CFA level 1 study notebook2 2015

I Considerthe functionQpgas=10.75-1.25Pgas+0.021+0.12PBt-0.01Pauto whereincomeandcarpricearemeasuredin thousands,and the price of bus travelismeasuredinaverage dollarsper100miles travele

BOOK 2 - ECONOMICS

StudySession6- Economics: Economics inaGlobalContext 210

SCHWESERNOTES™ 2015 CFALEVEL IBOOK2:ECONOMICS

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The

READING ASSIGNMENTS AND

Thefollowing materialisareviewoftheEconomicsprinciples designedtoaddress the

learningoutcome statements setforthbyCFA Institute

STUDY SESSION 4

Reading Assignments

Economics,CFAProgram Level I 2015Curriculum,Volume2(CFA Institute,2014)

13 Demand and Supply Analysis: Introduction

14 Demand and Supply Analysis: Consumer Demand

15 Demand and Supply Analysis: TheFirm

16.TheFirmand Market Structures

page 9page 48page 60

page94

STUDY SESSION 5

Reading Assignments

Economics,CFAProgram Level I2015Curriculum,Volume2 (CFAInstitute,2014)

17.Aggregate Output,Prices,andEconomicGrowth

18.UnderstandingBusinessCycles

19 Monetary and Fiscal Policy

page 126page 157

page179

STUDY SESSION 6

Reading Assignments

Economics,CFA Program Level I 2015Curriculum,Volume2 (CFAInstitute,2014)

20.International Trade and Capital Flows

21.CurrencyExchangeRates

page 210

page 231

LEARNINGOUTCOME STATEMENTS(LOS)

STUDY SESSION 4

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

13 Demand and Supply Analysis: IntroductionThe candidate should be ableto:

a. distinguish amongtypesofmarkets,(page9)

b explain the principles of demand and supply, (page10)

c describecausesof shiftsinandmovementsalong demand and supplycurves

(page12)

d describe the process of aggregating demand and supplycurves,(page13)

e. describe theconceptof equilibrium (partial and general), and mechanisms bywhich markets achieve equilibrium, (page14)

f distinguishbetween stable and unstable equilibria,includingpricebubbles,andidentifyinstancesof such equilibria, (page16)

g calculate and interpret individual andaggregatedemand,andinversedemandand supplyfunctions,and interpret individual andaggregatedemand and supply

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

14 Demand and Supply Analysis:ConsumerDemandThe candidate should be ableto:

a. describeconsumerchoice theory and utility theory, (page48)

b describe theuseof indifferencecurves,opportunitysets,and budgetconstraints

indecision making, (page49)

c. calculate and interpretabudgetconstraint,(page49)

d determineaconsumer’sequilibrium bundle of goods basedonutility analysis

(page52)

e. compare substitution andincomeeffects,(page52)

f distinguish between normal goods and inferior goods, and explain Giffen goodsand Veblen goodsinthiscontext,(page55)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

15 Demand and Supply Analysis: TheFirm

The candidate should be ableto:

a. calculate,interpret, andcompareaccountingprofit,economicprofit, normalprofit, andeconomicrent,(page60)

b calculate and interpret andcompare total, average,and marginalrevenue.

(page64)

c describeafirm’sfactors of production, (page66)

d calculate and interprettotal,average,marginal,fixed,and variablecosts.

(page68)

e. determine and describe breakeven and shutdown points ofproduction, (page72)

f describeapproachestodetermining the profit-maximizing level ofoutput.

(page76)

g describe howeconomiesof scale and diseconomies of scale affectcosts,(page78)

h distinguish between short-run and long-run profitmaximization,(page80)

i distinguishamongdecreasing-cost,constant-cost,and increasing-cost industries

and describe thelong-runsupply ofeach, (page81)

j calculate and interprettotal,marginal, and averageproduct oflabor,(page82)

k describe the phenomenon of diminishing marginalreturnsand calculate and

interpret the profit-maximizing utilization level ofaninput, (page83)

1 determine theoptimal combination ofresourcesthatminimizescost,(page83)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

16.TheFirmand MarketStructures

The candidate should be ableto:

a. describe characteristicsof perfect competition, monopolistic competition,

oligopoly, and pure monopoly, (page94)

b explain relationships between price, marginalrevenue,marginalcost,economic

profit, and the elasticity of demand under each marketstructure,(page96)

c. describeafirm’s supply function under each marketstructure,(page114)

d describe and determine the optimal price andoutputfor firms under each

marketstructure,(page96)

e. explain factors affecting long-run equilibrium under each marketstructure.

(page96)

f describe pricingstrategyunder each marketstructure,(page114)

g describe theuseand limitationsofconcentrationmeasures inidentifying market

structure,(page115)

h identify thetypeof marketstructurewithin whichafirmoperates,(page117)

STUDY SESSION 5

The topicalcoveragecorresponds with thefollowingCFA Instituteassigned reading:

17 Aggregate Output,Prices,andEconomicGrowth

The candidate should be ableto:

a. calculate and explain gross domestic product(GDP)usingexpenditure and

incomeapproaches, (page126)

b comparethe sum-of-value-added and value-of-final-output methods of

e. explain the fundamental relationship among saving,investment,the fiscal

balance,and the tradebalance,(page130)

f explain the IS and LMcurvesand how they combineto generatetheaggregatedemandcurve,(page131)

g explain theaggregatesupplycurve inthe shortrunand longrun.(page135)

h explaincausesofmovementsalong and shiftsinaggregatedemand and supply

curves,(page136)

i describe how fluctuationsinaggregatedemand andaggregatesupplycause

short-runchangesintheeconomyand the businesscycle, (page140)

j distinguish between the followingtypesofmacroeconomicequilibria: long-runfull employment, short-runrecessionarygap, short-run inflationary gap, andshort-run stagflation, (page140)

k explain howashort-runmacroeconomicequilibriummayoccur at alevel above

orbelow fullemployment, (page140)

1 analyze the elfect of combined changesinaggregatesupply and demandonthe

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

18 UnderstandingBusinessCyclesThe candidate should be ableto:

a. describe the businesscycle anditsphases, (page157)

b describe howresourceuse,housingsectoractivity,and external tradesector

activityvaryasaneconomy movesthrough the business cycle, (page158)

c. describe theories of the business cycle,(page161)

d describetypesof unemployment andmeasuresof unemployment, (page162)

e. explaininflation,hyperinflation,disinflation,anddeflation,(page163)

f explain theconstructionof indices usedtomeasureinflation,(page164)

g compareinflationmeasures,including theirusesandlimitations,(page167)

h distinguish between cost-push and demand-pullinflation,(page168)

i describeeconomic indicators,including theirusesandlimitations,(page170)The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

19 Monetary and Fiscal Policy

Thecandidate shouldbeableto:

a. comparemonetaryand fiscal policy, (page179)

b describe functions and definitionsofmoney,(page179)

c. explain themoney creationprocess,(page180)

d describe theories of the demand for andsupply ofmoney,(page182)

e. describe the Fishereffect,(page184)

f describe roles and objectives of centralbanks,(page184)

g contrastthecostsof expected and unexpectedinflation,(page185)

h describe tools usedtoimplementmonetarypolicy, (page187)

i describe themonetarytransmissionmechanism,(page187)

j describe qualities of effective centralbanks,(page188)

k explain the relationships betweenmonetarypolicy andeconomicgrowth,

inflation,interest,and exchangerates,(page189)

1 contrasttheuseofinflation, interestrate,and exchangeratetargeting by central

banks,(page190)

m. determine whethera monetarypolicyisexpansionaryorcontractionary

(page191)

n. describe limitationsofmonetarypolicy, (page192)

o. describe roles and objectives of fiscal policy, (page193)

p describe tools of fiscal policy, including their advantages and disadvantages

s. determine whetherafiscal policyisexpansionaryor contractionary,(page199)

t. explain theinteractionofmonetaryand fiscal policy, (page200)

STUDY SESSION 6

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

20 International Trade and Capital Flows

The candidate should be ableto:

a. comparegross domestic product and gross national product,(page211)

b describe benefits andcostsof internationaltrade,(page211)

c. distinguish between comparative advantage and absolute advantage, (page212)

d explain the Ricardian and Heckscher-Ohlin models of trade and thesource(s)of

comparativeadvantageineachmodel,(page215)

e. comparetypesof trade and capitalrestrictionsand theireconomicimplications

(page216)

f explainmotivationsfor and advantages of tradingblocs,commonmarkets,and

economicunions,(page219)

g describecommonobjectives of capitalrestrictionsimposed bygovernments.

j describe functions and objectives of the international organizations that facilitate

trade,including the WorldBank,the International MonetaryFund,and theWorldTrade Organization, (page223)

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

21 CurrencyExchangeRates

The candidate should be ableto:

a. defineanexchangerate,and distinguish between nominal and real exchange

ratesandspotand forward exchangerates,(page231)

b describe functionsof and participantsinthe foreign exchange market

e convertforward quotations expressedon apoints basisor inpercentage terms

intoanoutright forward quotation, (page235)

f explain thearbitragerelationship betweenspot rates,forwardrates,andinterestrates,(page236)

g calculate and interpretaforward discountorpremium, (page237)

h calculate and interpret the forwardrateconsistentwith thespot rateand the

interestrateineachcurrency,(page238)

i describe exchangerateregimes,(page239)

j explain the effects of exchangeratesoncountries’ international trade and capital

flows,(page240)

The following is a review Economics: Microeconomic Analysis principles designed address the

learning outcome statements set forth by CFA Institute This topic is also covered in:

INTRODUCTION

StudySession4

EXAM FOCUS

In this topicreview, weintroduce basicmicroeconomictheory Candidates will need

tounderstand theconceptsof supply,demand,equilibrium, and how marketscanlead

tothe efficient allocationofresourcestoall thevariousgoods andservicesproduced

Thereasonsfor and results of deviations from equilibrium quantities and pricesare

examined Finally, several calculationsarerequired basedonsupply functions and

demandfunctions,including price elasticity ofdemand,crossprice elasticity ofdemand,

incomeelasticity ofdemand,excesssupply,excessdemand, consumersurplus, and

producer surplus

LOS 13.a:Distinguishamongtypesof markets

CFA®ProgramCurriculum,Volume2,page7

Thetwo typesof markets considered herearemarketsfor factorsofproduction(factor

markets)and marketsforservicesand finished goods (goods marketsorproductmarkets)

Sometimesthis distinctionisquite clear Crude oil and laborarefactors of production,

andcars,clothing, andliquorarefinished goods, sold primarilytoconsumers.In

general, firmsarebuyersinfactor markets and sellersinproduct markets

Intel producescomputerchips thatareusedinthemanufacture ofcomputers.We refer

tosuchgoodsasintermediate goods, becausetheyareusedinthe production of final

goods

Capitalmarketsreferstothe markets where firmsraisemoneyforinvestmentby selling

debt (borrowing)orselling equities(claimstoownership),aswellasthe markets where

these debt and equity claimsaresubsequently traded

LOS 13.b:Explaintheprinciplesof demand andsupply.

CFA®ProgramCurriculum,Volume2,page8

The DemandFunction

Wetypically think of the quantity ofagoodorservicedemandedasdependingonprice

but, in fact, itdependson income,the prices of other goods,aswellasotherfactors Ageneral form of the demand function for Good Xover someperiod oftime is:

QDx =f(Px-I>Py> >

where:

Px =price of Good X

=somemeasureof individualoraverage incomeper year

Py =prices of relatedgoodsConsideranindividual’s demandfor gasolineover aweek The price of automobiles andthe price of bus travelmaybe independentvariables,along withincomeand the price of

gasoline

I

Considerthe functionQpgas=10.75-1.25Pgas+0.021+0.12PBt-0.01Pauto

whereincomeandcarpricearemeasuredin thousands,and the price of bus travelismeasuredinaverage dollarsper100miles traveled.Notethatan increase inthe price ofautomobiles will decrease demand for gasoline (theyarecomplements), andanincrease

inthe price of bus travel willincreasethe demand forgasoline(theyare substitutes)

Togetquantity demandedas afunction of only the price ofgas,we mustinsertvaluesfor all the other independent variables Assuming that the averagecarpriceis $25,000,income is $45,000,and the price of bus travelis $30,ourdemand function abovebecomes =10.75-1.25(Pgas)+0.02(45)+0.12(30) - 0.01(25)=15.00-

1.25Pgas,andat aprice of $4pergallon, the quantity ofgasdemandedperweekis 10

gallons

The quantity ofgasdemandedisa(linear)functionof the price ofgas Notethatdifferent valuesofincomeorthe price of automobilesorbus travel resultindifferentdemand functions Wesay that,other things equal(foragivensetof thesevalues),the

quantityofgasdemanded equals 15.00-1.25P

gas-Inthisform,wecanseethat each $1increase inthe price of gasoline reduces thequantity demanded by1.25 gallons.Wewill also haveoccasionto use adifferentfunctionalform that shows the price of gasolineas afunctionof the quantity demanded

Whilethisseems abitodd,wegraph demandcurveswith price(theindependent

variable)onthe vertical y-axis and quantity(thedependentvariable)onthe horizontal

x-axisbyconvention.Inorderto getthisfunctionalform,weinvertthe functionto

show priceas afunctionof the quantity demanded.For our function,

QDgas=15.00-1.25Pgas,wesimplyusealgebratosolveforPgas=12.00-0.80QD

Thisisourdemandcurvefor gasoline(basedon currentprices ofcarsand bus traveland the consumer’sincome).The graph of this function for positive pricesisshownin

gas’

Figure1.Thefact that the quantity demanded typicallyincreasesatlower pricesisoften

referredto asthe lawof demand

Figure1:Demandfor Gasoline

TheSupplyFunction

Forthe producer ofagood, the quantity he will willingly supply dependsonthe selling

priceaswellasthecostsof productionwhich, inturn,dependontechnology, thecostof

labor,and thecostof other inputsintotheproductionprocess.Consideramanufacturer

of furniture that produces tables.Foragiven level oftechnology, the quantity supplied

will dependonthe selling price, the price of labor (wagerate),and the price of wood

(forsimplicity,wewill ignore the price ofscrews,glue,finishes,andsoforth)

Anexample of suchafunctionis tables= -274+0.80Ptabÿs- 8.00Wage-0.20Pwood

where thewage is indollarsperhour and the price ofwoodis indollarsper 100board

feet.Togetquantitysuppliedas afunctionsolely ofsellingprice,we mustassumevalues

for the other independent variables and hold technologyconstant.Forexample, witha

wageof $12perhour and wood pricedat $150,Qjtables=-400+0.80Ptables.

Inordertograph this producers supplycurve wesimplyinvertthis supply function and

getPtabjes =500+1-250stab|es-This resulting supplycurve isshowninFigure2.The

fact thata greaterquantityissuppliedathigher pricesisreferredto asthelawof supply

Figure2:Supply of Tables

QoUo =-400+ 0.80PabfaP($)

E LOS 13.c:Describecausesof shiftsinandmovementsalong demand and

supplycurves

CFA®Program Curriculum, Volume2,page11

Itisimportanttodistinguish betweena movementalongagiven demandorsupplycurveandashift in the curveitself.Achangeinthemarket price thatsimplyincreases

ordecreasesthe quantitysuppliedordemandedisrepresented bya movementalongthe

curve.Achangeinoneof the independent variablesotherthanpricewill resultinashift

of thecurveitself

Forourgasoline demandcurveinourpreviousexample,achangein incomewill shift

thecurve, aswillachangeinthe price of bus travel Recalling the supply function for

tables in our previousexample,eitherachangein the price ofwoodor achangein thewageratewouldshift the curve Anincreaseineither wouldshift thesupplycurvetothe

leftasthequantitywillingly suppliedateachpricewould be reduced

Figure3illustratesadecreaseinthequantitydemandedfromQQtoQ, inresponseto an

increase inprice fromPQtoPyFigure 4 illustratesanincrease inthe quantity suppliedfrom QQto Qjinresponseto anincreaseinprice fromP(jtoPy

Figure3:Changein Quantity DemandedPrice

Quantity

Incontrast,Figure5 illustrates shifts (changes)indemandfrom changesin income

orthe prices of related goods.An increase (decrease) in incomeorthe price ofasubstitutewillincrease(decrease) demand,whileanincrease(decrease)inthepriceofacomplementwilldecrease(increase) demand

Figure 6 illustratesanincrease insupply, which would result fromadecreaseintheprice

ofaninput, andadecreaseinsupply, which would result fromanincrease inthe price of

An increase insupply

QuantityLOS13.d: Describe the process of aggregating demand andsupplycurves

CFA®ProgramCurriculum, Volume2,page17Giventhe supply functionsof the firms that comprisemarket supply,wecanadd

them togetherto getthemarket supply function.Forexample, iftherewere50 table

manufacturers with the supply functionQstables=-400+0.80Ptab]es,the market supply

would beQgtables=-(50 x 400) + (50 x 0.80)Ptables,whichis -20,000 +40Ptables.Now,

to getthe marketsupplycurve, weneedto invertthisfunctionto get:

Ptables=0-025Qstables+500

Note that theslope ofthesupplycurve isthecoefficientoftheindependent(inthis

form)variable,0.025

The following example illustrates the aggregation technique for getting market demandfrommanyindividual demandcurves.

Example: Aggregatingconsumerdemand

If10,000consumershave the demand function for gasoline:

Q-Dgas=10.75-L25Pgas+°-021+0-12Pbt- 0.0lPauto

whereincomeandcarpricearemeasuredin thousands,and the price of bus travelis

measuredin averagedollarsper 100 miles traveled Calculate the market demandcurve

ifthe price of bus travelis $20, income is $50,000,and the average automobile priceis

$30,000 Determinethe slope of the market demandcurve

Answer:

Market demandis:

O-Dgas=107,500-12,500Pgas+2001+1,200PBT-100Pauto

Inserting the values given,wehave:

Qyjgas=107,5°0—12,500p +200X50+ 1,200 X20- 100x30

QD gas=138,500- 12,500P

Inverting thisfunction,we getthe market demandcurve:

Pgas =11.08-0.00008%ÿ

The slope of the demandcurve is-0.00008, orifwemeasurequantity ofgas in

thousandsof gallons,we get-0.08

LOS 13.e:Describe theconceptofequilibrium (partialandgeneral),andmechanisms by which markets achieveequilibrium.

CFA®Program Curriculum,Volume2,page20

Whenwehaveamarket supply and market demandcurveforagood,wecansolveforthe priceatwhich the quantity supplied equals the quantity demanded.Wedefine thisasthe equilibrium price and the equilibrium quantity; graphically, theseareidentified bythe point where thetwocurvesintersect, asillustratedinFigure7

Figure7: Movement TowardEquilibrium

$/ton

Excesssupplydrivesprice Supply(MC)toward equilibrium

$600

Suppliers reduce production

in response todecliningprice

$500

respo rising jjrice

$400

Excessdemand

! drive?price !totvardequilibrium Demand(MB)

Quantity (tons)Su;;a Quantity

demanded

3,000

at $400/ton

at $<

Underthe assumptionsthatbuyerscompetefor available goodsonthebasisof price

only, and that supplierscompetefor sales onlyonthe basisof price, market forces will

drive thepriceto itsequilibrium level

ReferringtoFigure7,if the priceisaboveitsequilibriumlevel,the quantity willingly

supplied exceeds thequantity consumersarewillingtopurchase, andwehaveexcess

supply Suppliers willingtosellatlowerprices willoffer thosepricesto consumers,

driving the market price down towards the equilibrium level Conversely, if the market

priceisbelowitsequilibriumlevel, the quantitydemandedatthat price exceeds the

quantitysupplied, andwehaveexcessdemand Consumerswilloffer higher pricesto

competefor the available supply,drivingthe marketpriceuptowardsitsequilibrium

level

Considerasituationwhere the allocationofresources tosteel productionisnotefficient

InFigure7, wehaveadisequilibriumsituationwherethe quantityofsteelsuppliedis

greaterthan thequantitydemandedat aprice of$600/ton.Clearly, steelinventories

will buildup,and competition willputdownwardpressureonthe price of steel.Asthe

price falls,steel producers will reduce production and freeup resourcestobe usedinthe

productionof othergoods andservicesuntil equilibriumoutputandpricearereached

If steel priceswere$400/ton,inventorieswould be drawndown,which wouldputupwardpressureonpricesasbuyers competed for the available steel Suppliers would

increaseproductionin responsetorisingprices, and buyers would decrease theirpurchasesaspricesrose.Again,competitive markets tend toward the equilibrium priceand quantityconsistentwithanefficient allocationofresourcestosteel production

Ouranalysis of individual marketsisapartial equilibrium analysis becauseweare

taking the factors thatmayinfluence demandasfixedexceptfor the price.Inageneralequilibrium analysis, relationships between the quantity demanded of the good andfactors thatmayinfluence demandaretakenintoaccount.Consider thatachangein

the market price of printers will influence demand for ink cartridges(acomplementarygood)and, therefore, itsequilibrium price.Ageneral equilibrium analysis would takeaccountof this changeinthe equilibrium price of ink cartridges(fromchangesintheequilibrium price of printers)inconstructing the demandcurvefor printers Thatsaid,

formanytypesof analysis and especiallyoverasmall range of prices, partial equilibriumanalysisisoften useful and appropriate

LOS 13.f:Distinguishbetween stable and unstableequilibria, includingprice

bubbles,andidentifyinstancesof suchequilibria.

CFA®Program Curriculum,Volume2,page25

Anequilibriumistermed stable when thereareforces thatmoveprice and quantityback towards equilibrium values when they deviate from those values.Evenif the supply

curveslopesdownward,aslongasitcutsthrough the demandcurvefromabove,theequilibrium will be stable.Pricesabove equilibrium resultinexcesssupply andputdownwardpressure onprice, while prices below equilibrium resultinexcessdemand andputupward pressureonprice If the supplycurve isless steeply sloped than the demandcurve,thisisnotthecase,and prices above(below)equilibrium will tendto getfurtherfrom equilibrium.Werefertosuchanequilibriumasunstable.Weillustrate both ofthesecasesinFigure8,alongwithanexample ofanonlinear supplyfunction,whichproducestwoequilibria—onestable andoneunstable

Figure8:Stable and Unstable Equilibria

Bubbles,orunsustainableincreases inassetprices,areevidentinrealestateprices and

prices of otherassets atvarious times Inthesesituations,market participants takerecent

priceincreasesasanindicationof higher futureassetprices The expectation of higher

future prices thenincreasesthe demandfor theasset(i.e.,shifts the demandcurve tothe

right) which againincreasesthe equilibrium price of theasset.Atsomepoint, the widely

held beliefinever-increasing pricesisdisplaced byarealization that pricescanalso fall

This leadsto a“breaking of thebubble,”and theassetprice falls rapidly towardsanew

and sustainable equilibrium price(andperhaps belowit inthe shortrun)

Quantity

LOS 13.g: Calculate and interpret individual andaggregatedemand,and

inversedemand andsupplyfunctions,and interpret individual andaggregate

demand andsupplycurves

LOS13.h:Calculate and interpret theamountofexcessdemandor excess

supplyassociated withanon-equilibriumprice

CFA®ProgramCurriculum, Volume2,page10

Earlierinthis topicreview, weillustrated the technique of defining and inverting linear

demand and supply functions.Wethen aggregated individuals’ demand functions and

firms’ supply functionstoform market demand and supplycurves

Givenasupplyfunction,Qg =-400+ 75P,andademandfunction,QD=2,000-125P,

we candetermine that the equilibrium priceis 12by setting the functions equaltoeach

other and solving for P

Ataprice of10, wecancalculatethequantitydemandedasQQ=2,000- 125(10)=

750 and the quantity suppliedasQg =-400+75(10)=350.Excessdemandis750

-350=400

Ataprice of15, we cancalculate the quantity demandedasQD =2,000- 125(15) =

125 and the quantity suppliedas0$=-400+75(15)=725.Excesssupplyis725-125

=600

LOS 13.i:Describetypesofauctionsand calculate the winning price(s) ofanauction

CFA®Program Curriculum,Volume2,page 27

An auction isanalternativetomarketsfor determininganequilibrium price Thereare

varioustypesofauctionswith different rules fordeterminingthewinnerandthe priceto

be paid

We candistinguish betweenacommonvalueauctionandaprivatevalueauction

Inacommonvalueauction,the valueof theitemtobe auctioned will be thesameto

any bidder,but the bidders donotknow the valueatthetimeof theauction.Oillease

auctionsfallintothiscategorybecause the value of the oiltobe extractedisthesamefor

all,but biddersmustestimatewhat thatvalueis.Becauseauction participants estimate

the value witherror,the bidder whomostoverestimatesthe valueofalease will be thehighest (winning) bidder Thisis sometimesreferredto asthewinner’scurse,and thewinning biddermayhave lossesas aresult.Anexample ofaprivate valueauction isan

auctionofart orcollectibles The value that each bidder placeson anitem isthe valueithastohim,andweassumethatnobidder will bidmorethan that

Onecommontypeofauction isanascendingpriceauction,also referredto asan

Englishauction.Bidderscanbidanamount greaterthan the previous highbid,and thebidder that first offers the highest bid of theauction winstheitemandpaystheamountbid

Inasealed bidauction,each bidder providesonebid,whichisunknowntootherbidders The biddersubmittingthehighestbidwinstheitemandpaysthe price bid

Thetermreservationprice referstothe highest price thatabidderiswillingtopay.In

asealed bidauction,the optimal bid for the bidder with the highestreservationpricewould be just slightly above that of the bidder who values theitemsecond-most highly

Forthisreason,bidsare notnecessarily equaltobidders’reservationprices

Inasecond price sealed bidauction(Vickreyauction),the bidder submitting the highestbidwinstheitembutpaystheamountbidby the secondhighestbidder In thistype

ofauction,thereisno reasonforabiddertobid less than hisreservationprice Theeventualoutcomeismuch like that ofanascending priceauction,where the winningbidderpaysoneincrementof pricemorethan the price offered by the bidder who valuestheitemsecond-mosthighly

Adescending priceauction, orDutchauction,begins withapricegreaterthan whatany

bidder willpay,and thisoffer priceisreduced untilabidder agreestopay it.If therearemany units available,each biddermayspecify howmany unitsshe will purchase whenacceptinganoffered price If the first (highest) bidderagreestobuy three oftenunits

at$100,subsequent bidders willgetthe remainingunitsatlower pricesasdescendingoffered pricesareaccepted

Sometimes, adescending priceauction ismodified(modifiedDutchauction)sothat

winning bidders allpaythesameprice, whichisthereservationprice of the bidder

whose bidwinsthe lastunitsoffered

Asinglepriceisoften determined forsecuritiesthroughthefollowingmethod Consider

afirmthatwants tobuyback1million sharesofitsoutstandingstockthroughatender

offer.Thefirm solicitsoffersfromshareholders whospecifyapriceand howmanyshares

theyarewillingtotender.After suchsolicitation,the firm hasalistof offers suchas

those listedinFigure 9:

Figure 9: Tender Offer Indications

400,000

300,000 200,000

B C D E FThe firm determines thatthelowestpriceatwhichit canpurchase all1million shares

is$37.60, sotheoffers of shareholdersC, D, E,andFareaccepted, and allreceivethe

single price of$37.60 The shares offeredbyshareholders A andBare notpurchased

WithU.S.Treasurysecurities, asingle priceauction isheld but biddersmayalso submit

anoncompetitive bid Suchabid indicatesthat thosebidderswillaccepttheamount

of Treasuriesindicatedatthe pricedetermined bytheauction,rather thanspecifyinga

maximum price intheir bids Thepricedetermined by thistypeofauction isfoundas

inthe examplejustgiven, but theamountofsecuritiesspecifiedinthe noncompetitive

bidsissubtractedfrom thetotalamount tobesold.Thismethodisillustratedinthe

followingexample

Considerthat $35 billion facevalue ofTreasurybills will beauctionedoff Non¬

competitivebidsaresubmittedfor$5billionfacevalueof bills.Competitivebids, which

mustspecifyprice(yield) and face valueamount, areshowninFigure10.Notethata

bid withahigher quoted yieldisactuallyabidat alower price

Figure10:AuctionBidsforTreasury Bills

Becausethetotalfacevalueof bills offeredis$35 billion, and therearenon-competitive

we mustselecta minimumyield(maximumprice)for which $30billionfacevalueof billscanbesoldtothosemakingcompetitivebids.Atadiscountof0.1104%, $28 billioncanbesoldtocompetitivebidders butthatwould leave 35—5—

28 = $2 billion unsold Ataslightly higher yield of0.1117%, morethan$30 billionofbillscanbe soldtocompetitive bidders

bidsfor $5billion,

5 The singlepricefor theauction is adiscountof0.1117%.Allbiddersthat bidatlower

yields (higher prices)willgetall the billstheybidfor($28 billion);the non-competitive

bidderswillget$5 billion of billsasexpected.Theremaining$2 billion in bills go the

bidders who bidadiscountof0.1117% Sincetherearebidsfor $8billion inbillsatthediscountof0.1117%,andonly$2 billionunsoldat ayield of0.1104%, eachbidderreceives2/8of the faceamountof billstheybidfor

Figure11,thisis theshaded triangle.Thetotal valuetosociety of3,000 tonsof steelis

morethan the totalamountpaid for the3,000 tonsofsteel,byan amountrepresented

bythe shadedtriangle

Figure11 :ConsumerSurplus

Wecanalsorefertotheconsumersurplusforanindividual.Figure12showsa

consumer’sdemandforgasolineingallonsper week Itisdownward sloping becauseeachsuccessivegallonofgasolineisworth lesstotheconsumer than thepreviousgallon

Withamarketpriceof$3 pergallon,theconsumerchoosestobuy five gallonsperweek

foratotalof $15 While the firstgallonofgasoline purchasedeach weekisworth $5

tothisconsumer, itonlycosts $3,resultinginconsumersurplusof $2.Ifweadd up

themaximumprices thisconsumer iswillingtopayfor each gallon,wefindthe total

valueof the fivegallonsis$20 Totalconsumersurplusfor this individual fromgasoline

consumptionis$20 - $15 = $5

Figure12:AConsumer’sDemandfor Gasoline

$ pergallon

Consumer surplus from the second gall

Market price

Amount paid

for 5 gallons

Demand=Marginal Benefit (MB)

Gallonsper week

Producer Surplus

Undercertainassumptions(perfectmarkets),the industry supplycurve isalso the

marginalsocietal(opportunity)cost curve.Producersurplusistheexcessof the market

price above the opportunitycostofproduction;thatis,totalrevenue minusthe total

variablecostof producing thoseunits.Forexample,inFigure13,steel producersare

willingtosupply the2,500th tonof steelat apriceof$400.Viewingthesupplycurve

asthemarginalcost curve,thecostin termsofthe valueof othergoodsandservices

foregonetoproducethe2,500th tonof steelis$400.Producing and sellingthe2,500th

tonofsteelfor $500 increasesproducer surplus by$100 Thedifference betweenthe

total (opportunity)costof producing steel and the totalamountthat buyerspayforit

(producer surplus)is at a maximumwhen3,000 tons aremanufactured andsold

Figure 13:ProducerSurplus

Quantity (tons) 2,500 3,000

E Notethat the efficient quantity of steel(wheremarginalcostequals marginalbenefit)

isalsothequantityof productionthat maximizes totalconsumersurplusandproducersurplus Thecombinationofconsumersseekingto maximizeconsumersurplusand

producers seekingto maximizeproducer surplus (profits) leadstothe efficient allocation

ofresources tosteel production becauseit maximizesthe total benefittosocietyfromsteel production.Wecan saythat when the demandcurveforagoodis itsmarginal

social benefitcurveand thesupplycurvefor the goodisitsmarginal socialcost curve,

producingtheequilibrium quantityatthe price where quantitysupplied andquantity

demandedareequalmaximizesthesumof consumerandproducer surplus and bringsaboutanefficient allocation ofresources tothe production of the good

ObstaclestoEfficiencyandDeadweightLoss

Ouranalysissofar has presupposed that the demandcurve representsthe marginal socialbenefitcurve,the supplycurverepresentsthemarginal socialcost curve,andcompetitionleadsus to asupply/demand equilibriumquantityconsistentwith efficientresource

allocation Wenowwill consider how deviationsfrom theseideal conditionscanresult

inaninefficientallocationofresources.The allocationofresources isinefficientifthe

quantitysupplied doesnotmaximizethesumofconsumerand producer surplus Thereductionin consumer andproducersurplus duetounderproductionoroverproductionis

calledadeadweightloss, asillustratedin Figure14

Figure 14: DeadweightLoss

CalculatingConsumer and ProducerSurplus

Tocalculatetheamountofconsumersurplusorproducer surplus when demand and

supplyarelinear,weneed only findtheheight and width of thetriangles Considerthe

demandfunctionQ = 48-3P shownin Figure15,PanelA Notethatwhen Pis zero,

the quantitydemandedis48 SettingQto zeroandsolvingfor P gives usP=16,which

is the interceptonthe price axis

Givenamarketprice of8, we cancalculatethe quantitydemandedas48—3(8)=24

Noting that theareaofanytriangleis xh (base xheight),we cancalculate theconsumer

surplusas 14(8 x 24)=96units.

InFigure15,PanelB, wehave graphedthesimplesupply functionQ = -24+6P.The

interceptonthe priceaxis canbe found bysetting Qequalto zeroandsolving forP =4

Ataprice of8,the quantitysuppliedis—24+ 6(8)=24.Producersurpluscanbeseen

as atriangle with heightof4 and widthof 24,andwe cancalculate producer surplusas

14(4 x 24) =48

Figure 15: CalculatingConsumerand Producer Surplus

CFA®Program Curriculum,Volume2,page36

Imposition bygovernmentsofminimumlegal prices (pricefloors), maximumlegalprices(priceceilings),taxes,subsidies,andquotas canall leadtoimbalances betweenthequantitydemanded and thequantitysupplied and leadtodeadweight lossesasthequantityproduced and consumedisnotthe efficient quantity thatmaximizesthe totalbenefittosociety

In othercases,suchaspublic goods, markets with externalcostsor benefits, or commonresources,free markets donotnecessarily leadtomaximizationof total surplus, andgovernmentssometime intervenetoimproveresourceallocation

Obstaclestothe Efficient Allocationof Productive Resources

• Price controls,suchasprice ceilings and price floors These distort theincentives

of supply anddemand,leadingtolevels of production different from those ofan

unregulatedmarket Rent control andaminimum wage areexamples ofapriceceiling andaprice floor

• Taxes and traderestrictions,suchassubsidies andquotas. Taxesincreasetheprice that buyerspayand decrease theamountthat sellersreceive.Subsidiesare government payments toproducersthat effectivelyincreasetheamountsellers

receiveand decrease the price buyers pay, leadingtoproduction ofmorethan theefficient quantity of the good.Quotas aregovernment-imposedproductionlimits,

resultinginproduction of less than the efficient quantity of the good All three leadmarketsawayfrom producing the quantity for which marginalcostequals marginalbenefit

• Externalcosts, costsimposedonothers by the production of goods whicharenottakenintoaccountinthe production decision An example ofanexternalcostisthecostimposedonfishermen byafirm that pollutes theocean as partofitsproduction

process.The firm doesnotnecessarily consider theresultingdecreaseinthe fish

populationas partofitscostof production,eventhough thiscostisborne by the

fishing industry and society In thiscase,theoutputquantity of thepolluting firmis

greaterthan the efficient quantity The societalcostsaregreaterthan the directcosts

of production the producer bears The resultis anover-allocationofresourcesto

production by the polluting firm

• External benefitsarebenefitsof consumption enjoyed by people other than the

buyers of the good thatare nottakenintoaccountin buyers’ consumption decisions

Anexample ofanexternal benefitisthe development ofatropical gardenonthe

grounds ofanindustrial complex thatislocated alongabusy thoroughfare The

developer of the grounds only considers the marginal benefittothe firms within

the complex when deciding whethertotakeonthe grounds improvement,not

the benefit received by the travelers who take pleasureintheviewof the garden

External benefits resultindemandcurvesthat donot representthe societal benefitof

the goodorservice, sothe equilibrium quantity produced and consumedisless than

the efficient quantity

• Public goods andcommonresources.Public goodsaregoods andservicesthatare

consumedbypeople regardless of whetherornotthey paid for them National

defenseisapublic good If others choosetopayto protect a countryfrom outside

attack,all the residents of thecountryenjoy suchprotection, whether they havepaid

for their share ofitor not.Competitive markets willproduce less than the efficient

quantityof publicgoodsbecauseeachperson canbenefitfrom publicgoodswithout

paying for theirproduction Thisisoften referredto asthe“free rider” problem

Acommon resourceisonewhich allmayuse.Anexample ofacommon resource is

anunrestrictedoceanfishery Each fisherman will fishintheocean at no costand

will have littleincentivetomaintainorimprove theresource.Sinceindividuals

donothave theincentivetofishatthe economically efficient(sustainable) level,

over-fishingisthe result.Lefttocompetitive marketforces, common resources are

generally over-used andproduction of related goodsorservices isgreaterthan the

efficientamount.

Aprice ceilingisanupper limitonthe price whichasellercancharge If the ceiling

isabove the equilibrium price,itwill havenoeffect.AsillustratedinFigure16,if the

ceilingisbelow the equilibrium price, the result will beashortage(excessdemand)

atthe ceilingprice.The quantitydemanded,Qj,exceeds thequantitysupplied, Q

Consumersarewillingtopay (price with searchcosts)for the Q quantity suppliers

arewillingtosellatthe ceiling price,PQ.Consumersarewillingtoexpend effort witha

Figure 16:PriceCeiling

Inthe longrun,priceceilings lead tothefollowing:

• Consumers mayhavetowait inlong linestomake purchases Theypayaprice(an

opportunitycost)intermsof thetimethey spendinline

• Suppliersmayengage in discrimination,suchassellingtofriends and relatives first

• Suppliers “officially” sellatthe ceiling price but take bribestodoso.

• Suppliersmayalso reduce the quality ofthegoodsproducedto alevelcommensurate

withthe ceilingprice

Inthe housingmarket,price ceilingsareappropriately calledrentceilingsor rentcontrol.Rentceilingsare agoodexample of howapriceceilingcandistortamarket

Rentersmustwaitforunitstobecome available Rentersmayhaveto bribe landlordsto rent atthe ceilingprice.Thequality of theapartmentswill fall Otherinefficienciescandevelop.Forinstance, a rentermight be reluctanttotakea newjobacross townbecause

itmeansgivinguparent-controlledapartmentand riskingnotfinding another

(rent-controlled)apartment nearthenewplace ofwork

Aprice flooris aminimumprice thatabuyercanoffer foragood,service, or resource.

Ifthe pricefloorisbelow the equilibriumprice, itwillhavenoeffectonequilibrium

priceandquantity.Figure 17 illustratesapricefloorthatis setabove theequilibriumprice The result will beasurplus(excesssupply)atthe floor pricesincethe quantitysupplied,Qs,exceeds thequantity demanded,QD,atthe floorprice.Thereisalossofefficiency (deadweightloss)because thequantityactually transacted with theprice floor,

Qd,isless than the efficientequilibriumquantity,Qg

Figure17:Impact ofaPriceFloor

In thelongrun,pricefloors leadtoinefficiencies:

• Suppliers will divertresources tothe production of the good with the anticipation of

selling the goodatthefloor price but thenwillnotbe abletosellalltheyproduce

• Consumers willbuy less ofaproduct if the floorisabove the equilibriumpriceand

substituteother,lessexpensive consumptiongoods for thegoodsubjecttotheprice

floor

In the labormarket,asinallmarkets,equilibriumoccurswhen thequantitydemanded

(ofhoursworked, inthiscase)equals thequantitysupplied.Inthe labormarket,the

equilibrium priceiscalled thewagerate.Theequilibriumwagerateisdifferentfor labor

of different kinds and withvariouslevelsof skill Labor that requires the lowest skill

level(unskilled labor)generally has the lowestwagerate.

Insomeplaces, including the UnitedStates,thereis aminimum wagerate (sometimes

definedas alivingwage) thatpreventsemployers fromhiringworkersat awageless than

thelegalminimum.Theminimumwage isanexample ofapricefloor Ataminimum

wageabove the equilibriumwage,there willbean excesssupply ofworkers, sincefirms

cannotemploy all the workers whowant toworkatthatwage Sincefirmsmustpayat

least theminimum wagefor theworkers,firms substitute other productiveresources

for labor anduse morethan the economically efficientamountof capital The result

isincreased unemployment becauseevenwhen thereareworkers willingtoworkat a

wagelower than theminimum,firmscannotlegallyhirethem.Furthermore,firmsmay

decrease the qualityorquantity of thenonmonetarybenefits they previously offeredto

workers,suchaspleasant, safeworkingconditions and on-the-job training

Impact of Taxes

Atax on agoodor servicewillincrease itsequilibriumpriceand decreaseitsequilibrium

quantity.Figure18 illustratestheeffects ofa tax onproducers and ofa tax onbuyers

(e.g.,asalestax).InPanel(a),the points indicated by andQEdescribe the

equilibrium priortothetax.Asaresultof thistax,the supplycurveshifts(decreases)

fromSto5tax,where thequantityQtaxisdemandedatthepricePa

E Thetaxisthe difference between what buyerspayand what sellers ultimatelyearn

per unit.Thisisillustrated by the vertical distance between supplycurveSand supplycurveS’ At thenewquantity,Qtax,buyerspayP ,butnetof thetax,suppliers only

receivePc.Thetriangulararea is adeadweightloss(DWL).Thisisthe lossof gains

from production and trade that results from thetax(i.e.,because lessthantheefficientamountisproduced andconsumed)

NotethatinPanel(b),although thestatutoryincidenceof thetaxisonbuyers, the

actual incidenceof thetax,thereduction inoutput,and theconsequentdeadweightloss

areall thesame asin Panel(a),where thetax isimposedonsellers

Thetaxrevenueistheamountof thetax timesthenewequilibriumquantity,

Economic agents(buyers andsellers)inthe marketsharethe burdenof thetaxrevenue

Theincidenceofa tax isallocationofthistaxbetween buyers and sellers The rectangledenoted“revenue from buyers”representsthe portion of thetax revenuethat thebuyerseffectivelypay Therectangledenoted“revenuefrom sellers” illustrates the portion of the

taxthat thesuppliers effectivelypay

Figure18:IncidenceofaTaxonProducers andofaTaxonBuyers

(a) Tax onproducersPrice

St«

D

tax

SP„

P„ revebuv< \vrs

Actual and Statutory Incidence ofaTax

Statutory incidence referstowhoislegally responsible for paying thetax.The actual

incidenceofa taxreferstowho actually bears thecostof thetaxthroughanincrease

inthe price paid (buyers)ordecreaseinthe price received(sellers).In Figure18(a),we

illustrated theeffect ofa taxonthe sellersof thegoodasopposedtothebuyersof the

good(notethat the priceishigheroverall levels of production—the supplycurveshifts

up).Thus,thestatutoryincidenceinFigure18(a) is onthe supplier The resultisan

increase inpriceateach possible quantity supplied

Statutory incidenceonthe buyercauses adownward shiftof the demandcurveby the

amountof thetax.AsindicatedinFigure18(b),priortothe imposition ofa tax on

buyers, the equilibriumpriceandquantity areatthe point ofintersectionof the supply

and demandcurves (i.e.,PE,QE).The imposition of thetaxforces supplierstoreduce

output tothe pointQtax(amovementalong the supplycurve) Atthenewequilibrium,

price and quantityaredenotedbyPf3xand respectively

Thetaxthatwe areanalyzinginFigure18(b)could beasalestaxthatisaddedtothe

price of thegoodatthetimeof sale.So,instead of payingPE,buyersarenowforcedto

pay P ,(i.e.,tax=Ptax-P£).The buyer pays theentiretax(thestatutoryincidence)

Since,priortothe imposition of thetax,theirreference pointwasPE,the buyer only

seesthe pricerisefromPEtoPt3x(thebuyer’staxburden).Hence,the portion of thetax

borne by buyersistheareabetweenPEand.P , with width ;thisisthe actualtax

incidenceonbuyers

Notethat the supplycurve inFigure18(b)doesnotmoveas aresultofa taxonbuyers

and that given the original demandcurve, D,suppliers would have supplied the

equilibrium quantityQEatpricePE.The resultisthat suppliersarepenalized because

they would have producedattheQE,PEpoint, but insteadproduce quantityQcaxand

receivePs.Hence,the portion of thetaxborne by sellersistheareabetweenPEandPs,

with widthQÿithisisthe actualtaxincidenceonsellers.Note thatwearestill faced

with the triangular deadweight loss

Professor’sNote:The pointyouneedtoknowisthat the actualtaxincidenceis

independentofwhether thegovernmentimposesthetax(statutoryincidence)on consumers orsuppliers

HowElasticitiesofSupplyandDemand Influence the IncidenceofaTax

When buyers and sellers share thetaxburden,the relative elasticitiesof supply and

demand will determine the actual incidence ofa tax.Elasticityisexplainedindetail later

inthis topicreview

• If demandisless elastic(i.e.,the demandcurve issteeper) than supply,consumerswill

bearahigherburden—thatis,paya greaterportion of thetaxrevenue thansuppliers

• If supplyislesselastic(i.e.,thesupplycurve issteeper)thandemand,suppliers

will bearahigherburden—thatis,paya greaterportion of thetax revenuethan

consumers Here,thechangein the quantitysuppliedforagiven changein pricewillbesmall—buyers havemore“leverage”inthistypeof market.Thepartywith

themoreelasticcurvewill be ableto react more tothe changes imposed by thetax.

Hence,theycanavoidmoreofthe burden

Panels(a)and(b) inFigure19arethesame inall respects, exceptthat the supplycurve

in Panel (b)issignificantlysteeper—it islesselastic.ComparingPanel(a)with Panel(b),we can seethat the portionoftax revenue bornebythe sellerismuchgreaterthan

that bornebythebuyerasthesupplycurvebecomes less elastic Whendemandis more

elastic relativetosupply, buyerspayalowerportion of thetaxbecause they have the

greaterabilitytosubstituteawayfrom the good

affected andefficiencyisreduced less

Figure 19:ElasticityofSupplyand TaxIncidence(a) Elastic Supply Curve (b) Inelastic Supply Curve

loss(andthedecreaseinequilibrium output)issmaller whendemandis moreinelastic

Wecanalsoseethat the actual incidenceofa taxfallsmoreheavilyonbuyers whendemandis moreinelastic

Figure20:Elasticityof Demand andTax Incidence

(a) Elastic Demand Curve (b) Inelastic Demand Curve

tax revenue from sellers

tax revenue from sellers

Subsidies and Quotas

Subsidiesare paymentsmadebygovernments toproducers, often farmers.Theeffects

ofasubsidyareillustratedin Figure21,wherewe usethe marketforsoybeansas an

example.Noteherethatwithnosubsidies,equilibriumquantity in the market for

soybeansis60 milliontonsannuallyat apriceof$60 perton.Asubsidy of$30 perton

causes adownwardshiftinthe supplycurvefromSto (S—subsidy),which resultsin

an increasein theequilibriumquantityto90 milliontonsper year andadecrease in

theequilibriumprice(paid by buyers) to$45 perton.Atthenewequilibrium,farmers

receive$75 perton (themarketpriceof$45,plus the$30subsidy)

Recognizingthatthe (unsubsidized)supplycurverepresentsthemarginalcostandthat

thedemandcurve representsthemarginal benefit, themarginalcost is greaterthan the

marginalbenefitatthenewequilibriumwith thesubsidy.Thisleadsto adeadweightloss

from overproduction.Theresourcesusedtoproducetheadditional30 milliontonsof

soybeans haveavalueinsomeotherusethatis greaterthan the value of these additional

Productionquotas areusedtoregulate markets byimposinganupperlimitonthe

quantityofagoodthat may beproducedover aspecifiedtimeperiod.Quotasareoften

used bygovernments toregulate agriculturalmarkets

Continuingwithoursoybean example,let’s suppose thegovernmentimposesa

productionquota onsoybeans of60 milliontonsper year InFigure22, we seethat in

the absenceofa quota,soybean productionis90 milliontonsper yearat apriceof$45

perton.Witha60 millionton quota,theequilibriumpricerises to$75 perton.

The reductioninthe quantity of soybeans produced duetothequotaleadsto an

inefficient allocationofresourcesandadeadweightlosstotheeconomy.Thequota not

onlyincreasesthe market price, but also lowers themarginalcostofproducingthequota

quantity Atthequota amount,marginal benefit (price) exceeds marginalcost.Thisexplains why producers often seek theimpositionofquotas.

Notethat ifaquotais greaterthan the equilibriumquantityof 90 milliontons,nothingwill change because farmersarealready producing less than themaximumproductionallowed under thequota.

Further, notethat thedeadweightlossincludesalossof bothconsumerandproducersurplus The increased price,however, increasesproducer surplusonthe 60 milliontonssold byan amount greaterthan the producer surpluscomponentof the deadweightloss,

sothatproducers gain overall from thequota.

Figure22:Soybean ProductionQuotaPrice

(dollars per ton)

60-_Deadweight loss from underproduction

"Loss of producer surplus

45-

-MC Quota

30 -ÿ

D Quantity produced decreases

0

LOS 13.m: Calculate and interpret price,income,and cross-price elasticities ofdemand and describe factors that affect eachmeasure

CFA®ProgramCurriculum,Volume2,page 43

PriceElasticityof Demand

Priceelasticityisa measureof the responsiveness of the quantity demandedto achange

inprice.Itiscalculatedastheratioof thepercentagechangeinquantitydemandedto

a percentagechangein price.When quantity demandedisvery responsiveto achange

in price,wesaydemandiselastic;whenquantitydemandedis notvery responsiveto

achangein price,wesaythat demandisinelastic.InFigure23, weillustrate themost extreme cases:perfectly elastic demand(at ahigher pricequantitydemanded decreases

to zero)and perfectly inelastic demand(achangeinprice hasnoeffectonquantity

demanded)

Figure 23:Inelastic andElasticDemand

inelastic Consideradrug that keepsyoualive by regulatingyourheart.Iftwopillsper

day keepyou alive, youareunlikelytodecreaseyourpurchases if theprice goes upand

alsoquiteunlikelytoincrease yourpurchases ifprice goesdown

(b)Perfecdy elastic demand(elasticity=oc)

Whenoneormoregoodsareverygoodsubstitutesfor the goodin question,demand

will tendtobeveryelastic Considertwogas stationsalongyourregularcommute

that offer gasoline of equal quality.Adecreaseinthe posted priceat one stationmay

causeyoutopurchase allyourgasolinethere,whileapriceincrease mayleadyouto

purchaseallyourgasolineatthe otherstation Remember,wecalculate demandaswell

aselasticity, holding thepricesof related goods(inthiscase,thepriceofgasatthe other

station) constant.

Itis importanttounderstand that elasticityis notslope for demandcurves.Slope

isdependentontheunitsthat price and quantityaremeasuredin.Elasticityisnot

dependenton unitsofmeasurementbecauseit isbasedon percentagechanges Figure

24shows how elasticity changesalongalinear demandcurve.Intheupperpartof

thedemandcurve,elasticityis greater (inabsolutevalue)than-1;in otherwords,the

percentagechangeinquantity demandedisgreaterthan thepercentagechangeinprice

In the lowerpartof thecurve,thepercentagechangein quantitydemandedissmaller

than thepercentagechangein price

Figure 24:PriceElasticity AlongaLinearDemand CurvePrice($)

• Atprices less than$4.50(inelasticrange),totalrevenuewill increasewhenprice

isincreased Thepercentagedecreaseinquantity demanded will be less than the

percentage increasein price

• Atpricesabove$4.50(elasticrange),aprice increasewill decrease totalrevenue

sincethepercentagedecreasein quantitydemanded will begreaterthan thepercentageincrease inprice

An important pointtoconsider about thepriceandquantity combinationforwhichpriceelasticity equals-1.0(unitary elasticity)isthat totalrevenue(pricexquantity)is

maximizedatthat price.An increase inpricemoves us tothe elastic region of thecurve

sothat thepercentagedecreasein quantitydemandedisgreaterthan thepercentageincrease in price,resultinginadecreaseintotalrevenue.Adecreasein pricefrom thepoint ofunitaryelasticitymoves usintothe inelastic region of thecurve sothat thepercentagedecreaseinpriceis morethan thepercentageincrease in quantity demanded,

resulting againinadecreaseintotalrevenue.

Otherfactors affect demand elasticityinadditiontothe quality and availability ofsubstitutes

• Portionofincomespent on agood: The larger theproportionofincomethatis

spent on agood, themoreelasticanindividual’sdemandfor that good will be Ifthepriceofapreferred brand of toothpasteincreases, aconsumermaynotchange

brandsoradjust theamountused,preferringtosimplypaytheextra cost.Whenhousingcosts increase,however,a consumerwill be muchmorelikelytoadjustconsumption, becauserentisafairly large proportion ofincome

• Time:Elasticity of demand tendstobegreaterthe longer thetimeperiodsince

the price change.Forexample, whenenergyprices initiallyrise, someadjustments

toconsumptionarelikely made quickly Consumerscanlower the thermostat

temperature.Overtime,adjustments suchassmaller livingquarters,better

insulation, moreefficientwindows,and installationof alternative heatsources are

moreeasilymade,and the effect of the price changeonconsumption ofenergy is

greater.

IncomeElasticityof Demand

Recall thatoneof the independent variablesinourexample ofademand functionfor

gasolinewasincome.Thesensitivityof quantity demandedtochangein income is

termedincomeelasticity Holding otherindependent variablesconstant, we canmeasure

incomeelasticityastheratioof thepercentagechangeinquantity demandedtothe

percentagechangein income

Formostgoods, the sign ofincomeelasticityispositive—an increase in incomeleadsto

an increase inquantity demanded Goods for which thisisthecasearetermed normal

goods.Forother goods,it maybe thecasethatanincrease in incomeleadsto adecrease

inquantity demanded Wetermgoodsfor which thisistrueinferior goods

Aspecific goodmaybeaninferior good forsomerangesofincomeandanormal good

for other ranges ofincome Forareallypoor person orpopulation(thinkundeveloped

country),an increase in incomemayleadto greaterconsumption of noodlesor rice

Now,ifincomes riseabit(thinkcollege studentordeveloping country),moremeat

orseafoodmaybecomepartof their diet.Overthisrangeofincomes,noodlescanbe

aninferiorgoodand groundmeat anormal good Ifincomes riseto ahigherrange

(thinkgraduated from college andgot ajob), theconsumptionof groundmeatmayfall

(inferior) infavor of preferredcutsofmeat(normal)

For manyofus,commercial airline travelisanormal good Whenour incomesrise,

vacationsare morelikelytoinvolve airlinetravel,bemorefrequent, and extendover

longer distancessothat airline travelisanormal good.Forwealthypeople(thinkhedge

fund manager),an increase in incomemayleadtotravel by private jet andadecreasein

the quantity demanded of commercial airline travel

CrossPriceElasticityof Demand

Recall thatsomeof the independent variablesinademand functionarethe prices of

related goods(related inthesensethat their prices affect the demand for the goodin

question) Theratioof thepercentagechangeinthe quantity demanded ofagoodtothe

percentagechangein the price ofarelated goodistermed thecrossprice elasticity of

demand

Whenan increase inthepriceofarelated goodincreasesdemandforagood,wesay

that thetwogoodsaresubstitutes If BreadAand BreadB aretwobrandsofbread,

considered good substitutes bymanyconsumers,an increase inthe price ofonewill lead

consumers topurchasemoreof the other(substitutetheother).When thecrossprice

elasticity of demandispositive(price ofone up,quantity demanded for the otherup),

wesaythose goodsaresubstitutes

Whenanincrease inthe price ofarelated good decreases demand foragood,we

saythat thetwogoodsarecomplements Ifanincrease inthe price of automobiles

(lessautomobiles purchased) leadsto adecreaseinthe demandfor gasoline, theyare

complements Right shoes and left shoesareperfect complements formostofusand,as

aresult,theyarepriced by the pair If theywerepriced separately, thereislittle doubtthatanincrease inthe price of left shoes would decrease the quantity demanded of rightshoes.Overall,thecrossprice elasticity of demandismorepositive the better substitutestwogoodsareandmorenegative the bettercomplements thetwogoodsare

CalculatingElasticities

Recall the general form ofourdemandfor gasoline function:

QDgas=107,500-12,500Pgas+2001+1,200PBT-100Pauto

Notethat from the coefficientonincome(+200), wecantell that the goodisanormalgood (greaterincomeleadsto greaterquantitydemanded).The coefficientontheprice of bus travel(+1,200)tellsusthat bus travelisasubstitutefor gasoline (higherprice leadsto greaterquantity ofgasolinedemanded).The coefficientonthe price ofautomobiles(-100)tellsusthat automobiles and gasolinearecomplements(anincrease

inautomobile prices leadsto adecreaseinthequantityof gasolinedemanded)

In derivingaspecific demandcurvefor gasoline,weinserted valuesforincome,price ofbustravel,and price of automobilesto getquantity demandedas afunctionof only theprice of the good:

Example: Calculating price elasticity of demand

Fortheprevious demandcurve,calculate the price elasticityat agasoline price of $3

per gallon

Answer:

Wecancalculate the quantity demandedat aprice of $3pergallonas 138,500

12,500(3)=101,000.Substituting 3 forPQ,101,000forQQ,and-12,500for ,

we cancalculate the price elasticity of demandas: '

= — - — lx (-12,500) =-0.37

1101,000J v '

%AQ

%APForthis demandfunction,at aprice and quantity of $3pergallon and101,000

gallons, demandisinelastic

The technique for calculatingincomeelasticity andcrossprice elasticityis identical,

as weillustrateinthefollowingexample Weassumevaluesfor all the independent

variables,excepttheoneofinterest,and then calculateelasticity foragiven value of the

variableofinterest

Example: Calculatingincomeelasticity andcross priceelasticity

Anindividual has the following demand function for gasoline:

QDgas=15-3Pgas+0.021+0.11PBT-0.008Pauto

whereincomeandcarpricearemeasuredin thousands,and the price of bus travelis

measuredin averagedollars per100miles traveled

Assuming theaverageautomobile priceis $22,000, income is $40,000,the price of

bus travelis$25,and the price of gasolineis$3,calculate and interpret theincome

elasticity of gasoline demand and thecrossprice elasticity of gasoline demand with

respect tothepriceof bus travel

Ourslopeterm onincome is0.02,andforanincomeof40,000,Qpgas=9.4gallons.

Theformulafor theincomeelasticity of demandis:

I0

Substitutingourcalculatedvalues,wehave:

(S)X(0'02) =0-085

This tellsusthat for these assumed values(at asinglepointon thedemandcurve), a

1%increase (decrease)inincomewillleadto an increase (decrease)of 0.085% in thequantity ofgasoline demanded

Inorder tocalculate thecrosspriceelasticityofdemandfor bustraveland gasoline,

we construct ademand function with only the price of bus travelas anindependentvariable:

Thecrossprice elasticity of the demand for gasoline withrespect tothe price of bus

Asnoted,gasoline and bus travelare substitutes,sothecross priceelasticity of demand

ispositive.We caninterpret this valuetomeanthat forourassumedvalues,a1%

changeinthe price of bus travel will leadto a0.294%changeinthe quantity of

gasoline demandedinthesamedirection,other things equal

Inthe previous example,wecalculated theelasticity of demandat apointonthe

demandcurveusing theslope of thecurveat aspecific price and quantity.Giventwo

pointsonthe demandcurve(ratherthan the demandfunction),we cancalculate the

elasticityoverthat range of the demandcurve,thatis,thearcelasticity of demand

When calculating thepercentagechangesinprice andinquantity forarcelasticity,we

usethe midpoints of price and quantityoverthe rangesothatan increaseandadecrease

for either priceorquantity will yield thesame percentagechange

Example:Arcelasticity of demand

Ataprice of$4 per unitquantity demandedis 40,000 unitsandat aprice of$5 per

unitthe quantity demandedis35,000units.Calculate thearcelasticity of demand

overthis range

KEY CONCEPTS

LOS 13.aMarketsforgoodsandservicestoconsumers arereferredto asgoods marketsorproductmarkets

Markets forfactors of production(rawmaterials,goods andservicesusedinproduction)

arereferredto asfactor markets

Goods andservicesusedinthe production of finalgoodsandservices arereferredto asintermediate goods

LOS13.bThequantitysuppliedisgreater athigherprices.Thequantitydemandedisgreater atlower prices

Ademandfunction provides the quantity demandedas afunctionof price of the good

orservice,the prices of related goodsorservices,andsome measureofincome

Asupply functionprovides the quantity suppliedas afunctionof price of the good

or serviceand thepricesof productiveinputs,and dependsonthe technology usedtoproduce the goodor service

Using values for all the variables other than price and invertingademand (supply)function producesademand (supply)curve.

LOS 13.cThe changeinquantity demanded(supplied)inresponseto achangeinpricerepresents

a movementalongademand (supply)curve, not achangeindemand (supply)

Changesindemand (supply) refertoshiftsinademand (supply)curve

Demandisaffectedbychangesin consumertastesandtypicallyincreases (shiftstotheright) withincreases inincome,increases inthe price of substitute goods,ordecreasesin

the price of complementary goods

Supplyisincreased(shiftedtothe right) by advancesinproduction technology and bydecreasesininput prices(prices of factors of production)

LOS13.dTheaggregateormarket demand (supply) functioniscalculated by summing thequantities demanded(supplied)ateach price for individual demand (supply) functions