Unit 11

PRICES AND MARKET DYNAMICS

 Short-run and long-run equilibria

Point A is the short-run equilibrium.

We are holding something constant:
the number of firms in the market.
Firms are earning rents.

The long-run equilibrium (C) is where

a firm’s rent is zero:
P = MC = AC
 Short-run and long-run elasticities

The number of firms is exogenous in the short run, but endogenous in the long run.

This means that supply is more elastic in the long run, as more firms enter production.
 Market dynamics at work: oil prices

Prices reflect scarcity: if a good becomes scarcer (more costly to produce), the supply will
fall and price will tend to rise.
• Peak oil not evident: high prices stimulate further exploration
 Market dynamics at work: oil prices
The short-run fluctuations reflect short-run scarcity:

1. Demand is inelastic in the short run because of the limited substitution possibilities.
2. Supply is inelastic in the short run because
• oil wells are expensive to drill, and their capacity is fixed
• OPEC

A negative supply shock: the percentage increase in price is much larger than the
percentage decrease in quantity.
Assets and asset price
bubbles
 The value of assets
People buy assets for two reasons:
1. To benefit from owning it
2. To be able to sell it later

The value of a financial asset (a security) depends on:

1. the size of the cash flows that it is expected to generate (dividends)
2. the uncertainty in one’s forecasts of these cash flows.
 Bonds
When the stream of payments from an asset is fixed, the price of the asset will be
inversely related to the interest rate it yields.

Bond = A security that promises to pay fixed amount of money at specific intervals.

Ex: The contract stipulates the value in one year is 100.

1) The price of the bond today is 90. The return/interest rate will then be 100/90 = 1.11
= 11%
2) The price of the bond is increased to 95. The return/interest rate will then be 100/95
= 1.05 = 5%
 Stocks
Stocks (shares) = A claim on a part of assets of a firm, and hence on its profits.

Stocks offer no specific promised stream of payments, and the time period over which
payments will be made is not fixed.

Firms expected to generate greater net earnings will have higher valuations = higher
share price.
 Risk
Value of both bonds and stocks depends on uncertainty over its earnings.

• Systematic risk: Events that simultaneously affect broad classes of financial assets.
Undiversifiable.

• Idiosyncratic risk: Events that affect only a given firm/asset. Diversifiable and hence
irrelevant for valuation.
 Managing risk
Assume: 50% risk of rain and profit in good wether to be +15 and in rain -5.
Important concept: Expected Value:
EV = Pr1V1 + Pr2V2 + … + PrnVn
The expected value, EV, is the weighted average of the values of the outcomes,
sum of the product of the probability and the value of each outcome.

Our example: EV = [0.5 *15]+[0.5*(-5)] = 5

Gregg will earn an average of $5 per concert. Not every year, but on average (in
the long run)
 Managing risk
Variance:
2= Pr1(V1 – EV)2 + Pr2(V2 – EV)2 + …)2

Variance, 2: measures the spread of the probability distribution;

probability-weighted average of the squares of the differences between the
observed outcome and the expected value.

Our example: 2 = [0.5 (15-5)2] + [0.5 (-5-5)2] = 100

Problem: we measure the spread squared. If we have SEK, how to interpret

SEK2 ?
 Managing risk
Instead we use:

Standard Deviation:

 = square root of the variance

The standard deviation is another, closely related, measure of risk.

Our example:  = 10

Advantage: Easier to intepret

 Net present value: compounding
Assume you start with 100 and receives 4% interest rate. Thus, at the end of
Year 1, your account contains:
$100  1.04 = $100  1.041 = 104.00

By the end of Year 2, you have:

$104  1.04 = $100  1.04 2 = 108.16

At the end of Year 3, your account has
$108.16  1.04 = $100  1.043 = 112.49
 Net present value: compounding

If we extend this reasoning, by the end of Year t, you have:

$100  1.04t.
General form:

FV = PV  (1 + i )t .

Where FV = Future value, PV = Present value, i = interest, t = periods

 Net present value: NPV
From our expression we can go the other direction. What is the value today of
something happening in the future:
FV = PV  (1 + i )t .
FV
PV =
(1 + i )t
So if FV = $100 at the end of a year and the interest rate is i = 4%, then:

$100
PV = = $96.15
1.04
Interpretation: 100 in one year is similar to 96.15 today, or 96.15 is needed in the
bank today to have 100 next year.
 Invest or not? Using net present value
A firm should make an investment only if the present value of the
expected return exceeds the present value of the costs.

Invest if NPV is larger than zero where:

NPV = R – C
and
R = the present value of the expected returns to an investment and
C = the present value of the costs of the investment
 Invest or not? Using net present value
The initial year is t = 0, the firm’s revenue in year t is Rt, and its cost in year t is
C t.
If the last year in which either revenue or cost is nonzero is T, the net present
value rule holds that the firm should invest if:
𝑁𝑃𝑉 = 𝑅 − 𝐶

𝑅1 𝑅2 𝑅𝑇
= 𝑅0 + 1
+ 2
+. . . +
1+𝑖 1+𝑖 1+𝑖 𝑇
𝐶1 𝐶2 𝐶𝑇
− 𝐶0 + 1
+ 2
+. . . + 𝑇
> 0.
1+𝑖 1+𝑖 1+𝑖
 Two examples of NPV
(1) Invest 100 today (year 0) and get a return of 60 after one year and a return of 50
after two year. Assume i = 10%
Invest or not:
60 50
NPV = + 2 − 100 = −4,13
1,1 1,1
Not!

(2) Invest 120 today, 80 year 1 and 80 year 2. The return will be 100 for all three years.
Assume i = 10%
100 100 80 80
NPV = 100 + + 2 − 120 − − 2 = 14,71
1,1 1,1 1,1 1,1
Invest!
 Trading strategies
The fundamental value of a security = share price based on anticipated future earnings
and the level of systematic risk.

Trading strategies:
1. Buy assets that are priced below their perceived fundamental value, and vice versa.
2. Look for momentum in asset prices, buying when expecting prices to rise further, and
vice versa.

Both types of trading are a form of speculation.

 Continuous double auction
The trading mechanism in the financial market is called a continuous double auction.

1. To buy, submit a limit order (quantity and reservation price)

• Bids are orders to buy and asks are orders to sell.

2. A trade takes place if there is a match between a bid and an ask

3. If there isn’t anyone to trade with, the bid will be recorded in order book

The price is always adjusting to reconcile supply and demand and hence clear the market
(equilibration through rent-seeking).
 Asset market bubbles

Bubble = a sustained and significant departure of the price of any asset from its
fundamental value.
 Modelling bubbles
Good news about future profitability

Demand curve shifts to the right

Price increases

Positive feedback: the price increase is

interpreted as signal of future good news

Further increases in demand

 Prices and beliefs

Beliefs may dampen or amplify price rises

 Modelling crashes
The positive feedback process can continue indefinitely, until something
happens to change the expectation of continuously rising prices.

A trader can attempt to profit from identifying a bubble by short-selling.

Short-selling = The sale of an asset borrowed by the seller, with the

intention of buying it back at a lower price.