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
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

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
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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
P

Say W goes down from 10 to 7

Change in supply Shift
Horizontal movement
Vertical movement

Q
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Example 3

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
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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
S

Excess Supply

Excess Demand

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. Noncompetitive 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
Example 9

Q1
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Q
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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

Producer Surplus

P1

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 Floor

Price Ceiling
P

P
Deadweight loss

Deadweight loss

P*
P*

D
Q
Example 11

Q*

D
Q
Q*
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Q
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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.
2.
3.
4.

Own-Price
Income
Price of Substitute
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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