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 assets 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.
• Amazons 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 (1R) 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 tomorrows 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
• Adaptiveextrapolate events of recent past into
  future
• Rationalmakes 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 profitnot 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
  anothers delay, time saved by some with carbon
  monoxide inhaled by others, one persons intense
  dissatisfaction with anothers persons pleasure

25
Example cont.

• Without interpersonal value indicators, cant
  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 peoples
  voluntary choices
• Why do people choose to organize within a firms
  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 cited 169 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 ranchers cows destroyed his
  neighboring farmers 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.

• Ranchers 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 couples 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.