The Value of a Bond

A bond is a contract in which a borrower agrees to pay the bondholder (the lender) a stream of money. For example, a corporate bond (a bond issued by a corporation) might make “coupon” payments of $100 per year for the next ten years, and then a principal payment of $1000 at the end

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The Net Present Value Criterion for Capital Investment Decisions

One of the most common and important decisions that firms make is to invest in new capital. Millions of dollars may be invested in a factory or machines that will last—and affect profits—for many years. The future cash flows that the investment will generate are often uncertain. And once the factory has been built,

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Adjustments for Risk

We have seen that a risk-free interest rate is an appropriate discount rate for future cash flows that are certain. For most projects, however, future cash flows are far from certain. At our electric motor factory, for example, we would expect uncertainty over future copper prices, over the future demand and the price of

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Investment Decisions by Consumers

We have seen how firms value future cash flows and thereby decide whether to invest in long-lived capital. Consumers face similar decisions when they pur­chase durable goods, such as cars or major appliances. Unlike the decision to purchase food, entertainment, or clothing, the decision to buy a durable good involves comparing a flow of

Investments in Human Capital

So far, we have discussed how firms and consumers can decide whether to invest in physical capital—buildings and equipment, in the case of firms, and durable goods such as cars and major appliances, in the case of consumers. We have seen how to apply the net present value rule to these decisions: Invest when

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Intertemporal Production Decisions— Depletable Resources

Production decisions often have intertemporal aspects—production today affects sales or costs in the future. The learning curve, which we discussed in Chapter 7, is an example of this. By producing today, the firm gains experience that lowers future costs. In this case, production today is partly an investment in future cost reduction, and the

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How Are Interest Rates Determined?

We have seen how market interest rates are used to help make capital invest­ment and intertemporal production decisions. But what determines interest rate levels? Why do they fluctuate over time? To answer these questions, remember that an interest rate is the price that borrowers pay lenders to use their funds. Like any market price,

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General Equilibrium Analysis

So far, our discussions of market behavior have been largely based on partial equilibrium analysis. When determining the equilibrium prices and quantities in a market using partial equilibrium analysis, we presume that activity in one market has little or no effect on other markets. For example, in Chapters 2 and 9, we presumed that

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Efficiency in Exchange

We begin with an exchange economy, analyzing the behavior of two consum- ers who can trade either of two goods between themselves. (The analysis also applies to trade between two countries.) Suppose the two goods are initially allocated so that both consumers can make themselves better off by trading with each other. In this

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Equity and Efficiency

We have shown that different efficient allocations of goods are possible, and we have seen how a perfectly competitive economy generates a Pareto efficient allocation. But there are many Pareto efficient allocations, and some are likely to be more fair than others. How do we decide what is the most equitable alloca- tion? That

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Efficiency in Production

Having described the conditions required to achieve an efficient allocation in the exchange of two goods, we now consider the efficient use of inputs in the production process. We assume that there are fixed total supplies of two inputs, labor and capital, which are needed to produce the same two products, food and clothing.

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The Gains from Free Trade

Clearly there are gains from international trade in an exchange economy. We have seen that two persons or two countries can benefit by trading to reach a point on the contract curve. However, there are additional gains from trade when the economies of two countries differ so that one country has a comparative advantage

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An Overview—The Efficiency of Competitive Markets

Our analysis of general equilibrium and economic efficiency is now complete. In the process, we have obtained two remarkable results. First, we have shown that for any initial allocation of resources, a competitive process of exchange among individuals, whether through exchange, input markets, or output markets, will lead to a Pareto efficient outcome. The

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Why Markets Fail?

We can give two different interpretations of the conditions required for effi­ciency. The first stresses that competitive markets work. It also tells us that we ought to ensure that the prerequisites for competition hold, so that resources can be efficiently allocated. The second stresses that the prerequisites for competi­tion are unlikely to hold. It

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Quality Uncertainty and the Market for Lemons

Suppose you bought a new car for $20,000, drove it 100 miles, and then decided you really didn’t want it. There was nothing wrong with the car—it performed beautifully and met all your expectations. You simply felt that you could do just as well without it and would be better off saving the money

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Market Signaling

We have seen that asymmetric information can sometimes lead to a lemons prob- lem: Because sellers know more about the quality of a good than buyers do, buy- ers may assume that quality is low, causing price to fall and only low-quality goods to be sold. We also saw how government intervention (in the

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Moral Hazard

When one party is fully insured and cannot be accurately monitored by an insurance company with limited information, the insured party may take an action that increases the likelihood that an accident or an injury will occur. For example, if my home is fully insured against theft, I may be less diligent about locking

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The Principal–Agent Problem

If monitoring the productivity of workers were costless, the owners of a busi­ness would ensure that their managers and workers were working effectively. In most firms, however, owners can’t monitor everything that employees do—employees are better informed than owners. This information asymmetry creates a principal-agent problem. An agency relationship exists whenever there is an

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Managerial Incentives in an Integrated Firm

We have seen that owners and managers of firms can have asymmetric informa­tion about demand, cost, and other variables. We’ve also seen how owners can design reward structures to encourage managers to make appropriate efforts. Now we focus our attention on firms that are integrated—that consist of several divisions, each with its own managers.

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Asymmetric Information in Labor Markets: Efficiency Wage Theory

When the labor market is competitive, all who wish to work will find jobs for wages equal to their marginal products. Yet most countries have substantial unemployment even though many people are aggressively seeking work. Many of the unemployed would presumably work for an even lower wage rate than that being received by employed

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