Economic Concepts Chapter 19 Tools & Techniques of Financial Planning Copyright 2009, The National...

Economic Concepts Chapter 19Tools & Techniques of

Financial Planning

Copyright 2009, The National Underwriter Company 1

Financial Planning and the Economy

• No matter how well a person plans, external factors from the economy affect the success of that plan.

• This chapter focuses oncertain basic anduniversal concepts ofeconomics. While it is only the basics, thesekey concepts areimportant.


Financial Planning


Capitalism

• Although pure capitalism is possible in theory, the United States and most Western world countries’ economies are based on capitalism with some modification.

• Generally proven to be the most efficient or effective at allocating and using scarce resources to enhance economic prosperity.

• Requires a political system that maintains the rule of law, the rights to contract, the courts and tort system, and competitive market structures.


Financial Planning


Scarcity

• Economics is the art and science of dealing with scarce resources and almost unlimited needs and desires.

• All resources – Land, labor, capital, technology, or knowledge – are scarce.

• The objective of the economy is to maximize the output from resources while minimizing waste.

• There is no such thing as a free lunch. Everything costs something in terms of giving up another opportunity or using a resource.


Financial Planning


Opportunity Cost

• Every output costs something.• The cost is opportunities to produce

something else.• There is always a tradeoff. The cost is the

opportunity foregone as a result of using the inputs for one purpose, rather than for another purpose.


Financial Planning


Time Value

• The time value of money is one of the fundamental concepts of finance.

• Time is money. A dollar today is worth more than a dollar tomorrow.

• Receiving a dollar today allows one to use it to produce more than a dollar’s worth of goods later.

• In financial planning, optimal use of financial resources involves using the time value of money to achieve goals.


Financial Planning


Supply, Demand, Marginal Pricing, and Equilibrium

• The basic law of economics is this: supply equals demand for a price.

• Equilibrium is the point where market price matches the demand with the supply.

• In general, – When prices fall, demand will increase and supply will fall. – When prices rise, demand will fall and supply will increase.


Financial Planning


Supply-Demand Relationship


Financial Planning


Microeconomics

• Microeconomics (also called price theory) is the study of individual economic decisions and their aggregate consequences.

• Microeconomics is a bottom-up approach from individual and firm’s actions to government policies and international trade.


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Components of Microeconomic Theory

• Theory of the firm• Consumer behavior and utility• Opportunity costs• Marginal utility• Elasticity• Competitive market structures• Asset pricing


Financial Planning


Theory of the Firm

• The Theory of the Firm is the economics of business operations and profit maximization.

• The Theory of the Firm attempts to find the theoretical optimum mix of capital and labor to maximize the value of the firm.


Financial Planning


Conclusions from the Theory of the Firm

• Keep producing until there is no more profit in producing more.– Expand production until the marginal cost (MC) of a unit is

equal to the marginal revenue (MR) received when selling that unit.

• The optimum mix of labor and capital occurs when the amount of additional production from one more unit of either capital or labor is equal.– Firms should select their optimum mix of labor and capital by

balancing the marginal product of capital (MPC) with the marginal product of labor (MPL).


Financial Planning


Modigliani and Miller

• Studied the optimal capital structure between debt and equity to maximize firm value.

• Concluded that, in a world of pure competition, the balance between debt and equity is irrelevant.

• The assumptions that Modigliani and Miller made were in an ideal economic world. Therefore, their conclusions are purely theoretical and do not reflect the actual state of the world. There is differential taxation between debt and equity and information is rarely complete.

• Thus, management seeks to choose the mix between debt and equity to maximize the value of the (owners’) equity in relation to its risk.


Financial Planning


Marginal Revenue (MR) and Marginal Cost (MC)

• Marginal revenue is the incremental income from the next unit of sales.

• Marginal cost is the incremental cost of the next unit of production.

• Marginal revenue for small and large producers differs. – Small producer: MR = price– Large producer: MR declines with the level of production and

sales.

• MC tends to fall as economies of scale reduce costs, but then rises again as production continues to rise.


Financial Planning


Marginal Revenue & Marginal Cost


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Consumer Behavior and Marginal Utility

• Consumers want to get the most value possible for their money.

• The added value, usefulness, or benefit of the next unit of a product consumed is termed “marginal utility.”

• The law of “diminishing marginal utility” holds that the added utility of one additional unit of a good is less than that added by the previously consumed unit.


Financial Planning


How Consumers Maximize Utility

• Consumers maximize utility by purchasing just so many units of each desired good that the marginal utility of each good per dollar spent is equal.

• Maximization occurs when the consumer’s marginal utility equals the cost (C) of one additional unit, i.e., MU = C.

• Theoretically, people act to maximize the utility of their lifetime consumption, where, among other things, desired bequests or legacies are weighed and valued just like any other good.


Financial Planning


Financial Planning and Consumer Maximization of Utility• The classical economic theory of consumer behavior

discussed on the previous slide assumes that consumers will rationally maximize utility over their lifetimes.

• However, people often make irrational buying and investing decisions.

• Behavioral finance and behavioral economics are new fields that seek to identify why people make irrational financial decisions.


Financial Planning


Opportunity Costs

• Cost of passing up the next best choice when making a decision.

• For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best use of the asset.


Financial Planning


Price Elasticity of Demand

• Price elasticity of demand is a measure of the buyer’s responsiveness or sensitivity to changes in price.

• Elasticity varies with the importance of the purchase to the consumer. Price elasticity is greatest on commodities that are relatively easy to obtain.


Financial Planning


Formula for the Coefficient of Elasticity

ricePinChange

DemandedQuantityinChange

DemandedQuantity

ofElasticity %


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Interpreting the Elasticity Coefficient

• If the elasticity coefficient is greater than 1, the product is price elastic.

• If the elasticity coefficient is less than 1, the product is price inelastic.

• Elasticity tends to vary at different price levels and quantities, typically being less elastic at low quantities and high prices (buyers who want it, need it, so they are less sensitive to price) and more elastic at high quantities and lower prices (buyers want it, but they do not need it, so they are more sensitive to price).


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Competitive Market Structures

• Market structure influences firm behavior, strategies, and tactics.

• Market structure depends on – Barriers to free entry into the market; – To what degree each firm can differentiate its product within

the market (e.g., perfumes); – How much control each firm has over the supply or output

of the industry; and – How much control the firms have over the price they can

charge for the product.


Financial Planning


Competitive Market Structures

• Pure Competition

• Pure Monopoly

• Monopsony

• Oligopoly

• Monopolistic Competition


Financial Planning


Pure Competition

• A purely competitive market is characterized by – Entirely free entry and exit to the industry; – A homogeneous and undifferentiated product (e.g.,

commodities such as corn, iron ore, etc., where no consumer has any grounds for preferring one company’s product over that of another);

– A large number of buyers and sellers so that no individual seller can influence price;

– Sellers are price takers (they have to accept the market price); and

– Perfect or close to perfect information is available to buyers and sellers so that no buyer or seller can exploit the ignorance of others.


Financial Planning


Outcomes of Pure Competition

• Firms tend to have diminishing profits over time. (There is always someone who will sell at a lower price until there is no profit left.)

• Consumers benefit from lower prices and the efficiency of the firms.

• A firm with a new idea will have higher profits for a while until the other firms start to mimic it.


Financial Planning


Pure Monopoly

• A pure monopoly exists when there is only one firm in the industry.

• Even when there is no other producer, pure monopoly can be eroded by substitute goods.

• Certain industries where the economies of scale are great are natural monopolies. These typically become subject to government regulation.

• A firm may have many of the elements of monopolistic control when it controls as little as 25% of the market.


Financial Planning


Outcomes of Monopoly

• The firm controls the price, leading to abnormally high profits.

• May charge different prices to different consumers and overcharge some customers.

• Firm may use profits to fund research and development and ultimately produce new goods and services.

• However, the management of the firm may become complacent and fail to innovate.


Financial Planning


Oligopoly

• An oligopoly is an industry dominated by a small number of large firms.

• There may be a large number of small firms as well – the key word is “dominated.”

• Characterized by high barriers to entry.

• Competition is usually based on non-price factors such as service, style, etc.


Financial Planning


Signaling in Oligopolies

• Signaling is a method of skirting anti-trust laws that prohibit collusion.

• Since the law does not allow direct contact, signals are sent via public media as to actions to be taken.

• Signaling is used by the major players in the industry to control prices and output.


Financial Planning


Methods of Signaling

• Price movements

• Prior announcements

• Media discussions

• Counterattack

• Announce results

• Litigation


Financial Planning


Concentration

• Concentration is a measure of how oligopolistic a market is.

• It is expressed in terms of the number of major firms and the percentage of the market they control. For example, a three firm control of 81% of the market would be a three-firm concentration of 81%.

• The higher the concentration among the fewer firms, the tighter the control on prices and output.


Financial Planning


Monopolistic Competition

• Monopolistic competition is a market structure with many buyers and sellers and where entry and exit is relatively free, but where products are highly differentiated.

• This is the most common market structure in the United States.

• Marketing is a primary driver of success in monopolistic competition – the more product differentiation, the higher the profit.


Financial Planning


Components of Macroeconomic Theory

• Fiscal versus monetary policy

• Keynesian theory

• Monetary theory

• Rational expectations

• Supply-side economics

• Business cycles

• Inflation, deflation, and disinflation

• Interest rates and the yield curve


Financial Planning


Macroeconomics

• The study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices.

• Where microeconomics is bottom-up study of the economy, macroeconomics is top-down.

• Macroeconomics was largely unappreciated until the Great Depression of the 1930s.

• There are many theories.


Financial Planning


Fiscal Versus Monetary Policy

• Fiscal policy deals with government tax and spending as it affects the economy. The basic philosophy is that government intervention can improve the performance of the economy.

• Monetary policy deals with the effect of the money supply on economic activity. The philosophy of this school of thought is that the economy is more responsive to changes in the money supply and interest rates through the independent actions of businesses and individuals, than to government tax-and-spend policies.


Financial Planning


The Changing Debate

• Both fiscal and monetary policy have proven unable to successfully stabilize the economy.

• Now, the question is not which school of thought is correct, but whether or not government can do anything to control the economy at all.


Financial Planning


Rational Expectations Theory

• A theory proposed in the 1970s and 1980s that questions the efficacy of any government attempts to manage economic affairs.

• The theory holds that for most government fiscal or monetary policies to work:– People must either be ignorant of the policies or – People must not understand the implications of the

policies on economic activity. • One conclusion of this theory is that government

efforts to control the economy in fact destabilize it.


Financial Planning


Key Terms to Know about Gross National Product, Inflation, and the Keynesian View• Gross national product (GNP)• Gross domestic product (GDP)• Nominal GNP or GDP• Real GNP or GDP• GNP or GDP deflator• Consumer price index (CPI)• Producer price index (PPI)• Net national product (NNP)


Financial Planning


Keynesian Formula for GNP

GNP = C+I+G+X

Where

C = Consumption

I = Investment

G = Government purchases

X = exports - imports


Financial Planning


Fiscal Multiplier

• Any increase in government spending causes an increase in GNP.

• The marginal propensity to consume (MPC) is the ratio of how much more a person will spend given a unit increase in income.

• Government Spending Multiplier = 1/(1-MPC)

• Thus, a small increase in government spending will result in a large increase in nominal GNP.


Financial Planning


Where Does the Government Get Money to Spend?

• The government gets money in one of three ways:– Raise taxes– Borrow– Print money

• Raising taxes takes money out of the economy that the government then puts back into the economy.

• Borrowing could crowd out private borrowing.• Printing money is similar to borrowing money.


Financial Planning


IS/LM Curve of the Investment/Spending and Money Markets• The Investment-Saving/Liquidity-Money curve (IS/LM

curve) shows the relationship or tradeoff between investment and saving versus liquidity.

• Adjusting the equilibrium point is the purpose of many government attempts to control the economy.

• When interest rates rise, both investment and consumer buying falls.

• Durable goods are particularly affected since their purchase is often financed.

• The situation considered most desirable is when GDP can be increased without raising interest rates.


Financial Planning


IS/LM Curve of the Investment/Spending and Money Markets (cont)In Keynesian theory, if government spending increases, then there would normally be an increase in interest rates and GNP. However, if the money supply is increased at the same time, there could be an increase in GNP without a rise in interest rates.


Financial Planning


IS/LM Curve of the Investment/Spending and Money Markets (cont)

• The idea is that the downward pressure on interest rates from an increased money supply will offset the increase in demand through government spending. The net result could be an increase in GNP while interest rates remain level.


Financial Planning


Economic Growth and The Monetarist View

• Another theory of GNP is called the Quantity of Money Theory.

• Velocity is the rate at which money turns over in the economy.

• Money is currency plus “monetary equivalents” such as checking accounts and money-market funds. M1 money is cash, checking account balances, and traveler’s checks. M2 money is M1 plus savings accounts and money market accounts.


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Economic Growth and The Monetarist View (cont)

• The theory states: M (Money) x V (Velocity) = Nominal GNP

M (Money) x V (Velocity) = P (Price Level) x Real GNP (Q) M x V = P x Q

• This theory asserts that Velocity is relatively constant, so increasing the money supply increases Nominal GNP. (Although real GNP may not change.)


Financial Planning


Monetary Policy Tools: The Federal Reserve

• Change the discount rate.

• Buy or sell government securities.

• Change the reserve requirements of financial institutions.


Financial Planning


Premises of Supply-Side Economics

• Rejects Keynesian and monetary theory and returns to classical economic principles.

• Basic premise - the most effective and efficient form of government action is to provide incentives to market participants and let the competitive market work without interference from government.

• The actions of millions of market participants, where all individuals are pursuing their own enlightened self- interest, allocates resources more efficiently than government-mandated spending policies.


Financial Planning


Summary of Supply-side Economics

• Incentives matter.• Markets work. • Supply comes before demand in the economic process.• Supply creates demand.• The engines of economic growth (working, saving,

investing, risk taking, innovating, inventing, and creating) are all supply-side endeavors.

• The entrepreneur, not the government, drives the economy.

• A healthy economy depends upon sound money.


Financial Planning


Supply-Side Policies

• Fiscal Policies– Low marginal tax rates – Light regulatory burden– Small limited government– Free trade

• Monetary Policies– Price stability– Anchoring the dollar to gold


Financial Planning


The Business Cycle

• Business activity always expands and contracts.

• No one has yet been able to predict the length and course of a business cycle.


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Critical Features Of The Cycle

• The forces of supply and demand condition every business cycle.

• Credit drives consumption and business investment.• Every expansion inevitably leads to contraction. • During contractions, production and income recede to a

level that does not rely on a continuous growth in credit. • Every contraction sows the seeds of the subsequent

recovery.– Despite downturns, some of the gains of the prior expansions

have historically survived.


Financial Planning


Composite Economic Indicators

• The composite leading, coincident, and lagging indexes are the key elements in an analytic system designed to signal peaks and troughs in the business cycle.

• Compiled by the Conference Board, formerly compiled by the U. S. Dept. of Commerce.

• A change in direction in a composite index does not signal a cyclical turning point unless the movement is of significant size, duration, and scope.

• No one index has been determined to be a good indicator of future economic activity.

• The Composite Index of Leading Indicators is an average of several indices that tend to move prior to the whole economy.


Financial Planning


Components of the Index of Leading Indicators

• Unemployment claims• Orders for consumer

goods• Building permits• Interest-rate spread • Workweek

• Slower deliveries• Plant and equipment

orders• Stock prices• Money supply (M2)• Index of consumer

expectations


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Other Indicator Indices

• There is also a Coincident Indicator index and a Lagging Indicator Index.

• Economists have discovered that the ratio of the indexes of coincident indicators to lagging indicators provides, in general, an even greater lead time in predicting changes in economic activity than the leading index.

• This ratio has given a warning of a recession about four months earlier than the leading index, on average.


Financial Planning


Other Economic Indicators

• Consumer Demand and the Business Cycle– If consumer demand did not fluctuate, then the Business Cycle

would not fluctuate as much.– Why does consumer demand fluctuate? Don’t people always

want more goods and services?

• Inventories – Inventories are stocks of goods on hand: raw materials, goods

in process, or finished products. – Individual businesses use them to bring stability to their

operations.– However, they actually have a destabilizing effect on the

business cycle overall.


Financial Planning


Statistical Series Especially Indicative Of Consumer Demand • Consumer price index (CPI)

• Auto sales

• Consumer credit

• Housing starts


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Inventories

• The inventory-sales ratio, which is typically reported along with other business inventory statistics, is a critical statistic.

• It measures the number of months it would take businesses to run through stockpiles at the current sales rate.

• In the past, an inventory-sales ratio exceeding 1.6 was taken as a sign that inventories had become bloated and that either demand was waning or that businesses would soon begin to cut production to bring inventories more in line with sales, therefore signaling an impending contraction.


Financial Planning


Inflation, Deflation, and Disinflation

• Inflation is a sustained increase in price levels.

• Deflation is a sustained reduction in price levels.

• Disinflation is a level of inflation that is declining.

• The consumer price index (CPI) is often used as a measure of inflation.

• Inflation is often used as one of many economic indicators.


Financial Planning


Yield Curves

• A yield curve shows the relation of current interest rates to different time horizons.

• All other things being equal, an investment for a longer period of time is generally regarded as riskier and is rewarded with a higher interest rate than an investment for a shorter period of time.

• However, there have been times when the yield curve has been downward sloping; generally, when there is an expectation of lower interest rates in the future.

• Interest rates are often used as one of many economic indicators.


Financial Planning


Economics and Financial Planning

• For individuals and small businesses, the economy represents an external factor over which they have no control.

• Current financial planning practice does not assume a stable economy as was the case in its early days.

• Contingency techniques such as MonteCarlo analysis and scenario analysis test the impact of possible changes in the economy on the financial plan.

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