2019 Study Session # 4, Reading # 14

Gen. = Generally
MR. = marginal
revenue
“TOPICS IN DEMAND &
MC. = marginal cost
Prof. max. = profit SUPPLY ANALYSIS”
maximization
Q.D = Quantity
Demanded
Pmt. = payments 1. INTRODUCTION This reading explores how buyers & sellers interact
LR= long-run to determine transaction prices & quantities.
SR=short-run
SMC=short-run
marginal cost 2. DEMAND ANALYSIS
LMC = long-run
marginal cost
MP = marginal
productivity

2.1 2.2 2.3 2.4 2.5 2.6

Demand Own-Price Income Cross-Price Substitution Normal &
Concepts Elasticity of Elasticity of Elasticity of & Income Inferior
Demand Demand Demand Effects Goods

Law of Demand: %∆ $% &.( )* + %∆ $% &.( )* + Two reasons why • Substitution

=%∆ $% 6%.)7/ =%∆ $% ,-$./ )* 0
As the price of good ↑ demand is –vely effect of a ∆ in
(↓), buyers buy ↓ (↑). (other factors (other factors sloped: price of a good is
Demand Function: constant) constant) 1) Substitution always in the
Qdx = f(Px, I, Py) • income elasticity • if cross price- Effect: when price direction of
Demand Curve: can be +ve, -ve, or elasticity of two ↓, consumers buying more at a
Highest quantity zero. goods is: purchase ↑. less price or
purchased at given • Normal goods [+ve • +ve goods are 2)Income Effect: ↓ buying less at
price or highest price income elasticity] substitutes in price of a good more price.
paid at given quantity. • Inferior goods [-ve • -ve goods are results in ↑ in • Same is true for
income elasticity] complements consumer’s real Income effect for
income & if it is normal goods.
normal good, • For inferior
more of it will be goods, income
%∆ $% &.( )* +
=%∆ $% ,-$./ )* + purchased. effect &
(other factors constant) substitution
effect work in
• when the magnitude of elasticity is:
opposite
i. >1, demand is elastic.
directions.
ii. < 1, demand is inelastic.
iii. =−1, demand is unit elastic.
Giffen Goods:
Inferior goods that
consumer more
2.2.1 2.2.2 2.2.3 (less) as price rises
Extremes of Predicting Elasticity & Total (fall) i.e. income
Price Elasticity Demand Elasticity Expenditure effect overwhelms
their substitution
effect.
Vertical Demand Curve: Gen. Own-Price Elasticity of When demand is elastic Veblen Goods:
Same Q.D regardless of Demand will be ↑ (more sensitive) (inelastic): High status goods
price (inelastic demand) for items that: • Price & total that ↑ in
Horizontal Demand Curve: • have close substitutes. expenditure (PxQ) desirablility with ↑
A slight ↑in price will cause • occupy large portion of total move in opposite in price.
0 demand (perfectly elastic budget. (same) direction.
demand). • are optional
• have longer adjustment times.

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3.1
Marginal Returns
& Productivity
Increasing marginal returns:
• ↑ in marginal product as additional unit of
that input is employed.
3.1.1
Productivity: The
relation b/w
Production & Cost
Total cost of production:
TC = (w)(L) + (R)(K)
• TC can be ↓ by ↑
productivity or by ↓
input price & vice versa.
Benefits of increased
productivity
• ↓ business cost
• ↑ in mkt value of equity
• ↑ in worker rewards
• ↑ in firm’s competitive
position in the long-run.
2019 Study Session # 4, Reading # 14
3. SUPPLY ANALYSIS: THE FIRM
3.2 3.3
Breakeven & Understanding Economies
Shutdown Analysis & Diseconomies of Scale
• Short-run: time period during which at least one
of the factors of production is variable.
• Long-run: time period during which all factors of
production are variable.
3.1.2 3.3.1 3.3.2
Total, Average & Short & Long –run Defining Economies &
Marginal Product Cost Curves Diseconomies of Scale
of Labor
Total Product is sum of the • SR avg. total cost Economies of scale:
output from all inputs. Q x L curve (SATC): Avg. • ↓ in per unit cost by ↑ in
Average Product: is total total cost curve when production.
product divided by quantity of some costs are fixed. • LRAC curve with a –ve
8
a given input. . • LR avg. total cost slope.
9
Marginal Product: additional curve (LATC): Avg. Diseconomies of scale:
output resulting from one total cost curve when • ↑ in per unit cost by ↑ in
∆8 no cost is fixed. production.
additional unit of input. .
∆9 • LRAC curve with a +ve
• Compared to total product, slope.
average product & marginal
product better gauge firm’s
On next page
productivity.
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 2019 Study Session # 4, Reading # 14

3.2.1 3.2.2 3.2.3 3.2.4 3.2.5 3.2.6 3.2.7

Economic MR, MC & Understanding Revenue under Profit- Breakeven The
Cost vs. Profit the interaction conditions of maximization, Analysis Shutdown
Accounting Maximization b/w Total, Perfect & Breakeven & Decision
Cost Variable, Fixed & Imperfect Shutdown Points
MC & Output Competition of Production

Accounting cost:
Monetary value of
economic resources • TC curve lies parallel to & Under perfect Firm B.E.P →TR =
used in business above TVC by the amount competition: maximizes TC, a point
activity i.e. explicit of TFC. • Demand curve is profit by where a
out-of-pocket current • MC curve intersects both horizontal. producing Q firm earns
pmts or allocation of AVC & ATC at their min. • TR curve is linear where P = normal
historical pmts for points. with slope equal to SMC & SMC economic
resources. • If MC is ↓(↑) than AC, AC price per unit. is rising. profit.
Economic Cost: The must ↓ (↑). Under imperfect
sum of total • The rate of ∆ in TC mirrors competition:
accounting costs & the rate of ∆ in TVC. • Demand curve is –
implicit opportunity • Quasi-fixed cost: Cost that vely sloped.
costs. stays same over a range • TR curve rises in the
Accounting Profit: of production & then ∆ range where MR is
Income before tax on when production moves +ve & demand is
income statement. outside of that range. elastic & then falls in
Economic Profit: • AFC ↓ throughout the the range where MR
Accounting profit – production span. is –ve & demand is
implicit opportunity inelastic.
cost.

∆:;
MR = • Sunk costs must be ignored to continue to operate in the SR.
∆8
• A firm, covering its variable cost, should operate in the SR.
For a firm operating under:
• Shutdown point→ min. AVC.
• Perfect competition→MR = P
• Imperfect competition→MR < P • Breakeven point:→min.ATC.
∆:=
MC =
∆8 Rev. cost relation SR Decision LR Decision
SMC: additional incurred cost of variable TR = TC Stay in mkt. Stay in mkt.
input to ↑ 1 unit of output. TR = TVC but < TC Stay in mkt. Exit mkt.
LMC: additional incurred cost of all TR < TVC Shutdown production Exit mkt.
inputs to ↑ the level of output. Reference: Exhibit 22: CFA Institute’s curriculum Reading 14
Law of diminishing returns: additional
output must fall as more and more labor
is added to fixed capital.
For profit. maximization: firms should
produce the level of output such that:
i) MR = MC & ii) MC is not falling.

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