Foreign Exchange – Reply to Pallavi’s Questions February 13, 2012Posted by Chetan Chitre in International Business Management.
Tags: Cross Rates, foreign exchange, Interest Parity, Inverse Quotes, PPP
add a comment
Thanks for writing in.
Most of your questions are pertaining to the basis for determination of exchange rates.
We all know that exchange rates are primarily determined using two methods – (1) Fixed Rates – which are decided by the government – quite often by the Central Bank of a country. (2) Flexible or Floating Rates – which are decided by the market forces.
However, if one is to question the “correctness” of these rates – how would one go about it. So for example if the USD is valued in India at Rs. 45 – should we say that it is over-valued or would it be under-valued? Is there some base rate towards which the exchange rates should gravitate to? If yes then what is the basis or logic of determination of such a rate? Further if that logic is known – can it be used for predicting future movements of the exchange rates?
These are some of the questions that are answered using one or a combination of the following approaches –
(1) Purchasing Power Parity
(2) Interest Rate Parity and the Fisher effect which is some modification of the Interest Parity approach.
(3) Asset Approach
Let us examine them –
(1) Purchasing Power Parity –
This has to do with the purchasing power of the two currencies in their respective countries. Thus if a Mc D Burger costs $ 1 in USA and if the same Mc D Burger costs Rs.30 in India – then the exchange rate between the two currencies should be USD 1 = INR 30. So one can take some representative basket of commodities – check its price in USA in terms of USD (say USD 200) and then check the price of the same basket in India in terms of INR (say INR 5000). Equate the two currency values (USD 200 = INR 5000) and that should give you the exchange rate on Purchasing Power Parity (PPP) basis (USD 1 = 5000/200 = INR 25)
It is important to understand the use of the PPP rate. For example if very small or insignificant part of that basket is traded between the two countries, then PPP may not have any relation to the “actual” exchange rates between the two countries. What would influence the “actual” exchange rate is the amount of currency flows between the countries i.e. exports, imports and capital flows – which in turn would influence the demand and supply of currencies and thereby the market determined exchange rate. The Purchasing Power of a currency in the domestic market may not (atleast there exists a technical possibility that it will not) influence the exchange rate. It is by this logic that one of the solutions circulated for the current Euro crisis was to have a dual currency system for problem countries – i.e. one currency or one value for domestic transactions and another currency (say Euro) for international transactions.
PPP is more useful in making international comparisons of welfare such as in comparing GDP or Per Capita Income of two or more countries.
(2) Interest Rate Parity –
One view is that exchange rates should be influenced by interest rate differentials between two countries. Thus if the Spot USD / INR is 45, then the 90 days forward rate would be calculated as under –
What will be the value of INR 45 if it is kept in an Indian Bank as a Fixed Deposit or some other interest bearing instrument for a period of 90 days, in the interest is – say 12% p.a. So the value of INR 45 after 90 days at 12% p.a. would be INR 46.35.
What will be the value of USD 1 if invested in an American bank at interest rate of 4% p.a. for a period of 90 days? This value would be USD 1.01.
Thus after 90 days INR 45 will be INR 46.35
After 90 days USD 1 will be USD 1.01.
Thus 90 days forward rate would be = 46.35 / 1.01 = 45.89
A related concept is the International Fisher effect.
According to Irving Fisher real interest rates and nominal interest rates are independent of each other. The Real rates are a function of the real returns on capital in the productive sector and thus are independent of the monetary of financial phenomenon. The nominal rate being influenced by the monetary issues, are arrived at by adding the rate of inflation to the real rate of interest.
Thus while estimating the change in exchange rate over time, instead of using prices (as in say, PPP theory) Fisher thought that nominal interest rates would better serve the purpose. This is because the nominal rates of interest are arrived at by adding inflation to real interest rate. Thus Nominal Interest rate contains the effect of inflation within it.
Thus in the above example, if we are considering the nominal interest rate for calculating the Forward rate, it would include the effect of inflation on currency values.
An important implication of the International Fisher Effect is that the changes in exchange rates off-set interest rate differentials. Thus in the above example, an investor investing in USD will earn less interest (4%) however, this will be compensated by the appreciation in exchange rate of USD.
(3) Asset Approach –
Here we look at currencies as just another form of asset like say gold, land, shares, etc. Thus holding currency is looked upon in the same way as holding land or shares – i.e. based on the returns that it is likely to give over a period of time. The rate is therefore determined as a part of larger asset market equilibrium. So if Euro is likely to rise faster than say BSE, then people will sell their shares held on BSE and buy Euro. These shifts in demand for Euro from BSE would be a factor in determining the price of Euro. Thus demand and supply of various assets would determine the price of the currencies, when currencies are looked upon as just another kind of asset.
Inverse and Cross Rates –
(1) Inverse Rates / Indirect Quotes –
USD/INR = 45.50/45.80 is a direct quote
It says – Buy – INR 45.50 for USD 1 and Sell – INR 45.80 for USD 1.
If this is to be converted to inverse quotes – i.e. INR/USD – we will have to answer the following questions –
(1) Buy – How many USD for INR 1?
Step 1 – Note that one buys USD when one Sells INR. So we will use the Sell INR part of the Direct Quote here. i.e. INR 45.80 for USD 1
Step 2 – If INR 45.80 are used to buy USD 1, how many USD will you buy in INR 1 – So – 1/45.80 = USD 0.0218
Sell – How many USD for INR 1?
Step 1 – Note that one Sells USD when one Buys INR. So we will use the Buy INR part of the Direct Quote here. i.e. INR 45.50 for USD 1
Step 2 – If INR 45.50 are got when one sells USD 1, how many USD will you sell to get INR 1 – So – 1/45.50 = USD 0.0219
Direct Quote – USD / INR = Bid/Ask
Inverse Quote will be –
INR/USD = Bid = 1/Ask of Direct quote
INR/USD = Ask = 1/Bid of Direct quote
(2) Cross Rates
If I had INR and I wanted to convert them into GBP. Suppose if GBP/INR quote is not available. However, USD/INR quotes are available and USD/GBP quotes are available. Then I will have to first convert INR into USD and then convert USD into GBP. This will ultimately give me GBP/INR.
This conversion is done using the following formula –
Suppose X, Y and Z are 3 currencies. If X/Y and Y/Z is given – find X/Z
X/Z Bid = X/Y bid * Y/Z bid
X/Z Ask = X/Y ask * Y/Z ask
Note that if in the above example instead of Y/Z, Z/Y is available, then first convert Z/Y into Y/Z and then use it in the formula. This applies to X/Y and X/Z as well.
Hope this explains. Please feel free to post in case of any doubts.
Testing Utilities November 20, 2011Posted by Chetan Chitre in Uncategorized.
Gains from Trade September 13, 2011Posted by Chetan Chitre in International Business Management, International Trade Theory.
Tags: Dynamic Gains, Gains from Trade, Static Gains
add a comment
Various theories of International Trade explain why trade takes place between countries. These gains from trade can be broadly divided into two types –
(a) Static Gains and
(b) Dynamic Gains
Static Gains –
Static means a stationary state. So we are interested in the immediate effect of the trade.
Thus, Static gains are the immediate gains accruing to parties directly affected by trade. i.e. gains accruing (i) to the producing sector of the commodities that are being traded and (ii) to the consumers of these commodities in both countries.
These gains can be further summarized as –
(i) The exporting sector in both countries gain on account of –
(a) increased market size,
(b) opportunity to exploit increasing returns to scale
(c) higher profitability
(d) higher level of employment.
(ii) The consumers in both countries gain as –
(a) Quantity of world production of the traded commodities increases
(b) This leads to a fall in prices
(c) Thus increasing consumer welfare.
This can be represented by the following diagram –
(a) There are two commodities, Bread and Cloth
(b) Curve PP1 is the Production Possibility Frontier representing various combinations of Bread and Cloth that can be produced given certain fixed quantity of resources.
(c) Curves IC1, IC2 and IC3 are indifference curves. Each of these curves represent various combinations of Bread and Cloth, which when consumed will result in exactly the same level of satisfaction for the consumer. Further, higher indifference curves represent higher levels of satisfaction for the consumer. This satisfaction level of a consumer is higher at IC2than at IC1 and so on.
(d) YY1 is a line indicating the ratio of prices of Bread and Cloth in India.
(e) Under conditions of NO TRADE the economy is at equilibrium at point E. Here the rate of substitution between the two commodities for the producer (Marginal Rate of Technical Substitution) is equal to the rate of substitution for the consumer (Marginal Rate of Substitution) which in turn is equal to the ratio of prices of the two commodities.
(f) At this point the production and consumption of Bread is OB while the production and consumption of Cloth is OD
(g) In case there is trade with the outside world, the slope of the price line changes as internationally prevailing prices now have an effect on local prices.
(h) Assuming that internationally the price of cloth is higher than that in local economy while the price of bread is lower, the price line shifts to XX1.
(i) With the new set of prices, the consumer equilibrium shifts to point H. Note that point H is on a higher Indifference Curve thus indicating that the level of satisfaction of the consumer has increased.
(j) The producer shifts his equilibrium to point G.
(k) Note that with the new set of prices at XX1, and consumers’ and producers’ equilibrium at H and G respectively, the total production of Bread in the economy has come down to OC while the consumption of Bread has increased to OA. Thus AC quantity of Bread is imported.
(l) A similar explanation can be given in case of Cloth.
(m) Thus the total gains from trade to the economy can be summarized as – (i) The consumer moves to higher Indifference Curve thus to a higher level of satisfaction. (ii) The Cloth sector expands thus giving the sector greater opportunities to people involved in that sector.
These are the Static gains from Trade.
Gains from trade depends upon –
(a) Comparative Cost Advantage – Comparative costs advantage enjoyed by a country in production of certain commodity sets upper limit to the maximum gains from trade.
(b) Reciprocal Demand – Demand for exported commodities in foreign country and demand for imported commodity in domestic market determines the exact level of gains from trade.
(c) Elasticity of Demand – If price-elasticity of demand for exported commodity is low and for imported commodity is high, the gains from trade are likely to be high.
(d) Income elasticity of Demand – If Income elasticity of demand for exported commodities is high, the gains from trade are likely to high.
(e) Employment intensity of exported sector, if high, leads to higher gains from trade.
Dynamic Gains from Trade –
Dynamic Gains from Trade accrue to a country over longer period of time. The sectors involved in trade are the ones that are directly affected by trade are the first to experience positive effects. Over a period of time these positive effects spread in other sectors as well, gradually impacting the entire economy. These are referred to as the Dynamic Gains From Trade.
Examples of Dynamic Gains from Trade can be –
(1) Increase in National Income – Trade leads to an increase in National Income. Domestic consumption level may be limiting the production potential of the economy. Opening the economy to foreign trade brings in additional demand in the form of export demand, thus increasing the level of National Income.
(2) Increase in level of employment – Increase in level of Aggregate Demand on account of exports leads to rise in levels of GDP and thus increase in employment levels.
(3) Increase in overall standard of living –International trade leads to equalization of factor prices (factor prices in different countries gradually get equalized on account of international trade) Trade also leads to a downward pressure on general price levels as commodities which are available cheap in other countries can be imported. All this leads to a rise in standard of living of the population.
(4) Increase in overall productivity of the national economy – Products that are produced using advanced technology are imported. Domestic producers try to compete with these products, leading to more investment in R&D. This leads to overall rise in productivity of the economy.
(5) Increase in investments – Investments rise to take advantages of the additional opportunities that arise on account of foreign trade. The spillover effect of foreign trade, such as rise in aggregate demand leads to increase in overall level of investment.
(6) Terms of Trade move in favor of domestic economy – Gains of Trade can be measured using the concept of Terms of Trade. Gains from trade lead to Terms of Trade moving in favor of the domestic country.
(7) Improvement in balance of Payment Situation – Long Term gains from trade leads to an increase export earnings of an economy, thus leading to a sustained improvement in the Balance of Payments position.
Foucault’s Prison September 10, 2011Posted by Chetan Chitre in Uncategorized.
1 comment so far
Michael Foucault, the French philosopher in his book titled ‘Discipline and Punish’ had drawn comparisons between schools and the prison system. Foucault generally looks upon the prison system as a place where a deviant is made to fall in line – a place where one does not ‘go’ but is ‘admitted’ – and generally as an instrument in the hands of the establishment to ensure the protection and perpetuation of the existing system.
I sometimes wonder what he would have inferred if he had known the Indian organized crime scene – where criminals voluntarily get themselves into prison in order to enjoy State protection from a rival don. Where the criminals look upon their tenures in prison as indicators of seniority among the criminal fraternity – and prisons are looked upon as a place to make contacts, strike deals, and generally a meeting place for the fraternity with sponsorship coming from the State.
One also wonders if such a prison – different in essence than the one analyzed by Foucault – can also have its parallels in the education system.
So we have a place where ‘disciplining’ – both in behavioral as well as in academic sense – is not the objective – neither for the students nor for those who run the education system. The students get admitted there because in some sense the time spent in the education system gives them (a) Some advantage over (protection from) their rivals (in the job market) – though not necessarily because they have imbibed any discipline and (b) a place to socialize and make contacts, strike deals and belong to a fraternity.
This can be easily observed in any of the thousands of educational institutions spread across the country, especially in institutions of higher education, barring a few very select exceptions. The whole idea of teaching and learning a discipline has been jettisoned for a long time now. These days in most institutions in the non-metro cities, there is not even an effort made in this direction. Low attendance – both of students and teachers alike are clear indicators.
We have not only given up the idea of failing a student in a grade for not learning the discipline, we have even made it official. I have heard of some government order stating that all students should be promoted upto a certain grade regardless of their performance in the learning process. What is officially done upto a certain grade is further done on basis of an informal understanding in the higher grades.
Have we in some sense realized Foucault’s project of removing the ‘discipline’ part from the education system, at least to a limited extent.
Perhaps yes. But then that also calls for a reinvention of the key task of an educational institution. No longer does the principal play a role similar to a prison jailer and no more would teachers behave like wardens.
As a matter of fact, the very idea of educational institution as a means for preaching and perpetuating ‘disciplined’ knowledge is redundant. An educational institution instead becomes a social gathering – meeting place where people come to make social contacts which may or may not result in fruitful associations in future. I guess that is what most ‘management’ schools are doing with increasing emphasis. Providing the students a platform to interact with the fraternity – the industry, the alumni, peers. Some of these interactions may result in eureka moments at some point, others may fizzle out while most may achieve something in between the two extremes. An educational institution focuses on the process of letting interactions take place rather than being bothered with the outcomes. The certificate then is given for the time spent rather than any progress in the learning or ‘disciplining’ process.
In this system then, what would be the role of the teacher? Is there any space at all for the teacher? She knows her subject (discipline) and is ready to share it with anybody who is willing to listen. But who is? Can she be an arranger of interactions? But for that – mere academic excellence is not sufficient. One has to dabble in the ‘real’ world every once a while. It is essential that the teacher is able to establish a clear and visible link between her knowledge and the real world out there.
The picture indeed sounds interesting. However, I have two concerns.
Making academic pursuit excessively linked with the ‘real’ world – will it not limit the scope of the investigation? We have had researches in almost every discipline, where true potential of an idea was realized long after the initiation of the idea – sometimes many years after the death of the originator. One can’t imagine how these researches will get funded if immediate appreciation by the ‘real’ world becomes a precondition.
Secondly, we need to formalize the system. Today all schools have de facto become places of socialization and lectures, teachers, examinations, etc. are just incidental – some kind of necessary evils to be gotten away with. The managers of the educational institutions are, in many places, working with the older idea of an educational institution. This results in some kind of perversion. So while lectures are scheduled, nobody attends. Teachers are employed but nobody takes them seriously, as everybody realizes the redundancy of the conventional teacher.
It is high time that the managers of the educational institutions as also the state education apparatus come to terms with these changes in the role of an educational institution. Rather it is a fundamental change in the very definition of ‘education’ that we are witnessing. It is a takeover of the prison system by the prisoners. They have now twisted the very system to serve their own ends. If some democratic space is not conceded at this point, there is a danger that the twisted system may really look very ugly and be of no use to anybody.
Mergers and Acquisitions – Case Study March 31, 2011Posted by Chetan Chitre in Mergers & Acquisitions.
1 comment so far
Tata Corus Deal –
A good summary on the Tata Corus Deal is available online from London Business School. (Pl. click here)
It is important to understand the Deal Rationale for both Corus and Tata Steel. Also note that the deal rationale has to be understood in keeping in mind the history of both the Companies and the emerging Global Steel scenario.
So, the low levels of profitability and continued losses to the tune of 1.5 billion pounds in FY-2001 of Corus was one of the important reasons why it was looking for getting into the partnership with some low-cost steel producer. It realized that the reduction in losses in subsequent period was only on account of the excessive rise in steel prices, which may not be sustainable. Thus for long-term sustainability it had to do some fundamental re-thinking.
For Tatas, the ambition to be among the leading players in the world, entry into the European markets, etc. were major motivating factors for the deal. However, the most important issue perhaps was the Technology and opportunity to move up in the value chain in the auto and aviation industry.
An important aspect of the deal process was entry of CSN in the picture. This not only increased the value of the Deal by almost 50% but also led to the entire process getting prolonged. One has to appreciate transparency of the process and the eventual benefit of this going to the retail shareholders of Corus. The important role played by the legal and regulatory framework is clearly seen.
While the experts continue to debate over the valuation logic – what is clearly seen from this deal is the importance of perceptions in the valuation process. While the original management of the Company had almost sold the Company at 455 pence a share, there were at-least two other players in the market who thought that the value of the company was much higher. Beauty lies in the eyes of the beholder.
Also note here that the valuation perception was influenced by the fact that the steel prices during the period of the deal had shown an impressive rise. Different players would have different perceptions about the sustainability of the price rise and may therefore have different views on valuation.
Synergies with current operations of the buyer would also influence valuation arithmetic in important ways. If the synergies are high or strategic fit is strong, a buyer may offer better value than the other.
The way the Tatas Financed the Deal is also interesting. Note that out of the total Deal Value of USD 13 bn, the Tatas brought in only about USD 7 bn by way of various debt, equity and mezzanine instruments. The balance USD 6 bn was a non-recourse debt taken on the basis of the cash-flows of the target Company itself. The impact of this debt on the Balance-sheet of Tata Steel was further shielded by raising the debt in subsidiaries created for the purpose.
Bharti-MTN Deal –
This was another deal, which if successful would have made an excellent case study. However, possibly the deal failed because it would have raised a lot of regulatory issues. A good summary of the deal structure is available in the report by Angel Broking – (Pl. click here)
M&A Statistics –
For a summary of Global M&A statistics please click here
Social Cost-Benefit Analysis November 24, 2010Posted by Chetan Chitre in Costs, Managerial Economics.
Tags: Cost-Benefit Analysis
1 comment so far
Costs can be simply understood as compensation to be paid for use or damage caused to some property. Benefits on the other hand are monetary values attached to advantages gained.
The first step while taking a decision whether to set-up a project or not, is to conduct a detailed Cost-Benefit Analysis. Be it an infrastructure projects undertaken by the government like roads, dams, ports, airports, etc., or projects undertaken by private sector such as setting up a manufacturing unit – every project brings certain benefit to a set of people. At the same time there is a cost associated with setting up the project. It is advisable to set-up a given project only if the sum of benefits arising out of the project is greater than the sum of costs incurred on that project. Such a study, which compares the benefits and costs associated with a project is called a Cost-Benefit Analysis.
Social Cost-Benefit Analysis –
While, one is evaluating a project, quite often, the C-B Analysis that is conducted in Private Cost Benefit Analysis or what is more commonly called as Feasibility Study – i.e. only Costs and Benefits accruing to private investors or owners of the project are taken into consideration. So the Capital invested in the project is seen as cost while the monetary profits arising from the project are seen as benefits. The evaluation is then reduced to comparing whether the profits (i.e. Benefits) are sufficient to justify the capital investment (i.e. Costs)
However, Social C-B Analysis takes a different approach. Apart from considering the private costs and benefits arising out of a project, Social C-B Analysis also takes into consideration the costs and benefits arising out of a project to society at large.
If one is evaluating an industrial project, the private C-B Analysis will take into consideration following costs and benefits –
|Costs (C)||Benefits (B)|
|Capital Expenses in setting the project||Profits to shareholders|
If C < B then the project would be considered good for investment.
On the other hand while evaluating the Social C-B the list would include the following –
|Costs (C)||Benefits (B)|
|Change of use of land – if any||Employment generation|
|De-forestation – if any||Taxes paid to government|
|Loss of livelihood for people whose land was acquired||Development of ancillary activities around the industry – eg. restaurants, shops, etc.|
|Displacement of people – if any||Infrastructure development – if any|
|Damage to environment|
|Use of natural resources – water, minerals, etc.|
The above tables illustrate the difference in approach while conducting a Social C-B Analysis.
Steps in Social Cost-Benefit Analysis –
As key decision like whether to invest or not to invest in the project depend on the Cost-Benefit (C-B) analysis, it has to be conducted with utmost care. The following precautions are necessary while conducting the C-B Analysis –
(a) Identifying items of Costs and Benefits – Identifying items of costs and benefits while conducting a private C-B study is relatively easy. However, in Social C-B study, this poses a major challenge. This is because both, the Social Costs and Social Benefits may be spread over large range. The person conducting the study has to consider both temporal and spatial dimensions while identifying the costs and benefits.
For example – A factory is letting-out untreated toxic effluents in the near-by river. The river may be carrying the effluents a few hundred kilometers away where farmers use the water for food crops. The toxic substances enter the crop and are consumed by the consumer who is perhaps living in some other part of the world. If this consumer suffers any health hazard because of the toxic substances found in the food, the factory should be held responsible for it and should be made liable to pay damages. However, the geographical distance between the factory and the eventual site of the damage is so large that it would become extremely difficult to identify the damage and pay the costs.
Similarly, a dam that is constructed is going to benefit the population living in the vicinity for around 50-100 years. In such cases it would become difficult today to know who will enjoy the benefit 50 years hence.
Such issues associated with Social C-B analysis makes it difficult to know who, when and where gets benefited (or pays the cost).
(b) Valuation of Costs and Benefits – Another important challenge in conducting a Social C-B analysis is valuation of the cost or benefit. The C-B study computes all costs and benefits in terms of monetary values. However, it is not always possible to arrive at a monetary value to all costs or benefits. Some examples where computing a monetary value of costs and benefits would be a problem can be given as under –
(i) Hole in the Ozone layer caused by industrial pollution – the damage caused in this case would be so large that it is impossible to compute the value of compensation that will have to be paid. Or the cost of repair (if such a repair was possible) is unknown.
(ii) Water in the river – Quite often natural resources such as water, minerals, trees, etc. are valued at extraction costs and not at production cost, which is in itself wrong.
(iii) A person who was otherwise unemployed now gets employment in the factory and can now afford to give education to his children.
(c) Method of Compensation – Especially in the matter of payment of Social cost, the issue of appropriate method of paying the compensation poses a challenge. For example – A farmer lost his livelihood as his land was acquired for a project. The question is what would be the right method of compensating such a farmer – will it be a specific sum of money, will it be another piece of land in the vicinity, will it be a job for a family member at the project site? There could be pros and cons about each of these methods. Deciding a proper method for compensation poses a challenge for managers.
(d) Allocation of Costs – A Social cost or benefit quite often arises out of collective action of a number of players. For example, all motor vehicles used in the city are collectively responsible for the air and noise pollution in the city. It would be wrong to hold any single vehicle-user responsible. Similarly, mere setting-up an industry in a backward area does not result in development of the region. It has to be accompanied by roads, schools, water-supply, housing facilities, etc. A large number of factors thus contribute to the economic development of the area and it would be wrong for the factory to claim that the entire benefit to the area has been on the account of the factory alone.
Especially in the context of cost, then the question arises as to how the total cost is to be allocated among different players. So in the context of the above example of air-pollution in the city due to motor-vehicles – in case a few people suffer from respiratory problems on account of pollution, how should their medical bills be recovered between different vehicle owners in the city? Should the recovery from each vehicle owner be on the basis of distance travelled in a month, should it be on the basis of fuel efficiency of each vehicle, should it be on the basis of emission efficiency? Each of these criteria, if used for recovery will have its pros and cons.
(e) Who Gets Benefits and Who Pays Costs – This is another important issue to be considered in Social C-B study. While considering Private C-B the answer to this question is clear – i.e. we examine the C-B accruing to the shareholder. However, the same is not the case when one analyses the Social C-B. Here we are analyzing C-B accruing to the society at large. However, society is not a homogenous entity. It comprises of different groups of people whose interest may at times run in opposite directions. All these groups may not be affected by a given project in the same manner. For example, the Mumbai-Pune Expressway is a great benefit to the people travelling between Mumbai and Pune. However, it caused great hardships to people who land was acquired for the project. It then requires a comparison of the Costs (or hardships) suffered by one set of people against the benefits accruing to another set of people. Such a comparison has its own set of complications.
(f) Time Value of Money – The benefits of the projects accrue over the entire life of the project. The costs on the other hand are to be incurred in the first few years. In cases where the project is to be implemented in phases, the costs are also spread over a larger time frame. While conducting the study in the present time frame, one will have to discount the value cost and the benefit and find out their Present Values. This may be difficult as one would be required to know the total life span of the project, the interest rates that are likely to prevail over a period, possible levels of inflation in future, etc.
(g) Decision Criteria – In order to be in a position to take a decision at the end of the Cost-Benefit study, one has to fix a set of decision criteria. This involves the following considerations –
(i) Time period over which costs and benefits are to be considered. Normally this would be over the entire life of the project. However, deciding the life of the project itself may be difficult.
(ii) Accept-Reject criteria – The general rule would be that if C < B then the project is good and should be accepted. However, this may require modifications. So for a private investor he may want the benefits to exceed costs by a certain percentage as a matter of abundant caution. On the other hand, governments may decide to go ahead with the project even if the benefits are slightly higher than the costs in the interest of social welfare.
Uses of C-B Analysis –
Private C-B Analysis – can be of assistance to an investor to decide whether or not to invest in a particular project.
Social C-B Analysis – is normally conducted by the government while taking up social welfare project. However, it is important to note that quite often it would be advisable for the Private Sector to conduct a Social C-B analysis of their projects. Advantages of such an analysis may be the following –
(a) It helps the Corporate Sector to keep track of its record as a Social Citizen. Being a good Social Citizen can be a marketing advantage. However, more importantly it can be pursued as an end in itself.
(b) Social benefits arising out of a project can be leveraged with the governments while negotiating for tax concessions and such other incentives for the project.
(c) A deeper understanding of the issues in valuations and methodology of compensation may result in innovative ways of resolving compensation issues that do not directly affect the profitability of the project. For example – If land is acquired for a project for a particular amount, the company may not be willing to give additional compensation in terms of money as this will affect the profitability of the project. However, it may be more than happy to consider employing a member of the family whose land has been acquired. Also the farmer who has lost the land may feel that a job is a more meaningful compensation than a few additional rupees. Thus a detailed Social C-B analysis can result in a win-win solution for all concerned.
Some Commonly used Concepts November 23, 2010Posted by Chetan Chitre in Introduction, Managerial Economics.
Tags: cetris paribus, comparative statics, dynamics, marginal analysis, partial and general equilibrium, positive and normative approach, statics
add a comment
(i) Positive and Normative Approach –
Social sciences such as Economics can be studied using two different approaches. A study with Positive approach focuses on observation of the social phenomenon and recording the observations as they are. Thus a study with positive approach asks the question – “What is?” On the other hand a study done with Normative approach asks believes in not just recording facts but going further and making a value judgment on the observed facts. Thus a study with normative approach asks the question – “What should be?”
The above difference also results in the methodology adopted by the two approaches. Positive approach relies more on empirical observations, precise recording of observations and statistical analysis of observed data. On the other hand normative approach relies more on contemplation and logical reasoning. As a matter of fact many a times normative studies do not go into empirical observations at all.
While Positivism is rooted in the American Behavioral tradition, the normative approach largely is rooted in the European intellectual traditions more notably those coming from Plato.
An example of a normative study is the statement – When price of a commodity increases, the demand for the same should fall. An empirical or a study with positive approach however, shows that when demand for shirts of a certain style kept increasing despite steep rise in prices. A person adhering to any one of the approaches would dismiss the other’s conclusion as wrong. However, a more gainful understanding is had when one tries to bring about reconciliation between the two conclusions. While the law of demand holds true in general, individual tastes and fashions can influence demand in the opposite direction.
There had been purists adhering to either of the two approaches in the mid 20th century. However, over the years, it has been realized that a study to be useful will have to be a blend of the two approaches. A mere normative reasoning unless backed a statement on factual observations would end up being an exercise in day-dreaming. On the other hand, a mere statistical record of events is not enough to further our understanding of a subject. It is equally important that the statistical observations are consistent with logical and reasonable explanations of the observed phenomenon.
(ii) Economic Modeling –
Economics tries to study human behavior pertaining to their satisfaction of their material needs. However, it can be easily observed that there are numerous factors that influence even a single human act. In such a case, it would be very difficult to say what was the effect of a single factor on that act?
For example, our act of buying a shirt. There are numerous reasons that determine our decision – eg. the color, the price, the brand, the current fashion, the fabric, the behavior of the salesman, etc.
If we simultaneously try to study all these factors that affect human behavior it would make the study very complicated. It will also make it very difficult to understand how each of the various factors is affecting the human behavior – eg. in the above example, it would be very difficult to say exactly what was the proportionate role of the color of the shirt in our final choice.
In order to solve this problem, economists use ‘Economic Models’. Models are representations of reality. From the total real life situation which contains numerous factors acting at the same time, we select a few important factors and observe their effect on the final behavior – i.e. in the above case in case one has to understand the role of color in the decision to buy the shirt, it would be helpful if we present the person of choice of shirts with same price, same fabric, same brand, etc. but with different colors.
Such exercises are called Economic Modeling. Here we select a few variables and study the effect of those variable on human action. Variable to be studied are selected on the basis of their importance in explaining the phenomenon, the purpose of study, availability of data, etc.
Models are useful in understanding the relationships between different variables and thus helping in developing a more complete understanding of reality. The technique is applied in both microeconomic as well as macroeconomic analysis.
Models once developed in this manner can be used for furthering our understanding of the phenomenon by running various simulations on the given model. Models can thus be used for explaining the relationships between variables as also for predictive purposes. For example, once the relationship between price, income of consumers and demand for shirts is understood, this can be used for understanding demand for shirts priced differently among consumers from different income groups.
(iii) Ceteris Paribus –
As mentioned earlier, economists normally resort to economic modeling in order to understand economic phenomenon. A model is a representation of reality. Out of numerous factors that affect human behavior in reality, a model considers the effect changes in only a select few factors. As regards the rest of the factors, economists make the assumption of “Ceteris Paribus.”
Ceteris Paribus is a Latin phrase that means – ‘Other things being constant’. It was popularized by Alfred Marshal while explaining his partial equilibrium analysis.
Thus in the above example of decision to buy a shirt, while one is studying the effect of color on the choice of shirt by offering shirts of different colors but same price, same brand, etc., one is in effect making the Ceteris Paribus assumption regarding all variables such as price, brands, etc. except the variable – color of the shirt.
(iv) Partial and General Equilibrium –
This is another technique used by economists to simplify real life situations in order to develop a clearer understanding.
It is observed that in real life, various economic events are inter-connected. For example, the equilibrium price and quantity for tea is determined in the tea market. However, this equilibrium occurs when the petrol prices, the labor rates, the coffee prices, the soft drink prices, etc. were at a certain given level. Any change in any of these parameters will lead to a change of equilibrium in the tea market. And if the markets for coffee, petrol, labor, etc. are not in equilibrium, there is a great likely hood that the prices of these commodities will actually change and, thus cause a disturbance in tea market.
Theoretically, therefore it can be concluded that unless all the markets achieve their equilibrium simultaneously, it will not be possible for any single market to achieve equilibrium in isolation as in some way all markets goods and services are inter-elated. Such an approach is called as a “General Equilibrium Approach.” This approach was emphasized by economists like Leon Walras.
However, one can imagine the innumerable amount of goods and services being produced at any given time in an economy. It would be virtually impossible for all these markets to arrive at equilibrium at the same time. Such an event is almost entirely impossible and therefore study of such an event is merely of theoretical significance.
Alfred Marshal on the other hand advocated the “Partial Equilibrium Approach”. According to this approach, it is not necessary to study the entire reality simultaneously. One can partition reality into parts and study these parts in isolation. For example – one can look at equilibrium in the tea market in isolation from all the other markets.
While it is recognized that such a division does not exist in real life and the approach is an over-simplification of reality. However, it is advocated that Partial Equilibrium approach nevertheless is able to give a major part of the explanation of a phenomenon. So if one studies the tea market in general equilibrium approach, the level of additional accuracy and understanding gained is negligible when compared to the time and efforts required to make the general equilibrium analysis.
(v) Marginal Analysis –
This is a one of the important decision criterion used in economics. When one has to take a decision regarding optimization of a certain variable, the same is done on the basis of marginal values.
Thus decision regarding the equilibrium of the consumer is taken on the basis on marginal utility and not on the basis of total or average utility.
Similarly a decision regarding level of output required by the firm for achieving optimum profits is taken on the basis of marginal cost and marginal revenues.
This method of decision-making based on marginal quantities is called as Marginal Analysis.
Thus if a firm has to arrive at the profit maximizing level of output, it will not look at total costs or total revenues. It may be possible that the Total Revenue from selling 100 units of output is more than the Total Cost of producing them. However, this cannot be the correct basis for decision-making. The real question is whether the Marginal Cost (addition to total cost due to the last unit of output produced) of producing 100th unit was less than the marginal revenue obtained from it. If not then that additional money put in business has generated a loss. It could have been used more productively in some other manner.
It has to be noted that while traditional accounting and costing theories do not recognize marginal costs, revenues, etc., it is one of the important factors to be considered for managerial decision. Quite often the MIS will have to be designed to specially incorporate recording and recall of such Marginal quantities required for marginal analysis.
(vi) Statics, Comparative statics and Dynamics –
Methods of study used in economics can also be broadly classified as Statics, Comparative statics and Dynamics. The real world is continuously undergoing changes. The social reality and human behavior which is the subject matter of economics is being continuously influenced by numerous factors. It is moving at a very fast pace. At any given moment billions of humans engage in economic activity of buying selling, producing, trading, etc. if one has to undertake a study of such a dynamic society which is in a continuous state of motion and change, it would be very difficult.
As a result Economics tries to simplify the task by using the Static approach. In simple words it means studying the economic phenomenon as if it is stationary. It is similar to taking a photograph of a moving object and studying the photograph. So a statement or observation stating that in the month of January the price of shirts of a particular brand was Rs. 500/- and the total number of shirts sold in the city were 100,000 units. This is a static study.
Comparative static on the other hand compares two static situations. So we may have another static situation where in the month of February the price of shirts was Rs. 600/- and the demand for shirts decreased to 75,000 units. Comparing the static situation in the month of January and February we can conclude that as the price of shirts increased, the sale of shirts dropped. This is comparison of two static situations and the approach is therefore called Comparative static.
Most of the writings found in economics use the method of Comparative Statics. Statics and Comparative Statics helps in understanding relationships between different variables.
A dynamic study on the other hand concentrates on study of movement of variables, the speed of the movement and the path taken.
So in the above example when the price of shirts increased from Rs. 500/- to Rs. 600/-, the question would be – how did the demand decrease from 100,000 to 75,000 units. Did people first increase their purchase fearing a further price rise in future? Or did the demand immediately drop to 50,000 and then gradually increased and settled at 75,000? Or did the demand immediately fall to 75,000? The path of the adjustment would be a matter of dynamic study.
Dynamic studies are generally conducted in macroeconomics where the core concern is development and growth. Dynamic studies in microeconomics also help in studying various strategies adopted by players and its impact on the eventual equilibrium.
Scope of Managerial Economics November 23, 2010Posted by Chetan Chitre in Introduction, Managerial Economics.
Managerial Economics –
Managerial Economics is a branch of economics that studies application of principles of economics to various business situations.
A Business organization is essentially a group of people who have come together for attaining certain common objectives. These objectives are largely material in nature – eg. profits, salaries, production for the purpose of consumption, etc. The behavior of this group of people is therefore a subject matter of study for economics.
A Business Manager is responsible for leading this group of people in the direction of attainment of the objectives. In this capacity she has to take several decisions during the course of her day-to-day operations. An understanding and application of principles of economics would help the Business Manager to take appropriate decisions under various situations.
Scope of Managerial Economics –
Principle of Economics can help a Manager in taking decisions in various business situations. These can be summarized with the help of the following diagram –
Business Decisions are primarily centered around Production and Sales. In addition to this, the environment in which a business organization operates has an impact on the Business Decisions. Various topics in Economic Theory help Business Managers in their functions.
(i) Sales, Marketing and Advertising – Sales, marketing and advertising related decision need an in-depth understanding of the Consumer Behavior. We need to understand the reasons for consumption, factors affecting consumption, constraints faced by the consumers, the decision-making process of the consumer as regards price to be paid, quantity to be purchased, allocation of resources between different needs, etc.
Theory of Demand helps in developing an understanding between Price and quantity demanded.
Price Elasticity helps us understand the ability and willingness to pay of different categories of consumers. This also helps us in Market segmentation.
Cross Price Elasticity helps in identifying competitors which may not be essentially within the same product category – eg. Should soft-drinks manufacturers be seen as competitors for Tea?
Theory of Consumer’s Equilibrium helps in understanding how a consumer allocates his income between different needs.
Having understood the various factors that affect demand for a product and the decision-making process of a consumer helps business managers in devising more effective sales, marketing and advertising strategies.
(ii) Production – Production is perhaps the most important activity in a business organization. A Business Manager has to take several decisions regarding production – eg. What to produce, what should be the plant capacity, what should be the capacity utilization, which technology to use, etc.
While organizing of production activity, Business Managers have to take several factors into consideration, such as –
(a) Objective of the Firm – To begin with the firm has to decide its objective. A Firm could have various objectives such as profit maximization, sales maximization, maximization of market share, etc. Economics helps us to understand what impact these different objectives will have on key variables such as Sales, Production, Prices, Costs, Profits, etc. Organization Economics, a branch of economics helps us in understanding relationship between firm objectives and internal dynamics of an organization.
(b) Profit Maximization – In traditional theory we examine a firm that has profit maximization as its central objective. In order to maximize profits a firm has to minimize costs and maximize its revenues. Thus, a deeper understanding of the Costs and Revenues is required for achieving this objective.
(c) Revenues – Revenues of a firm depend on the demand scenario and the competitive scenario in the market. The understanding of the above two would be essential for a business manager to predict the revenues that the business will be able to generate.
(d) Demand scenario – To decide on the plant capacity and capacity utilization, an understanding of quantity demanded in the market in different time periods is important
(e) Market Structures – In addition to the quantity demanded, one has to understand the competitive scenario. How many players are competing for the given market demand? What is the market structure and how will it impact the firm’s own sales?
(f) Costs – In order to maximize profits, a firm needs to minimize costs. Costs are impacted by several factors. Primary among them are quantity of production and factor prices.
(g) Technology – Technology has multi-dimensional impact on costs. On one hand technology determines what combination of various factors is to be used – eg. capital-intensive technology or labor intensive technology.
Technology also determines the levels of production possible – both in terms of optimum capacity as also in terms of range of capacities at which a plant can operate. This in turn has an impact on the costs. – eg. The most efficient level of operation of a certain plant may be at 1000 units per day (where cost of production is lowest). However, it would be possible to operate the same plant within a range of 500 units per day to 1200 units per day (though may not be at same levels of efficiencies – i.e. it may result in higher costs).
Thus while taking a decision to select technology for production; its impact on costs will have to be kept in mind. Quite often the most advanced technology may not be the best choice in terms of its impact on costs.
(h) Factor Pricing – Technology dictates a certain combination of factors that need to be used. One has to check whether it would be affordable for business to employ those factors in the given quantities. Often prohibitively high price of factors would dictate choice of technology.
Thus, while taking important decisions regarding the production activity, understanding of Economics would be essential at every step.
(iii) Business Environment – Finally, businesses operate in a given social, political and economic environment. There is a symbiotic relationship between the business and its environment. A business organization, through its operations, causes an impact on the surrounding socio-economic conditions. So also, the socio-economic environment prevailing in the outer world has an impact on the business. From time to time, Business Managers are required to foresee the changes in the outer world, analyze their likely impact on their business and take necessary corrective actions. Events from the economic environment such as changes in government policies, tax structures, trade regulations, changes in key variables such as interest rates, inflation, etc., business cycles and growth projections are some of the important events that directly or indirectly impact every business activity. Knowledge of macroeconomics is quite often required to be able to predict these events in the economy and understand the likely impact of these changes on business.
Other Analytical Tools
Apart from these, economics equips the Business Manager with important analytical tools that help him in performing his functions in the following aspects :
(iv) Fundamental Principles of Behavior – As pointed out earlier, a Business Manager deals with a group of human beings plating different roles – eg. consumers, suppliers, share-holders, workers, etc. Economics studies the fundamental motivating factors behind behavior of these different economics agents. This knowledge would thus help the Business Manager in influencing behavior of these economic agents in a manner that enables the business to achieve its objectives.
(v) Decision Criterion – An important part of study of economics is to understand the decision criterion of different economic agents such as consumers, firms, workers, etc. Economics aims at arriving at a logical method of arriving at a decision given the objectives that the economic agent has to achieve and the constraints within which she operates. This technique is helpful to a Business Manager in taking the numerous decisions that she is required to take during the course of her work.
(vi) Resource Allocation – The above techniques of decision-making studied in economics can be used for taking a wide range of decisions including those regarding allocation of resources, capital management, distribution and logistics, etc. – eg. If a decision has to be taken for distributing a capital of Rs. 1 million between various used A, B and C, the technique of Marginal Analysis tells us that the Capital should be distributed in such a manner that the marginal returns from each use is equal.
(vii) Designing of Management Information Systems (MIS) – The decision criteria tells what information would be required so as to enable us to take the right decision. One can use this input in designing a proper MIS that is relevant and useful – eg. In the above case the MIS should be designed to give the manager information about marginal returns. Instead, if the MIS gives information about average and total returns, it would not help in the decision-making process.
(viii) Economic v/s Accounting Decisions – Economics introduces us to certain differences between good accounting decisions and good business decisions. It tells us how a result which may seemingly be good and proper in accounts may, in-fact be a wrong business decision – eg. it may not be taking into account opportunity costs or replacement costs.
(ix) Cost-Benefit Analysis – Economics helps Business Managers in enlarging their scope of Cost-Benefit Analysis. Economics informs us that the C-B Analysis should not be looked at from the narrow perspective of immediate increase in profitability to business. Along with this a more comprehensive Social Cost-Benefit Analysis is also essential to understand the long-term implications of business on the economy and the society. Such an understanding can also be leveraged to enhance the overall profitability of business – eg. Ability of business to generate employment in the economy can be used as leverage in extracting tax concessions from the government.
1 comment so far
Finally, a judgment was delivered on 26-11 case on expected lines. The accused was declared guilty and awarded the harshest punishment available. And as expected there was a sigh of relief.
In fact almost all the media reported news of celebration in the city of Mumbai and elsewhere. A few newspapers carried photographs of bursting of crackers and dancing and merry-making.
The city and the civil society had taken its revenge, though not in as cruel a manner as it would have liked to.
This blog is not an attempt to defend Kasab or protest against his punishment. His act was dastardly and of course deserved the harshest punishment. Not even giving the usual logic that one man’s terrorist is another man’s freedom fighter.
There are however, 2 points which bother and which I would like to make here.
The Due Course of Law
Thankfully, despite popular feeling of hatred, we allowed the law to take its course. There was a fair trial; the accused was given an opportunity to present his side, etc.
Questions were raised that the crime was obvious, it was committed in public with evidence being captured by mass media, etc. and so there was no reason for a court hearing, that the crime was self-evident and heinous and so the criminal should be publicly hanged, that the government should not ‘waste’ crores of rupees keeping a criminal alive, etc.
Thankfully better sense prevailed. There have been a few articles appreciating the process of law though such an opinion is found among a very miniscule minority. And then too, the rationale given for following the process of Law is quite often to do with our standing in the international community and the need for portraying ourselves as a Democratic and Just country before them.
While this is an important reason, I think a more important reason has to be internal. Regardless of what the international community thinks about the whole affair, it is more important for me as a society and as a person to be seen as a just person and a just society in my own eyes. The need for Justice and fairness has to be an internal need of the society and should not be seen as a matter of strategy.
Of course the state and the judiciary has to take the blame for the low levels of credibility that our judicial process has in the eyes of the citizens. However, it is disheartening when the media and the intellectuals succumb to a mass-hysteria and start demanding for subverting the process of law. Rather than talking of denying a fair trial to Kasab, one would have loved to see an opinion that the Kasab trial – its speed, the emphasis on fairness, the promptness with which the police filed the charge-sheet and presented the evidence, the treatment given to the accused, the living conditions in the jail, etc. – should be an example for all other trials pending in Indian courts.
Celebrating the Death Sentence
Another disturbing matter was the rejoicing and revelry seen on announcement of the death sentence. While one has all sympathies for the families of the deceased and all anger for the criminals involved, I feel one has to stop for a moment and ask – is this an occasion to celebrate.
A person, in this case – the criminal Kasab, is morally and psychologically ill. His behavior and values are deviant. In some sense it is our collective failure as a society that we could not cure him and make him realize the beauty in human life – even when he himself is staring in the face of death. We have failed to cure an illness, a disease and are condemned to watch him face death.
Is this a matter to celebrate?