Study session 4 in the CFA Level I curriculum covers microeconomic analysis and is composed of four readings (13-16). The material on economics concludes in study session 5 with macroeconomic analysis and is worth 10% of your total exam score.
While the material may get detailed at points, larger concepts and ideas are the key for most of your points in the economics section. The Institute isn’t expecting you to become a chief economist at some bank just by virtue of the curriculum. Get the big picture down and how it affects the investment decision-making process and move on to the “core” topic areas like FRA and equity.
Intro to Demand and Supply
Understand the difference between substitutes and complements and how price and demand is affected. A price increase for a substitute causes demand for the other product to increase while an increase for a complement drives down demand for the product.
Shifts versus movement along the supply/demand curves is easily testable and a fundamental concept. Remember that a change in price represents movement along the curves while changes in other variables (income, expectations, technology, number of buyers/sellers, price of related goods) will cause a shift in the curve.
Figuring out the areas under the curve can be a pain but is also something that has shown up on the exams. Remember your basic math: Area = ½ (base * height) and the terminology (consumer and producer surplus, deadweight loss, affects of a ceiling or floor on prices)
The terminology and interaction here is probably the more important part. Remember the income effect and substitution effect reacts from a change in price and how the changes are different for normal versus inferior goods.
Understanding how the terminology fits together mathematically is a big part of the reading (i.e. Total revenue minus explicit and implicit costs equals economic profit). There is a lot here and figuring out all the curves can be a pain for those that did not get it in their fundamental college course. For me, reading through the material only put me to sleep. The best way to understand the material was to work through problems and use the answers to understand how everything fit together.
- Firms will produce as long as their marginal revenue (MR) is greater than marginal costs (MC)
- The break even price is the point at which economic profit equals the average total cost (P = AR = MR = ATC or where TR = TC)
- If MR is greater than MC then profit can be increased by increasing output
- If MR is less than MC then profit can be increased by decreasing output
- When TR is less than TVC then the firm will shut down (short-run) and exit (long-run)
The differences between long-run and short-run decisions are important.
In the short-run, the firm can continue to operate even if TR is less than TFC and TVC. However, the industry will contract as existing firms leave over the long-run. If TR is greater than TC then firms will continue to operate in the short-run but the industry will attract competitors in the long-run.
The Firm and Market Structures
The reading is a huge relief after the previous one because the material is largely conceptual and fairly easy to grasp. The differences between the four market structures is key and the best way to see how they compare is to make yourself a table with: number of sellers, degree of differentiation, barriers to entry, pricing power of firm, non-price competition, firm demand, allocative efficiency and long-run profits.
Along with the table, make a quick note on the characterisitics and advantages of each structure.
- Perfect competition: Free entry and exit to industry with low barriers, homogenous products and a large number of buyers/sellers means sellers are price takers, efficient allocation of resources and only a normal profit
- Monopolistic competition: many buyers/sellers with some product differentiation but entry/exit is low-cost, firms have some control over price but must advertise
- Oligopoly: few sellers offering similar or identical products (close substitutes), barriers to entry/exit are high and firms have substantial control of price. Understand the terminology behind duopoly, collusion and cartels
- Monopoly: single seller and product, high barriers to entry and significant control over resources/price.
While the material in monopolistic competition and oligopoly is important, the curriculum seems to focus more time on the extremes and how they relate to supply/demand analysis.
Study session five concludes the topic area with macroeconomics and is incrementally more important to the other two CFA exams. Let me know if you’ve got any questions or comments.
‘til next time, happy studyin’
Joseph Hogue, CFA