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# CHAPTER 1

## DEMAND AND SUPPLY ANALYSIS:

INTRODUCTION
Presenters name
Presenters title
dd Month yyyy

1. INTRODUCTION

Economics
The study of
production, distribution,
and consumption

Microeconomics
The study of markets and
decision making of
individual economic units
Copyright 2014 CFA Institute

Macroeconomics
The study of aggregate
economic quantities
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2. TYPES OF MARKETS
Factor markets are markets for the factors of production.
- The factors of production are the inputs to production.
- Factor markets include labor markets.
Goods markets are markets for the outputs of production.
- 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 firms cash flow and assets (that is, debt
and equity securities).

Demand

Supply

## Willingness and ability

to purchase a good or
service at a given price

Willingness of sellers
to offer a good or
service for a given
price

## THE DEMAND FUNCTION

The demand function is
(1-1)
where
is the quantity demanded of good x
Px is the price of good x
I is the consumers income
Py is the price of good y
In equation form:
The demand curve depicts the quantity demanded for each price.
The law of demand: inverse relationship between price and quantity demanded.
Copyright 2014 CFA Institute

## THE SUPPLY FUNCTION

The supply function is
(1-7)
where
is the quantity supplied of good x
Px is the price of good x
W is the wage rate paid to labor
In equation form:
The supply curve depicts the quantity producers are willing to supply at each
price (or lowest price accepted for each quantity).
The law of supply: a positive relationship between price and quantity.

## CHANGES AND MOVEMENTS

Changes in quantity demanded
Change in its own-price
Movement along the demand curve
Change in price of other goods
Shift in the demand curve
Demand 1
Demand 2

## Changes in quantity supplied

Change in Supply
its own-factor
prices
1
Movement Supply
along2the demand curve
Change in supply
Shift in the supply curve
Price

Price

Quantity

Quantity

## AGGREGATING SUPPLY AND DEMAND CURVES

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

Solving for the equilibrium price or quantity requires setting the demand
function equal to the supply function and then solving.
- We can specify the functions in terms of variables that model behavior
(hence, behavioral equations) or in terms of variables other than own price
and quantity.
- Price and quantity are endogenous variables.
- Other variables, such as the wage rate or consumer income, are exogenous
variables.
There are two equations (supply function and demand function) and three
unknowns, so we must also introduce the fact that the quantity demanded must
be equal to the quantity supplied. That is,
This is the equilibrium condition. Now there are three equations and three
unknowns.

## Copyright 2014 CFA Institute

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

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## DEMAND AND SUPPLY FUNCTIONS

Consider an individuals demand curve:
This means that if the price is 0.5, the quantity demanded is 24.5 units.
The inverse demand curve is the price as a function of the quantity demanded:
This means that at the quantity of 100 units, the price is 15.
Consider a firms supply curve:
This means that if the quantity supplied is 10 units, the price is 15.
The inverse supply curve is the quantity supplied as a function of price :

This means that if the quantity supplied is 10, the price required is 1.5.
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## AGGREGATE SUPPLY AND DEMAND

The aggregate demand curve is the total quantity of goods that would be
demanded at each price.
- We calculate the aggregate demand curve by adding up the quantities (across
individuals) at each price.
The aggregate supply curve is the total quantity of goods that would be
produced for each level of price.
- We calculate the aggregate supply curve by adding up what sellers are willing
to sell at each level of price.
If the aggregate demand curve is
and the aggregate supply curve is
,
we calculate the equilibrium price by equating the demand and supply and solving
for the price. The equilibrium price is 1, and the equilibrium quantity is 15.

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## EXCESS SUPPLY AND DEMAND

If the price of a good is not in equilibrium, we can calculate the excess supply or
demand. Consider the last example:

The equilibrium price is 1. But what if the price were 1.5, instead?

## There would be excess supply of 20 10 = 10 units.

What if the price were 0.5, instead?

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TYPES OF AUCTIONS
Common value auction: The items 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
Suppose we have the following demand and supply curves:

## The equilibrium price is 1, and the equilibrium quantity is 15.

What is the amount of total surplus if the price per unit is 1?
If the price is 1, = 15.
- Intercept with vertical axis (Q = 0): Px = 2.5 0.1 = 2.4.
- Consumer surplus = Area of triangle = 0.5 (2.4 1) 15 = 10.5.
If the price is 1.0, = 15.
- Intercept with the vertical axis (Q = 0): Px = 0.5 + (0.10 0) = 0.5.
- Producer surplus = Area of triangle = 0.5 (1 0.5) 15 = 3.75.
If the price is 0.8, total surplus = 10.5 + 3.75 = 14.25.

## Copyright 2014 CFA Institute

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MARKET INTERFERENCE
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.
- Some consumers gain consumer surplus lost by suppliers, but some
consumer surplus is lost and not picked up by suppliers.
- 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.
- Sellers want to sell more, but buyers purchase less.
- 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
Demand
Equilibrium price

Demand
Equilibrium price

2.5

2.5

2.0

2.0

1.5

1.5

1.0
0.5

Price

1.0
0.5

Quantity

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20

17

14

11

23

20

17

14

11

0.0
8

0.0
5

Supply
Price floor

Price Floor

Price

Supply
Price ceiling

Quantity

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4. DEMAND ELASTICITIES
Own-price elasticity is the sensitivity of the quantity demanded of a good to
changes in the price of the good.
Q
Example for good x:,

where
is the quantity of good x demanded;

Px

is the slope.

## Because the slope depends on the unit of measure of Q, it is preferred to use

the own-price elasticity of demand, , specified as
slope
coefficient

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

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ELASTICITIES: SUMMARY
If the elasticity Then demand is
coefficient is

Interpretation

>1

elastic

demanded

= 1

unit elastic

## % in price results in a similar % change in

quantity demanded

<1

inelastic

## % in price results in a smaller % in quantity

demanded

=0

perfectly inelastic

## % in price does not affect quantity demanded

perfectly elastic

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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
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

1. Degree of substitutability
- The greater the degree of substitutability, the greater the elasticity.
2. Portion of budget spent on the good
- The greater the portion, the greater the elasticity.
3. Time allowed to respond to the change in price
- The longer the time allowed, the greater the elasticity.
4. Extent to which the good is deemed necessary
- The greater the extent to which the good is deemed as necessary, the more
inelastic its demand.

## Copyright 2014 CFA Institute

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INCOME ELASTICITIES
Income elasticity of demand is the change in the quantity demanded of a
good in response to the change in income:

## An income-elastic good is a good that has positive income elasticity: As

income increases, demand for the good increases; also known as a normal
good.
An inferior good is one that has a negative income elasticity: The demand for
the good falls as incomes rise.

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## 5. CONCLUSIONS AND SUMMARY

The basic model of markets is the demand and supply model: Equilibrium
occurs at the price at which the quantity demanded is equal to the quantity
supplied.
Markets are interactions between buyers and sellers.
The price of a good in a market is determined by supply and demand.
Auctions are sometimes used to seek equilibrium prices.
Markets ensure that the total surplus is maximized.
- Sometimes, government policies interfere with the free working of markets,
shifting surplus between consumers and producers, with some loss.
Elasticity is the ratio of the percentage change in the dependent variable to the
percentage change in the independent variable of interest.
- Elasticities are sensitivities of the quantity demanded to either the goods
own price, the price of other goods, or income.

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