CFA Level I Economics

Demand and Supply Analysis: Introduction

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 Contents
1. Introduction

2. Types of Markets

3. Basic Principles and Concepts

4. Demand Elasticities

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 1. Introduction
Economics is the study of production, distribution, and consumption; it is
divided into two broad areas: Microeconomics and Macroeconomics

Macroeconomics deals with aggregate economic quantities, such as

national output and national income

Microeconomics deals with markets and decision making of

individual economic units, including consumers and businesses.

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 2. Types of Markets
Factor markets refers to the markets for factors of production
Natural resources, mineral wealth, raw materials, labor
Firms are buyers

Goods markets refers to the markets for consumer goods and services
Firms are the sellers
Intermediate markets are where one firms outputs are another firms inputs

Capital markets refers to the markets for long term financial capital
Borrow money by selling debt instruments
Sell claims to ownership by selling equity instruments
Capital markets also include the secondary markets where debt and equity claims are
subsequently traded

Example 1
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 3. Basic Principles and Concepts
Demand is the willingness and ability of consumers to purchase a given amount
of a good or service at a given price.

Supply is the willingness and ability of sellers to offer a given amount of a good
or service at a given price.

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 3.1 The Demand Function and Demand Curve
Law of demand: as the price of a good rises, buyers will choose
to buy less of it, and as its price falls, they buy more

P
Demand function for Good A: QD = f(PA, I, PB)

QD = 10 0.5P + 0.06I 0.01PT

QD = 100 0.5P

Inverse demand function

P = 200 2Q

Q
Demand curve: graph of the inverse demand function

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 3.2 Changes in Demand vs. Movements along the Demand Curve
When own-price changes change in quantity demanded (movement along the demand curve)

A change in any other variable will shift the demand curve (change in demand)
Shift is both vertical and horizontal; what is the interpretation?

Changes (or shifts) in demand can be caused by changes in:

Income
Price of substitutes
Price of complements
Example 2
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 3.3 The Supply Function and Supply Curve
The willingness and ability to sell a good or service is called supply
Willingness to sell depends on price (P) and cost to produce (W)
Selling price marginal cost
Supply function for Good A: QSA = f(PA, W, )
P
Q = -300 + 4P 10W

Say W = 10, Q = -400 + 4P

Inverse supply function:

P = Q/4 + 100

Supply curve
Q

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 3.4 Changes in Supply vs. Movements along the Supply Curve
Law of supply: rise in price greater quantity supplied

Say W goes down from 10 to 7

Change in supply Shift

Horizontal movement

Vertical movement

Example 3
Q

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 3.5 Aggregating Demand and Supply Functions
Market: collection of demanders and suppliers

Aggregate demand by adding all buyers

Individual demand function:
QD = 100 0.5P
100 similar buyers of chairs.
What is the market demand?

Aggregate supply by adding all suppliers

Say we 2 similar suppliers
What is the supply curve?

Example 4 Example 5
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 3.6 Market Equilibrium
Market equilibrium: quantity willingly offered for sale by sellers at a given price is just equal to the
quantity willingly demanded by buyers at that same price.
P

Q
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 Solve for Equilibrium Quantity
Equilibrium Condition: Find the price such that Quantity Demanded = Quantity Supplied
Quantity Demanded = 10,000 50P and Quantity Supplied = -800 + 8P

Partial equilibrium analysis: concentrate on one market, taking values of exogenous variables as given

General equilibrium analysis: consider all variables and how they interact

Example 6
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 3.7 The Market Mechanism
Market Mechanism: price must adjust until there is neither an excess supply nor an
excess demand

P D P D
Excess Supply S
S

Excess Demand

Q Q
Example 7
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 More on Market Mechanism
Stable equilibrium

Unstable equilibrium
Both demand and supply are downward sloping
Non-linear supply curves

Price bubbles

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3.8 Auctions as a Way to Find Equilibrium Price
Common value auction: value of the item is the same to all bidders but may be unknown
Private value auction: value of the item is specific to each bidder

Auction Mechanisms

Ascending price (English) auctions

Sealed bid auction

Second price sealed bid (Vickery) auctions

Descending price (Dutch) auction

Single price Dutch auction

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 Dutch Auction Examples
Example 1: Company wants to buy back 3 million shares; offers to buy back at price between $26 and
$28. Current market price is 25.

Example 2: Treasury announces it will auction six-month T-bills with face value 100 million. Non-
competitive bids: 10 million. What is the winning price given the following competitive bids? What
percentage of the order will be filled for each bidder. Assume a single price auction.
Discount Price per Amount
rate bid 100 (millions)
2.0% 99.00 40

2.2% 98.90 30

2.4% 98.80 30

2.8% 98.60 20 Example 8

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 3.9 Consumer Surplus: Value minus Expenditure
Marginal Value

Demand curve can be considered a marginal value curve

P
Consumer Surplus = Value Expenditure

Consumer surplus

Market Demand = 240 2P

If P = 70 what is the consumer surplus?
P1

D
Q
Example 9 Q1

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 3.10 Producer Surplus: Revenue minus Variable Cost
Marginal cost is the cost of producing an additional unit

Supply curve can be considered a marginal cost curve

P
Producer Surplus = Revenue Variable Cost S

Producer Surplus
P1

Q
Example 10 Q1
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 3.11 Total Surplus: Total Value minus Total Variable Cost
Total Surplus = Consumer Surplus + Producer Surplus

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 3.12 Markets Maximize Societys Total Surplus
Free markets maximize societys net benefit from production and consumption of goods and services

Positive and negative externalities should be considered

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3.13 Market Interference The Negative Impact on Total Surplus
Price ceiling

Price floor

Per unit tax on buyers

Per unit tax on sellers

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 Price Ceiling and Price Floor

Price Ceiling Price Floor

P P

S S
Deadweight loss Deadweight loss

P*

P* P

P
D D
Q Q
Q Q* Q* Q

Example 11 www.irfanullah.co 22
 Per Unit Tax

Per-Unit Tax on Buyers Per-Unit Tax on Sellers

Whether tax is on buyer or seller, the net effect is the same

The relative tax burden depends on the steepness of the demand and supply curves

Example 12
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 4. Demand Elasticities
Demand elasticity quantifies how sensitive quantity demanded is to changes in the
independent variables:

1. Own-Price
2. Income
3. Price of Substitute
4. Price of Complement

Basic formula:
% change in quantity demanded
% change in variable

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 4.1 Own-Price Elasticity of Demand
Own-Price Elasticity of Demand = %Q / %P = (Q /P) x P/Q

For all negatively sloped, linear demand

curves, elasticity varies depending on
where it is calculated

Elastic and inelastic

Perfectly elastic and perfectly inelastic

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4.2 Own-Price Elasticity of Demand: Impact on Total Expenditure
What happens to total expenditure (P x Q) when price falls?

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 4.3 Income Elasticity of Demand: Normal and Inferior Goods
Income Elasticity of Demand = %Q / %I = (Q /I) x I/Q

For a normal good, income elasticity is positive

For an inferior good, income elasticity is negative

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 4.4 Cross Elasticity of Demand: Substitutes and Compliments
Cross Elasticity of Demand = %Q / %P = (Q /P) x P/Q

Positive for a substitute

Negative for a complement

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 4.5 Calculating Demand Elasticities from Demand Functions
QA = 2 0.4PA + 0.0005I + 0.10PB - 0.15PC
PA = 10
PB = 55
Pc = 10
I = 2,000

Calculate:
1. Own-price elasticity for demand for A
2. Income elasticity of demand for A
3. Cross-price elasticity of demand of A against price of B
4. Are A and B substitutes or complements
5. Cross-price elasticity of demand of A against price of C
6. Are A and C substitutes or complements

Example 13
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 Summary
Types of Markets
Demand
Supply
Aggregating
Consumer and Producer Surplus
Market Interference
Own Price Elasticity
Income Elasticity
Cross Elasticity
Calculating Elasticity

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 Conclusion
Read summary

Review learning objectives

Examples

Practice problems

Practice questions from other sources

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