We say that profits exhibit mean reversion silver

This preview shows page 51 - 53 out of 84 pages.

We say that “profits exhibit mean reversion” Silver lining to dark cloud (low profit will increase as firms exit the industry) Discussion: If profits recover, what does this say about EVA ® adoption? Reversion speed is 38% per year. So, if profits are 20% above the mean one year, in the next year they will be only 12.4% above the mean, on average. Indifference principle The ability of assets to move from lower- to higher-valued uses is the force that moves an industry toward long-run equilibrium. Definition: If an asset is mobile, then in long-run equilibrium, the asset will be indifferent about where it is used; that is, it will make the same profit no matter where it goes. Compensating wage differentials Wages adjust to restore equilibrium Discussion: Why do embalmers make more than rehabilitation counselors? Discussion: Give example of a compensating wage differential.
Is there a compensating marriage differential -- are women compensated for the relatively unpleasant task of marriage? (HINT: what happens to women’s income when they divorce?) (HINT: what happens to women’s happiness when they divorce?) Finance: risk vs. return Proposition: In equilibrium, differences in the rate of return reflect differences in the riskiness of the investment, e.g. risk premium o Expected return = (E[P t+1 ] - P t )/P t The higher return on a risky stock is known as the risk premium In equilibrium, differences in the rate of return reflect differences in the riskiness of an investment. Risk premia are analogous to compensating wage differentials: just as workers are compensated for unpleasant work, so too are investors compensated for bearing risk Stock volatility and returns DISCUSSION: VIX measures volatility. Why does higher volatility lead to lower stock prices? (HINT: investors must be compensated for bearing risk) Historical equity risk premium Gov’t bonds are considered risk-free, they return 1.7% while stocks return 6.9%. The difference is a risk premium that compensates investors for holding the more risky stocks. Monopoly (different story, same ending) Definition: A monopoly firm is one that faces a downward sloping demand curve. o They produce a product or service with no close substitutes; they have no rivals; and there are barriers to entry, so no other firms can enter the industry. Proposition: In the very long run, monopoly profits are driven to zero by the same competitive forces. o Entry makes demand more elastic (P- MC)/P=1/|e|, which forces price back down towards MC. Example: 1983 Macintosh was priced very high when it first appeared. Eventually, though, Windows copied the OS, and price was forced back down. Alternate intro anecdote In 1924, Kleenex tissue was invented as a means to remove cold cream. After studying customer usage habits, however, the manufacturer (Kimberly-Clark) realized that many customers were using the product as a disposable handkerchief.

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture

  • Left Quote Icon

    Student Picture