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1. INTRODUCTION
Economics
The study of
production, distribution,
and consumption
Microeconomics
The study of markets and
decision making of
individual economic units
Copyright 2014 CFA Institute
Macroeconomics
The study of aggregate
economic quantities
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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 firms cash flow and assets (that is, debt
and equity securities).
Demand
Supply
Willingness of sellers
to offer a good or
service for a given
price
Price
Quantity
Quantity
Quantity
Copyright 2014 CFA Institute
EQUILIBRIA
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.
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This means that if the quantity supplied is 10, the price required is 1.5.
Copyright 2014 CFA Institute
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The equilibrium price is 1. But what if the price were 1.5, instead?
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TYPES OF AUCTIONS
Common value auction: The items 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.
- In a multiple-unit format, price is lowered until all units are sold.
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Competitive
Bids
(in billions)
Cumulative
Competitive
Bids
(in billions)
Noncompetitive
Bids
(in billions)
Total
Cumulative
Bids
(in billions)
Discount
Rate Bid
Bid Price
per $100
0.0280%
99.99782
$5
$5
$5
$10
0.0285%
99.99778
$10
$15
$5
$30
0.0287%
99.99777
$15
$30
$5
$65
0.0290%
99.99774
$20
$50
$5
$120
0.0291%
99.99774
$15
$65
$5
$190
0.0292%
99.99773
$10
$75
$5
$270
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SURPLUS
Consumer surplus is the difference
between the maximum price the
consumer was willing to pay and the
actual price.
Price
Consumer surplus
Producer surplus
Quantity
Total surplus = Consumer surplus + Producer surplus
Copyright 2014 CFA Institute
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CALCULATING SURPLUS
Suppose we have the following demand and supply curves:
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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
resources efficiently.
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Price Ceiling
Demand
Equilibrium price
Demand
Equilibrium price
2.5
2.5
2.0
2.0
1.5
1.5
1.0
0.5
Price
1.0
0.5
Quantity
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14
11
23
20
17
14
11
0.0
8
0.0
5
Supply
Price floor
Price Floor
Price
Supply
Price ceiling
Quantity
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4. DEMAND ELASTICITIES
Own-price elasticity is the sensitivity of the quantity demanded of a good to
changes in the price of the good.
Q
Example for good x:,
where
is the quantity of good x demanded;
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ELASTICITIES
Elasticity is the sensitivity of the change in quantity for a given change in the
price of a good.
- The ratio of the percentage change in the quantity to the percentage change
in the price.
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.
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ELASTICITIES: SUMMARY
If the elasticity Then demand is
coefficient is
Interpretation
>1
elastic
= 1
unit elastic
<1
inelastic
=0
perfectly inelastic
perfectly elastic
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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.
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INCOME ELASTICITIES
Income elasticity of demand is the change in the quantity demanded of a
good in response to the change in income:
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