Write a paper explaining why in the long run the rate of return on investments reflects the riskiness of those investments.Requirements: Paper should be 300-500 words. Use APA format.

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  • Write a paper explaining why in the long run the rate of return on investments reflects the riskiness of those investments.
  • Requirements: Paper should be 300-500 words. Use APA format.

Write a paper explaining why in the long run the rate of return on investments reflects the riskiness of those investments.Requirements: Paper should be 300-500 words. Use APA format.
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages CHAPTER Economies of Scale and Scope 7 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points ● The law of diminishing marginal returns states that as you expand output, your marginal productivity (the extra output associated with extra inputs) eventually declines. ● Increasing marginal costs eventually cause increasing average costs and make it more difficult to compute break -even prices. When negotiating contracts, it is important to know what your costs curves look like; otherwise, you could end up accepting contracts with unprofitable prices. ● If average cost falls with output, then you have increasing returns to scale . In this case you want to focus strategy on securing sales that enable you to realize lower costs. Alternatively, if you offer suppliers big orders that allow them to realize economies of scale , try to share in their profit by demanding lower prices. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● If your average costs are constant with respect to output, then you have constant returns to scale . If average costs rise with output, you have decreasing returns to scale or diseconomies of scale . ● Learning curves mean that current production lowers future costs. It’s important to look over the life cycle of a product when working with products characterized by learning curves. ● If the cost of producing two outputs jointly is less than the cost of producing them separately — that is Cost(Q 1,Q 2) < Cost(Q 1) + Cost(Q 20 ) — then there are economies of scope between the two products. This can be an important source of competitive advantage and shape acquisition strategy. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Rayovac Company ● Founded in 1906, three entrepreneurs started a battery production company that grew to rival Energizer and Duracell. ● In 1996, The Thomas H. Lee Company acquired Rayovac – taking advantage of easy credit availability the company then bought many other battery production companies as well. A move the company said they made to take advantage of efficiencies and economies of scale. • They expected that as they produced more of the same good, average costs would fall. ● The company also bought many unrelated companies at the same time as the battery binge – the reasoning being that because of synergies, if they centralized the production of many different goods the costs of production would be lower. ● By February 2009 the new conglomerate was bankrupt ● Moral of the story? In business investments if you hear the words “efficiency” or “synergy,” hold on to your money. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Increasing Marginal Costs ● Definition : The law of diminishing marginal returns: as you try to expand output marginal productivity (the extra output associated with extra inputs) eventually declines • Diminishing marginal returns g marginal productivity declines • Diminishing marginal productivity g increasing marginal costs • Increasing marginal costs eventually lead to increasing average costs ● Some causes of diminishing marginal returns • Difficulty of monitoring and motivating a large work force • Increasing complexity of a large system • The “fixity” of some factor, like testing capacity ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Graph 1: Marginal Cost ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Graph 2: Marginal vs. Average Cost When marginal cost rises above average, the average rises. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Increasing Marginal Cost, cont. ● Example: Akio Morita and the Sony Transistor radio • In 1955, Akio Morita found a retailer that would sell his $29.95 transistor radio under his “Sony” brand name • The problem: the retailer wanted to buy 100,000 for its 150 stores, 10 times more than Mr. Morita’s capacity. • Mr. Morita had to turn down the offer • He knew that he would lose money producing 100,000 units because increasing output would require hiring/training more workers and an expansion of facilities • This would raise his average costs. • The retailer agreed to settle for 10,000 units, the rest is history • Lesson: know what your costs look like! ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Economies of Scale ● Definition : short run “fixity” vs. long run “flexibility” • i.e. factors that are fixed costs in the SR but become variable in the long run ● If long -run average costs are constant with respect to output, then you have constant returns to scale . ● If long run average costs rise with output, you have decreasing returns to scale or diseconomies of scale . ● If average costs fall with output, you have increasing returns to scale or economies of scale . ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Example: Poultry Industry ● In 1967 in the US, a total of 2.6 billion chicken and turkeys were processed ● By 1992, that number was almost 7 billion BUT the number of processing facilities dropped from 215 to 174 ● The share of shipment plants with over 400 employees grew immensely ● The shift in the structure of the industry was due largely to changes in technology, which reduced cost of processing poultry in larger plants ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Learning Curves ● Learning curve : when you produce more, you learn from the experience so that you produce at a lower cost in the future ● Use the maxim “Look ahead and reason back” ● Example: Every time an airplane manufacturer doubles production, marginal cost decreases by 20% ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Airplane Learning Curve ● American Airline negotiates with Boeing to purchase planes ● Boeing sees a big order from the world’s largest airline as a chance to “walk down its learning curve” Airplane Manufacturing Costs ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Airplane Learning Curve, cont. ● American knows its order will allow Boeing to reduce costs for future sales, they want to capture some of Boeing’s profit ● If American could know how many planes Boeing would make over the lifetime of the plane, they could offer Boeing’s average cost ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Airplane Learning Curve, cont. What actually happened with American and Boeing: ● American offered to purchase planes exclusively from Boeing over the next 30 years ● This provided Boeing with a big chunk of demand that would lower costs ● In exchange, Boeing offered a discounted price ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Guitar Fingerboards ● Firm X produces guitar fingerboards • Rosewood is used for budget guitars • Ebony is used for high -end guitars ● However, there is a decreasing supply streak -free of ebony • Brown streaks in ebony are seen as a blemish for high -end guitars, but a step up from rosewood. ● The streaked ebony can be used on budget guitars • Better than rosewood g cost and quality advantage ● Therefore, there are economies of scope between production of high -end and low -end guitars ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Economies of Scope ● If the cost of producing two products jointly is less than the cost of producing those two products separately then there are economies of scope between the two products Cost(Q 1, Q 2) < Cost(Q 1) + Cost(Q 2) ● You want to exploit economies of scale by producing both Q1 and Q2 ● Major cause of mergers ● Example: Kraft, Sara Lee and ConAgra sell a variety of meat products, hot dogs, sausage, and lunchmeats because they can derive economies of scope by distributing these products together ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Diseconomies of Scope ● Production can also exhibit diseconomies of scope when the cost of producing two products together is higher than the cost of separate production. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Pet Food Production ● AnimalSnax , a pet food company has 2,500 products (SKU’s) with 200 different formulas ● They receive a lot of pressure from large customers like Wal -Mart to reduce prices ● These requests worry the firm because of the so -called 80/20 rule (80% of a firm’s profit comes from 20% of its customers) ● To respond to Wal -Mart, the company shrinks it product offerings • AnimalSnax reduced its product offerings to 70 SKUs using only 13 different formulas AND it began offering price discounts for larger orders • The company could consolidate small orders into large ones to reduce setup costs ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Pet Food Production Graph ● Typical savings for one extruder line are illustrated below ● Under the new approach, the same amount of pet food could be produced faster ● This led to a 25% savings for the company because of reduced production costs (see graph) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Sample Question ● Learning curves : every time you double production, your costs decrease by 50%. The first unit costs you $64 to produce. On a project for 4 units, what is your break -even price? ● You can win another project for 2 more units. What is your break -even price for those units? ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Answer ● The break -even price for 4 units is $33. ● The extra costs for the fifth and sixth units is only $24, so break -even is $12/unit for those two. ● If the project were for six units total, break -even would be $26/unit for those six.Q MC TC AC 1 $64 $64 $64 2 $32 $96 $48 3 $21 $117 $39 4 $16 $133 $33 5 $13 $146 $29 6 $11 $157 $26 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb , L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018). Managerial economics: a problem solving approach (5 th ed.). Boston, MA: Cengage Learning.
Write a paper explaining why in the long run the rate of return on investments reflects the riskiness of those investments.Requirements: Paper should be 300-500 words. Use APA format.
©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages CHAPTER Relationships Between Industries: The Forces Moving Us Toward Long -Run Equilibrium 9 ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points ● A competitive firm can earn positive or negative profit in the short run until entry or exit occurs. In the long run, competitive firms are condemned to earn only an average rate of return. ● Profit exhibits what is called mean reversion, or “regression toward the mean.” ● If an asset is mobile, then in equilibrium the asset will be indifferent about where it is used (i.e., it will make the same profit no matter where it goes). This implies that unattractive jobs will pay compensating wage differentials, and risky investments will pay compensating risk differentials (or a risk premium). ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Summary Of Main Points, cont. ● The difference between stock returns and bond yields includes a compensating risk premium. When risk premia become too small, some investors view this as a time to get out of risky assets because the market may be ignoring risk in pursuit of higher returns. ● Monopoly firms can earn positive profit for a longer period of time than competitive firms, but entry and imitation eventually erode their profit as well. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Good to Great ● In 2001, Jim Collin published Good to Great, a book detailing how 11 companies used management principals to go from “good” to “great” • By 2009 many of these same companies were bankrupt – they had done amazingly well during the research period but failed to outperform the market after the book’s publication. Why? ● Mr. Collin’s made two fatal errors • The “fundamental error of attribution” • Successful firms aren’t necessarily successful because of their observed behavior (this will be discusses in a later chapter) • Ignoring long -run forces that erode profit • Competition erodes above -average profit (this will be discussed in this chapter) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Competitive Firms ● Definition : A competitive firm is a “price taker”. NOTE: All firms try to operate at the output where MC = MR • They produce a product or service with very close substitutes so they have very elastic demand • They have many rivals and no cost advantage over them • The industry has no barriers to entry or exit ● Competitive firms, • cannot affect price; they can choose only how much to produce • can sell all they want at the competitive price, so the marginal revenue of another unit is equal to the price (sometimes called “price taking” behavior). ● For competitive firms price = marginal revenue • so if P>MC, produce more and if PAC) leads to entry, decreasing price and profit • Negative profit (P In the long run, competitive firms earn only an average rate of return. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages “Mean Reversion” of Profits ● Asset flows (entry and exit) force price to average cost • e.g. even with demand and supply shocks that result in short -run price increases/decreases, economic profit will always revert back to zero • We say that “profits exhibit mean reversion ” ● Silver lining to dark cloud (low profit will increase as firms exit the industry) ● Reversion speed is 38% per year • So, if profits are 20% above the mean one year, in the next year they will be only 12.4% above the mean, on average ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages “Mean Reversion” of Profits, cont. ● An analysis of over 700 business units found the 90% of both above -average and below -average profitability differentials disappeared over a 10 -year period ● Return on investment reverted back to the mean level of approximately 20% for both over – and underperformers (shown below) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Indifference Principle ● The ability of assets to move from lower – to higher – valued uses is the force that moves an industry toward long -run equilibrium ● Indifference principle : If an asset is mobile, then in long -run equilibrium, the asset will be indifferent about where it is used; that is, it will make the same profit no matter where it goes ● Labor and capital are generally highly mobile assets • They flow into an industry when profits are high and out of an industry when profits are negative ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Indifference Principle Example ● Suppose San Diego, CA is more attractive to live in than Nashville, TN ● If labor is mobile, people will move from Nashville to San Diego • This will increase demand for housing g housing prices will increase to a point where San Diego becomes as unattractive as Nashville g migration to San Diego will stop g long run equilibrium! ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Compensating Wage Differentials ● Wages adjust to restore equilibrium • The indifference principle tells us that in long -run equilibrium, all professions should be equally attractive, provided labor is mobile • Once long -run equilibrium is reached, differences in wages are “compensating wage differentials” ● Compensating wage differentials reflect differences in the inherent attractiveness of various professions • Example: embalmers make 30% more than rehabilitation counselors because it is considered a relatively unattractive profession ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Finance: Risk vs. Return ● Can apply long -run analysis to fundamental relationships in finance • Investors prefer higher returns and lower risk if two investment options have the same return and one is less risky, the less risky one will be chosen and it will bid up the price of the less risky investment • The higher price decreases the investment’s expected rage of return • Therefore, n equilibrium, differences in the rate of return reflect differences in the riskiness of the investment, e.g. risk premium Expected return = (E[P t+1 ] – P t)/P t ● The higher return on a risky stock is known as the risk premium ● In equilibrium, differences in the rate of return reflect differences in the riskiness of an investment. ● Risk premia are analogous to compensating wage differentials: just as workers are compensated for unpleasant work, so too are investors compensated for bearing risk ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Stock Volatility and Returns ● CBOE Volatility Index (VIX) against the price of the S&P 500 stock index (GSPC) ● From Fall of 2008 through the Spring of 2009, the stock market declined by about 50% while the volatility index increased by about 100% ● Greater volatility reduced stock prices, increased expected returns to compensate investors for bearing more risk Change since Jan. 2008 (%) ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Historical Equity Risk Premium ● Government bonds are considered risk -free, they returned 1.7% over the last 80 years while stocks returned 6.9%. ● The difference is a risk premium that compensates investors for holding the more risky stocks ● The equity risk premium of stocks over bonds (in the graph below) has varied over time, from 0% to 9% ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Monopoly -Different Story, Same Ending ● Monopoly firms have attributes that protect them from the forces of competition: • They produce a product or service with no close substitutes • they have no rivals • there are barriers to entry, so no other firms can enter the industry. ● Proposition : In the very long run, monopoly profits are driven to zero by the same competitive forces though • Entry makes demand more elastic (P -MC)/P=1/|e|, which forces price back down towards MC • Example : In Oct. 2001, Apple released the iPod, which was a unique, user -friendly product with low elasticity of demand and high margins. Rivals began producing competing music players, which made demand for iPods more elastic. This reduced price – cost margins and lowered profit for Apple. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Kimberly -Clark ● In 1924, Kleenex tissue was invented as a means to remove cold cream. ● After studying customer usage habits, however, the manufacturer (Kimberly -Clark) realized that many customers were using the product as a disposable handkerchief. The company switched its advertising focus, and sales more than doubled. ● Kimberly -Clark built a leadership position by creating an innovative use for a relatively common product. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Innovation ● As others saw the profits, however, they moved into the market. ● The managers of the company maintained profitability through a continuing stream of innovations and investment in advertising/promotion. • Printed tissue in the 1930’s • Eyeglass tissue in the 1940’s • Space -saving packaging in the 1960’s • Lotion -filled tissue in the 1980’s. ● Without this continuing stream of innovations and brand support, the product’s profits would have been slowly eroded away by the forces of competition. ©2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password -protected website for classroom use. ©K ami ra/ S hut t ers t oc k I mages Reference Froeb , L. M., McCann, B. T., Shor, M., & Ward, M. R. (2018). Managerial economics: a problem solving approach (5 th ed.). Boston, MA: Cengage Learning.

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