Lecture Economics for investment decision makers: Chapter 1 - CFA In stitute

Chapter 1 - Demand and supply analysis: Introduction. The focus of the reading is on demand and supply analysis (microeconomics): How are prices and quantities of transactions determined? The theory of the consumer deals with how consumers make choices, and the theory of the firm is how profit-maximizing firms make choices.

1 Introduction

2 Types of markets

• Factor markets are markets for the factors of production.

- The factors of production are the inputs to production.

- Factor markets include labor markets.

• Goods markets are markets for the outputs of production.

- The outputs of production are goods and services, which may be

intermediate goods and services or final goods and services

• Capital markets serve as a means for providers of capital (that is, the

providers or suppliers of long-term sources of funding, or savers) to exchange their capital for long-term claims on a firm’s cash flow and assets (that is, debt and equity securities)

3 Basic Principles and Concepts

The demand function

(1-1)

The Supply function

(1-7)

Changes and movements

Changes in quantity demanded

Change in its own-price

Movement along the demand curve

Change in price of other goods

Shift in the demand curve

Changes in quantity supplied

Change in its own-factor prices Movement along the demand curve

Change in supply Shift in the supply curve

Aggregating Supply and demand curves

• Moving from the individual consumer or firm to the aggregate:

- Aggregating demand curves requires adding the individual quantities

demanded at each price

- Aggregating supply curves requires adding the firms’ quantities supplied at each price

• A market equilibrium is the situation in which the quantity demanded at a

given price is equal to the quantity supplied at that price

Price

Quantity

Solving for the equilibrium

• A stable equilibrium occurs when the price adjusts so that demand = supply.

• An unstable equilibrium occurs when the demand or supply curves are such

that an upward change of price does not reduce excess demand or supply (or

a downward change does not reduce excess demand or supply)

- Price bubbles are an example of an unstable equilibrium

Demand and supply functions

Aggregate Supply and Demand

Excess supply and demand

Types of auctions

• Common value auction: The item’s true value is revealed after bidding.

• Private value auction: Each bidder places a subjective value on the item, but

these valuations differ

• Ascending price auction: Also known as an English auction; highest bidder

wins auction for item

• First price sealed-bid auction: Bidders submit sealed bids that are not known

to other bidders; winning bidder is the one submitting the highest price

• Second price sealed-bid auction: Also known as a Vickery auction; the

bidder that submits the highest bid wins, but the price paid for the item is the next-lowest bid price

• Descending price auction: Also known as a Dutch auction; the auctioneer

begins with a very high price and lowers the price in increments until there is a willing buyer

Dutch Auction: US Treasury securities

Discount

Competitive Bids (in billions)

Cumulative Competitive Bids (in billions)

Noncompetitive

Bids (in billions)

Total Cumulative Bids (in billions)

Consumer surplus is the difference

between the maximum price the

consumer was willing to pay and the

actual price

Producer surplus is the difference

between what the producer sells a good or service for and the price at which the supplier was willing to sell

Calculating Surplus

Market Interference

• A government-imposed ceiling on a price that is less than the market

equilibrium price results in a reduction of surplus: Buyers want more than

sellers are willing to supply at that price

- Some consumers gain consumer surplus lost by suppliers, but some

consumer surplus is lost and not picked up by suppliers

- The loss in surplus is deadweight loss, which is a loss of surplus that is not

transferred to another party

• A government-imposed price floor that is higher than the market equilibrium

results in a reduction of surplus

- Sellers want to sell more, but buyers purchase less

- Sellers gain some producer surplus lost by consumers, but some of this

producer surplus is lost and not picked up by consumers

In general, market interference inhibits the role of the market to allocate

Effect of market interference

Equilibrium price = €1

0 2 4 6 8 10 12

B

0 2 4 6 8 10 12

A CA

4 Demand Elasticities

slope coefficient

Px

Qx a

b

• Own-price elasticity refers to the sensitivity of the quantity of a good

demanded to its own-price change

• Cross-price elasticity of demand is the response in the demand of a good to

a change in the price of another good

- A substitute is a good that has a positive cross-price elasticity.

- A complement is a good that has a negative cross-price elasticity

Elasticities: Summary

Elasticities: Example

Consider the case of the sensitivity of the demand for tires, in response to the price of gas per gallon:

Tires = 95 million – 3.2 Price per gallon of gas

• There is negative cross-elasticity between tires and gas; therefore, gas and tires are complements

• If the price per gallon increases by $1, the number of tires declines by 3.2 million

Factors that affect elasticities

1. Degree of substitutability

- The greater the degree of substitutability, the greater the elasticity

2. Portion of budget spent on the good

- The greater the portion, the greater the elasticity

3. Time allowed to respond to the change in price

- The longer the time allowed, the greater the elasticity

4. Extent to which the good is deemed necessary

- The greater the extent to which the good is deemed as necessary, the more inelastic its demand

Income elasticities

5 Conclusions and Summary

• The basic model of markets is the demand and supply model: Equilibrium

occurs at the price at which the quantity demanded is equal to the quantity

supplied

• Markets are interactions between buyers and sellers

• The price of a good in a market is determined by supply and demand

• Auctions are sometimes used to seek equilibrium prices

• Markets ensure that the total surplus is maximized

- Sometimes, government policies interfere with the free working of markets, shifting surplus between consumers and producers, with some loss

• Elasticity is the ratio of the percentage change in the dependent variable to the percentage change in the independent variable of interest

- Elasticities are sensitivities of the quantity demanded to either the good’s