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Producer choice and the law of supply

admin — Tue, 03 Nov 2009 10:32:46 +0000

Now let’s shift our focus to producers and the supply side of the market. How does the market process determine the amount of each good that will be produced? To figure this out, we first have to understand what influences the choices of producers. Producers convert resources into goods and services by doing the following:
1. organizing productive inputs and resources, like land, labor, capital, natural resources, and intermediate goods;
2. transforming and combining these inputs into goods and services; and
3. selling the final products to consumers.
Producers have to purchase the resources at prices determined by market forces. Predictably, the owners of these resources will supply the resources only at prices at least equal to what they could earn elsewhere. Put another way, each resource the producers buy to make their product has to be bid away from all other potential uses. Its owner has to be paid its opportunity cost. The sum of the producer’s cost of each resource used to produce a good will equal the opportunity cost of production.
There is an important difference between the opportunity cost of production and standard accounting measures of cost. Accountants generally do not count the cost of the firm’s assets, such as its buildings, equipment, and financial resources, when they calculate a product’s cost. But economists do. Economists consider the fact that these assets could be used some other way-in other words, that they have an opportunity cost. Unless these opportunity costs are covered, the resources will eventually be used in other ways. The opportunity cost of these assets to the firm is the amount of money the firm could earn from the assets if they were used another way. Consider a manufacturer that invests $10 million in buildings and equipment to produce shirts. Instead of buying buildings and equipment, the manufacturer could simply put the $10 million in the bank and let it draw interest. If the $10 million were earning, say, 10 percent interest, the firm would make $1 million on that money in a year’s time. This $1 million in forgone interest is part of the firm’s opportunity cost of producing shirts. Unlike an accountant, an economist will take that $1 million opportunity cost into account. If the firm plans to invest the money in shirt-making equipment, it had better earn more from making the shirts than the $1 million it could earn by simply putting the money in the bank. If the firm can’t generate enough to cover all of its costs, including the opportunity cost of assets owned by the firm, it will not continue in business.

Responsiveness of quantity demanded to price changes

admin — Mon, 12 Oct 2009 10:31:03 +0000

As we previously noted, the availability of substitutes is the main reason why the demand curve for a good slopes downward. Some goods, however, are much easier than others to substitute away from. As the price of tacos rises, most consumers find hamburgers a reasonable substitute. Because of the ease of substitutability, the quantity of tacos demanded is quite sensitive to a change in their price. Economists would say that the demand for tacos is relatively elastic because a small price change will cause a rather large change in the amount purchased. Alternatively, goods like gasoline and electricity have fewer close substitutes. When their prices rise, it is harder for consumers to find substitutes for these products. When close substitutes are unavailable, even a large price change may not cause much of a change in the quantity demanded. In this case, an economist would say that the demand for such goods is relatively inelastic.
Graphically, this different degree of responsiveness is reflected in the steepness of the demand curve. The flatter demand curve is for a product like tacos, for which the quantity purchased is highly responsive to a change in price. As the price increases from $1.25 to $2.00, the quantity demanded falls sharply from 10 to 4 units. The steeper demand curve (D2, right frame) is for a product like gasoline, where the quantity purchased is much less responsive to a change in price. For gasoline, an increase in price from $1.25 to $2.00 results in only a small reduction in the quantity purchased (from 10 to 8 units). An economist would say that the flatter demand curve D, is “relatively elastic,” whereas the steeper demand curve D, is “relatively inelastic.” The availability of substitutes is the main determinant of a product’s elasticity or in- elasticity and thus how flat or steep its demand curve is.
What would a demand curve that was perfectly vertical represent? Economists refer to this as a “perfectly” inelastic demand curve. It would mean that the quantity demanded of the product never changes-regardless of its price. Although it is tempting to think that the demand curves are vertical for goods essential to human life (or goods that are addictive), this is inaccurate for two reasons. First, in varying degrees, there are substitutes for everything. As the price of a good rises, the incentive increases for suppliers to invent even more new substitutes. Thus, even for goods that currently have few substitutes, if the price were to rise high enough, alternatives would be invented and marketed, reducing the quantity demanded of the original good. Second, our limited incomes restrict our ability to afford goods when they become very expensive. As the price of a good rises to higher and higher levels, if we do not cut back on the quantity purchased, we will have less and less income to spend on other things. Eventually, this will cause us to cut back on our purchases of it. Because of these two reasons, the demand curve for every good will slope downward to the right.

Consumer surplus

admin — Mon, 05 Oct 2009 10:30:25 +0000

Consumer surplus is simply the difference between the maximum amount consumers would be willing to pay and the amount they actually pay for a good. The height of the demand curve measures how much buyers in the market value each unit of the good. The price indicates the amount they actually pay. The difference between these two-the triangular area below the demand curve but above the price paid-is a measure of the total consumer surplus generated by all exchanges of the good. The size of the consumer surplus, or triangular area, is affected by the market price. If the market price for the goods falls, more of it will be purchased, resulting in a larger surplus for consumers. Conversely, if the market price rises, less of it will be purchased, resulting in a smaller surplus (net gain) for consumers.
Because the value a consumer places on a particular unit of a good is shown by the corresponding height of the demand curve, we can use the demand curve to clarify the difference between the marginal value and total value of a good-a distinction we introduced briefly in previous posts. If consumers are currently purchasing Q, units, the marginal value of the good is indicated by the height of the demand curve at Q,-the last unit consumed (or purchased). So at each quantity, the height of the demand curve shows the marginal value of that unit, which as you can see, declines along a demand curve. The total value of the good, however, is equal to the combined value of all units purchased. This is the sum of the value of each unit (the heights along the demand curve) on the x-axis, out to, and including, unit Q,. This total value is indicated graphically as the entire area under the demand curve out to Q, (the triangular area representing consumer surplus plus the unshaded rectangular area directly below it).
You can see that the total value to consumers of a good can be far greater than the marginal value of the last unit consumed. When additional units are available at a low price, the marginal value of a good may be quite low, even though its total value to consumers is exceedingly high. This is usually the case with water, for example, because it is essential for life. The value of the first few units of water consumed per day will be exceedingly high. The consumer surplus derived from these units will also be large when water is plentiful at a low price. As more and more units are consumed, however, the marginal value of even something as important as water will fall to a low level. Thus, when water is cheap, people will use it not only for drinking, cleaning, and cooking, but also for washing cars, watering lawns, flushing toilets, and maintaining fish aquariums. Thus, although the total value of water is rather large, its marginal value is quite low.
Consumers will tend to expand their consumption of a good until its price and marginal value are equal.
Thus, the price of a good (which equals marginal value) reveals little about the total value derived from the consumption of it. This is the reason that the market price of diamonds (which reflects their high marginal value) is greater than the market price of water (which has a low marginal value), even though the total value of diamonds is far less than the total value of water. Think of it this way, beginning from your current levels of consumption, if you were offered a choice between one diamond or one gallon of water right now, which would you take? You would probably take the diamond, because at the margin it has more value to you than additional water. However, if given a choice between giving up all of the water you use or all of the diamonds you have, you would probably keep the water over diamonds, because in total water has more value to you.

Consumer choice and the law of demand

admin — Sun, 27 Sep 2009 10:25:02 +0000

Clearly, prices influence our decisions. As the price of a good increases, we have to give up more of other goods if we want to buy it. Thus, as the price of a good rises, its opportunity cost increases (in terms of other goods that must be forgone to purchase it). A basic principle of economics is that if something becomes more costly, people will be less likely to buy it. This principle is called the law of demand.
The law of demand states that there is an inverse (or negative) relationship between the price of a good or service and the quantity of it that consumers are willing to purchase. This inverse relationship means that price and the quantity consumers wish to purchase move in opposite directions. As the price increases, buyers purchase less-and as the price decreases, buyers purchase more.
The availability of substitutes~goods that perform similar functions-helps explain this inverse relationship. No single good is absolutely essential; everything can be replaced with something else. A chicken sandwich can be substituted for a cheeseburger. Wood, aluminum, bricks, and glass can take the place of steel. Going to the movies, playing tennis, watching television, and going to a football game are substitute forms of entertainment. When the price of a good increases, people cut back on it and buy substitute products.

William Goldman – a stock market analyst?

admin — Sat, 19 Sep 2009 09:10:21 +0000

William Goldman is not a stock market analyst. He is the screen-writer of Butch Cassidy and the Sundance Kid, Marathon Man, and numerous other well-known motion pictures. William Goldman is also the author of a brilliant and entertaining book, Adventures in the Screen Trade, in which he coined a memorable phrase that summed up everything he’d ever learned about the movie business.
Here it is: “Nobody knows anything.”
What Goldman was saying was that you could take all of the sophisticated market research, all of the experience of studio heads and producers, all of the box office grosses of predecessor films, and all of the marketing savvy of the best distribution people, and throw it all out the window. If all of the widely available information known to everyone in the movie business meant anything, everyone would be making nothing but successful movies—and that sure isn’t happening.
Says Goldman:
•If anybody knew anything, B.J. Thomas’s advisers would not have been so upset after the first sneak preview of Butch Cassidy and the Sundance Kid. After hearing Thomas’s new song, “Raindrops Keep Falling on My Head,” in the context of Butch Cassidy, they were convinced that Thomas had made a potentially fatal career move.
•If anybody knew anything, Raiders of the Lost Arkwould not have been turned down by every studio in town before Paramount decided to make the film.
•If anybody knew anything, Columbia Pictures would not have told Steven Spielberg that it decided not to make E.T., even after the studio spent a million dollars developing the film. (E.T.wound up at Universal.)
•If anybody knew anything, Paramount Pictures would not have offered The Godfatherto 12 directors (all of whom turned it down) before they got around to offering it to Francis Ford Coppola, and they would not have offered the role of Michael Corleone to Robert Redford, Warren Beatty, Ryan O’Neal, Dustin Hoffman, and Martin Sheen before they got around to offering it to Al Pacino.
Now, if you think about it, you can apply William Goldman’s premise to the stock market, but with a slight variation.
In the stock market, when everybody knows everything, nobody knows anything.Overall, the evidence seems to indicate that the stock market, as a whole, is a pretty good “discounting” mechanism that takes into account everything that is knowable at any given time. The more analytical attention that is focused on the market or on a sector of the market or on any given stock, the more “efficient” the market becomes at determining a fair value.
This being the case, I would argue that the only way for an individual investor to get an “edge” on Wall Street is to go off the beaten path and to focus on areas of the market where analytical attention is slim or nonexistent. It also follows that there’s no “edge” to be had in terms of trying to outguess the general market, since virtually every analyst and investor is looking at the same information, which will therefore be pretty well discounted, just as William Goldman’s movie studio executives are all poring over the same current and historical data regarding box office grosses. If all of this “macro” publicly available information meant anything, everyone would be making the right move all of the time—and they’re not. This strongly suggests that the way to hit a home run is to take a left turn when the lemmings are turning right—to take the road less traveled, as it were. The same holds true for large-cap stocks. A1999 study by Peter Schliemann, a money manager formerly with David L. Babson & Co., revealed that stocks with a market capitalization of more than $4 billion had an average of 17 analysts following the company, while stocks with a market cap of less than $100 million had an average of less than one analyst following the company. This means that some of these companies with a market cap under $100 million had no analytical coverage at all.
In terms of large-cap stocks, you can see how efficient the market is and how difficult it is for any investor to get an edge on the competition by the way these stocks react to surprisingly good or bad information. When a widely followed stock trading at $66 misses its earnings estimate, there is no chance for anyone to sell at anywhere near $66. Every analyst in town lowers his or her earnings estimate and downgrades the stock, and your $66 large-cap stock simply opens at $50. That is how the efficient market works with widely followed stocks: Everybody immediately takes the new reality into account and the market adjusts its perception of value instantaneously.
Since everybody expected earnings of, say, $0.60 for the quarter, everybody knew everything—therefore, they knew nothing. Now that everybody knows earnings came in at, say, $0.50, everybody knows everything once again—but they still know nothing since there is no way to take advantage of that information to avoid the stock price decline.
So, when it comes to analyzing the general market or the widely followed big-cap stocks, nobody on Wall Street really knows anything at all— or maybe we should say that nobody really knows anything more than any- body else—or anything really worth knowing.
When you’re looking for an edge in an area of the stock market where everyone else is looking, you’ll find that new business becomes old business pretty darn quickly—usually too quickly to be of any use to an individual investor. By the time you hear any new significant information about the market in general or big-cap stocks, it’s a good bet that it will be old business already, no matter how new it seems to you.
Now, compare this instantaneous reaction to new business in the large-cap stocks to the way the market reacted to Laidlaw’s announcement that it would sell 12 percent of ADT Ltd. to Western Resources for $14 a share. Did ADT immediately jump to $20 or $25 a share based on the likelihood that this move would ultimately lead to a takeover bid? No, it did not. The stock moved up gradually, over time, providing numerous excellent entry points for tuned-in investors.
But if, say, IBM were to reveal that it had been buying shares of Dell Computer in the open market and that it had accumulated a 12 percent stake without talking it over with Dell’s management, what do you think would happen to Dell’s stock price? Most likely, the Wall Street analytical community would immediately take its best guess as to Dell’s potential takeover value and the stock would rise toward that level almost immediately.
This did not happen, as we will learn, with ADT. Nor did it happen with Rexel, Inc., even though the parent company, Rexel S.A., methodically bought shares in the open market, giving off a blatant clue that a takeover bid was on the way. With both of these stocks, investors had plenty of time to accumulate shares prior to the eventual takeover because the stock market was inefficient in pricing their stocks in light of this information.
That is the difference between how the market processes information involving widely followed large-cap stocks and less well-followed small-cap stocks. In fact, you can safely say that the market’s efficiency in processing significant information is directly related to the audience for that information—i.e., whether institutional investors and the analysts who are fighting for their commission business are paying attention will determine how accurately the market reflects new information.
You will find, over time, it is important to spend more time researching individual stocks that are off the beaten path and less time thinking about the overall stock market and the popular stocks of the moment.
Two very important points can be made now: First, if you really want to have an edge in the stock market, you can only gain that edge in terms of individual stocks, where it is sometimes possible to notice information and interpret that information in a way that can give you some unique insight into a particular situation.
In other words, where individual stocks are concerned, the prize goes to those investors who go the extra mile, who do their homework better than everybody else. Sometimes this involves digging deeper for information about the company itself. Other times it involves thinking in terms of cause and effect, where a seemingly unrelated news item in the maze of information released on a daily basis has a connection to a stock you are following. For example, when Brylane’s outside shareholder, Pinault Printemps, began rais- ing its stake in Brylane, I saw a connection to the Rexel takeover bid because Rexel S.A., which bought Rexel, was a subsidiary of Pinault Printemps. But how many investors—or professional analysts—would have known that if they had not lived through the Rexel takeover drama?
So, lesson number one is: Research individual stocks—and smaller stocks, at that—and don’t try to predict the market or compete with every analyst on Wall Street tracking the large-cap stocks. The second lesson is that a lot of valuable public information is available out there that is notreflected in stock prices, especially when you’re dealing with stocks that are not widely followed by the mainstream Wall Street analysts.
So, lesson number two: If you reallywant to get an edge on Wall Street, you should focus your attention on smaller-cap stocks that are not widely followed by analysts and their institutional clients. That is where you are most likely to turn up information and see a connection somewhere that is completely public but that has not been properly reflected in the stock price.
This principle explains why stocks like Rexel, ADT, Brylane, and others could easily have been purchased for months on end at bargain prices even though it was becoming increasingly likely to anyone paying attention that a takeover bid was on the way.
When you start to focus more of your attention on individual stocks and less attention on the general market, you’ll be better able to train yourself to think in new paradigm terms. You will notice a subtle change in the way you perceive the news. You’ll think in terms of cause and effect, and see connections between seemingly unrelated companies and events that others do not notice.
The more you think this way, the more likely you will be able to identify potential “superstocks”—and the less interested you’ll become in the daily blather that passes for stock market analysis.

If you’re like me, you won’t miss the market “analysis” at all.

admin — Tue, 01 Sep 2009 09:04:53 +0000

In fact, you may find it’s a relief to get it out of your hair because so much of it is meaningless anyway.
The sheer quantity of financial commentary being offered today on television, radio, the print media, and the Internet requires constant explanation and interpretation of every stock market gyration, no matter how unexplainable it may be. As a result, financial commentators, stockbrokers, and analysts are expected to have an answer for everything.
Most investors understand that much of what passes as market analysis is nothing more than gibberish, but they tolerate it because even stock market gibberish tends to be a lot more interesting than most other topics of conversation.
For some of you this may be difficult to accept, especially if you are an avid follower of television financial reporting or if you have one of those stockbrokers who seems to have an answer for everything.
“How’s the market?” you ask.
“Down 80 points,” he says.
“Eighty points? Why is it down 80 points?”
“Profit-taking.”
Now, you may not be the smartest investor who ever lived, but you’re smart enough to know that since the market has declined in 17 of the past 20 sessions, it is definitely not profit-taking that’s pushing the market lower today. Your broker knows that, too, but has to tell you something because he or she is supposed to know what’s going on. Consequently, the broker will have an answer for any question you can possibly come up with.
How does the broker do this?
On any given day there are probably 5 or 10 potentially bullish news items and 5 or 10 potentially bearish news items on the Dow Jones news wire. Depending on which way the market has gone that day, one or more of these innocent items will be plucked from the tape, like some Miss America from the crowd in Atlantic City, and this news item will be used to explain what the market did that day.
Let us say that, at ten-twenty in the morning, the Dow Jones Industrial Average is down 200 points. There are four major items of interest on the news wire: (1) the President has announced that he will seek a tax cut, (2) Iraq and Iran are at it again, and an Iraqi fighter plane has been shot down, (3) the bond market is higher, and (4) durable goods orders jumped 5.2 percent last month. Item 2 is meaningless but could be trotted out to explain a falling market, if necessary. Item 3 is bullish. And items 1 and 4 can be either bullish or bearish, depending on how you want to look at it.
Your broker can use any one of these news items to put a “spin” on why the Dow Jones is down 200 points.
Your stockbroker is sitting at his desk.
The phone rings. It’s you.
“How’s the market?” you ask.
“It’s down 200 points,” your broker says.
“Two hundred points? How come?”
“Well, the market has been depressed by a couple of news items this morning. First, the President says he wants a tax cut, and that’s bearish because the Fed may decide to raise interest rates to counteract the potential inflationary effect of a tax cut. Also, Iran and Iraq are fighting, and an Iraqi plane was shot down. And durable goods orders were up more than expected, which could be inflationary also.”
“Oh.”
On the other hand, the market might be up 200 points. With the very same items on the tape, the conversation would then go something like this:
“How’s the market?”
“Up 200 points.”
“Up 200 points? How come?”
“Well, the President says he wants a tax cut, and that’s bullish for the economy and for corporate earnings. Also, durable goods orders were up 5.2 percent, another sign of economic strength. Also, the bond market is higher this morning.”
“Oh.”
Since that sort of instant analysis is only a game to pass the time, the tough questions rarely, if ever, get asked, such as: If the market is down 200 points because the Fed might raise interest rates in light of the President’s tax cut proposal, how come the bond market is up? Or, what do Iran and Iraq have to do with the stock market?
Nevertheless, this ritual is repeated over and over again until the stock market closes. If the market turns around and manages to erase its 200-point loss and close higher, the “bearish” items will miraculously be interpreted as bullish, as in “Wall Street had second thoughts about President Clinton’s tax cut proposal . . .” and so on.
Believe me, once you get used to thinking in terms of superstock analysis, you will begin to see these stock market commentaries in an entirely different light—that is, if you bother to see them at all. Can you really invest in stocks while you completely ignore the stock market in general? Can you really ignore the stock market prognosticators and other talking heads who can always be counted on to have an explanation of what the stock market did on any given day, even if in truth there is no explanation?
Yes. Because when it comes to the trend of the general market, it’s doubtful that any one person can have much more insight than anyone else. All you really need to know is this: When interest rates are rising sharply and the no-risk rate of return begins to exceed the inflation rate by more than 3 or 4 percentage points, it’s time to think about reducing your market exposure.
Other than that, nobody knows anything.

If Everybody Knows Everything, Then Nobody Knows Anything

admin — Sun, 23 Aug 2009 09:00:00 +0000

By now you might be thinking: This is a blog about the stock market, yet the stock market itself will not be a factor in any of the super-stock takeover situations we discussed. Every one of these super-stocks generated a profit for reasons totally unrelated to the trend of the general stock market.
Which is precisely the point. When you’re dealing with super-stocks, pegging your stock selections to specific events or “catalysts” related to a particular company that are likely to force the stock price higher, for the most part you’re removing the behavior of the general stock market from the equation.
When you begin to think in terms of the new paradigm, you’ll find yourself zeroing in on news items that relate to the stocks you’re holding or to other stocks that could become potential superstocks. You’ll find yourself paying attention to “micro” news items rather than “macro” news items. You’ll become less interested in grandiose generalizations concerning the big picture and more interested in specific news items that will impact individual stocks you’re following. For example, you’ll find yourself paying more attention to CEO interviews (“We believe the consolidation in our industry will continue and we intend to be one of the major players by making additional acquisitions”), merger announcements (“We will continue to look for opportunities to grow our defense electronics segment”), or “shareholder rights plans” (“Although we know of no specific plans to acquire our company, this shareholder rights plan will ensure that our shareholders will receive fair value in the event of a bid”). You will find yourself taking note of stock buybacks (“We believe our stock is undervalued”) in consolidating industries. You will be paying close attention to 13-D filings that indicate an outside beneficial owner has increased his or her stake in a company. And your ears will perk up when you hear that a company plans to spin off one of its subsidiaries to “enhance shareholder value,”especially if the parent company or the subsidiary operates in an industry where takeovers are proliferating.
You will even notice when an outside beneficial owner receives a hostile takeover bid, because one way the beneficial owner can ensure protection from such a bid would be to turn around and make an acquisition itself—and therefore, what company would be a more logical takeover candidate than a company that is already partially owned by the outside beneficial owner?
On the other hand, you’ll pay less attention to durable goods orders, the consumer price index, the trade deficit, and whether Alan Greenspan might have gotten up on the wrong side of the bed this morning before he presided over the Federal Reserve’s Open Market Committee meeting. You would be more interested in the fact that WMS Industries has announced that it will spin off its three Puerto Rico hotel/casinos as a separately trading company because you will have noted a takeover wave in the hotel/casino industry. Therefore, while the TV talking heads are wringing their hands over what Greenspan may or may not do, you’ll be more interested in the possibility that the WMS spinoff might become a takeover target once the hotel/casinos are trading separately as a “pure play.” (It did.) You will also begin to realize that if Rexel S.A. plans to make a takeover bid for Rexel Inc., it will make the bid whether or not housing starts were up last month, and it won’t matter to Rexel S.A. if Apple Computer missed its earnings estimates by a penny. And you will know that Rexel S.A. is not going to scratch its takeover plans because some market strategist who has been bullish before now believes we may be headed for a 10 percent correction. The superstocks you’ll be tracking will be marching to their own drummers, and you’ll pay less attention to what “the market” is doing and more attention to the stream of information and scattered clues and evidence that directly impact the themes, trends, and specific superstocks you’re tracking.