introduced in 2011 and allotted these for projects to speed up government spending and boost economic growth

bull


bull The selling price is P100bull The variable cost per unit is P40 (of which is P5 marketing

costs)bull The total fixed manufacturing cost is P5000bull The total fixed administrative costs is P2200

bull Requirementsbull Compute for the break-even unitsbull If there are 150 units how much is the increase in net income

Consumer Surplus amp Producer SurplusConsumer Surplus amp Producer Surplusbull Consumer Surplus is the difference

between total value consumers place on a good produced less the amount paid

bull Producer Surplus is the difference between the price received for each good produced and the opportunity cost of producing the good

bull The difference between the lowest available price for a good and the highest price is the producer surplus

Price Takers amp SearchersPrice Takers amp Searchersbull Price takers must take the market

price in selling their product because each price takerrsquos output is small relative to total market

bull Price searchers have a downward sloping demand curve for their product The amount they are able to sell is inversely related to the price they charge

Price Taker Market Characteristics1048729 All firms are producing an identical product1048729 A large number of firms exist in the market1048729 Each firm supplies only a very small portion of total amount supplied to the market1048729 No barriers limit the entry or exit of firms in the market

Market StructuresMarket StructuresPerfect

Competition

of Sellers and Buyers

Many

Sellerrsquos Products

Identical

Barriers to entry None

Economies of Scale

Low

Competition Between Sellers

High

Other

Buyers have perfect

knowledge of product and

price

MonopolisticCompetition

Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers

No Close Substitutes

High

Often High

High or Low

Sellers are independent

but have incentive to form cartel

Monopoly

One Seller


Insurmountable

Often High

None

Macroeconomic ConceptMacroeconomic Conceptbull Macroeconomic concepts that have an impact on all firms

in the same environment be it a country a group of related countries or a particular industry

bull Topics covered concepts about the business cycle and how to forecast changes in the business cycle and the impact on among other things price levels and profitability

Macroeconomic Concept Business CycleMacroeconomic Concept Business Cyclebull

Moderating the Business Cycle

Policies can be used to moderate the business cycle

Status of the Economy

Appropriate Action

Using Fiscal Policy

Using Monetary Policy

RecessionGDP lt PotentialExcess unemployment

StimulusAD uarr

G uarr T darrDeficit uarr

M uarr

BoomGDP gt PotentialRising real wages

ContractionAD darr

G darr T uarrDeficit darr

M darr

bull The actions can be oDiscretionary actions require a policy change

Example bull Increase government spending on roadsbullRaise income tax rates

Moderating the Business Cycle (continued)

oAutomatic actions require no policy change and occur with changes in the level of economic activity Examples

bull Income taxes are based on progressive rates so total taxes fall at an accelerating rate with declining economic activity

bull Needs-based spending such as unemployment insurance automatically increases with rising unemployment


bull Discretionary policy is hampered by lags oRecognition oLaw-makingoImpact


bull bull The Rate of Inflation is calculated as Inflation = Last yearrsquos price index - This yearrsquos price index 100

rate Last yearrsquos price index

bull bull Inflation is an increase in the general level of prices

Macroeconomics Inflation

Inflation and Interest Rates

Nominal interest rates reflect both an expectation of inflation and a real rate of interest

bull Supply set by BSPbull Demand is a function of interest rate

bull Investment demand for capitalbull Savings supplybull Real interest rate is independent of inflation rate

Change in inflation expectations directly changes nominal rates

rnom = Real rate + E(inf)

Unexpected inflation redistributes income among economic groups

If inflation is higher than expected

Interest rates will have been set too low

Benefits borrowers at the expense of lenders

Causes borrowers to regret they did not borrow more and lenders to regret they did not lend less

Inflation and Interest Rates (continued)

If inflation is lower than expected

Interest rates will have been set too high

Benefits lenders at the expense of borrowers

Causes lenders to regret they did not lend more and borrowers to regret they did not borrow less


Two Types of Inflation

Demand-Pull Inflation starts with an increase in AD Typical causes of the increase include an increase in the money supply government spending or exports Assuming the economy is already at full employment

bull The increase in AD will increase GDPReal and the price level bull But rising costs will decrease SRAS leading to another increase in the

price level and decrease in GDPReal

bull Net result is a one time round of price increases and no change in GDPReal

bull However if the money supply continues to grow excessively and fuel AD the demand-pull inflation process can continue

Cost-Push Inflation starts with an increase in costs Typical causes of the increase include a rise in the money wage rate or raw material prices

Rising costs reduce the SRAS curve and the initial effect is to increase prices and decrease GDPReal

This fall below GDPPotential could precipitate government stimulation which will increase AD leading to another increase in prices and an increase back to GDPPotential

Net result is a one time round of price increases and no change in GDPReal

Two Types of Inflation (continued)

In the short run Some inputs (such as labor and raw materials) are variable but others (such as

property plant and equipment) are not Output can benefit by the specialization of labor All inputs are subject to the Law of Diminishing Returns

Output in the Short Run

AFC Falls as output rises and fixed cost is spread AVC and MC

bull First fall with specializationbull Then rise with Law of Diminishing Returns

MC When rising it will intersect the minimum points on AVC and ATC

Expected Relationships in the Short-Run


In the long run all costs are variable and the firm can alter the size of its plant to meet higher or lower product demand

bull If expanding plant size leads to more efficiency and specialization the minimum point on the SRATC curve will be lower

bull If expanding the plant size leads to less efficiency and specialization the minimum point on the SRATC curve will be higher

bull These minimum points become the firms LRATC curve (which can be upward flat or even downward sloping)

The minimum point on the LRATC curve is the firmrsquos minimum efficient scale

Costs in the Long Run (continued)

In the short run some costs are fixed and the firm will maximize profits by operating at the minimum point on its SRATC curve

Costs in the Long Run

The aggregate demand curve (AD) measures the amount of total real consumption expenditures (goods and services) demanded at various price levels

AD = Y = C+I+G + (XndashM) = GDPRealAD curversquos downward slope is caused by the

bull Wealth Effect Rising inflation (GDP Deflator uarr) causes financial assets to lose value All other things equal this leads to increased savings and decreased current spending

bull Substitution Effect Rising prices and inflation increase nominal interest rates which reduces borrowing to fund current consumer and investment spending

A change in AD curve is due to a factor other than price

Aggregate supply is the quantity of goods services supplied (GDPReal) It is a function of aggregate production which depends on

bull Quantity of Labor (L)

bull Quantity of Capital (K)

bull Level of Technology (T)

At any one point in time the level of technology and quantity of capital are fixed but the quantity of labor is variable This produces a vertical long-run aggregate supply and an upward sloping short-run aggregate supply curve

Potential GDP increases over time with increases in the

Increases in factor costs decrease the SRAS curve

bull ldquoFull employmentrdquo quantity of labor

bull Capital (human and physical)

bull Level of Technology

bull ldquoDoes not affect real factors of production and Potential GDP

bull Rising production costs decreases SRAS (higher price for any quantity of output)

bull Assuming all other prices rise at the same rate the economy remains at Potential GDP but at a higher price level

Classical View The economy is self regulating back to full employment

bull Wages and prices adjust fully and quickly to eliminate shortages and surpluses to restore economic efficiency and full employment

bull Taxes and government intervention are potential disruption to the market signals necessary for fully functioning competitive markets

bull Technology is the prime driver in increasing aggregate demand and supply over time

Keynesian View The economy is inherently unstable and does not return to a long-run equilibrium (potential GDP) without government intervention

bull Expectation are the primary determinant of AD and expectations are the subject to excesses of optimism and pessimism (leading to inflation and recession)

bull SRAS does not quickly adjust because wages in particular are ldquostickyrdquo in the downward direction

bull Government intervention to dampen or stimulate the economy is needed to maintain output at potential GDP

Monetarist View The economy is self regulating back to full employment as long as the money supply grows at an appropriate stable pace

bull The quantity of money fuels aggregate demandbull Recessions are caused by bad monetary policybull The wage rate is sticky which delays economic recoveries when

coming from recessionbull Taxes and government intervention are a potential disruption to the

market signals necessary to make competitive markets work

MONEYMoney is a means of payment to settle a debt for a current or prior purchase It has three functions

Medium of exchange for goods or services Credit cards are not money they just delay the debt Checks are not money They move funds (money) from one account to

another Checking account balances are money

Store of value that can be held and exchanged for goods in the futureUnit of account that allows relative prices to be quoted in a standard unit

The Supply and Demand for Money

The supply of money is fixed at any point in time by the Fed (hence the vertical supply curve)

The ldquopricerdquo of money is the interest rate

Equilibrium Price

Shortage leads to selling of investments

Surplus of money leads market participants to invest

bull The demand for money is affected by four major factorsoThe level of interest rates cause movement on the demand

curve and is inversely related to demandHigher rates create an incentive to invest instead of holding money

Higher rates are associated with higher inflation which causes money to lose value

The Supply and Demand for Money (continued)

oThe General Price LevelQuantity of nominal money demanded is directly related to the price level

Quantity of real dollars demanded is independent of the price level

oReal GDP demand for money is directly related to real income

oFinancial Innovation has generally led to greater liquidity and decreased demand for narrowly defined money


Two Categoriesbull Renewable resources are replenished by naturebull Nonrenewable resources are used up in production

Renewable Resourcesbull Total supply is fixed and inelasticbull Any one purchaser can obtain more by paying a higher price

Non-Renewable Resourcesbull Total supply (both known and expected to be recovered supply) is fixed known

and perfectly elasticbull Total demand (current and all future demand) determine future pricebull Current price is the PV of future price causing the current price to rise over time

at the rate of interest rates (Hotelling Principle)bull Lack of perfect knowledge of future supply demand and interest rate can lead to

surprise changes in price today

The materials balances model

bull Kneese Ayresand DrsquoArge (1970) (Thomas 2010) (Figure 10)

Environmental Policies

The Philippine Experience

bull PD 1151 Philippine Environmental Policy (1977)bull Renewable Energy Act (2008)bull In December of 2008 then President Gloria M Arroyo

signed into law the Republic Act 9513 Renewable Energy (RE) Act of 2008-an act promoting the development utilization and commercialization of renewable energy resources and for other purposes


bull Its targets were ldquofor the Philippines (Perez 2009) bull to be the No1 geothermal producer in the worldbull to be the No1 wind power producer in the Southeast

Asiabull to double its hydro capacity by 2013bull to expand contribution of biomass solar and ocean

energy by 250 MWrdquo


bull The Philippines has an abounding potential for generating energy from renewable resources (Perez 2009)bull Geothermal resource 1200 MW bull Wind 700 MWbull Solar no potential estimate which depends on solar panels put

up (but currently the largest solar manufacturing hub in Southeast Asia producing 400 MW)

bull Hydro 1784 MW from 888 sitesbull Biomass (bagasse) 235 MMBFOE


bull Amidst the so-called abundance of this Philippine potential for renewable energy about 50 of its power generation still comes from non-renewable sources (ie coal (26) and oil (23)) (Department of Trade and Industry 2009) DTI has forecasted that with growing industrial demand the country will still require 4000 to 4350 MW for sustainability (Department of Trade and Industry 2009)

Topical ObjectivesTopical Objectives

bull Review relevant microeconomic concepts

bull Review relevant macroeconomic concepts and

bull Identify the Green regulations affecting doing business








bull Elastic



bull Inelastic





































The Products Are








Negative



Inferior

As Income Rises






More Elastic Supply


Less Elastic Supply









































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price









































bull Elastic



bull Inelastic





































The Products Are








Negative



Inferior

As Income Rises






More Elastic Supply


Less Elastic Supply









































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price




































bull Inelastic





































The Products Are








Negative



Inferior

As Income Rises






More Elastic Supply


Less Elastic Supply









































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price






































































The Products Are








Negative



Inferior

As Income Rises






More Elastic Supply


Less Elastic Supply









































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price







































Negative



Inferior

As Income Rises






More Elastic Supply


Less Elastic Supply









































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price




































More Elastic Supply


Less Elastic Supply









































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price









































































bull














Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price















































Competition


Many


Identical


Economies of Scale

Low


High

Other

Buyers have perfect


price


Many

Slight Differences

None

Low

High

Oligopoly

A Few Sellers


High

Often High

High or Low



Monopoly

One Seller


Insurmountable

Often High

None








Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price









































Appropriate Action

Using Fiscal Policy



StimulusAD uarr


M uarr


ContractionAD darr


M darr































































































Equilibrium Price
































































































































Equilibrium Price


































2 economic foundations of fm

Documents

unit elasticity inelastic

overseas demand

equilibrium price level

examplesrich asians

luxury brands

property firms

foreign firms

southern philippines