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RIGOS CMA/CFM REVIEW
PART 1 - CHAPTER 1
INTRODUCTION AND MICROECONOMICS
A. Welcome to Rigos CMA/CFM Program
Welcome to Part 1 of the four-volume set of textbooks that is used as the exclusive source of study in the Rigos CMA/CFM seminars. All four volumes have six modules, each of which is to be covered in one 3-1/2 to 4 hour class. Accompanying the textual material are over one thousand old ICMA questions from actual exams as well as questions written by our editors.
B. CMA/CFM Exam Coverage of Part 1 Topics
Economic topics constitute 40% of Part 1. The Management and Finance topics constitute 35% and 25%, respectively. Legal consideration, tax issues, and current events (as covered in Management Accounting, Business Week, and The Wall Street Journal) may also be covered in Part 1. Beginning in 1997, the CMA/CFM examination is an interactive, computer-format examination administered at Prometric Testing Centers throughout the United States and at international locations. It consists of 110 multiple-choice questions to be completed in a three-hour period. There are no subjective essay or computational scheduling problems.
C. Textual Coverage Guide
The Rigos text breaks Part 1 topics down into seven chapters or modules to correspond with the current ICMA Content Specification Outline for exams beginning on July 1, 2004. The topics covered in each chapter are as follows:
1. The first chapter covers the information usually taught in a beginning microeconomics course. Microeconomics studies the economic characteristics of individual consumers and business firms in a free market setting. Also covered are the various competitive market structure models and synergism resulting from business combinations.
2. The second chapter covers the federal statutes affecting corporations and the macroeconomic topics which involve the economy as a whole. Examined are the subject areas of the general output measurements price levels, employment rate, business cycles, leading indicators, government spending, federal deficit, interest rates, and money supply, .
3. The third chapter covers the global business topics of foreign trade and currency exchange.
4. The fourth chapter covers the internal control system established by the corporation's management. Included is a discussion of risk assessment, internal auditing, and system controls and security measures.
5. The fifth chapter covers quantitative methods. Covered here is forecasting analysis (including regression analysis, learning curves, and time series analysis), linear programming, project management with networks, probabilities, and decision tree analysis.
6. Chapter six addresses financial standards and assurance. Topics include the development of accounting standards, an examination of the Statements of Financial Accounting Concepts, responsibilities for financial statement assurance, and the types of audit reports to be issued.
7. Chapter seven presents ratio analysis of the financial statements. Areas of analysis include short-term liquidity, a firm's capital structure and solvency, return on invested capital, profitability analysis, and earnings based analysis.
Part 1 text details the current situation covering a number of substantive economic and finance topics. The last full U.S. federal government fiscal-year reported is September 30, 2003. A number of the December 31, 2003 statistics are presented where useful to indicate key fiscal and monetary policies, foreign trade and international currency exchange statistics.
D. Adam Smith Resource Allocations
The Scottish economist, Adam Smith, in his 1776 masterpiece, The Wealth of Nations, founded modern economic theory known as economic liberalism. Smith's basic assumptions of economic analysis included that a consumer's economic needs and wants are unlimited, but that the available resources (land, labor and capital) are limited. Aggregate economy wide demand exceeds resource supply. The objective is the most efficient allocation of scarce resources to achieve the largest amount of goods and services. Smith's analysis concludes that a system of competitive free markets ("the invisible guiding hand") best accomplishes this result. Individuals pursuing their own selfish best interests promote efficiency through the division of labor; this specialization creates national and individual wealth and maximizes resource efficiency.
E. Basic Economic Systems and Decisions
Traditional economic analysis recognizes three basic economic systems.
1. Traditional System: Historically, economics was based on land and agriculture. Barter in transactions was common, but was limited to exchanges between people who wanted the same item. To resolve this restriction, rare metals began to serve as a medium of exchange. Examples include the European Middle Ages' feudal systems and some present-day underdeveloped countries.
2. Command System: The economic system is centrally controlled/planned and resources are usually publicly owned. This includes a variety of democratic, socialist, or communist political systems with centrally-controlled resources. Such centralized systems lack the efficiency of the free-market and are losing favor as a means for organizing economic activity. Many countries are privatizing businesses formerly owned by the Government. Russia plans to privatize 3/4 of the Soviet State businesses before the year 2005. But the transition to a free-market economy has proven difficult in Eastern Europe; government printing of money to cover deficits has produced high inflation and real incomes have fallen by 40% since 1992. There is accompanying political uncertainity.
3. Capitalism: Individuals and firms pursue their own private interests in the free market system of private ownership. More is determined by the market and less by the government. Consumer demands are fulfilled by free-enterprise firms operating for profit.
a. Consumer Votes: Consumers express their preferences in the global marketplace on a one vote, one dollar basis. They seek to obtain the best-quality product at the cheapest price. This price mechanism is the principal determinant of resource allocation.
b. Production Costs: Businesses compete for consumers' money in an egocentric search for profits. Competition forces producers to specialize and innovate. This leads to efficiency and reduced costs per unit. Costs of production, mixture of inputs and control are as important as revenue.
c. Efficiency and GDP: The free market economy is more efficient than a command system. This efficiency produces a maximum Gross Domestic Product (GDP) for the economy given a pre-existing level of income. Thus is created the highest standard of living for the people.
4. Mixed Systems: Most systems of today are mixed; part capitalistic and part command. Japan is an example where resources are privately owned, but the government organizes the economic climate through an industrial policy.
F. Free Market Decisions
The five basic free-market economic decisions include:
1. What to Produce? The goods that are demanded are determined by consumers voting for their preferences with dollars in the marketplace. Suppliers produce to meet the market demand.
2. How to Produce It? The production process is to be accomplished by the most efficient, least cost per unit, method possible.
3. How Much to Produce? The market will determine the quantity demanded. In a truly competitive environment, an individual firm can sell all the quantity it wants at the market price.
4. What Price to Charge? This decision as to the exchange price may not be available in a truly competitive environment. In other economic environments, the firm may have price elasticity.
5. Ownership Structure: This decision determines who shall receive the profit or bear the loss resulting from the sale of the goods or services. In the free market economy private individuals own the business entities and resources.
G. Production Possibilities Curve
The production possibilities curve is illustrated by Figure 1-1 (in text).
1. Purpose:This curve shows all possible combinations of two goods that a society can produce, employing its available level of resources at greatest efficiency. The slope of the curve represents the increasing opportunity cost of producing each successive unit of one good in terms of units of the other good for which production is foregone.
2. Variable Points: Points to the right of the curve are unattainable, due to scarcity of resources. Points to the inside of the curve represent underemployment of resources available. Growth in productive resource capacity or the productivity of workers (output per labor hour) causes the curve to shift outward. This enables the society to produce more of both goods. in the 1990s and early 200 decade, U.S. productivity increased about 3% per year.
II. DEMAND CURVE ANALYSIS
A. Utility and Consumer Demand
1. Dollar Votes: Dollar votes in the marketplace reflect the consumer's perception of a good's utility. Utility is a measurement of the satisfaction or benefit derived from consuming a unit of the good. Total utility (TU) is the cumulative satisfaction or benefit derived from all units consumed. Marginal utility (MU) is the satisfaction or benefit derived from the last unit consumed.
2. Savings Utility: The security and interest earned from savings provides some utility.
B. Marginal Utility Theory
Marginal utility theory is one approach used to explain how the consumer with a given level of income acts to maximize the utility provided by various goods. This theory assumes that utility can be quantified.
1. The Law of Diminishing Marginal Utility: Each successive unit of the same good consumed provides less additional, or marginal, satisfaction. The more you buy of an item, the less you want the next unit. This results in a downward-sloping demand curve. Graphically, it can be shown that as increased quantities of a good are consumed, the total utility curve rises at a decreasing rate, and the marginal utility curve falls.
2. Utility Maximization: Maximization of utility for a given consumer's level of income is where the marginal consumption utility (MU) per dollar price of all goods and savings are the same. If a, b, and c are different goods available to the consumer and s equals savings, the formula to maximize utility for a given consumer's income is:
MUa / Pa = MUb / Pb = MUc / Pc = Mus / Ps
C. Indifference Curve Analysis
Indifference curve analysis is an alternative approach to explain consumption behavior. This approach does not measure utility quantitatively. An indifference curve indicates all combinations of two goods which yield the same satisfaction level to the consumer, who is indifferent between combinations represented by points on the curve.
1. The Marginal Rate of Substitution: The slope of an indifference curve is the Marginal Rate of Substitution (MRS), or the amount of one commodity that the consumer is willing to forego to obtain one additional unit of the other commodity. The MRS diminishes along the curve due to the consumer's increasing unwillingness to give up successive units of one commodity to continue to acquire more and more of the other. A set of indifference curves is referred to as an indifference map. Convex curves further from the origin represent successively higher levels of consumption and corresponding satisfaction.
2. The Budget Line: The linear budget line shows all possible combinations of the two commodities that the consumer can purchase given the prices of the commodities and the level of income available to purchase them. A change in money income causes a parallel shift of the budget line - outward if income is increased, toward the origin if decreased. A change in the relative prices of the goods results in a change of the slope of the budget line.
3. Maximization of Consumer Satisfaction: When the budget line is superimposed upon the indifference map, the consumer's satisfaction is maximized at the point of tangency of the budget line to an indifference curve.
D. Basic Demand Curve Features
1. General Considerations: A demand schedule shows the quantity consumers will purchase at a given price. The law of demand states that as unit price falls, consumers will purchase more quantity. As unit price increases, quantity demanded will decrease. This produces a demand curve that is downward sloping to the right and normally convex to the origin.
2. Demand Curve Shift: A demand curve shift (a change in demand) is to be distinguished from a movement on the same demand schedule (a change in quantity demanded).
a. Cause of Change in Quantity Demanded: A change in quantity demanded results from a change in price, with all other factors remaining the same. This is a movement along the demand curve from one price-quantity combination to another.
b. Causes of Change in Demand: A change in demand is caused by changes in consumers' tastes, prices of complementary or substitute items, money income, expectations as to price or income changes, the range of available products, and the number of buyers.
c. Direction of Shift: A shift of the curve to the right, an increase in demand, can be caused by an increase in income or the elimination of a substitute good. A shift to the left, a decrease in demand, can result from a decrease in income or an increase in substitute goods.
E. Elasticity of Demand
Elasticity of Demand measures the responsiveness of quantity to a change in the product's price. For most goods, the basic determinant of the demand elasticity is the number of substitutes available. The more close substitutes a good has, the greater its elasticity of demand. Also, elasticity is greater over a longer period of time or when a larger portion of the consumer's income is required to purchase the commodity. The ultimate question is the effect of the change on total revenue.
1. Elastic Demand: Total Revenue increases from a decrease in price if the percentage change in quantity (Q) is greater than the percentage change in price (P). This occurs in the lower right section of a traditional concave demand schedule and the coefficient of elasticity is greater than one. If the elasticity of demand is 1.3, a 5% decrease in price will increase quantity demanded by 6.5%. In this portion, the demand curve is more horizontal (remember the elastic or rubber band). Luxury and expensive products usually have more elastic demand than necessary products. Demand is perfectly elastic (the coefficient is infinite) if the demand curve is horizontal at a given price.
2. Inelastic Demand: Total Revenue decreases from a decrease in price if the percentage change in Q is less than the percentage change in P. This is in the upper left section of a traditional concave demand schedule and the coefficient of elasticity is less than one. In this portion, the curve is more vertical. Inelasticity in the demand curve allows a seller to more easily pass additional costs, new taxes, etc. through to the buyer. The fewer substitutes for a good, the more inelastic is the demand (i.e. toilet paper). Demand is perfectly inelastic (the coefficient is zero) if the demand curve is vertical at a given quantity such as a diabetic's requirement for insulin.
3. Unitary Demand: This is the point on the demand curve where a decrease in price is exactly offset by an increase in quantity. The coefficient is exactly one. At this point, total revenue stays constant.
4. Price Elasticity of Demand: This is a measure to evaluate and quantify the elasticity relationship. The formula for the coefficient of elasticity shows the effect on quantity purchased resulting from a price change. The result is negative and is multiplied by (-1) to get a positive number.
Formula = % Change in Quantity / % Change in Price
a. % Change in Quantity = (Q2 - Q1) / [(Q1 + Q2) / 2] Average Quantity
b. % Change in Price = (P2 - P1) / [(P1 + P2) / 2] Average Price
Example: The unit price of a good fell from $15 to $12 and the unit quantity increased from 22 to 28. What was the elasticity nature of the demand curve and calculate the elasticity coefficient?
Answer: The demand curve was in the elastic portion of the schedule. A total revenue increase resulted from the change. ($12 x 28 = $336 > $15 x 22 = $330). The Coefficient is calculated as:
( 28 - 22) / [(28 + 22) / 2] = 6 / 25 (12 - 15) / [(12 + 15) / 2] = -3 / 13.5 (For simplicity, to eliminate the decimal, the price change fraction can be changed to -6/27).
[(6/25) / (-6/27)] x -1 = (6/25 x -27/6 x -1 = 27/25 = 1.08. Because this is greater than 1 the change is occurring in the lower right portion of the traditional demand curve.
5. Income Elasticity of Demand: A measurement of the effect on quantity purchased from a change in income.
Formula = % change in Quantity / % change in Income
a. Normal Good: If the elasticity coefficient is positive, it is a normal good. Quantity demanded increases with an increase in income, such as lobster.
b. Inferior Good: If the elasticity coefficient is negative, it is an inferior good. As income increases, quantity demanded decreases, such as beans.
6. Cross Elasticity of Demand: A measurement of the relationships of changes in two products. A typical exam question involves a manufacturer adding a product line or changing the unit price. The question is whether such an action will retard or stimulate the purchase of the other product.
Formula = % change in Quantity of Y / % change in Price of X
a. Substitute Goods: If the coefficient is positive, the goods are substitutes. They are alternatives. Consumers purchase one good or the other, such as Coke - Pepsi or butter - margarine. The greater the number of substitute products, the more elastic the demand schedule for any one. The demand curve for a firm's product will shift to the right if substitute goods increase their prices.
b. Complementary Goods: If the coefficient is negative, the goods are complements. One promotes the other. The purchase of one good stimulates the purchase of another, such as beer -pizza or baseballs - baseball bats. A decrease in the price of a complementary good will shift the demand curve of the joint commodity to the right.
7. Increase in Price or Income: Most of the exam questions testing the above formulas assume a price or income decrease (and the resulting effect on total revenue, etc.) An increase in price or income would have the opposite effect. For example, an increase in price (say from a sales tax increase) will be more easily shifted ahead to consumers if the demand curve is inelastic. Likewise, for a crop reduction program to increase farmers' incomes, the demand must be inelastic.
III. SUPPLY CURVE ANALYSIS
A. Basic Supply Curve Features
1. General Considerations: The supply schedule depicts the various quantities producers will bring to market at various prices. The law of supply states that sellers will offer more quantity at a higher price and less quantity at a lower price. The supply curve schedule is thus downward sloping to the left.
2. Supply Curve Shift: A shift in the supply curve (a change in supply) should be contrasted with a movement on the same schedule (a change in quantity supplied).
a. Cause of Change in Quantity Supplied: A change in quantity supplied is due to a change in price, with other factors remaining the same.
b. Causes of Change in Supply: A change in supply (a shift to the right of the supply curve) results from a change in one of the following: prices of inputs, technology, prices of other goods, the number of suppliers, and suppliers' expectations.
c. Direction of Shift:
1) Right: A decrease in the cost of the necessary inputs or a technological improvement are examples of changes that will shift the supply curve to the right; this will increase the quantity offered by a supplier at all price levels. If there was no quantity change, the price would be reduced.
2)Left: A decrease in the number of suppliers or increase in input prices will shift the supply curve to the left, resulting in a decrease in supply.
B. Elasticity of Supply
Elasticity of supply measures the responsiveness of quantity supplied to a change in the product's price.
Formula = % change in Quantity / % change in Price
1. Elasticity Measurement: Supply is elastic (percentage change in quantity exceeds percentage change in price) when the coefficient is greater than one; inelastic when the coefficient is less than one. Elasticity of supply is always a positive number. There are two special cases: the coefficient is zero with a vertical supply curve and infinite with a horizontal supply curve.
2. Determinants: Basic elasticity determinants are the ease of input substitution, length of time, and behavior of costs as output levels change. Supply is more elastic for a given commodity when it is relatively easy to shift the factors of production to another commodity, if the purchaser can vary input usage, when a longer time frame is involved, and when costs of production tend to not rise rapidly as output increases.
IV. INTERACTION OF DEMAND AND SUPPLY
The supply curve intersects the demand curve, producing the equilibrium market price and quantity. An equal increase in both supply and demand will increase market-clearing quantity.
B. Government Price Support Programs
The political process may believe that some industries or resource input fail to receive an equitable distribution of income under the free functioning of the market system. To remedy this, government price support programs dictate a particular price which is usually above the market equilibrium price. At this support price, there will be a greater quantity supplied than demanded. Minimum wage is an example. The surplus in quantity supplied is purchased by the government. Milk and wheat surplus programs are examples of these free market restrictions (and may result in milk lakes and wheat gifts to foreign countries). The affected producers of the surplus benefit while consumers pay higher prices.
C. Government Price Ceiling Programs
The government may set a maximum or ceiling price on a good that is lower than the market equilibrium price. Rent control is a good example. The quantity demanded exceeds the quantity supplied at the dictated price. The government may have to ration the product. Shortages and black markets eventually result from such a free market restriction. The long-term consequence is that the quality of goods subject to ceiling pricing will decrease.
V. PRODUCTION FUNCTION AND COST FACTORS
A. Efficiency of Production
The production function involves producing the quantity demanded by the market. This includes combining resource variable inputs (labor and raw materials) and fixed inputs (managerial capability, equipment and space). The objective is the most efficient use and combination of inputs. The state of technological efficiency (technical and engineering know-how) ultimately determines the maximum amount of physical output a firm can produce with a specific combination of resource inputs.
1. Increasing Returns to Scale: The short-run marginal output exceeds the marginal input. This is often called economies of scale and the short-run average cost of production is decreasing.
a. Marginal Product Increasing: In segment AB, the marginal product curve is increasing and is above the average product curve causing both the average product and the total product to rise. This results because the increased quantity produced has resulted in labor specialization. Specialization promotes efficiency. Also marketing advantages, by-product utilization and volume purchase discounts may add to economic efficiency.
b. Marginal Product Declining: In segment BC, marginal product begins declining for each additional unit of input. Average product continues to rise because the marginal product curve is above the average product curve. Total product continues to increase but at a decreasing rate.
2. Constant Returns to Scale: This condition assumes all resource inputs are variable. The additional output is constant to the input. There are no economies or diseconomies of scale. This is at point C. This is the quantity location of maximum average productivity.
3. Decreasing Returns to Scale: The Law of Diminishing Returns states that the marginal output (increase in total units) eventually decreases as more variable inputs are added to a given number of fixed inputs. Inefficiency has set in. This may also be called diseconomies of scale.
a. Positive Marginal Product: In segment CD in Figure 1-11 of the text, marginal product continues to decline but remains positive. Because the marginal product curve is below the average product curve, average product will decline in this range. Total product continues to increase, at a decreasing rate.
b. Maximum Output: At point D, output is at a maximum. Segment BD is the ideal output range because the marginal product for a unit of input resource is greater than zero and total product is still increasing.
c. Negative Marginal Output: Beyond D, the marginal output of product from a unit of variable resource input is negative; total product is therefore decreasing. Because the marginal product curve is below the average product curve, average product is decreasing as well. Diseconomies may result from bottlenecks, transportation problems and the management difficulties that result from coordinating large enterprises.
4. Management's Decision: Management would prefer to produce in some location within segment BD in figure 1-11 in the text. The optimal point is at C where average productivity is maximized. Management would consider production unacceptable in the segments of AB and DE. In segment AB the firm's capital is not being utilized efficiently. In segment DE marginal output is negative and additional units of variable resource inputs will cause total output to decrease.
B. Family of Costs
Total Costs = Total Fixed Costs + Total Variable Costs
1. Fixed Costs: These costs remain fixed in total over the relevant range of production.
2. Variable Costs: Variable costs vary directly with the level of production.
C. Short-Term Marginal Costs
Marginal costs (MC) are the change in Total Variable Costs in the short-run as one additional unit is produced. Fixed or sunk costs are not considered. Increasing returns to scale usually mean the cost curve will decrease at first. But eventually diminishing returns and/or increasing costs will result from each variable input unit in the short-term. Therefore marginal costs tend to increase as production expands. The entrepreneur should be aware of the relationship. The short-term marginal cost curve is upward sloping to the right.
D. Marginal Revenue Analysis
Marginal revenue (MR) is the change in total revenue derived from the sale of one additional unit. In a pure competitive market environment, one additional unit will not effect the per unit revenue from previous units' sales. But in most imperfect competitive markets there is a point where marginal revenue will begin to decrease.
E. MR - MC Relationship
An entrepreneur looks carefully at the MR and MC relationships facing his firm. As long as marginal revenue exceeds marginal cost (MR > MC), a firm should expand production because the additional gross margin contributes to fixed costs. This will result in a higher net profit or lower net loss. A firm's marginal cost curve in pure competition is thus its short-term supply curve.
F. Long-Term Cost Analysis
In the long term, all input costs become variable in nature. A firm can vary its physical plant size, method of production labor, and other resource inputs. Economies of scale is almost always a factor in lower output ranges as fixed costs are allocated over more units of output; this reduces average cost per unit. Even so, at some point diseconomies turn up the long-term average cost (LRAC) curve. Graphically, the long-run average cost curve equals the low point of all short-run average cost (SRAC) curves and is usually U-shaped.
G. Profit Measurement
Economics recognizes three profit measures. They include:
1. Accounting Profit: This is the GAAP measurement. Revenues are recognized when all transactional events have occurred. Explicit expenses are matched to the period of the associated revenue.
2. Normal Profit: This is the return on the firm's investment which is necessary to keep the venture capital from going elsewhere. This opportunity cost represents the imputed charges of capital and risk taking. This is considered a "cost" of resources from an economic standpoint. Economic cost thus includes the total of all explicit and implicit costs of the firm.
Example: A firm produces 50 units of output during a month in which its total variable production costs are $300, its total fixed production costs are $200, and its normal profits are $100. The firm's average total cost per unit of production in economic terms is
($300 + 200 + 100) / 50 = 600 / 50 = $12
3. Economic Profit: Economic or pure profits are the return in excess of the normal opportunity rate. If the actual return exceeds the return available from other opportunities, a firm will expand production and new entrepreneurs will enter the market. This will increase the supply available and eventually push the market price down. But, when the increase in quantity lowers the price, firms will begin making lower profits (or perhaps incurring losses). Marginally efficient firms will go out of business, and investment capital will flee the industry. This will reduce the quantity brought to market by suppliers and push prices back up. Eventually an equilibrium will be reached at the normal profit level. This will be at the rate of the firm's opportunity cost.
VI. RESOURCE PRICING AND EMPLOYMENT
In addition to the decisions that individual business firms make about output pricing and quantity, they must produce the goods. How well firms do in the production process determines their cost and thus their profits. The less the firm controls the market price, the more it must control costs.
A. Resource Returns
1. Various Input Resources: Land input returns rent; labor returns wages; capital returns interest or dividends. The real return to capital is the nominal return less the inflation rate. Economic rent is the total price paid for land and other natural resources when there is a completely fixed total supply. Because economic rent is higher than is necessary to induce supply of the resource, it is sometimes referred to as "surplus" rent.
2. Resource Price: Industry demand and supply curves for a particular input operate under the same principles we learned previously. These factors determine the equilibrium price and quantity used in the production process.
3. Labor Demand: Factors affecting the demand for labor include the total level of economic activity, the production function discussed above, and the skill level of the labor force. The supply of labor is affected by demographic factors, the financial and personal rewards of working, and the training, education and skill level required for a particular position. The productivity of labor is important because if it is high, it may be possible to raise wages and lower per-unit output costs at the same time.
4. Supply Elasticity: The supply input curve for an individual firm is horizontal for most inputs in the short-run. The supply curve becomes upward sloping as shortages begin to occur. An example would be the aeronautical engineers in Seattle when the Boeing Company is expanding.
5. Time Resource: Time which relates to all inputs has become a precious resource. The lead-time required between product initiation and market delivery (conception, design, production, marketing) is increasingly important. Coordinating time properly minimizes the cost of the production cycle and reduces non-value added costs such as storage or scrap. Quicker inventory turnover will result in lower levels of necessary working capital.
6. Opportunity Cost: This is the return on investment foregone that could have been realized by picking the next best alternative activity or product.
B. Input Demand Factors
A number of general factors affect a firm's input demand for a particular resource.
1. Derived Demand: Consumer demand for the firm's finished products or services create an expectation. Entrepreneurs analyze this factor and bid up the price of the necessary input resources. If demand for the output increases, there will be a shift to the right of the resource input demand curve. The greater the elasticity of product demand, the greater the elasticity of demand for the necessary resource inputs. Therefore, the input demand is derived from the output demand.
2. Technology and Productivity: The higher the technology, the more efficient may be the input. This condition could create a demand for a more technologically advanced resource. Productivity of labor is influenced by the education level, skill level and good health of the labor force. This is now at a 20 year high and allows wage increases without inflation.
3. Substitution: Input prices relative to input price of substitute resources affects the demand for a particular resource. The principle of substitution states entrepreneurs will pick the less expensive substitute. The larger the number of resource substitutes available, the greater will be the elasticity of demand for any particular resource.
4. Relative Profitability: This concerns the magnitude of potential marginal revenue derived from additional sales. The higher the marginal revenue and related profit, the more the demand for the resources necessary to attain it.
5. Materiality: This focuses on the percent of total costs attributable to that particular input. The lower the relative percent, the less the entrepreneur is concerned about the cost of that particular resource. Labor-intensive firms are especially aware of this factor.
6. Other Influences: Outside influences may also affect the input demands for a particular resource. Examples include strong labor unions or license-operating requirements. Governmental interference in the free market such as minimum wages, price controls, rationing, etc. may all influence the resource's input demand.
C. Optimum Usage Quantity
This analysis is similar to the Marginal Revenue (MR) and the Marginal Cost (MC) decisions in pricing output discussed above. Management makes decisions about the quantity and price of resources it purchases from employees and material vendors. Notice that the effect on previous units revenue and cost may effect the total revenue and total cost.
1. Marginal Physical Product: Marginal physical product (MPP) is the change in total physical output resulting from the addition of one unit of variable input while other production factors remain unchanged.
2. Marginal Revenue Product: Marginal Revenue Product (MRP) is the corresponding change in total revenue. A firm's MRP curve equals its resource demand curve.
3. Marginal Resource Cost: Marginal Resource Cost (MRC) is the change in total costs resulting from increasing one unit of input.
4. Decision Factors: As long as the MRP exceeds the MRC a firm should expand its production. But as more units are added, the marginal revenue will tend to decrease and the marginal costs will tend to increase. Where these two measures are equal (MRP = MRC) is the optimum production quantity and maximum efficiency of resource usage.
D. Resource Imperfections
Imperfections exist in supply and demand forces.
1. Minimum Wage: A minimum wage ensures marginal firms don't compensate for their weakness by paying substandard wages. However, it may also encourage firms to use less labor, discontinue uneconomical product lines and increase the use of labor-savings devices; this may hurt minorities and unskilled workers. Minimum wage indexing links the wage rate to a price level index; this and cost-of-living-adjustments (COLAs) may cause inflationary pressure on the economy.
2. Wage-Employment Preference Path: Wage-Employment Preference Path examines the effect of organized labor on the free market. The theory is that if labor input demand curve increases, an increase in quantity should result. However, if demand decreases labor unions will opt for quantity decrease to try and maintain the higher price. This creates a supply curve that is similar to a backward kinked curve.
3. Conditions Favoring Labor Unions: Labor unions will win above-average wage gains under certain favorable conditions. This includes where industry is highly unionized; industry-wide bargaining is in effect; profits are high; work stoppages effect the whole economy; unions control trade entry through apprentice programs. A fertile area for unionization is where the existing wage is less than the marginal value product. Since 1975 overall membership in unions as a proportion of the total labor force has declined because manufacturing jobs have been replaced by service industry jobs. Increasingly labor and management are finding they must form mutual interest partnerships to remain competitive in the world markets.
4. Wage and Price Controls: Government imposed wage and price controls are usually effective to break an inflationary wage-price spiral. But, such controls are inherently unstable, may create shortages, black markets and dislocations of the market. If in place for long, rationing may become necessary.
5. Energy Resource Pricing: At present, energy expenditures constitute a large portion of GDP. Petroleum, coal, solar and hydro-generation sources are limited. Transportation, heating, appliance and industrial use continues to grow. Imported oil from the Organization of Petroleum Exporting Countries (OPEC) cartel provides most of the U.S. non-hydro energy. Market prices will eventually rise and domestic producers may reactivate alternative energy sources development. Consumption will reduce and high mileage vehicles may again become popular.
VII. MARKET STRUCTURE
There are four models of market structures within which an enterprise interacts with competitors. The different market structure models and their characteristics are heavily tested on the CMA/CFM exam. Comparisons between the four models are possible.
A. Perfect or Pure Competition
1. Characteristics - LAPPI
a. Large Number of Players: Numerous independent buyers and sellers compete in the market. Each competitor's actions are assumed to be independent of the other players.
b. Access Free: There is free mobility of resources. New suppliers can easily enter (and leave) the market and the required capital investment is not large. Entrepreneurs will be more prone to commit venture capital to such an industry.
c. Price Takers: No individual seller (or buyer) is large enough to exert any control over the price; each must therefore take the market price. Consumer demand is perfectly elastic at the market price; each seller decides the quantity. There is thus no logical reason to advertise.
d. Perfect Knowledge: All players are assumed to have perfect knowledge about all relevant information and make rational decisions. Buyers maximize the utility derived from their limited income because they have perfect information about prices and products. Firms know exactly what their revenue and costs are. Significant research and development is not necessary.
e. Identical Products: This market model assumes a homogeneous, standardized product and no differentiation in quality perception; buyers, therefore, pick the cheapest brand. Examples include sugar, farm products and Douglas fir lumber.
2. Short-Run Determinants: The supply and demand curves' interaction determines price and output. Short-run equilibrium is shown by Figure 1-15 in the text.
a. Horizontal Demand Curve: The individual firm faces a horizontal (perfectly elastic) demand curve at the market price. Therefore the firm is able to sell all it produces.
b. Profit Maximization: Profit maximization for an individual firm is at that quantity where Marginal Revenue (MR) = Marginal Cost (MC). In the short run, the firm may realize excess profits (or incur losses).
1) In pure competition, MR = Market Price; MC = Unit Variable Cost. Changes in input prices may affect MC. The firm will sell Q1 quantity of goods at a price of P1.
2) If MR exceeds MC, more units will contribute to fixed costs and increase profits or decrease losses.
3) If MC exceeds MR, the firm should close down, because variable costs are not covered.
d. Short-Run Supply Curve: A firm's short-run supply curve is thus the same as the marginal cost curve. Notice that in perfect competition, the MR is the same as the market price. In all other types of market structure the MR curve is below the price axis. Because the MC curve is upward sloping to the right, MR and MC curve will intersect at a higher quantity. Therefore perfect competition produces the greatest rate of output at the lowest cost so resource allocation is optimal.
e. Industry Supply Curve: Add all the firms' individual supply curves to equal the industry supply curve.
f. Government Intervention: The Government supports perfect competition through the Sherman and Clayton Acts which prohibit business combinations or collusion which substantially lessen competition. On the other hand, patent and copyright laws create a barrier to entering an industry and price supports and ceilings for agricultural products override the free market forces.
3. Long-Run Consequences:
a. Profits Attract Competitors: If the industry is highly profitable, existing firms will expand and new entrepreneurs will enter the market. This will increase the supply available and put downward pressure on price.
b. Profits Decrease: If the resulting increase in supply is excessive, the market price may be driven down below that necessary to earn a normal profit. Firms will begin making lower profits (or perhaps incurring losses). Marginally efficient firms will curtail production or leave the industry. This will reduce the quantity brought to market by suppliers and push prices back up.
c. Stabilization: Eventually, price will stabilize at an equilibrium point. This will equal long-run average cost and there will be no economic (excess) profits. Perfect competition, therefore, maintains a lower price and a higher (larger) quantity than other market structures.
B. Monopolistic Competition
1. Characteristics - PEDAL
a. Price Manipulations: Individual firms have some ability to manipulate the market price. Sellers are price searchers. There is some downward slope to the demand curve.
b. Easy Entry: New suppliers may easily enter (and leave) the market. Required capital is not large and there are no government restrictions on entrance.
c. Differentiated Products: While very similar products, there are perceived differences. Examples include breakfast cereal, computers, men's suits and the fast food industry. This produces a broad range of products and gives the firms some degree of price control.
d. Advertising: Non-price competition is usual. Examples include advertising designed to promote tradename distinctions, quality of service, etc.
e. Large Number of Firms: The industry has many players so that each seller acts independently of the others.
2. Elasticity of Demand: Highly elastic demand curve is near the horizon. Price elasticity of demand will depend on the degree of product differentiation and the number of rival firms.
3. Short-Run Determinants: Profit maximization is where MR = MC. The firm may realize excess profits (or losses) in the short run.
4. Long-Run Consequences: In the long-run, production may be at less quantity than that necessary to coordinate with the lowest average unit cost. Therefore, fewer firms could produce total output at less cost (or higher efficiency). Excess profits (losses) are eliminated in the long run.
1. Characteristics - FREEK
a. Few Large Firms: The industry supply is dominated by a small number (usually 5 or less) of large players who supply the major portion of the output. Examples include the OPEC cartel or the airline industry. Notice that this produces a high degree of interdependence between competitors. Duopoly is where there are only two sellers in a given market.
b. Rigid Prices: Prices are not as flexible as in pure and monopolistic competition. Price leadership is usual and covert cooperation is often present. Consumer demand may be cyclical and seasonal. This leads to sticky price changes.
c. Entrance is Difficult: These are barriers to entry. High start-up costs are usually required. Economies of scale may be necessary to operate profitably.
d. Either Differentiated or Standardized Product: The good may be either pure or different from others in the industry.
1) Pure Oligopoly: A pure oligopoly is a homogeneous standardized product, such as gasoline or steel.
2)Differentiated Oligopoly: A differentiated oligopoly includes automobiles and airlines.
3) Advertising: Since the players find price competition undesirable, advertising is used to differentiate one good from another and create brand or name recognition; this gives an established firm an advantage over new market entrants.
e. Kinked Demand Curve: This is a phenomena that is unique to oligopoly. It addresses the slope of the demand curve if the price is raised above the market price.
2. Mutual Interdependence: The industry has only a few players, and they all anticipate all their competitors' next move. For example, oligopolistic firms will consider the expected reactions of their rivals before making a decision to alter price. Collaboration on prices through price leadership and "conscious parallelism" are usual to avoid "price wars". Output may be restricted. Firms in an oligopoly industry can therefore create free-market failures in the same manner as a monopoly.
3. Kinked Demand Curve Diagram: The curve is highly elastic above the market price. Competitors usually go down to meet a price cut but may disregard a price increase. The segment on the demand curve above the "kink" is highly elastic and quantity very responsive to price changes.
D. Pure Monopoly
1. Characteristics - BUTSS
a. Blocked Entry: Industry entrance is closed because of natural conditions or governmental directive. By definition this leads to only one supplier in a given market.
b. Unique Product Without Substitute: There are no close alternatives that are viable for most consumers. Examples include a city's water supply.
c. Tying Ability: The monopolist has significant marketing advantages. This includes the ability to tie new or less desirable goods to the required monopoly good. This may be illegal under the anti-trust laws.
d. Single Firm in Industry: Only one player is at the table in a given market. This high market concentration may mean there is little incentive for a business to innovate, introduce new products, or find and implement new cost-savings technologies; efficiency is not usually maximized. Advertising may also be used to convert buyers from a substitute good (electricity vs. natural gas vs. coal).
e. Significant Ability to Set Prices: A monopolist can implement different business plans by varying prices. The demand curve may be highly inelastic. As compared to pure competition, monopolists usually charge a higher price and produce a lower rate of output. This produces the ability to extract excess profits from the market.
2. Graphical Depiction: Pricing, Quantity and Profit of a monopoly are as shown in Figure 1-18 of the text.
a. Demand Curve: The monopolist's demand curve is the industry's demand curve. The marginal revenue curve is below the demand curve.
b. Profit Maximization: Profit maximization is still where MR = MC. This is not necessarily at the highest price. The output level for a monopolist is where total revenue exceeds total costs by the greatest amount. There is excess profit, less quantity is produced, and an inefficient allocation of resources. The monopolist's profit is the rectangular area of P1 to P2 x 0 to Q1.
c. Higher Price: The restriction on output will force consumers to pay a higher price as compared to pure competition.
3. Governmental Regulation Justifications: A natural monopoly exists because technical conditions and/or economic efficiency promote only one supplier serving a market.
a. Efficiencies Present: Because of economies of scale, a natural monopolist may be able to produce at a lower average cost than two or more firms over the same relevant range of output. Examples include a neighborhood's water, electricity services, and cable television franchises. Regulated monopolies usually have highly inelastic demand curves and a public interest in a stable market.
b. Regulation Necessary: Regulation may be necessary to prevent the monopolist from exploiting its position. In such a situation, a government agency may set the price and quantity decisions normally made by the free market forces. Rates are usually set at a level allowing the monopoly a reasonable return on investment based on the cost of capital. (See also the Sherman and Clayton Acts restraining provisions discussed below for controls placed upon monopolists).
VIII. Structural Integration
Due to a more relaxed federal anti-trust policy and the availability of debt to finance mergers and acquisitions, the number of combinations increased radically in the 1980s and 1990s. Traditional economic analysis recognizes three types of merger combinations.
A. Conglomerate Expansion
A firm purchases or merges with a firm that has no significant overlap in products within its current marketing mix.
1. Advantages: This diversification may provide cyclical stability in sales and earnings. Such investment opportunities in diversified ventures may be less expensive than starting a new business. In addition, a conglomerate merger may provide immediate availability of productive facilities, skilled management and established vendor sources and distribution channels. Greater financial strength and easier acquisition of capital for expansion may follow.
2. Disadvantages: But, at present, there is a growing view that de-diversification may increase productivity as management concentrates their attention on their area of expertise.
B. Horizontal Expansion
A firm merges with a competitor that produces or sells comparable products.
1. Advantages: This may provide for economies of scale and the fuller use of excess production and distribution capacity. In addition, it may allow increased market share and thus more control over pricing decisions.
2. Anti-Trust Consideration: Because the usual effect of horizontal expansion is to restrict competition, there may also be anti-trust implications. (See Chapter 2 for federal statutes controlling this area.)
C. Vertical Expansion
A firm expands its influence within its own industry. This may involve a purchase of an upstream supplier or a downstream distribution outlet.
1. Upstream Advantages: Vertical integration can provide for more certainty and reliability in the input decisions and lessen chances of supply disruptions.
2. Downstream Advantages: Quality standards may more easily be controlled and imposed upon a distributor if it is a part of the company.
3. Competitive Advantages: Such expansion may also create a potential barrier to the entry of competitors into the industry. Overall, vertical expansion usually produces a more eff