Professor Paul Palley's
          Economics Seminars

Here is an interesting column to read about the limits of behavioral economics as the sole explanatory approach to many problems.

We would expect that higher gasoline prices lead people to want to live closer to work. This fact would have a real impact on the housing market. If you are interested, see this link for a paper produced by the Federal Reserve about this topic and result: http://www.federalreserve.gov/pubs/feds/2010/201036/201036pap.pdf

In an effort to better understand decision-making by both businesses and consumers, especially in the wake of the recession and economic crisis that started in 2007-08, economists have increasingly sought to better understand just how rational we are. The evidence increasingly shows that people can behave in ways that contrast with rational decision-making. This paper produced by economists and the Federal Reserve focuses on consumer decision-making: http://www.federalreserve.gov/pubs/feds/2010/201025/201025pap.pdf

Paul

Efforts to maximize profits over time focus on increasing revenues and reducing the cost of doing business. The ability of a firm to increase revenues will depend either on the ability of the firm to increase the demand for their product (outward shift of the demand curve), or to realize greater revenues due to a change in the price of the product (this depends on the price elasticity of demand). Invariably, the market structure within which the firm competes will also greatly impact the ability of a firm to enhance its profits. On the other hand, efforts to reduce the average costs associated with producing a product depends on the ability of a firm to more effectively utilize its resources or to employ new technology to increase productivity.

All firms maximize their profits when they produce a level of output where the marginal revenue equals the marginal cost. The logic is as follows; as long as the marginal revenue exceeds the marginal cost then the additional revenue that results from producing the next unit of output will exceed the cost associated with producing the next unit of output. As a result, the firm will see its profits increase and it should produce more. It will then produce more, and continue to do so until the marginal revenue equals the marginal cost because every unit of output produced up to this point will lead to greater profits. With this definition established, the next step is to focus on each market structure.

In the case of firms that compete in the pure or perfect competition market structure, the problem of profit maximization is a very difficult one to solve. They are contrained to charging the market price and they participate in a market structure where firms are free to enter at will. Any profits lead to new entants and those profits will then disappear. As a result, these firms will focus primarily on cost control. They look to become more productive as a way to lower their average and marginal costs. The classic example of these firms would be that of farmers. Farmers are largely tied to market prices as they are determined in the commodity markets. You will therefore see them focus on cost management.

Monopolists face the market demand curve because they are the only firm providing the good or service in that market. As a result, on the revenue side of the equation they can focus on the price they charge and also seek to increase demand for their product (outward shift of the demand curve). Adjusting the price they charge will either lead to an increase or decrease in revenues depending on the price elasticity of demand. If demand is price elastic then higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. If demand is price inelastic then higher prices will lead to higher revenues but lower prices will lead to an a reduction in revenues. Many monopolists face a demand curve that is price inelastic (local utilities are a classic example). The other opportunity to increase revenues will be through marketing efforts, the introduction of new products, or by exploiting changes in economic conditions, to enjoy an increase in demand. Then at any given price people will want to buy more of thei firm’s products. Remember also that any change in output will lead to a change in the cost of production. The firm must keep this in mind. If the firm is operating at a point of diminishing returns then the firm’s marginal and average costs will increase as ouput increases. The firm will seek to mitigate this by working to employ new technologies or other means to increase productivity and lower the firm’s marginal and average costs.

Firms who compete in the monopolistic competition market structure face the same opportunities that monopolists do in that they can attack both the revenue and cost sides of the profit equation, but with a very important difference. They have to contend with many more competitors producing similar substitutes leading to a demand curve that is far more price elastic. As a result, higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. The problem with lowering their prices is that competitors can follow suit leading to price wars. The lower prices may also hurt their image in the marketplace. Instead, monoplistic competitors will seek to differentiate themselves from their competitors in order to retain control over the price they charge (restaurants are good examples of this). The cost side is also important because they do face a significant amount of competition and as a result they face a lot of price pressures. They will therefore work to increase productivity to manage their costs. The oligopolist faces the same issues monopolistic competitors face, but the number of competitors is greatly reduced. As a result demand tends to be more price inelastic. The competition among a small group of strong competitors can be very fierce making product differentiation very important.

Think about the firm you work for. How do they maximize profits and what competitive conditions do they face that affect their profit outcomes?

There are differences between the short-run and long-run that have real implications for the productivity of a business’ inputs and the cost of doing business. In order to understand this concept it is important to clarify a few definitions and concepts. Then, understanding these points allows for an appreciation of why a business makes decisions at different points of time related to their workforce and capital. To start, labor encompasses the work force. The capital items owned by a business include plant facilities and equipment. This could include computers and other technology, distribution centers, factories, machines, and many other capital items. In fact, it is the desire by businesses to keep up technological trends that trigger many of the changes to capital most prominently monitored by the press and the public.

The difference between the short-run and long-run is not defined by a set point of time. Instead, the short-run is a period of time in which the composition and amount employed of one of the inputs used in the production process, usually capital, is fixed. On the other hand, in the long-run the composition and amount employed of one of the inputs used in the production process, usually labor, is variable. How long the short-run lasts depends to a great extent on the particular business or industry. For example, restaurants may make investments in new dining fixtures or kitchen equipment every few months as they adapt to new demands from customers, or due to changes the competition makes, or variations in their menu. As a result, the short-run in this case lasts only a few months. On the other hand, Intel spends two or three billion dollars on their factories and retools them only every two or three years. As a result, their short-run lasts two or three years.

Another important concept to consider when comparing the issues businesses deal with evaluating decision-making in the short-run and long-run is the law of diminishing returns. The concept is that as firms add additional units of their variable input to their fixed inputs in the short-run, after some point, the increment to total output will decline. In other words, productivity diminishes. This limitation to productivity demands innovation and investment in order to increase productivity and lower both average and marginal costs. Once a decision is made to alter your productive inputs then we are clearly now reflecting the difference between short-run rigidity and the long-run which permits opportunities for various combinations of inputs and new capital and labor opportunities.

As a result, the fact that the long-run is a period where all inputs are variable indicates that the firm can vary its inputs and make capital investments in order to find the lowest cost way of doing business. Due to this, average and marginal costs will always be lower in the long-run than the short-run. The firm will invest in new software or computer equipment, the factory, a printing press, new robotic equipment, or other capital items because of the increasing productivity and lower costs that result. The smart firms do this proactively as they search for opportunities for continuous improvement and a competitive advantage.

Here are some interesting resources to read about technology on a day by day basis. The Wall Street Journal is a very good resource for daily business news, and it includes a Tech section that is updated throughout the day (see http://online.wsj.com/public/page/news-tech-technology.html). The New York Times also includes a Technology section in their online addition that can be monitored each day (see http://www.nytimes.com/pages/technology/index.html). Both the Wall Street Journal and the New York Times offer good Blogs as well. Google offers an online Sci/Tech link that aggregates news related to science and technology and may serve as a good starting place for you daily reading (see http://news.google.com/news/section?pz=1&cf=all&ned=us&topic=t&ict=ln). Have fun with identifying other good resources that will be interesting to review as you monitor trends related to technology.

Current economic conditions and anticipated future economic conditions affect strategic plans, the prices that firms charge, choices related to investments in labor and capital, and finances. In addition we know that government fiscal and monetary policies can greatly impact the economy. Furthermore, data related to economic indicators including real GDP, interest rates, the prices of goods and services, the unemployment rate, exchange rates, and other variables will be used to support decision-making and the formulation of forecasts. Historical economic data facilitates efforts to evaluate the impact of economic conditions in the past on organizations and as a result makes it easier to understand the impact of forecasts on organizations. Where can someone go to easily obtain this kind of important economic information? In fact, much of this information is available to you free or for relatively little money on the internet.

The internet is a source of a tremendous amount of information for economists and professionals in all fields, including real estate. Data, forecasts, and news related to the real estate and other markets, interest rates, employment, population growth, income, price indices, and consumer confidence are all readily available. Political issues that may affect the economy are monitored and debated online on an ongoing basis. The economy and financial markets are analyzed by economists and other professionals, and their reports are readily available. The list presented below includes excellent sources of information whether you are interested in the global economy or the economy in the United States, or financial markets. Databases available from the United States government, reports and data produced by the Federal Reserve, and business and real estate oriented web sites are also listed. The web sites that I have listed below do not represent a comprehensive list, but should help you get started.

Historical economic data contributes to the understanding of important historical economic events. It also facilitates the analysis of how changing economic trends affect businesses, industries, and investors. Some excellent resources for historical economic data include; the Board of Governors of the Federal Reserve System (http://www.federalreserve.gov/); the Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/); the United States Department of Commerce, Bureau of Economic Analysis (http://bea.gov/index.htm). The United States Department of Commerce provides other very good sources of data including Economics Indicators and Economics Links (https://www.esa.doc.gov/index.cfm). Other very good resources include; the United States Census Bureau (http://www.census.gov/); and the Bureau of Labor Statistics (http://stats.bls.gov/). The National Association of Home Builders makes available data and information related to the national economy, the local and national home building industry, and the prices and availability of building materials (http://www.nahb.com/). Data related to energy issues and energy prices are made available by the United States Department Energy’s Energy Information Agency (http://www.eia.doe.gov/). See also the International Energy Agency (http://www.iea.org/).

After an analyst has completed an analysis of historical economic data, understands the impact of historical economic events, and evaluates the quality of the data, then the analysis of the impact of future adjustments in the economy becomes easier. Excellent resources are available online that provide forecasts of key economic indicators. Some of these resources include the government; the Congressional Budget Office (http://www.cbo.gov/) and the Federal Reserve Bank of Philadelphia Livingston Survey, the oldest continuous survey of economists’ expectations (http://www.philadelphiafed.org/econ/liv/index.html). Industry specific resources include; the Mortgage Bankers Association of America (http://www.mbaa.org/); National Association of Home Builders (http://www.nahb.org/); and the National Association of Realtors® (http://www.realtor.org/). Other online resources that are available include; Global Insight (http://www.globalinsight.com/) and the National Association for Business Economics (NABE) (http://www.nabe.com/).

Given the growing importance of trade on the economy, and the accompanying progression of globalization, it is helpful to review websites focused on global economic conditions and trade. These may include; the World Trade Organization (http://www.wto.org/); the European Union (http://europa.eu.int/); and the European Central Bank (http://www.ecb.int/ecb/html/index.en.html). Other available resources include; the World Bank (http://www.worldbank.org/); International Monetary Fund (http://www.imf.org/external/index.htm); and the Organization for Economic Co-operation and Development (OECD) (http://www.oecd.org/home/0,3305,en_2649_201185_1_1_1_1_1,00.html)

There are also organizations that are dedicated political policy research that includes economic policy and analysis. These organizations make available to readers articles and reports focused on a wide variety of topics including economics and economic data. Reviewing these reports provide perspectives from a variety of economic and political viewpoints. See the Economic Policy Institute (http://www.epinet.org/); Hoover Institution (http://www.hoover.org/); Center for Economic and Policy Research (http://www.cepr.net/); and the Brookings Institution (http://www.brookings.edu/); Heritage Foundation (http://www.heritage.org/); and RGE Monitor, A Roubini Global Economics Service (http://www.rgemonitor.com/).

Firms make a strategic decision to launch a new product, invest in a capital item, or launch a partnership with an eye on its expected profits and return on investment. While it is understood that there are roles for financial professionals and accountants, marketing expertise, and in many cases a lawyer, in evaluating the feasibility of a project, a sound understanding of economics is also important. One effective way to evaluate the feasibility of a new project is through a detailed cash flow analysis that allows the firm the flexibility to evaluate the impact of potential changes in the business climate on the project and the expected internal rate of return generated by the investment. If the project will in all likelihood yield a sufficient return on investment then the firm will make that investment. An example that illustrates the role of economics in this process of evaluating the feasibility of a project follows with a particular focus on the concepts of supply and demand.

The developer of a master planned community can use cash flow forecasts that are flexible enough to evaluate the impact of changing scenarios to make strategic investment decisions. On the revenue side of such a model will be details related to expected sales of new homes and the prices of these homes, and expected sales of commercial parcels and the prices of those parcels. Variations in the rate at which these sales occur and the prices paid for new homes and commercial parcels will affect the developer’s rate of return. The cost side of these models will include the prices paid for the land, financing, planning, engineering, zoning, and legal costs. Other very important variables will include, among others, the cost of constructing infrastructure, building materials, and marketing. We can see the role for economics in the evaluation of each of these revenue and cost items.

The rates of new home sales and the prices of new homes are directly affected by changes in the market for new homes. Demand side factors include; incomes; the mortgage rate; rents, population growth; and expected price increases. A stronger local and national economy leads to greater population and employment growth, higher incomes, and the expectation that home prices will increase. Each of these events leads to an increase on demand for new homes and as a result higher home prices and an increase in the rate of sales of new homes. On the other hand, lower incomes and higher interest rates lead to a decrease in demand and as a result slow the pace at which homes sales will occur. Another important factor affecting this picture is the presence of competing developments in the neighborhood. This increase in supply will adversely affect the developer by reducing the rate at which they can sell new homes and will potentially reduce home price increases or even lead to lower home prices.

The rate of sales and prices paid for commercial parcels will depend on the rate at which new homes and other forms of housing are built in the area. As a result, any factors that affect the demand for homes and the supply of homes will affect the commercial developer. Fluctuations in interest rates will also be an important factor for the commercial developer as higher interest rates increase the costs of financing the construction of shopping centers and office buildings and can adversely affect the feasibility of the development. Higher interest rates will also slow the rate of home building. This will delay the time in which a shopping center or office building will become financially viable.

Expanding these points, the costs associated with financing the purchase of new homes and also the development and construction of a master planned community are greatly affected by fluctuations in interest rates. Interest rates are determined in the money market, and the single most important factor affecting the supply and demand of money is inflation expectations. For example, higher expected rates of inflation lead to an increase in demand for money as borrowers will want to borrow now rather than later. In addition, higher rates of inflation are often associated with a stronger economy, and this strength leads to an increase in demand for money. On the other hand, higher inflation expectations lead to a decrease in supply as lenders would prefer to lend in the future rather than today. The combination of this increase in demand for money combined with a decrease in supply leads to higher interest rates.

The value of a parcel of land depends on the profits that will be generated by the land use. In the case we are looking at here, the land use is the development of a master planned community. That being said, using supply and a demand as a framework for analysis is appropriate. Demand for land by developers and home builders will be dependent on the profits they anticipate and this is a function of the expected revenues produced by the project and the expected costs. The supply side is dictated by existing land owners. Their decision calculation will be based on a cost and benefit analysis; how much will I realize from selling the land versus the cost or in this case opportunity cost based on the return they would earn from using the land for another purpose.

Planning, engineering, legal, and zoning costs are associated very closely with the salaries paid to the professionals who are responsible with for completing these critical tasks. As with the salaries paid to all workers in the labor market, the salaries paid to the engineers, planners, and lawyers are also market determined. The same is also true for the accounting and marketing staff as well. During a strong economy when the demand for labor is increasing. As a result, these professionals will demand higher salaries. On the other hand, during a weak economy the salaries for these professionals will be more static.

In recent years we have seen some very large increases in the cost of infrastructure and building materials. The Bureau of Labor Statistics producer price index data indicates that the price of lumber and wood products increased 16.8 percent in 2004. The price of materials and components for construction increased 8.3 percent in 2004. This contrasts with little real change in these prices during the period of 1998 to 2003 for both the prices of lumber and wood products and materials and components for construction. The price pf construction machinery and equipment increased by 6.2 percent in 2005 when the greatest increase in the period of 1997 to 2004 was 3.5 percent in 2004. Price increases for construction machinery and equipment were in the range of 0.3 percent and 2.1 percent in prior years. The reason for these larger price adjustments were large increases in demand for housing and related construction during the recent housing boom. Plus, globalization facilitates exports of building materials and equipment to the rapidly growing economies of China, India, and other countries. The economic growth in these countries leads to new development and construction projects and an increase in demand for all building materials.

This example illustrates the point that underlying each component in the process of analyzing the financial viability of the development of a master planned community is the concept of supply and demand analysis and economics. The cash flow analysis that is done requires the analyst to project the revenues that will be earned by the development of the master planned community, the costs they will incur, and the resulting profits. The analyst can then calculate the resulting expected internal rate of return generated by the project and determine if it meets the developer’s feasibility standard. The rate at which the development generates revenues and incurs costs, and the amount of profits that result, are dependent on market forces. It is the interaction between supply and demand that leads to the prices, costs, and revenues that then result in the necessary data to facilitate making an investment decision like this.