BOOK
2 - ECONOMICS
Readings
and
Learning
Outcome
Statements 3
Study
Session 4 - Economics: Microeconomic Concepts 9
Study
Session 5 - Economics: Market Structures
and
Macroeconomic Concepts
75
Study
Session 6 - Economics: Macroeconomic
Theory
146
Self-
Test
- Economics 201
Formulas 206
Index'
208
'I
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and
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cover, it was
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wirhout
permission
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Division
of
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You,
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rhis law
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Outcome
Statemenrs, CFA Institute
Standards
of
ProfessionaL
Conduct.
and
CFA Insriture's
GlobaL
Investment
Pe'formal'lCe
Standards
with permission from CFA Institute.
All
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These materials may
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The
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of
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Disclaimer:
The
Schweser Notes should
be
used in conjunction wirh rhe original readings
as
set
fonh
by
CFA InstitUte
in
their 2008
CfA
Leve! I
Study
Guide.
The information contained
in
these Notes covers wpies contained in rhe readings referenced
by
CFA Institute and
is
believed

[Q
be
accurate. However, their accuracy cannot
be
guaranteed nor
is
any warranry conveyed
as
w your ultimate exam success.
The
authors
of
the
referenced readings have
not
endorsed or sponsored these Notes,
nor
are they affiliared with Schweser Study Program.
Page
2 ©2008
Schweser
READINGS
AND
LEARNING
OUTCOME
STATEMENTS
READINGS
The
following
material

is
a rfl'ieu'
of
the
EcollomiC-'
principleJ designed
to
addresJ the learning outcome statements
Jet
forth
by
CFA Institute.
STUDY SESSION 4

.
Reading
Assignments
Economics, CFA Program
Curriculum,
Volume 2 (CFA
Institute,
2008)
13. Elasticit)'
14. Efficienc)'
and
Equity
15. Markets in Action
16.
Organizing
Production

17.
Output
and
COStS
STUDY SESSION 5
Reading
Assignments
Economics, CFA Program
Curriculum,
Volume 2 (CFA
Institute,
2008)
18. Perfect
Competition
19.
Monopoly
20.
Monopolistic
Competition
and
Oligopoly
21.
Demand
and Supply in FactOr Markets
22.
Monitoring
Cycles, Jobs, and the Price Level
23. Aggregate Supply
and
Aggregate

Demand
STUDY SESSION 6
Reading
Assignments
Economics, CFA Program
Curriculum,
Volume 2 (CFA
Institute,
2008)
24. Money,. Banks,
and
the Federal Reserve
25. Money, Interest, Real
<;;DP,
and
the Price Level
. 26. Inflation
27. Fiscal Policy
28.
Monetary
Policy
©2008
Schweser
i',
i
page 9
page 20
page 33
page 48
page 62

page 75
page 86
page 97
page 110
page 122
page 135
page 146
page 156
page
166
page 176
page
186
',1
Page
3:
Economics
Readings
and
Learning
Outcome
Statements
LEARNING
OUTCOME
STATEMENTS
(LOS)
STUDY
SESSION
'4.
The topical coverage corresponds

with
the
following
CFA Institute assigned reading:
13.
Elasticity
The
candidate
should
be able to:
a.
calculate
and
interpret
the
elasticities
of
demand
(price
elasticity, cross elasticity,
income
elasticity)
and
the
elasticity
of
supply,
and
discuss
the

factors
that
influence
each
measure.
(page
9)
b.
calculate
elasticities
on
a
straight-line
demand
curve,
differentiate
among
elastic,
inelastic,
and
unit
elastic
demand
and
describe
the
relation
between
price
elasticity

of
demand
and
total
revenue. (page 15)
The topical coverage corresponds
with
the
following
CFA Institute assigned reading:
14. Efficiency
and
Equity
The
candidate
should
be able to:
a.
explain
allocative efficiency,
marginal
benefit
and
marginal
cOSt,
and
demonstrate
why
the
efficient

quanti
ty
occurs
where
marginal
benefi
t
equals
marginal
cost.
(page
20)
b.
distinguish
between
the
price
and
the
value
of
a
product
and
explain
the
demand
curve
and
consumer

surplus.
(page 21)
c.
distinguish
between
the
COSt
and
the
price
of
a
product
and
explain
the
supply
curve
and
producer
surplus.
(page 23) .
d. discuss the
relationship
between
consumer
surplus,
producer
surplus,
and

equilibrium.
(page 23),
e.
explain
1)
how
efficient
markets
ensure
optimal
resource
utilization
and
2)
the
obstacles
to
efficiency
and
the
resulting
underproduction
or
overproduction,
including
the
concept
of
deadweight
loss.

(page
24)
f.
explain
the
two
groups
of
ideas
about
the fairness
principle
(utilitarianism
and
the
symmetry
principle)
and
discuss
the
relation
between
fairness
and
efficiency. (page
27)
The topical coverage corresponds
with
the
following

CFA
Institute
aJJigned reading:
15.
Markets
in
Action
The
candidate
should
be able to:
a

explain
market
equilibrium,
distinguish
between
long-term
and
short-term
impacts
of
outside
shocks.
and
describe
the
effects
of

rent
ceilings
on
the
existence
of
black
markets
in
the
housing
sector
and
on
the
market's
efficiency. (page 33)
b.
describe
labor
market
equilibrium
and
explain
the
efleers
and
inefficiencies
of
a

minimum
wage
above
the
equilibrium
wage. (page
36)
c.
explain
the
impact
of
taxes
on
supply,
demand,
and
market
equilibrium,
and
describe
tax
incidence
and
its
relation
to
demand
and
supply

elasticity. (page
37)
d. discuss the
impact
of
subsidies,
quotas,
and
markets
for illegal
goods
on
demand,
supply,
and
market
equilibrium.
(page 41)
The topical coverage correJpondJ'
with
the
following
CFA
Imriwte
tlJ'J'igned
Telzding:
16.
Organizing
Production
The

candidate
should
be
able
to:
a.
explain
the types
of
opportunity
cOSt
and
their
reLltion
to
economic
profit,
and
calcubte
economic
proFit. (page 48)
b.
discuss a firm's
constraints
and
their
impact
on
achievability
of

maximum
profit.
(page
49)
Page 4 ©200H Schwesel'
Economics
Readings
and
Learning
Outcome
Statements
c.
differentiate
between
technological
efficiency
and
economic
efficiency,
and
calculate
economic
efficiency
of
various firms
under
different
scenarios.
(page 50)
d.

explain
command
systems
and
incentive
systems
ro
organize
production,
the
principal-agent
problem,
and
measures
a firm uses
to
reduce
the
principal-agent
problem.
(page
51)
e.
describe
the
different
types
of
business
organization

and
the
advantages
and
disadvantages
of
each.
(page
52)
f.
characterize
the
four
market
types. (page
53)
g.
calculate
and
interpret
the
four-firm
concentration
ratio
and
the
Herfindahl-Hirschman
Index,
and
discuss

the
limitations
of
concentration
measures.
(page
54)
h.
explain
why
firms
are
often
more
efficient
than
markets
in
coordinating
economic
activity.
(page
55)
The topical coverage corresponds with the following
CFA
Institute assigned reading:
17.
Output
and
Costs

The
candidate
should
be able
to:
a.
differentiate
between
short-run
and
long-run
decision
time
frames.
(page 62)
b.
describe
and
explain
the
relations
among
rotal
product
of
labor,
marginal
product
of
labor,

and
average
product
of
labor,
and
describe
increasing
and
decreasing
marginal
returns.
(page 62)
c.
disringuish
among
rotal
COSt
(including
both
fixed
cost
and
variable
cost),
marginal
COSt,
and
average
COSt,

and
explain
the
relations
among
the
various
coSt
curves.
(page
64)
d.
explain
the
firm's
production
funcrion,
its
properties
of
diminishing
returns
and
diminishing
marginal
producr
of
capital,
the
relation

between
short-run
and
long-run
cOStS,
and
how
economies
and
diseconomies
of
scale affect
long-run
coses.
(page
69)
STUDY SESSION 5
The topical coverage corresponds with the following CFA Institute assigned reading:
18.
Perfect
Competition
The
candidate
should
be
able
ro:
a.
describe
the

characreristics
of
perfect
competition,
explain
why
firms in a
perfectly
comperitive
market
are
price
takers,
and
differentiate
between
market
and
tlrm
demand
curves. (page 75)
b.
determine
the
profit
maximizing
(loss
minimizing)
output
for a

perfectly
competitive
tlrm,
and
explain
marginal
cost,
marginal
revenue,
and
economic
profit
and
loss. (page 76)
c.
describe
a
perfectly
competitive
tlrm's
short-run
supply
curve
and
explain
the
impact
of
changes
in

demand,
entry
and
exit
of
firms,
and
changes
in
plant
size
on
the
long-run
equilibrium.
(page 78)
d. discuss
how
a
permanent
change
in
demand
or
changes
in
technology
affecr price,
outpUt,
and

economic
profit.
(page 80)
The topical coverage "orresponds with the following
CFA
Irutitute assigned reading:
19.
Monopoly
The
candidate
should
be able
to:
a.
describe
the
characteristics
of
a
monopoly.
including
factors
that
allow a
monopoly
ro arise,
and
monopoly
price-secring strategies. (page
86).

b.
explain
the
relation
between
price,
marginal
revenue,
and
elasticity
fo;
.•
monopolY,
and
derermine
a
monopoly's
profit-maximizing
price
and
quantity.
(page 87)
c.
explain
price
discrimination.
and
why
perfect
price

discriminarion
is
efficient.
(page 88)
d.
explain
how
consumer
and
producer
surplus
are
redisrributed
in
~l
monopoly.
including
rhe
occurrence
of
deadweight
loss
and
rent
s,-·~king.
(page
StY)
e.
explain
the

potenrial
gains
trom
monopoly
,lnd
the
regulation
of
a
namral
monoplll~"
(page <)0)
@~ll()~
Schweser
1:,,'011 0
III
i
,'~
Rcadinp
and
Lc:trnillg
Outn1l11l'
Statcments
20.
Ij,r
ro/,iml
c01'('I'IIgr
l'OI'l'f.ll'Olldr
II/irl
l

rllt.f(J!I(lIl'ill,~
CI;A
Illsrir!lft
IISS<r;lIrr!
I'rrlrlillg:
Monopolistic
Competition
and
Oligopoly
The
candiJan:
should
bc
able
to:
a.
describe
the
characteristics
of
monopolisric
compcririon
and
oligopol)'. (f1age 97)
b.
derermine
the
profit-maximizing
(Ioss-minimi7,ing)
ouq

1
ut
under
monopolisric
competition
and
oligopol)',
explain
why
long-run
economic
pr~)fir
under
monopolisr'ic
competition
is
zero.
and
determine
if
monopolistic
competition
is
efficient. (page
98)
c.
explain
the
importance
of

innovation.
product
developmenr.
advertising,
and
branding
under
monopolistic
competition.
(page 100)
d.
explain
the
kinked
demand
curve
model
and
the
domin:lnr
firm
modeL
and
describe
oligopoly
games
including
the
Prisoners'
Dilemma.

(page 101)
The ropical COl
i
frOgC
corresponds wirh
rJ.1t'
following
CFA
Imrirute assigned reading:
21.
Demand
and
Supply
in
Factor
Markets
The
c:lndidate
should
be
able
to:
a.
explain
why
demand
for
the
factors
of

production
is called
derived
demand,
differentiate
between
marginal
revenue
and
marginal
revenue
product
(MRP),
and
describe
how
the
MRP
determines
the
demand
for
labor
and
the
wage
rate.
(page 110)
b.
describe

the
factors
that
cause
changes
in
the
demand
for
labor
and
the
factors
that
determine
the
elasticity
of
the
demand
for labor.
(page
Ill)
c.
describe
the factors
determining
the
supply
of

labor,
including
the
substitution
and
income
effects,
and
discuss
the
factors
related
to
changes
in
the
supply
of
labor,
including
capital
accumulation.
(page
112)
d.
differentiate
between
physical
capital
and

financial
capital.
and
explain
the
relation
between
the
demand
for
physical
capital
and
the
demand
for
financial
capital.
(page 113)
e.
discuss
the
role
of
the
present
value
technique
in
determining

the
demand
for
capital.
(page
113)
f.
explain
the
factors
that
influence
the
supply
of
capital.
(page 114)
g.
differentiate
between
renewable
and
non-renewable
natural
resources
and
describe
the
supply
curve

for each.
(page
115)
h.
differentiate
between
economic
rent
and
opportunity
costs. (page 116)
The topical couerage corresponds
with
the following
CFA
Insritute as.rigned reading:
22.
Monitoring
Cycles,
jobs,
and
the
Price Level
The
candidate
shou'1d
be
able
to:
a.

describe
the phases
of
the
business
cycle,
define
an
unemploved
person,
and
interpret
the
main
labor
market
indicators
and
their
relation
to
the
business cycle.
(page
122)
b.
define
aggregate
hours
and

real wage rates,
and
explain
their
relation
to gross
domestic
product
(GOP).
(page 124)
c.
explain
the
types
of
unemployment,
full
employment,
the
natural
rate
of
unemployment,
and
the
relation
between
unemployment
and
real

GOP.
(page 124)
d.
explain
and
calculate
the
consumer
price
index
(CPl),
describe
the
relation
between
the
CPl
and
the
inflation
rate,
and
explain
the
main
sources
of
CPl
bias. (page 125)
The topical coverage corresponds

with
the following
CFA
Institute assigned reading:
23. Aggregate
Supply
and
Aggregate
Demand
The
candidate
should
be
able
to:
a.
explain
the
factors
that
influence
real
GOP
and
long-run
and
short~run
aggregate
supply,
explain

movement
along
the
long~run
and
shorr-run
aggregate
supply
curves
(LAS
and
SAS),
and
discuss
the
reasons
for
changes
in
potential
GOP
and
aggregate supply.
(page
135)
Page 6
©200HSchweser
Economics
Readings
and

Learning
Outcome
Statements
b.
explain rhe
componenrs
of
and
rhe facrors rhat affect real
GDP
demanded,
describe
the
aggregate
demand
curve
and
why
it slopes
downward,
andexplain
the
facrors
that
can
change
aggregate
demand.
(page 137)
c.

differenriate
between
shore-run
and
long-run
macroeconomic
equilibrium,
and
explain
how
economic
growth,
inflation,
and
changes in aggregate
demand
and
supply
influence
the
macroeconomic
equilibrium
and
the business cycle. (page 139)
d.
compare
and
contrast
the
Keynesian, Classical,

and
Monetarist
schools
of
macroeconomics.
(page 141)
;
STUDY
SESSION 6
The topicaL coverage corresponds
with
the ftLLowing CFA Institute assigned reading:
24. Money, Banks,
and
the Federal Reserve
The
candidate
should
be able
co:
a.
explain
the
functions
of
money. (page
146)
b.
describe
the

componenrs
of
the
M 1
and
M2
measures
of
money,
and
discuss
why
checks
and
credit
cards are
not
counred
as
money. (page
146)
c.
describe
the
economic
functions
of
and
differentiate
among

the various deposicory
institutions,
and
explain
the
impact
of
financial
regulation,
deregulation,
and
innovation.
(page 147)
d.
discuss
the
creation
of
money,
including
the
role played by excess reserves,
and
calculate
the
amount
of
loans a
bank
can generate, given

new
deposits. (page 149)
e.
explain
the
goals
of
the
U.S. Federal Reserve (Fed)
in
conducting
monetary
policy
and
how
the
. Fed uses its
policy
cools
co
concrol the
quantity
of
money,
and
describe
the
assets
and
liabilities

on
the Fed's balance sheet. (page 149)
f.
describe
the
monetary
base,
and
explain
the
relation
among
the
monetary
base,
the
money
multiplier,
and
the
quantity
of
money. (page 150)
The topicaL coverage corresponds
with
the
ft
LLo
wing
CFA Institute assigned reading:

25. Money, Interest, Real
GDP,
and the Price Level
The
candidate
should
be able
co:
a.
explain
the
faccors
that
influence
the
demand
for money,
and
describe
the
demand
for
money
curve,
including
the
effects
of
changes in real
CDP

and
financial
innovation.
(page 156)
b.
explain
interest
rate
determination
and
the
shore-run
and
long-run
effects
of
money
on
real CDP.
(page 157)
c.
discuss the
quantity
theory
of
money
and
its relation
ro
aggregate

supply
and
aggregate
demand.
(page 160)
The topicaL coverage correspondJ'
with
the ftLLowing CFA Institute assigned reading:
26. Inflation
The
candidate
should
be able
to:'
a.
differenriate
between
inflation
and
the price level,
and
calculate an
inflation
rate. (page 166)
b.
describe
and
distinguish
among
the factors resulting in

demand-pull
and
cost-push
inflation,
and
describe rhe
evolution
of
demand-pull
and
cost-push
inf1ationary processes. (page 166)
c.
explain the effects
of
unanricipated
infhtion
in
the
labor
market
and
the
market for financial
capital. (page 168)
d.
distinguish
between
anticipated
and

unanticipated
inflation,
and
explain the costs
of
anticipated
inflation.
(page 169)
e.
explain the
impact
of
inthtion
on
unemployment.
and
describe
the
shore-run
and
long-run
Phillips curve,
including
the
dTect
of
changes
in
the
natural

rate
of
unemployment.
(page 170)
©.!()08 Sdnvc:sc:r
Page. 7
Eeo
11
0
111
i
es
Readings
and
Lcarning
Outcomc
Statements
f.
explain
the
relation
among
innation,
nominal
interest
rate~.
and
the
demand
and

supply
of
mone~·.
(page 171)
The
ropier11
co/lerage
((IITC.ipondJ
wirh
th(
/t,L!owilig
CF4
lJl.it;rutr
11.rs<r;ncd
reading:
27. Fiscal Potier
The
candidate
should
be .able to:
a.
explain
supply-side
effects
on
employment.
potential
CDr,
and
aggregate

supply,
including
the
income
tax
and
taxes
on
expenditul:e.
and
describe
the
Laffer
curve
and
its
relation
to
supply-side
economics.
(page
1(6)
b.
discuss
the
sources
of
investment
finance
and

the
influence
of
fi~ca]
policy
on
capital
markets,
including
the
crowding-out
effect. (page 178)
c. discuss
the
generational
effects
of
fiscal policy,
including
generational
accounting
and
genera
tiona]
imbalance.
(page
179)
d. discuss
the
use

of
fiscal
policy
to
stabilize
the
economy,
including
the
effects
of
the
government
purchases
multiplier,
the
tax
multiplier,
and
the
balanced
budget
multiplier.
(page 179)
e.
explain
the
limitations
of
discretionary

fiscal policy,
and
differentiate
between
discretionary
fIscal
policy
and
automatic
stabilizers.
(page
180)
The
topicaL
coverage
corresponds with the
foLLowing
CFA
lmritute assigned reading:
28.
Monetary
Policy
The
candidate
should
be
able
to:
a. discuss
the

U.5.
Federal
Reserve's
primary
goal
of
price
stabili
ty,
the
secondary
goal
of
maintaining
sustainable
real
GDP
growth,
and
the
intermediate
targets
of
monetary
policy,
and
compare
and
contrast
the

policies
that
can
be
used
to
achieve
price
level stability. (page
186)
b.
compare
and
contrast
fixed-rule
and
feedback-rule
monetary
policies
to
stabilize
aggregate
demand,
and
explain
the
problem
of
monetary
policy

lags. (page 187)
c.
discuss
the
fixed-rule
and
feedback-rule
policies
to
stabilize
aggregate
supply
in
response
to
a
productivity
shock
and
a
cost-push
inflation
shock. (page
188)
d. discuss
the
im
ponance
of
policy

credi
bility
in
monetary
policy
implementation.
(page 191)
e.
compare
and
contrast
the
new
monetarist
and
new
Keynesian
feedback
rules. (page 195)
Page
8
«)2008
Schwcser
The
following
is a
review
of
the
Economics

principles
designed
to
address
the
learning
outcome
statements
set
forth
by
CFA
InsticuteC»
This
topic
is
also
covered
in:
ELASTICITY
Study
Session 4
EXAM
Focus
Elasticity
is
a measure
of
the
ratio

of
the
percentage
change
in
one
variable
to
the
percentage
change
in
another
variable. It
is
commonly
used
as
a
measure
of
how
sensitive the
quantity
demanded
is
to
changes in
the
price

of
a good. After
learning
all
about
price elasticity
of
demand,
learn
how
to
apply
this
concept
to
calculate
and
interpret
the
cross
elasticity
of
demand,
the
income
elasticity
of
demand,
and
the elasticity

of
supply. You
must
also gain a
good
understanding
of
the factors
that
influence a good's elasticity
of
demand
and
elasticity
of
supply.
LOS
13.a:
Calculate
and
interpret
the
elasticities
of
demand
(price
elasticity,
cross
elasticity,
income

elasticity)
and
the
elasticity
of
supply,
and
discuss
the
factors
that
influence
each
measure.
The
price
elasticity
of
demand
measures the change in the
quantity
demanded
in
response
to
a
change
in
market
price (i.e., a

movement
along
a
demand
curve).
The
fotmula
used
to
calculate
the
price elasticity
of
demand
is:
percent change in quantity demanded
price elasticity
of
demand =
-' = = '
percent change in price
where:
O/O~Q
%~p
percent change =
change in value _ ending value - beginning value
.average value - ( ending value
+
:eginnin
g

value
J
Professor)" Note:
It
is
cUHomary
to
use average values when (tlkl/I,lting
~
percentage changes used
in
elasticity computations.
Thij"
way
11
change from 8
to
~
J0
and
a change
from
J0
to
8 both result in the j'ame percentage change
of
2/9
=22.2%.
Use
thij'

method
on the exam!
Figure 1 illustrates the general categories
of
price elasticity
of
denund.
A discussion
or"
each
is
presented below:
•
[f
a
j'mal/percentage
price change results
in
a
Il1rge
percemage change
i~
quantity
demanded.
the
demand
for thar good
is
said
[0

be highly d,lsri

Apples are
,tn
example
of
an elastic
good.
The
absolure value
of
price elasticirv
is
greater
than
Page 9
Stud,'
Sc:~~iOll
4
Cro~~-Refcrcnce
to
CFA I
n~tirlilc
A~signed
Reading
#
13
- Elasricir)"
one.
meaning

that
the percentage change
in
Q
is
greater
than
the percentage change
in
P.
•
If
a IflIg(' percentage price change
result~
ina
mud!
percentage change in
quantity
·demanded.
demand
is
,.('Illtill{'~l'
illrlmtir. Gasoline
is
an
exanlJ.1le
of
a relatively
inelastic good.
The

absolute
value
of
price
elasticit~·
is
less
than
one.
meaning
that
the percentage change in Q
is
less
than
the
percentage change
in
P.
• A
p('/:f('rt~J'
rLastic
demand
curve
is
horizontal. and its elasticity
is
infinite.
If
the

price increases.
quantity
demanded
goes
to
zero.
• A
perfect~y
ineLastic
demand
curve
is
vertical, and elasticity
is
zero.
If
the price
changes,
there
will be
no
change in
the
quantity
demanded.
Figure 1: Price
Elasticity
of
Demand
Elastic

Price Price
Inelastic
Price
Perfectly Inelastic/Elastic
D
Quanti!!'
Quantity
D
Perfectly
Inel3.5ric
D
Perfecdr
Elastic
Quantity
Factors
that
influence
the
elasticity
of
demand
are (1)
the
availability and
clos~ness
of
substitutegoods,
(2)
the
relative

amount
of
income
spent
on
the
good,
and
(3)t,4erime
that
has passed since
the
price change
of
the
good. .
• AvailabiLity
of
substitutes.
If
good
substitutes
are available, a price increase in
one
product
will
induce
consumers
to
switch

to
a
substitute
good.
As
such, elasticity
of
demand
is
determined,
in parr, by the availability
of
good
substitutes.
For
example,
the
demand
for gasoline
is
inelastic (less
than
one) because it has no practical
substitutes,
at
least in
the
shorr
run.
On

the
other
hand,
the
price elasticity for
beef
is
high
because
there
are
many
suitable substitutes, such
as
fish
or
chicken.
Page lO
©2008
Schweser
StuJy
Session 4
Cross-Reference
to
CFA
Institute
Assigned
Reading
# 13 -
Elasticity

Relative
amount
o/income
spent
on
the good.
When
the
portion
of
consumer
budgets
spent
on a
particular
good
is
relatively small,
demand
for
that
good will
tend
to be
relatively
inelastic. For example, consider toothpaste versus automobiles. Since
people
spend
a relatively small
amount

of
their incomes on
toothpaste,
a
10%
increase in the
price
of
toothpaste
is
not
likely to change their
consumption
significancly, if at all.
On
the ocher
hand,
since the cost
of
an
automobile
is
typicaJly a significant
proportion
of
a person's
budget,
a 10% increase in
car
prices

may cause
annual
demand
for cars to decrease significancly.
Consumers
can drive
less
and
do
more
repairs to keep existing vehicles longer,
or
they can switch
co
alternative forms
of
transportation.
• Time since the price change.
The
price elasticity
of
demand
for most
products
is
greater in the
long
run
than
in the

short
run.
Consider
the
situation
in the 1970s
when oil
and
gas prices rose significantly from hiscoricallevels.
The
short-run
response was
that
people simply drove less (picking a closer vacation Spot, taking
the bus
co
work, or carpooling)
and/or
kept
their homes
at
a
slighdy
lower
temperature
in
the
winter.
Over
time, however,

other
substitutions
were made.
People
bought
smalJer cars, chose to live closer
co
work, installed more
home
insulation,
and
installed
wood
burning
scoves
as
an alternative source
of
hear.
Cross
Elasticity
Cross
elasticity
of
demand
measures the change in the
demand
for a good in response
co
the change in price

of
a
substitute
or
complementary
good.
The
formula
for
calculating cross elasticity
of
demand
is:
percent change in quantity demanded
cross elasticity
of
demand
= '' ''' ' ' '-
percent change in price
of
substitute or complement
When
cwo
goods are reasonable
substitutes
for each other, cross ela:icicity
is
positive.
On
the

other
hand,
cross elasticity
is
negative
when
tWO
goods are
complements.
Complements
are goods
that
are usually used cogether,
so
that
an increase in
the
price
of
one
would
tend
to decrease the quanticy
demanded
of
the other. An example
would
be aucomobiles
and
gasoline.

Example:
Cross
elasticity
of
demand
(substitutes)
Suppose
that
the
price
bf
ice
cr~aIn
at
your
local ice cream
paJrIor~j)$i>~1'C
;Hld600scoopspetd~y
are
sot~.!"f~w)
assume that
anne
same
fro~~rt
yogtll't
inc5ease~
$1.25t():;;~\1'·7
5
per
scoop.

~hile
nOlt,b:!Jo.g,1
tnat'couM
affec17cu~t~'Iners"hu#i#~)~atternstthe
saleof~cecre
',""""'"""
to
750"
scoops
per
dajr;:(:aleufaretfre; cross'eliisri
city
of
d'eman:d'b~·.
,",
,
,.
to,'
frozen.
yogurt. "
"'i
"j'/'::)':~:\"\
.
'"(",
[)ag.: I I
Stud,'
Session 4
Cross-
Rd<:rencc
10

CFA
I
nSlilUlt'
Assigned
Reading
#
I.')
-
Elasricin'
Answer:
The
average
quantity
of
ice cream
demanded
is
(750
+600).1 2 = 675 scoops,
sO
the
percentage change' in
thequanrity
of
ice cream
demanded
is
(750
-600)
/675=

+22.2%.
The
average price
for
frozen
yogurt
is
($L25
+
$1.75)
/ 2
=$150
per
'
scoop, so
the
percentage change in
the
price
of
frozen yogurt
is
($1.75 - $1.25) /
$1.50=
+33.3%.
The
cross elasticity
of
demand
for

ice cream
relative
tome
price
of
yogurt is
22.2
/33.3
=
+0.67.
Prqfessor's
Note:For
manypeopLe, ice
cr~arn,tln4fiqfen
yogurrare
substit:u,te$,
so
the
cross
eLasticity
of
ice cream
relativetothepri¢e:of
Jrozenyqgurt
is.
"'0
positive.
Example:
Cross
elasticity

of
demand
(complements')
.Suppose
that
the
price
of
donuts
is
$0.50
and
the
localdonutshopserves800do~uts
per
,day.
At
the
same
donut
shop, the price
ofc0ffeeisinCl"~~~
fro~$O.75
tOi~~:;Gr'"
.
permp.
No
other
changes have
occu~~edandthe


ntlmber·of~{)nuts·'s():ld'decreas.~~'~~
.'

600
per
day. .Calculate
the
.cross elasticity
of.dell:utndfor,dgRt,lts·relaciy:~;tom~.pf~ge;<Y
•.Clfco'ffee.
'.
.••
.
'.
.
"'C-
.'.
,
.•
(·;~:ii·

··;'HiTf~;·!i<;
,·;,<,~~\~t#,.".~{
:.,,' v

Income
Elasticity
The
income

elasticity
of
demand
measures the sensitivity
of
the
quantity
of
a
good
or
service
demanded
to
a change in a consumer's income.
The
formula for income
elasticity
of
demand
is:
income elasticity
of
demand
percent change in quantity demanded
=
percent change
in
income
Income elasticity

of
demand
is
related
to
the rype
of
good being evaluated.
An
inferior
good has negative income elasticity.
As
income increases (decreases),
quantity
demanded decreases (increases). Inferior goods include things like bus travel and
generic margarine.
In
contrast, a
normal
good
has positive income elasticity, which
means
that
as
income increases (decreases), demand for the good increases (decreases).
BreAd
and tobacco are generally considered normal goods. Normal goods
that
h:'lve
re:,tively low income elasticities (between 0 and

+l)
are considered necessities, while
Page 12
@200H
Schw(;~er
.)tuJy
Session
If
Cross-Reference
to
CFAJ
nSlitute
Assigned
Reading
#
13
-
Elasticity
normal
goods
with
high
income
elasticities (values
greater
than
I) are generally
considered
luxury goods.
" . .

,','
.'"
.~a.Dlple::IJ1co~~elas~city
"

,.'.
Elasticity
of
Supply
The
price
elasticity
of
supply
is
similar
to
the
price elasticity
of
demand.
It
is
a
measure
of
the
responsiveness
of
the

quantity
supplied
to changes
in
price.
That
is:
. I

f I percent change in quamity supplied
O/O~Q
pnce e asnClty 0 supp Y=

=
percem change ID
pnce
%~P
As
shown
in panel
(a)
of
Figure 2 below, a perfeccly inelastic (vertical)
supply
curve
has
an
elasticity
of
supply

of
zero. Panel (b) illustrates a perfeccly elastic (horizontal)
supply
curve
with
an
elasticity
of
supply
equal
to
infinity. For
most
goods
and
services.
however, the elasticity
of
supply
falls
somewhere
between these
cwo
extremes.
Figure
2:
Inelastic
and
Elastic
Supply

P
s
I
PI
,
I 5
I
I
I
I
Q
(a)
Perfectly inelastic
supply
(elasticity =0)
Q
(b) Perfectly elastic
supply
(elasticity =
00
)
Page:
13
Stlllh· Session 4
CrosN-Reference
to
CFA InNtitute Assigned
Reading
#13
- Elasticity

i?::&:ample:Elasticity
of
supply
Factors
that
influence
the
elasticity
of
supply
are:
(l)
the
available
substitutes
for
resources (inputs) used
to
produce
the
good
and
(2) the
time
that
has elapsed since the
price change.
AvailabLe resource substitutions.
When
a good

or
service
can
only
be
produced
using
unique
or
rare
inputs,
the elasticity
of
supply will be low.
That
is,
the
short-run
supply
curve may be nearly vertical for these goods.
On
the
other
hand,
consider agricultural
goods such
as
sugar
and
rice.

These
goods
can
be grown
using
the
same
land
(resources),
and
the
opportunity
cost
of
substituting
one
for
the
other
is
nearly
constant.
As
such,
both
of
these
products
have highly elastic (nearly horizontal)
supply

curves.
SuppLy decision
time
frame.
Three
time-dependent
supply curves
must
be considered
when
evaluating
how
the
length
of
time
following a price change affects
the
elasticity
of
supply: (1)
momentary
supply, (2) short-rerm supply,
and
(3)
long-term
supply.
1.
Momentary
suppL)'

refers
to
rhe change in
the
quantiry
of
a good
supplied
immediarely following
the
price change.
When
producers
cannor
change
the
outpur
of
a good immediately,
the
momentary
supply
curve
is
vertical
or
nearly
vertical,
and
rhe

good
is
highly inelastic. Grapes
and
oranges are examples.
of
goods for
which
the
q
uantiry
produced
cannot
be
immediately
changed
in
response
to
price changes.
On
the
other
hand,
goods such
as
electriciry have
nearly perfectly elastic
momentary
supply

curves.
No
matter
what
the
demand
for electricity,
the
amount
provided can be
changed
without
a significant
change
in price.
2. Short-term suppLy refers
to
rhe shape a supply curve rakes
on
as
the
sequence
of
long-rerm
adjustments
are made
to
the
production
process. For example,

manufacturing
firms will adjusr the
amount
uflabor
they use in response
to
a
price change.
The
resulting increase
or
decrease in
tbe
cosr
of
rhis
input
cbanges
the
shape
of
tbe
supply curve.
As
rime passes, additional
adjustments
may
be
made, sucb
as

rechnulugical innovariuns
and
training
new workers,
wbicb will furtber cbange rhe shape
of
rhe supply curve,
making
ir
more
elasric
rhe lunger rhe adjusrmenr period.
Page
J"
Study
Session 4
Cross-Reference
to
CFA
Institute
Assigned
Reading
#13 -
Elasticity
3. Long-term
supp~y
refers
to
the
shape

of
the
supply
curve
after
all
of
the
possible
ways
of
adjusting
supply
have
been
employed.
This
is
usually
a
lengthy
process.
It
may
involve
building
new
factories
or
distribution

systems,
and
training
workers
to
operate
them.
Typically,
long-term
supply
is
more
elastic
than
shon-term
supply,
which
is
more
elastic
than
momentary
supply.
LOS
13.b:
Calculate
elasticities
on
a
straight-line

demand
curve,
differentiate
among
elastic, inelastic,
and
unit
elastic
demand
and
describe
the
relation
between
price
elasticity
of
demand
and
total
revenue.
Price
elasticity
of
demand
is
different
at
different
points

along
a
linear
demand
curve.
Consider
the
demand
curve
presented
in
Figure
3.
Figure
3:
Price
Elasticity
Along
a
Linear
Demand
Curve
Price($)
8
(a)
high elasticiry
Quantiry
•
•
•

:
r ~ ·.·.·-·;


:elasticiry =
-2.6
I : : :
5
! ( ··r· ~ :
(b) unitary elasticity
4
I_.
~

~
;

; elasticiry = -1
3
fl

·

·i
~


!
(c)
low elasticity

2
· : r
r : ~

·~

~
e1asticiry =
-0.2
-
_.

~-

.~
~.

-
~


-
~-_.
-
··i-

-

j.


_._;
.
I : ' • ! ' , , ,
10
20
30 40 50
60
70
80
At
point
(a), in a
higher
price
range,
the
price
elasticity
of
demand
is
greater
than
at
point
(c) in a
lower
price
range.
Price

elasticity
in
the
$6
to
$7
range
is
[(20 - 30) /
25J
/ [(7 -
6)
/ 6.5J =
-2.6.
Price
elasticity
in
the
$1
to
$2
range
is
[(70 - 80) /
75J
/ [(2 -
1)
/ 1.5J =
-0.2
The

elastici
ty
at
point
(b) is
-1;
a 1%
increase
in
price
leads
to
a 1%
decrease
in
quantity
demanded.
This
is
the
point
of
greatest
total
revenue
(P x Q)
which
equals
4.50 x 45 =$202.50.
At

prices
less
than
$4.50
(inelastic
range)
total
revenue
will
increase
when
price
is
increased.
The
percentage
decrease
in
quantity
demanded
will
be
less
than
the
percentage
increase
in
price.
At

prices
above
$4.50
(elastic
range)
a
price
increase
will
decrease,total
revenue
since
the
percentage
decrease
in
quantity
demanded
will
be
greater
than
the
percentage
increase
in
price.
~
Professor's Note:
It

is
important
that
you notice
that
price eLasticity
of
demand
~
changes
as
you move
aLong
the
demand
curve. Elasticity
is
not simpLy the
sLope
of
the
demand
curve!
©2008 Schweser
Page
15
%t.Q
O/ot.P
income elasticity
of

demand
Study Session 4
Cross-Reference
to
CFA
Institute
Assigned Reading #
13
- Elasticity
- "
KEy
CONCEPTS . . . ,
. . ,
1.
Price elasticity
of
demand
measures the change in
the
quantity
demanded
in
response
to
a change in
market
price.
percent change in quantity demanded
price elasticity
of

demand =
-= = " '
percent change in price
where:
%t.
uses
average values
2. Price elasticity
of
demand
for a good
is
primarily
determined
by three factors:
(1) the relative attractiveness
of
substitute
goods, (2) the relative
proportion
of
income
spent
on
the good,
and
(3) the time
that
has passed since the price
change occured.

3. Cross elasticity
of
demand
measures the change in the
demand
for a
good
in
response
to
a change in the price
of
ano ther good.
The
formula for calculating
cross elasticity
of
demand
is:
percent change in quantity demanded
cross elasticity
of
demand =
percent change in price
of
substitute or complement
4. Cross elasticity
of
demand
is

positive for goods
that
are substitutes for each
other,
and
negative for goods
that
are
complements.
5.
Income
elasticity
of
demand
measures the sensitivity
of
the
quantity
demanded
to
an increase or decrease in a consumer's income.
The
formula for
income
elasticity
of
demand
is:
percent change in quantity demanded
=

percent change in income
6.
Inferior goods have negative
income
elasticities
and
normal
goods have positive
income
elasticities.
Normal
goods
that
have
income
elasticities between 0
and
+1 are considered necessities, while
normal
goods
with
income
elasticities
greater
than
+1 are generally considered luxury, goods.
7.
The
price elasticity
of

supply
is
a measure
of
the responsiveness
of
the
quantity
supplied to changes in price.
. 1

f'
I percent change
in
quantity supplied
pnce e astlClty
0 supp y = . .
percent change
III
pnce
8.
Elasticity
of
supply
is
influenced by the time frame
within
which the
supply
decision

is
made
and
by the ability
ro
make
substitutions
between
productive
resources.
9. Price elasticity
of
demand
is
different at different
points
along a linear
demand
curve.
Demand
becomes less elastic (price elasticity becomes less negative) at
lower prices
and
higher
quantities.
10. Total revenue
is
maximized at
the
price

and
quantity
where
demand
is
unit
elastic (price elasticity =
-1).
In the range where
demand
is
elastic, total revenue
decreases
when
price
is
increased. In the range where
demand
is
inelastic, rotal
revenue increases
when
the price
is
increased.
P:lge 16
©2008
Schweser
Study
Session 4

Cross-Reference to CFA
Institute
Assigned Reading #13 - Elasticity
CONCEPT CHECKERS
1.
If
the
number
of
ice cream bars demanded increases from 19 to
21
when
the
price decreases from
$1.50
to
$0.50,
the price elasticity
of
demand
is:
A.
-5.
B.
-0.2.
e.
-O.l.
D. 1.
2.
If

quantity
demanded
increases 20% when the price drops 2%, this good
exhibits:
A.
elastic,
but
not
perfectly elastic demand.
B.
inelastic, but
not
perfectly inelastic demand.
e.
perfectly elastic
demand.
D. perfectly inelastic demand.
3.
The
primary factors
that
influence the price elasticity
of
demand
for a
product
are:
A.
changes in consumers' incomes, the time since the price change occurred,
and

the availability
of
substitute goods.
B.
changes in consumers' price expectations, changes in consumers' incomes,
and
the
expected time until the price change will occur.
e.
the proportions
of
consumers' budgets spent on the product, the size
of
the
shift in the
demand
curve for a product,
and
changes in consumers' price
expectations.
D. the availability
of
substitute
goods, the time
that
has elapsed since the price
of
the good changed,
and
the proportions

of
consumers' budgets
spent
on
the product.
4.
If
a good has elastic demand, a small percentage price increase will cause:
A.
no change in the
quantity
demanded.
B.
a smaller percentage increase in the quantity demanded.
e.
a larger percentage decrease in the quantity demanded.
D. a larger percentage increase in
quantity
demanded.
5.
The
cross elasticity
of
demand
for a substitute good
and
the income elasticity
for an inferior good are:
Cross elasticity Income elasticity
A.

< 0 > 0, < 1
B.
< 0 < 0
e.
> 0 > 0, <
D. > 0 < 0
6. Income elasticity
is
defined
as
the percentage change in:
A.
quantity
demanded
divided by the percentage change in income.
B.
income divided by the percentage change in the quantity
demanded.
e.
quantity
demanded
divided by the percentage change in the price
of
tile
producr.
D. the price
of
a
product
divided by the percentage change in the

quantity
demanded.
©
2008
Schwesc:r
Study Session 4
Cross-Reference to CFA
Institute
Assigned Reading #13 - Elasticity
Page 18
7.
8.
9.
10.
11.
If
quantity
demanded
for a good rises 20% when incomes rise
2%,
the good
is
a(n):
A.
necessIty.
B.
luxury good.
e.
inferior good.
D. inelastic good.

\);"Then
household incomes
go
up
and
the
quantity
of
a
product
demanded
goes
down, the
product
is
a(n):
A.
necessi
ty.
B.
luxury good.
e.
inferior good.
D. normal good.
If
the price elasticity
of
demand
is
-2

and
the price
of
the
product
decreases by
5%, the
quantity
demanded
will:
A.
decrease 2%.
B.
decrease 10%.
e.
increase 5%.
D. increase 10%.
Which
of
the following
is
most
likely a factor
that
influences the e1asticiry
of
supply for a good?
A.
The
price

of
the productive resources used to produce it.
B.
The
proportion
of
consumers' budgets
spent
on the good.
e.
The
availabiliry
of
substitute productive resources.
D.
The
price elasticiry
of
demand
for the good.
If
the price e1asticiry
of
a linear
demand
curve is
-1
at the
current
price, an

increase in price will lead to:
A.
no change in total revenue.
B.
a decrease in profits.
C. an increase in total revenue.
D. a decrease in total reven
ue.
©2008 Schweser
Srud\' Sessioll
'1
Cross-Reference
10
CFA
Institute
Assigned
Reading
#13
- Elasticity
:ANsWERS':'-
CONCEPT
CHECKERS

•
~
'L.
I. C
If
the
Ilumber

of
widgets
demanded
changes from 19
to
21
\\'hen the price changes
from
$1.50
to
$0.50,
the percentage change in
quantit~·
is
(2] - 19) / [(21 + 19)
/2]
'=
10%
and
the percentage change in price
is
(0.50 -
1.
50) / !(1. 'iO+
0.50)
/
2J
'=
-1
00%.

Thus.
price elasticity = J
0%
/
-100%
=
-0.1.
2. A
If
quantity
demanded
increases
20%
when
the price
drops
2%. this good exhibits
elastic
demand.
~rhenever
demand
changes by a greater
percentage
than price,
demand
is
considered
to be elastic.
3. D
The

three primary' factors influencing
the
price elasticity
of
demand
for a
good
are
the
availability
of
substitute
goods, the
proportions
of
consumers'
budgets
spent
on the
good,
and
the
time
since
the
price change.
If
there are
good
substitutes,

when
the price
of
the
good
goes up,
some
customers will switch to
substitute
goods. For goods
that
represent
a relatively small
proportion
of
consumers' budgets. a change in price will
have little effect on
the
quantity
demanded.
For
most
goods.
the
price elasticity
of
demand
is
greater in the
long

run
than
in
the
short
run.
4.
C
If
a
good
has elastic
demand,
a small price increase will cause a larger decrease in
the
quantity
demanded.
Demand
is
elastic when
the
percentage change in
quantity
demanded
is
larger
than
the
percentage change in price.
5.

D
The
cross elasticity
of
substitutes
is
positive
and
the
income
elasticit~,
of
an inferior
good
is
negative.
6.
A
Income
elasticity
is
defined
as
the
percentage
change in
quantitv
demanded
divided by
the

percentage change in income.
Normal
goods have positive values for
income
elasticity
and
inferior
goods have negative
income
elasticity.
7.
B A
luxury
good
is
a
good
for which the percentage increase in
quantity
demanded
is
greater than the
percentage
increase in income. A necessity
is
a
good
for which, when
income
increases by a given percentage,

the
quantity
demanded
increases,
but
by a
smaller percentage. Since
quantity
demanded
rose
20%
when
incomes rose 2%, the
good
in question
is
a
luxury
good.
8.
C
When
household
incomes increase and
the
quantity
demanded
of
a good decreases, the
product

is
an inferior
good.
Examples
of
inferior goods are bus travel
and
margarine
(for
some
income
ranges).
9. D
If
the price elasticity
of
demand
is
-2,
and
the
price
of
the
product
decreases by 5%,
the
quantity
demanded
will increase

10%.
The
value,
-2,
indicates
that
the percentage
increase in
the
quantity
demanded
will be twice the percentage decrease in price.
10. C
The
factors
that
influence
the
elasticity
of
supply are the possible resource
substitutes
and
the
time
frame for
the
supply decision.
II.
D

On
a linear
demand
curve,
demand
is
elastic at prices above the
point
of
unitary
elasticity so a price increase will decrease total revenue.
The
effect on profits
is
indeterminate
without
information
on costs.
«)l008
Schwcscr
Page
J9
1
.!
. .
)
.


The

following
is
a review
of
the Economics principles designed to address
the
learning
outcome
statements
set
forth by CFA
Institute
liJ
•
This
topic
is
also covered in:
EFFICIENCY
AND
EQUITY
Study
Session
4
EXAM Focus
The
primary
focus
of
this

review
is
the
efficient
allocation
of
resources.
The
concepts
of
marginal
benefit,
marginal
.
cost,
consumer
surplus,
and
producer
surplus
are
all
central
to
understanding
the
efficient
allocation
of
productive

resources.
A basic
understanding
of
the
obstacles
co
the
efficient
allocation
of
resources
and
of
the
tWO
schools
of
thought
on
economic
"fairness"
should
be
sufficient.
Page
20
LOS
14.a:
Explain

allocative efficiency,
marginal
benefit
and
marginal
cost,
and
demonstrate
why
the
efficient
quantity
occurs
where
marginal
benefit
equals
marginal
cost.
"Marginal"
here
refers
to
an
additional
unit,
so
the
comparison
between

marginal
benefit
and
marginal
cost
compares
the
benefit
of
one
additional
unit
co
the.
cost
of
producing
that
unit.
As we
shall
see,
the
efficient
allocation
of
a society's
resources,
and
therefore

the
production
of
the
efficient
quantity
of
each
good
or
service,
is
achieved
when
the
benefit
to
society
of
producing
one
more
unit
JUSt
equals
the
cost
to
society
of

producing
that
additional
unit.
We
measure
the
benefit
co
society
as
the
value
that
a
user
places
on
the
additional
unit
produced.
We
measure
the
cost
co
society
as
the

opportunity
cost
of
production,
i.e.,
the
value
.0F
other
goods
and
services
we
must
forego
co
produce
the
additional
unit.
Wpen
markets
function
well,
the
demand
curve
For
a
good

or
service
illustrates
the
(decreasing)
value
to
consumers
of
additional
units
of
a
good
or
service.
and
the
supply
curve
illustrates
the
opportunity
cost
of
production
of
additional
units
of

a
good
or
service.
We
draw
downward
sloping
demand
curves
to
reflect
the
fact
that
each
successive
unit
consumed
will
be
less
highly
valued
by
consumers.
\v'e
draw
upward
sloping

supply
curves
to
retlect
the
fact
that
the
opportunity
cost
of
producing
additional
units
of
a
good
increases as
more
and
more
resources
are
bid
away
from
other
productive
uses
to

produce
additional
units
0['
the
good.
Given
tnese
interpretations
of
demand
and
supplv
curves.
we
can
sute
that
the
eFFicient
quantity
of
any
good
or
service
is
the
quantity
where

the
demand
curve
;Ind
supplv
curve
intersect.
Figure
1
illustrates
this
result.
If
the
economy
produces
less
than
3.000
cons
of
steel. we
have
not
maximized
the
benefit
to
society
of

stedproductioll.
The
value-that
consumers
pLlce
on
additional
units
of
steel
is
greater
than
the
value
consumers
place
on
the
other
goods
and
services
foregone
to
produce
those
units.
Conversely,
if

the
economy
produces
1110n:
than
3.000
tons
of
steel.
eadl
unit
;lbove
3.000
tons
requires
thar
society
give
up
orher
goods
and
services
more
highly
v:llued
by
consumers
tnan
the

additionalunirs
of
sreel
above
3.000 rOils. As
11)llg
:IS
rhe
demand
©2
()OS
Sc:hwt'sc:r
Srud\" Session 4
Cross-Reference
to CFA
Instirute
Assigned
Reading
#14 - Efficiency
and
Equity
curve represenrs
the
marginal henefit ro society
and
the supply curve represents
marginal cost to societ)"
the
henefit
to

society derived from
producing
steel
is
maximized
at
.'=1,000
tons.
Figure
1:
Equilibrium
and
Efficient
Quantity
£/ton
Marginal Cost
(Me)
= supply
$500
3,000
MarginaJ
cosr
grearer
than
marginal
benefit
Marginal Benefir (MB) =demand
Quantity
(rons)
We refer to

the
quantity
where
the
supply
and
demand
curves
intersect
as
the
efficient
quantity
of
production
and
economists
measure
economic
efficiency
of
production
,against this idealized
solution.
In
a capitalist economy, each consumer's
attempts
to
purchase
that

combination
of
goods
that
he values
most
highly,
and
each
producer's
attempts
to maximize profits
from
production,
result
in
allocative efficiency. Allocative
efficiency
is
attained
when
the allocation
of
an economy's
productive
resources leads
to
the
production
of

quantities
of
all goods
and
services
that
have
the
maximum
total
benefit
to
consumers.
Contrast
this
with
a
centrally
planned
economy, where
the
government
economic
authority
must
determine
the
"right"
quantity
of

every good
or
service
produced
in
the
economy,
and
you will
understand
the
magnitude
of
the
problem
of
providing
the
quantity
of
each good
and
service
that
will result in
the
greatest
economic
welfare for a
country's

citizens.
LOS
14.b:
Distinguish
between
the
price
and
the
value
of
a
product
and
explain
the
demand
curve
and
conslimer
surplus.
The
difference between
the
rotal value
to
consumers
of
the
units

of
a
good
that
they
buy
and
the
total
amount
they
must
pay for those
units
is
called
consumer
surplus.
In
Figure 2, this
is
the
shaded
triangle.
The
total value to society
of
3,000
tons
of

steel
is
more
than
the
total
amount
paid
for the
3,000
tons
of
steel by an
amount
represented
by
the
shaded
triangle.
©2008
Schweser
Page
21
Study Scs,ion 4
Cross-Reference to CFA
Institute
Assigned
Reading
# 14 - Efficiency
and

Equity
Figure 2:
Consumer
Surplus
Siron
$50()
Consumer Surplus
Supply (MC)
Demand (MB)
' ~
Quancity
([Ons)
3,000
We can also refer
co
rhe
consumer
surplus
for an individual. Figure 3 shows a
consumer's
demand
for gasoline in gallons
per
week.
Ir
is
downward
sloping
because
each successive gallon

of
gasoline
is
worth
less
co
rhe
consumer
rhan rhe previous
gallon.
Wirh
a
marker
price
of
$3.00
per
gallon, rhe
consumer
chooses
co
buy 5 gallons
per
week for a coral
of
$15.
While
rhe firsr gallon
of
gasoline

purchased
each week
is
worth
$5.00
co
rhis
consumer,
ir
only
cosrs
$3.00,
resujring in
consumer
surplus
of
$2.00.
Ifwe
add
up rhe
maximum
prices rhis
consumer
is
willing
[Q
pay
for each
gallon,
we

find
rhe coral value
of
rhe 5 gallons
is
$20.
Toral
consumer
surplus for rhis
individual
from gasoline
consumprion
is
20 -
15
=
$5.
Figure
3: A
Consumer's
Demand
for
Gasoline
$ per gallon
Page:
22
$5.00
$4.50
$4.00
$3.50

$3.00
Consumer surplus
from rhe second gallon
($4.50 -
noo = 51.50)
Consumer surplus
rrom
the'
gallons =
$';,00
I-~ ! : '-" l_ ,
Marker
price
AmOUnt
paid
for 5
gal
Ions
Demand = J\brgin,] Bendlc (MBl
Gallons per
week
2 3 4 5
~)
.!OOS
Schw.:sn
Srudy Session 4
Cross-Reference to CFA
Institute
Assigned Reading # 14 - Efficiency
and

Equity
LOS 14.c:
Distinguish
between
the
cost
and
the
price
of
a
product
and
explain
the
supply
curve
and
producer
surplus.
Under
certain
assumptions (perfect markets), the
industry
supply
curve
is
also the
marginal societal
(opportunity)

coSt curve.
Producer
surplus
is
the excess
of
the
market price above the
opportunity
cost
of
production.
For example, in Figure 4, steel
producers are willing to
supply
the
2,500th
ton
of
steel at a price
of
$400.
Viewing the
supply curve
as
the marginal cost curve, the cost in terms
of
the value
of
other

goods
and
services foregone to
produce
the
2,500th
ton
of
steel
is
$400.
Producing
and
selling the
2,500th
ton
of
steel for
$500
increases
producer
surplus by
$100.
The
difference between the total
(opportunity)
cost
of
producing
steel

and
the total
amount
that buyers
pay
for it (producer surplus)
is
at a
maximum
when
3,000
tons
are
manufactured
and
sold.
This
is illustrated
in
Figure 4.
Figure 4:
Producer
Surplus
Siron
Demand (MB)
Supply
(MC)
' ! : , Producer surplus
for
2,500th

ron
= $100
Total
consumer
surplus
L-
'-
Quantity
(rons)
$500
$400
2,500 3,000
LOS
14.d
Discuss
the
relationship
between
consumer
surplus,
producer
surplus,
and
equilibrium.
Note
that
the
efficient
quantity
of

steel (where marginal cost equals marginal benefit)
is
also the
quantity
of
production
thai
maximizes total
consumer
surplus
and
producer
surplus.
The
combination
of
consumers seeking to maximize
consumer
surplus
and
producers seeking to maximize
producer
surplus (profits) leads to the efficient
allocation
of
resources to steel
production
because
it
maximizes

the
total
benefit to
society from steel
production.
We can say
that
when the
demand
curve for a good
is
its
marginal social benefit curve
and
the
supply curve for the
good
is
its
marginal
social
cost curve,
producing
the
equilibrium
quantity
at the price where
quantity
supplied
and

quantity
demanded
are equal maximizes the
sum
of
consumer
and
producer
surplus
and
brings
about
an efficient allocation
of
resources to the
production
of
the
good.
©2008
Schweser
Page
23
Study Session 4
Cross-Reference
to
CFA
Institute
Assigned
Reading

#14
- Efficiency
and
Equity
LOS
14.e:
Explain
1)
how
efficient
markets
ensure
optimal
resource
utilization
and
2)
the
obstacles
to
efficiency
and
the
resulting
underproduction
or
overproduction,
including
the
concept

of
deadweight
loss.
Consider
a
situation
where the allocation
of
resources w steel
producoon
is
nOt
efficient. In Figure 5, we have a
disequilibrium
situation
where rhe
quantity
of
steel
supplied
is
greater
than
the
quantity
demanded
at
a price
of
$600/wn.

Clearly, steel
inventories will
build
up
and
competition
will pUt
downward
pressure
on
the
price
of
steel.
As
the price falls, steel producers will reduce
production
and
free up resources w
be
used in the
production
of
other
goods
and
services
until
equilibrium
output

and
price are reached.
If
steel prices were
$400Iron,
invenwries
would
be
drawn
down,
which would
pur
upward
pressure
on
prices
as
buyers
competed
for the available steel. Suppliers
would
increase
production
in response w rising prices
and
buyers
would
decrease
their
purchases

as
prices rose. Again,
competitive
markers
tend
wward
rhe
equilibrium
price
and
quantity
consistent
with
an efficient allocation
of
resources w steel
production.
Figure
5:
Movement
Toward
Allocative Efficiency
S/ron
Excess
supply
drives price
coward
equilibrium
SupDly
,),fC)

$600
5500
l r
i Suppliers reduce producrion
I
:.
+ :
in
response
ro
declining price
I
I
I
I
;
L
~_~
__
___'_
' _
QU<!f1[:r:
•con,)
Quantirv
3.UOO
Quantiry
demanded
iUopiied
at
$600/<011

at
5600/<011
I
I
ISuppliers increase .
$500 .
f Im?-4!!~.ti9 ~jn
__
.
5400
Ill
~i~r;gn;~_i~~____
~

hcess~eman4
J
//
:
driveS
price:
i
cor
ard
equilibri\ull
I , ,
I
QualHitv
.'.llOO
Qual1titv
;upptied demanded

at
$'!OO/ron
:It
$'!OO/tlHl
Supph
I\[U
'Page 24
©200S
Schwescr
Study Session 4
Cross-Reference to
CFA
Institute
Assigned
Reading
*'
14
- Efficiency
and
Equity
Obstacles
to
Efficiency
and
Deadweight
Loss
Our
analvsis so far has presupposed
that
the

demand
curve represenrs the marginal
social benefit curve,
the
supply curve represenrs the marginal social
COSt
curve, and
competition
leads
us
to a
supplv/demand
equilibrium
'quantity
consistenr
with
efficienr
resource allocation, \)?e now will consider ho",'
deviatiom
from these ideal
conditions
can result in an inefficienr allocation
of
resources.
The
allocation
of
resources
is
inefficienr

if
the
quantity
supplied does
not
maximize
the
sum
of
consumer
and
producer
surplus.
The
reduction in
consumer
and
producer
surplus due to
underproduction
or
overproduction
is
called a
deadweight
loss.
Figure 6:
Deadweight
Loss
Siron

Demand
(MB)
Supply (MC)
Deadweight loss
from overproduction
I
f
-





' ~ ~
Quanrity (rons)
$500
$iron I
I
I
I
$500
Supply
(MC)
Deadweight loss
from underproduction
Demand (MB)
0:
-' _ '
Quantity
(rons)

Obstacles
to
the
efficient
allocation
of
productive
resources include:
Price
controls,
such
as
price ceilings and price floors,
distort
the incentives
of
supply
and
demand,
leading to levels
of
production
different from those
of
an
unregulated
marker. Renr
control
and a
minimum

wage are examples
of
a price
ceiling
and
a price floor.
©2008
Schweser
Page 25