Level I – Economics

Topics in Demand and Supply Analysis

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Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.

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 Contents
1. Introduction

2. Demand Analysis: The Consumer

3. Supply Analysis: The Firm

4. Summary

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 1. Introduction

• Economics is the study of production, distribution, and consumption; it is

divided into two broad areas: Microeconomics and Macroeconomics

• Macroeconomics deals with aggregate economic quantities, such as

national output and national income

• Microeconomics deals with markets and decision making of

individual economic units, including consumers and businesses.

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 2. Demand Analysis: The Consumer
1. Demand Concepts

2. Own Price Elasticity of Demand

3. Income Elasticity of Demand

4. Cross-Price Elasticity of Demand

5. Substitution and Income Effects

6. Normal and Inferior Goods

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 2.1 Demand Concepts
Law of demand: as the price of a good rises (own price), buyers
will choose to buy less of it, and as its price falls, they buy more

P the highest quantity willingly

Demand function for Good A: QD = f(PA, I, PB…) purchased at each price

QD = 10 – 0.5P + 0.06I – 0.01PT the highest price willingly paid for

each quantity

If I = 1633.33 and PT = 800, then:

QD = 100 – 0.5P

Inverse demand function: P = 200 – 2Q

Demand curve: graph of the inverse demand function

Q

Movement along the curve verses

shift in the curve.
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 A Basic Mathematical Rule

A = 10 + 5B – 6C + 8D QD = 10 – 0.5 P + 0.06 I – 0.01 PT

ΔA / ΔB = 5

ΔA / ΔC = -6

ΔA / ΔD = 8

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 2.2 Own-Price Elasticity of Demand
∆Qxd QD = 10 – 0.5 P + 0.06 I – 0.01 PT
%∆Qxd Qxd  ∆Qxd  Px 
=
E dp = =   
x %∆Px ∆Px  ∆Px  Q d 
  x 
Px

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 Own-Price Elasticity of Demand
∆Qxd
%∆Qxd Qxd  ∆Qxd  Px 
=
E dp = =   
x %∆Px ∆Px  ∆Px  Q d 
  x 
Px

For all negatively sloped, linear demand

curves, elasticity varies depending on
where it is calculated

Elastic, inelastic and unit elastic

Perfectly elastic and perfectly inelastic

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 Factors that Affect Demand Elasticity

• Substitutes

• Portion of total budget

• Time horizon

• Discretionary (optional) versus non-discretionary (necessary)

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 Elasticity and Total Expenditure

∆Qxd
%∆Qxd Qxd  ∆Qxd  Px 
=
E dp = =   
x %∆Px ∆Px  ∆Px  Q d 
  x 
Px

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 2.3 Income Elasticity of Demand

% ∆Q d QD = 10 – 0.5 P + 0.06 I – 0.01 PT

EId = x
%∆I

For a normal good, income elasticity is positive

For an inferior good, income elasticity is negative

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 2.4 Cross Elasticity of Demand

%∆Qxd QD = 10 – 0.5 P + 0.06 I – 0.01 PT

E dp =
y %∆Py

Positive for a substitute

Negative for a complement

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 Calculating Elasticities from a Demand Function
QA = 60 − 12PA + 0.015I + 3PB - 4.5PC
PA = 10
PB = 55
Pc = 10
I = 2,000

Calculate:
1. Own-price elasticity for demand for A
2. Income elasticity of demand for A
3. Cross-price elasticity of demand of A against price of B
4. Are A and B substitutes or complements
5. Cross-price elasticity of demand of A against price of C
6. Are A and C substitutes or complements

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 2.5 Substitution and Income Effects

Decrease in price
Substitution Effect causes quantity Income Effect
demanded to
increase

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 2.6 Normal and Inferior Goods

Substitution Effect Income Effect

Normal Good

Inferior Good

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 Exceptions to the Law of Demand
• Giffen Goods

• Veblen Goods

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 3. Supply Analysis: The Firm

1. Marginal Returns and Productivity

2. Breakeven and Shutdown Analysis

3. Understanding Economies and Diseconomies of Scale

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 3.1 Marginal Returns and Productivity
Factors of production
or inputs

Labor (L)

Capital (K) Production Output or

Product

Other…

Total product
Output Labor Hours Average Product of Labor
Company X 250,000 250 1,000 Average product
Company Y 450,000 500 900
Company Z 500,000 625 800 Marginal product

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 Total, Average, and Marginal Product of Labor
(L) (QL) (APL) (MPL)
0 0 0 0
1 250 250 250 Increasing marginal returns
2 525 263 275
3 750 250 225
4 900 225 150
5 1,000 200 100
Decreasing marginal returns
6 1,050 175 50
7 875 125 -175
8 600 75 -275

Input productivity and marginal returns are directly related.

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 3.2 Breakeven and Shutdown Analysis
• Economic profit, accounting profit and normal profit

• Marginal revenue is the additional revenue from increasing output by one unit per time period:
ΔTR/ ΔQ
 Perfect competition
 Imperfect competition

• Marginal cost (MC) is the increase in total cost from increasing output by one unit per time period
 Short-run marginal cost (SMC) = w/MPL
 Long-run marginal cost (LMC)

• Average variable cost (AVC) = TVC / Q = w/APL

• Fixed costs generally stay the same over a given rage but move to another constant level when
production increases
 Quasi-fixed costs and normal profit

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 Total, Average, Marginal, Fixed and Variable Costs

Cost Cost
TC

TVC

TFC

Quantity of Output Quantity of Output

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 Tabular Presentation
Q TFC AFC TVC AVC TC ATC MC
0 3,000 — 0 — 3,000 — —
1 3,000 3,000 1,500 1,500 4,500 4,500 1,500
2 3,000 1,500 2,250 1,125 5,250 2,625 750
3 3,000 1,000 3,750 1,250 6,750 2,250 1,500
4 3,000 750 6,300 1,575 9,300 2,325 2,550
5 3,000 600 9,000 1,800 12,000 2,400 2,700
6 3,000 500 13,500 2,250 16,500 2,750 4,500
7 3,000 429 19,500 2,786 22,500 3,214 6,000
8 3,000 375 27,000 3,375 30,000 3,750 7,500
9 3,000 333 36,000 4,000 39,000 4,333 9,000
10 3,000 300 46,500 4,650 49,500 4,950 10,500

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 Demand and Total Revenue Functions
Perfect Competition Imperfect Competition

P P

Q Q
TR TR

Q Q

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 Profit Maximization
Profit maximization condition: MR = SMC and SMC is rising Alternatively: TR – TC is maximized

Perfect Competition Imperfect Competition

Q Q

Is profit maximized when ATC is minimized?

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 Breakeven Analysis
Perfect Competition Imperfect Competition

Q Q

Breakeven when: TR = TC or when AR = ATC

If economic profit = 0, a firm is covering the opportuning cost of all factors of production

Normal profit

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 The Shutdown Decision
Short-Run Decision Long-Run Decision
TR ≥ TC Continue Continue
TR ≥ TVC but TR < TC Continue Exit Assuming that fixed costs are sunk costs
TR < TVC Shut down Exit

Minimum AVC is the shutdown point

Q

Minimum ATC is the breakeven point

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3.3 Understanding Economies and Diseconomies of Scale
• Short-run: at least one factor of production is fixed
• Long-run (planning horizon): all factors of production are variable

STC for different levels of capital input

Shape of the STC curve reflects the
diminishing marginal returns to labor.

The long-run total cost is derived from the

lowest level of STC for each level of output.

The long-run total cost curve is called the

envelope curve. It envelopes or encompasses
Q all combination of technology, plant size and
physical capital.

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 Economies of Scale
Short-run average total cost curves for different
Factors contributing to economies of scale:
plant sizes and long-run average cost curve (LRAC)
• Increase in output larger than increase in input
• Specialization
• More expensive but more efficient equipment
• Lower waste and lower costs
• Better use of market information
• Volume discounts from suppliers

Economies of scale: decreasing long-run cost per unit as output increases.

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 Diseconomies of Scale
Short-run average total cost curves for different
Factors contributing to diseconomies of scale:
plant sizes and long-run average cost curve (LRAC)
• Increases in output are less than increases in input
• Too large to manage efficiently
• Duplication
• Higher labor costs
• Higher resource costs

Diseconomies of scale: increasing long-run cost per unit as output increases.

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 Economies and Diseconomies of Scale

Minimum efficient scale: minimum point on the LRAC curve; represents optimal firm size under
perfect competition in the long-run.

Increasing returns to scale, decreasing returns to scale and constant returns to scale.

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 Application
Scenario 1: Firm A and Firm B are in the same industry. The LRAC curve for Firm A is lower than Firm B’s
LRAC curve. All else equal, which firm is more likely to have higher profitability?

Scenario 2: Firm A is operating to the right of the minimum efficient scale in a perfectly competitive
industry. What is the appropriate action for this firm?

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 Market Equilibrium
Market equilibrium: quantity willingly offered for sale by sellers at a given price is just equal to the
quantity willingly demanded by buyers at that same price.
P

Q
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 Summary
• Elasticity of demand QD = 10 – 0.5 P + 0.06 I – 0.01 PT
 Own price
 Cross price
 Income
• Factors impacting elasticity of demand
• Substitution and income effects
• Normal goods and inferior goods
• Breakeven point
• Shutdown point
• Economies of scale
• Diseconomies of scale

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