More on the invisible hand Present value Today: Wrap-up of the invisible hand; present value of...
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Transcript of More on the invisible hand Present value Today: Wrap-up of the invisible hand; present value of...
More on the invisible handPresent value
Today: Wrap-up of the invisible hand; present value
of payments made in the future
Leaving the test before time expires
The following rule applies to leaving before the end of a test You are allowed to turn in your test
early if there are at least 10 minutes remaining. As a courtesy to your classmates, you will not be allowed to leave during the final 10 minutes of the test.
Previously…
…we saw that market forces will tend to lead to suppliers having zero economic profits
However, the transition to zero economic profit often takes time (as we saw in Las Vegas)
Today
More on the invisible hand Regulated markets Stocks and bonds More on equilibrium
Present value Future payments Permanent annual payments
Today:More on the invisible hand
Let self-interested actions determine resource allocation
Prices help determine how much is allocated for production of each good or service Rationing function Allocative function
Rationing function of price
Efficiency cannot be obtained unless goods and services are distributed to those that value these goods and services the most
In general, prices can obtain this goal We will examine exceptions in some
of the later chapters
Allocative function of price
As prices of goods change, some markets become overcrowded, while others get to be underserved
Without any government controls or barriers to entry/exit, resources will be redirected in the long run such that economic profits get driven to zero
Regulated markets
Sometimes, markets are regulated with public interest in mind
However, the invisible hand sometimes leads to results that were not intended
Note that this type of regulation may lead to barriers to entry
A regulated market of the past: Airlines
Most of you have lived a life without regulation of major commercial airlines in the U.S.
However, in the early to mid 1970s, fares were set such that airlines could make economic profits if the airplane was full
Regulation of airlines Airlines were required to use some
economic profits of popular routes to pay for routes that had negative economic profits
Problem: The invisible hand Piano bars, extravagant meals, and more
frequent flights Conclusion: Be careful what you
regulate
Possible solution: Grant a monopoly
This sometimes happens, but it has its own potential set of problems
Example: Regulated utilities Regulation may state that economic
profits need to be set to zero What if “profits are too high?”
Solution: Extravagant office buildings
Part of British Columbia (heavily populated area circled)
Possible solution: Grant a monopoly
Another example: BC Ferries in British Columbia
More on monopolies in Chapter 8
Before we move on…
…we need to define and understand present and future value
Money can be invested relatively safely in many ways Government debt Savings accounts and CDs in banks Bonds of some corporations
Present and future value
Suppose that the rate of return of safe investments is 5%
If I invest $100 today, it will be worth $105 in a year
Working backwards, I am willing to pay up to $100 for a payment of $105 a year from now
Working backwards We can calculate how much a future
payment is by discounting it by interest rate r
We calculate the present value of a future payment as follows Payment of M is received T years from now PV represents present value:
Tr
MPV
)1(
Example
What is the present value of a $12,100 payment to be received two years from now if the interest rate is 10%?
Plug in M = $12,100, r = 0.1, and T = 2
PV = $10,000
Present value of a permanent annual payment
What happens if we receive a constant payment every year forever?
We can add up all of the discounted payments, or we can use a simple formula to calculate the PV of these payments
Present value of a permanent annual payment Present value of an
annual payment of M every year forever, when the interest rate is r :
r
MPV
Question 18 from the practice problems
If you won a contest that pays you $100,000 per year forever, how much is its present value if the interest rate is always at 10 percent?
Solution: M is $100,000 and r is 10%, or 0.1 PV is M / r, or
$100,000 / 0.1 = $1,000,000
Finally, more on equilibrium Remember that equilibrium is not an
instantaneous process Sometimes, trial and error is needed to
find what equilibrium is By the time this is figured out, a new
equilibrium may emerge The bigger the costs of finding
equilibrium, the less optimal the market generally is
Finally, more on equilibrium
Some people have a good ability to quickly determine what such an equilibrium is
These people can earn money from this skill Example: Recognizing the value of a
stock before other people
Example: Winning a contest
Which is worth more: Winning $50,000 a year forever or $1,000,000 today?
Assume that the interest rate is 4% The $50,000 forever has a present
value of $50,000 / 0.04, or $1,250,000
Take the $50,000 forever
Example: A stock
Suppose that you own a stock that will pay you $1 a year forever with no risk
Assume that the annual interest rate is 5% in this example
Value is $1 / 0.05, or $20, for the stock
Example: Winning a contest that pays you only 30 years
Back to winning a contest, except now the two options are $50,000 a year for 30 years $1,000,000 today
Which one is worth more?
Example: Winning a contest that pays you only 30 years This is a perfect example of having to
think like an economist to solve this problem quickly
You could discount each of the 30 payments appropriately to determine how much the present value of those payments is
However, there is another way of solving this
Example: Winning a contest that pays you only 30 years To solve this, we must recognize that
this problem is equivalent to the previous contest problem, except that we must take away payments made 30 years or more in the future
To calculate this, we must calculate how much this contest is worth today and how much this contest is worth 30 years from now
Example: Winning a contest that pays you only 30 years
If you won the contest that paid forever, it would be worth $1,250,000 We already did this calculation
How much is this contest worth 30 years from now? We need to discount $1,250,000 by thirty
years $1,250,000 / (1.04)30 = $385,398
Example: Winning a contest that pays you only 30 years
The present value of 30 yearly payments is $1,250,000 – $385,398, or $864,602
So, if the $50,000-per-year prize is only over 30 years, you should take the $1,000,000 prize today
Summary
Today, we have finished our study of the invisible hand
We also examined discounting, and ways of summing constant yearly payments made forever