ECON1101 Study Guide - Final Guide: Expected Return, Diminishing Returns, Marginal Revenue
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Capital and Financial Markets
Demand for Physical Capital
ā¢ Physical capital refers to the machines, buildings and physical resources needed to produce
output.
ā¢ Demand for capital is a derived demand.
ā¢ Marginal product of capital (MRK) ā additional output from additional (or last unit of)
capital.
o As K increases ā MPK decreases, i.e. diminishing returns to capital.
ā¢ Marginal revenue product of capital (MRPK) ā additional revenue from additional (or last
unit of) capital.
o MRPK = P x MPK
ā¢ Demand for capital: Producer thinks on the margin
o MB = MC for firm
o Profit maximising: MRPK = r
ā¢ MRPK = P x MPK
o As K increases ā MPK decreases ā MRPK decreases.
ā¢ KD is downward sloping due to diminishing MPK.
Rental Markets
ā¢ If a firm purchases capital, there is an implicit rental price.
ā¢ There is a depreciation cost ā the decrease in value from when bought to when sold.
ā¢ Implicit rental price = depreciation cost + interest cost.
ā¢ Implicit rental rate = implicit rental price/price of capital = depreciation rate + interest rate.
ā¢ Interest rate increases ā implicit rental rate increases ā quantity of KD decreases.
ā¢ i decreases ā r increases ā quantity of KD increases.
Financial Capital
ā¢ Via capital markets, firms obtain financial capital to buy physical capital.
ā¢ Finance with:
o Equity - issue stocks or shares.
o Debt ā issue corporate bonds, take out bank loans.
ā¢ Return on stocks = dividend + capital gain (loss)
Present Discounted Value
ā¢ Present discounted value ā the value in the present of a future payment.
ā¢ Let the present discounted value = PDV, the discount rate = i, the future payment = F, and
number of years = N.
ā¢ PDV = F/(1 + i)N
ā¢ The higher the discount rate or the further in the future the payment is to be received, the
lower the present discounted value of a future payment.
ā¢ The PDV of a series of future payments F1, F2, ā¦, FN over N years is: PDV = F1/(1 + i) + F2/(1 +
i) + ā¦ + FN/(1 + i)N
Risk Versus Expected Return
ā¢ Expected returns on financial assets vary with the amount of risk.
ā¢ Expected return - the return on an uncertain investment calculated by weighting the gains
or losses by the probability that they will occur.
ā¢ Most individuals are said to be risk-averse, i.e. view risk as bad so choose less or no risk.
ā¢ Risk-averse investors who take on more risk must be compensated with a higher expected
return.
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