cfa-program2024L1PrereqRead-Economics (1).PDF

© CFA Institute. For candidate use only. Not for distribution. ECONOMICS CFA® Program Curriculum 2024 • LEVEL PREREQUISITE READING • VOLUME 2 © CFA Institute. For candidate use only. Not for distribution. ©2023 by CFA Institute. All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by CFA Institute for this edition only. Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. © CFA Institute. For candidate use only. Not for distribution. CONTENTS How to Use the CFA Program Curriculum Errata vii vii Economics Learning Module 1 Learning Module 2 Topics in Demand and Supply Analysis Introduction Demand Concepts Price Elasticity of Demand Extremes of Price Elasticity Predicting Demand Elasticity, Price Elasticity, and Total Expenditure Income Elasticity of Demand, Cross-Price Elasticity of Demand Cross-Price Elasticity of Demand Substitution and Income Effects; Normal Goods, Inferior Goods, and Special Cases Normal and Inferior Goods Supply Analysis: Cost, Marginal Return, and Productivity Marginal Returns and Productivity Marginal Revenue, Marginal Cost and Profit Maximization; Short-Run Cost Curves: Total, Variable, Fixed, and Marginal Costs Understanding the Interaction between Total, Variable, Fixed, and Marginal Cost and Output Summary Practice Problems Solutions 3 3 4 6 9 9 11 11 14 15 17 17 22 24 29 31 34 Introduction to the Firm and Market Organization 37 Analysis of Market Structures 37 Analysis of Market Structures 38 Perfect Competition 40 Demand Analysis in Perfectly Competitive Markets 41 Other Factors Affecting Demand 42 Consumer Surplus: Value minus Expenditure 43 Supply Analysis, Optimal Price, and Output in Perfectly Competitive Markets 45 Optimal Price and Output in Perfectly Competitive Markets 47 Long-Run Equilibrium in Perfectly Competitive Markets 50 Monopoly Markets: Demand/Supply and Optimal Price/Output 52 Demand Analysis in Monopoly Markets 54 Supply Analysis in Monopoly Markets 55 Optimal Price and Output in Monopoly Markets 56 Price Discrimination and Consumer Surplus 58 Monopoly Markets: Long-Run Equilibrium 60 Summary 61 References 63 Practice Problems 64 indicates an optional segment iv Learning Module 3 Learning Module 4 © CFA Institute. For candidate use only. Not for distribution. Contents Solutions 66 Aggregate Output, Prices, and Economic Growth Introduction Aggregate Output and Income Gross Domestic Product The Components of GDP Relationship among Saving, Investment, the Fiscal Balance and the Trade Balance Aggregate Demand and Aggregate Supply Aggregate Demand Aggregate Supply Shifts in the Aggregate Demand Curve Equilibrium GDP and Prices Economic Growth and Sustainability The Production Function and Potential GDP Sources of Economic Growth Measures of Sustainable Growth Measuring Sustainable Growth Summary References Practice Problems Solutions 67 68 69 70 77 79 82 83 87 89 102 111 112 114 119 122 124 128 129 134 Introduction to Business Cycles Introduction Consumer Behavior Consumer Confidence Measures of Consumption Income Growth Saving Rates Housing Sector Behavior Available Statistics Sensitivity to Interest Rates and Relationship to Credit Cycle The Role of Demographics Impact on the Economic Cycle External Trade Sector Behavior Cyclical Fluctuations of Imports and Exports The Role of the Exchange Rate Overall Effect on Exports and Imports Unemployment The Unemployment Rate Overall Payroll Employment and Productivity Indicators Inflation Deflation, Hyperinflation, and Disinflation Measuring Inflation: The Construction of Price Indexes Price Indexes and Their Usage Explaining Inflation Summary 137 137 138 138 138 139 140 141 141 141 141 142 142 143 143 144 145 146 147 149 150 150 151 155 161 indicates an optional segment Contents © CFA Institute. For candidate use only. Not for distribution. v Practice Problems Solutions 165 169 Learning Module 5 Monetary and Fiscal Policy Introduction to Monetary and Fiscal Policy Money: Functions, Creation, and Definition The Functions of Money Paper Money and the Money Creation Process Definitions of Money Money: Quantity Theory, Supply and Demand, Fisher Effect The Demand for Money The Supply and Demand for Money The Fisher Effect The Costs of Inflation Summary Practice Problems Solutions 171 171 173 173 174 177 178 178 180 182 183 184 186 188 Learning Module 6 International Trade and Capital Flows Introduction & International Trade: Basic Terminology International Trade Patterns and Trends in International Trade and Capital Flows Comparative Advantage and the Gains from Trade: Absolute and Comparative Advantage Gains from Trade: Absolute and Comparative Advantage Ricardian and Heckscher–Ohlin Models of Comparative Advantage Balance of Payments: Accounts and Components Balance of Payments Accounts Balance of Payments Components National Economic Accounts and the Balance of Payments Summary References Practice Problems Solutions 189 189 190 191 Currency Exchange Rates Introduction & The Foreign Exchange Market Market Functions Exchange Rates and the Trade Balance: The Elasticities Approach Exchange Rates and the Trade Balance: The Absorption Approach Summary Practice Problems Solutions 217 217 218 223 226 230 233 234 Glossary G-1 Learning Module 7 indicates an optional segment 195 195 198 200 200 201 204 208 211 212 214 © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution. How to Use the CFA Program Curriculum The CFA® Program assumes basic knowledge of Economics, Quantitative Methods, and Financial Statements as presented in introductory university-level courses in Statistics, Economics, and Accounting. CFA Level I candidates who do not have a basic understanding of these concepts or would like to review these concepts can study from any of the three prerequisite-reading volumes as follows: ■ Prerequisite reading volume 1: Quantitative Methods ■ Prerequisite reading volume 2: Economics ■ Prerequisite reading volume 3: Financial Statement Analysis ERRATA The curriculum development process is rigorous and includes multiple rounds of reviews by content experts. Despite our efforts to produce a curriculum that is free of errors, there are instances where we must make corrections. Curriculum errata are periodically updated and posted by exam level and test date online on the Curriculum Errata webpage (www.cfainstitute.org/en/programs/submit-errata). If you believe you have found an error in the curriculum, you can submit your concerns through our curriculum errata reporting process found at the bottom of the Curriculum Errata webpage. vii viii © CFA Institute. For candidate use only. Not for distribution. How to Use the CFA Program Curriculum © CFA Institute. For candidate use only. Not for distribution. Economics © CFA Institute. For candidate use only. Not for distribution. © CFA Institute. For candidate use only. Not for distribution. LEARNING MODULE 1 Topics in Demand and Supply Analysis by Richard V. Eastin, PhD, and Gary L. Arbogast, PhD, CFA. Richard V. Eastin, PhD, is at the University of Southern California (USA). Gary L. Arbogast, PhD, CFA (USA). LEARNING OUTCOMES Mastery The candidate should be able to: calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure compare substitution and income effects contrast normal goods with inferior goods describe the phenomenon of diminishing marginal returns determine and interpret breakeven and shutdown points of production INTRODUCTION In a general sense, economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income, and is rooted in microeconomics, which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and the theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-maximizing firms. It is expected that candidates will be familiar with the basic concepts of demand and supply. In this reading, we will explore how buyers and sellers interact to determine transaction prices and quantities. 1 4 Learning Module 1 2 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis DEMAND CONCEPTS calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure The fundamental model of the private-enterprise economy is the demand and supply model of the market. In this section, we examine three important topics concerning the demand side of the model: (1) elasticities, (2) substitution and income effects, and (3) normal and inferior goods. The quantity of a good that consumers are willing to buy depends on a number of different variables. Perhaps the most important of those variables is the item’s own price. In general, as the price of a good rises, buyers will choose to buy less of it, and as its price falls, they buy more. This is referred to as the law of demand. Although a good’s own price is important in determining consumers’ willingness to purchase it, other variables also influence that decision. Consumers’ incomes, their tastes and preferences, and the prices of other goods that serve as substitutes or complements are just a few of the other variables that influence consumers’ demand for a product or service. Economists attempt to capture all these influences in a relationship called the demand function. (A function is a relationship that assigns a unique value to a dependent variable for any given set of values of a group of independent variables.) Equation 1 is an example of a demand function. In Equation 1, we are saying, “The quantity demanded of good X depends on (is a function of ) the price of good X, consumers’ income, and the price of good Y”: Qxd = f( Px , I, P y ) (1) where Qxd = the quantity demanded of some good X (such as per household demand for gasoline in liters per month) Px = the price per unit of good X (such as € per liter) I = consumers’ income (as in €1,000s per household annually) Py = the price of another good, Y. (There can be many other goods, not just one, and they can be complements or substitutes.) Often, economists use simple linear equations to approximate real-world demand and supply functions in relevant ranges. Equation 2 illustrates a hypothetical example of our function for gasoline demand: Qxd = 84.5 – 6.39Px + 0.25I – 2Py (2) where the quantity of gasoline demanded (Qxd)is a function of the price of a liter of gasoline (Px), consumers’ income in €1,000s (I), and the average price of an automobile in €1,000s (P y). The signs of the coefficients on gasoline price (negative) and consumers’ income (positive) reflect the relationship between those variables and the quantity of gasoline consumed. The negative sign on average automobile price indicates that if automobiles go up in price, fewer will likely be purchased and driven; hence, less gasoline will be consumed. As discussed later, such a relationship would indicate that gasoline and automobiles have a negative cross-price elasticity of demand and are thus complements. Demand Concepts © CFA Institute. For candidate use only. Not for distribution. To continue our example, suppose that the price of gasoline (Px) is €1.48 per liter, per household income (I) is €50,000, and the price of the average automobile (P y) is €20,000. In this case, this function would predict that the per-household monthly demand for gasoline would be 47.54 liters, calculated as follows: Qxd= 84.5 – 6.39(1.48) + 0.25(50) – 2(20) = 47.54 recalling that income and automobile prices are measured in thousands. Note that the sign on the “own-price” variable (Px) is negative; thus, as the price of gasoline rises, per household consumption would decrease by 6.39 liters per month for every €1 increase in gas price. Own price is used by economists to underscore that the reference is to the price of a good itself and not the price of some other good. In our example, there are three independent variables in the demand function and one dependent variable. If any one of the independent variables changes, so does the quantity demanded. It is often desirable to concentrate on the relationship between the dependent variable and just one of the independent variables at a time. To accomplish this goal, we can hold the other independent variables constant and rewrite the equation. For example, to concentrate on the relationship between the quantity demanded of the good and its own price, Px, we hold constant the values of income and the price of good Y. In our example, those values are 50 and 20, respectively. The equation would then be rewritten as Qxd= 84.5 – 6.39Px + 0.25(50) – 2(20) = 57 – 6.39Px (3) The quantity of gasoline demanded is a function of the price of gasoline (6.39 per liter), per household income (€50,000), and the average price of an automobile (€20,000). Notice that income and the price of automobiles are not ignored; they are simply held constant, and they are “collected” in the new constant term, 57 [84.5 + (0.25)(50) – (2) (20)]. Notice also that we can solve for Px in terms of Q xdby rearranging Equation 3, which gives us Equation 4: xd Px = 8.92 − 0.156 Q (4) Equation 4 gives the price of gasoline as a function of the quantity of gasoline consumed per month and is referred to as the inverse demand function. Qx in Equation 4 must be restricted to be less than or equal to 57 so that price is not negative. The graph of the inverse demand function is called the demand curve and is shown in Exhibit 1.1 1 Following usual practice, we show linear demand curves intersecting the quantity axis at a price of zero. Real-world demand functions may be non-linear in some or all parts of their domain. Thus, linear demand functions in practical cases are approximations of the true demand function that are useful for a relevant range of values. 5 6 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis Exhibit 1: Household Demand Curve for Gasoline Px (€ per liter) 8.92 2.48 1.48 Qx (liters per month) 47.54 41.15 57 The demand curve represents the highest quantity willingly purchased at each price as well as the highest price willingly paid for each quantity. In this example, this household would be willing to purchase 47.54 liters of gasoline per month at a price of €1.48 per liter. If price were to rise to €2.48 per liter, the household would be willing to purchase only 41.15 liters per month. This demand curve is drawn with price on the vertical (y) axis and quantity on the horizontal (x) axis. It can be correctly interpreted as specifying either the highest quantity a household would buy at a given price or the highest price it would be willing to pay for a given quantity. In our example, at a price of €1.48 per liter, households would each be willing to buy 47.54 liters per month. Alternatively, the highest price they would be willing to pay for 47.54 liters per month is €1.48 per liter. If the price were to rise by €1, households would reduce the quantity they each bought by 6.39 units, to 41.15 liters. The slope of the demand curve is measured as the change in price, P, divided by the change in quantity, Q (∆P/∆Q, where ∆ stands for “the change in”). In this case, the slope of the demand curve is 1/–6.39, or –0.156. The general model of demand and supply can be highly useful in understanding directional changes in prices and quantities that result from shifts in one curve or the other. Often, though, we need to measure how sensitive quantity demanded or supplied is to changes in the independent variables that affect them. This is the concept of elasticity of demand and elasticity of supply. Fundamentally, all elasticities are calculated in the same way: They are ratios of percentage changes. Let us begin with the sensitivity of quantity demanded to changes in the own price. 3 PRICE ELASTICITY OF DEMAND calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure In Equation 1, we expressed the quantity demanded of some good as a function of several variables, one of which was the price of the good itself (the good’s “own price”). In Equation 3, we introduced a hypothetical household demand function for gasoline, assuming that the household’s income and the price of another good (automobiles) were held constant. That function was given by the simple linear expression © CFA Institute. For candidate use only. Not for distribution. Price Elasticity of Demand Qxd= 57 – 6.39Px. Using this expression, if we were asked how sensitive the quantity of gasoline demanded is to changes in price, we might say that whenever price changes by one unit, quantity changes by 6.39 units in the opposite direction; for example, if price were to rise by €1, quantity demanded would fall by 6.39 liters per month. The coefficient on the price variable (–6.39) could be the measure of sensitivity we are seeking. There is a drawback associated with that measure, however. It is dependent on the units in which we measured Q and P. When we want to describe the sensitivity of demand, we need to recall the specific units in which Q and P were measured—liters per month and euros per liter—in our example. This relationship cannot readily be extrapolated to other units of measure—for example, gallons and dollars. Economists, therefore, prefer to use a gauge of sensitivity that does not depend on units of measure. That metric is called elasticity. Elasticity is a general measure of how sensitive one variable is to any other variable, and it is expressed as the ratio of percentage changes in each variable: %∆y/%∆x. In the case of own-price elasticity of demand, that measure is illustrated in Equation 5: d %Δ Qx Epdx = _ %Δ P (5) x This equation expresses the sensitivity of the quantity demanded to a change in price. Epdx is the good’s own-price elasticity and is equal to the percentage change in quantity demanded divided by the percentage change in price. This measure is independent of the units in which quantity and price are measured. If quantity demanded falls by 8% when price rises by 10%, then the elasticity of demand is simply –0.8. It does not matter whether we are measuring quantity in gallons per week or liters per day, and it does not matter whether we measure price in dollars per gallon or euros per liter; 10% is 10%, and 8% is 8%. So the ratio of the first to the second is still –0.8. We can expand Equation 5 algebraically by noting that the percentage change in any variable x is simply the change in x (∆x) divided by the level of x. So, we can rewrite Equation 5, using a few simple steps, as %Δ Qxd Epdx = _ %Δ P = x Δ Qxd _ d Qx _ Δ P _x P x = ( _ Δ P ) (_ d ) Qx x Δ Qxd Px (6) To get a better idea of price elasticity, it might be helpful to illustrate using our hypothetical demand function: Q xd= 57 − 6.39Px. When the relationship between d two variables is linear, Δ Qx / Δ Px is equal to the slope coefficient on Px in the demand function. Thus, in our example, the elasticity of demand is –6.39 multiplied by the ratio of price to quantity. We need to choose a price at which to calculate the elasticity coefficient. Using our hypothetical original price of €1.48, we can find the quantity associated with that particular price by inserting 1.48 into the demand function as given in Equation 3: Q = 57 − (6.39)(1.48) = 47.54 and we find that Q = 47.54 liters per month. The result of our calculation is that at a price of 1.48, the elasticity of our market demand function is −6.39(1.48/47.54) = −0.2. How do we interpret that value? It means, simply, that when price equals 1.48, a 1% rise in price would result in a fall in quantity demanded of 0.2%. In our example, when the price is €1.48 per liter, demand is not very sensitive to changes in price because a 1% rise in price would reduce quantity demanded by only 0.2%. In this case, we would say that demand is inelastic. To be precise, when the magnitude (ignoring algebraic sign) of the own-price elasticity coefficient has a value of less than one, demand is said to be inelastic. When that magnitude is greater than 7 8 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis one, demand is said to be elastic. And when the elasticity coefficient is equal to negative one, demand is said to be unit elastic, or unitary elastic. Note that if the law of demand holds, own-price elasticity of demand will always be negative because a rise in price will be associated with a fall in quantity demanded, but it can be either elastic (very sensitive to a change in price) or inelastic (insensitive to a change in price). In our hypothetical example, suppose the price of gasoline was very high, say, €5 per liter. In this case, the elasticity coefficient would be −1.28: Q = 57 − (6.39)(5) = 25.05 and −6.39 (5/25.05) = −1.28 Because the magnitude of the elasticity coefficient is greater than one, we know that demand is elastic at that price.2 In other words, at lower prices (€1.48 per liter), a slight change in the price of gasoline does not have much effect on the quantity demanded, but when gasoline is expensive (€5 per liter), consumer demand for gas is highly affected by changes in price. ■ elastic good: the quantity demanded is sensitive to changes in price ■ inelastic good: the quantity demanded is not very sensitive to changes in price By examining Equation 6 more closely, we can see that for a linear demand curve the elasticity depends on where on the curve we calculate it. The first term, ∆Q/∆P, which is the inverse of the slope of the demand curve, remains constant along the entire demand curve. But the second term, P/Q, changes depending on where we are on the demand curve. At very low prices, P/Q is very small, so demand is inelastic. But at very high prices, Q is low and P is high, so the ratio P/Q is very high and demand is elastic. Exhibit 2 illustrates a characteristic of all negatively sloped linear demand curves. Above the midpoint of the curve, demand is elastic; below the midpoint, demand is inelastic; and at the midpoint, demand is unit elastic. Exhibit 2: The Elasticity of a Linear Demand Curve P Elastic Demand above Midpoint Unit-Elastic Demand at Midpoint Inelastic Demand Below Midpoint Q Note: For all negatively sloped, linear demand curves, elasticity varies depending on where it is calculated. 2 If interested, evidence on price elasticities of demand for gasoline can be found in Molly Espey, “Explaining the Variation in Elasticity Estimates of Gasoline Demand in the United States: A Meta-analysis,” Energy Journal, vol. 17, no. 3 (1996): 49–60. The robust estimates were about –0.26 for short-run elasticity—less than one year—and –0.58 for more than a year. © CFA Institute. For candidate use only. Not for distribution. Predicting Demand Elasticity, Price Elasticity, and Total Expenditure 9 Extremes of Price Elasticity There are two special cases in which linear demand curves have the same elasticity at all points: vertical demand curves and horizontal demand curves. Consider a vertical demand curve, as in Panel A of Exhibit 3, and a horizontal demand curve, as in Panel B. In the first case, the quantity demanded is the same, regardless of price. There is no demand curve that is perfectly vertical at all possible prices, but it is reasonable to assume that, over some range of prices, the same quantity would be purchased at a slightly higher price or a slightly lower price. Thus, in that price range, quantity demanded is not at all sensitive to price, and we would say that demand is perfectly inelastic in that range. Exhibit 3: The Extremes of Price Elasticity Panel A Panel B P P Q Note: A vertical demand has zero elasticity and is called perfectly inelastic. Q Note: A horizontal demand has infinite elasticity and is called perfectly elastic. In the second case, the demand curve is horizontal at some given price. It implies that even a minute price increase will reduce demand to zero, but at that given price, the consumer would buy some large, unknown amount. This situation is a reasonable description of the demand curve facing an individual seller in a perfectly competitive market, such as the wheat market. At the current market price of wheat, an individual farmer could sell all she has. If, however, she held out for a price above market price, it is reasonable to believe that she would not be able to sell any at all; other farmers’ wheat is a perfect substitute for hers, so no one would be willing to buy any of hers at a higher price. In this case, we would say that the demand curve facing a seller under conditions of perfect competition is perfectly elastic. PREDICTING DEMAND ELASTICITY, PRICE ELASTICITY, AND TOTAL EXPENDITURE calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure 4 10 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis Own-price elasticity of demand is a measure of how sensitive the quantity demanded is to changes in the price of a good or service, but what characteristics of a good or its market might be informative in determining whether demand is highly elastic? Perhaps the most important characteristic is whether there are close substitutes for the good in question. If there are close substitutes for the good, then if its price rises even slightly, a consumer would tend to purchase much less of this good and switch to the less costly substitute. If there are no substitutes, however, then it is likely that the demand is much less elastic. Consider a consumer’s demand for some broadly defined product, such as bread. There really are no close substitutes for the entire category of bread, which includes all types from French bread to pita bread to tortillas and so on. So, if the price of all bread were to rise, perhaps a consumer would purchase a little less of it each week, but probably not a significantly smaller amount. Now, consider that the consumer’s demand is for a particular baker’s specialty bread instead of the category “bread” as a whole. Surely, there are close substitutes for Baker Bob’s Whole Wheat Bread with Sesame Seeds than for bread in general. We would expect, then, that the demand for Baker Bob’s special loaf is much more elastic than for the entire category of bread. In addition to the degree of substitutability, other characteristics tend to be generally predictive of a good’s elasticity of demand. These include the portion of the typical budget that is spent on the good, the amount of time that is allowed to respond to the change in price, the extent to which the good is seen as necessary or optional, and so on. In general, if consumers tend to spend a very small portion of their budget on a good, their demand tends to be less elastic than if they spend a very large part of their income. Most people spend only a little on toothpaste each month, for example, so it really does not matter whether the price rises 10%. They would probably still buy about the same amount. If the price of housing were to rise significantly, however, most households would try to find a way to reduce the quantity they buy, at least in the long run. This example leads to another characteristic regarding price elasticity. For most goods and services, the long-run demand is much more elastic than the short-run demand. For example, if the price of gasoline rises, we probably would not be able to respond quickly to reduce the quantity we consume. In the short run, we tend to be locked into modes of transportation, housing and employment location, and so on. With a longer adjustment period, however, we can adjust the quantity consumed in response to the change in price by adopting a new mode of transportation or reducing the distance of our commute. Hence, for most goods, long-run elasticity of demand is greater than short-run elasticity. Durable goods, however, tend to behave in the opposite way. If the price of washing machines were to fall, people might react quickly because they have an old machine that they know will need to be replaced fairly soon anyway. So when price falls, they might decide to go ahead and make a purchase. If the price of washing machines were to stay low forever, however, it is unlikely that a typical consumer would buy more machines over a lifetime. Knowing whether the good or service is seen to be discretionary or non-discretionary helps to understand its sensitivity to a price change. Faced with the same percentage increase in prices, consumers are much more likely to give up their Friday night restaurant meal (discretionary) than they are to cut back significantly on staples in their pantry (non-discretionary). The more a good is seen as being necessary, the less elastic its demand is likely to be. In summary, own-price elasticity of demand is likely to be greater (i.e., more sensitive) for items that have many close substitutes, occupy a large portion of the total budget, are seen to be optional instead of necessary, or have longer adjustment times. Obviously, not all these characteristics operate in the same direction for all goods, so elasticity is likely to be a complex result of these and other characteristics. © CFA Institute. For candidate use only. Not for distribution. Income Elasticity of Demand, Cross-Price Elasticity of Demand 5 INCOME ELASTICITY OF DEMAND, CROSS-PRICE ELASTICITY OF DEMAND calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure Elasticity is a measure of how sensitive one variable is to change in the value of another variable. Up to this point, we have focused on price elasticity, but the quantity demanded of a good is also a function of consumer income. Income elasticity of demand is defined as the percentage change in quantity demanded ( %Δ Q xd) divided by the percentage change in income (%∆I), holding all other things constant, as shown in Equation 7: d %Δ Qx EId = _ %ΔI (7) The structure of this expression is identical to the structure of own-price elasticity given in Equation 5. (All elasticity measures that we will examine have the same general structure; the only thing that changes is the independent variable of interest.) For example, if the income elasticity of demand for some good has a value of 0.8, we would interpret that to mean that whenever income rises by 1%, the quantity demanded at each price would rise by 0.8%. Although own-price elasticity of demand will almost always be negative, income elasticity of demand can be negative, positive, or zero. Positive income elasticity means that as income rises, quantity demanded also rises. Negative income elasticity of demand means that when people experience a rise in income, they buy less of these goods, and when their income falls, they buy more of the same good. ■ normal goods: positive income elasticity ■ inferior goods: negative income elasticity In our discussion of the demand curve, we held all other things constant, including consumer income, to plot the relationship between price and quantity demanded. If income were to change, the entire demand curve would shift one way or the other. For normal goods, a rise in income would shift the entire demand curve upward and to the right. For inferior goods, however, a rise in income would result in a downward and leftward shift in the entire demand curve. Cross-Price Elasticity of Demand We previously discussed a good’s own-price elasticity. However, the price of another good might also have an impact on the demand for that good or service, and we should be able to define an elasticity with respect to the other price (P y) as well. That elasticity is called the cross-price elasticity of demand and takes on the same structure as own-price elasticity and income elasticity of demand, as represented in Equation 8: d %Δ Qx Epdy = _ %Δ P y 11 (8) Note how similar this equation is to the equation for own-price elasticity. The only difference is that the subscript on P is now y, where y indicates some other good. This cross-price elasticity of demand measures how sensitive the demand for good X is to changes in the price of some other good, Y, holding all other things constant. For some pairs of goods, X and Y, when the price of Y rises, more of good X is demanded; the 12 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis cross-price elasticity of demand is positive. Those goods are referred to as substitutes. In economics, if the cross-price elasticity of two goods is positive, they are substitutes, irrespective of whether someone would consider them “similar.” This concept is intuitive if you think about two goods that are seen to be close substitutes, perhaps like two brands of beer. When the price of one of your favorite brands of beer rises, you would probably buy less of that brand and more of a cheaper brand, so the cross-price elasticity of demand would be positive. For substitute goods, an increase in the price of one good would shift the demand curve for the other good upward and to the right. Alternatively, two goods whose cross-price elasticity of demand is negative are said to be complements. Typically, these goods tend to be consumed together as a pair, such as gasoline and automobiles or houses and furniture. When automobile prices fall, we might expect the quantity of autos demanded to rise, and thus we might expect to see a rise in the demand for gasoline. Although a conceptual understanding of demand elasticities is helpful in sorting out the qualitative and directional effects among variables, using an empirically estimated demand function can yield insights into the behavior of a market. For illustration, let us return to our hypothetical individual demand function for gasoline in Equation 2, duplicated here for convenience: Qxd = 84.5 – 6.39Px + 0.25I – 2Py The quantity demanded of a given good ( Qxd)is a function of its own price (Px), consumer income (I), and the price of another good (P y). To derive the market demand function, the individual consumers’ demand functions are simply added together. If there were 1,000 individuals who represented a market and they all had identical demand functions, the market demand function would be the individual consumer’s demand function multiplied by the number of consumers. Using the individual demand function given by Equation 2, the market demand function would be as shown in Equation 9: Qxd = 84,500 – 6,390Px + 250I – 2,000Py (9) Earlier, when we calculated own-price elasticity of demand, we needed to choose a price at which to calculate the elasticity coefficient. Similarly, we need to choose actual values for the independent variables—Px, I, and P y—and insert these values into the “estimated” market demand function to find the quantity demanded. Choosing €1.48 for Px, €50 (in thousands) for I, and €20 (in thousands) for P y, we find that the quantity of gasoline demanded is 47,543 liters per month. We now have everything we need to calculate own-price, income, and cross-price elasticities of demand for our market. Those elasticities are expressed in Equation 10, Equation 11, and Equation 12. Each of those expressions has a term denoting the change in quantity divided by the change in each respective variable: own price, ∆Qx/∆Px; income, ∆Qx/∆I; and cross price, ∆Qx/∆P y. As we stated in the discussion of own-price elasticity, when the relationship between two variables is linear, the change in quantity ( Δ Qxd) divided by the change in own price (∆Px), income (∆I), or cross price (∆P y) is equal to the slope coefficient on that other variable. The elasticities are calculated by inserting the slope coefficients from Equation 9 into the elasticity formulas. Own-price elasticity: Epdx = (_ Δ P ) (_ d ) = ( − 6, 390)(_ 47, 542.8 ) = − 0.20 Qx x Δ Qxd Income elasticity: Px 1.48 (10) © CFA Institute. For candidate use only. Not for distribution. Income Elasticity of Demand, Cross-Price Elasticity of Demand EId = ( _ ΔI )(_ Id ) = ( 250)(_ 47, 542.8 ) = 0.26 Δ Qxd Qx 50 (11) Cross-price elasticity: Δ P ) (_ d ) = ( − 2000)(_ 47, 542.8 ) = − 0.84 Epdy = (_ Qx y Δ Qxd Py 20 (12) In our example, at a price of €1.48, the own-price elasticity of demand is –0.20; a 1% increase in the price of gasoline leads to a decrease in quantity demanded of about 0.20% (Equation 10). Because the absolute value of the own-price elasticity is less than one, we characterize demand as being inelastic at that price; for example, an increase in price would result in an increase in total expenditure on gasoline by consumers in that market. The income elasticity of demand is 0.26 (Equation 11): A 1% increase in income would result in an increase of 0.26% in the quantity demanded of gasoline. Because that elasticity is positive (but small), we would characterize gasoline as a normal good. The cross-price elasticity of demand between gasoline and automobiles is −0.84 (Equation 12): If the price of automobiles rose by 1%, the demand for gasoline would fall by 0.84%. We would, therefore, characterize gasoline and automobiles as complements because the cross-price elasticity is negative. The magnitude is quite small, however, so we would conclude that the complementary relationship is weak. EXAMPLE 1 Calculating Elasticities from a Given Demand Function An individual consumer’s monthly demand for downloadable e-books is given by the equation Qeb d = 2 – 0.4Peb + 0.0005I + 0.15Phb, where Qeb d equals the number of e-books demanded each month, I equals the household monthly income, Peb equals the price of e-books, and Phb equals the price of hardbound books. Assume that the price of e-books is €10.68, household income is €2,300, and the price of hardbound books is €21.40. 1. Determine the value of own-price elasticity of demand for e-books. Solution to 1: The own-price elasticity of demand is given by (Δ Qeb d / Δ Peb )(Peb / Qeb d ). = −0.4. Inserting the Notice from the demand function that Δ Qeb d / Δ Peb given variable values into the demand function yields Qeb d = 2 − (0.4)(10.68) + (0.0005)(2,300) + (0.15)(21.4) = 2.088. So at a price of €10.68, the ownprice elasticity of demand equals (–0.4)(10.68/2.088) = −2.046, which is elastic because in absolute value the elasticity coefficient is greater than 1. 2. Determine the income elasticity of demand for e-books. Solution to 2: Recall that income elasticity of demand is given by (Δ Qeb d / ΔI)(I / Qeb d ). Notice from the demand function that Δ Qeb d / ΔI= 0.0005. Inserting the values for I and Qeb d yields income elasticity of (0.0005)(2,300/2.088) = 0.551, which is positive, so e-books are a normal good. 13 14 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis 3. Determine the cross-price elasticity of demand for e-books with respect to the price of hardbound books. Solution to 3: Recall that cross-price elasticity of demand is given by (∆Qeb/∆Phb)(Phb/ Qeb), and notice from the demand function that ∆Qeb/∆Phb = 0.15. Inserting the values for Phb and Qeb yields a cross-price elasticity of demand for e-books of (0.15)(21.40/2.088) = 1.537, which is positive, implying that e-books and hardbound books are substitutes. 6 SUBSTITUTION AND INCOME EFFECTS; NORMAL GOODS, INFERIOR GOODS, AND SPECIAL CASES compare substitution and income effects contrast normal goods with inferior goods The law of demand states that if nothing changes other than the price of a particular good or service itself, a decrease in that good’s price will tend to result in a greater quantity of that good being purchased. Simply stated, it is the assumption that a demand curve has negative slope; that is, where price per unit is measured on the vertical (y) axis and quantity demanded per time period is measured on the horizontal (x) axis, the demand curve is falling from left to right, as shown in Exhibit 4. Exhibit 4: A Negatively Sloped Demand Curve—The Law of Demand Px Demand Curve for Good X Qx There are two reasons why a consumer would be expected to purchase more of a good when its price falls and less of a good when its price rises. These two reasons are known as the substitution effect and the income effect of a change in price. We address these two effects separately and then examine the combination of the two. When the price of something—say, gasoline—falls, that good becomes relatively less costly compared with other goods or services a consumer might purchase. For example, gasoline is used in driving to work, so when its price falls, it is relatively cheaper to drive to work than to take public transportation. Hence, the consumer is likely to substitute a little more driving to work for a little less public transportation. © CFA Institute. For candidate use only. Not for distribution. Substitution and Income Effects; Normal Goods, Inferior Goods, and Special Cases On its own, the substitution effect suggests that when the price of something falls, consumers tend to purchase more of that good. But another influence is often at work as well—the income effect. Consider a consumer spending all of her “money income” on a given combination of goods and services. (Her money income is simply the quantity of currency available to spend in any given time period.) Now suppose the price of something she was regularly purchasing falls while her money income and the prices of all other goods remain unchanged. Economists refer to this as an increase in purchasing power or real income. For most goods and services, consumers tend to buy more of them when their income rises. So when the price of a good—say, beef—falls, most consumers would tend to buy more beef because of the increase in their real income. Although the consumer’s money income (the number on her paycheck) is assumed not to have changed, her real income has risen because she can now buy more beef—and other goods, too—as a result of the fall in the price of that one good. So, quite apart from the substitution effect of a fall in a good’s price, the income effect tends to cause consumers to purchase more of that good as well. Substitution and income effects work the other way, too. If the price of beef were to rise, the substitution effect would cause the consumer to buy less of it and substitute more chicken for the now relatively more expensive beef. Additionally, the rise in the price of beef results in a decrease in the consumer’s real income because now she can buy less goods with the same amount of money income. If beef is a good that consumers tend to buy more of when their income rises and less of when their income falls, then the rise in beef price would have an income effect that causes the consumer to buy less of it. Normal and Inferior Goods Economists classify goods on various dimensions, one of which relates to how consumers’ purchases of a good respond to changes in consumer income. Earlier, when discussing income elasticity of demand, we introduced the concept of normal goods and inferior goods. For most goods and services, an increase in income would cause consumers to buy more; these are called normal goods. But that does not hold true for all goods: There are goods that consumers buy less of when their income rises and goods that they buy more of when their incomes fall. These are called inferior goods. This section will contrast normal goods with inferior goods. We previously discussed income and substitution effects of a change in price. If a good is normal, a decrease in price will result in the consumer buying more of that good. Both the substitution effect and the income effect are at play here: ■ A decrease in price tends to cause consumers to buy more of this good in place of other goods—the substitution effect. ■ The increase in real income resulting from the decline in this good’s price causes people to buy even more of this good when its price falls—the income effect. So, we can say that for normal goods (restaurant meals, for example, as most people tend to eat out more often when their incomes rise), the substitution and the income effects reinforce one another to cause the demand curve to be negatively sloped. For inferior goods (cheaper cuts of meat or generic beverages, for example, which most people buy less of as their incomes rise), an increase in income causes consumers to buy less, not more, and if their incomes fall, they buy more, not less. “Inferior” does not imply anything at all about the quality of the good; it is simply used to refer to a good for which an increase in income causes some people to buy less of it. The same good could be normal for some consumers while it is inferior for others. Consider a very low-income segment of the population. For those consumers, an increase in their income might very well result in their buying more fast-food meals. 15 16 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis They might take some of that added income and enjoy eating out at a fast-food restaurant a little more often. Now consider a high-income group. If their income rises, they might be much less inclined to eat at fast-food restaurants and instead do their dining out at a fashionable French bistro, for example. So, fast-food meals might be a normal good for some people and an inferior good for others. Let us now consider the substitution and income effects of a change in the price of normal and inferior goods. The substitution effect says that if the price of a good falls, the consumer will substitute more of this good in the consumption bundle and buy less of some other good. The substitution effect is true for both normal and inferior goods. Exhibit 5 summarizes the substitution and income effects for normal and inferior goods. Exhibit 5: The Substitution and Income Effects of a Price Decrease on Normal and Inferior Goods Substitution Effect Income Effect Normal good Buy more because the good is relatively cheaper than its substitutes. Buy more because the increase in purchasing power raises the total consumption level. Inferior good Buy more because the good is relatively cheaper than its substitutes. Buy less because the increase in real income prompts the consumer to buy less of the inferior good in favor of its preferred substitutes. EXAMPLE 2 Income and Substitution Effects of a Decrease in Price Monica has a monthly entertainment budget that she spends on (a) movies and (b) an assortment of other entertainment items. When the price of each movie is $8, she spends a quarter of her budget on six movies a month and the rest of her budget on other entertainment. Monica was offered an opportunity to join a movie club at her local theater that allows her to purchase movies at half the regular price, and she can choose each month whether to join the movie club or not. There is a membership fee she must pay for each month she belongs to the club. Monica is exactly indifferent between (a) not buying the membership and, therefore, paying $8 for movies and (b) buying the membership and paying $4 per movie. So, she flips a coin each month to determine whether to join the club that month. In months that she does join the club, she sees eight movies. For her birthday, a friend gave her a one-month club membership as a gift, and that month she saw 12 movies. 1. If there were no club and the price of movies were to simply fall from $8 to $4, how many more movies would Monica buy each month? Solution to 1: Six movies. When her friend gave her a club membership, she bought 12 movies instead of her usual 6. With the gift of the club membership, Monica could buy movies at a price of $4 without paying for that privilege. This is the same as if the price of each movie fell from $8 to $4. © CFA Institute. For candidate use only. Not for distribution. Supply Analysis: Cost, Marginal Return, and Productivity 17 2. Of the increased number of movies Monica would purchase if the price were to fall from $8 to $4, determine how much of the increase would be attributable to the substitution effect and how much to the income effect of that price decrease. Solution to 2: When Monica pays the club membership herself, she buys eight movies, two more than usual. Because Monica is equally well off whether she joins the club for a monthly fee and thereby pays half price or whether she does not join the club and pays full price, we can say that the income effect of the price decrease has been removed by charging her the monthly fee. So the increase from six movies to eight is the result of the substitution effect. When Monica’s friend gave her the gift of a club membership, allowing her to pay half price without paying for the privilege, Monica bought 12 movies, 6 more than usual and 4 more than she would have had she paid the membership fee. The increase from 8 movies to 12 is the result of the income effect. 3. For Monica, are movies a normal or inferior good? Solution to 3: When the price fell from $8 to $4, Monica bought more movies. Additionally, because the substitution effect and the income effect are in the same direction of buying more movies, they are a normal good for Monica. The substitution effect caused her to buy two more movies, and the income effect caused her to buy an additional four movies. SUPPLY ANALYSIS: COST, MARGINAL RETURN, AND PRODUCTIVITY describe the phenomenon of diminishing marginal returns To fully comprehend the supply side of a consumer goods market, an analyst must understand the firm’s costs. The firm’s marginal cost is the foundation of the firm’s ability and willingness to offer a given quantity for sale, and its costs depend on both the productivity of its inputs and their prices. In this section, we will describe the firm’s cost curves—total, average, and marginal costs in both the short run and in the long run—paying special attention to what economists call the law of diminishing marginal returns. We will then use this information to explore the conditions under which a firm would find it beneficial to continue operation, even if its economic profits are negative, and at what levels of production its shutdown and breakeven points occur. Long-run costs will be examined in the context of economies and diseconomies of scale. Marginal Returns and Productivity There is an economic phenomenon known as increasing marginal returns, in which marginal product—the productivity of each additional unit of a resource—increases as additional units of that input are employed. 7 18 Learning Module 1 © CFA Institute. For candidate use only. Not for distribution. Topics in Demand and Supply Analysis Initially, a firm can experience increasing returns from adding labor to the production process because of the concepts of specialization and division of labor. At first, by having too few workers relative to total physical capital, the understaffing situation requires employees to multi-task and share duties. As more workers are added, employees can specialize, become more adept at their individual functions, and realize an increase in marginal productivity. But after a certain output level, the law of diminishing marginal returns becomes evident. When more and more workers are added to a fixed capital base, the marginal return of the labor factor eventually decreases because the fixed input restricts the output potential of additional workers. As an illustration, consider automobile production. When an auto manufacturing plant is operating at full capacity, adding additional labor will not increase production because the physical plant is already 100% employed. More labor hours will merely add to costs without adding to output. Assuming all workers are of equal quality and motivation, the decline in marginal product occurs in the short run, where all other resources (typically, plant size, physical capital, and technology) are fixed. Marginal returns are directly related to input productivity, a measure of the output per unit of input. Productivity: The Relationship between Production and Cost The cost of producing anything depends on the amount of inputs, or factors of production (these terms are synonymous), and the input prices. Examples of factors of production are employee hours, machine hours, raw materials, and so on. For simplicity, economists typically concentrate on only two inputs, labor and capital, although obviously there can be many inputs to a particular production process. The labor input is simply employee time, and it is measured as labor hours per time period, such as per week or per month. We denote labor hours as L. If a firm is using two laborers per week and each laborer works 35 hours per week, then L equals 70 labor hours per week. We denote hours of capital as K. If the firm is using three machines and each one is used for 12 hours per week, then K equals 36 machine hours per week. That is, the capital input is measured as machine hours used per time period. In this way, capital and labor are stated in similar terms. They represent flows of services—labor hours and machine hours—that are used to produce a flow of output per time period. Accordingly, the respective input prices would be the wage rate per labor hour (we use w to denote wage rate) and the rental rate per machine hour (we use r to denote the rental rate per machine hour). It is helpful to think of a firm as renting the services of labor and of machines. Although the firm might own its own machines, it could in theory rent its machines out to another user, so it is forgoing the rate it could earn elsewhere when it is using its machines internally instead of renting them out. So, a firm is not using its own machines “for free.” It is incurring the opportunity cost of not being able to rent those machines to another user. The total cost of production (TC) is the number of hours of labor multiplied by the wage rate plus the number of machine hours multiplied by the rental rate of machines: TC = (w)(L) + (r)(K) This formula illustrates that the total cost is just the cost of all the firm’s inputs. It is not a cost function, however, which is a relationship between the cost of production and the flow of output. The cost function C = f(Q), where (Q) denotes the flow of output in units of production per time period, relates the production cost per time period to the number of units of output produced per time period. Two things could cause the cost of producing any given level of output to fall: Either the price of one or both inputs could fall or the inputs themselves could become more productive and less of them would be needed (e.g., a worker is more productive © CFA Institute. For candidate use only. Not for distribution. Supply Analysis: Cost, Marginal Return, and Productivity when fewer hours of labor are needed to produce the same output). The reverse is true also: A rise in cost could result from either a rise in input prices or a fall in input producti

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