ECO 2143 Lecture Notes - Lecture 10: Consumer Choice, Root Mean Square, Consumption Function

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10 Apr 2016

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People and companies understand that booms and depressions are temporary. As such, they consume (and invest) rather smoothly. Because consumers will try to consume smooth, consumption is much more constant across the years then investment (which is very volatile). However, they both react together in the same way. Furthermore, since consumption takes up a much larger part of gdp, uctuations in both markets a ect total gdp in the same way. However, two theories based on expectations a ect spending: Permanent income theory of consumption: consumers look beyond their current income. Life cycle theory of consumption: consumers" planning horizon is their entire lifetime. The very foresighted consumer theory considers two types of wealth. In this theory, we divide total wealth by the number of years still alive to nd the amount we should consume every year to have smooth consumption. If a future boost in output is guaranteed, then consumption goes up today for two reasons:

Related Questions

1- Milton Friedman viewed current income as the sum of permanent income and:

A) bonus income. B) transitory income. C) temporary income. D) surprise income.

2- Permanent and transitory income differ in the way that permanent income is ______ than is transitory income.

A) larger B) more persistent C) taxed at a higher rate D) more variable

3- If consumers have rational expectations and follow the permanent-income hypothesis, their current consumption will increase when:

A) previously announced tax reductions are implemented.

B) they receive an anticipated raise.

C) they receive an unexpected inheritance.

D) they make the last payment on their automobile loan

4- Consumers with time-inconsistent preferences:

A) base consumption decisions on transitory rather than permanent income.

B) seek to consume more in retirement than during their working years.

C) may alter decisions simply because time passes.

D) face borrowing constraints that prevent rational behavior.

5- The most volatile component of real GDP is:

A) consumption spending. B) government spending. C) investment spending. D) net exports.

6-If the capital stock is fixed and something happens to raise the marginal product of capital (MPK) for any given quantity of capital, then the real rental price of capital will:

A) remain the same. B) rise. C) fall. D) fall and then rise.

7- The investment spending component of GDP includes all of the following except:

A) business fixed investment. B) net foreign investment. C) residential investment. D) inventory investment.

8- The real cost of capital is the:

A) purchase price of a unit of capital divided by the price level.

B) purchase price of a unit of capital minus the rate of inflation.

C) cost of a unit of capital less the marginal product of capital.

D) cost of buying and renting out a unit of capital measured in units of the economy's output.

9- The profit rate of a firm that rents capital is equal to:

A) the marginal product of capital minus the cost of capital.

B) the cost of capital minus the marginal product of capital.

C) zero.

D) a negative number, if it is adding to its capital stock.

10- Other things being equal, the neoclassical model of investment predicts that net investment will increase when the:

A) marginal product of capital falls.

B) price of new capital goods rises.

C) real interest rate falls.

D) depreciation rate rises.

11- If Tobin's q is greater than 1, then managers should:

A) increase the capital stock of the firm.

B) maintain the existing capital stock of the firm.

C) allow inventories to run down.

D) decrease the capital stock of the firm.

12- According to Keynes, movements in stock prices:

A) follow a random walk.

B) reflect rational valuations of underlying economic fundamentals.

C) result when new information becomes available.

D) are often driven by irrational waves of optimism and pessimism.

After reading the case that is below, how can a foreign company entering China ensure that it tackles the most important little things that end up being huge barriers to success as we approach the year 2020 when China is expected to have significantly increased purchasing power among its middle class? Write your opinion, as a manager, on how to face cultural issues like those described in the case, when entering foreign markets.

The People's Republic of China opened up to foreign investments in the late 1970s. Since that time, numerous companies have tried to establish operations and sell their products to customers in China. Many more companies will try in the years to come China is expected to have some 190 million people in the middle- and upper-income categories by 2020. This is an increase from only about 17 million people in these income brackets as recently as in 2010. China's purchasing power for virtually all products and services has strong potential, and foreign companies will seek these market opportunities. What have we learned culturally that can help Western-based companies in China's marketplace?

Some background on China can serve as a starting point for a better understanding of the culture in China and what some well-known companies such as Best Buy and eBay have done to target the Chinese marketplace. The motivation for many foreign companies to enter China beyond those that have been there for a few decades for reasons of low-cost production was the triple growth of the Chinese economy that was seen from 2000 to 2010. China overtook Japan to become the second-largest economy in the world behind only the United States, and its large population makes for an enormous target market. Investment from foreign companies was the largest driver of China's growth in the decade from 2000 to 2010. However, many companies also increased their exports to China. The United States, for example, saw its companies increase exports to China by 542 percent from 2000 to 2011 (from about $16.2 billion to $103.9 billion), while total exports to the rest of the world increased by only 80 percent in the same time period.

Interestingly, while foreign investments grew, domestic consumption as a share of the Chinese economy declined from 46 percent in 2000 to 33 percent in 2010. This consumption declineâcoupled with slower growth globally and, ultimately, the worldwide economic downturn that started in 2008âraised questions about China's momentum. Right now, around 85 percent of mainstream Chinese consumers are living in the top 100 wealthiest cities. By the year 2020, these advanced and developing cities will have relatively few customers who are lower than the middle- and upper-income brackets by Chinese standards. The expectation is that these consumers will be able to afford a range of products and services, such as flat-screen televisions and overseas travel, making the Chinese customer much more of a target for a wide variety of consumption. This begs the question, can the unprecedented Chinese growth really continue, and would it come from increased consumption?

The resounding answer is yes according to research conducted by McKinsey & Company. McKinsey found that barring another major economic shock similar to what we saw in 2008, China's gross domestic product (GDP) will continue to grow, albeit not at the historic levels seen between 2000 and 2010 when it grew about 10.4 percent annually. The growth from 2010 to 2020 is expected to be about 7.9 percent per year, which is still far above the expected growth for the United States (2.8 percent annually), Japan (1.2 percent annually), and Germany (1.7 percent annually) the three countries among the top four worldwide economies along with China. And, the key is that consumption will now be the driving force behind the growth instead of foreign investment. The consumption forecast opens up opportunities for foreign companies to engage with Chinese consumers who are expected to have more purchasing power and discretionary spending. But culturally translating market success from one country or even a large number of countries to the Chinese marketplace is not necessarily as straightforward as it may seem. Often, a combination of naivety, arrogance, and cultural misunderstanding has led many well-known companies to fail in China. Lack of an understanding of issues such as local demands, buying habits, consumption values, and Chinese customers' personal beliefs led to struggles for companies that had been very successful elsewhere in the world. Let's take a brief look at Best Buy and eBay as two examples.

Best Buy, the mega-store mainly focused on consumer electronics, was founded in 1966 as an audio specialty store. Best Buy entered China in 2006 by acquiring a majority interest in China's fourth-largest appliance retailer, Jiangsu Five Star Appliance, for $180 million. But culture shock hit Best Buy, best described by Shaun Rein, the founder of China Market Research Group. He pointed to a few reasons for this culture shock and lack of success. First, the Chinese will not pay for Best Buy's overly expensive products unless they are a brand like Apple. Second, there is too much piracy in the Chinese market, and this reduces the demand for electronics products at competitive market prices. Third, like many Europeans, the Chinese do not want to shop at huge mega-stores. So, these three seemingly easy-to-understand cultural issues created difficulties for Best Buy. Solving these issues, Best Buy believed that it would have to develop and implement a different business model for the Chinese market than it has used, for example, in the United States. Now, how far should a company go outside its normal business model to adhere to the cultural values and beliefs of a new market? Strategically moving forward, Best Buy opted to close all of its Best Buy branded stores in China and focus on its wholly-owned local Jiangsu Five Star chain of stores. But will this new strategic business model be successful with the new makeup of customers in China expected by 2020?

eBay, the popular e-business site focused on consumer-to-consumer purchases, was founded in 1995. The company was one of the true success stories that lived through the dot-com bubble in the 1990s. It is now a multi-billion-dollar business with operations in more than 30 countries. But China's unique culture created problems for eBay in that market. Contrary to the widespread cultural issues that faced Best Buy, one company in particular (TaoBao) and one feature more specifically (built-in instant messaging) shaped a lot of the problems that eBay ran into in China. Some 200 million shoppers are using TaoBao to buy products, and the company accounts for almost 80 percent of online transaction value in China. Uniquely, TaoBao's built-in instant messaging system has been cited as the main reason for its edge over eBay in China. Basically, customers wanted to be able to identify a seller's online status and communicate with them directly and easily function not seamlessly incorporated into eBay's China system. Clearly, built-in instant text messaging is a solvable obstacle in doing business in China. It sounds easy now when we know about it, but may not always be the case when we take into account all the little things that are important in a market.

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ECO 2143 Lecture Notes - Lecture 10: Consumer Choice, Root Mean Square, Consumption Function

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