Download Tools & Techniques of Financial Planning Leimberg, Satinsky, Doyle

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
certain basic and
universal concepts of
economics. While it is
only the basics, these
key concepts are
important.
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Economic Concepts
Chapter 19
Tools & Techniques of
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
Tools & Techniques of
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
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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
Tools & Techniques of
Financial Planning
Supply-Demand Relationship
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Economic Concepts
Chapter 19
Tools & Techniques of
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
Chapter 19
Tools & Techniques of
Financial Planning
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
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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).
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Marginal Revenue & Marginal Cost
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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
Chapter 19
Tools & Techniques of
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.
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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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Formula for the Coefficient of Elasticity
Elasticity of
% Change in Quantity Demanded

Quantity Demanded
Change in Price
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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
Chapter 19
Tools & Techniques of
Financial Planning
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
Tools & Techniques of
Financial Planning
Competitive Market Structures
• Pure Competition
• Pure Monopoly
• Monopsony
• Oligopoly
• Monopolistic Competition
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Methods of Signaling
• Price movements
• Prior announcements
• Media discussions
• Counterattack
• Announce results
• Litigation
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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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
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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)
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Keynesian Formula for GNP
GNP = C+I+G+X
Where
C = Consumption
I = Investment
G = Government purchases
X = exports - imports
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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 Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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)
MxV=PxQ
• This theory asserts that Velocity is relatively constant, so
increasing the money supply increases Nominal GNP.
(Although real GNP may not change.)
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Monetary Policy Tools: The Federal Reserve
• Change the discount rate.
• Buy or sell government securities.
• Change the reserve requirements of financial
institutions.
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Economic Concepts
Chapter 19
Tools & Techniques of
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 selfinterest, allocates resources more efficiently than
government-mandated spending policies.
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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
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
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Economic Concepts
Chapter 19
Tools & Techniques of
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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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
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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Economic Concepts
Chapter 19
Tools & Techniques of
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.
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Economic Concepts
Chapter 19
Tools & Techniques of
Financial Planning
Components of the Index of Leading Indicators
• Unemployment claims
• Orders for consumer
goods
• Building permits
• Interest-rate spread
• Workweek
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• Slower deliveries
• Plant and equipment
orders
• Stock prices
• Money supply (M2)
• Index of consumer
expectations
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Economic Concepts
Chapter 19
Tools & Techniques of
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, 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.
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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 there is an
expectation of lower interest rates in the future.
• Interest rates are often used as one of many economic
indicators.
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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.
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