BOOK 2 - ECONOMICS Readings and Learning Outcome Statements 3 Study Session 4 - Economics: Microeconomic Concepts 9 Study Session 5 - Economics: Market Structures and Macroeconomic Concepts 75 Study Session 6 - Economics: Macroeconomic Theory 146 Self- Test - Economics 201 Formulas 206 Index' 208 'I If rhis book does nor have a from and back cover, it was disuibuted wirhout permission of Schweser, a Division of Kaplan, Inc., and : is in direct violarion of global copyrighr laws. You, assisrance in pursuing poremial violators of rhis law is greatly appreciared. Required CFA Insritute® disclaimer: "CFA® and Chartered Financial A.l1Jyst@ are uademarks owned by CFA Institure. CFA Insritute (formerly the Association for Investment Management and Research) does not endorse, promOte, review, or warrant rhe accuracy of the producrs or services offered by Schweser Swdy Program®." Cerrain materials contained wirhin rhis texr are the copyrighted properryofCFA Instiwte. The following is me copyrighr disclosure for these mate- rials: "Copyrighr, 2008, CFA Insritute. Reproduced and republished from 2008 Learning Outcome Statemenrs, CFA Institute Standards of ProfessionaL Conduct. and CFA Insriture's GlobaL Investment Pe'formal'lCe Standards with permission from CFA Institute. All RighLl Reserved." These materials may not be copied without wrinen permission from the author. The unauthorized duplication of these notes is a violation of global copyright laws and the CFA InstitUte Code of Erhics. Your assistance in pursuing potential violawrs of this law is gready appreciated. Disclaimer: The Schweser Notes should be used in conjunction wirh rhe original readings as set fonh by CFA InstitUte in their 2008 CfA Leve! I Study Guide. The information contained in these Notes covers wpies contained in rhe readings referenced by CFA Institute and is believed [Q be accurate. However, their accuracy cannot be guaranteed nor is any warranry conveyed as w your ultimate exam success. The authors of the referenced readings have not endorsed or sponsored these Notes, nor are they affiliared with Schweser Study Program. Page 2 ©2008 Schweser READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a rfl'ieu' of the EcollomiC-' principleJ designed to addresJ the learning outcome statements Jet forth by CFA Institute. STUDY SESSION 4 . Reading Assignments Economics, CFA Program Curriculum, Volume 2 (CFA Institute, 2008) 13. Elasticit)' 14. Efficienc)' and Equity 15. Markets in Action 16. Organizing Production 17. Output and COStS STUDY SESSION 5 Reading Assignments Economics, CFA Program Curriculum, Volume 2 (CFA Institute, 2008) 18. Perfect Competition 19. Monopoly 20. Monopolistic Competition and Oligopoly 21. Demand and Supply in FactOr Markets 22. Monitoring Cycles, Jobs, and the Price Level 23. Aggregate Supply and Aggregate Demand STUDY SESSION 6 Reading Assignments Economics, CFA Program Curriculum, Volume 2 (CFA Institute, 2008) 24. Money,. Banks, and the Federal Reserve 25. Money, Interest, Real <;;DP, and the Price Level . 26. Inflation 27. Fiscal Policy 28. Monetary Policy ©2008 Schweser i', i page 9 page 20 page 33 page 48 page 62 page 75 page 86 page 97 page 110 page 122 page 135 page 146 page 156 page 166 page 176 page 186 ',1 Page 3: Economics Readings and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS) STUDY SESSION '4. The topical coverage corresponds with the following CFA Institute assigned reading: 13. Elasticity The candidate should be able to: a. calculate and interpret the elasticities of demand (price elasticity, cross elasticity, income elasticity) and the elasticity of supply, and discuss the factors that influence each measure. (page 9) b. calculate elasticities on a straight-line demand curve, differentiate among elastic, inelastic, and unit elastic demand and describe the relation between price elasticity of demand and total revenue. (page 15) The topical coverage corresponds with the following CFA Institute assigned reading: 14. Efficiency and Equity The candidate should be able to: a. explain allocative efficiency, marginal benefit and marginal cOSt, and demonstrate why the efficient quanti ty occurs where marginal benefi t equals marginal cost. (page 20) b. distinguish between the price and the value of a product and explain the demand curve and consumer surplus. (page 21) c. distinguish between the COSt and the price of a product and explain the supply curve and producer surplus. (page 23) . d. discuss the relationship between consumer surplus, producer surplus, and equilibrium. (page 23), e. explain 1) how efficient markets ensure optimal resource utilization and 2) the obstacles to efficiency and the resulting underproduction or overproduction, including the concept of deadweight loss. (page 24) f. explain the two groups of ideas about the fairness principle (utilitarianism and the symmetry principle) and discuss the relation between fairness and efficiency. (page 27) The topical coverage corresponds with the following CFA Institute aJJigned reading: 15. Markets in Action The candidate should be able to: a explain market equilibrium, distinguish between long-term and short-term impacts of outside shocks. and describe the effects of rent ceilings on the existence of black markets in the housing sector and on the market's efficiency. (page 33) b. describe labor market equilibrium and explain the efleers and inefficiencies of a minimum wage above the equilibrium wage. (page 36) c. explain the impact of taxes on supply, demand, and market equilibrium, and describe tax incidence and its relation to demand and supply elasticity. (page 37) d. discuss the impact of subsidies, quotas, and markets for illegal goods on demand, supply, and market equilibrium. (page 41) The topical coverage correJpondJ' with the following CFA Imriwte tlJ'J'igned Telzding: 16. Organizing Production The candidate should be able to: a. explain the types of opportunity cOSt and their reLltion to economic profit, and calcubte economic proFit. (page 48) b. discuss a firm's constraints and their impact on achievability of maximum profit. (page 49) Page 4 ©200H Schwesel' Economics Readings and Learning Outcome Statements c. differentiate between technological efficiency and economic efficiency, and calculate economic efficiency of various firms under different scenarios. (page 50) d. explain command systems and incentive systems ro organize production, the principal-agent problem, and measures a firm uses to reduce the principal-agent problem. (page 51) e. describe the different types of business organization and the advantages and disadvantages of each. (page 52) f. characterize the four market types. (page 53) g. calculate and interpret the four-firm concentration ratio and the Herfindahl-Hirschman Index, and discuss the limitations of concentration measures. (page 54) h. explain why firms are often more efficient than markets in coordinating economic activity. (page 55) The topical coverage corresponds with the following CFA Institute assigned reading: 17. Output and Costs The candidate should be able to: a. differentiate between short-run and long-run decision time frames. (page 62) b. describe and explain the relations among rotal product of labor, marginal product of labor, and average product of labor, and describe increasing and decreasing marginal returns. (page 62) c. disringuish among rotal COSt (including both fixed cost and variable cost), marginal COSt, and average COSt, and explain the relations among the various coSt curves. (page 64) d. explain the firm's production funcrion, its properties of diminishing returns and diminishing marginal producr of capital, the relation between short-run and long-run cOStS, and how economies and diseconomies of scale affect long-run coses. (page 69) STUDY SESSION 5 The topical coverage corresponds with the following CFA Institute assigned reading: 18. Perfect Competition The candidate should be able ro: a. describe the characreristics of perfect competition, explain why firms in a perfectly comperitive market are price takers, and differentiate between market and tlrm demand curves. (page 75) b. determine the profit maximizing (loss minimizing) output for a perfectly competitive tlrm, and explain marginal cost, marginal revenue, and economic profit and loss. (page 76) c. describe a perfectly competitive tlrm's short-run supply curve and explain the impact of changes in demand, entry and exit of firms, and changes in plant size on the long-run equilibrium. (page 78) d. discuss how a permanent change in demand or changes in technology affecr price, outpUt, and economic profit. (page 80) The topical coverage "orresponds with the following CFA Irutitute assigned reading: 19. Monopoly The candidate should be able to: a. describe the characteristics of a monopoly. including factors that allow a monopoly ro arise, and monopoly price-secring strategies. (page 86). b. explain the relation between price, marginal revenue, and elasticity fo; .• monopolY, and derermine a monopoly's profit-maximizing price and quantity. (page 87) c. explain price discrimination. and why perfect price discriminarion is efficient. (page 88) d. explain how consumer and producer surplus are redisrributed in ~l monopoly. including rhe occurrence of deadweight loss and rent s,-·~king. (page StY) e. explain the potenrial gains trom monopoly ,lnd the regulation of a namral monoplll~" (page <)0) @~ll()~ Schweser 1:,,'011 0 III i ,'~ Rcadinp and Lc:trnillg Outn1l11l' Statcments 20. Ij,r ro/,iml c01'('I'IIgr l'OI'l'f.ll'Olldr II/irl l rllt.f(J!I(lIl'ill,~ CI;A Illsrir!lft IISS<r;lIrr! I'rrlrlillg: Monopolistic Competition and Oligopoly The candiJan: should bc able to: a. describe the characteristics of monopolisric compcririon and oligopol)'. (f1age 97) b. derermine the profit-maximizing (Ioss-minimi7,ing) ouq 1 ut under monopolisric competition and oligopol)', explain why long-run economic pr~)fir under monopolisr'ic competition is zero. and determine if monopolistic competition is efficient. (page 98) c. explain the importance of innovation. product developmenr. advertising, and branding under monopolistic competition. (page 100) d. explain the kinked demand curve model and the domin:lnr firm modeL and describe oligopoly games including the Prisoners' Dilemma. (page 101) The ropical COl i frOgC corresponds wirh rJ.1t' following CFA Imrirute assigned reading: 21. Demand and Supply in Factor Markets The c:lndidate should be able to: a. explain why demand for the factors of production is called derived demand, differentiate between marginal revenue and marginal revenue product (MRP), and describe how the MRP determines the demand for labor and the wage rate. (page 110) b. describe the factors that cause changes in the demand for labor and the factors that determine the elasticity of the demand for labor. (page Ill) c. describe the factors determining the supply of labor, including the substitution and income effects, and discuss the factors related to changes in the supply of labor, including capital accumulation. (page 112) d. differentiate between physical capital and financial capital. and explain the relation between the demand for physical capital and the demand for financial capital. (page 113) e. discuss the role of the present value technique in determining the demand for capital. (page 113) f. explain the factors that influence the supply of capital. (page 114) g. differentiate between renewable and non-renewable natural resources and describe the supply curve for each. (page 115) h. differentiate between economic rent and opportunity costs. (page 116) The topical couerage corresponds with the following CFA Insritute as.rigned reading: 22. Monitoring Cycles, jobs, and the Price Level The candidate shou'1d be able to: a. describe the phases of the business cycle, define an unemploved person, and interpret the main labor market indicators and their relation to the business cycle. (page 122) b. define aggregate hours and real wage rates, and explain their relation to gross domestic product (GOP). (page 124) c. explain the types of unemployment, full employment, the natural rate of unemployment, and the relation between unemployment and real GOP. (page 124) d. explain and calculate the consumer price index (CPl), describe the relation between the CPl and the inflation rate, and explain the main sources of CPl bias. (page 125) The topical coverage corresponds with the following CFA Institute assigned reading: 23. Aggregate Supply and Aggregate Demand The candidate should be able to: a. explain the factors that influence real GOP and long-run and short~run aggregate supply, explain movement along the long~run and shorr-run aggregate supply curves (LAS and SAS), and discuss the reasons for changes in potential GOP and aggregate supply. (page 135) Page 6 ©200HSchweser Economics Readings and Learning Outcome Statements b. explain rhe componenrs of and rhe facrors rhat affect real GDP demanded, describe the aggregate demand curve and why it slopes downward, andexplain the facrors that can change aggregate demand. (page 137) c. differenriate between shore-run and long-run macroeconomic equilibrium, and explain how economic growth, inflation, and changes in aggregate demand and supply influence the macroeconomic equilibrium and the business cycle. (page 139) d. compare and contrast the Keynesian, Classical, and Monetarist schools of macroeconomics. (page 141) ; STUDY SESSION 6 The topicaL coverage corresponds with the ftLLowing CFA Institute assigned reading: 24. Money, Banks, and the Federal Reserve The candidate should be able co: a. explain the functions of money. (page 146) b. describe the componenrs of the M 1 and M2 measures of money, and discuss why checks and credit cards are not counred as money. (page 146) c. describe the economic functions of and differentiate among the various deposicory institutions, and explain the impact of financial regulation, deregulation, and innovation. (page 147) d. discuss the creation of money, including the role played by excess reserves, and calculate the amount of loans a bank can generate, given new deposits. (page 149) e. explain the goals of the U.S. Federal Reserve (Fed) in conducting monetary policy and how the . Fed uses its policy cools co concrol the quantity of money, and describe the assets and liabilities on the Fed's balance sheet. (page 149) f. describe the monetary base, and explain the relation among the monetary base, the money multiplier, and the quantity of money. (page 150) The topicaL coverage corresponds with the ft LLo wing CFA Institute assigned reading: 25. Money, Interest, Real GDP, and the Price Level The candidate should be able co: a. explain the faccors that influence the demand for money, and describe the demand for money curve, including the effects of changes in real CDP and financial innovation. (page 156) b. explain interest rate determination and the shore-run and long-run effects of money on real CDP. (page 157) c. discuss the quantity theory of money and its relation ro aggregate supply and aggregate demand. (page 160) The topicaL coverage correspondJ' with the ftLLowing CFA Institute assigned reading: 26. Inflation The candidate should be able to:' a. differenriate between inflation and the price level, and calculate an inflation rate. (page 166) b. describe and distinguish among the factors resulting in demand-pull and cost-push inflation, and describe rhe evolution of demand-pull and cost-push inf1ationary processes. (page 166) c. explain the effects of unanricipated infhtion in the labor market and the market for financial capital. (page 168) d. distinguish between anticipated and unanticipated inflation, and explain the costs of anticipated inflation. (page 169) e. explain the impact of inthtion on unemployment. and describe the shore-run and long-run Phillips curve, including the dTect of changes in the natural rate of unemployment. (page 170) ©.!()08 Sdnvc:sc:r Page. 7 Eeo 11 0 111 i es Readings and Lcarning Outcomc Statements f. explain the relation among innation, nominal interest rate~. and the demand and supply of mone~·. (page 171) The ropier11 co/lerage ((IITC.ipondJ wirh th( /t,L!owilig CF4 lJl.it;rutr 11.rs<r;ncd reading: 27. Fiscal Potier The candidate should be .able to: a. explain supply-side effects on employment. potential CDr, and aggregate supply, including the income tax and taxes on expenditul:e. and describe the Laffer curve and its relation to supply-side economics. (page 1(6) b. discuss the sources of investment finance and the influence of fi~ca] policy on capital markets, including the crowding-out effect. (page 178) c. discuss the generational effects of fiscal policy, including generational accounting and genera tiona] imbalance. (page 179) d. discuss the use of fiscal policy to stabilize the economy, including the effects of the government purchases multiplier, the tax multiplier, and the balanced budget multiplier. (page 179) e. explain the limitations of discretionary fiscal policy, and differentiate between discretionary fIscal policy and automatic stabilizers. (page 180) The topicaL coverage corresponds with the foLLowing CFA lmritute assigned reading: 28. Monetary Policy The candidate should be able to: a. discuss the U.5. Federal Reserve's primary goal of price stabili ty, the secondary goal of maintaining sustainable real GDP growth, and the intermediate targets of monetary policy, and compare and contrast the policies that can be used to achieve price level stability. (page 186) b. compare and contrast fixed-rule and feedback-rule monetary policies to stabilize aggregate demand, and explain the problem of monetary policy lags. (page 187) c. discuss the fixed-rule and feedback-rule policies to stabilize aggregate supply in response to a productivity shock and a cost-push inflation shock. (page 188) d. discuss the im ponance of policy credi bility in monetary policy implementation. (page 191) e. compare and contrast the new monetarist and new Keynesian feedback rules. (page 195) Page 8 «)2008 Schwcser The following is a review of the Economics principles designed to address the learning outcome statements set forth by CFA InsticuteC» This topic is also covered in: ELASTICITY Study Session 4 EXAM Focus Elasticity is a measure of the ratio of the percentage change in one variable to the percentage change in another variable. It is commonly used as a measure of how sensitive the quantity demanded is to changes in the price of a good. After learning all about price elasticity of demand, learn how to apply this concept to calculate and interpret the cross elasticity of demand, the income elasticity of demand, and the elasticity of supply. You must also gain a good understanding of the factors that influence a good's elasticity of demand and elasticity of supply. LOS 13.a: Calculate and interpret the elasticities of demand (price elasticity, cross elasticity, income elasticity) and the elasticity of supply, and discuss the factors that influence each measure. The price elasticity of demand measures the change in the quantity demanded in response to a change in market price (i.e., a movement along a demand curve). The fotmula used to calculate the price elasticity of demand is: percent change in quantity demanded price elasticity of demand = -' = = ' percent change in price where: O/O~Q %~p percent change = change in value _ ending value - beginning value .average value - ( ending value + :eginnin g value J Professor)" Note: It is cUHomary to use average values when (tlkl/I,lting ~ percentage changes used in elasticity computations. Thij" way 11 change from 8 to ~ J0 and a change from J0 to 8 both result in the j'ame percentage change of 2/9 =22.2%. Use thij' method on the exam! Figure 1 illustrates the general categories of price elasticity of denund. A discussion or" each is presented below: • [f a j'mal/percentage price change results in a Il1rge percemage change i~ quantity demanded. the demand for thar good is said [0 be highly d,lsri Apples are ,tn example of an elastic good. The absolure value of price elasticirv is greater than Page 9 Stud,' Sc:~~iOll 4 Cro~~-Refcrcnce to CFA I n~tirlilc A~signed Reading # 13 - Elasricir)" one. meaning that the percentage change in Q is greater than the percentage change in P. • If a IflIg(' percentage price change result~ ina mud! percentage change in quantity ·demanded. demand is ,.('Illtill{'~l' illrlmtir. Gasoline is an exanlJ.1le of a relatively inelastic good. The absolute value of price elasticit~· is less than one. meaning that the percentage change in Q is less than the percentage change in P. • A p('/:f('rt~J' rLastic demand curve is horizontal. and its elasticity is infinite. If the price increases. quantity demanded goes to zero. • A perfect~y ineLastic demand curve is vertical, and elasticity is zero. If the price changes, there will be no change in the quantity demanded. Figure 1: Price Elasticity of Demand Elastic Price Price Inelastic Price Perfectly Inelastic/Elastic D Quanti!!' Quantity D Perfectly Inel3.5ric D Perfecdr Elastic Quantity Factors that influence the elasticity of demand are (1) the availability and clos~ness of substitutegoods, (2) the relative amount of income spent on the good, and (3)t,4erime that has passed since the price change of the good. . • AvailabiLity of substitutes. If good substitutes are available, a price increase in one product will induce consumers to switch to a substitute good. As such, elasticity of demand is determined, in parr, by the availability of good substitutes. For example, the demand for gasoline is inelastic (less than one) because it has no practical substitutes, at least in the shorr run. On the other hand, the price elasticity for beef is high because there are many suitable substitutes, such as fish or chicken. Page lO ©2008 Schweser [...]... sLope of the demand curve! 20 08 Schweser Page 15 Study Session 4 Cross-Reference to CFA Institute Assigned Reading # 13 - Elasticity - " KEy CONCEPTS , , 1 Price elasticity of demand measures the change in the quantity demanded in response to a change in market price percent change in quantity demanded price elasticity of demand = - = - - - - - - - = - - - - " - - - ' - - - - percent change in price... Linear Demand Curve Price($) 8 : (a) high elasticiry r. -. ~ ·.·. - ; - :elasticiry = -2 . 6 I : : : 5 ! ( ··r· ~ -: 4 I_ 3 ~ ~ fl - ·i (b) unitary elasticity ; ; elasticiry = -1 ~ - ! ·~ -~ (c) low elasticity · : -r I r -: -~ -_ . ~- .~ 2 ~ .-~ -~ -_ - ·i j _._; : ' • ! 30 40 ' , , e1asticiry = -0 .2 , Quantiry 10 20 • • • 50 60 70 80 At point (a), in a higher price range, the price... Consumers are willing to expend effort with a value of P"" - Pc in search activity to find the scarce good The reduction in quantity exchanged due to the price ceiling leads to a deadweight loss in efficiency as noted in Figure 2 Figure 2: Price Ceiling Price demand Pws supply Deadweight loss Pc 1 - - - - - - " - 1 " - - - - " , , : - - - ceiling price (maximum) L L ' Quami(}, With an effective... Reading #13 - Elasticity - I C If the Ilumber of widgets demanded changes from 19 to 21 \\'hen the price changes from $1.50 to $0.50, the percentage change in quantit~· is (2] - 19) / [ (21 + 19) /2] '= 10% and the percentage change in price is (0.50 - 1 50) / !(1 'iO+ 0.50) / 2J '= -1 00% Thus price elasticity = J 0% / -1 00% = -0 .1 2 A If quantity demanded increases 20 % when the price drops 2% this good... range Price elasticity in the $6 to $7 range is [ (20 - 30) / 25 J / [(7 - 6) / 6.5J = -2 . 6 Price elasticity in the $1 to $2 range is [(70 - 80) / 75J / [ (2 - 1) / 1.5J = -0 .2 The elastici ty at point (b) is -1 ; a 1% increase in price leads to a 1% decrease in quantity demanded This is the point of greatest total revenue (P x Q) which equals 4.50 x 45 = $20 2.50 At prices less than $4.50 (inelastic range)... , , Demand , , _,' _ -L, Quantity Equilibrium quanti!}' decreases in sliort run (b) Long-term impact Price Supply after outslde shock (before producers adjust) Supply after producers adjust Increased ?utpUt - - -1 - - - : causes pnce to : decrease r !- -i , i , , , , , , ' - - ', , , , Demand , -~ , ~ , Producers respond to highe~ price by Increasmg outpUt Quantity An example of a... demanded is (750 + 600).1 2 = 675 scoops, sO the percentage change' in thequanrity of ice cream demanded is (750 -6 00) /675= +22 .2% The average price for frozen yogurt is ($L25 + $1.75) / 2 =$150 per ' scoop, so the percentage change in the price of frozen yogurt is ($1.75 - $1 .25 ) / $1.50= +33.3% The cross elasticity of demand for ice cream relative tome price of yogurt is 22 .2 /33.3 = +0.67 Prqfessor's... Figure 2, this is the shaded triangle The total value to society of 3,000 tons of steel is more than the total amount paid for the 3,000 tons of steel by an amount represented by the shaded triangle 20 08 Schweser Page 21 Study Scs,ion 4 Cross-Reference to CFA Institute Assigned Reading # 14 - Efficiency and Equity Figure 2: Consumer Surplus Siron Consumer Surplus Supply (MC) $50() Demand (MB) ' -~ ... noo = 51.50) $5.00 $4.50 $4.00 Consumer surplus rrom the' gallons = $';,00 $3.50 $3.00 Marker price I-~ ! :. '-" -l_ , - AmOUnt for paid 5 gal Ions Demand = J\brgin,] Bendlc (MBl Gallons per week 2 Page: 22 3 4 5 ~) !OOS Schw.:sn Srudy Session 4 Cross-Reference to CFA Institute Assigned Reading # 14 - Efficiency and Equity LOS 14.c: Distinguish between the cost and the price of a product and explain... opportunity, not equality of results 20 08 Schweser Page 29 ."Iudy Session 4 Cross- Reference to CFA Institute Assigned Reading # 14 - Efficiency and· Equity CONCEPT CHECKERS 1 If a consumer is willing differe nce is: A consumer surplus B consumer deficie C producer deficie D producer surplus 2 The marginal benefic from consuming che chird unic of a product is $ 12, and che marginal cost co che producer . a lower price range. Price elasticity in the $6 to $7 range is [ (20 - 30) / 25 J / [(7 - 6) / 6.5J = -2 . 6. Price elasticity in the $1 to $2 range is [(70 - 80) / 75J / [ (2 - 1) / 1.5J = -0 .2 The elastici ty at point (b) is -1 ; a 1% increase in price leads to a. elasticity 2 · : r r : ~ ·~ ~ e1asticiry = -0 .2 - _. ~- .~ ~. - ~ - ~-_ . - ··i- - j. _._; . I : ' • ! ' , , , 10 20 30 40 50 60 70 80 At point (a), in a higher price range, the price elasticity of demand is greater than at point (c). Real <;;DP, and the Price Level . 26 . Inflation 27 . Fiscal Policy 28 . Monetary Policy 20 08 Schweser i', i page 9 page 20 page 33 page 48 page 62 page 75 page 86 page 97 page 110 page 122 page 135 page 146 page