Question

Suppose you have invested in a new computer company whose profitability depends on two factors: whether the U.S. Congress passes a tariff raising the cost of Japanese computers and (2) whether the U.S. economy grows slowly or quickly. What are the four mutually exclusive states of the world that you should be concerned about?

Short answer

The four mutually exclusive states of the world are: (1) The U.S. Congress passes the tariff and the U.S. economy grows slowly, (2) The U.S. Congress passes the tariff and the U.S. economy grows quickly, (3) The U.S. Congress does not pass the tariff and the U.S. economy grows slowly, (4) The U.S. Congress does not pass the tariff and the U.S. economy grows quickly.

Step-by-step solution

Identify all possible outcomes for the first variable

For the first variable, the U.S. Congress can either pass the tariff or not. So, there are two possible outcomes for the first variable.

Identify all possible outcomes for the second variable

For the second variable, the U.S. economy can either grow slowly or quickly. So, there are also two possible outcomes for the second variable.

Combine all possible outcomes of the two variables

By combining all the possible outcomes of the two variables, we get four different scenarios or 'states of the world': \n\n1. The U.S. Congress passes the tariff and the U.S. economy grows slowly.\n2. The U.S. Congress passes the tariff and the U.S. economy grows quickly.\n3. The U.S. Congress does not pass the tariff and the U.S. economy grows slowly.\n4. The U.S. Congress does not pass the tariff and the U.S. economy grows quickly.

Key concepts

Tariff Effects

Understanding the impact of tariffs is critical for any business, especially when investments in international markets or sectors sensitive to trade policies are involved. A tariff is essentially a tax imposed on imported goods. Its effects are multifaceted and can reverberate through the economy.

For instance, if the U.S. Congress passes a tariff on Japanese computers, as suggested in the exercise, the immediate effect would be an increase in the cost of these imports. This could lead to various outcomes:

• Higher prices for Japanese computers in the U.S. market, potentially decreasing demand for these imports.
• Increased competitiveness for domestically produced computers, potentially increasing sales and profits for local manufacturers.
• Retaliatory measures from trade partners, affecting not just the technology sector but possibly other industries involved in international trade.

In the scenario where a tariff is imposed, the computer company in the exercise may benefit if it produces domestically, as the tariff could shield it from lower-cost international competitors. On the other hand, if the company relies on imported components or finished products, it could face increased costs and decreased margins.

Economic Growth

Economic growth is a fundamental driver for businesses and investment prospects. It usually refers to the increase in the real output of goods and services within an economy, often measured as the percentage increase in real gross domestic product (GDP). Economic growth can influence consumer spending, corporate earnings, and various other economic factors.

When considering our computer company, different growth scenarios come into play:

• Slow Growth: In a slow growth environment, consumers may be more cautious with their spending, leading to lower demand for non-essential items like high-end computers. This can limit the company's revenue and profit potential.
• Rapid Growth: Conversely, a rapidly growing economy tends to boost consumer confidence and spending power, which could translate into higher sales for luxury or cutting-edge technology products.

For the exercise at hand, these growth scenarios are crucial as they hugely affect consumer behavior and, consequently, the profitability of the new computer company.

Scenario Analysis

Scenario analysis is a process used to evaluate the potential outcomes of different future events or economic conditions and their impacts on business performance. It incorporates various 'what-if' situations to aid decision-making, which is especially useful in planning and risk management.

Applying scenario analysis to our exercise, we explore four potential futures, each a combination of whether or not a tariff is imposed and the speed of economic growth. These scenarios help stakeholders understand the range of possible outcomes and prepare for them accordingly:

• The coexistence of a tariff with slow economic growth may limit market size and increase production costs.
• A tariff coupled with rapid economic growth could lead to higher sales, albeit at potentially higher cost inputs.
• The absence of a tariff with slow growth could maintain current competition levels but within a limited market.
• Lastly, no tariff and rapid growth could present an ideal scenario with strong consumer demand and stable costs.

Through scenario analysis, the computer company can develop strategic plans to navigate each possibility effectively.