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Lecture notes CFA - Chartered Financial Analyst
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Economics and Financial statement-Lecture notes CFA - Chartered Financial Analyst
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Economics and Financial StatementsDemand concepts
Demand function: Qd= f(Px, I, Py)- price of good, income and price of other goods
Own price is used to reference the price of the good itself and not the price of some other good
The slope of demand is Change in P/ Change in QD
Elasticity of demand
Elasticity is general measure of how sensitive one variable is to another variable. This is
expressed as ratio of percentage change in each variable. (Change of Y/Change of X)
In the case of Own price elasticity of demand its change of Qd/ change of price
Inelastic is when the response is less than 1
Elastic is when the response is greater than 1
Unit elastic is when the response is equal to 1 or -1
Law of one price states that the own price elasticity will always be negative
Two extreme cases:
1. Perfectly inelastic- vertical demand has zero elasticity
2. Perfectly elastic- horizontal demand has infinite elasticity. A small change in price will
lead to the demand being zero. At some price point would buy a large unknown amount
In the case of normal goods, the income and substitution effects are reinforcing, leading to an
increase in the amount purchased after a drop in price
Factors affecting PED
Substitution: If there is a close substitute for a good then if its price rises a consumer will tend to
purchase less of this good and switch to a less costly substitute- e.g mars and snickers
Portion of budget- if spend a small amount more likely to be elastic than if spend a large amount
of income on it. E.g spend a low amount on toothpaste if it increase 10% in price probs buy the
same amount. However, if rent increased by 10% then would reduce the QD
Time allowed to respond to change in price- in LR more elastic than the SR as more time to
adjust to a situation. This might be the opposite for a durable good such as a washing machine.
In the SR if prices fall might buy to replace and thus are reactive elastic in SR
Extent to whether good a necessity/optional- Optional more elastic than necessity
Income elasticity of demand and Cross-Price Elasticity of demand
YED= Change of Qd/ Change of Y
Can be negative, positive or zero
Positive YED- as income rises Qd rises- known as a normal goods
Negative YED- as income rises Qd falls- known as inferior goods
XED= Change in QD of the good in question/ Price Change in price of another good
XED= Positive means substitutes. Negative=complements
Exception to the law of demand:
1. Giffen goods. The income effect is so strong that it overpowers the substitute effect.
More of good is consumed as the price rises and less consumed as it falls
2. Veblen goods- symbol of status. Increasing the price leads to higher QD
Marginal returns and productivity
Increasing marginal returns is where marginal product (the productivity of each additional unit
of resource- increases as additional units of that input are employed)
, Initially experience increasing return from adding labour to production due to specialisation and
Division of labour-certain point the law of diminishing marginal returns becomes evident
Fixed resources in SR of (plant size, physical capital and technology)
Marginal returns are directly related to input productivity- measure of output per unit of input
When companies have similar market shares, competitive forces tend to outweigh the benefits
of collusion.
Production and cost
Cost of producing anything depends on inputs or factors of production and the input prices
Two main input factors: labour and capital
Total cost= (W)(L)+(r)(K)= (Wage per hour *Labour units)+ (rental rate per machine
hour*machine hours)
Total cost depends on productivity and cost of the inputs
Productivity is based on total product, average product and marginal product of labour
Total product: Sum of Q from all inputs during a time period usually based on output or
labour Q. useful when looking at market share.
Average product: Total product divided by Q of given input: measured as total product
divided by number of worker hours used at that output level (Q/L).
Marginal product- Amount of additional output resulting from using one more unit of
input assuming the other is fixed: difference in total product divided by change in Q of
labour
Diminishing marginal returns is when the added unit of labour decreases the increase in
marginal product- however this isn’t negative this is less than the last point
Marginal revenue, Marginal cost and profit max
Perfect competition is where no single firm has pricing power over the other and they sell
identical products. Low or zero barriers to entry. Horizontal or inelastic. If it increases its price it
will lose all its customers. Doesn’t have to lower price so MR=P
SMC is additional cost of variable input, labour and must be incurred to increase the level of
output by one unit.
LMC is additional cost of all inputs necessary to increase level of output by one unit allowing the
firm the flexibility of changing both labor and capital inputs in a way that maximizes efficiency
Profit max should increase Q if MR>MC
Add labour until SMC becomes positively sloped. MR=MC and MC is not falling
Normal profit is also considered to be a fixed cost because it is a return required by investors on
their equity capital regardless of output level.
Normal profit is the level of accounting profit such that implicit opportunity costs are just
covered; it is equal to a level of accounting profit such that economic profit is zero
Perfect competition
The firm is maximizing profit by producing Q*,
where price is equal to SMC and SMC is rising.
If market price were to rise, the firm’s demand
and MR curve would simply shift upward, and
the firm would reach a new profit-maximizing
output level to the right of Q*.
This profit is possible in the short run, but in
the long run, competitors would enter the
, market to capture some of those profits and would drive the market price down to a level equal
to each firm’s ATC.
Breakeven= Under perfect competition, price equals marginal revenue. A firm break even when
marginal revenue equals average total cost
Monopoly
Goal- level of Q that equates SMC to MR—in this
case, Q*.
The optimal price to charge is given by the firm’s
demand curve at P*. This monopolist is earning
positive economic profit because its price exceeds
its ATC
Breakeven analysis
Breakeven where TR=TC or if a firms AR is equal to ATC
This is true under perfect and imperfect conditions
Sometimes the best a firm can do is cover its economic costs- sum
of accounting cost plus OC
Economists would say a firm is earning a normal profit but not a
positive economic profit
Earning a profit exactly equal to rate of return on OC- the excess
rate of return would attract entrants who will drive the price down
eroding the additional profit
Break even shown on the right
Shut down decision
In LR if a firm cannot earn at least a zero economic profit it will not
operate because its not covering the OC of all its factors of
production- labour and capital
In SR worth continuing if MR>MC
If Price is greater than AVC then firm covers VC and portion of fixed
costs
However, the firm might be earning an economic
loss- condition in which revenue falls short of TC
Economists refer to the minimum AVC point as the
shutdown point and the minimum ATC point as the
breakeven point
Must cover VC in the SR . If TR doesn’t cover TVC
shuts down production to minimise the loss to just
the fixed costs
In the LR must cover both TFC and TVC or must shut
down. Shut down for perfect shown on right
Economies and diseconomies of scale
When a firm increases all of its inputs in order to increase its level of output- LR concept. Its said
to scale up its production
ECOS occur if a firm increases output and cost per unit of production falls- LRAC slopes down
DECOS occur if cost rise as output increases-LRAC slopes up
ECOS can occur from:
, o Increasing returns of scale- when a production process allows increased output in
proportion to inputs
o Division of labour and specialisation
o More efficient tech/equipment
o Effectively reducing costs through waste reduction
o Buying in bulk
DECOS:
o Decreasing returns of scale
o Too large to manage
o Overlapping and duplication of business functions
o Supplier constraints due to ordering more inputs
Minimum point on the LRAC is known as the minimum efficient scale
This is the optimal point for a perfectly competitive firm
Firms and market structures
Types of structures
1. Perfect competition- Homogeneous product, no single producer is large enough to influence the
market price (price takers). Profits are driven by required return paid by the entrepreneurs-
normal profit.
2. Monopolistic competition- Mix of monopoly and perfect comp. Large no.firms, product
differentiation and can exercise some power over price
3. Oligopoly- Small number of firms. Retaliatory
strategies relied upon based on production and
price changes
4. Monopoly- No other goods substitute for the
given product or service. Single who controls
price and production.
Factors that determine market structure
1. Number of firms supplying the product
2. Degree of product differentiation
3. Power of the seller over pricing decisions
4. Relative strength of the barriers to market entry and exit
5. Degree of non-price competition
Extreme versions of PED
Horizontal demand schedule- Implies that at a given price the response is QD infinite. This is the
demand schedule faced by a PC as it’s a price taker.
Vertical demand schedule- Implies that some fixed QD is demanded regardless of the price.
Consumer surplus
Difference between the value a customer places on the units purchases and amount they
actually pay
Value gained by the buyer from the transaction
The highest price that consumers are willing to pay declines as they consume more units.
Must sacrifice in order to consume. Marginal value curve.
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