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The Theory of Rational Expectations maintains that as soon as the information is made public, the price plays a catch-up and soon starts to reflect the new announcement. Finally strong form suggests that not only publicly available information is useless, but also all the information concerning the company is useless, as that will have no impact over the stock price. Rational expectations relates to the efficient market theory as investors, based on their expectations, value a stock, for example if they think earnings visibility is good they bid the prices higher, and if perceive earnings visibility to be low, they bid prices to be low and this is reflected in the stock prices so their estimates or expectations are reflected in the stock prices. Talking of the criticism faced by the theory, we can argue that the theory of efficient market itself suggests that all the announcements and news about the company are already fully reflected in the price, so expectations do not drive the result and hence investors expectations have nothing to do with the future market price. Also the theory is based on future (predicting the earnings) which can not be predicted.Another application of the theory pertains to The Permanent Income Theory of Consumption which states that there is a direct positive relationship between the peoples consumption and their income. Friedman believed that people not only consume depending upon their current income, but also considering their future income. Analysis of future income in his work is due to the expectations that people have about their future, so the concept directly relates to the rational expectations theory. The specific model of consumption and income has been tested time and again and results have varied greatly, as the studies show that the model works, but imperfectly. It can be argued to overpower the above mentioned point that many people have certain consumption habits and if they stick to their habits, it becomes literally improbable for them to care about their resources and income. Many such cases happen with addicts or people who abuse drugs or alcohol. Rational expectations theory can also be applied to the Expectation Error Models of the Business Cycle, which states that errors in peoples forecasts are a major cause of business fluctuations. Phillips curve shows the inverse relationship between unemployment and inflation, where there is a non-accelerating inflation rate of unemployment. The PC which is the long red line changes in the long run because of the change in expectations and thus only a single rate of unemployment was consistent with the inflation rate. If the unemployment rate stays behind the red line inflationary expectations will rise which will tale the short term PC upwards as indicated by B.
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