Lecture Economics for investment decision makers: Chapter 1 - CFA In stitute

Chapter 1
Demand and Supply Analysis:
Introduction
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1. Introduction

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2. Types of markets

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Factor markets are markets for the factors of production.
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The factors of production are the inputs to production.

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Factor markets include labor markets.

Goods markets are markets for the outputs of production.

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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 firm’s cash flow and assets (that is, debt
and equity securities).

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3. Basic Principles and Concepts

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The demand function

(1-1)

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The Supply function

(1-7)

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Changes and movements
Changes in quantity demanded

Changes in quantity supplied
Change in its own-factor prices
Movement along the demand curve

Change in price of other goods
Shift in the demand curve

Change in supply
Shift in the supply curve

Price

Price

Change in its own-price

Movement along the demand curve

Quantity

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Quantity

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Aggregating Supply and demand curves

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Moving from the individual consumer or firm to the aggregate:
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Aggregating demand curves requires adding the individual quantities
demanded at each price.

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Aggregating supply curves requires adding the firms’ quantities supplied at
each price.

A market equilibrium is the situation in which the quantity demanded at a
given price is equal to the quantity supplied at that price.

Price

Quantity

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Solving for the equilibrium

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Equilibria

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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).
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Price bubbles are an example of an unstable equilibrium.

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Demand and supply functions

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Aggregate Supply and Demand

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Excess supply and demand

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Types of auctions

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Common value auction: The item’s 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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Dutch Auction: US Treasury securities

Example: Dutch auction for $120 billion of US Treasury 28-day bills

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.

Producer surplus is the difference
between what the producer sells a
good or service for and the price at
which the supplier was willing to sell.

Price

Consumer surplus

Producer surplus

Quantity
Total surplus = Consumer surplus + Producer surplus
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Calculating Surplus

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Market Interference

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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.
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Some consumers gain consumer surplus lost by suppliers, but some
consumer surplus is lost and not picked up by suppliers.

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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.
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Sellers want to sell more, but buyers purchase less.

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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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•


Effect of market interference
Equilibrium price = €1

Price Ceiling

Price Floor

10

10

8

8

6

6

4

4

Price

12

Price

A

12

2

2

C
A
B
0

0
Quantity

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Quantity

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4. Demand Elasticities

Qx
a
b
Px

slope
coefficient

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Elasticities

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Elasticity is the sensitivity of the change in quantity for a given change in the
price of a good.
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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.
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A substitute is a good that has a positive cross-price elasticity.

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A complement is a good that has a negative cross-price elasticity.

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Elasticities: Summary

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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
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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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Factors that affect elasticities
Degree of substitutability

1.

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The greater the degree of substitutability, the greater the elasticity.
Portion of budget spent on the good

2.

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The greater the portion, the greater the elasticity.
Time allowed to respond to the change in price

3.

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The longer the time allowed, the greater the elasticity.
Extent to which the good is deemed necessary

4.

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The greater the extent to which the good is deemed as necessary, the more
inelastic its demand.

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Income elasticities

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