Elasticities are ratios of percentage changes. It is used because it is "unit" agnostic e.g. pounds, dollar, euros etc.
If the law of demand holds, own-price elasticity of demand will always be negative because a rise in price will be associated with a fall in demand., but it can be either elastic (very price sensitive) or inelastic (insensitive to a change in price)
To be precise, when the magnitude (ignoring the sign) is greater than 1 then demand is elastic
When the magnitude is less than 1 then demand is inelastic
When the elasticity of demand is equal to –1, demand is unit elastic. An important point to note is that at unit elastic is that total revenue (price × quantity) is maximized at that price.
Factors other than "own-price" affecting demand elasticity are (not a comprehensive list)
Substitutability
Portion of the typical budget
Long-run demand elasticity is much more elastic than a short-run demand.
Discretionary vs. Non-Discretionary.
All of the above (and more) points contribute to demand elasticity – in different directions, so demand elasticity is likely to be a complex result of these factors.
Elasticity and Total Expenditure
When demand is elastic, price and total expenditure move in opposite directions.
When demand is inelastic price and total expenditure move in the same direction.
Curve
P vs. Q (negative slope – typical demand curve)
TE vs. Q (TE curve)
The TE curve is at its peak point when the demand curve is at unit elastic point.
Own Price Elasticity of demand will almost always be negative, income price elasticity of demand can be negative, positive or zero.
Income Elasticity:
Positive income elasticity means that if the incomes rise, quantity demanded will also rise.
Negative income elasticity means that if the incomes rise, quantity demanded will fall. So when their income falls, quantity demanded will rise.
Goods with positive income elasticity are called normal goods. The demand curve ( P vs. Q) will shift upwards and to the right in this case.
Goods with negative income elasticity are called inferior goods. The demand curve ( P vs. Q) will shift downwards and to the left in this case.
Cross Price Elasticity of Demand
Same Concept. However, this time the elasticity is computed by using price of a different good than "own-price".
Positive Elasticity: If the demand of good Y increase due to an increase in price of good X then these goods are considered as substitutes. Thus an increase in price of a good will result in upward and right movement of demand curve of good Y.
Negative Elasticity: If the demand of good Y decreases due to increase in price of good X, then these are complements.
The general law of demands states that the quantity demanded is inversely proportional to "own-price". This is depicted in the demand curve as a negatively sloped line. There are two reasons why the customers would be expected to purchase more of a good if its price decreases (and vice versa) a) Substitution Effect and b) Income Effect – Normal Good
The substitution effect of a change in price of a good will always be in the direction of buying more at a lower price or less at a higher price. The income effect of that same price change, however, depends on whether the good is a normal good or an inferior good.
If the good is normal, then the income effect and substitution effect work together to lead to a negative sloped demand curve.
If the good is inferior, then the income and substitution effect work in opposite directions; the income effect tends to mitigate the substitution effect.
The cost of producing anything depends on the amount of inputs or factors of production. For simplicity, economists typically concentrate on two inputs, labor and capital.
The total cost of production = w*L + r*K where L is labor hours and K is machine hours.
Sunk Cost – The money that is already spent on Plant and Equipment.
Accounting Depreciation – backward looking , Economic Depreciation – forward looking – Opportunity Cost. Both concepts are important. Economic Depreciation helps in making managerial decisions and Accounting Depreciation helps in spreading historical costs for tax and reporting purposes.
Marginal Revenue = Price + (Slope of Demand Curve)*Q
For a perfectly competitive market MR = P
For a negative demand slope MR is less than P
There are two types of Marginal Costs
Short Run Marginal Cost(SMC) = w/MP - wages/marginal productivity – Labor Cost is variable in this case
LMC – Long Run Marginal Cost – Both Labor and Equipment costs are variable in this case
In general, in long run all costs are variable.
Profit maximization decision for an operating firm
MR = MC
MC is not falling.
Economic Cost = Accounting Cost + Opportunity Cost.
Normal Profit in economics sense means that the firm's revenue is equal to its economic costs.
Firms that are operating in a very competitive environment with no barriers to entry from other competitors can expect in the long run to be unable to make a positive economic profit. This situation, of course does not imply that the firm is earning ZERO accounting profit.
The short run is a time period in which atleast one of the factors of production (e.g. Labor, Plant etc.) is fixed.
The long run is a time period in which all costs are variable. The long run is referred to as a planning horizon. The firm is always operating in the short term but planning in the long run.
The long run total cost curve is derived from the lowest level of short run total cost curves by varying quantities (huh?). This curve is called an envelope curve.
Extending that further there is a Short Run Average Total Cost Curve and a corresonding LRAC curve (the envelope curve of all possible SATC)
Economies of Scale can be observed by negatively sloped LRAC and Diseconomies of Scale can be observed by positively sloped LRAC
Four Types of Market Structures:
Perfect Competition
Monopolistic Competition – The competitive characteristic is a notably large number of firms and monopolistic aspect is focused on product differentiation. E.g. Coca Cola, a beverage company but they have managed to convince the consumers that their product is different than their competitor's (e.g. Pepsi)
Oligopoly – Relatively small number of firms supplying the product in the market but they need to be mindful of what others are charging (worry about retailatory pricing)
Monopoly
As a technical issue, the difference between price elasticity of demand and income elasticity of demand is that
The demand adjustment for price elasticity represent a movement along the demand curve
The demand adjustment for income elasticity represent a shift of the demand curve upwards or downwards. If the good is normal then the demand curve will shift upwards right and away from the origin.
Marginal Value Curve: Demand curve can be considered as marginal value curve as it shows the highest price consumers are willing to pay for each additional unit.
The profit-maximizing output is the quantity at which marginal revenue equals marginal cost. In a price-searcher industry structure (i.e., any structure that is not perfect competition), price is greater than marginal revenue.
Schumpeter pointed out that technical change in economics can happen due to Process Innovation or Product Innovation
He suggested that perfect competition is more of a long-run type of market. In short run, a company develops a cool gadget and the inventor makes high profits. The "swarming" happens when others try to imitate the product and finally in the third stage new technology is no longer new because everyone has imitated it.
TC includes all costs to the firm including the opportunity costs. Therefore, economic profit is a signal to the market and this signal attracts competition.
In long-run equilibrium, output and price are stable. There is no change in price or output that will increase profits for firms.
Oligopoly pricing strategy: 3 types 1) Cournot 2) Nash and 3) Pricing Interdependence
Aggregate Output is the value of all goods and services produced during a specified period.
Aggregate Income is the value of all payment earned by suppliers of factors of production of goods and services.
For simplicity, it is standard in macroeconomics to attribute all income to households sector.
Aggregate Expenditure is the total amount spent on the goods and services produced during the specified period.
AO = AI = AE
In a simplified world, the income is received by the households, who provide labor and capital to the business. The business receives the expenditure by the households and provides good and services and income to the households.
GDP can be measured in one of two ways:
Income Approach: The total amount earned by households and companies in the economy.
Expenditure Approach: Total amount spent on goods and services produced within the economy
As a general rule, only the value of goods and services whose value can be determined by being sold in the market are included in the GDP measurement. Exceptions are Government Services and Owner Occupied Housing.
In general, the number of goods and services with imputed values are excluded in GDP measurement.
Economists use Real GDP
Nominal GDP = P(t) * Q(t) where P(t) is the price in the year t and Q(t) is the quantity produced in year t.
Real GDP = P(b) * Q(t) where P(b) is the price in the baseline year b.
GDP Deflator
Value of the current output at current year prices / Value of the current output at base year prices
Real GDP = Nominal GDP / GDP Deflator
Major Components of GDP
Household
Business
Government
Foreign
GDP = C + I + G + (X-M) OR C+G(c)+G(I)+X-M
C+S+T = C + I + G + (X-M)
S = I + (G-T) + (X-M)
G-T = (S-I) - (X-M)
Fiscal Deficit can be observed if G-T > 0 which means that 1) X-M < 0 2) S-I is greater than X-M 3) or both
Household Disposable Income = Personal Income Less Taxes.
Household Net Saving = HDI – Expenses.
According to consumption function, either an increase in income or a decrease in taxes will increase aggregate consumption.
Somewhat more sophisticated models of consumption recognize that consumption not only depends on income but also on wealth. Individuals tend to spend a higher fraction of their current income as their wealth increases because with higher current wealth, there is less need to save to provide for future consumption.
For global investors, estimating sustainable rate of economic growth (GDP growth) for an economy is important in valuing a variety of assets. Growth in potential GDP matters for long-run equity market appreciation, Potential GDP can be used to gauge inflationary pressures, credit quality, assess likelihood of a change in monetary policy, all of which are relevant to fixed income investors.
Roughly the same time as peaks or troughs, and lagging indicators that don’t tend to change direction until after expansions or contractions are already underway.
Four Phase of the cycle
Recovery – The economy is at a "trough", the actual output is at its lowest level relative to potential output. Economic Activity below potential but is starting to increase.
Expansion – Actual output above potential output – boom phase.
Slowdown – Economy reaches its highest level relative to its potential, growth rate begins to slow
Contraction – Output falls below potential output.
Investors pay attention to credit cycles because
It helps them understand the housing and construction market developments
Anticipate Monetary policy actions. Whereas monetary and fiscal policy traditionally concentrate on reducing the volatility of business cycles, macro prudential stabilization policies to dampen financial booms have gained importance.
Although a small part of the economy, changes in inventories can influence economic growth measures because they occur with substantial speed and frequency.
In general, unemployment is at its lowest just after the economy has peak and it is at its highest just after the recovery has started.
In general, inflation is pro-cyclical, I.e, it goes up and down with the cycle), but with a lag of a year or more.
In all of the key theories, movements in either aggregate demand or supply create business cycles over time.
An increase in inventories is counted in the GDP statistics as economic output, whether the increase is planned or unplanned. An analyst who looks only at GDP growth, rather than the inventory-sales ratio, might see economic strength rather than the beginning of weakness.
Leading indicators that have been known to change direction before peaks or troughs in the business cycle, coincident indicators that change direction at roughly the same time as peaks or troughs, and lagging indicators that don’t tend to change direction until after expansions or contractions are already underway.
The classical view is that the aggregate supply curve is very steep and the prices and wages adjust quickly and therefore recessions are mild and short-lived.
Keynesian – Fiscal support is needed to stabilizing the aggregate demand curve as it is viewed the price and wages are sticky.
1970s gave rise to Monetarism - it advocates the importance of monetary policy and advocates stable money growth to keep the aggregate demand curve stable, inflation under control and reduce business cycle volatility.
According to monetarists, business cycle may occur due to exogenous shocks and/or fiscal intervention.
The practice of lending customer's money to others on the assumption that not all customers will want all of their money back at any one time is knows as Fractional reserve banking.
The amount of money that the banking system creates through the practice of fractional reserve banking is function of 1 divided by the reserve requirement, a quantity known as money multiplier.
Quantity Equation
M*V = P*Y
M = Quantity of Money
V = Velocity
P = Average Price Level
Y = Output
Money Neutrality
The belief that real variables (real GDP and velocity) are not affected by monetary variables (money supply and prices) is referred to as money neutrality.
If money neutrality holds then increase in supply of money will not increase output and therefore no change in velocity. Thus the only change due to change in supply of money is change in price.
The nominal interest rate in an economy is the sum of required real rate of interest and expected rate of inflation
R(nom) = R(real) + Inflation expectations
However, investors can never be sure about future values of inflation and real growth. Thus, they need to be compensated via risk premium.
So, all nominal rates are composed of 3 variables
Real rate, Inflation and Risk Premium.
The higher the policy rate, the higher the potential penalty the bank will have to pay to the central bank if they run short of liquidity, the greater will be their willingness to reduce lending and more likely that broad money growth will shrink.
Monetary Transmission Mechanism:
Asset Prices
Interest Rates
FX
Expectations of future growth
Independence can be evaluated based on both operational independence and target independence. Operational independence means that the central bank is allowed to independently determine the policy rate. Target independence means the central bank also defines how inflation is computed, sets the target inflation level, and determines the horizon over which the target is to be achieved. The ECB has both target and operational independence, while most other central banks have only operational independence.
Monetary policy is often adjusted to reflect the source of inflation. For example, if inflation is above target due to higher aggregate demand (consumer and business spending), then contractionary monetary policy may be an appropriate response to reduce inflation. Suppose, however, that inflation is higher due to supply shocks, such as higher food or energy prices, and the economy is already operating below full employment. In such a situation, a contractionary monetary policy may make a bad situation worse. In the United States, the Federal Reserve focuses on core inflation (i.e., excluding volatile food and energy prices) for this reason.
Neutral Rate = Trend Growth of the underlying economy + Inflation Target
If the central bank's policy rate is greater than the neutral rate then it is considered contractionary. Otherwise Expansionary.
The pegging country essentially commits to a policy intended to make its inflation rate equal to the inflation rate of the country to which they peg their currency.
Keynesians believe that fiscal policy can have powerful effects on aggregate demand.
Interesting Metrics
Revenue to GDP
Expenses to GDP
Automatic stabilizer
Auto pilot in the sense that in recession, the revenue (taxes) for the government will decrease which implies an automatic tax relief and increase in social benefit programs like unemployment benefits.
Similarly, in boom times, the revenue will increase as more taxes will be collected.
If an economy grows at a real growth rate that is higher than the real interest rate then the debt burden will reduce.
Vice versa, if the economy grows at a slower pace then the real interest rate then the debt burden will increase thus putting burden on servicing its debt.
Crowding Out
Situation where government borrowing may divert private sector investment from taking place; if there is limited amount of savings to be spent on investment, then larger government demands will lead to higher interest rates and lower private sector investing.
Fiscal Policy Tools:
Transfer Payments e.g. entitlements, unemployment benefits etc.
Current Government Spending on items like Healthcare, Education and Defence.
Capital Expenditures e.g. Infrastructure.
Direct government spending has a far bigger impact on aggregate spending and output than income tax cuts or transfer increases;however, if the latter are directed at the poorest (who tend to spend all their income), then this will give a relatively strong boost.
G (Spending) - T (Tax Revenue) + B (Transfer Spending) = Deficit or Surplus
YD (Disposible Income) = Y – Y (t) where t is the net tax rate
GDP – Value of final products that are produced within the country
So this includes the products that are produced by foreigners within the country
And Excludes products that are produced by the citizens of the country living outside the country.
GNP – Value of final products that are produced by the citizens of the country
Vice Versa
Generally, GDP is used as the measure of economic activity as it provides a view of activity happening within a given country. Therefore, gives an idea of employment and investment environment.
Terms of Trade is a the ratio of price of exports to price of imports
If exports are greater than imports then the terms of trade have improved as the country can more than pay for the imports.
Vice Versa
Typically a index number – normalized to 100 in some base year.
Trade Deficit – Imports more than exports and typically has to either borrow or sell some of its assets to foreigners.
Autarky - is a state in which a country does not trade with other countries. It is also known as a closed economy.
Open Economy – Trades with other countries and price it pays is the price that is prevailing in the world market – World Price.
Free Trade occurs when there are no government restrictions on a country's ability to trade. Equilibrium of demand and supply is set by world's aggregate demand and supply.
Trade Protection – Government imposes tariffs and quotas.
In a longer run, a persistent current account deficit leads to a permanent increase in claim held by other countries against the deficit country. As a result, foreign investors may require rising risk premiums for such claims, a process that appears to lead to a depreciating currency.