Fundamental Economic Concepts

Chapter 2
» Total, Average, and Marginal
» Finding the Optimum Point
» Present Value, Discounting & NPV
» Risk and Uncertainty
» Risk-Return & Probability
» Standard Deviation & Coefficient of Variation
» Expected Utility & Risk-Adjusted Discount Rates
» Use of a z-value
2002 South-Western Publishing Slide 1
 How to Maximize Profits
• Decision Making Isn’t Free
» Max Profit { A, B}, but suppose that we don’t
know the Profit {A} or the Profit {B}
» Should we hire a consultant for $1,000?
• Should we market an Amoretto
Flavored chewing gum for adults?
» complex combination of marketing,
production, and financial issues
Slide 2
 Break Decisions Into Smaller Units:
How Much to Produce ?
• Graph of output profit
GLOBAL
and profit MAX
• Possible Rule:
MAX
» Expand output until
profits turn down
» But problem of
local maxima vs.
global maximum

A quantity B
Slide 3
 Average Profit = Profit / Q
PROFITS
• Slope of ray from the
MAX origin
C » Rise / Run
B » Profit / Q = average profit
• Maximizing average
profits profit doesn’t
maximize total profit
Q quantity
Slide 4
 Marginal Profits = ∆Π/∆Q
• profits of the last unit profits max
produced C
B
• maximum marginal
A
profits occur at the
Q
inflection point (A)
• Decision Rule: average
produce where profits
marginal
marginal profits = 0. profits
Q
Slide 5
Figure 2.1 Total, Average, and Marginal
Profit Functions

Slide 6
 Using Equations
• profit = f(quantity) or
• Π = f(Q)
»dependent variable &
independent variable(s)
»average profit = Π/Q
»marginal profit = ∆Π / ∆Q
Slide 7
 Optimal Decision (one period)
example of using marginal reasoning
• The scale of a
project should
expand until
• MB = MC
Example: screening MC
for prostate or
breast cancer
» How often?
MB
frequency per decade Slide 8
 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 PVIFn =[1/(1+i)]n
Slide 9
• Net Present Value
» NPV = Present value of future returns minus Initial outlay.  
» This is for the simple example of a single cost today 
yielding a benefit or stream of benefits in the future.  
• For the more general case, NPV = Present value of 
all cash flows (both positive and negative ones).
• NPV Rule:  Do all projects that have positive net 
present values.  By doing this, the manager 
maximizes shareholder wealth.
• Some investments may increase NPV, but at the 
same time, they may increase risk.  
Slide 10
 Net Present Value (NPV)
• Most business decisions are long term
» capital budgeting, product assortment, etc.
• Objective: max the present value of profits
• NPV = PV of future returns - Initial Outlay
• NPV = Σ t=0 NCFt / ( 1 + rt )t
» where NCFt is the net cash flow in period t
• Good projects have
» High NCF’s
» Low rates of discount Slide 11
 Sources of Positive NPVs
• Brand identify • Difficulty for others to
and loyalty acquire factors of
• Control over production
distribution • Superior financial
• Patents or legal resources
barriers to entry • Economies of large
• Superior scale or size
materials • Superior management
Slide 12
 Risk and Uncertainty
• Most decisions involve a gamble
• Probabilities can be known or unknown, and
outcomes can be known or unknown
• Risk -- exists when:
» Possible outcomes and probabilities are known
» e.g., Roulette Wheel or Dice
• Uncertainty -- exists when:
» Possible outcomes or probabilities are unknown
» e.g., Drilling for Oil in an unknown field
Slide 13
 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 Σ pi = 1
States of Nature
Strategy Recession Economic Boom
p = .30 p = .70

Expand Plant - 40 100

Don’t Expand - 10 50
Slide 14
Figure 2.3 A Sample Illustration of
Areas Under the
Normal Probability Distribution
Curve

Slide 15
 Payoff Matrix
• Payoff Matrix shows payoffs for each state of
nature, for each strategy
• Expected Value = r^ = Σ ri pi .
^
• r = Σ ri pi = (-40)(.30) + (100)(.70) = 58 if
^
Expand
• r = Σ ri pi = (-10)(.30) + (50)(.70) = 32 if Don’t
Expand ^

• Standard Deviation = σ = √ Σ (ri - r ) 2. pi

Slide 16
 Example of
Finding Standard Deviations
σexpand = SQRT{ (-40 - 58)2(.3) + (100-58)2(.7)}
= SQRT{(-98)2(.3)+(42)2 (.7)} = SQRT{
4116} = 64.16
σdon’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, but
higher expected return.
Slide 17
Figure 2.2 Continuous Probability
Distribution for
Two Investments

Slide 18
Table 2.5 Computation of the Standard
Deviations for
Two Investments

Slide 19
 Coefficients of Variation
or Relative Risk
^
• Coefficient of Variation (C.V.) = σ / r.

» C.V. is a measure of risk per dollar

of expected return.
• The discount rate for present values depends on
the risk class of the investment.
» Look at similar investments
• Corporate Bonds, or Treasury Bonds
• Common Domestic Stocks, or Foreign Stocks
Slide 20
 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
.5 10 } σ = SQRT{(10-15)2(.5)+(20-15)2(.5)]
.5 20 } = SQRT{25} = 5
C.V. = 5 / 15 = .333
B: Prob X } R = 30
.5 20 } σ = SQRT{(20-30)2 ((.5)+(40-30)2(.5)]
.5 40 } = SQRT{100} = 10
C.V. = 10 / 30 = .333 Slide 21
 Continuous Probability
Distributions (vs. Discrete)
• Expected valued is the mode for symmetric
distributions
B
A is riskier, but it
has a higher
expected value

^ ^
RB RA
Slide 22
 What Went Wrong at LTCM?
• Long Term Capital Management was a ‘hedge
fund’ run by some top-notch finance experts
(1993-1998)
• LTCM looked for small pricing deviations between
interest rates and derivatives, such as bond futures.
• They earned 45% returns -- but that may be due to
high risks in their type of arbitrage activity.
• The Russian default in 1998 changed the risk level
of government debt, and LTCM lost $2 billion

Slide 23
 The St. Petersburg Paradox 
• The St. Petersburg Paradox is a gamble of 
tossing a fair coin, where the payoff doubles for 
every consecutive head that appears.  The 
expected monetary value of this gamble is: 
$2∙(.5) + $4∙(.25) +  $8∙(.125) + $16∙(.0625) + ... 
=  1 + 1 + 1 + ... = ∞.  
• But no one would be willing to wager all he or 
she owns to get into this bet.  It must be that 
people make decisions by criteria other than 
maximizing expected monetary payoff. 
Slide 24
 Expected Utility Analysis
to Compare Risks
• Utility is • Risk Neutral -- if indifferent
“satisfaction” between risk & a fair bet
• Each payoff .5•U(10) + .5•U(20) U
is a fair bet for 15
has a utility
• As payoffs U(15)
rise, utility
rises
10 15 20
Slide 25
 Risk Averse Risk Seeking
• Prefer a certain • Prefer a fair bet to a
amount to a fair bet certain amount
U U

certain

risky

risky

certain

10 15 20 10 15 20
Slide 26
 Expected Utility: an example
• Suppose we are given a quadratic utility
function:
• U = .09 X - .00002 X2
• Gamble: 30% probability of getting 100;
30% of getting 200; and a 40% probability
of getting 400.
» Versus a certain $150?
» U(150) = 13.05 (plug X=150 into utility function)
• Find “Expected Utility” of the gamble
• EU = Σ pi U(Xi)
• EU = .30(8.8) + .30(17.2) + .40( 32.8) = 20.92
Slide 27
 Risk Adjusted Discount Rates
• Riskier projects should be
discounted at higher discount rates
• PV = Σ π t / ( 1 + k) t where k varies
with risk and π t are cash flows.
• kA > kB as in B
diagram since
A is riskier
A
Slide 28
Sources of Risk Adjusted
Discount Rates
• Market-based rates
» Look at equivalent risky
projects, use that rate
» Is it like a Bond, Stock,
Venture Capital?
• Capital Asset Pricing
Model (CAPM)
» Project’s “beta” and the
market return

Slide 29
 z-Values
• z is the number of standard deviations away from
the mean
• z = (r - r^ )/ σ
• 68% of the time within 1 standard deviation
• 95% of the time within 2 standard deviations
• 99% of the time within 3 standard deviations
Problem: income has a mean of $1,000 and a
standard deviation of $500.
What’s the chance of losing money?
Slide 30
 Diversification 
The expected return on a portfolio is the weighted average of 
expected returns in the portfolio. 
Portfolio risk depends on the weights, standard deviations of 
the securities in the portfolio, and on the correlation 
coefficients between securities. 
The risk of a two­security portfolio is:
   σp =  √(WA2∙σA2 + WB2∙σB2 + 2∙WA∙WB∙ρAB∙σA∙σB )
• If the correlation coefficient, ρAB, equals one, no risk
reduction is achieved.  
• When   ρAB < 1, then σp <  wA∙σA + wB∙σB.  Hence, 
portfolio risk is less than the weighted average of the 
standard deviations in the portfolio. Slide 31
Figure 2.4 Payoff Table for Investment
Decision Problem

Slide 32
Figure 2.5 Utility Function Exhibiting
Diminishing
Marginal Utility

Slide 33
Figure 2.6 Utility Function Exhibiting
Increasing
Marginal Utility

Slide 34
Figure 2.7 Utility Function Exhibiting
Constant
Marginal Utility

Slide 35
Figure 2.8 Decision Tree for Investment
Decision Problem

Slide 36
Figure 2.9 An Illustration of the
Simulation Approach

Slide 37