CFA LEVEL 1 STUDY SESSION 04, 05 & 06

ECONOMICS

Calculation: Price elasticity of demand =

a
Highly elastic Relatively inelastic Perfectly elastic Perfectly inelastic

Types

Figure 1:

Availability of substitutes

Cross elasticity of demand =

Price elasticity of DEMAND Factors

Relative amount of income spent on the good Time since the price change

Income elasticity

13. Elasticity

Figure 3: b. On a straight-line demand curve

Elastic Differentiate Inelastic Unitary elastic Relation between price elasticity of demand and total revenue

Calculation: Price elasticity of supply =

Price elasticity of SUPPLY

Available resource substitutions Factors Supply decision time frame Momentary supply Short-term supply Long-term supply

b. Marginal Benefit (MB)

=Demand curve Consumer surplus = Value - Price

c. Marginal Cost (MC)

=Supply curve Producer surplus = Price - Cost

a. Allocative efficiency

MB = MC

a,b,c,d. EFFICIENCY

a,d. Efficient quantity

Where D and S intersect (Equilibrium)

Consumer surplus

Efficient markets & optimal resource utilization

14. Efficiency And Equity

Inefficiency and Deadweight loss (DWL)

Overproduction

Underproduction

Price controls

Ceilings Floors

e. Inefficiency
Taxes Subsidies Quotas

Trade restrictions Obstacles to efficiency Monopoly Costs Benefits

External

Public goods Common resources

Utilitarianism

f. EQUITY: Fairness principles (2 schools of thoughts)

Symmetry principle

a1. Market Equilibrium

Short term impacts

a2. Outside shocks

Long term impacts

a
Housing sector

a3. Price ceilings

Black market

Market efficiency

Labor market

15.1. Markets In Action

b. Price floor

LR --> Inefficiencies

Tax on supply

Tax on demand

c. Tax

Tax revenue

Tax incidence

Statutory incidence Actual incidence Influence of Elasticities

Subsidies Quotas

d. Impact of
Markets for illegal goods

c. Tax a

15.2. Markets In ActionFigures

Subsidies

Quotas

d. Impact of

Markets for illegal goods

Definition Explicit costs Definition Including Own CapitalImplicit rental rate Implicit costs Time and financial resources of owners Relation to economic profit Economic depreciation Foregone interest Normal profit Foregone wages

a. Opportunity cost

Technology

b. Constraints on Profit maximization

Information Market constraints

Technological efficiency (TE) Economic efficiency (EE) Relationship EE-->TE

c. Efficiency

16. Organizing Production

Command system

d. Ways to organize productions

is _____ Incentive system Principal- agent problem Reduced by Agents (managers & workers) do not have the same motives & incentives as the firm's principals (owners) Ownership Incentive pay Longer term contracts

Proprietorship

e. Types of business organization

Partnership Corporation

2 primary measures

Four firm concentration ratio HerfindahlHirschman Index

f. Concentration measures
Limitations

Market coordination Lower transaction costs

g. Firm coordination vs. Market coordination

Firm coordination

Economies of scale Economies of scope Economies of team production

a
Short run

a. Decision time frame

Product of labor

Long run

Total Marginal Average

b.

Marginal returns

Fixed Total Variable Total cost curves Marginal MC curve ATC AFC AVC

c. Costs
Average

17. Output And Costs

Example

Output= f() Production function Diminishing returns

Capital Labor

Diminishing marginal product of capital Example Short run -

d.
Costs Economies of scale Long run Diseconomies of scale

Savings due to mass production Specialization of labor and machinery Experience Increasing bureaucracy Problems motivating a larger workforce Greater barriers to innovation & entrepreneurial activity Increased principal-agent problems

Price taker market Identical products Large number of independent firms Each seller is small relatively No barriers to entry & exit Demand curve for Market Firm

a. Characteristics of perfect competition

MC MR Economic P&L

b. Profit maximization output

Price taker

18. Perfect Competition

SR supply curve

c.

LR equilibrium is impacted by

Changes in demand Entry and Exit Changes in plant size

Permanent change in demand

d. Price, output & economic profit are affected by

Changes in technology

One seller Product specific, well-defined no good substitutes High barriers to entry Legal barriers Natural barriers single firm supplying the entire market for the product large economies of scale (greater output lower average cost of production) single price price discrimination (when reselling is not possible)

a. Characteristics of monopoly

Alternative monopoly price-setting strategies

a
Price

b1. Relation between

Marginal Revenue Elasticity

b2. Profit-maximizing price and quantity

Diagram

19. Monopoly

c. Price discrimination & efficiency

For price discrimination to work, seller must

Face a downward-sloping demand curve Have at least 2 identifiable groups of customers with different price elasticities of demand for the product Be able to prevent the customers paying the lower price from selling the product to the customers paying the higher price

d. Consumer and Producer surplus redistributed

e1. Potential gains from monopoly

Forms of regulation

Average cost pricing

Forces monopolists to reduce price to where the firm's ATC intersects the market demand curve

Increase output and decrease price Increase social welfare (allocative efficiency) Ensure a normal profit Increase output and reduce price Monopolist incurs a loss --> government subsidy to provide a normal profit

e2. Regulation of a natural monopoly

Marginal cost pricing (efficient regulation) Regulators sometimes go astray

Forces monopolists to reduce price to where the firm's MC curve intersects the market demand curve

Lack of information: regulators may not know firm's ATC, MC or demand curve Cost shifting: firm has no incentive to reduce costs Quality regulations Special interest effect: political manipulation

Large number of independent sellers Monopolistic competition Differentiated product Compete on price, quality and marketing Low barriers to entry Firm demand curve: downward sloping, highly elastic

a. Characteristics of
Oligopoly

Small number of sellers Interdependence among competitors --> highly dependent upon the actions of rivals Significant barriers to entry (large economies of scale) Product: similar or differentiated

Monopolistic competition

LR economic profit = 0 Efficient? c. Compare to perfect competition

b,c. Profitmaximization output under

Oligopoly

20. Monopolistic Competition And Oligopoly

d. Monopolistic competitionimportance of

Innovation

Product development

Advertising

Branding

Kinked demand curve model

e.
Dominant firm model

Oligopoly f. Oligopoly games

Prisoners' Dilemma

Derived demand

is demand for a productive resource depending on the demand for the final goods

Marginal revenue

a.
Marginal Revenue Product (MRP) determine Demand for labor Wage rate

Price of output Demand for labor Price of another factor that factor is a complement or a substitute to labor

b. Factors affecting
Elasticity of Demand for labor

Technological improvements SR vs LR Labor intensive Degree of substitution by capital

Labor

21. Market For Factors Of Production

c. Supply of labor (LS)

Factors determining (moving along the LS curve) Factors related to changes (shifting the LS curve)

Wage rate

substitution effect income effect

Size of adult population Capital accumulation

d. Effects on wages of

Labor unions Monopsony

e. Types of capital

Physical Financial

Capital f. Factors affecting

Demand for capital

Role of present value technique Interest rate

Supply of financial capital

Current income Expected future income

Renewable

g. Natural resources

Non- renewable

Economic rent

h. Differentiate

Opportunity costs

last 4 weeks a. Define "unemployed person" laid off, waiting next 30 days a. Discouraged workers Unemployment rate= a. Labor market indicators Labor-force participation rate= Employment-topopulation ratio= b1. Aggregate hours

a,b,c. Labor
b2. Real wage rate

22. Monitoring Jobs And The Price Level

c. Types of unemployment

Frictional Structural Cyclical

c. Full employment

Natural rate of unemployment Potential GDP

Select CPI basket BLS's calculation Conduct monthly price survey Calculate CPI=

d. CPI

Inflation rate= New goods CPI bias Quality changes Commodity substitution Outlet substitution

Real GDP

a1. Factors influencing

SAS

LAS

a2. Movement along LAS & SAS curve

a3. Reasons for changes in potential GDP and AS

=C+I+G+X

b. AD

23. Aggregate Supply And Aggregate Demand

SR vs LR

Impacts of Economic growth

c. Macroeconomic equilibrium

Impacts of Inflation

Impacts of Changes in AD

Impacts of Changes in AS

Classical

d. Schools of macroeconomics
Keynesian

Medium of exchange

a. Functions of money

Unit of account Store of value

currency not held at banks travelers' checks M1 checking account deposits individuals firms NOT government

b. Money supply

M1 M2 Deposits Time deposits Savings deposits

Money market mutual fund balances NOT Outstanding checks Credit cards

Commercial banks Primary types savings banks Thrifts credit unions savings and loan associations (S&Ls)

24.1. Money, The Price Level, And Inflation- Part 1

c. Depository institutions

Money market mutual fund Economic functions Create liquidity Financial intermediaries Monitor risk better Pool default risk --> portfolio Capital adequacy Financial regulations Reserve requirement Restrictions on types of deposits Proportion of loans (commercial loans) Deregulation and Financial innovation new fin. products computers --> lower trx cost ATM, Internet banking

Goals in conducting monetary policy Policy tools Discount rate Bank reserve requirement OMO Gold, deposits with central banks, special drawing rights at IMF

d. Fed

Fed's balance sheet

Assets

US Treasuries (90%) Loans to banks (reserved loaned at discount rate)

Liabilities

Fed Reserve notes=US currency in circulation (90%) Bank reserve deposits

Fractional reserve banking

e. Creation of money

Required reserve ratio Multiplier effect

Monetary base = Fed notes, coins + Banks' reserve deposits at FED

f.

Money multiplier=

Quantity of money

Definition

currency in circulation + checking account deposits + traveler's checks

24.2. Money, The Price Level And Inflation- Part 2

Supply of money

determined by central bank independent of interest rate

g. Money

Demand for money

Households & firms affected by Changes in real GDP Financial innovations

h1. Interest rate determination

h2. SR and LR effects of money on Real GDP a

i. Quantity theory of money

Inflation

a. Differentiate

a
Price level

Demand pull

b. Inflation processes

25.1. US Inflation, Unemployment, And Business Cycles- Part 1

Cost push

c. The costs of anticipated Inflation

Inflation Nominal interest rate

d. Relation

higher rates of inflation D&S of money higher rates of growth of money supply lead to higher rates of expected inflation higher nominal interest rates

Phillips curve

Short run

a
Long run

e. Inflation and Unemployment

Changes in natural rate of unemployment

Size & makeup of labor force Sources of changes Changes that affect labor mobility Advances in technology that replace some jobs and create new ones

Shift LR Phillips curve

Economic growth

f. Business cycle is affected by

Inflation Unemployment

25.2. US Inflation, Unemployment, And Business Cycles- Part 2

LRAS increases steadily Variation in AD results in cyclicality in the rates of output growth, price inflation & unemployment

Mainstream business cycle theory

g. Theory

Real business cycle theory

Variation in the rate of growth of LRAS due to changing rates of productivity growth (from technological change) results in cycles between higher and lower rates of growth of real GDP, employment & inflation

Income tax

Tax wedge

a. Supply-side effects on employment, potential GDP & AS

Taxes on expenditure Laffer curve

Sources of investment finance

National savings Borrowing from foreigners Government savings

b.

Influences of fiscal policy on capital markets

Crowding-out effect

Larger budget deficit --> decrease quantity of savings --> increase real i/r --> firms reduce borrowing --> decrease in growth rate of capital --> reduce potential GDP Current deficit increases --> greater taxes in the future --> taxpayers increase current savings (reduce current consumption) increase in savings of taxpayers = Govt. borrowing (if issues bonds)

Ricardo-Barro effect Ricardo-Barro equivalence

26. Fiscal Policy

c. Generational effects of fiscal policy

Generational accounting Generational imbalance

Government spending

Government expenditure multiplier

d. Use of fiscal policy to stabilize the economy

Taxes

Tax multiplier

Balanced budget multiplier

Not exact science Limitations Complications --> delays Recognition delay Administrative/ law making delay Impact delay

e. Discretionary fiscal policy

# automatic stabilizers Induced taxes Needs-tested spending

Goals

1. Maximum employment, (maximum sustainable growth of the economy) 2. Stable prices 3. Moderate long-term interest rates

a. Goals of US monetary policy & Fed's means

How Fed operationalizes those goals

a
Core inflation Difference between actual and potential economic output

Instrument rules

Taylor rule

FFR = 2% + actual inflation + 0.5 (actual inflation -2%) + 0.5 (output gap)

b. How Fed conducts monetary policy

through FFR (Federal funds rate)

Targeting rules Open market operations Market for reserves

based on a forecast of future inflation and set FFR so that forecast inflation = target inflation (typically 2%)

27. Monetary Policy

c. Monetary policy's transmission mechanism

McCallum rule

Growth rate of MS targeting rule

d. Alternative monetary policy strategies (rejected by Fed)

Exchange rate targeting rule

Inflation targeting rule

a. Functions of a central bank

28. An Overview Of Central Banks

Discount rate

b. Monetary policy & tools

Bank reserve requirements

Open market operations