CFA Level 1 (2009) - 2

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(~)20()8 Kaplan ~chwcser. All rig-hL rc:,crvcd.

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Disclaimer: The Schweser Notes should bc used in conjunction with the original readings as ser forth byeFA Institure in their 2009 CFA Levell Study Guide. The information conraincd in these Nores covers topics contained in the readings referenced by CFA Institute and is believed to be accurate, However, their accuracy cannor bc guaranteed nor is any warranry conveyed as to your ultimare exam success, The authors of rhe referenced readings have nor endorsed or sponsored these Notes.

©2008 Kaplan Schweser

READINGS AND

LEARNING OUTCOME STATEMENTS

READINGS

The following material is a review ofthe Economics principles designed to address the learning olitcome statements set forth by CFA Institute,

Book 2 - 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 candidare should be able co:

a.calculare and inrerprer rhe elasriciries of demand (price e1asricity, cross elasriciry, income e1asricity) and rhe e1asriciry of supply, and discuss the faccors rhar influence each measure. (page 10)

b.calculare e1asriciries on a srraighr-Iine demand curve, differenriare among e1asric, inelasric, and unir elasric demand, and describe rhe relarion becween price elasricjr.1' of demand and coral revenue. (page 16)

Thr topical collemgr corresponds u,itl, tI)c((Jllowing ('fA lmtitllu assigncd reading:

] 4. Efficiency and Equit~·

The:- landidare should he abk w:

a.explain rhe various means of markers ro alloure resources efficienrl~" 1l1:1rginal benefir and marginal cosr, and demonsrrare why rhe efficienr quanriry occurs where marginal benefir equals marginal cost. (page 2] )

b.disringuish berween rhe price and rhe valuc or a producr and explain rhe demand curve and conSUI1lt'( surplus. (page 23)

c.disringuish benveen rhe cosr and rhe price of a producr and explain rhe suppl\' curve and producer surplus. (page 24)

d.discuss rhe relarionship bervveen consumer SUI ellIS. producer surplus, and equilibrium. (pagt' 25)

e.explain 1) how efficienr markers ensure oprimal resource urilizarion and 2) rhe obsracles co efficiency and rhe resulring underproducrion or overproducrion,

including rhe concepr of deadweighr loss. (page 25)

f.explain rhe cwo groups of ideas about rhe fairness principle (urilirarianism and rhe symmerry principle) and discuss the relarion becween fairness and efficiency. (page 28)

The topical coverage correspOluL( with theloLlowing CFA lwtitttte assigned reading:

a.explain marker equilibrium, disringuish becween long-rerm and shorr-rerm impacrs of ourside shocks. and describe rhe effecrs of rem ceilings on rhe exisrence of black markers in rhe housing seeror and on rhe marker's efficiency. (page 35)

b.describe labor marker equilibrium and explain rhe effecrs and inefficiencies of a minimum wage above rhe equilibrium wage. (page 38)

c.explain rhe impacr of raxes on supply, demand, and marker equilibrium, and describe rax incidence and irs relarion ro demand and supply elasricity. (page 39)

d.discuss rhe impacr of subsidies, quoras, and markers for illegal goods on demand, supply, and marker equilibrium. (page 42)

Book 2 - Economics

Readings and Learning Outcome Statements

The topicaL coverage corresponds with the fOLLowing CFA Institute assigned reading:

16. Organizing Production

The candidate should be able to:

a. explain the types of opportunity cost and their relation to economic profit, and calculate economic profit. (page 50)

b. discuss a firm's constraints and their impact on achievability of maximum proht. (page 51)

c. differentiate between technological efficiency and economic efficiency, and calculate economic efficiency of various firms under different scenarios. (page 52)

d. explain command systems and incentive systems to organize production, the principal-agent problem, and measures a firm uses to reduce the principal-agent

TIJ(' topiCilI cO/leragc correspolld' uJith thc((ILLolUing CFA hwitllt!' (/,f)'igllcd reading:

17. Output and Costs

The candidate should be able to:

a.differentiate between shon-run and long-run decision time frames. (page 64)

b. describe and explain the relations among total product of Jabor, marginal product of labor, and average product of labor, and describe increasing and decreasing marginal returns. (page 64)

c.distinguish among total COSt (including both fixed COSt and variable cost), marginal cost, and average COSt, and explain the relations among the various cosI'curves. (page 66)

d.explain the firm's production function, its properties of diminishing returns and diminishing marginal product of capital, the relation between short-run and longrun costs, and how economies and diseconomies of scale affect long-run COStS. (page 70)

STUDY SESSION 5

The topicaL coverage corresponds with thefbLLowing CfJl Institute assigned reading:

18. Perfect Competition

The candidate shou Id be able to:

a.describe the characrerisrics of perfect competition, explain why firms in a perfecrl)' competitive marker are price takers, and differentiate between market and firm demand curves. (page 78)

b.determine the profit maximizing (loss minimizing) output for a perfectly competitive firm, and explain marginal cost, marginal revenue, and economic profit and loss. (page 79)

c.describe a perfectly competitive firm'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 81)

Book 2 - Economics

Readings and Learning Outcome Statements

d.discuss how a permanent change in demand or changes in technology affect price. output, and economic profit. (page 83)

The topical coverage corresponds with the fOllowing CFA Institute assigned reading:

19. Monopoly

The candidate should be able to:

a. describe the characteristics of a monopoly. including factors that allow a monopoly to arise. and monopoly price-setting strategies. (page 91)

b.explain the relation between price, marginal revenue, and elasticity for a monopoly. and determine a monopoly's profit-maximizing price and quantity. (page 92)

c.explain price discrimination, and why perfect price discrimination is efficient. (page 93)

d.explain how consumer and producer surplus are redistributed in a monopoly, including the occurrence of deadweight loss and rent seeking. (page 94)

e.explain the potential gains from monopoly and the regulation of a natural monopoly. (page 9'1)

Th(' !(JpiCilI COUt'J"!!!." CO/'l"C-'pOi/r/.' wirl· !hc!()lloll'ing Cl·>1 In.mt/Il(, iI.iC<'f/1cd },cddi/lg'

20. Monopolistic Competition and Oligopoly The candidate should be able to:

a.describe the characteristics of monopolistic competition and an oligopoly. (page 1(2)

b.determine the profit-ma,imiz1I1g (loss-minimizing) omput under monopolistic competition and an oligopoly, explain why long-run economic profit under monopolistic competition is zero. and determine if monopolistic competition is efficient. (page 1(3)

c.explain the importance of innovation, product development, advertising, and branding under monopolistic competition. (page 1(5)

d.explain the kinked demand curve model and the dominant finn model, and describe oligopoly games including the Prisoners' Dilemma. (page] 06)

The topical coverage corresponds with the fOllowing CFA Institute assigned reading:

21. Markets for Factors of Production

The candidate 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 114)

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 115)

c.describe the factors determining the supply of labor. incl uding the substitution and income effects, and discuss the factors related to changes in the supply of labor. including capital accumulation. (page 1] 6)

d.describe the effects on wages of labor unions and of a monopsony, and explain the

possible consequences for a market that offers an efficient wage. (page 1] 7)

e.differentiate between physical capital and financial capital. and explain the relation between the demand for physical capital and the demand for financial capital.

(page 119)

f. explain the factors that influence the demand and supply of capital. (page 119)

g.differentiate between renewable and non-renewable natural resources and describe the supply curve for each. (page 121)

Book :2 - Economics

Readings and Learning Outcome Statements

h.differelHiate berween economic reor and opponuniry cosrs. (page] 22)

FIJI' topical COlJeragt' corresponds with thcfoltowing CFA Institute assigned reading:

22. Monitoring Jobs and the Price Level The candidare should be able [0:

a.define an unemployed person. and iorerprer rhe main labor marker indica[Ors. (page 129)

b.define aggregare hours and real wage rales. and explain their relation [() gross domestic product (GOP). (page] 30)

c.explain the types of unemployment, full employment, the natural rate of unemploymeor, and the relation berween unemployment and real GOP. (page 130)

d.explain and calculate the consumer price index (CP!) and the inflation rate,

describe rhe rebrion berween rhe CPI and rhe inflarion rare, and explain the main sources of cpr bias. (page 13])

The topical co/1crag(' correspond., Luitf, tlz(,follOluing CfA 1I1Jtiwtc msiglled rCl1dillg.

23. Aggregate Supply and Aggregate Demand The candit{;)re should be ahle [0:

;to explain the faclor' rh,lI inHuc'nce real (;[ )1> ~lIId Ions-run ,lI1d shorl-rull aggreS~lll supph'. cxpLtin 11100'Cl11enr ~dong rhe long-run and short-run aggregare sllPPh' curves (LAS and SAS), and discuss the reasons for changes in potelHial GOP and aggregate supply. (page] 40)

h.explain rhe componenlS orand the factors lh,l[ arleCl real CDP demanded. descrihe rhe .lggregate demand curve and W)lI' it slopes downward, and explain the ractors that e1l1 change aggrq;atc dellland. (page] 4.11

c.dittcrentiate between shorr-run and long-run macroeconomic equilibrium, and explain hoy\' economic growth, inflation, and changes in aggregate demand and suppl\' influence [he macroeconomic equilibrium. (page 144)

d.compare and contrast the classical. Keynesian. and monetarist schools of macroeconomics. (page] 47)

STUDY SESSION 6

rhc topittll COll{:ragc corresprllld.i with thc.f{)/Iowillg CfA Institute assign{'(1 readillg:

24, Money, the Price Level, and Inflation

The candidate should be able to:

c.describe the economic functions of and differentiate among the various depository institutions, and explain the impact of financial regularion. dereglll:Hion, and innovation. (page 153)

d.explain rhe goals of rhe U.S. Federal Reserve (Fed) in conducting monetary polic:'

and how the Fed uses irs policy rools to control the quanrit}, of money, and describe the assets and liabilities on the Fed's balance sheet. (page 154)

e.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 156)

f.describe rhe monetary base, and explain the relation among the monetary base, the money multiplier, and the quantity of money. (page 156)

Book 2 - Economics

Readings and Learning Outcome Statements

g.explain the factors that influence the demand for money, and describe the demand for money curve, including the effects of changes in real GOP and financial innovation. (page 157)

h.explain interest rate determination, and the shorr-run and long-run effects of

money on real GOP. (page 158)

1.discuss the quantity theory of money and its relation to aggregate supply and aggregate demand. (page 161)

The topical coverage corresponds with the following CFA Institute assigned reading:

25. U.S. Inflation, Unemployment, and Business Cycles The candidate should be able to:

a.differentiate between inflation and the price-level. (page 168)

b.describe and distinguish among the factors resulting in demand-pull and cost-push inflation, and describe the evolution of demand-pull and cost-push inflationary processes. (page 168)

c.distinguish between anricipatcd and unanticipated inflation, and explain the costs of anriciparcd inflation. (page j"'O)

d.explain the imp:Ju 01 intLHion all unemploymenL ~lnd de;,cribc rhe short-run and long-run Phillips ClIfW, including the cffcer or changes in rhe natural rate 01 unemployment. (page 172)

e.explain the rdation among inflation. nominal interest rates, and the demand and supplv of money. (page 1~3)

f.explain how economic grovv"th, inflation, and lllH:mploymenr affect the business c~·cle. (page 174)

g.describe mainstream business cycle theory and real business cycle (RBC) theory, and distinguish between them. including rhe role of productivity changes. (page 17))

The topical coverage corresponds with theIollowing CFA Institute assigned reading:

26. Fiscal Policy

The candidate should be able to:

a.explain supply-side effects on employment, potential GOP, and aggregate supply, including the income tax and taxes on expenditure. and describe the Laffer curve and its relation to supply-side economics. (page 182)

b.discuss the sources of investment finance, and the influence of fiscal policy on capital markets. including the crowding-our effect. (page 184)

c.discuss the generational effects of fiscal policy, including generational accounting and generational imbalance. (page 185)

d.discuss the use of fiscal policy to stabilize the economy, including the effects of the government expenditure multiplier, the tax multiplier. and the balanced budget multiplier. (page 186)

e.explain the limitations of discretionary fiscal policy, and differentiate between discretionary fiscal policy and automatic stabilizers. (page 186)

The topical coverage corresponds with the following CFA Institute assigned reading:

27. Monetary Policy

The candidate should be able to:

a.discuss the goals of U.S. monetary policy and the Federal Reserve's (Fed's) means for achieving the goals, including how the Fed operationalizes those goals.

(page 192)

Book 2 - Economics

_ Readings and Learning Outcome Statements

b.describe how the Fed conducts monetary policy, and explain the Fed's decisionmaking strategy including an instrument rule, a targeting rule, open-market operations, and the market for reserves. (page 193)

c.discuss monetary policy's transmission mechanism (chain of events) between changing the federal funds rate and achieving the ultimate monetary policy goal when fighting either inflation or recession, and explain loose links and time lags in the adjustment process. (page 194)

d.describe alternative monetary policy strategies, and explain why they have been rejected by the Fed. (page 195)

The topical coverage corresponds with the/ollowing CPA Institute assigned reading:

28. An Overview ofCenrral Banks The candidate should be able to:

a.identi~r the functions of a central bank. (page 201)

b.discuss monetary policy and the tools utilized by central banks to carry out

monetary policy (page 20 I)

The following is a review of the Economics principles designed to address the learning outcome statements set forth by CFA Institute®. This topic is also covered in:

ELASTICITY

Study Session 4

EXAM Focus

LOS 13.,.: Calculate and interpret the elasticities of demand (price eI;tsticir)', cross elasricity, income elasticity) and the elasticity of supplv. ane discuss the factors th.:.t influence each measure.

The price elasticity of demand measurcs the change in the quantitv demanded in response [(1 a change in market price (i.e .. a movemenr along a demand

Pl'Ofessor's Naif: It is custOl1lrll:J' to USt (WCI"rlgt vlz/ues u,htn calcul,uing perc('Iltagc changes used in elasticit), computations. This wa)' a changcfrom R to J() and a changc fi'om 1() to 8 both result 117 the sllmc percentage change 0(2/9 = ]2.2%. Usc thi.- method 011 tilt exam.'

Figure 1 illustrates the general categories of price elasticity of demand. A discussion of each is presented below:

If a small percentage price change results in a large percentage change in quantity demanded, the demand for that good is said to be highLy eLastic. Apples are an example of an elastic good. The absolute value of price elasticity is greater than one, meaning that the percentage change in Q is greater than the percentage change in P.