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Investment - Demand and Supply
Properly functioning markets are vital to capitalism because the interaction of buyers and sellers determines the price and amount of a product or service exchanged. The structuring of markets is crucial in microeconomics.
Demand
Buyers desire a product, and sellers supply the product. Consumers buy things, such as vehicles, books, and furniture, from manufacturers and retailers who sell them in markets. These marketplaces can take the form of physical facilities, such as supermarkets or shops, or they might be virtual, internet-based markets, such as eBay or Amazon.
In certain markets, there is a single provider of a product or service, whereas in other markets, there are several companies providing the same or similar products or services. There may be only one regional power company producing electricity, for example, but multiple companies providing home insurance. How markets are arranged can affect how the enterprises engaged in these markets set pricing.
When economists refer to demand, they mean the desire for a product or service paired with the ability and willingness to pay a specific price for it. Consumers will want and pay for a product as long as the perceived advantage is greater than its cost or price.
The Law of Demand
It seems natural that if the price of a product goes higher, people will typically buy less of the product.
For instance, if the price of fuel rises, car owners will use their cars less and hence buy less fuel. The quantity desired of a product and its price are usually inversely connected, which is known as the law of demand.
The Demand Curve
The law of demand can be represented on a graph, with the amount demanded on the horizontal axis and the price of the product on the vertical axis. The curve that depicts the quantity demanded at different prices is the demand curve.
Shift in Demand Curve to the Right
Properly functioning markets are vital to capitalism because the interaction of buyers and sellers determines the price and amount of a product or service exchanged. The structuring of markets is crucial in microeconomics.
Demand
Buyers desire a product, and sellers supply the product. Consumers buy things, such as vehicles, books, and furniture, from manufacturers and retailers who sell them in markets. These marketplaces can take the form of physical facilities, such as supermarkets or shops, or they might be virtual, internet-based markets, such as eBay or Amazon.
In certain markets, there is a single provider of a product or service, whereas in other markets, there are several companies providing the same or similar products or services. There may be only one regional power company producing electricity, for example, but multiple companies providing home insurance. How markets are arranged can affect how the enterprises engaged in these markets set pricing.
When economists refer to demand, they mean the desire for a product or service paired with the ability and willingness to pay a specific price for it. Consumers will want and pay for a product as long as the perceived advantage is greater than its cost or price.
The Law of Demand
It seems natural that if the price of a product goes higher, people will typically buy less of the product.
For instance, if the price of fuel rises, car owners will use their cars less and hence buy less fuel. The quantity desired of a product and its price are usually inversely connected, which is known as the law of demand.
The Demand Curve
The law of demand can be represented on a graph, with the amount demanded on the horizontal axis and the price of the product on the vertical axis. The curve that depicts the quantity demanded at different prices is the demand curve.
Shift in Demand Curve to the Right
If people’s tastes change and they cease like pizza as much, demand will shift to the left, suggesting that consumers would demand less of the product at a given price. The range of pricing for the product has not changed, but the quantity requested at each price has reduced.
The figure depicts how a change in a factor that has made the product more attractive alters the demand curve to the right from D to D1.
Now, we will take a deeper look at the primary elements that affect the demand curve.
Effect of Income on Demand
A change in demand for a product coming from a change in purchasing power is called the income effect.
For most items, which are called typical goods, if income improves, demand increases too. Meat is an example of a normal good in most emerging nations.
For lesser commodities, the relationship works in the reverse direction. That is, demand for lesser things diminishes as income increases. Grain is frequently regarded an inferior good. So, when incomes are higher, individuals consume more meat relative to grain.
Demand for poor products often grows during recessions. When faced with a time of downturn in economic activity, people prefer to move to lower-cost brands and purchase more at discount stores than at department stores. During such a period, investors may focus on companies that sell inferior goods because they expect their stocks to perform better.
Effect of the Expected Future Price of a Product on Demand
There is a positive association between the predicted future price of a product and its current demand. In other words, the predicted future price and current demand move in the same direction.
If consumers predict that the price of rice will increase as a result of a shortage, the current quantity of rice requested may grow as consumers accumulate it to avoid paying a higher price in the future.
The amount demanded at all prices will rise in anticipation of the price increase, resulting to a change in the demand curve to the right.
In contrast, if the price of a product is predicted to reduce in the future, present demand may go down as people wait for the price to decrease before purchasing.
Effect of Changes in General Tastes and Preferences on Demand
Changes in consumers’ likes and preferences might impact a product’s demand curve.
If a report that linked eating chocolate to greater health is published, demand for chocolate bars may soar.
In that circumstance, the demand curve for chocolate will shift to the right. Investors and analysts typically examine demographic changes and shifts in consumers’ interests and preferences when appraising an investment.
Effect of Prices of Other Products on Demand
As we observed earlier, if the price of sandwiches increases, individuals may eat more pizza instead. The influence of a change in the prices of other items on a product’s demand curve relies on the sort of link between the products.
Substitute Products
A substitute product or substitute might normally take the place of another product. For many customers, Coke and Pepsi are regarded reasonably close replacements. Consumers exchange relatively cheaper products for relatively more expensive ones. If the price of a substitute product lowers, demand for the alternative may increase and demand for the original product may decline.
Example: The Effect of a Change in Coke’s Price on the Demand for Coke and Pepsi
If the price of Coke lowers, there is likely to be an increase in demand for Coke and a decrease in demand for Pepsi.
If a bottle of Coke and Pepsi each sell for USD1, individuals will have no preference based on price. But if the Coca-Cola Company seeks to boost its market share, it might decrease — possibly just momentarily — the price of a bottle of Coke to 90 cents.
Although there will still be many faithful Pepsi fans, there will probably be a number of people who will buy Coke instead of Pepsi because it is now cheaper.
Coca-Cola expects that some of these people then develop a preference for Coke over Pepsi and become loyal Coke drinkers, and Coca-Cola may subsequently return its price to USD1.
Complementary products or complements are products that are frequently consumed together. When the price of a product lowers, it leads to an increase in demand for both the product and for its complimentary products.
For example, printing paper and ink cartridges are complementary products. If the price of ink cartridges lowers, consumers may print more and purchase both more ink cartridges and printing paper.
Demand for a given product may be altered by the prices of other products that are not replacements or complements. A big increase in oil prices sometimes causes demand for other products, including pizzas, to decline. The reason is that many people use automobiles to travel to work, school, or shopping, and they will have to pay more to put petrol in their cars if the price of oil rises. As a result, they will have less money to buy other things.
Psychology is typically engaged in decision making, which makes the effects of price changes on demand challenging to analyze. Because individuals commonly buy oil-related products, they constantly watch how the price of these things fluctuates, and they may consume less overall if oil prices climb. And yet, an increase in the price of cars, which has a greater effect on the household budget, may not lead to a fall in demand.
The explanation is that consumers tend to pay less attention to the price adjustments of things that they purchase infrequently. Evaluating these types of psychological aspects helps investors determine if, for instance, a pizza company may notice a decline in sales when oil costs increase.
Supply
The supply curve illustrates the quantity supplied at different prices. The law of supply states that when the price of a commodity increases, the amount supplied increases too. Thus, the supply curve is upward sloping from left to right. The law of supply and the supply curve are represented in the following exhibit. S and S1 are supply curves.
Supply Curve
The figure depicts how a change in a factor that has made the product more attractive alters the demand curve to the right from D to D1.
Now, we will take a deeper look at the primary elements that affect the demand curve.
Effect of Income on Demand
A change in demand for a product coming from a change in purchasing power is called the income effect.
For most items, which are called typical goods, if income improves, demand increases too. Meat is an example of a normal good in most emerging nations.
For lesser commodities, the relationship works in the reverse direction. That is, demand for lesser things diminishes as income increases. Grain is frequently regarded an inferior good. So, when incomes are higher, individuals consume more meat relative to grain.
Demand for poor products often grows during recessions. When faced with a time of downturn in economic activity, people prefer to move to lower-cost brands and purchase more at discount stores than at department stores. During such a period, investors may focus on companies that sell inferior goods because they expect their stocks to perform better.
Effect of the Expected Future Price of a Product on Demand
There is a positive association between the predicted future price of a product and its current demand. In other words, the predicted future price and current demand move in the same direction.
If consumers predict that the price of rice will increase as a result of a shortage, the current quantity of rice requested may grow as consumers accumulate it to avoid paying a higher price in the future.
The amount demanded at all prices will rise in anticipation of the price increase, resulting to a change in the demand curve to the right.
In contrast, if the price of a product is predicted to reduce in the future, present demand may go down as people wait for the price to decrease before purchasing.
Effect of Changes in General Tastes and Preferences on Demand
Changes in consumers’ likes and preferences might impact a product’s demand curve.
If a report that linked eating chocolate to greater health is published, demand for chocolate bars may soar.
In that circumstance, the demand curve for chocolate will shift to the right. Investors and analysts typically examine demographic changes and shifts in consumers’ interests and preferences when appraising an investment.
Effect of Prices of Other Products on Demand
As we observed earlier, if the price of sandwiches increases, individuals may eat more pizza instead. The influence of a change in the prices of other items on a product’s demand curve relies on the sort of link between the products.
Substitute Products
A substitute product or substitute might normally take the place of another product. For many customers, Coke and Pepsi are regarded reasonably close replacements. Consumers exchange relatively cheaper products for relatively more expensive ones. If the price of a substitute product lowers, demand for the alternative may increase and demand for the original product may decline.
Example: The Effect of a Change in Coke’s Price on the Demand for Coke and Pepsi
If the price of Coke lowers, there is likely to be an increase in demand for Coke and a decrease in demand for Pepsi.
If a bottle of Coke and Pepsi each sell for USD1, individuals will have no preference based on price. But if the Coca-Cola Company seeks to boost its market share, it might decrease — possibly just momentarily — the price of a bottle of Coke to 90 cents.
Although there will still be many faithful Pepsi fans, there will probably be a number of people who will buy Coke instead of Pepsi because it is now cheaper.
Coca-Cola expects that some of these people then develop a preference for Coke over Pepsi and become loyal Coke drinkers, and Coca-Cola may subsequently return its price to USD1.
Complementary products or complements are products that are frequently consumed together. When the price of a product lowers, it leads to an increase in demand for both the product and for its complimentary products.
For example, printing paper and ink cartridges are complementary products. If the price of ink cartridges lowers, consumers may print more and purchase both more ink cartridges and printing paper.
Demand for a given product may be altered by the prices of other products that are not replacements or complements. A big increase in oil prices sometimes causes demand for other products, including pizzas, to decline. The reason is that many people use automobiles to travel to work, school, or shopping, and they will have to pay more to put petrol in their cars if the price of oil rises. As a result, they will have less money to buy other things.
Psychology is typically engaged in decision making, which makes the effects of price changes on demand challenging to analyze. Because individuals commonly buy oil-related products, they constantly watch how the price of these things fluctuates, and they may consume less overall if oil prices climb. And yet, an increase in the price of cars, which has a greater effect on the household budget, may not lead to a fall in demand.
The explanation is that consumers tend to pay less attention to the price adjustments of things that they purchase infrequently. Evaluating these types of psychological aspects helps investors determine if, for instance, a pizza company may notice a decline in sales when oil costs increase.
Supply
The supply curve illustrates the quantity supplied at different prices. The law of supply states that when the price of a commodity increases, the amount supplied increases too. Thus, the supply curve is upward sloping from left to right. The law of supply and the supply curve are represented in the following exhibit. S and S1 are supply curves.
Supply Curve
Lower manufacturing costs, which may be the result of improvements in technology, cheaper raw materials or labour, or lower taxes, will result in higher supply for a given price. The supply curve will move to the right. Changes in the supply curve are of major interest to investors and analysts. A shift in the supply curve induced by greater or lower costs might alter the profits generated by a corporation. A car manufacturer facing increased steel prices may be willing to build fewer automobiles at a given price level, which affects the supply curve. Whether a corporation can pass on any cost increases to customers helps investors assess the company’s potential profits.
A corporation that cannot cover its costs and earn a profit at prices along particular regions of the supply curve would not supply products at those prices. Companies may perceive factors affecting the supply curve as transient and be ready to continue operating despite short-term losses. But if the discrepancy between sales and costs remains for extended periods, it can trigger corporate shutdowns and bankruptcy.
Many airlines have confronted this dilemma as their manufacturing expenses, such as the cost of fuel, increased.
Their capacity to hike fares was constrained since passengers may have selected an alternate airline or mode of travel.
Equally, they could not readily raise or reduce the number of seats on their planes. Some airlines have accrued enormous losses and been forced to declare bankruptcy.
A corporation that cannot cover its costs and earn a profit at prices along particular regions of the supply curve would not supply products at those prices. Companies may perceive factors affecting the supply curve as transient and be ready to continue operating despite short-term losses. But if the discrepancy between sales and costs remains for extended periods, it can trigger corporate shutdowns and bankruptcy.
Many airlines have confronted this dilemma as their manufacturing expenses, such as the cost of fuel, increased.
Their capacity to hike fares was constrained since passengers may have selected an alternate airline or mode of travel.
Equally, they could not readily raise or reduce the number of seats on their planes. Some airlines have accrued enormous losses and been forced to declare bankruptcy.
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Investment - Market Equilibrium
The concept of economic equilibrium helps explain how prices are set in a world of supply and demand.
To discover how prices are set in a world of supply and demand, it is vital to comprehend the notion of economic equilibrium.
Market equilibrium happens at the price when amount demanded equals quantity supplied.
At the equilibrium price, quantity sought and quantity supplied are in balance, and neither buyers nor sellers have an incentive to try to modify the price, all other factors staying unchanged.
Interaction of Demand and Supply Curves
As seen in the illustration below , the interplay between the demand and supply curves determines the equilibrium price of a commodity.
The equilibrium price (EP) is the price at which the amount demanded (D) equals the quantity supplied (S).
In other terms, it is the point at which the demand and supply curves intersect.
The concept of economic equilibrium helps explain how prices are set in a world of supply and demand.
To discover how prices are set in a world of supply and demand, it is vital to comprehend the notion of economic equilibrium.
Market equilibrium happens at the price when amount demanded equals quantity supplied.
At the equilibrium price, quantity sought and quantity supplied are in balance, and neither buyers nor sellers have an incentive to try to modify the price, all other factors staying unchanged.
Interaction of Demand and Supply Curves
As seen in the illustration below , the interplay between the demand and supply curves determines the equilibrium price of a commodity.
The equilibrium price (EP) is the price at which the amount demanded (D) equals the quantity supplied (S).
In other terms, it is the point at which the demand and supply curves intersect.
At any price over the equilibrium price in the above exhibit, suppliers are willing to produce more of a product than customers are willing to buy. A price that is greater than the equilibrium price may result in increased stocks, which creates an incentive for suppliers to drop prices to reduce their stockpiles. Prices will thus gravitate back towards the equilibrium price.
Conversely, if the price is below the equilibrium price, customers will demand more of a product than providers find it profitable to create.
To fulfill consumers’ greater demand, suppliers’ inventory may be decreased. Once stockpiles are exhausted, suppliers have an incentive to raise prices and expand production. Prices will thus gravitate back towards the equilibrium price.
The only price at which suppliers and customers are both pleased, with no imbalance between the quantity produced and the quantity required, is at the equilibrium price.
Conversely, if the price is below the equilibrium price, customers will demand more of a product than providers find it profitable to create.
To fulfill consumers’ greater demand, suppliers’ inventory may be decreased. Once stockpiles are exhausted, suppliers have an incentive to raise prices and expand production. Prices will thus gravitate back towards the equilibrium price.
The only price at which suppliers and customers are both pleased, with no imbalance between the quantity produced and the quantity required, is at the equilibrium price.
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Investment - Elasticities of Demand
Although supply and demand curves are vital to an understanding of price and quantity changes, they are less effective in determining the magnitude of these changes. To gauge the change in amounts required by consumers and provided by producers, we employ elasticity metrics.
In economics, elasticity refers to how the quantity required or supplied fluctuates in reaction to tiny changes in a relevant element, such as price, income, or the price of a substitute or complementary product. If we understand that the demand for items rises dramatically as incomes increase, investors and analysts may be able to identify the companies and industries that will develop the quickest as the economy grows. Elasticity of demand so has relevance as we estimate which companies and industries will be successful in the future.
Price Elasticity of Demand
Price elasticity of demand allows for the comparison of the responsiveness of quantity sought with changes in pricing. Two extensively used measurements are own price elasticity of demand and cross-price elasticity of demand.
Own Price Elasticity of Demand
The own price elasticity of demand is the percentage change in the quantity requested of a product as a function of the percentage price change of that product. It is computed as the percentage change in the amount required of a product divided by the percentage change in the price of that product.
Own price elasticity of demand explains the change in the quantity requested of a product as a result of a price change in the same product.
But investors and analysts are especially interested in the changes when more than one product is involved.
This is cross-price elasticity of demand, the percentage change in the quantity requested of a product in response to a percentage change in the price of another product.
Own Price Elasticity of Demand
Although supply and demand curves are vital to an understanding of price and quantity changes, they are less effective in determining the magnitude of these changes. To gauge the change in amounts required by consumers and provided by producers, we employ elasticity metrics.
In economics, elasticity refers to how the quantity required or supplied fluctuates in reaction to tiny changes in a relevant element, such as price, income, or the price of a substitute or complementary product. If we understand that the demand for items rises dramatically as incomes increase, investors and analysts may be able to identify the companies and industries that will develop the quickest as the economy grows. Elasticity of demand so has relevance as we estimate which companies and industries will be successful in the future.
Price Elasticity of Demand
Price elasticity of demand allows for the comparison of the responsiveness of quantity sought with changes in pricing. Two extensively used measurements are own price elasticity of demand and cross-price elasticity of demand.
Own Price Elasticity of Demand
The own price elasticity of demand is the percentage change in the quantity requested of a product as a function of the percentage price change of that product. It is computed as the percentage change in the amount required of a product divided by the percentage change in the price of that product.
Own price elasticity of demand explains the change in the quantity requested of a product as a result of a price change in the same product.
But investors and analysts are especially interested in the changes when more than one product is involved.
This is cross-price elasticity of demand, the percentage change in the quantity requested of a product in response to a percentage change in the price of another product.
Own Price Elasticity of Demand
If a 10% fall in the price of automobiles leads to a 15% increase in the quantity of cars wanted, then the own price elasticity of demand for cars is
If a 10% increase in the price of hotel rooms leads to a 20% drop in the amount of hotel rooms required, then the own price elasticity of demand for hotel rooms is
When looking at elasticities, two elements matter: the sign and the magnitude. The sign of price elasticity of demand offers information on how the amount demanded changes related to a change in price.
The degree of price elasticity of demand offers information on the strength of the relationship between quantity sought and changes in price.
When price elasticity is less than –1, such as in the automobile and hotel room cases, the price elasticity of demand is strong, or elastic. This suggests that a minor change in price creates a disproportionally bigger change in demand.
Conversely, if price elasticity is between –1 and 0, the price elasticity is low, or inelastic. Changes in prices for inelastic products are accompanied by less than proportional changes in the quantity demanded, which suggests demand is not extremely price sensitive.
If the price elasticity of demand is exactly –1, it is said that demand is unit elastic. In this situation, a percentage change in price is matched by a similar, but opposite, percentage change in the amount demanded.
Products for which demand increases as price increases have positive own price elasticities. This result usually suggests that the product is a luxury goods. For luxury products, such as expensive vehicles, watches, and jewelry, an increase in price may lead to an increase in quantity demanded.
The sign and amount of the own price elasticity helps a corporation define its pricing strategy. A corporation wants to know whether a minor percentage increase in pricing will lead to a loss in sales and if it does whether it is a large or small percentage decrease in sales. Cutting the price of a commodity with strongly negative elastic demand, such as coffee or butter, tends to lead to an increase in overall revenue.
Total revenue is normally measured as the quantity of things sold times their price. When elasticity is highly negative, the fall in price is more than countered by a higher rise in quantity demanded. By contrast, decreasing the price of a product with inelastic demand results to a drop in total income since the % rise in quantity is less than the percentage decrease in price.
Uniform, non-differentiated products, such as natural resources (e.g., petroleum and iron ore) and supermarket staples (e.g., bagged ice and lentils), are often products with significantly negative own price elasticities of demand. Companies with multiple competitors providing identical products may find that increasing pricing leads to a drop in income.
Perfectly inelastic demand suggests that amount demanded will not change at all, even in the face of substantial price increases or declines. Perfectly inelastic demand may emerge with things that have no substitutes and are requirements, such as pharmaceuticals under patent. If the drug is useful and under patent protection, the company should be able to charge a higher price without losing sales. Once the patent expires and cheaper generic pharmaceuticals become available, the producer may have to lower its price to maintain sales.
Interpreting Price Elasticities of Demand
If a product is easy to substitute because similar products exist, then the own price elasticity will be significant and negative, which is to imply that demand is elastic. If a product offers no immediate substitutes, such as a new drug, or if usage of the product is strongly entrenched by habit, such as tobacco, demand is inelastic.
Another example of a price-inelastic product is one that has a well-defined identity, such as the Apple iPad.
The reason is because, in the view of many consumers, other items do not compare with the iPad, and the demand for the brand means many people are willing to pay a premium for Apple products.
As a result, the quantity sold may be insensitive to price increases and an increase in price of the iPad may lead to higher revenues for Apple.
Elasticity of demand lets market participants assess the consequences of price changes. Investors and analysts use elasticity of demand to analyze a company’s potential as an investment.
As described in the preceding section, whether a firm will see its sales increase or fall as a result of a change in prices, and by how much, helps investors and analysts understand what drives a company’s profit, which, in turn, affects its stock valuation.
Income Elasticity of Demand
Income elasticity of demand is the percentage change in the quantity requested of a product divided by the corresponding percentage change in income. It quantifies the influence of changes in income on quantity required of a product when other parameters, like as the price of the product and the prices of similar products, remain the same.
Most products have positive income elasticities, meaning that when consumers’ income improves, they purchase a bigger quantity of the commodity.
Products having positive income elasticities are called normal products. In contrast, if people purchase less of a product as their income increases, the income elasticity is negative and the products are dubbed inferior goods. Consumers desire less inferior commodities when their income improves and they replace more expensive and desirable things, such as meat instead of potatoes or rice.
Income elasticity of demand also enables investors to discern between luxuries and requirements.
A luxury product usually has an income elasticity of larger than one.
A need product may have an income elasticity of almost zero; the quantity demanded will not change with a change in income.
Luxury purchases may include foreign vacation, spa treatments, and golf club memberships.
What is considered as a luxury item may alter over time since income elasticities will change as a society’s income improves.
Although a smartphone may be a luxury product at a specific income level, it may become a need at another.
The degree of price elasticity of demand offers information on the strength of the relationship between quantity sought and changes in price.
When price elasticity is less than –1, such as in the automobile and hotel room cases, the price elasticity of demand is strong, or elastic. This suggests that a minor change in price creates a disproportionally bigger change in demand.
Conversely, if price elasticity is between –1 and 0, the price elasticity is low, or inelastic. Changes in prices for inelastic products are accompanied by less than proportional changes in the quantity demanded, which suggests demand is not extremely price sensitive.
If the price elasticity of demand is exactly –1, it is said that demand is unit elastic. In this situation, a percentage change in price is matched by a similar, but opposite, percentage change in the amount demanded.
Products for which demand increases as price increases have positive own price elasticities. This result usually suggests that the product is a luxury goods. For luxury products, such as expensive vehicles, watches, and jewelry, an increase in price may lead to an increase in quantity demanded.
The sign and amount of the own price elasticity helps a corporation define its pricing strategy. A corporation wants to know whether a minor percentage increase in pricing will lead to a loss in sales and if it does whether it is a large or small percentage decrease in sales. Cutting the price of a commodity with strongly negative elastic demand, such as coffee or butter, tends to lead to an increase in overall revenue.
Total revenue is normally measured as the quantity of things sold times their price. When elasticity is highly negative, the fall in price is more than countered by a higher rise in quantity demanded. By contrast, decreasing the price of a product with inelastic demand results to a drop in total income since the % rise in quantity is less than the percentage decrease in price.
Uniform, non-differentiated products, such as natural resources (e.g., petroleum and iron ore) and supermarket staples (e.g., bagged ice and lentils), are often products with significantly negative own price elasticities of demand. Companies with multiple competitors providing identical products may find that increasing pricing leads to a drop in income.
Perfectly inelastic demand suggests that amount demanded will not change at all, even in the face of substantial price increases or declines. Perfectly inelastic demand may emerge with things that have no substitutes and are requirements, such as pharmaceuticals under patent. If the drug is useful and under patent protection, the company should be able to charge a higher price without losing sales. Once the patent expires and cheaper generic pharmaceuticals become available, the producer may have to lower its price to maintain sales.
Interpreting Price Elasticities of Demand
If a product is easy to substitute because similar products exist, then the own price elasticity will be significant and negative, which is to imply that demand is elastic. If a product offers no immediate substitutes, such as a new drug, or if usage of the product is strongly entrenched by habit, such as tobacco, demand is inelastic.
Another example of a price-inelastic product is one that has a well-defined identity, such as the Apple iPad.
The reason is because, in the view of many consumers, other items do not compare with the iPad, and the demand for the brand means many people are willing to pay a premium for Apple products.
As a result, the quantity sold may be insensitive to price increases and an increase in price of the iPad may lead to higher revenues for Apple.
Elasticity of demand lets market participants assess the consequences of price changes. Investors and analysts use elasticity of demand to analyze a company’s potential as an investment.
As described in the preceding section, whether a firm will see its sales increase or fall as a result of a change in prices, and by how much, helps investors and analysts understand what drives a company’s profit, which, in turn, affects its stock valuation.
Income Elasticity of Demand
Income elasticity of demand is the percentage change in the quantity requested of a product divided by the corresponding percentage change in income. It quantifies the influence of changes in income on quantity required of a product when other parameters, like as the price of the product and the prices of similar products, remain the same.
Most products have positive income elasticities, meaning that when consumers’ income improves, they purchase a bigger quantity of the commodity.
Products having positive income elasticities are called normal products. In contrast, if people purchase less of a product as their income increases, the income elasticity is negative and the products are dubbed inferior goods. Consumers desire less inferior commodities when their income improves and they replace more expensive and desirable things, such as meat instead of potatoes or rice.
Income elasticity of demand also enables investors to discern between luxuries and requirements.
A luxury product usually has an income elasticity of larger than one.
A need product may have an income elasticity of almost zero; the quantity demanded will not change with a change in income.
Luxury purchases may include foreign vacation, spa treatments, and golf club memberships.
What is considered as a luxury item may alter over time since income elasticities will change as a society’s income improves.
Although a smartphone may be a luxury product at a specific income level, it may become a need at another.
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Investment - Profit and Costs of Production
We have focused on supply and demand curves and how they influence equilibrium quantity and price. We have also looked at estimating demand variations by using the elasticity notion. Now, we move our attention to a company’s manufacturing costs and how these costs influence the company’s profitability. This is crucial because investors and analysts need to analyze a company’s capacity to produce money.
Accounting Profit vs. Economic Profit
Although accountants and economists agree that profit is the difference between the revenues gained from selling products and services and the cost of creating them, they disagree over how to calculate profit, partly because they do not necessarily examine the same sorts of costs.
Consider the proprietor of a restaurant in France. For a given period, the restaurant has revenues of EUR5,000,000. The costs of operating the restaurant, which include renting the premises, paying the workers, and procuring the raw food, is EUR3,000,000. The accounting profit analyzes only the explicit costs and is, in this case, EUR2,000,000 (EUR5,000,000 – EUR3,000,000).
But economists adopt a broader perspective of expenses and also deduct implicit costs from revenues and explicit costs to arrive at economic profit. The owner of the restaurant risks her capital by operating the restaurant; if the restaurant fails, she loses all her money. She may have used her skills differently and risked her capital differently.
Assume that the restaurant’s owner might obtain employment and make EUR1,600,000 by earning a salary and from investing her wealth elsewhere. The sum she may have gotten from these actions represents what economists call an opportunity cost.
An opportunity cost is the value forgone by choosing a certain course of action relative to the best option that is not taken.
Because the owner forgoes EUR1,600,000 by operating the restaurant, the restaurant’s accounting profit should be at least equivalent to this. Otherwise, operating the business is an inefficient deployment of its owner’s resources.
The economic benefit from operating the restaurant is EUR400,000, which is the accounting profit of EUR2,000,000 minus the opportunity cost of EUR1,600,000.
To determine accounting profit, only explicit costs are considered. To calculate economic profit, both explicit costs and the implicit opportunity costs are included.
Fixed Costs vs. Variable Costs
Fixed Costs
Companies combine people, capital equipment, raw materials, and managerial abilities to produce products and services. Costs that do not fluctuate with the level of the company’s output are called fixed costs or overhead, as seen in the graphic below.
We have focused on supply and demand curves and how they influence equilibrium quantity and price. We have also looked at estimating demand variations by using the elasticity notion. Now, we move our attention to a company’s manufacturing costs and how these costs influence the company’s profitability. This is crucial because investors and analysts need to analyze a company’s capacity to produce money.
Accounting Profit vs. Economic Profit
Although accountants and economists agree that profit is the difference between the revenues gained from selling products and services and the cost of creating them, they disagree over how to calculate profit, partly because they do not necessarily examine the same sorts of costs.
Consider the proprietor of a restaurant in France. For a given period, the restaurant has revenues of EUR5,000,000. The costs of operating the restaurant, which include renting the premises, paying the workers, and procuring the raw food, is EUR3,000,000. The accounting profit analyzes only the explicit costs and is, in this case, EUR2,000,000 (EUR5,000,000 – EUR3,000,000).
But economists adopt a broader perspective of expenses and also deduct implicit costs from revenues and explicit costs to arrive at economic profit. The owner of the restaurant risks her capital by operating the restaurant; if the restaurant fails, she loses all her money. She may have used her skills differently and risked her capital differently.
Assume that the restaurant’s owner might obtain employment and make EUR1,600,000 by earning a salary and from investing her wealth elsewhere. The sum she may have gotten from these actions represents what economists call an opportunity cost.
An opportunity cost is the value forgone by choosing a certain course of action relative to the best option that is not taken.
Because the owner forgoes EUR1,600,000 by operating the restaurant, the restaurant’s accounting profit should be at least equivalent to this. Otherwise, operating the business is an inefficient deployment of its owner’s resources.
The economic benefit from operating the restaurant is EUR400,000, which is the accounting profit of EUR2,000,000 minus the opportunity cost of EUR1,600,000.
To determine accounting profit, only explicit costs are considered. To calculate economic profit, both explicit costs and the implicit opportunity costs are included.
Fixed Costs vs. Variable Costs
Fixed Costs
Companies combine people, capital equipment, raw materials, and managerial abilities to produce products and services. Costs that do not fluctuate with the level of the company’s output are called fixed costs or overhead, as seen in the graphic below.
Fixed costs include costs linked with buildings and machinery, insurance, salaries of full-time personnel, and interest on loans.
Variable Costs
In contrast, costs that fluctuate with the level of output of the company are called variable costs, as seen in the exhibit below. Raw materials tend to be a variable cost because the more units the company produces, the more raw materials it needs.
Variable Costs
In contrast, costs that fluctuate with the level of output of the company are called variable costs, as seen in the exhibit below. Raw materials tend to be a variable cost because the more units the company produces, the more raw materials it needs.
Total Costs
The sum of fixed costs and variable costs equals total costs, indicated by the green line in the graphic.
The sum of fixed costs and variable costs equals total costs, indicated by the green line in the graphic.
Revenue Costs
The blue line in example below indicates the company’s revenues. If the revenues are higher than the total costs — the right side of the graph — the company is earning a profit. By contrast, if the revenues are lower than total costs – the left side of the graph — the company is experiencing a loss.
The blue line in example below indicates the company’s revenues. If the revenues are higher than the total costs — the right side of the graph — the company is earning a profit. By contrast, if the revenues are lower than total costs – the left side of the graph — the company is experiencing a loss.
In the long run, all elements of production can be changed and some costs that are viewed as fixed become variable because, for instance, a corporation can transfer its premises or purchase new equipment. Some costs, such as advertising, may be set but are also discretionary, meaning that the corporation can alter spending on them.
When production first starts, fixed expenditures associated to production will be incurred. As production increases, the average fixed costs or fixed costs per unit of output will fall because the fixed costs are spread over more units. For example, the same building is used to create more units of output. Average variable costs or variable costs per unit of production may also fall a little but are normally pretty steady. Average total costs or total costs per unit of output, which are the sum of both average fixed costs and average variable costs, should drop as output expands.
The drop in overall costs per unit will continue until one or more factors of production achieves full capacity or breaks down and additional resources must be added.
For example, machinery that is being utilized continuously, giving no time for maintenance, is prone to break down. Breakdowns result in lower output, expensive repairs, and higher overtime as workers move production to operating machines.
When this happens, additional fixed expenditures may be required, such as the purchase of a new machine. So, we watch total expenses per unit drop until the point of full capacity, and then we see them grow as new fixed costs are incurred.
Economies of scale are cost reductions stemming from a considerable increase in output without a matching growth in fixed expenses. These cost savings lead to a reduction in overall costs per unit as a result of increased production.
Economies of scale can be realized if, for example, staff, buildings, and machinery are unchanged but output grows, which results in reduced fixed costs per unit and lower total costs per unit.
Although adding inputs of one variable factor, such as manpower, to fixed inputs of production, such as machinery, increases total output, the gain in output will grow at a diminishing rate as labour increases, even if the fixed inputs of production remain same.
This economic theory is known as the law of diminishing returns and is shown in the following illustration.
The point at which the revenue and total costs lines connect is termed the breakeven point. It indicates the number of units produced and sold at which the company’s profit is zero, which is when revenues exactly cover all costs.
Effect of Fixed Costs on Profitability
The relative level of fixed and variable costs has a substantial effect on profitability.
Imagine the investment needed to create a steel mill, which is a facility or business that manufactures steel. If production levels are very low, the fixed expenses are large proportion to the revenues, and the steel mill will generate a poor profit or perhaps suffer a loss.
As production increases, variable costs will increase with more inputs going into the steelmaking process, such as acquiring raw materials and consuming greater electricity.
But as indicated before, the overall costs per unit of steel produced will reduce since average fixed costs will fall. The steel factory will be increasingly lucrative as output rises and its fixed expenses are dispersed over more units.
Companies and sectors with high fixed costs hence have higher opportunity for increased profitability by boosting output. Examples of high-fixed-cost projects are the construction of a significant gold mine and the construction of a shipbuilding plant.
Companies may boost capacity by incurring more fixed costs. For example, an airline can buy an additional aircraft and landing rights, or a retailer may open a new store. In many circumstances, economies of scale occur as fixed expenses are dispersed over more passengers or retail customers.
As total expenses per unit of a product reduce, profitability should improve, providing that the proper price has been chosen. The cost to the corporation of producing an incremental or additional unit is known as the marginal cost. The amount of money a corporation receives for that additional unit is known as its marginal revenue.
The general rule is that the marginal cost can be increased up to the point where it equals the marginal revenue. Producing to the point at which marginal revenue equals marginal cost will, in theory, maximise profit.
When production first starts, fixed expenditures associated to production will be incurred. As production increases, the average fixed costs or fixed costs per unit of output will fall because the fixed costs are spread over more units. For example, the same building is used to create more units of output. Average variable costs or variable costs per unit of production may also fall a little but are normally pretty steady. Average total costs or total costs per unit of output, which are the sum of both average fixed costs and average variable costs, should drop as output expands.
The drop in overall costs per unit will continue until one or more factors of production achieves full capacity or breaks down and additional resources must be added.
For example, machinery that is being utilized continuously, giving no time for maintenance, is prone to break down. Breakdowns result in lower output, expensive repairs, and higher overtime as workers move production to operating machines.
When this happens, additional fixed expenditures may be required, such as the purchase of a new machine. So, we watch total expenses per unit drop until the point of full capacity, and then we see them grow as new fixed costs are incurred.
Economies of scale are cost reductions stemming from a considerable increase in output without a matching growth in fixed expenses. These cost savings lead to a reduction in overall costs per unit as a result of increased production.
Economies of scale can be realized if, for example, staff, buildings, and machinery are unchanged but output grows, which results in reduced fixed costs per unit and lower total costs per unit.
Although adding inputs of one variable factor, such as manpower, to fixed inputs of production, such as machinery, increases total output, the gain in output will grow at a diminishing rate as labour increases, even if the fixed inputs of production remain same.
This economic theory is known as the law of diminishing returns and is shown in the following illustration.
The point at which the revenue and total costs lines connect is termed the breakeven point. It indicates the number of units produced and sold at which the company’s profit is zero, which is when revenues exactly cover all costs.
Effect of Fixed Costs on Profitability
The relative level of fixed and variable costs has a substantial effect on profitability.
Imagine the investment needed to create a steel mill, which is a facility or business that manufactures steel. If production levels are very low, the fixed expenses are large proportion to the revenues, and the steel mill will generate a poor profit or perhaps suffer a loss.
As production increases, variable costs will increase with more inputs going into the steelmaking process, such as acquiring raw materials and consuming greater electricity.
But as indicated before, the overall costs per unit of steel produced will reduce since average fixed costs will fall. The steel factory will be increasingly lucrative as output rises and its fixed expenses are dispersed over more units.
Companies and sectors with high fixed costs hence have higher opportunity for increased profitability by boosting output. Examples of high-fixed-cost projects are the construction of a significant gold mine and the construction of a shipbuilding plant.
Companies may boost capacity by incurring more fixed costs. For example, an airline can buy an additional aircraft and landing rights, or a retailer may open a new store. In many circumstances, economies of scale occur as fixed expenses are dispersed over more passengers or retail customers.
As total expenses per unit of a product reduce, profitability should improve, providing that the proper price has been chosen. The cost to the corporation of producing an incremental or additional unit is known as the marginal cost. The amount of money a corporation receives for that additional unit is known as its marginal revenue.
The general rule is that the marginal cost can be increased up to the point where it equals the marginal revenue. Producing to the point at which marginal revenue equals marginal cost will, in theory, maximise profit.
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Investment - Market Environment
The market environment in which a firm operates has a considerable influence on its price, supply, and efficiency. Consider an environment’s degree of competition. At one extreme, if there is a great degree of competition, a market is considered to be perfectly competitive. At the other extreme, if there is no competition, a market is said to be a monopoly. Most markets reside between these two extremes.
Perfect Competition
In a completely competitive market, both producers and consumers are price-takers, meaning that they work with the price the market has established without much hope or purpose of changing it.
Production and consumption decisions that individual consumers and sellers make do not alter the market price of products or services.
A fully competitive market is described by the following: Both producers and consumers are price-takers and unable to change the market price, with no firm having large market share.
Industry output is standardised.
Participants enjoy freedom of entry and leave.
Market equilibrium sees marginal revenue equal marginal cost.
Pure Monopoly
A pure monopoly is a market with a single seller called the monopolist and many purchasers.
Unlike the sellers in a completely competitive market, the corporation possessing a pure monopoly has great control over the market price of its commodity or service.
A monopolistic firm is distinguished by the following:
It is a price-maker.
It controls the amount of the product it sells.
It enjoys strong obstacles to entry preventing other enterprises from joining.
It is likely to demand higher prices and generate lesser numbers of things than it could properly offer.
Monopolistic Competition
Monopolistic competition is a market situation where several firms are competing in an industry in which they manufacture similar but differentiated items.
Examples include restaurants, clothes shops, hotels, consumer service businesses, and PC makers.
The characteristics of this habitat include the following:
Many enterprises are present.
Each firm provides similar yet differentiated items.
Firms are not price-takers.
There are no substantial hurdles to entrance.
Firms compete by modifying product quality, price, and how they market the product.
Oligopoly
An oligopoly refers to a market in which a small number of enterprises operate, and no single firm has a substantial market share. The hurdles to entrance are substantial. No single firm is able to raise its pricing higher than the price that obtains under a totally competitive market.
Most oligopolies emerge in businesses where products are relatively homogenous and give the same benefits to consumers no matter which entity is supplying them.
Examples of oligopolies include oil-based sectors, telecommunication industries, and in some countries, the banking business.
The market environment in which a firm operates has a considerable influence on its price, supply, and efficiency. Consider an environment’s degree of competition. At one extreme, if there is a great degree of competition, a market is considered to be perfectly competitive. At the other extreme, if there is no competition, a market is said to be a monopoly. Most markets reside between these two extremes.
Perfect Competition
In a completely competitive market, both producers and consumers are price-takers, meaning that they work with the price the market has established without much hope or purpose of changing it.
Production and consumption decisions that individual consumers and sellers make do not alter the market price of products or services.
A fully competitive market is described by the following: Both producers and consumers are price-takers and unable to change the market price, with no firm having large market share.
Industry output is standardised.
Participants enjoy freedom of entry and leave.
Market equilibrium sees marginal revenue equal marginal cost.
Pure Monopoly
A pure monopoly is a market with a single seller called the monopolist and many purchasers.
Unlike the sellers in a completely competitive market, the corporation possessing a pure monopoly has great control over the market price of its commodity or service.
A monopolistic firm is distinguished by the following:
It is a price-maker.
It controls the amount of the product it sells.
It enjoys strong obstacles to entry preventing other enterprises from joining.
It is likely to demand higher prices and generate lesser numbers of things than it could properly offer.
Monopolistic Competition
Monopolistic competition is a market situation where several firms are competing in an industry in which they manufacture similar but differentiated items.
Examples include restaurants, clothes shops, hotels, consumer service businesses, and PC makers.
The characteristics of this habitat include the following:
Many enterprises are present.
Each firm provides similar yet differentiated items.
Firms are not price-takers.
There are no substantial hurdles to entrance.
Firms compete by modifying product quality, price, and how they market the product.
Oligopoly
An oligopoly refers to a market in which a small number of enterprises operate, and no single firm has a substantial market share. The hurdles to entrance are substantial. No single firm is able to raise its pricing higher than the price that obtains under a totally competitive market.
Most oligopolies emerge in businesses where products are relatively homogenous and give the same benefits to consumers no matter which entity is supplying them.
Examples of oligopolies include oil-based sectors, telecommunication industries, and in some countries, the banking business.
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Investment - Introduction to Macroeconomics
Macroeconomics is a discipline of economics that looks at how the general economy acts, and the influence that behaviour has on the decision making of consumers, corporations, and governments.
Although it is commonly referred to as a single entity, the economy represents millions of purchasing, selling, lending, and borrowing decisions made by individuals, companies, and governments.
Macroeconomics is the study of the economy as a whole. Macroeconomics studies the effects of inflation, economic growth, unemployment, interest rates, and currency rates on economic activity. The effects of these factors on corporate, consumer, and governmental economic decisions reflect a junction of micro- and macroeconomics.
Macroeconomic concerns also affect the decisions taken by investment firms. Some assets benefit from slow economic growth and low inflation, whilst others do well during periods of relatively rapid economic growth with moderate inflation. Investment professionals utilize macroeconomic data to anticipate the earnings potential of companies and to decide which asset classes may be more attractive.Investment Instruments is an asset class is a large collection of comparable sorts of investments, such as shares, bonds, real estate, and commodities.
Macroeconomics is a discipline of economics that looks at how the general economy acts, and the influence that behaviour has on the decision making of consumers, corporations, and governments.
Although it is commonly referred to as a single entity, the economy represents millions of purchasing, selling, lending, and borrowing decisions made by individuals, companies, and governments.
Macroeconomics is the study of the economy as a whole. Macroeconomics studies the effects of inflation, economic growth, unemployment, interest rates, and currency rates on economic activity. The effects of these factors on corporate, consumer, and governmental economic decisions reflect a junction of micro- and macroeconomics.
Macroeconomic concerns also affect the decisions taken by investment firms. Some assets benefit from slow economic growth and low inflation, whilst others do well during periods of relatively rapid economic growth with moderate inflation. Investment professionals utilize macroeconomic data to anticipate the earnings potential of companies and to decide which asset classes may be more attractive.Investment Instruments is an asset class is a large collection of comparable sorts of investments, such as shares, bonds, real estate, and commodities.
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Investment - Gross Domestic Product
Economic activity may fluctuate in the short term because of seasonal variations in output, but a true business cycle is a fluctuation that affects a substantial part of the economy over a longer period of time. Real gross domestic product (GDP) is affected by business cycles, and financial professionals and economists spend a considerable lot of energy trying to predict real GDP.
Gross Domestic Product and the Business Cycle
GDP is another phrase we hear regularly without necessarily pausing to think about what it means.
Gross domestic product, more generally known as GDP and also referred to as total output, is the total value of all final items and services generated in a country over a period of time. GDP is an essential notion in macroeconomics. Economists may phrase it on a per person or per capita basis.
GDP per capita is equal to GDP divided by the population. This measure facilitates comparisons of GDP between nations or within a country over time since varying population levels among countries or within a country are compensated for.
For countries with the highest total GDP, it is partly a consequence of their population. When GDP is adjusted for the size of the population, smaller yet relatively prosperous countries move to the top of the list. In other words, although the United States is the world’s wealthiest country, the typical resident of Monaco or Norway is relatively wealthier than the average citizen of the United States.
GDP can be computed in two ways: by using an expenditure (spending) method, or by using an income approach. Summing all the expenditures or all of the income will produce an approximation of GDP.
THE INCOME APPROACH
The sum might be referred to as gross domestic income.
Gross domestic income (GDI) should = gross domestic product (GDP).
After all, what one economic entity spends is another economic unit’s income. This equivalency relationship is a crucial cross-check when statisticians are assessing economic activity, because, in actuality, GDP is difficult to measure and vulnerable to error. The findings of the two methodologies can be compared to guarantee that the estimate of GDP gives a realistic depiction of the economic production of an economy.
THE EXPENDITURE APPROACH GDP is approximated with the following equation:
GDP = C + I + G + (X – M)
The equation demonstrates that GDP is the sum of the following components:
• Consumer (or household) spending, C • Business spending (or gross investment), I • Government spending, G • Exports (or foreign expenditure on domestic products and services), X • Imports (or domestic spending on foreign products and services), M
The term (X – M) denotes net exports. Exports result in spending by inhabitants in other nations on domestically produced products and services, whereas imports include domestic citizens spending money on foreign-made items and services. Exports are considered as spending on domestic output and are added to GDP, whereas imports are removed from GDP. Household spending (or consumer spending) is often the largest component of total spending and may contribute up to 70% of GDP.
GDP changes when the amount that an economy spends varies. Changes in the amount spent could be the consequence of changes in either the quantity purchased or the prices of products and services purchased. If a change in GDP is entirely the result of changes in prices with no accompanying growth in the number of items and services that were purchased, then the economic production of the country has not increased.
This result is like a corporation increasing its pricing by 5% and reporting a subsequent 5% rise in sales. In fact, the company’s production has not grown, therefore looking at nominal (reported) sales would not appropriately reflect the change in output.
Similarly, nominal GDP, which depicts the current market value of items and services, unadjusted for any price changes, may exaggerate or understate actual economic growth.
Real GDP is the nominal GDP adjusted for changes in price levels. Changes in real GDP, which represent changes in actual physical output, are a better measure of economic growth than changes in nominal GDP.
In the United States, when GDP is stated in real terms, it may be referred to as constant dollar GDP. Other countries use similar language to differentiate between nominal and real data.
Economic activity may fluctuate in the short term because of seasonal variations in output, but a true business cycle is a fluctuation that affects a substantial part of the economy over a longer period of time. Real gross domestic product (GDP) is affected by business cycles, and financial professionals and economists spend a considerable lot of energy trying to predict real GDP.
Gross Domestic Product and the Business Cycle
GDP is another phrase we hear regularly without necessarily pausing to think about what it means.
Gross domestic product, more generally known as GDP and also referred to as total output, is the total value of all final items and services generated in a country over a period of time. GDP is an essential notion in macroeconomics. Economists may phrase it on a per person or per capita basis.
GDP per capita is equal to GDP divided by the population. This measure facilitates comparisons of GDP between nations or within a country over time since varying population levels among countries or within a country are compensated for.
For countries with the highest total GDP, it is partly a consequence of their population. When GDP is adjusted for the size of the population, smaller yet relatively prosperous countries move to the top of the list. In other words, although the United States is the world’s wealthiest country, the typical resident of Monaco or Norway is relatively wealthier than the average citizen of the United States.
GDP can be computed in two ways: by using an expenditure (spending) method, or by using an income approach. Summing all the expenditures or all of the income will produce an approximation of GDP.
THE INCOME APPROACH
The sum might be referred to as gross domestic income.
Gross domestic income (GDI) should = gross domestic product (GDP).
After all, what one economic entity spends is another economic unit’s income. This equivalency relationship is a crucial cross-check when statisticians are assessing economic activity, because, in actuality, GDP is difficult to measure and vulnerable to error. The findings of the two methodologies can be compared to guarantee that the estimate of GDP gives a realistic depiction of the economic production of an economy.
THE EXPENDITURE APPROACH GDP is approximated with the following equation:
GDP = C + I + G + (X – M)
The equation demonstrates that GDP is the sum of the following components:
• Consumer (or household) spending, C • Business spending (or gross investment), I • Government spending, G • Exports (or foreign expenditure on domestic products and services), X • Imports (or domestic spending on foreign products and services), M
The term (X – M) denotes net exports. Exports result in spending by inhabitants in other nations on domestically produced products and services, whereas imports include domestic citizens spending money on foreign-made items and services. Exports are considered as spending on domestic output and are added to GDP, whereas imports are removed from GDP. Household spending (or consumer spending) is often the largest component of total spending and may contribute up to 70% of GDP.
GDP changes when the amount that an economy spends varies. Changes in the amount spent could be the consequence of changes in either the quantity purchased or the prices of products and services purchased. If a change in GDP is entirely the result of changes in prices with no accompanying growth in the number of items and services that were purchased, then the economic production of the country has not increased.
This result is like a corporation increasing its pricing by 5% and reporting a subsequent 5% rise in sales. In fact, the company’s production has not grown, therefore looking at nominal (reported) sales would not appropriately reflect the change in output.
Similarly, nominal GDP, which depicts the current market value of items and services, unadjusted for any price changes, may exaggerate or understate actual economic growth.
Real GDP is the nominal GDP adjusted for changes in price levels. Changes in real GDP, which represent changes in actual physical output, are a better measure of economic growth than changes in nominal GDP.
In the United States, when GDP is stated in real terms, it may be referred to as constant dollar GDP. Other countries use similar language to differentiate between nominal and real data.
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Investment - Introduction to Economics and Microeconomics
Microeconomics vs. Macroeconomics
Economics is the study of production, distribution, and consumption, or you may reasonably think of it as the study of decisions in the presence of scarce resources, and it is separated into two broad areas: microeconomics and macroeconomics.
Microeconomics is the study of how individuals and corporations make decisions to allocate scarce resources, which assists in understanding how individuals and companies prioritise what they want.
Macroeconomics is the study of an economy as a whole; for example, it investigates factors that affect a country’s economic growth.
Supply refers to the quantity of a product or service sellers are willing to sell, whereas demand refers to the quantity of a product or service purchasers desire to buy.
The combination of supply and demand is a driving force behind the economy and is part of the ‘invisible hand’1 that, over time, should contribute to greater prosperity for individuals, companies, and society at large.
Understanding microeconomics is essential to organizations when evaluating such topics as how much to charge for their products and services and what reaction they may get from competitors. Microeconomics lets investment analysts estimate the profitability of a company under numerous situations.
For example, the analyst may wish to establish whether a company has the ability to boost revenues by decreasing the pricing of its products and increasing the quantities it sells. To do so, the analyst will have to analyze demand for the company’s products and the degree of competition in the company’s market.
Similarly, microeconomic concepts help investors allocate their savings. Investors attempt to supply capital to companies that will make the most efficient use of that cash.
Microeconomics vs. Macroeconomics
Economics is the study of production, distribution, and consumption, or you may reasonably think of it as the study of decisions in the presence of scarce resources, and it is separated into two broad areas: microeconomics and macroeconomics.
Microeconomics is the study of how individuals and corporations make decisions to allocate scarce resources, which assists in understanding how individuals and companies prioritise what they want.
Macroeconomics is the study of an economy as a whole; for example, it investigates factors that affect a country’s economic growth.
Supply refers to the quantity of a product or service sellers are willing to sell, whereas demand refers to the quantity of a product or service purchasers desire to buy.
The combination of supply and demand is a driving force behind the economy and is part of the ‘invisible hand’1 that, over time, should contribute to greater prosperity for individuals, companies, and society at large.
Understanding microeconomics is essential to organizations when evaluating such topics as how much to charge for their products and services and what reaction they may get from competitors. Microeconomics lets investment analysts estimate the profitability of a company under numerous situations.
For example, the analyst may wish to establish whether a company has the ability to boost revenues by decreasing the pricing of its products and increasing the quantities it sells. To do so, the analyst will have to analyze demand for the company’s products and the degree of competition in the company’s market.
Similarly, microeconomic concepts help investors allocate their savings. Investors attempt to supply capital to companies that will make the most efficient use of that cash.
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Investment - Real Estate
Real estate investments take numerous forms. For many people, it is the purchase of their property, which may be a considerable chunk of their net worth. Houses, apartments, and other residential properties that are owner-occupied constitute the core of many individuals’ financial plans. Although considered part of their financial strategy, most residential real estate is not included in individuals’ investment portfolios.
Generally, residential real estate transactions involve owner-occupiers (that is, persons who live in the home they own) and are made for personal reasons as opposed to merely investment-related reasons. Individuals or groups of individuals may invest in residential real estate for investment-related goals, such as renting out holiday houses.
Many investors focus their real estate investments on what is often referred to as commercial real estate — that is, income-generating real estate.
Commercial Real Estate Segments
Commercial real estate is made up of several categories, which all have their own qualities, advantages, and restrictions. The key segments are land, offices, multifamily residential dwellings, retail and industrial properties, and hotels.
Land
Undeveloped, or raw, land can be highly speculative because there are no income inflows from tenants or occupants, only cash outflows in the form of real estate taxes and other costs of owning the land. As improvements are completed, such as acquiring construction permits and adding roads, utilities, and other facilities, the land gets more developed, and its value grows based on a predicted stream of future revenue flows. Investing in undeveloped land is risky because values can plummet dramatically when home demand dips.
As an example, CalPERS (California Public Employee Retirement System), one of the largest US pension plans representing public employees in California, had a USD970 million investment in 15,000 acres of undeveloped land outside Los Angeles that lost more than 90% of its value in the aftermath of the 2008 global financial crisis.
Offices
Offices comprise one of the largest divisions of commercial real estate. They are usually controlled by real estate investment businesses that lease space to tenants in varied terms, from short-term monthly leases to lengthy multiyear leases. Because renters are responsible for paying their leases whether they occupy the space or not, the income connected with office rent is reasonably predictable for the term of the lease. In addition, office rentals often adjust for inflation, which makes offices an excellent investment for individuals wishing to preserve their real estate income against inflation.
Multifamily Residential Dwellings
Also known as apartments or flats, multifamily residential dwellings form a large percentage of the investible commercial real estate market. They are commercial properties that incorporate many units inside a single property or development. These units are rented to individuals or families. Most leases tend to be for durations of one year or less, so the multifamily residential dwellings category is subject to supply and demand dynamics in the local marketplace.
Retail Properties
The retail section comprises such assets as shopping malls, commercial shopping centres, and other structures dedicated for retail purposes. The owner, or investor, lends the space to a store with lease durations extending from weeks to years.
Industrial Properties
The industrial section includes such properties as manufacturing facilities, research and development space, and warehouse/distribution space. Again, lease agreements vary in length
Hotels Hotels include branded short-term stay facilities and longer-stay facilities catering to contract workers in remote regions, as well as boutique and independent facilities.
Depending on the country, there may be different commercial real estate segments. For example, in many developed economies, senior housing tailored for those aged 55+ and student housing for post-secondary education have both attracted large expenditures.
How To Invest in Real Estate
Investors who have sufficient cash can acquire real estate directly. Otherwise, they might obtain exposure to real estate through either the private or public markets.
PUBLIC MARKET INVESTMENTS
In contrast to real estate limited partnerships and real estate equity funds that are private investments, real estate investment trusts (REITs) are investments through public markets. Like other equity instruments, the shares of REITs are traded on exchanges, which makes them more liquid than real estate limited partnerships and real estate equity funds. REITs are companies that largely own, and in most cases run, income-producing real estate. Most REITs are involved at all stages of the real estate business, from the development of land to the construction of buildings and the administration of the properties.
PRIVATE MARKET INVESTMENTS
In the private market, the principal form of investing in real estate is through real estate limited partnerships and real estate equity funds.
Real estate limited partnerships are partnerships that specialise in real estate investing. Their structure and mechanics are comparable to those of the private equity partnerships. The partnership is generally founded by a real estate development firm that becomes the general partner. The general partner then seeks funds from investors, who become the real estate limited partnership’s limited partners.
The capital raised is invested in real estate developments. Real estate projects take numerous forms, such as the development of an office block or an apartment complex. If the general partner is a real estate development firm, it may also manage the real estate projects. As with private equity partnerships, the limited partners in a real estate limited partnership must pay the general partner management fees on the pledged capital and carried interest on the profit produced on the real estate assets.
Similar to investments in private equity partnerships, investments in real estate limited partnerships are illiquid. In addition, the limited partners may suffer years of negative cash flows since the general partner may not receive cash distributions until the real estate assets – the office block or the apartment complex — are sold.
Real estate equity funds generally hold stakes in hundreds of commercial properties. These properties are diversified by region, property type, and vintage year (that is, the year the acquisition was made). Real estate equity funds are frequently open-end funds, meaning that they issue or redeem shares when investors desire to purchase or sell. Redemptions could take place at regular times, such as quarterly, or on demand. They are made out of the real estate equity funds’ cash flows, such as the money obtained from rents and the sale of properties. So, real estate equity funds are, in theory, more liquid than real estate limited partnerships. But there is no certainty that the cash flows will be sufficient to accommodate investors’ redemption requests.
Real estate investments take numerous forms. For many people, it is the purchase of their property, which may be a considerable chunk of their net worth. Houses, apartments, and other residential properties that are owner-occupied constitute the core of many individuals’ financial plans. Although considered part of their financial strategy, most residential real estate is not included in individuals’ investment portfolios.
Generally, residential real estate transactions involve owner-occupiers (that is, persons who live in the home they own) and are made for personal reasons as opposed to merely investment-related reasons. Individuals or groups of individuals may invest in residential real estate for investment-related goals, such as renting out holiday houses.
Many investors focus their real estate investments on what is often referred to as commercial real estate — that is, income-generating real estate.
Commercial Real Estate Segments
Commercial real estate is made up of several categories, which all have their own qualities, advantages, and restrictions. The key segments are land, offices, multifamily residential dwellings, retail and industrial properties, and hotels.
Land
Undeveloped, or raw, land can be highly speculative because there are no income inflows from tenants or occupants, only cash outflows in the form of real estate taxes and other costs of owning the land. As improvements are completed, such as acquiring construction permits and adding roads, utilities, and other facilities, the land gets more developed, and its value grows based on a predicted stream of future revenue flows. Investing in undeveloped land is risky because values can plummet dramatically when home demand dips.
As an example, CalPERS (California Public Employee Retirement System), one of the largest US pension plans representing public employees in California, had a USD970 million investment in 15,000 acres of undeveloped land outside Los Angeles that lost more than 90% of its value in the aftermath of the 2008 global financial crisis.
Offices
Offices comprise one of the largest divisions of commercial real estate. They are usually controlled by real estate investment businesses that lease space to tenants in varied terms, from short-term monthly leases to lengthy multiyear leases. Because renters are responsible for paying their leases whether they occupy the space or not, the income connected with office rent is reasonably predictable for the term of the lease. In addition, office rentals often adjust for inflation, which makes offices an excellent investment for individuals wishing to preserve their real estate income against inflation.
Multifamily Residential Dwellings
Also known as apartments or flats, multifamily residential dwellings form a large percentage of the investible commercial real estate market. They are commercial properties that incorporate many units inside a single property or development. These units are rented to individuals or families. Most leases tend to be for durations of one year or less, so the multifamily residential dwellings category is subject to supply and demand dynamics in the local marketplace.
Retail Properties
The retail section comprises such assets as shopping malls, commercial shopping centres, and other structures dedicated for retail purposes. The owner, or investor, lends the space to a store with lease durations extending from weeks to years.
Industrial Properties
The industrial section includes such properties as manufacturing facilities, research and development space, and warehouse/distribution space. Again, lease agreements vary in length
Hotels Hotels include branded short-term stay facilities and longer-stay facilities catering to contract workers in remote regions, as well as boutique and independent facilities.
Depending on the country, there may be different commercial real estate segments. For example, in many developed economies, senior housing tailored for those aged 55+ and student housing for post-secondary education have both attracted large expenditures.
How To Invest in Real Estate
Investors who have sufficient cash can acquire real estate directly. Otherwise, they might obtain exposure to real estate through either the private or public markets.
PUBLIC MARKET INVESTMENTS
In contrast to real estate limited partnerships and real estate equity funds that are private investments, real estate investment trusts (REITs) are investments through public markets. Like other equity instruments, the shares of REITs are traded on exchanges, which makes them more liquid than real estate limited partnerships and real estate equity funds. REITs are companies that largely own, and in most cases run, income-producing real estate. Most REITs are involved at all stages of the real estate business, from the development of land to the construction of buildings and the administration of the properties.
PRIVATE MARKET INVESTMENTS
In the private market, the principal form of investing in real estate is through real estate limited partnerships and real estate equity funds.
Real estate limited partnerships are partnerships that specialise in real estate investing. Their structure and mechanics are comparable to those of the private equity partnerships. The partnership is generally founded by a real estate development firm that becomes the general partner. The general partner then seeks funds from investors, who become the real estate limited partnership’s limited partners.
The capital raised is invested in real estate developments. Real estate projects take numerous forms, such as the development of an office block or an apartment complex. If the general partner is a real estate development firm, it may also manage the real estate projects. As with private equity partnerships, the limited partners in a real estate limited partnership must pay the general partner management fees on the pledged capital and carried interest on the profit produced on the real estate assets.
Similar to investments in private equity partnerships, investments in real estate limited partnerships are illiquid. In addition, the limited partners may suffer years of negative cash flows since the general partner may not receive cash distributions until the real estate assets – the office block or the apartment complex — are sold.
Real estate equity funds generally hold stakes in hundreds of commercial properties. These properties are diversified by region, property type, and vintage year (that is, the year the acquisition was made). Real estate equity funds are frequently open-end funds, meaning that they issue or redeem shares when investors desire to purchase or sell. Redemptions could take place at regular times, such as quarterly, or on demand. They are made out of the real estate equity funds’ cash flows, such as the money obtained from rents and the sale of properties. So, real estate equity funds are, in theory, more liquid than real estate limited partnerships. But there is no certainty that the cash flows will be sufficient to accommodate investors’ redemption requests.
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Investment - Commodities
Commodities, such as precious and base metals, energy items, and agricultural products, tend to grow in price with inflation. So, they can give inflation protection in a portfolio.
There are various ways for investors to obtain exposure to commodities:
Buy the physical commodity
Buy shares of natural resources or commodity-related corporations
Buy commodity derivatives
Purchase the Physical Commodity
Theoretically, an investor may buy a barrel of oil, a herd of cattle, or a bushel of wheat. But the transportation and storage problems connected with purchasing a physical commodity mean that it is not customary for investors to obtain access to commodities this way.
Purchase Shares of Natural Resources or Commodity Related Companies
Investors can buy shares of companies that have a large percentage of their operations in the exploration, recovery, production, and processing of commodities. For example, an investor who seeks exposure to gold may buy shares in gold producers, such as Newmont Goldcorp (NEM: NYSE), Barrick Gold Corporation (GOLD: NYSE), Franco-Nevada Corporation (FNV: NYSE), or Newcrest Mining (NCMGY: OTCMKTS). Growing concern for the environment, along with increased inflation risk, has resulted in continuous interest in linking commodities financing with sustainability.
Purchase Commodity Derivatives
Investors can buy derivatives in which the underlying asset is a commodity or a commodities index. Typical commodities derivatives are forwards, futures, options, and swaps. Recall that futures and other types of options are traded on exchanges, whereas forwards, swaps, and other types of options are privately negotiated agreements.
Commodities, such as precious and base metals, energy items, and agricultural products, tend to grow in price with inflation. So, they can give inflation protection in a portfolio.
There are various ways for investors to obtain exposure to commodities:
Buy the physical commodity
Buy shares of natural resources or commodity-related corporations
Buy commodity derivatives
Purchase the Physical Commodity
Theoretically, an investor may buy a barrel of oil, a herd of cattle, or a bushel of wheat. But the transportation and storage problems connected with purchasing a physical commodity mean that it is not customary for investors to obtain access to commodities this way.
Purchase Shares of Natural Resources or Commodity Related Companies
Investors can buy shares of companies that have a large percentage of their operations in the exploration, recovery, production, and processing of commodities. For example, an investor who seeks exposure to gold may buy shares in gold producers, such as Newmont Goldcorp (NEM: NYSE), Barrick Gold Corporation (GOLD: NYSE), Franco-Nevada Corporation (FNV: NYSE), or Newcrest Mining (NCMGY: OTCMKTS). Growing concern for the environment, along with increased inflation risk, has resulted in continuous interest in linking commodities financing with sustainability.
Purchase Commodity Derivatives
Investors can buy derivatives in which the underlying asset is a commodity or a commodities index. Typical commodities derivatives are forwards, futures, options, and swaps. Recall that futures and other types of options are traded on exchanges, whereas forwards, swaps, and other types of options are privately negotiated agreements.