Every once and awhile discoveries are made that change the game. A large part of my college experience has been learning about these “game changing” discoveries and how the world is now view differently. Sometimes game changers are best demonstrated graphically. Below are four game changing graphs. I understand there are many more than four, but his game changers all relate to the field of business and finance. Drop me a comment about which graphs you would include.
Supply and Demand
Supply and demand is based on perhaps the most fundamental concept in economics– the scarcity of goods. Its existence is essential for a free market economy. The idea is simple. There is always equilibrium between supply (red line) and quantity demanded (blue line). Scarcer goods demand higher prices than goods that are abundant. When prices are set above or below equilibrium, there will always be a surplus or storage. It’s important to remember that supply and demand is relative and thus consistently updated. This concept is easy enough to understand. The price for a gallon of milk does not change after each customer buys a unit. Even though supply has decreased (red line shifts leftward) price will remain the same. Supply and demand is relevant to the whole market.
Product Life Cycle
The product life cycle has more to do with marketing than economics, but is important none-the-less. The product life cycle explains how a new product progresses through a sequence of stages. Companies need to recognize where their products are in this cycle so that they can alter their marketing strategies. A lot of companies are strategic about how, when and where they release their product so that they charge a price premium for longer. So companies are known to delay the release of a product in international markets to extend a product’s life.
Capital Structure
Two famous Nobel Prize winners, Modigliani and Miller are credited with much of the progress made in the field of capital structure. Modigliani and Miller were interested in finding the optimal balance of debt to equity. Modigliani and Miller publish 2 articles (’58 & ’63) together and sometime after (’73) Miller published by himself. Each paper assumed different things and came to different conclusions. They attempted to measure the effect of leverage on value of firm. The graph shows the results of much research. It illustrates that up to a point the tax advantages of debt add value, but after a point the costs associated with bankruptcy reduce the value of a firm. Modigliani and Miller were very influential on corporate decision-making. In the time after they published the rate at which corporations were levered increased significantly.
Efficient Portfolio
The efficient portfolio comes from the modern portfolio theory introduced by Harry Markowitz. The graph illustrates all possible combinations of assets in a portfolio. This is known as the “feasible set.” The upper curve of the feasible set is known as the “efficient frontier.” The efficient frontier represents portfolios with the highest return for a given level of risk or the lowest amount of risk for a desire level of return. Risk is measured by standard deviation of historical return. All rational investors will hold portfolio on the efficient frontier because investors are risk adverse. Now, it is possible to hold risk-free assets in a portfolio. The ‘tangent portfolio” represents the possibilities if risk-free asset where included.
