Law of demand

Demand function Demand concepts

Demand curve (graph of

inverse demand function)

Elastic, Unit-​elastic, and Inelastic

Elasticity

Perfectly elastic and inelastic

Elasticity and total expenditure on a good

Price elasticity of demand

Own-​price

Larger for goods with close substitutes, occupy a large

portion of the budget, are seen as discretionary, or
have longer time to adjust to changes in its price.

Cross-​price

Income

Substitution and income effects

Law of diminishing marginal returns

Total cost: TC = wL + rK Supply analysis : cost, marginal returns, and productivity

w = hourly wage; L = labor hours; r =
rental rate of capital; K = capital hours

Total, average, and marginal product of labor

Economic profit = Total revenue (TR) - Economic cost (total cost (TC))
Accounting profit = TR - Accounting cost
Economic vs Accounting

Economic depreciation: What am I giving up if I use

my resources to produce output in the coming period?

Accounting depreciation: How should I distribute the

historical cost—​that I have already paid—​across units
of output that I intend to produce this period?

Marginal revenue (MR) and marginal cost (MC) Demand & Supply
Cooperative vs Non-​cooperative countries

Landlocked countries rely on neighbors for access to vital resources => cooperation
Total, Variable, Fixed, and Marginal Costs more important.
National security or military
S, the lowest point on the AVC curve, is where MC = AVC. Beyond quantity QAVC, MC > AVC;
thus, the AVC curve begins to rise. Countries highly connected to trade routes or acting as a conduit for trade use their
T, the lowest point on the ATC curve, is where MC = ATC. Beyond quantity QATC, MC > ATC; geographic location as a lever of power in broader international dynamics.
thus, the ATC curve is rising.
A, the difference between ATC and AVC at output quantity Q1, is exactly the AFC.
R is the lowest point on the MC curve. Beyond this point of production, fixed input Domestically, growing national wealth and limiting income inequality contribute to
constraints reduce labor productivity. Economy social stability, an important component of national security.
X is the difference between ATC and AVC at Q2. X < A because AFC (Y) falls with output.
Internationally, countries that cooperates in support of their economic interest are focused
Motivations for cooperation on 1 of 2 factors:
(1) securing essential resources through trade, or
(2) leveling the global playing field for their companies/industries through standardization.

Livable geography and climate, access to food and water, etc.

Perfect and imperfect competition Highly unequal among countries.

Geophysical Resource Endowment
More endowed with a resource => more political leverage
when dealing with another in need of that resource.

Resource-​rich => use or sale of the resource benefits certain

Resource Endowment, Standardization, and Soft Power
groups more than others => internal political instability.

State actors (national governments) & Political cooperation Regulatory cooperation:

Basel Committee on Banking Supervision (BCBS): more effective supervision of the
global banking sector and international capital flows.
Standardization

Perfectly competitive firm

Process standardization:
Profit-​Maximization, Breakeven, and
Society for Worldwide Interbank Financial Telecommunication (SWIFT): global payment
Shutdown Points of Production
infrastructure.
Monopolist firm

Operational synchronization:
Containerization: reduces time and cost of shipping.

Historical or modern
Cultural Considerations and “Soft Power”
Cultural programs, advertisement, travel grants, and university exchanges, etc.

Generally, strong institutions => more stable internal and external political forces =>
more opportunity to develop cooperative relationships.

The Role of Institutions

Countries with strong institutions => more authority and independence in the international space.

Increasing returns to scale. Stronger institutions => more durable cooperative relationships.
Specialization in one task rather than perform many duties.
More efficient equipment, and adaptation the latest in technology. Economies of scale Every country has different resources, goals, and leadership => different priorities.
Marketable byproducts, less energy consumption, and enhanced quality control.
Better use of market information for more effective decision making.
Economies and Diseconomies of scale
Obtaining discounted prices on resources when buying in bulk. Priorities may shift as political leadership turns over or as global events change.
Hierarchy of Interests and Costs of Cooperation
Breakeven: P = MR = SMC = ATC
Shutdown: SMC = AVC Decreasing returns to scale. Some elements on the hierarchy of national interests may be universally clear-​cut. However, as
Being so large that it cannot be properly managed. Power of the Decision Maker basic societal needs are met, the hierarchy of national interests can become more subjective.
Overlapping and duplication of business functions
and product lines.
Diseconomies of scale The length of a country’s political cycle has an important impact on priority designation.
Higher resource prices because of supply
constraints when buying inputs in bulk.

Political Non-​Cooperation

Features of globalization

Raising sales
Raising profits
Reducing costs (lower tax-​operating environments, reduce labor costs, or seek other supply
Motivations for globalization chain efficiency gains)

Portfolio investment flows

Non-​state actors & Forces of globalization Access to resources and markets
Marginal revenue (MR) and marginal cost (MC)
FDI

Intrinsic gain (personal growth and education, improved productivity, higher standards)

Unequal Accrual of Economic and Financial Gains

Lower Environmental, Social, and Governance Standards

Political Consequences (income/wealth inequality, differences in opportunity

Costs of globalization Interdependence (if there is a disruption to the supply chain,

firms may not be able to produce the good themselves)

Reshoring essentials

How firms fortify their supply chains Re-​globalizing production

Perfect competition
Doubling down on key markets
Monopolistic competition
4 market structures Autarky
Oligopoly Self-​sufficiency, sometimes swifter economic and political development, but gradual
loss of economic and political development within the country

Monopoly Assessing geopolitical actors and risks

Hegemony
Geopolitics Regional or global leaders, influence on global affairs, but may become more
Number and relative size of firms competitive and increase geopolitical risk when gaining or losing influence

Degree of product differentiation Multilateralism

Both capable of and highly dependent on international cooperation for economic growth.
Regionalism
Pricing power Determinants of market structure
In between the two extremes of bilateralism and multilateralism.
Analysis of market structures Bilateralism
In regionalism, a group of countries cooperate with one another.
One-​at-​a-​time agreements without multiple partners.
Barrier to entry and exit Both bilateralism and regionalism can be conducted at the exclusion of other groups.

National security tools

Degree of non-​price competition

Economics 1 Cooperative: trade agreements, WTO, common markets/currency

Threat of entry
Economic tools
Non-​cooperative: nationalization, voluntary export restraints, domestic content requirements
Power of suppliers

Cooperative: currency exchange

Power of buyers Porter's 5 forces
Financial tools Reduce geopolitical risk if they encourage cooperation in security, economic, or
Tools of geopolitics financial arenas.
Threat of substitutes May cause vulnerabilities (e.g., global use of the USD)

Rivalry among existing competitors Non-​cooperative: limiting access to local currency markets, restricting foreign investments,
sanctions

Q = a - bP
Perfect competition Multi-​tool approaches Cabotage: the right to transport passengers or goods within a country by a foreign firm

MR = ΔTR/ΔQ
Geopolitical Risk and Comparative Advantage
A consistent threat of conflict may drive more regular volatility in asset prices.
Own-​price
Countries/regions with limited geopolitical risk may attract more labor and capital.
Not every country will be endowed with the same factors and capabilities => benefit
Substitutes => (+) from trade => more variety of products, higher competition between firms, and more
efficient resource allocation.
Cross-​price
Complements => (-)
Event risk: evolves around set dates, such as elections, new legislation, or
other date-​driven milestones, such as holidays or political anniversaries,
Income known in advance.

Elasticity of demand
Horizontal demand schedule (perfectly elastic)
Exogeneous risk: sudden or unanticipated risk that impacts either a country’s
Extremes Types of geopolitical risk
cooperative stance, the ability of non-​state actors to globalize, or both.
Vertical demand schedule (perfectly inelastic)

Thematic risk: known risks that evolve and expand over a period of time (climate
Price elasticity will be higher if there are many close substitutes for the product. change, pattern migration, the rise of populist forces, threat of terrorism, and cyver
threats)

The greater the share of the consumer’s budget spent on the item, the higher the price elasticity of demand. Determinants
Black swan risk: An event that is rare and difficult to predict but has an important impact.

The length of time within which the demand schedule is being considered.
Likelihood (how likely the risk is to happen)

Long term:
TR, MR and price elasticity
Impact investors' asset allocation.
May have important environmental, social, governance, and other impacts.
Immediate impact on portfolios is likely to be more limited.
Incorporating geopolitical risk into investment
Velocity (how quickly the risk impacts investment portfolios) Time horizon
Assessing Geopolitical Threats Medium term:
The difference between the value that a consumer places on units purchased and the Consumer surplus Impair companies’ processes, costs, and investment opportunities, resulting in lower valuations.
amount of money that was required to pay for them. Impact some more than others.

Short term:
Volatility in the markets may affect entire industries or even the entire market.
Economic costs = Total accounting costs - Implicit opportunity costs Long-​term changes are unnecessary.

P = AR = MR
Optimal price and output in perfect competition Supply analysis, optimal price, and output in perfectly competitive markets Low => adjust asset allocation

Law of diminishing returns => Profit maximization at output level where MR = MC

Quickness Medium => adjust investments in specific sectors

Only perfect competition has a defined supply function.

High => flight to quality (the herd-​like behavior of investors to shift out of risky assets during
financial downturns or bear markets)
Profit maximization at output level where MR = MC Firm and market structures

Impact
The long-​run marginal cost schedule is the perfectly competitive firm’s supply curve.
Long-​run equilibrium in perfect competition
The firm’s demand curve is dictated by the aggregate market’s equilibrium price. Groupthink: thinking or making decisions as a group in a way that discourages creativity or
individual responsibility. For scenario analysis to be useful in portfolio management, teams
Scenario analysis: evaluating portfolio outcomes across potential circumstances or states of the world.
must build creative processes, identify scenarios, track these scenarios, and assess the need
The long-​run competitive equilibrium occurs where MC = AC = P for action on a regular cadence.

Tracking risks according to signposts

Short-​run profit maximization at output level where MR = MC

Acting on Geopolitical Risk Consider objectives, risk tolerance, and time horizon.
There is no well-​defined supply function. The information used to determine the
appropriate level of output is based on the intersection of MC and MR. However, Monopolistic competition
the price that will be charged is based on the market demand schedule.

Long-​run equilibrium in monopolistic competition: MR = MC High levels of geopolitical risk reduce investment, employment, and price level of the stock market.

Observations from the Geopolitical Risk Index (GPR) Firms reduce investment in the wake of idiosyncratic events, which would be unlikely to repeat.

The threat of an event was shown to have a larger impact over time than that of the actual events themselves.
In a market where collusion is present, the aggregate market demand curve is divided up by
the individual production participants.

Under non-​colluding market conditions, each firm faces an individual demand curve
depending on the pricing strategies adopted by the participating firms.

1. If price increases, the competitor ignores it so demand is more responsive (more elastic).
2. If the price falls, the competitor matches it so demand is less responsive (more inelastic).
The kink point => current price offered by the market.

Assumption in which each firm determines its profit-​maximizing

production level assuming that the other firms’ output will not change.
Cournot assumption

The Cournot strategy’s solution can be found by setting Q = q1 + q2,

where q1 and q2 represent the output levels of the two firms. Oligopoly and pricing strategies

When two or more participants in a non-​cooperative game have no incentive to deviate

from their respective equilibrium strategies given their opponent’s strategies.

The number and size distribution of sellers: number of firms is small or if one firm is dominant.

The similarity of the products: products are homogeneous.

Nash equilibrium

Cost structure: similar the cost structures. Determinants of successful cartel

Order size and frequency: orders are frequent, received on a regular basis, and relatively small.

The strength and severity of retaliation: low threat.

The degree of external competition.

Stackelberg model: a prominent model of strategic decision making in which firms are
assumed to make their decisions sequentially.
Top-​dog strategy: the leader aggressively overproduce to force the follower to scale
back its production or even punish or eliminate the weaker opponent.

The price leader identifies its profit-​maximizing output where MRL = MCL, at output QL.

No single optimum price and output analysis that fits all

oligopoly market situations because of the interdependence. Optimal price, output, and long-​run equilibrium in Oligopoly

Optimal price is determined at the output level where MR = MC (at kinked point)

Long-​run economic profits are possible for firms operating in oligopoly markets but over
time, the market share of the dominant firm declines.

The profit-​maximizing level of output occurs where MR = MC. Demand/Supply and Optimal Price/Output

First-​degree: charge each customer the highest price the customer is willing to pay.
Monopoly

Second-​degree: charge different per-​unit prices using the quantity purchased. Price discrimination and consumer surplus

Third-​degree: segregates customers into groups based on characteristics and offers different pricing to each group.

Economic profit is possible.

To maintain a monopoly market position in the long run, the firm must be protected by Long-​run equilibrium in monopoly
substantial and ongoing barriers to entry, or national ownership of the monopoly.

The regulator sets price equal to LRAC.

Observed price and quantity are the equilibrium values of price and quantity and do not
represent the value of either supply or demand.
Econometric approaches

Must use a model with 2 equations, an equation of demanded quantity and an equation of Identification of market structure
supplied quantity.

Concentration ratio Simpler approaches

Herfindahl–Hirschman index Unaffected by mergers among the top market incumbents.
Does not directly quantify market power and threat of entrance.