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Cfa1 3 Economics Notes

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CFA Level 1

Unit 3: Economics

UOLLB CFA Top Notes
Level 1 Exam

Unit 3: Economics
Table of Contents
Elasticity............................................................1
Substitute and Complement..............................2
Normal and Inferior Goods...............................2
Inelastic and Elastic Supply..............................2
Efficiency..........................................................3
Markets in Action..............................................4
Production.........................................................6
Markets and Competitive Environment............7
Measures of Concentration................................7
Output and Costs...............................................7
Short-run Technology Constraint......................7
Shifts in Cost Curves.........................................8
Long-Run Average Cost (LRAC)......................8
Technological Advancement.............................9
Competition and Efficiency..............................9
Regulating Monopoly......................................10
Game Theory...................................................11
Labour Market Power......................................12
Natural Resource Markets...............................14
Jobs and Prices................................................14
Unemployment and Full Employment............14
Consumer Price Index (CPI)...........................15
Biased CPI.......................................................15
Aggregate Supply and Demand.......................15
Business Cycle................................................16
Money, Price Level and Inflation....................17
Price Level.......................................................19
Inflation Cycles...............................................20
Inflation and Business Cycle...........................20
Business Cycles...............................................20
Fiscal Policy....................................................21
Monetary Policy..............................................23
Decision Making Strategy for Fed..................23
Open Market Operations.................................23
Effects of Change in Federal Funds Rate........23
Alternative Monetary Policy...........................24
Elasticity
Price Elasticity of Demand (PED)
 A measure of the responsiveness of quantity demanded to change in price
 % Change = (New Amount - Old Amount) /
Old Amount
 PED = % Change in QD / % Change in P

Perfectly Elastic Demand (PED = )
 Horizontal D: QD becomes infinite in response to a tiny change in P
Elastic Demand ( > PED > 1)
 Gentle D: Change in QD > Change in P
1 CFA Level 1

Unit 3: Economics

Unit Elastic Demand (PED = 1)
 45o D: Change in QD = Change in P

Complements (CED < 0)
 P of Y, then QD of X

Inelastic Demand (0 < PED < 1)
 Steep D: Change in QD < Change in P

Income Elasticity of Demand (IED)
 A measure of the responsiveness of demand for a good / service to a change in income
 IED = % Change in QD / % Change in
Income

Perfectly Inelastic Demand (PED = 0)
 Vertical D: QD remains constant no matter how P changes

Normal and Inferior Goods
Total Revenue and Elasticity
 Total Revenue (TR) = Total Q sold  P
Price Cut and Elasticity
 Elastic Demand: P, QD, TR
 Inelastic: P, QD, TR
 Unit Elastic: P, QD, TR (No Change)

Income Elastic (Normal Goods) (IED > 1)
 % Change in QD > % Change in Income
Income Inelastic (Normal Goods) (0 < IED <
1)
 % Change in QD < % Change in Income

Price Increase and Elasticity
 Elastic Demand: P, QD, TR
 Inelastic: P, QD, TR
 Unit Elastic: P, QD, TR (No Change)

Negative Income Elastic (Inferior Good)
(IED < 0)
 Income, QD

Factors Affecting PED
 Closeness of Substitutes
 Closeness, Elasticity

Price Elasticity of Supply (PES)
 A measure of the responsiveness of Q
supplied to a change in P
 PES = % Change in QS / % Change in P

Proportion of Income Spent on the Good
 Proportion, Elasticity
Time Elapsed since a Price Change
 Time Elapsed, Elasticity
Type of Goods
 Necessities, Inelastic
 Luxuries, Elastic
Gross Elasticity of Demand (CED)
 A measure of responsiveness of demand for
Good X to change in the price of Good Y.
 CED = % Change in QD of X / % Change in
P of Y
Substitute and Complement
Close Substitute (Large CED)
 P of Y, then QD of X
Substitute (CED > 0)
 P of Y, then QD of X
Unrelated Goods (CED = 0)
 P of Y (Changed), then QD of X (Unchanged)

Inelastic and Elastic Supply
Perfectly Elastic Supply (PES = )
 Horizontal S: QS becomes infinite in response to a tiny increase in P
Elastic Supply ( > PES > 1)
 Gentle S: Change in QS > Change in P
Unit Elastic Supply (PES = 1)
 45o S: Change in QS = Change in P
Inelastic Supply (0 < PES < 1)
 Steep S: Change in QS < Change in P
Perfectly Inelastic Supply (PES = 0)
 Vertical S: QS remains constant no matter how P changes
Factors Affecting PES
 Resource Substitution Possibilities
 Substitution Possibility, PES  Close to 0
Rarity of Resources 2 CFA Level 1

Unit 3: Economics

 Rarity, Substitution Possibility, PES 
Close to 0
Time frame for the Supply Decision
 Momentary Supply
 Long-run Supply
 Short-run Supply
Momentary Supply Curve
 The response of QS immediately following a change in P.
Long-run Supply Curve
 The response of QS to a change in P after incorporating all available technologies
Short-run Supply Curve
 The response of QS to a change in P after incorporating some available technologies
Calculation Considerations
 Use Average P and Q
 Average = (New Value - Old Value) / 2
Absolute Value of PED
 Measuring magnitude
 Ignore minus sign
Units-free Measure
 Due to the ratio of two percentages
Percentages and Proportions
 Proportionate Change in Q = Change in Q /
Average Q
 Proportionate Change in P = Change in P /
Average P
 PED = % Change in QD / % Change in P
 PED = (Change in QD / Average Q) /
(Change in P / Average P)
Elasticity and Slope
 Elasticity, Slope
Efficiency
Resource Allocation Methods
 Market Price
 People who can pay get the resources
Command System
 By order of someone in authority

Majority Rule
 Contest
 Winner(s) get the resources
 First-come First-served (Queue)
 Lottery (Luck)
 Personal Characteristics (Discrimination)
 People with the right characteristics get the resources
 Force
 War or Legal power enforced by courts
Marginal Benefit (MB) (Demand)
 The value of one more unit of a good or service
 The max price consumers are willing to pay for another unit of the good
 Demand Curve = MB Curve
 Value = what a consumer receives
 Price = what a consumer pays
Marginal Cost (MC) (Supply)
 The cost of producing one more unit of a good / service
 The min. price producers must receive to induce them to sell another unit of good
 Supply Curve = MC Curve
 Cost = what a producer gives up
 Price = what a producer receives
Equilibrium
 Marginal Benefit = Marginal Cost
 Efficient price
 Efficiency Quantity
Consumer Surplus
 The amount consumers benefit from buying a good at a lower price
 = Value (MB) of a good - price paid for the good
Producer Surplus
 The amount producers benefit by selling a good at a higher price
 = Price received for a good - min supply price (MC)
Marginal Social Benefit (MSB)
 Incremental marginal benefit as viewed by the society
 Sum of all marginal external benefit and marginal private benefit
Marginal Social Cost (MSC)
3 CFA Level 1

 Incremental marginal cost as viewed by the society
 Sum of all marginal external cost and marginal private cost
Inefficiency (MSB ≠ MSC)
 Underproduction: Produce less than can be consumed by society
 Overproduction: Produce more than can be consumed by society
 Both result in deadweight loss
Obstacles to Efficiency
 Price Regulations
 Price Ceiling, Price Floor, Min Wage
Quantity Regulations
 Ration Limit (Demand), Quota Limit
(Supply)
Taxes
 QS, Underproduction
Subsidies
 QS, Overproduction
Externalities
 A cost / benefit that affects someone other than the seller / buyer
Public Goods
 Free-rider problem
Common Resources
 Tragedy of commons (exploitation of resources)
Monopoly
 Produce too little and charge too high a price for profit max
High Transactions Costs
 Underproduction
Fairness in Resource Allocation
 It is not fair if the result is considered unfair
 It is not fair if the rules are considered unfair
 Fairness is the one that benefits the less well off
Utilitarianism
 To achieve the greatest happiness for the greatest no. of people
 Income must be transferred from the rich to

Unit 3: Economics

the poor until all are equally rich
Tradeoff between Efficiency and Fairness
 Taxing the rich
 Subsidizing the poor
 The rich work less to reduce the amount being taxed
 Q produced is less than efficient
Symmetry Principle (Moral Principle)
 A requirement that people in similar situations be treated similarly
 Behave toward other people in the way you expect them to behave toward you
Fairness of Rules
 The state must enforce laws that establish and protect private property
 Private property may be transferred only by voluntary exchange
 Anything that blocks voluntary exchange is unfair
Markets in Action
Housing Markets and Rent Ceilings
 Short-run Supply of Housing (SSH)
 Long-run Supply of Housing (LSH)
 Short-run Demand of Housing (SDH)
 Long-run Demand of Housing (LDH)
Perfectly Elastic Short-run Supply of
Housing
 Rent > MC, Developers will keep on building
 Rent = MC, Developers will build according to the market demand
 Rent < MC, Developers will stop building
Short-run Effects of Natural Disasters
 Case 1: Damages to Buildings: SSH,
Rent
 Case 2: Death of People: SDH, Rent
Long-run Adjustment
 Case 1: Constructions of Buildings: SH,
then LSH (Original), Rent (Original)
 Case 2: Birth of People: DH, then LDH
(Original), Rent (Original)
Rent Ceiling (c.f. Price Ceiling)
 Illegal to charge a price higher than a specific level 4 CFA Level 1

Rent Ceiling > Equilibrium Rent
 No effect
Rent Ceiling < Equilibrium Rent
 DH (Unchanged), but SH
 Deadweight Loss (Inefficiency), Consumer
Surplus, Producer Surplus
 Shortage of Housing
Effects of Rent Ceiling
 Search Activity (Potential CS Loss): Time /
Resources spent looking for housing
 Black Market (Potential CS Loss): Rent exceeds the legally imposed rent ceiling
Labour Market and the Min Wage
 Short-run Supply of Labour (SSL)
 Long-run Supply of Labour (LSL)
 Short-run Demand of Labour (SDL)
 Long-run Demand of Labour (LDL)
Perfectly Elastic Short-run Supply of Labour
 Wage > MR, Companies will not hire
 Wage = MR, Companies will hire according to the market demand
 Wage < MR, Companies will keep on hiding
Short-run Effects of Labour Saving
Technologies
 SDL, but SSL (Unchanged), then Wage
Long-run Adjustment
 People Leaving the Labour Market, then
LSL, Wage (Original)
Min Wage (c.f. Price Floor)
 Illegal to hire labour with a wage lower than a specified level
Min Wage > Equilibrium Wage
 DL (Unchanged), but SL
 Deadweight Loss (Inefficiency), Firms'
Surplus, Workers' Surplus
 Oversupply of Labour, Unemployment
Min Wage < Equilibrium Wage
 No Effect
Effects of Min Wage
 Search Activity (Potential FS Loss): Time /
Resources spent looking for job

Unit 3: Economics

 Black Market (Potential FS Loss): Wage below the legally imposed min wage
Living Wage
 An hourly wage that enables a person to rent adequately.
 Using less than 30% of the wage earned from 40-hour work per week.
Tax Incidence
 Division of tax burden between a buyer and a seller
 Depend on the elasticity of demand and supply
A Tax on Sellers
 S (S - T), D (Unchanged), Q
 P Received by Sellers = Original P - T 
Slope of S
 P Paid by Buyers = Original P - T  Slope of
D
 Deadweight Loss, Consumer Surplus,
Producer Surplus
 Gov Revenue = (Original CS - New CS) +
(Original PS - New PS)
Tax on Buyers
 S (Unchanged), D (D - T), Q
 P Received by Sellers = Original P - T 
Slope of S
 P Paid by Buyers = Original P - T  Slope of
D
 Deadweight Loss, Consumer Surplus,
Producer Surplus
 Gov Revenue = (Original CS - New CS) +
(Original PS - New PS)
Equivalence Tax on both Buyers and Sellers
 S (S - T/2), D (D - T/2), Q
 P Received by Sellers = Original P - T/2 x
Slope of S
 P Paid by Buyers = Original P - T/2 x Slope of D
 Deadweight Loss, Consumer Surplus,
Producer Surplus
 Gov Revenue = (Original CS - New CS) +
(Original PS - New PS)
Tax Division and Elasticity of Demand
 Perfectly Inelastic Demand  Buyers pay all the tax
 Perfectly Elastic Demand  Sellers pay all the tax 5 CFA Level 1

Unit 3: Economics

Tax Division and Elasticity of Supply
 Perfectly Inelastic Supply  Sellers pay all the tax
 Perfectly Elastic Supply  Buyers pay all the tax
Subsidy (per Unit)
 A payment made by Gov to a producer
 S, P
 Total Production Cost due to Q
 Per Unit Production Cost (Unchanged)
 Overproduction, Deadweight Loss
Production Quotas
 An upper limit to the quantity of a good that may be produced in a specified period
 Total Production Cost due to Q
 Per Unit Production Cost (Unchanged)
 Underproduction, P, Deadweight Loss
Markets for Illegal Goods (e.g. marijuana,
cocaine, heroin)
 Cost of Breaking Law (CBL) = Penalty +
Effectiveness of Policing
Penalties on Sellers Only
 S (S - CBL), D (Unchanged), P, Q
Penalties on Buyers Only
 S (Unchanged), D (D - CBL), P, Q
Penalties on Both Sellers and Buyers
 D = D - CBL
 S = S - CBL
 Q
 P paid by Buyers = P + CBL
 P received by Sellers = P - CBL
Production
Opportunity Cost (OC)
 The benefit foregone by selecting one alternative over another
 OC = Explicit Cost + Implicit Cost
Explicit Cost
 Costs paid to obtain one alternative over another
Implicit Cost
 Costs incurred but no actual payment is made

Implicit Rental Cost
 OC incurred as a result of own assets for operations instead of other alternative uses
Implicit Rental Rate of Capital
 Economic Depreciation
 Interest Forgone
Normal Profit
 Profit expected to earn in each type of market (e.g. zero profit in perfect competition)
Economic Profit
 = Total Revenue - Total Cost
Accounting Profit (Before Tax)
 = Accounting Revenue - Accounting Cost
Profit Max Concerns
 What to offer and in what quantity
 How to produce and what production techniques are available
 How to organize and compensate its managers and workers
 How to market and price its products
 What to produce and what to buy from others
Firms Constraints
 Technology Constraints
 Information Constraints
 Market Constraints
Technological Efficiency
 When the firm produces a given output by using the least amount of inputs
Economic Efficiency
 When the firm produces a given output at the lowest cost
Command System
 A method of organizing production that uses a managerial hierarchy
 Commands pass downward and Info passes upward through the hierarchy
Incentive System
 A method of organizing production that uses a market-like mechanism inside the firm
 Creates compensation schemes to induce workers to max firm profit ()
6 CFA Level 1

Principal-Agent Problem
 Problem of inducing an agent (A) to act in the best interest of a principal (P)
 The goal of P = Max 
  depends on the actions of A
 P cannot monitor A
 A pursues their own goals often imposes costs on P
Coping with Principal-Agent Problem
 Ownership: Assign ownership (or partownership) to A
 Incentive Pay: Pay schemes related to performance
 Long-term Contracts: Encourage A to take a long-term view and devise long-term strategies
Types of Business Organization
 Proprietorship: A firm with a single owner who has unlimited liability
 Partnership: A firm with 2 or more owners who have unlimited liability
 Corporation: Firm owned by one or more limited liability stockholders
Markets and Competitive Environment

Unit 3: Economics




No Close Substitute
High Barrier to Entry / Exit
Concentration Ratio = 100
HHI = 10000
Measures of Concentration (Degree of
Competition)

Four-Firm Concentration Ratio
 Percentage of the total industry sales made by the 4 largest firms in an industry
 Percentage of the Value of Sales for the 4
Largest Firms (L)
 Percentage of the Value of Sales for the
Whole Industry (W)
 = L / W  100
Herfindahl-Hirschman Index (HHI)
 Sum of the squared percentage market share of the 50 largest firms in an industry
 Market Share of Largest Firm (L1)
 Market Share of Second Largest Firm (L2)
 = L12 + L22 + L32 + … + L502
Limitations of Concentration Measures
Geographical Scope of the Market
 Concentration measures take a national view of the market
 Not all goods are sold in a national market

Perfect Competition
 Many Firms and Many Buyers
 Identical Product
 No Barriers to Entry / Exit
 Concentration Ratio = 0
 HHI less than 100

Barriers to Entry and Firm Turnover
 Concentration measures do not measure barriers to entry
 Some industries have easy entry and a high turnover of firms

Monopolistic Competition
 Many Firms and Many Buyers
 Product Differentiation
 No Barriers to Entry / Exit
 Low Concentration Ratio
 HHI from 101 to 999

Non-correspondence between Market and
Industry
 Markets are often narrower than industries
 Most firms make several products
 Firms switch from one market to another for profit

Oligopoly
 Few Firms and Many Buyers
 Production Differentiation
 Strong Barrier to Entry / Exit
 High Concentration Ratio
 HHI more than 1000

 Firm Coordination
 When firms can coordinate economic activity more efficiently than markets can

Monopoly
 One Firm and Many Buyers

Advantages of Firm Coordination
 Transaction Costs
 Economies of Scale (Q, AC)
 Economies of Scope (AC as the range of goods increases)
7

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