In the following post, we`ll present this concepts in a form of study note as a part of preparation for CFA Level 1 exam. The demand and supply analysis is part of CFA Curriculum. It can be found in Reading 8 as part of the topic no. 2 called Economics. You can find the complete CFA Curriculum by following this link.
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INTRODUCTION
The law of supply and demand is one of the key concepts in economics, or more precisely microeconomics. While economics is the study of production, distribution, and consumption, microeconomics focus on behavior of individual market participants and their decision making regarding the allocation of scarce resources.
DEMAND
Demand is an economic principle describing consumers’ willingness and ability to purchase certain quantity of goods at various prices. Relationship between quantity and price is known as the law of demand. It is inverse relationship described by demand curve: as price increase, consumers demand less of a good or service.
Main factors influencing the quantity demanded, apart from price, are income and prices of related products. Elasticity is the measure of change in quantity demanded as a result of percentage change in one of these main factors. Therefore, we can distinguish:
PRICE ELASTICITY
Price elasticity – with the change in price, demand moves along the demand curve. There are also two extreme cases. First where quantity demanded is very responsive (perfectly elastic demand) or not responsive at all (perfectly inelastic demand).
INCOME ELASTICITY
Income elasticity – with the change in income demand curve shifts inward or outwards. There are several factors that can influence the shift in demand and they can be remembered by acronym B.I.T.E.R. (Buyers, Income, Tastes and preferences, Expectations, Related goods).
Normal goods have positive income elasticity, meaning that increase in income leads to an increase in quantity demanded. For inferior goods, opposite is true, meaning that increase in income actually leads to a decrease in quantity demanded. Most common examples are junk food, public transport, cheap clothes, supermarket own brand goods etc. This is determined by consumer behavior. With higher income, some consumers will shift to more expensive products because of higher quality, socio-economic status, extra features of products etc.
CROSS PRICE ELASTICITY
Cross price elasticity tries to identify relations between goods. Substitute goods may be used instead of another good. It means that increase in price of one good will lead to decrease in quantity demanded of that good and eventually increase the demand for substitute good. For example if price of apple juice increases, consumers can easily substituted it by orange juice. Same case is for cigarettes and e-cigarettes, tea and coffee, butter and margarine etc.
Complementary goods, on the other hand, are goods that are used or consumed jointly with another product. Therefore, if price of one good increases and quantity decreases, this will also lead to decrease in demand of complementary good.
For example, cars and petrol are complementary goods. If price of one goes up, the demand for both the goods will fall. Other examples are printers and ink cartridges, computer hardware and software, gaming consoles and video games etc.
INCOME EFFECT
When faced with a budget constraint, optimal choice that maximizes consumer`s utility is when an indifference curve is tangential to the budget line. Budget line consists of all bundles that are affordable at given prices and income.
Figure shows several indifference curves for consumers. Obviously, I1 is preferred to I0 and I2 is preferred to I1 but this is not affordable due to budget constraint. Therefore, if consumer behave rationally, most preferred affordable combination is achieved at point E (tangent point between indifference curve and budget line). Optimum quantities of Good A and Good B are achieved showing us how much of each good will be demanded by consumer.
SUBSTITUTION EFFECT
Now let`s assume a change in price of Good B. If price decreases, demand for Good B will increase and as a result, Good A is now relatively more expensive in terms of Good B and Good B is now relatively less expensive in terms of Good B. Change in consumption such that the consumer’s level of utility does not change is measured by the substitution effect. It is therefore shown as a movement along the same indifference curve and results in a change in consumption from Q0 to Q1. Due to the price decrease of Good B there is a part of income left over and consumers will typically respond by buying more of the cheaper product. This is called income effect.
This is valid when Good A and B are normal goods. However, income effect can also decrease in case of inferior or Giffen goods and cause following total effects:
Special case are Veblen goods where higher price could actually lead to higher demand and upward slopping demand curve. Some examples of Veblen goods are designer handbags, jewelry, luxury cars etc.
Presented by graph, income effect in case of inferior effect would lead to decrease in demand but this effect is weaker then substitution effect:
quantity demanded of Good B will decrease. Good with such a properties are called Giffen goods. It should be noted that every Giffen good is an inferior good but every inferior good is not necessarily a Giffen good. Graphically, this case can be presented as:
PREPARATION FOR CFA
After finishing the Reading, CFA candidates should master the following Learning outcomes:
Learning outcomes
a) calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure;
b) compare substitution and income effects;
d) describe the phenomenon of diminishing marginal returns;
e) determine and interpret breakeven and shutdown points of production;
f) describe how economies of scale and diseconomies of scale affect costs
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