Theory of Consumer Choice
Theory of Consumer ChoiceI think that it is right to begin with the Theory of consumer choice. The above consumer has expressed his preference of choice. He has a taste for seafood which he prefers above all other types of food. This does not mean that he only eats seafood, but in line with the last two elements of the theory of consumer choice, he has shown his preference for taste and on that assumption, will do the best that he can for himself to consume as much seafood as he can. The elements of the theory which govern exactly how much seafood he will consume are the first two, namely the consumer’s income and the price of seafood.
We can assume therefore, that the consumer will devote as much of his budgeted income for food, to as much seafood as he can afford in preference to other foods such as hamburgers.
A budget line can be drawn up to show a trade off between say, fish suppers and hamburgers to indicate the combinations of fish suppers and hamburgers the consumer can afford given his income and the prices of each meal. Points on the buget line will all be within the consumers budget for food. All points below the line will show the possible combinations of dinners avaiable for his choice. All points above the line wil be unaffordable. It will be possible to see how far the consumer could indulge his passion for seafood in one week.
(Slope of budget line = -Pu/Pv)
The next considerations that might be taken are the marginal rate of substitution of one meal for another without changing the total utility, the diminishing marginal rate of substitution which will hold utility constant and representation of taste as indifference curves. I will not elaborate on these at this point as I believe that the marginal utility and diminishing marginal utility are more relevany and pertinent to the question.
I shall now contunue by defining utility. In economic jargon, utility is a numerical method of appreciating a consumer’s satisfaction. The word itself, as far as meaning is concerned, has nothing to do with its meaning in everyday language. It has nothing to do with usefulness, it is a satisfaction based unit of measurement.
Marginal utility on the other hand is, in a sense, an extra utility. What is meant in economic jargon by marginal is the additional pleasure a specific good gives to a consumer.
Diminishing marginal utility is the marginal utility lessening due to the growth of consumption. For example, a consumer consumes a pound of fish, and his utility is 10 units, and his marginal utility is 10 units. If the same consumer consumed two pounds of fish, his utility would be 15, but his marginal utility would be 7. The same effect on marginal utility would take place if the amount consumed further increase. Since marginal utility diminishes as the quantity of fish consumed increases, we are faced with diminishing marginal utility.
The point is that no matter how good the the consumer’s fish dinners are , the more that is consumed, the less satisfaction will the consumer have compared to the initial portion. This of course is down to personal taste, for consumer A may have a diminishing marginal utility that decreases a lot more slowly than consumer B. The fact remains, that at some point, both comsumers will become saturated by their love for seafood and the law of diminishing marginal utility will make itself apparent.
Our consumer, as this point, will seek to substitute some of his fish dinners with hamburgers or another alternative.
To conclude, the title question based on the argument above, the statement: “I love seafood so much I can’t get enough of it” may be passionate, but economically speaking is implausible. Even if theoretically speaking the consumer had access to an infinite amount of seafood and an unlimited budget, in the end the good would not satisfy the consumer enough to remain a preferred good, thus this change in preference would result in the consumer literally having had enough.
First we must consider suppy and demand. Supply is the quantity of a good that sellers want to sell at every price. Demand is the quantity of a good that buyers want to buy at every price. Equilibrium is the point where the supply is equal to the demand. At a particular price these behaviours become quantity supply, quantity demand and equilibrium price.
We must now look at the elasticity of supply and elasticity of demand. The elacticity of supply measures the responsiveness of the quantity suppled, to a change in the price of that good.
Supply elasticity = (% change in quantity supplied)
(% change in price)
The elasticity of supply informs us how the equilibrium price and the quantity will change if there is a change in the demand. The elasticity of demand shows us the shift in the equilibrium point if there is a change in supply.
The elasticity of supply and the elasticity of demand directly affect each other in the following ways.
As seen on the graphs below, the cross section changes. This results in a change of position for the equilibrium point.
In the particular case of a 5-pence per gallon tax imposition on petrol, considering that the current price of petrol is roughly 69.6-pence per gallon, there is no drastic shift in the supply curve. Nevertheless, a slight shift in the supply curve triggers a slight shift in the demand curve as shown below.
This scenario is better portrayed in the lower left graph of the image below (fig.15.4). Since petrol in England has no substitute or alternative good, (unlike the U.S.), the consumer has no other mean of mobilizing his or her essential equipment of transportation. This automatically makes the demand elasticity low.
It is needless to say that as a result of these minor shifts the deadweight loss is minimal.
The producer unlike the consumer, in this case will not be affected in terms of tax incidence, the reason being that as a producer of this specific good, there is no immediate “obligation” to bear the tax incidence himself, thus the burden of tax is loaded onto the consumer.
The legislator, or better known as “the government”, will suffer no incidence of any sort. The only way the legislator will be affected is through the update of this particular tax, which is an annual bureaucratic budgeting process.
Over the last century many countries throughout the world have experienced inflation as their major economic problem. Expensive wars have traditionally been recognized as the sources of inflation. Governments, in effort to squeeze more production out of an economy, have often resorted to printing or releasing more money to finance the purchase of arms and soldiers1. In an economy already producing at full capacity, the issuing of additional money serves to bid up the prices of the output of the economy, resulting in inflation. It was generally assumed from past experience, that once the economy returned to its normal state, the persistent tendency for overall prices to rise would disappear, bringing inflation rates back to normal. World War II brought the persistent inflation that economists came to expect. In the 50’s and early 60’s inflation resumed to very low rates concomitant with large growth increases and low unemployment. But, from 1967 to 1974 the rates of inflation reached alarming proportions in many countries, such as Japan and Britain, for no apparent reason. This acceleration in inflation has forced many economists to reevaluate their views, and often align themselves with a specific school of thought regarding the causes and cures for inflation.
There are two opposite theories regarding inflation. Monetarism indicates that inflation is due to increases in the supply of money. The classic example of this relationship is the inflation that followed an inflow of gold and silver into Europe, resulting from the Spanish conquest of the Americas. According to monetarists, the only way to cure inflation is by government action to reduce growth of the money supply.
At the other end is the cost-push theory. Cost-pushers believe that the source of inflation is the rate of wage increases. They believe that wage increases are independent of all economic factors, and generally are determined by workers and trade unions. More specifically, inflation occurs when the wages demanded by trade unions and workers add up to more than the economy is capable of producing. Cost- pushers advocate limiting the power of trade unions and using income policies to help fight off inflation.
In between the cost-push and monetarism theory is Keynesianism. Keynesians recognize the importance of both the money supply and wage rates in determining inflation. They sometimes advise using monetary and incomes policies as complimentary measures to reduce inflation, but most often rely on fiscal policy as the cure.
Before we can understand the policies suggested by these different schools of thought, we must look at the historical development of our understanding of inflation.
For approximately 200 years before John Maynard Keynes wrote the General Theory of Employment, Interest , and Money, there was a broad agreement among economists as to the sources of inflationary pressure, known as the quantity theory of money2. The Quantity theory of money is easily understood through fisher’s equation MV=PY ( money supply times velocity of circulation of money equals price times real income)
Quantity theorists believe that over an extended period of time the size of M, the money supply, cannot affect the overall economic output, Y. They also assume that for all practical purposes V was constant because short term variations in the circulations of money are short lived, and long term changes in the velocity of circulation are so small as to be inconsequential . Lastly, this theory rests on the belief that the supply of money is in no way determined by the economic output or the demand for money itself.
The central prediction that can now be made is that changes in the money supply will lead to equiproportionate changes in prices. If the money supply goes up then individuals initially find themselves with more money. Normally individuals will tend to spend most of their excess money. The attempt of people to buy more than they normally do must result in the bidding up of prices because of the competitive nature of the market, inflation.
Also essential to the quantity theory is the belief that in a competitive market, where wages and prices are free to fluctuate, there would be an automatic tendency for the market to correct itself and full employment to be established.
In figure 1, w stands for the real wage rate (the amount of goods and services that an individuals money income can buy), L d for the demand for labor and L s for the supply for labor. Suppose now that the economic system inherited a real wage rate w 1, The supply of labor is L s1 while the demand for labor is only L d1. At this point there is substantial unemployment because labor is costly for employers to buy. According to Classicalists, The existence of an excess supply of labor will lead to a competitive struggle between the unemployed and employed for the available jobs. This struggle will lead to a reduction of real wages, thus employers will begin hiring more workers. Eventually competition will drive down wages to an equilibrium called labor- arket clearance, where the demand and supply for labor is equal; this is We Le. Classicalists define Labor market clearance as the point of full employment. Thus, persistent unemployment can only be explained by a mechanism which interferes with a competitive market. They specifically blame monopolistic trade unions for preventing the wage rate from falling to We. Unions may use many threatening tactics to fight wage cuts. Those most effective mentioned in the textbooks are collective bargaining and strikes.
The Great depression, as experienced by the US and the countries of western Europe, cast a shadow over the Classical approach to economics3. The self-righting properties of classical economics were clearly not working when wages and unemployment failed to decrease. Blaming trade unions for these massive increases in unemployment seemed far fetched.
John Maynard Keynes was the first writer to produce a non-classical, coherent, and convincing explanation of the inter-war depression. He traced the sources of unemployment to a deficiency of effective demand. Put simply, unemployment occurred when total spending on output was not enough to fully employ the available workforce. Effective demand, called expenditures, was split into two groups by Keynes, consumption and investment. Consumption, the purchase of goods and services, far outweighed investment as the major component of effective demand.
At the theories” core lay Keynes’ belief that an economies” total production, Y, will eventually adapt itself to changes expenditures. Moreover Keynes argued that the equilibrium of wages exist when the output of producers is equal to the amount that consumers and investors are willing to spend on their output.
Consider figure 2 Total expenditure, that is the sum of consumption and investment , is measured on the vertical and real income on the horizontal. For practical purposes investment will remain a constant in the graph and be represented by line I. If we add the consumption function and the investment line, we get the the sum total expenditures, line E (E = C+I).
For any given amount of expenditures, Y can be located anywhere for a short time. If Y is above E, then producers are simply accumulating unsold stocks of goods. Eventually they will be forced to cut back on production until they can sell their existing stocks, earning capital enough capital to restart production. Conversely, If Y is below E, producers will be selling out of goods. Normally they will increase production as soon as possible to catch up to the demand and make the most profit. This is where, the 45 line comes into use. Y, according to Keynes, will shift to the point where E intersects the 45 line. When Y intersects E at the 45 line, there is an equilibrium between expenditures and total output, and wages are stable.
In order to illustrate how Keynes’ principle of effective demand accounts for unemployment, let us assume that the economy starts off at full employment where Ld (demand for labor) equals Ls (supply). The label of the output necessary to sustain full employment is Yf, f denoting full employment. If expenditures were smaller than Yf, than Yf would adjust itself to the left on the graph to accommodate for this. Because the level of total output has shrunk, the demand for labor also has, and unemployment has risen correspondingly .
If one accepts the Keynesian model, there are generally two things that can be done to raise the level of aggregate demand to a point where Y adjusts to full employment. Raising government expenditures, G, stimulating private investment, or lowering taxes, raising consumption because people will have more money to spend, will both raise the level of aggregate demand. Both these policies come under the heading of fiscal policy, which is deliberate manipulation of the government budget deficit in order to achieve an economic objective.
During the great depression, many people rejected Keynes’ ideas on unemployment because they were scared to be different. The contemporary orthodox view was that cuts in the money wages would automatically be accompanied by cuts in the real wages, thus raising employment. Classicalists prescribed the government a remedy for unemployment based on implementing money wage reductions. Keynes rejected this idea on both theoretical and empirical grounds.
After the first World War, collective bargaining rendered the downward flexibility of wages highly improbable. Any attempts at cutting money wages would be fiercely
resisted, as seen as the 1926 General Strike in Britain painfully demonstrated. Keynes regarded the trade unions’ resistance to wage cuts as a product of the rigid structure of wage differentials. This is actually just the relative position of the wages of a particular type of labor to all others, F.E. mechanics get paid 1$,Electricians get 2$, plumbers get 3$. If any one group received generally higher wages, other groups would surely demand higher wages to preserve the structure. On the other hand, if a single group wantonly decided to accept a wage cut, other groups would likely not follow. Therefore labor groups vehemently resisted wage cuts.
Theoretically, Keynes believed that drops in the money wages would eventually be accompanied by a drops in prices. This balanced deflation would bring real wages, the amount of goods that could be bought, to their original amount. Employers would not take on more workers because their real revenue, amount of goods they sell, would remain unchanged.
In order to fully consider this statement, we must first look at the terms used and consider their definitions with respect to the larger content of the question.
We will first consider Positive Economics. A positive economic statement is one which relies on real data, given true statistics and related directly to a true situation. Following this, we can say that a normative economic statement is one which is not purely objective although it is related to a positive economic situation. What the normantive statement does is to follow on with an opinion which is subjective, biased and based purely on the personal feelings of the speaker.
“Positive economics is about what is; normative economics is about what should be.”
Economics, John B. Taylor, Houghton Mifflin Company, 1995, p.25
Now we must consider the definition of “Fair”.
“Fair: satisfactory, just, unbiased, according to the rules.”
The Concise Oxford Dictionary, Fifth Edition, Edited by H. W. Fowler and F. G. Fowler, Oxford University Press, 1964
I propose to return to this deffinition having discussed the first part of the question.
When we are dealing with positive economics, we are strictly involved with a “clinical” procedure of thought and analysis where the thought pattern lacks the usual influence of personal bias and emotional charge. Positive economics relate explicitly to the existing situation based on true data and real facts. It can be expressed as a bird’s eye view of a real given situation. Since logic is the dominant factor in this thought/perception process, it is natural for positive economics to be described as “what is”, because very seldom does a situation occur where “what is” achieves the goal of “what should be”.
The normative side of economics, unlike the bird’s eye view of positive economics, is a viewpoint from within a given situation. This of course directly involves “the personal bias, the subjective opinion ralated to real or given data”. Only when perceiving a situation from within, from a specific internal standpoint can you express the “what should be”. The positive unbiased process of factual data lacks the reality of the emotionally charged normative thought process where comparisons and conclusions are drawn from a basis of personal criteria. The normative statement need not necessarily be “what should be”, it can just as easily relate to “what should not be”, either positive or negative but it will always be based on a subjective opinion brought about by a personal attitude to a positive economic situation.
We can therefore look at the given statement and immediately see that, although there is undoubtably a distribution of wealth in the United Kingdom, and this is indisputably a positive economic statement, the hypothesis that it is not fair is purely based on supposition of the speaker and therefore a normative statement.
Dealing with the word “fair” in general provocates an emotional connotation. There is a direct link of meaning with equilibrium, but equilibrium can vary depending on what angle fair is expressed from. “Fair” can vary greatly in accordance with its definition. If we consider the distribution of wealth in the United Kingdom “according to the rules” we must ask whose rules. If they are the rules of the political party in power, then the distribution is fair. If they are the rules of a Marxist minority party, then the distribution is not fair. In both cases “fair” is unsed non-normatively.
The opinion of the unemployed or the lower social orders does not count in this case, as there are no recognised rules for these groups of people. Any opinion offerred from them regarding “fair” is automatically normative.
The same will apply if taking into account the other officially accepted definitions of the meaning of “fair”. There can be ambivalence about the objective or subjective interpretation of the word “satisfactory”. The word “just” can also be interpreted both objectively in a legal connotation and subjectively in a personal connotation.
In a specific case though, for example, “The distribution of income in the United Kingdom is not fair.”, when examined from a positive point of view through the accepted definitions , one can arrive at a conclusion which may very well be “Yes, the distribution is fair.”, but this conclusion can opnly have been derived from an omni perceptive and non-biased angle, if the word “fair” has been given a formally accepted definition. It must also relate in the particular circumstance to the real statistical data taken into consideration, regarding the real distribution of wealth in the United Kingdom.
If this distribution of income were to be looked at from a normative angle, there would of course not have been a conclusion such as the one above, the reason being that normative thought is “personalized” thought, and in the real world, which is what normative economics deals with, one’s view dramatically differs from another’s, therefore, a statement such as “The distribution of income in the United Kingdom is not fair.” would sound more like an opinion rather than a scientific conclusion and would belong to the definitioin “Biased” and “satisfactory”.
In conclusion to the essay question regarding “fair” being used non-normatively, my view is that it is possible. Personal view or preference does not prevent one from appreciating a situation as a whole if looked at from a “temporarily” neutral and dispassionate standpoint. For example, one may not particularly like the work of a certain acclaimed writer, but one can appreciate his/her work’s worth and quality as an axample of literary expressionism.
The given statement for the essay is undoubtably normative. It could, however, have been been made positive, as could any other statement containing the word “fair” by defining the concept of fairness within the terms relating to the reality.
Financing a small firm can be achieved in three ways. The most preferable but at the same time the least likely is self financing from retained earnings, otherwise, the firm will have to resort to either one of the two following financial markets. Debt capital and equity capital ( which strictly speaking is the same as retained earnings, both having their advantages and disadvantages.
Only after 1979 did clearing banks start making loans with a maturity term in excess of ten years. In the case of a loan to smaller companies, the fixed interest rates are usually set at a premium over base rate ( 3% - 6%). Larger companies who have a good credit rating will probably be offerred the premium on the inter-bank rate which is lower than the base rate. Loans are usually secured on the personal guarantee of the Directors or the owner of small companies and in the case of larger ones, a charge is made against the assets of the company. If the charges are “fixed”, that means that they are linked with a specific asset of the company. “Floating” charges are made on the general assets.
All bank loans are based on three elements which the company has to be able to satisfy. The interest rate demanded by the bank, the security demanded by the bank and the terms of repayment which are open to individual arrangements between bank and borrower although they usually consist of systematic amortization payments made over the full time of the loan.
A small company will have to ensure its capability of all three in spite of the fact that in comparison to a larger company, it will be paying a higher interest rate, will be risking security based on the owner’s personal assets rather than company assets and repayment terms will probably be more rigid rather than flexible as banks rightly see the small company borrower as a higher risk. (This is explained later on when discussing the problems faced by the small company in raising finance.)
There are sources of loans other than from banks. Companies usually resort to these financial institutions as a last resort because their interest payments are fixed and if inflation falls, this will make the borrowing very expensive. These financial sources can include pension funds, insurance companies, merchant banks, the European Investment Bank and the ICFC. (Investment and Commercial Finance Corp[oration)
There is also the “medium term note” open as an alternative which is a promisory note issued by the company promising to pay a specified amount on a specified date. The procedure is for the company to write the note and then to sell it in the market place. The interest rate can be fixed or may fluctuate and the maturity date of the note can be anything from under one year to as long as fifteen years.
The small company may issue a debenture, which is a document issued in return for money lent. There are various types of debentures but they all have some features in common. They are usually in the form of a bond, undertaking the repayment of a loan on a specified date and with regular stated payments of interest between the date of issue and the date of maturity. These dividends have priority to be paid before any other dividend is paid to any other class of shareholder. The Companies Acts define the word “debenture” as including debenture stock and bonds. Often the terms debenture and bond or loan stock are interchangeable although I shall mention Bond and Loan Stock a little later on.
There are a number of reasons why an investor would chose debentures in preference to other forms of company financing. The major factor has to do with risk. Debt financing usually has a fixed maturity. The investor enjoys priority both in interest and in the possibility of the company going into liquidation. In addition,debenture holders receive a fixed return on the investment and if the company does not make large profits, will continue to receive the fixed interest rate while the ordinary shareholders may have to wait the Board’s decision on what and how much to pay out.
Now we must look at why a company would issue debentures. The primary advantage is that the cost of the debt is known and is limited. If the company makes greater profits, these are not shared out with the debenture holders. The cost of the debt is also limited because the risk of the debenture holders is lower than that of the shareholder. Also, and importantly, the interest payment that is made to the debenture holder is deductable against tax.
Debenture issues are not an unqualified benefit for the company. There are some disadvantages in that assumptions that were made ten years ago about the future trading position of the company might prove to be wrong and the decision for long term debt unwise. The company still has to repay the debt on the date of maturity.
A warrant, is in principle, a call option issued by the company on its own stock.The warrant holder is able to buy a specified number of shares at a specified price on a specified date. Problems that face the young company will be discussed later but for a company without a proven track record, raising finance can be difficult. The warrant can be used as an enticer. Debenture holders have no option to benefit from the company which performs well but companies can tempt investors to their debenture stock by issuing convertibles or warrents in return for lower interest rates in the immediate term. (a convertible is a bond which can be converted to ordinary shares) The most common issuers of warrants and convertibles are risky companies, young companies and those whose risk profile is difficult to estimate. In other words, those who may not fare so well in the credibility stakes at the bank.
The company can issue preference shares and holders are part owners of the company, but preference shares are closer to loan capital than to ordinary shares.In the heirarchy they come higher than ordinary shares and lower than debentures. The clear company advantage is that preference shares are a source of long term , though not permanent, finance and that the dividend does not have to be paid if company profits do not justify it. Preference shares are not really popular with companies or investors. In 1993 they were only 7.7% of the total.
There are a number of characteristics shared by small companies which make it difficult for them to obtain funds. Their shorter trading records means that less is known about them and their size often precludes fewer accounting skills in the company which are necessary to put over a strong case for financing. Small companies have limited access to markets for securities, and in particular, the Stock exchange, which is both difficult and expensive.It is a view widely held, that smaller companies are more likely to have to face liquidation and so potential lenders will be much harder to pursuade.
The Financial institutions which dominate the market for finance, usually seek to invest in such a way so as to ensure that their particular investment is unlikely to affect share prices. This is the strategy to invest small amounts in large companies. These finance Institutions obviously prefer stable long term growth and the most unlikely place to find this is in a young or small company.
These characteristics, combined with those already mentioned in earlier paragraphs, for instance, fixed transaction costs for raising finance putting the small company at a disadvantage, make the small companies more or less dependent on banks for finance. Institutions that invest in smaller companies will see a higher level of risk; as a consequence, the expected returns are higher and so the cost of the capital is raised.
Companies which find themselves in need of additional finance and look to the public for this via the Stock Exchange have access to variable income and capital investments and fixed income investments. The capital market offers three types of securities, Company securities such as loan stock, shares, and options; public sector securities, such as guilt-edged securities issued by governments and well established companies; and Eurobonds.
There are two facets to the capital markets and each has its distinct function. The primary market issues and deals in new securities. So, companies wishing to raise new equity on the Stock Market “New Issues Market” is dealt with by the primary market. The secondary market deals with existing financial claims. Dealing on the secondary market does not raise new finance for the quoted company, but it enables the lender to transfer the repayment rights to another, while the borrower remains unaffected.
The secondary market is important to the investor because it allows the initial investor to sell the investment as and when he chooses. Without the secondary market, companies would find investors less willing to tie up their money for any length of time so making the raising of finance by share issue more difficult.
The primary function of these markets is to match the lenders to the borrowers and effect the directing of funds between them.
Not all companies are in a position to use the Stock Exchange to raise finance. All companies wishing to enter the Stock Market must be quoted and this is a costly procedure. Many companies are either too small or too new to gain a listing full listing but they need not be excluded from this method of raising finance because there is then the Unlisted Securities Market where the requirements for trading are lower. Companies have to show a three year trading record and offer 10% of shares at the primary issue.
There are four major benefits to a company which can issue ordinary or equity shares. There are no fixed charges associated with ordinary shares. The company may pay a dividend if sufficient profit is generated but it does not have to do so. There is no fixed maturity date. If the company loses, the shares can be sold to increase the creditworthiness of the company and they can be sold more easily than debentures or preference shares because they carry a higher expectation of better returns and so represent a better hedge against inflation.
The downside for the company comes in the shape of costs and control aspects.
There is also the question of “what does the firm want the financing for?”. The reason can either be for the purpose of expansion or settling previously acquired debt. The truth is that even in the healthiest of cases, a small firm faces certain standard small firm problems such as the difficulty to diversify and transaction costs. For example, if a firm is small, this means that whatever it produces or trades is dealt with in much smaller quantities than a larger firm. Thus, the small firm’s accounts read a higher cost in purchasing raw materials (per unit), than the costs a large firm has when purchasing the same raw materials at a much greater quantity.
Another problem on the top of the problem list of a small firm is its total worth. In order for the firm to enter into either a debt market or an equity market, it must be of a substantial value. For the case of the debt market, the small firm will not be able to acquire a substantial amount of capital through a loan due to its lack in required collateral. In the case of the equity market, it is difficult for a small firm to enter this market for the same reason, but not implausible.
The main concern for the small firm is the interest rate the debentures or loans it has issued carry. It is for this reason that these sources of finance are preferred to be used as short term solutions. In the case of a small firm though, these debentures or loans may be the only way to kick-start the firm into growth. There must be a source of finance for the firm to use in order for it to invest long term through short term financial sources.
Long term investments are an integral part of a small firm’s growth. Investments in technology mainly, give a firm the potential to expand, provided that the new investment(s) are managed and utilized appropriately, and integrated accordingly into the previous assets of the small firm.
For the manager looking to raise finance for the company the Stock Exchange offers a number of possibilities, if the company is in a position to meet with the process of listing and the costs. If not, debt capital and its distinguishing features of being less expensive than equity capital, being of lower risk and therefore having a lower rate of return together with tax deductable interest payments, are commonly experienced by managers of small companies.
As an epilogue, an alternative to borrowing, the economic value of leasing is calculated by discounting the incremental cashflows of the lease over the borrowing alternative. In addition to the taxation benefits, leasing helps to preserve cash, varies the borrowing portfolio and provides a less restrictive form of finance. Its certainty and flexibility reduces risk and allows the small companies a greater freedom in their investment decision process because rentals are operating expenses.
I think that it is right to begin with the Theory of consumer choice. The above consumer has expressed his preference of choice. He has a taste for seafood which he prefers above all other types of food. This does not mean that he only eats seafood, but in line with the last two elements of the theory of consumer choice, he has shown his preference for taste and on that assumption, will do the best that he can for himself to consume as much seafood as he can. The elements of the theory which govern exactly how much seafood he will consume are the first two, namely the consumer’s income and the price of seafood.
We can assume therefore, that the consumer will devote as much of his budgeted income for food, to as much seafood as he can afford in preference to other foods such as hamburgers.
A budget line can be drawn up to show a trade off between say, fish suppers and hamburgers to indicate the combinations of fish suppers and hamburgers the consumer can afford given his income and the prices of each meal. Points on the buget line will all be within the consumers budget for food. All points below the line will show the possible combinations of dinners avaiable for his choice. All points above the line wil be unaffordable. It will be possible to see how far the consumer could indulge his passion for seafood in one week.
(Slope of budget line = -Pu/Pv)
The next considerations that might be taken are the marginal rate of substitution of one meal for another without changing the total utility, the diminishing marginal rate of substitution which will hold utility constant and representation of taste as indifference curves. I will not elaborate on these at this point as I believe that the marginal utility and diminishing marginal utility are more relevany and pertinent to the question.
I shall now contunue by defining utility. In economic jargon, utility is a numerical method of appreciating a consumer’s satisfaction. The word itself, as far as meaning is concerned, has nothing to do with its meaning in everyday language. It has nothing to do with usefulness, it is a satisfaction based unit of measurement.
Marginal utility on the other hand is, in a sense, an extra utility. What is meant in economic jargon by marginal is the additional pleasure a specific good gives to a consumer.
Diminishing marginal utility is the marginal utility lessening due to the growth of consumption. For example, a consumer consumes a pound of fish, and his utility is 10 units, and his marginal utility is 10 units. If the same consumer consumed two pounds of fish, his utility would be 15, but his marginal utility would be 7. The same effect on marginal utility would take place if the amount consumed further increase. Since marginal utility diminishes as the quantity of fish consumed increases, we are faced with diminishing marginal utility.
The point is that no matter how good the the consumer’s fish dinners are , the more that is consumed, the less satisfaction will the consumer have compared to the initial portion. This of course is down to personal taste, for consumer A may have a diminishing marginal utility that decreases a lot more slowly than consumer B. The fact remains, that at some point, both comsumers will become saturated by their love for seafood and the law of diminishing marginal utility will make itself apparent.
Our consumer, as this point, will seek to substitute some of his fish dinners with hamburgers or another alternative.
To conclude, the title question based on the argument above, the statement: “I love seafood so much I can’t get enough of it” may be passionate, but economically speaking is implausible. Even if theoretically speaking the consumer had access to an infinite amount of seafood and an unlimited budget, in the end the good would not satisfy the consumer enough to remain a preferred good, thus this change in preference would result in the consumer literally having had enough.
First we must consider suppy and demand. Supply is the quantity of a good that sellers want to sell at every price. Demand is the quantity of a good that buyers want to buy at every price. Equilibrium is the point where the supply is equal to the demand. At a particular price these behaviours become quantity supply, quantity demand and equilibrium price.
We must now look at the elasticity of supply and elasticity of demand. The elacticity of supply measures the responsiveness of the quantity suppled, to a change in the price of that good.
Supply elasticity = (% change in quantity supplied)
(% change in price)
The elasticity of supply informs us how the equilibrium price and the quantity will change if there is a change in the demand. The elasticity of demand shows us the shift in the equilibrium point if there is a change in supply.
The elasticity of supply and the elasticity of demand directly affect each other in the following ways.
As seen on the graphs below, the cross section changes. This results in a change of position for the equilibrium point.
In the particular case of a 5-pence per gallon tax imposition on petrol, considering that the current price of petrol is roughly 69.6-pence per gallon, there is no drastic shift in the supply curve. Nevertheless, a slight shift in the supply curve triggers a slight shift in the demand curve as shown below.
This scenario is better portrayed in the lower left graph of the image below (fig.15.4). Since petrol in England has no substitute or alternative good, (unlike the U.S.), the consumer has no other mean of mobilizing his or her essential equipment of transportation. This automatically makes the demand elasticity low.
It is needless to say that as a result of these minor shifts the deadweight loss is minimal.
The producer unlike the consumer, in this case will not be affected in terms of tax incidence, the reason being that as a producer of this specific good, there is no immediate “obligation” to bear the tax incidence himself, thus the burden of tax is loaded onto the consumer.
The legislator, or better known as “the government”, will suffer no incidence of any sort. The only way the legislator will be affected is through the update of this particular tax, which is an annual bureaucratic budgeting process.
Over the last century many countries throughout the world have experienced inflation as their major economic problem. Expensive wars have traditionally been recognized as the sources of inflation. Governments, in effort to squeeze more production out of an economy, have often resorted to printing or releasing more money to finance the purchase of arms and soldiers1. In an economy already producing at full capacity, the issuing of additional money serves to bid up the prices of the output of the economy, resulting in inflation. It was generally assumed from past experience, that once the economy returned to its normal state, the persistent tendency for overall prices to rise would disappear, bringing inflation rates back to normal. World War II brought the persistent inflation that economists came to expect. In the 50’s and early 60’s inflation resumed to very low rates concomitant with large growth increases and low unemployment. But, from 1967 to 1974 the rates of inflation reached alarming proportions in many countries, such as Japan and Britain, for no apparent reason. This acceleration in inflation has forced many economists to reevaluate their views, and often align themselves with a specific school of thought regarding the causes and cures for inflation.
There are two opposite theories regarding inflation. Monetarism indicates that inflation is due to increases in the supply of money. The classic example of this relationship is the inflation that followed an inflow of gold and silver into Europe, resulting from the Spanish conquest of the Americas. According to monetarists, the only way to cure inflation is by government action to reduce growth of the money supply.
At the other end is the cost-push theory. Cost-pushers believe that the source of inflation is the rate of wage increases. They believe that wage increases are independent of all economic factors, and generally are determined by workers and trade unions. More specifically, inflation occurs when the wages demanded by trade unions and workers add up to more than the economy is capable of producing. Cost- pushers advocate limiting the power of trade unions and using income policies to help fight off inflation.
In between the cost-push and monetarism theory is Keynesianism. Keynesians recognize the importance of both the money supply and wage rates in determining inflation. They sometimes advise using monetary and incomes policies as complimentary measures to reduce inflation, but most often rely on fiscal policy as the cure.
Before we can understand the policies suggested by these different schools of thought, we must look at the historical development of our understanding of inflation.
For approximately 200 years before John Maynard Keynes wrote the General Theory of Employment, Interest , and Money, there was a broad agreement among economists as to the sources of inflationary pressure, known as the quantity theory of money2. The Quantity theory of money is easily understood through fisher’s equation MV=PY ( money supply times velocity of circulation of money equals price times real income)
Quantity theorists believe that over an extended period of time the size of M, the money supply, cannot affect the overall economic output, Y. They also assume that for all practical purposes V was constant because short term variations in the circulations of money are short lived, and long term changes in the velocity of circulation are so small as to be inconsequential . Lastly, this theory rests on the belief that the supply of money is in no way determined by the economic output or the demand for money itself.
The central prediction that can now be made is that changes in the money supply will lead to equiproportionate changes in prices. If the money supply goes up then individuals initially find themselves with more money. Normally individuals will tend to spend most of their excess money. The attempt of people to buy more than they normally do must result in the bidding up of prices because of the competitive nature of the market, inflation.
Also essential to the quantity theory is the belief that in a competitive market, where wages and prices are free to fluctuate, there would be an automatic tendency for the market to correct itself and full employment to be established.
In figure 1, w stands for the real wage rate (the amount of goods and services that an individuals money income can buy), L d for the demand for labor and L s for the supply for labor. Suppose now that the economic system inherited a real wage rate w 1, The supply of labor is L s1 while the demand for labor is only L d1. At this point there is substantial unemployment because labor is costly for employers to buy. According to Classicalists, The existence of an excess supply of labor will lead to a competitive struggle between the unemployed and employed for the available jobs. This struggle will lead to a reduction of real wages, thus employers will begin hiring more workers. Eventually competition will drive down wages to an equilibrium called labor- arket clearance, where the demand and supply for labor is equal; this is We Le. Classicalists define Labor market clearance as the point of full employment. Thus, persistent unemployment can only be explained by a mechanism which interferes with a competitive market. They specifically blame monopolistic trade unions for preventing the wage rate from falling to We. Unions may use many threatening tactics to fight wage cuts. Those most effective mentioned in the textbooks are collective bargaining and strikes.
The Great depression, as experienced by the US and the countries of western Europe, cast a shadow over the Classical approach to economics3. The self-righting properties of classical economics were clearly not working when wages and unemployment failed to decrease. Blaming trade unions for these massive increases in unemployment seemed far fetched.
John Maynard Keynes was the first writer to produce a non-classical, coherent, and convincing explanation of the inter-war depression. He traced the sources of unemployment to a deficiency of effective demand. Put simply, unemployment occurred when total spending on output was not enough to fully employ the available workforce. Effective demand, called expenditures, was split into two groups by Keynes, consumption and investment. Consumption, the purchase of goods and services, far outweighed investment as the major component of effective demand.
At the theories” core lay Keynes’ belief that an economies” total production, Y, will eventually adapt itself to changes expenditures. Moreover Keynes argued that the equilibrium of wages exist when the output of producers is equal to the amount that consumers and investors are willing to spend on their output.
Consider figure 2 Total expenditure, that is the sum of consumption and investment , is measured on the vertical and real income on the horizontal. For practical purposes investment will remain a constant in the graph and be represented by line I. If we add the consumption function and the investment line, we get the the sum total expenditures, line E (E = C+I).
For any given amount of expenditures, Y can be located anywhere for a short time. If Y is above E, then producers are simply accumulating unsold stocks of goods. Eventually they will be forced to cut back on production until they can sell their existing stocks, earning capital enough capital to restart production. Conversely, If Y is below E, producers will be selling out of goods. Normally they will increase production as soon as possible to catch up to the demand and make the most profit. This is where, the 45 line comes into use. Y, according to Keynes, will shift to the point where E intersects the 45 line. When Y intersects E at the 45 line, there is an equilibrium between expenditures and total output, and wages are stable.
In order to illustrate how Keynes’ principle of effective demand accounts for unemployment, let us assume that the economy starts off at full employment where Ld (demand for labor) equals Ls (supply). The label of the output necessary to sustain full employment is Yf, f denoting full employment. If expenditures were smaller than Yf, than Yf would adjust itself to the left on the graph to accommodate for this. Because the level of total output has shrunk, the demand for labor also has, and unemployment has risen correspondingly .
If one accepts the Keynesian model, there are generally two things that can be done to raise the level of aggregate demand to a point where Y adjusts to full employment. Raising government expenditures, G, stimulating private investment, or lowering taxes, raising consumption because people will have more money to spend, will both raise the level of aggregate demand. Both these policies come under the heading of fiscal policy, which is deliberate manipulation of the government budget deficit in order to achieve an economic objective.
During the great depression, many people rejected Keynes’ ideas on unemployment because they were scared to be different. The contemporary orthodox view was that cuts in the money wages would automatically be accompanied by cuts in the real wages, thus raising employment. Classicalists prescribed the government a remedy for unemployment based on implementing money wage reductions. Keynes rejected this idea on both theoretical and empirical grounds.
After the first World War, collective bargaining rendered the downward flexibility of wages highly improbable. Any attempts at cutting money wages would be fiercely
resisted, as seen as the 1926 General Strike in Britain painfully demonstrated. Keynes regarded the trade unions’ resistance to wage cuts as a product of the rigid structure of wage differentials. This is actually just the relative position of the wages of a particular type of labor to all others, F.E. mechanics get paid 1$,Electricians get 2$, plumbers get 3$. If any one group received generally higher wages, other groups would surely demand higher wages to preserve the structure. On the other hand, if a single group wantonly decided to accept a wage cut, other groups would likely not follow. Therefore labor groups vehemently resisted wage cuts.
Theoretically, Keynes believed that drops in the money wages would eventually be accompanied by a drops in prices. This balanced deflation would bring real wages, the amount of goods that could be bought, to their original amount. Employers would not take on more workers because their real revenue, amount of goods they sell, would remain unchanged.
In order to fully consider this statement, we must first look at the terms used and consider their definitions with respect to the larger content of the question.
We will first consider Positive Economics. A positive economic statement is one which relies on real data, given true statistics and related directly to a true situation. Following this, we can say that a normative economic statement is one which is not purely objective although it is related to a positive economic situation. What the normantive statement does is to follow on with an opinion which is subjective, biased and based purely on the personal feelings of the speaker.
“Positive economics is about what is; normative economics is about what should be.”
Economics, John B. Taylor, Houghton Mifflin Company, 1995, p.25
Now we must consider the definition of “Fair”.
“Fair: satisfactory, just, unbiased, according to the rules.”
The Concise Oxford Dictionary, Fifth Edition, Edited by H. W. Fowler and F. G. Fowler, Oxford University Press, 1964
I propose to return to this deffinition having discussed the first part of the question.
When we are dealing with positive economics, we are strictly involved with a “clinical” procedure of thought and analysis where the thought pattern lacks the usual influence of personal bias and emotional charge. Positive economics relate explicitly to the existing situation based on true data and real facts. It can be expressed as a bird’s eye view of a real given situation. Since logic is the dominant factor in this thought/perception process, it is natural for positive economics to be described as “what is”, because very seldom does a situation occur where “what is” achieves the goal of “what should be”.
The normative side of economics, unlike the bird’s eye view of positive economics, is a viewpoint from within a given situation. This of course directly involves “the personal bias, the subjective opinion ralated to real or given data”. Only when perceiving a situation from within, from a specific internal standpoint can you express the “what should be”. The positive unbiased process of factual data lacks the reality of the emotionally charged normative thought process where comparisons and conclusions are drawn from a basis of personal criteria. The normative statement need not necessarily be “what should be”, it can just as easily relate to “what should not be”, either positive or negative but it will always be based on a subjective opinion brought about by a personal attitude to a positive economic situation.
We can therefore look at the given statement and immediately see that, although there is undoubtably a distribution of wealth in the United Kingdom, and this is indisputably a positive economic statement, the hypothesis that it is not fair is purely based on supposition of the speaker and therefore a normative statement.
Dealing with the word “fair” in general provocates an emotional connotation. There is a direct link of meaning with equilibrium, but equilibrium can vary depending on what angle fair is expressed from. “Fair” can vary greatly in accordance with its definition. If we consider the distribution of wealth in the United Kingdom “according to the rules” we must ask whose rules. If they are the rules of the political party in power, then the distribution is fair. If they are the rules of a Marxist minority party, then the distribution is not fair. In both cases “fair” is unsed non-normatively.
The opinion of the unemployed or the lower social orders does not count in this case, as there are no recognised rules for these groups of people. Any opinion offerred from them regarding “fair” is automatically normative.
The same will apply if taking into account the other officially accepted definitions of the meaning of “fair”. There can be ambivalence about the objective or subjective interpretation of the word “satisfactory”. The word “just” can also be interpreted both objectively in a legal connotation and subjectively in a personal connotation.
In a specific case though, for example, “The distribution of income in the United Kingdom is not fair.”, when examined from a positive point of view through the accepted definitions , one can arrive at a conclusion which may very well be “Yes, the distribution is fair.”, but this conclusion can opnly have been derived from an omni perceptive and non-biased angle, if the word “fair” has been given a formally accepted definition. It must also relate in the particular circumstance to the real statistical data taken into consideration, regarding the real distribution of wealth in the United Kingdom.
If this distribution of income were to be looked at from a normative angle, there would of course not have been a conclusion such as the one above, the reason being that normative thought is “personalized” thought, and in the real world, which is what normative economics deals with, one’s view dramatically differs from another’s, therefore, a statement such as “The distribution of income in the United Kingdom is not fair.” would sound more like an opinion rather than a scientific conclusion and would belong to the definitioin “Biased” and “satisfactory”.
In conclusion to the essay question regarding “fair” being used non-normatively, my view is that it is possible. Personal view or preference does not prevent one from appreciating a situation as a whole if looked at from a “temporarily” neutral and dispassionate standpoint. For example, one may not particularly like the work of a certain acclaimed writer, but one can appreciate his/her work’s worth and quality as an axample of literary expressionism.
The given statement for the essay is undoubtably normative. It could, however, have been been made positive, as could any other statement containing the word “fair” by defining the concept of fairness within the terms relating to the reality.
Financing a small firm can be achieved in three ways. The most preferable but at the same time the least likely is self financing from retained earnings, otherwise, the firm will have to resort to either one of the two following financial markets. Debt capital and equity capital ( which strictly speaking is the same as retained earnings, both having their advantages and disadvantages.
Only after 1979 did clearing banks start making loans with a maturity term in excess of ten years. In the case of a loan to smaller companies, the fixed interest rates are usually set at a premium over base rate ( 3% - 6%). Larger companies who have a good credit rating will probably be offerred the premium on the inter-bank rate which is lower than the base rate. Loans are usually secured on the personal guarantee of the Directors or the owner of small companies and in the case of larger ones, a charge is made against the assets of the company. If the charges are “fixed”, that means that they are linked with a specific asset of the company. “Floating” charges are made on the general assets.
All bank loans are based on three elements which the company has to be able to satisfy. The interest rate demanded by the bank, the security demanded by the bank and the terms of repayment which are open to individual arrangements between bank and borrower although they usually consist of systematic amortization payments made over the full time of the loan.
A small company will have to ensure its capability of all three in spite of the fact that in comparison to a larger company, it will be paying a higher interest rate, will be risking security based on the owner’s personal assets rather than company assets and repayment terms will probably be more rigid rather than flexible as banks rightly see the small company borrower as a higher risk. (This is explained later on when discussing the problems faced by the small company in raising finance.)
There are sources of loans other than from banks. Companies usually resort to these financial institutions as a last resort because their interest payments are fixed and if inflation falls, this will make the borrowing very expensive. These financial sources can include pension funds, insurance companies, merchant banks, the European Investment Bank and the ICFC. (Investment and Commercial Finance Corp[oration)
There is also the “medium term note” open as an alternative which is a promisory note issued by the company promising to pay a specified amount on a specified date. The procedure is for the company to write the note and then to sell it in the market place. The interest rate can be fixed or may fluctuate and the maturity date of the note can be anything from under one year to as long as fifteen years.
The small company may issue a debenture, which is a document issued in return for money lent. There are various types of debentures but they all have some features in common. They are usually in the form of a bond, undertaking the repayment of a loan on a specified date and with regular stated payments of interest between the date of issue and the date of maturity. These dividends have priority to be paid before any other dividend is paid to any other class of shareholder. The Companies Acts define the word “debenture” as including debenture stock and bonds. Often the terms debenture and bond or loan stock are interchangeable although I shall mention Bond and Loan Stock a little later on.
There are a number of reasons why an investor would chose debentures in preference to other forms of company financing. The major factor has to do with risk. Debt financing usually has a fixed maturity. The investor enjoys priority both in interest and in the possibility of the company going into liquidation. In addition,debenture holders receive a fixed return on the investment and if the company does not make large profits, will continue to receive the fixed interest rate while the ordinary shareholders may have to wait the Board’s decision on what and how much to pay out.
Now we must look at why a company would issue debentures. The primary advantage is that the cost of the debt is known and is limited. If the company makes greater profits, these are not shared out with the debenture holders. The cost of the debt is also limited because the risk of the debenture holders is lower than that of the shareholder. Also, and importantly, the interest payment that is made to the debenture holder is deductable against tax.
Debenture issues are not an unqualified benefit for the company. There are some disadvantages in that assumptions that were made ten years ago about the future trading position of the company might prove to be wrong and the decision for long term debt unwise. The company still has to repay the debt on the date of maturity.
A warrant, is in principle, a call option issued by the company on its own stock.The warrant holder is able to buy a specified number of shares at a specified price on a specified date. Problems that face the young company will be discussed later but for a company without a proven track record, raising finance can be difficult. The warrant can be used as an enticer. Debenture holders have no option to benefit from the company which performs well but companies can tempt investors to their debenture stock by issuing convertibles or warrents in return for lower interest rates in the immediate term. (a convertible is a bond which can be converted to ordinary shares) The most common issuers of warrants and convertibles are risky companies, young companies and those whose risk profile is difficult to estimate. In other words, those who may not fare so well in the credibility stakes at the bank.
The company can issue preference shares and holders are part owners of the company, but preference shares are closer to loan capital than to ordinary shares.In the heirarchy they come higher than ordinary shares and lower than debentures. The clear company advantage is that preference shares are a source of long term , though not permanent, finance and that the dividend does not have to be paid if company profits do not justify it. Preference shares are not really popular with companies or investors. In 1993 they were only 7.7% of the total.
There are a number of characteristics shared by small companies which make it difficult for them to obtain funds. Their shorter trading records means that less is known about them and their size often precludes fewer accounting skills in the company which are necessary to put over a strong case for financing. Small companies have limited access to markets for securities, and in particular, the Stock exchange, which is both difficult and expensive.It is a view widely held, that smaller companies are more likely to have to face liquidation and so potential lenders will be much harder to pursuade.
The Financial institutions which dominate the market for finance, usually seek to invest in such a way so as to ensure that their particular investment is unlikely to affect share prices. This is the strategy to invest small amounts in large companies. These finance Institutions obviously prefer stable long term growth and the most unlikely place to find this is in a young or small company.
These characteristics, combined with those already mentioned in earlier paragraphs, for instance, fixed transaction costs for raising finance putting the small company at a disadvantage, make the small companies more or less dependent on banks for finance. Institutions that invest in smaller companies will see a higher level of risk; as a consequence, the expected returns are higher and so the cost of the capital is raised.
Companies which find themselves in need of additional finance and look to the public for this via the Stock Exchange have access to variable income and capital investments and fixed income investments. The capital market offers three types of securities, Company securities such as loan stock, shares, and options; public sector securities, such as guilt-edged securities issued by governments and well established companies; and Eurobonds.
There are two facets to the capital markets and each has its distinct function. The primary market issues and deals in new securities. So, companies wishing to raise new equity on the Stock Market “New Issues Market” is dealt with by the primary market. The secondary market deals with existing financial claims. Dealing on the secondary market does not raise new finance for the quoted company, but it enables the lender to transfer the repayment rights to another, while the borrower remains unaffected.
The secondary market is important to the investor because it allows the initial investor to sell the investment as and when he chooses. Without the secondary market, companies would find investors less willing to tie up their money for any length of time so making the raising of finance by share issue more difficult.
The primary function of these markets is to match the lenders to the borrowers and effect the directing of funds between them.
Not all companies are in a position to use the Stock Exchange to raise finance. All companies wishing to enter the Stock Market must be quoted and this is a costly procedure. Many companies are either too small or too new to gain a listing full listing but they need not be excluded from this method of raising finance because there is then the Unlisted Securities Market where the requirements for trading are lower. Companies have to show a three year trading record and offer 10% of shares at the primary issue.
There are four major benefits to a company which can issue ordinary or equity shares. There are no fixed charges associated with ordinary shares. The company may pay a dividend if sufficient profit is generated but it does not have to do so. There is no fixed maturity date. If the company loses, the shares can be sold to increase the creditworthiness of the company and they can be sold more easily than debentures or preference shares because they carry a higher expectation of better returns and so represent a better hedge against inflation.
The downside for the company comes in the shape of costs and control aspects.
There is also the question of “what does the firm want the financing for?”. The reason can either be for the purpose of expansion or settling previously acquired debt. The truth is that even in the healthiest of cases, a small firm faces certain standard small firm problems such as the difficulty to diversify and transaction costs. For example, if a firm is small, this means that whatever it produces or trades is dealt with in much smaller quantities than a larger firm. Thus, the small firm’s accounts read a higher cost in purchasing raw materials (per unit), than the costs a large firm has when purchasing the same raw materials at a much greater quantity.
Another problem on the top of the problem list of a small firm is its total worth. In order for the firm to enter into either a debt market or an equity market, it must be of a substantial value. For the case of the debt market, the small firm will not be able to acquire a substantial amount of capital through a loan due to its lack in required collateral. In the case of the equity market, it is difficult for a small firm to enter this market for the same reason, but not implausible.
The main concern for the small firm is the interest rate the debentures or loans it has issued carry. It is for this reason that these sources of finance are preferred to be used as short term solutions. In the case of a small firm though, these debentures or loans may be the only way to kick-start the firm into growth. There must be a source of finance for the firm to use in order for it to invest long term through short term financial sources.
Long term investments are an integral part of a small firm’s growth. Investments in technology mainly, give a firm the potential to expand, provided that the new investment(s) are managed and utilized appropriately, and integrated accordingly into the previous assets of the small firm.
For the manager looking to raise finance for the company the Stock Exchange offers a number of possibilities, if the company is in a position to meet with the process of listing and the costs. If not, debt capital and its distinguishing features of being less expensive than equity capital, being of lower risk and therefore having a lower rate of return together with tax deductable interest payments, are commonly experienced by managers of small companies.
As an epilogue, an alternative to borrowing, the economic value of leasing is calculated by discounting the incremental cashflows of the lease over the borrowing alternative. In addition to the taxation benefits, leasing helps to preserve cash, varies the borrowing portfolio and provides a less restrictive form of finance. Its certainty and flexibility reduces risk and allows the small companies a greater freedom in their investment decision process because rentals are operating expenses.
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