Money Instructor – Page 79 – Articles and Informational Resources: Money, Personal Finance, Business, Careers, Lifestyle

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%

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)

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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

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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.

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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.

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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%

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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.

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Macroeconomics: A General Overview

Finance is based on economics. Therefore, to properly understand financial markets and their behavior one must first understand economics. Economics at its core is concerned with the production, distribution, trade and consumption of goods and services. To put this in human terms we can say that economics is the science that arises out of the interplay between limited resources and unlimited human wants and needs.

There are two basic ways to view economics. There is the broad and distant view, which attempts to view things in aggregate for a society at large. We call this view “Macroeconomics”. Macroeconomics is concerned with the status of the economy as a whole. Thus, it looks at overall employment of a general population or overall income of a nation as opposed to a more focused view of a population segment or specific industry. This view is helpful because it is only by this kind of analysis that we can see the general trends which a society or nation is following. Macroeconomic theory and analysis is employed most often by governments and institutions, which have a responsibility to make policies and decisions which affect the economy as a whole.

Some terms you may have heard of which concern themselves with the macroeconomic view of the economy are Gross National Product, Inflation, Consumer Price Index and Fiscal Policy. The meaning of each of these is listed below.

Gross National Product – This is the most common measure of economic productivity for an aggregate population. GNP is defined as the total value of all goods and services produced in final form during a specific period of time (usually 1 year).

Inflation – Inflation is defined as a condition of generally increasing prices. The term used for measuring these prices can vary according to the desires of the individual, government or institution doing the evaluation.

Consumer Price Index – The CPI is a measure of how much prices have increased or decreased as compared to a baseline years prices. The prices used in arriving at this figure are standard goods and services determined by the evaluator. Thus, the CPI for the United States might vary greatly as compared the CPI for a country from the Middle East.

Fiscal Policy – Fiscal Policy is essentially the manner in which a government achieves economic objectives through government spending and taxation. Fiscal policy is the alternative to Monetary Policy.

Monetary Policy – Monetary Policy is essentially the practice of a government managing the supply of money to achieve economic objectives. The United States uses the Federal Reserve System to either increase or decrease the supply of money, which in turn effects the overall economic environment as a whole.

The principles of Macroeconomics are important in analyzing and understanding longer-term trends and aggregate market behavior. Therefore, for the individual managing his own portfolio it may be helpful to know the current fiscal policy and how it may affect the value of any government bond holdings. One of the ways the government will manage fiscal policy is to buy back these bonds or issue more depending on their objective. This is just one example of the way in which Macroeconomics affects the individual investor.

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Opportunity Cost – Basic Economics Concept

Should I go to work today? Should I go to college after high school? Should the government spend money on a new weapon system? These are decisions that are made everyday; however, what is the cost of our decisions? What is the cost of going to work, or the decision not to go to work? What is the cost of college, or not to go to college? Finally what is the cost of buying that weapon system, or the cost of not buying that weapon? In economics it is called opportunity cost.

Opportunity cost is the cost we pay when we give up something to get something else. There can be many alternatives that we give up to get something else, but the opportunity cost of a decision is the most desirable alternative we give up to get what we want.

Let’s look at our examples from above. If you have a job, what do you give up to go to work? There are many possibilities. I could sleep in. If it is a nice day I could take my dog to the park and play all day. Or, I could even spend the day looking for a better job right? I give up all of these things if I choose to go to work. What I get from working is a greater benefit than the cost of giving up these things. But, opportunity cost is the most desirable thing given up not the aggregate of the things we gave up.

Let’s look at the college example. We are all told to go to college so you can get a good education and that will translate into a good job. How do we know that college is such a good thing? How much college do we need? Let’s look at some numbers from a study on education from the Institute of Government and Public Affairs:

There are distinct benefits of a college education. A study conducted by the Institute of Government and Public Affairs for the Illinois Board of Higher Education, showed the following benefits:

Higher Earnings – Earning a bachelor’s degree provides the average student with over $590,000 in future earnings. Similarly a professional degree provides a present value to the student of almost $1.25 million in future earnings.
Labor force participation rates and employment rates for people aged 25 and over increase with increased levels of education.
People with college experience contribute time and money to charitable causes at a higher rate than those with less education.
Increased levels of education are associated with the increased likelihood of voting or registering to vote.

“In addition, college can provide many other benefits that are less tangible, and will help your child become a better-rounded individual. Benefits include increased self-awareness, the ability to think critically, and an opportunity to meet many different people. Overall, the entire college experience will provide your child with a lifetime of benefits”.

As we can see there are many benefits to a college education. So what are the costs? There are monetary costs for sure. Also, we will spend four or more years going to classes. We could be working and earning money instead of going to college. Finally we will be giving up free time for study time that could be used to do other things.

What about spending money on a missile defense system? In the fiscal year 2006 budget the taxpayers of Colorado will spend, as a fraction of overall federal spending, $150.7 million for the ballistic missile defense system (Center on Arms Control and Nuclear Proliferation). That same money could pay for 27,547 people to get health care (Centers for Medicare and Medicaid Data Compendium) or, 37,384 scholarships for university students (National Center for Education Statistics). These represent real choices that the government must make with our Tax dollars. The opportunity costs in this case depend upon what you value more military spending, health care, or college scholarships.

To get a graphical representation of how an economy makes decisions on what to produce, or spend their money on, we will use a Production Possibilities Curve.

Production Possibilities Curve shows the choices a country can make with respect to its available resources.

Resources are Land, Labor, and Capital

Land– this refers to all natural resources used to produce goods and services. This includes crops that are grown on a land, minerals that are mined from land and rent that is paid to an owner of land for its use.

Goods and services are the things that we buy like mp3 players or hair cuts. A good is a physical thing you can hold a service is some thing that gets used up right after it is purchased.

Labor– this is the effort that an individual person puts into making a good or service. This for this effort the person is paid a wage. Labor includes factory workers, medical personal, and teachers. They all provide their labor for a wage.

Capital– this is anything that is used to produce other goods and services. If you make cars you need machines to make the metal that is used in the cars. It is also the truck that drives the cars to the dealer who sells them, and it is the building that the cars are made in. All of these are the resource known as capital.

If we look at a simple model of an economy for the country of Appleoplios it shows that they can produce two goods apples and shoes, we can get a better idea of what choices they have for production. When the resources of Appleoplios are used to their full potential they can produce 100 million apples (point A) a year or they can produce 4 million pairs of shoes (point B), but they cannot produce all of both.

The line that connects points A and B is called a production possibilities frontier (PPF). It represents all of the possible combinations of production possibilities available to Appleoplios. If the economy decides that it needs apples and shoes it can choose to produce at any point along the production possibilities curve. If they choose to produce at point C they are making a combination of let’s say shoes 3.5 million shoes and 50 million apples. With that in mind, what is the opportunity cost of producing 3.5 million shoes? What did we give up to produce the shoes? We gave up 50 million apples. Opportunity cost is always expressed in terms of what we gave up in order to get something else. In this case we gave up 50 million apples so we could move some resources in to the production of shoes.

What about point D on the curve? At point D Appleoplios can produce 80 million apples and 2 million shoes. What is the opportunity cost in terms of shoes? How many shoes did they give up in order to make 80 million apples? They gave up 2 million shoes. So using all the available resources the country of Appleoplios has a variety of production choices. When the produce on the production possibilities curve they are using all of their resources to there maximum potential. This is their most efficient point.

What about some other possible points for consideration? Can they, for example produce at point E? Yes they can. This is a point of under utilization of resources. They are not operating at peak efficiency. Why would thy do this? If Appleoplios wants to save some resource for future use then they would produce at a point inside their PPF. Maybe they want to save water or another resource to use at a later date.

What about point F? Can Appleoplios produce at point F? Not at this time. They do not have enough resources to produce at this point. Would the country like to produce at point F? Sure they would, but how do they do it? They need to fine more resources or use technology to increase their production possibilities. Like all economies they want to produce more then the year before. They want to move their production possibilities curve out to point F and further the next year.

This is a new PPF that is achieved with the introduction of new resources or a new technology that can help the production process.

For a teaching lesson plan for this lesson see:
Economics Opportunity Cost Lesson Plan

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What is Economics?

Economics is the study of how a society uses its resources to satisfy its wants and needs. What does that mean? Consider the following three scenes. First, a household works together to do the chores. They cut wood for the fire place, cook meals, go to the store to buy food, and rent movies at the local video store.

Second, the managers of a large firm are deciding to produce a new product for line of electronics. They are making decisions on their best place to put their advertising dollars, either online or in traditional television commercials.

Third, law makers in Washington D.C. are deciding how to spend federal money. Should they spend money on preschool programs for minority children, or should they invest in a new military weapon system that could make the country safer? Additionally, how much money should the government spend on health care or what controls should be placed on the internet?

All of these questions are about economics.

The first question that comes to mind is why don’t we fund them all? We would if we could. But we cannot. This brings us to our first major term in economics:

Scarcity– all resources are limited and therefore are scarce. Everyone cannot have everything they want. There is not enough stuff to go around.

To decide how funds get allocated we need to look at our wants and needs. These are our next important terms. Needs are our basic needs to survive, food, clothes, and shelter. Wants, put simply, are everything else and they are unlimited. I want a new car, new mp3 player, or a new house. I don’t need any of them to survive.

Economics is the study of how we satisfy our wants and needs with the limited resources we have.

Finally, what are the resources that we have to use to satisfy our wants and needs? There are three basic resources known as the factors of production.

Goods and services are the things that we buy like mp3 players or hair cuts. A good is a physical thing you can hold a service is some thing that gets used up right after it is purchased.

Now that we know what economics is, why do we study it?

We study economics for two reasons. First, we want to be good consumers. Since our resources are limited we have to make choices. We can only buy a limited amount of goods and services with our limited income right? So we study economics to be good consumers.

Consumers are the people in an economy that purchase goods and services.

We also study economics to be good citizens.

Citizens are the people in a country. In a Republic Democracy like the United States of America they are also the ones who hold the political power to elect new governments.

Economics affects us as a citizen through our voting decisions. If we are in agreement with government policies then we should support them by voting in their favor. On the other hand, if we do not like how the government is spending money they we have a responsibility to vote the out of office.

Let us now look back at our three scenes from the beginning of the lesson. What factors of production do they have to use? One or more of the family members will work for a wage, which is labor, they are cutting wood to use for heat, that’s land, and anything they use to cut the wood is capital. They are using all of the factors of production.

What about the business? What decisions do they have to make to invest in a new product? Since, like all sectors of society, their resources are scarce, what do they need to do to fund the development of a new product? They need to take resources, land, labor, or capital form something else they make, right? They can use profits to fund their research, or they can spend less on wages to produce other goods.

How do they decide where to advertise? They do not have unlimited resources to advertise so where do they spend their money? It all depends on the product. If they are making a product that can record play digital music on a small device, you would probably want to advertise on the internet. If it is an alarm clock that is really loud for people who take their hearing aide out at night. That is probably an older population that does not use the internet as much, so you need to advertise on television.

Finally, what about government? Where do they get their money to spend? All the money the government spends is from its people in the form of taxes. Like the other parts of our economy their resource are also limited. They make decisions on spending on a larger scale then families or businesses, but they cannot fund everything. The government must decide what programs to fund. Do they spend more money on military projects, or should they spend money on preschool programs for underprivileged children? Both are beneficial to the citizens. But which one gets the money?

The answer to all of the scenes on where do the resources go is, what gives the most benefit to each sector. If it is expensive to heat your house in the winter then spending resources on the production of wood for burning is in your best interest. If you are a business you want to make a profit, so you advertise to the audience that will buy the most products. Finally, the government wants one thing, to stay in power and to do that they must make decisions on spending to have people vote for them in the next election.

We study economics for a variety of reasons. We want to have good information as consumers to make sure we spend our limited resources in a good way. As a citizen we want to make sure the government is spending our money in a way that we agree with. If we don’t agree with them then we can exercise our right as a citizen and vote for change.

For a teaching lesson plan for this lesson see:
What is Economics Lesson Plan

Economics, Investing and Financial Planning, Personal Finance
basics
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The Business of Importing and Exporting

Businesses who want to sell their products or services worldwide are involved in the export business; those who want to buy products and services from countries outside of the United States are in the import business. They may choose to do this in any number of ways. They can use an export trading house in their own country, they can find a distributor in the export market to sell their products, or they can sell their products to customers in a targeted market directly.

There are thousands of import and export businesses in the United States. Many businesses are involved in both sides, that is, they import some products and export others. These businesses are not regulated (outside of standard regulations that apply to solely domestic businesses, such as in pharmaceuticals or food products) but they are monitored and often supported by many divisions of the U.S. Government. These government organizations help importers and exporters (but especially exporters- the government is interested in selling more products abroad) in setting up an international business, locating trading partners, keeping abreast on the latest news in global trade, negotiating and communicating with businesses in other countries. Companies who import or export goods need to give careful consideration to the all of the practical aspects of international trading, how to get the goods into or out of the country, as well as the many legal requirements and restrictions.

An importer must make sure that the items they’re planning to import are allowed into the country freely, or whether they will need an import license. Import restrictions exist on many products because those products may be directly competing with American products, and if those products are seen to be crucial to our economy, there may be restrictions on their importation. The steel industry, for instance, is strongly protected. An importer may also be liable, under the principles of product liability, for any harm caused by the imported items. In addition, there may be laws in the items’ country of origin that apply to that product; these need to be adhered to as well.

Exporters receive the bulk of assistance from government and quasi-government organizations. The United States has a balance of trade deficit in excess of $50 billion each month. This is caused by more products being imported into the U.S. than are exported out of it. The government therefore assists American companies in exporting their goods in order to increase the level of U.S. exports.

Increased U.S. exports will lead to increased demand for dollars and an increased supply of foreign currency on foreign exchange markets. This increased demand will lead to a stronger dollar relative to other currencies. On the other hand, an increase in U.S. payments due to increased U.S. imports will lead to an increase in the supply of dollars and thus a weaker dollar relative to foreign currencies. Among the many organizations that help U.S. exporters are: the U.S. Department of Commerce, the U.S. Export-Import Bank, the Bureau of Industry and Security (formally the Bureau of Export Affairs), the Small Business Administration and OPIC (Overseas Private Investment Corporation).

These organizations offer exporters export counseling, market research, advocacy services in case of export problems within a foreign country, dispute resolution services, advice on regulatory problems, assistance in finding buyers and establishing business relationships, trade shows and trade missions, and, most importantly for most exporters financial assistance. The Export Import Bank assists in the export financing of U.S. goods and services through a variety of insurance, loan and guarantee programs and the Small Business Administration (SBA) issues guarantees to commercial lenders for loans to exporting firms.

Investing and Financial Planning
basics, foreign exchange
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International Free Trade Negotiations

In international trade, all countries strive to reach a contradictory goal. They would like to foster their exports in order to maximize income and profits for their business and industry and earn foreign exchange to strengthen their economy, while at the same time impose restrictions and tariffs to prevent other countries from exporting to them.

Free trade negotiations try to merge these two interests. Each country’s ideal foreign trade policy would be to have unrestricted access to foreign markets for their goods, and impose restrictions on goods from other countries so that they only import what they need and do not import products that will compete in their domestic market. This is, of course, completely impossible as all countries try to achieve this same end.

Free trade negotiations are a result of this give and take between nations as they try to maximize exports and minimize imports. Free trade negotiations between nations occur on a global scale around the year, and free trade agreements have been established between trading nations to achieve some compromises in this arena.

The United States is party to the North American Free Trade Association (NAFTA), the Central American Free Trade Association (CAFTA) and the General Agreement on Tariffs and Trade (GATT), the World Trade Organization (WTO) as well as other smaller free trade agreements and organizations. At these organizations, United States trade representatives meet routinely with the representatives of other nations to hammer out the details of how they will trade with one another. Promoters of international trade agreements usually include large corporations who want unrestricted access to as many markets as possible, but have to prove to the domestic public that jobs will not be lost and individuals suffer.

NAFTA, for example, when it was formed in 1994 “promised it would create hundreds of thousands of new high-wage U.S. jobs, raise living standards in the U.S., Mexico and Canada, improve environmental conditions and transform Mexico from a poor developing country into a booming new market for U.S. exports.” (Public Citizen-Global Trade Watch).

Countries use tariffs, quotas, subsidies, import regulations, laws, legislation and regulatory measures as well as restrictions on capital flows and investment in order to control the flow of goods across their borders or protect industries threatened by global trade. Free trade negotiations involve concessions in some of these areas in order to achieve a balance and arrive at fair agreements. Here is an example of free trade negotiations at work. In 2005, the European Union has a maximum ceiling of $19.1billion and the United States a maximum ceiling of $75billion to spend on farm subsidies to protect their agricultural industries. (Subsidies to farmers lead to excess crops, pushing prices down, creating a disadvantage for farmers in other countries. The European Union and Japan, who both subsidize their farmers have opposed a U.S. plan requiring them to cut that aid.) As part of the Doha trade negotiations in October, 2005, the United States offered to lower their ceiling by 60% if the European Union cut theirs by 80%. (The Economist October 15, 2005.) Of course, further rounds of negotiations will take place and a compromise will be agreed upon, as each nation tries to give as little as possible and get as much as possible to protect its interests.

Investing and Financial Planning
basics, foreign exchange
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