CFA Program Curriculum 2025 Level 1 Volume 2 PDF

© CFA Institute. For candidate use only. Not for distribution. ECONOMICS CFA® Program Curriculum 2025 LEVEL 1 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...

© CFA Institute. For candidate use only. Not for distribution. ECONOMICS CFA® Program Curriculum 2025 LEVEL 1 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 pro- fessional 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. ISBN 9781953337993 (paper) ISBN 9781961409118 (ebook) May 2024  © CFA Institute. For candidate use only. Not for distribution. CONTENTS How to Use the CFA Program Curriculum   vii CFA Institute Learning Ecosystem (LES)   vii Designing Your Personal Study Program   vii Errata   viii Other Feedback   viii Economics Learning Module 1 The Firm and Market Structures   3 Introduction   3 Profit Maximization: Production Breakeven, Shutdown and Economies of Scale   6 Profit-Maximization, Breakeven, and Shutdown Points of Production   7 Breakeven Analysis and Shutdown Decision   9 The Shutdown Decision   10 Economies and Diseconomies of Scale with Short-Run and Long-Run Cost Analysis   14 Introduction to Market Structures   20 Analysis of Market Structures   20 Monopolistic Competition   25 Demand Analysis in Monopolistically Competitive Markets   26 Supply Analysis in Monopolistically Competitive Markets   27 Optimal Price and Output in Monopolistically Competitive Markets   27 Long-Run Equilibrium in Monopolistic Competition   28 Oligopoly   29 Oligopoly and Pricing Strategies   29 Demand Analysis and Pricing Strategies in Oligopoly Markets   30 The Cournot Assumption   32 The Nash Equilibrium   34 Oligopoly Markets: Optimal Price, Output, and Long-Run Equilibrium   36 Determining Market Structure   40 Econometric Approaches   41 Simpler Measures   42 Practice Problems   45 Solutions   48 Learning Module 2 Understanding Business Cycles   49 Introduction   49 Overview of the Business Cycle   51 Phases of the Business Cycle   52 Leads and Lags in Business and Consumer Decision Making   55 Market Conditions and Investor Behavior   55 Credit Cycles   57 Applications of Credit Cycles   58  © CFA Institute. 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Not for distribution. iv Contents Consequences for Policy   59 Economic Indicators over the Business Cycle   60 The Workforce and Company Costs   60 Fluctuations in Capital Spending   61 Fluctuations in Inventory Levels   63 Economic Indicators   65 Types of Indicators   65 Composite Indicators   66 Leading Indicators   66 Using Economic Indicators   67 Other Composite Leading Indicators   68 Surveys   70 The Use of Big Data in Economic Indicators   70 Nowcasting   70 GDPNow   71 Practice Problems   74 Solutions   77 Learning Module 3 Fiscal Policy   79 Introduction   79 Introduction to Monetary and Fiscal Policy   80 Roles and Objectives of Fiscal Policy   83 Roles and Objectives of Fiscal Policy   83 Deficits and the National Debt   88 Fiscal Policy Tools   92 The Advantages and Disadvantages of Different Fiscal Policy Tools   95 Modeling the Impact of Taxes and Government Spending: The Fiscal Multiplier   96 The Balanced Budget Multiplier   97 Fiscal Policy Implementation   98 Deficits and the Fiscal Stance   99 Difficulties in Executing Fiscal Policy   100 Practice Problems   103 Solutions   104 Learning Module 4 Monetary Policy   105 Introduction   105 Role of Central Banks   106 Roles of Central Banks and Objectives of Monetary Policy   107 The Objectives of Monetary Policy   109 Monetary Policy Tools and Monetary Transmission   111 Open Market Operations   112 The Central Bank’s Policy Rate   112 Reserve Requirements   113 The Transmission Mechanism   113 Monetary Policy Objectives   116 Inflation Targeting   116 Central Bank Independence   117  © CFA Institute. 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Contents v Credibility   117 Transparency   118 The Bank of Japan   121 The US Federal Reserve System   121 Exchange Rate Targeting   123 Contractionary and Expansionary Monetary Policies and Their Limitations   125 What’s the Source of the Shock to the Inflation Rate?   126 Limitations of Monetary Policy   126 Interaction of Monetary and Fiscal Policy   132 The Relationship Between Monetary and Fiscal Policy   132 Practice Problems   137 Solutions   139 Learning Module 5 Introduction to Geopolitics   141 Introduction   141 National Governments and Political Cooperation   144 State and Non-State Actors   144 Features of Political Cooperation   145 Resource Endowment, Standardization, and Soft Power   147 The Role of Institutions   148 Hierarchy of Interests and Costs of Cooperation   149 Power of the Decision Maker   150 Political Non-Cooperation   150 Forces of Globalization   152 Features of Globalization   154 Motivations for Globalization   156 Costs of Globalization and Threats of Rollback   157 Threats of Rollback of Globalization   159 International Trade Organizations    160 Role of the International Monetary Fund   161 World Bank Group and Developing Countries   163 World Trade Organization and Global Trade   164 Assessing Geopolitical Actors and Risk   167 Archetypes of Country Behavior   167 The Tools of Geopolitics   173 The Tools of Geopolitics   173 Multifaceted Approaches   177 Geopolitical Risk and Comparative Advantage   178 Geopolitical Risk and the Investment Process   179 Types of Geopolitical Risk   179 Assessing Geopolitical Threats   182 Impact of Geopolitical Risk   184 Tracking Risks According to Signposts   185 Manifestations of Geopolitical Risk   186 Acting on Geopolitical Risk   188 Practice Problems   190 Solutions   192  © CFA Institute. 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Not for distribution. vi Contents Learning Module 6 International Trade   195 Introduction   195 Benefits and Costs of Trade   196 Benefits and Costs of International Trade   197 Trade Restrictions and Agreements—Tariffs, Quotas, and Export Subsidies   199 Tariffs   200 Quotas   202 Export Subsidies   203 Trading Blocs and Regional Integration   205 Types Of Trading Blocs   206 Regional Integration   207 Practice Problems   211 Solutions   213 Learning Module 7 Capital Flows and the FX Market   215 Introduction   215 The Foreign Exchange Market and Exchange Rates   216 Introduction and the Foreign Exchange Market   216 Market Participants   223 Market Composition   226 Exchange Rate Quotations   229 Exchange Rate Regimes: Ideals and Historical Perspective   233 The Ideal Currency Regime   233 Historical Perspective on Currency Regimes   234 A Taxonomy of Currency Regimes   237 Exchange Rates and the Trade Balance: Introduction   245 Capital Restrictions   246 Practice Problems   250 Solutions   251 Learning Module 8 Exchange Rate Calculations   253 Introduction   253 Cross-Rate Calculations   254 Forward Rate Calculations   258 Arbitrage Relationships   259 Forward Discounts and Premiums   262 Practice Problems   266 Solutions   268 Glossary   G-1  © CFA Institute. For candidate use only. Not for distribution. vii How to Use the CFA Program Curriculum The CFA® Program exams measure your mastery of the core knowledge, skills, and abilities required to succeed as an investment professional. These core competencies are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of four components: A broad outline that lists the major CFA Program topic areas (www​.cfainstitute​.org/​programs/​cfa/​curriculum/​cbok/​cbok) Topic area weights that indicate the relative exam weightings of the top-level topic areas (www​.cfainstitute​.org/​en/​programs/​cfa/​curriculum) Learning outcome statements (LOS) that advise candidates about the specific knowledge, skills, and abilities they should acquire from curricu- lum content covering a topic area: LOS are provided at the beginning of each block of related content and the specific lesson that covers them. We encourage you to review the information about the LOS on our website (www​.cfainstitute​.org/​programs/​cfa/​curriculum/​study​-sessions), including the descriptions of LOS “command words” on the candidate resources page at www​.cfainstitute​.org/​-/​media/​documents/​support/​programs/​cfa​-and​ -cipm​-los​-command​-words​.ashx. The CFA Program curriculum that candidates receive access to upon exam registration Therefore, the key to your success on the CFA exams is studying and understanding the CBOK. You can learn more about the CBOK on our website: www​.cfainstitute​.org/​programs/​cfa/​curriculum/​cbok. The curriculum, including the practice questions, is the basis for all exam questions. The curriculum is selected or developed specifically to provide candidates with the knowledge, skills, and abilities reflected in the CBOK. CFA INSTITUTE LEARNING ECOSYSTEM (LES) Your exam registration fee includes access to the CFA Institute Learning Ecosystem (LES). This digital learning platform provides access, even offline, to all the curriculum content and practice questions. The LES is organized as a series of learning modules consisting of short online lessons and associated practice questions. This tool is your source for all study materials, including practice questions and mock exams. The LES is the primary method by which CFA Institute delivers your curriculum experience. Here, candidates will find additional practice questions to test their knowledge. Some questions in the LES provide a unique interactive experience. DESIGNING YOUR PERSONAL STUDY PROGRAM An orderly, systematic approach to exam preparation is critical. You should dedicate a consistent block of time every week to reading and studying. Review the LOS both before and after you study curriculum content to ensure you can demonstrate the  © CFA Institute. For candidate use only. Not for distribution. viii How to Use the CFA Program Curriculum knowledge, skills, and abilities described by the LOS and the assigned reading. Use the LOS as a self-check to track your progress and highlight areas of weakness for later review. Successful candidates report an average of more than 300 hours preparing for each exam. Your preparation time will vary based on your prior education and experience, and you will likely spend more time on some topics than on others. ERRATA The curriculum development process is rigorous and involves multiple rounds of reviews by content experts. Despite our efforts to produce a curriculum that is free of errors, in some instances, we must make corrections. Curriculum errata are periodically updated and posted by exam level and test date 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. OTHER FEEDBACK Please send any comments or suggestions to info@​cfainstitute​.org, and we will review your feedback thoughtfully. © 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 The Firm and Market Structures by Gary L. Arbogast, PhD, CFA, Richard V. Eastin, PhD, Fritz Richard, PhD, and Gambera Michele, PhD, CFA. Gary L. Arbogast, PhD, CFA (USA). Richard V. Eastin, PhD, is at the University of Southern California (USA). Richard Fritz, PhD, is at the School of Economics at Georgia Institute of Technology (USA). Michele Gambera, PhD, CFA, is at UBS Asset Management and the University of Illinois at Urbana-Champaign (USA). LEARNING OUTCOMES Mastery The candidate should be able to: determine and interpret breakeven and shutdown points of production, as well as how economies and diseconomies of scale affect costs under perfect and imperfect competition describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly explain supply and demand relationships under monopolistic competition, including the optimal price and output for firms as well as pricing strategy explain supply and demand relationships under oligopoly, including the optimal price and output for firms as well as pricing strategy identify the type of market structure within which a firm operates and describe the use and limitations of concentration measures INTRODUCTION This learning module addresses several important concepts that extend the basic 1 market model of demand and supply to the assessment of a firm’s breakeven and shutdown points of production. Demand concepts covered include own-price elas- ticity of demand, cross-price elasticity of demand, and income elasticity of demand. Supply concepts covered include total, average, and marginal product of labor; total, variable, and marginal cost of labor; and total and marginal revenue. These concepts are used to calculate the breakeven and shutdown points of production.  © CFA Institute. For candidate use only. Not for distribution. 4 Learning Module 1 The Firm and Market Structures This learning module surveys how economists classify market structures. We analyze distinctions between the different structures that are important for under- standing demand and supply relations, optimal price and output, and the factors affecting long-run profitability. We also provide guidelines for identifying market structure in practice. LEARNING MODULE OVERVIEW Firms under conditions of perfect competition have no pricing power and, therefore, face a perfectly horizontal demand curve at the market price. For firms under conditions of perfect competition, price is identical to marginal revenue (MR). Firms under conditions of imperfect competition face a negatively sloped demand curve and have pricing power. For firms under condi- tions of imperfect competition, MR is less than price. Economic profit equals total revenue (TR) minus total economic cost, whereas accounting profit equals TR minus total accounting cost. Economic cost considers the total opportunity cost of all factors of production. Opportunity cost is the next best alternative use of a resource forgone in making a decision. Maximum economic profit requires that (1) MR equals marginal cost (MC) and (2) MC not be falling with output. The breakeven point occurs when TR equals total cost (TC), otherwise stated as the output quantity at which average total cost (ATC) equals price. Shutdown occurs when a firm is better off not operating than continu- ing to operate. If all fixed costs are sunk costs, then shutdown occurs when the market price falls below the minimum average variable cost. After shutdown, the firm incurs only fixed costs and loses less money than it would operating at a price that does not cover variable costs. In the short run, it may be rational for a firm to continue to operate while earning negative economic profit if some unavoidable fixed costs are covered. Economies of scale is defined as decreasing long-run cost per unit as output increases. Diseconomies of scale is defined as increasing long- run cost per unit as output increases. Long-run ATC is the cost of production per unit of output under con- ditions in which all inputs are variable. Specialization efficiencies and bargaining power in input price can lead to economies of scale. Bureaucratic and communication breakdowns and bottlenecks that raise input prices can lead to diseconomies of scale. The minimum point on the long-run ATC curve defines the minimum efficient scale for the firm. Economic market structures can be grouped into four categories: per- fect competition, monopolistic competition, oligopoly, and monopoly.  © CFA Institute. For candidate use only. Not for distribution. Introduction 5 The categories of economic market structures differ because of the following characteristics: The number of producers is many in perfect and monopolistic competition, few in oligopoly, and one in monopoly. The degree of product differentiation, the pricing power of the pro- ducer, the barriers to entry of new producers, and the level of non- price competition (e.g., advertising) are all low in perfect competition, moderate in monopolistic competition, high in oligopoly, and gener- ally highest in monopoly. A financial analyst must understand the characteristics of market structures to better forecast a firm’s future profit stream. The optimal MR equals MC. Only in perfect competition, however, does the MR equal price. In the remaining structures, price generally exceeds MR because a firm can sell more units only by reducing the per unit price. The quantity sold is highest in perfect competition. The price in perfect competition is usually lowest, but this depends on factors such as demand elasticity and increasing returns to scale (which may reduce the producer’s MC). Monopolists, oligopolists, and producers in monopolistic competition attempt to differentiate their products so that they can charge higher prices. Typically, monopolists sell a smaller quantity at a higher price. Investors may benefit from being shareholders of monopolistic firms that have large margins and substantial positive cash flows. In perfect competition, firms do not earn economic profit. The market will compensate for the rental of capital and of management ser- vices, but the lack of pricing power implies that there will be no extra margins. In the short run, firms in any market structure can have economic profits, the more competitive a market is and the lower the barriers to entry, the faster the extra profits will fade. In the long run, new entrants shrink margins and push the least efficient firms out of the market. Oligopoly is characterized by the importance of strategic behavior. Firms can change the price, quantity, quality, and advertisement of the product to gain an advantage over their competitors. Several types of equilibrium (e.g., Nash, Cournot, kinked demand curve) may occur that affect the likelihood of each of the incumbents (and potential entrants in the long run) having economic profits. Price wars may be started to force weaker competitors to abandon the market. Measuring market power is complicated. Ideally, econometric esti- mates of the elasticity of demand and supply should be computed. However, because of the lack of reliable data and the fact that elastic- ity changes over time (so that past data may not apply to the current situation), regulators and economists often use simpler measures. The concentration ratio is simple, but the Herfindahl-Hirschman index (HHI), with a little more computation required, often produces a bet- ter figure for decision making.  © CFA Institute. For candidate use only. Not for distribution. 6 Learning Module 1 The Firm and Market Structures 2 PROFIT MAXIMIZATION: PRODUCTION BREAKEVEN, SHUTDOWN AND ECONOMIES OF SCALE determine and interpret breakeven and shutdown points of production, as well as how economies and diseconomies of scale affect costs under perfect and imperfect competition Firms generally can be classified as operating in either a perfectly competitive or an imperfectly competitive environment. The difference between the two manifests in the slope of the demand curve facing the firm. If the environment of the firm is perfectly competitive, it must take the market price of its output as given, so it faces a perfectly elastic, horizontal demand curve. In this case, the firm’s marginal revenue (MR) and the price of its product are identical. Additionally, the firm’s average revenue (AR), or revenue per unit, is also equal to price per unit. A firm that faces a negatively sloped demand curve, however, must lower its price to sell an additional unit, so its MR is less than price (P). These characteristics of MR are also applicable to the total revenue (TR) func- tions. Under conditions of perfect competition, TR (as always) is equal to price times quantity: TR = (P)(Q). But under conditions of perfect competition, price is dictated by the market; the firm has no control over price. As the firm sells one more unit, its TR rises by the exact amount of price per unit. Under conditions of imperfect competition, price is a variable under the firm’s control, and therefore price is a function of quantity: P = f(Q), and TR = f(Q) × Q. For simplicity, suppose the firm is monopolistic and faces the market demand curve, which we will assume is linear and negatively sloped. Because the monopolist is the only seller, its TR is identical to the total expenditure of all buyers in the market. When price is reduced and quantity sold increases in this environment, a decrease in price initially increases total expenditure by buyers and TR to the firm because the decrease in price is outweighed by the increase in units sold. But as price continues to fall, the decrease in price overshadows the increase in quantity, and total expenditure (revenue) falls. We can now depict the demand and TR functions for firms under conditions of perfect and imperfect competition, as shown in Exhibit 1.  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 7 Exhibit 1: Demand and Total Revenue Functions for Firms under Conditions of Perfect and Imperfect Competition A. Perfectly Competitive Firm B. Imperfectly Competitive Firm P P Demand Curve: P = MR Demand Curve Q Q TR TR MR Curve TR Curve TR Curve Q Q Panel A of Exhibit 1 depicts the demand curve (upper graph) and total revenue curve (lower graph) for the firm under conditions of perfect competition. Notice that the vertical axis in the upper graph is price per unit (e.g., GBP/bushel), whereas TR is measured on the vertical axis in the lower graph (e.g., GBP/week). The same is true for the respective axes in Panel B, which depicts the demand and total revenue curves for the monopolist. The TR curve for the firm under conditions of perfect competition is linear, with a slope equal to price per unit. The TR curve for the monopolist first rises (in the range where MR is positive and demand is elastic) and then falls (in the range where MR is negative and demand is inelastic) with output. Profit-Maximization, Breakeven, and Shutdown Points of Production We can now combine the firm’s short-run TC curves with its TR curves to represent profit maximization in the cases of perfect competition and imperfect competition. Exhibit 2 shows both the AR and average cost curves in one graph for the firm under conditions of perfect competition.  © CFA Institute. For candidate use only. Not for distribution. 8 Learning Module 1 The Firm and Market Structures Exhibit 2: Demand and Average and Marginal Cost Curves for the Firm under Conditions of Perfect Competition ATC SMC AVC P Demand Curve P = MR Q Q′ Q* The firm is maximizing profit by producing Q*, where price is equal to short-run marginal cost (SMC) and SMC is rising. Note at another output level, Q′, where P = SMC, SMC is still falling, so this cannot be a profit-maximizing solution. If market price were to rise, the firm’s demand and MR curve would simply shift upward, and the firm would reach a new profit-maximizing output level to the right of Q*. If, however, market price were to fall, the firm’s demand and MR curve would shift downward, resulting in a new and lower level of profit-maximizing output. As depicted, this firm is currently earning a positive economic profit because market price exceeds average total cost (ATC), at output level Q*. This profit is possible in the short run, but in the long run, competitors would enter the market to capture some of those profits and would drive the market price down to a level equal to each firm’s ATC. Exhibit 3 depicts the cost and revenue curves for the monopolist that is facing a negatively sloped market demand curve. The MR and demand curves are not identical for this firm. But the profit-maximizing rule is still the same: Find the level of Q that equates SMC, to MR—in this case, Q*. Once that level of output is determined, the optimal price to charge is given by the firm’s demand curve at P*. This monopolist is earning positive economic profit because its price exceeds its ATC. The barriers to entry that give this firm its monopolistic power mean that outside competitors would not be able to compete away this firm’s profits. Exhibit 3: Demand and Average and Marginal Cost Curves for the Monopolistic Firm P ATC SMC AVC P* Demand Curve P = AR MR Curve Q Q*  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 9 Breakeven Analysis and Shutdown Decision A firm is said to break even if its TR is equal to its TC. It also can be said that a firm breaks even if its price (AR) is exactly equal to its ATC, which is true under conditions of perfect and imperfect competition. Of course, the goal of management is not just to breakeven but to maximize profit. However, perhaps the best the firm can do is cover all of its economic costs. Economic costs are the sum of total accounting costs and implicit opportunity costs. A firm whose revenue is equal to its economic costs is covering the opportunity cost of all of its factors of production, including capital. Economists would say that such a firm is earning normal profit, but not positive eco- nomic profit. It is earning a rate of return on capital just equal to the rate of return that an investor could expect to earn in an equivalently risky alternative investment (opportunity cost). Firms that are operating in a competitive environment with no barriers to entry from other competitors can expect, in the long run, to be unable to earn a positive economic profit; the excess rate of return would attract entrants who would produce more output and ultimately drive the market price down to the level at which each firm is, at best, just earning a normal profit. This situation, of course, does not imply that the firm is earning zero accounting profit. Exhibit 4 depicts the condition for both a firm under conditions of perfect com- petition (Panel A) and a monopolist (Panel B) in which the best each firm can do is to break even. Note that at the level of output at which SMC is equal to MR, price is equal to ATC. Hence, economic profit is zero, and the firms are breaking even.  © CFA Institute. For candidate use only. Not for distribution. 10 Learning Module 1 The Firm and Market Structures Exhibit 4: Examples of Firms under Perfect Competition and Monopolistic Firms That Can, at Best, Break Even A. Perfect Competition P ATC SMC AVC Demand Curve P = AR = MR Q Q* B. Monopolist P ATC AVC SMC P* Demand Curve P = AR MR Curve Q Q* The Shutdown Decision In the long run, if a firm cannot earn at least a zero economic profit, it will not operate because it is not covering the opportunity cost of all of its factors of production, labor, and capital. In the short run, however, a firm might find it advantageous to continue to operate even if it is not earning at least a zero economic profit. The discussion that follows addresses the decision to continue to operate and earn negative profit or shut down operations. Recall that typically some or all of a firm’s fixed costs are incurred regardless of whether the firm operates. The firm might have a lease on its building that it cannot avoid paying until the lease expires. In that case, the lease payment is a sunk cost: It cannot be avoided, no matter what the firm does. Sunk costs must be ignored in the decision to continue to operate in the short run. As long as the firm’s revenues cover  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 11 at least its variable cost, the firm is better off continuing to operate. If price is greater than average variable cost (AVC), the firm is covering not only all of its variable cost but also a portion of fixed cost. In the long run, unless market price increases, this firm would exit the industry. But in the short run, it will continue to operate at a loss. Exhibit 5 depicts a firm under conditions of perfect competition facing three alternative market price ranges for its output. At any price above P1, the firm can earn a positive profit and clearly should continue to operate. At a price below P2, the minimum AVC, the firm could not even cover its variable cost and should shut down. At prices between P2 and P1, the firm should continue to operate in the short run because it is able to cover all of its variable cost and contribute something toward its unavoidable fixed costs. Economists refer to the minimum AVC point as the shutdown point and the minimum ATC point as the breakeven point. Exhibit 5: A Firm under Conditions of Perfect Competition Will Choose to Shut Down If Market Price Is Less Than Minimum AVC P ATC SMC AVC P1 Breakeven Point P2 Shutdown Point Q EXAMPLE 1 Breakeven Analysis and Profit Maximization When the Firm Faces a Negatively Sloped Demand Curve under Imperfect Competition Revenue and cost information for a future period including all opportunity costs is presented in Exhibit 6 for WR International, a newly formed corporation that engages in the manufacturing of low-cost, prefabricated dwelling units for urban housing markets in emerging economies. (Note that quantity increments are in blocks of 10 for a 250 change in price.) The firm has few competitors in a market setting of imperfect competition. ​ Exhibit 6: Revenue and Cost Information for WR International ​ ​ Total Revenue Total Cost Quantity (Q) Price (P) (TR) (TC)a Profit 0 10,000 0 100,000 –100,000 10 9,750 97,500 170,000 –72,500  © CFA Institute. For candidate use only. Not for distribution. 12 Learning Module 1 The Firm and Market Structures Total Revenue Total Cost Quantity (Q) Price (P) (TR) (TC)a Profit 20 9,500 190,000 240,000 –50,000 30 9,250 277,500 300,000 –22,500 40 9,000 360,000 360,000 0 50 8,750 437,500 420,000 17,500 60 8,500 510,000 480,000 30,000 70 8,250 577,500 550,000 27,500 80 8,000 640,000 640,000 0 90 7,750 697,500 710,000 –12,500 100 7,500 750,000 800,000 –50,000 ​ a Includes all opportunity costs 1. How many units must WR International sell to initially break even? Solution: WR International will initially break even at 40 units of production, where TR and TC equal 360,000. 2. Where is the region of profitability? Solution: The region of profitability will range from greater than 40 units to less than 80 units. Any production quantity of less than 40 units and any quantity greater than 80 units will result in an economic loss. 3. At what point will the firm maximize profit? At what points are there eco- nomic losses? Solution: Maximum profit of 30,000 will occur at 60 units. Lower profit will occur at any output level that is higher or lower than 60 units. From 0 units to less than 40 units and for quantities greater than 80 units, economic losses occur. Given the relationships between TR, total variable costs (TVC), and total fixed costs (TFC), Exhibit 7 summarizes the decisions to operate, shut down production, or exit the market in both the short run and the long run. The firm must cover its variable cost to remain in business in the short run; if TR cannot cover TVC, the firm shuts down production to minimize loss. The loss would be equal to the amount of fixed cost. If TVC exceeds TR in the long run, the firm will exit the market to avoid the loss associated with fixed cost at zero production. By exiting the market, the firm’s investors do not suffer the erosion of their equity capital from economic losses. When TR is enough to cover TVC but not all of TFC, the firm can continue to produce in the short run but will not be able to maintain financial solvency in the long run.  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 13 Exhibit 7: Short-Run and Long-Run Decisions to Operate or Not Revenue–Cost Relationship Short-Run Decision Long-Term Decision TR = TC Stay in market Stay in market TR = TVC but < TC Stay in market Exit market TR < TVC Shut down production Exit market EXAMPLE 2 Shutdown Analysis For the most recent financial reporting period, a London-based business has revenue of GBP2 million and TC of GBP2.5 million, which are or can be broken down into TFC of GBP1 million and TVC of GBP1.5 million. The net loss on the firm’s income statement is reported as GBP500,000 (ignoring tax implications). In prior periods, the firm had reported profits on its operations. 1. What decision should the firm make regarding operations over the short term? Solution: In the short run, the firm is able to cover all of its TVC but only half of its GBP1 million in TFC. If the business ceases to operate, its loss would be GBP1 million, the amount of TFC, whereas the net loss by operating would be minimized at GBP500,000. The firm should attempt to operate by nego- tiating special arrangements with creditors to buy time to return operations back to profitability. 2. What decision should the firm make regarding operations over the long term? Solution: If the revenue shortfall is expected to persist over time, the firm should cease operations, liquidate assets, and pay debts to the extent possible. Any residual for shareholders would decrease the longer the firm is allowed to operate unprofitably. 3. Assume the same business scenario except that revenue is now GBP1.3 mil- lion, which creates a net loss of GBP1.2 million. What decision should the firm make regarding operations in this case? Solution: The firm would minimize loss at GBP1 million of TFC by shutting down. If the firm decided to continue to do business, the loss would increase to GBP1.2 million. Shareholders would save GBP200,000 in equity value by pursuing this option. Unquestionably, the business would have a rather short life expectancy if this loss situation were to continue. When evaluating profitability, particularly of start-up firms and businesses using turnaround strategies, analysts should consider highlighting breakeven and shutdown points in their financial research. Identifying the unit sales levels at which the firm  © CFA Institute. For candidate use only. Not for distribution. 14 Learning Module 1 The Firm and Market Structures enters or leaves the production range for profitability and at which the firm can no longer function as a viable business entity provides invaluable insight when making investment decisions. Economies and Diseconomies of Scale with Short-Run and Long-Run Cost Analysis Rational behavior dictates that the firm select an operating size or scale that maxi- mizes profit over any time frame. The time frame that defines the short run and long run for any firm is based on the ability of the firm to adjust the quantities of the fixed resources it uses. The short run is the time period during which at least one of the factors of production, such as technology, physical capital, and plant size, is fixed. The long run is defined as the time period during which all factors of production are variable. Additionally, in the long run, firms can enter or exit the market based on decisions regarding profitability. The long run is often referred to as the “planning horizon” in which the firm can choose the short-run position or optimal operating size that maximizes profit over time. The firm is always operating in the short run but planning in the long run. The time required for long-run adjustments varies by industry. For example, the long run for a small business using very little technology and physical capital may be less than a year, whereas for a capital-intensive firm, the long run may be more than a decade. Given enough time, however, all production factors are variable, which allows the firm to choose an operating size or plant capacity based on different technologies and physical capital. In this regard, costs and profits will differ between the short run and the long run. Short- and Long-Run Cost Curves Recall that when we addressed the short-run cost curves of the firm, we assumed that the capital input was held constant. That meant that the only way to vary output in the short run was to change the level of the variable input—in our case, labor. If the capital input—namely, plant and equipment—were to change, however, we would have an entirely new set of short-run cost curves, one for each level of capital input. The short-run total cost includes all the inputs—labor and capital—the firm is using to produce output. For reasons discussed earlier, the typical short-run total cost (STC) curve might rise with output, first at a decreasing rate because of specialization economies and then at an increasing rate, reflecting the law of diminishing marginal returns to labor. TFC, the quantity of capital input multiplied by the rental rate on capital, determines the vertical intercept of the STC curve. At higher levels of fixed input, TFC is greater, but the production capacity of the firm is also greater. Exhibit 8 shows three different STC curves for the same technology but using three distinct levels of capital input—points 1, 2, and 3 on the vertical axis.  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 15 Exhibit 8: Short-Run Total Cost Curves for Various Plant Sizes STC2 $/Time Period STC1 STC3 Use Smallest Plant Use Largest Plant 3 2 Use Medium 1 Plant Q Qa Qb Plant Size 1 is the smallest and, of course, has the lowest fixed cost; hence, its STC1 curve has the lowest vertical intercept. Note that STC1 begins to rise more steeply with output, reflecting the lower plant capacity. Plant Size 3 is the largest of the three and reflects that size with both a higher fixed cost and a lower slope at any level of output. If a firm decided to produce an output between zero and Qa, it would plan on building Plant Size 1 because for any output level in that range, its cost would be less than it would be for Plant Size 2 or 3. Accordingly, if the firm were planning to produce output greater than Qb, it would choose Plant Size 3 because its cost for any of those levels of output would be lower than it would be for Plant Size 1 or 2. Of course, Plant Size 2 would be chosen for output levels between Qa and Qb. The long-run total cost curve is derived from the lowest level of STC for each level of output because in the long run, the firm is free to choose which plant size it will operate. This curve is called an “envelope curve.” In essence, this curve envelopes—encompasses—all possible combinations of technology, plant size, and physical capital. For each STC curve, there is also a corresponding short-run average total cost (SATC) curve and a corresponding long-run average total cost (LRAC) curve, the envelope curve of all possible short-run average total cost curves. The shape of the LRAC curve reflects an important concept called economies of scale and disecon- omies of scale. Defining Economies of Scale and Diseconomies of Scale When a firm increases all of its inputs to increase its level of output (obviously, a long-run concept), it is said to scale up its production. Scaling down is the reverse— decreasing all of its inputs to produce less in the long run. Economies of scale occur if, as the firm increases its output, cost per unit of production falls. Graphically, this definition translates into an LRAC curve with a negative slope. Exhibit 9 depicts several SATC curves, one for each plant size, and the LRAC curve representing economies of scale.  © CFA Institute. For candidate use only. Not for distribution. 16 Learning Module 1 The Firm and Market Structures Exhibit 9: Short-Run Average Total Cost Curves for Various Plant Sizes and Their Envelope Curve, LRAC: Economies of Scale $/Unit SATC1 SATC2 SATC3 SATC4 LRAC Units/Time Period Diseconomies of scale occur if cost per unit rises as output increases. Graphically, diseconomies of scale translate into an LRAC curve with a positive slope. Exhibit 10 depicts several SATC curves, one for each plant size, and their envelope curve, the LRAC curve, representing diseconomies of scale. Exhibit 10: Short-Run Average Total Cost Curves for Various Plant Sizes and Their Envelope Curve, LRAC: Diseconomies of Scale $/Unit SATC4 LRAC SATC3 SATC2 SATC1 Units/Time Period As the firm grows in size, economies of scale and a lower ATC can result from the following factors: Achieving increasing returns to scale when a production process allows for increases in output that are proportionately larger than the increase in inputs. Having a division of labor and management in a large firm with numerous workers, which allows each worker to specialize in one task rather than perform many duties, as in the case of a small business (as such, workers in a large firm become more proficient at their jobs). Being able to afford more expensive, yet more efficient equipment and to adapt the latest in technology that increases productivity. Effectively reducing waste and lowering costs through marketable by-products, less energy consumption, and enhanced quality control. Making better use of market information and knowledge for more effective managerial decision making.  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 17 Obtaining discounted prices on resources when buying in larger quantities. A classic example of a business that realizes economies of scale through greater physical capital investment is an electric utility. By expanding output capacity to accommodate a larger customer base, the utility company’s per-unit cost will decline. Economies of scale help explain why electric utilities have naturally evolved from localized entities to regional and multiregional enterprises. Walmart is an example of a business that has used its bulk purchasing power to obtain deep discounts from suppliers to keep costs and prices low. Walmart also uses the latest technology to monitor point-of-sale transactions to gather timely market information to respond to changes in customer buying behavior, which leads to economies of scale through lower distribution and inventory costs. Factors that can lead to diseconomies of scale, inefficiencies, and rising costs when a firm increases in size include the following: Realizing decreasing returns to scale when a production process leads to increases in output that are proportionately smaller than the increase in inputs. Being so large that it cannot be properly managed. Overlapping and duplicating business functions and product lines.[ Experiencing higher resource prices because of supply constraints when buying inputs in large quantities. Before its restructuring, General Motors (GM) was an example of a business that had realized diseconomies of scale by becoming too large. Scale diseconomies occurred through product overlap and duplication (i.e., similar or identical automobile models), and the fixed cost for these models was not spread over a large volume of output. In 2009, GM decided to discontinue three brands (Saturn, Pontiac, and Hummer) and also to drop various low-volume product models that overlapped with others. GM had numerous manufacturing plants around the world and sold vehicles in more than a hundred countries. Given this geographic dispersion in production and sales, the company had communication and management coordination problems, which resulted in higher costs. In 2017, GM sold its European arm, Opel, to Groupe PSA, the maker of Peugeot and Citroën. GM also had significantly higher labor costs than its competitors. As the largest producer in the market, it had been a target of labor unions for higher compensation and benefits packages relative to other firms. Economies and diseconomies of scale can occur at the same time; the impact on LRAC depends on which dominates. If economies of scale dominate, LRAC decreases with increases in output. The reverse holds true when diseconomies of scale prevail. LRAC may fall (economies of scale) over a range of output and then LRAC might remain constant over another range, which could be followed by a range over which diseconomies of scale prevail, as depicted in Exhibit 11. The minimum point on the LRAC curve is referred to as the minimum efficient scale. The minimum efficient scale is the optimal firm size under perfect competition over the long run. Theoretically, perfect competition forces the firm to operate at the minimum point on the LRAC curve because the market price will be established at this level over the long run. If the firm is not operating at this least-cost point, its long-term viability will be threatened.  © CFA Institute. For candidate use only. Not for distribution. 18 Learning Module 1 The Firm and Market Structures Exhibit 11: LRAC Can Exhibit Economies and Diseconomies of Scale $/Unit SATC1 SATC6 SATC2 SATC3 SATC4 SATC5 LRAC Units/Time Period EXAMPLE 3 Long-Run Average Total Cost Curve Exhibit 12 displays the long-run average total cost curve (LRACUS) and the short-run average total cost curves for three hypothetical US-based automobile manufacturers—Starr Vehicles (Starr), Rocket Sports Cars (Rocket), and General Auto (GenAuto). The LRAC curve for foreign-owned automobile companies that compete in the US auto market (LRACforeign) is also indicated in the graph. (The market structure implicit in the exhibit is imperfect competition.) 1. To what extent are the cost relationships depicted in Exhibit 12 useful for an economic and financial analysis of the three US-based auto firms? ​ Exhibit 12: Long-Run Average Total Cost Curves for Three Auto Manufacturers ​ Cost Per Unit Starr GenAuto LRACus Rocket LRACforeign Q0 Quantity of Output Solution: First, it is observable that the foreign auto companies have a lower LRAC compared with that of the US automobile manufacturers. This competitive position places the US firms at a cost—and possibly, pricing—disadvantage in the market, with the potential to lose market share to the lower-cost foreign competitors. Second, only Rocket operates at the minimum point of the LRACUS, whereas GenAuto is situated in the region of diseconomies of scale and Starr is positioned in the economies of scale portion of the curve. To become more efficient and competitive, GenAuto needs to downsize and restructure, which means moving down the LRACUS curve to a smaller  © CFA Institute. For candidate use only. Not for distribution. Profit Maximization: Production Breakeven, Shutdown and Economies of Scale 19 yet lower-cost production volume. In contrast, Starr has to grow in size to become more efficient and competitive by lowering per-unit costs. From a long-term investment prospective and given its cost advantage, Rocket has the potential to create more investment value relative to GenAu- to and Starr. Over the long run, if GenAuto and Starr can lower their ATC, they will become more attractive to investors. But if any of the three US auto companies cannot match the cost competitiveness of the foreign firms, they may be driven from the market. In the long run, the lower-cost foreign automakers pose a severe competitive challenge to the survival of the US manufacturers and their ability to maintain and grow shareholders’ wealth. QUESTION SET 1. An agricultural firm operating in a perfectly competitive market supplies wheat to manufacturers of consumer food products and animal feeds. If the firm were able to expand its production and unit sales by 10%, the most likely result would be: A. a 10% increase in total revenue. B. a 10% increase in average revenue. C. a less than 10% increase in total revenue. Solution: A is correct. In a perfectly competitive market, an increase in supply by a single firm will not affect price. Therefore, an increase in units sold by the firm will be matched proportionately by an increase in revenue. 2. The marginal revenue per unit sold for a firm doing business under condi- tions of perfect competition will most likely be: A. equal to average revenue. B. less than average revenue. C. greater than average revenue. Solution: A is correct. Under perfect competition, a firm is a price taker at any quanti- ty supplied to the market, and AR = MR = Price. 3. A profit maximum is least likely to occur when: A. average total cost is minimized. B. marginal revenue is equal to marginal cost. C. the difference between total revenue and total cost is maximized. Solution: A is correct. The quantity at which average total cost is minimized does not necessarily correspond to a profit maximum. 4. The short-term breakeven point of production for a firm operating under perfect competition will most likely occur when: A. price is equal to average total cost. B. marginal revenue is equal to marginal cost.  © CFA Institute. For candidate use only. Not for distribution. 20 Learning Module 1 The Firm and Market Structures C. marginal revenue is equal to average variable costs. Solution: A is correct. Under perfect competition, price is equal to marginal revenue. A firm breaks even when marginal revenue equals average total cost. 3 INTRODUCTION TO MARKET STRUCTURES describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly Different market structures result in different sets of choices facing a firm’s decision makers. Thus, an understanding of market structure is a powerful tool in analyzing issues, such as a firm’s pricing of its products and, more broadly, its potential to increase profitability. In the long run, a firm’s profitability will be determined by the forces associated with the market structure within which it operates. In a highly competitive market, long-run profits will be driven down by the forces of competi- tion. In less competitive markets, large profits are possible even in the long run; in the short run, any outcome is possible. Therefore, understanding the forces behind the market structure will aid the financial analyst in determining firms’ short- and long-term prospects. Market structures address questions such as the following: What determines the degree of competition associated with each market structure? Given the degree of competition associated with each market structure, what decisions are left to the management team developing corporate strategy? How does a chosen pricing and output strategy evolve into specific decisions that affect the profitability of the firm? The answers to these questions are related to the forces of the market structure within which the firm operates. Analysis of Market Structures Traditionally, economists classify a market into one of four structures: perfect com- petition, monopolistic competition, oligopoly, and monopoly. Economists define a market as a group of buyers and sellers that are aware of each other and can agree on a price for the exchange of goods and services. Although internet access has extended a number of markets worldwide, certain markets remain limited by geographic boundaries. For example, the internet search engine Google operates in a worldwide market. In contrast, the market for premixed cement is limited to the area within which a truck can deliver the mushy mix from the plant to a construction site before the compound becomes useless. Thomas L. Friedman’s international best seller The World Is Flat challenges the concept of the geographic limitations of the market. If the service being provided by the seller can be digitized, its market expands worldwide. For example, a technician can scan your injury in a clinic in Switzerland. That radiographic image can be digitized and sent to a radiologist in India to be read. As a customer (i.e., patient), you may never know that part of the medical service provided to you was the result of a worldwide market. Some markets are highly concentrated, with the majority of total sales coming from a small number of firms. For example, in the market for internet search, three firms controlled 98.9 percent of the US market (Google 63.5 percent, Microsoft 24 percent, and Oath (formerly Yahoo!) 11.4 percent) as of January 2018. Other markets  © CFA Institute. For candidate use only. Not for distribution. Introduction to Market Structures 21 are fragmented, such as automobile repairs, in which small independent shops often dominate and large chains may or may not exist. New products can lead to market concentration. For example, Apple introduced its first digital audio player (iPod) in 2001 and despite the entry of competitors had a world market share of more than 70 percent among digital audio players in 2009. THE IMPORTANCE OF MARKET STRUCTURE Consider the evolution of television broadcasting. As the market environment for television broadcasting evolved, the market structure changed, resulting in a new set of challenges and choices. In the early days, viewers had only one choice: the “free” analog channels that were broadcast over the airwaves. Most countries had one channel, owned and run by the government. In the United States, some of the more populated markets were able to receive more chan- nels because local channels were set up to cover a market with more potential viewers. By the 1970s, new technologies made it possible to broadcast by way of cable connectivity and the choices offered to consumers began to expand rap- idly. Cable television challenged the “free” broadcast channels by offering more choice and a better-quality picture. The innovation was expensive for consumers and profitable for the cable companies. By the 1990s, a new alternative began to challenge the existing broadcast and cable systems: satellite television. Satellite providers offered a further expanded set of choices, albeit at a higher price, than the free broadcast and cable alternatives. In the early 2000s, satellite television providers lowered their pricing to compete directly with the cable providers. Today, cable program providers, satellite television providers, and terrestrial digital broadcasters that offer premium and pay-per-view channels compete for customers who are increasingly finding content on the internet and on their mobile devices. Companies like Netflix, Apple, and Amazon offered alternative ways for consumers to access content. Over time, these companies had moved beyond the repackaging of existing shows to developing their own content, mir- roring the evolution of cable channels, such as HBO and ESPN a decade earlier. This is a simple illustration of the importance of market structure. As the market for television broadcasting became increasingly competitive, managers have had to make decisions regarding product packaging, pricing, advertising, and marketing to survive in the changing environment. In addition, mergers and acquisitions as a response to these competitive pressures have changed the essential structure of the industry. Market structure can be broken down into four distinct categories: perfect com- petition, monopolistic competition, oligopoly, and monopoly. We start with the most competitive environment, perfect competition. Unlike some economic concepts, perfect competition is not merely an ideal based on assump- tions. Perfect competition is a reality—for example, in several commodities markets, in which sellers and buyers have a strictly homogeneous product and no single producer is large enough to influence market prices. Perfect competition’s characteristics are well recognized and its long-run outcome is unavoidable. Profits under the conditions of perfect competition are driven to the required rate of return paid by the entrepreneur to borrow capital from investors (so-called normal profit or rental cost of capital). This does not mean that all perfectly competitive industries are doomed to extinction by a lack of profits. On the contrary, millions of businesses that do very well are living under the pressures of perfect competition. Monopolistic competition is also highly competitive; however, it is considered a form of imperfect competition. Two economists, Edward H. Chamberlin (United States) and Joan Robinson (United Kingdom), identified this hybrid market and came  © CFA Institute. For candidate use only. Not for distribution. 22 Learning Module 1 The Firm and Market Structures up with the term because this market structure not only has strong elements of com- petition but also some monopoly-like conditions. The competitive characteristic is a notably large number of firms, while the monopoly aspect is the result of product differentiation. That is, if the seller can convince consumers that its product is uniquely different from other, similar products, then the seller can exercise some degree of pricing power over the market. A good example is the brand loyalty associated with soft drinks such as Coca-Cola. Many of Coca-Cola’s customers believe that their beverages are truly different from and better than all other soft drinks. The same is true for fashion creations and cosmetics. The oligopoly market structure is based on a relatively small number of firms supplying the market. The small number of firms in the market means that each firm must consider what retaliatory strategies the other firms will pursue when prices and production levels change. Consider the pricing behavior of commercial airline com- panies. Pricing strategies and route scheduling are based on the expected reaction of the other carriers in similar markets. For any given route—say, from Paris, France, to Chennai, India—only a few carriers are in competition. If one of the carriers changes its pricing package, others likely will retaliate. Understanding the market structure of oligopoly markets can help identify a logical pattern of strategic price changes for the competing firms. Finally, the least competitive market structure is the monopoly. In pure monopoly markets, no other good substitutes exist for the given product or service. A single seller, which, if allowed to operate without constraint, exercises considerable power over pricing and output decisions. In most market-based economies around the globe, pure monopolies are regulated by a governmental authority. The most common exam- ple of a regulated monopoly is the local electrical power provider. In most cases, the monopoly power provider is allowed to earn a normal return on its investment and prices are set by the regulatory authority to allow that return. Factors That Determine Market Structure The following five factors determine market structure: 1. The number and relative size of firms supplying the product; 2. The degree of product differentiation; 3. The power of the seller over pricing decisions; 4. The relative strength of the barriers to market entry and exit; and 5. The degree of non-price competition. The number and relative size of firms in a market influence market structure. When many firms exist, the degree of competition increases. With fewer firms supplying a good or service, consumers are limited in their market choices. One extreme case is the monopoly market structure, with only one firm supplying a unique good or service. Another extreme is perfect competition, with many firms supplying a similar product. Finally, an example of relative size is the automobile industry, in which a small number of large international producers (e.g., Volkswagen and Toyota) are the leaders in the global market, and a number of small companies either have market power because they are niche players (e.g., Ferrari or McLaren) or have limited mar- ket power because of their narrow range of models or limited geographical presence (e.g., Mazda or Stellantis). In the case of monopolistic competition, many firms are providing products to the market, as with perfect competition. However, one firm’s product is differentiated in some way that makes it appear to be better than similar products from other firms. If a firm is successful in differentiating its product, this differentiation will provide pricing leverage. The more dissimilar the product appears, the more the market will  © CFA Institute. For candidate use only. Not for distribution. Introduction to Market Structures 23 resemble the monopoly market structure. A firm can differentiate its product through aggressive advertising campaigns; frequent styling changes; the linking of its product with other complementary products; or a host of other methods. When the market dictates the price based on aggregate supply and demand con- ditions, the individual firm has no control over pricing. The typical hog farmer in Nebraska and the milk producer in Bavaria are price takers. That is, they must accept whatever price the market dictates. This is the case under the market structure of perfect competition. In the case of monopolistic competition, the success of product differentiation determines the degree with which the firm can influence price. In the case of oligopoly, there are so few firms in the market that price control becomes possible. However, the small number of firms in an oligopoly market invites complex pricing strategies. Collusion, price leadership by dominant firms, and other pricing strategies can result. The degree to which one market structure can evolve into another and the dif- ference between potential short-run outcomes and long-run equilibrium conditions depend on the strength of the barriers to entry and the possibility that firms fail to recoup their original costs or lose money for an extended period of time and there- fore are forced to exit the market. Barriers to entry can result from large capital investment requirements, as in the case of petroleum refining. Barriers may also result from patents, as in the case of some electronic products and drug formulas. Another entry consideration is the possibility of high exit costs. For example, plants that are specific to a special line of products, such as aluminum smelting plants, are non-redeployable, and exit costs would be high without a liquid market for the firm’s assets. High exit costs deter entry and therefore also are considered barriers to entry. In the case of farming, the barriers to entry are low. Production of corn, soybeans, wheat, tomatoes, and other produce is an easy process to replicate; therefore, those are highly competitive markets. Non-price competition dominates those market structures in which product differentiation is critical. Therefore, monopolistic competition relies on competitive strategies that may not include pricing changes. An example of non-price competi- tion is product differentiation through marketing. In other circumstances, non-price competition may occur because the few firms in the market feel dependent on each other. Each firm fears retaliatory price changes that would reduce total revenue for all of the firms in the market. Because oligopoly industries have so few firms, each firm feels dependent on the pricing strategies of the others. Therefore, non-price competition becomes a dominant strategy. Characteristics of Market Structure Exhibit 13: Characteristics of Market Structure Pricing Number of Degree of Product Barriers Power of Market Structure Sellers Differentiation to Entry Firm Non-Price Competition Perfect competition Many Homogeneous/ Standardized Very Low None None Monopolistic competition Many Differentiated Low Some Advertising and Product Differentiation Oligopoly Few Homogeneous/ Standardized High Some or Advertising and Product Considerable Differentiation Monopoly One Unique Product Very Considerable Advertising High  © CFA Institute. For candidate use only. Not for distribution. 24 Learning Module 1 The Firm and Market Structures From the perspective of the owners of the firm, the most desirable market structure is that with the most control over price, because this control can lead to large profits (Exhibit 13). Monopoly and oligopoly markets offer the greatest potential control over price; monopolistic competition offers less control. Firms operating under perfectly competitive market conditions have no control over price. From the consumers’ perspective, the most desirable market structure is that with the greatest degree of competition because prices are generally lower. Thus, consumers would prefer as many goods and services as possible to be offered in competitive markets. As often happens in economics, there is a trade-off. While perfect competition gives the largest quantity of a good at the lowest price, other market forms may spur more innovation. Specifically, firms may incur high costs in researching a new prod- uct, and they will incur such costs only if they expect to earn an attractive return on their research investment. This is the case often made for medical innovations, for example—the cost of clinical trials and experiments to create new medicines would bankrupt perfectly competitive firms but may be acceptable in an oligopoly market structure. Therefore, consumers can benefit from less-than-perfectly-competitive markets. PORTER’S FIVE FORCES AND MARKET STRUCTURE A financial analyst aiming to establish market condition