Economics Chapter 27 Homework Both Investment Decisions Must Made With Less than perfect

251

Chapter 27 (14 Micro)

Investment, the Capital Market, and the Wealth of Nations

OUTLINE

I. Why People Invest

A. Capital and Investment

1. Types of capital:

3. Saving is income not spent on current consumption.

B. Savings and Investment

1. Investment and saving are closely linked:

a. Saving is the non-consumption of income.

b. Investment is the use of unconsumed income to produce a capital resource.

c. Savings is required for investment.

C. Investment and Consumption

1. Can often produce more consumption goods in future by:

2. Delaying consumption is less desirable since people have a positive rate of time

preference prefer goods sooner rather than later.

II. Interest Rates

A. Interest Rate

2. It is the premium that borrowers must pay to lenders to acquire goods now rather

than later.

B. Determination of Interest Rates

1. Interest rates are determined by the supply and demand for loanable funds.

2. The demand for loanable funds comes from two sources:

4. The market interest rate will bring the quantity of funds demanded by borrowers

into balance with the quantity supplied by lenders.

C. The Money Rate vs. Real Rate of Interest

1. During inflation, the nominal interest rate, or money rate of interest is misleading

of the true cost of borrowing.

252 Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations

a. The money interest rate will include an inflationary premium reflecting the

D. Interest Rates and Risk

1. More than one interest exists in loanable funds market.

a. Ex: mortgage rate, credit card rate.

E. Components of Money Interest Rate

1. Pure rate of interest.

a. Price for earlier availability.

2. Inflationary premium.

3. Risk premium.

a. Reflects probability of default.

III. The Present Value of Future Income and Costs

A. Present Value

1 The interest rate connects the value of dollars today with the value of dollars in the

future.

2. The present value (PV) of a payment received one year from now is:

a. PV = receipts one year from now/(1 + interest rate)

IV. Present Value, Profitability, and Investment

A. Discounted Present Value

B. Expected Future Earnings and Asset Value

1. The present value of expected future net earnings will determine the value of

V. Investing in Human Capital

VI. Uncertainty, Entrepreneurship, and Profit

A. Economic Profit

1. Economic profit plays a central role in the allocation of capital and the

determination of which investment projects will be undertaken.

2. In a competitive environment, profit reflects:

B. Returns to Physical and Human Capital

1. Employee compensation and self-employment income represent primarily returns

VII. Why is the Capital Market so Important?

A. If the potential gains from innovative ideas and human ingenuity are going to be fully

realized, it must be relatively easy for individuals to try their innovative and potentially

ingenious ideas, but difficult to continue if the idea is a bad one

B. To grow and prosper, a nation must have a mechanism that will attract savings and

channel into investment projects that create wealth.

2. When property rights are defined and securely enforced, productive investments

will also be profitable.

C. Political Allocation and the Structure of Incentives

1. When investment funds are allocated by the government, rather than by the market,

3. Businesses will use contributions, lobbying, and other resources to attract favors

OBJECTIVES

Many goods are durable that is, they provide a stream of future services (or revenues). The focus

of this chapter is the decision making with regard to assets and costs that have a time dimension.

The interest rate enables a present value to be assigned to a flow of future revenues (or

costs). Stock data can thus be transformed into flow, and vice versa. In this chapter, we discuss the

meaning of interest and explain why the interest rate is generally positive. The concept of net present

value is introduced and used to explain how the value of a stream of future revenues or costs is

determined. The investment decisions of firms are analyzed in this framework.

Ownership of capital assets involves risk as well as the sacrifice of interest income. Persons

who seek to avoid risk will require compensation for this cost before they will undertake capital

ownership. The pure profit return on capital and entrepreneurship is analyzed within this

framework.

We emphasize the crucial importance of a private capital market to a society and the

destructiveness of interest rate controls.

254 Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations

IMPORTANT POINTS AND TEACHING SUGGESTIONS

1. Discuss the meaning of investment in terms of roundabout methods of production, and indicate

3. Discuss how each of the following serves to determine the interest rates:

a. the time preference of consumers for goods

4. Even though money interest rates in the 1970s were quite high, it could be argued that real

interest rates were often low. At various points during the 1970s, the real interest rate may

5. After defining net present value, work several calculations with the formula. Without the use of

discounting procedures, it would be impossible to compare the value of a stock figure (for

6. Discuss how each of the following contribute to the yield derived from the ownership of capital

assets:

7. While non-pecuniary factors are generally more important for investment decisions involving

human capital, there are many similarities between business investment decisions and the

8.

9. A good present value illustration is the explanation of why more expensive cars are generally

maintained better (adding to their longevity, which is often touted in their ads). Answer: the

costs of not maintaining a more expensive car in terms of added depreciation are far higher. It

10. Looking ahead to the special topic about natural resources, now is a good time to introduce the

11. An interesting sidelight to the present value discussion of this chapter is to ask students whether

12. Games 1 to 2 will help reinforce the material in chapter 27.

GAMES

1. The Universal Replicator

Type: In-Class Assignment

Topics: technological change

Textbook: Chapter 26 Investment, the Capital Market, and the Wealth of Nations

Materials Needed: none

Time: 20 minutes

Class limitations: works in any size class

Purpose

This assignment explores the economic implications of an imaginary new technology, called the

Universal Replicator. Many issues about growth and change are raised.

Instructions

The Universal Replicator is a machine that can replicate any physical good. If a car is put into the

Universal Replicator, the machine will create an exact working duplicate, at the touch of a button.

It will work on any non-living object.

256 Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations

Common answers and points for discussion

1. What impact would the Universal Replicator have on the economy?

2. What jobs would not be needed?

3. What would happen to the price of goods?

4. What kinds of problems would you expect?

5. What benefits do you see?

6. What kinds of jobs would still be necessary?

ge has had very

similar effects. For example, look at the long-term advances in agriculture. Two hundred years

ago 80 percent of the U.S. labor force worked in farming. Today, farming accounts for 2 percent

of U.S. jobs. Agricultural production has increased tremendously and food prices have decreased

substantially.

258 Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations

NAME _______________ Course __________________

Universal Replicator Assignment

1. What impact would the Universal Replicator have on the economy?

2. What jobs would not be needed?

3. What would happen to the price of goods?

4. What kinds of problems would you expect?

5. What benefits do you see?

6. What kinds of jobs would still be necessary?

2. Create a Portfolio

Type: Take-home Assignment

Topics: financial markets

Textbook: Chapter 26 Investment, the Capital Market, and the Wealth of Nations

Class limitations: works in any size class

Purpose

This assignment requires students to use the financial pages of the newspaper to create their own

portfolio. Many students are unfamiliar with the basic elements of stock and bond tables. This

assignment then asks students to analyze elements that would affect their portfolio.

Instructions

Ask the students to do the following assignment. Many possible variations exist. It can be

worthwhile to have students reevaluate their portfolio at the end of the semester.

Common answers and points for discussion

Most students pick a mix of common stocks, mutual funds, and bonds. Some choose familiar,

260 Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations

Name____________________ Course ______________

Financial Portfolio

1. Assume you have $100,000 in savings. Create a portfolio of securities worth $100,000. Decide

2. What objectives do you have for this portfolio? Was it chosen to maximize short-term gains,

long-term stability, or some other objective?

3. Explain how each of the following economic events would affect the value of your portfolio.

a. an increase in interest rates

Chapter 27 (14 Micro)/Investment, the Capital Market, and the Wealth of Nations 261

HINTS FOR ANSWERING CRITICAL THINKING QUESTIONS

3. Human and physical capital investment principles are the same, but non-pecuniary