Economics for Investment Decision Makers

Micro, Macro, and International Economics

Christopher D. Piros, Jerald E. Pinto

• Publisher: Wiley
• Year: 2013
• ISBN:
  9781118416242
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The economics background investors need to interpret global economic news distilled to the essential elements: A tool of choice for investment decision-makers.

Written by a distinguished academics and practitioners selected and guided by CFA Institute, the world's largest association of finance professionals, Economics for Investment Decision Makers is unique in presenting microeconomics and macroeconomics with relevance to investors and investment analysts constantly in mind. The selection of fundamental topics is comprehensive, while coverage of topics such as international trade, foreign exchange markets, and currency exchange rate forecasting reflects global perspectives of pressing investor importance.

• Concise, plain-English introduction useful to investors and investment analysts
• Relevant to security analysis, industry analysis, country analysis, portfolio management, and capital market strategy
• Understand economic news and what it means
• All concepts defined and simply explained, no prior background in economics assumed
• Abundant examples and illustrations
• Global markets perspective

CHAPTER 1

DEMAND AND SUPPLY ANALYSIS: INTRODUCTION

Richard V. Eastin

Gary L. Arbogast, CFA

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

• Distinguish among types of markets.
• Explain the principles of demand and supply.
• Describe causes of shifts in and movements along demand and supply curves.
• Describe the process of aggregating demand and supply curves, the concept of equilibrium, and mechanisms by which markets achieve equilibrium.
• Distinguish between stable and unstable equilibria and identify instances of such equilibria.
• Calculate and interpret individual and aggregate demand and inverse demand and supply functions, and interpret individual and aggregate demand and supply curves.
• Calculate and interpret the amount of excess demand or excess supply associated with a nonequilibrium price.
• Describe the types of auctions and calculate the winning price(s) of an auction.
• Calculate and interpret consumer surplus, producer surplus, and total surplus.
• Analyze the effects of government regulation and intervention on demand and supply.
• Forecast the effect of the introduction and the removal of a market interference (e.g., a price floor or ceiling) on price and quantity.
• Calculate and interpret price, income, and cross-price elasticities of demand, and describe factors that affect each measure.

1. INTRODUCTION

In a general sense, economics is the study of production, distribution, and consumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income. Macroeconomics has its roots in microeconomics, which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics is a logical starting point for the study of economics.

This chapter focuses on a fundamental subject in microeconomics: demand and supply analysis. Demand and supply analysis is the study of how buyers and sellers interact to determine transaction prices and quantities. As we will see, prices simultaneously reflect both the value to the buyer of the next (or marginal) unit and the cost to the seller of that unit. In private enterprise market economies, which are the chief concern of investment analysts, demand and supply analysis encompasses the most basic set of microeconomic tools.

Traditionally, microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility-maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-maximizing firms. The theory of the consumer and the theory of the firm are important because they help us understand the foundations of demand and supply. Subsequent chapters will focus on the theory of the consumer and the theory of the firm.

Investment analysts, particularly equity and credit analysts, must regularly analyze products and services—their costs, prices, possible substitutes, and complements—to reach conclusions about a company’s profitability and business risk (risk relating to operating profits). Furthermore, unless the analyst has a sound understanding of the demand and supply model of markets, he or she cannot hope to forecast how external events—such as a shift in consumer tastes or changes in taxes and subsidies or other intervention in markets—will influence a firm’s revenue, earnings, and cash flows.

Having grasped the tools and concepts presented in this chapter, the reader should also be able to understand many important economic relationships and facts and be able to answer questions such as:

• Why do consumers usually buy more when the price falls? Is it irrational to violate this law of demand?
• What are appropriate measures of how sensitive the quantity demanded or supplied is to changes in price, income, and prices of other goods? What affects those sensitivities?
• If a firm lowers its price, will its total revenue also fall? Are there conditions under which revenue might rise as price falls, and, if so, what are those conditions? Why might this occur?
• What is an appropriate measure of the total value consumers or producers receive from the opportunity to buy and sell goods and services in a free market? How might government intervention reduce that value, and what is an appropriate measure of that loss?
• What tools are available that help us frame the trade-offs that consumers and investors face as they must give up one opportunity to pursue another?
• Is it reasonable to expect markets to converge to an equilibrium price? What are the conditions that would make that equilibrium stable or unstable in response to external shocks?
• How do different types of auctions affect price discovery?

This chapter is organized as follows. Section 2 explains how economists classify markets. Section 3 covers the basic principles and concepts of demand and supply analysis of markets. Section 4 introduces measures of sensitivity of demand to changes in prices and income. A summary and a set of practice problems conclude the chapter.

2. TYPES OF MARKETS

Analysts must understand the demand and supply model of markets because all firms buy and sell in markets. Investment analysts need at least a basic understanding of those markets and the demand and supply model that provides a framework for analyzing them.

Markets are broadly classified as factor markets or goods markets. Factor markets are markets for the purchase and sale of factors of production. In capitalist private enterprise economies, households own the factors of production (the land, labor, physical capital, and materials used in production). Goods markets are markets for the output of production. From an economics perspective, firms, which ultimately are owned by individuals either singly or in some corporate form, are organizations that buy the services of those factors. Firms then transform those services into intermediate or final goods and services. (Intermediate goods and services are those purchased for use as inputs to produce other goods and services, whereas final goods and services are in the final form purchased by households.) These two types of interaction between the household sector and the firm sector—those related to goods and those related to services—take place in factor markets and goods markets, respectively.

In the factor market for labor, households are sellers and firms are buyers. In goods markets, firms are sellers and both households and firms are buyers. For example, firms are buyers of capital goods (such as equipment) and intermediate goods, while households are buyers of a variety of durable and nondurable goods. Generally, market interactions are voluntary. Firms offer their products for sale when they believe the payment they will receive exceeds their cost of production. Households are willing to purchase goods and services when the value they expect to receive from them exceeds the payment necessary to acquire them. Whenever the perceived value of a good exceeds the expected cost to produce it, a potential trade can take place. This fact ...