Money Instructor – Page 68 – Articles and Informational Resources: Money, Personal Finance, Business, Careers, Lifestyle

Perpetuities – Definition & Calculation

Perpetuity Definition:

A perpetuity is an annuity that provides payments indefinitely. Since this type of annuity is unending, its sum or future value cannot be calculated.

Examples of perpetuity:

Local governments set aside monies so that funds will be available on a regular basis for cultural activities.
A children’s charity club set up a fund designed to provide a flow of regular payments indefinitely to needy children.

Therefore, what happens in a perpetuity is that once the initial fund has been established the payments will flow from the fund indefinitely which implies that these payments are nothing more than annual interest payments.

How to calculate a perpetuity?

With perpetuities it is necessary to find a present value based on a series of payments that go on forever.

The formula for calculating the present value of a perpetuity is:

R
A ∞ = —-
i

Where:

R = the interest payment each period

i= the interest rate per payment period

Example:
Alan wants to retire and receive $3,000 a month. He wants to pass this monthly payment to future generations after his death. He can earn an interest of 8% compounded annually. How much will he need to set aside to achieve his perpetuity goal?

Solution: R = $3,000

i = 0.08/12 or 0.00667

Substituting these values in the above formula, we get

$3000
A ∞ = ———
0.00667

= $449,775

If he wanted the payments to start today, we must increase the size of the funds to handle the first payment. This is achieved by depositing $452,775 which provides the immediate payment of $3,000 and leaves $449,775 in the fund to provide the future $3,000 payments.

Finance
basics, calculation, definition, formula
Leave a comment

Standard Deviation — Definition & Calculation

Definition: Standard deviation is a measure of how far apart the data are from the average of the data. If all the observations are close to their average then the standard deviation will be small.

How to calculate standard deviation:
Suppose that an investor has $600 to invest and is considering investing all of it in the shares of one firm, currently trading at $30. The investor assesses a 0.75 probability that the shares will increase in market value to $33 over the coming period and a 0.25 probability that the share will decrease in its market value to $26. Assume that the firm will pay $1 dividend per share at the end of the year.

The payoffs from the proposed investment are as follows:

If shares increase: $33 x 20 shares + $20dividend = $680
If shares decrease: $26 x 20 shares + $20dividend = $540

PAYOFF ($)	RATE OF RETURN	PROBABILITY	EXPECTED RATE OF RETURN	VARIANCE
(1)	(2)	(3)	(4) = (2) x (3)	(5)

680	(680 – 600)/600 = 0.13	0.75	0.0975	(0.13 – 0.0725)^2 x 0.75 = 0.0025

540	(540 – 600)/600 = – 0.10	0.25	-0.025	(-0.1 – 0.0725)^2 x 0.25 = 0.0074

		sum (x)	0.0725	Add the above two results to get σ² = 0.0099

The standard deviation is the square root of the variance. In the above example, the standard deviation is square root of 0.0099 i.e. 0.0995 or 9.95%

How to calculate the standard deviation using an ordinary calculator?
Key in 0.0099 and then press the √ key to get 0.0095 or 9.95%

Finance
basics, calculation, definition
Leave a comment

Information Asymmetry

An economy is said to be characterized by information asymmetry when some parties to business transactions may have an information advantage over others.

Types of information asymmetry

The first is adverse selection. Adverse selection occurs because some persons, such as managers and other insiders know more about the current condition and future prospects of the firm than outside investors. There are various ways that managers and other insiders can exploit their information advantage at the expense of others, for example, by biasing or otherwise managing the information released to investors. This may affect the ability of investors to make good investment decisions. Financial reporting is one of the mechanisms that are used to control the problem of adverse selection by credibly converting inside information into outside information.

The second one is moral hazard. This problem occurs because of the separation of ownership and control that characterizes most medium and large businesses. It is almost impossible for shareholders to observe directly the extent and quality of top managerial effort on their behalf. A manager may take advantage of this by shirking on effort and blaming any deterioration of firm performance on factors beyond his or her control. If this happens there are serious implications for investors.

Accounting net income can be one of the effective antidotes to the problem of moral hazard. Net income can be incorporated into executive compensation contracts to motivate manager performance. Net income can also inform the securities and managerial labor markets, so that a manager who shirks will suffer a decline in income, reputation, and market value over time.

Importance of Information asymmetry

Information asymmetry is a very important concept because securities markets are subject to information asymmetry problems. This is because of the presence of inside information and insider trading. Insiders know more than outsiders about the true quality of the firm. They may take advantage of their privileged position of information to earn excess profits. They may take actions that are beneficial to them but are detrimental to the interests of investors.

Finance
basics, definition
Leave a comment

Bond Valuation — Calculation

Bonds can be purchased at any time. To value the bond, the procedures differ depending on whether the bond is purchased on the date interest is regularly paid (interest date) or whether it is purchased “between interest dates”.

How to calculate the Purchase Price of a Bond on an Interest Date

Formula to be used:

PP = R[1-(1+i)^-n]
—————— + RD (1+i) ^ -n
i

Valuing Bonds

Example:

A $5,000 bond pays the holder an interest rate of 10% payable semi-annually. The bond will be redeemed at par in 10 years. An investor wants to purchase the bond on the bond market to yield a return of 12% payable semi-annually. What would be the purchase price of the bond?

Solution:
Since the bond pays 10% on $5,000 semiannually, the regular interest payment will be:

R = F * r

= $5,000[0.1 / 2]
= $250

From the information given, the remaining number of interest periods is:

N=10*2, or 20

The redemption value of the bond in ten years is the par value or the face value of the bond:

RD = $5,000

Now to compute the purchase price, we must calculate the present values of the payments and the redemption value. Since the yield rate is the rate the investor wants to receive, it is the rate we must use to find the present values in determining the purchase price. Substituting the values into our formula, we have:

PP = $250[1-(1+i) ^ -n]
———————— + $ 5,000(1+i) ^ -n
I

(the payments part of the + (the redemption part of the
formula) formula)

Substituting the remaining values gives:

I = 0.12 /2, or 0.06 yield rate

N= 20

PP= $250[1-(1+0.06) ^ -20]
—————————— + $5,000(1+0.06) ^ -20
0.06

PP = $2,867.50 +$1,559.02

PP (purchase price) = $4,426.52

How to calculate the Purchase Price of a Bond, if it is purchased between interest dates:

Most bond sales occur between interest dates.

Example: Consider the same example given above. Assume the bond is purchased 156 days after April 1 (the interest date).

Then the purchase price would be:

$ 4,426.52 [1 + 0.06(156/183)]

(as calculated in the above example)

PP = $ 4,652.93

The issuer may at the time of issue of the bonds commit to redeem the bonds at a premium. Assume that in the above example the bonds are to be redeemed at 102; this means that for every dollar of face value, $ 1.02 will be paid upon redemption.

The reason an issuer may offer such an arrangement is to encourage people to buy the bond and hold until it is redeemed. To this investor this represents a slight increase in the return. In the above example, the $5,000 bond would be redeemed at $5,100. To calculate the purchase price, replace the $5,000 considered in the redemption value of the formula by $ 5,100.

Finance
calculation, computation, definition, equation
Leave a comment

Capital Budgeting – Procedure & Decision Process

Capital budgeting is the process by which the financial manager decides whether to invest in specific capital projects or assets. In some situations, the process may entail in acquiring assets that are completely new to the firm. In other situations, it may mean replacing an existing obsolete asset to maintain efficiency.

During the capital budgeting process answers to the following questions are sought:

What projects are good investment opportunities to the firm?
From this group which assets are the most desirable to acquire?
How much should the firm invest in each of these assets?

Components of Capital Budgeting

Initial Investment Outlay:
It includes the cash required to acquire the new equipment or build the new plant less any net cash proceeds from the disposal of the replaced equipment. The initial outlay also includes any additional working capital related to the new equipment. Only changes that occur at the beginning of the project are included as part of the initial investment outlay. Any additional working capital needed or no longer needed in a future period is accounted for as a cash outflow or cash inflow during that period.

Net Cash benefits or savings from the operations:
This component is calculated as under:-
(The incremental change in operating revenues minus the incremental change in the operating cost = Incremental net revenue) minus (taxes) plus or minus (changes in the working capital and other adjustments).

Terminal Cash flow:
It includes the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital.

The Net Present Value technique:
Although there are several methods used in Capital Budgeting, the Net Present Value technique is more commonly used. Under this method a project with a positive NPV implies that it is worth investing in.

Example:
A company is studying the feasibility of acquiring a new machine. This machine will cost $350,000 and have a useful life of three years after which it will have no salvage value. It is estimated that the machine will generate operating revenues of $300,000 and incur $75,000 in annual operating expenses over the useful life of three years. The project requires an initial investment of $15,000 in working capital which will be recovered at the end of the three years. The firm’s cost of capital is 16%. The firm’s tax rate is 25%.

To simplify the problem, depreciation is not considered.

Solution:
Initial Investment is $350,000

Initial Net Working Capital is $15,000

Present Value of the annual operating cash flow after tax

= ($300,000-$75,000) x (1-0.25) x PVIFA(16%,3years)
= $225,000 x 0.75 x 2.2459
= $378,996

Note: The number 2.2459 can be obtained by using an ordinary calculator. Procedure to be followed:

For Year 1, divide 1 by 1.16 = 0.8621
For Year 2, the calculator screen shows 0.8621, press the = key, you will get 0.7432
For Year 3, the calculator screen shows 0.7432, press the = key, you will get 0.6406

Add up all the three to get 2.2459

Since the asset will not have any salvage value at the end of the third year we need not calculate the Present Value.

Present Value of the net working capital at the end of the project

= $15,000 x PVIFA(16%,3rd year)
= $15,000 x 0.6406
= $9,609

Net Present Value = ($ 350,000) + ($ 15,000) + $ 378,996 + $ 9,609 = $ 23,605

Since the NPV is positive it is feasible to purchase the equipment.

Finance
basics
Leave a comment

Cost of Capital WACC — Formula & Calculation

The cost of capital is the expected return that is required on investments to compensate you for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average basis (WACC).

It is alternatively referred to as the opportunity cost of capital or the required rate of return.
It is calculated based on the expected average rate of return of investors in a firm.

Calculating Cost of Capital

Numerical Example :

Bonds	$ 200,000
Common shares	$ 200,000
Retained Earnings	$ 100,000
	————-
	$ 500,000
	=========

Bonds:
• Annual interest rate 6%
• Years to maturity is 9 years

Common shares:
• Shares held 100,000
• Current share price $5
• Market return over next year 12%
• Beta (somewhat risky) 1.15
• Treasury bills currently yield 4%

• Tax rate 25%

Calculation of Cost of Capital:
First, determine market values

Bonds:
FV = $200,000
Interest per year = $200,000 x 0.06 = $12,000
N (number of years) = 9
i (interest rate) = 6%
PV (present value of the bonds)

S
P = ———-
(1+rt)

$ 200,000
P = ————-
[1 + (0.06)^9]

$ 200,000
P = ————–
1.54

P = $129,870.12

Let’s check it out:
Interest per year = $129,870.12 x 0.06 = $7,792.21
Interest for nine years = $ 7,792.21 x 9 = $ 70,129.88

Amount to be paid at maturity =
$ 129,870.12 + $ 70,129.88 = $ 200,000 (this is the face value).

• Common Shares:
100,000 shares x $ 5 = $ 500,000

Second, determine weightings based on market values:

Bonds	$ 129,870	0.2062
Common shares	$ 500,000	0.7938
	—————	———
	$ 629,870	1.0000 (should always be 1)

Third, determine costs:
• Common shares:
Rate of return = Risk-free rate (treasury bills rate) + [market return over next year – risk free rate]Beta
= 0.04 +(0.12 -0.04)1.15
= 0.04 + 0.092
= 0.132

• Bonds:
PV = $ 129,870
FV = $ 200,000
i (after tax) = $ 12,000 (1 – 0.25)
= $ 12,000 x 0.75
= $ 9,000
Effective rate = $ 9,000/$ 200,000 = 0.045 or 4.5%

Finally, determine cost of capital:

	Weightings	Costs	Weightings x Costs
Bonds	0.2062	0.045	0.0093
Common Shares	0.7938	0.132	0.1048
			———
			0.1141
			======

Cost of Capital = 11.41%

Finance
basics
Leave a comment

CAPM – Capital Asset Pricing Model

In an efficient securities market, prices of securities, such as stocks, always fully reflect all publicly available information. This raises the question “What should the price be?”

The well-known Sharpe-Lintner capital asset pricing model (CAPM) provides an answer. According to the model a share’s current market price will be such that:

Expected return on the share E(Rjt) = a constant Rt(1 – βj) + expected return on market portfolio E(Rмt) x beta of the share βj

Using CAPM Formula Equation

An example of the model:

Assume the following:
Risk-free return = 6%
Expected market return = 12%
Beta of firm j = 0.8
Dividend of firm j = $ 1.00

Share price at the beginning of the period = $ 20.00

Find the share price at the end of the period for the given expected value.

First, calculate the expected return on the firm’s shares from CAPM:

Expected return = Risk-free rate (1 – Beta) + Beta (Expected market rate of return)

= 0.06 (1 – 0.8) + 0.8(0.12)
= 0.012 + 0.096
= 10.8 %

Then, calculate the ending price that supports an 10.8 % expected return.

For calculating the ending price, apply the net rate of return formula as under:

Expected return = [(Expected ending price + Expected dividend) / Beginning price] – 1
0.108 = [P(end) +1.00/20.00] – 1
1.108 = [P(end) +1.00]/20.00
20.00 x 1.108 = P(end) + 1.00
22.16 = P(end) + 1.00
22.16 – 1 = P(end)
P(end) = $ 21.16

If bad earnings news about the firm arrives in the market at the beginning of the year resulting in the expected return on the firm’s shares falling from 10.8 % to 10%, this would only support an ending price of $ 21.00 calculated as under by applying the net rate of return formula:

0.10 = [P(end) + 1.00/20.00] – 1
1.10 = [P(end) + 1.00]/20.00
20 x 1.10 = P(end) + 1.00
22.00 – 1.00 = P(end)
P(end) = $ 21.00

One of the variables has to change to keep the expected at 10.8% It is important to note that the factors that make up the CAPM are independent of earnings news. The fixed rate would come from treasury bills or government bonds. Beta is assumed as constant and the expected return on the market portfolio is independent of the firm, and so does not change. The only variable where change is possible is the beginning share price. What should it fall to?

0.108 = [(21.00 + 1.00/P(beg.)] – 1
0.108 + 1 = 21.00 +1.00/P(beg.)
1.108 = 21.00 + 1.00/P(beg.)
P(beg.) = 22.00/1.108
P(beg) = $ 19.86

To maintain the 10.8% expected return, the share price will have to fall to $ 19.86, and the share price at the end of the year would be $21.00

Verification: [$ 21.00 (price at the end of the year) + $ 1.00 (expected dividend) –
$ 19.86(price at the beginning of the year]/ $ 19.86
= 2.14/19.86 x 100
= 10.8 % (expected return)

Finance
basics, formula
Leave a comment

Present Value – Formula & Calculation

Present value refers to today’s value of a future amount.

Present Value Formula:

S
P = ————
(1+rt)

Instead of beginning with the principal which is invested, you could start from what you want to accumulate in the future, and then work backward to see the amount that you must invest to reach the required amount.

For example, if you wish to retire within a certain number of years you can begin working in reverse to determine what amount must be invested today to accumulate the desired amount at the time of your retirement in the future.

Example
Assume you need $20,000 in three years for a down payment on a house. If the simple interest rate is 5%, how much would you have to invest today to accumulate the $20,000 in three years?

In this example:

S= $20,000 (amount of maturity value)
t = 3 years
r = 0.05

The calculation for principal is:

S
P = ———-
(1+rt)

$20,000
P = ————-
[1 + (0.05)3]

$20,000
P = ————-
1.15

P = $17,391.30

Therefore, if you invest $17,391.30 today at 5% simple interest, you will have $20,000 in three years.

Let’s check it out:
Interest per year = $17,391.30 x 0.05 = $869.57
Interest for three years = $869.57 x 3 = $2,608.70

Therefore, the amount available for down payment at the end of three years is $17.391.30 + $2,608.70 = $20,000

Instead of 5% simple interest, consider 5% compound interest payable semiannually:

Formula to be used:
P = S(1+i)^-n

S = 20,000
i = 0.05 / 2 = 0.025
n = 2 x 3 = 6

P = $ 20,000(1+0.025)^-6

= $ 20,000(1.025)^-6

= $ 20,000 x 1
———
(1.025)^6

= $ 20,000 / 1.16

= $ 17,241.38

Let’s check it out using the compound interest formula:

S = P(1 + i)^n
= $ 17,241.38(1 + 0.025)^6
= $ 17,241.38(1.025)^6
= $ 17,241.38 x 1.16
= $ 20,000

Finance
basics
Leave a comment

Efficient Markets Hypothesis – Theory & Definition

Definition
An efficient securities market is one where the prices of securities traded on that market at all times “properly reflect” all information that is publicly known about those securities.

Noteworthy Points of the Theory

First, market prices are efficient with respect to publicly known information.
The possibility, therefore, of inside information is not ruled out. Persons who possess inside information know more about the company than the market. If they wish to take advantage of their inside information, insiders may be able to earn excess profits on their investments. This is because the market prices of these investments do not incorporate the knowledge that insiders possess. Market prices reflect information that is available in the public domain.

Second, market efficiency is a relative concept.
The market is efficient relative to the quantity and quality of publicly available information. There is nothing in the definition to suggest that the market prices always reflect real underlying firm value. Market prices can be wrong in the presence of inside information, for example. The definition does imply, however, that once new or corrected information becomes publicly available, the market price will quickly adjust to this new information. This adjustment occurs because rational investors will revise their beliefs about future returns as soon as new information, irrespective of the source, becomes known. As a result, the expected returns and risk of their existing portfolios will change and they will enter the market to restore their optimal risk/return tradeoffs. The resulting buy-and-sell decisions will quickly change security prices to reflect the new information.

Third, investing is fair game if the market is efficient.
This means that investors cannot expect to earn excess returns on a security, or portfolio of securities, over and above the normal expected return on that security or portfolio. One way to establish a normal return benchmark is by means of a capital asset pricing model.

Implication of the hypothesis
An implication of securities market efficiency is that a security’s market price should fluctuate randomly over time. The reason being anything about a firm that can be expected will be properly reflected in its security price by the efficient market as soon as the expectation is formed. The only reason that prices will change is if some relevant, but unexpected, information comes along and unexpected events occur randomly.

Finance
basics
Leave a comment

Calculating Compound Interest

Compound interest means that the interest will include interest calculated on interest.

For example, if an amount of $5,000 is invested for two years and the interest rate is 10%, compounded yearly:

• At the end of the first year the interest would be ($5,000 * 0.10) or $500

• In the second year the interest rate of 10% will applied not only to the $5,000 but also to the $500 interest of the first year. Thus, in the second year the interest would be (0.10 * $5,500) or $550.

Unless simple interest is stated one assumes interest is compounded.

When compound interest is used we must always know how often the interest rate is calculated each year. Generally the interest rate is quoted annually. e.g. 10% per annum.

Compound interest may involve calculations for more than once a year, each using a new principal (interest + principal). The first term we must understand in dealing with compound interest is conversion period. Conversion period refers to how often the interest is calculated over the term of the loan or investment. It must be determined for each year or fraction of a year.

e.g.: If the interest rate is compounded semiannually, then the number of conversion periods per year would be two. If the loan or deposit was for five years, then the number of conversion periods would be ten.

Compound Interest Formula:
S = P(1+i)^n

Where
S = amount
P = principal
i = Interest rate per conversion period
n = total number of conversion periods

Example:
Alan invested $10,000 for five years at an interest rate of 7.5% compounded quarterly

P = $10,000
i = 0.075 / 4, or 0.01875
n = 4 * 5, or 20, conversion periods over the five years

Therefore, the amount, S, is:
S = $10,000(1 + 0.01875)^20
= $ 10,000 x 1.449948
= $14,499.48

So at the end of five years Alan would earn $ 4,499.48 ($14,499.48 – $10,000) as interest.

Note: How to calculate 1.449948,
(1 + 0.01875)^20 = multiply 1.01875 twenty (20) times
1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 x 1.01875 (you will find the number is used 20 times)

If he had invested this amount for five years at the same interest rate offering the simple interest option, then the interest that he would earn is calculated by applying the following formula:

S = P(1 + rt),
P = 10,000
r = 0.075
t = 5

Thus, S = $10,000[1+0.075(5)]
= $ 13,750

Here, the interest that he would have earned is $3,750.
A comparison of the interest amounts calculated under both the method indicates that Alan would have earned $749.48($4,499.48 – $3,750) more under the compound interest method than under the simple interest method.

Finance
basics, beginner, definition
Leave a comment

Simple Interest – Definition and Calculation

When we borrow money we are expected to pay for using it – this is called interest.

There are three components to calculate simple interest: principal (the amount of money borrowed), interest rate and time.

Formula for calculating simple interest:

I = Prt

Where,
I = interest
P = principal
r = interest rate (per year)
t = time (in years or fraction of a year)

CALCULATING SIMPLE INTEREST EXAMPLES

Example:
Alan borrowed $10,000 from the bank to purchase a car. He agreed to repay the amount in 8 months, plus simple interest at an interest rate of 10% per annum (year).

If he repays the full amount of $ 10,000 in eight months, the interest would be:

P = $ 10,000 r = 0.10 (10% per year) t = 8/12 (this denotes fraction of a year)

Applying the above formula, interest would be
I = $ 10,000(0.10)(8/12)
= $ 667

If he repays the amount of $10,000 in fifteen months, the only change is with time. Therefore, his interest would be:
I = $ 10,000 (0.10)(15/12)
= $ 1,250

The Bankers Rule:
In the world of finance, time is often expressed in days rather than months. Two kinds of times are used: Exact time and Approximate time.

Exact Time
It uses the precise number of days for time of the loan or investment. Assumes that each year has 360 days.
Approximate time: Assumes that each year has 360 days and each month has 30 days.

The Bankers rule
Is widely used in the United States, and uses the combination of ordinary interest and exact time.

Example: An investment of $5,000 is made on August 31 and repaid on December 31 at an interest rate of 9%
Applying the Bankers rule, interest would be:

I = Prt
= $5,000(0.09)(106/360)
= $ 132.50

Determining the maturity value:
Maturity value = Interest + Principal

Formula: S = P (1 + rt)
Refer the example given under the Bankers rule. Maturity value would be,

S = $ 5,000 [1 + 0.09(106/360)]
= $ 5,000 (1.0265)
= $ 5,132.50

Note: How to calculate 1.0265. First, divide 106 by 360, you will get 0.2944. Then, multiply 0.2944 by 0.09, you will get 0.0265. Add 1 to 0.0265 to get 1.0265

Finding time:
Formula: t = I/Pr
Using the same example above, time would be
t = $ 132.50/[$ 5,000*0.09]
= 132.50/$ 450
= 0.2944
We have considered 360 days in a year. Therefore number of days would be,

t = 0.2944 x 360
= 106 days

Finding the interest rate:
Formula: r = I/Pt

Using the same example above, time would be
r = $ 132.50/[$ 5,000*(106/360)]
= 132.50/$ 1,472.22
= 0.09 i.e. 9%

Finance, Investing and Financial Planning
basics, beginner, definition
1 Comment

Microeconomics: A General Overview

Besides Macroeconomics, the other basic way to view economics is the “Microeconomic” view. This view concerns itself with the particulars of a specific segment of the population or a specific industry within the larger population of good and service providers. More importantly, from a financial standpoint microeconomics concerns itself with the distribution of products, income, goods and services. Of course it is this distribution, which directly affects financial markets and the overall value of any particular resource at a specific point in time. If there is one concept integral to an understanding of microeconomics it is the law of supply and demand. A more detailed look at supply and demand as well as how they affect price will be helpful in understanding microeconomics.

Before discussing supply and demand it is helpful to understand what price is as a concept and how it relates to supply and demand. Price is essentially the feedback both the buyer and seller receive about the relative demand of a product, good or service. When the price is high then demand will be low and when the price is low demand will be high.

There are two laws intrinsically related to microeconomics. These two laws are the Law of Supply and the Law of Demand. A closer look at each will illustrate how they relate to pricing and the distribution of goods and services.

According to the LAW OF DEMAND, as price goes up; the quantity demanded by consumers goes down. As the price falls, the quantity demanded by consumers goes up. This law concerns itself with the consumer side of microeconomics. It tells us the quantity desired of a given product or service at a given price.

The LAW OF SUPPLY concerns itself with the entrepreneur or business, which supplies the products and services. This law tells us the amount of a product or service businesses will provide at a given price. Essentially, if everything else remains the same, businesses will supply more of a product or service at a higher price than they will at a lower price. This is because the higher price will attract more providers who seek to make a profit on the good or service. By the same token a low price will not attract additional suppliers and as a result the overall supply will remain low.

These two laws help to determine the overall price level of a product with a defined market. When evaluating the prices of an undefined market then another factor must be considered. This additional factor is called OPPORTUNITY COST. Opportunity cost is the relative loss of opportunity one must deal with in making a decision to invest time and money in something else. Needless to say, determining opportunity cost is very complicated and hard to evaluate in terms of economics.

Opportunity Cost is also used in evaluating the net cost of any good or service currently being utilized by an individual or the market as a whole. This can be illustrated by the decision a city makes to allocate a zone of land toward public recreation in the form of a park. The opportunity cost in this situation would be the loss of revenue the city would suffer by allocating the park instead of zoning the land for industrial use. Most situations involving opportunity cost are not so clear though.

The important concept to take away from opportunity costs is that for every purchasing or investing decision made there are other alternatives, which one is giving up. Therefore one is not just investing $5000 in government bonds but one is choosing to invest in bonds over funding the education of a child or of taking a vacation to the Bahamas for the entire family. Whether the investment is good or not depends on the value the family and the individual places on the alternative. These are the type of insights a microeconomic view can give the individual investor when applied correctly.

Economics, Investing and Financial Planning
beginner
Leave a comment