MICROECONOMICS by Robert S. Pindyck Daniel Rubinfeld Ninth Edition.

MICROECONOMICS by Robert S. Pindyck Daniel Rubinfeld Ninth Edition

Chapter 15 Investment, Time, and Capital Markets (1 of 2)
CHAPTER OUTLINE 15.1 Stocks versus Flows 15.2 Present Discounted Value 15.3 The Value of a Bond 15.4 The Net Present Value Criterion for Capital Investment Decisions 15.5 Adjustments for Risk 15.6 Investment Decisions by Consumers 15.7 Investments in Human Capital 15.8 Intertemporal Production Decisions Depletable Resources 15.9 How Are Interest Rates Determined? LIST OF EXAMPLES 15.1 The Value of Lost Earnings 15.2 The Yields on Corporate Bonds 15.3 The Value of a New York City Taxi Medallion 15.4 Capital Investment in the Disposable Diaper Industry 15.5 Choosing an Air Conditioner and a New Car 15.6 Should You Go to Business School? 15.7 How Depletable Are Depletable Resources?

Investment, Time, and Capital Markets (2 of 2)
Capital expenditures involve the purchases of factories and equipment that are expected to last for years. This introduces the element of time. How much are future profits worth today? In this chapter, we will learn how to calculate the current value of future flows of money. This is the basis for our study of the firm’s investment decisions. Individuals also make decisions involving costs and benefits occurring at different points in time, and the same principles apply. We will also discuss investments in human capital. Does it make economic sense, for example, to go to college or graduate school rather than take a job and start earning an income? In §14.1, we explain that in a competitive factor market, the demand for each factor is given by its marginal revenue product—i.e., the additional revenue earned from an incremental unit of the factor.

15.1 Stocks versus Flows If a firm owns an electric motor factory worth $10 million, we say that it has a capital stock worth $10 million. Let’s take a closer look at this producer. Labor and raw materials: 20,000 worker-hours and 20,000 pounds of copper per month Output: 8000 electric motors per month Wage: $15 per hour Price of copper: $2.00 per pound Variable cost: (20,000)($15) + (20,000)($2.00) = $340,000 per month Average variable cost: $340,000 per month/8000 units per month = $42.50 per unit Price of a motor: $52.50 each. Average profit: $52.50 – $42.50 = $10.00 per unit Total profit: $80,000 per month. The factory is expected to last for 20 years. The flow of $80,000 per month for 20 years should be greater than $10 million. A profit of $80,000 per month for 20 years comes to ($80,000)(20)(12) = $19.2 million. That would make the factory seem like an excellent investment. But is $80,000 five years—or 20 years—from now worth $80,000 today? The $19.2 million can be invested to yield more money in the future. As a result, $19.2 million received over the next 20 years is worth less than $19.2 million today. Recall from §6.1 that a firm’s production function involves flows of inputs and outputs: It turns certain amounts of labor and capital each year into an amount of output that same year. Inputs of labor and raw materials are measured as flows. The output of the firm is also a flow

15.2 Present Discounted Value (1 of 3)
interest rate Rate at which one can borrow or lend money. present discounted value (PDV) The current value of an expected future cash flow. Suppose the annual interest rate is R. Then $1 today can be invested to yield (1 + R) dollars a year from now. Therefore, 1 + R dollars is the future value of $1 today. Now, what is the value today, i.e., the present discounted value (PDV), of $1 paid one year from now? $1 a year from now is worth $1/(1 + R) today. This is the amount of money that will yield $1 after one year if invested at the rate R. $1 paid n years from now is worth $1/(1 + R)n today We can summarize this as follows:

TABLE 15.1 PDV OF $1 PAID IN THE FUTURE INTEREST RATE 1 YEAR 2 YEARS 5 YEARS 10 YEARS 20 YEARS 30 YEARS 0.01 $0.990 $0.980 $0.951 $0.905 $0.820 $0.742 0.02 0.980 0.961 0.906 0.820 0.673 0.552 0.03 0.971 0.943 0.863 0.744 0.554 0.412 0.04 0.962 0.925 0.784 0.614 0.377 0.308 0.05 0.890 0.747 0.558 0.312 0.231 0.06 0.935 0.873 0.713 0.508 0.174 0.07 0.258 0.131 0.08 0.926 0.857 0.681 0.463 0.215 0.099 0.09 0.917 0.842 0.650 0.422 0.178 0.075 0.10 0.909 0.826 0.621 0.386 0.149 0.057 0.15 0.870 0.756 0.497 0.247 0.061 0.015 0.20 0.833 0.694 0.402 0.162 0.026 0.004 Table 15.1 shows, for different interest rates, the present value of $1 paid after 1, 2, 5, 10, 20, and 30 years. Note that for interest rates above 6 or 7 percent, $1 paid 20 or 30 years from now is worth very little today. But this is not the case for low interest rates. For example, if R is 3 percent, the PDV of $1 paid 20 years from now is about 55 cents. In other words, if 55 cents were invested now at the rate of 3 percent, it would yield about $1 after 20 years.

Valuing Payment Streams TABLE 15.2 TWO PAYMENT STREAMS Blank Cell TODAY 1 YEAR 2 YEARS Payment Stream A: $100 $ 0 Payment Stream B: $ 20 Which payment stream in the table above would you prefer to receive? The answer depends on the interest rate TABLE 15.3 PDV OF PAYMENT STREAMS Blank Cell R = .05 R = .10 R = .15 R =.20 PDV of Stream A: $195.24 $190.91 $186.96 $183.33 PDV of Stream B: 205.94 193.55 182.57 172.78 For interest rates of 10 percent or less, Stream B is worth more; for interest rates of 15 percent or more, Stream A is worth more. Why? Because even though less is paid out in Stream A, it is paid out sooner.

EXAMPLE 15.1 THE VALUE OF LOST EARNINGS
In this example, Harold Jennings died in an automobile accident on January 1, 2016, at the age of 53. The PDV of his lost earnings until retirement at the end of 2023 is where W0 is his salary in 2016, g is the annual percentage rate at which his salary is likely to have grown (so that W0 (1 + g) would be his salary in 2017, W0(1 + g)2 his salary in 2018, etc.), and m1, m2, , m7 are mortality rates, i.e., the probabilities that he would have died from some other cause by 2017, 2018, , 2023. TABLE 15.4 CALCULATING LOST WAGES YEAR W0(1 + g)t (1 – mt) 1/(1 + R)t W0(1 + g)t(1 – mt)/1/(1 + R)t 2016 $85,000 0.991 1.000 $84,235 2017 91,800 0.990 0.952 86,554 2018 99,144 0.989 0.907 88,937 2019 107,076 0.988 0.864 91,386 2020 115,642 0.987 0.823 93,902 2021 124,893 0.986 0.784 96,487 2022 134,884 0.985 0.746 99,143 2023 145,675 0.984 0.711 101,872 By summing the last column, we obtain a PDV of $742,517.

15.3 The Value of a Bond (1 of 4) Bond Contract in which a borrower agrees to pay the bondholder (the lender) a stream of money. FIGURE 15.1 PRESENT VALUE OF THE CASH FLOW FROM A BOND Because most of the bond’s payments occur in the future, the present discounted value declines as the interest rate increases. For example, if the interest rate is 5 percent, the PDV of a 10-year bond paying $100 per year on a principal of $1000 is $1386. At an interest rate of 15 percent, the PDV is $749. (15.1)

15.3 The Value of a Bond (2 of 4) Perpetuities Perpetuity Bond paying out a fixed amount of money each year, forever. The present value of the payment stream is given by the infinite summation: The summation can be expressed in terms of a simple formula: (15.2) So if the interest rate is 5 percent, the perpetuity is worth $100/(.05) = $2000, but if the interest rate is 20 percent, the perpetuity is worth only $500.

15.3 The Value of a Bond (3 of 4) The Effective Yield on a Bond EFFECTIVE YIELD effective yield (or rate of return) Percentage return that one receives by investing in a bond. Suppose the market price—and thus the value—of the perpetuity is P. Then from equation (15.2), P = $100/R, and R = $100/P. Thus, if the price of the perpetuity is $1000, we know that the interest rate is R = $100/$1000 = 0.10, or 10 percent. This interest rate is called the effective yield, or rate of return. If the price of the bond is P, we write equation (15.1) as: The more risky an investment, the greater the return that an investor demands. As a result, riskier bonds have higher yields.

15.3 The Value of a Bond (4 of 4) FIGURE 15.2 EFFECTIVE YIELD ON A BOND The effective yield is the interest rate that equates the present value of the bond’s payment stream with the bond’s market price. The figure shows the present value of the payment stream as a function of the interest rate. The effective yield is found by drawing a horizontal line at the level of the bond’s price. For example, if the price of this bond were $1000, its effective yield would be 10 percent. If the price were $1300, the effective yield would be about 6 percent. If the price were $700, it would be 16.2 percent.

EXAMPLE 15.2 THE YIELDS ON CORPORATE BONDS
Blank Cell MICROSOFT CAESARS ENTERNAINMENT Price ($): 123.50 95.88 Coupon (%): 5.300 11.000 Maturity Date: Feb. 8, 2041 Oct. 1, 2021 Yield to Maturity (%): 3.821 12.062 Current Yield (%): 4.291 11.473 Rating: AAA CCC– Prices as of May 26, 2016 The yield on the Microsoft bond is given by the following equation To find the effective yield, we must solve this equation for R. The solution is approximately R* = percent. The yield on the Caesars Entertainment bond is given by: R* = percent.

15.4 The Net Present Value Criterion for Capital Investment Decisions (1 of 6)
net present value (NPV) criterion Rule holding that one should invest if the present value of the expected future cash flow from an investment is larger than the cost of the investment. NPV criterion: Invest if the present value of the expected future cash flows from an investment is larger than the cost of the investment. Suppose a capital investment costs C and is expected to generate profits over the next 10 years of amounts π1, π2, , π10. We then write the net present value as In §7.1, we explain that a sunk cost is an expenditure that has been made and cannot be recovered. (15.3) where R is the discount rate that we use to discount the future stream of profits. Equation (15.3) describes the net benefit to the firm from the investment. The firm should make the investment only if that net benefit is positive—i.e., only if NPV > 0. discount rate Rate used to determine the value today of a dollar received in the future.

DETERMINING THE DISCOUNT RATE opportunity cost of capital Rate of return that one could earn by investing in an alternate project with similar risk. Had the firm not invested in this project, it could have earned a return by investing in something else. The correct value for R is therefore the return that the firm could earn on a “similar” investment. By “similar” investment, we mean one with the same risk. We’ll see how to evaluate the riskiness of an investment in the next section. If we assume that this project has no risk (i.e., the firm is of its future profit flows), then the opportunity cost of the investment is the risk-free return—e.g., the return one could earn on a government bond. If the project is expected to last for 10 years, the firm could use the annual interest rate on a 10-year government bond to compute the NPV of the project. If the benefit from the investment was equal the opportunity cost, the firm would be indifferent between investing and not investing. If the NPV is greater than zero, the benefit exceeds the opportunity cost, so the investment should be made. Opportunity cost is discussed in §7.1.

The Electric Motor Factory With an initial investment of $10 million, 8000 electric motors per month are produced and sold for $52.50 over the next 20 years. The production cost is $42.50 per unit, for a profit of $80,000 per month. The factory could be sold for scrap (with certainty) for $1 million after it becomes obsolete. Annual profit equals $960,000. (15.4)

FIGURE 15.3 NET PRESENT VALUE OF A FACTORY The NPV of a factory is the present discounted value of all the cash flows involved in building and operating it. Here it is the PDV of the flow of future profits less the current cost of construction. The NPV declines as the discount rate increases. At discount rate R*, the NPV is zero. For discount rates below 7.5 percent, the NPV is positive, so the firm should invest in the factory. For discount rates above 7.5 percent, the NPV is negative, and the firm should not invest. R* is sometimes called the internal rate of return on the investment.

Real versus Nominal Discount Rates The real interest rate is the nominal rate minus the expected rate of inflation. If we expect inflation to be 5 percent per year on average, the real interest rate would be 9 − 5 = 4 percent. This is the discount rate that should be used to calculate the NPV of the investment in the electric motor factory. Note from Figure 15.3 that at this rate the NPV is positive.

Negative Future Cash Flows Negative future cash flows create no problem for the NPV rule; they are simply discounted, just like positive cash flows. Suppose that our electric motor factory will take a year to build: $5 million is spent right away, and another $5 million is spent next year. Also, suppose the factory is expected to lose $1 million in its first year of operation and $0.5 million in its second year. Afterward, it will earn $0.96 million a year until year 20, when it will be scrapped for $1 million, as before. (All these cash flows are in real terms.) Now the net present value is (15.5)

EXAMPLE 15.3 THE VALUE OF A NEW YORK CITY TAXI MEDALLION
In example 9.5 we noted that the value of a taxi medallion in 2011 was $880,000. The taxi company charges the driver a flat fee for use of the medallion, but that fee is capped by the city. In 2011, the fee was $110 per 12-hour shift, or $220 per day. Assuming the cab is driven 7 days per week and 50 weeks per year, the taxi company would earn (7)(50)($220) = $77,000 per year from the medallion. Little risk is involved (there is a shortage of taxis, so it is easy to find drivers willing to lease the medallion), and the capped fee has increased with inflation. Therefore a 5-percent discount rate would probably be appropriate for discounting future income flows. Assuming a time horizon of 20 years, the present value of this flow of income is therefore: Thus a medallion price in the range of $880,000 is consistent with the flow of income that the medallion will bring to the taxi company. The value of a medallion fell substantially after This was due to the entry of Uber, Lyft, and other “ride share” services. By 2016, New York City taxi medallions were selling for about $500,000.

15.5 Adjustments for Risk (1 of 4)
risk premium Amount of money that a risk-averse individual will pay to avoid taking a risk. Diversifiable risk can be eliminated by investing in many projects or by holding the stocks of many companies. Nondiversifiable risk cannot be eliminated in this way. Only nondiversifiable risk affects the opportunity cost of capital and should enter into the risk premium. Diversifiable versus Nondiversifiable Risk DIVERSIFIABLE RISK diversifiable risk Risk that can be eliminated either by investing in many projects or by holding the stocks of many companies. Because investors can eliminate diversifiable risk, assets that have only diversifiable risk tend on average to earn a return close to the risk-free rate. if the project’s only risk is diversifiable, the opportunity cost is the risk-free rate. No risk premium should be added to the discount rate.

NONDIVERSIFIABLE RISK nondiversifiable risk Risk that cannot be eliminated by investing in many projects or by holding the stocks of many companies. For capital investments, nondiversifiable risk arises because a firm’s profits tend to depend on the overall economy. To the extent that a project has nondiversifiable risk, the opportunity cost of investing in that project is higher than the risk-free rate. Thus a risk premium must be included in the discount rate.

The Capital Asset Pricing Model Capital Asset Pricing Model (CAPM) Model in which the risk premium for a capital investment depends on the correlation of the investment’s return with the return on the entire stock market. The expected return on the stock market is higher than the risk-free rate. Denoting the expected return on the stock market by rm and the risk-free rate by rf , the risk premium on the market is rm – rf. This is the additional expected return you get for bearing the nondiversifiable risk associated with the stock market. The CAPM summarizes the relationship between expected returns and the risk premium by the following equation: (15.6) where ri is the expected return on an asset. The equation says that the risk premium on the asset (its expected return less the risk-free rate) is proportional to the risk premium on the market.

asset beta A constant that measures the sensitivity of an asset’s return to market movements and, therefore, the asset’s nondiversifiable risk. If a 1-percent rise in the market tends to result in a 2-percent rise in the asset price, the beta is 2. THE RISK-ADJUSTED DISCOUNT RATE Given beta, we can determine the correct discount rate to use in computing an asset’s net present value. That discount rate is the expected return on the asset or on another asset with the same risk. It is therefore the risk-free rate plus a risk premium to reflect nondiversifiable risk: (15.7) company cost of capital Weighted average of the expected return on a company’s stock and the interest rate that it pays for debt.

EXAMPLE 15.4 CAPITAL INVESTMENT IN THE DISPOSABLE DIAPER INDUSTRY (1 of 4)
Here, we’ll examine the capital investment decision of a potential entrant in the disposable diaper industry. To take advantage of scale economies in production, you would need to build three plants at a cost of $60 million each, with the cost spread over three years. When operating at capacity, the plants would produce a total of 2.5 billion diapers per year. These would be sold at wholesale for about 16 cents per diaper, yielding revenues of about $400 million per year. You can expect your variable production costs to be about $290 million per year, for a net revenue of $110 million per year. You will, however, have other expenses. Using the experience of P&G and Kimberly-Clark as a guide, you can expect to spend about $60 million in R&D before start-up to design an efficient manufacturing process, and another $20 million in R&D during each year of production to maintain and improve that process. Finally, once you are operating at full capacity, you can expect to spend another $50 million per year for a sales force, advertising, and marketing. Your net operating profit will be $40 million per year. The plants will last for 15 years and will then be obsolete.

Is the investment a good idea? To find out, let’s calculate its net present value. We assume that production begins at 33 percent of capacity when the plant is completed in 2015, takes two years to reach full capacity, and continues through the year Given the net cash flows, the NPV is calculated as Table 15.5 shows the NPV for discount rates of 5, 10, and 15 percent.

TABLE 15.5 DATA FOR NPV CALCUALTION ($ MILLIONS) Blank Cell PRE-2005 2015 2016 2017 … 2030 Sales LESS 133.3 266.7 400.0 Variable cost 96.7 290.0 Ongoing R&D 20.0 Sales force, ads, and marketing 50.0 Operating profit LESS –33.4 40.0 Construction cost 60.0 Initial R&D NET CASH FLOW –120.0 –93.4 –56.6 Discount Rate: 0.05 0.10 0.15 NPV: 80.5 –16.9 –75.1

Note that the NPV is positive for a discount rate of 5 percent, but it is negative for discount rates of 10 or 15 percent. What is the correct discount rate? First, we have ignored inflation, so the discount rate should be in real terms. Second, the cash flows are risky—we don’t know how efficient our plants will be, how effective our advertising and promotion will be, or even what the future demand for disposable diapers will be. Some of this risk is nondiversifiable. To calculate the risk premium, we will use a beta of 1, which is typical for a producer of consumer products of this sort. Using 4 percent for the real risk-free interest rate and 8 percent for the risk premium on the stock market, our discount rate should be At this discount rate, the NPV is clearly negative, so the investment does not make sense. You will not enter the industry, and P&G and Kimberly-Clark can breathe a sigh of relief. Don’t be surprised, however, that these firms can make money in this market while you cannot. Their experience, years of earlier R&D, and brand name recognition give them a competitive advantage that a new entrant will find hard to overcome.

15.6 Investment Decisions by Consumers
The decision to buy a durable good involves comparing a flow of future benefits with the current purchase cost Let’s assume a car buyer values the service at S dollars per year. Let’s also assume that the total operating expense (insurance, maintenance, and gasoline) is E dollars per year, that the car costs $20,000, and that after six years, its resale value will be $4000. The decision to buy the car can then be framed in terms of net present value: (15.8) What discount rate R should the consumer use? The consumer should apply the same principle that a firm does: The discount rate is the opportunity cost of money.

EXAMPLE 15.5 CHOOSING AN AIR CONDITIONER AND A NEW CAR
Assuming an eight-year lifetime and no resale, the PDV of the cost of buying and operating air conditioner i is where Ci is the purchase price of air conditioner i and OCi is its average annual operating cost. The preferred air conditioner depends on your discount rate. A high discount rate would make the present value of the future operating costs smaller. In this case, you would probably choose a less expensive but relatively inefficient unit. As with air conditioners, a consumer can compare two or more cars by calculating and comparing the PDV of the purchase price and expected average annual operating cost for each.

15.7 Investments in Human Capital
human capital Knowledge, skills, and experience that make an individual more productive and thereby able to earn a higher income over a lifetime. THE NPV OF A COLLEGE EDUCATION Let’s assume that the total economic cost of attending college to be $45,000 per year, and the opportunity cost is another $ The gain of $30,000 in salary persists for 20 years. The NPV of this investment is therefore A reasonable real discount rate would be about 5 percent. This rate would reflect the opportunity cost of money for many households. The NPV is then about 180,000. A college education is an investment with close to free entry. In markets with free entry, we should expect to see zero economic profits, which implies that investments will earn a competitive return. In §15.4, we discuss real versus nominal discount rates, and explain that the real discount rate is the nominal rate minus the expected rate of inflation. In §8.7 we explain that zero economic profit means that a firm is earning a competitive return on its investment.

EXAMPLE 15.6 SHOULD YOU GO TO BUSINESS SCHOOL? (1 of 3)
The typical MBA program in the United States takes two years and involves tuition and expenses of $45,000 per year. It is important to include the opportunity cost of the foregone pre-MBA salary, i.e., another $45,000 per year. Thus, the total economic cost of getting an MBA is $90,000 per year for each of two years. The NPV of this investment is therefore Using a real discount rate of 5 percent, the NPV comes to about $180,000. Because many more people apply to MBA programs than there are spaces, the return on the degree remains high. Should you go to business school? As we have just seen, the financial part of this decision is easy: Though costly, the return on this investment is very high.

TABLE 15.6 SALARIES BEFORE AND AFTER BUSINESS SCHOOL UNIVERSITY PRE-MBA SALARY AVERAGE SALARY 3 YEARS AFTER MBA Stanford Graduate School of Business $99,433 $185,939 University of Pennsylvania: Wharton $96,672 $177,877 Harvard Business School $88,918 $172,501 Columbia Business School $85,360 $169,866 MIT Sloan School of Management $84,416 $162,923 University of Chicago: Booth $84,163 $159,909 Dartmouth College: Tuck $76,454 $158,259 Yale School of Management $80,334 $156,652 New York University: Stern $73,188 $152,232 University of Virginia: Darden $76,401 $150,510 University of Michigan: Ross $70,029 $147,104 Duke University: Fuqua $74,461 $144,961 Cornell University: Johnson $70,675 $142,764 UCLA: Anderson $74,110 $140,067 Carnegie Mellon: Tepper $65,863 $136,996 University of Texas at Austin: McCombs $69,957 $134,317

TABLE 15.6 SALARIES BEFORE AND AFTER BUSINESS SCHOOL UNIVERSITY PRE-MBA SALARY AVERAGE SALARY 3 YEARS AFTER MBA Georgetown University: McDonough $60,817 $126,500 University of Southern California: Marshall $61,359 $118,422 Vanderbilt University: Owen $62,701 $116,624 Indiana University: Kelly $55,886 $114,567 University of Rochester: Simon $60,497 $112,524 Pennsylvania State University: Smeal $52,965 $111,226 INTERNATIONAL BUSINESS SCHOOLS Indian Institute of Management, Ahmedabad (India) $88,915 $174,274 Insead (France/Singapore) $84,95 $166,510 International Institute for Management Development (IMD) (Switzerland) $86,032 $157,439 University of Cambridge: Judge (UK) $80,166 $156,323 London Business School $77,075 $154,150 Hong Kong UST Business School (China) $67,431 $144,303 HEC Paris (France) $64,567 $134,299 Incae Business School (Costa Rica) $36,695 $89,902

15.8 Intertemporal Production Decisions—Depletable Resources (1 of 5)
Production decisions often have intertemporal aspects—production today affects sales or costs in the future. Intertemporal production decisions involve comparisons between costs and benefits today with costs and benefits in the future. The Production Decision of an Individual Resource Producer How fast must the price rise for you to keep the oil in the ground? Your production decision rule is: Keep all your oil if you expect its price less its extraction cost to rise faster than the rate of interest. Extract and sell all of it if you expect price less cost to rise at less than the rate of interest. Letting Pt be the price of oil this year, Pt+1 the price next year, and c the cost of extraction, we can write this production rule as follows: If (P t+1−C) > (1+R)(Pt −C), keep the oil in the ground. If (P t+1−C) < (1+R)(Pt −C), sell all the oil now. If (P t+1−C) = (1+R)(Pt −C), makes no difference. Recall from §7.6 that with a learning curve, the firm’s cost of production falls over time as managers and workers become more experienced and more effective at using available plant and equipment.

FIGURE 15.4 PRICE OF AN EXHAUSTIBLE RESOURCE In (a), the price is shown rising over time. Units of a resource in the ground must earn a return commensurate with that on other assets. Therefore, in a competitive market, price less marginal production cost will rise at the rate of interest. Part (b) shows the movement up the demand curve as price rises.

The Behavior of Market Price Suppose there were no OPEC cartel and the oil market consisted of many competitive producers with oil wells like our own. We could then determine how quickly oil prices are likely to rise by considering the production decisions of other producers. Price less marginal cost must rise at exactly the rate of interest. To see why, suppose price less cost were to rise faster than the rate of interest. In that case, no one would sell any oil. Inevitably, this would drive up the current price. If, on the other hand, price less cost were to rise at a rate less than the rate of interest, everyone would try to sell all of their oil immediately, which would drive the current price down.

User Cost user cost of production Opportunity cost of producing and selling a unit today and so making it unavailable for production and sale in the future. We saw in Chapter 8 that a competitive firm always produces up to the point at which price is equal to marginal cost. However, in a competitive market for an exhaustible resource, price exceeds marginal cost (and the difference between price and marginal cost rises over time). The reason is that the total marginal cost of producing an exhaustible resource is greater than the marginal cost of extracting it from the ground. There is an additional opportunity cost because producing and selling a unit today makes it unavailable for production and sale in the future. In Figure 15.4, user cost is the difference between price and marginal production cost. It rises over time because as the resource remaining in the ground becomes scarcer, the opportunity cost of depleting another unit becomes higher.

Resource Production by a Monopolist Since the monopolist controls total output, it will produce so that marginal revenue less marginal cost—i.e., the value of an incremental unit of resource—rises at exactly the rate of interest: If marginal revenue less marginal cost rises at the rate of interest, price less marginal cost will rise at less than the rate of interest. We thus have the interesting result that a monopolist is more conservationist than a competitive industry. In exercising monopoly power, the monopolist starts out charging a higher price and depletes the resource more slowly. In §10.1, we explain that a monopolist maximizes its profit by choosing an output at which marginal revenue is equal to marginal cost.

EXAMPLE 15.7 HOW DEPLETABLE ARE DEPLETABLE RESOURCES
Depletable resources, such as oil, natural gas, and helium, have known and potentially discoverable in- ground reserves equal to only 50 to 100 years of current consumption. For these resources, the user cost of production can be a significant component of the market price. Other resources, such as coal and iron, have very large reserves. For these resources, the user cost is very small. If the market is competitive, user cost can be determined from the economic rent earned by the owners of resource-bearing lands. Resource depletion has not been very important as a determinant of resource prices over the past few decades. Much more important have been market structure and changes in market demand. But over the long term, depletion will be the ultimate determinant of resource prices. TABLE 15.7 USER COST AS A FRACTION OF COMPETITIVE PRICE RESOURCE USER COST/ COMPETITIVE PRICE Crude oil .4 to .5 Natural gas Uranium .1 to .2 Copper .2 to .3 Bauxite .05 to .2 Nickel .1 to .3 Iron ore Gold .05 to .1

15.9 How Are Interest Rates Determined? (1 of 3)
An interest rate is the price that borrowers pay lenders to use their funds. FIGURE 15.5 SUPPLY AND DEMAND FOR LOANABLE FUNDS Market interest rates are determined by the demand and supply of loanable funds. Households supply funds in order to consume more in the future; the higher the interest rate, the more they supply. Households and firms both demand funds, but the higher the interest rate, the less they demand. Shifts in demand or supply cause changes in interest rates.

A Variety of Interest Rates Treasury Bill Rate A Treasury bill is a short-term (one year or less) bond issued by the U.S. government. It is a pure discount bond—i.e., it makes no coupon payments but instead is sold at a price less than its redemption value at maturity. Treasury Bond Rate A Treasury bond is a longer-term bond issued by the U.S. government for more than one year and typically for 10 to 30 years. Rates vary, depending on the maturity of the bond. Discount Rate Commercial banks sometimes borrow for short periods from the Federal Reserve. These loans are called discounts, and the rate that the Federal Reserve charges on them is the discount rate. Federal Funds Rate This is the interest rate that banks charge one another for overnight loans of federal funds. Federal funds consist of currency in circulation plus deposits held at Federal Reserve banks.

A Variety of Interest Rates Commercial Paper Rate Commercial paper refers to short-term (six months or less) discount bonds issued by high-quality corporate borrowers. Because commercial paper is only slightly riskier than Treasury bills, the commercial paper rate is usually less than 1 percent higher than the Treasury bill rate. Prime Rate This is the rate (sometimes called the reference rate) that large banks post as a reference point for short-term loans to their biggest corporate borrowers. Corporate Bond Rate Newspapers and government publications report the average annual yields on long-term (typically 20-year) corporate bonds in different risk categories (e.g., high-grade, medium-grade, etc.). These average yields indicate how much corporations are paying for long-term debt. However, as we saw in Example 15.2, the yields on corporate bonds can vary considerably, depending on the financial strength of the corporation and the time to maturity for the bond.

Copyright

MICROECONOMICS by Robert S. Pindyck Daniel Rubinfeld Ninth Edition.

Similar presentations

Presentation on theme: "MICROECONOMICS by Robert S. Pindyck Daniel Rubinfeld Ninth Edition."— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

MICROECONOMICS by Robert S. Pindyck Daniel Rubinfeld Ninth Edition.

Similar presentations

Presentation on theme: "MICROECONOMICS by Robert S. Pindyck Daniel Rubinfeld Ninth Edition."— Presentation transcript:

Similar presentations

About project

Feedback