Economics - Notes de cours 4 PDF

Preview

Summary

CFA 1st Degree Training (EBP-B5-FIN-006-E-L-BOD CFA) - 2017-S2 (Toutes sections)...

Description

ECONOMICS Topics Demand and Supply Analysis Price Elasticity of Demand %∆Qd/%∆P which can become (P₀/Q₀) x slope of P Elastic price increase leads people to search for a substitute and decreases demand. The flatter the demand curve the more elastic demand is. Inelastic ∆ in price has little impact on demand. i.e. a drug you need to survive. The more inelastic demand the steeper the demand curve. Factors that make something more elastic 1. Availability of substitutes. The more substitutes the more elastic demand will be. 2. Portion of income spent on good. The more income spent the more elastic you are going to be. 3. Time. Elasticity increases with time b/c people have more time to respond and change consumption behavior. Cross-price elasticity of demand %∆ in Qd of a good / %∆ in P of a related good, which becomes P₀ of good/Q₀ x slope Substitute An increase in the P of a related good increases demand for a good (ie price of Crest toothpaste goes up so you buy Colgate). Positive cross price elasticity of demand. Complements Increase in price of a related good decreases demand for a good. I.e. Coke and pizza. Negative cross price elasticity of demand. Substitution Effect The decrease in a price of a good always increases consumption b/c people substitute in more of this good Income Effect Positive for a normal good and negative for an inferior good. In some cases a strong negative income effect can outweigh the positive substitution effect (i.e. Giffen Effect)

The Firm and Market Structures What are the four main criteria for differentiating types of markets? Markets are differentiated based on four main criteria: • • • •

The # of firms and their relative sizes The elasticity of the demand curves they face The competitive dynamics between firms (i.e. how they fight for sales) The barriers to entry (or lack thereof) for firms to enter and exit the market

List the key characteristics of Perfect Competition.

1|

ECONOMICS On the most competitive end of this spectrum we have perfect competition where firms compete solely on price with a non-differentiated product (e.g. wheat). Perfect competition will have zero long term economic profits. It is characterized by: • • • • • • •

Large number of independent firms, each small relative to the total market A homogenous / standardized product – i.e. perfect substitutes Very low barriers to entry Zero pricing power for individual firms A perfectly elastic (horizontal) demand curve faced by each firm Firms compete exclusively on price (which is determined by market supply and demand) List the key characteristics of Monopolistic Competition. Monopolistic competition is the next most competitive market after perfect competition. Monopolistic competition is characterized by somewhat differentiated products. Think your brand of toothpaste etc. Monopolistic competition will have zero long term economic profits. •

• • • • • • •

Large number of independent firms with small market share A slightly differentiated product with many close substitutes Low barriers to entry Quite limited pricing power – results from advertising and product differentiation Demand is elastic, the demand curve is downward sloping Fierce competition on price, features, and marketing List the key characteristics of Oligopoly. • Oligopoly markets are characterized by only a few firms competing. Thus firms must be very aware and respond directly to the moves made by their competitors in terms of setting prices / strategy. Firms are interdependent. Oligopolies will have positive long term economic profits. •

• • • • • •

The characteristics of monopolistic competition include:

The characteristics of oligopoly include:

Few sellers (no more than a handful) Either an identical product (e.g. oil) or slightly differentiated (e.g. car manufacturers) High barriers to entry Pricing power ranges from moderate to significant Demand is elastic (can be more or less than in monopolistic competition) and downward sloping Fierce competition on price, features, and marketing List the key characteristics of Monopoly. Monopolies are characterized by a single seller with no close substitutes for their product. Monopolies generally arise because of control over a natural resource, government protection (patents), or technological network effects. A natural monopoly is one that results from economies of scale (decreasing cost of production). Monopolies will have positive, significant long term economic profits b/c of high barriers to entry and lots of pricing power. Characteristics include:

• • • • • •

A single seller A product with no (good) substitutes Very high barriers to entry Significant pricing power Demand is the market demand curve and is downward sloping Competition for market share is based on advertising

2|

ECONOMICS •

Summarize the 4 Types of Market Structures by # of sellers, product differentiation, barriers to entry, pricing power, long-run profits, and the type of demand curve they face

Graphically identify Long-run Equilibrium in Perfect Competition and discuss the long-term equilibrium mechanism. We start at point A earning positive economic profits. Because barriers to entry are low, if firms are earning positive economic profit new firms will enter the market. This shifts the market supply curve down and to the right, increasing the quantity and lowering price until eventually P = ATC and there are zero economic profits. Thus the long run equilibrium with perfect competition occurs where P = MC = ATC.

Identify the Long-run Equilibrium point in Monopolistic Competition. A firm will produce where MR = MC. The graph of the short run on the left should look familiar. But what happens in the long run? Again because barriers to entry are low new firms will enter the market if economic profits are positive. This will increase the diversity of products in the marketplace, reduce demand for each individual firm, and driving price to the ATC.

3|

ECONOMICS

• • •

List the Differences between Perfect competition and Monopolistic competition. First, we see that in monopolistic competition Price ≠ MC, as a firm has the ability to mark up its price (so P > MC). That means that the MR = MC level of output for each firm will actually occur at a less than efficient level (Q < efficient quantity). Finally, because firms compete on product differentiation there tends to be greater product diversity and product innovations Describe the Long run move to equilibrium and resulting economic profit under Perfect Competition. We start at point A earning positive economic profits. Because barriers to entry are low, if firms are earning positive economic profit new firms will enter the market. This shifts the market supply curve down and to the right, increasing the quantity and lowering price until eventually P = ATC and there are zero economic profits. Thus the long run equilibrium with perfect competition occurs where P = MC = ATC. For an individual firm any change in price/MR will impact their optimal output decision. If the change in either demand or supply is permanent a firm will adjust in the long run by either increasing their capacity or exiting the market. If we’re dealing with a situation of negative economic profit, as those firms exit the market supply curve will shift and prices will increase until we reach a new equilibrium.

Describe the Long run move to equilibrium and resulting economic profit under Monopolistic Competition.

4|

ECONOMICS Define the Kinked Demand Curve theory under Oligopoly.

1. There is a section of the demand curve where the competitor will NOT follow a price increase 2. There is a section of the demand curve where the competitor WILL follow a price decrease This is determined by the perception of the elasticity of the demand curve. •

•

•

Left of the kink represents an area where a firm believes that if it raises prices its competitors will not follow suit (i.e. the firm’s demand is more elastic/curve is flatter) and it will lose market share if P↑ Right of the kink competitors will follow P↓ by cutting their own prices (so demand curve is thought to be relatively inelastic). Price war leads to TR ↓ but not a large increase in market share Note the discontinuous section of the marginal revenue curve. Fluctuations of the MC curve within this discontinuous portion of MR leave the profit-maximizing price and quantity unchanged. What is the Cournot Duopoly Model? Model assumes only two firms competing in the market with identical and constant marginal costs. Each firm knows how much is supplied by the other firm and can anticipate its future output. Thus the firms can subtract the competitor quantity supplied from the market demand curve in order to build their own demand and marginal revenue curves in order to maximize profit. Under the model, firms will continue to make adjustments each period (simultaneously) until the quantities supplied eventually become equal. Once that occurs there is no longer any additional profit to be made and we will have reached a stable equilibrium where MP > Efficient price. What is the Prisoners’ Dilemma and how does it relate to oligopoly?

5|

ECONOMICS

The optimal solution is for both prisoner’s to remain silent, however, if they make the rational choice in pursuit of their own self-interest given the possible actions by other players they will actually both choose to confess. This choice is an example of a Nash equilibrium. The same thing occurs with duopolies competing on price. Define a Nash Equilibrium. A Nash equilibrium is reached when the choices of all players leads to a situation in which there is no other choice that makes any other player better off. In the prisoner’s dilemma the Nash equilibrium is for both prisoners to confess since neither prisoner will then have the unilateral ability to increase their outcome. In oligopoly the Nash equilibrium is for both firms to cheat on price in order to try to capture more market share. What Factors increase the chances of Collusion? The ability to collude in oligopoly can lead to higher economic profit for all firms (it will more closely resemble a monopoly). But enforcing or maintaining collusion can be difficult (and is often illegal). Collusion, or cartel behavior, is more likely to occur / be enforceable if: • • • • • • • • •

There are fewer firms The threat of new entrants is low Products are more homogenous (less differentiation) Cost structures are similar Relatively small and frequent purchases Retaliation is swifter, more guaranteed, and severe Anti-collusion laws and enforcement are weak Describe the dominant Firm Model in Oligopoly. In the dominant firm model one firm maintains a dominant market position because of its scale and lower cost structure over other smaller competitors. In this case, the dominant firm (DF) acts like a monopoly and is a price-setter, setting its price and output to maximize profit (where it’s MR = MC). The other firms have to take this price as given and will produce where their MC = Price (just like in PC).

6|

ECONOMICS

•

What is price discrimination? Price discrimination occurs with monopolies. It is the practice of charging different consumers different prices based on their willingness and ability to pay. It is only possible if: • • •

Consumers are unable to resell the product The monopoly is able to engage in price discovery Describe Profit Maximization in Monopoly and compare social welfare relative to perfect competition. • A monopolist in a single price environment will maximize their profit where MC = MR. To find profit from there you need to go up to the demand curve to find the price at which the monopolist will sell the optimal quantity (Q*) indicated by the intersection of the curves.

•

Note that the profit maximizing quantity will always lie on the elastic part of the demand curve. Compared to perfect competition a monopolist will produce less than the efficient amount resulting in a DWL.

•

7|

ECONOMICS •

Consumer surplus is reduced not just by the reduction in quantity but also by the higher price a monopolist will charge on each unit. What is Price Discrimination? When is it possible? (Profit Maximization in Monopoly) Long run Shifts, Profitability, & Moves to Equilibrium in Monopoly The goal of the monopolist with price discrimination is to capture more economic profit (which comes from their increased ability to capture consumer surplus). The most common example of this is tickets. Price discrimination is possible when:

• • •

There is a downward sloping demand curve There are at least two identifiable customer groups with different price elasticities of demand It is possible to prevent customers from reselling the product Take the theoretical example of perfect price discrimination. A monopolist would be able to charge each consumer exactly what they felt the good was worth (i.e. the price = demand curve). This would lead to them producing the market efficient amount but capturing all of the CS as profit. What is a natural monopoly? Natural monopolies occur when there are significant economies of scale (and the average cost of production falls for a single firm through the relevant range of consumer demand). Generally this occurs in industries with high fixed costs and low variable costs We can tell there is a natural monopoly if another firm entering the market would increase the average cost of production would increase for both firms. Regulations are put in place to ensure that a natural monopoly will not cause too significant a DWL. This can be through efforts to encourage competition or by regulating the price monopolies are allowed to charge. Define Price Regulation, Average Cost Pricing & Marginal Cost Pricing. Average cost pricing is the most common form of regulation. It involves reducing price to where ATC intersects demand. This increases output and social welfare (and economic profit = 0). Marginal cost pricing, also called efficient pricing, involves reducing price to where MC equals demand. This actually causes the monopolist to lose money, however, because the price is below the ATC. In response the government will create a subsidy to allow for a normal profit. Summarize the profit maximizing price point for PC, MC, oligopoly, and monopoly.

8|

ECONOMICS • •

How can you use Elasticity to identify the type of market? A high elasticity would tell us we’re close to perfect competition A low elasticity would indicate monopoly-like conditions Bonus: What slope indicates which type of elasticity? In practice, however, measuring elasticity is very difficult. Another approach is to use regression analysis (either cross-sectional or time series) to estimate the elasticity of supply and demand. Again this is quite complex and often hard to achieve which is why we also use concentration measures as a proxy for market power. What is the N-firm concentration ratio? The N-Firm concentration ratio is calculated as the sum of or percentage market shares of the largest N firms in the market. As a general rule of thumb we’d classify the market according to how concentrated those N firms were in terms of overall market size:

A key limitation to the N-firm ratio is that it does not account for mergers amongst the top firms. What is the Herfindah-Hirshman Index (HHI)? HHI is the sum of the squared % market share of the n largest firms in a market. An HHI = 1 would indicate a perfectly competitive industry. Unlike the n-concentration ratio, HHI does change to account for mergers amongst the top firms. Both HHI and N-concentration ratio do not consider barriers to entry and potential competition in assessing the type of market (i.e. they’re not a direct measure of market power).

Aggregate Output, Prices, and Economic Growth What is GDP? Gross domestic product is defined as the market value of all goods and services produced within a nation during a particular period of time (typically a year). • • • • • • • • •

Market prices are used to determine value Only "final" goods and services (those consumed by the end user) are included. It does include an estimated value of occupying your own home What are the Limits to using GDP to measure value? Does not account for changes in quality or introduction of new goods, i.e. the smartphone Does not value/take into account Leisure and things like safety on the job Ignores the underground / barter economy Does not account for negative externalities like pollution Things you make / grow but do not sell are not accounted GDP – Expenditure vs. Income Approach. Two different approaches are used to calculate GDP: Expenditure vs. Income. In theory, the amount spent for goods and services should be equal to the income paid to produce the goods and services, and other costs associated with those goods and services so these should be equivalent.

•

Expenditure Approach: ∑Total spent on on goods & services in the country during a given time period

9|

ECONOMICS •

Income Approach: ∑Total income earned by households & businesses in the country during a given time period Compare Nominal vs Real GDP. This is a KEY concept. Nominal GDP measures the value of goods at services at their current price. It includes inflation in the price. That is:

Real GDP measures that value using prices from a given base year.

Taking different price levels into account is essential to figuring out if we’re actually better off in terms of our ability to buy more stuff Nominal GDP will be higher than Real GDP. We switch between them with the GDP Deflator. What is the GDP Deflator and how is it calculated? We use the GDP deflator to compare nominal and real GDP. The deflator is a price index that converts output measured at current prices into prices measured in a base year. Removing the effect of pricing changes shows how much a change in the base year's GDP relies upon changes in the price level.

Calculate GDP under the Expenditure Method. GDP=C+I+G+(X−M) C = Consumption – Personal/Household expenditures, sometimes broken down into durable goods, non-durable goods, and services. Makes up about 70% of GDP (in the USA) I = Investment, Gross Private Investment (fixed income and changes in business inventory) G = Government expenditures. Does not include transfer payments X = Exports M = Imports (X−M) = Net exports 10 |

ECONOMICS Define: National Income Personal Income Personal (disposable) Income National Income is the sum of all income received by the factors of production and used in the production of final output. This can include employee compensation, corporate and government profit, interest income, rent, and indirect business taxes net of subsidies. Personal income is the pretax income received by households (i.e. your take home pay). It is a determinant of purchasing power (recall income elasticity from microeconomics? Personal disposable income takes out the taxes you owe. Its personal income after taxes. = Income×(1−Taxes). It’s an indicator of how much consumers can spend and save. How does private saving and investment relate to the fiscal and trade balance? Private saving and investment relate to both the fiscal and trade balance. A fiscal deficit is financed by some combination of a (1) trade deficit and/or (2) more private saving than private investment. Note the following equation is derived from a combination of the income and expenditure models of GDP.

Define and calculate Aggregate Demand. Aggregate demand shows the relationship between the quantity of real output demanded (=real income) and the price level. It slopes downward because higher prices decrease real wealth, increase interest rates, and make domestic goods more...