CFA basics the schweser study guide to getting started

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A Schweser

CFA

@

Basics

Pre-Level

1

The Schweser Study Guide
to Getting Started
By

Dr.

Bruce Kuhlman

Associate Professor of Finance
University of Toledo

Edited by

Dr.

Greg

CFA

Filbeck,

Senior Vice President

Schweser Study Program

and
Dr.

Andrew Temte CFA
#

President and Chief Executive Officer

Schweser Study Program

Simon
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10020

2001 by Schweser Study Program, a Kaplan Professional Company.

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NJ 08075.

Contents
Foreword

CFA®

v

Basics

Chapter

1:

Economics

Chapter

2:

Financial Statement Analysis

45

Chapter

3:

Quantitative Methods

89

3

Chapter 4: Corporate Finance

133

Chapter

5:

Capital Markets

185

Chapter

6:

Security Valuation

225

Chapter

7:

Portfolio

Theory

275

Appendixes
Appendix A:

Ethics

311

Appendix

Acronyms and Abbreviations

321

B:

Appendix C: Glossary

323

Appendix D: Index

343


Digitized by the Internet Archive
in

2013

/>

Foreword
CFA®. Each year, students and investment professionals from around the world invest considerable time
and energy in their quest to include those three letters behind their names. Those who are able to achieve
this goal show that they have acquired a well-rounded understanding of the tools of investment finance
and have made a pledge to the investing public to uphold the highest ethical conduct. If you are reading
book, chances are that you, too, are considering joining the thousands of students and

this

professionals

Who

who

are currently

working toward

their Charter.

Should Use this Book?

This book

is

for those

who

are interested in

not be prepared to enter the

CFA Program™
also enter the

is

becoming

CFA Program™

a bachelor's degree

from

a Chartered Financial

right away.

One

Analyst™ but

who might

of the requirements for entry into the

a four-year college or university (graduating seniors

program, but their graduation date must be no

later

than the

summer term

may

following

CFA® Level 1 examination). But what if you received your degree in chemistry
Or what if you have been out of school for 10 years and cannot recall much from

their first crack at the

or political science?

your undergraduate days? The purpose of this

economic, and financial background that

What

Is

is

text

is

to help

you gain

(or regain) the basic accounting,

necessary to begin your studies in the

the Structure of the CFA

CFA Program™.

Program™?

The CFA Program™ is a series of three examinations that are given once per year on the first Saturday
after Memorial Day (typically the first Saturday in June) by the Association for Investment
Management and Research® (AIMR®). Each exam is a six-hour experience (three hours in the morning
and three hours in the afternoon). In your first year of the program, you prepare for the CFA® Level 1
examination. If you pass the Level 1 exam, you are allowed to take the Level 2 exam the following year.
Pass the Level 2 exam, and you can take the Level 3 exam. However, if you fail an examination along
the way, you must wait until the next year to retake it. It takes a minimum of three years and a

maximum

of seven years to pass

by re-registering
•

all

three levels (although the seven-year deadline

may be extended

for the program).

Level 1-Investment Tools (100 percent multiple-choice):
tools of investment finance.

The

five

main

The

Level

1

curriculum focuses on the

topic areas that are covered are: ethical

and profes-

sional standards; quantitative methods; economics; financial accounting/corporate finance;
asset valuation (includes equity, debt, derivatives,

exam

management. The
relatively short and focuses on
Level

exam

is

an exercise

in

1

is all

and

alternative investments);

about breadth, not depth. As a

a particular concept

— almost

result,

to the point of

minutiae. There are 240 multiple-choice questions

and portfolio

each question

seeming

on the

-

like

Level

1

is

the

exam.

MA Schweser

Study Program-


Foreword
and Valuation (combination essay and multiple-choice): The purpose of the
and expand upon the tools that were introduced at Level 1 For
example, at Level 1, you learn about the basics of derivative securities in the asset valuation
section. The Level 2 derivatives curriculum is much more in depth, introducing additional
tools and instruments and applying those tools to investment analysis. The primary areas of
Level 2-Analysis

•

Level 2

exam

is

to apply

.

coverage are: ethics; quantitative methods; economics; financial accounting; asset valuation;

and portfolio management. Also, the questions focus on a deeper treatment of the material
and are much more difficult in comparison to the Level 1 exam.

and Portfolio Management (combination essay and multiple-choice): The
main focus of the Level 3 exam is portfolio management. Here, you will use the tools and
analysis from the previous two levels to develop investment policies and appropriate portfolios for both individual and institutional investors (pension funds, endowments, and life
insurance companies). Also, you will learn to protect existing investment positions from the
effects of market volatility through the use of debt and derivative instruments (hedging).

Level 3-Synthesis

•

on an annual basis, we urge you to visit
download informational pamphlets and learn more about the specifics of the CFA

Since the structure of the

www.aimr.org

to

exam

subject to change

is

Program™.
In addition to passing the three exams,

you must

also have accrued three years of relevant

rience prior to the award of your Charter (though
rience while

How Do

you

I

are taking the

CFA®

Register for the

Registration for the

CFA Program™

from AIMR®. After

registering,

you do not have

to have

exams).

CFA Program™?
which can be obtained
take the Level 1 exam. The eas-

involves completing an application form,

you will have three years in which to
iest way to contact AIMR® is by visiting their Website at www.aimr.org.
Charlottesville, Virginia, and Hong Kong, SAR.

What Can
If

you

work expe-

any relevant work expe-

the CFA® Designation

Do

for

AIMR®

has offices in

Me?

are serious about a career as an investment analyst, portfolio manager, high- net

worth money

manager, credit analyst, or any of several other careers that deal primarily with the "investment deci-

sion-making process," the

CFA® designation

is

for you.

There are

many firms that

require their

employ-

ees to attain the designation. Just look in the Wall Street Journal at the job listings that are posted.

Most

of the positions that you will see will ask for or require that the applicant hold the Charter. In addition,

AIMR®

periodically publishes a survey of

its

members

regarding their income.

The

global

median

more about the median in the Quantitative Methods chapter of this book) of an
AIMR® member with more than 10 years of experience is well over $200,000. The bottom line is that
income

(you'll learn

your investment

VI

in the

JSchweser
„

Study Program-

CFA Program™

will

pay off

in the

long run.


Foreword

How

Can Schweser Study Program™ Help

Schweser

is

the premier provider of study tools for the

Study Notes, but we also provide

live

Me

CFA®

Achieve

examination.

my

Our

preferred learning method, Schweser can help you pass the
for

How

Use

this

our

CFA®

No

exams. Please

matter what your

visit

our Website

at

Book?

This study guide will help you understand the basics of the
the

is

more information.

www.schweser.com

I

core product

seminars around the world, produce instructional videos,

audiotapes, and flashcards, and host a world-class online educational program.

Should

Goals?

CFA Program™. The

chapters are broken

down by

critical

topic:

content areas that are covered in

economics; financial statement analysis;

quantitative methods; corporate finance; capital markets; security valuation;

and portfolio

theory.

Depending on your educational background and work experience, you can start to build an understanding of the fundamentals by working through the book chapter by chapter, or you can target your
particular areas of weakness by going straight to the relevant chapters or sections. You can further target
your studying by using the glossary in the back of the book to learn or review important concepts.
The learning objectives outlined in each chapter and the practice questions and answers at the end

of every chapter will help to reinforce the concepts you are studying.

Make no

mistake, the road to success in the

marathon: training and pace are

From

preparation.
process.

We

critical.

CFA Program™

is

not

easy.

Each exam

is

like

running

a

Dedication and hard work are the hallmarks of CFA® exam

breakdown given above, you can see that the CFA Program™ is a growth
when you are finished with all three exams, you will not only breathe
of relief, but you will also have grown significantly-both professionally and aca-

the

are confident that

a well-deserved sigh

demically.

Best regards,

Dr. Carl Schweser,

CFA

Dr.

Andrew Temte, CFA

Chairman

President and Chief Executive Officer

Schweser Study Program

Schweser Study Program

Schwesei
Stud) Program"

VII



CFA® Basics:
Content Review



CHAPTER ONE

Economics

Merriam

economics as "the
social science concerned chiefly with the description and analysis of
production, distribution, and consumption of goods and services."
Economical, on the other hand, is defined as "operating with little
Webster's Collegiate Dictionary defines

waste or at a savings; a thrifty use of material resources."

1

and Public Choice, Gwartney, Stroup, and Sobel
2
is about how people choose." From the most
important to the most mundane, any decision is economic in nature.
Every choice is made in terms of the decision maker's utility, which
In Economics: Private

contend that "economics

we make, we

try to

which maximizes our

utility

can be thought of as satisfaction. In every choice
find that combination of cost

and

benefit,

Every choice

maximize
is

is

made

utility,

satisfaction derived

from the choice.

(satisfaction).

The economic implications of business

decisions are usually fairly

obvious. Their results often include increased revenues or reduced
costs.

But what about the small, seemingly insignificant decisions we

make every day? Consider the simple choice of crossing the

street in the

middle of the block or walking to the corner to use the crosswalk.

did

'

2

we make

Merriam

the decision?

It

How

to

which

"Economics

how

is

about

people choose."

probably had to do with the reason we

Webster's Collegiate Dictionary, 10E, 1998.

Gwartney, Stroup, and Sobel, Economics: Private and Public Choice, 9E (The Dryden Press,

2000).

A

Set weser
-'-

dy Program-


Chapter One
wanted

to cross the street, the distance to the nearest crosswalk,

quickly

we needed

Is

this decision

ity?

Most

to get to the other side,

economic

certainly! If

we

in nature?

how

and the amount of traffic.

Did we

maximize our utilwe might
our goal (making it to the
try to

cross in the middle of the block,

save valuable time (a benefit)

and

get to

more quickly. That's very satisfying! On the other hand, if
traffic is heavy, we might have to wait a long time to cross, we might
get stuck in the middle of the street, or we might even be hit by a car
and never make it to the other side. That's not very satisfying! Is the
other side)

potential cost of crossing in the middle of the block worth the potential

benefit?

There

is

much

corner, wait for the signal,

less risk if

we

take the time to walk to the

and use the crosswalk, but

it

takes longer to

get to the other side.

Every time
choice,

we

we make

a

balance the

potential costs with
potential benefits.

In

fact,

any decision we make can be

summed up

in very

much

the

same terms. The decision maker weighs the potential gains (benefits)
against the potential losses (costs) and makes the decision that maximizes utility. Once you have accepted the fact that each decision you
make is economic in nature, it is a fairly simple step to make the jump
to understanding the

importance of economics in business decision-

making. Referring to Webster's definition of economics, we see the

and
However,

clear orientation to the business world. All production, delivery,

consumption decisions are based upon
costs must always be considered.
Section

1

a perceived benefit.

of this chapter discusses the evolution of economic thought

from the era of Sir Francis Bacon to John Maynard Keynes, one of the
most widely studied and respected economists of modern times.
Section 2 provides examples and discusses some of the most widely
used economics terms.
In this chapter, your learning objectives are the following:

1.

To understand the origin and development of economics

as a

discipline.

|

I

v;

- >

,

Study Program"

2.

To understand the three most important forms of government:
capitalism, socialism, and communism.

3.

To master an

essential

economics vocabulary.


Economics

SECTION

1:

A HISTORICAL OVERVIEW OF

ECONOMICS
Although he most certainly did not think of it in those terms, earliest
man made economic decisions; the cost of a decision made little dif-

when

To walk many
miles to gather food versus taking it from some great beast was not
really a decision. If food was not otherwise readily available, he was
willing to walk whatever distance necessary. Risking his life to try to
take food from a lion or other man-eating beast would have been
insane if an alternative had been available. Thus, his decision was easy.
The pervasiveness of economics in our lives from the very earliest periference

the benefit

was

eating, or even survival.

od cannot be debated.
To

any

truly understand

exact time

decision

subject,

when scholars started to

making (and

body's guess, but

you must

study

take notice of the

started to call

many

first

it

its

origins.

economic nature of

economics, for that matter)

man

will

is

go to achieve

wealth. Let's investigate the writings of four well-known economists

have

made

significant contributions to the

Sir Francis
Sir Francis
entist,

cally

any-

on the

early philosopher/economists wrote

nature of business and the lengths to which

The

who

development of economics.

Bacon

Bacon (1561-1626) was an English

and philosopher. The writings of

politician, barrister, sci-

early philosophers

were typi-

based in religious doctrine, and Bacon was no exception. In 1597,

Bacon wrote The

Essays. In this collection of his opinions,

laced throughout with his religious

and philosophical

which

Most
were

early economists
in fact

philosophers.

is

Bacon
and the

beliefs,

good grasp of the mind of modern man

concept of economics. For instance, in the essay titled "Of Truth,"
Bacon states, " to think what should be in it, that men should love lies;
seems to have a

fairly

whether neither they make for pleasure, as with poets, nor for advantage, as

with the merchant; but for the

lie's

addressing the overall concept of truth versus

man would "embrace"
people

The

lie is

to gain

Bible passage,

world, and lose his
in

which wealth

lies.

to believe the reason business

an advantage. (Surely not

"What

own
is

He seems

is

a

man

Of course, Bacon is
lies, and questions why

sake."

profited,

if

a

unique opinion!)

he

shall gain the

whole

(Matthew 16:26) speaks about the fashion
accumulated. Although not always on religious
soul?"

A Schweser

^

^1 Study Program-

c

3


Chapter One
Sir Francis

Bacon was an

grounds, most philosophers embrace honesty and integrity, and these

early philosopher/

ideals flow

economist. His writings

as the

were based in religious
doctrine. He spoke
against waste and greed
(wealth for wealth's

nor

through their writings. In "Of Riches," Bacon writes, "For

baggage

left

is

to

an army, so

behind, but

it

is

riches to virtue.

It

cannot be spared

hindereth the march; yea and the care of

sometimes loseth or disturbeth the

victory." Is

it

he implying that virtue

hinders or even stops the "march" toward wealth?

Or

is

he implying

although virtue makes the march longer and harder, it should
accompany the march? His opinion of the accumulation and use of
wealth is quite clear. "Seek not proud riches, but such as thou mayest get

justly, use soberly, distribute cheerfully, and leave contentedly." He continues: "Therefore measure not thine advancements by quantity
and defer not charities till death ..."
that,

sake).

.

.

.

"Of Expense," Bacon writes, "Riches are for spending, and spending
for honor and good actions .... A man had need, if he be plentiful in
some kind of expense, to be as saving again in some other." In this passage, Bacon recognizes the concept of a limit to spending, or a budget,
as we would call it today. This belief was most certainly embraced by
In

our next philosopher/economist.

Adam
Adam

Smith was a

classical

economist.

They believe

Adam

Smith

Smith (1723-1790), a Scottish economist and philosopher,

is

regarded as the founder of economics as a separate discipline and

is

in strict

probably the most famous of

laissez-faire;

government should not
interfere with the

natural working of the

economy.

all

early economists.

He was

Professor of

Moral Philosophy at Edinburgh from 1748 to 1751 and published his
Theory of Moral Sentiments in 1759. In Theory, Smith, as most philosophers before and after him, dealt with the role of standards of ethical
conduct as the glue that holds society together. In 1776, he published
what would be his greatest work and one of the most influential works
of all time, An Inquiry into the Nature and Causes of the Wealth of
Nations. Wealth of Nations introduces us to the "invisible hand" and
the idea of a "free enterprise" system. In a free enterprise system, private business

is

free to operate

without governmental interference

(beyond regulation necessary to protect the public

interest).

Smith puts into words what many others of the time suspected but were
unable to articulate. Smith contends that in a free market, participants'
actions are controlled by competition. Competition

stood and accepted today, but

M

- v:
Study Program-

/I 'v.
I

!

'

it

is

widely under-

was quite an enlightening concept

at


Economics
that time.

Smith makes the point that participants in the market make
an "invisible hand" were guiding them. This

selfish decisions as if

invisible

hand, or market pressure,

ing activities

The end

will ultimately direct the self-seek-

of the individual to the betterment of society as a whole.

result

is

that only those

goods and services that society needs

Adam
hand

Smith's invisible

market pressure,

is

the unseen force that
affects individuals'

choices.

are provided.

With the

common goal of maximizing personal wealth, market

ipants (sellers
price.

attract

and buyers)

As long

as there

is

will strive to

no

new customers by

prices (collusion,

which

buy or

sell at

partic-

the best possible

price collusion, each seller will try to

offering a lower price than other sellers'

is

illegal,

occurs

when competitors

agree to maintain high prices or agree not to compete

on

secretly

price, so as to

keep prices high). Since manufacturers want to pay the lowest possible
price, they will naturally

When

buy from the supplier

offering the best prices.

the high-priced suppliers realize that they are losing business,

they will lower their prices in order to remain competitive.

However, there
sell.

is

a

minimum

price at

which

a supplier

is

willing to

This price depends upon the price that the supplier, as a customer,

same competitive
in this way until
prices reach a minimum, or equilibrium level. When they can no
longer compete using price, suppliers begin competing on the basis of
service and product quality. The process continues in both directions,
backward up the chain of suppliers, and forward through the chain of
must pay

for the product. His suppliers are in the

struggle with rival suppliers.

The process continues

customers. Theoretically, consumers are guaranteed the highest possible quality product at the best possible price.

The same argument can be applied to ensure society produces only
those products it needs and wants. Products that are in high demand
get the most attention from manufacturers, and the supply of these
products

will increase.

attention,

and

Products with relatively low

their supply

is

illustrate this concept,

quantities of

level

forces are perfectly

balanced.

receive less

reduced. In this way, the supply of

products will reach an equilibrium

To

demand

Equilibrium: opposing

all

with their respective demands.

assume your company manufactures equal

two products, forks and spoons.

Now

assume soup sud-

denly becomes very popular, and your customers rush to buy more
spoons. Although your customers

still

occasionally eat with forks, they

Sc iweser
Study Program-


Chapter One

When consumer
change, the

new

tastes

demand

for

products increases.

Producers and suppliers
will shift resources

to

supply those products.

don't have to

forks. Since

your customers are buying only

spoons, and your production mix of spoons and forks has not changed,

your inventory (supply) of forks increases. Thus, you reduce fork production and
spoons. You

much of your fork-making resources into producing
now produce more spoons, which are in higher demand,
shift

and fewer forks, which

demand. Society is happy, due to the
ready supply of reasonably priced spoons, and you spend less of your
scarce resources (labor, raw materials, and cash) on a product that no
one wants to buy. Of course, your competitors will shift production to
spoons, and all suppliers will compete on price, quality, and service.
This ensures consumers the best quality spoons at the best possible
price. If and when the demand for forks increases, you and your competitors will

Capitalism

buy new

are in lower

once again realign your production resources.

Smith's "invisible hand" (market pressure) makes sense to us today, as

is

probably did to readers in his day. As a result of the widespread

synonymous with free

it

enterprise.

respect

Smith
call

and acceptance

is

for his contribution to

economic thought,

considered the "father" of the free enterprise system, what

we

capitalism today. There are, however, economists with other ideas

of the ideal system.

Our

next economist

is

well

known, not only

for his

considerable intellect and understanding of capitalism, but also for his
willingness to display both.

Karl
Karl

Marx believed

Marx

in a

natural social decay to

Karl

Marx (1818-1883) was born

in Trier,

communism. Capitalism

of his time analyzing capitalism, and

is

Germany. Marx spent much
widely

known

as the chief

leads to class struggle,

antagonist of the capitalist economic system. His devotion to dialectic

which leads to
revolution and socialism.
Unequal distribution

materialism 3 led him to study the workings of the

within socialism leads to

society called

revolution and

League's Second Congress (London, November, 1847) that they drew

communism.

nomic system

as

it

relates to

the working man

Marx and his closest friend, Frederick Engels, joined a
the Communist League. It was at the request of the

spring of 1847,

up The Communist Manifesto, 4 which appeared
Manifesto outlines a

*

Dialectics

is

the

method of reasoning, which
is

tries to

Communist Manifesto

Capital, 1867, his study

,4 Schweser
JM Study Program-

and

February 1848. The
materialism.

understand things by form and substance,

the philosophy that asserts that the material world

foundation of thought. In this context, materialism does not
4 Although The

in

new world order based upon

rather than appearance. Materialism

8

capitalistic eco-

(the proletariat). In the

is

mean what

it

means

is

the

today.

probably the best-known work of Karl Marx, Das
is his most influential work.

analysis of capitalism,


—
Economics
Marx was

concerned with what he saw as the glaring flaw in
capitalism: the conflict inherent to a system that encourages social
chiefly

Rather than the

classes.

elite

being more important and controlling

Marx believed the working people themselves should hold this
position. He saw ownership and control of industry by individuals as

society,

causing an irreversible class struggle, which ultimately leads to revolution.

His thoughts are best summarized in his

And now

existence of classes in

modern

due

is

to

me

words:

for discovering the

society or the struggle between

development of this

omists, the

new was

credit

me bourgeois 5

them. Long before
historical

no

as to myself,

own

Under communism,
is no formal
government.

there

had described the
and bourgeois econWhat I did that was

historians

class struggle

economic anatomy of classes.

to prove:

(1) that the existence

of classes

bound up with

only

is

the partic-

phases in the development of production,

ular, historical

(2) that the class struggle necessarily leads to the dictatorship

of

the proletariat, and
(3) that this dictatorship itself

the abolition of

all

classes

As you can imagine, Marx was not
wherever he went. In

fact,

only constitutes the transition 6 to

and

typically

he spent a

country or another, where leaders

to a classless society. 7

felt

lot

his ideas

with both spoken and written words that

and

ire

welcomed with open arms
of time in exile from one
were dangerous.

Marx drew

It

was

the attention

—of governments:

From

the

moment

members of society,

all

or at least the vast

majority, have learned to administer the state themselves, have

taken this work into their

own

hands, have organized control

over the insignificant capitalist minority, over the gentry

who

and over the workers
who have been thoroughly corrupted by capitalism from
this moment the need for government of any kind begins to
disappear altogether. The more complete the democracy, the
nearer the moment when it becomes unnecessary. The more
wish to preserve their

capitalist habits

—

'

6
7

Bourgeois

refers to business

Transition

is

Letter to

owners,

capitalists. Collectively,

they are called the bourgeoisie.

Marx's mild word for change, not necessarily peacefully.

Weydemeyer, March

5,

1852.

Schweser
Study Program-


Chapter One

democratic the

which

more

'state'

which consists of the armed workers, and

'no longer a state in the proper sense of the word,' the

is

form of

rapidly every

state begins to

wither away. 8

John Maynard Keynes
In The General Theory of
Employment, Interest,
and Money, John
Maynard Keynes
changed the way we

look at macro-

economics.

Completely opposed to Marxist thought, John Maynard Keynes (pro-

nounced

(1883-1946)

"canes")

was

devoted

to

capitalism.

Philosopher, economist, and mathematician, Keynes was born in

Cambridgeshire, England.

It is

interesting to note that while Keynes

remains one of the most influential modern economists, his formal
education was in mathematics and
sertation at King's College

was

statistics.

In fact, his fellowship dis-

in probability theory. In the field of

economics, Keynes was largely self-educated.

Keynes taught economics

at

Cambridge during World War

I,

and

in

1915 went to work in the Treasury. Never a dedicated politician,

Keynes was always quick and blunt with

his

comments and

criticism.

At one point he called the comments of Lloyd George, then Chancellor
Unlike classical

of the Exchequer, 9 "rubbish." In 1919 he even attacked the leading

economists, Keynes

of the Versailles Peace Conference in The Economic

political figures

believed the

intervene during a

Consequences of the Peace, in which he strongly criticizes the peace
terms that punished the defeated Germany. He would probably

recession by increasing

respond to the

government needs to

its

expenditures.

you

of Adolph Hitler with an admonishing,

later rise

"I told

so!"

Keynes recognized the importance of government intervention during
the Great Depression of the 1930s. In 1936, he published The General

Theory of Employment, Interest, and Money in which he revolutionized
way economists think about macroeconomics. 10 He clearly laid out

the

how and why recessions happen and what must be done to

recover from

them. His very controversial strategy for recovery from a recession was
for

government

employment. In

to

run

this,

he

deficits

in order to

varies widely

stimulate

demand and

from classical economists, such as

Adam Smith, who advocate a strict "hands off" approach to government.

8 Karl Marx, The State
9

The Exchequer

is

and Revolution, September 1917.

the department of state in Great Britain charged with the receipt and care of

the national revenue.
'0

Microeconomics focuses on the

while macroeconomics focuses on
are discussed in Section Two.

10

Schweser
Study Program-

of human behavior on households or individual firms,
how human behavior affects entire, aggregate markets. Both

effects


1

Economics

Classical

quickly

economists argue that market wages and prices

enough during

a recession to bring

will decline

about economic recovery.

Classical economists favor a school of thought referred to as supply-side

economics. Supply-side economics holds that supply creates demand by
providing jobs and wages. The prices of goods for which there

supply will

and the

fall,

demand can

prices of

goods

in

demand

is

excess

will rise. Deficient

never be a problem, because the production of goods will

always generate (through employment) sufficient
the goods produced.

economy to

The markets

demand

to purchase

will always adjust quickly to direct

employment. It is argued that if unemployment is
temporarily high, wages will fall, which will reduce costs and prices.
Reduced prices will increase product demand, which will increase the
the

demand

full

for labor until the excess supply of labor

is

Keynes: The level of
employment in society

is

determined by the
aggregate spending of
consumers, investors,

government, and
foreigners.

eliminated.

Keynes, however, believed that wages and prices are "sticky," meaning

they will

resist

downward adjustment.

It is

the national government's spending that

employment

only through the help of

demand

is

stimulated and

increased.

Keynes's views can be

summarized with the following quote:

"Businesses will produce only the quantity of goods and services they
believe consumers, investors, governments,

When

and foreigners

will

buy

....

aggregate expenditures are deficient, there are no automatic

forces capable of assuring full
will persist." 11

employment. Prolonged unemployment

Keynes argues that the aggregate expenditures of these

four sectors (consumers, investors, governments, and foreigners)

determine the extent of employment, and that the government must
step

up expenditures during

a recession to

make up

for deficiencies in

the other three sectors. This concept, whether universally accepted or
not, should be recognized as at least partially responsible for recovery

from the Great Depression of the 1930s.
We've looked

at

pher/economists
right,

today.

four of the most respected and widely read philosoin history.

Whether they

are completely right, partly

or completely wrong, they remain very influential in economics

The

writings of these four individuals,

among many

others, led

people to think, discuss, and debate economics as a true and separate
discipline.

1

Gwartney, Stroup, and Sobel, Economics, 272.

hweser
Progranr

11


Chapter One

SECTION

TERMS

IMPORTANT CONCEPTS AND
ECONOMICS

2:

IN

In this section

we

economics terms,

more commonly used
without employing graphs and charts. A basic
will explore

understanding of these terms
the

CFA® exam, but

co-workers and

The

easiest

way

some of

will

will also

the

not only aid in your preparation for

prove invaluable for arguments with

relatives!

to impress

your associates

is

to share

your knowledge

of the three most important economic systems: capitalism, socialism,

and communism.

Capitalism
The writings of

Sir Francis

Bacon,

Adam

Smith, and John

Keynes focused on the concept of capitalism.
Capitalism

is

based upon

free enterprise.

(economy)

is

A

Maynard

capitalistic society

characterized by free enterprise: private ownership of

productive resources with prices determined by market forces (supply

and demand). Government has the limited role of developing and
enforcing a structure of laws. The laws define and enforce contracts,
protect private ownership rights, and protect individuals from fraud,
misrepresentation, and violence.
Capitalism

is

the

economic system

that the United States defends

promotes. The individual's opportunities for success within a

and

capitalist

system are limited only by his or her imagination and determination.

Socialism
What we now know
With socialism, the
government owns all
income-producing assets,
and allocation of wages
and goods is done
according to effort.

as Russia

and the former communist-bloc nations

were once collectively known as the Union of Soviet

In a socialist nation, the government owns all income-producing assets
and determines which products will be produced and in what quantities. Unlike capitalism, which calls for no or very limited intervention
by government, allocation of resources is done through a centralized
planning committee or agency rather than by market forces.

In the writings of Karl Marx, socialism

between capitalism and communism.

12

Socialist Republics.

It is

is

the intermediate step

characterized by the distri-


Economics
bution of goods and pay according to the amount of work done. Marx
says this leads to

unequal distribution and the continued evolution

toward a communist system.

Communism
The communist doctrine mandates, "From each according to his abilities,
to each according to his needs."
in

Marx's decline of capitalism.

Communism
It is

is

the final stage of society

characterized by having

no formal

government. As with socialism, a single authoritarian party controls

is

has no

Allocation

is

"from each

all

state-owned means of production, though the inequities of allocation

no private ownership of property, as all property
communally owned and available to each, according to need.

are removed. There

Communism

formal government.

is

according to

his abilities,

to each according to his

needs."

Supply
Supply and demand are probably two of the most commonly used
words in our economics vocabulary, so a discussion of each is quite
appropriate. Although the textbook definition for supply might
include such terms as aggregate production, marginal

revenue

12
,

let's

think of supply as the

cost,

amount of an item

or marginal
available for

The amount of an item available for purchase is based upon
factors such as the number of producers, the profit from producing the
item, the number of customers, the selling price, and the costs for

purchase.

Supply
a

good

is

the amount of

or service

available for purchase.

shipping the item around the country or globe. For the typical con-

mean much. What is important is
available when and where we want it and

sumer, these factors don't really

whether the item we want
at

the price

so

let's

we want

is

to pay.

Many

variables

must be considered

here,

take a look at an example.

you are a wholesaler and your company supplies two
products: gerbil bedding and gold necklaces. You purchase gold chain
directly from the manufacturer in 1,000-inch rolls at $2.00 per inch. It
costs you another $25.00 per necklace to cut the chain to length, add
clasps, and prepare it for shipping. The bedding material is actually

Assume

that

^

In economics, a good synonym for the word marginal is last. Marginal cost is the total cost to
produce the last item produced. Marginal revenue is the revenue received from selling the last
item. Since production costs may increase or decrease with the amount produced, the marginal
cost may be higher or lower than that for the second to the last item. A similar argument would

apply to marginal revenue.

Study Program*

13


Chapter One

wood chips and mulch left over from a lumberyard. It costs you $0.10
per pound and comes by truckload. (A pound of the bedding material
is

about two cubic

another $0.15 to

enough for the typical gerbil cage.) It costs you

put one pound in a labeled plastic bag and prepare it
feet,

for shipping.

Shipping presents an interesting problem for these vastly different

When
is

a finished product

cost intensive,

more

cost

than the product

is

itself.

a finished product

value intensive,

handling, packaging,

and shipping are
portion of

its

size (vol-

a small

final value.

light

makes gold necklaces very value-intensive products, meanThe bedding, on the other hand,
is very cost intensive. It is very light and inexpensive, but must be
shipped in much larger containers. The result is that 100 necklaces can
be shipped for about the same cost as 20 bags of bedding. (Let's
assume the shipping cost for each is $10.00.) So where is this discussion going? Let's take a look at the total cost to prepare and ship one
necklace versus one bag of bedding.
item. This

ing they are valuable, light, and small.

The gold

When

upon weight and

ume), a small, heavy item costs no more than a large (bulky),

handling, packaging,

and shipping

products. Since shipping costs are based

for a 20-inch necklace costs $40.00,

and the

clasps

and pack-

aging cost another $25.00, resulting in a total of $65.00 to assemble

and prepare one necklace for shipping. Since jewelers place orders for
100 necklaces at a time, and 100 necklaces can be shipped for $10.00,
shipping adds only an additional $0.10 to the cost of each necklace,
bringing the total costs to assemble and ship one necklace to $65. 10. In
turn, we assume that we can sell the necklace to a jeweler for $100.00.
Next,

let's

look

at the

bedding. The costs for the material and packaging

one bag of bedding is $0.25. Since it costs $10.00 to ship 20 bags,
one bag is $0.50. This brings the total to $0.75 per bag.
Let's assume that you can sell them to pet stores for $0.65. The result?
It is very cost effective for you to ship gold necklaces just about anywhere. The bedding, on the other hand, can only be sold locally, since
to package, prepare it for shipping, and ship it costs more than the
price you can sell it for.
for

the cost to ship

What

is

the point of all this?

ding any distance. In

fact,

Of course, you

unless

you can

will

not ship your gerbil bed-

distribute the

bedding

locally at

you won't
supply gerbil bedding. And, as long as costs are about the same for all suppliers of gerbil bedding, all suppliers are faced with the same situation.
a

aA

JSchweser
I

Study Program-

total

cost

that

is

lower

than

your

selling

price,


Economics
Now,

assume it costs about $0.10 per bag to distribute bedding
opposed to $0.50 to ship it longer distances. That means it
costs a total of $0.35 per bag ($0.25 material and packaging plus $0.10
transportation) to supply bedding locally. If you can sell it for $0.65, a
gross profit of $0.30 per bag will be realized. As long as you don't try
let's

locally, as

to charge local retailers

more than $1.00 or

so,

out-of-town suppliers

won't be enticed to compete with you. (Remember, out-of-town suppliers

can ship

As long

it

in to

your local market

at a total cost

as the local selling price doesn't

suppliers to

sell in

make

it

of $0.75 per bag.

profitable for outside

your market, they won't.)

Local suppliers want to maximize profits, so they want to

sell at

the

highest price possible, without reaching the estimated $1.00 that

would

when

is

the only thing

among them-

bedding

selves in the local market. Gerbil

don't care about the label

compete on quality or

The bottom
amount the

line

is

Note that price

gerbil-bedding suppliers compete

attract nonlocal competition.

that matters

on

it

or

who

is

gerbil bedding;

provides

it,

customers

so suppliers can't

that the supply of

bedding

is

constrained by the

can provide. Gold chains, on the other

hand, are a totally different product. Since

it is

profitable to ship

them

anywhere, the gold chains consumers see in stores can be from any-

where

in the world. This

a

good

or service supplied will

depend upon the price

received compared to

service.

local suppliers

The amount of

the total costs to supply
it.

The higher the

price

received by suppliers,

the greater the supply.

makes the supply of gold chains limited only

by the worldwide supply of gold.

The above arguments

are completely

pliers receive. If the total cost to

below the

selling price, that

dependent upon the price sup-

make and

ship an item

item will be supplied.

price does not provide revenues sufficient to cover

vide a profit, the item
crucial,

and

it

is

is

When
all

sufficiently

the selling

costs

and pro-

not supplied. Therefore, the selling price

was simply assumed

in the

is

arguments.

Demand
Demand

is

how much

society wants of a

you have a bicycle you want
ested in buying it.

to

sell,

good or

and there

is

service. Let's

assume

only one person inter-

iweser
ly

Program*

15