Elasticity of Demand Formula
(ΔQ/Pre-ΔQ) / (ΔP/Pre-ΔP)
or
%ΔQ / %ΔP
- Microeconomics
- Macroeconomics
- International Economics
- Micro - individuals, households, businesses
- Macro - decision making entities as a whole together, entire nations or major sections of a national economy
- International - activity between nations
Relationships of Dependent and Independent Variables on a Graph
If slope is downward, it’s an inverse relationship (negative) If slope is upward (supply), it’s a positive relationship
Y = mx + b
- Y = unknown value of Y
- m = slope of plotted line
- x = value of variable x
- b = “intercept”, value of Y when X is 0
- Example: TC = FC + VC(units)
Substitute Goods (Price/Demand impact)
Direct relationship: Price and Demand between good of concern and it’s substitute good move in same direction.
Ex. When price of butter increases, so does the demand for it’s substitute, margarine.
Complimentary Goods (Price/Demand impact)
Inverse relationship:
Ex. shoelaces and shoes, as price for shoes goes up, demand for shoe laces goes down.
The term “quantity is the function of price.” which variable is dependent and independent?
Quantify is dependent on price (independent). pay attention to terminology, typically Quantity is on the X axis and is the independent variable.
Price Ceiling versus Price Floor
Price Ceiling (rent cap) results in a supply shortage Price Floor (minimum wage) results in a supply surplus
A company has a policy of frequently cutting prices to increase sales. Product demand is significantly elastic. What impact would this have on the company’s situation?
Quantity increases proportionally more than the price declines. Remember elasticity equation, the numerator is change in Quantity. if Elasticity is > 1, then this makes sense.
Marginal Utility vs. Total Utility
- Marginal Utility decreases as more units are acquired.
- Total Utility increases at a decreasing rate.
Average Fixed Cost Curve AFC
is NOT U-shaped, Simply put, more units are being produced for a fixed cost. Therefore, the average fixed cost decreases continuously over the relevant range of production.
Perfect Competition
- (a) It is composed of a large number of sellers, each of which are too small to affect the price of the product or service
- (b) The firms sell a virtually identical product
- (c) Firms can enter or leave the market easily (no barriers to entry)
Remember that PC does not actually exist in the real world.
- MR is less than AVC: Firm is not covering variable cost the loss increases with every unit produced. Firm should shut down.
- Price equals Marginal Revenue
- Firm is a price taker and its demand curve is horizontal
- they can sell as many as they produce, but not at higher price.
- Firm will break even when MR = ATC.
- No firm in the long run in Perfect Competition will make a profit.
- Optimum profit is where MR = MC
When a firm has increasing returns to scale, it is considered to have a…
Natural Monopoly, such that a single firm can produce at a lower cost than two or more firms.
Monopolistic Demand Curve in a perfectly competitive environment
- A monopolistic firm is the only firm in an industry and faces a conventional negatively sloped demand curve for its commodity. In order to sell more of its commodity, it must reduce its selling price.
- In a perfectly competitive environment, the DC is horizontal and the firm can sell any quantity at the market price.
Cross Elasticity of Demand
%ΔQD in Product X / %ΔP of Product Y
- Positive CE = Substitute Goods
- Negative CE = Complementary Goods
- Average Total Cost
- Marginal Cost
ATC = Total Cost x # Units
MC = Total Cost of Unit B - Total Cost of Unit A
Marginal Revenue
Marginal revenue is defined as the amount of additional revenue received from the sale of one additional unit.
Oligopoly (Car Industry)
Collusive Pricing and Tacit Collusion
Oligopoly is a market characterized by:
- Few Sellers (meaning there is an inter-dependency among sellers)
- Firms sell either homogeneous or differentiated products and compete via non-price methods
- Significant barriers to entry (meaning long run profits expected)
- Demand Curve is said to have a kink in it where above kink D is more elastic and below kink D is less elastic
Collusive pricing occurs when the few firms in an oligopolistic market (or industry) conspire to set the price at which a good or service will be provided. Such collusion typically is carried out to establish a price higher than would exist under normal competition. Overt collusive pricing is illegal in the U.S.A.
Tacit Collusion (such as airlines matching pricing) is legal and a common occurrence.
Marginal Propensity to Consume
Δ Consumption / Δ Income
The most important instrument of monetary policy that aids in controlling the money supply is?
Open Market Operations - through bond sales and purchases are flexible (government securities can be purchased or sold in large or small amounts), cause prompt changes in bank reserves, and are more subtle than reserve ratio changes.
(Macro) Examples of Economic Leakages
Def: Individuals income not spent on consumption
Ex. Payments for - Taxes, Savings, Imports
(Macro) Examples of Economic Injections
Def: Additions to domestic production NOT from individual expenditures.
Ex. Investment Expenditures, Government Spending, Exports
Marginal Propensity to Save
Δ Savings / Δ Income
Inherent vs. Residual Risk
- Inherent risk is the risk to the organization if management does nothing to alter its likelihood or impact.
- Residual risk is the risk of the event after considering management’s response.
Product Differentiation
- Physical characteristics (e.g., higher quality, additional features, etc.)
- Perceived differences (e.g., advertising, brand name, etc.)
- Support service differences (e.g., exchange policies, assistance, after-sale support, etc.)
Measure of the maximum amount of goods and services an economy can produce at a given time, assuming available technology and full utilization of available economic resources, including labor.
Potential GDP
Net National Product
NNP = GNP - Depreciation
Production-Possibility Frontier (Curve)
Measures the maximum amount of various goods and services an economy can produce at a given time with available technology and efficient use of all available resources.
GDP Gap
GDP Gap = Potential GDP - Real GDP
- Negative GDP gap indicates that the economy is operating above normal full capacity, which will put upward pressure on prices.
Average Ratios (as opposed to marginal ratios)
Average propensity to consume (APC): Measures the percent of disposable income spent on consumption goods.
- CS / DI
Average propensity to save (APS): Measures the percent of disposable income not spent, but rather saved.
- S / DI
Remember that APC + APS = 1, the measures are reciprocal of each other.
Which competition form describes an industry that has a relatively large number of firms operating noncollusively and producing differentiated products?
- A. Pure Competition
- B. Pure Monopoly
- C. Monopolistic Competition
- D. Oligopoly
C. Monopolistic Competition
Pure Competition is incorrect because in pure competition, products are standardized and firms have no control over prices.
Leading Economic Indicators
- Average weekly hours, manufacturing
- Average weekly initial claims for unemployment insurance
- Manufacturer’s new orders, consumer goods and materials
- Vendor performance, slower deliveries diffusion index
- Manufacturer’s new orders, nondefense capital goods
- Building permits, new private housing units
- Stock prices, 500 common stocks
- Money supply, M2
- Interest rate spread, 10-year Treasury bonds less federal funds
- Index of consumer expectations
The balance of payments account includes what? Also, name the three account types.
The balance of payments accounts include all international payments made by one nation to another, including capital movements.
- Current
- Capital
- Financial
Balance of payments
Balance of payments is used to refer to a system of accounts that catalogs the flow of goods between the residents of two countries. If country X is a net exporter of goods and therefore has a surplus balance of trade, countries purchasing the goods must use country X’s currency. This increases the demand of the currency and therefore its relative value.
Transaction risk relates to the possibility of gains and losses resulting from income transactions (denominated in foreign currency) occurring during the year.
What are three ways to hedge transaction risk?
- Forward Contract to buy or sell (hedging in a forex market)
- Money Market Hedge
- Currency Futures Market Hedge
Fiscal vs. Monetary Policy
- The Federal Reserve System seeks to achieve national economic objectives through its exercise of monetary policy, that is, through its control of the money supply.
- The Fed does not establish or implement fiscal policy.
- Fiscal policy is established primarily by the U.S. Congress, through its control of the level of government spending and the tax system (rate, etc.).
Direct vs. Indirect Exchange Rates
Direct = D = Domestic, domestic price of 1 unit of a foreign currency. 1 EUR costs $1.10.
Indirect = Foreign price of 1 unit of domestic currency. $1 will buy .90 EUR.
Currency Demand Factors
- Political and Economical Environment = stronger they are the more demand for currency.
- Relative Interest Rates = higher rates relative to comparable countries increases investment in country which creates increased demand.
- Relative Inflationary Rates = lower rates retain PPow and increases demand
- Level of public debt (higher = inflation), deters investment and decreases currency demand.
- Status of Current Account Balance = higher deficit (Imports > Exports) = increases demand for foreign currency relative to domestic currency.
Changes in Exchange Rates - Appreciation
Value of currency increases (stronger) relative to another currency. It takes less domestic currency to buy foreign currency or goods sold in foreign currency.
What happens to a country’s currency if it’s demand for foreign currency is greater than the demand (or it’s falling) for it’s own domestic currency by foreign buyers?
- Higher imports = higher demand for foreign currencies, which exceeds other country’s demand for host country currency.
- Host currency declines with respect to other currencies.
Freely fluctuating exchange rates perform what function?
They automatically correct a lack of equilibrium in the balance of payments.
For example, with a U.S. deficit in the balance of payments, the U.S. demand for foreign currencies will exceed the foreign currencies provided by foreign currency inflows.
As a result, there will be an increase in demand for foreign currencies relative to the U.S. dollar, and freely fluctuating exchange rates will enable the value of the dollar relative to other currencies (i.e., the exchange rate) to fall and help move the balance of payments back into equilibrium.
How can a firm mitigate transaction risks?
- Matching - incur equal payables and receivables in the same currency to offset effects.
- Leading/Lagging Payments Hedging - contra transaction used so that a loss on one would be offset by a gain on the other.
Translation Risk
Possible unfavorable impact of changes in currency exchange rates on financial statements of foreign operation that are converted from a foreign currency to the domestic currency.
Economic Risk
Δ’s in FX Rates may make future revenues convert to fewer dollars or future expenses convert to more dollars.
What is a put option?
A put is an option that gives its owner the right to sell a specific security at fixed conditions of price and time. A put option is a contract that gives the owner the right, but not the obligation, to sell a specified amount of an underlying asset (e.g., security) at a specified price within a specified time
International Monetary Fund
The IMF maintains order in the international monetary system by providing funds to countries in financial crisis, including currency crisis, banking crisis, or debt crisis.
Foreign Direct Investment
Foreign direct investment involves investments in non-monetary assets (e.g., property, plant, equipment, etc.) in a foreign location.
Buying Foreign Bonds is NOT FDI.
Worldwide output is measured by…
Adding together the GDP of the world’s countries.
Studies have shown that most mergers and acquisitions…
do not result in creating value for the acquiring entity.
Which of the following statements regarding importing and exporting, if any, is/are correct?
- Goods with a low value-to-weight ratio are less likely to be suitable for importing than goods with a high value-to-weight ratio.
- In the exporting of goods, one may encounter import restrictions imposed by the country of destination.
Both are correct
What are the general steps in the strategic planning process?
- Establish mission, values and goals.
- Assess environment
- Establish Objectives
- Formulate strategies
- Implement strategies
- Evaluate and control activities
Michael Porter’s 3 Generic Strategies
- Cost Leadership
- Differentiation
- Focus
Which of the following identifies a framework for gauging the attractiveness of the competitive environment of an industry?
- Five Forces
- SWOT
- PEST
- Focus
Michael Porter’s “Five Forces” - specifically analyzes the nature of competition in an industry or market.
PEST Analysis is a?
Macro assessment of: Political Economic Social Technological elements of a business environment.
SWOT analysis does what?
Develops a profile of internal strengths and weaknesses and external opportunities and threats.
- Internal Environment (S/W) - relates to situations that enhance or hurt an entity’s competitive advantage.
- External Environment (O/T) - opportunities (benefit from unmet demand) and threats (risk of adverse consequence as result of external forces).
Characteristics of a Cost Leadership entity
- Seek to minimize costs
- Invest significantly in production and distribution assets
- Efficient Distribution, Manufacturing and Product Design
PEST analysis and SWOT analysis are assessment techniques used in the strategic planning process. Are these forms of analysis primarily concerned with “where” an entity should be located or with “how” an entity should operate?
PEST (external only analysis) analysis is a form of macro-environmental analysis and is primarily concerned with where an entity should operate.
SWOT is a form of micro-environmental analysis and is primarily concerned with how an entity should operate.
Import Tariffs will…
Increase the price of the item to domestic consumers, resulting in the reallocation of expenditures to other products. This will lead to lower domestic consumption of the item.
Effective management must analyze and forecast the general environment to identify opportunities and threats to the firm. In doing so, the following techniques are used:
Scanning - study of all segments of the general environment. High level look.
Monitoring - study of environmental changes identified by scanning.
Forecasting
Assessing - determining changes in firm’s strategy that are necessary as a result of information obtained from forecasting.
Monopolistic Competition
- Non-price competition, which is based on subtle product differentiation
- All firms have some influence and are not price takers
- THE RESTAURANT INDUSTRY
In monopolistic competition, firms sell a product or service that is only slightly differentiated; the product or service is similar to, but not identical with, other products or services. A firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms
In addition, monopolistic competition has the following characteristics:
- A large number of sellers.
- Close substitutes for the product or service.
- Ease of entry into or exit from the market (few barriers to entry)
- In the long run, a monopolistically competitive firm will make zero economic profit.
Profit is maximized when MR = MC.
When maximizing utility in economics, what is being maximized?
Satisfaction
GDP Approaches: Expenditure
Expenditure - this measures GDP using the value of final sales and is derived as the sum of the spending of:
- Individuals - consumption expenditures for durable and non-durable goods and for services;
- Businesses - investments in residential and non-residential (e.g., plant and equipment) construction and new inventory;
- Governmental entities - in the form of goods and services purchased;
- Foreign buyers - in the form of net exports (exports - imports) of U.S. produced goods and services.
GDP Approaches: Income
Income - this measures GDP as the value of income and resource costs and is derived as the sum of:
- Compensation to employees
- Rental income
- Proprietor’s income
- Corporate profits
- Net interest
- Taxes on production and inputs
- Depreciation
- Business transfer payments
Less: Government enterprise surplus
Plus: Statistical adjustment
= GDP
Real GDP
Measures the total output of final goods and services produced for exchange in the domestic market during a period (usually a year) at constant prices ( it adjusts for changing prices using a price index).
Real GDP = (Nominal GDP/GDP Deflator) × 100
GDP Deflator
The GDP deflator is a comprehensive measure of price levels used to derive real GDP.
Real GDP Per Capita
Real GDP/Population
Real GDP per capita is a common measure of the standard of living in a country.
Net Domestic Product (NDP)
NDP Measures GDP less a deduction for “capital consumption” during the period—the equivalent of depreciation. Thus, NDP is GDP less the amount of capital that would be needed to replace capital consumed during the period.
Gross National Product (GNP)
Measures the total output of all goods and services produced worldwide using economic resources of U.S. activities. In 1992 GNP was replaced by GDP as the primary measure of the U.S. economy. GNP includes both the cost of replacing capital (the depreciation factor) and the cost of investment in new capital.
- National Income
- Personal Income
- Personal Disposable Income
- Measures the total payments for economic resources included in the production of all goods and services, including payments for wages, rent, interest, and profits, but not taxes included in the cost of final output.
- Measures the amount (portion) of national income, before personal income taxes, received by individuals.
- Measures the amount of income individuals have available for spending, after taxes are deducted from total personal income.
- Unemployment Rate
- Natural Rate of Unemployment
- Unemployed (including all categories) / Size of Labor Force
- Natural Rate of Unemployment = Frictional + Structural + Seasonal Unemployed/Size of Labor Force
Full employment exists when?
There is no cyclical unemployment. Even with frictional and structural unemployment, officially full employment can exist.
Said another way, if unemployment is due solely to frictional, structural and seasonal causes (i.e., the natural rate of unemployment), the economy is in a state of full employment.
Model of Employment / Unemployment Elements
Aggregate Demand & Curve
- AgD is a macroeconomic demand measure
- Curve is traditional downward sloping and shows quantity demanded at various prices
AgD Components are total spending by:
- Individual consumers (consumption spending),
- businesses on investment goods, and
- by governmental entities, and
- foreign entities on net exports.
Impact of transfer payments on Aggregate Demand.
Direct relationship with AgD.
- An increase in transfer payments will increase AgD
- It is the spending of transfer payments by recipients that increases aggregate demand.
- A decrease in transfer payments will decrease AgD
Aggregate Demand Curve Shift Impacts
- Income Taxes
- Consumer Confidence
- Technological Advances
- Corporate Taxes
- Interest Rates
- Government Spending
- Exchange Rates / Net Exports
- Wealth Changes
- Income Taxes - if up, AgD down
- Consumer Confidence - if up, AgD up
- Technological Advances - if up, AgD up
- Corporate Taxes - if up, AgD down
- Interest Rates - if up, AgD down
- higher rates equate to lower levels of investment.
- Government Spending - if up, AgD up
- Exchange Rates / Net Exports - if a country’s currency weakens, it’s goods & services become less expensive relative to other countries and exports will rise, causing AgD to also increase.
- Wealth Changes - if up, AgD up
Multiplier Effect
Factors that cause a shift in aggregate demand have a ripple effect through the economy. For example, an increase in investment spending by business results in certain increases in personal disposable income, which further spurs demand. This cascading effect on demand is called “the multiplier effect.”
Multiplier Effect = Initial Change in Spending × (1/(1 − MPC))
or
Multiplier Effect = Initial Change in Spending × (1/MPS)
Unemployment Types
- Frictional - due to imperfections in the labor market and relates to workers searching for jobs or waiting to take jobs in the near future.
- Cyclical - caused by the recession phase of the business cycle, that is, by a deficiency of aggregate spending.
- Structural - changes over time in the structure of consumer demand, which in turn alters the structure or composition of the demand for labor, is what is referred to as structural unemployment.
- Full Employment - sum of frictional and structural unemployment. Full employment does not mean zero unemployment.
Market Structure:
Short-run and Long-run Profit ability
In the Short-run:
- it is possible for all structures to make a profit but NO FIRM is assured of profit. It is not a guarantee in the short-run or the long-run.
In the Long-run:
- Long-run profit is only possible in the following market structures:
- Oligopoly
- Perfect Monopoly
- Firms in a monopolistic competition and perfect competition structure will not make profit in the long-run.
What effect on net exports will an expansionary fiscal policy have?
An increase in governmental spending causes an increase in domestic interest rates and international capital inflows. These capital inflows cause the domestic currency to appreciate, which has a negative effect on net exports.
International purchasing power effect
When domestic price levels increase relative to foreign currencies, foreign products become less expensive causing an increase in imported goods and a decrease in exported goods. This decreases the aggregate demand of domestic products.
- When foreign products become less expensive for U.S. buyers, this will increase imports and increase the trade deficit, decreasing aggregate demand for domestic products.
An increase in spending on imported goods will have what impact:
- Shift aggregate supply to the right
- Shift aggregate demand to the right
- Shift aggregate supply to the left
- Shift aggregate demand to the left
Shift aggregate demand to the left
An increase in spending on imported goods would most likely shift the aggregate demand curve to the left–a reduction in demand. An increase in spending on imported goods would shift the demand curve to the left as demand for domestic goods is replaced by imports.
An increase in the value of the Chinese currency (the RMB) relative to the U.S. dollar would most likely cause what?
Remember tricky wording here…
Chinese currency strenghtens against the dollar, this would likely result in increased aggregate demand in the U.S.
An increase in the value of the Chinese RMB relative to the U.S. dollar would most likely increase aggregate demand in the U.S. An increase in the value of the Chinese RMB relative to the U.S. dollar would make Chinese goods more expensive in the U.S. and U.S. goods less expensive in China. As a consequence, fewer goods would be bought from China by U.S. consumers and more goods would be bought from the U.S. by Chinese consumers. Furthermore, U.S. consumers might also buy (substitute) more U.S. goods for the now more expensive Chinese goods.
International Trade:
- Absolute Advantage
- Comparative Advantage
- In the law of comparative advantage, the country that should produce a specific product is determined by?
- AA: If a country has an absolute advantage (e.g., low-cost labor, technology, etc.) in the production of a particular good, there is an incentive for that country to produce more than its citizens need to export the good to countries with higher production costs.
- CA: a comparative advantage means that country has no alternate uses of its resources that would involve a higher return. In the long term, production of specific goods and services will migrate to countries that have a comparative advantage.
- Opportunity Costs
Analysis of the Business Environment - Techniques Firms Engage in
- Scanning—a study of all segments in the general environment. The objective is to predict the effects of the general environment on the firm’s industry. Management can use this information to modify its strategies and operating plans. Scanning of the general environment is critical to firms in volatile industries. Sources of information for scanning include trade publications, newspapers, business publications, public polls, government publications, etc.
- Monitoring—a study of environmental changes identified by scanning to spot important trends. As an example, the trend in aging of the population in this country would definitely be important to firms that provide services to retired individuals. Effective monitoring involves identifying the firm’s major stakeholders (e.g., customers, investors, employees, etc.).
- Forecasting—Developing probable projections of what might happen and its timing. As an example, management might attempt to forecast changes in personal disposable income or the timing of introduction of a major technological development.
- Assessing—Determining changes in the firm’s strategy that are necessary as a result of the information obtained from scanning, monitoring, and forecasting. It is the process of evaluating the implications of changes in the general environment on the firm.
Returns to Scale Concepts
In the long run all inputs are variable because additional plant capacity can be built. If in the long run a firm increases all production factors by a given proportion, there are the following three possible outcomes:
- Constant returns to scale—Output increases in same proportion.
- Increasing returns to scale—Output increases by a greater proportion.
- Decreasing returns to scale—Output increases by a smaller proportion.
Aggregate Demand
- Net Exports/Imports
- When net exports is positive (exports greater than imports), aggregate demand is increased.
- When net exports are negative (exports less than imports), aggregate demand is decreased.
A number of factors enter into determining a country’s level of imports and exports with other countries, including:
- Relative levels of income and wealth—the higher the income and wealth, the greater the spending, including on imports;
- Relative value of currencies—a weaker currency stimulates exports and makes imports more expensive (and vice versa);
- Relative price levels—the higher the price level, the more costly are goods/services for foreign buyers;
- Import and export restrictions and tariffs—the greater the restrictions and tariffs, the lower the level of imports and/or exports;
- Relative inflationary rates—the higher the inflation rate, the higher the cost of inputs, causing outputs to be more costly and less competitive in the world market.
Classical Aggregate Supply Curve
- This curve is completely vertical, reflecting no relationship between aggregate supply and price level.
- This form of supply curve is sometimes associated with the nature of supply in the very short term when factors of production cannot be changed and in the long term when all inputs to the production process are fully utilized (including having full employment).
Keynesian Aggregate Supply Curve
This curve is horizontal up to the (assumed) level of output at full employment, then slopes upward, reflecting that output is not associated with price level until full employment is reached, at which point increased output is associated with higher price levels.
Conventional Aggregate Supply Curve
This curve has a continuously positive slope with a steeper slope beginning at the (assumed) level of output at full employment, reflecting that at full employment increased output is associated with proportionately higher increases in price levels.
Aggregate Supply Curve Shifts
Changes other than price level will affect aggregate supply and shift the aggregate supply curve under any of the theoretical assumptions described above. Factors that may change the position of the supply curve include:
- Resource availability – An increase in economic resources (e.g., increase in working age population) will shift the curve outward (to the right); a decrease would have the opposite effect;
- Resource cost – A decrease in the cost of economic resources (e.g., lower oil prices) will shift the curve outward (to the right); an increase will have the opposite effect;
- Technological advances – (e.g., more efficient production processes) will shift the curve outward (to the right). Government prohibitions on the use of an existing technology, in the absence of a comparable alternative, will shift the curve inward (to the left).
