CHAPTER 1 DEMAND AND SUPPLY ANALYSIS: INTRODUCTION Presenter’s name Presenter’s 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 Macroeconomics The study of aggregate economic quantities Copyright © 2014 CFA Institute 2

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 firm’s cash flow and assets (that is, debt and equity securities). Copyright © 2014 CFA Institute 3

3. BASIC PRINCIPLES AND CONCEPTS Demand Willingness and ability to purchase a good or service at a given price Supply Willingness of sellers to offer a good or service for a given price Copyright © 2014 CFA Institute 4

THE DEMAND FUNCTION Copyright © 2014 CFA Institute 5 (1-1)

THE SUPPLY FUNCTION Copyright © 2014 CFA Institute 6 (1-7)

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 Changes in quantity supplied Change in its own-factor prices Movement along the demand curve Change in supply Shift in the supply curve Copyright © 2014 CFA Institute 7

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. Copyright © 2014 CFA Institute 8 Price Quantity

SOLVING FOR THE EQUILIBRIUM Copyright © 2014 CFA Institute 9

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. Copyright © 2014 CFA Institute 10

DEMAND AND SUPPLY FUNCTIONS Copyright © 2014 CFA Institute 11

AGGREGATE SUPPLY AND DEMAND Copyright © 2014 CFA Institute 12

EXCESS SUPPLY AND DEMAND Copyright © 2014 CFA Institute 13

TYPES OF AUCTIONS Common value auction: The item’s 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. Copyright © 2014 CFA Institute 14

DUTCH AUCTION: US TREASURY SECURITIES Discount Rate Bid Bid Price per $100 Competitive Bids (in billions) Cumulative Competitive Bids (in billions) Noncompetitive Bids (in billions) Total Cumulative Bids (in billions) % $5 $ % $10$15$5$ % $15$30$5$ % $20$50$5$ % $15$65$5$ % $10$75$5$270 Copyright © 2014 CFA Institute 15 Example: Dutch auction for $120 billion of US Treasury 28-day bills

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. Copyright © 2014 CFA Institute 16 Price Quantity Producer surplus Consumer surplus Total surplus = Consumer surplus + Producer surplus

CALCULATING SURPLUS Copyright © 2014 CFA Institute 17

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. Copyright © 2014 CFA Institute 18

EFFECT OF MARKET INTERFERENCE EQUILIBRIUM PRICE = €1 Price CeilingPrice Floor Copyright © 2014 CFA Institute 19 A

4. DEMAND ELASTICITIES Copyright © 2014 CFA Institute 20 slope coefficient PxPx QxQx a b

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. Copyright © 2014 CFA Institute 21

ELASTICITIES: SUMMARY Copyright © 2014 CFA Institute 22

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. Copyright © 2014 CFA Institute 23

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 24

INCOME ELASTICITIES Copyright © 2014 CFA Institute 25

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 good’s own price, the price of other goods, or income. Copyright © 2014 CFA Institute 26