Entry and Exit Decisions in the Long Run

ENTRY AND EXIT DECISIONS PROBLEM: A SURVEY Andrea Girometti ∗ Master in Advanced Studies in Finance University of Z¨urich - ETH Z¨urich andreagirometti@yahoo.it January 2004 Abstract In this survey, the entry-exit decisions problem is studied. The problem concerns to the investment and disinvestment decisions process of a firm, when its output price is stochastic. Typically, this is the problem faced by an oil company or by a firm involved in the commodi- ties markets. The first approach, here analyzed in detail, was proposed by Dixit in 1989 and it is based on the contingent claim theory. In particular, the values of a firm in both activity and inactivity states are determined by using the theory of real options pricing. Thanks to the so-called value-matching and smooth-pasting conditions, it is pos- sible to interlink these two firm’s values and, therefore, to determine a pair of trigger prices, giving an optimal decision policy. The optimal policy fixes the levels of the output prices at which it is economically convenient either to start the production or to abandon the market. In addition, some interesting extensions of the basic model are presented and, finally, the two most recent approaches are explained. The first one is based on the ”mark-up” concept, the second one is based on the optimal stopping time theory. ∗ The author is grateful to Ente Luigi Einaudi for the support. He is also grateful to Paolo Casini, Paolo Verzella and Antonio Sciarretta for useful discussions. 1 1 Introduction In this survey, the entry-exit decisions problem is studied. In its simplest version, the problem concerns to the investment and disinvestment decisions process faced by a firm, when its output price is considered being stochastic. This is essentially the problem faced by a firm exploiting natural resources (i.e. oil, copper, etc.) whose output prices are daily traded in the commodi- ties markets. As a general framework, a single firm having access to a single good production opportunity is considered. If {Z t } t≥0 is a stochastic process taking discrete values 0, 1 and indicating the current firm’s state, at time t such a monopolistic firm is supposed to be either inactive Z t = 0 or already active Z t = 1. In the inactive state there is no production at all, and the firm is waiting the best conditions to enter in the market and to produce. If the firm is already active, it has full capacity utilization, the resource is infinite and it can abandon the market if its profitability is not satisfying. Suppose that the firm, changing its state Z t , switches production on or off instantaneously. Switching production on, the firm can invest a lump-sum cost K I in order to start the production and, in the opposite case, the firm has to pay a lump- sum cost K E in order to exit to the market. It is assumed that K I + K E > 0, otherwise a firm could have an infinite profit switching continuously. The firm’s activity implies also a variable production cost w o per each unit of output flow. This is the operating cost. Moreover, it is supposed that the firm has to pay again the lump-sum entry cost K I if it exits and wants to re-entry later. All these costs are supposed constant over time. The riskless cost of capital, at which all values will be discounted, is r and it is constant. The uncertainty comes uniquely from the market price of the output. This price is represented by the stochastic process {P t } t≥0 , and it is assumed that it is driven by a geometric Brownian Entry and Exit Decisions in the Long Run Entry and Exit Decisions in the Long Run By: OpenStaxCollege The line between the short run and the long run cannot be defined precisely with a stopwatch, or even with a calendar It varies according to the specific business The distinction between the short run and the long run is therefore more technical: in the short run, firms cannot change the usage of fixed inputs, while in the long run, the firm can adjust all factors of production In a competitive market, profits are a red cape that incites businesses to charge If a business is making a profit in the short run, it has an incentive to expand existing factories or to build new ones New firms may start production, as well When new firms enter the industry in response to increased industry profits it is called entry Losses are the black thundercloud that causes businesses to flee If a business is making losses in the short run, it will either keep limping along or just shut down, depending on whether its revenues are covering its variable costs But in the long run, firms that are facing losses will shut down at least some of their output, and some firms will cease production altogether The long-run process of reducing production in response to a sustained pattern of losses is called exit The following Clear It Up feature discusses where some of these losses might come from, and the reasons why some firms go out of business Why firms cease to exist? Can we say anything about what causes a firm to exit an industry? Profits are the measurement that determines whether a business stays operating or not Individuals start businesses with the purpose of making profits They invest their money, time, effort, and many other resources to produce and sell something that they hope will give them something in return Unfortunately, not all businesses are successful, and many new startups soon realize that their “business adventure” must eventually end In the model of perfectly competitive firms, those that consistently cannot make money will “exit,” which is a nice, bloodless word for a more painful process When a business 1/6 Entry and Exit Decisions in the Long Run fails, after all, workers lose their jobs, investors lose their money, and owners and managers can lose their dreams Many businesses fail The U.S Small Business Administration indicates that in 2009–2010, for example, 533,945 firms “entered” in the United States, but 593,347 firms “exited.” About 96.3% and 96.6% of these business entries and exits, respectively, involved small firms with fewer than 20 employees Sometimes a business fails because of poor management or workers who are not very productive, or because of tough domestic or foreign competition Businesses also fail from a variety of causes that might best be summarized as bad luck For example, conditions of demand and supply in the market shift in an unexpected way, so that the prices that can be charged for outputs fall or the prices that need to be paid for inputs rise With millions of businesses in the U.S economy, even a small fraction of them failing will affect many people—and business failures can be very hard on the workers and managers directly involved But from the standpoint of the overall economic system, business exits are sometimes a necessary evil if a market-oriented system is going to offer a flexible mechanism for satisfying customers, keeping costs low, and inventing new products How Entry and Exit Lead to Zero Profits in the Long Run No perfectly competitive firm acting alone can affect the market price However, the combination of many firms entering or exiting the market will affect overall supply in the market In turn, a shift in supply for the market as a whole will affect the market price Entry and exit to and from the market are the driving forces behind a process that, in the long run, pushes the price down to minimum average total costs so that all firms are earning a zero profit To understand how short-run profits for a perfectly competitive firm will evaporate in the long run, imagine the following situation The market is in long-run equilibrium, where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC No firm has the incentive to enter or leave the market Let’s say that the product’s demand increases, and with that, the market price goes up The existing firms in the industry are now facing a higher price than before, so they will increase production to the new output level where P = MR = MC This will temporarily make the market price rise above the average cost curve, and therefore, the existing firms in the market will now be earning economic profits However, these economic profits attract other firms to enter the market Entry of many new firms causes the market supply curve to shift to the right As the supply curve shifts to the right, the market price starts decreasing, and with that, economic profits fall for new and existing firms ...[...]... and how they invest their savings Economists also study how people interact with one another For instance, they examine how the multitude of buyers and sellers of a good together determine the price at which the good is sold and the quantity that is sold Finally, economists analyze forces and trends that affect the economy as a whole, including the growth in average income, the fraction of the population... Policy Influences Aggregate Demand 474 The Theory of Liquidity Preference 475 The Downward Slope of the Aggregate-Demand Curve 477 FYI Interest Rates in the Long Run and the Short Run 478 Changes in the Money Supply 479 The Role of Interest-Rate Targets in Fed Policy 481 IN THE NEWS The FOMC Explains Itself 482 CASE STUDY Why the Fed Watches the Stock Market (and Vice Versa) 482 How Fiscal Policy Influences... Expectations 501 The Long- Run Phillips Curve 501 The Meaning of “Natural” 503 Reconciling Theory and Evidence 504 The Short -Run Phillips Curve 505 The Natural Experiment for the Natural-Rate Hypothesis 506 Shifts in the Phillips Curve: The Role of Supply Shocks 508 IN THE NEWS Will Stagflation Return? 511 The Cost of Reducing Inflation 512 The Sacrifice Ratio 512 Rational Expectations and the Possibility... 225 The Consumer Price Index 226 How the Consumer Price Index Is Calculated 226 Problems in Measuring the Cost of Living 228 FYI What Is In the CPI’s Basket? 229 IN THE NEWS Accounting for Quality Change 230 The GDP Deflator versus the Consumer Price Index 232 Correcting Economic Variables for the Effects of Inflation 233 Dollar Figures from Different Times 234 Indexation 234 Real and Nominal Interest... 13 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM 271 Financial Institutions in the U.S Economy 272 Financial Markets 272 Financial Intermediaries 274 FYI Key Numbers for Stock Watchers 275 Summing Up 276 PART V THE REAL ECONOMY IN THE LONG RUN 243 CHAPTER 12 PRODUCTION AND GROWTH 245 Economic Growth around the World 246 FYI A Picture Is Worth a Thousand Statistics 248 FYI Are You Richer Than the Richest... “preview of coming attractions.” HOW PEOPLE MAKE DECISIONS There is no mystery to what an economy is Whether we are talking about the economy of Los Angeles, the United States, or the whole world, an economy is just a group of people dealing with one another as they go about their lives Because the behavior of an economy reflects the behavior of the individuals who make up the economy, we begin our study... Benefits of International Trade 186 IN THE NEWS Should the Winners from Free Trade Compensate the Losers? 187 The Arguments for Restricting Trade 188 The Jobs Argument 188 IN THE NEWS Offshore RESEARC H ARTIC LE Open Access Change in quality of life and their predictors in the long-term follow-up after group cognitive behavioral therapy for social anxiety disorder: a prospective cohort study Norio Watanabe 1* , Toshi A Furukawa 1 , Junwen Chen 1 , Yoshihiro Kinoshita 1 , Yumi Nakano 1 , Sei Ogawa 1 , Tadashi Funayama 1 , Tetsuji Ietsugu 2 , Yumiko Noda 1 Abstract Background: Social anxiety disorder (SAD) is one of the most common anxiety disorders. The efficacy of cognitive behaviour therapy (CBT) has been examined but to date its effects on Quality of Life (QoL) have not been appropriately evaluated especially in the long term. The study aimed to examine, in the long term, what aspects of Quality of Life (QoL) changed among social anxiety disorder (SAD) patients treated with group cognitive behaviour therapy (CBT) and what predictors at baseline were associated with QoL. Methods: Outpatients diagnosed with SAD were enrolled into group CBT, and assessed at follow-ups for up to 12 months in a typical clinical setting. QoL was evaluated using the Short Form 36. Various aspects of SAD symptomatology were also assessed. Each of the QoL domains and scores on symptomatology were quantified and compared with those at baseline. Baseline predictors of QoL outcomes at follow-up were investigated. Results: Fifty-seven outpatients were enrolled into group CBT for SAD, 48 completed the whole program, and 44 and 40 completed assessments at the 3-month and 12-month follow-ups, respectively. All aspects of SAD symptomatology and psychological subscales of the QoL showed statistically significant improvement throughout follow-ups for up to 12 months. In terms of social functioning, no statistically significant improvement was observed at either follow-up point except for post-treatment. No consistently significant pre-treatment predictors were observed. Conclusions: After group CBT, SAD symptomatology and some aspects of QoL improved and this improvement was maintained for up to 12 months, but the social functioning domain did not prove any significant change statistically. Considering the limited effects of CBT on QoL, especially for social functioning, more powerful treatments are needed. Background Social anxiety disorder (SAD), also known as social pho- bia, is one of the most common psychiatric disorders, with a 12-month and lifetime preval ence of 7% [1] and 12% [2], respectively. SAD typically begins during the early teenage years and has a chronic course [2]. For example, prospective, long-term, naturalistic studies have indicated that only one-third of individuals attain remission from SAD within 8 years [3]. People with SAD are also at great risk for comorbid depression [4,5] and other anxiety disorders [6]. SAD is associated with significant disability and dimin- ished quality of life (QoL) [7,8], which refers not only to one’s subjective judgment of the satisfaction with every- day life, but also to objective indicators such as health status and external life situations [9]. Diagnostic-specific * Correspondence: noriow@med.nagoya-cu.ac.jp 1 Department of Psychiatry and Cognitive-Behavioral Medicine, Nagoya City University Graduate School of Medical Sciences, Nagoya, Japan Full list of author information is available at the end of the article Watanabe et al. BMC Psychiatry 2010, 10:81 http://www.biomedcentral.com/1471-244X/10/81 © 2010 Watanabe et al; licensee BioMed Central Ltd. This is an Open Access article distributed under the terms of the Creative Commons Attribution License (http://creativecommons.org/licenses/by/2.0), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work i s pro perly cited. symptom measures for anxiety disorders explained only a small proportion of the variance in QoL [10,11], suggest- ing that an individual’s perception of quality of life is an additional factor that should be part of a complete assess- ment. Depressive comorbidity in SAD Page 1 of 2 (page number not for citation purposes) Available online http://ccforum.com/content/11/4/150 Abstract Prospective medical decision-making through the use of advanced directives is encouraged and frequently helpful in guiding treatment for the critically ill. It is important to recognize the attendant shortcomings when using such tools in clinical practice. In this issue of Critical Care, Tillyard [1] explores whether advanced directives are effective at guiding treatment decisions for incapacitated patients. Tillyard concludes that although advanced directives should ideally improve decision- making, this frequently does not translate effectively at the bedside. Studies have shown that, in themselves, advanced directives are insufficient to withstand the complexities of end-of-life care [2,3]. To resolve this divide between theory and practice, however, it is helpful to refocus the issue. We ought not to be overly concerned with the execution and application of advanced directives but with the motivation behind them and the dialogue they engender over time [4]. In the United States, advanced directives are used as a blanket term that can refer either to a living will or a durable power of attorney, two distinct methods designed to safeguard autonomous choice. A living will is a written document that expresses a preference for or against specific types of treatment; it typically becomes effective only when the patient is incompetent and either terminally ill or permanently unconscious. A durable power of attorney is a document that empowers an individual surrogate (appointed by the patient) to assume decision-making authority as soon as the patient loses decisional capacity. Used independently of durable powers of attorney, living wills are seldom helpful, for a number of reasons. Unless individuals have already been diagnosed with a particular illness and been informed of the prognosis, it is difficult for them to predict what their future holds; that is, what kind of illness/injury they will suffer and what types of medical interventions they must consider [5]. Because medicine is not static, making a prospective determination regarding the types of treatment one would want in the future is difficult. The quality of life that patients may find intolerable while healthy is apt to change when options are limited between choosing a compromised life or choosing death; thus, the psychological transition that an individual will undergo when faced with such choices is heavily nuanced and cannot be accurately predicted in advance [6]. Further, living wills tend to be inflexible in that they express a preference but do not offer any supporting rationale, thus leaving little room for interpretation or authentic knowledge of the individual. The bioethics literature suggests that it is best to combine a living will with a durable power of attorney to ensure a comprehensive approach to future decision-making. In this regard an informed surrogate can adjust to changing circumstances and maintain a collaborative relationship with the health care team while promoting the patient’s particular value system and respecting the individual’s autonomy. Despite the fact that the United States is known for supporting an assertive vision of autonomy and has witnessed the importance of advanced decision-making played out in the media (for example the Schiavo case), a relatively small percentage of Americans complete advanced directives, as Tillyard notes. The reasons for this may be multifactorial, ranging from the demands of managed care in which the doctor–patient relationship has been undercut by the consumer-driven market, to the fact that in the United States there is disparate access to health care: one-quarter of the population is uninsured or underinsured. Other reasons for individuals not availing themselves of the opportunity to complete or even discuss advanced directives may include fear, ignorance or a false sense of security International Financial market and Korean Economy Prepared by Seok-Kyun HUR Monetary Approaches in the Long Run Introduction  In the long run, prices and exchange rates will always adjust so that the purchasing power of each currency remains comparable over baskets of goods in different countries  This hypothesis provides another key building block in the theory of how exchange rates are determined  The theory we develop here has two parts The first part involves the theory of purchasing power, which links the exchange rate to price levels in each country in the long run  In the second part of the chapter, we explore how price levels are related to monetary conditions in each country Exchange Rates and Prices in the Long Run: Purchasing Power Parity and Goods Market Equilibrium  Just as arbitrage occurs in the international market for financial assets, it also occurs in the international markets for goods  The result of goods market arbitrage is that the prices of goods in different countries expressed in a common currency tend to be equalized  Applied to a single good, this idea is referred to as the law of one price; applied to an entire basket of goods, it is called the theory of purchasing power parity The Law of One Price The law of one price (LOOP) states that in the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility (where no individual sellers or buyers have power to manipulate prices and prices can freely adjust), identical goods sold in different locations must sell for the same price when prices are expressed in a common currency By definition, in a market equilibrium there are no arbitrage opportunities If diamonds can be freely moved between New York and Amsterdam, both markets must offer the same price Economists refer to this situation in the two locations as an integrated market The Law of One Price We can mathematically state the law of one price as follows, for the case of any good g sold in two locations: g US / EUR q  Relative price of good g in Europe versus U.S = ( E$ / € P ) /  g EUR European price of good g in $ g US P  U.S price of good g in $ g US / EUR q expresses the rate at which goods can be exchanged: it tells us how many units of the U.S good are needed to purchase one unit of the same good in Europe E$ / € expresses the rate at which currencies can be exchanged ($/€) The Law of One Price We can rearrange the equation for price equality g E$ / € PEUR = PUSg to show that the exchange rate must equal the ratio of the goods’ prices expressed in the two currencies: g E$ / € = PUSg / PEUR    Exchange rate Ratio of goods? prices Purchasing Power Parity The principle of purchasing power parity (PPP) is the macroeconomic counterpart to the microeconomic law of one price (LOOP) To express PPP algebraically, we can compute the relative price of the two baskets of goods in each location: qUS / EUR = ( E$ / € PEUR ) / PUS    Relative price of basket in Europe versus U.S European price of basket expressed in $ U.S price of basket expressed in $ There is no arbitrage when the basket is the same price in both locations qUS/EUR = PPP holds when price levels in two countries are equal when expressed in a common currency This statement about equality of price levels is also called absolute PPP The Real Exchange Rate The relative price of the baskets is one of the most important variables in international macroeconomics, and it has a special name: it is known as the real exchange rate The U.S real exchange rate qUS/EUR = E$/€ PEUR/PUS tells us how many U.S baskets are needed to purchase one European basket; it is the price of the European basket in terms of the U.S basket The exchange rate for currencies is a nominal concept The real exchange rate is a real concept; it says how many U.S baskets can be exchanged for one European basket The Real Exchange Rate The real exchange rate has some terminology ... charging in the long run? Why? 5/6 Entry and Exit Decisions in the Long Run Critical Thinking Questions Many firms in the United States file for bankruptcy every year, yet they still continue... supply, resulting in declining equilibrium price 4/6 Entry and Exit Decisions in the Long Run Key Concepts and Summary In the long run, firms will respond to profits through a process of entry, where... limited inputs, such 3/6 Entry and Exit Decisions in the Long Run as skilled labor As the demand for these workers rise, wages rise and this increases the cost of production for all firms The industry