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ECONOMIC FOUNDATIONS OF FINANCE9

ACC08/FMS01

LECTURES

Financial Management Part 1

Economic Foundation of Financial

Management

Topical ObjectivesAt the end of this section, you are expected to :

1. Review relevant microeconomic concepts;

2. Review relevant macroeconomic concepts; and

3. Identify the Green regulations affecting doing business.

Why study microeconomics?Understanding these concepts enables analysts to differentiate

among various companies on an individual level, and to

determine their attractiveness for an investor

Elasticity

-a concept related to the equilibrium between demand and

supply

-measures the dependency between demand and supply and theimpact of changes in either on the equilibrium price level.

Law of Supply and Demand

Demand curve is downward sloping to the right: the

quantity demanded is increasing as price is decreasing

Supply curve is upward sloping to the right: the

quantity supplied is increasing as price is increasing

Differentiate between movement along the curve and

shifting curve

Gems

I am notafraid of

storms, for I am

learning how to

sail my ship.-Louisa May

Alcott (1832-1888)

ECONOMICS

comes from the combinedGreek words oikos(house) and nomos(custom or law)
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ACC08FINANCIAL MANAGEMENT PART 1


Factors that increase (decrease) demand for goods

Increase the Demand for Goods Decrease the Demand for Goods

A risein the number of consumers in the

marketA risein consumer income

A risein the price or declinein availability

the substitute

Afallin the price of a complementarygood

A risein the expected future price of the

good

Changes in consumer preferences

Changes in distribution of consumer

income

Afallin the number of consumers in the

market

Afallin consumer income

Afallin the price or increase in availability

the substitute

A rise in the price of a complementarygood

Afall in the expected future price of the

good

Changes in consumer preferences

Changes in distribution of consumer

income

Factors that increase (decrease) supply of goods

Increase the Supply for Goods Decrease the Supply for Goods

A fall in the resource price used in

producing the good

A technological change allowing cheaper

production

Favorable weather, political factors, etc.

A reduction the taxes

A rise in the resource price used in

producing the good

A technological change allowing cheaper

production

Unfavorable weather, political factors, etc.

An increase in the taxes

Short- vs. long-run equilibrium

Short-run Equilibrium Long-run Equilibrium

Short run is a time period where the decision

makers could not fullyadjust to market

changes ; one can alter only the labor and

raw materials, but with existing plant and

equipment

Short-run equilibrium:

a balance between amount supplied andamount demanded

Long run is a time period of sufficient length

to enable decision makers to adjust fullyto

market changes

Long-run equilibrium:

a balance between amount supplied andamount demanded

+ opportunity cost of producing the product

must equal to the market price

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Price elasticity of demand

Total expenditures and Price Elasticity of Demand

Downward sloping demand curve means that the quantity demanded will be lower if the

price increasesTotal expenditures/revenue = Price x Quantity

? = x

? = x

Demand is Expenses change as Price

changes

Revenues change as Price

changes

Inelastic (0 -> 1) Same direction Same direction

Elastic ( > 1) Opposite Direction Opposite DirectionUnitary ( = 1) Constant Constant

Price Elasticity of Supply

Same concept as demand elasticity

Marginal Benefit vs. Marginal Cost

Definitions

Marginal BenefitBenefit that an individual gets from consuming an additional unit of

good or service. However each additional unit consumed results in smaller marginalbenefit and results in diminishing returns.

Marginal BenefitCost of producing an additional unit of output; also referred to as

opportunity cost.

Important concepts

1. Demand measures the benefit from consuming an additional good (benefit measured as the

willingness to pay for the extra good).

2. Demand measures the marginal benefit.

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3. Supply measures the cost of producing an additional good.

4. Supply measures the marginal cost.

5. We want an activity to continue to take place as long as the marginal benefit is higher than

the marginal cost.

Consumer surplus

Consumer Surplus is the difference between total value consumers place on a good produced less

the amount paid

Producer surplus

Producer Surplus is the difference between the price received for each good produced and the

opportunity cost of producing the good.

Price Takers Vs. Price Searchers

Price takers must take the market price in selling their product, because each price takers

output is small relative to total market

Price searchers have a downward sloping demand curve for their product. The amount they

are able to sell is inversely related to the price they charge

Market Structures

The market environment influences the price a firm can demand for its goods or services.

Among the most important of these market forms are monopoly and perfect competition,

although monopolistic competition and oligopoly are also covered.

Price Taker Market Characteristics

All firms are producing an identical product

A large number of firms exist in the market

Each firm supplies only a very small portion of total amount supplied to the market

No barriers limit the entry or exit of firms in the market

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Price, Marginal Revenue, And Elasticity For AMonopolyThe profit maximizing output for a monopolist iswhere MR = MC.Monopolists want to maximize profits, not price.Monopolists areprice searchers and haveimperfect information regarding market demand.

They must experiment with different prices to findthe one that maximizes profit.

Oligopoly marketsIt is competition among the fewThere are two conflicting tendencies:Strong incentive to collude among them tomaximize the joint profit, butalso strong incentive to cheat secretly on thecollusive agreement in order to increase its share

of the joint profitCartel: an organization of sellers designed to

coordinate supply decisions so that the joint profitsof the members will be maximized (e.g.: OPEC)

Monopolies

Characterized by one seller of a specific,

well-defined product that has no good

substitutes. For a firm to maintain its

monopoly position it must be the case that

barriers to entry to the market are high.

Legal Barriers

Natural Barriers: there are large economies of

scale, it means that the average cost of production

decreases as a single firm produces greater and

greater output.

Monopoly Price-Setting Strategies

Single price

Price discrimination.

Monopolistic CompetitionA large number of independent sellers:

Each firm has a relatively small market share, so no individual firm has any significant power

over price.

Firms need only pay attention to average market price, not the price of individual

competitors.

There are too many firms in the industry for collusion (price fixing) to be possible.

Each seller produces a differentiated product.

Firms compete on price, quality, and marketing

Quality is a significant product differentiating characteristic.

Marketing is a must in order to inform the market about a product's (differentiating)characteristics.

Low barriers to entry.

Their demand curves are highly elasticbecause competing products are perceived by

consumers as close substitutes.

Oligopoly

A small number of sellers.

Interdependence among competitors

Significant barriers to entry which often

include large economies of scale.

Products may be similar or differentiated.Oligopolists are highly dependent upon the

actions of their rivals when making business

decisions.

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Monopolistic Competition

MR= MC, but due to low barriers to entry, competitors will enter the market in pursuit of

these economic profits.

After new firms have entered the market, the demand curve faced by each individual firm

down to the point where price equals average total such that economic profit is zero.

Efficiency of monopolistic competition is unclear increased information vs. increased costs

Macroeconomics Concepts

Macroeconomic concepts that have an impact on all firms in the same environment, be it a

country, a group of related countries, or a particular industry.

Topics covered concepts about the business cycle, and how to forecast changes in the business

cycle and the impact on, among other things, price levels and profitability.

The Business Cycle

In the past, ups and downs have

often characterized aggregate business

activity.

Despite these fluctuations, there has

been an upward trend in real GDP in

the United States and other industrial

nations.

What is Inflation?

The Rate of Inflation is calculated as:

Inflation = Last years price index - This years price index * 100

rate Last years price index

Inflation is an increase in the general level of prices.

High rates of inflation are almost always associated with substantial year-to-year swings in

the inflation rate, making them difficult to forecast accurately.

Aggregate Demand for Goods & Services

Aggregate demand (AD) curve:

indicates the various quantities of domestically produced goods & services that purchasers

are willing to buy at different price levels .

TheAD curve slopes downward to the right, indicating an inverse relationship between the

amount of goods & services demanded and the price level.

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Short-Run Aggregate Supply (SRAS)

SRAS indicates the various quantities of goods and services that domestic firms will

supply in response to changing demand conditions that alter the level of prices in the

goods and services market.

SRAS curve slopes upward to the right.

The upward slope reflects the fact that in the short run an unanticipated increase in the price

level will improve the profitability of firms.

Firms respond to this increase in the price level with an expansion in output.

In the short-run, firms will expand

output as the price level increases

because higher prices improve profit

margins since many components of costs

will be temporarily fixed as the result of

prior long-term commitments.

The SRAS shows the relationshipbetween the price level and the quantity

supplied of goods & services

Long-Run Aggregate Supply (LRAS)

LRAS indicates the relationship between the price level and quantity of output after decision

makers have had sufficient time to adjust their prior commitments where possible.The LRAS curve is vertical.

LRAS is related to the economy's production possibilities constraint. A higher price level does

not loosen the constraints imposed by the economy's resource base, level of technology, and the

efficiency of its institutional arrangements.

In the long-run, a higher price level

will not expand an

economys rate of output. Once

people have time to adjust their

long-term commitments, resourcemarkets (and costs) will adjust

to the higher levels of prices and

thereby remove the incentive

of firms to continue to supply a

larger output.

An increase in theprice level will increase

the quantity suppliedin the short run.

Change in price level

does not affect quantitysupplied in the long run.

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An economysfull employment rate of output (YF), the

maximum output rate that is sustainable, is determined by the

supply of resources, level of technology, and the structure of the

institutions, factors that are insensitive to changes in the price

level. Hence the vertical LRAS curve.

Aggregate Demand Curve

Other things constant, a lower price level

will increase the wealth of people holding

the fixed quantity of money, lead to lower

interest rates, and make domestically

produced goods cheaper relative to foreign

goods.

Monetary sector of an

economy

It examines the functions of money and how it is created, highlighting the special role of the

central bank within an economy. Supply and demand for resources, such as labor and capital,

and goods are strongly interrelated.

Describes circumstances when this may lead to inflation and the transmission mechanisms

between the monetary sector and the real part of the economy.

Four Main Economic Functions of Depository Institutions

Create liquidity - using the funds from (short-term) deposits to make (longer-term) loans.

Be a financial intermediary - lower the cost of funds for borrowers.

Monitor the risk of loans.

Pool the default risks of individual loans.

Money Creation And The Multiplier Effect

A bank is only required to hold a fraction of its deposits in reserve. Deposits in excess of

the required reserve (excess reserves) may be loaned. The required reserve ratio is usedto measure the, reserve requirement.

Multiplier effect - process of re-lending, re-spending, and depositing.

Goals of Reserve

Inflation targeting - Keep inflation low by managing the money supply.

A reduction in the price level willincrease the quantity of goods &services demanded.

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Promote economic growth and full employment.

The 3 Tools the Monetary Board Uses to Control the Money Supply

1. Reserve requirements: a percent of a specified liability category (for example transaction

accounts) that banking institutions are required to hold as reserves against that type of

liability.

When the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks

allowing them to extend additional loans, expanding the money supply.

Raising the reserve requirements has the opposite effect.

2. Open Market Operations: the buying and selling of securities (national debt in the form of bonds)

by the BSP.

This is the primary tool used by the BSP.

BSP buys bonds the money supply expands:

bond buyers acquire money

bank reserves increase, placing banks in a position to expand the money supply through theextension of additional loans.

BSP sells bonds the money supply contracts:

bond buyers give up money for securities

bank reserves decline, causing them to extend fewer loans.

3. Discount Rate: the interest rate the Fed charges banking institutions for borrowed funds.

An increase in the discount rate decreases the money supply (restrictive)because it discourages

banks from borrowing from the Reserve to extend new loans.

A reduction in the discount rate increases the money supply (expansionary)because it makes

borrowing from the Reserve less costly.Households either consume (spend) or save their incomes.

Demand for money is largely determined by interest rates.

The opportunity cost of holding money (cash balances) is the interest rate.

Supply of money - determined by the central bank

Is independent of the interest rate. This accounts for the vertical (perfectly inelastic) supply

curve.

Real money supply - the money supply in terms of constant purchasing power.

Interest Rate Determination

To decrease (increase) short-term interest rates the Central Bank can do so by buying

(selling) securities in the open market.

The cash paid (received) for the securities increases (decreases) the real money supply and

bank reserves, which leads to a further increase (decrease) in the real money supply as banks

make loans based on the increase (decrease) in excess reserves. This shifts the real money

supply curve to the right (left).

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There is now excess (less) supply of money balances. To reduce (increase) their money

holdings, firms and households buy (sell) securities, increasing (decreasing) securities prices

and decreasing (increasing) interest rates until the new equilibrium interest rate is

achieved.

Inflation And Prices

Inflation is a persistent increase in the price level over time.

Erodes the purchasing power of a currency.

Unchecked, inflation ultimately can destroy a country's monetary system, forcing individuals

and businesses to adopt foreign money or revert to bartering physical goods.

If inflation is present, the prices of almost all goods and services are increasing.

Demand-pull vs. Cost-push InflationDemand-pull inflation - results from an increase in aggregate demand; can result from an

increase in the money supply, increased government spending, or any other cause thatincreases aggregate demand.

Cost-push inflation - results from a decrease in aggregate supply; can also result from an initial

decrease in aggregate supply caused by an increase in the real price of an important factor of

production, such as wages or energy.

If the decline in GDP brings a policy response that stimulates aggregate demand so output

returns to its long-run potential, the result would be a further increase in the price level.

Fiscal Policy, Budget Deficits, And Budget Surpluses

Fiscal policy - refers to the federal government's use of spending and taxation to meet

macroeconomic goals.

The federal budget is said to be balanced when tax revenues equal federal government

expenditures. A budget surplus occurs when government tax revenues exceed expenditures,

and a budget deficit occurs when government expenditures exceed tax revenues.

Taxes are increased and/or government spending reduced during inflationary periods, and

taxes are decreased and/or government spending increased during recessionary periods.

Multiplier Effect

Changes in government spending, taxation, or both have magnified effects on aggregate

demand.The multiplier effect applies equally to increases and decreases in government spending and

increases and decreases in taxes.

The government purchases multiplier is greater than the tax multiplier making the balanced

budget multiplier positive.

An increase (decrease) in government spending coupled with an equal increase (decrease) in

taxes will tend to increase (decrease) aggregate demand.

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Environmental (green) policies and their implications for the

management of the economy and the firm

The Materials Balances Model

Using the materials balance model adapted from Kneese, Ayresand DArge (1970) (Thomas,

2010) (Figure 1.0), the relationship between the natural environment and the economic decision

making activities of the firm can be seen1:

Natural resources drawn from

Nature Residuals from Production

Residuals from

Consumption

Recovery, recycling, reuse

Figure 1.0 Nature and the Market

Production and consumption produce residuals that can damage the environment from which

resources are drawn. It appears that not only desirable goods are provided

in the free market. But the existence of environmental pollution (residualsproduction) causes market failures such as externalities and public goods.

The externality theory

suggests that

environmental problems

cause market failure since

they are caused outsidethe market process. Recall

that one of the barriers

cited for the investor is the

failure to internalize

environmental costs andbenefits into the market

model.

On the other hand,

1The figures in bold typesetting are the components in the market where the main activities are production and consumption.The

relationships among them were no longer included in the diagram.

Households Firms

Nature

Outputmarket

Factor

market

Market Failure by Externalities

-Civil /class action

-Making it punishable by law

-Education

-Taxes or Subsidies

Tragedy of Commons-limitation of amount of common good

available for use (use of P _ _ _ _ _S)

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environmental quality is considered a public good because of its non-rivalness and non-

excludability characteristics. The failure rests on the difficulty of identifying the market demand

which is represented by the willingness to pay of consumers. This difficulty is caused by the fact

that consumers preferences for environmental quality provision are unrevealed.

The Philippine ExperienceLegal Basis1. P.D. 1151 Philippine Environmental Policy (1977)

2. Renewable Energy Act (2008)

In December of 2008, then President Gloria M. Arroyo signed into law the Republic Act 9513 Renewable Energy(RE) Act of 2008-an act promoting the development, utilization, and commercialization of renewable energyresources and for other purposes.

Its targets were, for the Philippines, (Perez, 2009):

to be the No.1 geothermal producer in the world

to be the No.1 wind power producer in the Southeast Asia to double its hydro capacity by 2013

to expand contribution of biomass, solar, and ocean energy by 250 MW

The Philippines has an abounding potential for generating energy from renewable resources (Perez, 2009):

Geothermal resource: 1,200 MW

Wind: 700 MW

Solar: no potential estimate which depends on solar panels put up (but currently the largest solarmanufacturing hub in Southeast Asia producing 400 MW)

Hydro: 1,784 MW from 888 sites

Biomass (bagasse): 235 MMBFOE

Amidst the so-called abundance of this Philippine potential for renewable energy, about 50% of its powergeneration still comes from non-renewable sources (i.e. coal (26%) and oil (23%)) (Department of Trade andIndustry, 2009). DTI has forecasted that with growing industrial demand, the country will still require 4,000 to4,350 MW for sustainability (Department of Trade and Industry, 2009).

In economic theory, when there is potential demand, entrants will soon be attracted to the market to providesupply.

3. Other Environmental Laws in the Philippines

Republic Act No. 7394

The Consumer Act of the Philippines


Code of Conduct and Ethical Standards for

Public Officials and Employees.


Petroleum Act of 1949

Presidential Decree No. 972

Coal Development Act of 1976


Atomic Energy Regulatory and Liability Act of

1968

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Department of Energy Act of 1992


Strategic Environmental Plan (SEP) for PalawanAct


Grants a franchise for an electricity system for

the Municipality of Tumauini, Isabela.


Philippine Clean Air Act of 1999

Republic Act 8550

The Philippine Fisheries Code of 1998


An Act to Address the National Water Crisis


Provides penalties for improper disposal of

garbage and other forms of uncleanliness.


The Revised Coast Guard Law of 1974


Established a program phasing-out tetraethyllead (TEL) in gasoline.


Establishes small-scale mining as a new

dimension in mineral development


Amends section eighty of the Revised Philippine

Forestry Code (PD 705)

Presidential Decree No. 1160Gives authority to Barangay Captains to enforce

Pollution and Environmental Control Laws

DENR Memorandum Circular No. 06, June 4, 1992

Covers the implementation of Project CARE

Activities After Species Adoption by Each

Barangay, Municipality, City and Province

Executive Order No. 15

Created the Philippine Council for Sustainable

Development

DENR Administrative Order No. 91-24

Shift in Logging from the Old Growth (Virgin)Forests to the Second Growth (Residual) Forests.


Provides for the exploration, exploitation,

utilization and conservation of coral resources.

REPUBLIC ACT NO. 9147

Wildlife Resources Conservation and Protection

Act.


The Ecological Solid Waste Management Act

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Economic Foundation of Financial Management1

The Philippine Experiencethe sad truth legally speakingRead: An excerpt from LEGAL MARKETING OF ENVIRONMENTAL LAW: THE PHILIPPINES EXPERIENCE by OPOSA,ANTONIO A. JR delivered in the FOURTH INTERNATIONALCONFERENCE ON ENVIRONMENTAL COMPLIANCE AND ENFORCEMENT

2 PRINCIPLES OF EFFECTIVE ENVIRONMENTAL LAW IMPLEMENTATION

If one carefully examines the innumerable provisions of formal and informal laws (i.e. statutory and traditional or customary laws), the potential fcreativity to make sustainable development work effectively is contained in or in-between the very lines of the Law. Voluntary compliance is morsocially desirable than coerced compliance. Put a little differently, the best form of law enforcement is that where the law does not need to beenforced. In the course of years of environmental law practice, both in the public interest and private sectors, the author has identified severalprinciples of effective environmental law implementation.

First, recall that a law is an agreement of minds, a social contract. As an agreement, the participants must fully understand and appreciate thereason behind . and the need for . the law. In legal language, this is the Ratio Legis, the reason for the law. In sociological terms, this is the .socproduct. and the .common good. which the law seeks to promote. And voluntary compliance is possible only when those whose conduct is sougto be regulated or modified fully understand the reason for the law and appreciate its value. If their understanding is secured that the socialproduct and policy are desirable, then their mental and emotional .agreement. is reached. In addition, the body politic must also participate in thmaking of the law. When the social policy is generally agreed upon, there is consensus, a characteristic mode of reaching an agreement in Asiansocieties. Then, the law is nothing more than the informal agreement formally crystallized into words.

Second, legal marketing, or selling the law, may be used to promote voluntary compliance. The legitimacy and effectiveness of a law is in largepart dependent on publicizing the law. As ordinary marketing sells a product; law sells a mode of conduct. Thus, in like manner that activemarketing, advertising and promotions are techniques used to sell a consumer product, so must creative marketing use proactive methods to .sthe social good and the mode of conduct desired.

Third, the manner of implementing the law must be socio-culturally sensitive. It must take into account the social and cultural characteristics of thpeople who are the target market of the law. This is particularly true in situations and countries and regions that may have some commonalties intheir socio-cultural traits such as Asia.

Fourth, the law must contain an aspect of punishment in order to modify behavior and serve as a deterrent. That is, people must be aware thatdeviating from the conduct which promotes social good carries a penalty. Penal law must, however, be reserved only for the hard-headed.

And it is effective as a deterrent if, and only if, its application is swift, painful and public. Human conduct is such that it responds to the stimuli ofpleasure and pain. To promote behavior, therefore, it must promise a pleasure, and to discourage it, it must present the possibility of extremepain.

Technically, the term used is .incentives-and-disincentives.. It is also called the .carrot and- stick. market-based incentives (MBIs). For thisdiscussion, however, a more graphic term shall be used: .candies-and-needles.. Candies are so irresistible that unless one has severe dietaryrestrictions, it is generally accepted, taken and ingested. On the other hand, the prospect of a sharp and long needle being pierced into onesflesh is so squirmingly painful by its mere appearance that one would generally not want to tangle with it. The following will illustrate someapproaches and examples by which the candies-and needles technique may be applied to address environmental law non-compliance.

3 CANDIES AND NEEDLES APPLIEDIn the application of this approach, care must be taken to consider the socio-cultural characteristics of the target market. Among Filipinos, asamong many Asians, the following cultural attributes are significant:

Highly personal.Filipinos are a highly personal people. They would rather .talk things over. than issue or receive written orders. When peoplehave problems with one another, they are more inclined to approach the person concerned.

Debt-of-gratitude. One value the people hold dear is the debt-of-gratitude. When a favor is owed, it is the source of great shame when one willrefuse to requite it.

Face value sanction. .Loss of face. is a sanction of the highest order, higher than ordinary legal sanction. A man can pay a big fine quietly and

be done with it. But even a small fine if well-publicized will inflict much greater pain. And the pain extends not only to one.s self but also to his

family. Thus, the sanction is imposed also on the strongest social tie and ultimate psychological crutch of the wrongdoer. It is so painful, one

would not even want to think of it.

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Economic Foundation of Financial Management2

Samples of Environmental Policy Statement

http://www.environcorp.com/img/media/ISOpreview.pdf

http://www.environmentalpolicy.org.uk/statement.html

http://www.adb.org/documents/policies/environment/default.asp?p=policies

The Board of Directors' approved the Environment Policy R-Paper on 8 November 2002. The Environment Policy representsthe culmination of two years of extensive consultations with internal and external stakeholders, including a Board seminar,country workshops, and several rounds of inter-departmental review. It also incorporates comments and suggestions made byBoard members during the Board discussion of the Environment Policy working paper in April 2002.

The Environment Policy has been prepared to address five main challenges:1. the need for environmental interventions to reduce poverty2. the need to mainstream environmental considerations into economic growth and development planning

3. the need to maintain regional and global life support systems4. the need to work in partnership with others5. the need to further strengthen the processes and procedures for addressing environmental concerns in ADB's own

operations

The Policy highlights a number of areas that require attention in ADB's environmental assessment process. It addresses theneed for more upstream environmental assessment at the level of country programming, the need for more structuredconsultation in the conduct of environmental assessments, the need for greater emphasis on monitoring and compliance withenvironmental requirements during project implementation, and finally the need to view environmental assessment as anongoing process rather than a one-time event.

References

Varian, Hal, Intermediate Microeconomics, 3rd ed., 1993, W.W. Norton and Company, Inc.

Dornbusch, Rudiger and Fisher, Stanley, Macroeconomics, 7th ed., 1998, Mcgraw-Hill

Publishing Company (earlier editions are also acceptable)

CFA institute materials
http://www.environcorp.com/img/media/ISOpreview.pdfhttp://www.environmentalpolicy.org.uk/statement.htmlhttp://www.adb.org/documents/policies/environment/default.asp?p=policieshttp://www.adb.org/documents/policies/environment/default.asp?p=policieshttp://www.environmentalpolicy.org.uk/statement.htmlhttp://www.environcorp.com/img/media/ISOpreview.pdf

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