CFA Institute Level 1 Volume 2 2023 Economics PDF

© CFA Institute. For candidate use only. Not for distribution. ECONOMICS, FINANCIAL STATEMENT ANALYSIS CFA® Program Curriculum 2023 LEVEL 1 VOLUME 2 © CFA Institute. For candidate use only. Not for distribution. ©2022 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 978-1-950157-97-6 (paper) ISBN 978-1-953337-24-5 (ebook) 2022 © CFA Institute. For candidate use only. Not for distribution. CONTENTS How to Use the CFA Program Curriculum xi Errata xi Designing Your Personal Study Program xi CFA Institute Learning Ecosystem (LES) xii Feedback xii Economics Learning Module 1 Topics in Demand and Supply Analysis 3 Introduction 3 Demand Concepts 4 Demand Concepts 4 Price Elasticity of Demand 6 Extremes of Price Elasticity 8 Predicting Demand Elasticity, Price Elasticity and Total Expenditure 9 Elasticity and Total Expenditure 11 Income Elasticity of Demand, Cross-Price Elasticity of Demand 12 Cross-Price Elasticity of Demand 13 Substitution and Income Effects; Normal Goods, Inferior Goods and Special Cases 15 Normal and Inferior Goods 17 Supply Analysis: Cost, Marginal Return, and Productivity 20 Marginal Returns and Productivity 20 Economic Profit Versus Accounting Profit 25 Economic Cost vs. Accounting Cost 25 Marginal Revenue, Marginal Cost and Profit Maximization; Short-Run Cost Curves: Total, Variable, Fixed, and Marginal Costs 26 Understanding the Interaction between Total, Variable, Fixed, and Marginal Cost and Output 28 Perfect and Imperfect Competition, Profit Maximization 32 Profit-Maximization, Breakeven, and Shutdown Points of Production 34 Breakeven Analysis and Shutdown Decision 35 The Shutdown Decision 36 Economies and Diseconomies of Scale with Short-Run and Long-Run Cost Analysis 40 Short- and Long-Run Cost Curves 41 Defining Economies of Scale and Diseconomies of Scale 42 Summary 45 Practice Problems 49 Solutions 57 Learning Module 2 The Firm and Market Structures 61 Introduction and Analysis of Market Structures 61 Analysis of Market Structures 62 Perfect Competition 67 indicates an optional segment © CFA Institute. For candidate use only. Not for distribution. iv Contents Demand Analysis in Perfectly Competitive Markets 67 Elasticity of Demand 69 Other Factors Affecting Demand 71 Consumer Surplus: Value Minus Expenditure 73 Supply Analysis, Optimal Price, and Output in Perfectly Competitive Markets 76 Optimal Price and Output in Perfectly Competitive Markets 77 Long-Run Equilibrium In Perfectly Competitive Markets 81 Monopolistic Competition 84 Demand Analysis in Monopolistically Competitive Markets 85 Supply Analysis in Monopolistically Competitive Markets 86 Optimal Price and Output in Monopolistically Competitive Markets 86 Long-Run Equilibrium In Monopolistic Competition 87 Oligopoly and Pricing Strategies 88 Demand Analysis and Pricing Strategies in Oligopoly Markets 89 The Cournot Assumption 91 The Nash Equilibrium 94 Oligopoly Markets: Optimal Price, Output, and Long-Run Equilibrium 97 Optimal Price and Output in Oligopoly Markets 98 Factors Affecting Long-Run Equilibrium in Oligopoly Markets 98 Monopoly Markets: Demand/Supply and Optimal Price/Output 99 Demand Analysis in Monopoly Markets 101 Supply Analysis in Monopoly Markets 102 Optimal Price and Output in Monopoly Markets 103 Price Discrimination and Consumer Surplus 105 Monopoly Markets: Long-Run Equilibrium 107 Identification of Market Structure 108 Econometric Approaches 109 Simpler Measures 109 Summary 111 References 113 Practice Problems 114 Solutions 119 Learning Module 3 Aggregate Output, Prices, and Economic Growth 121 Introduction 122 Aggregate Output and Income 123 Gross Domestic Product 124 The Components of GDP 131 GDP, National Income, Personal Income, and Personal Disposable Income 135 Relationship among Saving, Investment, the Fiscal Balance and the Trade Balance 140 Aggregate Demand and Aggregate Supply 144 Aggregate Demand 144 Aggregate Supply 148 Shifts in the Aggregate Demand Curve 150 Equilibrium GDP and Prices 162 Economic Growth and Sustainability 173 The Production Function and Potential GDP 175 indicates an optional segment © CFA Institute. 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Contents v Sources of Economic Growth 177 Measures of Sustainable Growth 182 Measuring Sustainable Growth 185 Summary 188 References 192 Practice Problems 193 Solutions 199 Learning Module 4 Understanding Business Cycles 203 Introduction 203 Overview of the Business Cycle 204 Phases of the Business Cycle 205 Leads and Lags in Business and Consumer Decision Making 209 Market Conditions and Investor Behavior 209 Credit Cycles and Their Relationship to Business Cycles 211 Applications of Credit Cycles 212 Consequences for Policy 213 Business Cycle Fluctuations from a Firm’s Perspective 214 The Workforce and Company Costs 214 Fluctuations in Capital Spending 215 Fluctuations in Inventory Levels 217 Consumer Behavior 219 Consumer Confidence 219 Measures of Consumption 219 Income Growth 220 Saving Rates 221 Housing Sector Behavior 222 Available Statistics 222 Sensitivity to Interest Rates and Relationship to Credit Cycle 222 The Role of Demographics 222 Impact on the Economic Cycle 223 External Trade Sector Behavior 223 Cyclical Fluctuations of Imports and Exports 224 The Role of the Exchange Rate 224 Overall Effect on Exports and Imports 224 Theoretical Considerations 226 Historical Context 226 Neoclassical Economics 227 The Austrian School 228 Monetarism 228 Keynesianism 229 Modern Approach to Business Cycles 231 Economic Indicators 232 Types of Indicators 233 Composite Indicators 234 Leading Indicators 234 Using Economic Indicators 235 Other Composite Leading Indicators 236 Surveys 237 indicates an optional segment © CFA Institute. 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Not for distribution. vi Contents The Use of Big Data in Economic Indicators 238 Nowcasting 238 GDPNow 239 Unemployment 242 Unemployment 242 Inflation 246 Deflation, Hyperinflation, and Disinflation 247 Measuring Inflation: The Construction of Price Indexes 248 Price Indexes and Their Usage 250 Explaining Inflation 254 Summary 260 References 263 Practice Problems 264 Solutions 272 Learning Module 5 Monetary and Fiscal Policy 277 Introduction to Monetary and Fiscal Policy 278 Monetary Policy 280 Money: Functions, Creation, and Definition 281 The Functions of Money 281 Paper Money and the Money Creation Process 282 Definitions of Money 285 Money: Quantity Theory, Supply and Demand, Fisher Effect 287 The Demand for Money 288 The Supply and Demand for Money 289 The Fisher Effect 291 Roles of Central Banks & Objectives of Monetary Policy 294 The Objectives of Monetary Policy 297 The Costs of Inflation 299 Monetary Policy Tools 301 Open Market Operations 301 The Central Bank’s Policy Rate 301 Reserve Requirements 302 The Transmission Mechanism 303 Inflation Targeting 305 Central Bank Independence 306 Credibility 306 Transparency 307 Exchange Rate Targeting 311 Monetary Policies: Contractionary, Expansionary, Limitations 314 What’s the Source of the Shock to the Inflation Rate? 315 Limitations of Monetary Policy 315 Roles and Objectives of Fiscal Policy 321 Roles and Objectives of Fiscal Policy 321 Deficits and the National Debt 325 Fiscal Policy Tools 329 The Advantages and Disadvantages of Using the Different Tools of Fiscal Policy 332 indicates an optional segment © CFA Institute. 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Contents vii Modeling the Impact of Taxes and Government Spending: The Fiscal Multiplier 333 The Balanced Budget Multiplier 335 Fiscal Policy Implementation 336 Deficits and the Fiscal Stance 336 Difficulties in Executing Fiscal Policy 337 The Relationship between Monetary and Fiscal Policy 340 Factors Influencing the Mix of Fiscal and Monetary Policy 341 Quantitative Easing and Policy Interaction 342 The Importance of Credibility and Commitment 342 Summary 344 References 346 Practice Problems 347 Solutions 353 Learning Module 6 Introduction to Geopolitics 357 Introduction 357 National Governments and Political Cooperation 358 Features of Political Cooperation 359 Motivations for Cooperation 359 Resource Endowment, Standardization, and Soft Power 361 The Role of Institutions 362 Hierarchy of Interests and Costs of Cooperation 362 Power of the Decision Maker 363 Political Non-Cooperation 364 Non-State Actors and the Forces of Globalization 365 Features of Globalization 366 Motivations for Globalization 368 Costs of Globalization and Threats of Rollback 369 Assessing Geopolitical Actors and Risk 372 Autarky 373 Hegemony 373 Multilateralism 375 Bilateralism 376 The Tools of Geopolitics 377 National Security Tools 378 Economic Tools 380 Financial Tools 380 Multi-Tool Approaches 381 Geopolitical Risk and Comparative Advantage 382 Incorporating Geopolitical Risk into the Investment Process 383 Types of Geopolitical Risk 383 Assessing Geopolitical Threats 385 Tracking risks according to signposts 389 Manifestations of Geopolitical Risk 390 Acting on Geopolitical Risk 392 Summary 393 Practice Problems 396 Solutions 399 indicates an optional segment © CFA Institute. 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Not for distribution. viii Contents Learning Module 7 International Trade and Capital Flows 403 Introduction & International Trade-Basic Terminology 403 International Trade 404 Patterns and Trends in International Trade and Capital Flows 407 Benefits and Costs of International Trade 411 Comparative Advantage and the Gains from Trade: Absolute and Comparative Advantage 414 Gains from Trade: Absolute and Comparative Advantage 414 Ricardian and Heckscher–Ohlin Models of Comparative Advantage 420 Trade and Capital Flows: Restrictions & Agreements- Tariffs, Quotas and Export Subsidies 422 Tariffs 423 Quotas 425 Export Subsidies 426 Trading Blocs, Common Markets, and Economic Unions 428 Capital Restrictions 433 Balance of Payments- Accounts and Components 436 Balance of Payments Accounts 437 Balance of Payment Components 438 Paired Transactions in the BOP Bookkeeping System 440 Commercial Exports: Transactions (ia) and (ib) 441 Commercial Imports: Transaction (ii) 441 Loans to Borrowers Abroad: Transaction (iii) 441 Purchases of Home-Country Currency by Foreign Central Banks: Transaction (iv) 442 Receipts of Income from Foreign Investments: Transaction (v) 443 Purchase of Non-financial Assets: Transaction (vi) 443 National Economic Accounts and the Balance of Payments 444 Trade Organizations 449 International Monetary Fund 450 World Bank Group 452 World Trade Organization 453 Summary 456 References 459 Practice Problems 460 Solutions 465 Learning Module 8 Currency Exchange Rates 469 Introduction & The Foreign Exchange Market 470 The Foreign Exchange Market 471 Market Functions 477 Market Participants, Size and Composition 483 Market Size and Composition 486 Exchange Rate Quotations 488 Exchange Rate Quotations 489 Cross-Rate Calculations 492 Forward Calculations 496 Exchange Rate Regimes- Ideals and Historical Perspective 503 The Ideal Currency Regime 504 indicates an optional segment © CFA Institute. 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Contents ix Historical Perspective on Currency Regimes 505 A Taxonomy of Currency Regimes 507 Arrangements with No Separate Legal Tender 509 Currency Board System 509 Fixed Parity 510 Target Zone 511 Active and Passive Crawling Pegs 511 Fixed Parity with Crawling Bands 511 Managed Float 511 Independently Floating Rates 511 Exchange Rates and the Trade Balance: Introduction 515 Exchange Rates and the Trade Balance: The Elasticities Approach 517 Exchange Rates and the Trade Balance: The Absorption Approach 521 Summary 525 References 529 Practice Problems 530 Solutions 534 Financial Statement Analysis Learning Module 1 Introduction to Financial Statement Analysis 539 Introduction 539 Scope of Financial Statement Analysis 540 Major Financial Statements - Balance Sheet 546 Financial Statements and Supplementary Information 547 Statement of Comprehensive Income 551 Income Statement 551 Other Comprehensive Income 554 Statement of Changes in Equity and Cash Flow Statement 555 Cash Flow Statement 556 Financial Notes, Supplementary Schedules, and Management Commentary 558 Management Commentary or Management’s Discussion and Analysis 561 Auditor's Reports 562 Other Sources of Information 565 Financial Statement Analysis Framework 566 Articulate the Purpose and Context of Analysis 567 Collect Data 568 Process Data 569 Analyze/Interpret the Processed Data 569 Develop and Communicate Conclusions/Recommendations 569 Follow-Up 570 Summary 570 References 573 Practice Problems 574 Solutions 577 Learning Module 2 Financial Reporting Standards 579 Introduction 579 The Objective of Financial Reporting 580 indicates an optional segment © CFA Institute. 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Not for distribution. x Contents Accounting Standards Boards 581 Accounting Standards Boards 582 Regulatory Authorities 583 International Organization of Securities Commissions 583 The Securities and Exchange Commission (US) 584 Capital Markets Regulation in Europe 588 The International Financial Reporting Standards Framework 588 Qualitative Characteristics of Financial Reports 589 Constraints on Financial Reports 590 The Elements of Financial Statements 591 Underlying Assumptions in Financial Statements 592 Recognition of Financial Statement Elements 592 Measurement of Financial Statement Elements 593 General Requirements for Financial Statements 593 Required Financial Statements 594 General Features of Financial Statements 595 Structure and Content Requirements 596 Comparison of IFRS with Alternative Reporting Systems 597 Monitoring Developments in Financial Reporting Standards 598 New Products or Types of Transactions 599 Evolving Standards and the Role of CFA Institute 599 Summary 600 Practice Problems 602 Solutions 605 indicates an optional segment © CFA Institute. For candidate use only. Not for distribution. xi 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) Topic area weights that indicate the relative exam weightings of the top-level topic areas (www.cfainstitute.org/programs/cfa/curriculum) Learning outcome statements (LOS) that advise candidates about the spe- cific knowledge, skills, and abilities they should acquire from curriculum content covering a topic area: LOS are provided in candidate study ses- sions and 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. The CFA Program curriculum that candidates receive 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 entire curriculum, including the practice questions, is the basis for all exam questions and is selected or developed specifically to teach the knowledge, skills, and abilities reflected in the CBOK. 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. 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 that you have mastered the © CFA Institute. For candidate use only. Not for distribution. xii How to Use the CFA Program Curriculum applicable content and can demonstrate the knowledge, skills, and abilities described by the LOS and the assigned reading. Use the LOS 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 study sessions than on others. CFA INSTITUTE LEARNING ECOSYSTEM (LES) Your exam registration fee includes access to the CFA Program Learning Ecosystem (LES). This digital learning platform provides access, even offline, to all of the curricu- lum content and practice questions and is organized as a series of short online lessons with associated practice questions. This tool is your one-stop location for all study materials, including practice questions and mock exams, and the primary method by which CFA Institute delivers your curriculum experience. The LES offers candidates additional practice questions to test their knowledge, and some questions in the LES provide a unique interactive experience. FEEDBACK Please send any comments or feedback to [email protected], and we will review your suggestions carefully. © 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 OUTCOME 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 describe how economies of scale and diseconomies of scale affect costs INTRODUCTION In a general sense, economics is the study of production, distribution, and consumption 1 and can be divided into two broad areas of study: macroeconomics and microeco- nomics. 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 is a logical starting point for the study of economics. 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. This material is covered in detail in the recommended prerequisite readings. In this reading, we will explore how buyers and sellers interact to determine transaction © CFA Institute. For candidate use only. Not for distribution. 4 Learning Module 1 Topics in Demand and Supply Analysis prices and quantities. The reading is organized as follows: Section 2 discusses the consumer or demand side of the market model, and Section 3 discusses the supply side of the consumer goods market, paying particular attention to the firm’s costs. Section 4 provides a summary of key points in the reading. 2 DEMAND CONCEPTS 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 candidate is assumed to have a basic under- standing of the demand and supply model and to understand how a market discovers the equilibrium price at which the quantity willingly demanded by consumers at that price is just equal to the quantity willingly supplied by firms. Here, we explore more deeply some of the concepts underlying the demand side of the model. Demand Concepts 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, economists believe that as the price of a good rises, buyers will choose to buy less of it, and as its price falls, they buy more. This opinion is so nearly universal that it has come to be called 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 com- plements 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( y ) Px , I, P (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) © CFA Institute. For candidate use only. Not for distribution. Demand Concepts 5 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 automo- biles 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 gaso- line and automobiles have a negative cross-price elasticity of demand and are thus complements.) 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 gaso- line 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) xdby rearranging Equation 3, (20)]. Notice also that we can solve for Px in terms of Q 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. © CFA Institute. For candidate use only. Not for distribution. 6 Learning Module 1 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) 57 41.15 47.54 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 axis and quantity on the horizontal 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 sup- plied 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 (auto- mobiles) 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 7 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 mea- sure. 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 d Ep x = %Δ P = Δ P = ( Δ P ) (_ d ) %Δ Qxd _ _ Qx Δ Qxd Px d _ (6) x _x P x Q x x 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 two variables is linear, Δ d 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 © CFA Institute. For candidate use only. Not for distribution. 8 Learning Module 1 Topics in Demand and Supply Analysis than 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. 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. 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 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 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 Q Note: A vertical demand Note: A horizontal demand has zero elasticity and is has infinite elasticity and is called perfectly inelastic. 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 4 calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure 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 © CFA Institute. For candidate use only. Not for distribution. 10 Learning Module 1 Topics in Demand and Supply Analysis 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-discretion- ary helps to understand its sensitivity to a price change. Faced with the same percent- age 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. In the end, the actual elasticity of demand for a particular good turns out to be an empirical fact that can be learned only from careful observation and, often, sophis- ticated statistical analysis. © CFA Institute. For candidate use only. Not for distribution. Predicting Demand Elasticity, Price Elasticity and Total Expenditure 11 Elasticity and Total Expenditure Because of the law of demand, an increase in price is associated with a decrease in the number of units demanded of some good or service. But what can we say about the total expenditure on that good? That is, what happens to price times quantity when price falls? Recall that elasticity is defined as the ratio of the percentage change in quantity demanded to the percentage change in price. So if demand is elastic, a decrease in price is associated with a larger percentage rise in quantity demanded. Although each unit of the good has a lower price, a sufficiently greater number of units are purchased so that total expenditure (price times quantity) would rise as price falls when demand is elastic. If demand is inelastic, however, a given percentage decrease in price is associated with a smaller percentage rise in quantity demanded. Consequently, when demand is inelastic, a fall in price brings about a fall in total expenditure. In summary, when demand is elastic, price and total expenditure move in opposite directions. When demand is inelastic, price and total expenditure move in the same direction. This relationship is easy to identify in the case of a linear demand curve. Recall that above the midpoint, demand is elastic, and below the midpoint, demand is inelastic. In the upper section of Exhibit 4, total expenditure (P × Q) is measured as the area of a rectangle whose base is Q and height is P. Notice that as price falls, the areas of the inscribed rectangles (each outlined with their own dotted or dashed line) at first grow in size, become largest at the midpoint of the demand curve, and thereafter become smaller as price continues to fall and total expenditure declines toward zero. In the lower section of Exhibit 4, total expenditure is shown for each quantity purchased. Exhibit 4: Elasticity and Total Expenditure P In the elastic range, a fall in price accompanies a rise in total expenditure In the inelastic range, a fall in price accompanies a fall in total expenditure Q Total Expenditure Q Note: Figure depicts the relationship among changes in price, changes in quantity, and changes in total expenditure. Maximum total expenditure occurs at the unit-elastic point on a linear demand curve (the cross-hatched rectangle). © CFA Institute. For candidate use only. Not for distribution. 12 Learning Module 1 Topics in Demand and Supply Analysis The relationships just described hold for any demand curve, so it does not matter whether we are dealing with the demand curve of an individual consumer, the demand curve of the market, or the demand curve facing any given seller. For a market, the total expenditure by buyers becomes the total revenue to sellers in that market. It follows, then, that if market demand is elastic, a fall in price will result in an increase in total revenue to sellers as a whole, and if demand is inelastic, a fall in price will result in a decrease in total revenue to sellers. If the demand faced by any given seller were inelastic at the current price, that seller could increase revenue by increasing its price. But because demand is negatively sloped, the increase in price would decrease total units sold, which would almost certainly decrease total production cost. If raising price both increases revenue and decreases cost, such a move would always be profit enhancing. Faced with inelastic demand, a one-product seller would always be inclined to raise the price until the point at which demand becomes elastic. 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 gen- eral 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. Goods with positive income elasticity are called “normal” goods. Goods with negative income elasticity are called “inferior” goods. Typical examples of inferior goods are rice, potatoes, or less expensive cuts of meat. We will discuss the concepts of normal and inferior goods in a later section. 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. © CFA Institute. For candidate use only. Not for distribution. Income Elasticity of Demand, Cross-Price Elasticity of Demand 13 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 (8) y 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 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. Whether two goods are substitutes or complements might not be immediately intuitive. For example, grocery stores often put things like coffee on sale in the hope that customers will come in for coffee and end up doing their weekly shopping there as well. In that case, coffee and, say, cabbage could very well empirically turn out to be complements even though we would not think that the price of coffee has any relation to sales of cabbage. Regardless of whether someone would see two goods as related in some fashion, if the cross-price elasticity of two goods is negative, they are complements. 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 func- tions 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) © CFA Institute. For candidate use only. Not for distribution. 14 Learning Module 1 Topics in Demand and Supply Analysis 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)(_ Δ Qxd 47, 542.8 ) = − 0.20 Px 1.48 (10) x Qx Income elasticity: EId = ( ΔI )(_ Id ) Δ Qxd = ( 250)(_ 47, 542.8 ) = 0.26 50 _ (11) Qx Cross-price elasticity: Epdy = (_ Δ P ) (_ d ) = ( − 2000)(_ Δ Qxd Py 47, 542.8 ) 20 = − 0.84 (12) y Qx 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 Q d = 2 – 0.4Peb + 0.0005I + 0.15Phb, where Q eb d equals the eb 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. © CFA Institute. For candidate use only. Not for distribution. Substitution and Income Effects; Normal Goods, Inferior Goods and Special Cases 15 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 )(Peb d / Δ Peb d ). / Qeb Notice from the demand function that Δ Qebd / Δ Peb = −0.4. Inserting the given variable values into the demand function yields Qeb d = 2 − (0.4)(10.68) + (.0005)(2300) + (0.15)(21.4) = 2.088. So at a price of €10.68, the own-price 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 Q d / ΔI)(I / Qeb eb d ). No- tice from the demand function that Δ Qeb d / ΔI= 0.0005. Inserting the values d yields income elasticity of (0.0005)(2,300/2.088) = 0.551, which for I and Qeb is positive, so e-books are a normal good. 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. Insert- ing 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. SUBSTITUTION AND INCOME EFFECTS; NORMAL GOODS, INFERIOR GOODS AND SPECIAL CASES 6 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 axis

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