Ekonomi managerial

Managerial EconomicsManagerial EconomicsPricing
Program Pascasarjana, Universitas Gunadarma, Magister Management , Budi Hermana-1
Invest.&Budgeting Product&Strategy Cases Research Question
Introduction The Firm ConsumerProduction&Cost Demand The Market
MANAGERIAL
ECONOMICSAn Analysis of Business Issues

Introduction
DefinitionDouglas - “Managerial economics is .. the application of economic
principles and methodologies to the decision-making process within
the firm or organization.”
Pappas & Hirschey - “Managerial economics applies economic
theory and methods to business and administrative decision-
making.”
Salvatore - “Managerial economics refers to the application of
economic theory and the tools of analysis of decision science to
examine how an organisation can achieve its objectives most
effectively.”
Howard Davies and Pun-Lee Lam - “It is the application of economic
analysis to business problems; it has its origin in theoretical
microeconomics.”

Why Managerial
Economics?
• A powerful “analytical engine”.
• A broader perspective on the firm.
• what is a firm?
• what are the firm’s overall objectives?
• what pressures drive the firm towards profit
and away from profit
• The basis for some of the more rigourous
analysis of issues in Marketing and
Strategic Management.
Introduction

Questions
 How do markets work?
 How do customers value products?
 What are the relevant production and cost measures for
decision making?
 How does competition affect business decisions in
different market structures?
 What prices should be set?
 What would be the impact of changes in interest rates on
costs, accounting, or capital budgeting?
 How important to managerial and marketing decisions
are changes, in foreign exchange rates, in technology, in
incomes, in government regulations, in sources of energy,
in the balance of payments?
Introduction

Introduction
Content
StructureCompetition, market
structures and business
decisions
Competition, market
structures and business
decisions
Managerial
Economics
Managerial
Economics
Production and CostsProduction and Costs
Basic economics principles:
demand and supply.
Basic economics principles:
demand and supply.
Introduction. The nature of
managerial economic decision
making
Introduction. The nature of
managerial economic decision
making
Pricing strategies and
practices
Pricing strategies and
practices
Business and Government.Business and Government.
Capital budgetingCapital budgeting
Research question
Business and current
economic situation.
Research question
Business and current
economic situation.
Demand analysis
and estimation
Demand analysis
and estimation

Introduction
What is the purpose of
economic analysis?
Why do we want to apply
economic analysis to
business problems?
For the academic economist: to understand, to make
predictions about firm’s behavior. The “positive” approach to
theory: What is?
For the businessperson: “to assist decision-making”, to
provide decision-rules which can be applied The “normative”
approach to theory: What should be?
These purposes are different, they can lead to misunderstanding,
and economists are not always honest about the limitations of their
approach for practical purposes.

How Can
Managerial
Economics Assist
Decision-Making?
Adopt a general perspective,
not a sample of one
Simple models provide
stepping stone to more
complexity and realism
Thinking logically has value
itself and can expose sloppy
thinking
Introduction

Introduction
Managerial Economics
&Industrial Economics
In industrial economics (or industrial
organization), the emphasis is (or was) upon the
behavior of the whole industry, in which the
firm is simply a component.
In managerial economics, the emphasis is upon
the firm, the environment in which the firm
finds itself, and the decisions which individual
firms have to take.

Introduction
The Structure-Conduct-
Performance Paradigm
Basic Conditions: factors which shape the market of the industry,
e.g. demand, supply, political factors
Structure: attributes which give definition to the supply-side of
the market, e.g. economies of scale, barriers to entry, industry
concentration, product differentiation, vertical integration.
Conduct: the behavior of firms in the market, e.g. pricing behavior
advertising, innovation.
Performance: a judgement about the results of market
behaviour, e.g. efficiency, profitability, fairness/income
distribution, economic growth.
How can the government improve the performance in an industry?

Managerial
Economics &
Management
Science
Management science: is essentially concerned with
techniques for the improvement of decision-making and
hence it is essentially normative;firms are not assumed to
find the optimal solutions for themselves. They are found
by the researchers who then present them as prescriptions
for what the firm should do.
Managerial economics: is often concerned with
finding optimal solutions to decision problems.However,
the primary purpose of using models is to predict how
firms will behave, not to advise them what ought to do.
Managers are assumed to find the optimal solutions for
themselves and that is how predictions are made.
Introduction

Thenatureof
managerialeconomic
decisionmaking
Economic
optimisation
Economic
optimisation
The value of firmThe value of firm
Economic constraintsEconomic constraints
The basic economic
variables
The basic economic
variables
DemandDemand
SupplySupply
CostsCosts
RevenueRevenue
ProfitProfit
The role of managerial
economics in
managerial decision
making
The role of managerial
economics in
managerial decision
making
Managerial economic
as an economics
discipline
Managerial economic
as an economics
discipline
Introduction

Managerial
economicasan
economics
discipline
Macroeconomics
Economics
Microeconomics
International Economics
Regional Economics
Money, finance, banking “Sector” economics
Labor economics
Environmental
economics
Managerial economics
Economics development
Introduction

Introduction
The role of
m
anagerial econom
ics in
managerial decision
m
aking
Managerial decision problems
Product price and output
Make or buy
Production technique
Internet strategy
Advertising media and intensity
Investment and financing
Managerial decision problems
Product price and output
Make or buy
Production technique
Internet strategy
Advertising media and intensity
Investment and financing
Economic concepts
Theory of consumer behaviour
Theory of firm
Theory of market structure and
pricing
Economic concepts
Theory of consumer behaviour
Theory of firm
Theory of market structure and
pricing
Decision making tools
Numerical analysis
Statistical analysis
Forecasting
Game theory
Optimisation
Decision making tools
Numerical analysis
Statistical analysis
Forecasting
Game theory
Optimisation
Use of economics concepts and
decision making tools to solve
managerial decision problems
Use of economics concepts and
decision making tools to solve
managerial decision problems
Optimal solutionsOptimal solutions

Choose alternative
that produces a result the most
consistent
with managerial objective
Choose alternative
that produces a result the most
consistent
with managerial objective
What is the primary
managerial objective?
It depends upon the property structure
Profit maximisation?
Sales/revenue maximisation?
The value of firm
maximisation?
IntroductionEconomicoptimisation

1 1
cos
(1 ) (1 )
N N
t t
t t
t t
Profit Total revenue Total t
Value
i i= =
−
= =
+ +
∑ ∑
N – firm’s life time
I - discount rate
- current value of the
profit earned in t years
time
N – firm’s life time
I - discount rate
- current value of the
profit earned in t years
time
(1 )
t
t
Profit
i+
Introductionhevalueof
firm

Short-run & Long-run
TheFirm
1. The firm is a profit-maximiser - it optimises
2. The firm can be treated in a holistic way
3. There is perfect certainty
ModeloftheFirm
-Neoclassical
The firm is a profit-maximiser: it is assumed to make as much
profit as possible.
This means that the model is an ‘optimising’ model: the firm
attempts to achieve the best possible performance, rather than
simply seeking “feasible” performance which meets some set of
minimum criteria
It is a holistic model: the firm is a single entity which has
objectives of its own and which can be said to take decisions
It assumes perfect certainty. Cost and demand conditions are
perfectly known
ModelNatureMergerMNE

TheFirm
Demand: Average Revenue
$
Quantity
Produced
P1
P2
Q1 Q2
Quantity
Produced
Marginal Revenue
$
Marginal
Revenue
Marginal Cost$
Quantity
Produced
Profit maximising
output
Profit
maximisingprice
Quantity
Produced
Demand: Average
Revenue
Marginal Revenue
Marginal Cost
$
Profit maximising output
Profitmaximising
price
Average Cost
The firm aims to maximise profit by choosing the level of output
which gives the biggest difference between revenue and costs
ModeloftheFirm
-Neoclassical

• Comparative Statics
– begin with an initial equilibrium position - the starting point
– change something
– identify the new equilibrium, e.g:
• When demand increases?
• When costs rise?
• When a fixed cost increases?
– This is the main purpose of the model -what it was designed to do
• Normative prescriptions
– it will cost me $30 per unit to supply something which will give
me $20 per unit in revenue- should I do it?
– I must pay $20 billion to set up in my industry. Should I charge
higher prices to get that money back?
• Positive and Normative are linked by “if?” IF the aim of
the firm is to maximise profit what will it do/what should it do?
TheFirmModeloftheFirm
-Neoclassical
What Can We Do With This Model?

The Managerial School argues that:
1. Ownership and control are in the hands of different groups of
people.
2. The interests of owners (shareholders) and Controllers
(managers) are different.
3. Managers have the power to let their interests over-ride those of
the shareholders.
4. Therefore firms are run in the interests of the managers.
In place of the profit-maximising model, the managerial school
substitute a variety of alternatives - sometimes referred to as
managerial discretion models:
 Sales-revenue maximising (Baumol)
 Managerial utility maximising (Williamson)
“Managerial” Criticisms of the Profit-Maximising Model
Berle and Means (1932)
– firms are owned by shareholders but controlled by managers
– owners’ and managers’ interests are different
– managers have discretion to use the firm’s resources in their own interests
-ManagerialSchool

-BehaviouralApproach  Organisations do not have objectives, only people have objectives
 The firm does not exist - it is a set of shifting coalitions of individuals
 Individuals and groups do not maximise - they satisfice
 Information about the environment is very limited
 If all aspirations are being met - everyone is satisfied - do nothing
 BUT then aspiration levels will rise until someone is not satisfied
 THEN rules of thumb used to find solutions to “the problem”
 Aspiration levels, which adjust according to experience
 Problem-oriented ‘rules of thumb’ based on past experience
 A dynamic model
 not “holistic”
 not “deterministic”
 not optimising

 Behavioural approach is a more accurate description of what happens INSIDE
the firm.
 BUT it tells us almost nothing about how the firm will respond to changes in
the environment.
 To use it to make predictions about how the firm will react to changes in the
environment we need to know everything about the individual firm.
 However, if shareholders are a powerful group and their aspiration level
requires making maximum profit the firm will again behave in the same way as
a profit-maximiser.
In Conclusion?
The behavioural approach is a useful complement to
the profit-maximising and managerial
approaches, not a substitute for them
Which Approach is Most Useful?

Introduction The Firm ConsumerProduction&Cost Demand The MarketTheNatureoftheFirm
TheFirm
What is a Firm?
a set of transactions* coordinated by authority instead of by
the market
a transaction takes place whenever a good or a service is transferred from one
party to another
Why Do Firms Exist?
 Some transactions are co-ordinated by markets
 Some transactions take place inside firms
 The firm is the supersession of the market mechanism
 The firm is that set of transactions which is co-
ordinated by managerial authority instead of the
market
 Why does this happen?

Introduction The Firm ConsumerProduction&Cost Demand The MarketTheNatureoftheFirm
TheFirm
The SetupA Firm
 Produce ouput y, which it can sell for price p(y)
 From quantities of input (factors): X1, X2, …
 Input costr (per unit): w1, w2, …
How Can this firm produce
 Technology
How Should this firm produce
 Cost minimitation
How much should this firm produce
 Profit maximization

Transactions inside a firm
Factor
Market
Product
Market
FIRM
Entrepreneur
Factor of
Production
Product
(Goods &
Services) e.g. a
shirt
Consumers
TheNatureoftheFirm
TheFirm

The “Coasian”Analysis
1. Transaction cost problem; firm supersedes market
2. Transactions are “normally” done through markets; market is
the default
3. Some transactions are done inside firms
4. Transactions are done in a firm when the costs of transacting on
the market is higher than costs of transacting in the firm
Why Firm Exists?
Transaction Cost Analysis
TheNatureoftheFirm
TheFirm
What decides whether a transaction takes place
through the market or inside a firm?
Answer: TRANSACTIONS COSTSTRANSACTIONS COSTS

What Are Transactions Costs? A transaction takes place when a good or a service is transferred from one party to
another
 Direct costs arise in respect of:
• locating buyers and sellers
• acquiring information about their availability, quality, reliability and prices
• negotiating, re-negotiating and concluding contracts
• co-ordinating the agreed actions of the parties
• monitoring performance with respect to fulfilment of contracts
• taking action to correct any failure to perform
 Opportunity costs arise in respect of:
• inefficiencies if inappropriate equipment used
• failure to adapt to changing conditions
TheNatureoftheFirm
TheFirm
Transaction costs include:
 information and measurement costs
 negotiation costs
 contracting costs (ink costs, legal costs)
 monitoring and enforcing costs, etc.

 As firm becomes larger marginal cost of transacting increases
 managerial diseconomies arise
 larger firms may pay more for resources
 physical distance
 dissimilarity of transactions
 rapidly changing environment
Transactions will be organised in the least-cost way
TheNatureoftheFirm
TheFirm
Limitations of Transaction Cost Analysis?
 So flexible it explains everything after the event, but can it really predict much before
the event?
 Transaction costs not directly observable, so empirical work must be indirect
 May be many efficient solutions, so which one will occur?
 Is opportunism really universal? Should it be something we explain instead of an
assumption?
 Ghoshal and Moran (1996) - teaching it is bad for business!!!
The costs of transacting inside firm rise with:

The Extent of Diversification
What factors determine the extent to which a firm diversifies across different
industries?
 Diversification will be efficient if there is SYNERGY
 SYNERGY can come from
– economies of scope
– exploitation of specific assets
– reduction of risk and uncertainty
 BUT DOES IT REALLY EXIST IN PRACTICE?
Diversification&Merger
TheFirm
The history of diversification is not good
 In the 1960s and 1970s the “conglomerate” was a favourite form of business
 Although the purchased firms were usually good performers, the merged firm
tended to have poor performance
 It became clear in the 1980s and 90s that there is a “diversification discount” of
about 15% on average
 WHY?
Firms seemed to not understand the sectors they entered

Introduction The Firm ConsumerProduction&Cost Demand The MarketDiversification&Merger
TheFirm
If there is a diversification discount
why did firms do it?
 Perhaps the discount only emerged in the 80s
 some studies suggest it was not evident in the 70s
 Mergers were to satisfy the managers, not the
shareholders
 With more liberalized and efficient financial markets,
“focus” has been the trend for some time now

Introduction The Firm ConsumerProduction&Cost Demand The MarketDiversification&Merger
TheFirm
Mergers and Take-overs
 Horizontal:
with competitors
Vertical:
with suppliers or customers
Conglomerate:
with unrelated firms
1. Alternative forms of of merger
2. Mergers in a perfect world
 All managers are efficient;they work in the interests of shareholders; stock
markets price shared efficiently;no uncertainty; everyone uses the same
discount rate
 In that situation there are only two reasons for mergers to take place:
 SYNERGY: 2+2>4; economies of scope or scale, joint use of key
resources or capabilities
 MARKET POWER: merger gives some degree of monopoly power

3. Mergers as the transfer of resources to better
managers
 If a firm is run inefficiently, share price will be low
 The firm will be purchased by someone who installs better managers
 Share price rises
 BUT IF THIS WERE TRUE PERFORMANCE WOULD BE
BETTER AFTER MERGERS!
TheFirm
4. Mergers as the result of manipulation
or valuation discrepancies
 Manipulation: planting rumours, “bootstrapping”
– my P/E is 15: 1. If I buy a firm whose ratio is 10:1 its share price
will rise until the P/E is 15:1
 Valuation discrepancies
– when there is a lot of “turbulence” in the environment, different
people will make different judgements. Some will think a firm is
worth more than the market valuation

5. The performance consequences of mergers
 Shareholders of the acquired firms gain -
because the acquiring firm pays a premium
 The pattern of results for the acquiring firm is
very mixed with values tending to fall, not rise!
6. Are mergers really for managers?
 CEOs and senior managers like mergers
larger firms involve more prestige and often more
pay
larger and more diverse firms reduce risk for
managers (but not for shareholders who could do it
another way)
publicity is welcomed by many CEOs
TheFirm

Definition
TheMultinationalEnterprise
TheFirm
“An enterprise that controls and manages
production establishments - plants - located
in at least two countries.” (Caves, 1996)
Note that the MNE is involved in Foreign
Direct Investment, not simply Portfolio
Investment

Introduction The Firm ConsumerProduction&Cost Demand The MarketTheMultinationalEnterprise
TheFirm
A
history of the M
NE’sEarly 19th century:
Almost all European-based (e.g. British American Tobacco, Lever Brothers,
Michelin and Nestle), reflected distribution of colonial influence and most were
involved in backward integration into agriculture and minerals in the colonies.
In the 1920s and 1930s:
Establishment of international cartels in many industries for global competition.
From the 1950s to the early 1970s:
Led by American firms moving into the European market (The American
Challenge); research-intensive manufacturing industries.
In the 1970s, 1980s and 1990s:
Emergence of the Japanese multinationals, “export-platform” activities in the
newly-industrializing countries. More diversity; more host countries; more home
countries; more in and out.

Economic theory and the multinational
Equi-marginal productivity of capital
TheMultinationalEnterprise
TheFirm
MPB MP
A
0A 0B
RateofReturn(%)
Capital
 diminishing returns to
capital investment
 capital will flow from
countries (B) with lower
rates of returns to those
with higher rates of returns
(A) until rates of return are
equal
 but this does not explain the MNE:owners of capital can
simply invest in portfolios (buying shares and bonds), no
need for foreign direct investment (setting up
offices/subsidiaries, involving management and control)

TheFirm
The Hymer-Kindleberger proposition
 multinationals must face some disadvantages relative to incumbents
 they must possess some form of offsetting competitive advantage over the incumbents;
these advantages can be exploited by producing in overseas markets.
 Competitive advantages of multinationals: technology, capital, management sills, etc.
 But why not produce in home country and export the goods?
Locational theory
 The host countries possess some locational advantages, otherwise the firm would
simply operate in a single location
 e.g. some countries have cheap resources: cheap and abundant supply of land and
labour; some are close to the customers.
 But why not license the competitive advantage of multinationals?
Internalization and transaction cost theory
 High transaction costs involved in using marketing transactions; e.g. costs in enforcing
licensing agreements.
 Buckley and Casson’s analysis: five advantages that an internalised transaction over
the market:
 increased ability to control and plan
 the opportunity for discriminatory pricing
 avoidance of bilateral monopoly
 reduction of uncertainty
 avoidance of government intervention
The“eclectic”framework:
OLI

TheFirm
Licensing
Exporting
FDI
Ownership Internalization Location
From the viewpoint of the MNE:
What are the advantages of foreign direct investment
(MNE) over exporting and licensing?

TheFirm
The Impact of the Multinational on Host Economies
Resource transfer and technology transfer effects
Trade and balance of payments effects
Effects on competitive structure and performance
Effects of sovereignty and local autonomy
Some concerns:
Balance of payments effects
Employment effects
The loss of technological lead
Tax avoidance and loss of sovereignty
The impact of the MNE on its home country

Production&Cost
The Relationship Between Inputs and Outputs
 The fundamental relationship is that between inputs and
outputs - expressed as the production function
 This can be examined at a number of levels
the economy as a whole
the industry
the firm
 A number of different mathematical forms can be used to
model the relationship
Cobb-Douglas: Q = aKa
Lb
translog production function

The Cobb-Douglas
 Q = aKa
Lb
: Where K= capital; L = Labour
 As each individual input (K,L) is increased, output
increases, but at a decreasing rate - the principle of
diminishing returns - one of the most fundamental
economic ideas
 A production function identifies many different techniques
within the same technology
Production&Cost
If (a+b) > 1; economies of scale
If (a+b) < 1; diseconomies of scale
If (a+b) = 1; constant returns to scale

Production&Cost
Production Function
 A Production function tells you how much output (at most) you can get from given
quantities of inputs (factors)
 Example (Cobb-Douglas) y= f(x1, x2) = X1
0,5
X2
0,5
Short-Run Production Function
 In the short-run, not all input can be varied: at least one input is fixed
 Suppose input 2 is fixed at x2 = x2 : y = f(x1, x2)
Marginal Product
 Suppose input 2 is held constant: How does output change as we change input 1?
 The Marginal Product (MP) of input 1 is the partial derivative of the
production function with respect to input 1
MP1 = = f1(x1, x2
o
)
∂ f(x1, x2)
∂ x1

Production&Cost
 What is the marginal product of input 1 of the Cobb-Douglass
production function
 f(x1, x2) = x1
0,5
x2
0,5
?
 Does the marginal product increase or decrease as the firm uses
more of input 1 ?
Answer :
Isoquants
 An isoquant is the locus of
all input combination that
yield the sama level of output
x1
x2

Production&Cost
Technical Rate of Substituion
 The technical rate of substitution (RTS) is the slope of and isoquant at
a point
 That is, holding total output constant (remaining on the same
isoquant), at wahta rate can we exchange input 2 for input 1 ?
RTS = =
∂ x2
∂ x1
f1
f2
 What is the technical rate of substitution (slope of the isoquant)
for the Cobb-Douglass production function
 f(x1, x2) = x1
0,5
x2
0,5
?
 …… at the point x1 = x2 = 2 ?
 …… at the point x1 = 4, x2 = 1 ?
Answer :

Production&Cost
From Production Functions to Cost Curves
 Short run cost curves
• each short run curve shows costs for a specific set of plant and equipment
• AFC declines
• Average variable cost rises after some point
• AC is U-shaped
 Long run cost curves
• the firm can choose from all of the known sets of plant and equipment
• the shape of the curve depends upon economies or diseconomies of scale
 Short run - some inputs are fixed. (K). The firm is restricted to a fixed
set of plant and equipment
– capacity utilisation decisions
 Long run - both inputs are variable. (K,L). The firm can choose the set
of plant and equipment it wants
– investment decisions

Production&Cost
Production&Cost
Average & Marginal Cost
ShortRun

Production&Cost
If a production function exhibits constant returns to scale, a doubling of
all inputs results in a doubling of output. If you double all inputs, long-run total
cost doubles:
LTC = r · k + w · l;
r·2k + w·2l = 2LTC
So: a production process exhibits constant returns to scale if a doubling of output
results in a doubling of cost, that is, if the LTC curve is a straight line.
If a production function exhibits increasing returns to scale, a
proportional change in all inputs results in more than a proportional change in
output. If you change all inputs by a factor of t, long-run total cost changes by a
factor of t:
LTC = r · k + w · l;
r·tk + w·tl = tLTC
So: a production process exhibits increasing returns to scale if a change in output
(by a factor of t) results in a change in long-run total cost of less than a factor t;
that is, the LTC curve is concave.
If a production function exhibits decreasing returns to scale, a
proportional change in all inputs results in less than a proportional change in
output. If you change all inputs by a factor of t, long-run total cost changes by a
factor of t:
LTC = r · k + w · l;
r·tk + w·tl = tLTC
So: a production process exhibits decreasing returns to scale if a change in
output (by a factor of t) results in a change in long-run total cost of more than a
factor t; that is, the LTC curve is convex.
LongRun

Introduction The Firm ConsumerProduction&Cost Demand The MarketConsumerBehaviuorTheory
Consumer
The Main Approaches
Utility Theory
Indifference Analysis
Revealed Preference
The Characteristics Approach
Character.RevealedIndifferenceUtility

Introduction The Firm ConsumerProduction&Cost Demand The MarketBehaviuorTheory
Consumer
Utility Theory
 Consumers seek to maximise their UTILITY, which increases as
they consumer more ‘goods’ and decreases as they consumer
more ‘bads’
 As a consumer has more of a ‘good’, the extra (marginal) utility
they enjoy from each successive extra unit of the good declines
 the principle of diminishing marginal utiity
 A utility-maximising consumer will purchase a combination of
goods such that the extra utility acquired per $ or cent, £ or
penny, is the same for every good OR:
 the ratio of the marginal utilities is equal to the ratio of the
prices

Consumer
Utility Theory and Falling Prices
 If a consumer has a fixed income and begins in
equilibrium:
 MUapples/Papples = MUpears/Ppears
 Then the price of apples falls
 Left-hand side of the equation> Right-hand side
 There is an opportunity to increase UTILITY- how to
do it?
 Shift spending from pears to apples - WHY DOES
THIS WORK?
 Because each extra penny spent on apples gives more
additional utility than each extra penny spent on pears
BehaviuorTheory

IndifferenceAnalysis
Consumer
 UTILITY theory requires us to think in terms of a cardinally
measurable unobservable concept, which is rather ‘heroic’
 INDIFFERENCE ANALYSIS explains consumer behaviour on the
basis of less restrictive assumptions (tho’ the logic is very similar)
 The following assumptions are made about ‘rational’ consumers
– they know when they prefer one bundle of goods to another or are
indifferent between them - their preferences are complete
– Preferences are symmetric. If I prefer A to B, I cannot prefer B to A.
– Preferences are transitive. If I prefer A to B and B to C I must prefer A to
C.
(These are not as unproblematic as they may
seem)

IndifferenceAnalysis
Consumer
• Good A
Good B
All combinations of A
and B for which the
consumer is indifferent
AN INDIFFERENCE
CURVE
• Good A
Good B
Slopes show relative
preferences for A and B
An A-lover
• Good A
Good BBudget
Line
• Good A
Good BBudget
Line
More B is bought
and (in this
example only)
the same amount
of A
If the Price of B FallsOptimal Combination of A&B

Consumer
 Assume that the utility function is U = q1q2, that p1 = 2
dollars, p2 = 5 dollars, and that the consumer’s income
for the period is 100 dollars. The budget constraint is
 100 – 2q1 – 5q2 = 0
At the utility maximum level:
 q1 = ……?
 q2 = ……?
Answer :

Consumer
Revealed Preference
Less restrictive assumptions - consumers are
consistent in their choices
A budget line is constructed and the consumer’s
choice observed
When price of one good falls, a new choice is
made
The new choice cannot involve less of the good
whose price has fallen

Consumer
Revealed Preference
Apples
Oranges
• Why?
X
Z
If combination X is the original choice and Z is the new
choice (after the price of oranges falls), X to Z is the price
effect. The broken line shows the goods which could be
bought if income remained at the level requiredto buy the
original basket of goods, but the new price ratio held. We
don’t know exactly where the consumer would choose to be,
but they cannot be to the left of X because they have already
rejected superior combinations in favour of X

Consumer
The Characteristics Approach
 Lancaster 1966
 Consumers do not desire ‘goods’ but bundles of
‘characteristics’
– not a computer but
• processing speed
• memory
• storage
• functions
 Different brands offer different combinations of
characteristics. Combining brands may allow other
combinations to be achieved
 Desirable mixes of characteristics might be identified

Demand
The Determinants of Demand
 Demand is the quantity of a product that purchasers are
willing and able to purchase in a specified period
 It is determined by
– Own Price - Po
– Price of other products, especially close substitutes and
complements, Pc,s
– Consumers’ disposable incomes, Yd
– Consumers’ tastes, T
– The amount spent on advertising the product, Ao
– The amount spent on advertising complements and substitutes, A
c,s
– Interest rates (i) and credit availability (C)
– Expectations of future prices and supply conditions(E)

Demand
These Relationships May be
Represented As:
A ‘demand function’ - the general
mathematical form
• Qd = f(Po,Po,Ps,Yd,Ao,Ac,As,I,C,E)
A ‘demand curve’
Price
Quantity Demanded
The demand curve shows the quantity that would
be bought at each price, for some fixed
combination of all other factors

Demand
Concepts of Elasticity
 Own price elasticity is:
– percentage change in quantity demanded, divided by percentage change
in price:
 If demand is price-elastic, revenue increases with lower prices.
 If demand is price-inelastic, revenue decreases with lower prices
 Cross-price elasticity of demand between substitutes is positive
 Income-elasticity determines how demand changes with customers’
incomes. For most goods income-elasticity is positive.
 Advertising elasticity is important in deciding on advertising budgets. It is
positive. As the level of advertising increases, we would expect
advertising elasticity to fall.

Demand
Zero-elasticity at all prices
Price
Quantity
Ed = 0
Infinite elasticity at all prices
Price
Quantity
Ed = ∞
Unitary elasticity at all prices
Price
Quantity
Ed = -1
This curve is a ‘rectangular
hyperbola’ such that price x
quantity is a constan

Demand
Price
Quantity
π1
π2
p0
q0
p1
q1
π1π2 >
If demand is price-elastic, decrease
the price to gaining higher revenue

Demand
Price
Quantity
π1
π2
p0
q0
p1
q1
π1π2 <
If demand is price-inelastic, lower prices
will decreases revenue

Demand
Determinants of Own-price Elasticity
 Substitutes: how close and at what prices?
– How narrowly defined is the product? The more narrowly defined the more close
substitutes
 Proportion of consumers’ income spent on the product (or % of industrial
buyers’ costs accounted for)
 Time. Demand is more elastic over longer periods of time
Determinants of Other Elasticities Income Elasticity
– Type of good
• necessities - salt, drinking water, zero elasticity
• luxuries, zero at low levels of income then high when income thresholds
exceeded
• inferior goods - negative, purchase less as income rises - bus travel, low-grade
margarine, paraffin
 Cross-price elasticity
– substitutes or complements,and how close?
– An industry is a group of firms producing products with high positive
cross-elasticities

Demand
EstimationEstimation attempts to quantify the links between the
level of demand for a product and the variables which
determine it.
 The demand for hotel rooms depends upon:
 their price
 the price of bed and breakfast accommodation
 household incomes in visitors’ home countries
 natural events (the weather, foot-and-mouth disease)
ForecastingForecasting simply attempts to predict the level of sales
at some future date
 How many Japanese tourists will visit Hong Kong in 2000?
 How many delegates will attend conferences in London in 2001?

Demand
Econometric Estimation Qd = f(Po, Pc, Ps, Yd, T, Ao, Ac, As, I. C, E)
– THE GENERAL FORM OF THE DEMAND FUNCTION
– (CANNOT BE ESTIMATED BY THE USUAL METHODS UNTIL A
PARTICULAR LINEAR FORM IS CHOSEN)
 Qd = a + b1Po+b2Pc+b3 Ps+b4 Yd+b5T +b6Ao +b7Ac+b8As+b9 I+b10C+b11E
– THE SIMPLE LINEAR FORM
 Qd= Po
a
.Pc
b
,.Ps
c
Yd
d
Te
.Ao
f
Ac
g
As
h
Ii
. Cj
, Ek
– THE EXPONENTIAL FORM
 log Qd= alogPo+blogPc+clogPs+dlogYd+elogT+flogAo+glog Ac
+hlogAs+ilogI+jlog C+klogE
– THE LOGLINEAR FORM

Demand
• Simplest Method is EXTRAPOLATION
Forecasting Demand
The DECOMPOSITION METHOD
How To Evaluate the
Forecast?• Objectivity. Does the result depend on the data or on the person making the forecast?
• Validity. How closely does a series of forecast estimates correlate with the actual time
series, for the time period used to make the forecast?
• Reliability. If we take different starting points for the forecast, do the results stay
approximately the same?
• Accuracy.How close are the forecasts to the actual figures, for the period outside that
used to generate the forecast?
• Confidence. Is there are high probability that we can accept the results?
• Sensitivity.If we use the method to make forecasts using data with very different
patterns, do we get very different results?
Etc

Demand
What Other Methods are
Available?
Barometric forecasting - leading indicators are used: variables
which change in advance of the variable you wish to predict
Market Surveys,
Sales Force Opinion
Expert Opinion ‘Delphi’ approach
Market Testing

Demand
Which Technique Is Best For
Each Product?
 An industrial product with a
limited market
 A consumer good which has
been on sales for many years
 A new product whose full scale
launch will be very expensive
 A technically very complex
product, to be sold in a very
wide market
 Time-series analysis
 Expert opinion
 Market testing
 Survey of buyer’s intentions
• THIS ISJUST ONE
POSSIBLE ANSWER . YOU
MAY BE ABLE TO JUSTIFY
OTHERS

TheMarket
Formal Textbook Models
Economic analysis identifies four types of market structure
PERFECT COMPETITION
MONOPOLY
OLIGOPOLY
MONOPOLISTIC COMPETITION
The basis for the STRUCTURE-CONDUCT-
PERFORMANCE approach to industrial organization.
– Structuredetermines pricesand profitability

TheMarket
Perfect Competition
 Large No of Small Firms, (i.e.No Economies of Scale), Identical
Products, Free Entry to the Industry, Perfect Knowledge of market
Opportunities
 SHORT RUN
– price is determined at industry level by supply and demand
– each firm has a horizontal demand curve at the market price
– demand and marginal revenue curve are the same
– MR = P = MC
 LONG RUN
– entry takes place, shifting supply curve to the right and price down
– super-normal profits are competed away, P= minimum LAC

TheMarket
Perfect Competition:
Short Run
• Industry Firm
P P
Q Q
D
S
P
q0 q1 q2
P2
P1
D=AR=MR
SMC

TheMarket
The Firm in More DetailSMC
SAC
P = AR =MR
q
AC
PL is the only possible
long run price
SAC
P = AR =MR
q
PL
LAC

TheMarket
Monopoly
 One firm, no entry is possible - ‘pure monopoly’
 Firm’s demand-curve is industry’s demand curve
 Price >Marginal Cost - economic inefficiency. Super-
profits can be made in the long run. The firm does not
necessarily use the plant which gives lowest cost
 Most countries have some kind of anti-monopoly policy
– note that the economic rationale for monopoly policy is P>MC not P>AC
– the problem is inefficiency not inequity

TheMarket
Monopoly
• A monopolist produces less and charges a higher price,
relative to the socially optimal
Pmonopoly
Qmonopoly
Psocially
optimal
Qsocially optimal
MC
Demand

TheMarket
Monopolistic Competition
• Many firms, free entry, differentiated products
• Downward-sloping demand-curves
• In the long-run Price = Average Cost. Firms have
plants which are too small to take full advantage
of scale economies. (But there is only an
equilibrium in this market structure if heroic and
perhaps contradictory assumptions made)
– when new firms enter, they take customers in equal proportions
from all old firms
– all firms have same cost and demand curves, while producing
different products
– will new firms not imitate successful old ones?

TheMarket
Monopolistic Competition
• The ‘excess capacity’ result: but which firm is shown here? ALLOF THEM?
Differentiated products but identical cost and demand conditions?
MC
AC
Demand = AR
MR

TheMarket
OligopolyCompetition amongst the Few
Key feature is interdependence and rivalry
Small number of firms (2 = duopoly)
Condition of Entry may vary
Product differentiation may vary
Possible outcomes include:
– co-operation and collusion - the monopoly price
– price war - the perfectly competitive price
The modern approach to oligopoly is through game
theory

TheMarket
What Do These Models Tell Us
About the Impact of Structure?
Entry Conditions are Important: They affect whether high
profits can be maintained in the long run.
The Number of Competitors and their Behaviour is
Important. A few co-operating “competitors” can lead to
monopoly-type profits
Product Differentiation is Important. Without it all firms
must charge the same price in a competitive market

TheMarket
Features of the four marketFeatures of the four market
structuresstructures

Pricing
The Basic Rule for Profit-Maximization
• (Price - Marginal Cost)/Price = 1/-Ed
• Not an operational decision rule - a statement of the condition required for maximum
profit
• Can be re-stated in an “average cost plus margin” format
Pricing and Market Structures
• Under perfect competition, firms are price-takers
• Under monopoly, firms are price-makers (but still constrained by the requirement to
make maximum profit)
• Under monopolistic competition, prices settle at the ‘excess capacity’ level where P=AC
Price Discrimination
• Price discrimination exists when the same product is sold for different prices, that are
not attributable to differences in the cost of supply
• Two conditions are needed:
– the market must be divisible into sub-markets between which there cannot be any
arbitrage
– demand conditions (elasticity) must be different in the sub-markets

Pricing
Third Degree Price Discrimination
• A number of sub-markets, each containing a number of potential customers
• These markets may be separated by:
– distance ( car prices differ between Europe and the UK - but is it really price
discrimination?)
– time (for non-storable commodities) - peak versus off-peak journeys
– age and status - Student Railcards, Old Person Railcards
Second Degree Price Discrimination
• Customers are charged one price for the first block of units they purchase, then
a different price for the second block
– electricity, water, gas tariffs
– the producer appropriates part of the consumer surplus
First Degree Price Discrimination
• Every buyer is charged the maximum they are willing to pay (the demand
curve becomes the marginal revenue curve)
• Can be difficult to evaluate willingness to pay but first degree discrimination
may be possible in personal, household or commercial services
• Note that the socially optimal level of output will be produced but all the
surplus accrues to the producer

Pricing
Pricing and the Product Life Cycle
.
Introduction
Growth
Maturity Decline
Time
Sales
Volume
What Happens to Elasticity of Demand
and Marginal Cost Over the Product Life
Cycle?
 Introduction - product is new. Elasticity may be low because there are no
substitutes or high if buyers need to be persuaded to try the new product. Marginal cost
is relatively high. Appropriate price will reflect high MC combined with high/low
elasticity
 Growth - imitation begins, and learning takes place. Elasticity rises, MC falls. Price
falls?
 Maturity - competition from many locations, substitutes and next-generation
products have been invented, elasticity high, MC low
 Decline - fierce competition for a declining market, very low margins

Pricing1
Pricing New Products• For new products, there is a significant amount of uncertainty about demand conditions. Two
strategies have been suggested (Dean 1950)
• SKIMMING - set an initially high price. IF that produces a high level of profits, leave the price high
until conditions change and demand becomes more elastic. Do this when:
– there is a significant group of buyers prepared to pay high prices
– when demand is inelastic
– when the high price will not induce entry
– when the cost penalty for low volume is small
• PENETRATION - set a low price from the beginning in order to build a large market share quickly.
Do this when:
– demand is elastic
– low volume is very high cost
– entry is a major danger
Is Skimming v Penetration Just an Application of the
Simple Model?
• YES - set a high price when elasticity is low and MC is high, set a low price when the opposite is true
• BUT -
– skimming may have another benefit. If experience shows it is the wrong strategy, the price can be cut without
much customer resistance. If the penetration approach is used but it becomes clear that skimming would be
better, it is more difficult to raise price than to lower it
– skimming may provide a means of price discrimination through time. If a market contains a group of
‘trendsetters’ or ‘first-adopters’ who must have, or like to have, a product first and are willing to pay more for it.
Skimming allows them to be charged a higher price.
– E.g new major dictionaries, new types of mobile phone

Pricing
PricinginPractice
Pricing Objectives
 The central objective of pricing is PROFIT MAXIMIZATION
 Companies may either express this in a different way, or have
intermediate level objectives for pricing.
 Those intermediate level objectives may or may not be consistent
with profit-max
 achieve a target rate of return: might be the maximum, might be a
‘satisficing objective, might be to deter entry
 target market share: might be the share which is consistent with profit-
maximisation or it might be a managers’ target
 stabilize output - keep the factory running and the workers employed
 match the competition

Pricing
A Good Example of the Theory/Practice
Relationship
• A simplistic interpretation of the Oxford findings is that the economic model
of pricing is incorrect
– it is clear from the evidence that managers do not describe their pricing practices in
marginalist terms, in terms of MC=MR or in terms of elasticity and MC
– some analysts (including the original researchers and many accountants) have
concluded that the MC=MR model is therefore incorrect
PricinginPractice
• However, the conclusion that the evidence on cost-plus pricing invalidates the
profit-maxing model is a misunderstanding of the relationship between models and
practice.
• This is very important for general understanding and can be approached in a
number of ways
• First
– the profit-maxing model can be re-written in cost-plus form
(P-MC) = 1 is the same as P = MC . (Ed)
– P Ed (Ed -1)
– If average variable cost is constant (which is often assumed in management accounting) then
AVC = MC

Pricing
PricinginPracticeThe Marginal Pricing Model is Equivalent to a
Cost-Plus Model in Many Common
Circumstances
 If AVC is constant , therefore = MC the profit-max model can be
re-written:
 P = AVC. (Ed) Average cost plus a margin
 (Ed -1)
 Calculate the margin when elasticity takes the following values
• 1.2 P = AVC.1.2/.2 = AVCx6 Margin = 600%
• 2.5 P = AVC.2.5/1.5 = AVCx1.66 - Margin = 66%
• 3 P = AVC.3/2 = AVCx1.5 Margin = 50%
• 10 P = AVC 10/9 = AVCx 1.11 Margin = 11%
 (Why can we not find a value if elasticity is less than 1?)
 If managers use margins which are consistent with these values,
they are profit-maximising

Pricing
PricinginPractice
But That Is Not the Most Important Point
• Close examination shows that
– rigid cost plus pricing must lead to irrational results. Managers would be stupid to use it
– in practice, firms do take other factors into account, which allows them to approximate
the profit-maxing solution
Why Is Rigid Cost-plus Pricing
Irrational?
• There is a circularity problem. In many circumstances cost per unit depends on the volume of output
sold. But the volume of output sold depends upon the price!.
– Unless cost is constant over a very wide range of output a firm does not know its cost per unit until it
knows the price !
• Cost-plus pricing completely ignores the demand side and the behaviour of customers and
competitors For instance:
– if my competitors lower their prices, how would a cost-plus price change?
– if demand increases how will my cost plus price change?

Pricing
PricinginPractice
Why Is Rigid Cost-plus Pricing
Irrational?
• If my competitors lower their prices, my sales volume will fall. That will
increase my cost per unit.
• IF I USE COST-PLUS PRICING, I WILL RAISE MY PRICE!
• If demand increases and my sales volume increases, my costs will usually fall.
• IF I USE COST-PLUS PRICING I WILL LOWER MY PRICE!
• NOTICE THAT THE PROFIT-MAXING, MC=MR MODEL GIVES
MUCH BETTER PREDICTIONS OF FIRMS’ BEHAVIOUR THAN A
COST-PLUS ‘MODEL’ OF PRICING!

Pricing
PricinginPractice What Can We Conclude on the Cost-Plus
Practice Versus MC=MR Theory?
 The theory is not supposed to describe pricing practices. It
should be no surprise that it does not.
 The purpose of the MC=MR theory is to predict how firms will
change their prices when cost and demand conditions change.
The predictions make more sense, and are more accurate than
those derived from a ‘cost-plus’ theory of price.
 Managers are not dumb. They do not use cost-plus in a rigid
way and they do not have the accurate information needed to do
an MC= MR calculation. They feed their experience and
knowledge into a complex decision-making process and in the
end often behave ‘as if’ they were fully-informed maximisers.

Pricing
PricinginPractice
Pricing Methods II:Other Approaches
• Target return pricing - identify target profit and set the margin
equal to that required to provide the target profit
• Going rate pricing - behave as a price-taker
• Sealed bids - for auctions
Transfer Pricing
• How to set prices for internal transfers so that divisions taking their
own decisions will bring maximum profit to the firm as a whole?
– If there is no external market for the intermediate product the amount
of that product that the final producing division wishes to purchase
must correspond to the profit-maxing output for the firm as a whole
– if there is an intermediate market for the product the final production
division can buy on the open market as well as acquire in-house.
Transfer price is the market price

Pricing
PricinginPractice
Pricing in Public Enterprise
 The basic rule? Set price equal to marginal cost?
 But which marginal cost - long-run or short-run?
 It doesn’t matter if you have the appropriate set of plant and equipment
because in that case SMC =LMC
 What about surpluses or deficits?
– If there are scale economies at the optimal level of output, MC pricing must lead to
losses (and vice versa for diseconomies)
– Some planning theorists hoped that losses and gains would just balance out!
– If a public enterprise makes losses it might be because of the pricing rule, or it
might be due to inefficiency - difficult to tell the difference
• The second-best problem - if there are ‘n’ conditions for an optimum and 1 cannot
be achieved - the others may be redundant
 If MC pricing in all industries is optimal but it is impossible in one industry - MC
pricing may not be optimal in the others - VERY DESTRUCTIVE OF THE PRICING
RULE
 But a partial approach may be possible. If the price of oil is too high, oil output will be
too low and coal and gas output will be too high. Therefore ‘lean’ against the distortion
by also raising their prices>MC

Investment
Investment Theory
Investment is the change in capital stock during a period.
Consequently, unlike capital, investment is a flow term and
not a stock term
Capital is the stock of
assets that will generate
a flow of income in the
future.
Capital budgeting is the planning
process for allocating all expenditures
that will have an expected benefit to the
firm for more than one year.
The investment flow at time period t can be
defined as
It = Kt – Kt-1
Kt
is the stock of capital at the end of
period t and Kt-1
is the stock of capital at
the end of period t-1
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Investing Defined
?
?
?To consume, to save, or to invest
a dollar that is earned ?
Both saving and investing amount to
consumption shifting through time.
However, investing is risky,
saving is not.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Three Reasons for Investing
Why invest ???
People invest to …
 supplement their income
 earn capital gains
Appreciation is an increase in the
value of an investment.
 experience the excitement of the
investment process
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
The Academic Study of Investments
Theoretical research builds
mathematical models and
proposes pricing relationships
rather than studying actual
market data.
E.g. arbitrage relationships,
impact of stock splits and
cash dividends on investors
Theoretical models are tested by
conducting empirical research.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
An anomaly is an observed result that
defies explanation within the known
theoretical framework.
Empirical research uses actual market
data rather than mathematical models.
The Academic Study
of Investments
The investment community can learn much from both rigorous
academic research and from the life experiences of people on the
front lines of the marketplace.
vs.
Professors Practitioners
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&ReturnThe Relationship between Risk and Return
Expected
Return
RiskRisk-free
Return
Riskier securities have higher expected returns.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&ReturnThe Relationship between Risk and Return
Empirical financial research reveals clear evidence of the direct
relationship between systematic risk and expected return.
Expected
Return
Risk
Small
Company
Stocks
Large
Company
Stocks
Long-term Government BondsT-bills
Inflation
Long-term Corporate Bonds
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&Return
Holding
period =
return
Ending Beginning
value value Income
Beginning value
_
+
The simplest measure
of return is the holding
period return.
Buy 100 shares
at $25 per share
Time
Dividend of
$0.10 per share
Sell the shares
at $30 per share
Holding period return = = 20.4%
$30 - $25 + $0.10
$25
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Alternative States of Information
Certainty: we have perfect information about
future outcomes
Risk: we know what future outcomes are
possible and we can attach probabilities to each
outcome
Uncertainty: we do not know the precise nature
of the outcomes or their probabilities
Risk&Return
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&Return
Expected Monetary Values (EMV)
 In a situation of RISK we could use Expected Monetary
Values (EMV) to take a decision
 EMV = ΣpiVi Where:
 pi = probability of the i’th outcome
 Vi = value of the i’th outcome
Weather Probability Takings
Sunny 0.2 $500
Cloudy 0.4 $300
Raining 0.4 $100
EMV = ?
Example:
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&ReturnEMV- Limitations of EMV
 Will you accept a 50/50 bet for $5? Probably YES
 Will you accept a 50/50 bet for $5m? Probably NO
 BUT BOTH HAVE AN EMV = 0!
 In some way you ‘care’ more about losing $5m than winning
$5m
 Your house is worth $200,000
 The probability of destruction by fire is 1/10,000
 EMV of the loss = $20
 So $20 is the most you will pay for insurance?
 NO, YOU CARE MORE ABOUT THE CHANCE OF LOSING
YOUR HOUSE
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&ReturnEMV- Limitations of EMV
How to Take This Into Account
Decision-makers have different ‘attitudes to risk’
RISK NEUTRAL - values gains and losses equally
RISK AVERSE - values losses more highly than gains
RISK LOVER - values gains more than losses
A Risk-Averse Person
Utility
Income
• A Risk-Neutral Person
Income
Utility Utility
Income
A Risk-Lover
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Decision-makers Are Usually Assumed to be Risk-averse
• Instead of using EMV, use Expected Utility (EU)
• EU = ΣpiUi Where:
– pi = probability of the i’th outcome
– Ui = utility of the i’th outcome
Risk&Return
The Expected Value of Information
• EVPI = difference between the expected value of future actions, given the information
currently available, and the expected value of future action, if perfect advance state
revelation were available
Techniques for Coping with Uncertainty
• If we do not know the possible outcomes, there is little we can do
• If we know the possible outcomes, but not their probabilities, a number of techniques are
possible
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&Return
Minimax Criterion
Actions States of Nature
A B C
1 20 40 180
2 -40 100 220
3 60 70 90
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Investment Alternatives
Assets
financial assets real assets
e.g. bond, stock e.g. land
Assets are things that people own.
Financial assets have a
corresponding liability,
while real assets do not.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Securities
Derivative Assets
e.g. futures,
options
Fixed Income
Securities
e.g. bonds,
preferred stock
Equity
Securities
e.g. common
stock
Investment
Securitization is the process of
converting an asset or collection
of assets into a more marketable
form.
A security is a legal document that
shows an ownership interest.
Securities are historically
associated with financial assets,
but are also applicable to real
assets.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Major Classes of Financial Securities
Debt
Money market instruments
Bonds
Common stock
Preferred stock
Derivative securities
Markets and Instruments
Money Market
Debt Instruments
Derivatives
Capital Market
Bonds
Equity
Derivatives
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Money Market Instruments
Treasury bills
Certificates of deposit
Commercial Paper
Bankers Acceptances
Eurodollars
Repurchase Agreements (RPs) and
Reverse
RPs
Federal Funds
Capital Market: Equity
Common stock
Residual claim
Limited liability
Preferred stock
Fixed dividends - limited
Priority over common
Tax treatment
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Investment Management
 FIVE STEP PROCEDURE:
– SETTING INVESTMENT POLICY
– PERFORMING SECURITY ANALYSIS
– CONSTRUCTING A PORTFOLIO
– REVISING THE PORTFOLIO
– EVALUATING THE PORTFOLIO
 TRADITIONAL INVESTMENT MANAGEMNT
ORGANIZATIONS
– Security Analysts play a key role and rely upon information and reports
from
• economists
• technicians
• market experts
– Investment Committee is advised by the analyst to create
– An Approved List of Securities
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
SETTING INVESTMENT POLICY
 DETERMINE THE INVESTMENT OBJECTIVE
 estimate the client’s level of risk tolerance
PERFORMING SECURITY ANALYSIS
 Security Selection: A 2 Stage Procedure
 STAGE I: forecast
• expected returns
• standard deviation
• covariances
• identify optimal portfolio
 STAGE II: Asset Allocation
• strategic
– refers to how a portfolio’s funds would be divided, given the manager’s long-term
forecasts from Stage I
• tactical
– given short-term forecasts, who will assets be allocated at any one time
– 90% + 90%0%
Average Standard
Series Annual Return Deviation Distribution
Large Company Stocks 13.0% 20.3%
Small Company Stocks 17.7 33.9
Long-Term Corporate Bonds 6.1 8.7
Long-Term Government Bonds 5.6 9.2
U.S. Treasury Bills 3.8 3.2
Inflation 3.2 4.5
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
REVISING THE PORTFOLIO
Use Cost-Benefit Analysis
 transaction costs should be examined since they complicate the management decision
 portfolio revisions must be weighed against the cost of revision particularly with regard
to transaction costs
Swap Methodology
 a cost saving method which involves exchanges of assets rather than purchases or sales
 TYPES OF SWAPS:
 Equity
The Agreement
» one party agrees to pay the other a variable-sized cash payment
» the other party agrees to a fixed-sized cash payment
Results in a restructured portfolio without incurring any transaction costs
 Interest Rate
The Agreement
» one party pays the second a variable-sized stream of cash based on the current level of
an agreed-upon interest rate (e.g. LIBOR)
» second party pays the first a fixed-sized payment stream based on the interest rate at
the time of the Agreement
Results in a restructured portfolio without incurring any transaction costs
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Common Methods of Appraisal
The common methods are:
• PAYBACK
• DISCOUNTED PAYBACK
• RETURN ON INVESTMENT
• INTERNAL RATE OF RETURN
• NET PRESENT VALUE
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
•PAYBACK
Payback period is the amount of time sufficient to cover the initial cost of an investment.
But it ignores any returns accrue after the pay-back period; ignores the pattern of returns;
ignores the time value (time cost) of money.
Example:
Initial investment: $10 million
Cash flow: $2 million per year
Payback-period?
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
RETURN ON INVESTMENT
• Accept a project of the Return on Investment is greater than an agreed
target return
• Note that there is no economically defensible way to estimate the cut-
off rate
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
INTERNAL RATE OF RETURN
• Accept a project of the Internal Rate of Return exceeds the
opportunity cost of capital
• Note that the opportunity cost of capital is economically
defensible because it relates to the risk of the project
Internal rate of return (IRR) is the rate of return that will
equate the present value of a multi-year cash flow with the cost
of investing in a project.
Using the NPV equation: the IRR is the discount rate that
renders the NPV of the project equal to zero.
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
NET PRESENT VALUE
• Accept a project if the NPV is greater than zero when discounted at
the opportunity cost of capital
• Note that the NPV is economically defensible because it uses the
opportunity cost of capital
The present value of a single future amountThe present value of a single future amount
In general, present value (PV) refers to the value now of payments to be
received in the future (I). The present value of I after n year at r is:
I
(1+r)n
PV=
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
NET PRESENT VALUE
NPV = -P + I0 +
I1
(1+r)
I2
(1+r)2
+ … ++
In
(1+r)n
NPV = -P +
I
r
where:
P: =capital cost, accruing in full at the beginning of the project
I1,2,…n =net cash flows arising from the project in years 1 to n
r =the opportunity cost of capital
or
Theory
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Foreign Direct InvestmentTheory
Risk&Return
Alternatives
Criterion
Management
FDI
What is FDI?
FDI (Foreign Direct Investment):
• « Direct investment is the category of international investment
that reflects the objective of obtaining a lasting interest by a
resident entity in one economy (the direct investor) in an
enterprise (foreign direct investment enterprise) resident in
another economy. » (IMF)
• « Foreign direct investment (FDI) occurs when a foreign
investor develops a long term relationship with a domestic
enterprise and owns enough of the equity of the enterprise to
exercise a significant degree of influence on the management of
the enterprise » (IMF)

Investment
Risk&Return
Alternatives
Criterion
Management
FDI
Meaning of Foreign Direct Investment (FDI)
Concept of control
 Control must accompany the investment
 100 percent share does not guarantee control
 government intervenes in company operations
 Direct investment usually implies an ownership share of 10 – 25 %
Concern about control
 Government concern—when foreign investors control a company,
decisions of national importance may be made abroad
 Investor concern—transfer of resources to acquiring company
 appropriability theory—company receiving resources may
undermine the competitive position of the transfer company
 Internalization—control by self-handling of foreign operations,
usually down the supply chain

Investment
Risk&Return
Alternatives
Criterion
Management
FDI
FDI Today: The differences
The new determinants of FDI location:
 Policy liberalization
 Rapid technical progress
 New management and organizational techniques
Yesterday: Economic factors were critical
Today : New variables increase the complexity of FDI
FDI Requirements
Factors of decision:
 Large domestic markets
 Abundance of natural resources
 Cheap labour
These conditions are required to make a FDI in a host country.
However, these motivations belong to the Old Economy.

Investment
Risk&Return
Alternatives
Criterion
Management
FDI

Investment
Risk&Return
Alternatives
Criterion
Management
FDI
OECD Survey, 1999

Ekonomi managerial

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