Transcript Chapter 19 - New 2012 Textbooks from National Underwriter

Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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 on the basics of understanding
economics. It is, however, only the basics, and a
deeper understanding will
enhance your value as a
planner.
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Economic Concepts
Chapter 19
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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.
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Economic Concepts
Chapter 19
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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.
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Economic Concepts
Chapter 19
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Financial Planning
Opportunity Cost
• Every output costs something.
• Government is not free, all government does is transfer
goods and services from one segment of society to
another.
• The cost is opportunities to produce something else.
• For example, money spent on fighter planes cannot be
used to help poor people, money used to help poor
people cannot be used to build better hospitals, money
spend on hospitals cannot be used to build roads and
bridges, and money spent on roads and bridges cannot
be spent on army tanks and rifles.
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Economic Concepts
Chapter 19
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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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
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Financial Planning
Supply-Demand Relationship
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Economic Concepts
Chapter 19
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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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Economic Concepts
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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.
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Economic Concepts
Chapter 19
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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.
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Economic Concepts
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Conclusions from the Theory of the Firm
• Keep producing until there is no more profit in
producing more:
– This is expressed as “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.
– This is expressed as “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).”
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Chapter 19
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Modigliani and Miller
• Studied the optimal capital structure between debt and
equity to maximize firm value.
• Concluded that in a world of pure competition that 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.
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Economic Concepts
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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.
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Economic Concepts
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Marginal Revenue & Marginal Cost
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Economic Concepts
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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.
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Economic Concepts
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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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
See 10 Questions with... Daniel Kahneman on Humans and Decision Making.
Journal of Financial Planning, Aug 2004, Vol. 17 Issue 8, pp. 10-13.
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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.
• Opportunity cost analysis is an important part of a
company's decision-making processes, but is not treated
as an actual cost in any financial statement.
• In financial planning, because individuals often have
fewer resources than companies do, opportunity costs
constantly have to be weighed in decision making.
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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.
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Financial Planning
Formula for the Coefficient of Elasticity
Elasticity of
% Change in Quantity Demanded

Quantity Demanded
Change in Price
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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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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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Economic Concepts
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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.
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Economic Concepts
Chapter 19
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Financial Planning
Competitive Market Structures
• Pure Competition.
• Pure Monopoly.
• Oligopoly.
• Monopolistic Competition.
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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.
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Economic Concepts
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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. (An example
is the Swiffer and its imitators.)
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Economic Concepts
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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.
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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.
See a discussion of Microsoft in Seattle Weekly at
http://www.seattleweekly.com/features/0330/news-microsoft.php.
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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.
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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.
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Methods of Signaling
• Price movements.
• Prior announcements.
• Media discussions.
• Counterattack.
• Announce results.
• Litigation.
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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.
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Economic Concepts
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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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
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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.
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Things to Remember about Macroeconomics
• There are many theories, virtually none of which have
been proven.
• Macroeconomics has a large political element.
Proponents of various theories typically belong to
different political parties and their preference for a
particular theory reflects their political ideology.
• The fact that it is virtually impossible to objectively test
macroeconomic theory is the reason for the variation in
theory and belief.
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Economic Concepts
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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.
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Economic Concepts
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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.
• The concept of it being government’s job to regulate the
overall economy was a product of the Great Depression
and the feeling that “Government has to do something.”
More than 75 years later, it is still not apparent whether or
not government can.
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Economic Concepts
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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.
• An important conclusion of this theory is that government
efforts to control the economy in fact destabilize it.
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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).
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Keynesian Formula for GNP
GNP = C+I+G+X
Where
C = Consumption
I = Investment
G = Government purchases
X = exports - imports
To get an excellent and interesting historical view of economics and the economists who came up
with the various economic theories, see Heilbroner, R. (1999.) The Worldly Philosophers : The
Lives, Times And Ideas Of The Great Economic Thinkers, 7th ed. New York: Touchstone.
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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.
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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.
• This concept of fiscal multipliers only makes sense if
one believes that the government can spend the
money more productively and efficiently than can the
people themselves.
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Economic Concepts
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IS/LM Curve of the Investment/Spending &
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.
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IS/LM Curve of the Investment/Spending &
Money Markets
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.
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Financial Planning
IS/LM Curve of the Investment/Spending &
Money Markets
•
The idea is that the downward
pressure on interest rates from
an increased money supply will
offset the increase in demand
through government spending.
However, think about the
overall effect on prices of more
money and demand chasing
the same amount of goods and
services -- this would cause
prices to rise, unless there was
enough surplus production
capacity to produce more
goods and services.
In economics, there is so much dependency between
the variables that changes in one can often have
unforeseen consequences.
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Economic Concepts
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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 and M2 money is M1 plus savings accounts and
money market accounts.
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Economic Concepts
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Economic Growth and The Monetarist View (cont’d)
• The theory states:
M (Money) x V (Velocity) = Nominal GNP
M (Money) x V (Velocity) = P (Price Level) x Real GNP (Q)
MxV=PxQ
• This theory asserts that Velocity is relatively constant, so
increasing the money supply increases Nominal GNP.
(Although real GNP may not change.).
• There is some question whether the M1 or M2 definition
of money is the right one to use in the Quantity of Money
theory.
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Economic Concepts
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Monetary Policy Tools: The Federal Reserve
• Aimed at changing the M2 money supply.
• Change the discount rate.
• Buy or sell government
securities.
• Change the reserve
requirements of
financial institutions.
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Photo of the Federal Reserve Bank of New
York from
www.ny.frb.org/aboutthefed/photos.html
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Supply-Side Economics
Political economists are divided between the
– Keynesians, who emphasize consumption as a driving force.
• Emphasize government spending.
• Tax rebates.
• Temporary tax cuts aimed at low-income earners.
– Supply-siders, who emphasize production, subject to a
free market.
• Emphasizes tax cuts
• Tax cuts provide incentives for working, investing, and risk-taking
• Supply-siders say their viewpoint encompasses both short and longterm solutions, rather than temporary relief as practiced by the
Keynesians.
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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 selfinterest, allocates resources more efficiently than
government-mandated spending policies.
For a discussion on the application of supply-side economics in today’s economy, see Dzinkowski,
“Robert Mundell on Economic Recovery”.Strategic Finance. 84:11 (2003).
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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.
For more information about supply–side economics, check Wanniski, The Way the World Works, 20th Anniversary Edition
(South Bend, IN: Gateway Editions, 1998).
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Supply-Side Policies
• Fiscal Policies
–
–
–
–
Low marginal tax rates.
Light regulatory burden.
Small limited government.
Free trade.
• Monetary Policies
– Price stability.
– Anchoring to gold.
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The Business Cycle
• The economy always expands and contracts.
• The period of expansion and contraction varies: Since WW II has
averaged 3 to 5 years. Great depression lasted 43 months from
peak to trough.
• Longest period of economic expansion occurred from March 1991 to
March 2001.
• No one has yet been able to predict the length of a business cycle or
the depth of a recession. Since economic expansion lasted longest
in U. S. history during President Clinton’s administration, some
quote his “three pivotal factors: fiscal discipline, greater investments
in technology and education, and expanded trade” as being keys to
long expansions.*
* The White House (12/3/1999) “Remarks by the President on Economic Growth.” Office of the Press
Secretary. http://www.usembassy.it/file9912/alia/99120304.htm
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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.
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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.
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Composite Index of Leading Indicators
• Has accurately forecast eight of the ten recessions since
1950, by an average of five months in each of the eight
accurate cases.
• Since 1950, the index has also predicted four recessions
that never arrived. In 1962, 1966*, 1984, and 1987*, the
index fell for at least three consecutive months although
no recession followed.
• Therefore, the index is a good general barometer of the
business cycle, but it is neither flawless nor complete.
* In 1966-67, there was a “mini-recession,” so-called because it did not last quite long enough to be a true
recession. In 1987, the stock market dropped precipitously.
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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.
* Alan Greenspan was influenced greatly by Geoffrey Moore, who founded ECRI, an economic research firm based on
the business cycle. See http://www.businesscycle.com/about.php and http://www.businesscycle.com/approach.php.
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Financial Planning
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Statistical Series Especially Indicative Of
Consumer Demand
• Consumer price index (CPI).
• Auto sales.
• Consumer credit.
• Housing starts.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Inflation, Deflation, & 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
(inflation is decelerating).
• Inflation is often measured in terms of percentage
increase per year.
• Disinflation occurs when the first derivative of inflation
is negative.
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Economic Concepts
Chapter 19
Tools & Techniques of
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 inflation is
thought to be high for a short time, since interest rates
are made up of a risk factor and an inflation adjustment.
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Economic Concepts
Chapter 19
Tools & Techniques of
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 Monte
Carlo analysis and scenario analysis
test the impact of possible changes
in the economy on the financial plan.
See Bernicke, Reality Retirement Planning: A New Paradigm for an Old
Science. Journal of Financial Planning, 18:6:26-28 (2005).
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