Capital

1. Capital • Indirectly through financial markets • Value of capital is only as great as the value of the services (net return) over time • INVESTMENT: flow that increases stock of physical capital (used as an input in future production processes)

2. Depreciation • decrease in asset’s value over time; wear & tear • business can be put on a depreciation schedule for various reasons

3. Financial Capital • financial markets developed to increase efficiency of transfer of savings to investment • reduce transaction costs • increase liquidity • increase diversification/reduces risk • reduces information costs

4. Source of confusion:"Investment" has 2 meanings. • 100 shares of Amazon.com are afinancial investment. • Amazon’s new warehouse is acapital investment. • Both are part of process that turns savings into new capital goods.

5. Obtaining Financial Capital • bank loans • IPO/shares of stock • bonds • other • translate financial capital into physical capital

6. Financial intermediaries: • They are the channels between saving and capital investment. • Banks are only one. All provide • Lower transaction costs • Lower information costs • Liquidity • Diversification • Many offer tax benefits.

7. Yield is the percent gain from purchase to maturity:

8. Uncertainty • Expected Return • outcome x probability (likelihood)

9. Present Discounted Value • PDV, NPV • put returns over time (costs and benefits into same unit) • NOT due to inflation, due to SRTP (social rate of time preference) • = sum of value each year discounted by (1+R) to the t power

10. Efficient Market Theory • Demand for any Asset • Expected return (risk adjusted) • liquidity • tax considerations If an asset yields a higher average return, it is higher risk, less liquid, or less favorable tax treatment.

11. Arbitrage • General presumption of the efficient market theory is that high returns can only be obtained as a result of bearing high risks. • Opportunities for high returns at little or no risk quickly disappear in competitive markets • Arbitrage (same item being bought and sold at different prices)

12. Shifts in Market for Assets • In early 1600s, one bulb in Holland sold for equivalent of $16k today • On October 19, 1987 prices in stock market fell by one-half trillion dollars (almost 25%) • Can we explain with our static S/D model? • Shift in demand

13. Shifts in Market for Assets • Assets are long-lived so prices today depend not only on immediate benefits but also some expectation of what tomorrow’s conditions will be • Concept of PDV tells us how to measure and compare anticipated returns….so changes in PDV would shift demand curve

14. PDV can shift due to... • change in interest rate • change in expected price of an asset at the time one expects to sell it. • Such expectations can be quite volatile which explains volatility in asset prices

15. Forming Expectations • Myopic (short-sighted)…what is true today will be true tomorrow • Adaptive…extrapolate events of recent past into future • Rational…makes use of all available information

16. Risk-averse • Psychologists have found most people are risk-averse • Seek to avoid or minimize serious risks • simplest way to respond to risk is to avoid it

17. Market for risk • our economy needs to encourage risk-taking • new ventures are risky but also engine of economic growth • society is less risk-averse than an individual (longer-life)

18. Responding to Risk • Obtain information/research • Maintain options (avoid irreversible consequences) • Diversify • Transfer & share risk (insurance) • Moral hazard • Adverse selection • Reduces incentive (risk/”reward)

19. Entrepreneurs • risk-takers • all business decision making involves risk taking • “wind-fall profit”…not “wind-fall loss”

20. Formula for PDV • for $100 to be paid at end of 3 years • for $1000 to be paid at end of 1 year and again at end of 2nd year • if interest rate is 10%, what is PDV • $75.13 • $1735.54

21. Economic Efficiency • To economists, efficiency is a relationship between ends and means. • When we call a situation inefficient, we are claiming the desired ends could be achieved with less means, or that the means employed could produce more of the ends desired.

22. Economic Efficiency • Crucial prerequisites for the generation of these monetary values are 1) private ownership of resources & 2) unrestricted rights to exchange. • Effective social cooperation requires making interpersonal comparisons of values and monetary units supply a common denominator that works pretty well.

23. Economic Efficiency • Proof that a particular resource is being used efficiently is that no one is willing to pay more in order to divert it to a “better” use. • Every concept of efficiency has to employ some measure of value.

24. W/out system to assign value • EXAMPLE: URBAN CAR TRAFFIC • How can we arrive at a judgment about the overall efficiency of the commuting process? • Need to compare one person convenience with another’s delay, time saved by some with carbon monoxide inhaled by others, one person’s intense dissatisfaction with another’s person’s pleasure

25. Example cont. • Without interpersonal value indicators, can’t find out if Jack values a speedy commute more than Jill values clean air. • Urban commuting creates congestion as well as pollution

26. Transaction Costs (definition) • extra costs (beyond the price of purchase) of conducting a transaction, whether those costs are money, time, or inconvenience.

27. Ronald H Coase • 1910- • won Nobel Prize in 1991 • in a 60 year career, wrote only about a dozen significant papers • uses little or no math “blackboard economics” • native of Britain

28. Why do firms exists? • Firms like centrally planned economies • But unlike because they are formed of people’s voluntary choices • Why do people choose to organize within a firm’s structure • Coase decided it was marketing costs (now called transaction costs) • IF MARKETS WERE COSTLESS, FIRMS WOULD NOT EXIST. • Article (“The Nature of the Firm”, Economica, 1937) was cited169 times in academic journals between 1966 and 1980

29. Another way of looking at insight, • Question of boundary of firm (size and number of products) • When does a company find it easier to deal with another company through the market, rather than produce it itself?

30. Problem of large manufacturer • wants to offer health insurance to employees • could continue to pay premiums to outside firm or because of its large work force, has option to pay medical bills directly. • If it sets up division to run health insurance, faces scarce talent for that produce and no comparative advantage in production • When those transaction costs are taken into account, to continue with outside use of market.

31. “The Problem of Social Cost” (Journal of Law and Economics, Oct 1960) • cited 661 times between 1966 and 1980 • gave rise to the field called law and economics • this insight made the case for government intervention weaker than previously thought.

32. Before Coase If a cattle rancher’s cows destroyed his neighboring farmer’s crop, the government should intervene by stopping the rancher from letting his cattle roam or tax him. • Justification: negative externality

33. Coase challenged accepted view • If rancher had no legal liability & • If transaction costs were zero, • then farmer & rancher could come to a mutually beneficial agreement. • Farmer pays for rancher to cut back on herd.

34. EXAMPLE CONT.’ • Rancher’s net return $2/steer • Steer doing $3 worth of damage to crops • So rancher would accept something over $2 to give up steer, farmer willing to pay up to $3 to get rid of it

35. Why important? • transaction costs are never zero • sometimes very high • So courts are still needed to adjudicate • Moreover, strategic behavior by the parties involved can prevent them reaching an agreement, even if gains outweigh transaction costs.

36. Government intervention • simple rearrangement of property rights • then let market take care of externality

37. BUT this theorem • caused economists to look differently at many policy issues • lead, for example, to H. Elizabeth Peters showing empirically that whether a state has traditional barriers to divorce or not has no effect on divorce rate. If the sum of a couple’s net gain from marriage (as seen by the couple) is negative, then no agreement on distributing the gains from the marriage can keep them together.

38. Summary Statement • When parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient, regardless of how the property rights are specified.