CFA 2018 level 1 economics

Diminishing marginal returnsBreakeven and shutdown points of production LOS d LOS e Marginal returns refer to the additional output produced by using one more unit of labor or capital w

Price elasticity Income elasticity Cross price elasticity

Demand curve

Sensitivity of quantity demanded to change in price Sensitivity of quantity demanded to change in income Sensitivity of quantity demanded to change in price of related goods (compliment or substitute)

Every Giffen good is an inferior good but every inferior good is not a Giffen good For Giffen goods, income effect is more dominant than substitution effect

Price elasticity

Income elasticity

Cross price elasticity

P = +ve: Good is substitute e

P = −ve: Good is complement e

I = +ve: Good is a normal good e

I = −ve: Good is an inferior good e

Inferior but not Giffen good (P È 10%) Ç Q 10% d È Q 5% d

Inferior and Giffen good (P È 10%) Ç Q 10% d È Q 15% d

Veblen Good - Higher price makes goods more desirable

Eg Louis Vuitton bag May have a positively sloped demand curve

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Diminishing marginal returns

Breakeven and shutdown points of production

LOS d

LOS e

Marginal returns refer to the additional output produced by using one more

unit of labor or capital while keeping the other constant

Quantity

of labor

Quantity Cost

Total output

Marginal product increasing

Marginal cost curve

ATC curve AVC curve

AFC curve

Marginal product decreasing Marginal product

negative

Inputs beyond this quantity are said to produce diminishing marginal returns

Perfect competition

Imperfect competition

Economies and diseconomies of scale

Long run ATC curve

Long run ATC curve shows minimum ATC for each level of output

assuming that scale of the firm can be adjusted

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-In equilibrium,

P > MR = MC

P > 1 e

Economic profit +ve in long run Profits may be zero

-The Firm And Market Structures

Characteristics of different markets

Firm’s supply function (Perfect competition)

Relationships between P, MR, MC, economic profit and P under different market structurese

Oligopoly Monopoly

Product differentiation Homogeneous Differentiated Homogeneous Unique

Pricing power of

Some or considerable Considerable

Non price competition None

Advertising + Product differentiation

Advertising + Product differentiation

Short run market supply curve ATC curve

AVC curve

D = MR

In the short run, MC curve is above AVC curve

In the long run, supply curve MC is above ATC curve There is no well defined supply curve for other markets

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Under monopolistic competition, oligopoly and monopoly, equilibrium quantity is determined by the intersection of MC and MR

Firms maximize profits by producing the quantity where MC = MR

In perfect competition P = MR

In monopolistic competition and monopoly, price is the intersection of

demand curve and profit maximizing quantity of output

Increase in a firm’s product price will not be followed by its competitors, but a decrease in price will Kink is the price above which the demand is elastic and below which the demand is inelastic

LOS d

LOS e

Optimal price and output for firms

Factors affecting long-run equilibrium under each market structure

Pricing strategies in oligopoly Kinked demand curve

An increase in demand will increase economic profits in the short run under all market structures +ve economic profits result in entry of firms into the industry (except oligopoly and monopoly)

−ve economic profits result in exit of firms When firms enter an industry, market supply increases, which causes decrease in market price

and an increase in equilibrium quantity

Quantity

Price

Marginal cost curve

Marginal revenue curve

Nash equilibrium

Dominant firm model

Nash equilibrium is reached when the choices of all firms are such that there

is no other choice that makes any firm better off Eg prisoner’s dilemma

One firm has significantly large market share because of its greater scale and lower cost

structure (Dominant firm) Market price is determined by the dominant firm and other firms take this price as given

Firm’s decisions are interdependent

If there is a price war, then dominant firm’s market share Ç

If there is no price war, then over time dominant firm’s market share È

Single firm supplying the entire market demand for the product

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Natural monopoly

Firms under any market maximize profits by producing the quantity where MC = MR

In perfect competition P = MR = AR =MC = ATC

In monopolistic competition, oligopoly and monopoly, price is the intersection of

demand curve and profit maximizing quantity of output Pricing strategies under oligopoly - Kinked demand curve, Cournot model, Nash

equilibrium, dominant firm model

Considers a duopoly i.e two firms with identical and constant marginal cost of production

Price

Quantity

-Cournot model

Perfect competition

Perfect competition

Choices:

High price

Low price

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LOS h Identifying the market structure in which firm operates

ΠExamine no of firms in the industry, check if products are homogeneous or differentiated,

see barriers to entry/exit and check if there is any non price competition

 Compare these with the characteristics that define each market structure

ratio

Hirschman Index

Herfindahl-Eg N = 4 Add up the market share of 4 largest companies in the industry Limitations :

ΠDoes not comment on pricing power

 Does not capture the merger effect

Eg N = 4 Add up the square of market shares of

4 largest companies in the industry

It captures the merger effect

Value of final output

GDP is calculated by adding the value created at each stage of production

GDP is calculated using only the final value of good and

services

Nominal GDP Real GDP × 100

Output - Current year Output - Current year

ª Gross domestic product (GDP) is the total market value of final goods and

services produced within a country during a certain time period

ª It is most widely used measure of the size of a nation’s economy

ª It includes only purchases of newly produced goods and services

ª Sale or resale of goods produced in previous periods is excluded

ª Goods and services provided by government are included in GDP (valued at cost)

ª Value of owner-occupied housing is also included in GDP (value is estimated)

Aggregate Output, Prices And Economic Growth

GDP using expenditure and income approach

National income

Personal income

Personal disposable income

-GDP under income approach can also be calculated as :

National income

Personal income

+ Transfer payments by govt.

− Corporate and indirect taxes

− Personal taxes

− Undistributed corporate profits

+ Corporate and govt profits before tax + Non corporate business income + Rent

+ (Indirect taxes − Subsidies) + Interest

National income + Capital consumption +

allowance

Statistical discrepancy

Depreciation of physical capital

Adjustment for difference between GDP under income and expenditure

approach

Total income must equal total expenditures GDP under income approach = GDP under expenditure approach

C + S + T = C + I + G + (X − M)

S = I + (G − T) + (X − M)

(G − T) = (S − I) + (M − X) Fiscal deficit must be financed by some combination of trade deficit or excess of savings over investment

Fiscal deficit

Trade surplus

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IS and LM curves

Aggregate demand curve

LOS f

Real income

Output (y)

Output (y)

LM 1

LM 2

IS

Real income

Π+ve relation

r and (S − I)

 −ve relation

y and (S − I) Therefore,

−ve relation b/w

r and y

Assumption - Real money supply is constant

(S − I) = (G − T) + (X − M)

y ÇFiscal deficit & Trade surplusÈ= (S −I)È

Ÿ y Ç= Precautionary & transaction demand Ç

Ÿ Demand for money = Cost of money Ç Ç

IS curve - −ve relation (r & y)

LM curve - +ve relation (r & y) Aggregate demand curve -

−ve relation (p & y)

IS - Investment and Savings

LM - Liquidity and Money supply

ª Marginal propensity to save (MPS) - Proportion of additional income that is saved

ª Marginal propensity to consume (MPC) - Proportion of additional income spent on consumption

ª MPS + MPC = 100%

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Aggregate supply curve

Causes of movements along and shifts in aggregate

demand and supply curves

è VSRAS - Firms adjust output without changing price VSRAS curve is perfectly elastic

è SRAS - When prices increase, input costs (such as wages) do not increase as they

are fixed in the short run

è LRAS - All input prices are variable in the long run LRAS curve is perfectly inelastic

and it shows the level of potential GDP

è Price level has no long run effect on aggregate supply

ª High future income expectation by consumer

ª High capacity utilization

ª Expansionary monetary policy

ª Expansionary fiscal policy

ª Home currency depreciation

ª Global economic growth

ª Increase in productivity

ª Increase in supply and quality of labor

ª Increase in supply of natural resources

ª Increase in the stock of physical capital

ª Technology improvement

ª Currency appreciation

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Short-run effects of changes in aggregate demand and supply

Recessionary gap Inflationary gap Stagflation

Aggregate supply

Real GDP Price level

LOS l

LOS m

Short-run effects of shifts in both aggregate demand and supply

Sources of economic growth

Sustainability of economic growth

ª Rate of increase in labor productivity

Growth in technology + W (Growth in labor) L + W (Growth in capital) C

Growth in technology + W (Growth in capital) C

Growth in per capita potential GDP Growth in potential GDP

Describes relationship between output and labor, capital and total factor productivity

Total factor productivity (TFP) - It is a multiplier that quantifies the amount of output

growth that cannot be explained by the increases in labor and capital Increase in total

factor productivity can be attributed to advances in technology

Growth of labor

Residual income that explains the effect of technology

Growth of capital

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GDP Ç

Supply (labor) Ç

Subsistence Wages Ç

Economy neutral stay

Population explosion Wages È

ª Firms are slow in laying off employees in early contraction period

ª Firms are slow in hiring employees in early expansion period

ª Housing activity decreases if home prices rise faster than income

ª Firms use their physical capital more intensively during expansion and

less intensively during contraction

ª Imports increase during expansion

ª Exports increase during contraction

ª Expansion - Increase in output, employment, consumer spending, business investment and inflation

ª Contraction - Decrease in output, employment, consumer spending, business investment and inflation

ª Peak - Inventory/sales ratio is highest

ª Trough - Inventory/sales ratio is lowest

ª Business cycles recur but not at regular intervals

ª Beginning of expansion/contraction - 2 consecutive quarters of growth/decline in real GDP

Trend Cycle

Understanding Business Cycles

Business cycle and its phases

Fluctuations in sector as economy moves through the business cycle

Theories of the business cycle

New classical school

Economists believe that shifts in ADC and ASC are

caused by changes in technology They also believe business cycles are temporary

Economists believe that shifts in aggregate demand are due to changes in

expectations Keynesian economists believe that wages are downward sloping Policy prescription - Increase aggregate demand directly, through

monetary policy or fiscal policy

Adds the assertion that inputs as well as wages are sticky

Business cycles are caused by inappropriate decisions by the monetary authorities They suggest, the central bank should follow a policy of steady and predictable

increases in money supply

They believe that business cycles are caused by government intervention

These economists introduced real business cycle theory (RBC) RBC emphasizes the effect of real economic variables such as change in technology

and external shocks RBC holds that policymakers should not intervene in business cycles

Caused by changes in general level of economic

activity +ve in contraction & −ve

in expansion

Caused by long-run changes in the economy Workers lack requisite

skills

Time taken by employees

to find the jobs that fit

Labor force = Workers employed + workers unemployed

Underemployed worker - Worker employed at a low paying job despite being qualified

Discouraged worker - Workers who are not actively seeking work They are not considered as a part of unemployed workers and therefore not a part of labor force

Workers unemployed Labor force Unemployment rate =

Labor force Working age population Activity ratio/Labor force participation ratio =

Consumer price index (CPI) - Cost of basket at current prices Cost of basket at base prices x 100

ª Weights assigned to each good and service in CPI basket can differ significantly across

countries and regions

ª Headline inflation - Price indexes for all goods

ª Core inflation - Price indexes that exclude food and energy (because their prices are volatile)

Laspeyres price index Paasche price index Fisher price index

Quantity Base year Price - Base year LPI :

Quantity Current year Price - Base year PPI :

-It is geometric mean of a LPI and PPI

ª Hyperinflation - Inflation that accelerates out of control

ª To consider a situation of rising prices as inflation, the prices of almost all goods should rise

ª Inflation erodes the purchasing power of currency

ª Inflation favors borrowers at the expense of lenders

Hedonic pricing is used to measure the upward bias present

Economic indicators

LOS i

Manufacturers’ new orders for

consumer goods and materials

Manufacturers’ new orders for

non-defense capital goods

ex-aircraft Building permits

S&P 500 equity price index

10-year T-bonds less federal

funds Consumer expectations

Inventory-sales ratio Labor cost per output Average prime lending rate Change in consumer price

index Average duration of unemployment

Real personal income Index of industrial production Manufacturing and trade sales

Cost-push inflation Demand-pull inflation

Caused by increase in aggregate demand Increases price level and temporarily increase real GDP above nominal GDP Central bank can try to bring economy back to potential GDP

Aka wage pushed inflation Caused by decrease in aggregate supply Initially decreases GDP

LOS h

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Quantity of money Total spendingMoney supply × Velocity = Price × Real Output

Velocity - Average number of times a unit of currency changes hands Monetarists believe that money is not neutral in the short run

Money neutrality - Money Supply Price «¢ «

ª Money - Generally accepted medium of exchange

ª Primary functions

-Ÿ Serves as a medium of exchange

Ÿ Serves as a unit of account

Ÿ Provides store of value

ª Narrow money = Currency and coins in circulation + Balances in checkable bank deposits

ª Broad money = Narrow money + Amount available in liquid assets

LOS b

LOS c

LOS d

Functions and definitions of money

Fractional reserve banking system

Demand for money Quantity theory of money

Monetary And Fiscal Policy

Undertaken by country’s central

bank Expansionary (accommodative) - When the central bank increases the quantity of money and credit Contractionary (restrictive) - When the central bank reduces the quantity of money and credit

Undertaken by government Budget surplus = (T − G) > 0 Budget deficit = (G − T) < 0 Can also be used as a tool for redistribution of income and

wealth

Total amount of money created - Reserve ratio New deposit Money multiplier - Reserve ratio 1

ª Transaction demand - Money held to meet the need for undertaking transactions

GDP «¢ Transaction demand«

ª Precautionary demand - Money held for unforeseen future needs

GDP «¢ Precautionary demand«

ª Speculative demand - Money that is available to take advantage of investment opportunities in future

Opportunity cost »¢ Speculative demand«FinTree