Investment Tools Economics Microeconomic Analysis.doc

五、 Investment Tools: Economics: Microeconomic Analysis1.A: Preliminary Reading: Supply, Demand, and the Market Processa: Explain the laws of supply and demand.All else held constant, a higher price will increase the supply of goods produced and offered for sale. Existing producers will produce more, and new suppliers will enter the market. The law of supply states that there is a direct relationship between the price of a good and the amount of that good that will be supplied in the market place.Peoples desire for goods exceeds the purchasing power of their incomes. This forces them to make choices. People will choose those alternatives that enhance their welfare most relative to their cost. An increase in the cost of an item relative to alternative consumption choices reduces the likelihood of purchasing that item. Higher prices reduce the demand for an item and lower prices raise the demand for an item. This is called the law of demand. The availability of substitutes is the main reason that consumers buy less of a product as its price increases. Substitutes are goods that perform similar functions. The law of demand states that there is an inverse relationship between the price of a good and the amount buyers are willing to purchase.Market demand schedule: The demand curve will slope downward to the right, indicating that the number of units demanded will increase as the price declines. Some goods are much more responsive to changes in price than others. The greater the number of viable substitutes for a good the more responsive demand is to price. When interpreting the demand curve, remember that we have assumed that factors other than price, such as consumer income, have not changed significantlyb: Discuss how market prices respond to changes in supply and demand.A market is the environment that encompasses the trading arrangements of buyers and sellers that underlie the forces of supply and demand. Equilibrium occurs when the conflicting forces creating supply and demand are in balance. In the absence of shifts in supply and demand curves, if the price is so high that supply exceeds demand, some businesses will decrease their prices to sell their excess inventory while others elect to reduce production. The result is a reduction in both price and supply until the market is in equilibrium. Conversely, if demand exceeds supply, the price of the product will rise, resulting in reduced demand as consumers find substitutes and increased supply as producers add capacity. This will occur until the market is in equilibrium.c: Explain the difference between shifts in and movements along supply and demand curves.The demand curve isolates the impact that price has on the amount of a product purchased. A movement along a specific demand curve shows a change in quantity demanded resulting from a change in price. d: Discuss the factors that cause a demand curve to shift.Changes in consumer income: Consumers have more money so they can buy more of everything.Changes in the prices of related goods (substitutes and compliments): The price of butter goes up, so consumers buy less butter and more margarine.Changes in consumer expectations: Consumers expect the price of cars to rise next month, so they buy a new car now before the price increases later.Changes in the number of consumers in the market: As cities grow and shrink, and as international markets open to domestic markets, the change in the number of customers changes the demand curves of many products.Demographic changes: In recent years, the number of people in the U.S. aged 15 to 24 declined by more than 5 million. This change will shift the demand curve to the left for such things as jeans and pizza.Changes in Market Demographics: Changes in the population can have a large influence in markets. Population increases cause the curve to shift to the right.Changes in consumer tastes and preferences: As consumer tastes and preferences change, shifts in the demand curves for various products will shift.e: Define short-run and long-run market equilibrium.The short run is a time period of insufficient length to permit sellers to adjust fully to changes in market conditions. Producers are only able to increase the supply of a good offered for sale by using more labor and raw materials. New plant and equipment cannot be brought on line in the short run. In the short run, the market price of goods will change in the direction that brings the price which consumers are willing to pay into balance with the price at which producers are willing to sell.The long run refers to a time period of sufficient length to enable producers to adjust fully to market changes. In the long run, producers have the time to alter their productive factors and increase or decrease the physical size of their plants.In the short run, the balance between the amount supplied and the amount demanded that brings about market equilibrium is done by price alone. In the long run, production will increase supply as long as the return exceeds the opportunity cost of producing the item. When returns exceed opportunity costs, capital will flow into the industry and output will expand. This increased production will cause prices to fall eliminating the excess profits. If opportunity costs exceed returns from production, firms will remove capital from the production process, thus reducing supply and causing prices to rise.f: Explain how shortages and surpluses affect the analysis of supply and demand.Price ceilings are legally set maximum prices that sellers may charge. Ceilings are usually initiated during inflationary periods. Ceilings prevent the producer from increasing the selling price to cover rising costs. This will lead to a reduction in supply that will cause a shortage. A shortage exists when the amount of a good offered by sellers is less than the amount demanded by buyers at the existing price. An increase in price would eliminate the shortage, but since prices are capped, producers will direct resources away from these goods, reducing supply and increasing the shortage.Price floors are legally established minimum prices that buyers must pay for a good. Price floors will stimulate production, since producers are receiving more than the equilibrium price. Buyers, however, will shift their consumption to lower price alternatives causing supply to exceed demand, causing a surplus.g: Explain how the invisible-hand principle works.The invisible hand principle refers to the tendency of market prices to direct individuals pursuing their own interests into productive activities that also promote the economic well being of society. The market does this by:1. Communicating information to decision makers: Without the information provided by market prices, it would be impossible for decision makers to determine how intensely a good is desired relative to its opportunity costs. 2. Coordinating actions of market participants: Prices direct producers to undertake those projects that are demanded most intensely by consumers. 3. Motivating economic players: Market prices establish a reward-penalty structure that induces the participants to work, cooperate with others, use efficient production methods, supply goods that are desired, and invest for the future. 4. Pricing products and providing order to the market: The market process works automatically without the need for any government decision or central planners. The market system sets prices, determines production, and distribution channels without any outside control. 1.B: Preliminary Reading: The Economic Role of Governmenta: Define economic efficiency and discuss the role of government in achieving economic efficiency.Economic efficiency for the government means that for any given level of effort (cost), we obtain the largest possible benefit. Since everyone wants more rather than less, individuals are best served when the economic pie is as big as possible. Two conditions must exist for economic efficiency to exist:1. Undertaking an economic action will be efficient if it produces more benefits than costs for the individuals in the economy. 2. Undertaking an economic action will be inefficient if it produces more costs than benefits to the individuals. The role of government in creating/supporting economic efficiency is controversial. However, there is general agreement that the following two governments functions will help create the proper environment for economic efficiency.1. Protective function of government: One of the two functions of government that are generally recognized as legitimate is to maintain an infrastructure of rules so that citizens can interact peacefully with each other. This includes creating and enforcing laws against physical harm, theft, fraud, etc. It also includes national defense. 2. Productive function of government: A second function of government that is generally recognized as legitimate is to produce (provide) goods and services that a market is unable or unwilling to provide efficiently on its own. While police and fire protection fall into this category, perhaps the most important service is a stable economic environment. b: Explain how the market pricing system may fail to generate ideal economic efficiency because of lack of competition, externalities, the presence of public goods, or economic instability.Recall that the invisible hand of market forces generally provides individuals with the incentive to work hard to create value. There are four important factors that can limit the ability of the invisible hand to do this, which creates a potential need for government productive action.Lack of competition. Competition is vital to the proper operation of the pricing mechanism. When there are only a few firms in the industry, the competition from new entrants can be restrained. Sellers may, thus, be able to rig the market in their favor.Externalities - failure to recognize all costs and benefits. Externalities are the side effects, or spillover effects, of an action between two parties that influences the well being of other individuals. The presence of externalities means that decision-makers do not have the proper cost and price information on which to make decisions.Public goods difficult for the market to provide: Public goods are goods consumed by the public as a whole. Police protection and sponsored medical research are examples of public goods.Potential information problems: When individuals are unable to evaluate the quality of products properly, the makers of poor quality products thrive and the makers of high quality products have low or negative profits. For example, few individuals are capable of evaluating the safety features built into cars.c: Discuss the differences and similarities between market action and collective action in seeking economic efficiency.1. Competitive behavior is present in both the market and public sector. 2. Public-sector organization can break the individual consumption-payment link. With government, there is no direct link between the size of the payment and the amount of consumption. Some pay little in taxes and receive large benefits and vice versa. 3. Scarcity imposes the aggregate consumption payment link in both sectors. As in the private sector, aggregate consumption equals aggregate payment (there is no free lunch). Someone must pay for everything provided by the government. 4. In the private sector, individuals make choices with mutual gain as the foundation. In the public sector, the “majority” makes decisions, which generates some winners and some losers. 5. When collective decisions are made legislatively, voters must choose among candidates who represent a bundle of positions on issues. 6. Income and power are distributed differently in the two sectors. Success in the market place depends on ones ability to provide products at a reasonable price. d: Discuss the role of government in attempting to correct the shortcomings of the market.Recall that the invisible hand of market forces generally provides individuals with the incentive to work hard to create value. There are four important factors that can limit the ability of the invisible hand to do this, which creates a potential need for government productive action.Lack of competition. Competition is vital to the proper operation of the pricing mechanism. When there are only a few firms in the industry, the competition from new entrants can be restrained. Sellers may, thus, be able to rig the market in their favor.Externalities - failure to recognize all costs and benefits. Externalities are the side effects, or spillover effects, of an action between two parties that influences the well being of other individuals. The presence of externalities means that decision-makers do not have the proper cost and price information on which to make decisions.Public goods difficult for the market to provide: Public goods are goods consumed by the public as a whole. Police protection and sponsored medical research are examples of public goods.Potential information problems: When individuals are unable to evaluate the quality of products properly, the makers of poor quality products thrive and the makers of high quality products have low or negative profits. For example, few individuals are capable of evaluating the safety features built into cars.2.A: Demand and Consumer Choice, including addendum Consumer Choice and Indifference Curvesa: Explain consumer choice in an economic framework.As consumption increases, the marginal utility (that is the benefit derived from consuming that next unit) decreases. For example, your twelfth consecutive beer does not taste nearly as good as your first beer. This is known as the Law of Diminishing Marginal Utility. The law of diminishing marginal utility helps determine the shape of an individuals demand curve. The height of the demand curve at any point is the marginal benefit to the customer (the maximum price the consumer would pay for an additional unit). Marginal utility and consumer choice: Given a fixed income and price schedule, consumers will maximize their satisfaction (total utility) by ensuring that the last dollar spent on each item yields an equal degree of marginal utility.Price change and consumer choice:1. The substitution effect: If a good becomes cheaper relative to other goods, you will consume more of that good and 2. The income effect: As the price of a good drops, your real income rises, you will consume more of that good (and other goods). Time cost and consumer choice: Time, like money, is scarce to the consumer. Thus, a lower time cost, like a lower money price, makes a product more attractive.b: Identify, describe, and calculate the determinants of price and income elasticity of demand.Price elasticity of demand indicates the degree of consumer response to variation in price. It is determined by the % change in quantity demand divided by the % change in price.Example: If the price of product A is increased from $1.00 per unit to $1.10 per unit, the demand will decrease from 5.0 million units to 4.8 million units. What is the price elasticity of demand for product A? Is product A an elastic good?% change in quantity = (4.8 - 5.0) / (5.0 + 4.8) / 2 = - 0.2 / 4.9 = -0.041 or -4.1% change in price = (1.10 - 1.00) / (1.10 + 1.00) / 2 = 0.10 / 1.05 = .095 = 9.5%Price elasticity of demand for product A = -4.1% / 9.5% = -.43. Because the price elasticity of demand is below 1.0, product A is inelastic.Price elasticity of demand is determined by:1. Availability of substitutes: Many substitutes indicate elastic demand. The most important determinant of the price elasticity of demand is the availability of substitutes. When good substitutes for a product are available, a price rise induces many consumers to switch to other products and 2. Share of budget spent on product: Goods that occupy a relatively small portion of your budget will tend to be price inelastic. Income elasticity is the sensitivity of demand to change in consumer income. It is determined by the % change in quantity demanded divided by the % change in income.An inferior good has negative income elasticity. As income increases (decreases), quantity demanded decreases (increases). Inferior goods include such things as bus travel and margarine. The opposite type of good, a normal good, has positive income elasticity meaning that, as income increases (decreases), demand for the good increases (decreases). Normal goods include things like bread and tobacco.Generally, normal goods have low income elasticities (absolute values between 0 and 1) are considered necessities. Normal goods with high-income elasticities (absolute values greater than 1) are generally considered luxury goods.Example: Suppose that your income has risen by $10,000 from a base rate of $50,000. During this period, your demand for bread has increased from 100 loaves per year to 110 loaves per year. Given this information, determine whether or not bread is a necessity or a luxury good.The percentage change in income is (60,000 - 50,000) / 50,000 = 20%, while the percentage change in the quantity of bread demanded is (110 - 100) / 100 = 10%. Hence, the income elasticity of bread is 10 / 20 = .50. This good is a necessity.c: Explain why the price elasticity of demand tends to increase in the long run.The effect of time on elasticity: In general, when the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run. Thus, the demand for most products will be more elastic in the long run than in the short run. This is sometimes called the second law of demand.Total revenue, total expenditures, and price elasticity of demand: An impor