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CFA LEVEL 1 – MICROECONOMICS
DEMAND AND CONSUMER CHOICE
Explain consumer choice in an economic framework.
Choice assumptions:
1. Individuals have fixed incomes.
2. Consumers make decisions to maximize their welfare.
3. Substitute goods are available.
4. Perfect information is never available.
5. As consumption increases, the marginal utility gained from next unit of consumption
decreases.
Marginal utility: Measures how much additional utility a person gets from the
consumption of another unit of the good.
Law of diminishing marginal utility: As consumption of an item increases the utility
received from the consumption of the item decreases.
Substitution effect: If a good becomes cheaper relative to other goods, you'll consume
more of that good. If two goods are complements then when the price of one decreases
you’ll consume more of both goods.
Income effect: As the price of a good decreases, one's real income increases, hence you'll
consume more of that good.
Time cost: As time is scarce, if the time cost for an activity or good is lower one will
consume more of that good.
Consumer surplus: Is the difference between the maximum amount a consumer is
willing to pay for a good and the amount actually paid.
Identify the factors that cause a demand curve to shift.
Movement on the demand curve is influenced by the price of the product.
Factors that cause a demand curve to shift - a change in:
1. consumer income
2. income distribution
3. prices of substitutes and complement products
4. market demographics
5. consumer preferences
6. expectations about future prices
Explain the difference between a change in demand and a change in quantity
demanded.
A change in demand leads to a shift in the demand curve (due to the above factors). A
change in quantity demanded leads to a movement along the demand curve, which is in
response to price changes.
Discuss the effects of advertising on consumer decisions.
Advertising delivers information about price, quality and availability, and assists the
consumer to make an informed decision. Opponents state it is wasteful, misleading and
manipulative.
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CFA L1 - Microeconomics
Describe price elasticity of demand and identify its determinants.
Price elasticity of demand is the percentage change in the quantity of a product
demanded divided by the percentage change in the price of a product (%∆Qd / %∆P).
If price elasticity of demand is elastic (>1) a small price change leads to a large change in
quantity demanded (e.g. a decrease in price will increase expenditure on that good).
If price elasticity of demand is inelastic (<1) a large price change results in a small change
in quantity demanded (e.g. a decrease in price will decrease expenditure on that good).
Percentage change in the price elasticity equals the change in the variable divided by the
average of the variable.
Determinants of price elasticity: Availability of substitutes; share of one's budget spent
on the product; adjustment time; total expenditure.
Income elasticity is the percentage change in the amount of a product demanded divided
by the percentage change in consumer income (%∆Qd / %∆Y). It tells how responsive the
demand for a good is to a change in income.
Normal goods have an income elasticity >0. Other normal goods, such as luxury
goods--which exhibit a large change in quantity demanded given a small change in
income--have an income elasticity >1. Necessity goods--with a large change in income
they exhibit a large change in quantity demanded--have an income elasticity >0<1.
Inferior goods--as income increases, quantity demanded falls--have an income elasticity
<0.
Describe the effect of tax policy on price elasticity.
Goods with inelastic demand allow producers to "pass along" a tax increase to the
consumer. Goods with elastic demand force sellers to absorb a portion of the new tax. If
supply is elastic consumers will bear most of a tax increase.
Elasticity of supply is the percentage change in quantity supplied divided by the
percentage change in price (%∆Qs / %∆P).
Costs and the Supply of Goods
Describe the principal-agent problem of the firm.
When ownership (principal) and management (agent) have different objectives it is
difficult or costly for the principal to monitor the agent's actions. There is an incentive for
the agent to shirk work.
Distinguish between (1) explicit costs and implicit costs, (2) economic profit and
accounting profit, and (3) the short run and the long run in production.
Explicit costs are measurable cash flows for operating expenses. Implicit costs measure
opportunity costs of using a firm's assets (i.e. the opportunity cost of a machine is the
highest return available from an alternative use).
Economic profit includes implicit and explicit costs. Economic profit is also the difference
between the firm's total revenues and total costs. Accounting profit includes only
explicit costs. Zero economic profit means that the firm earns a normal rate of return.
Accounting profit exceeds economic profit by the normal rate of return. (Accounting
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CFA L1 - Microeconomics
profit is sales revenue minus expenses over a time period. No allowance is made for the
opportunity cost of equity capital of the firm's owners, or other implicit costs).
Total cost equals the explicit plus implicit cost. Total cost equals fixed costs plus
variable costs.
The short run (SR) is the period over which plant and equipment cannot be changed;
costs in the SR are sunk. The long run (LR) allows the firm to change all its production
methods and resource usage – all resources are variable.
The opportunity cost of equity capital (which is the implicit rate of return) (which is
equal to implicit cost) to induce investors to continue to supply capital to the firm is the
rate of return which could be earned if the capital was put to the next best use. It is also
called the normal rate of return.
Accounting profit equals sales revenue minus expenses over a time period. No allowance
is made for the opportunity cost of equity capital of the firm's owners, or other implicit
costs.
Define various types of costs, including opportunity costs, sunk costs, fixed costs,
variable costs, marginal costs, and average costs.
Opportunity cost equals the highest return available from an alternative use.
Sunk costs equal the costs that have already been incurred as a result of past decisions.
Fixed costs equal costs that do not vary with output. They will be incurred as long as a
firm continues in business and the assets have alternative uses.
Variable costs are those that vary with the rate of output (e.g. wages, and payments for
materials).
Marginal cost is the change in total cost required to produce an additional unit of output.
Explicit costs equal payments by a firm to purchase the services of productive resources.
Implicit costs equal the opportunity costs associated with a firm's use of resources that it
owns. These do not involve a direct money payment, e.g. the business owner's labor.
Opportunity cost equals the highest valued alternative that must be sacrificed as a result
of choosing among alternatives. The opportunity cost for using a resource, to the
resource owner, is the foregone highest valued alternative.
Average total cost equals average fixed cost plus average variable cost.
Average total cost equals fixed cost divided by the number of units produced, plus
average cost divided by the number of units produced.
State the law of diminishing returns and explain its impact on a firm's costs.
As more and more units of a variable resource are combined with a fixed amount of
other resources, employment of additional units of the variable source will eventually
increase output only at a decreasing rate. Once diminishing returns are reached it will
take successively larger amounts of the variable factor to expand output by one unit.
This implies that marginal costs are increasing, so that as quantity of output increases
associated costs are increasing at an ever increasing rate, so that total cost rises per unit
of output.
Define economies of scale and explain how diseconomies of scale are possible.
Economies of scale: Reduction in the firm's per unit costs that are associated with the use of
large plants to produce a large volume of output - unit costs decline as output expands.
Diseconomies of scale are present when costs rise as output increases.
Constant returns to scale: Unit costs are constant as scale of the firm is altered.
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CFA L1 - Microeconomics
Identify the factors that cause cost curves to shift.
(1) Price of resources, (2) taxes and (3) technology. An increase in the cost of one or
more increases the marginal cost of a unit of output, thus increasing average total cost
and shifting average cost curves upward.
Price Takers and the Competitive Process
Distinguish between price takers and price searchers.
Price takers are firms that must take the market price as given.
They face a perfectly elastic demand curve.
Price searchers are firms which have price setting power.
They set a price to maximize profit.
They face a downward sloping demand curve.
List the conditions that characterize a purely competitive market.
Purely competitive market:
-all firms in the market produce a homogenous product.
-there are a large number of independent firms.
-each buyer and seller are small relative to the total market.
A firm, as a price taker, has a demand curve that is purely elastic. The market's supply
and demand determines the price; the firm has no control over price and must sell at that
price.
Identify the conditions under which a price taker would maximize profits.
A price taker will increase output until MC=MR where short-run (SR) profits are
maximized to the point where MR=MC=P, and where total revenue minus total cost is
maximum. The demand curve for the firm overlaps the price curve and MR curve, so
d=P=MR. Losses will occur when P<ATC. But if the firm believes it is temporary and
can cover its variable cost (i.e. P>AVC) it will continue to operate at a loss but cover its
fixed cost. If the firm believes the situation is temporary but can't cover its variable cost
(P<AVC) then it will shut down because it is losing more than its fixed cost. It must go
out of business if the price won't ever again exceed ATC, as this is the only way to
eliminate fixed costs.
Describe the short-run supply curve for a firm and for a competitive market.
The short run supply curve is the portion of the marginal cost curve above the AVC
curve. The short run supply curve for the market is the sum of the short run supply
curves of all firms.
In the long run there is free entry and exit; so if there are profits more firms will enter,
thus increasing supply and reducing prices and profits. In the long run profits are zero
- zero economic profit means the firm earns a normal rate of return. The firms long run
supply curve is more elastic.
Describe the factors that determine the shape of a long-run supply curve.
The long run supply curve indicates the minimum price at which firms will supply
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CFA L1 - Microeconomics
various output levels. The shape of it depends on the shape of the industry's
production cost schedule:
Constant cost industries: production costs remain constant as output expands; supply is
perfectly elastic or horizontal.
Increasing cost industries: production cost rises as output increases; supply is directly
related to price and the curve sweeps upward to the right.
Decreasing cost industries: production cost declines as the industry expands; supply is
inversely related to price; the curve sweeps down to the right (which is atypical).
Price-Searcher Markets with Low Entry Barriers
List the distinguishing characteristics of competitive price-searcher markets.
Or Monopolistic competition.
These are markets where firms have some power to set prices but barriers to entry and
exit are low. A monopolistic competitive firm faces a downward sloping demand curve.
In a monopolistic competitive market:
-there are a large number of independent sellers.
-each produces a differentiated product.
-the market has low barriers to entry.
Explain how price searchers choose price and output combinations.
Price searchers produce until MC=MR (similar to price takers) but a monopolistically
competitive firm does not produce at a point where marginal revenue equals price (as
does the price taker) but at a point in the long run where MR=MC and d=P=ATC and
where he earns zero profit. In the short run there may be profit or loss.
Summarize the debate about the efficiency of price-searcher markets with low barriers
to entry.
A monopolistically competitive firm faces a downward sloping demand curve; in the
long run he doesn't produce at a point where ATC is minimized. Competitive price
searcher markets do not achieve allocative efficiency but they do have competition in
quality and product differentiation.
One is unsure whether competition in quality makes up for the utility loss from
inefficient levels of production (that is, increased social cost from not producing where
price equals marginal cost) relative to perfectly competitive markets.
Explain why competition is an important disciplinary force in a market where barriers
to entry are low.
Competition promotes economic progress by:
-promoting efficient production and consumer satisfaction.
-providing incentive for firms to find new and more efficient production technologies.
-encouraging firms to find the optimal scale of production.
Price-Searcher Markets with High Entry Barriers
Identify entry barriers that protect some firms against competition from potential
market entrants.
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CFA L1 - Microeconomics
1. Economies of scale
2. Government licensing and legal barriers
3. Patents.
4. Resource control
List the distinguishing characteristics of a monopoly and an oligopoly.
A monopolist is a price searcher, and
1. The single seller of the product.
2. A well-defined product.
3. No substitutes.
4. High barriers to entry.
Oligopoly:
1. A small number of sellers.
2. Interdependence among competitors.
3. Large economies of scale.
4. Significant barriers to entry.
5. Either homogenous or differentiated products.
Describe how a profit-maximizing monopolist sets prices and determines output.
A monopolistic faces a downward sloping demand curve. Marginal revenue is positive
(MR>0) in the elastic and negative (MR<0) in the corresponding sections of the demand
curve – MR<P and the marginal revenue curve lies below the demand curve.
A monopolist only sells in the elastic section of the demand curve because as price
decreases marginal revenue will increase, therefore production expands to an optimal
output quantity, where marginal revenue equals marginal cost.
The demand curve must live above ATC. Price is set on the demand curve where
output is optimal (i.e. where marginal revenue equals marginal cost).
Discuss why oligopolists have a strong incentive to collude.
Collusion is an agreement between firms to avoid various competitive practices,
particularly price reductions.
Oligopolists collude to maximize profits that are not possible in a competitive market –
without competition, the quantity produced is reduced and sold at a higher price. With
competition price reduction will occur to where LRATC=P and at a lower price, greater
output and where zero economic profits are achieved. Oligopolists will form a cartel,
which is an organization of sellers designed to coordinate supply decisions so that the
joint profits of members will be maximized.
Identify the obstacles to collusion among oligopolistic firms.
Obstacles to collusion:
1. When the number of oligopolists is large, effective collusion is less likely.
2. When it is difficult to detect and eliminate price cuts, collusion is less attractive.
3. Low entry barriers.
4. Unstable demand conditions.
5. Vigorous antitrust action increases the cost of collusion.
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CFA L1 - Microeconomics
Review policy alternatives to reduce the problems stemming from high barriers to
entry.
1. Restructuring industry to allow natural monopolies.
2. Reduced artificial barriers to trade.
3. Regulate the protected producer by placing price ceilings on monopoly pricing. For
example, first, average cost pricing - this increases output, decreases price, increases
social welfare and ensures the monopolist has normal (i.e. zero economic) profit. Second,
marginal cost pricing – this forces the monopolist to reduce price to where the MC curve
equals the demand curve; this will increase output and reduce price, but the monopolist
will incur a loss requiring a government subsidy.
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CFA L1 - Microeconomics