Investment Lecture 7 New

Economics for CEDNomi Giszpenc Spring 2004 Lecture 5: Micro: Markets and Information Investment and InsuranceMarch 30, 2004

3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*What is investment?Investment means to apply resources in ways that you hope will produce more resources later. Wealth creationAlso necessary to shore up used-up resources--replacement & maintenanceDoes not add to net investment

Economics for CED: Lecture 5, Nomi Giszpenc

3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*How do firms decide to invest?Based on calculation: By the book--will expected returns exceed expected costs by an acceptable margin?A great deal of uncertainty exists about the future: a lot of guesswork involvedBased on confidence: leap in the darkExpectations about what other investors are doing


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*A detour into accountingBasic accounting equation: Assets = Liabilities + EquityCan be seen as a description of capitals Uses and SourcesDifferent (combos of) uses bring different returnsDifferent sources have different costs


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Structure of a balance sheet

AssetsLiabilites and EquityCurrent Assets (cash, A/R, inventory)Current Liabilities (A/P, ST loans)Non-current Assets (Land, plant, equipment)Non-current Liabilities (LT loans, mortgages)Owners Equity & Retained EarningsTotal AssetsTotal Liabilities & Equity


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Uses & sources: returns & costsAnnual costs/returns per $100$ Quantity of fundsInvestment projectsInvestment 1Investment 2Investment 3Investment 40Cost of capital funds


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*4 sources of capitalEquity: creating & selling new sharesPays dividends dependent on performanceDilutes stock of existing shareholdersRetained earnings: internal fundsCheapest & most common sourceBonds: promises to pay interest & principalBuyers of bonds can trade these in marketsBank debt: easier to obtain than bond-buyersMust pay market rate of interest, meet conditions


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Calculating return (5 ways)Total return: good for one-off, immediate & definite return projectsCompare percent difference between returns and costs with market interest ratePayback: useful for comparing similar investments with similar lifetimesHow long will it take for project to cover costs and start earning?What will assets be worth and what will they earn after the payback period?Ex: Farm, office building, bus


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Calculating return: 5 ways (cont.)Accounting rate of returnGood for productive investments with regular returns, analogous to interest ratesDiscounted present value of cash flowFor investments with different patterns of earning over timeThe amount of money that would need to be invested now, at compound interest at current or expected interest rates, to generate the future asset or income.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Calculating return: 5 ways (cont.)Internal rate of returnThe rate of compound interest that would yield the expected return to an investmentDiscounts returns in the future because tied-up capital could be used & earning elsewhereCan be used to compare alternative investments; compare expected returns w/market returns; estimate present value of future returns


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Example: Bonds vs. Pine trees

OutlayAvg. Acctg rate of returnInternal rate of returnPaybackTotal returnPresent value8% bonds$1 m.8%8%Year 9$4.66 m.$1 m.Pine trees$1 m.8%4.9%Year 20$2.6 m.$0.56 m.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Effects of different tax regimesNet profit split between dividends to shareholders and retained earningsRetained earnings lead to investment, growth in share value --> capital gains for shareholdersDifferent taxation of dividends & K gains: can encourage or discourage retentionChosen policy depends on beliefs about how firms, investors choose to invest funds


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Why does investment fluctuate?Lumpy capitalMuch productive building & equipment can be paid for over time but must be acquired all at onceInnovationNew product to be produced or new processExpectationsBetter to invest when strong demand expectedFirms tend to invest when others are investingAcceleration and decelerationIntensifies booms and slumps


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Portfolios of investmentshedge: reduce overall risk by spreading investment over many independent projectsThe word risk from sailors word for steep rock: merchants could lose all their investment in one cataclysmSo they invented insurance


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*What is insurance?To make sure. To remove uncertainty and protect against risk.People prefer certainty: they have an aversion to risk.In particular people would not like to see income (or rather consumption) dip below a certain minimum. Willing to pay to smooth consumption


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Risk, uncertainty, and insuranceEconomists use lotteries to think about uncertain situations:Example 1: say you pay $10 to get:10% chance of winning $10090% chance of losing (winning 0)Example 2: (real life uncertainty --- no charge)5% chance of losing $1,000 in a burglary95% chance of no burglary, so loss = 0Example 3: Plaintiff is injured in an accident and files a lawsuit. She has a70% chance of winning damages of $10,000.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Expected ValueExample 1: EV = .10(100) + .90(0) = $10Note: this lottery is fair, because the cost of the lottery ticket equals the EV of what the buyer will get.Example 2: EV = .05(-1,000) + .95(0) = -$50.Example 3: EV = .70(10,000) = $7,000


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Attitudes toward riskRisk neutral: a risk neutral person is indifferent about fair bets. She doesnt care how much uncertainty she bears. So s/he gets equal utility from having $10 or having a 10% chance of receiving $100 and a 90% chance of receiving 0 (the winnings in example 1).Risk averse: a risk averse person prefers certainty over fair bets. So s/he prefers to have $10 over having the lottery in example 1.Risk loving: a risk loving person prefers fair bets over certainty. So s/he prefers having the lottery in example 1 to having $10.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Utility and Uncertainty: EUUtility in each state is weighted by its probability of occurring; EU is weighted sum.Example 2Suppose the persons initial wealth is W. She faces two possible outcomes:If the burglary occurs, her wealth falls from W to W-1000, and her utility is U(W-1000), which is lower than...If no burglary occurs, and her utility is U(W). Situation (1) occurs with probability .05 and (2) occurs with probability .95.So her expected utility (the expected value of her U) is: EU = .05 U(W-1000) + .95 U(W)


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Expected WealthStill Example 2:The persons expected wealth (or the expected value of her wealth) is: EW = .05(W-1000) + .95 (W) = W 50Risk neutral people act as though they are maximizing their expected wealth.They are indifferent to more/less uncertainty and only care about the expected value of their wealth.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Relationship of wealth to utilityThe slope is the additional utility that individuals receive from an extra dollar of (expected) wealth.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Relationship of wealth to utilityUtility from wealth leads to risk preferencesFor risk neutral people, the slope is constant.This means that they get the same increase in happiness/utility from an additional dollar, regardless of whether they are poor or rich.For risk averse people, the slope declines as W rises. Therefore they get a larger increase in happiness/utility from an additional dollar when they are poor than when they are rich. Because of this, they dont like uncertainty.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Relationship of wealth to utility: risk averse peopleSuppose that instead of W, they have either W+100 or W-100, each with .5 probability. The value of the extra $100 in additional utility is less than the cost in lost utility of losing $100. So they gain less from having an additional $100 than they lose from having $100 fewer dollars.Their utility level when they have W with certainty is U(W), and their expected utility level if they have W+100 or W-100, each with equal probability, is .5U(W+100) + .5U(W-100).So U(W) > .5U(W+100) + .5U(W-100).So if they face uncertainty, they will want insurance.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Relationship of wealth to utilityRisk loving people are the opposite of risk averse people. They get a larger increase in happiness/utility from an additional dollar if they are rich than if they are poor. As a result, they prefer having W+1 or W-1, each with the same probability, to always having W.So U(W) < .5U(W+100) + .5U(W-100).Most people are risk averse.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*A role for insuranceInsurance helps reduce or eliminate uncertainty.Example 2 with burglary insurance:Suppose there are 20 people who face the same risk of losing $1000 with 5% probability. They each put $50 into a cigar box, so $1000 is collected in total.Over the next year, one of them has a burglary and the $1000 is paid to her.So the insurance provides coverage of $1000 for losses in return for a premium of $50/year.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Fair insuranceFair insurance if the insurance premium ($50) just equals the expected value of each insured persons loss, which is ($1000)(.05) = $50. So the insurance company makes zero profit.With the insurance, the person no longer faces uncertainty. She has wealth ofW 50 if no burglary occurs orW- 50 1000 + 1000 = W - 50 if a burglary occurs.So her utility is U(W-50), regardless of whether a burglary occurs or not.Suppose the fair insurance premium is called f.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Risk preferences and premiumsrisk neutral: indifferent between certainty or uncertain situation with same expected wealth, as in the burglary example. Indifferent to fair insurance against the risk: expected wealth EW is W-50, regardlessrisk averse: prefer certainty over uncertain situation with same expected wealth. Better off buying fair insurance.Means that they would be willing to pay more than the fair insurance premium of $50 to get the insurance.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Risk preferences and premiumsrisk loving: prefer uncertainty over facing an uncertain situation with same expected wealth. If offered fair insurance, better off not buying it. Means they would be willing to pay less than the fair insurance premium of $50 to get the insurance.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Risk aversion and willingness to payAssume U= WRisk from example 2: 5% chance of a burglary and loss of $1000.If no insurance, then EU = .05 U(W-1000) + .95 U(W)Initial wealth, W, is $2,000.EU = .05*( 1000) + .95*( 2000) = 44.066 utilsSay person buys fair insurance for a premium of f = $50then her wealth is always $1950 and her utility is:U = (1950) = 44.159 utils (higher)


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Maximum premiumUtility if no insurance is U = 44.06.The maximum insurance premium that she would be willing to pay would leave her with same utility as no insurance: 44.06 utils. Suppose the max insurance premium is denoted m.If she buys insurance for m, then she always will have wealth of 2000 m and her utility will be U = (2000 m) with certainty.So U = (2000 m) = 44.06 and m = $58.15.This is more than the fair insurance premium of $50.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Conclusions on premiumsa risk averse person is better off if she can buy full insurance for a fair premium than if she goes uninsured.a risk averse person is willing to pay more than the fair premium to obtain insurance, so m > f.Note: People can be more/less risk averse. The closer their utility functions are to straight lines, the less risk averse they are and the closer m is to f.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Who buys insurance? Who sells?Risk averse people: willing to buy insurance for more than the fair insurance premium.So selling insurance is profitable. (Selling fair insurance means making zero profit.)So risk neutrals sell insurance to risk averses.Risk neutral people absorb riskbut are made better off: they receive premiums that are higher than the fair level.Risk averse people pay more than the fair insurance premiumbut are better off because they get rid of risk.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Problems w/ storys assumptionsMany insurance buyers w/ identical risks.In our example, all have a 5% chance/year of losing $1000 in a burglary.The law of large numbers allows the insurance company to predict risks very accurately.Insured persons risks of loss independent: one persons probability of a loss unaffected by whether another person has a burglary.Examples of non-independent risks: Burglars who steal from several apartments in a building. Hurricane or earthquake insurance. These risks are positively correlated.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Problems w/assumptions (cont.)No moral hazard. Refers to increases in the probability of an event occurring if it is insured against.Example of moral hazard: people with burglary insurance may become careless about locking their doors.Or, if there is moral hazard, then insurance companies have perfect information.Example: an insured person doesnt lock his door. So his probability of loss rises from 5% to 20%. The insurer observes this and raises the premium from $50 to $200.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Real world insuranceIn actuality, the assumptions for fair insurance arent met.So insurance companies use deductibles and co-insurance to reduce moral hazard.Deductibles: if a loss occurs, the insured person pays the first $100.Co-insurance: if a loss occurs, the insured person pays 10%.Sometimes insurance isnt available, particularly when risks are positively correlated. Example is earthquake insurance, which is only available as a government program. Why?


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Adverse selectionImperfect information sometimes leads to good risks dropping their insurance coverage.Example: there are healthy people with 1% chance of getting a disease and unhealthy people with 5% chance of getting the same disease.People know their types, but insurance companies cant observe individuals types. So it charges all insureds the same premium of .03L, where L is the cost of treating the disease.So the healthy subsidize the unhealthy and this causes some healthy people to drop the coverage.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Adverse selection (cont.)The proportion of unhealthy people in the group of people buying insurance rises. So the insurance company must raise the price of insurance in order to avoid losing money. But the unhealthy people may not be willing to pay the high premium. If so then the insurance disappears completely.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Breakdowns in the systemIf buyer of insurance knows more than seller of insurance, there could be adverse selection or moral hazardIf buyer of labor knows less than sellers, could be group-based discriminationWorks the same way in deciding loansAmong results: redlining (not selling insurance or awarding loans in particular areas or for particular populations)


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Lemons example: used car marketTwo types of used cars: good cars and lemonsSellers know if their used cars are lemons or not.Value of a lemon is L, and value of a good used car is G: G > L.Buyers cant find out if individual used cars are lemons or not. They only know the overall probability of used cars being lemons = p.Buyers willingness-to-pay for used cars is the expected value of a used car: EV = pL + (1-p)G


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Lemons example continuedSellers incentives: keep good cars because G > EVsell lemons because L < EV.Adverse selection makes good used cars disappear.Buyers eventually learn thisso p rises and EV falls. This makes sellers incentives to keep good cars even stronger.The market for used cars turns into a market for lemons only.


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Bankruptcy exampleSuppose a person borrows an amount B and promises to repay B(1+r) next year.Next year, with probability p she will lose her job. In this case, her income falls from Y to Y.Her expected utility without bankruptcy is EU = (1-p)U(Y-B(1+r)) + pU(Y-B(1+r))Introduce bankruptcy: If she files for bankruptcy her debt will be discharged. No obligation to repay from future earnings.Now her expected utility with bankruptcy is EU = (1-p)U(Y-B(1+r)) + pU(Y)


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Bankruptcy example continuedBankruptcy makes borrower better off by partially insuring against job loss.Bankruptcy may cause problems:lenders raise the interest rate on loans, since borrowers who lose their jobs dont repay. This makes those who repay their debts worse off.Bankruptcy is estimated to cost the average debtor who repays $400/yr in extra interest payments.borrowers may work less hard and become more likely to lose their jobs, since the bad outcome isnt so bad (moral hazard).What problems caused w/no bankruptcy laws?


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*Workarounds the breakdownsSignaling (costly)Pay to reveal your type orUndertake activity that is less costly for your type of personExamples: university degrees, resume paperSocial capitalInvestments in reciprocal relationshipsForm of insurance, loan guarantees


3/30/04Economics for CED: Lecture 5, Nomi Giszpenc*More workaroundsConditionality Often imposed by banks(doesnt change underlying motivations)Loan sharksLoan to populations thought to be bad risks and charge high premiumsOften use inside knowledge; sometimes threat of violence


*Stretton p. 441He references Ch. 12 of Keynes General Theory of Employment Interest and Money (1936)*Stretton p. 436 figure 35-1*Stretton 432-3*Stretton pp. 438-9*\Risk\, n. [F. risque; cf. It. risco, risico, rischio, Pg. risco, Sp. riesgo, and also Sp. risco a steep rock; all probably fr. L. resceare to cut off; pref. re- re- + secare to cut; -- the word having been probably first used among sailors. See Section.] 1. Hazard; danger; peril; exposure to loss, injury, or destruction.

a.The danger or probability of loss to an insurer.b.The amount that an insurance company stands to lose.4.a.The variability of returns from an investment.b.The chance of nonpayment of a debt.

*The next bunch of slides is from Economics 118: Law and EconomicsFall 2003Professor Michelle White ( [email protected])http://econ.ucsd.edu/~miwhite/econ118/ --> Lecture 2*Note: the used car market insures sellers of used cars against whether their cars are lemons or not.

Investment Lecture 7 New

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