Law of demand
Demand function
Demand concepts
Demand curve (graph of
inverse demand function)
Elastic, Unit-​elastic, and Inelastic
Elasticity
Perfectly elastic and inelastic
Elasticity and total expenditure on a good
Price elasticity of demand
Own-​price
Larger for goods with close substitutes, occupy a large
portion of the budget, are seen as discretionary, or
have longer time to adjust to changes in its price.
Cross-​price
Income
Substitution and income effects
Law of diminishing marginal returns
Supply analysis : cost, marginal returns, and productivity
Total cost: TC = wL + rK
w = hourly wage; L = labor hours; r =
rental rate of capital; K = capital hours
Total, average, and marginal product of labor
Economic profit = Total revenue (TR) - Economic cost (total cost (TC))
Accounting profit = TR - Accounting cost
Economic vs Accounting
Economic depreciation: What am I giving up if I use
my resources to produce output in the coming period?
Accounting depreciation: How should I distribute the
historical cost—​that I have already paid—​across units
of output that I intend to produce this period?
Marginal revenue (MR) and marginal cost (MC)
Demand & Supply
Cooperative vs Non-​cooperative countries
Total, Variable, Fixed, and Marginal Costs
Landlocked countries rely on neighbors for access to vital resources => cooperation
more important.
National security or military
S, the lowest point on the AVC curve, is where MC = AVC. Beyond quantity QAVC, MC > AVC;
thus, the AVC curve begins to rise.
T, the lowest point on the ATC curve, is where MC = ATC. Beyond quantity QATC, MC > ATC;
thus, the ATC curve is rising.
A, the difference between ATC and AVC at output quantity Q1, is exactly the AFC.
R is the lowest point on the MC curve. Beyond this point of production, fixed input
constraints reduce labor productivity.
X is the difference between ATC and AVC at Q2. X < A because AFC (Y) falls with output.
Countries highly connected to trade routes or acting as a conduit for trade use their
geographic location as a lever of power in broader international dynamics.
Domestically, growing national wealth and limiting income inequality contribute to
social stability, an important component of national security.
Economy
Internationally, countries that cooperates in support of their economic interest are focused
on 1 of 2 factors:
(1) securing essential resources through trade, or
(2) leveling the global playing field for their companies/industries through standardization.
Motivations for cooperation
Livable geography and climate, access to food and water, etc.
Highly unequal among countries.
Perfect and imperfect competition
Geophysical Resource Endowment
More endowed with a resource => more political leverage
when dealing with another in need of that resource.
Resource-​rich => use or sale of the resource benefits certain
groups more than others => internal political instability.
Resource Endowment, Standardization, and Soft Power
Regulatory cooperation:
Basel Committee on Banking Supervision (BCBS): more effective supervision of the
global banking sector and international capital flows.
State actors (national governments) & Political cooperation
Standardization
Perfectly competitive firm
Process standardization:
Society for Worldwide Interbank Financial Telecommunication (SWIFT): global payment
infrastructure.
Profit-​Maximization, Breakeven, and
Shutdown Points of Production
Monopolist firm
Operational synchronization:
Containerization: reduces time and cost of shipping.
Historical or modern
Cultural Considerations and “Soft Power”
Cultural programs, advertisement, travel grants, and university exchanges, etc.
Generally, strong institutions => more stable internal and external political forces =>
more opportunity to develop cooperative relationships.
The Role of Institutions
Countries with strong institutions => more authority and independence in the international space.
Increasing returns to scale.
Specialization in one task rather than perform many duties.
More efficient equipment, and adaptation the latest in technology.
Marketable byproducts, less energy consumption, and enhanced quality control.
Better use of market information for more effective decision making.
Obtaining discounted prices on resources when buying in bulk.
Breakeven: P = MR = SMC = ATC
Shutdown: SMC = AVC
Decreasing returns to scale.
Being so large that it cannot be properly managed.
Overlapping and duplication of business functions
and product lines.
Higher resource prices because of supply
constraints when buying inputs in bulk.
Stronger institutions => more durable cooperative relationships.
Economies of scale
Every country has different resources, goals, and leadership => different priorities.
Economies and Diseconomies of scale
Priorities may shift as political leadership turns over or as global events change.
Hierarchy of Interests and Costs of Cooperation
Some elements on the hierarchy of national interests may be universally clear-​cut. However, as
basic societal needs are met, the hierarchy of national interests can become more subjective.
Power of the Decision Maker
Diseconomies of scale
The length of a country’s political cycle has an important impact on priority designation.
Political Non-​Cooperation
Features of globalization
Raising sales
Raising profits
Reducing costs (lower tax-​operating environments, reduce labor costs, or seek other supply
chain efficiency gains)
Motivations for globalization
Portfolio investment flows
Non-​state actors & Forces of globalization
Marginal revenue (MR) and marginal cost (MC)
Access to resources and markets
FDI
Intrinsic gain (personal growth and education, improved productivity, higher standards)
Unequal Accrual of Economic and Financial Gains
Lower Environmental, Social, and Governance Standards
Political Consequences (income/wealth inequality, differences in opportunity
Costs of globalization
Interdependence (if there is a disruption to the supply chain,
firms may not be able to produce the good themselves)
Reshoring essentials
How firms fortify their supply chains
Re-​globalizing production
Perfect competition
Doubling down on key markets
Monopolistic competition
4 market structures
Autarky
Self-​sufficiency, sometimes swifter economic and political development, but gradual
loss of economic and political development within the country
Oligopoly
Monopoly
Assessing geopolitical actors and risks
Hegemony
Regional or global leaders, influence on global affairs, but may become more
competitive and increase geopolitical risk when gaining or losing influence
Geopolitics
Number and relative size of firms
Degree of product differentiation
Multilateralism
Both capable of and highly dependent on international cooperation for economic growth.
Pricing power
Regionalism
In between the two extremes of bilateralism and multilateralism.
In regionalism, a group of countries cooperate with one another.
Both bilateralism and regionalism can be conducted at the exclusion of other groups.
Determinants of market structure
Bilateralism
One-​at-​a-​time agreements without multiple partners.
Analysis of market structures
Barrier to entry and exit
National security tools
Degree of non-​price competition
Cooperative: trade agreements, WTO, common markets/currency
Economics 1
Threat of entry
Economic tools
Non-​cooperative: nationalization, voluntary export restraints, domestic content requirements
Power of suppliers
Power of buyers
Porter's 5 forces
Tools of geopolitics
Financial tools
Threat of substitutes
Cooperative: currency exchange
Reduce geopolitical risk if they encourage cooperation in security, economic, or
financial arenas.
May cause vulnerabilities (e.g., global use of the USD)
Non-​cooperative: limiting access to local currency markets, restricting foreign investments,
sanctions
Rivalry among existing competitors
Q = a - bP
Multi-​tool approaches
Perfect competition
Cabotage: the right to transport passengers or goods within a country by a foreign firm
MR = ΔTR/ΔQ
Geopolitical Risk and Comparative Advantage
A consistent threat of conflict may drive more regular volatility in asset prices.
Countries/regions with limited geopolitical risk may attract more labor and capital.
Not every country will be endowed with the same factors and capabilities => benefit
from trade => more variety of products, higher competition between firms, and more
efficient resource allocation.
Own-​price
Substitutes => (+)
Cross-​price
Complements => (-)
Event risk: evolves around set dates, such as elections, new legislation, or
other date-​driven milestones, such as holidays or political anniversaries,
known in advance.
Income
Elasticity of demand
Horizontal demand schedule (perfectly elastic)
Types of geopolitical risk
Extremes
Exogeneous risk: sudden or unanticipated risk that impacts either a country’s
cooperative stance, the ability of non-​state actors to globalize, or both.
Vertical demand schedule (perfectly inelastic)
Thematic risk: known risks that evolve and expand over a period of time (climate
change, pattern migration, the rise of populist forces, threat of terrorism, and cyver
threats)
Price elasticity will be higher if there are many close substitutes for the product.
Determinants
The greater the share of the consumer’s budget spent on the item, the higher the price elasticity of demand.
Black swan risk: An event that is rare and difficult to predict but has an important impact.
The length of time within which the demand schedule is being considered.
Likelihood (how likely the risk is to happen)
Long term:
Impact investors' asset allocation.
May have important environmental, social, governance, and other impacts.
Immediate impact on portfolios is likely to be more limited.
TR, MR and price elasticity
Incorporating geopolitical risk into investment
Assessing Geopolitical Threats
The difference between the value that a consumer places on units purchased and the
amount of money that was required to pay for them.
Velocity (how quickly the risk impacts investment portfolios)
Time horizon
Consumer surplus
Medium term:
Impair companies’ processes, costs, and investment opportunities, resulting in lower valuations.
Impact some more than others.
Short term:
Volatility in the markets may affect entire industries or even the entire market.
Long-​term changes are unnecessary.
Economic costs = Total accounting costs - Implicit opportunity costs
P = AR = MR
Optimal price and output in perfect competition
Supply analysis, optimal price, and output in perfectly competitive markets
Low => adjust asset allocation
Law of diminishing returns => Profit maximization at output level where MR = MC
Quickness
Medium => adjust investments in specific sectors
Only perfect competition has a defined supply function.
Profit maximization at output level where MR = MC
High => flight to quality (the herd-​like behavior of investors to shift out of risky assets during
financial downturns or bear markets)
Firm and market structures
Impact
The long-​run marginal cost schedule is the perfectly competitive firm’s supply curve.
Long-​run equilibrium in perfect competition
The firm’s demand curve is dictated by the aggregate market’s equilibrium price.
Scenario analysis: evaluating portfolio outcomes across potential circumstances or states of the world.
The long-​run competitive equilibrium occurs where MC = AC = P
Groupthink: thinking or making decisions as a group in a way that discourages creativity or
individual responsibility. For scenario analysis to be useful in portfolio management, teams
must build creative processes, identify scenarios, track these scenarios, and assess the need
for action on a regular cadence.
Tracking risks according to signposts
Short-​run profit maximization at output level where MR = MC
There is no well-​defined supply function. The information used to determine the
appropriate level of output is based on the intersection of MC and MR. However,
the price that will be charged is based on the market demand schedule.
Acting on Geopolitical Risk
Consider objectives, risk tolerance, and time horizon.
Monopolistic competition
Long-​run equilibrium in monopolistic competition: MR = MC
High levels of geopolitical risk reduce investment, employment, and price level of the stock market.
Observations from the Geopolitical Risk Index (GPR)
Firms reduce investment in the wake of idiosyncratic events, which would be unlikely to repeat.
The threat of an event was shown to have a larger impact over time than that of the actual events themselves.
In a market where collusion is present, the aggregate market demand curve is divided up by
the individual production participants.
Under non-​colluding market conditions, each firm faces an individual demand curve
depending on the pricing strategies adopted by the participating firms.
1. If price increases, the competitor ignores it so demand is more responsive (more elastic).
2. If the price falls, the competitor matches it so demand is less responsive (more inelastic).
The kink point => current price offered by the market.
Assumption in which each firm determines its profit-​maximizing
production level assuming that the other firms’ output will not change.
Cournot assumption
The Cournot strategy’s solution can be found by setting Q = q1 + q2,
where q1 and q2 represent the output levels of the two firms.
Oligopoly and pricing strategies
When two or more participants in a non-​cooperative game have no incentive to deviate
from their respective equilibrium strategies given their opponent’s strategies.
The number and size distribution of sellers: number of firms is small or if one firm is dominant.
The similarity of the products: products are homogeneous.
Nash equilibrium
Cost structure: similar the cost structures.
Determinants of successful cartel
Order size and frequency: orders are frequent, received on a regular basis, and relatively small.
The strength and severity of retaliation: low threat.
The degree of external competition.
Stackelberg model: a prominent model of strategic decision making in which firms are
assumed to make their decisions sequentially.
Top-​dog strategy: the leader aggressively overproduce to force the follower to scale
back its production or even punish or eliminate the weaker opponent.
The price leader identifies its profit-​maximizing output where MRL = MCL, at output QL.
No single optimum price and output analysis that fits all
oligopoly market situations because of the interdependence.
Optimal price, output, and long-​run equilibrium in Oligopoly
Optimal price is determined at the output level where MR = MC (at kinked point)
Long-​run economic profits are possible for firms operating in oligopoly markets but over
time, the market share of the dominant firm declines.
The profit-​maximizing level of output occurs where MR = MC.
Demand/Supply and Optimal Price/Output
First-​degree: charge each customer the highest price the customer is willing to pay.
Second-​degree: charge different per-​unit prices using the quantity purchased.
Monopoly
Price discrimination and consumer surplus
Third-​degree: segregates customers into groups based on characteristics and offers different pricing to each group.
Economic profit is possible.
To maintain a monopoly market position in the long run, the firm must be protected by
substantial and ongoing barriers to entry, or national ownership of the monopoly.
Long-​run equilibrium in monopoly
The regulator sets price equal to LRAC.
Observed price and quantity are the equilibrium values of price and quantity and do not
represent the value of either supply or demand.
Econometric approaches
Identification of market structure
Must use a model with 2 equations, an equation of demanded quantity and an equation of
supplied quantity.
Herfindahl–Hirschman index
Concentration ratio
Unaffected by mergers among the top market incumbents.
Does not directly quantify market power and threat of entrance.
Simpler approaches