on 10-Nov-2016 (Thu)

Statistics can refer to numerical data (e.g., a company's average revenue for the past 20 years). It can also refer to methods of collecting, classifying, analyzing, and interpreting numerical data. Statistical methods provide a powerful set of tools for making decisions in business and other fields.

Statistics involves two different processes:

• Describing sets of data. Descriptive statistical methods can be used to describe the important aspects of data sets that have been collected. This reading will focus on the use of descriptive statistics to consolidate a mass of numerical data into useful information.
• Drawing conclusions (making estimates, judgments, predictions, etc.). Inferential statistical methods can be used to draw conclusions about a large group from a smaller group actually observed.

We use statistical methods to analyze the results of data. Since the amount of information available may be vast, it may be extremely time-consuming and expensive to collect all the necessary data. For instance, suppose we are interested in the durability of tennis balls. Theoretically, in order to carry out an accurate assessment, we would need to collect large quantities of all different makes of tennis balls from all over the world. Clearly, this is not practical; aside from taking up lots of time, it would be cost-prohibitive to purchase all the balls we would need for our study. A more practical solution would be to use a sample.

A population consists of an entire set of objects, observations, or scores that have something in common. It comprises every possible member of the specified group. In our example above, the population of tennis balls consists of every tennis ball that has ever been manufactured anywhere in the world. This is a huge number of tennis balls. Another example of a population would be all males between the ages of 15 and 18.

A sample is a subset of a population. The sample is comprised of some of the members of the population. Since it is usually impractical (or too expensive or time-consuming) to test every member of a population, using data gathered from a sample of the population is typically the best approach available for describing that population.

In our example above, a sample might be a selection of 1,000 tennis balls of various makes collected from different sources. It would be a virtually impossible task to collect every possible tennis ball in the world; this same size provides a manageable number to work with as well as a substantial amount of possible data.

Before we move on, there are several points worth noting:

• Don't be fooled by the word "population." This does not necessarily refer to people. As with the example above, we can have a population of tennis balls. A population can consist of anything, living or not.
• Although populations are often vast, they can also be of manageable size. For example, the population of even numbers between 1 and 9 would comprise the numbers 2, 4, 6 and 8. In this case, it is possible to sample the entire population and get accurate results. This is rare, however, and for your purposes, populations can generally be considered to be vast.
• In general, the bigger the sample, the better your results will be (because you are using data from more of the population for analysis). However, this point can present difficulties, as you will see when we study variance and standard deviation later.
• The ideal process would be to select a sample that is "representative" of the population (a sample that takes into account extreme values on both sides but contains many "average" values). In this way, the results that we get will be more meaningful. Because we frequently don't know about the exact values of a population (which is why we sample in the first place), we will never really know if our sample is truly representative or not. It's a

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Measures of central tendency specify where data are centered. They attempt to use a typical value to represent all the observations in the data set.

Population Mean

The population mean is the average for a finite population. It is unique; a given population has only one mean.

where:

• N = the number of observations in the entire population
• X_i = the ith observation
• ΣX_i = add up X_i, where i is from 0 to N

Sample Mean

The sample mean is the average for a sample. It is a statistic and is used to estimate the population mean.

where n = the number of observations in the sample

Arithmetic Mean

The arithmetic mean is what is commonly called the average. The population mean and sample mean are both examples of the arithmetic mean.

• If the data set encompasses an entire population, the arithmetic mean is called a population mean.
• If the data set includes a sample of values taken from a population, the arithmetic mean is called a sample mean.

This is the most widely used measure of central tendency. When the word "mean" is used without a modifier, it can be assumed to refer to the arithmetic mean. The mean is the sum of all scores divided by the number of scores. It is used to measure the prospective (expected future) performance (return) of an investment over a number of periods.

• All interval and ratio data sets (e.g., incomes, ages, rates of return) have an arithmetic mean.
• All data values are considered and included in the arithmetic mean computation.
• A data set has only one arithmetic mean. This indicates that the mean is unique.
• The arithmetic mean is the only measure of central tendency where the sum of the deviations of each value from the mean is always zero. Deviation from the arithmetic mean is the distance between the mean and an observation in the data set.

The arithmetic mean has the following disadvantages:

• The mean can be affected by extremes, that is, unusually large or small values.
• The mean cannot be determined for an open-ended data set (i.e., n is unknown).

Geometric Mean

The geometric mean has three important properties:

• It exists only if all the observations are greater than or equal to zero. In other words, it cannot be determined if any value of the data set is zero or negative.
• If values in the data set are all equal, both the arithmetic and geometric means will be equal to that value.
• It is always less than the arithmetic mean if values in the data set are not equal.

It is typically used when calculating returns over multiple periods. It is a better measure of the compound growth rate of an investment. When returns are variable by period, the geometric mean will always be less than the arithmetic mean. The more dispersed the rates of returns, the greater the difference between the two. This measurement is not as highly influenced by extreme values as the arithmetic mean.

Weighted Mean

The weighted mean is computed ...

respiratory acidosis (in preg) occurs in vessels when CO2 transport from fetus to placenta is disrupted (e.g. cord compression). It's a part of normal delivery.

Metabolic acidosis (in preg) develops as a result of fetal hypoxia that causes the fetus to shift to anaerobic metabolism to maintain positive energy balance. Metabolic acidosis is generated in hypoxic tissues, takes longer to develop and disappear, and has the potential to cause significant fetal damage.

Early decel (FHR) is reflex vagal response due to head compression; not normally associated with fetal acidemia

A market is any arrangement that enables buyers and sellers to get information and do business with each other. A competitive market is a market that has many buyers and many sellers so that no single buyer or seller can influence prices.

Broadly speaking there are two types of markets:

• Goods markets are markets where final products from businesses or firms are exchanged. Households and firms are usually buyers and firms are sellers.

• Factor markets are markets for the factors of production. Factors include labor, capital, raw materials, entrepreneurship, etc. For example, in labor markets, households are sellers and firms are buyers.

The demand for a factor exists because there is a demand for goods that the resource helps to produce. The demand for each factor is thus a derived demand; it is derived from the demand of consumers for products. For example, engineers are needed to design cars. A car manufacturer's demand for engineers thus depends entirely upon the demand for cars. The demand for engineers is a derived demand.

The demand function represents buyers' behavior.

Prices influence consumers' purchase decisions. The demand function can be depicted as a negatively sloped demand curve.

• If all other factors are equal, as the price of a good rises, consumer demand falls. This is mainly due to the availability of substitutes, which are goods that perform similar functions.
• As the price of a good falls, consumer demand rises.

Therefore, there is an inverse relationship between the price of a good and the amount that consumers are willing to buy. The demand curve normally slopes downward. It tells the analyst the quantity that consumers are willing to buy for each possible price when all other influences on consumers' planned purchases remain the same.

Example 1

Refer to the graph below. What is the quantity of cassettes demanded when their price is $4.00 per week?

Answer: Two cassettes per week. The demand curve tells how much is demanded at each price. To determine the quantity demanded, find $4.00 on the vertical axis and read across until you meet the demand curve. Then read the quantity from the horizontal axis.

When any factor that influences buying plans, other than the price of the good, changes, there is a change in demand for that good. When the quantity of the good that people plan to buy changes at each and every price, there is a new demand curve. These factors include changes in income, number of consumers in the market, changes in the price of a related good, etc.

Example 2

Assume the graph below reflects demand in the automobile market. Which arrow best captures the impact of increased consumer income on the automobile market?

Answer: D. Income is a shift factor of demand. An increase in income increases the number of automobiles demanded at each price. Therefore demand has shifted to the right.

• When demand increases, the quantity that people plan to buy increases at each and every price, so the demand curve shifts rightward.
• When demand decreases, the quantity that people plan to buy decreases at each and every price, so the demand curve shifts leftward.

A Change in the Quantity Demanded Versus a Change in Demand

The demand curve isolates the impact of price on the amount of a product purchased.

• A change in quantity demanded (caused by price change ONLY) is a movement along a demand curve from one point to another.
• Changes in other factors (anything other than price), such as income, tastes, expectations, and the prices of closely related goods, will shift the entire demand curve inwards or outwards. This is referred to as change in demand.

Example 3

Refer to the graph below. Consumers began purchasing more of a product due to a decrease in price. Which arrow best represents this statement?

Answer: C. A change in price causes a movement along the demand curve. When price falls, the movement is downward and to the right.

The Supply Function and ...

Aggregate Demand and Aggregate Supply

An aggregate demand curve is simply a schedule that shows amounts of a product that buyers collectively desire to purchase at each possible price level.

An aggregate supply curve is simply a curve showing the amounts of a product that all firms will produce at each price level.

Example 1

Refer to the graph below. What is the market quantity that would be supplied at a price of $2.00?

Market quantity is the sum of individual quantities supplied at each price. At a price of $2.00, Ann supplies 4, Barry supplies 3, and Charlie supplies 0. The market supply is 7.

Market Equilibrium

Equilibrium is a state in which conflicting forces are in balance. In equilibrium, it will be possible for both buyers and sellers to realize their goals simultaneously.

The following graph depicts the market supply and demand for concert tickets at Madison Square Garden in New York City.

Equilibrium price and quantity are where the supply and demand curves intersect. Draw a horizontal line from the intersection to the price axis. This is equilibrium price: $60. Draw a vertical line from the intersection to the quantity axis. This is equilibrium quantity: 300. It is equilibrium because quantity demanded equals quantity supplied at $60 per ticket. At this price, there is neither surplus (excess supply) nor shortage (excess demand), so there is no downward or upward pressure for the price to change.

Surplus will push prices downward towards equilibrium.

• Suppose the price is initially above the equilibrium price (P₂) and sits at P₁.
• Quantity supplied (Q_1s) will exceed quantity demanded (Q_1D), creating a surplus.
• The surplus will put downward pressure on prices since producers will begin to lower their prices to sell the surplus.
• As a result, the price will fall, the quantity supplied will decrease, and the quantity demanded will increase until the equilibrium price (P₂) is restored.
• This process involves movements along supply-and-demand curves since the changes are caused by price fluctuations.

Similarly, shortages push prices upward towards equilibrium.

Because the price rises if it is below equilibrium, falls if it is above equilibrium, and remains constant if it is at equilibrium, the price is pulled toward equilibrium and remains there until some event changes the equilibrium. We refer to such an equilibrium as being stable because whenever price is disturbed away from the equilibrium, it tends to converge back to that equilibrium.

An unstable equilibrium is an equilibrium that is not restored if disrupted by an external force. While most equilibria studied in economics are of the stable variety, a few cases of unstable equilibria do emerge from time to time, in limited circumstances.

Auctions can be used to arrive at equilibrium price.

• Auctions can have bidders trying to buy an item (e.g., Christie's, eBay).
• Auctions can have bidders trying to sell an item (e.g., Procurement, priceline.com).

Auctions can be classified as one of two types:

• Common value auction: the value of the item is the same to everyone but different bidders have different estimates about the underlying value. Examples: oil, timber, items with resale value.
• Private value auction: bidders know the value of the item to themselves with certainty but there is uncertainty regarding other bidders' values. Examples: collectibles, art items.

There are also many different methods for auctioning items:

• Open outcry English (ascending price) auction: The auctioneer starts at a reserve price and increases the price until only one bidder is left. That bidder wins the auction at the current price.
• First-price sealed-bid auction: Everyone writes down a bid in secret. The person with the highest bid wins the object and pays what he bids.
• Second-price sealed-bid (Vickery) auction: Everyone writes down a bid in secret. The person with the highest bid wins the object and pays the second highest bid (used for stamps and by Goethe).
• Dutch (descending price) auction: The auctioneer starts at a high price and decreases the price until a bidder accepts the price.

The winner's curse means that the winner of an auction will frequently have bid too much for the auctioned item: you win, you lose money, and you curse.

A Dutch auction share repurchase is when a company agrees to buy back a fixed amount of its outstanding shares within a certain price range. Offers come in from investors who specify the price within the given range at which they'll sell their shares. The company then buys back the shares of those who bid the lowest first and continues on up the line until they have bought back the amount that they said they would.

The U. S. Treasury security auctions are conducted using the single-price auction method. All successful competitive bidders and all noncompetitive bidders are awarded securities at the price equivalent to the highest rate or yield of accepted competitive tenders.

Consumer Surplus

Consumer surplus is the area below the demand curve but above the actual price paid. It is the difference between the amount consumers are willing to pay and the amount they have to pay for a good.

Consider the market for a good.

• If the market price is $100, then the 30th unit will not sell because those who demand it are only willing to pay $60 for the good.
• At $100, the 17th unit will sell because those who demand it are willing to pay up to $100 for the good.
• At $100, the 5th unit will sell because those who demand it are willing to pay up to $133 for the good.

• For all those goods under 17 units, people are willing to pay more than $100.
• The area represented by the distance above the actual price paid and below the demand curve is called consumer surplus.
• This area represents the net gains to buyers from market exchange.

Lower market prices increase the amount of consumer surplus in the market.

Producer Surplus

Producer surplus is the difference between the minimum supply price, represented by the supply curve, and the actual sales price.

• It is measured by the area below the price and above the supply curve, up to the quantity sold.
• It accrues to owners of firms and resource suppliers.

Example

The actual selling price of bananas is $9 per kg.

Now imagine that there are only 10,000 kg bananas being supplied at the moment. The marginal cost per kg is only $3 but the selling price is $9. So there is an additional $6 per kg being raised. This is the producer surplus per kg. The total producer surplus when 10,000 kg are produced is thus $60,000.

Due to the surplus, more producers enter the market and another 10,000 kg are produced, so there are now 20,000 kg of bananas on the market. The marginal costs of producing this additional 10,000 kg have risen to $4.

Producer surplus is not the same as profit. Remember that profit is the return that accrues to owners of a firm and is the difference between sales revenue and total (not marginal) costs of production.

Total Surplus

The following figure shows that a competitive market creates an efficient allocation of resources at equilibrium.

• In equilibrium, the quantity demanded equals the quantity supplied.
• At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity.
• The sum of consumer and producer surplus is maximized at this efficient level of output. It is here that all potential gains from production and exchange are realized.

The equilibrium price set by the market mechanism is often deemed to be unfair: buyers complain that the price is too high, while sellers believe that it is too low. In such cases, the government may regulate the price of the good or service. This is known as price control. A price control is a government-mandated price that may either be greater or less than the market equilibrium price. Price ceilings and floors are two types of price controls.

A Price Ceiling

A price ceiling is a legal restriction that prohibits exchanges at prices greater than a designated price: the ceiling price. Price ceilings are usually imposed when the equilibrium price is considered too high to be fair. A typical price ceiling results in a lower price than market forces would produce. A shortage will result in a situation in which the quantity demanded by consumers exceeds the quantity supplied by producers at the existing price.

A typical example of a price ceiling is a "rent ceiling," implemented by over 200 U.S. cities. If the rent ceiling is set above the equilibrium rent, it has no effect. The market works as if there were no ceiling. But if the rent ceiling is set below the equilibrium rent, it has powerful effects.

If a rent ceiling is set below the equilibrium price P₀, for example, at P₁, there is a reduction in the quantity that producers are willing to supply qs and an increase in the quantity that consumers demand q_d relative to the original equilibrium quantity q.

Because the legal price cannot eliminate the shortage, other mechanisms operate. For example, a black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed. A shortage of housing creates a black market in housing. Illegal arrangements are made between renters and landlords at rents above the rent ceiling - and generally above what the rent would have been in an unregulated market.

A rent ceiling leads to an inefficient use of resources. The quantity of rental housing is less than the efficient quantity and there is a deadweight loss.

A rent ceiling decreases the quantity of rental housing, shrinks the total producer and consumer surplus by using resources such as search activity, and creates a deadweight loss. It also transfers part of the producer surplus from producers to consumers. The consumer surplus becomes the green area + the pink area.

A Price Floor

A price floor is a minimum price that can be legally charged. It usually fixes the price of a good or resource above the market equilibrium level. Price floors are usually imposed when the equilibrium price is considered too low to be fair. Agricultural price supports and minimum wage legislation are examples of price floors.

If a price floor is set above the equilibrium price, p0, for example, at p1, there is a reduction in quantity demanded from q0 to qd, whilst the quantity supplied increases from q0 to qs. The result is a surplus of qs-qd.

Example 1

Refer to the graph below. A price floor set by the government would be binding and cause the greatest distortion in the market if it were established at what price?

...

Elasticity means "responsiveness." The elasticity of demand measures the responsiveness of the quantity demanded of a product to changes in any of the factors that affect demand. Analysts are interested in knowing how much the quantity demanded will rise or fall for a given change in price or income.

Price elasticity of demand is the percentage change in the quantity of a product demanded divided by the percentage change in the price causing the change in quantity. It indicates the degree of consumer response to variation in price. Specifically, it tells the analyst the percentage change in the quantity demanded for a good caused by a 1% increase in the price of that good.

The change in price is expressed as a percentage of the average price - the average of the initial and new price, and the change in the quantity demanded is expressed as a percentage of the average quantity demanded - the average of the initial and new quantity. Using the average price and average quantity, the same elasticity value is obtained regardless of whether the price rises or falls.

The measure is units-free because it is a ratio of two percentage changes and the percentages cancel each other out. Changing the units of measurement of price or quantity leave the elasticity value the same.

Because a change in price causes the quantity demanded to change in the opposite direction, this ratio is always negative, although economists always ignore the sign and simply use the absolute value. It is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change.

Example 1

A Pizza Hut store can sell 50 pizzas per day at $7 each or 70 pizzas per day at $6 each. The price elasticity is: [(50 - 70)/60] / [(7 - 6) / 6.5] = -2.17.

Own-Price Elasticity of Demand

Demand can be inelastic, unit elastic, or elastic, and can range from zero to infinity. (Note: the negative sign is ignored.)

• If the elasticity coefficient is greater than 1, demand is elastic. A small price change leads to a large change in the quantity demanded. The more elastic the demand, the flatter the demand curve over any specific range. Demands for goods with many substitutes (e.g., juice) are relatively elastic. If the demand curve of a good is completely horizontal, the demand is perfectly elastic. Consumers will buy all of that good at the market price.
• When the elasticity coefficient is less than 1, demand is inelastic. The more inelastic the demand, the steeper the demand curve. Demands for goods with few substitutes (e.g., cigarettes) are relatively inelastic.
• When the elasticity coefficient is equal to 1, demand is said to be unitary elastic.

Because elasticity is a relative concept, the elasticity of a straight-line demand curve will differ at each point along the demand curve. Specifically, a straight-line demand curve is more elastic when price is high. Note that the elasticity is not the slope of the demand curve. Elasticity is used since it is independent of the units of measure.

Example 2

Refer to the graph below. Which of the following is true?

A. Areas C and E are smaller than area A, so demand must be elastic between $10 and $30.
B. Areas C and E are smaller than area A, so demand must be inelastic between $10 and $30.
C. Area F is smaller than areas B and C, so demand must be inelastic between $10 and $30.

Answer: C. Since at $30 the demand is unit elas...

Utility refers to the total satisfaction received by a person from consuming a good or service.

• Completeness. A person can compare any two bundles, A and B, in such a way that it leads to one of the three following results: (i) A is preferred to B, (ii) B is preferred to A, or (iii) A and B are the same (they are indifferent).
• Transitivity. Consider any three bundles A, B, and C. If a person prefers A to B and also prefers B to C, she or he must prefer A to C.
• Nonsatiation. Consider two bundles, A and B. A has more than B in every commodity and yet all these commodities are not economic "bads"; then a person will rank A higher than B.

Utility theory is a quantitative model of consumer preferences and is based on the above axioms. Consumer preferences can be represented by an ordinal utility function:

This is a mathematical expression that shows the relationship between utility values and every possible bundle of goods.

This ordinal - not cardinal - utility captures only ranking and not strength of preferences.

An indifference curve shows the combination of two products that provide an individual with a given level of utility (satisfaction). It is a curve, convex from below, that separates the consumption bundles that are more preferred by an individual from those that are less preferred. The points on the curve represent combinations of goods that are equally preferred by the individual. For example, the bundle at point A of 10 apples and 3 fish provides the same satisfaction as the bundle at point B of 6 apples and 5 fish.

Indifference curves provide a diagrammatic picture of how an individual ranks alternative consumption bundles.

• More goods are preferable to fewer goods. Thus, bundles on indifference curves lying farthest to the northeast of a diagram are always preferred. For example, the bundle at C is clearly preferred to those points along the indifference curve and the bundle at point D is clearly inferior to those points along the curve.

• Goods are substitutable. Therefore, indifference curves slope downward to the right.

• The value of a good declines as it is consumed more intensively. Therefore, indifference curves are always convex when viewed from below. The slope of the indifference curve is equal to the marginal rate of substitution: the amount of one good that is just sufficient to compensate the consumer for the loss of a unit of the other good.

• Indifference curves are everywhere dense. That is, an indifference curve can be drawn through any point on the diagram; any two bundles of goods can be compared by the individual.

• Indifference curves for one consumer cannot cross. If they did, rational ordering would be violated and the postulate that more goods are better than fewer goods would be violated.

If two consumers have different marginal rates of substitution, they can both benefit from the voluntary exchange of one good for the other.

Assume a world with only two consumer goods, X and Y. P_x is the price of good X. X is also the quantity of good X that is purchased by the consumer. P_x x X is the consumer's expenditure on good X.

Total expenditure is P_x x X + P_y x Y.

M is the consumer's income or budget. The consumer cannot spend more than her budget allows. P_x x X + P_y x Y <= M is the consumer's budget constraint.

To draw a budget constraint, a line that shows the maximum amount of goods a buyer can purchase with her available funds, you need to know two things: 1) how much money she has, and 2) the prices of the two goods being considered.

Assume a consumer has an income of $24. The two goods are rice (price: $2) and beans (price: $3).

This is the basic budget line. Its slope is an indication of relative prices ($2/$3).

This is when the price of rice decreases and the consumer can purchase more rice.

When income doubles, the line will shifts outward, parallel to the original constraint.

Similarly, a company's production opportunity set represents the greatest quantity of one product that a company can produce for any given amount of the other good it produces. The investment opportunity set represents the highest return an investor can expect for any given amount of risk undertaken.

The budget constraint line separates consumption bundles that are attainable from those that are unattainable. A consumer will maximise utility by consuming on the highest possible indifference curve (i.e., we assume all income is spent). This is where an indifference curve is tangent to the highest possible budget line.

A consumer could consume at G, for example, but would be on a higher indifference curve at H. This means that to maximise utility the consumer would consume Q1 of product A and Q2 of product B.

The consumer is maximising utility where the budget line and indifference curve are tangent, i.e., MU_B/MU_A = P_B/P_A.

An Increase in Income

An increase in income shifts the budget line out parallel. The new combinations of products that maximise utility can be identified.

If this is a normal good, an increase in income increases the quantity demanded.

Inferior goods have a negative income elasticity of demand. Demand falls as income rises.

Indifference curve analysis lies behind a demand curve. It can be used to examine the effect of price changes and income changes.

If the price of B now falls, the budget line will pivot. The consumer now maximises utility consuming Q3 of product A and Q4 of product B. The fall in the price of product B has led to an increase in the quantity demanded of Q2Q4. This can be shown on a demand curve.

There are two different phenomena underlying a consumer's response to a price drop:

• As the price of a product declines, the lower opportunity cost will induce consumers to buy more of it since it becomes less expensive - even if they have to give up other products. This is called the substitution effect.
  To isolate this effect diagrammatically, we move the new budget line inwards and parallel until it is tangent to the old indifference curve. The new slope reflects the new relative prices but the utility is the same as it was originally. The substitution effect is Q2Q6. The substitution effect will always lead to more of the relatively cheaper product being demanded.

• With a fixed amount of money income, a reduction in the price of a product will increase a consumer's real income - the amount of goods and services consumers are able to purchase. Typically, consumers will respond by purchasing more of the cheaper products (as well as other products). This is called the income effect. The income effect is identified by shifting the budget line back outwards again. In this case, this leads to an increase in the quantity demanded of Q6 Q4.

The substitution and income effects will generally work in the same direction, causing consumers to purchase more as the price falls and less as the price rises. The indifference curve can be used to separate these two effects.

In the case of a normal good, higher real income leads to an increase in quantity demanded; this complements the increase due to the substitution effect. This change is shown in the diagram below.

In the case of an inferior product, the income effect leads to a fall in the quantity demanded, which will work against the substitution effect. In the following diagram the substitution effect is Q2 Q5; the income effect is Q5 Q4. However, the substitution effect outweighs the income effect and overall the quantity demanded rises. The overall change in quantity demanded results in an increase of Q2 Q4. This means the demand curve is downward-sloping, because a price fall increases the quantity demanded.

When a good is inferior and the income effect outweighs the substitution effect, it is called a Giffen good. This is, however, unlikely, because the substitution effect is almost always stronger than the income effect.

Another exception is the case where an increase in price causes an increase in demand. This results in an upward-sloping demand curve, and...

Accounting Profit

Accounting profit is the profit used by accountants to determine a firm's net income.

Accounting profit = Total revenue - Total accounting costs

Economic profit equals a firm's total revenue minus its total opportunity costs of production.

Economic profit = Total revenue - Total opportunity costs

The total opportunity costs include both explicit and implicit costs of all the resources used by a firm. Implicit opportunity cost is the unearned or nominal profit that the resource-owner did not make from investing in the next best alternative. As a result, you can have a significant accounting profit with little to no economic profit.

Example

Suppose a person uses his own resources, land, capital, and time in the production of goods. The opportunity costs of these resources are shown below:
Accounting Profit = $55,000
Entrepreneur's own forgone salary = $40,000
Foregone interest on capital = $1,000
Foregone rent = $2,000
Economic Profit = 55,000 - 40,000 - 1,000 - 2,000 = $12,000

For publicly traded corporations, economic profit is accounting profit - required return on equity capital.

When economic profit is zero, a firm's accounting profit becomes normal profit, which is effectively the total implicit opportunity cost.

Accounting profit = Economic profit + Normal profit

When a firm's total revenues are just equal to its total costs, its economic profit is zero, but it still makes accounting profit. Zero economic profit does not mean that the firm is about to go out of business. Instead, it just indicates that the owners are receiving exactly the market (normal) rate of return on their investment.

Economic Rent

The total income received by an owner of a factor of production is made up of its economic rent and its opportunity cost.

• Economic rent is the income received by the owner of a factor of production over and above the amount required to induce that owner to offer the factor for use.
• The opportunity cost of using a factor is the income required to induce its owner to offer the resource for use, which is the value of the factor in its next best use.

The following figure illustrates the division of a factor income into economic rent and opportunity cost.

The portion of income comprised of economic rent depends upon the elasticity of supply for the factor.

• The less elastic the supply for a factor, the greater the share of income that is comprised by economic rent. When the supply is perfectly inelastic, all of the income is economic rent.
  

• The more elastic the supply for a factor, the smaller the share of income that is economic rent. When the supply is perfectly elastic, none of the income is economic rent.
  

Revenue is the income generated from the sale of output in product markets.

• Total revenue (TR) is the sum of individual units sold multiplied by their respective prices:
• Average revenue (AR) =
• Marginal revenue (MR) is the change in revenue from selling one extra unit of output:

In a perfectly competitive market, each firm is a price taker. Since each unit of output sold by a price taker is sold at the market price, the MR for each unit is also equal to the market price, i.e., P = MR.

Under imperfect competition, a firm's marginal revenue is always less than the price of its good. Why? As the firm reduces price in order to expand output and sales, there will be two conflicting influences on total revenue.

• The increase in sales due to the lower price will, by itself, add to the revenue of the monopoly.
• The price reduction, however, also applies to units that would otherwise have been sold at a higher price. This factor itself will cause a reduction in total revenue.

These two conflicting forces will result in marginal revenue - the change in total revenue - that is less than the sales price of the additional units. Thus, the marginal revenue curve of the firm will always lie below the firm's demand curve, which is also the market's demand curve.

TR is maximized when MR = 0.

Factors of Production

A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. Such factors include land, labor, capital, and materials.

The total product curve shows how total product changes with the quantity of variable input employed.

As more and more units of a variable resource are combined with a fixed amount of other resources, employment of additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached, it will take successively larger amounts of the variable factor to expand output by one unit.

The law of diminishing returns basically explains the old adage: "too many cooks spoil the broth," or too much of a good thing is bad.

Total, Average, Marginal, Fixed, and Variable Costs

To produce more output in the short run, the firm must employ more variable inputs, which means that it must increase its costs. In the short run, a firm's total costs (TC) can be broken down into two categories: fixed costs and variable costs (TC = TFC + TVC). Which costs are fixed and which costs are variable depends on the time horizon being dealt with. For a short time horizon, most costs are fixed. For a long time horizon, all costs are variable.

• Total Fixed Cost. The sum of the costs that do not vary with output. They will be incurred as long as a firm continues in business and the assets have alternative uses. Examples of fixed costs include rent, property taxes and insurance premiums.

• Average Fixed Cost. Total fixed cost divided by the number of units produced. It always declines as output increases.
  

• Total Variable Cost. The sum of those costs that rise as output increases. Total variable costs are zero if output is zero. Examples are wages paid to workers and payments for raw materials.

• Average Variable Cost. The total variable cost divided by the number of units produced.

• Average Total Cost. Total cost divided by the number of units produced. It is sometimes called per unit cost.
  ATC is high at low levels of output, decreases as output increases (since fixed costs are spread across more units), and then increases as the firm's maximum capacity is approached (since marginal costs increase).

• Marginal Cost. The change in total cost required to produce an additional unit of output.
  
  The law of diminishing returns implies that the marginal costs of producing each additional unit will increase by increasing amounts. Initially, as output expands, the cost of producing each additional unit of output falls, but then begins to rise as the firm approaches its maximum capacity (e.g., too many workers, congested production lines).

Over the output range with increasing marginal returns, marginal cost falls as output increases. Once a firm confronts diminishing returns, larger and larger additions of the variable factor are required to expand output by one unit. This will cause marginal cost (MC) to rise. As MC continues to increase, eventually it w...

For a price taker (a firm in a perfectly competitive market):

Profit = Total Revenue - Total Cost = (Price - Average Total Cost) x Quantity

However, maximum profit is not always a positive economic profit. In the short run, the firm might break even (making a zero economic profit), make an economic profit, or incur an economic loss.

1. If the price equals minimum average total cost, the firm breaks even and makes a normal profit.

2. The ATC of producing each of q₂ units is labeled as c₁.

c₁BAP indicates the economic profit being made by this firm. The firm is making a profit since the price per unit exceeds the ATC per unit and the total revenue exceeds the total costs.

3. What would happen to profits if the price fell to below the ATC curve?

The firm therefore will produce q₁ units of output, as shown where MC = MR. At q₁, the firm can only charge P per unit, and yet the ATC per unit is higher, at c₂. This means that the firm is making a total economic loss equal to the shaded area, PBAc₂, or the distance of c₂ to P per unit.

If the firm's current sales revenues can cover its variable cost, and the firm anticipates that the lower market price is temporary, it will continue to operate and will face short-run economic losses. It will produce the quantity at which MC = P. This option is better than "shut down" since the firm is able to cover its variable costs and pay some of its fixed costs. If it were to shut down, the firm would lose the entire amount of its fixed costs.

The shutdown point is the output and price at which the firm just covers its total variable cost.

• This point is where average variable cost is at its minimum.
• It is also the point at which the marginal cost curve crosses the average variable cost curve.
• At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action.

If the market price is below the firm's average variable cost, a temporary shutdown is preferable to short-run operation. If the firm continues to operate, operating losses merely add to losses resulting from the firm's fixed costs. Shutdown will reduce losses.

The Firm's Short-Run Supply Curve

The price taker that intends to stay in business will maximize profits (or minimize losses) when it produces the output level at which P = MC AND variable costs are covered. At this output level, the price taker can maximize its profits or minimizes its losses. Therefore, the portion of the firm's short-run marginal cost curve that lies above its average variable cost is the short-run curve of the firm.

In the above graph, if price is below P₁, the firm should be shut down.

Short-Run Cost and Long-Run Cost

The short-run analysis relates costs to output for a specific size of plant. In the long-run, all resources used by the firm are variable.

For each plant size, there is a set of short-run, U-shaped costs curves for MC, AVC, and ATC. This diagram shows the ATC curves of three (of many) possible plant sizes: small, medium, and large.

Using this information, firms can plan, when in their blueprint stages, the optimal plant size they should be relative to the output they want to produce. For example, if a firm wanted to produce more than Q₁ units of output, it would make sense to build a large firm, since costs per unit would be less than they would be with a small or medium firm.

Long-Run Average Cost Curve

To explain this process, imagine the output level Q₂. Looking at the relevant costs on the vertical axis, the large firm is far cheaper per unit than both the small and medium-sized firms.

Thus, should a firm be planning for output in excess of Q₁, a large firm should be built. For levels of output between Q₀ and Q₁, it would be cheaper per unit if the firm was of a medium size.

• If a firm is planning to produce less than Q₀ units, a small firm would be best.
• For output between Q₀ - Q₁ units, a medium firm is preferable.
• For output in excess of Q₁ units, a large firm is preferable

The long-run average total cost curve is indicated in black.

It shows the minimum average cost of producing each output level when the firm is free to choose among all possible plant sizes. It can best be thought of as a planning curve, because it reflects the expected per-unit cost of producing alternative rates of output while plants are still in the blueprint stage. No single plant size could produce the alternative output rates at the costs indicated by the planning curve.

In reality, there are an infinite number of firm sizes:

Economies and Diseconomies of Scale

Economies of scale are reductions in the firm's per-unit costs that are associated with the use of large plants to produce a large volume of output. They are present over the initial range of outputs when the long-run ATC curve is falling. There are three reasons why economies of scale exist:

• Mass production is more economical.
• Specialization of labor and equipment improves productivity.
• Workers at a larger firm tend to learn more from their experience.

Diseconomies of scale are situations in which the long-run average total costs are greater in larger firms than they are for smaller firms. They are possible: as a firm gets bigger and bigger, bureaucratic inefficiencies may result. Principal-agent problems grow; they are prese...

The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.

• Total cost is the opportunity cost of production, which includes normal profit.
• Under perfect competition, a firm's total revenue equals price, P, multiplied by quantity sold, Q, or P x Q.

Marginal revenue is the addition to total revenue earned by a firm when one more unit of output is sold: MR = ΔTR/ΔQ. Since each unit of output sold by a price taker is sold at the market price, the MR for each unit is also equal to the market price, i.e., P = MR.

MR plotted against quantity sold would thus yield the same curve as P plotted against quantity sold (i.e., the demand curve) for the price taker.

We say that the MR curve of a price taker lies on the demand curve of a price taker.

There are three approaches to calculating the point of profit maximization in the short run. All three approaches yield the same profit-maximizing quantity of output.

MC = MR Approach

Produce that quantity of output where: MC = P = MR

• Each unit of output produced and sold by a price taker will generate revenue that equals the market price of the product (MR).
• However, due to the law of diminishing returns, as output increases, costs per unit will eventually also begin to increase (MC).
• The profit-maximizing quantity of output occurs where MC = MR = P.

Here are two familiar curves: the MC curve and the MR curve of a certain firm. Note that the MC curve clearly illustrates the Law of Diminishing Returns. Given this information, what quantity of output should this profit-maximizing price taker produce?

What about producing q₁ units?

Can you see that at q₁, MR exceeds MC by the distance shown by the arrow? This means that the revenue received from the sale of that unit would exceed the cost of its production, so it would be profitable for the firm to produce that unit. But would the firm be maximizing its profits, or should the firm produce more?

What about producing q₂ units?

MR still exceeds MC, shown by the distance of the arrow. This means that the revenue received from the sale of unit q₂ also exceeds its cost of production, so the firm would make even more profit if it produced that unit too.

But would the firm be maximizing its profits? Could the firm produce still more units?

At q₃, the MR earned from the sale of the unit is equal to the MC involved in producing the unit, so unit q3 generates neither a profit nor a loss for the firm.

If the firm produced more than q...

Average product and marginal product, which are derived from total product, are key measures of a firm's productivity.

• Total Product. The total output of a good associated with alternative utilization rates of a variable input. It increases as more and more units of the variable input are used.
• Marginal Product. The increase in the total product as a variable input increases by one extra unit.
• Average Product. The total product divided by the number of units of the variable input used in production.

Law of Diminishing Returns

The total product curve shows how total product changes with the quantity of variable input employed.

As more and more units of a variable resource are combined with a fixed amount of other resources, employment of additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached, it will take successively larger amounts of the variable factor to expand output by one unit.

The law basically explains the old adage: "too many cooks spoil the broth," or too much of a good thing is bad. As a single resource is applied more intensively, the resource eventually tends to accomplish less and less. Essentially, this is a constraint imposed by nature.

Let's use labor as the input. Initially, hiring more laborers may mean more productive use of machines, which were underutilized. Output may thus initially increase. After a while, the firm may have hired too many laborers, given the number of machines. There may be overcrowding on the work floor and mistakes may result, causing productivity to fall whilst costs will increase.

As units of variable input are added to a fixed input, total product will increase, first at an increasing rate and then at a declining rate. This will cause both marginal and average product curves to rise at first and then decline. Note that the marginal product curve intersects the average product curve at its maximum. The smooth curves indicate that the input can be increased by amounts of less than a single unit.

Profit Maximization

Firms demand labor, amongst other factors, to produce goods and services. The Marginal Revenue Product (MRP) of labor is the change in the total revenue of a firm that results from the employment of one additional unit of labor. The marginal revenue product of an input is equal to its marginal product multiplied by the marginal revenue of the good or service produced: MRP = MP x MR, where

• Marginal Product (MP) is the change in total output that results from the employment of one additional unit of labor.
• Marginal Revenue (MR) is the change in a firm's total revenue that results from the production and sale of one additional unit of output.

Because of the law of diminishing returns, the marginal product of labor will fall as employment of the labor expands, and thus the marginal revenue product of labor will also fall as employment expands.

The firm has two equivalent conditions for maximizing profit. They are:

• Hire the quantity of labor at which the marginal revenue product of labor (MRP) equals the wage rate (W).
• Produce the quantity of output at which marginal revenue (MR) equals marginal cost (MC).

Why?

MRP = W => MP x MR = W => MR = W/MP, since W/MP = MC => MR = MC.

This relationship indicates why wage differences across skill categories will tend to reflect product...

A financial analyst must understand the characteristics of market structures to better forecast a firm's future profit stream.

We focus on those characteristics that affect the nature of competition and pricing. They are:

• The number of firms (including the scale and extent of foreign competition).
• The extent of product differentiation (which affects cross-price elasticity of demand).
• The pricing power of seller(s). Can a firm influence the market price?
• Barriers to entry. Exit costs should also be considered.
• Non-price competition such as product differentiation.

The characteristics of each market structure will be discussed in subsequent subjects of this reading.

An industry with perfect competition displays the following characteristics:

• All the firms in the market are producing an identical product (e.g., wheat of the same grade).
• No barriers limit the entry or exit of firms in the market.
• A large number of firms exist in the market. Established firms have no advantages over new ones.
• Sellers don't have market-pricing power.
• There is no non-price competition.

Perfect competition arises:

• When a firm's minimum efficient scale is small relative to market demand so there is room for many firms in the industry, and
• When each firm is perceived to produce a good or service that has no unique characteristics, so consumers don't care which firm they buy from.

The demand analysis in perfectly competitive markets is covered in Reading 13.

The supply analysis, optimal price and output, and long-run equilibrium in perfectly competitive markets are covered in Reading 15.

In perfect competition, each firm is a price taker. Price takers are sellers who must take the market price in order to sell their products.

• There is no price decision to make: they will merely attempt to choose the output level that will maximize profit.
• Each price taker's output is small relative to the total market: the output of a firm exerts little or no effect on the market price.

This diagram represents the market demand and supply curve for a certain product - for example, eggs.

As usual, the intersection of the demand and supply curve creates the market price (P) per egg. Now remember that a firm that is a price taker can sell all it wants to at that price, but can sell nothing at a higher price.

Price takers can sell all their output at the market price, but they are unable to sell any of their output at a price higher than the market price. That is, a price taker faces a horizontal demand curve. Each firm's output is a perfect substitute for the output of the other firms, so the demand for each firm's output is perfectly elastic.

• They can sell as much as they would like at the going market price.
• There is no need for them to reduce their price in order to sell more.
• Moreover, at any price above the market price there is no demand; their sales would be zero (nobody would buy from that firm because there are so many other firms from which to obtain the product at the market price).
• This reflects the fact that perfectly competitive firms have no control over their price.

When a perfectly competitive market is in long-run equilibrium:

• Quantity supplied and quantity demanded must be equal in the market.
• Firms in the market must earn zero economic profit at the prevailing market price (that is, firms are earning the "normal rate of return"). This occurs when market price = marginal revenue = marginal cost = minimum ATC. Note that accounting profits may still be positive.

Why do firms earn zero economic profit in the long-run equilibrium?

• If firms earn positive economic profit in the long-run equilibrium, these firms will have an incentive to expand their capacity, and new firms will enter the market. This will lead to an increase in supply, forcing the market price down

...

A monopolistic market is also called a competitive price searcher market.

Characteristics are:

• A large number of firms. This is due to low entry barriers and causes intense competition in these markets. Firms face competition from existing firms and potential entrants to the market.

• Firms produce differentiated products. This means that each firm makes a product that is slightly different from the products of competing firms. This is the most distinctive characteristic of such a market.

• Low entry barriers. Entry into and exit from the market are relatively easy. Sellers in competitive price searcher markets face competition both from firms already producing in the market and from potential new entrants into the market. If profits are present, firms can expect that new rivals will be attracted. Because of the low entry barriers, competitive forces will be strong in monopolistic markets, and firms cannot earn an economic profit in the long run.

• Competition on quality, price, and marketing. Demand is not simply given for a monopolistic competitor. The firm has some pricing power and can alter the demand for its products by changing product quality (design, reliability and service), location and by advertising. The firm faces a downward-sloping demand curve. This demand curve is highly elastic because good substitutes for a firm's output are readily available from other suppliers.

Consider two hamburger companies: McDonald's and Burger King.

• Both firms are producing burgers but customers view them as differentiated.
• If McDonald's increases the price of its burger, it will not lose all its customers, as some will continue to pay the higher price, preferring McDonald's.
• Thus, differentiation explains the downward-sloping demand curve. The more firms producing burgers (substitutes), the more elastic McDonald's demand curve will be, since the greater the decrease in quantity demanded as price increases.

The Firm's Short-Run Output and Price Decision

As with price takers, monopolistic competitors maximize profits by expanding output to where MR = MC.

A firm in monopolistic competition operates much like a single-price monopolist.

According to the demand curve, the firm can charge P1 per unit.

• The total revenue earned is the shaded area 0P₁AQ₁.
• The total cost is the shaded area 0CBQ₁.
• It earns an economic profit (as in this example) when P > ATC. The total profit is thus the difference between total revenue and total costs, and is given by the shaded area CP₁AB.

A firm might incur an economic loss in the short run when P < ATC.

Long Run: Zero Economic Profit

Whenever firms can freely enter and exit a market, profits and losses play an important role in determining the size of the industry. Economic profits will attract new competitors to the market and economic losses will cause competitors to exit from the market. In the short run, a price searcher may make either economic profits or losses, depending on market conditions. As firms enter the industry, each existing firm loses some of its market share. The demand for its product decreases and the demand curve for its product shifts leftward.

The decrease in demand decreases the quantity at which MR = MC and lowers the maximum price that the firm can charge to sell...

Literally, oligopoly means "few sellers." This market structure is characterized by:

• A small number of rival firms. The firms are interdependent because each is large relative to the size of the market. The decisions of a firm often influence the demand, price, and profit of rivals, and an oligopolist must consider the potential reaction of rivals.

• High entry barriers into the market. Either natural or legal barriers to entry can create oligopoly.
  • Economies of scale are probably the most significant entry barrier here. Achieving minimum per-unit cost is required, and thus a small number of large-scale firms will be able to produce the entire market demand for the product. This is what distinguishes an oligopoly from a monopolistic competitive market.
  • A legal oligopoly might arise even where demand and costs leave room for a larger number of firms.

In short, an oligopoly is competition among the few.

Pricing Strategies

• Like a monopolist, an oligopolist faces a downward-sloping demand curve and seeks to maximize profit, not price.
• Unlike a monopolist, an oligopolist cannot determine the product price that will deliver maximum profit simply by estimating market demand and cost conditions.

A key factor here is the pricing behavior of close rivals, or interdependence between firms. This means that each firm must take into account the likely reactions of other firms in the market when making pricing decisions. Because the reactions of those rivals cannot be determined, the precise price and output that will emerge under an oligopoly cannot be determined. Only a potential range of prices can be indicated.

There are three basic pricing strategies.

1. The assumption of pricing interdependence is that firms will match a price reduction and ignore a price increase. The idea is that if a firm raises prices, other firms won't follow, because they won't worry about losing market share to a firm that is raising its prices. However, if the firm lowers its prices, other firms will respond by lowering their prices also, since they don't want to lose market share.

The demand curve that a firm believes it faces has a kink at the current price P and quantity Q.

The kinked demand curve can be thought of as two demand curves.

• Above the price P, an individual firm is afraid of putting up prices. A price increase would, it assumes, not be matched by competitors, hence the demand curve above P is elastic. It will be remembered that if demand is elastic and price rises, revenue falls.
• Similarly, a price fall has the same effect on revenue. This time the firm imagines that dropping its own price leads to others dropping theirs. Overall, quantity demand increases as the demand curve slopes down, but the increase is less than proportionate. That is the demand curve below price P is inelastic.

The kink in the demand curve means that the MR curve is discontinuous at the current quantity - shown by the gap AB in the figure.

Fluctuations in MC that remain within the discontinuous portion of the MR curve leave the profit-maximizing quantity and price unchanged.

For example, if costs increased so that the MC curve shifted upward from MC₀ to MC₁, the profit-maximizing price and quantity would not change.

The beliefs that generate the kinked demand curve are not always correct and firms can figure out this fact. If MC increases enough, all firms raise their prices and the kink vanishes.

2. The assumption of the Cournot...

Literally, monopoly means "single seller." It is a market structure characterized by:

• High entry barriers.
• A single seller of a well-defined product for which there are no good substitutes.

Barriers to entry include legal or natural constraints that protect a firm from potential competitors.

• Legal barriers to entry create a legal monopoly, a market in which competition and entry are restricted by the granting of a:
  • Public franchise. The U.S. Postal Service franchises to deliver first-class mail.
  • Government license. Licensing is a requirement that one obtain permission from the government in order to perform certain business activities or work in various occupations. It limits entry and restricts the right to buy and sell goods. Sometimes these licenses cost little and are designed to ensure certain minimum standards. In other cases, they are expensive and designed primarily to limit competition. For example, in many U.S. states a license is required for operating a taxi.
  • Patent and copyright. The entry barrier created by the grant of a patent generally leads to higher consumer prices for products that have already been developed. On the other hand, the absence of patent protection might well lead to a slowdown in the pace of technological innovation.

• Natural barriers to entry (for example, economies of scale) create a natural monopoly, which is an industry in which one firm can supply the entire market at a lower price than two or more firms can. In some industries, larger firms will always have lower unit costs. It will be difficult for small firms to enter the market, build a reputation, and compete effectively. Economies of scale tend to eventually result in the market being dominated by one large firm.

• Other barriers, such as strong brand loyalty or the increasing returns associated with network effects.

Demand and Supply Analysis

A monopoly faces no competition, and as a result there is no product differentiation. It is a price setter, not a price taker like a firm in perfect competition. Because the monopoly is the only seller in the market, the demand for its product is the market demand curve. It is downward-sloping because demand will decline as price increases.

Marginal Revenue and Price

A monopoly must choose between lower prices with larger quantities sold and higher prices with smaller sales. Although a monopoly can set the price for its products, market forces will determine the quantity sold at alternative prices. To maximize profit, a monopoly must estimate the relationship between price and the quantity of its products demanded.

As the monopoly reduces price in order to expand output and sales, there will be two conflicting influences on total revenue.

• The increase in sales due to the lower price will, by itself, add to the revenue of the monopoly.
• The price reduction, however, also applies to units that would otherwise have been sold at a higher price. This factor will cause a reduction in total revenue.

These two conflicting forces will result in marginal revenue - the change in total revenue - that is less than the sales price of the additional units. Thus, the marginal revenue curve of the monopoly will always lie below the firm's demand curve, which is also the market's demand curve:

MR < P

The following example illustrates this concept.

Portico produces beauty soaps.

• If Portico charges $10 for each bar of soap, the demand will be only 1

...

Price discrimination is a practice whereby a seller charges different consumers different prices for the same product or service. It converts consumer surplus into economic profit.

• In first-degree price discrimination each consumer is charged the maximum he is willing to pay. Consumer surplus is nil, while producer surplus is maximized. The output is the same as in a competitive market.
• In second-degree price discrimination, prices vary across units but not people. Consumers self-select into consumption groups and seek the largest surplus.
• In third-degree price discrimination, consumers are segregated by demographic or other traits. Prices are determined by the demands of each group.

When sellers can segment their market (at a low cost) into groups with differing price elasticities of demand, price discrimination can increase profits. For each group, the seller will maximize profit by equating marginal cost and marginal revenue. The number of units sold also increases because the discounts provided to price-sensitive groups increase the quantity sold more than the higher prices charged the less price-sensitive groups reduce sales.

Imagine that the MC per unit for a monopoly is constant at $60, producing a horizontal MC curve, as shown below.

The firm produces where MC = MR. It thus produces 100 units and charges $200 per unit. Total revenue (price x quantity) for the firm is thus: $200 x 100 = $20,000. Total costs (cost per unit x quantity) are: $60 x 100 = $6,000. Total profit is thus: $20,000 - $6,000 = $14,000.

Imagine that this firm is an airline and that it now decides to increase its profits using price discrimination. It identifies two groups of people: businessmen, who are fairly price-inelastic, and students, who are fairly price-elastic (responsive to changes in price). By increasing the price of businessmen's tickets and decreasing the price of student's tickets, it can increase its total revenue and thus increase its profit.

The airline starts by doubling the price of businessmen's tickets to $400. By equating the businessmen's MR curve to the MC curve (for simplicity, the MR curve is not shown), the airline finds that the quantity demanded decreases, but by relatively little, given the large increase in price, to 60 tickets.

Next, it equates MC to the students' MR curve and finds that it can decrease the price of students' tickets from $200 to $150, whilst the quantity demanded increases to 150 tickets. (Note: for simplicity, the students' MR curve is not shown).

Therefore, the total revenue is as follows: $400 x 60 + $150 x 150 = $46,500.
Total costs are: $60 x 60 + $60 x 150 = $12,600.
Total profits are thus: $46,500 - $12,600 = $33,900.

This is more than the $14,000 profit the firm made in the absence of price discrimination.

Measuring market power is complicated. Ideally, econometric estimates of the elasticity of demand and supply should be computed. However, because of the lack of reliable data and the fact that elasticity changes over time (so that past data may not apply to the current situation), regulators and economists often use simpler measures.

The N-firm concentration ratio is the percentage of market output generated by the N largest firms in the industry. The ratio is used as an indicator of the relative size of firms in relation to the industry as a whole. It may also assist in determining the market form of the industry. The larger the measure of market concentration, the less competition exists in the industry.

The concentration ratio is simple to compute. However, it does not directly quantify market power, meaning it does not take the possibility of entry into account. Another disadvantage is that it ignores mergers among the top market players.

The Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman index is the sum of the squared market shares of the top N largest firms in the industry.

H = M₁² + M₂² + M₃² + ... + M_N²

where M_i is the market share of an individual firm.

Suppose there are a total of four firms in a specific industry. Three firms have a 20% share each and one has a 40% market share, H = 0.20² + 0.20² + 0.20² + 0.40² = 0.28.

The advantages of the Herfindahl index are that it reflects more firms in the industry and it gives greater weight to the companies with larger market shares.

Properties of the Herfindahl index:

• It is always smaller than or equal to 1. In a monopoly, the HHI is 1.
• One can classify the competition structure of a market based on this ratio. For example,
  • An H below 0.1 indicates a competitive market.
  • An H of 0.1 to 0.18 indicates moderate competitive.
  • An H above 0.18 indicates uncompetitive.

• If all firms have an equal share, H = N x (1/N)² = 1/N. Note that the reciprocal of the index shows the number of firms in the industry.
• When the firms have unequal shares in the industry, the reciprocal of the index indicates the "equivalent" number of firms in the industry. Using the above example, the market structure is equivalent to having 1/0.28 = 3.57 firms of the same size.

Limitations: HHI fails to consider barriers to entry and firm turnover. For example, for some industries, few firms may be currently operating in the market but competition might be fierce, with firms regularly entering and exiting the industry. Even potential entry might be enough to maintain competition.

Gross Domestic Product (GDP) is the total market value of all domestically produced final goods and services for a particular year. Its five key factors are: market value, final goods and services, produced, within a country, during a specific time period.

• Only final goods and services count; GDP includes goods and services purchased by final users. Intermediate goods purchased for resale or for the production of another good or service are excluded, to avoid double-counting. Their value is embodied in the value of the goods purchased by the end user.

• GDP is a flow variable; it measures the market value of production that flows through the economy.

• Financial transactions and income transfers (e.g., social security and welfare payments) are excluded because they represent exchanges, not productions, of goods and services. GDP counts transactions that add to current production.

• GDP counts only goods and services produced domestically, whether by citizens or foreigners.

• It includes only goods produced during the current period. Thus, sales of used goods are not counted in GDP. However, sales commissions count toward GDP because they involve services provided during the period.

Government services and household production are estimated and included in the GDP. Activities occurring in the underground economy, although sometimes productive, are not included in GDP.

Nominal and Real GDP

When comparing GDP across time periods, we confront a problem: the nominal value of GDP may increase as the result of either expansion in the quantities of goods produced or higher prices. Since the former will improve our living standards, we have to adjust the nominal values (nominal GDP, or money values) for the effects of inflation to get real values (real GDP).

A price index is used for the adjustment. It measures the cost of purchasing a market basket or bundle of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference period (e.g., a base year).

Consumer price index (CPI) (not included in the required reading) is an indicator of the general level of prices. It attempts to compare the cost of purchasing the market basket bought by a typical consumer during a specific period with the cost of purchasing the same market basket during an earlier period. The CPI is better at determining how rising prices affect the money income of consumers. The CPI is more widely used for price changes over time.

The GDP deflator is a price index that reveals the cost during the current period of purchasing the items included in GDP relative to the cost during a base year. Because the base year is assigned a value of 100, as the GDP deflator takes on values greater than 100, it indicates that prices have risen. It is a broader price index than the CPI since it is better at giving an economy-wide measure of inflation. It is designed to measure the change in the average price of the market basket of goods included in GDP. In addition to consumer goods, the GDP deflator includes prices for capital goods and other goods and services purchased by businesses and governments. The GDP deflator also allows the basket of goods to change as the composition of GDP changes, while the CPI is computed using a fixed basket of goods.

We can use the GDP deflator together with nominal GDP to measure the real GDP (GDP in dollars of constant purchasing power).

Real GDPi = Nominal GDPi x (GDP Deflator for base year/ GDP Deflator for year i)

Suppose the nominal GDPs in 1992 and 2010 were $6244 and $8509 billion dollars, respectively. This amount has increased by 36.3%. The GDP deflator for 1992 and 2010 was 100 and 112.7, respectively. The re...

GDP is a measure of both output and income. The revenues that firms derive from the sale of goods and services are paid directly to resource suppliers in the form of wages, self-employment income, rents, profits, and interest.

There are two ways of measuring GDP. GDP derived by these two approaches will be equal.

The expenditure approach totals the expenditures spent on all final goods and services produced during the year. Under this approach, GDP is a measure of aggregate output. There are four components of GDP under this approach:

• GDP = C + I + G + (X - M)
• C (personal consumption expenditures): This is the largest component with this approach: durable goods, non-durable goods, and services.
• I (gross private domestic investment): The flow of private sector expenditures on durable assets plus the addition to inventories during a period. It is the production or construction of capital goods that provide a flow of future service. It indicates the economy's future productive capacity.
• G (government consumption and gross investment): Government purchases, not including transfer payments. It includes both (1) expenditures on such items as office supplies, law enforcement, and the operation of veteran hospitals and (2) the capital purchase of long-lasting capital goods such as missiles, highways, and dams for flood control. Government expenditures, which include transfer payments like social security, are not equal to government consumption.
• E - M (net exports to foreigners): This is exports minus imports. Exports are domestically produced goods and services sold to foreigners. Imports are foreign-made goods and services purchased by domestic consumers, investors and governments. When measuring GDP using the expenditure approach, we must add exports and subtract imports. Net exports may be either positive or negative.

GDP can be measured either from the value of the final output or by summing the value added at each stage of the production and distribution process. The sum of the value added by each stage is equal to the final selling price of the good.

Under the income approach, GDP is a measure of aggregate income. It is calculated by summing the income payments to resource suppliers and the other costs of producing those goods and services. It includes employee compensation (wages and salaries), self-employment income, rents, profits and interest, etc. Employee compensation is the largest source of income generated by the production of goods and services.

Personal income is the total income received by domestic households and non-corporate businesses. It is available for consumption, saving, and payment of personal taxes. Personal disposable income is an individual's available income, after personal taxes are paid, that can be either consumed or saved.

Aggregate demand (AD) is the quantity of goods and services that households, businesses, and foreign customers want to buy at any given level of prices.

The IS Curve

GDP = C + I + G + (X - M)

• Consumption (C) is a function of disposable income. Consumption increases when income(Y) increases and/or taxes decrease.
  The marginal propensity to consume (MPC) is defined as additional current consumption divided by additional current disposable income. The marginal propensity to save (MPS) = 1 - MPC.

• Investment spending depends on the interest rate (i) and output/income level.

• Government purchases are assumed to be unrelated to both interest rates (i) and income (Y). Although tax policy is also considered an exogeneous variable, the actual taxes collected depend on income (Y) and are therefore endogenous. The government's deficit (G - T) increases as income decreases and vice versa.

• Net exports (X - M) depends on relative income and prices between the domestic country and the rest of the world.

We can also derive the following equation, which shows that domestic saving has three uses: investment, government deficits, and trade surplus:

S = I + (G - T) + (X - M), where S is domestic saving.

If we combine these relationships together we can derive the IS curve: the combination of GDP (Y) and the real interest rate (i) such that aggregate income/output equals planned expenditures.

Note that there is an inverse relationship between income and the real interest rate. For example, when interest rates are high, investment falls and therefore Y must fall as well.

Note that changes in Y caused by changes in i are reflected as movements along the IS curve. On the other hand, changes in Y that are brought about by factors other than interest rates will cause Y to change, regardless of the level of interest rates in the economy. For example, changes in government purchases will not change the slope but will change the intercepts; in other words, they will cause the IS curve to shift.

The LM Curve

The IS curve depicts combinations of interest rates and output that clears markets for goods and services. The IS curve by itself does not pin down the interest rate that prevails in the economy. In order to do so, we look at the money market. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply.

The quantity theory of money: MV = PY, where V is the velocity of money.

• When interest rates (i) are high, the demand for money is low because money pays no interest; the opportunity cost of holding money rises.
• When Y is high, the demand for money is high; richer people buy more goods and are likely to hold more money.
• When P is hig,h the demand for money is high because we need more money to buy goods.

When the money market is in equilibrium, money supply = money demand. The LM curve summarizes all the combinations of income and interest rates that equate money demand and money supply. It is an upward-sloping relationship between i and Y.

Intuitively, we can explain the upward-sloping LM curve as follows: Let's consider some combination of income and interest rates that equates money demand with the money supply set by the Fed. Now suppose there is ...

The aggregate quantity of goods and services supplied depends on three factors: labor (L), capital (K), and the state of technology (T).

Y = F (L, K, T)

The aggregate supply curve (AS) represents the relationship between the quantity of goods and services supplied and the price level. It is important to distinguish between long-run aggregate supply and short-run aggregate supply.

The short-run aggregate supply curve typically slopes upward to the right. In the short run, some prices (e.g., rents, wages) are temporarily fixed as the result of prior commitments. Therefore, firms will expand outputs as the price level increases because higher prices will improve profit margins. Short-run equilibrium occurs when the aggregate quantity of goods and services demanded is equal to the aggregate quantity supplied.

The long-run aggregate supply curve is vertical. In the long run, people have sufficient time to alter their behavior to adjust fully to price changes. The sustainable level of output is determined by a nation's resource base, technology, and the efficiency of its institutional factors. The price level has no effect on a nation's long-run aggregate supply. In long-run equilibrium, current output (Y_full) will equal the economy's potential GDP, the economy is operating at full employment, and the actual rate of unemployment will equal the natural rate of unemployment.

Aggregated demand and supply determine the level of real GDP and the price level of a nation.

Factors that Shift Aggregate Demand

At each price level, the AD curve shifts to the right due to changes in C, I, G, and X.

• An increase in real wealth: greater wealth increases the demand for all goods.
• Increased optimism about the future: both current consumption and investment increase.
• High capacity utilization: companies have to increase investment spending to expand production.
• Expanding fiscal policy: higher government spending and lower taxes will increase G and C.
• An increase in money supply: higher income and expenditure.
• A lower interest rate - when borrowing is cheaper, investment increases; consumption is cheaper with a lower interest rate.
• A decrease in exchange rate: increases export demand.
• Growth in the global economy: increases export demand.

And vice versa.

Factors that Shift Aggregate Supply

We need to differentiate between the long-run and short-run effects.

Increases in short-run aggregate supply (SRAS) that don't affect long-run aggregate supply are caused by:

• A decrease in resource prices/production costs (e.g., nominal wages, input prices). Unless the lower prices of resources reflect a long-term increase in the supply of resources, they will not alter LRAS.
• A reduction in the expected rate of inflation. If high inflation is expected, suppliers would like to reduce supplies now to sell them at higher prices later but consumers would like to spend more money now.
• Lower business taxes and higher government subsidies.
• Favorable exchange rates for importers of raw materials.

And vice versa.

Long-run supply refers to the economy's long-run production possibilities (maximum rate of sustainable output). Increase in long-run aggregate supply (LRAS) is caused by:

• An increase in the supply of resources. This will expand the economy's sustainable rate of output. Note that an economy's resource base includes physical capital, natural resources and human capital.
• An improvement in technology and productivity. This will increase the average output per unit of resources.

And vice versa.

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve. If real GDP is below equilibrium GDP, firms increase production and raise prices, and if real GDP is above equilibrium GDP, firms decrease production and lower prices. These changes bring a movement along the SAS curve towards equilibrium.

In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP - when the economy is on its LAS curve.

Note two things:

• At the price chosen by suppliers (P), the aggregate demand (AD) is exactly equal to the amount suppliers are willing to supply (SAS).
• This equilibrium between SAS and AD coincides with the maximum capacity of the economy, as indicated by the LAS curve. The level of output produced is labeled as Y_f, indicating full employment of resources.

Long-run equilibrium thus occurs where LAS, AD, and SAS coincide.

Economic Growth and Inflation

Economic growth occurs because the quantity of labor grows, capital is accumulated, and technology advances, all of which increase potential GDP and bring a rightward shift of the LAS curve. The following figure illustrates economic growth and inflation.

Inflation occurs because the quantity of money grows faster than potential GDP, which increases aggregate demand by more than long-run aggregate supply. The AD curve shifts rightward faster than the rightward shift of the LAS curve.

The Business Cycle

The business cycle occurs because aggregate demand and short-run aggregate supply fluctuate.

• A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP. The amount by which potential GDP exceeds real GDP is called a recessionary gap.
• Long-run equilibrium is an equilibrium in which potential GDP equals real GDP.
• An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP is called an inflationary gap.

Let's look at the inflation gap.

An economic boom may be the result of an increase in AD. Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward.

The prices of goods and services increase, which in turn induces suppliers to expand output to a level that is unsustainable in the long run (which is why a boom is followed by an economic contraction). That is, firms increase output and prices - a movement along the SRAS curve.

Since prices are currently high (P₁) and the situation is moving into the long run, people will expect prices to continue to be high. There is an inflationary gap.

Stagflation

In the resource market, a supply shock such as a drought or high oil prices is reflec...

Economic growth is the sustained expansion of production possibilities measured as the increase in real GDP over a given period. The economic growth rate is the annual percentage change of real GDP. It tells us how rapidly the total economy is expanding.

The standard of living depends on real GDP per person. Real GDP per person is real GDP divided by the population. It grows only if real GDP grows faster than the population grows.

The Production Function and Potential GDP

Y = A F(L, K)

The quantity of real GDP supplied, Y, depends on the quantity of labor, L, the quantity of capital, K, and the state of technology, A (total factor productivity).

This equation shows that output depends on inputs and the level of technology.

• More inputs mean more output. That is, the marginal product of labor (the increase in output generated by increased labor) and the marginal production of capital (the increase in output generated by increased capital) are both positive.
• The higher the level of technology, the more output is produced for a given level of inputs.

The law of diminishing returns: As the quantity of one input increases with the quantities of all other inputs remaining the same, output increases but by ever smaller increments. As capital per hour of labor rises, output rises (the marginal product of capital is positive) but output rises less at high levels of capital than at low levels. This is the key explanation of why the economy reaches a steady state rather than growing endlessly.

Convergence is the process of one economy catching up with another economy. According to the neoclassical growth theory, countries with a low level of capital would have a higher marginal product of capital because of diminishing returns and hence attract more investment and grow faster.

Growth in Y = Growth in technology + W_L (growth in labor) + W_C (growth in capital)

where W_L and W_C = 1 - W_L are the shares of labor and capital in GDP.

Sources of Economic Growth

There are five important sources of growth for an economy:

• Labor supply is the quantity of the work force. It is determined by population growth, the labor force participation rate, and net immigration.
• Human capital measures the quality of the labor force. Human capital acquired through education, on-the-job training, and learning-by-doing is the most fundamental source of economic growth. It is the source of increased labor productivity and technological advance.
• Physical capital results from saving and investment decisions. The accumulation of new capital increases capital per worker and labor productivity.
• Technology. Technological change - the discovery and the application of new technologies and new goods - has contributed immensely to increasing labor productivity. It is the main factor affecting economic growth in developed countries.
• Natural resources account for some of the differences in growth among countries.

Measures of Sustainable Growth

Labor productivity is the quantity of real GDP produced by an hour of labor. The growth of labor productivity depends on physical capital growth, human capital growth, and technology advances.

Potential GDP = Aggregate hours worked x Labor productivity

Potential growth rate = Long-term growth rate of labor force + Long-term labor productivity growth rate

The business cycle is the fluctuations in the general level of economic activity as measured by such variables as the rate of unemployment and changes in real GDP. Periods of growth in real output and other aggregate measures of economic activity followed by periods of decline are distinguishing characteristics of business cycles. A complete business cycle is represented by A to G in the diagram below:

• Peak
  When most businesses are operating at capacity level and real GDP is growing rapidly, a business peak or boom is present.

• Contraction
  Aggregate business conditions are slow, real GDP grows at a slower rate or even declines, and the unemployment rate increases. This indicates that the economy begins the contraction, or recessionary, phase of a business cycle.
  • Firms start to cut hours and freeze hiring, followed by outright layoffs.
  • As final demand starts to fall off the downturn in investment spending usually occurs abruptly.
  • Inventories accumulate involuntarily, and firms cut production below even reduced sales levels to let their inventories decline. This eventually accelerates the economic downturn.

• Trough
  The bottom of the contraction phase is referred to as the recessionary trough. When a contraction is prolonged and characterized by a sharp decline in economic activity, it is called a depression.

• Expansion
  After the downturn reaches bottom and economic conditions begin to improve, the economy enters the expansion phase of the cycle. Here business sales rise, GDP grows rapidly, and the rate of unemployment declines.
  • Hiring new workers is a costly process. Firms will wait until it's clear that the economy is in this phase. They will then start full-time rehiring as overtime hours rise.
  • As inventories dwindle, businesses ultimately find themselves short of inventory. As a result, they start increasing inventory levels by producing output greater than sales, leading to an economic expansion. This expansion continues as long as the rate of increase in sales holds up and producers continue to increase inventories at the preceding rate.
  • Changes in sales can result in magnified percentage changes in investment expenditures. Suppose a firm is operating at full capacity. When sales of its goods increase, output will have to be increased by increasing plant capacity through further investment. This accelerates the pace of economic expansion, which generates greater income in the economy, leading to further increases in sales. Thus, once the expansion starts, the pace of investment spending accelerates.
    Orders for new equipment are early signals of recovery. Since it usually takes longer to plan and complete large construction projects than for equipment orders, construction projects may be less influenced by business cycles.
  The expansion eventually blossoms into another peak.

We consider a few fundamentally different theories of the business cycle.

Neoclassicial and Austrian Schools - Self-Correcting Economy

The neoclassical economists assumed that the economy would not operate with real GDP (Y) away from the level of natural real GDP (Y^N) for any length of time; if Y < Y^N, then firms would be producing below capacity, and would tend to cut nominal wages and prices, which would continue until Y^N was again reached. If Y > Y^N, then above-capacity production could support hikes in nominal wages and prices, until real output fell back to Y^N. The consequence was no business cycle in real GDP.

The Austrian school economists argued that business cycles are caused by governments as they try to increase GDP and employment.

Keynesian School - No Self-Correction

It is the changes in output and employment, not price changes, that restores equilibrium in the Keynesian model.

• Aggregate demand fluctuations. Demand is the driving force of the economy. Expectations are the most significant influence on aggregate demand.
• Aggregate supply response. Wages and prices are highly inflexible, particularly in a downward direction. With a sticky price level, the short-run aggregate supply curve is horizontal at a fixed price level.
• Policy response is needed. When aggregate expenditures are deficient, there are no automatic forces capable of assuring full employment. Recessions and depressions result when total spending falls because businesses reduce production. Therefore, government intervention is required to keep the economy at full employment capacity without inflation.

To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed.

Monetarist School

The economy is self-regulating and it will normally operate at full employment if monetary policy is properly timed and the pace of money growth is kept steady. The quantity of money is the most significant influence on aggregate demand.

The New Classical Model - Policy Ineffectiveness

Real business cycle theory assumes that real shocks to the economy are the primary cause of business cycles.

• Adverse cost shocks lead to a recession, as individuals should spend less time working because it is not profitable.
• Favorable cost shocks lead to a boom period because it is advantageous to produce as much as possible.

Production fluctuates because of the changing value of output and the changing productivity of the economy. Government intervention is generally not necessary because it may exacerbate this fluctuation or delay the convergence to equilibrium.

The Neo-Keynesian school assumes that the prices of most goods don't change daily (sticky price, or menu cost), as the cost of changing prices may outweigh the benefits of changing prices. Therefore, markets do not reach equilibrium quickly.

The U.S. Census Bureau conducts monthly surveys to determine the status of the labor force in the U.S.

To be counted as unemployed, a person must be actively seeking employment but currently without work.

The unemployment rate is the percentage of persons in the labor force who are unemployed. This is a key parameter of conditions in the aggregate labor market.

There are special categories of unemployment, such as:

• Long-term unemployed: people who are unemployed because they do not have the skills required by the openings or reside far from the jobs.
• Frictionally unemployed: people who are not working because they are in between jobs.

Unemployment rate tends to be a lagging instead of a leading indicator of the economy, confirming but not foreshadowing long-term market trends. It tends to peak after the trough of the business cycle and bottom after the peak of the business cycle. This is because:

• The employment data is compiled afterwards.
• Employers are reluctant to lay people off when the economy turns bad. For large companies, it can take months to put together a layoff plan. Companies are even more reluctant to hire new workers until they are sure the economy is well into the expansion phase of the business cycle.

Underemployed is a measure of employment and labor utilization in the economy. It looks at how well the labor force is being utilized in terms of skills, experience, and availability to work.

Discouraged workers believe that continuing the job search is fruitless and thus give up looking for a job. They wish to work but because they are not actively searching for work they are excluded from the labor force and are not counted in the unemployment rate. The unemployment rate may fall during recessions as discouraged workers leave the labor force.

Voluntary unemployment refers to the number of persons in an economy without jobs because they choose to be unemployed.

Analysts also use other measures to get a better picture of the employment cycle. These measures include the size of payrolls, hours worked, and the use of temporary workers.

Inflation is a continuing rise in the general level of prices of goods and services. It can also be defined as a decline in the value (the purchasing power) of the monetary unit. There is too much money chasing too few goods.

• It is a rise in the price level, not in the price of a particular commodity. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs.
• It is an ongoing process, not a one-time jump in the price level.

There are different types of inflation.

• Deflation is a decrease in the general price level of goods and services.
• Disinflation is a slowing in the rate of increase in the general price level.
• Hyperinflation indicates a very high and increasing rate of inflation.

The annual inflation rate is simply the percentage change in the price index (PI) from one year to the next:

For example, the CPI is 115 for 2010 and 120 for 2011. The inflation rate during 2011 is: (120 - 115)/115 = 4.35%.

The Laspeyres index uses the same group of commodities purchased in the base period.

• Advantages: It requires quantity data from only the base period. This allows a more meaningful comparison over time. The changes in the index can be attributed to changes in the price.
• Disadvantages: It does not reflect changes in buying patterns over time. It may also overweight goods when prices increase.

The Paasche index uses the current composition of the basket. It tends to understate inflation.

The Fisher index is the geometric mean of the two indices.

Many countries use their own consumer price indices to track domestic inflation. These indices have different names and baskets.

Inflation is not simply a matter of rising prices. In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the short run, there are endemic and perhaps diverse reasons for causes at the root of inflation.

Inflation can result from either an increase in aggregate demand (demand-pull inflation) or a decrease in aggregate supply (cost-push inflation).

• Cost-push inflation is a result of decreased aggregate supply as well as increased costs of production (itself a result of different factors). It basically means that prices have been "pushed up" by increases in the costs of any of the production factors (money wage rate and money price of raw materials) when companies are already running at full production capacity. Increased costs are passed on to consumers, causing a rise in the general price level (inflation).
  • The non-accelerating inflation rate of unemployment (NAIRU), or the natural rate of unemployment (NARU), is defined as the rate of unemployment when the rate of wage inflation is stable.
  • The unit labor cost (ULC) indicator is calculated as total compensation per worker divided by total output per worker. Higher labor costs may pass through to prices.

• Demand-pull inflation occurs when total demand for goods and services exceeds total supply. Buyers, in essence, "bid prices up" and cause inflation. This excessive demand usually occurs in an expanding economy.
  The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, the authorities may allow the money supply to grow faster than the ability of the economy to supply goods and services, so there is "too much money chasing too f

...

Economic indicators are statistics on macroeconomic variables that help in understanding which stage of the business cycle an economy is in. Economic indicators can be leading, lagging, or coincident, which indicates the timing of their changes relative to how the economy as a whole changes.

• Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and improves before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

• Lagging: A lagging economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagging economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

• Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

No single indicator is able to forecast accurately the future direction of the economy. In the U.S., economists often refer to the Conference Board's diffusion index when judging the moves in the leading index. The diffusion index can measure the breadth of a move in any BCI index, showing how many of an index's components are moving together with the overall index. The index generally turns down prior to a recession and turn up before the beginning of a business expansion.

However, there are two problems with the index.

• There has been significant variability in the lead time of the index. For example, a downturn in the index is not always an accurate indicator of the future.
• The index has often given false alarms. For example, a recession forecasted by a decline in the index does not materialize.

While we cannot predict the future perfectly, economic indicators help us understand where we are and where we are going.

Fiscal policy refers to the use of government expenditure, tax, and borrowing activities to achieve economic goals. Monetary policy refers to central bank activities to control the supply of money. Their goals are maximum employment, stable prices, and moderate long-term interest rates.

The Functions of Money

Money performs three basic functions.

• It serves as a medium of exchange to buy and sell goods and services. Money simplifies and reduces the costs of transactions.
  In the absence of money, a barter economy would exist. Acquiring a belt, for example, would entail finding a belt maker who happened to want what you had to offer in exchange, making transactions tedious, enormously costly, and inefficient.
  Money permits us to realize the enormous gains from the specialization, division of labor, and mass-production processes that underlie our modern standard living.

• It is used as an accounting unit to compare the value and cost of things. As a unit of measurement, like a centimeter, money is used by people to post prices and keep track of revenues and costs.

• It provides a way of storing value to allow the movement of purchasing power from one period to another. Although it is not the only way of storing value, it is the most liquid of all assets, due to its function as the medium of exchange. However, many methods of holding money do not yield an interest return and the purchase power of money will decline during a time of inflation.

The Money Creation Process

Reserves are the cash in a bank's vault and deposits at Federal Reserve Banks. Under the fractional reserve banking system, a bank is obligated to hold a minimum amount of reserves to back up its deposits. Reserves held for that purpose, which are expressed as a percentage of a bank's demand deposits, are called required reserves. Therefore, the required reserve ratio is the percentage of a bank's deposits that are required to be held as reserves.

Banks create deposits when they make loans; the new deposits created are new money.

Example

Suppose the required reserve ratio in the U.S. is 20%, and then suppose that you deposit $1,000 cash with Citibank. Citibank keeps $200 of the $1,000 in reserves. The remaining $800 of excess reserves can be loaned out to, say, John. After the loan is made, the money supply increases by $800 (your $1,000 + John's $800). After getting the loan, John deposits the $800 with Bank of America (BOA). BOA keeps $160 of the $800 in reserves and can now loan out $640 to another person. Thus, BOA creates $640 of money supply. The process goes on and on. With each deposit and loan, more money is created. However, the money creation process does not create an infinite amount of money.

The money multiplier is the amount by which a change in the monetary base is multiplied to calculate the final change in the money supply. Money Multiplier = 1/b, where b is the required reserve ratio. In our example, b is 0.2, so money multiplier = 1/0.2 = 5.

Definitions of Money

There are different definitions of money. The two most widely used measures of money in the U.S. are:

• The M1 Money Supply: cash, checking accounts and traveler's checks. This is the narrowest definition of the money supply. This definition focuses on money's function as a medium of exchange.
• The M2 Money Supply: M1 + savings + small time deposits + retail money funds. This definition focuses on money's function as a medium of exchange and store of value.

Credit cards are not purchasing power, but instead are a convenient means of arranging a loan. Credit is a liability acquired when one borrows funds, while money is a financial asset that provides the holder with future purchasing power. However, the wid...

At any given interest rate, the amount of wealth that households and businesses desire to hold in the form of money balances, either as cash or any other highly liquid form of value (such as checking accounts), is called the demand for money.

People hold (demand) money to conduct transactions, to deal with emergencies (precautionary motive), and for speculative activities.

There is an inverse relationship between the demand for money and interest rates when all other influences on the amount of money that people wish to hold remain the same.

A rise in the interest rate brings a decrease in the quantity of money demanded. A fall in the interest rate brings an increase in the quantity of money demanded.

The money supply schedule is vertical since domestic supply of money is determined by the central bank and reserve requirements. The supply of money is not affected by changes in the interest rate.

Money market equilibrium occurs when people are willing to hold all the money supplied by the monetary authorities at the prevailing interest rate; the supply of money equals the demand for money. It occurs at i_e in the diagram.

However, disequilibrium exists at the interest rate i₂.

People are not willing to hold all the money supplied by the monetary authorities as money balances. Instead, they demand high-interest earning assets such as bonds. This will increase the price of bonds, which in turn reduces their interest yield, driving i₂ down towards i_e and eventually restoring equilibrium.

Disequilibrium also exists at the interest rate i₃.

People would like to hold more money balances than the monetary authorities are willing to supply. The resultant low demand for bonds reduces their prices, thus increasing their interest rate (yield), and slowly restores equilibrium at i_e.

The Fisher Effect

R_nom = R_real + R_inflation + risk premium

The nominal rate of interest is comprised of three components:

• A real required rate of return.
• A component to compensate lenders for future inflation.
• A risk premium to compensate lenders for uncertainty.

Central banks all have similar roles:

• Issue currency
• The government's bank, and bank of the banks
• Lender of last resort to the banking sector
• Regulator and supervisor of the payments system
• Set monetary policy
• Regulate banking system

A nation's monetary policy objectives and the framework for setting and achieving those objectives stems from the relationship between the central bank and the government. Central banks in different countries have a variety of objectives, such as maximum employment, stable prices, and moderate long-term interest rates. In the long run, these objectives are in harmony and reinforce each other, but in the short run, they might be in conflict.

The key objective is price stability. It is the source of maximum employment and moderate long-term interest rates.

The Costs of Inflation

Unanticipated inflation is an increase in the general level of prices that was not expected by most decision makers. It is a surprise to most individuals. For example, if someone anticipates an inflation rate of 3% but the actual inflation rate turns out to be 10%, it will catch that person off guard.

Unanticipated inflation redistributes income, creates uncertainty, and can have a potentially destabilizing impact on the economy.

Monetary Policy Tools

Central banks manipulate the money base that creates the change in the money supply. When following an expansionary monetary policy, they increase the growth rate of the money supply. Conversely, when following a restrictive monetary policy, they reduce the growth rate of the money supply.

Central banks have three major means of controlling the money stock.

Open Market Operations. Since it can be undertaken easily and quietly, this is the most common tool used by a central bank to alter the money supply. For example, to increase the money supply, the central bank buys government securities from commercial banks. This increases the money supply.

The Central Bank's Policy Rate. Sometimes banks find themselves in a position where they are not holding enough bank reserves relative to the value of the deposits they hold (i.e., they have extended too many loans!). As a result, they may need to acquire a short-term loan from the central bank to cover this shortage of required reserves. They may apply to the central bank for a loan; the interest charged on the loan is known as repo rate (in the U.S. it is called the discount rate).

An increase in the policy rate is restrictive on money supply - it tends to discourage banks from shaving their excess reserves to a low level.

In the U.S., borrowing from the Fed amounts to less than one-tenth of 1% of the available loanable funds of banks. A bank can go to the federal funds market to borrow to meet its reserve requirements. The market is where banks with excess reserves extend short-term loans to those banks seeking additional reserves. The interest rate in this market is called the federal funds rate. The federal funds rate and the discount rate tend to move together.

Reserve Requirements. The central bank sets the rules. Since banking institutions will want to hold interest-earning assets rather than excess reserves, an increase in the reserve requirements will reduce the supply of money, and vice versa. However, the central banks of developed countries have seldom used their regulatory power over reserve requirements to alter the supply of money, due to its disruptive impact on banking operations - small changes in reserve requirements can sometime lead to large changes in the money supply.

The Transmission Mechanism

When a central bank lowers its official interest rate:

• Other short-term interest rates fall. Short-term rates move closely together and follow the official interest rate.
• The exchange rate falls. The exchange rate responds to changes in the domestic interest rate relative to the interest

...

Inflation Targeting

Price stability is the primary goal of inflation-targeting monetary policy strategy. Inflation is usually defined as a range of permissible values (e.g., 1%-3%) rather than as a point value (e.g., 2.4%). The definition of inflation also varies from country to country.

There are three key concepts:

Central bank independence. Central bank independence exists on two dimensions. Goal independence is the freedom that the central bank has to select the objectives of monetary policy, whether they are low inflation, the target rate of unemployment, the level of GDP, etc. Instrument independence is the freedom that the central bank has to pick appropriate policies to produce a certain outcome in the economy. Most inflation-targeting countries only lay out the goals and not the operating procedures; the central bank does have operational independence.

Credibility. Central bankers who are unable to credibly convince the public that they are serious about fighting inflation will be faced with a high inflation rate as a result.

Transparency. It is well known that credibility requires transparency. The benefits of transparency are obvious: it improves the efficiency of monetary policy, allows for a more effective management of expectations, and promotes the discussion and evaluation of monetary policy.

Exchange Rate Targeting

Many countries have viewed pegging their nominal exchange rate to a stable, low-inflation foreign currency as a means of achieving domestic price stability. In a sense, countries that target their exchange rates against an anchor currency attempt to "borrow" the foreign country's monetary policy credibility. However, this monetary policy deprives the central bank of its ability to respond to idiosyncratic domestic shocks. Such countries can become prone to speculation against their currencies.

An expansionary monetary policy decreases the interest rate in order to increase the size of money supply. A contractionary monetary policy increases the interest rate to reduce the size of money supply.

The idea behind the concept of neutral rate of interest is that there might be a rate of interest that neither deliberately seeks to stimulate aggregate demand and growth nor deliberately seeks to weaken growth from its current level. In other words, a neutral rate of interest would be one that encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP.

The neutral rate is a useful method of measuring the stance of monetary policy. It has two components:

Neutral rate = Trend growth + Inflation target

When the neutral rate is reached, the state of equilibrium is attained, implying that the economy is now well-balanced and the price level is stable.

Certainly there can be no such thing as an exact measure of the neutral rate, and it will differ from country to country.

A demand shock is a sudden surprise event that increases or decreases demand. If inflation is caused by an unexpected increase in aggregate demand, a contractionary monetary policy might be appropriate, to cause inflation to fall. However, if inflation is caused by a supply shock such as a sudden increase in oil price, a contractionary monetary policy might make the situation worse.

Limitations of Monetary Policy

Central banks cannot control the money supply. This is because:

• They cannot control the amount of money that households and corporations put in banks on deposit.
• They cannot control the willingness of banks to create money by expanding credit.

In quantitative easing (QE), a central bank buys any financial assets to inject money into the economy. It is different from the traditional policy of buying or selling government bonds to keep market interest rates at a specified target value. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional money in order to increase their capital reserves.

Fiscal policy refers to the use of government expenditure, tax, and borrowing activities to achieve economic goals, including the overall level of aggregate demand in an economy (and hence the level of economic activity), the distribution of income and wealth among different segments of the population, and, ultimately, the allocation of resources between different sectors and economic agents.

Government expenditures include transfer payments, the purchase of goods and services (current government spending), and capital expenditure.

Government revenues are generated through taxes. There are direct and indirect taxes. Direct taxes are difficult to change without considerable notice. Indirect taxes can be adjusted almost immediately.

The four desirable attributes of a tax policy are simplicity, efficiency, fairness, and revenue sufficiency.

A budget is the annual statement of the government's expenditures and tax revenues. A balanced budget implies that current government revenue is equal to current government expenditures.

A budget deficit exists when total government spending exceeds government revenue. A budget deficit is financed through the issuance of government securities. Such issuance of securities adds to the national debt.

A budget surplus occurs when revenues exceed spending. Under a budget surplus, excess revenue is applied to the total outstanding debt accumulated during prior periods, therefore reducing it by the amount of the surplus.

There are arguments for and against being concerned with the size of a fiscal deficit.

The arguments against being concerned about national debt:

• The debt is owed internally by fellow citizens.
• Some borrowed money may have been used for capital investment projects or enhancing human capital.
• Large deficits require tax changes which may be desirable.
• Richardian equivalence: the timing of any tax change does not affect consumers' change in spending.
• Debt could improve employment.

The arguments for being concerned about national debt:

• Higher deficits -> higher tax rates -> less incentive to work and invest -> lower long-term growth
• The central bank may have to print money to finance a deficit. This may lead to high inflation.

The crowding-out effect is the reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the capital market. It suggests that budget deficits will exert less impact on aggregate demand than the basic Keynesian model implies. Because financing the deficit pushes up interest rates, budget deficits will tend to retard private spending, particularly spending on investment. This reduction will at least partially offset additional spending emanating from the deficit.

Multipliers

As disposable income increases, consumption expenditures increase, but by a smaller fraction than the increase in income. This is reflected in the marginal propensity to consume (MPC), which is less than one.

Marginal propensity to save (MPS) is defined as additional savings divided by additional current disposable income.

MPC + MPS = 1 If we add tax rate t, then:

MPC + MPS = 1 - t An expenditure multiplier is the ratio of the change in equilibrium output relative to the independent change in consumption, investment, and government spending or spending on net exports that brings about the change.

The government purchases multiplier is the magnification effect of a change in government purchases of goods and services on aggregate demand. It exists because government purchases are a component of aggregate expenditure; an increase in government purchases incre...

Fiscal policy actions seek to stabilize the business cycle by changing aggregate demand. These policy actions can be:

• Discretionary. Discretionary fiscal policy is a policy action that is initiated explicitly by the government.
• Automatic. Automatic fiscal policy is a change in fiscal policy triggered by the state of the economy.

To reduce economic disturbances, fiscal policy must be put into effect at the proper time in the business cycle. Policy changes take time; thus, when they take effect, the recession or inflationary overheating may have passed. For example, during an economic downturn, a government uses expansionary fiscal policy to stimulate aggregate demand. Suppose, by the time the expansionary fiscal policy starts to exert its primary impact, the economy's self-corrective mechanism has restored full employment capacity. Therefore, the stimulus injected by expansionary fiscal policy will result in excessive demand and inflation, causing more economic instability.

The use of discretionary fiscal policy is hampered by three time lags:

• Recognition lag. There is usually a time lag between when a change in policy is needed and when its need is widely recognized by policymakers. Forecasting a forthcoming recession or boom is a highly imperfect science.
• Action lag. There is generally a lag between the time when the need for a fiscal policy change is recognized and the time when it is actually instituted. The time required to change tax laws and government expenditure programs is quite lengthy.
• Impact lag. Even after a policy is adopted, it may be 6 to 12 months before its major impact is felt.

Changes in fiscal policy must be timed properly if they are going to exert a stabilizing influence on an economy. However, the use of fiscal policy to calm the business cycle is very difficult; it may accentuate the corrective action of the economy rather than correct the problem for which it was intended. In the real world, a discretionary change in fiscal policy is like a double-edged sword - it has the potential to do harm as well as good. If timed correctly, it will reduce economic instability. If timed incorrectly, however, the fiscal change will increase rather than reduce economic instability.

Automatic Stabilizers

Automatic stabilizers apply stimulus during a recession and restraint during a boom even though no legislative action has been taken. Their major advantage is that they institute counter-cyclical fiscal policy without the delays associated with policy changes that require legislative action. During a recession, they trigger government spending without the authorization of Congress (unemployment compensation and welfare programs). During inflationary overheating, they take spending power out of the economy without the delays caused by legislative actions, thereby minimizing the problem of proper timing.

Income taxes and transfer payments are automatic stabilizers.

When the economy starts to fall into a recession, unemployment increases. Government payments for unemployment compensation will increase while government receipts from the employment tax that finances unemployment benefits will decline. As a result, the unemployment compensation program automatically promotes a budget deficit. Similarly, when the economy expands into an inflationary boom, the program promotes a budget surplus.

When the economy expands into an inflationary boom, personal income will grow sharply. As a result, more people will fall into the "tax due" category, and others will be pushed into higher tax brackets. Therefore, income tax revenues will rise more rapidly than income, reducing the momentum of consumption growth. In addition, higher tax revenues will promote a budget surplus.

Governments use fiscal and monetary policies to respond to changes in the business cycle. Although both fiscal and monetary policy can alter aggregate demand, they work through different channels. Consider the effects of using monetary or fiscal policy to increase aggregate demand:

• Central banks can respond with lower interest rates and an expanded money supply. This will lead to an increase in investment and consumer spending. Since investment spending results in a large capital stock, incomes in the future will also be higher. However, inflation may result.
• Keynes argued that the government should boost spending but that if this is financed by higher borrowing, it may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in aggregate demand. However, since investment spending is lower, the capital stock is lower than it would have been and future incomes will be lower.

Monetary policy and fiscal policy are not interchangeable. When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree; they argue that changes in monetary policy can impact consumer and business behaviour quite quickly and strongly.

However, there may be factors which make fiscal policy ineffective aside from the usual crowding-out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals "undo" government fiscal policy through changes in their own behaviour - for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this.

Monetary and fiscal policies also differ in the speed with which each takes effect. The time lags are variable and they can conceivably work against one another unless the government and central bank coordinate their objectives.

GDP is the total market value of all domestically produced final goods and services for a particular year. Its five key factors are: market value, final goods and services, produced, within a country, during a specific time period.

• Only final goods and services count: GDP includes goods and services purchased by final users. Intermediate goods purchased for resale or for the production of another good or service are excluded, to avoid double-counting. Their value is embodied in the value of the goods purchased by the end user.

• GDP is a "flow" variable; it measures the market value of production that flows through the economy.

• Financial transactions and income transfers (e.g., social security and welfare payments) are excluded because they represent exchanges, not productions, of goods and services. GDP counts transactions that add to current production.

• GDP counts only goods and services produced domestically, whether by citizens or foreigners.

• It includes only goods produced during the current period. Thus, sales of used goods are not counted in GDP. However, sales commissions count toward GDP because they involve services provided during the period.

GNP is the total market value of all final goods and services produced by the citizens of a country. It measures the output that is produced by the "nationals" of a country. This figure is the output generated by the labor and capital owned by the citizens of the country, regardless of whether that output is produced domestically or abroad. Consider the case of the United States. GNP is the income earned by Americans, regardless of whether that income is earned in the United States or abroad. It omits the income foreigners earn in the United States, but counts the income that Americans earn abroad. It is equal to GDP minus the net income of foreigners.

GNP = GDP + Income received by citizens for factors of production supplied abroad - Income paid to foreigners for the contribution to domestic output

In short, GNP measures the worldwide output of a nation's citizens while GDP measures the domestic output of the nation.

• In general, the bulk of output is produced domestically using resources owned by nationals of the country. Thus, GDP often differs only slightly from GNP.
• These two measures differ substantially only when a country attracts a large number of foreign workers or investments (the country's GDP will exceed its GNP).
• If a relatively large number of a country's citizens work abroad, or its citizens have made substantial investments abroad, the country's GNP will exceed its GDP.

Benefits and Costs

Here are the benefits:

• International trade and specialization result in lower prices and higher domestic consumption for imported products, and higher prices and lower domestic consumption for exported products.
• International trade permits the residents of each nation to concentrate on the things they do best (produce at a low cost) while trading for those they do least well.
• Industries experience greater economies of scale.
• Households and firms have greater product variety.
• Resources are allocated more efficiently.

Costs:

• International trade may result in the loss of jobs in developed countries.
• The potential for greater income inequality increases.

Countries have different resource endowments. Some have an abundance of labor whilst others possess fertile lands. Differences in resource endowments result in countries incurring different opportunity costs of production for the same products.

Comparative advantage is the ability to produce a good at a lower opportunity cost than others can produce it. Relative costs determine comparative advantage.

If each country has a comparative advantage in producing a specific good, international trade will lead to mutual gain because it allows the residents of each country to:

• Specialize more fully in the production of those things that they do best (i.e., at a lower opportunity cost).
• Import goods when foreigners are willing to supply them at a lower cost than domestic producers.

A nation can have a comparative advantage in producing a good even if it has no absolute advantage in producing any good. As long as the relative costs of producing two goods differ in two countries, comparative advantage exists and gains from specialization and trade will be possible. When this is the case, each country will find it cheaper to trade for goods that can be produced only at a high opportunity cost.

We are going to start with some simplifying assumptions:

• Only two countries exist: X and Y.
• Only two products are produced in each country: wine and fish.
• The only resource in each country is labor.

Country X has an absolute advantage in producing both products (i.e., country X's laborers are more efficient than those in country Y).

• Each worker in X is able to produce either 5 fish or 10 bottles of wine per day. The opportunity cost of 1 fish produced in X is 2 bottles of wine.
  A production possibilities frontier (PPF) represents the various maximum combinations of outputs of the two products that a country is able to produce given its current resources.
  
  Any point on the PPF represents an attainable combination of fish and wine. The slope of the PPF represents the opportunity cost of wine relative to fish. For example, if X was consuming 250 million fish and no wine at point A, the cost of increasing wine consumption to 250 million bottles would be that 125 million fish would have to be sacrificed (i.e., it would move to point B).

• In Y, each worker can produce either 2 fish or 1 bottle of wine per day. One bottle of wine costs 2 fish.
  

In the absence of trade, a country's consumption possibilities are constrained by the country's production possibilities frontier (i.e., country X could not consume 125 million fish and more than 250 million bottles of wine).

...

Governments restrict international trade to protect domestic producers from competition by using many trade policies. All trade restriction policies result in higher prices and higher domestic production (more producer surplus) but lower domestic consumption (less consumer surplus).

For purposes of international trade policy and analysis:

• A small country cannot affect the world price of traded goods. In a small country, trade barriers always generate a net welfare loss arising from distortion of production and consumption decisions and the associated inefficient allocation of resources.
• A large country's production and/or consumption decisions do alter the relative prices of traded goods. Trade barriers can generate a net welfare gain in a large country if it imposes an even larger welfare loss on its trading partners.

Tariffs

A tariff is a tax levied on goods imported into a country. It benefits domestic producers and the government at the expense of consumers.

Let's illustrate the impact of a tariff on automobiles. Without a tariff, the world market price (P_w) would prevail in the domestic market. U.S. consumers purchase Q₁ units while U.S. producers supply Q_d1 units. When the U.S. imposes a tariff (t) on imports of automobiles, U.S. consumers now pay (P_w + t) to purchase automobiles from foreigners. Due to the higher price, U.S. consumers will reduce demand from Q₁ to Q₂, while U.S. producers will increase supply from Q_d1 to Q_d2. Imports from foreigners will reduce from Q₂ to Q_d2.

The tariff benefits domestic producers and the government. It protects domestic producers from foreign competition. Consequently, domestic producers can supply goods at a higher price. Domestic producers gain the area S in the form of additional revenue. The government gains the area T in the form of tax revenues collected on imports.

The tariff harms domestic consumers as they have to pay a higher price for fewer goods. They lose the area S + U + T + V. Note that areas U and V are a deadweight loss (loss of efficiency) for the economy since they do not benefit either producers or the government.

In effect, a tarrif acts as a subsidy to domestic producers. Potential gains from specialization and trade go unrealized.

Quotas

An import quota is a specific limit or maximum quantity (or value) of a good permitted to be imported into a country during a given period. It is designed to restrict foreign goods and protect domestic industries.

Assume that a quota limits imports of automobiles to (Q₂ - Q_d2), a quantity below the free trade level of imports (Q₁ - Q_d1). Since the quota reduces foreign supply, domestic price will be pushed up to P₂. Due to the higher price, U.S. consumers will reduce demand from Q₁ to Q₂, while U.S. producers will increase supply from Q_d1 to Q_d2. Like a tariff, an import quota benefits domestic producers but harms domestic consumers.

However, different from a tariff, an import quota benefits foreign producers at the expense of the government; with a quota, foreign producers who are granted permission to sell in the domestic market can charge premium prices for the limited supply of foreign goods. The area T represents the gains of those foreign producers. Under a tariff, the government would gain the area T in the form of tariff revenues. This po...

When we buy something from another country, we use the currency of that country to make the transaction. We record international transactions in the balance of payments accounts.

A country's balance of payments accounts records its international trading, borrowing, and lending.

• It summarizes the transactions of the country's citizens, businesses, and government with foreigners.
• Its accounts reflect all payments and liabilities to foreigners (debits) and all payments and obligations received from foreigners (credits).

Balance-of-payments accounts are recorded using the regular bookkeeping method.

• Any transaction that creates a financial inflow is recorded as a credit. That is, if a country has received money, this is known as a credit. Exports are an example of a credit item.
• Any transaction that creates a financial outflow is recorded as a debit. That is, if a country has paid or given money, the transaction is counted as a debit. Imports are an example of a debit item.

The main categories of the balance of payments are:

• Current account
  It records payments for imports of goods and services from abroad, receipts from exports of goods and services sold abroad, net interest paid abroad, and net transfers (such as foreign aid payments).
  When combined, goods and services together make up a country's balance of trade (BOT). The BOT is typically the biggest bulk of a country's balance of payments as it makes up total imports and exports.

• Capital account
  This is where is where all international capital transfers are recorded. It also includes net sales of non-produced, non-financial assets. Capital inflow transactions are recorded as credits and capital outflow transactions are recorded as debits.

• Financial account
  This documents all international monetary flows related to investment in financial assets such as bonds and stocks. Also included are government-owned assets such as foreign reserves, gold, and special drawing rights (SDRs) held with the International Monetary Fund.

Analysts often lump financial account and capital account into one category named "capital account," which consists of portfolio investment flows (short-term) and foreign direct investment (long-term).

Example

A U.S. citizen purchases a rug from India for $100. The U.S. debits its current account for $100. Now the Indian rug-maker has two options:

• Deposit the $100 into a U.S. bank. The U.S. asset (a bank deposit) will show up as a credit to the U.S. capital account.
• Convert the $100 to rupees. The Indian bank then has 2 options.
  • Lend the $100 to a customer for the purchase of U.S. goods. This is to credit the U.S. current account.
  • Purchase U.S. government bonds. This is to credit the U.S. capital account.

In each case the balance of payments will balance.

The balance of payments must balance, meaning the balances of these three components must sum to zero. A deficit in one area implies an offsetting surplus in other areas. A current-account deficit implies a capital-account surplus (and vice versa).

What do these balances mean in economic terms? A country that runs a current account deficit is spending more than it produces, making up the difference between how much a country saves and how much it invests. A rising current account deficit could imply rising investment or falling saving, or both.

CA = S_p + S_g - I To reduce a current account deficit, a country must save more and/or invest less. Higher saving can come from the private sector or from the government through a smaller budget deficit.

Net exports are ...

Created after WWI, the International Monetary Fund, the World Bank, and the World Trade Organization are the three major international organizations that provide necessary stability to the international monetary system and facilitate international trade and development.

The IMF's mission is to ensure the stability of the international monetary system, the system of exchange rates and international payments which enables countries to buy goods and services from each other. The IMF helps keep country-specific market risk and global systemic risk under control.

The World Bank's mission is to help developing countries fight poverty and enhance environmentally sound economic growth. It helps create the basic economic infrastructure essential for the creation and maintenance of domestic financial markets and a well-functioning financial industry in developing countries.

The WTO provides the legal and institutional foundation of the multinational trading system and is the only international organization that regulates cross-border trade relations among nations on a global scale. Its mission is to foster free trade by providing a major institutional and regulatory framework of global trade rules. Without such global trade rules, today's global transactional corporations would be hard to conceive.

An exchange rate is the current market price at which one currency can be exchanged for another. The convention used in the reading is the number of units of one currency (price currency) that one unit of another currency (base currency) will buy.

Let's say a:b = S.

• a is the price currency.
• b is the base currency.
• S is the cost of one unit of currency b in terms of currency a.

For example, US$ : £ = 1.5 indicates that £1 is priced at US$1.5.

The exchange rate above is referred to as the nominal exchange rate. The real exchange rate is the nominal rate adjusted somehow by inflation measures.

For example, if country A has an inflation rate of 10%, country B an inflation rate of 5%, and no changes in the nominal exchange rate took place, then country A now has a currency whose real value is higher than before.

Market Functions and Participants

A foreign exchange market is a place where foreign exchange transactions take place. Measured by average daily turnover, the foreign exchange market is by far the largest financial market in the world. It has important effects, either directly or indirectly, on the pricing and flows in all other financial markets.

There is a wide diversity of global FX market participants that have a wide variety of motives for entering into foreign exchange transactions. Commercial companies undertake FX transactions during cross-border purchases and sales of goods and services. Hedge funds trade FX currencies for hedging or even speculative purposes. Central banks use their FX reserves to stabilize the market and control the money supply. Large dealing banks provide FX price quotes to their clients. With so many different market participants, motives, and strategies, it is very difficult to describe the FX market adequately with simple characterizations.

Most countries use a system of direct quotation. A direct exchange rate quote gives the home (domestic) currency price of a certain quantity of the foreign currency quoted (Domestic Currency/Foreign Currency, or DF/FC). In this case, the home currency is the price currency and the foreign currency is the base currency.

For example, the price of foreign currency is expressed in yen in Japan and pesos in Mexico. Direct quotation is used in most countries. For an American investor, a quote €:$ = 1.25 is a direct quote; he is expected to pay $1.25 for a €. Note that when there are two currencies, the base currency is always mentioned first, the opposite order of the actual ratio (price currency / base currency).

Indirect quotation (FC/DC) is also used in some markets. It is just the opposite of a direct quote; they are reciprocals of each other. For example, a bank in London will quote the value of the pound sterling (GBP) in terms of the foreign currency (i.e., £:$ = 1.4410).

Example

For a U.S. resident, ¥:$ = 0.0085 is the direct quote for Japanese yen and $:¥ = 119.46 is the indirect quote for Japanese yen.

In a direct quote, an appreciation of the foreign currency (a depreciation of the domestic currency) causes an increase in the direct quote.

• The domestic currency moves in the opposite direction of the exchange rate.
• The foreign currency moves in the same direction as the exchange rate.

The opposite is true for an indirect quote: the domestic (foreign) currency moves in the same(opposite) direction as the exchange rate.

Bid-Ask (Offer) Quotes and Spreads

Dealers (e.g., banks) do not normally charge a commission on their currency transactions but they profit from the spread between the buying and selling rates on both spot and forward transactions. Quotes are always in pairs: the first rate is the buy, or bid, price (for a dealer); the second is the sell, or ask, offer (for a dealer). The ask rate is usually higher than that bid rate, so the dealer can make a profit. The average of the bid and ask price is known as the midpoint price: midpoint price = (Ask + Bid) / 2.

When direct quotations are converted to indirect quotations, bid and ask quotes are reversed. That is:

• The direct ask price is the reciprocal of the indirect bid price.
• The direct bid price is the reciprocal of the indirect ask price.
• No matter how the quote is made, dealers will always buy low and sell high.

For example, here is a direct quote for the Japanese yen from the U.S. perspective: ¥:$ = 0.0081-83. That is, the dealer is willing to buy ¥ at $0.0081 (direct bid price) and sell them at $0.0083 (direct ask price). The indirect bid price is (1/0.0083) $:¥ = 120.48 and the indirect ask price is (1/0.0081) = $:¥ = 123.45.

The bid-ask spread is the spread between bid and ask rates for a currency: Bid-ask spread = ask price - bid price. It is usually stated as a percentage of the ask price:

For example, with GBP quoted at £:$ = 1.4419 - 28, the percentage spread is: (1.4428 - 1.4419) x 100 / 1.4428 = 0.062%.

Note that the percentage spread is the same irrespective of whether the exchange rate is expressed in direct or indirect quotations.

The bid-ask spread is based on the breadth and depth of the market for that currency as well as on the currency's volatility.

A cross rate is the exchange rate between two countries computed from each country's exchange rate against a third country. For example, since most currencies are quoted against the U.S. dollar, sometimes we need to work out the cross rates for currencies other than the U.S. dollar.

If we interpret a:b as a "divide" sign, then a:b is actually b/a. Assume we have currencies a, b and c. If a:b and b:c are both known, then a:c = a:b x b:c. For example, if the Mexico peso (MXN) is selling for $0.0923 (MXN:USD = 0.0923) and the buying rate for the EUR is $0.7928 (USD:EUR = 0.7928), then the MXN/EUR cross rate is MXN:EUR = 0.0923 x 0.7928 = 0.0732.

Cross-Rate Calculations with Bid-Ask Spreads

Example

The rate between Japanese ¥ and the U.S. $ is $:¥ = 119.05 - 121.95 and the rate between the euro and the U.S. $ is $:€ = 0.7920 - 0.7932. The direct quote between the yen and the euro in Japan will be: (¥119.05/$)/(€0.7932/$) = ¥150.0883/€, and (¥121.95/$)/(€0.7920/$) = ¥153.9773/€.

The lower rate is the bid, and the higher rate is the ask. Therefore, the rate between yen and euro is €:¥ = 150.0883 - 153.9773.

In fact, each cross-currency transaction is the combination of two trades:

• The bid price: a bank will buy U.S. dollars with yen low ($:¥ = 119.05), and sell U.S. dollars for euro high ($:€ = 0.7932). Thus, the bid price is €:¥ = 150.0883.
• The ask price: a bank will sell U.S. dollars for yen high ($:¥ = 121.95), and buy U.S. dollars with euro low ($:€ = 0.7920). Thus, the ask price is €:¥ = 153.9773.

Note that in calculating the cross rates you should always assume that you have to sell a currency at the lower (or bid) rate and buy it at the higher (or ask) rate, giving you the worst possible rate. This method of quotation is how dealers make money in foreign exchange.

Similarly, the direct quote in France or Germany is ¥:€ = 0.006494 - 0.006663

Spot and Forward Exchange Rates

In the spot market, currencies are traded for immediate delivery. In the forward market, contracts are made to buy or sell currencies for future delivery.

In a typical forward transaction, a U.S. company buys textiles from England with payment of £1 million due in 90 days. The importer is thus short £ - that is, it owes £ for future delivery. Suppose the present price of £ is $1.71. Over the next 90 days, however, £ might rise against the U.S. dollar, raising the U.S. dollar cost of the textiles. The importer can guard against this exchange risk by immediately negotiating a 90-day forward contract with a bank at a price, say, £:$ = 1.72. In 90 days the bank will give the importer £1 million and the importer will give the bank 1.72 million U.S. dollars. By going long in the forward market, the importer is able to convert a short underlying position in £ to a zero net exposed position.

Three points are worth noting:

• The gain or loss on the forward contract is unrelated to the current spot rate of £:$ = 1.71.
• The forward contract gain or loss exactly offsets the change in the U.S. dollar cost of the textile order that is associated with movements in the GBP's value.
• The forward contract is not an option contract. Both parties must perform the agreed-on behavior.

Forward exchange rates are often quoted as a premium, or discount, to the spot exchange rate. A base currency is at a forward discount if the forward rate is below the spot rate, whereas a forward premium exists if the forward rate is above the spot rate.

For example, if the one-month forward exchange rate is $:€ = 0.8020 and the spot rate is $:€ = 0.8000, the $ quotes with a premium of 0.0020 €/$. In the language of currency traders, the $ is "strong" relative to the €.

Consequently, when a trader announces that a currency quotes at a premium (discount), the premium (discount) should be added to (subtracted from) the spot exchange rate to obtain the value of the forward exchange rate.

Occasionally, forward rates are presented in terms of percentages relative to the spot rate:

Interest Rate Parity

According the interest rate parity (IRP) theory, the currency of the country with a lower interest rate should be at a forward premium in terms of the currency of the country with the higher rate. In an efficient market with no transaction costs, the interest differential should be (approximately) equal to the forward differential.

The exact relationship between the forward rate and the spot rate of two currencies is as follows:

• The exchange rate is d:f = S for the spot rate and F for the forward rate.
• Both i_d and i_f are periodic interest rates, which should be computed as i = annual interest rate x number of days till the forward contract expires / 360.
• It is assumed that there are no transaction costs.

Example

Suppose that the annual interest rate in the U.S. is 5%. The spot exchange rate £:$ = 1.50 and the 180-day forward rate is £:$ = 1.45. The U.S. periodic interest rate (180) is: 0.05 x 180 / 360 = 0.025. If interest rate parity holds:

(1.45 - 1.5)/1.5 = (0.025 - i_UK)/(1+i_UK) => i_UK = 6%

Therefore, the annual UK interest rate is approximately 12%.

Similarly, you can calculate the forward rate based on the two interest rates and ...

The exchange rate regime is the way a country manages its currency in relation to other currencies and the foreign exchange market.

An ideal currency regime would have three properties:

• The exchange rate between any two currencies would be credibly fixed.
• All currencies would be fully convertible.
• Each country would be able to undertake fully independent monetary policy in pursuit of domestic objectives, such as growth and inflation targets.

However, these conditions are not consistent. A country cannot have a fixed exchange rate and fully convertible currency without giving up its ability to implement independent monetary policy.

In a flexible exchange rate regime, the exchange rate is determined by the market forces of supply and demand, and therefore fluctuates freely in the market. The central bank intervenes in the foreign exchange market only to smooth temporary imbalances. The advantages are that the exchange rate reflects economic fundamentals at a given point in time and governments are free to adopt independent monetary and fiscal policies. However, exchange rates can be extremely volatile in this regime.

A fixed exchange rate is an exchange rate that is set at a determined amount by government policy. The distinguishing characteristic of a fixed rate, unified currency regime is the presence of only one central bank with the power to expand and contract the supply of money. Those linking their currency at a fixed rate to the U.S. dollar or the euro are no longer in a position to conduct monetary policy. They essentially accept the monetary policy of the nation to which their currency is tied. They also accept the exchange-rate fluctuations of that currency relative to other currencies outside of the unified zone.

In practice, most regimes fall between these extremes. The type of exchange rate regime used varies widely among countries and over time.

No Separate Legal Tender

In this regime a country does not have its own legal tender. There are two sub-types:

• Dollarization. The country uses another country's currency as its domestic currency. The benefit is the elimination of exchange rate fluctuations. However, this leads to the loss of monetary policy autonomy.
• Monetary union. In this case a group of countries share a common currency, e.g., the European Union and the euro.

Currency Board System

The monetary authority is required to maintain a fixed exchange rate with a foreign currency. Its foreign currency reserves must be sufficient to ensure that all holders of its own currency can convert them into the reserve currency. That is, the monetary authority will only issue one unit of local currency for each unit of foreign currency it has in its vault.

The major benefit is currency stability and the main drawback is the loss of ability for the country to set its own monetary policy.

Fixed Parity

The country tries to keep the value of its currency constant against another country but it has no legal obligation to do so. This is also known as the pegged exchange rate system. There can be a very small percentage allowable deviation (band) on both sides of the rate.

Target Zone

This is a fixed parity with a somewhat wider band.

Crawling Peg

In this case, the exchange rate is fixed and then adjusted periodically to keep pace with the inflation rate.

Crawling Band

This is initially a fixed parity, followed by widening band around the central parity. It is used to gradually exit from the fixed parity.

Managed Float

A country's exchange rate is adjusted based on the country's internal or external targets.

Independently Float

In this case, the market determines the ...

Countries that attract a net inflow of foreign capital tend to run current account deficits. The U.S. is an example. In general, a trade deficit (surplus) has to be offset by a capital account surplus (deficit). That is, a current account deficit implies a capital account surplus.

X - M = (S - I ) + (T - G)

This relationship shows that a trade surplus is equal to the sum of public and private savings. A country saves more than enough to fund its investment (I) in plants and equipment. If a country runs a trade deficit, it has to rely on foreign capital to finance its investment (a capital surplus).

Now we analyze the impact of the exchange rate on trade and capital flows.

The Elasticities Approach

This approach emphasizes price changes as a determinant of a country's balance of payments and exchange rate.

The exchange rate is an important price in an economy. When a country's currency depreciates, domestic goods become relatively cheaper and foreign goods relatively more expensive in the global market. Hence, we would expect exports to rise and imports to decline. The elasticities approach considers the responsiveness of imports and exports to a change in the value of a country's currency.

For example, if import demand is highly elastic, a depreciation of the domestic currency will cause a disproportionate decline in the country's imports.

The Marshall-Lerner condition states that a depreciation of domestic currency can improve a country's balance of payments only when the sum of the demand elasticity of exports and the demand elasticity of imports exceeds unity.

The J-Curve is an observed phenomenon.

What is observed is that, following a depreciation or devaluation, a country's balance of payments worsens before it improves. This is because, in the short-run, exports and imports volume does not change that much, so that the price effect dominates, leading to a worsening of the current account.

Absorption Approach

This approach assumes that prices remain constant and emphasizes changes in real domestic income. Hence, the absorption approach is a real-income theory of the balance of payments.

Absorption refers to the total goods and services taken off the market domestically. In other words, absorption equals the sum of consumption plus investment.

Whether a currency depreciation can improve the current account (then the balance of payments) depends on its effect on national income and on domestic expenditure (absorption).

• On the supply side, effective depreciation requires idle resources in the economy.
• On the demand side, effective depreciation requires the Marshall-Lerner condition to be met.

The role of financial reporting is to provide information about a company's financial position and performance for use by parties both internal and external to the company. Financial statements are issued by management, who is responsible for their form and content.

The role of financial statement analysis, on the other hand, is to take these financial statements and other information to evaluate the company's past, current, and prospective financial position and performance for the purpose of making rational investment, credit, and similar decisions.

The primary users of financial statements are equity investors and creditors.

• Equity investors are primarily interested in the company's long-term earning power, growth, and ability to pay dividends.
• Short-term creditors (e.g., banks and trade creditors) are more interested in the company's immediate liquidity, because they seek an early payback of their investment.
• Long-term creditors (e.g., corporate bond owners such as insurance companies and pension funds) are primarily concerned with the company's long-term asset position and earning power.

Financial statements are the most important outcome of the accounting system. They communicate financial information gathered and processed in the company's accounting system to parties outside the business.

The four principal financial statements are:

• Income statement (statement of earnings)
• Balance sheet (statement of financial position)
• Cash flow statement
• Statement of changes in owners' or stockholders' equity

These four financial statements, augmented by footnotes and supplementary data, are interrelated. In addition, there are other sources of financial information, such as management discussion and analysis, auditor's reports, etc.

Income Statement

The income statement summarizes revenues earned and expenses incurred, and thus measures the success of business operations for a given period of time. It explains some but not all of the changes in the assets, liabilities, and equity of the company between two consecutive balance sheet dates.

The income statement lists income and expenses as they are directly related to the company's recurring income. The format of the income statement is not specified by U.S. GAAP and actual format varies across companies. The following is a generic sample:

The goal of income statement analysis is to derive an effective measure of future earnings and cash flows. Analysts need data with predictive ability, hence income from continuing (recurring) operations is considered to be the best indicator of future earnings. As operating expenses do not include financing costs such as interest expenses, operating income (EBIT) is independent of the company's capital structure.

In the typical income statement this means segregating the results of normal, recurring operations from the effects of nonrecurring or extraordinary items to improve the forecasting of future earnings and cash flows. The idea here is that recurring income is persistent. If an item in the unusual or infrequent component of income from continuing operations is deemed not to be persistent, then recurring (pre-tax) income from continuing operations should be adjusted.

The net income figure is used to prepare the statement of retained earnings.

Balance Sheet

A balance sheet provides a "snapshot" of a company's financial condition. Think of the balance sheet as a photo of the business at a specific point in time. It reports major classes and amounts of assets, liabilities, stockholders' equity, and their interrelationships as of a specific date.

Assets = Liabilities + Stockholders' Equity

• Assets are the economic resources controlled by the company.
• Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
• Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.

Cash Flow Statement

The primary purpose of the cash flow statement is to provide information about a company's cash receipts and cash payments during a period. It reports the cash receipts and cash outflows classified according to operating, investment, and financing activities.

The cash flow statement is useful because it provides answers to the following simple yet important questions:

• Where did the cash come from during the period?
• What was the cash used for durin

...

Financial Notes and Supplementary Schedules

Financial footnotes are an integral part of financial statements. They provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Supplementary Schedules: In some cases additional information about the assets and liabilities of a company is provided as supplementary data outside the financial statements. Examples include oil and gas reserves reported by oil and gas companies, the impact of changing prices, sales revenue, operating income, and other information for major business segments. Some of the supplementary data is unaudited.

Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

Auditor's Reports

See next subject for details.

Other Sources of Information

• Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

• Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

• Companies' websites, press releases, and conference calls.

The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

• Whether the financial statements are presented in accordance with generally accepted accounting principles.
• It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
• Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

• An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
• A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
• An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

• A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

Auditor's Report on In...

The financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

• Articulate the purpose and context of the analysis.
  What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?
  The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

• Collect input data.
  Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

• Process data.
  Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

• Analyze / interpret the processed data.
  Interpret the output to support a conclusion (e.g., a buy decision).

• Develop and communicate conclusions and recommendations.
  Communicate the conclusion or recommendation in an appropriate format.

• Follow up.
  Periodic review is required to determine if the original conclusions and recommendations are still valid.

Business activities can be classified into three groups:

• Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:
  • Selling goods and services
  • Employing managers and workers
  • Buying goods and services
  • Paying taxes

• Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:
  • Buying resources such as land, buildings, and equipment needed in the operation of the business.
  • Selling these resources when no longer needed.
  Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

• Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:
  • Issuing stock
  • Paying dividends to stockholders
  • Obtaining loans from creditors
  • Repaying amounts plus interest to creditors
  Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.

In Reading 27 [Understanding the Cash Flow Statement] a more detailed discussion of different business activities and their impact on cash flows will be provided.

An account is a label used for recording and reporting a quantity of almost anything. It is the:

• Means by which management keeps track of the effects of transactions.
• Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

• An asset is usually listed on the balance sheet.
• It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

• Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
• Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
• Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
• Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

• Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
• Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

• Contributed capital is the amount invested in the busines

...

Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings

Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

• Dividends and expenses decrease owners' equity.
• Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of $10 par value stock.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
A = $50,000							L + OE = $50,000
Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for $25,000.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land	Building		A/P	Common Stock	Retained Earnings
1	$50,000							$50,000
2	-35,000			$10,000	$25,000			$50,000
bal	$15,000			$10,000	$25,000			$50,000
A = $50,000							L + OE = $50,000
This transaction only affects one side of the accounting equation: assets. Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged.

3. Purchase of Assets by Incurring a Liability - Purchased office supplies for $500 on credit.

Assets						=	Liab.	Owners' Equity
	Cash	A/R	Supplies	Land

...

Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

• A balance sheet must list all assets and liabilities at the end of the accounting period.
• An income statement must list all revenues and expenses applicable to the accounting period.

Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

• Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

• Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

• Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

• Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.

In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

• If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
• If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other com

...

Here are financial statements based on previous transactions for ABC Realty.

It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

• General journal is the simplest and most flexible.
• A separate journal entry records each transaction.
• Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.

An awareness of the reporting framework underlying financial reports can assist in security valuation and other financial analysis. This framework describes the objectives of financial reporting, desirable characteristics for financial reports, the elements of financial reports, and the underlying assumptions and constraints of financial reporting. An understanding of the framework that is broader than knowledge of a particular set of rules offers an analyst a basis from which to infer the proper financial reporting, and thus security valuation implications, of any financial statement element transaction.

The objective of financial reporting:

• The objective of financial statements is to provide information about a company's financial position, performance, and any changes in financial position; this information should be useful to a wide range of end-users for the purpose of making economic decisions.
• Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to attempt to ensure some type of consistency in these judgments.

Private sector standard-setting bodies and regulatory authorities play significant but different roles in the standard-setting process. In general, standard-setting bodies make the rules and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish financial reporting standards in their jurisdictions.

International Accounting Standards Board (IASB)

This is essentially the international equivalent of the Financial Accounting Standards Board (FASB).

• It was preceded by the International Accounting Standards Committee (IASC), which was established in 1973.
• It is comprised of 14 members (12 full-time, 2 part-time); seven members are liaisons with a national board.
• It works toward harmonization of international accounting standards.
• The standard development process is open.
• Standards are principles-based.
• Since the establishment of the IASB, the focus is on global standard-setting rather than harmonization per se.

International Organization of Securities Commissions (IOSCO)

This is essentially the international equivalent of the U.S. Securities and Exchange Commission (SEC).

• It works to achieve improved market regulation internationally.
• It works to facilitate cross-border listings.
• It advocates for the development and adoption of a single set of high-quality accounting standards.

Financial Accounting Standards Board (FASB)

The FASB is a non-governmental body that sets accounting standards for all companies issuing audited financial statements. All FASB pronouncements are considered authoritative; new FASB statements immediately become part of GAAP.

U.S. Securities and Exchange Commission (SEC)

In the U.S., the form and content of the financial statements of companies whose securities are publicly traded are governed by the SEC through its regulation S-X. Although the SEC has delegated much of this responsibility to the FASB, it frequently adds its own requirements. The SEC functions as a highly effective enforcement mechanism for standards promulgated in the private sector.

Audited financial statements, related footnotes, and supplementary data are presented in both annual reports sent to stockholders and those filed with the SEC. These filings often contain other valuable information not presented in stockholder reports.

Convergence of Global Financial Reporting Standards

As capital markets become more international in scope, the need for global accounting standards and the demand for multiple listings has grown. The IASB and FASB, along with other standard-setters, are working to achieve convergence of financial reporting standards.

Pros:

• Expedite the integration of global capital markets and make the cross-listing of securities easier.
• Facilitate international mergers and acquisitions.
• Reduce investor uncertainty and the cost of capital.
• Reduce financial reporting costs.
• Allow for easy adoption of high-quality standards by developing countries.

Cons:

• Significant differences in standards currently exist.
• The political cost of eliminating differences.
• Overcoming nationalism and traditions.
• Will cause "standards overload" for some firms.
• Diverse standards for diverse places are acceptable.

The IFRS Framework sets forth the concepts that underlie the preparation and presentation of financial statements for external end-users, provides further guidance on the elements from which financial statements are constructed, and discusses the concepts of capital and capital maintenance.

Objectives of Financial Statements

The Framework identifies the central objective of financial statements as providing information about a company that is useful in making economic decisions. Financial statements prepared for this purpose will meet the needs of most end-users. Users generally want information about a company's financial performance, financial position, cash flows, and ability to adapt to changes in the economic environment in which it operates.

The Framework identifies end-users as investors and potential investors, employees, lenders, suppliers, creditors, customers, governments, and the public at large.

Qualitative Characteristics of Financial Statements

The Framework prescribes a number of qualitative characteristics of financial statements. The key characteristics are relevance and reliability. Preparers can face a dilemma in satisfying both criteria at once. For example, information about the outcome of a lawsuit may be relevant, but the financial impact cannot be measured reliably.

Financial information is relevant if it has the capacity to influence an end-user's economic decisions. Relevant information will help users evaluate the past, present, and most importantly, future events in a company.

To be reliable, financial information must represent faithfully the effects of the transactions and events that it reflects. The true impact of transactions and events can be compromised by the difficulty of measuring transactions reliably.

• Financial information faithfully represents transactions and events when accounted for in accordance with their substance and economic realityand not merely their legal form. Commonly, a legal agreement will purport that a company has "sold" assets to a third party. However, an analysis of the substance of the arrangement indicates that the company retains control over the future economic benefits and risks embodied in the asset, and should continue to recognize it on its own balance sheet.
• Financial information is reliable if it is free from material error and is complete. Information is material if its omission or misstatement could influence decisions that end-users make on the basis of the financial statements. Information is reliable when it is neutral or free from bias and prudence. A degree of prudence when preparing financial information enhances its reliability. However, a company should not use prudence as the basis for the recognition of, for example, excessive provisions.

Financial information must be easily understandable in addition to being relevant and reliable. Preparers should assume that end-users have a reasonable knowledge of business and economic activities, and an ability to comprehend complex financial matters.

End-users must be able to compare a company's financial statements through time in order to identify trends in financial performance (comparability). Hence, policies on recognition, measurement, and disclosure must be applied consistently over time. Where a company changes its accounting for the recognition or measurement of transactions, it should disclose the change in the Basis of Accounting section of its financial statements and follow the guidance set out in IFRS.

The application of qualitative characteristics and accounting standards usually results in financial statements that show a true and fair view, or fairly present a company's financial position and performance.

The Elements of Financial Statements

The Framework outlines definition and recognition criteria fo...

The objective of IAS No. 1 is to prescribe the basis for the presentation of general-purpose financial statements, to ensure comparability both with the company's financial statements of previous periods and with the financial statements of other entities. To achieve this objective, this Standard sets out overall requirements for the presentation of financial statements, guidelines for their structure, and minimum requirements for their content.

Components of Financial Statements

A complete set of financial statements comprises:

• a balance sheet
• an income statement
• a statement of changes in equity showing either:
  • all changes in equity, or
  • changes in equity other than those arising from transactions with equity-holders acting in their capacity as equity-holders

• a cash flow statement
• notes, comprising a summary of significant accounting policies and other explanatory notes

Fundamental Principles Underlying the Preparation of Financial Statements

A company whose financial statements comply with IFRS shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRS unless they comply with all the requirements of IFRS.

Underlying principles:

• Fair presentation. Financial statements shall present fairly the financial position, financial performance, and cash flows of a company. In virtually all circumstances, a fair presentation is achieved by compliance with applicable IFRS.

• Going concern. A business is presumed to be a going concern. If management has significant concerns about the company's ability to continue as a going concern, the uncertainties must be disclosed.

• Accrual basis. IAS No. 1 requires that a company prepare its financial statements, except for cash flow information, using the accrual basis of accounting.

• Consistency. The presentation and classification of items in the financial statements shall be retained from one period to the next unless a change is justified either by a change in circumstances or requirements of new IFRS.

• Materiality and Aggregation. Each material class of similar items must be presented separately in the financial statements. Dissimilar items may be aggregated only if they are individually immaterial.

Presentation requirements:

• No offsetting. Assets and liabilities, and income and expenses, may not be offset unless required or permitted by IFRS.

• Classified balance sheet. A business must normally present a classified balance sheet, separating current and non-current assets and liabilities. Only if a presentation based on liquidity provides information that is reliable and more relevant may the current/non-current split be omitted.

• Minimum information on the face of the financial statements. IAS No. 1 specifies the minimum line item disclosures on the face of, or in the notes to, the balance sheet, the income statement, and the statement of changes in equity.

• Minimum information in the notes. IAS No. 1 specifies disclosures about information to be presented in the financial statements.

• Comparative information. Comparative information shall be disclosed in respect of the previous period for all amounts reported in the financial statements, both on the face of financial statements and in notes.

A significant number of the world's listed companies report under either IFRS or U.S. GAAP. Although these standards are moving toward convergence, there are still significant differences in the framework and individual standards. Frequently, companies provide reconciliations and disclosures regarding the significant differences between reporting bases. These reconciliations can be reviewed to identify significant items that could affect security valuation.

The income statement presents information on the financial results of a company's activities over a period of time. The format of the income statement is not specified by U.S. GAAP and the actual format varies across companies.

Here are common components:

• Sales or revenue: amount charged for the delivery of goods or services.
  • Follows the revenue recognition rule: Revenue is recognized even though cash may not be collected until the following accounting period.
  • Net sales = gross sales - sales returns and allowances - discounts.
  • Amount of sales and trends in net sales over time are used to analyze a company's progress.

• Cost of goods sold is the amount paid for merchandise sold, or the cost to manufacture products that were sold, during an accounting period.

• Gross margin = net sales - costs of goods sold. Also called gross profit.
  Management is interested in both:
  • The amount of gross margin; and
  • The percentage of gross margin (gross margin/net sales).
  Both are useful in planning business operations.

• Operating expenses are expenses other than the cost of goods sold that are incurred in running a business.
  • These expenses are grouped into categories: selling expenses, general and administrative expenses, and other revenues and expenses.
  • Careful planning and control of operating expenses can improve a company's profitability.

• Income from operations (also called operating income) is the difference between gross margin and operating expenses. It represents the income from a company's normal, or main, business. It is used to compare the profitability of companies or divisions within a company.

• Other revenues and expenses are not part of a company's operating activities. These include:
  • Revenues or expenses from investments (e.g., dividends and interest).
  • Interest and other expenses from borrowing.
  • Any other revenue or expense not related to the company's normal business operations.
  They are also called non-operating revenues and expenses.

• Income before income taxes is the amount a company has earned from all activities - operating and non-operating - before taking into account the amount of income taxes the company incurred.
  This is used to compare the profitability of two or more companies or divisions within a company. Comparisons are made before income taxes are deducted because companies may be subject to different income tax rates.

• Income taxes (also called provision for income taxes) represent the expense for federal, state, and local taxes on corporate income.
  The income taxes account is shown as a separate item on the income statement. Tax rates are substantial (usually 15-38%) and have a significant effect on business decisions. Most other types of taxes are shown among operating expenses.

• Net income is what remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and income taxes are deducted. It is the final figure, or "bottom line," of the income statement.
  Net income = Income before income taxes - income taxes
  Net income is an important performance measure.
  • It represents the amount of business earnings that accrue to stockholders.
  • It is the amount transferred to retained earnings from all income generating activities during the year.
  • It is often used to determine whether a business has been operating successfully.

The...