on 12-Nov-2016 (Sat)

Total product of labor (TPL) is the total output of a firm that uses a specific amount of capital (i.e., plant and equipment are fixed).

The CAPM

Capital market theory builds on portfolio theory. CAPM refers to the capital asset pricing model. It is used to determine the required rate of return for any risky asset.

In the discussion about the Markowitz efficient frontier, the assumptions are:

• Investors have examined the set of risky assets and identified the efficient frontier.
• Every investor will choose the optimal portfolio of risky assets on the efficient frontier. The optimal portfolio lies at the point where the highest indifference curve is tangent to the efficient frontier.

The CAPM uses the SML or security market line to compare the relationship between risk and return. Unlike the CML, which uses standard deviation as a risk measure on the X axis, the SML uses the market beta, or the relationship between a security and the marketplace.

The use of beta enables an investor to compare the relationship between a single security and the market return rather than a single security with each and every other security (as Markowitz did). Consequently, the risk added to a market portfolio (or a fully diversified set of securities) should be reflected in the security's beta. The expected return for a security in a fully diversified portfolio should be:

E(R_M) - R_f is the market risk premium, while the risk premium of the security is calculated by β[E(R_M) - R_f].

Note that the "expected" and the "required" returns mean the same thing. The expected return based on the CAPM is exactly the return an investor requires on the security.

• To compute the required rate of return:.
• To compute the expected rate of return of an individual security, you need to use forecasted future security price and dividend: R = (Future price - current price + dividend) / Current price.

The SML represents the required rate of return, given the systematic risk provided by the security. If the expected rate of return exceeds this amount, then the security provides an investment opportunity for the investor. The difference between the expected and required return is called the alpha (α) or excess rate of return. The alpha can be positive when a stock is undervalued (it lies above the SML) or negative when the stock is overvalued (it falls below the SML). The alpha becomes zero when the stock falls directly on the SML (properly valued).

Security Market Line vs. Capital Market Line:

• The CML examines the expected returns on efficient portfolios and their total risk(measured by standard deviation). The SML examines the expected returns on individual assets and their systematic risk (measured by beta). If the relationship between expected return and beta is valid for any individual securities, it must also be valid for portfolios constructed with any of these securities. So, the SML is valid for both efficient portfoliosand individual assets.
• The CML is the graph of the efficient frontier and the SML is the graph of the CAPM.
• The slope of the CML is the market portfolio's Sharpe ratio and the slope of the SML is the market risk premium.
• All properly priced securities and efficient portfolios lie on the SML. However, only efficient portfolios lie on the CML.

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In the exercise of the liberal arts, the action begins in the agent and ends in the agent, who is perfected by the action

-Blame = Past

-Values = Present

-Choice = Future

Aristotle liked the future best of all.

The rhetoric of the present handles praise and condemnation, separating the good from the bad, distinguishing groups from other groups and individuals from each other.

productive arguments use [...] tense, the language of choices and decisions.

Answer someone who expresses doubt about your idea with “Okay, let’s tweak it.”

Now focus the argument on revising your idea as if the group had already accepted it.

This is a form of concession

​Rhetorical device of pretending to refuse.

The oh-you-shouldnt-have figure.

Pretend disinterest, while actually desiring it. (akkismos affectation).

Accismus is showing disinterest in something while secretly wanting it. It's a form of irony where one pretends indifference and refuses something while actually wanting it.

In Aesop's fable, the fox pretends he doesn't care for the grapes. Caesar, in Shakespeare's Julius Caesar, is reported as not accepting the crown.

the accismus -- a fake refusal -- makes you look like less of a jerk than you really are.

Ask yourself what you want at the end of an argument:

Change your audience’s mind?

Get it to do something or stop doing it?

Start by changing the mood, turn it into a receptive audience, eager to hear your solution.

Then change its mind. Convince that something is the best way to achieve something.

Finally, fill it with the desire to act. Show them that the action you want to take is the best one, and inspire it. This requires stronger emotions that turn a decision into a commitment.

Do you want to fix blame?

Define who meets or abuses your common values?

Or get your audience to make a choice?

The most productive arguments use choice as their central issue. Don’t let a debate swerve heedlessly into values or guilt. Keep it focused on choices that solve a problem to your audience’s (and your) advantage.

It is, generally possible to tell the gender of a noun by its ending in the nominative and genitive singular, and it is also according to these endings that Latin nouns are grouped into five classes, which are called declensions.

Each declension has a distinctive set of endings which indicate both case and number, just as in English we have child, child’s, children, children’s, though Latin distinguishes more cases.

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.

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?

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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.

Financial statements are the primary information that firms publish about themselves, and investors and creditors are the primary users of financial statements. Analysts, who work for investors and creditors, may need to make adjustments to reflect items not reported in the statements or assess the reasonableness of managements' judgments. For example, an important first step in analyzing financial statements is identifying the types of accruals and valuation entries in a company's financial statements.

Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

For example, companies may improperly record costs as assets rather than as expenses and amortize the assets over future periods. The goal is to impress shareholders and bankers with higher profits. Consider advertising expenses, which should be charged against income immediately. Certain companies, particularly those selling memberships to customers (e.g., health clubs and Internet access providers), aggressively capitalize these costs and spread them over several periods.

Companies may amortize long-term assets too slowly. Slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits are higher.

The basic structure for enforcing the Code and Standards: Rules of Procedure.

The Disciplinary Review Committee (DRC) enforces the Code and Standards.

Professional Conduct staff monitor compliance through Professional Conduct Statements, public complaints, public information, and media reports.

The rules related to information-gathering and conviction follow a criminal justice system approach. The procedures require a careful investigation of the charges followed by a hearing, findings and appeal.

An overview follows:

• Grounds for Discipline. Any act which violates the Code and Standards.

• Investigation by Designated Officer (DO). The officer may conclude the inquiry with no disciplinary sanction, issue a cautionary letter, or continue proceedings to discipline the member or candidate. If the investigation determines that a violation occurred, a disciplinary sanction is recommended. The member or candidate may accept the recommended sanction or proceed to a hearing panel.

• Hearing. If the member rejects the proposed sanction, a case against the member will be prepared and take place in front of a hearing panel of three or more members.

Authorized sanctions include suspension or revocation of membership/designation, private/public censure, and private reprimand.

Members and Candidates must:

• Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.

• Place the integrity of the investment profession and the interests of clients above their own personal interests.

• Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.

• Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.

• Promote the integrity of, and uphold the rules governing, capital markets.

• Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals.

The Code of Ethics establishes the framework for ethical decision-making in the investment profession.

It applies to CFA Institute's members, CFA charterholders and CFA candidates.

I. PROFESSIONALISM

A. Knowledge of the Law. Members and candidates must understand and comply with all applicable laws, rules, and regulations (including the CFA Institute Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, members and candidates must comply with the more strict law, rule, or regulation. Members and candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations.

B. Independence and Objectivity. Members and candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another's independence and objectivity.

C. Misrepresentation. Members and candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

D. Misconduct. Members and candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.

II. INTEGRITY OF CAPITAL MARKETS

A. Material Nonpublic Information. Members and candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on the information.

B. Market Manipulation. Members and candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

III. DUTIES TO CLIENTS

A. Loyalty, Prudence, and Care. Members and candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and candidates must act for the benefit of their clients and place their clients' interests before their employer's or their own interests.

B. Fair Dealing. Members and candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

C. Suitability.

• When members and candidates are in an advisory relationship with a client, they must:
  a. Make a reasonable inquiry into a client's or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must reassess and update this information regularly.
  b. Determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives, mandates, and constraints before making an investment recommendation or taking investment action.
  c. Judge the suitability of investments in the context of the client's total portfolio.
• When members and candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of that portfolio.

D. Performance Presentation. When communicating investment performance information, members or candidates must make reasonable efforts to ensure that it is fair, accurate, and complete.

E. Preservation of Confidentiality. Members and candidates must keep information about current, former, and prospective clients confidential unless:

• The information

...

I. PROFESSIONALISM

A. Knowledge of the Law.

Members and Candidates must understand and comply with all applicable laws, rules, and regulations (including CFA Institute's Code of Ethics and Standards of Professional Conduct) of any government, regulatory organization, licensing agency, or professional association governing their professional activities. In the event of conflict, Members and Candidates must comply with the more strict law, rule, or regulation. Members and candidates must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations.

This standard adopts principles that apply to the general activities of members and candidates. As with any service there are certain rules and regulations that members and candidates need to abide by, although they are not required to have detailed knowledge of all laws.

A. Relationship between the Code and Standards and local law.

Members and candidates should always aspire to the highest level of ethical conduct. This statement assists members in avoiding legal and ethical traps and violations of the Code of Ethics.

In general, members in all countries should comply at all times with the Code and Standards. Since laws in different countries may establish different standards, the rule of thumb is to choose the stricter regulations.

• If the laws are tougher than the Code and Standards, adhere to the laws.
• If there are no laws, or if the Code and Standards are tougher, adhere to the Code and Standards.
• If a member or candidate lives or works in a foreign country, or works for foreign firms outside of his or her own country, he or she should comply with the strictest of his/her country's laws, the foreign country's laws, and the Code and Standards.

Example

You are working in the foreign office of a U.S.-based firm. Analysts in this foreign country routinely solicit insider information and use it as the basis for trading decisions. You are told that this is not illegal in this country. In this case, the Code and Standards are stricter. They prohibit use of material nonpublic information. You should refrain from trading on the basis of insider information.

B. Don't participate or assist in violations.

Don't knowingly break or help others break laws. If a member:

• Feels that a standard or law has been violated (e.g., receiving information contradictory to a registration statement), he or she should seek the advice of the firm's counsel. If the member believes that the counsel is both competent and unbiased and he or she follows the counsel's advice, there is no violation.
• Knows that a standard or law has been violated (e.g., discovering that a client has knowingly misstated information on a prospectus), he or she should report the incident to the appropriate supervisory person in the firm. If the situation is not remedied, the member should disassociate from the situation. He or she may also seek legal advice to see if other actions should be taken.

Note:

• Members are not required by the Code and Standards to report violations to the appropriate governmental or regulatory organizations. However, if the law requires an individual to report, he or she must do so.
• Members are encouraged, but not required, to report violations to CFA Institute.

Example

An associate of yours is engaging in illegal trading practices and he tells you to refrain from disclosing this because it will make the firm look bad and it is highly profitable. You should choose one of the three actions above. If you seek legal counsel and are told that the activity is actually not illegal, you have met your obligation. This assumes that you believe the legal counsel to be competent. If you report your associa...

I. PROFESSIONALISM

B. Independence and Objectivity.

Members and Candidates must use reasonable care and judgment to achieve and maintain independence and objectivity in their professional activities. Members and Candidates must not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably could be expected to compromise their own or another's independence and objectivity.

Every member must avoid situations that may result in a potential conflict of interest. External sources may try to influence the investment process by offering investment managers a variety of perks. Excessive gifts or lavish investor relation functions could prejudice a member's opinions about a sponsor. One type of benefit is the allocation of shares in oversubscribed IPOs to investment managers for their personal accounts. Every member shall avoid situations that might cause or be perceived to cause a loss of independence or objectivity in recommending investments or taking investment action.

Modest gifts and entertainment are acceptable. For example, gifts that do not exceed $100 may be accepted, as well as entertainment.

Gifts from clients can be distinguished from gifts given by other parties seeking to influence a member to the detriment of clients. Gifts from clients are deemed less likely to impair a member's independence than gifts from other parties seeking to influence the member's outlook. Members and candidates must disclose to their employers any such benefits from clients.

Example 1

You are an analyst for the banking industry. The head of investor relations for one of the larger firms in this industry offers to take you to dinner at a posh restaurant and discuss the upcoming quarterly earnings figures. He provides you with a new state-of-the-art titanium golf club as his limo drops you off at the end of the evening. He calls you the next day to ask if your report on his firm is progressing and indicates that there is a job waiting for you at the bank if you decide to leave your current position. First, the bank officer may have violated his fiduciary duty to his shareholders if he provided you with material nonpublic information. Regardless, you have been wined and dined and received a gift and a job offer from a senior officer of a firm you evaluate. Even if these inducements do not compromise your independence and objectivity, they may provide that perception. This violates the standard.

Example 2

An analyst follows the stock of company XYZ. He is invited by XYZ for a visit to the company. XYZ pays all travel expenses for him. In general, when allowing companies to pay for expenses, analysts should ensure that such arrangements do not impinge on their independence and objectivity. In this case, as long as the trip is strictly for business without lavish hospitality, such payment is acceptable.

Example 3

An analyst is asked by a firm's executives to issue favorable recommendations to secure the client's business. The analyst should conduct the review and make the recommendation based on his or her own independent and objective view. Note that members may experience pressure from their own firms to issue favorable reviews of certain companies. In a full-service investment house, the corporate finance department may be an underwriter for a company's securities and be loath to antagonize that company by publishing negative research reports.

Example 4

Steve, a portfolio manager, directs a large amount of his commission business to a London brokerage house. In appreciation for all the business, the London brokerage house gives Steve two tickets to travel anywhere in Europe. Steve fails to disclose receiving this package to his supervisor. Steve has violated the standard because accepting these perks, worth more than $100, may hinder his independence and objectivity.

Procedures for...

I. PROFESSIONALISM

C. Misrepresentation.

Members and Candidates must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities.

Members and candidates shall not make any statements, orally or in writing, that misrepresent:

• The services that they or their firms are capable of performing.
• Their qualifications or the qualifications of their firms.
• Their academic or professional credentials.

A misrepresentation is any untrue statement of a fact or any statement that is otherwise false or misleading. This standard relates to misrepresentations by members about their qualifications and services, and it disallows any misleading guarantees about investments and their returns.

Members and candidates shall not make or imply, orally or in writing, any assurances or guarantees regarding any investment except to communicate accurate information regarding the terms of the investment instrument and the issuer's obligations under the instrument. It prohibits statements or assumptions that an investment is "guaranteed," or that superior returns can be expected based on the member's past success.

This standard applies to oral representations, advertising, electronic communications (including web pages and emails) and written materials (whether publicly disseminated or not).

Note: This standard does not rule out correct statements that some investments are actually guaranteed in some way with guaranteed returns. Examples of these types of investments would be insurance contracts or short-term treasury securities.

This standard also prohibits plagiarism in the preparation of material for distribution to employers, associates, clients, prospects or the general public. Plagiarism involves copying or using substantially the same materials as those prepared by others without acknowledging the source of that material. The only exception is copying factual information, as published by several recognized financial institutions, as well as statistical information.

• Members and candidates should always attribute quotations, projections, data, model/product ideas, and methodologies to their sources and/or authors.
• This standard applies to written materials, oral communications, visits with clients, use of audio/video media, and electronic data transfer.
• Members and candidates can use recognized sources (S&P, Moody's) of factual information (information that is already in the public realm) without acknowledgement.
• Situations to which this Standard applies also depend on whom the member is representing. Members are not required to attribute ideas, methodologies, etc. developed by people within their firms when speaking with clients and prospects.
• Members and candidates should keep copies of materials used in preparing research reports.

In ethical terms, a member or candidate indulging in plagiarism is not conducting himself or herself with integrity. By plagiarizing, he or she is not only stealing the ideas of others, but also exposing himself or herself to violations of other standards by making recommendations that may not have a reasonable basis and may not avoid material misrepresentations.

Procedures for compliance

Members can prevent unintentional misrepresentations of the qualifications of services the member or the member's firm is capable of performing if each member understands the limit of the individual's or firm's capabilities and the need to be accurate and complete in presentations.

Firms can provide guidance for employees who make written or oral presentations to clients or potential clients by providing a written list of the firm's available services and a description of the firm's qualification, and compensations that are both accurate and suitab...

I. PROFESSIONALISM

D. Misconduct.

Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit, or commit any act that reflects adversely on their professional reputations, integrity, or competence.

Members and candidates shall not compromise the integrity of the CFA designation, or the integrity or validity of the CFA examinations.

Standard I (A) states the obligation to comply with all applicable laws and regulations. This standard addresses personal behavior that will reflect poorly on the profession as a whole. Any act that involves lying, cheating, stealing, or other dishonest conduct, if the offence reflects adversely on a member or candidate's professional (not personal) activities, would violate the standard.

Procedures for compliance

Members and candidates should encourage their employers to:

• Adopt a Code of Ethics to which every employee must subscribe. Make clear that any personal behavior that reflects poorly on the individual involved, the institution as a whole, or the investment industry will not be tolerated.
• Disseminate to all employees a list of potential violations and associated disciplinary sanctions, up to and including dismissal from the firm.
• Conduct background checks on potential employees to ensure that they are of good character and not ineligible to work in the investment industry because of past infractions of the law.

Example 1

An investment advisor executes excessive trading volume to generate fees. He tells clients that the high level of trading in their discretionary accounts is needed to maintain proper diversification. If this statement is misrepresentative, the advisor is clearly engaging in professional misconduct.

Example 2

A portfolio manager has three martinis at lunch and returns to the office to resume his regular duties. If the manager's judgment is impaired and he is engaging in investment decision-making activities, he is in violation of this standard.

II. INTEGRITY OF CAPITAL MARKETS

A. Material Nonpublic Information.

Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on that information.

Information is material if its disclosure may affect the price of a security, or if reasonable investors would want to know the information before investing. Topics which should be considered material in an insider trading context include:

• A forthcoming dividend declaration or mission.
• Corporate reorganizations or takeovers.
• The acquisition or loss of a major contract.
• A major purchase or sale of company assets.
• An event of default.
• Knowledge of forthcoming press coverage of a company's affairs, whether positive or negative.
• Substantial increases or decreases in earnings projections.

The source or relative reliability of the information also determines materiality. The less reliable a source, the less likely the information provided would be considered material.

Information is nonpublic if it has not been disseminated to the marketplace in general, or if investors have not had an opportunity to react to the information. Note that disclosing the information to a selected group of analysts does not make it public. For example, a disclosure made to a room full of analysts does not make the disclosed information "public."

Note that this standard prohibits use of material nonpublic information, not:

• Nonmaterial public information.
• Nonmaterial nonpublic information.
• Material public information.

Members are prohibited from seeking out or using any inside information in analyzing investments, making investment recommendations, or making investment decisions if:

• Such trading would breach a duty.
• The information is misappropriated.
• The information relates to a tender offer.
• Members receive material information in confidence.

Mosaic Theory

Insider trading violations should not result when a perceptive analyst reaches a conclusion about a corporate action or event through an analysis of public information and items of nonmaterial nonpublic information (i.e., a "mosaic" of information).

Under mosaic theory, financial analysts are free to act without risking liability. That is, a financial analyst may use nonpublic information as the basis for investment recommendations and decisions even if that conclusion would have been material inside information had it been communicated directly to the analyst by a company.

Procedures for compliance

If members receive inside information in confidence, they shall make reasonable efforts to achieve public dissemination of material nonpublic information disclosed in breach of duty. This effort usually means encouraging the issuing company to make the information public.

Members and their firms should adopt written compliance procedures designed to prevent trading while in the possession of material nonpublic information. The most common and widespread approach to preventing insider trading by employees is an information barrier known as a "fire wall." The purpose of a fire wall is to prevent communication of material nonpublic information and other sensitive information from one department of a firm to other departments. The minimum elements of such a precaution include the following:

• Substantial control (preferably by the compliance department) of relevant interdepartmental communications.
• Review of employee trading through effective maintenance of some combination of "watch," "restricted," and "rumor" lists.
• Documentation of the procedures designed to limit the flow of infor

...

II. INTEGRITY OF CAPITAL MARKETS

B. Market Manipulation.

Members and Candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants.

Market manipulation is a deliberate attempt to interfere with the free and fair operation of the market. It includes practices that distort security prices or trading volume with the intent to deceive people or entities that rely on information in the market.

Market manipulation examples include:

• Price manipulation. Placing buy or sell orders (or both) into the trading system in order to change or maintain the price of a stock. The motives for attempting to do this vary: to increase the value of a position in the market for finance or accounting purposes, to be able to issue new shares at a higher price or to cause such a price rise that other investors are attracted to the stock, creating demand that the manipulator can sell into (called "pump and dump").

• Marking the close or ramping. Making a purchase or sale of a security near the close of the day's trading, with the objective of affecting published prices, particularly the reported closing price. This might be done to avoid margin calls (when the trader's position is not self-financed) to support a flagging price or to affect the valuation of a portfolio (called "window dressing"). A common indicator is trading in small parcels of the security just before the market closes.

• Wash trades and pre-arranged trading. A wash trade is a trade in which there is no change in the beneficial ownership of the securities - the buyer is, in reality, also the seller. A pre-arranged trade involves two parties trading on the basis that the transaction will be reversed later, or with an arrangement that removes the risk of ownership from the buyer. "Pooling or churning" can involve wash sales or pre-arranged trades executed in order to give an impression of active trading, and therefore investor interest, in the stock.

• False or misleading information. Companies can be tempted to re-release information or present information in an over-optimistic manner, in order to generate interest in the company's securities or help a flagging market. In some cases this includes unrealistic, unsubstantiated, or incorrect data, projections or evaluations. When the perpetrators use the demand generated by the false information they have spread to sell their own shares, the operation is known as "hype and dump."

• Capping and pegging. This involves activity on both the stock market and the derivatives market. A trader writes an option, which obliges the trader to sell to (in the case of a call option) or buy from (in the case of a put option) the option holder a specified number of shares at a specified price. The trader then trades in the shares covered by the option in order to affect the share price in a direction that will make the option unprofitable to exercise.

The intent of the action is critical to determining whether it is a violation of this standard. The standard does not prohibit legitimate trading strategies that exploit a difference in market power, information, or other market inefficiencies. It also does not prohibit transactions done for tax purposes (e.g., selling and immediately buying back a particular stock).

III. DUTIES TO CLIENTS

A. Loyalty, Prudence, and Care.

Members and Candidates have a duty of loyalty to their clients and must act with reasonable care and exercise prudent judgment. Members and Candidates must act for the benefit of their clients and place their clients' interests before their employer's or their own interests.

This standard relates principally to members who have discretionary authority over the management of client's assets.

Fiduciary duty refers to the obligations of loyalty and care in regard to the responsibility of managing someone else's assets. A fiduciary duty is a position of trust.

• A fiduciary is someone with the duty of acting for the benefit of another party.
• Loyalty is owed to clients and prospects.
• Clients' interests come before yours.
• A heightened level of fiduciary duty arises if the fiduciary has "custody" or effective control of the client's assets.
• Governing documents (e.g., trust documents and investment management agreements) are primary determinants of a fiduciary's powers and duties.

Fiduciary standards apply to a large number of persons in varying capacities, but exact duties may differ in many respects, depending on the nature of the relationship with the client or the type of account under which the assets are managed. The first step in fulfilling a fiduciary duty is to determine what the responsibility is and the identity of the "client" to whom the fiduciary duty is owed.

• When managing personal assets of an individual, the investment manager owes loyalty to that individual (i.e., the client).
• When managing the portfolios of a pension plan or trust, the investment manager owes loyalty to beneficiaries of the plan or trust (i.e., the "client"), not the person who hires the manager.

A fiduciary must make investment decisions in the context of the portfolio as a whole rather than by individual investments within the portfolio. The fiduciary should thoroughly consider the risk of loss, potential gains, diversification, liquidity and returns.

Often a manager may direct clients' trades through a particular broker because an investment manager often has discretion over the selection of brokers. The broker may provide research services that provide a broad benefit to the manager. The manager has thus used "soft dollars" to purchase beneficial services through brokerage, which is an asset to the manager's clients. Since the manager would expect to purchase research services anyway, the soft dollar arrangement is not necessarily inappropriate. The manager must seek the best price and execution, and disclose any soft dollar arrangements.

Procedures for compliance

• Follow all the applicable laws and rules.
• Establish the investment objectives of the client, taking into account:
  • The client's needs and circumstances.
  • The investment's basic characteristics.

• Diversification. All portfolios should be adequately diversified, unless the plan guidelines state otherwise.
• Deal fairly with all clients.
• Conflicts of interest. All conflicts must be disclosed.
• Disclose compensation agreements.
• Proxy solicitations. Proxies must be voted in the best interest of the beneficiaries.
• Confidentiality. Members must maintain the confidentiality of their dealings at all times.
• Best execution. The best execution that is reasonably available should be provided to all clients.
• Loyalty - members must always act in the best interest of their clients.

Example 1

A client anxiously tells you that he needs to liquidate a bond portfolio immediately because he needs funds to pay for an operation for a relative. The bonds are highly liquid, but ...

III. DUTIES TO CLIENTS

B. Fair Dealing.

Members and Candidates must deal fairly and objectively with all clients when providing investment analysis, making investment recommendations, taking investment action, or engaging in other professional activities.

"Fairly" implies that members must not discriminate against or favor any clients. Fairness shall be maintained in quality and timing of services, and allocation of investment opportunities. The term "fairly," rather than "equally,", is used because it would be physically impossible to reach all customers at the same exact instant, and not all recommendations or investment actions are suitable for all clients.

Members and candidates are NOT required to give the same level of services to all clients. For example, you can give more information and research to discretionary clients than to transaction-only clients.

Members and candidates are required to adhere to the standard in:

• Dissemination of recommendations: Establish procedures for simultaneous dissemination of recommendations; all clients must be informed at approximately the same time.
  An investment recommendation is any opinions on buying, selling, or holding a security or other investment. Good business practice dictates that initial recommendations be made available to all customers who indicate interest. Although a member need not communicate a recommendation to all customers, the selection process by which customers receive information should be based on suitability and known interest, not on any preferred or favored status. A common practice to ensure fair dealing is to communicate recommendations within the firm and to customers simultaneously.
  A material change in a firm's recommendation is one that could be expected to affect a client's judgment. A change in the recommendation from buy to sell is a material change; this standard needs to be abided by in disseminating the change.

• Investment actions: Develop trade allocation procedures to ensure fairness to clients (both in priority of execution and allocation of price obtained on block trades), timeliness of execution, accuracy of trade records, and client positions.
  Clients in discretionary accounts should be treated the same as those who are not in discretionary accounts. Note that investment action can affect the market value of a security.
  If an issue is oversubscribed, members should forgo any sales to themselves or their immediate families. Members must disclose to clients or prospects the allocation procedures, and how they can affect the clients or prospects. Members shall not withhold "hot issue" securities for their own benefits or use such securities as rewards or incentives for others. Members shall not trade ahead of the dissemination of research reports or recommendations to clients.

Procedures for compliance

• Limit the number of people involved.
• Shorten the time frame between decision and dissemination.
• Publish personnel guidelines for pre-disseminations.
• Disseminate information simultaneously to all parties.
• Maintain a list of clients and their holdings.
• Develop and disclose written trade allocation procedures.
• Establish systematic account review.
• Disclose levels of service.

Members and their firms are required to take the following steps to ensure that adequate trade allocation practices are followed:

• Obtain advance indications of client interest for new issues.
• Allocate new issues by client rather than by portfolio manager.
• Adopt a pro rata or similar objective method or formula for allocating trades.
• Treat clients fairly in terms of both trade execution order and price.
• Execute orders in an efficient and

...

III. DUTIES TO CLIENTS

C. Suitability.

1. When Members and Candidates are in an advisory relationship with a client, they must:
a. Make a reasonable inquiry into a client or prospective client's investment experience, risk and return objectives, and financial constraints prior to making any investment recommendation or taking investment action and must re-assess and update this information regularly.
b. Determine that an investment is suitable to the client's financial situation and consistent with the client's written objectives, mandates, and constraints prior to making an investment recommendation or taking investment action.
c. Judge the suitability of investments in the context of the client's total portfolio.

2. When Members and Candidates are responsible for managing a portfolio to a specific mandate, strategy, or style, they must only make investment recommendations or take investment actions that are consistent with the stated objectives and constraints of the portfolio.

Members must always consider the appropriateness and suitability of the client's investment action and match this up against the needs and circumstances of the particular client in order to determine the suitability of the investment for the client.

In the event that a new client is obtained or an existing client's previous investment matures, the member need not immediately obtain client information if he or she first re-invests these funds in some form of cash equivalent. The member will then obtain the client's investment preferences. He or she will need to determine from the client the level of risk that the client is prepared to accept (in other words, the client's risk tolerance level). This needs to be ascertained before any investment action is taken.

You are required to:

• Know the type and nature of your clients'.
• Know the return objectives and risk tolerance of your clients.
• Know the liquidity needs, expected cash flows, investable funds, time horizon, tax considerations, regulatory and legal circumstances, and other constraints of your clients.

You are NOT required to change an existing client portfolio as soon as it comes under your discretion; it is best to take a bit of time, plan and implement actions in an organized way.

Procedures for compliance

A written investment policy statement should be developed.

• Client identification: Identify the type and nature of clients, and the existence of separate beneficiaries.
• Investor objectives:
  • Return objectives (income, growth in principal, maintenance of purchase power).
  • Risk tolerance (suitability and stability of values).

• Investor constraints: Liquidity needs, expected cash flows (patterns of additions and/or withdrawals), investable funds (assets and liabilities or other commitments), time horizon, tax considerations, regulatory and legal circumstances, investor preferences, circumstances, unique needs, and proxy voting responsibilities and guidance.
• Performance measurement benchmarks.

The investor's objectives and constraints should be maintained and reviewed periodically to reflect any changes in the client's circumstances. Annual review is reasonable unless business or other reasons dictate more or less frequent review.

Example 1

After a five-minute interview, you advise a client how to invest a substantial proportion of her wealth. You have violated the "Know your customer" rule. You do not have adequate basis to make a detailed recommendation.

Example 2

An analyst tells a client about the upside potential, without discussing the downside risks. He violates the standard because he should discuss the downside risks as well.

Example 3

When recomm...

III. DUTIES TO CLIENTS

D. Performance Presentation.

When communicating investment performance information, Members and Candidates must make reasonable efforts to make sure that this information is fair, accurate, and complete.

In the past there have been several practices that have hindered performance presentation and comparability, such as:

• Representative accounts - only the best results are presented.
• Survivorship bias - accounts that have been terminated are excluded from the results presented.
• Portability of investment results - results from previous employment are disclosed.
• Varying time periods - only the results for the good time periods are reflected.

A firm cannot claim that they are/were in compliance with CFA Institute's standards unless they comply in all material respects with CFA Institute's standards.

Procedures for compliance

Misrepresentations about the investment performance of the firm can be avoided if the member maintains data about the firm's investments performance in written form and understands the classes of investments or accounts to which those data apply and the risks and limitations inherent in using such data. In analyzing information about the firm's investment performance, the member should ask the following questions:

• How many years of past performance does this information reflect?
• Does it reflect performance for the prior year only, after several years of poor performance, or an average of several years of performance?
• Has the performance been measured in accordance with CFA Institute's standards?
• Does investment performance vary widely among different classes of funds or accounts? If so, the member must describe investment performance by classes rather than by an overall average figure and accurately explain what the performance figures represent.

Example

Your bond fund has generated a below average performance for four of the past five years. You use this as the basis for expectations of an above-average performance for the upcoming year. If your average or expected performance is properly determined, you should have a 50% probability of meeting or exceeding that average. Thus, it is inappropriate to declare that because performance was below average last year it is likely to be above average next year.

III. DUTIES TO CLIENTS

E. Preservation of Confidentiality.

Members and Candidates must keep information about current, former, and prospective clients confidential unless:

• The information concerns illegal activities on the part of the client or prospective client.
• Disclosure is required by law.
• The client or prospective client permits disclosure of the information.

The analyst must preserve confidentiality when the following two criteria are met:

• The analyst must be in a relationship of trust with the client who has engaged him or her.
• The information received must result from or be relevant to the portion of the client's business that is the subject of the confidential relationship.

You are required to:

• Avoid discussing any information received from a client, except to fellow employees working with the same client.
• Ask yourself if the disclosure is necessary and beneficial to the client in cases where you have to disclose information.
• Forward confidential information to the PCP (CFA Institute's Professional Conduct Program) if the PCP requests, even if the client and you have a settlement agreement with confidentiality clauses. This is because any information turned over to the PCP is kept in the strictest confidence. Members and candidates who will not provide necessary information because of confidentiality will be seen as failing to co-operate with the investigation and will be subject to summary suspension of membership under CFA Institute's bylaws.

However, if the information concerns illegal activities by the client, the analyst may be required to consult with his supervisor and with legal counsel before deciding whether to report the activities to the appropriate governmental organization.

Procedures for compliance

The simplest, most conservative, and most effective way to comply with this standard is to avoid disclosing any information received from a client except to authorized fellow employees who are also working for the client. In some instances, however, a member may want to disclose information received from clients that is outside the scope of the confidential relationship and does not involve illegal activities. Before making such a disclosure, a member should ask the following questions:

• In what context was the information disclosed?
• If disclosed in a discussion of work being performed for the client, is the information relevant to the work?
• Is the information background material that, if disclosed, will enable the member to improve service to the client?

Example 1

You work in the trust department of a large bank. A client tells you that she must sell a significant portion of her personal stock portfolio in order to generate cash to meet the payroll of her small business. Shortly after the meeting, a colleague in the commercial lending department of the bank mentions seeing you with the client. She has applied for a large business loan. He asks you if you have any information that could help the bank with the loan decision. You cannot disclose the content of your meeting with the client. If the colleague wants additional information, he should contact your client directly.

Example 2

The employer of a client asks to meet with you. The employer suspects your client of embezzling funds from his place of work. You are aware that the client has made several substantial additions into his discretionary account during the past two months. It may be appropriate to provide information if it pertains to illegal activities. However, you are expected to preserve client confidentiality unless there is a clear indication of these activities. Contact your supervisor or legal counsel before providing information about your client.

...

IV. DUTIES TO EMPLOYERS

A. Loyalty.

In materials related to their employment, Members and Candidates must act for the benefit of their employer and not deprive their employer of the advantage of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.

Independent practice

Members shall not undertake any independent practice that could result in compensation or other benefit in competition with their employer unless they obtain written consent from their employer.

• "Practice" means any service that the employer currently makes available for payment.
• "Undertake" means that the member actually has to participate in such activities while the member is still employed in order to violate this standard.

If members and candidates plan to engage in independent business while still employed, they must provide a written statement to their employer describing the types of services, the expected duration, and the compensation.

Note: Members have to participate in the activities. They do not actually have to receive any remuneration for this standard to apply.

Leaving an employer

Until their resignation becomes effective, members and candidates must continue to act in the employer's best interest, and must not engage in any activities that would conflict with this duty. A member can make preparations (but not undertake competitive business) to begin a competitive business as a departing employee, provided that the preparations do not breach the employee's duty of loyalty. Examples of this would be finding office space to rent for a member's future business.

Nature of employment

You can be exempt from the standard if you are an independent contractor.

Definition of employee: someone in the service of another who has the power to control and direct the employee in the details of how work is to be done. An employee is not a contractor (you cannot control the details of how a contractor does a job). Employment relationship does not require written or implied contract or actual receipt of monetary compensation.

Violations

• You get a new job, but before leaving your current job you solicit your employer's clients (for both current and potential clients).
• Misuse of confidential information or misappropriation of trade secrets (e.g., taking home client lists, investment statements, marketing presentations, and buy lists).
• You provide consulting services on your own time. You must get written consent from your employer.
• Copying your employer's computer models and other property.
• Encouraging colleagues to leave your employer to join your new company.

Example 1

You agree to serve as an investment advisor to a non-profit institution run by a friend. Your firm provides similar services, but you elect to do this on your own for a very modest fee. Even if no fee was involved, you are obliged to obtain written consent from your employer.

Example 2

An independent investment advisor is hired by a brokerage firm. However, she wants to keep her existing clients for herself. In this case, she must get the employer's written consent.