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Cfa1 3 Economics Notes

Finance Notes > CFA Level 1 Notes

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CFA Level 1

Economics

Elasticity
Price Elasticity of Demand (PED)
A measure of the responsiveness of quantity demanded to changes in price
% Change = (New Amount - Old Amount) / Old Amount
PED = % Change in QD / % Change in P
Inelastic and Elastic Demand

1. Perfectly Elastic Demand (PED = )
Horizontal D: QD becomes infinite in response to a tiny change in P

2. Elastic Demand ( > PED > 1)
Gentle D: Change in QD > Change in P

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

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

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

Total Revenue and Elasticity
Total Revenue (TR) = Total Q sold  P
Price Cut and Elasticity

1. Elastic Demand: P, QD, TR

2. Inelastic: P, QD, TR

3. Unit Elastic: P, QD, TR (No Change)
Price Increase and Elasticity

1. Elastic Demand: P, QD, TR

2. Inelastic: P, QD, TR

3. Unit Elastic: P, QD, TR (No Change)
Factors Affecting PED

1. Closeness of Substitutes
Closeness, Elasticity

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2. Proportion of Income Spent on the Good
Proportion, Elasticity

3. Time Elapsed since a Price Change
Time Elapsed, Elasticity

4. Type of Goods
Necessities, Inelastic
Luxuries, Elastic

Economics

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

1. Close Substitute (Large CED)
P of Y, then QD of X

2. Substitute (CED > 0)
P of Y, then QD of X

3. Unrelated Goods (CED = 0)
P of Y (Changed), then QD of X (Unchanged)

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

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
Normal and Inferior Goods

1. Income Elastic (Normal Goods) (IED > 1)
% Change in QD > % Change in Income

2. Income Inelastic (Normal Goods) (0 < IED < 1)
% Change in QD < % Change in Income

3. Negative Income Elastic (Inferior Good) (IED < 0)
2 CFA Level 1

Economics

Income, QD
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
Inelastic and Elastic Supply

1. Perfectly Elastic Supply (PES = )
Horizontal S: QS becomes infinite in response to a tiny increase in P

2. Elastic Supply ( > PES > 1)
Gentle S: Change in QS > Change in P

3. Unit Elastic Supply (PES = 1)
45o S: Change in QS = Change in P

4. Inelastic Supply (0 < PES < 1)
Steep S: Change in QS < Change in P

5. Perfectly Inelastic Supply (PES = 0)
Vertical S: QS remains constant no matter how P changes

Factors Affecting PES

1. Resource Substitution Possibilities
Substitution Possibility, PES  Close to 0

2. Rarity of Resources
Rarity, Substitution Possibility, PES  Close to 0

3. 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 3 CFA Level 1

Economics

Short-run Supply Curve
The response of QS to a change in P after incorporating some available technologies
Calculation Considerations

1. Use Average P and Q
Average = (New Value - Old Value) / 2

2. Absolute Value of PED
Measuring magnitude
Ignore minus sign

3. Units-free Measure
Due to the ratio of two percentages

4. 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)

5. Elasticity and Slope
Elasticity, Slope

Efficiency
Resource Allocation Methods

1. Market Price
People who can pay get the resources

2. Command System
By order of someone in authority

3. Majority Rule

4. Contest
Winner(s) get the resources

5. First-come First-served (Queue)

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Economics

6. Lottery (Luck)

7. Personal Characteristics (Discrimination)
People with the right characteristics get the resources

8. 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)
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Economics

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

1. Price Regulations
Price Ceiling, Price Floor, Min Wage

2. Quantity Regulations
Ration Limit (Demand), Quota Limit (Supply)

3. Taxes
QS, Underproduction

4. Subsidies
QS, Overproduction

5. Externalities
A cost / benefit that affects someone other than the seller / buyer

6. Public goods
Free-rider problem

7. Common resources
Tragedy of commons (exploitation of resources)

8. Monopoly
Produce too little and charge too high a price for profit max

9. 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 6 CFA Level 1

Economics

Utilitarianism
To achieve the greatest happiness for the greatest no. of people
Income must be transferred from the rich to 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)
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