Define a Perfectly Competitive Industry
- Firms produce a product with very close substitutes,
- Demand is very “elastic”
- Demand curve is flat
- Firms have many rivals and no cost advantage
- a competitive firm cannot affect price
- it can only choose how much to produce
- the industry has no entry or exit barriers
Key quote: In the long run, no competitve industry earns more than an average rate of return
Define Long term equilibrium
When economic profit is zero, firms break even and price equals average cost
Remember:
Profit = (Price - Average Cost) x Quantity
Profit = (P - AC) x Q
What is the Mean Reversion of Profit
The principle that economic profits return to zero for companies in competitive industries, regardless of short term profit increases or decreases
Important Note: Profit moves back towards an average rate of return at the speed of about 38% per year
Key: Asset flows (entry and exit) force price to average cost
Describe the Mean Reversion of Profitability (ROI, Return on Investment)
ROI over a 10 year period shows a strong tendency to revert to a mean of approximately 20% for both over and under performers
What is the 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.
Note: Positive profit attracts entry; negative profit leads to exit
Key: Labor and wages restore to equilibrium
What are Compensating Wage Differentials
Wage differences that reflect differences in the inherent attractiveness of various professions
Define a risk premium
The higher return on a riskier stock is called a risk premium
In equilibrium, differences in the rate of return reflect differnces in the riskiness of an investment
What is risk-on risk-off investing
the so-called risk-on and risk-off investing is where investors attempt to profit by increasing their risk exposure when they expect favorable macro developments, and decreasing it when they foresee unfavorable developments.
This is an application of the idea of long-run equilibrium
Define Monopolies and Their 3 Attributes
Companies protected from the forces of competition
- Produce a product or service with no close substitute
- Have no rivals
- Barriers to entry prevent other firms from entering the industry
What is the main difference between a competitive firm and a monopoly
The main difference is the length of time that a firm can earn above-average profit
Key: in the long run, even monopoly profit is driven to zero
What is the equation a firm uses to define their price point
(P - MC) / P = 1 / |e|
In the very long run
- the forces of entry and imitation (the development of close substitutes) make the monopolist’s demand more elastic.
- The elastic demand will push price down toward marginal cost and will eventually drive economic profit to zero
How do some investors view risk premia becoming too small
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
Define the price equation for competitive firms
For competitive firms price = marginal revenue
so if P>MC, produce more and if P
Describe the long-run effects of profit on competitive firms
In the long run:
- Positive profit (P>AC) leads to entry, decreasing price and profit
- Negative profit (Pleads to exit, increasing price and profit
Describe the effects of profit in the short-run for competitive firms
In the short run,
- A price increase that leads to a profit increase attracts capital to existing firms or new entrants come into the industry.
- This increases supply, which leads to a decrease in price until firms are no longer earning above-average profit, so capital flow stops = long-run equilibrium
Define the Delta b/t Government Bonds and Stocks
- Government bonds are considered risk-free,
- they returned 1.7% over the last 80 years while
- stocks returned 6.9%.
