Estimated study time: 45 minutes
Content:
Microeconomics analyzes decision-making at the level of individual consumers, firms, and markets. For CFA candidates, the most important microeconomic concepts are supply and demand dynamics, price elasticity, market structures, and the theory of the firm — all of which feed directly into industry analysis, equity valuation, and understanding competitive dynamics. Demand curves slope downward (as price rises, quantity demanded falls) while supply curves slope upward (as price rises, quantity supplied increases). Market equilibrium occurs where supply equals demand. Shifts in the demand or supply curve — caused by changes in income, substitute prices, input costs, technology, or expectations — change the equilibrium price and quantity. For investment analysis, anticipating these shifts allows analysts to forecast industry revenue and margin trends.
Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price: PED = % change in quantity demanded / % change in price. Elastic demand (|PED| > 1) means consumers are price-sensitive; a small price increase leads to a proportionally larger drop in quantity demanded, reducing total revenue. Inelastic demand (|PED| < 1) means consumers are price-insensitive; a price increase raises total revenue. Unit elastic demand (|PED| = 1) means a price change causes an equal proportional change in quantity, leaving total revenue unchanged. Factors affecting elasticity include availability of substitutes, necessity versus luxury, and the time horizon. Cross-price elasticity measures how the demand for one good responds to a price change in another: positive cross-price elasticity indicates substitutes; negative indicates complements.
Market structures describe the competitive environment in which firms operate. In perfect competition, many small firms sell homogeneous products with no pricing power; price equals marginal cost in the long run and economic profit is zero. Monopolistic competition features many firms selling differentiated products; firms have some pricing power due to differentiation but face competition from close substitutes. Oligopoly involves a small number of large firms with significant pricing power; strategic interdependence (each firm considers rivals' reactions) is the defining characteristic. In a monopoly, a single firm faces no direct competition and sets price above marginal cost, generating economic profit. The degree of pricing power — and hence profit margin sustainability — depends critically on market structure.
The theory of the firm examines how production costs determine supply decisions. Economists distinguish between the short run (at least one input is fixed) and the long run (all inputs are variable). Key cost concepts include: fixed costs (FC), variable costs (VC), marginal cost (MC = change in TC / change in Q), average total cost (ATC = TC / Q), average variable cost (AVC = VC / Q), and average fixed cost (AFC = FC / Q). Profit maximization occurs where marginal revenue (MR) equals marginal cost (MC). In perfect competition, P = MR = MC at the profit-maximizing output. In monopoly, MR < P, so P > MC, creating a deadweight loss (inefficiency). For investment analysis, understanding the relationship between operating leverage (fixed vs. variable cost structure) and profitability at different output levels is a direct application of microeconomic cost theory.
Key Terms:
Quiz Questions:
Q1. A pharmaceutical company sells a drug that treats a life-threatening condition with no alternative treatments. Demand for this drug is most likely:
A) Highly elastic because healthcare spending is a large portion of consumer budgets B) Highly inelastic because patients need the drug regardless of price C) Unit elastic because changes in price and quantity will be proportional D) Elastic because the drug is a luxury good rather than a necessity
Answer: B — Demand for necessities with no substitutes is highly inelastic. Patients who need the drug for a life-threatening condition cannot substitute it for another product, so quantity demanded falls very little even as price rises sharply. This is one reason pharmaceutical companies with patent-protected drugs can charge very high prices and still maintain sales volumes — the demand inelasticity allows margin expansion.
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Q2. In a perfectly competitive market, a firm is currently producing at a level where marginal revenue exceeds marginal cost. To maximize profit, the firm should:
A) Decrease output until MR = MC B) Increase output until MR = MC C) Set price equal to average total cost D) Exit the market since competition prevents profit
Answer: B — The profit-maximizing rule for any firm is to produce where MR = MC. When MR > MC, each additional unit produced adds more to revenue than to cost, so the firm should increase production. The firm should continue expanding output until MR = MC. In perfect competition, MR = P, so the firm produces where P = MC. Option C describes break-even pricing, not profit maximization.
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Q3. An analyst observes that when the price of streaming video subscriptions rises, demand for DVD rentals increases. This relationship indicates that streaming video and DVD rentals are:
A) Complementary goods with a negative cross-price elasticity B) Substitute goods with a positive cross-price elasticity C) Normal goods with a positive income elasticity D) Inferior goods with a negative income elasticity
Answer: B — When the price of one good rises and demand for another good increases, the two goods are substitutes. The cross-price elasticity of demand = % change in quantity demanded of Good B / % change in price of Good A. For substitutes, this is positive: a higher streaming price makes DVDs relatively cheaper, so consumers switch to DVDs. Complements (Option A) have negative cross-price elasticity — when one price rises, demand for the complement falls (e.g., printers and ink cartridges).
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Q4. Which market structure is characterized by a small number of large firms, high barriers to entry, and strategic interdependence — where each firm's pricing decision depends on anticipated reactions from competitors?
A) Perfect competition B) Monopolistic competition C) Oligopoly D) Monopoly
Answer: C — Oligopoly is defined by a small number of large firms with significant market power and high barriers to entry. Strategic interdependence is the hallmark: each firm must consider how its competitors will respond to pricing or output changes. This creates behavior such as price leadership, tacit collusion, and the kinked demand curve. Airlines, mobile telecoms, and major beer companies are classic oligopoly examples.
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Q5. A firm's total fixed cost is $100,000 and its total variable cost at an output of 1,000 units is $200,000. What is the average total cost per unit?
A) $100 B) $200 C) $300 D) $150
Answer: C — Average total cost (ATC) = Total cost / Quantity = (FC + VC) / Q = ($100,000 + $200,000) / 1,000 = $300,000 / 1,000 = $300 per unit. AFC = $100 per unit, AVC = $200 per unit, and ATC = AFC + AVC = $300. In the long run, competitive markets drive price toward the minimum ATC, eliminating economic profit.
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