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BCOM - Economics 1

Managerial Economics (Regent Business School)

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BCOM - Economics 1

Managerial Economics (Regent Business School)

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BACHELOR OF COMMERCE

ECONOMICS I

BACHELOR OF COMMERCE

ECONOMICS I

MODULE GUIDE

REGENT BUSINESS SCHOOL

including photocopying machines, without the written permission of the publisher.

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BACHELOR OF COMMERCE 1

ECONOMICS I

TABLE OF CONTENTS

INTRODUCTION TO ECONOMICS ................................................................. 3

CHAPTER ONE:

Introduction to Economics ................................................................................ 8

CHAPTER TWO:

Economics Systems ....................................................................................... 26

CHAPTER THREE:

Demand, Supply, and Prices .......................................................................... 57

CHAPTER FOUR:

Changes in Demand and Supply .................................................................... 68

CHAPTER FIVE:

Elasticity ......................................................................................................... 88

CHAPTER SIX:

The Theory of Demand: The Utility Approach .............................................. 103

CHAPTER SEVEN:

Cost of Production ........................................................................................ 109

CHAPTER EIGHT:

Market Structures ......................................................................................... 132

CHAPTER NINE:

Labour Market .............................................................................................. 149

CHAPTER TEN:

Fiscal and Monetary Policy .......................................................................... 161

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CHAPTER ELEVEN:

Aggregate Demand and Aggregate Supply .................................................. 173

CHAPTER TWELVE:

Economic Growth, Unemployment, and Inflation ......................................... 181

CHAPTER THIRTEEN:

The Foreign Sector....................................................................................... 201

LIST OF REFERENCES .............................................................................. 215

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ECONOMICS I

INTRODUCTION TO ECONOMICS

1. Introduction

Welcome to the Bachelor of Commerce Programme and the Economics 1 guide. As

part of your studies, you are required to study and successfully complete a module on

economics.

2. Module Overview

The module, Economics, focuses on an introduction to Economics. Business

professionals across South Africa and globally, play a critical and crucial role in the

country's current economic affairs.

3. How to use the Guide

This module should be studied using the prescribed textbook against sections

presented in this guide. Read about the topic that you intend to study in the appropriate

section before starting to read the textbook in detail. Ensure notes are made as you

work through both the textbook and this module. You will find a list of objectives and

outcomes at the beginning of each section. These outline the main points that you

need to understand when you have completed the section/s. The purpose of this guide

is to help you study. It is important for you to work through all the tasks and self-

assessment exercises as they provide guidelines for examination purposes.

Exercises and questions are listed at the end of each chapter. These allow you to

reflect on the concepts and frameworks in the module and to gauge your current level

of understanding and application. It is recommended that each chapter is studied in

conjunction with the prescribed textbook so you have a solid understanding of the

concepts introduced.

3.1 Essential (Prescribed) Reading

Mohr, P. (2020). Economics for South African Students. 6th ed. Pretoria: Van Schaik

Publishers.

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4. Aim of the Module

This module will introduce you to the theory of economics and aids in forming a solid

understanding of foundational principles within a contemporary South African

background. Theoretical frameworks of supply and demand will be explored, including

the effect of the labour market. This will support your learning aspects of aggregate

demand and supply. Fiscal and monetary policies will be discussed within the South

African context, exploring the effects of unemployment and inflation on economic

growth.

5. Module Specific Outcomes and Chapter Alignment

Upon completion of this module, the student should be able to:

Programme Specific Outcomes:

Chapter Alignment

SO1:

Explain in detail the subject of economics from a

theoretical perspective and apply the basic economic

problem to the first basic economic model

Chapter 1

SO2:

Determine the typical characteristics and economic

arrangement of the world's real economies

Chapter 2

SO3:

Proficiently analyse how buyers and sellers interact

with each other to determine the prices and quantities

of goods and services in different market systems

Chapter 3-4

SO4:

Explain in detail and sufficiently differentiate the

varying measures of elasticity and how it influences

the behaviour of buyers and sellers in a market for a

specific good or service

Chapter 5

SO5:

Adequately gauge the measure of satisfaction that a

consumer gets from buying a good or service

Chapter 6

SO6:

Examine with the required insight the relationship that

exists between inputs used in production and the

resulting outputs and costs for firms characterised

into the main theoretical market structures

Chapter 7

SO7:

Comprehend how firms would be classified into the

different market structures that exist in economic

theory and fully explain their equilibrium positions

according to their various characteristics as per

economic thought

Chapter 8

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Programme Specific Outcomes:

Chapter Alignment

SO8:

Clearly identify and explain the behaviour of labour,

one of the main factors of production and to efficiently

demonstrate the behaviour of this factor of production

in the labour market when it acts as an intermediary

in the buying and selling of an economy’s workforce

Chapter 9

SO9:

Proficiently explain the purpose of fiscal policy and

monetary policy and how these policies are applied in

order to influence the macroeconomic outcomes of a

national economy

Chapter 10

SO10:

Demonstrate a thorough understanding of the

underlying factors affecting the aggregate demand-

aggregate supply model representative of a real

economy

Chapter 11

SO11:

Effectively demonstrate the required level of

knowledge of key macroeconomic challenges against

the background of these challenges also being the

key macroeconomic objectives of a national economy

Chapter 12

SO12:

Demonstrate a basic understanding of the theoretical

notions, principles and protective measures involved

in countries building strong economic links with the

rest of the world

Chapter 13

6. Specific Outcomes and Assessment Criteria

Programme Specific

Outcomes:

Assessment Criteria:

The student should have demonstrated the

ability to:

SO1:

Explain in detail the subject of

economics from a theoretical

perspective and apply the basic

economic problem to the first

basic economic model

Explained all the aspects of the subject of

economics from an acceptable theoretical

viewpoint and applied the elementary

economic challenge to the first basic

economic model

SO2:

Determine the typical

characteristics and economic

arrangement of the world's real

economies

Presented a sound argument of the

distinctive characteristics and economic

systems of the world's real economies with

reference to the production, purchase and

flow of goods and services within an

economy

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Programme Specific

Outcomes:

Assessment Criteria:

The student should have demonstrated the

ability to:

SO3:

Proficiently analyse how buyers

and sellers interact with each

other to determine the prices and

quantities of goods and services

in different market systems

Investigated and evaluated with insight how

the main market participants interrelate with

each other to ascertain the prices and

quantities of goods and services in diverse

market systems

SO4:

Explain in detail and sufficiently

differentiate the varying

measures of elasticity and how it

influences the behaviour of

buyers and sellers in a market for

a specific good or service

Provided a differentiated clarification of the

several categories of elasticity and how it

impacted the actions of buyers and sellers in

a market for a specific good or

service

SO5:

Adequately gauge the measure

of satisfaction that a consumer

gets from buying a good or

service

Successfully measured the amount of utility

that a consumer derives from purchasing a

product or service

SO6:

Examine with the required insight

the relationship that exists

between inputs used in

production and the resulting

outputs and costs for firms

characterised into the main

theoretical market structures

Adequately studied the connection that is

present between inputs used in production

and the resulting outputs and costs for firms

falling into the core theoretical market

structures

SO7:

Comprehend how firms would be

classified into the different market

structures that exist in economic

theory and fully explain their

equilibrium positions according to

their various characteristics as per

economic thought

Described with comprehension how

businesses would be categorised into the

various market structures that prevail in

economic theory and wholly explained their

equilibrium situations according to their

numerous characteristics in terms of

economic standpoints.

SO8:

Clearly identify and explain the

behaviour of labour, one of the

main factors of production and to

efficiently demonstrate the

behaviour of this factor of

production in the labour market

when it acts as an intermediary in

the buying and selling of an

economy’s workforce

Demonstrated evident knowledge of the

economic conduct of labour, whilst

proficiently demonstrated the behaviour of

this factor of production in the labour market

whereby it serves as a medium in the buying

and selling of an economy’s labour

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Programme Specific

Outcomes:

Assessment Criteria:

The student should have demonstrated the

ability to:

SO9:

Proficiently explain the purpose of

fiscal policy and monetary policy

and how these policies are applied

in order to influence the

macroeconomic outcomes of a

national economy

Competently explained the purpose of fiscal

policy and monetary policy and how these

policies function in order to steer the national

economy in a desired direction of economic

welfare

SO10:

Demonstrate a thorough

understanding of the underlying

factors affecting the aggregate

demand-aggregate supply model

representative of a real economy

Provided a comprehensive description and

explanation of the fundamental aspects

influencing the aggregate demand-

aggregate supply model illustrative of an

actual economy

SO11:

Effectively demonstrate the

required level of knowledge of key

macroeconomic challenges

against the background of these

challenges also being the key

macroeconomic objectives of a

national economy

Demonstrated an acceptable level of

theoretical knowledge of key

macroeconomic challenges against the

simultaneous background of these

challenges serving as the main

macroeconomic goals of a national economy

SO12:

Demonstrate a basic

understanding of the theoretical

notions, principles and protective

measures involved in countries

building strong economic links with

the rest of the world

Sufficiently demonstrated an elementary

understanding of the theoretical concepts,

principles and defensive measures involved

in countries building strong economic links

with foreign countries

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CHAPTER ONE:

Introduction to Economics

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Define economics

• Understand the centralised economic challenge of scarcity and choice

• Illustrate scarcity, choice, and opportunity cost: The production possibilities

curve

• Differentiate between microeconomics and macroeconomics

• Identify the key economic role players

• Describe the circular flow within an economy

This chapter provides an introduction to economics, In other words, what Economics

is all about. The introduction of important concepts of scarcity, choice and opportunity

cost, and its relation to the production possibilities curve model are discussed. The

aspects of microeconomics and macroeconomics are also discussed. Further

understanding is garnered on learning that macroeconomics is the study of the

performance, structure, behaviour and decision-making of an economy as a whole.

Discussion of microeconomics is then presented in order to impart to the learner that

this aspect focuses on economic interactions of a specific person, a single entity or a

company.

1.1. Introduction to Economics

Economics is the study of choices that individuals, businesses, governments, and

other stakeholders in society make. Understanding economics can help individuals

answer questions, such as, should Toyota increase its production of motor vehicles?

Should taxes in South Africa be raised or lowered? Should the government prohibit

the sale of alcohol and cigarettes during a global COVID-19 pandemic? Economic

questions like these arise every day because we make choices. These choices are

necessary because each of us faces the economic facts of life known as scarcity. We

all have desires or wants (i.e., maybe a new Ferrari, a huge penthouse, a personal

jet). However, the means to achieve these desires are scarce. Due to having scarce

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resources, we need to make choices. Therefore, we want to use these resources

efficiently. (Mohr, 2020).

Economics can be generally defined as: “the social science that studies the choices

individuals, businesses, governments, and entire societies make as they cope with

scarcity and the incentives that influence and reconcile those choices”. (Mohr, 2020).

Table 1.1: Formal Definitions of Economics.

Source: (Mohr, 2020:3)

1.2. Scarcity, Choice, and Opportunity Cost

Economics is the management of scarcity. There are limited resources to satisfy

everyone's wants. The points below outline the difference between needs and wants.

• Wants: These are human desires for goods and services. Our wants are

unlimited (e.g., we want a huge mansion to live in, or a fancy sports car).

• Needs: These are things we cannot survive without, such as food, water,

shelter, and clothing. These are considered to be necessities.

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Economics can be divided into two parts:

• Microeconomics is the study of choices that individuals and businesses make,

the way these choices interact in markets, and the influence of government on

those choices.

• Macroeconomics is the study of the effects on the national economy and the

global economy of the choices that individuals, businesses, and governments

make. (Mohr, 2020).

Now that we have examined wants, let us examine why we say resources are limited.

There are three types of resources: natural resources (such as agricultural land,

minerals, and fishing resources), human resources (such as labour), and man-made

resources (such as machines). These resources are the means with which goods and

services can be produced. In economics, these resources are called factors of

production.

Factors of production are resources that are the building blocks of the economy. These

include what people use to produce goods and services. In this regard, economists

divide the factors of production into four categories: land, labour, capital, and

entrepreneurship (Econ Ed, 2012).

• Land

The first factor of production is land and anything that comes from the land. This

may be a natural resource to produce goods and services. Examples of land

may include water, oil, copper, natural gas, coal, and forests. Land resources

are the raw materials in the production process. As such, these resources may

be renewable, such as forests, or non-renewable such as oil or natural gas.

Rent is the income that resource owners earn in return for land resources.

• Labour

The second factor of production is labour in order to produce goods and

services. Labour resources include the work done by the waiter who brings your

food at a local restaurant as well as the engineer who designed the bus that

transports you to school. It includes an artist's creation of a painting as well as

the work of the pilot flying the airplane overhead. If you have ever been paid for

a job, you have contributed labour resources to the production of goods or

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services. The income earned by labour resources is called wages and is the

largest source of income for most people.

• Capital

The third factor of production is capital such as machinery, tools and buildings

humans use to produce goods and services. Some common examples of

capital include hammers, forklifts, conveyer belts, computers, and delivery

vans.

• Entrepreneurship:

The fourth factor of production is entrepreneurship. An entrepreneur is a person

who combines the other factors of production - land, labour, and capital - to

earn a profit. Entrepreneurs thrive in economies where they have the freedom

to start businesses and buy resources freely. The payment to entrepreneurship

is profit.

Since resources are limited, it follows that the goods and services with which we can

satisfy our wants are also limited. All individuals and societies are confronted by the

problem of unlimited wants and limited means. They must therefore make choices.

Some wants will be satisfied, but many will be left unsatisfied. In each case, it must be

decided which of the available alternatives will have to be sacrificed. Economic

decisions are all difficult. The fact that we live in a world of scarcity forces us to make

difficult choices (Econ Ed, 2012).

When resources are used to produce a certain good, they are not available to produce

other goods. A decision to produce more of one good, therefore, also means that less

of another good can be produced.

Scarcity must not be confused with poverty. Scarcity affects everyone. The rich are

also subject to scarcity. Even the wealthiest person on earth will have unsatisfied

wants and will have to make economic decisions.

An example (provided below) is how Hendrik Mathi Bela, Anne van der Merwe, and

the South African government were all faced with difficult choices between different

alternatives. This is what the economic problem is all about.

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When we are faced with such a choice, we can measure the cost of the alternative we

have chosen in terms of the alternatives that we have to sacrifice. This is called

opportunity cost.

Example

Anne only must choose between studying and going to the movies; the opportunity

cost of studying would be forgoing a visit to the movies. Likewise, if Hendrik must

choose between a cool drink and chocolate; the opportunity cost of the cool drink

would be the chocolate that he has to sacrifice (assuming that he cannot afford

both). When there are more than two alternatives, the opportunity cost is somewhat

more complicated. We then measure the opportunity cost of a particular alternative

in terms of the best alternative that must be sacrificed.

Source: (Mohr, 2015:5).

The opportunity cost of a choice is the value to the decision-maker of the best

alternative that could have been chosen but was not chosen. In other words, the

opportunity cost of a choice is the value of the best-forgone opportunity. Every time a

choice is made, opportunity costs are incurred.

1.3. Illustrating Scarcity, Choice, and Opportunity Cost:

The Production Possibilities Curve

Scarcity, choice, and opportunity cost can be illustrated with the aid of a production

possibilities curve, also called a production possibilities frontier.

Consider an isolated rural community along the Wild Coast whose main foods are

potatoes and fish. The people have found that by devoting all their available time and

other resources to fishing, they can produce five baskets of fish per working day.

Alternatively, if they spend all their production time gardening, they can produce 100

kilograms (kg) of potatoes per working day. It is possible for them to produce either

five baskets of fish or 100 kg of potatoes, but in each case, the entire production of

the other good must be sacrificed. The only way that the inhabitants can enjoy a diet

that includes both fish and potatoes is by using some of their resources for fish

production and some for potato production. Resources must be shifted from one

production possibility to produce the other.

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Combinations of fish and potatoes in Table 1.2 represent the maximum amounts that

can be produced with all the available resources. If the people decide to produce

Combination E they will be able to produce four baskets of fish and 40 kg of potatoes

per day. However, in producing this combination, they have had to decide not to

produce more fish or more potatoes. In producing four baskets of fish, they have had

to forgo the additional 60 kg of potatoes they could have produced if they had used all

their resources to grow potatoes. Likewise, in the production of 40 kg of potatoes, they

have decided to forgo the extra (5th) basket of fish which they might have produced.

The opportunity cost of producing the 40 kg of potatoes is the basket of fish, and the

opportunity cost of producing the four baskets of fish is the 60 kg of potatoes that has

to be forgone. The community, therefore, has to choose between more potatoes and

less fish, or more fish and fewer potatoes.

Table 1.2: Combinations of Fish and Potatoes

Combination

Fish (baskets)

Potatoes (kgs)

100

Given the available resources, it is impossible to produce more of one good without

decreasing the production of the other good. The different combinations can be

illustrated graphically in a production possibilities curve, as in Figure 1-1. The curve

shows the possible levels of output in an economy with limited resources and fixed

production techniques.

The production possibilities curve indicates the combinations of any two goods or

services that are attainable when the community's resources are fully and efficiently

employed.

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As we move along the production possibilities curve from point A to point B through to

point F, the production of fish increases while the production of potatoes decreases.

To produce the first basket of fish, the community has to sacrifice 5 kg of potatoes

(from 100kg to 95kg). To produce the second basket of fish, the sacrifice is an

additional 10 kg of potatoes (the difference between 95kg and 85kg). To produce the

third basket of fish, an additional 15 kg of potatoes have to be forgone (the difference

between 85kg and 70kg). The opportunity cost of each additional basket of fish,

therefore, increases as we move along the production possibilities curve. This is why

the curve bulges outwards from the origin. The production possibilities curve is a very

useful way of illustrating scarcity, choice, and opportunity cost.

Figure 1.1: Production Possibilities Curve

Source: Mohr (2020:6)

Scarcity is illustrated by the fact that all points to the right of the curve (such as G) are

unattainable. The curve thus forms a frontier or boundary between what is possible

and what is not possible. Choice is illustrated by the need to choose among the

available combinations along the curve. Opportunity cost is illustrated by what we refer

to as the negative slope of the curve, which means that more of one good can be

obtained only by sacrificing the other good. Opportunity cost, therefore, involves what

we call a trade-off between the two goods. Also, note point H in the diagram. This point

denotes 70 kg of potatoes and two baskets of fish. Such a combination is obtainable

but inefficient. Why? Because more potatoes (85 kg) can be produced at C without

sacrificing any production of fish. Alternatively, more fish (3 baskets) can be produced

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at D without sacrificing any production of potatoes. Point G illustrates an unattainable

combination as it is outside and above the curve.

The bulging shape of the curve illustrates increasing opportunity costs: as we move

along the curve, more of the one good has to be sacrificed to obtain an extra unit of

the other good. With a given level of resources and a given state of technology, the

community can produce different combinations of potatoes and fish. But it cannot

move beyond ABCDEF. That is why the curve is sometimes also called the production

possibility boundary or frontier. It indicates the maximum attainable combinations of

the two goods, also called the potential output.

Given the available resources and the current production techniques, a combination

such as that indicated by G is impossible. We only have enough resources to produce

along the line, whilst also being efficient. However, the quantity of available resources

may increase, or production techniques may improve over time. If this happens, it can

be illustrated by a production possibilities curve that shifts outwards. Such an outward

movement illustrates economic growth. (Mohr, 2020).

Bloomenthal (2020) also states that in business analysis, the production possibility

frontier (PPF) is a curve that illustrates the variations in the amounts which can be

produced of two products if both depend upon the same finite resource for their

manufacture. In macroeconomics, the PPF is the point at which a country’s economy

is most efficiently producing its various goods and services and, therefore, allocating

its resources in the best way possible.

Think Point

Economists use PPF’s to demonstrate that an efficient nation produces what it is

most capable of producing and trades with other nations for the rest.

Given the available resources and the current production techniques, a combination

such as that indicated by G is impossible. We only have enough resources to produce

along the line, whilst also being efficient. However, the quantity of available resources

may increase, or production techniques may improve over time. If this happens, it can

be illustrated by a production possibilities curve that shifts outwards. Such an outward

movement illustrates economic growth.

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Consider the case of PPF on a National Scale

As another example, consider the diagram below. Imagine a national economy that

can produce only two goods: wine and cotton. According to the PPF, points A, B,

and C on the PPF curve represent the most efficient use of resources by the

economy.

For instance, producing five units of wine and five units of cotton (point B) is just

as desirable as producing three units of wine and seven units of cotton. Point X

represents an inefficient use of resources, while point Y represents a goal that the

economy simply cannot attain with its present levels of resources.

Figure 1.2: Production Possibilities Curve

Source: (Bloomenthal, 2020)

As we can see, in order for this economy to produce more wine, it must give up

some of the resources it is currently using to produce cotton (point A). If the

economy starts producing more cotton (represented by points B and C), it would

need to divert resources from making wine and, consequently, it will produce less

wine than it is producing at point A.

Moreover, by moving production from point A to B, the economy must decrease

wine production by a small amount in comparison to the increase in cotton output.

But if the economy moves from point B to C, wine output will be significantly

reduced while the increase in cotton will be quite small.

Keep in mind that A, B, and C all represent the most efficient allocation of resources

for the economy. The nation must decide how to achieve the PPF and which

combination to use. If more wine is in demand, the cost of increasing its output is

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proportional to the cost of decreasing cotton production. Markets play an important

role in telling the economy what the PPF ought to look like.

Consider point X on the figure above. Being at point X means that the country's

resources are not being used efficiently or, more specifically, that the country is not

producing enough cotton or wine given the potential of its resources. On the other

hand, point Y, as we mentioned above, represents an output level that is currently

unattainable by this economy.

If there were an improvement in technology while the level of land, labour, and

capital remained the same, the time required to pick cotton and grapes would be

reduced.

Output would increase, and the PPF would be pushed outwards. A new curve,

represented in the figure below on which Y would fall, would show the new efficient

allocation of resources.

Figure 1.3: Production Possibilities Curve: Shift

When the PPF shifts outwards, it implies growth in an economy. When it shifts

inwards, it indicates that the economy is shrinking due to a failure in its allocation

of resources and optimal production capability.

A shrinking economy could be a result of a decrease in supplies or a deficiency in

technology.

An economy can only produce on the PPF curve in theory. In reality, economies

constantly struggle to reach an optimal production capacity. As scarcity forces an

economy to forgo some choice in favour of others, the slope of the PPF will always

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be negative. That is, if the production of product A increases then the production

of product B will have to decrease.

Source: (Bloomenthal, 2020)

1.4. A Discussion on Goods and Services

• Goods are real or concrete items such as property, cars, furniture and clothing.

• Services are abstract items like medical services, legal services, financial

services, the services of an economics lecturer, and the services provided by

public servants.

Student Activity

Complete the following student activity on the “Nature of Services”

The definition of service is “any intangible product, which is essentially a

transaction and is transferred from the buyer to the seller in exchange for some

consideration (or no consideration).

Provide the following examples of types of services:

1. Intangibility:

2. Inconsistency:

3. Inseparability:

4. Storage:

Source: (Toppr.com, 2018).

Economic activity is for the pursuit of satisfying human wants. Wants are satisfied

with goods and services. Goods can be further broken into consumer goods and

capital goods.

• Consumer goods are goods that are used or consumed by individuals or

households (i.e., consumers) to satisfy wants. Examples include food, wine,

clothing, shoes, furniture, household appliances, and motorcars.

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• Capital goods are goods that are not consumed in this way but are used in the

production of other goods. Example, machinery, plant, and equipment used in

manufacturing and construction. Capital goods permit for more production and

satisfaction in the future.

1.5. Different Categories of Consumer Goods

Consumer goods can be classified into three groups: non-durable, semi-durable, and

durable.

• Non-durable goods are goods that are used once only. Examples are food,

wine, tobacco, petrol, and medicine.

• Semi-durable goods can be used more than once and usually last for a limited

period. Examples are clothing, shoes, bedding, and motorcar tyres.

• Durable goods normally last for a number of years. Examples are furniture,

refrigerators, washing machines, dishwashers, and motorcars. Apart from

purchasing goods, individuals and households can also satisfy some of their

wants by purchasing services such as those listed earlier.

Student Activity

1. Consumer goods: Indicate the general lifespan of consumer durable goods.

2. Capital goods (tangible items such as buildings, machinery, and equipment

produced and used in the production of other goods and services): what makes

the service durable?

Indicate examples of consumer durable goods.

1.5.1. Final Goods and Intermediate Goods

Final goods are the goods that are used or consumed by individuals, households,

and firms. A loaf of bread consumed by a household, for example, is a final good.

Intermediate goods, on the other hand, are goods purchased to be used as inputs in

producing other goods. Intermediate goods are thus processed further before they are

sold to end-users. The flour used by a baker is an intermediate good. The baker does

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not consume it. The flour is processed into bread, cake, or something else. However,

when a household purchases flour, it is a final good since the purpose is to consume

it in some form or another. (Mohr, 2020)

1.5.2. Private Goods and Public Goods

A private good is a product that must be purchased to be consumed, and consumption

by one individual prevents another individual from consuming it. A good is considered

to be a private good if there is competition between individuals in order to obtain it.

Also, it is private if consuming the good prevents someone else from consuming it.

Public goods are open for everyone’s use. Consumption by one party does not deter

another party's ability to use it. Many public goods can be consumed at no cost.

Drinking taps in public places would qualify as public goods, as they can be used by

anyone and there is no reasonable possibility of it becoming fully used up. (Chen,

2020)

1.5.3. Economic Goods and Free Goods

Mohr (2020) describes an economic good as a good that is produced at a cost from

scarce resources. Economic goods are, therefore, also called scarce goods. As one

would expect, most goods are economic goods.

A free good is a good that is not scarce and therefore has no price. Air, sunshine, and

seawater at the coast are usually regarded as free goods. Nowadays, however, air

and seawater are often polluted, with the result that clean air and seawater are not

always freely available.

1.5.4. Homogeneous Goods and Heterogeneous Goods

Homogeneous goods are produce that has essentially the same physical

characteristics and quality as similar products from other suppliers. Therefore, one

product can easily be substituted for the other.

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Student Activity

As a shopper, which items in the store of the same type would be homogenous?

Note: If you were shopping to buy the 'best' product, a main difference would be

price. The term is usually applied to agricultural products, and metal and energy-

based commodities.

An example: When you buy a bag of oranges, one is not sure where they are from.

You base your selection on price alone.

In contrast, a heterogeneous product is a product that is readily distinguishable from

competing products and cannot be easily substituted for another. The buyer has to

determine which features are the most important. For example, physical

characteristics for similar items may vary between suppliers. Aspects such as

advertising, brand names, packaging, and design elements, such as colour, size and

shape, influences one’s decision. The price would vary significantly from one product

to another because the suppliers are able to make their product seem different from

the competition.(Michael, 2015)

Figure 1.4: Improvement in Technique for Producing Capital Goods

Source: Mohr (2020, pp.9)

If an improved technique for producing capital goods is developed, it will be possible

to produce more capital goods with the available factors of production. The original

production possibilities curve is illustrated in Figure 1-2 as AB. If we assume that the

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available factors of production and the technique for producing consumer goods

remain the same, the maximum potential production of consumer goods remains at A.

However the maximum potential output of capital goods (if all available resources are

used to produce capital goods) increases from B to C. The new production possibilities

curve is thus indicated by AC. Except at point A, it is now possible to produce more

capital goods and more consumer goods than before. For example, at point Y, more

of both types of good is produced than at point X.

Figure 1.5: Improved Technique in Producing Consumer Goods

Source: Mohr (2020:10)

If an improved technique for producing consumer goods is developed, while the

available resources and the technique for producing capital goods remain the same,

the maximum potential output of consumer goods will increase as shown in Figure 1-

5. The original production possibilities curve is again indicated as AB. But this time,

the maximum potential output of consumer goods increases (from A to D), while the

maximum potential output of capital goods remains unchanged (at B). Again, the

production possibilities curve swivels, but this time on point B rather than on point A.

Except at point B, it is now possible to produce more consumer goods and capital

goods than before, as illustrated, by the movement from point X to point Y.

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Figure 1.6: Increase in the Quantity of the Available Resources for Production.

Source: Mohr (2020:10)

If the amount of available resources (e.g., the number of workers) or productivity of

available resources increase, it will be possible to produce more consumer goods and

more capital goods than before. This can be illustrated by a shift of the original

production possibilities curve (AB) to the right (to EF), as in Figure 1-6. Figures 1-2, 1-

3, and 1-4 all illustrate economic growth.

1.6. Economics is a Social Science

Economics is a social science. In this regard, economics has two important attributes.

Economics studies human activities and constructions in environments with scarce

resources. Economics also uses the scientific method and empirical evidence to build

its base of knowledge.

In evaluating human interactions as it relates to preferences, decision making and

constraints is an important basis of economic theory. The complexity of the dynamics

of human motivation and systems has led to the establishment of assumptions that

form the basis of the theory of consumer and firm behaviour, each of which are used

to model circular flow interactions within the economy.

Economics provides frameworks in order to analyse complex societal interactions,

which includes consumer and firm behaviour.

Economics also allows individual agents to balance expectations. To get an

understanding of the ebb and flow of the economy through dynamic business cycles,

allows for the potential for emotional balance by reminding agents to limit desperation

in downturns and exuberance in expansions. (Lumen, 2019)

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Economists cannot discover regular patterns of behaviour by conducting laboratory

experiments, nor can they test their theories in this way. Economists study the

behaviour of people in a constantly changing environment. They cannot place people

in test-tubes to determine how they will react to any particular change. They cannot

hold other things constant while the impact of one particular change is investigated.

Economists, therefore, have to resort to other methods. (Mohr, 2020)

1.7. Positive and Normative Economics

Another important distinction is between positive and normative economics. A

positive statement is an objective statement of fact. A normative statement involves

an opinion or value judgement. Positive statements can be proven or disproved by

comparing them with the facts. Normative issues can be debated, but they can never

be settled by science or by an appeal to facts.

1.8. Microeconomics and Macroeconomics

The study of economics is usually divided into two parts: microeconomics and

macroeconomics.

In Microeconomics, the focus is on individual parts of the economy. The decisions or

functioning of decision-makers such as individual consumers, households, firms, or

other organisations are considered in isolation from the rest of the economy. The

individual elements of the economy are, figuratively speaking, each put under the

microscope and examined in detail. Examples include the study of the decisions of

individual households (what to do, what to buy, etc.) and of individual firms (what

goods to produce, how to produce them, what prices to charge etc.). It also includes

the study of the demand, supply, and prices of individual goods and services like

petrol, maize, haircuts, and medical services.

Macroeconomics is concerned with the economy as a whole. In macroeconomics,

we focus on the "big picture." We develop an overall view of the economic system,

and we study total or aggregate economic behaviour. The emphasis is on topics such

as total production, income and expenditure, economic growth, aggregate

unemployment, the general price level, inflation, and the balance of payments.

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There are many overlaps with Macroeconomics and Microeconomics. What happens

at the individual (micro) level affects the overall (macro) performance of the economy

and vice versa. Think about the maths equation, 1+2+3+4 = 10. In Microeconomics

we are concerned about 1+2+3+4 (individual components). On the other hand,

Macroeconomics is only concerned with 10 (whole component).

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CHAPTER TWO:

Economics Systems

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Identify the major role players in an open economy

• Describe the mechanics of the circular flow model of a country

• Know the different economy types that exist

• Know the main economic questions of an open economy

Following the main economic central concepts, such as scarcity, choice and

opportunity cost from Chapter 1 leads us to the next three central questions in Chapter

2. It is imperative to understand the aspects of Chapter 2 in order to understand the

basic types of economic systems. The three questions focus on the type of goods and

services being produced and their quantities; how will the goods and services be

produced; whom the goods and services are produced for.

2.1. Introduction to Economic Systems

Three main types of economic systems are then defined and described:

• the traditional system,

• the command system and

• the market system.

Their key features, advantages, and disadvantages are discussed, and the mixed

economic system is also defined.

2.1.1. The Economic Problem

All societies face an economic problem. The problem usually centres on how best to

use limited, or scarce, resources. The economic problem exists as there are less

resources to satisfy the needs and wants of people.

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America’s first Nobel Prize winner for economics, the late Paul Samuelson, is often

credited with providing the first clear and simple explanation of the economic problem

– namely, that in order to solve the economic problem societies must endeavour to

answer three basic questions:

1. What will be produced in a market system?

2. How will it be produced?

3. For whom will the goods and services be produced?

These are the three central questions, which have to be solved in every society.

ECONOMICSONLINE (n.d)

2.2. Economic Systems

An economic system is the mixture of the various agencies and entities that provide

the economic structure that defines the social community. An economic system may

involve production, allocation of economic inputs, distribution of economic outputs,

landlords and land availability, households (earnings and expenditure consumption of

goods and services in an economy), financial institutions, firms, and the government.

Furthermore, an economic system is the set of principles by which problems of

economics are addressed, such as the economic problem of scarcity through

allocation of finite productive resources (Boettke and Heilbroner, 2020)

2.2.1. The Traditional System

The oldest solution to the three central questions is tradition. By this, we mean that the

same goods are produced and distributed in the same way by each successive

generation. In a traditional system, each participant's task and methods of production

are prescribed by custom. Men do what their fathers did. Women do what their mothers

did. People use the same techniques of production as their parents did, and production

is distributed according to long-established traditions.

A traditional economic system provides clear and easy answers to the three central

questions. It is, however, a rigid system, which is slow to adapt to changing conditions

and stubbornly resists innovation. Traditional systems tend to be subsistence

economies. But this is usually not considered a drawback by the participants

themselves. In traditional systems, economic activity is not the first priority. Economic

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activity is usually secondary to religious and cultural values and the desire to

perpetuate the status quo.

Student Activity

1. Indicate examples of the traditional system with regards to land.

2. Challenge how explorative or innovative the traditional system is.

3. Determine to what extent does the close family indulge in traditional systems

and how, provide examples.

2.2.2. The Command System

The second solution to the central questions is the command economy. In a command

system, the participants are instructed what to produce and how to produce it by a

central authority, which also determines how the output is distributed. Because the

economy is governed and coordinated by a central authority, command systems are

also called centrally planned systems.

Central planning is obviously a tremendous task. Decisions have to be taken on how,

where, and for what purpose every natural resource, every labourer, and every capital

good are to be applied. The planners have to determine what consumer goods should

be produced, how to produce them and how they are to be divided among consumers,

how many resources should be allocated to the production of capital goods and how

many to consumer goods, and what types of capital goods should be produced.

Command economies are often described as socialist or communist systems.

Although central planning has been used mostly in socialist or communist systems,

central planning is not necessarily synonymous with socialism or communism.

Student Activity

1. Provide a discussion of the command economies in the role of government. In

your response, indicate countries of strong command and moderate command

with justified examples.

2. Discuss the advantages and disadvantages of command economies.

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2.2.3. The Market System

The market system requires more detailed explanation. In a market system, the

method of coordination is so subtle and intricate that it could not have been invented.

It simply happened. To explain this, we first have to explain what a market is.

Most people think of markets as specific places (or locations) where certain goods are

bought and sold. Most of you have seen a meat market, fish market, vegetable market,

fruit market, or flea market in action. These markets all have particular venues. But a

market does not require a specific location.

A market is any contact or communication between potential buyers and potential

sellers of a good or service. This contact can be personal, or it can take place by

means of a telephone, a fax machine, a computer, a smartphone, newspaper

advertisements, or any other means. Any institution or mechanism which brings

potential buyers ("demanders") and prospective sellers ("suppliers") of particular

goods and services into contact with each other is regarded as a market. Markets can

be local, regional, national, or international. The corner cafe and a spaza shop are

examples of local markets. The JSE is a national market where shares are traded. The

London gold market is an example of an international or world market. When we

explain how markets work, in the rest of this guide, we shall often use concrete

examples of markets with a specific location, such as fruit and vegetable markets.

For a market to exist, the following conditions have to be met:

• There must be at least one potential buyer and one potential seller of the

good or service

• The seller must have something to sell

• The buyer must have the means with which to purchase it

• An exchange ratio-the market price-must be determined

• The agreement must be guaranteed by law or by tradition

Mohr and Fourie (2007)

A market system is one in which individual decisions and preferences are

communicated and coordinated through the market mechanism (i.e., the mechanism

which meets the conditions listed above). The most important elements of this

mechanism are market prices. Market prices are signals or indices of scarcity, which

indicate to consumers what they have to sacriﬁce to obtain the goods or services

concerned. At the same time, market prices also indicate to the owners of the various

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factors of production how these factors can best be employed. However, the types of

goods and services produced also depend on the distribution of income – the

consumers with the most "money votes" have the largest impact on demand, market

prices, and the structure of production. They, therefore, dominate the outcome of the

market processes.

Market systems are often called capitalist systems. Like socialism, capitalism refers to

a particular type of ownership of the factors of production. Whereas most factors of

production in a socialist system are owned by the state (or by society at large), a

capitalist system is characterised by private ownership. Market systems are, however,

not necessarily capitalist systems. The market mechanism can also be used in

socialist systems. It is thus possible to have market socialism. But just as the command

mechanism tends to be used primarily in socialist systems, the use of the market

mechanism tends to coincide with the capitalist system of ownership.

Market mechanism works like an invisible hand that coordinates the selﬁsh actions of

individuals to ensure that everyone is better off. Let us take a closer look at how this

is achieved.

2.3. Three Central Questions

2.3.1. What will be produced in a market system?

The answer is those goods and services that consumers are willing to spend their

income on and which can be supplied proﬁtably. Goods that consumers do not want

will not be produced. If some uninformed business person happens to produce

unwanted goods, he or she will incur losses and cease to produce the goods in

question. Only those goods which can be produced and sold proﬁtably will continue to

be produced.

2.3.2. How will it be produced?

In a market system, producers are forced to combine resources in the cheapest

possible way (for a particular standard or quality). Their decisions on the combination

of factors of production are governed by the prices of the various factors and their

productivity.

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2.3.3. For whom will the goods and services be produced?

In a market system, the goods and services go to those who have the means to

purchase them. This, in turn, is linked to the production process. Production generates

income, and free marketeers argue that in a pure market system, the income earned

will reﬂect the value placed on each person's resources. In other words, they argue

that there is a direct link between what you put into the system and what you get out

of it. Exceptions arise only if a society, through its government, chooses to assist

certain individuals and groups, for example, the handicapped and the elderly.

Competition is an important feature of market capitalism. It occurs on each side of

the market, that is, among suppliers (sellers) or among buyers (consumers).

Competition should not be confused with negotiation, which occurs between buyers

and sellers, that is, across the different sides of the market. Competition among sellers

protects consumers against exploitation and promotes efﬁciency and growth. Such

competition creates order among suppliers. The successful ones are rewarded in the

form of proﬁt while the unsuccessful ones make losses and are eliminated.

Unfortunately, competition is not always free and fair. Most markets in the real world

are characterised by imperfect competition (Mohr, 2020).

Student Activity

1. Research the five elements that are needed for a market to work.

2. Read up on Rodrik (2000:5-10) who has identified 5 non-market institutions that

are needed for markets to perform.

In Table 2.1 the elements identified by McMillan and Rodrik in the preceding two

bulleted lists are compared.

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Table 2.1: Comparison of McMillan’s five elements with Rodrik’s non-market

institutions

Source: (Cunningham, 2011)

2.4. The South African Mixed Economy

The South African economy is a mixed economy in which private property, private

initiative, self-interest, and the market mechanism all play an important role. The South

African economy is, however, also characterised by a substantial degree of

government intervention. In this section, we take a brief look at South Africa's mixed

economy. In pure market capitalism, all factors of production are privately owned.

2.4.1. The Men Behind the Systems: Smith, Marx, and Keynes

Adam Smith (1723–1790)

Smith transformed the subject into a science who ﬁrst provided a detailed intellectual

justiﬁcation for free markets, both domestically and internationally. He is, therefore,

universally regarded as the intellectual father of the market system and of capitalism.

As the title of his book indicates, Smith's primary aim was to ﬁnd the sources of the

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wealth of nations.

Smith said that the purpose of economic activity is to satisfy human wants. To him,

therefore, the wealth of a nation consisted of the annual production of goods that can

be used to satisfy human wants. In other words, he emphasised the importance of

total output or national product.

As far as the sources of wealth (or the national product) are concerned, Smith

emphasised the importance of three interrelated concepts: the division of labour, free

trade, and a limited role for government.

Karl Marx (1818–1883)

Marx was a political scientist, historian, sociologist, and economist. The central theme

of his work was the historical evolution of institutions. In particular, he regarded

capitalism as a speciﬁc and temporary form of social organisation. He argued that

capitalism was self-destructive and that it would be replaced by a classless system

in which there would be no private property.

His argument was briefly as follows- Labour is the source of all value. The value of

every commodity ultimately depends on the labour embodied in it. Workers, however,

are only paid enough to survive (i.e., a subsistence wage). Capitalists extract surplus

value from the workers since the value of the workers' contribution exceeds the

amount they receive in wages. The primary aim of capitalists is to increase this

surplus-value. They attempt to achieve this by employing more machinery and

equipment. This increases total production but causes technological unemployment,

which Marx called the industrial reserve army of the unemployed. Unemployment

succeeds in keeping wages down but cannot create surplus value. Surplus value can

only be created by the employment of labour.

John Maynard Keynes (1883–1946)

Keynes main message was that the aggregate level of economic activity is

determined by the aggregate demand for goods and services. This was directly in

contrast to the idea of the classical economists that total production (or aggregate

supply) would create its own demand. This was called Say's law, after the French

economist Jean- Baptiste Say.

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2.4.2. Production, Income, and Spending

Economics is essentially concerned with what to produce, how to produce it, and

how to distribute the products between the various participants. Note that the focus

is on production. It stands to reason, therefore, that the total production of goods and

services is of major concern to economists. But production is not pursued for its own

sake. The aim is to use or consume the products to satisfy human wants. The logical

sequence is, therefore, as follows: production creates income (earned in the

production process by the various factors of production), and this income is then

spent on purchasing the products.

The sequence contains three major elements: production, income, and spending. In

practice, of course, everything is happening at the same time: production occurs,

income is earned, and all or part of the income is spent on buying the goods and

services that are available. In other words, there is a continuous circular ﬂow of

production, income, and spending in the economy.

Figure 2.1: The three major ﬂows in the economy

Source: Mohr (2020:53)

Figure 2.1 highlights the Production, Income, and Spending which are all flows. To

understand what this means, we have to distinguish between stocks (which are

measured at a particular point in time) and flows (which are measured over a period).

To illustrate this, consider the level of water in a dam. The level of the water in a dam

can only be measured exactly at a particular point in time. For example, at 00:00 on

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25 April 2014, the level of the Hazelmere dam was at 95.8% of its capacity. This kind

of variable, which can only be measured at a particular point in time, is called a stock

variable, or simply a stock. The ﬂow of water into the dam, on the other hand, can

only be measured over a period, that is, as a rate, irrespective of how short such a

period might be. Thus, the ﬂow into the Hazelmere dam can be expressed as so

many cubic metres of water per second, per minute, per hour, or per day. For

example, on 25 April 2014, the inﬂow into the Hazelmere dam was measured at 88

cubic metres per second. This kind of variable, which can only be measured over a

period, is called a flow variable or simply a flow.

Production, income, and spending all fall into this category – they are all ﬂows which

can only be measured over a period. In practice, the total production, income, and

spending in the economy are measured quarterly, but the main interest is in the

annual levels of production, income, and spending.

2.4.3. Sources of Production: The Factors of Production

1. Natural Resources (Land)

Natural resources (sometimes called land) consists of all the gifts of nature. They

include mineral deposits, water, arable land, vegetation, natural forests, marine

resources, other animal life, the atmosphere, and even sunshine. Natural

resources are ﬁxed in supply. Their availability cannot be increased if we want

more of them. It is, however, often possible to exploit more of the available

resources. For example, new mineral deposits are still being discovered and

exploited every year. But once they are used, they cannot be replaced. We,

therefore, refer to minerals as non-renewable or exhaustible assets.

As with all other factors of production, both the quality and the quantity of natural

resources are important. Some countries cover a vast area, but the land is of

limited value. A desert, for example, has little or no agricultural value. But it may

contain valuable mineral deposits. Some countries have a relatively small

geographical area but a plentiful supply of arable land and minerals.

The situation can also vary within a country. For example, in South Africa, there

are large areas with little or no agricultural or mineral value. But there are also

areas that are rich in minerals or arable land. Because natural resources are in

ﬁxed supply, the rate at which they are exploited is often a cause of concern.

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Nowadays, environmentalists are extremely concerned about pollution and the

destruction of natural resources such as rain forests.

2. Labour

Goods and services cannot be produced without human effort. Labour can be

deﬁned as the exercise of human mental and physical effort in the production of

goods and services. It includes all human effort exerted with a view to obtaining

a reward in the form of income. The efforts of gold miners, rubbish collectors,

professional boxers, civil servants, engineers, and university lecturers are all

classiﬁed as labour.

The quantity of labour depends on the size of the population and the proportion

of the population that is able and willing to work. The latter, in turn, depends on

factors such as the age and gender distribution of the population. The proportion

of children, women, and elderly people all affect the available quantity of labour,

which is called the labour force.

The quality of labour is even more important than the quantity of labour. The

quality of labour is usually described by the term human capital, which refers to

the skill, knowledge, and health of the workers. Education, training, and

experience are all important determinants of human capital.

3. Entrepreneurship

The availability of natural resources, labour, and capital is not sufﬁcient to ensure

economic success. These factors of production have to be combined and

organised by people who see opportunities and are willing to take risks by

producing goods in the expectation that they will be sold.

An entrepreneur is the driving force behind production. Entrepreneurs are the

initiators, the people who take the initiative. They are also the innovators, the

people who introduce new products and new techniques on a commercial basis.

And they are the risk-bearers, the people who take chances. They do this

because they anticipate that they will make proﬁts. But they may also suffer

losses and perhaps bankruptcy.

The entrepreneur is more than a manager. The entrepreneur is dynamic, a

restless spirit, an ideas person, a person of action who has the ability to inspire

others. Because entrepreneurship is such an important factor of production, a lot

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of research has been done to identify the characteristics of successful

entrepreneurs.

Entrepreneurship is thus an important economic force. In countries where

entrepreneurship is lacking, the government is sometimes forced to act as an

entrepreneur in an attempt to stimulate economic development.

4. Technology

Technology is sometimes identiﬁed as a ﬁfth factor of production. At any given

time, a society has a certain amount of knowledge about the ways in which goods

can be produced. When new knowledge is discovered and put into practice, more

goods and services can be produced with a given amount of natural resources,

labour, capital, and entrepreneurship. If this happens, we say that technology

has improved.

The discovery of new knowledge is called invention, while the incorporation of

this knowledge into actual production techniques and products is called

innovation. The wheel, the steam engine, and the modern computer are all

examples of important inventions. For these inventions to be used in actual

production, new machines (i.e., capital goods) have to be developed. In other

words, the inventions have to be embodied in capital. The application of

inventions also requires entrepreneurs to identify the opportunities and exploit

them. Thus, while technology is important, it can be argued that it forms part of

capital and entrepreneurship. In this book, we, therefore, do not deal with it as a

separate factor of production.

5. Money is not a Factor of Production

Money is often regarded as the key to everything else. People frequently say,

"money can buy anything" or "money is power." Money is important, but it is not

a factor of production. Goods and services cannot be produced with money. As

we explain in more detail later, money is a medium of exchange. Money can be

exchanged for goods and services. Money is, therefore, something that facilitates

the exchange of goods and services. But money cannot be used to produce

goods and services. To produce goods and services, we need factors of

production, such as natural resources, labour, and capital.

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6. The Choice of Technique

The question of how the goods and services should be produced essentially

involves choosing the best methods of production to produce various goods and

services. Frequently, various techniques are available to produce a particular

good. For example, a dam or a road may be built with large machines and

relatively little labour, or it may be built with less sophisticated equipment and

more labour.

When the production process is dominated by machines, we talk about capital-

intensive production. On the other hand, if the emphasis is on labour, the

technique is labour intensive. The appropriate choice of technique will depend

on the availability and quality of the various factors of production as well as their

relative cost. In a rural community that does not have access to capital goods

such as tractors, there may be no option but to use unsophisticated equipment

and a lot of physical effort to produce food or other goods. However, in the

modern economy, where different options are available, the choice of technique

will depend, inter alia, on the relative prices of the factors of production (e.g.,

wages and interest rates).

2.4.4. Sources of Income: The Remuneration of the Factors of Production

As indicated earlier, income is generated through production. The only way in which

the total income in the economy can be raised is by increasing production. Individuals

may, of course, beneﬁt at the expense of other individuals. For example, if Jabu wins

the lottery, he beneﬁts, but at the expense of all those who bought tickets and won

nothing. However, for the economy at large, income can be increased only by

producing more. Total income and total production are two sides of the same coin.

Broadly speaking, there are four types of income, each associated with a different

factor of production. The remuneration of natural resources (or land) is called rent.

Wages and salaries are the remunerations of labour, while the remuneration of

capital is called interest. Finally, profit is the remuneration of entrepreneurship.

The total income in the economy thus consists of rent, wages and salaries, interest

and proﬁt, and the value of total income is identically equal to the value of total

production.

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2.4.5. Sources of Spending: The Four Spending Entities

There are four basic sources of spending in the economy: households, ﬁrms, the

government, and the rest of the world (the foreign sector). We now deal in turn with

each of these entities.

1. Households

A household can be deﬁned as all the people who live together and who make

joint economic decisions or who are subjected to others who make such decisions

for them. A household can consist of an individual, a family, or any group of people

who have a joint income and make decisions together. Every person in the

economy belongs to a household.

The household is the basic decision-making unit in the economy. Members of

households consume goods and services to satisfy their wants. They are,

therefore, called consumers. The act of using or consuming goods and services

is called consumption. The total spending of all households on consumer goods

and services is called total or aggregate consumption expenditure, or simply total

consumption. We use the symbol C to indicate total consumption or consumer

spending in the economy. (Note that a symbol is merely an abbreviation or

shorthand for a concept or a variable)

Because households are the basic units in the economy, we often use the term

households when we refer to individuals or consumers. In other words, the terms

households, individuals, and consumers are used interchangeably. In a market

economy, it is households or consumers who largely determine what should be

produced.

In a mixed economy, most of the factors of production are owned by households.

Labour is obviously owned by the members of households. Many of the other

means of production, such as capital goods, are also owned by individuals. For

example, even large business concerns like Anglo American, Sanlam, and Pick

n Pay are owned by their shareholders. The factors of production of these

companies are, therefore, ultimately owned by individuals or households.

Although households own the factors of production, these factors cannot satisfy

human wants directly. Households, therefore, sell their factors of production

(labour, capital, etc.) to ﬁrms that combine these factors and convert them into

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goods and services. In return for the factors of production that they supply, the

households receive income in the form of salaries and wages, rent, interest, and

proﬁt. This income is then used to purchase consumer goods and services that

satisfy their wants.

In economic analysis, we assume that consumers are rational. By this, we mean

that households always attempt to maximise their satisfaction, given the means

at their disposal.

2. Firms

The next component of the mixed economy is the ﬁrm. A ﬁrm can be deﬁned as

the unit that employs factors of production to produce goods and services that are

sold in the goods markets. Firms are the basic productive units in the economy.

A ﬁrm is actually an artiﬁcial unit. It is ultimately owned by or operated for the

beneﬁt of one or more individuals or households. As mentioned above, even large

ﬁrms are ultimately owned by their shareholders. Firms can take different forms.

Whereas households are engaged in consumption, ﬁrms are engaged primarily

in production. Firms are the units that convert factors of production into the goods

and services that households desire. Firms are therefore the buyers in the factor

markets and the sellers in the goods markets. In a market economy it is ﬁrms

which largely decide how goods and services will be produced.

Firms, like households, are also rational. By this we mean that ﬁrms always aim

to achieve maximum proﬁt. Profit is the difference between revenue and cost.

When analysing the decisions of ﬁrms, we ignore the differences between

different types of ﬁrms. This enables us to treat the ﬁrm as the basic decision-

making unit on the production or supply side of goods markets.

One of the factors of production purchased by ﬁrms is capital. As explained

earlier, capital goods are man-made factors of production, such as machinery and

equipment, which are used to produce goods and services. The act of purchasing

capital goods is called investment or capital formation, which is denoted by the

symbol I. Whereas households are responsible for spending on consumer goods

(C), ﬁrms are responsible for spending on capital goods (I).

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3. The Government

The third main source of spending in the economy is government. Government is

a broad term that includes all aspects of local, regional (or provincial) and national

government. In economics, we often refer to the public sector, which includes

everything that is owned by government, as the representative of the people.

Government includes all politicians, civil servants, government agencies, and

other bodies belonging to or under the control of government. It, therefore,

includes the President, cabinet ministers, provincial premiers, mayors, everyone

working for central government, provincial governments and municipalities, and

public corporations such as Eskom, Transnet, and the South African Reserve

Bank.

In their ofﬁcial capacities, the President, the Minister of Finance, all other

politicians, and all civil servants are part of the government sector, but in their

private capacities they are all members of households as well. When they decide

which goods to consume, they are driven by the same motives as any other

individual or household, but in their ofﬁcial capacities they are supposed to serve

the community at large.

Government also purchases factors of production (primarily labour) from

households in the factor market and also purchases goods and services from

ﬁrms in the goods market. In return, government provides households and ﬁrms

with public goods and services such as defence, law, and order, education, health

services, roads, and dams. These goods and services are ﬁnanced mainly by

levying taxes on the income and expenditure of households and ﬁrms.

Government also transfers some of its tax revenue directly to needy people such

as old-age pensioners. Government's economic activity thus involves three

important ﬂows:

• Government expenditure on goods and services (including factor

services)-this is usually denoted by the symbol G.

• Taxes levied on (and paid by) households and firms-taxes are usually

represented by the symbol T.

• Transfer payments, that is the transfer of income and expenditure from

certain individuals and groups (e.g., the wealthy) to other individuals and

groups (e.g., the poor).

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4. The Foreign Sector

The fourth major sector to consider is the rest of the world, which we call the foreign

sector. The South African economy has always had strong links with the rest of the

world. The South African economy is thus an open economy. Many of the goods

produced in South Africa are sold to other countries, while many of the consumer

and capital goods consumed and used in South Africa are produced in the rest of

the world. In addition, many foreign companies operate in South Africa, while some

South African firms also operate elsewhere. The various flows between South

Africa and the rest of the world are summarised in the balance of payments.

The foreign sector consists of all countries and institutions outside the country's

borders. The flows of goods and services between the domestic economy and the

foreign sector are exports, which we denote with the symbol X, and imports,

which we denote with the symbol Z.

Exports (X) are goods that are produced within the country but sold to the rest of

the world.

Imports (Z) are goods that are produced in the rest of the world but purchased for

use in the domestic economy. South Africa's exports consist mainly of minerals,

while the country's imports are mainly capital and intermediate goods that are used

in the production process.

2.4.6. Putting Things Together: A Simple Diagram

Figure 2.2: The Different Components of Production, Income, and Spending

Source: Mohr (2020: 61)

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Figure 2.2 above shows that production is created by the factors of production (natural

resources, labour, capital and entrepreneurship). These factors earn income (rent,

wages and salaries, interest and profit). Spending is done by households, firms,

government and the foreign sector (C + I + G + X – Z).

2.4.7. Illustrating Interdependence: Circular Flows of Production, Income, and

Spending

1. Households and Firms

Households and ﬁrms interact via the goods market and the factor market. The

interaction may be illustrated with the aid of a simple diagram, called the circular flow

of goods and services. In Figure 2.3, we show the households, the ﬁrms, the goods

market, and the factor market. The households offer their factors of production for sale

on the factor market where these factors are purchased by the ﬁrms. The ﬁrms

combine the factors of production and produce consumer goods and services. These

goods and services are offered for sale on the goods market, where they are

purchased by households. Figure 2.3 shows the ﬂow of goods and services and

factors of production between households and ﬁrms. The interaction between

households and ﬁrms can also be illustrated by showing the circular flow of income

and spending, as in Figure 2.4. The ﬂow of income and spending is usually a

monetary

flow, and its direction is opposite to the ﬂow of

goods and services. Firms purchase

factors of production in the factor market. This spending by ﬁrms represents the

income (wages, salaries, rent, interest and proﬁt) of the households. The households,

in turn, spend the income by purchasing goods and services in the goods market. The

spending by households represents the income of the ﬁrms.

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Figure 2.3:

The Circular Flow of Goods and Services

Source: Mohr (2020:62)

Households sell their factors of production to ﬁrms in the factor market. The ﬁrms

transform these factors into goods and services which are then sold to households in

the goods market.

Figure 2.4:

The Circular Flow of

Income and Spending

Source: Mohr (2020:63)

Firms purchase factors of production in the factor market. Their spending represents

the income of the households (i.e., the sellers of the factors of production). Households

spend their income in the goods market on purchasing goods and services. Their

spending represents the income of the ﬁrms.

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2. Adding the

Government

As mentioned earlier, government's economic activity involves three important ﬂows:

government spending G, taxes T and transfer payments. Unlike government spending

and taxes, transfer payments do not directly affect the overall size of the production,

income, and expenditure ﬂows. We, therefore, focus only on government spending

and taxes. Government spending G constitutes an addition or injection into the ﬂow of

spending and income, while taxes T constitute a leakage or withdrawal from the

circular ﬂow of income between households and ﬁrms. The various links between

government, on the one hand, and households and ﬁrms, on the other, are illustrated

in Figure 2.5.

Figure 2.5: The Government in the Circular Flow of Production, Income, and Spending

Source: Mohr (2020:63)

The government purchases factors of production (mainly labour) from households in

the factor market, and goods from firms in the goods market. Government provides

public goods and services to households and firms. Government spending is finances

by taxes paid by households and firms.

3. Adding the Foreign Sector

As mentioned earlier, the spending on exports originates in the rest of the world.

Exports thus constitute an addition or injection into the circular ﬂow of income and

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spending in the domestic economy. In the case of imports, the production occurs in

the rest of the world, while the spending originates in the domestic economy.

Imports thus constitute a leakage or withdrawal from the circular ﬂow of income and

spending in the domestic economy. As in the other cases, the ﬂow of income and

spending is in the opposite direction to the ﬂow of goods and services. We concentrate

on the ﬂow of income and spending between the domestic economy and the foreign

sector rather than on the ﬂow of goods and services. This ﬂow of income and spending

is shown in Figure 2.6.

Figure 2.6: The Foreign Sector in the

Circular Flow of Income and Spending

Source: Mohr (2020:64)

Figure 2.7: Financial Institutions in the

Circular Flow of Income and Spending

Source: Mohr (2020:64)

Households and ﬁrms do not spend all their income. Part of their income is saved.

The saving ﬂows to the ﬁnancial sector, which then lends funds to ﬁrms to ﬁnance

investment spending.

2.4.8. Financial Institutions in the Circular Flow of Income and Spending

Financial institutions include banks such as Standard Bank and Nedbank, insurance

companies such as Old Mutual and Sanlam, pension funds such as the Mine

Employees Pension Fund, and the JSE. These institutions are not directly involved in

the production of goods. They act as links between households or ﬁrms with surplus

funds and other participants that require funds, for example, ﬁrms that wish to expand

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their activities. In this regard, one can distinguish between surplus units (i.e., those

who are in a position to save because they spend less than they earn) and deficit

units (i.e., those who require funds because their spending exceeds their income).

To indicate the position of ﬁnancial institutions or the financial sector in the economy,

we use a simple circular ﬂow that excludes government and the foreign sector.

Households and ﬁrms who do not spend all their income during any particular period

(i.e., surplus units) save some of their income. We use the symbol S to indicate

saving. As far as households are concerned, the decision to save is a decision not to

consume. In other words, saving can be deﬁned as the act of not consuming.

Likewise, ﬁrms can also save by not spending all their income. When saving occurs,

there is a leakage or withdrawal from the circular ﬂow of income and spending.

Saving is channelled to ﬁnancial institutions, for example, in the form of saving

deposits with banks. These funds are then available to ﬁrms that wish to borrow to

expand their productive capacity (i.e., deﬁcit units). Firms expand their productive

capacity by purchasing capital goods such as machinery and equipment. Recall that

this is called investment (I). When ﬁrms purchase capital goods, that is, when they

invest, there is an addition or injection into the circular ﬂow of income and spending.

The main function of the ﬁnancial sector is, therefore, to act as a funnel through which

saving can be channelled back into the circular ﬂow in the form of investment

spending.

In Figure 2.8, we show the circular ﬂow of income and spending between households,

ﬁrms, and the ﬁnancial sector. The ﬁnancial sector acts as an intermediary between

those who save and those who wish to invest. Households and ﬁrms channel their

savings to the ﬁnancial sector, which then lends the funds to those ﬁrms that wish to

borrow to invest. Saving is a withdrawal or leakage from the circular ﬂow, whereas

investment is an addition or injection. This also points to a connection between the

expansion of the production capacity (through investment) and the decision to refrain

from spending on consumer goods (saving).

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Everything Together

Figure 2.8: The Major Elements of the Circular Flow of Income and Spending

Source: Mohr (2020:65)

This ﬁgure summarises the essence of the previous circular ﬂow diagrams. The basic

ﬂow is between households and ﬁrms. This represents consumption expenditure (C).

Saving (S), taxes (T), and imports (Z) are all leakages from the circular ﬂow.

Investment spending (I), government spending (G), and exports (X) are all injections

into the circular ﬂow.

In this section, the main ﬂows and the four sectors have been combined to construct

a number of pictures of how the main elements of the economy ﬁt together. All the

details were not included in every picture. Many other possible pictures can,

therefore, also be constructed. It is a combination of Figures 2.6, 2.7 and 2.8, and

summarises most of the important concepts introduced in this chapter.

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Student Activity Based on Chapter 1-2

These questions were adapted from

http://thinus.weebly.com/uploads/3/0/6/3/30633117/economics_5_mcq_c3_question

s_only.doc.

Answer the following questions by selecting the appropriate answer from the list

below.

Question 1

Simple economies can be described in terms of three major economic flows.

These are:

A. income, spending and saving.

B. spending, production and saving.

C. income, saving and production.

D. income, spending and production.

E. income, spending and net exports.

Question 2

The two major market types in the simple circular flow of income and expenditure

are:

A. public markets and private markets.

B. free markets and regulated markets.

C. factor markets and foreign exchange markets.

D. goods markets and service markets.

E. goods markets and factor markets.

Question 3

Complete the following statement. Households sell their ____________ in the

__________ market. They then use their income to buy __________ in the

__________ market.

A. goods; goods; factors of production; factor

B. factors of production; factor; goods; goods

C. goods; factor; factors of production; goods

D. factors of production; goods; goods; factor

Question 4

Which of the following would not be viewed by economists as a firm?

A. The University of South Africa

B. Pizza Hut

C. Spoornet

D. The Consumer Council

E. A cell phone service provider such as MTN

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Question 5

Which one of the following statements is incorrect?

A. The three major flows in the economy are total production, total income and total

spending.

B. There are two sets of markets in a simple economy: goods markets and factor

markets.

C. In the simple circular flow of economic activity, “real” flows of goods and factors,

and financial flows, move in opposite directions.

D. Firms are buyers in goods markets and sellers in factor markets, while households

are buyers in factor markets and sellers in goods markets.

E. Firms are the largest purchasers of capital goods.

Question 6

In the simple circular flow of economic activity, goods and services flow via:

A. factor markets to goods markets.

B. factor markets from households to firms.

C. goods markets from households to firms.

D. factor markets from firms to households.

E. goods markets from firms to households.

Question 7

In the circular flow of economic activity, ________ households in ________

markets represents ________ firms. Taxes and imports represent ________ the

circular flow.

A. expenditure by; goods; income to; injections into

B. expenditure by; factor; income to; withdrawals from

C. income to; factor; expenditure by; withdrawals from

D. income to; goods; expenditure by; injections into

E. expenditure by; factor; income to; injections into

Question 8

In the circular flow of income and spending in South Africa, ________ firms in the

factor market becomes ________ households, while ________ households in the

goods market becomes ________ firms. Expenditure by foreigners on South

African products constitutes ________ the circular flow.

A. income to; spending by; income to; spending by; a leakage from

B. income to; income to; spending by; spending by; an injection into

C. spending by; income to; spending by; income to; an injection into

D. spending by; spending by; income to; income to; a leakage from

E. production of; spending by; production of; income to; a leakage from

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Question 9

In the context of the circular flow of economic activity, which of the following would

NOT be a traditional activity of the government?

A. Purchases of labour services from households.

B. Purchases of capital goods from firms.

C. Provision of public goods and services.

D. Transfers of tax revenues to low-income groups or regions.

E. Sales of consumer goods to foreign buyers.

Question 10

In the circular flow of income and spending, ie the basic flow of income and

spending between households and firms supplemented by the foreign, financial

and government sectors:

A. exports are leakages from the circular flow.

B. investment is a leakage from the circular flow.

C. savings are injections into the circular flow.

D. imports are injections into the circular flow.

E. taxes are leakages from the circular flow.

Question 11

Which of the following is a leakage from the circular flow of income and

expenditure in South Africa?

A. Defence expenditure by the South African government, via contracts with local

military suppliers.

B. Government purchases of textbooks for state-run schools.

C. The sale of export fruit to the European Union.

D. Investment by South African Breweries in a new brewery.

E. A decision by a major supermarket chain to sell Danish beer.

Question 12

In a mixed economy, which of the following is not a legitimate area of government

intervention?

A. Expenditure on major infrastructure projects.

B. Taxation of the profits of private companies.

C. Taxation of the income of wage and salary earners.

D. Control of prices that change in response to changes in demand.

E. Transfers of tax revenues to poor communities.

Question 13

In South Africa, the largest single component of aggregate expenditure is:

A. net exports.

B. private consumption spending.

C. private investment spending.

D. government spending on consumption and investment goods.

E. private savings.

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Question 14

Aggregate spending on South African production comprises:

A. private consumption, government spending, private investment and total savings.

B. private consumption, government spending, private investment and net exports.

C. private consumption, government transfers, private investment and net exports.

D. private consumption, government investment, private savings and net exports.

E. private consumption, government spending, private investment and spending by

foreigners on South African goods.

Question 15

Which one of the following statements is correct?

A. The quality of the factors of production is insignificant; it is only the quantity that

matters.

B. The difference between capital goods and consumer goods is that the former

maintain their full value over time.

C. Capital as a factor of production refers to the amount of money required to produce

a good or service.

D. It is possible to increase the total income for the economy as a whole without

increasing production. This is the miracle of the modern monetary economy.

E. The total income in the economy is equal to the total remuneration of the factors

of production.

Question 16

Which one of the following statements is false?

A. There are four broad groups of decision-making units in the economy: households,

firms, government and the foreign sector.

B. Imports are an important injection into the circular flow of income and spending in

the economy.

C. Taxes are a leakage or withdrawal from the flow of income and spending in the

economy.

D. Spending by households on consumer goods and services is called consumption

spending.

E. Spending on capital goods is called investment spending and is an important

addition to, or injection into, the circular flow of income and spending in the

domestic economy.

Question 17

Which one of the following is NOT a major source of spending in the economy?

A. Households

B. Banks

C. Firms

D. Government

E. The foreign sector

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Question 18

Which one of the following does NOT represent an injection into the flow of income

and spending in the economy?

A. Spending by local government.

B. Spending on imported goods and services.

C. Spending on exports.

D. Spending on capital goods.

E. Investment spending.

Question 19

Which one of the following does NOT represent an injection into the flow of income

and spending in the economy?

A. Investment spending.

B. Spending by provincial government.

C. Spending by national government.

D. Spending on exports.

E. Money created by the South African Reserve Bank.

Question 20

Which one of the following is/are NOT a leakage or withdrawal from the circular

flow of income and spending in the domestic economy?

A. Personal income tax.

B. Value added tax.

C. Spending on imported goods and services.

D. Government transfer payments (eg old-age pensions).

E. Fuel levies.

Question 21

Which one of the following statements is false?

A. Total spending in the economy consists of consumption spending by households

plus investment spending by firms plus government spending plus net spending

by the foreign sector (ie exports minus imports).

B. From a macroeconomic point of view, total income in the economy is equal to the

total value of production.

C. Total income in the economy consists of the total remuneration of the various

factors of production.

D. Total spending in the economy is equal to the total value of injections minus the

total value of withdrawals (leakages).

E. Households and firms are linked via the goods market and the factor market.

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Question 22

Which one of the following statements is false?

A. The flow of income and spending in the economy runs in the opposite direction to

the flow of goods and services.

B. Firms are suppliers in the goods market.

C. Households are suppliers in the factor market.

D. Households earn income by selling their factors of production in the goods market.

E. Government spends in the goods market and the factor market.

Question 23

Which one of the following statements is incorrect?

A. Money is the most important factor of production. Without money, nothing can be

produced.

B. Natural resources (also called land) is one of the factors of production.

C. Both the quality and the quantity of factors of production are important.

D. Capital as a factor of production refers to tangible things that are used to produce

other things.

E. Although the quantity of labour is important, the quality of labour is usually more

important.

Question 24

Which one of the following statements is incorrect?

A. An entrepreneur is a person who combines the other factors of production and

is the driving force behind production.

B. The quality of labour is usually described by the term human capital.

C. Capital as a factor of production refers to the finance that is required to make

production possible.

D. The quality of labour in South Africa is a serious concern.

E. Even capital goods do not have an unlimited life.

Question 25

Which one of the following statements is false?

A. A truck used to transport goods is a capital good.

B. A bus used to transport people is a capital good.

C. A mathematics lecture is an example of a service.

D. A large loan (eg a mortgage bond) is a capital good.

E. Capital goods lose their value over time.

Question 26

Which one of the following is not a capital good?

A. A machine tool.

B. A wrist-watch.

C. A power saw.

D. A truck.

E. A business computer.

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Question 27

Which of the following would not be viewed by economists as part of the factor of

production, capital?

A. The lecture theatres at the University of Cape Town.

B. The subsidy income received by the University of Pretoria from the National

Department of Education.

C. The Volkswagen motor vehicle assembly plant in Uitenhage.

D. The unsold stocks of motor vehicles held by the Toyota factory in Durban.

E. The N3 national road between Durban and Johannesburg.

Question 28

Which of the following would not be viewed by economists as a factor of

production?

A. The chemistry laboratories at Stellenbosch University.

B. A skilled bricklayer.

C. An unskilled labourer.

D. The wages earned by a skilled bricklayer.

E. A sugar-cane plantation in northern KwaZulu-Natal.

Question 29

A commercial forest planted to provide raw material inputs into a wood pulp mill

would be viewed by economists as

A. Part of the factor production, land.

B. Part of the factor of production, labour, since labour has to be used to create

and maintain the commercial forest.

C. Part of the capital stock of the economy.

D. An unproductive use of land, and therefore not a factor of production.

E. An unproductive asset, since it may take several years before the forest is

ready for harvesting.

Question 30

In economics, the four main factors of production are

A. land, human capital, physical capital and finance capital.

B. natural resources, man-made resources, labour and money.

C. land, capital, labour and notes and coins in circulation.

D. human capital, physical capital, financial capital and entrepreneurship.

E. land, labour, capital and entrepreneurship.

Question 31

Which one of the following does not pertain to the factor markets?

A. Capital

B. Entrepreneurship

C. Money

D. Labour

E. Natural resources

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Question 32

Which one of the following does not represent the income of a factor of production?

A. Rent

B. Money

C. Wages

D. Profit

E. Interest

Question 33

Which one of the following is NOT a factor of production?

A. Money

B. Capital

C. Entrepreneurship

D. Labour

E. Natural resources

Question 34

Which one of the following is NOT a factor of production?

A. The service rendered by a dustman.

B. A loan advanced by Standard Bank to a budding entrepreneur.

C. A lawnmower purchased by a garden services operator.

D. The service rendered by a computer technician.

E. A fertile area of land cultivated by a farmer.

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CHAPTER THREE:

Demand, Supply, and Prices

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Analyse the interaction of buyers and sellers with each other to determine the

prices and quantities of goods and services

• Identify the most important determinants of demand and supply in a complex

market system

• Express demand and supply verbally, numerically, and graphically

• Differentiate between a movement along a demand curve and a shift of a

demand curve using a model

• Distinguish between a movement along a supply curve and a shift of a supply

curve using a model

• Accept change on equilibrium price and quantity if an economic variable

changes in a market.

• Understand the economic impact of price controls imposed by government in a

free market

• Apply the concept of producer surplus, consumer surplus, and total surplus

In this chapter the focus is on the total production, determinants of demand and

supply which is further illustrated by graphs on demand and supply. Another important

Market equilibrium is a situation where for a particular good supply = demand.

Therefore, this discussion leads to further understanding that supply and demand

curves share a commonality of representation of responses to price. In a perfectly

competitive market an equilibrium is achieved when supply equates to demand. The

chapter goes onto further discuss prediction changes in equilibrium price and

equilibrium quantity; consumer and producer surplus.

3.1. Introduction

Households are entrepreneurs who sell their goods to firms in the factor markets and

receive rent, wages and salaries, interest, and proﬁt. Firms combine these factors of

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production to produce goods and services that are sold in the goods markets to

households who use the income (derived from selling their factors of production) to

purchase goods and services. With regards to these markets, the firms are the

suppliers and the households are the consumers who demand goods and services.

Demand is simply the quantities of a good or service that expected buyers are willing

and able to purchase during a certain term.

3.2. Important Determinants of Demand

Verbal Representation

Let's consider the demand for tomatoes of an imaginary consumer, Jessica Dion.

Jessica is a single mother of three teenagers. What determines the quantity of

tomatoes that Jessica plans to purchase in a particular period?

• The price of the product. The lower the price of tomatoes, the larger the

number of tomatoes she will be willing and able to buy, ceteris paribus.

• The prices of related products. Jessica's decision about how many tomatoes

to purchase will also depend on the prices of related products. There are two

distinguishing factors, namely; complements and substitutes. Complements are

goods that can be used along with. Regarding the tomatoes, the complement

would include rolls (Tomato and cheese roll). Substitutes are goods that will

replace the good in question. Tomatoes can be replaced by, for example, mixed

vegetables (in a stew).

• The income of the consumer. Jessica's plans will also be affected by her

income. Her income determines how much she can afford to buy, that is, her

ability to purchase tomatoes. The more she earns, the more tomatoes she can

afford to buy.

• The preference of the consumer. Jessica's decision will also be inﬂuenced

whether the tomatoes are up to date, as well as her children's tastes. The more

the family like tomatoes or dishes which require tomatoes as an ingredient, the

more tomatoes she will plan to buy. On the other hand, she might not like them,

or she may be under doctor's orders not to eat them (because of their dietary

plan). Taste can have a positive or a negative impact on the quantity

demanded.

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• The size of the household. With regards to Jessica's situation she has three

children therefore she would tend to buy more tomatoes than a household

consisting of one person, but less than a larger household.

Numerical Representation

Table 3.1: Sample Demand Schedule for Tomatoes

Source: Mohr (2020:77)

Graphical Representation

Figure 3.2: Sample Weekly Demand for Tomatoes

Source: Mohr (2020:77)

• Using words: The higher the price of the good, the lower the quantity

demanded, ceteris paribus.

• Using numbers: the demand schedule. The demand schedule is a table which

shows the quantities of a good demanded at each possible price, ceteris

paribus. The quantity demanded decreases as the price increases.

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• Using graphs: the demand curve. The demand curve is a line that indicates

the quantity demanded of a good at each price, ceteris paribus. A negative

slope of the curve clearly indicates that the quantity demanded increases as

the price decreases.

• Using symbols: the demand equation. The demand equation is a shorthand

way of expressing the relationship between the quantity of a good demanded

and its price, ceteris paribus.

The difference between the movement along a demand curve (a change in the quantity

demanded) and a shift of the demand curve (a change in demand) using a model.

Figure 3.3: Shift in Demand Curve

Source: Mohr (2015:63)

If the price of the product changes, we obtain the change in the quantity demanded by

comparing the relevant points on the ﬁxed, given, or unchanged demand curves by

moving along the curve. This is how we determine a change in the quantity

demanded; however, a change in any of the determinants of demand other than the

price of the product will shift the demand curve.

Student Activity:

Define the following terms below:

1. Demand

2. Demand Schedule

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3. Demand Curve

4. Law Of Demand

5. Quantity Demanded

6. Change In Quantity Demanded

7. Change In Demand

8. Determinants Of Demand

9. Normal Good

10. Inferior Good

11. Substitute Goods

12. Complement Goods

3.3. Supply

In economics supply means the amount of some good or service a producer is willing

to supply at each price. Price is what the producer receives for selling one unit of a

good or service. A price increase almost always leads to an increase in the quantity

supplied a particular good or service. Alternatively, a decrease in price will decrease

the quantity supplied (Khan Academy, 2020).

For instance, when the price of diesel escalates, it encourages profit-seeking firms to

take several actions. They can either expand exploration for oil reserves, drill for more

oil, invest in more pipelines and oil tankers to bring the oil to plants where it can be

refined into gasoline, put up new refineries, buying additional pipelines and trucks to

ship the diesel to petrol stations, and open more petrol stations or keep existing petrol

stations open longer hours.

This positive relationship as economists state, between price and quantity supplied—

is that a higher price leads to a higher quantity supplied and a lower price leads to a

lower quantity supplied—the law of supply. The law of supply assumes that all other

variables that affect supply are held constant (Khan Academy, 2020).

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3.3.1. Important Determinants of Supply

Let's consider the supply of tomatoes by a farmer, John.. John is a vegetable farmer

in Cape Town who sells his produce on the Pretoria fresh produce market. The

following would determine the supply of tomatoes in a particular year:

• The price of tomatoes: The higher the price of tomatoes, the greater the

quantity that John will plan to grow and sell, ceteris paribus.

• The prices of alternative products: John's plan on the production of tomatoes

will depend on the prices of substitute products. As a farmer, he must decide

which vegetables to grow, and how much of each. For example, if the price of

tomatoes increases, relative to the price of tomatoes, he would then consider

producing more tomatoes over tomatoes. As producers, they will always

consider the prices of alternative outputs that they can produce with the same

resources. These outputs are sometimes referred to as substitutes in

production.

• Prices of factors of production and other inputs. The quantities of tomatoes

that John plans to sell at different prices will also depend on the cost of

production. For John to make a proﬁt, he has to cover his costs of production.

If, for example, the price of one or more of his machinery increases, a smaller

quantity of tomatoes will be supplied by Jake at each price than before. Simply

because it would cost more to produce each quantity.

• Expected future prices: Unlike consumers who could make decisions quickly,

producers often have to plan long in advance. For example, the higher he

expects the future price of tomatoes to be, ceteris paribus, the more tomatoes

he will plan to produce. Farmers may also postpone their supply to a future

period.

• Changes in technology: Technology will always be upgraded, which enable

producers to produce at lower costs, will increase the quantity supplied at each

price. An example would be a new fertiliser which is less susceptible to plant

disease will tend to increase the supply of tomatoes, ceteris paribus.

Supply can be expressed in four ways, but in this module, we shall deal with the

following three:

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Verbal Representation- Using words- The higher the price of the good, the greater

the quantity supplied; and the lower the price of the good, the lower the quantity

supplied, ceteris paribus

Numerical Representation- Using numbers - The supply schedule is a table which

shows the quantity of a good supplied at each price, ceteris paribus.

Graphical Representation- Using graphs - The supply curve is a line or graph which

indicates the quantity supplied of a good at each price, ceteris paribus.it is a visual

representation of supply (Mohr, 2020).

Figure 3.4: Differentiation between a movement along a supply curve and a shift of a

supply curve using a model

Source: Mohr (2020:85)

At a price of P1 the quantity supplied is Q1, as indicated by combination 'a' in the

figure. If the price increases to P2, the quantity supplied will increase to Q2, as

indicated by combination 'b' in the figure. The supply curve shows that the quantity

supplied will increase if the price increases, ceteris paribus.

3.3.2. Market Equilibrium

Once demand and supply are understood, we can now incorporate them to explain

equilibrium in the market for a particular good or service. Pettinger (2019) states the

following definitions of market equilibrium. Market equilibrium is a situation where for

a particular good supply = demand. When the market is in equilibrium, there is no

tendency for prices to change. We say the market-clearing price has been achieved.

• A market occurs where buyers and sellers meet to exchange money for goods.

• The price mechanism refers to how supply and demand interact to set the

market price and amount of goods sold.

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• At most prices, planned demand does not equal planned supply. This is a state

of disequilibrium because there is either a shortage or surplus and firms have

an incentive to change the price

Figure 3.5. Market Equilibrium where Demand and Supply Intersect

Source: Mohr (2015:77)

In order to achieve equilibrium, an adjustment procedure takes place in the market. If

the price level is P1, higher than the equilibrium price Pe, this would mean that the

market is in disequilibrium, that is, quantity supplied Qs for the product exceeds the

quantity demanded, QD.

Note:

Equilibrium price is the price at which the quantity demanded equals the quantity

supplied.

Equilibrium quantity is the quantity bought and sold at the equilibrium price.

3.3.3. Prediction Changes in Price and Quantity

Change in demand

- An increase in demand shifts the demand curve to the right.

- A decrease in demand shifts the demand curve to the left.

Change in supply

- An increase in supply shifts the supply curve to the right.

- A decrease in supply shifts the supply curve to the left.

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The following factors change demand:

• The price of substitute goods

• The price of complementary goods

• Expected future prices

• Income level of the consumer

• Expected future income of the consumer

• The population size

• The consumer's preferences and taste

Any change in the above factors will cause a shift in the demand curve either to the

left or to the right. The following factors change supply:

• The cost of factors of production

• The prices of related goods

• Availability of substitutes

• Availability of complements

• Expected future prices

• The number of suppliers in the market

• Changes in technology

Any change in the above factors will cause a shift in the supply curve either to the

left or right. These changes that cause shifts in demand and supply will be discussed

in more detail in chapter 4.

3.2.4. Consumer Surplus

Consumer surplus is an economic measurement of consumer benefits. Consumer

surplus happens when the price that consumers pay for a product or service is less as

opposed to what they willing to pay. It is a measure of the additional benefit that

consumers get because they are paying less for a product or good than what they

were willing to pay.

A consumer surplus occurs when the consumer is willing to pay more for a given

product than the current market price.

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Figure 3.6: Consumer Surplus

Source: Mohr (2020:89)

DD is the demand curve, P1 the market price, and Q1 the quantity demanded at the

market price. For each quantity between 0 and Q1 (i.e., except Q1), consumers are

willing to pay more than the price P1 they are actually paying. Consumer surplus is

the shaded area in the figure above.

3.3.5. Producer Surplus

Producer surplus is parallel to consumer surplus.

Figure 3.7: Producer Surplus

Source: Mohr (2020:89)

SS is the supply curve, P1 the market price, and Q1 the quantity supplied at the market

price. For each quantity between 0 and Q1 (i.e., except Q1), producers are willing to

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supply at a lower price than the price P1 that they are actually receiving. Producer

surplus is the shaded area in the figure above, which shows the gain to producers.

3.3.6. Consumer Surplus and Producer Surplus at Market Equilibrium

The consumer surplus is indicated by the darker shaded triangle DP1E and the

producer surplus by the lighter shaded triangle SP1E.

Figure 3.8: Consumer and Producer Surplus

Source: Mohr (2020:89)

In Figure 3.8, DD is the demand curve, SS the supply curve, P1 the equilibrium price,

and Q1 the equilibrium quantity. At all quantities less than Q1 consumers pay a lower

price (P1) for the product than the highest prices they are willing to pay. There is thus

a consumer surplus, indicated by the darker shaded triangle DP1E. Likewise, at all

quantities less than Q1 producers receive a higher price (P1) than the lowest prices

they are prepared to supply the product. There is thus also a producer surplus,

indicated by the lighter shaded triangle SP1E.

Student Reading: Facts as additional insight

Consumer surplus happens when the price consumers pay for a product or service

is less than the price they are willing to pay.

Consumer surplus is the benefit or good feeling of getting a good deal.

Consumer surplus always increases as the price of a good falls and decreases as

the price of a good rises.

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CHAPTER FOUR:

Changes in Demand and Supply

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Describe how a change in demand affects the equilibrium price and quantity in

the market

• Know how change in supply affects the equilibrium price and quantity in the

market

• Foresee the effects of simultaneous changes in demand and supply

• Inspect the interaction between related markets

• Foresee what happens if the government interferes in the market, for example,

by setting minimum or maximum prices

Expanding from Chapter 4 of supply and demand, is the interpretation of changes in

demand and supply. This chapter will also illustrate the difference between shifts in

curves and movements along curves. The chapters goes on to discuss the interaction

between related markets. In this instance introspection is given to what would happen

in the market for tyres if the cost of producing motorcars increases. In the event of

consumers not being happy with prices, what would the government do as an

intervention. In the event of prices being fixed or outside government sanctions, the

black market is another aspect which is discussed in this chapter.

4.1. Changes in Demand

When the demand increases, there will be an increase in the price of the product and

the quantity exchanged, ceteris paribus. The following are sources of an increase in

demand

• The price of a substitute product will increase

• Consumers’ income will increase

• More consumer preference for the product

• The price of the product would rise

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When demand increase, supply remains unchanged; however, there will be an

increase in the quantity supplied as the price of the product increase. This actually

implies an upward movement along the supply curve.

Figure 4.1: Changes in Demand

Source: Mohr (2020:94)

Looking at the movement from E to E1 in Figure 4.1(a). illustrates when demand

increases, there is an excess demand at the original price P0. The price of the product

is bid up as purchasers compete to obtain the available quantity supplied. When the

price rises, suppliers increase the quantity supplied, while the quantity demanded falls.

This process continues until equilibrium is re-established at E1, that is, at a higher

price (P1) and a higher quantity (Q1) than before.

When demand decrease it will lead to a decrease in the price of the product and a

decrease in the quantity changed, ceteris paribus.

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Figure 4.2: Decrease in Demand

Source: Mohr (2020:94)

When demand decreases, the price of the product falls and this leads to a reduction

in the quantity supplied, however the supply curve remains unchanged, it represents

a downwards movement along the supply curve, such as the movement from E to E2

in Figure 4.2. When demand decreases, there is an excess supply at the original price

P0.

In Figure 4.2, it shows a leftward shift of the demand curve from  to. The

decrease in demand could be the result of a change in any of the determinants of

demand except the price of the product. The following possibilities would arise:

• There would be a fall in the price of the product

• The products preference would be reduced

• The price of the product would have an expected fall

• Consumers’ income will fall

As shown in the figure below when there is a decrease in demand, it would illustrate

a shift by the demand curve from DD to D2D2. Both the equilibrium price and the

equilibrium quantity fall, to P2 and Q2 respectively. There is a downward movement

along the supply curve from E to E2.

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Figure 4.3: Examples of Changes in Demand

Source: Mohr (2015:85)

4.2. Changes in Supply

When supply increases, it would result in a fall in the price of the product and would

lead to an increase in the quantity exchanged, ceteris paribus. In Figure 4.4(a), the

supply curve shifts to the right (or downwards) from SS to S1S. When such an increase

in supply happens, it means that more goods are supplied at each price than before,

or the possibilities could be that each quantity is supplied at a lower price than before.

The possibilities to the shift of the supply curve could result in any of the determinants

of supply other than the price of the product.

• The price of an alternative product or a rise in the price of a joint product would

fall

• The price of any of the factors of production would lead to a reduction

• The productivity of the factors of production would show some improvement

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Figure 4.4a: Changes in Supply (increase)

Source: Mohr (2020:95)

When supply increases, demand remains unchanged, but the quantity demanded

increases as the price of the product falls. There is a downward movement along the

demand curve, such as the movement from E to E1 in Figure 4.4(a). There would also

be an excess supply at the original price P0. An excess supply results in a decrease

in the price of the product.

Some companies compete with each other by lowering the price of the product. As the

price falls, the quantity demanded increases, while the quantity supplied falls. This

process continues until equilibrium is re-established at E1, that is, at a lower price (P1)

and a higher quantity (Q1) than before Khan Academy (2020).

Student Reading Activity:

Supply curve shift: Changes in production cost and related factors can cause an

entire supply curve to shift to the right or to the left. This causes a higher or lower

quantity to be supplied at a given price.

The ceteris paribus assumption: Supply curves relate prices and quantities supplied

assuming no other factors change. This is called the ceteris paribus assumption.

This article talks about what happens when other factors aren't held constant.

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A decrease in supply would lead to an increase in the price of the product, and a

decrease in the quantity exchanged, ceteris paribus. In Figure 4.4(b) by a leftward

(upward) shift of the supply curve from SS to S2S2. When this kind of a decrease in

supply happens, it leads to fewer goods being supplied at each price than before or

the possibilities that each quantity is supplied at a higher price than before. The shift

of the supply curve could be the result of a change in any of the determinants of supply

other than the price of the product. The following possibilities may include:

• The price of an alternative product or a rise in the price of a joint product would

increase.

• The price of any of the factors of production would lead to an increase.

• The productivity of the factors of production would show some deterioration.

When supply decreases demand remains unchanged, however there is an upward

movement along the demand curve, such as the movement from E to E2 in Figure

4.4(b). When supply decreases, there is excess demand at the original price P0.

Consumers bid up the price of the product in their attempt to obtain the available

quantity supplied. As the price increases, the quantity demanded decreases, while the

quantity supplied increases. This process continues until equilibrium is re-established

at E2, that is, at a higher price (P2) and lower quantity (Q2) than before.

Figure 4.4b: Changes in Supply (increase)

Source: Mohr (2020, pp.95)

The following are examples of changes in supply.

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Figure 4.5: Examples of Changes in Supply

Source: Mohr (2015, pp.87)

An added reading below is giving to indicate other factors that affect supply.

Student Reading Activity

Other Factors That Affect Supply.

Natural conditions

In 2014, the Manchurian Plain in North-Eastern China—which produces most of

the country's wheat, corn, and soybeans—experienced its most severe drought in

50 years. A drought decreases the supply of agricultural products, which means

that at any given price, a lower quantity will be supplied. Conversely, especially

good weather would shift the supply curve to the right.

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New technology

When a firm discovers a new technology that allows it to produce at a lower cost,

the supply curve will shift to the right as well. For instance, in the 1960s, a major

scientific effort nicknamed the Green Revolution focused on breeding improved

seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds

of the wheat and rice in low-income countries around the world was grown with

these Green Revolution seeds—and the harvest was twice as high per acre. A

technological improvement that reduces costs of production will shift supply to the

right, causing a greater quantity to be produced at any given price.

Government policies

Government policies can affect the cost of production and the supply curve through

taxes, regulations, and subsidies. For example, the U.S. government imposes a

tax on alcoholic beverages that collects about $8 billion per year from producers.

Taxes are treated as costs by businesses. Higher costs decrease supply for the

reasons discussed above. Another example of policy that can affect cost is the

wide array of government regulations that require firms to spend money to provide

a cleaner environment or a safer workplace; complying with regulations increases

costs.

A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs

when the government pays a firm directly or reduces the firm’s taxes if the firm

carries out certain actions. From the firm’s perspective, taxes or regulations are an

additional cost of production that shifts supply to the left, leading the firm to produce

a lower quantity at every given price. Government subsidies, however, reduce the

cost of production and increase supply at every given price, shifting supply to the

right.

4.3. Simultaneous Changes in Demand and Supply

If demand and supply change at the same time, the result thereof cannot be predicted;

however, this would lead to it being a special case of a general economic problem.

When one factor is allowed to change, it is usually possible to determine or predict the

effects of such a change. But when more than one change is involved, it is seldom

possible to predict the outcome, since the changes may work in opposite directions.

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The method we use here requires that only one variable or force is allowed to change

at a time.

An example is when demand and supply both decreases, it is possible to predict what

will happen to the quantity exchanged since both forces have the same impact on the

equilibrium quantity. Their combined impact on the equilibrium price is, however,

uncertain, since a decrease in demand reduces the price, ceteris paribus, while a

decrease in supply raises the price, ceteris paribus. The equilibrium price could rise,

remain unchanged, or fall, all depending on the relative magnitudes of the changes in

demand and supply.

Figure 4.6: A Simultaneous Increase in Demand and Decrease in Supply

Source: Mohr (2020;97)

In all three diagrams, the original demand, supply, equilibrium price, and equilibrium

quantity are represented by DD, SS, P0, and Q0. A simultaneous increase in demand

(illustrated by a rightward shift of the demand curve) and a decrease in supply

(illustrated by a leftward shift of the supply curve) raises the price of the product. The

impact on the equilibrium quantity depends on the relative magnitude of the changes.

In (a), the quantity remains unchanged at Q0. In (b), it falls to Q2, and in (c), it

increases to Q3.

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4.4. Interaction Between Related Markets

The increase in costs in the motorcar industry can be illustrated by a leftward (upward)

shift of the supply curve, as in Figure 4.7(a). However, if fewer motorcars were being

produced, the demand for new tyres will decrease, which would mean a leftward

(downward) shift of the demand curve in Figure 4.7(b).

The original demand and supply curves are DD and SS and the equilibrium prices and

quantities P0 and Q0, respectively. When looking at Figure 4.7(a), you would notice

that the impact of an increase in the costs of producing motorcars would create a

leftward (upward) shift of the supply curve from SS to S1S1. The equilibrium price of

motorcars increases from P0 to P1, and the equilibrium quantity falls from Q0 to Q1.

When looking at Figure 4.7(b), the consequent decrease in the demand for tyres would

create a leftward (downward) shift of the demand curve from DD to D1D1. The

equilibrium price of tyres falls from P0 to P1, and the equilibrium quantity also

decreases from Q0 to Q1.

Figure 4.7: Interaction Between Markets for Motorcars and Tyres

Source: Mohr (2020:99)

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4.5. What does Government Intervention Mean?

Government intervention is simply consumers, trade unions, farmers, businesspeople,

and politicians who are unsatisﬁed with the prices and quantities determined by market

demand and supply. Their dissatisfaction puts pressure on government to alter the

results that inﬂuence prices and quantities in the market. There are different forms for

such an intervention, namely:

• Maximum prices (price ceilings, price control)

• Minimum prices (price supports, price ﬂoors)

• Subsidies

• Taxes

• Quotas

• Import tariffs

4.6. Maximum Prices (Price Ceilings, Price Control)

There are prices that are still ﬁxed by government, and consumers often call for price

control. Therefore, there is always a possibility that the government may reintroduce

it. Governments set maximum prices to:

• To assist the poor by keeping basic foodstuff low, such as bread

• To avoid unfair price hikes

• Fight inflation

• Restrict the production of certain goods and services

When looking at Figure 4.8, we can see the demand curve (DD), a supply curve (SS),

the equilibrium price (P0), and the equilibrium quantity exchanged (Q0). Suppose the

government then sets a maximum price (Pm) below the equilibrium price (P0). At the

lower price (Pm), consumers will demand a quantity (Q2), which is higher than the

equilibrium quantity (Q0). Suppliers, however, will be willing to supply only Q1, which

is lower than Q0. There is thus a market shortage (or excess demand) equal to the

difference between Q2 and Q1 (or ab). In the absence of price control, this excess

demand will raise the price until equilibrium is re-established at P0 and Q0. But when

price control is introduced, different ways of solving the problem of excess demand

have to be found. When market prices are not allowed to fulﬁl their rationing function,

someone or something else must do the job.

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Figure 4.8: Maximum Prices

Source: Mohr (2020, pp.100)

Ways to allocate the available quantity supplied (Q1) between consumers who

demand a total of Q2 of the good concerned:

• First come, first serve basis which results in a waiting list

• An informal rationing system

• A coupon system

Ofﬁcial rationing systems amount to additional government intervention, which could

lead to corruption (e.g., bribery of rationing ofﬁcials). Another consequence of

maximum price ﬁxing is the development of black markets.

4.7. Black Markets

A black market is economic activity that takes place outside government-sanctioned

channels. Black market transactions usually occur “under the table” to let participants

avoid government price controls or taxes (Kenton, 2020).

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Student Activity

Think of one big public music event where tickets are needed to enter a

show.

1. Describe how obtaining a Black Market ticket will help in ensuring that

some people attend the music event.

2. Debate the necessity of Black Markets

4.8. The Welfare Costs of Maximum Price Fixing

The idea of consumer surplus and producer surplus can be used to demonstrate the

welfare loss associated with maximum price ﬁxing. Shown in Figure 4.9, a maximum

price Pm is set below the market-clearing price P1. As a result, the quantity exchanged

falls from the equilibrium level Q1 to Qm. At the market-clearing price P1, the

consumer surplus was P1DE. At the new ﬁxed price, Pm, the consumer surplus is

PmDRU Consumers have lost the shaded triangle indicated by A, since only Qm is

exchanged; but they have gained rectangle B, since those who can obtain the product

now pay less for it than before. Area B used to be part of the producer surplus but now

becomes part of the consumer surplus. All that remains of this surplus after the

maximum price is set is the small triangle 0PmU. Therefore, rectangle B is transferred

to the consumer surplus. Triangle C simply disappears, since only Qm is produced

and exchanged. The total welfare loss to society is triangle A plus triangle C. This is

usually referred to as deadweight loss. Too little is being produced, and in the end

society (which consists of consumers and producers) is worse off as a result of the

interference in the market system.

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Figure 4.9: The Welfare Costs of Maximum Price Fixing

Source: Mohr (2020:103)

4.9. Minimum Prices (Price Supports, Price Floors)

Markets for agricultural products are usually characterised by a relatively stable

demand, but also by a supply which is subject to large fluctuations. Prices, therefore,

tend to fluctuate, and farmers’ income is unstable and uncertain.

When minimum prices are introduced, it serves as guaranteed prices to producers. If

the minimum price is below the ruling equilibrium price, the operation of market forces

is not disturbed, but if the minimum price is above the ruling equilibrium price, there is

a surplus.

DD and SS, represented below, is the demand and supply of beef. The equilibrium

price is R30 per kg, and the equilibrium quantity is 7 million kg. The introduction of a

minimum price of R40 per kg results in a market surplus of 5 million kg (represented

by ab).

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Figure 4.10: A Minimum Price

Source: Mohr (2020:103)

Further government intervention is required when government fixes the minimum price

above the equilibrium price which creates a market surplus and the following options

are derived:

• Government exports the purchased surplus

• Government stores the purchased surplus

• Production quotas are introduced by government to limit the quantity

supplied to the quantity demanded at the minimum price

• The purchased surplus is destroyed by government

• The surplus is destroyed by producers

Prior to price ﬁxing, the equilibrium price is P1 and the equilibrium quantity Q1.

Government then ﬁxes a minimum price Pm above the equilibrium price. If producers

respond to actual demand, the quantity supplied (and exchanged) falls to Qm.

Rectangle A is transferred from the consumer surplus to the producer surplus. Triangle

B, which used to be part of the consumer surplus, and triangle C, which used to be

part of the producer surplus, both disappear. The total deadweight loss to society is

equal to B plus C.

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Figure 4.11: The Welfare Costs of Minimum Price Fixing

Source: Mohr (2020:104)

A better alternative for government to assist certain producers with the direct cash

subsidies, which is paid only to those producers who are struggling. There would be

no interference in the price mechanism, and those who are supposed to benefit will

receive the subsidy, and the cost of the subsidy is explicit and not hidden.

If government wishes to assist certain producers, then direct cash subsidies paid only

to those producers is a better alternative than ﬁxing a minimum price. With direct

subsidies, there is no interference in the price mechanism. Only those who are

supposed to beneﬁt receive the subsidy and the cost of the subsidy is explicit, instead

of being hidden.

The concepts of consumer surplus and producer surplus can also be used to illustrate

the welfare loss of minimum price ﬁxing. In Figure 4.11, the equilibrium price and

quantity are P1 and Q1, respectively. The government now ﬁxes a minimum price Pm

above the equilibrium price. If we assume that producers respond to actual demand,

then the quantity supplied (and exchanged) will fall to Qm. In the absence of price

ﬁxing, the consumer surplus is P1DE, and the producer surplus is 0P1E. After

minimum price ﬁxing, the consumer surplus is PmDR. Consumers thus lose rectangle

A (to the producers) and triangle B (which disappears). The producer surplus becomes

0PmRT. Producers gain rectangle A at the expense of consumers, but triangle C

disappears. The total deadweight loss to society is thus triangle B plus triangle C. As

in the case of maximum price ﬁxing, too little is produced, and society is worse off as

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a result of the interference in the market system. If producers ignore and do not

respond to actual demand, the situation is slightly more complicated, since a surplus

will be produced.

4.10. Subsidies

An alternative to setting maximum or minimum prices is to subsidise consumers or

producers. In this subsection, we examine a subsidy paid to producers to illustrate the

impact of such a subsidy on the market price and the quantity exchanged. In Figure

4.12, DD and SS are the original demand and supply curves, respectively. The

equilibrium price is P0, and the equilibrium quantity is Q0. Suppose the government

wants to lower the price to the consumers and increase production by subsidising the

producers. The new supply curve is illustrated by S1S1 and the subsidy per unit by

the vertical difference between SS and S1S1. The new equilibrium is at E1, indicating

a price P1 and a quantity Q1. At Q1, the producers receive a price P2 equal to what

the consumers pay (P1) plus the subsidy per unit (the difference between P2 and P1).

Figure 4.12: A Subsidy Paid to Suppliers

Source: Mohr (2020:104)

4.11. Taxes

The taxes government levies on goods and services are the largest source of tax

revenue. The basic principles of taxation are that the party that actually pays the tax

to the authorities does not necessarily bear the burden, or at least the full burden, of

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the tax. This means that the effective incidence of the tax may differ from the statutory

incidence of the tax. We now use the impact of a speciﬁc excise tax, namely the tax

on cigarettes.

Figure 4.13: The Incidence of an Excise Tax on Cigarettes

Source: Mohr (2020:105)

SS is the supply curve before the imposition of the tax of R8,00 per packet of

cigarettes. DD is the demand curve. The original equilibrium price is R24,00 per

packet, and the equilibrium quantity is 150 000 packets per week. After the imposition

of the tax, the supply curve shifts up by R8,00 to STST. The new equilibrium is

indicated by E1. The equilibrium price is R28,80 per packet, and the equilibrium

quantity is 120 000 packets per week. The suppliers receive the selling price less the

tax, that is, R20,80 per packet. This is indicated by E2 on the original supply curve.

The difference between E1 and E2 is the tax. The consumers pay R4,80 extra per

packet, and the suppliers receive R3,20 less per packet than before. Three groups are

actually shared from the burden of an excise tax, namely:

• Consumers who have to pay more

• Owners of shareholders of the suppliers

• Employees of the suppliers

4.12. The Welfare Implications of a Specific Excise Tax

Looking at Figure 4.14, you would notice that before the imposition of the tax, the

equilibrium price and quantity are P0 and Q0, respectively. After the imposition of the

tax, the equilibrium price and quantity are P0 and Q0, respectively. The government

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gains rectangle A (at the expense of the consumers) and rectangle B (at the expense

of the producers). Triangles X and Y disappear. X plus Y represents the deadweight

loss of the tax.

Figure 4.14: The Welfare Costs of a Specific Excise Tax

Source: Mohr (2020:106)

4.13. Agricultural Prices

Agricultural products generally go hand in hand with fluctuated prices much more than

the prices of manufactured goods, all of these take place due to the supply conditions.

Simply because the supply of agricultural products varies from season to season and

is affected by the weather, by diseases, and by the fact that many products are

perishable and, therefore, cannot be stored for long periods. Therefore, as supply

varies, prices vary, even if demand conditions remain unchanged.

In Figure 4.18 below, the demand and supply in Year 1 are represented by DD and

S1S1. The equilibrium price is P1, the equilibrium quantity is Q1and farmers’ total

income from potatoes is represented by the area 0P1E1Q1 (i.e., the price (P1) times

the quantity sold (Q1)). Expecting high prices for potatoes, farmers increase their

supply of potatoes to S2S2 in Year 2. With demand unchanged, the quantity sold

increases to Q2, but the price falls to P2 farmers' total income from potatoes in Year

2, represented by the area 0P2E2Q2, which is lower than in Year 1 (i.e., 0P1E1Q1 >

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0P2E2Q2). As a group, they are thus worse off in Year 2 than in Year 1, despite having

produced and sold more potatoes.

Figure 4.18: An Increase in Supply as a Result of Expected High Prices of Potatoes

Source: Mohr (2020:108)

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CHAPTER FIVE:

Elasticity

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Define elasticity

• Describe the meaning and significance of price elasticity of demand

• Know how to calculate the Price Elasticity of Demand

• Differentiate between the five categories of price elasticity of demand

• Know the determinants of price elasticity of demand

• Explain income elasticity and cross elasticity of demand

• Define the meaning and significance of price elasticity of supply

This chapter focuses on elasticity and the general definition and discussion; the

responsiveness of the quantity demanded, and the quantity supplied to changes in

price and other determinants of the quantity demanded and the quantity supplied.

Furthermore, this chapter will focus on absolute or relative sizes of the changes in

price and quantity be equilibrium price increase if supply decreases; how much the

equilibrium quantity may change; the revenue of suppliers, if any fact a higher or lower

price will affect them.

5.1. What is Elasticity?

Elasticity is a measure of a variable's sensitivity to a change in another variable,

most commonly this sensitivity is the change in price relative to changes in other

factors. In business and economics, elasticity points to the degree to which

individuals, consumers or producers alter their demand or the amount supplied

in response to price or income changes. It is mainly used to assess the change

in consumer demand as a result of a change in a good or service's price (Hayes,

2020). Mohr (2020) states that the measure of such responsiveness or sensitivity is

called elasticity. Elasticity can be formally defined as: “the per centage change in a

dependent variable (the one that is affected) if the relevant independent variable (the

one that causes the change) changes by one per cent”. This is obtained by dividing

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the per centage change in the dependent variable by the per centage change in the

independent variable:

   



Student Activity: Reading

Elasticity is an economic measure of how sensitive an economic factor is to

another, for example changes in price to supply or demand, or changes in demand

to changes in income.

If demand for a good or service is relatively static even when the price changes,

demand is said to be inelastic, and its coefficient of elasticity is less than 1.0.

Examples of elastic goods include clothing or electronics, while inelastic goods are

items like food and prescription drugs.

Source: (Hayes, 2020)

5.2. Price Elasticity of Demand

Price elasticity of demand is concerned with the sensitivity of the quantity demanded

to a change in the price of the product. In the case of a demand curve the dependent

variable is the quantity demanded and the independent variable is the price of the

product. The price elasticity of demand is the per centage change in the quantity

demanded if the price of the product changes by one per cent, ceteris paribus. This is

obtained by dividing the per centage change in the quantity demanded by the per

centage change in the price of the good or service concerned. Using the symbol ep

for the price elasticity of demand, we therefore write:

   



For example, if the price of the product changes by 5 per cent and this results in a 10

per cent change in the quantity demanded, ceteris paribus, then ep = 10 per cent ÷ 5

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per cent = 2. This implies that a one per cent change in the price of the product will

lead to a two per cent change in the quantity demanded.

Merely knowing that the demand and supply curve shifts is not enough. Price elasticity

will enable us to know to know by how much the price and the quantity will change,

and thus how much of a shift there will be. With price elasticity of demand, we measure

the per centage change in quantity demanded that results from a per centage change

in the price. In other words, how sensitive the quantity demanded is to a change in the

price. This sensitivity of the quantity demanded to a change in the price will depend

on the slope of the demand curve.

Figure 5.1: The Impact of Demand Elasticities on the Equilibrium Price and Quantity

Source: Mohr (2020:115)

The figure above illustrates two graphs with the same supply curve, but differently

sloped demand curves. It can be observed in graph (b) that the change in quantity

demanded is smaller due to the steeper demand curve- and the price change is larger.

5.3. Calculating the Price Elasticity of Demand

To calculate the price elasticity of demand we have to calculate the per centage

change in the quantity demanded and divide it by the per centage change in the price

of the product. If we denote the quantity demanded by Q, and the change in quantity

demanded by ΔQ, then:

( a ) ( b )

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   



Similarly:

   



Therefore, price elasticity of demand (ep):

   































 



The slope of a linear demand curve is given by the change in price (ΔP) divided by the

change in quantity (ΔQ). The first part of the right-hand side of Equation 5-2 (i.e.,

ΔQ/ΔP) thus represents the inverse of the slope of a linear demand curve. Since the

slope of a straight line is constant, the inverse of the slope is also constant. The second

part of the right-hand side of Equation 5-2 (i.e., P/Q) represents the ratio between the

price (P) and the quantity (Q) at a point on the demand curve. Since this ratio varies

along the demand curve, it follows that the price elasticity of demand will be different

at each point on the demand curve. The elasticity coefficient calculated at a point on

a demand curve is called point elasticity (in contrast to arc elasticity, which is explained

below). If the price change is relatively small, the point elasticity formula (Equation 5-

2) may be used, but if there are larger fluctuations in the price a different formula,

called the arc elasticity formula, should be used

Assume the following:

Point 1 on a graph: P1=10; Q1=17; P2=8; Q2=19

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The points are displayed in the graph below:

Figure 5.2: Elasticity Point

Source: Mohr (2015:107)

To calculate the arc elasticity between these two points:

Ep=󰇛󰇜󰇛󰇜

󰇛󰇜󰇛󰇜

=󰇛󰇜󰇛󰇜

󰇛󰇜󰇛󰇜

=



=

5.4. Price Elasticity of Demand and Total Revenue

The price elasticity of demand can be used to determine by how much the total

expenditure by consumers on a product (which is also the total revenue of the firms

producing that product) changes when the price of the product changes. This is

probably the most important reason why economists, businesspeople and

policymakers are so interested in information concerning the price elasticity of

demand.

The total revenue (TR) accruing to the suppliers of a good or service (or the total

expenditure by the consumers) is equal to the price (P) of the good or service

multiplied by the quantity (Q) sold. We know that there is an inverse relationship

between the quantity demanded (Q) and the price of a product (P). Any change in

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price leads to a change in the quantity demanded in the opposite direction to the

change in price. The effect of a price change on total revenue will thus depend on the

relative sizes of the price change and the change in the quantity demanded:

• If the change in price leads to a proportionately greater change in quantity

demanded Q (i.e., if the price elasticity of demand is greater than one), total

revenue TR (= PQ) will change in the opposite direction to the price change.

• If the change in price leads to an equi-proportional change in the quantity

demanded (i.e., if the price elasticity of demand is equal to one), total revenue

will remain unchanged.

• If the change in price leads to a proportionally smaller change in the quantity

demanded (i.e., if the price elasticity of demand is smaller than one), total

revenue will change in the same direction as the price change.

5.5. Different Categories of Price Elasticity of Demand

Perfectly Inelastic Demand

Perfectly inelastic demand (which is unlikely to occur in the real world) refers to a

situation where the price elasticity of demand is zero. A perfectly inelastic demand

curve is represented by a vertical line parallel to the price axis, such as the figure

below. This shows that consumers plan to purchase a fixed amount of the product,

irrespective of its price. If the demand for a product is perfectly inelastic, the producers

can raise their revenue by raising the price of the product. As explained earlier, the

producers’ total revenue TR is equal to the price of the product P times the quantity

sold Q (i.e. TR = P u Q). When P increases and Q remains constant, TR increases.

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Figure 5.3: Perfectly Inelastic Demand

Source: Mohr (2020:119)

Inelastic Demand

Demand is said to be inelastic when the quantity demanded changes in response to a

change in price, but the per centage change in the quantity is less than the per centage

change in the price of the product. The value of the price elasticity of demand, or the

elasticity coefficient, is thus greater than zero but smaller than one. In contrast to the

case of perfect inelasticity, we cannot draw a linear demand curve (i.e. a straight line)

which represents inelastic demand all along the curve.

Figure 5.4: Inelastic Demand

Source: Mohr (2020:119)

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Unitarily Elastic Demand

Unitary elasticity occurs when the per centage change in the quantity demanded is

exactly equal to the per centage change in price. The elasticity coefficient is thus equal

to one. Unitary elasticity is the dividing line between inelastic and elastic demand. It

cannot be represented by a straight-line demand curve, but those of you with a

mathematical background will realise that a unitarily elastic demand curve can be

represented by a rectangular hyperbola. When faced with an elastic demand,

producers will have no incentive to raise their prices, since the resulting decrease in

the quantity demanded will be proportionally greater than the increase in the price of

the product, so total revenue will fall.

Figure 5.5: Unitary Elastic Demand

Source: Mohr (2020, pp.119)

Elastic Demand

Demand is said to be elastic when a price change leads to a proportionally greater

change in the quantity demanded, that is, when the elasticity coefficient is greater than

one. An elastic demand curve cannot be represented by a unique downward-sloping

linear demand curve, since the elasticity coefficient varies along such a curve. If

producers are faced with an elastic demand for their product, they can increase their

total revenue by lowering the price of the product. When the price of the product P

decreases there will be a proportionally greater increase in the quantity demanded Q.

Total revenue TR (= P u Q) will thus increase. An increase in total revenue should not,

however, be confused with an increase in total profit. The impact on profit will also

depend on the change in total cost.

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Figure 5.6: Elastic Demand

Source: Mohr (2020:119)

Perfectly Elastic Demand

A perfectly elastic demand curve has an elasticity coefficient of infinity and is depicted

by a horizontal line, as in Figure 5.3(e). This curve shows that consumers are willing

to purchase any quantity at a certain price (P1), but if the price is raised only

fractionally, the quantity demanded falls to zero. An example of a perfectly elastic

demand curve is provided later in the book, where we discuss the position of an

individual firm in a perfectly competitive market.

Figure 5.7: Perfectly Elastic Demand

Source: Mohr (2020:119)

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5.5.1. Determinants of Price Elasticity of Demand

Demand elasticity measures how sensitive demand for a good or service is to changes

in other variables. There are many factors that are pivotal in determining the demand

elasticity for a good or service. This includes the price level, type of good or service,

the availability of a substitute, and levels of consumer incomes (Nickolas, 2020).

Substitution Possibilities

The availability of substitutes is undoubtedly the most important determinant of

consumers’ reactions to a price change. The larger the number of substitutes and the

closer (or better) the substitutes are, the greater is the price elasticity of demand,

ceteris paribus. If the price of a good with close substitutes increases, consumers will

tend to switch to the substitutes, which become relatively cheaper.

Complementary Good for the Product

In the case of highly complementary goods (i.e. goods which tend to be used jointly

with other goods rather than on their own) the price elasticity of demand tends to be

low. Demand is therefore inelastic.

The Type of Want Satisfied by the Product

The price elasticity of the demand for necessities, like basic foodstuffs, electricity,

petrol and medical care, tends to be lower than the price elasticity of luxury goods and

services such as recreation, entertainment, swimming pools and luxury motor

vehicles. There are no hard and fast rules to determine whether a particular good or

service is a necessity or a luxury. All we can really say is that the demand for a product

that is considered a necessity tends to be relatively inelastic, whereas the demand for

a product that is considered a luxury tends to be relatively elastic.

Time Period under Consideration

Demand tends to be more price elastic in the long run than in the short run. When the

price of a product changes, ceteris paribus, consumers usually need time to adjust to

the change in relative prices.

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Other Demand Elasticities

Elasticity is a measure of responsiveness that can be applied to any causal

relationship between two variables. Two other demand elasticities exist: income

elasticity of demand and the cross elasticity of demand.

Income Elasticity of Demand

The income elasticity of demand (ey) measures the responsiveness of the quantity

demanded to changes in income. Applying our general definition of elasticity, it is

defined as the ratio between the per centage change in the quantity demanded (the

dependent variable) and the per centage change in consumers’ income (the

independent variable). As consumers’ incomes rise, the quantity usually demanded

increases, ceteris paribus. The question is, by how much?

   



Income elasticity of demand may be positive or negative. A positive in come elasticity

of demand means that an increase in income is accompanied by an increase in the

quantity demanded of the product concerned (or that a decrease in income is

accompanied by a decrease in the quantity demanded). Goods with a positive income

elasticity of demand are called normal goods. A negative income elasticity of demand

means that an increase in income leads to a decrease in the quantity demanded of

the good concerned (or that a decrease in income leads to an increase in the quantity

demanded). Goods with a negative income elasticity of demand are called inferior

goods. Normal goods are further classified as luxury goods or essential goods. When

the income elasticity of demand is greater than one, that is, when the per centage

change in the quantity demanded is greater than the per centage change in income,

the good is called a luxury good. When the income elasticity of demand is positive but

less than one, that is, when the per centage change in the quantity demanded is

smaller than the per centage change in income, the good is called an essential good.

Cross Elasticity of Demand

The quantity demanded of a particular good also depends on the prices of related

goods. The cross elasticity of demand measures the responsiveness of the quantity

demanded of a particular good to changes in the price of a related good. Cross

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elasticity of demand (ec) is the ratio between the per centage change in the quantity

demanded of a product (the dependent variable) and the per centage change in the

price of a related product (the independent variable), that is:

   



When two goods are unrelated (e.g., motorcar tyres and margarine), the cross

elasticity of demand will be zero. In the case of substitutes (e.g., butter and margarine),

the cross elasticity of demand is positive. A change in the price of the one product

(e.g., butter) will lead to a change in the same direction in the quantity demanded of

the substitute product. For example, when the price of butter increases, more

margarine will be demanded, ceteris paribus, as consumers switch to the relatively

cheaper margarine. In the case of complements, the cross elasticity of demand is

negative. A change in the price of the one product (e.g., motorcars) will lead to a

change in the opposite direction in the quantity demanded of the complementary

product (e.g., motorcar tyres). For example, if the price of motorcars falls, the quantity

of motorcars demanded will increase and as a result more motorcar tyres will be

demanded.

Price Elasticity of Supply

The price elasticity of supply measures the responsiveness of the quantity supplied of

a product to changes in the price of the product. More formally, the price elasticity of

supply (es) is the ratio between the per centage change in the quantity supplied of a

product (the dependent variable) and the per centage change in the price of the

product (the independent variable), that is:

   



5.6. Different Categories of Supply Elasticity

Price elasticity of supply measures the responsiveness to the supply of a good or

service after a change in its market price. In Economics theory, supplying of a good

will increase when its price rises. Also, the supply of a good will decrease when its

price decreases (Ross, 2020).

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Perfectly inelastic supply (es=0)

The supply curve in the figure below is perfectly inelastic. It has the same shape as a

perfectly inelastic demand curve, indicating that the quantity supplied is unresponsive

to (or independent of) changes in the price of the product.

Figure 5.8: Perfectly Inelastic Supply

Source: Mohr (2020:127)

Inelastic supply (es greater than 0 but smaller than 1)

The supply curve in the figure below is an inelastic supply curve. Any upward-sloping

linear supply curve which intersects the horizontal (quantity) axis has a positive

elasticity of less than one (but greater than zero). This indicates that the per centage

change in the quantity supplied is less than the per centage change in the price of the

product.

Figure 5.9: Inelastic Supply

Source: Mohr (2020:127)

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Unitarily elastic supply (es=1)

The supply curve in the figure below has unitary elasticity. Any upward sloping linear

supply curve which passes through the origin has an elasticity of one, indicating that

the per centage change in the quantity supplied is equal to the per centage change in

the price of the product.

Figure 5.10: Unitarily Elasticity

Source: Mohr (2020:127)

Elastic Supply

The supply curve in the figure below is an elastic supply curve. Any upward-sloping

linear supply curve which intersects the vertical (price) axis has an elasticity greater

than one but less than infinity. This indicates that the per centage change in the

quantity supplied is greater than the per centage change in the price of the product

Figure 5.11: Elastic Supply

Source: Mohr (2020, pp.127)

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Perfectly Elastic Supply

Figure 5.12: Perfect Elastic Supply

Source: Mohr (2020, pp 127)

The supply curve in the figure below is perfectly elastic, indicating that any quantity

can be supplied at a given price. It, too, has the same shape as a perfectly elastic

demand curve.

Student Activity:

Based on the above sections:

1. Discuss what is demand elasticity.

2. Specify what is income elasticity of demand and give examples

3. Specify what is cross elasticity of demand and give examples

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CHAPTER SIX:

The Theory of Demand: The Utility Approach

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Define utility, marginal utility, and weighted marginal utility

• Explain the relationship between total, average and marginal values

• State the conditions of consumer equilibrium

• Use a weighted marginal utility to derive a demand curve

This chapter focuses on consumer behaviour more intensely. Further discussions are

centred around the reasons for demand curves and the consumer choice: the utility

approach and the indifference approach. More centrally, utility, marginal utility and

weighted marginal utility are further discussed. The discussions of a consumer and

analysing consumer behaviour is important as it refers to an act of consuming a good

or service. Consumer behaviour is the study of how individuals, groups and

organizations select, buy, use and dispose of goods, services, ideas, and experiences

to satisfy their needs and wants (Kotler).

6.1. What is Utility?

Utility, in economics refers to the total satisfaction received from consuming a

good or service. Theories in economics based on rational choice usually

assume that consumers will strive to maximize their utility. The economic utility

of a good or service is important to understand, as it directly influences the

demand, and therefore price, of that good or service. Practically, a consumer's

utility is impossible to measure and quantify. Then again, some economists

believe that they can indirectly estimate what is the utility for an economic good

or service by employing various models. (Investopedia Staff, 2020).

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6.2. Cardinal and Ordinal Utility

Cardinal utility involves the idea that utility can be measured in some way, while ordinal

utility involves the ranking of different bundles of consumer goods or services in order

of preference (“ordinal” is derived from “order(ing)”). The utility approach to the

analysis of consumer behaviour is based on the assumption that a consumer can

assign values to the amount of satisfaction (utility) that he or she obtains from the

consumption of each successive unit of a consumer good or service. the utility

approach is based on the notion of cardinal utility.

6.3. Marginal Utility and Total Utility

The utility approach to the analysis of consumer behaviour is based on the assumption

that an individual consumer can and does subjectively assign units of value to the

utility derived from the consumption of successive units of a product. To distinguish

these units from other units of measurement (such as metres, litres, and Rand) we call

them utils.

Let us consider Mark’s consumption of apples during a particular period, illustrated in

the table below.

Table 6.1: Marks marginal utility and total utility derived from the consumption of

apples

Source: Mohr (2020:132)

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• It can be seen from the table above that Mark derives 50 units of utility from

the consumption of 1 apple, shown in the Marginal utility column (also

known as 50 utils).

• Because he has consumed an apple, his desire to consume another

decreases. Therefore, consumption of another apple derives a smaller

utility, or satisfaction.

• The utility gained from the consumption of the second apple is 35 utils,

shown in the Marginal utility column. Therefore, marginal utility is the

additional utility the consumer derives from the consumption of an extra unit

of the good.

• The total utility derived from the consumption of two apples is 85, shown in

the Total utility column.

• If identical (homogeneous) units of a good are consumed one after the

other, marginal utility will decline until it reaches zero-thereafter becoming

negative utility, called disutility.

• The above example illustrated the law of diminishing marginal utility, which

states that marginal utility of a good or service declines as more of it is

consumed.

6.4. Consumer Equilibrium in the Utility Approach

In the analysis of consumer behaviour, it is assumed that every consumer attempts to

maximise his or her satisfaction of wants by consuming goods and services. The aim

is thus to obtain the highest attainable level of total utility. The adjective “attainable”

is important. Since a consumer’s income and the prices of the various goods and

services limit his or her capacity to satisfy wants. For a given income and a given set

of prices of goods and services, a consumer will be in equilibrium if he or she obtains

the maximum possible total utility. When a consumer obtains the maximum possible

total utility from his or her income, given the prices of the various goods and services,

there is no incentive for the consumer to change his or her plans.

A consumer will be in equilibrium if it is impossible to increase total utility (i.e., the total

satisfaction of wants) by purchasing more of one good and less of another. This

position will be reached when the last monetary unit (Rand in our example) spent on

each good yields the same satisfaction or utility. This happens when the weighted

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marginal utility of each good is the same (provided that the specific combination is

affordable). To obtain the consumer’s equilibrium position, we must determine which

combinations are affordable and at which of these combinations the weighted marginal

utility (i.e., the marginal utility divided by the price of the product) is the same for all

the goods in question. When the weighted marginal utilities are equal, and all money

has been spent, a consumer will be at equilibrium. At equilibrium, a consumer will

derive the same utility from the last Rand spent on each product.

Assume there three products that a consumer can buy, bread, meat, and rice. The

consumer will be in equilibrium only when:





  



  



  

Where ,  and  are the marginal utilities of bread, meat, and rice

respectively, and , and  are the prices of bread, meat, and rice, respectively.

The two conditions that have to be met in order for a consumer to be in equilibrium

are:

• The combination of goods purchased has to be affordable.

• The weighted marginal utilities of the different goods must be equal.

This is also known as the law of equalising the weighted marginal utilities.

6.5. Derivation of an Individual Demand Curve for a Product

A demand curve shows the quantities demanded of a good or service at different

prices. We now use a simple example to illustrate how a consumer’s equilibrium

changes if the price of a product changes. Suppose that Helen Meyer has R10,00

available per week to spend on chocolates and yoghurt, which cost R2,00 and R3,00

per unit, respectively. Her scale of preferences is illustrated in Table below. The

subscript C denotes chocolates, and the subscript Y denotes yoghurt. The best that

Helen can do with her R10,00 is to purchase 2 units of chocolate and 2 units of yoghurt

per week. The weighted marginal utility of chocolate ( / ) is then equal to the

weighted marginal utility of yoghurt (/). Her R10,00 yields a total utility of (50 +

69) = 119 utils. This is the maximum that she can achieve by spending her R10,00 on

the two products (Mohr, 2020).

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Table 6.2: Helen Meyer’s Utility from Chocolate and Yoghurt (per week)

Source: Mohr (2020:137)

Marginal utility at equilibrium is the same as the ratio between the prices of the two

products:





  

   



  



If the price of chocolates falls to R1,00, Hellen’s new position is illustrated in the table

below:

Table 6.3: Hellen Meyer’s Utility from Chocolate and Yoghurt After the Price of

Chocolate has Decreased

Source: Mohr (2020:138)

After the price change, only the price and weighted marginal utilities of different

quantities of chocolate have changed.

She now maximises her utility by consuming 4 units of chocolate and 2 units of yoghurt

per week. The weighted marginal utility in each case is 10. Her total utility increases

from 119 utils to (74 + 69) = 143 utils.

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Once again, the ratio between the marginal utilities of the two products at equilibrium

is the same as the ratio between the prices of the products:





  

   



  



This means Hellen will increase her utility by consuming more chocolates than before,

that is when the price of chocolate falls. This is merely the demand curve. Hence, a

utility maximising consumer will demand a greater quantity of a product when the price

of the product falls, ceteris paribus. The figure below illustrates the two quantities of

chocolate demanded by Hellen.

Figure 6.1: Hellen’s Demand Curve for Chocolate

Source: Mohr (2020:138)

At R2,00, Hellen will purchase 2 units of chocolate, while at R1,00, Hellen will purchase

4 units. The table below summarises the various effects of different types of goods.

Table 6.4: Various Possible Substitution, Income, and Price Effects Summarised.

Effects of a price change

Type of good

Price change

Substitution

effect

Income effect

Total price

effect

Normal

P decreases

P increases

Qd increases

Qd decreases

Qd increases

Qd decreases

Qd increases

Qd decreases

Inferior (but not

Giffen)

P decreases

P increases

Qd increases

Qd decreases

Qd increases

Qd decreases

Giffen

P decreases

P increases

Qd increases

Qd decreases

Qd increases

Qd decreases

Qd increases

Source: Mohr (2015, pp.130)

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CHAPTER SEVEN:

Cost of Production

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Interpret the various revenue, cost, and proﬁt concepts

• Understand the difference between the total, average, and marginal product of

a variable input

• Explore the relationship between the law of diminishing returns and the shapes

of the total, average and marginal product curves in the short run

• Interpret the difference between total, average, and marginal cost

• Describe the relationship between the product curves and the cost curves in the

short run

• Describe the nature of production and costs in the long run

This chapter focuses on the theory behind the supply curve, and to examine firms’

decisions about how many units of a good or a service to supply at each price. Further

consideration is given to how firms behave and respond to changes in market forces

and economic policies. In this chapter the discussion is more-so on revenue, cost and

profit; production and cost. The aspects of total, average and marginal product and

total, average and marginal cost are also discussed with distinguishing further on short

run and the long run.

7.1. Introduction

A firm is a for-profit business organization—such as a corporation, limited liability

company (LLC), or partnership—that provides professional services. Some firms have

just one location. However, a business firm consists of one or more physical

establishments, in which all fall under the same ownership and use the same employer

identification number (EIN).

When used in a title, "firm" is typically associated with businesses that provide

professional law and accounting services, but the term may be used for a wide variety

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of businesses, including finance, consulting, marketing, and graphic design firms,

among others. (Kenton, 2020).

7.2. Firms

7.2.1. Types of Firms

A firm's business activities are typically conducted under the firm's name, but the

degree of legal protection—for employees or owners—depends on the type of

ownership structure under which the firm was created. Some organization types, such

as corporations, provide more legal protection than others. There exists the concept

of the mature firm that has been firmly established. Firms can assume many different

types based on their ownership structures:

• A sole proprietorship or sole trader is owned by one person, who is liable for all

costs and obligations, and owns all assets. Although not common under the

firm umbrella, there exists some sole proprietorship businesses that operate as

firms.

• A partnership is a business owned by two or more people; there is no limit to

the number of partners that can have a stake in ownership. A partnership's

owners each are liable for all business obligations, and together they own

everything that belongs to the business.

In a corporation, the businesses' financials are separate from the owners' financials.

Owners of a corporation are not liable for any costs, lawsuits, or other obligations of

the business. A corporation may be owned by individuals or by a government. Though

business entities, corporations can function similarly to individuals. For example, they

may take out loans, enter into contract agreements, and pay taxes. A firm that is owned

by multiple people is often called a company.

A financial cooperative is similar to a corporation in that its owners have limited liability,

with the difference that its investors have a say in the company's operations (Kenton,

2020).

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7.2.2. The Goal of the Firm

The theory of the supply of goods (or supply theory) attempts to explain the behaviour

of ﬁrms. That is why it is also called the theory of the ﬁrm. To understand how ﬁrms

behave, we have to know what their goals are. Let’s assume that all ﬁrms seek to

maximise proﬁts. Firms may, of course, also have other objectives. Some ﬁrms

attempt to dominate the market by maximising their sales or market share, even

though this might involve reducing their proﬁt margins. Their ultimate aim is to

dominate the market to such an extent that they feel stable and secure. The fact that

most large ﬁrms are not owner-managed also has implications for the objectives of

these ﬁrms. Although the owners (the shareholders) may want the ﬁrm to make

maximum proﬁt, the managers may pursue their own objectives, such as expanding

the size of the ﬁrm, since their status, power, and remuneration tend to increase as

the ﬁrm grows. This is an example of the principal-agent problem in economics. The

principal-agent problem is a conflict in priorities between a person or group and the

representative authorized to act on their behalf. An agent may act in a way that is

contrary to the best interests of the principal. – see Box 7-1.

A variety of managerial, behavioural and other theories have been developed to

explain the behaviour of ﬁrms that pursue other, non-proﬁt-maximising goals. For our

purposes, however, it is sufﬁcient to focus on proﬁt maximisation. Proﬁt is an important

objective of any privately- owned ﬁrm. If a ﬁrm is not proﬁtable, it cannot continue to

exist in the long run. That is why ﬁrms are sometimes deﬁned as proﬁt-seeking

business enterprises.

Box 7.1: The Principal-Agent Problem

For example, a company's stock investors, as part-owners, are principals who rely

on the company's chief executive officer (CEO), as their agent, to carry out a

strategy in their best interests. That is, they want the stock to increase in price or

pay a dividend, or both. If the CEO opts instead to plough all the profits into

expansion or pay big bonuses to managers, the principals may feel they have been

let down by their agent.

There are a number of remedies for the principal-agent problem, and many of them

involve clarifying expectations and monitoring results. The principal is generally the

only party who can or will correct the problem.

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7.2.3. Proﬁt, Revenue, and Cost: A Brief Introduction

Proﬁt is simply the surplus of revenue over cost. To understand the behaviour of a

proﬁt-maximising ﬁrm, we, therefore, have to examine its revenue structure as well as

its cost structure, with a view to determining at which level of output the difference

between total revenue and total cost (i.e., the ﬁrm’s total proﬁt) is at a maximum. A

ﬁrm’s total revenue (TR) is simply the total value of its sales and is equal to the price

(P) of its product multiplied by the quantity sold (Q). Average revenue (AR) is equal to

total revenue (TR or PQ) divided by the quantity sold (Q). If all units are sold at the

same price, then average revenue is equal to the price of the product. Marginal

revenue (MR) is the additional revenue earned by selling an additional unit of the

product. More detail about the various revenue concepts is provided in Box 7-2. The

revenue structure of a ﬁrm is determined by the type of market in which it operates.

Some ﬁrms are price takers. They have to accept the price determined in the market

and cannot set their own prices. Other ﬁrms are price makers or price-setters and can,

within certain limits, decide at what prices to sell their products.

The revenue structures of the two sets of ﬁrms will thus differ. In contrast to their

revenue structures, the cost structures of ﬁrms are more universal and are not

speciﬁcally linked to the types of markets in which they operate. Firms use inputs (e.g.,

the various factors of production) to produce output. It follows that cost of production

will depend on factors such as the technological link between inputs and outputs (i.e.,

the state of technology) and the prices and productivity of the various inputs. In other

words, the theory of costs is based on the theory of production.

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Box 7.2: Total, Average, and Marginal Revenue

Source: Mohr (2020:157)

7.2.4. The Short Run and the Long Run in Production and Cost Theory

An important distinction in production and cost theory is that between the short run

and the long run. The short run is deﬁned as the period during which at least one of

the inputs is ﬁxed. An example would be a ﬁrm that has a factory in which certain

machinery has been installed and which can only vary its inputs of labour, raw

materials, etc.

In the long run, all the inputs are variable. For example, this would be a period that is

long enough for the ﬁrm to decide whether or not to open another factory or install

additional machines. The difference between the short run and the long run in

production and cost theory depends on the variability of the inputs and not on calendar

time. In some industries, for example, the clothing industry, the actual period required

for all inputs to be variable might be quite short, while in other industries, for example,

the steel industry, the actual period might be quite long. Before analysing production

and cost, in the short run as well as in the long run, we ﬁrst have to explain the meaning

of cost and proﬁt in economic analysis.

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7.3. Basic Cost and Proﬁt Concepts

7.3.1. Cost

Cost, in a basic economic sense, is the measure of the alternative opportunities

foregone in the choice of one good or activity over others. This fundamental cost is

usually referred to as opportunity cost. For a consumer with a fixed income, the

opportunity cost of purchasing a new domestic appliance may be, for example, the

value of a vacation trip not taken (Encyclopædia Britannica, 2008). The difference

between accounting costs and economic costs can be explained by distinguishing

between explicit costs and implicit costs.

Accountants tend to consider explicit costs only. Explicit costs are the monetary

payments for the factors of production and other inputs bought or hired by the ﬁrm.

These costs are, of course, also opportunity costs, since the payments for inputs

reﬂect opportunities that are sacriﬁced. For example, if a ﬁrm pays R1 million for a

certain machine, it means that it has decided not to do something else with the funds

(like purchasing a different machine, purchasing a building, or depositing the funds

with a ﬁnancial institution). Economists, however, use a broader concept of opportunity

cost and consider implicit costs as well as explicit costs. Implicit costs are those

opportunity costs that are not reﬂected in monetary payments. They include the costs

of self-owned or self-employed resources. The economist recognises that the use of

resources owned by the ﬁrm is not free. For example, the owner of an individual

proprietorship (i.e. a one-person business) must consider what he or she would have

earned if he or she had not been running the ﬁrm (i.e., the opportunity cost of the

owner’s time must be included in the cost of production). These implicit opportunity

costs are added to his explicit costs to arrive at his total economic (or opportunity)

costs of producing furniture. We thus have:

Economic costs of production

= opportunity costs

= explicit costs + implicit costs

The monetary payments that the ﬁrm’s resources could have earned in their best

alternative uses are called normal proﬁt. Normal proﬁt can be regarded as the

minimum return required by the owner(s) of the ﬁrm to engage in a particular operation.

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If revenue is insufﬁcient to cover the economic costs of production (including all implicit

costs), the ﬁrm is not a viable concern. Normal proﬁt forms part of the ﬁrm’s costs of

production. Thus, when an economist says that a ﬁrm is just covering its costs, it

means that all explicit and implicit costs are being met and that the ﬁrm is earning a

normal proﬁt. As in the case of revenue, we distinguish between total, average, and

marginal costs. Total cost (TC) is simply the cost of producing a certain quantity of the

ﬁrm’s product. Average cost (AC) is the total cost (TC) divided by the number of units

(or quantity) of the product produced (Q). Marginal cost (MC) is the addition to total

cost (ΔTC) required to produce an additional (extra) unit of the product (ΔQ).

The relationships between total, average and marginal cost are the same as the

relationships between any other set of total, average and marginal magnitudes, as the

quantity produced increases.

• Total cost increases when marginal cost is positive

• Average cost increases when marginal coast is greater than average cost

• Average coast decreases when marginal cost is lower than average cost

• Average cost remains unchanged when marginal cost is equal to average

cost

Student Activity

Research the following costs:

1. Actual Costs

2. Discretionary Costs

3. Attributed Costs

7.3.2. Proﬁt

Proﬁt is the difference between revenue and cost. In other words, a ﬁrm’s proﬁt is the

difference between the revenue it earns by selling its product and the cost of producing

it. The economist’s deﬁnition of proﬁt is, however, not the same as the accountant’s

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deﬁnition of proﬁt. Accounting proﬁt is, therefore, an ex post concept based on

recorded transactions. Economists, on the other hand, are interested in explaining and

predicting behaviour and do not necessarily deal with things that have already

occurred. Also, recall that accountants usually consider only explicit costs, whereas

economists consider all costs, including implicit costs.

Implicit costs are those opportunity costs that are not reﬂected in actual payments.

As economists, we distinguish between total (or accounting) proﬁt, normal proﬁt, and

economic proﬁt:

• Total (or accounting) proﬁt is the difference between total revenue from the sale

of the ﬁrm’s product(s) and total explicit costs.

• Normal proﬁt is equal to the best return that the ﬁrm’s resources could earn

elsewhere and forms part of the cost of production.

• Economic proﬁt is the difference between total revenue from the sale of the

ﬁrm’s product(s) and total explicit and implicit costs (i.e. the total economic, or

opportunity, costs of all resources, including normal proﬁt).

We thus have:

Accounting proﬁt = total revenue – total explicit costs

Economic proﬁt = total revenue – total costs (explicit and implicit), including normal

proﬁt

7.4. Production

The functional relationship between physical inputs (or factors of production) and

output is called production function. It assumed inputs as the explanatory or

independent variable and output as the dependent variable. Mathematically, we may

write this as follows:

Q = f (L,K)

Here, ‘Q’ represents the output, whereas ‘L’ and ‘K’ are the inputs, representing labour

and capital (such as machinery) respectively. Note that there may be many other

factors as well but we have assumed two-factor inputs here.

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Figure 7.1: Time Period and Production Functions

Source: Toppr.com. (2018).

The production function is differently defined in the short run and in the long run. This

distinction is extremely relevant in microeconomics. The distinction is based on the

nature of factor inputs.

Those inputs that vary directly with the output are called variable factors. These are

the factors that can be changed. Variable factors exist in both, the short run and the

long run. Examples of variable factors include daily-wage labour, raw materials, etc.

On the other hand, those factors that cannot be varied or changed as the output

changes are called fixed factors. These factors are normally characteristic of the short

run or short period of time only. Fixed factors do not exist in the long run.

Consequently, we can define two production functions: short-run and long-run. The

short-run production function defines the relationship between one variable factor

(keeping all other factors fixed) and the output. The law of returns to a factor explains

such a production function.

For example, consider that a firm has 20 units of labour and 6 acres of land and it

initially uses one unit of labour only (variable factor) on its land (fixed factor). So, the

land-labour ratio is 6:1. Now, if the firm chooses to employ 2 units of labour, then the

land-labour ratio becomes 3:1 (6:2).

The long-run production function is different in concept from the short run production

function. Here, all factors are varied in the same proportion. The law that is used to

explain this is called the law of returns to scale. It measures by how much proportion

the output changes when inputs are changed proportionately.

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Our maize farmer’s simple production function is presented as a schedule in Table

7.1. The first column shows how many units of land the farmer uses. Since we are

examining the short run, the quantity of land (the fixed input), and remains constant at

20 units. Various quantities of labour can be combined with this fixed quantity of land.

Some possible quantities are indicated in the second column. The third column shows

the maximum quantities of output (in tons) that can be produced with the various

combinations of the two inputs, given the current state of technology. In economics,

we refer to these figures as total product (TP). Note that product is expressed in

physical units, not in money terms.

Table 7.1: Production Schedule of a Maize Farmer with One Variable Input

Source: Mohr (2020:162)

7.4.1. The Law of Diminishing Returns

The S-shape of the total product curve reﬂects actual production functions so

frequently that economists have formulated a “law” to express it. This is called the law

of diminishing returns, or the law of diminishing marginal returns. As the quantity of

labour is increased, the initial beneﬁts are gradually exhausted. All the possible

savings from the division of labour have been gained, and the addition of more labour

brings no more savings of this kind.

The law of diminishing returns states that as more of a variable input is combined with

one or more ﬁxed inputs in a production process, points will eventually be reached

where ﬁrst the marginal product, then the average product, and ﬁnally the total product

starts to decline.

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7.4.2. Average and Marginal Product

The average product (AP) of the variable input is simply the average number of units

of output produced per unit of the variable input. It is obtained by dividing the total

product (TP) by the quantity of the variable input (N). AP is shown in column 5 of Table

7.2. The ﬁrst three columns of Table 7.2 contain the same information as Table 7.1.

The marginal product (MP) of the variable input is the number of additional units of

output produced by adding one additional unit (the marginal unit) of the variable input.

As a marginal concept, MP is similar to all other marginal concepts.

Table 7.2: Production Schedule of a Maize Farmer with One Variable Input

Source: Mohr (2020:164)

Figure 7.2: Total, Average, and Marginal Product of Labour.

Source: Mohr (2020, pp.165)

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In (a), we show the total product of labour TP, while the average and marginal product

of labour (AP and MP) are shown in (b). The same scales are used on the horizontal

axes in (a) and (b), but the vertical scale in (b) is larger (more “stretched out”) than in

(a). TP increases as long as MP is positive but falls once MP becomes negative. AP

increases if MP is above it, reaches a maximum where it is equal to MP, and then falls

when MP is below it.

7.4.3. Comparison of Total, Average, and Marginal Product

The total, average, and marginal product of labour are all based on the same basic

information and are therefore interrelated. If the total product curve is smooth, the

average and marginal curves are also smooth, as shown in Figure 6.3. In this case,

the curves display the following mathematical characteristics (see also Box 7-3):

• AP and MP are shaped like inverted “U”s, that is, as the variable input is

increased, they rise at declining rates, reach maximum points and then

decrease at increasing rates.

• MP reaches its maximum before AP reaches its maximum.

• Before AP reaches a maximum, MP lies above AP.

• 7P equals AP at the maximum point of AP.

• After the maximum point of AP is reached, MP lies below AP.

Box 7.3: The Total, Average, and Marginal Product Mathematical Interpretation

Source: Mohr (2020:166)

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7.5. Costs in the Short Run

In economics, “short run” and “long run” are not broadly defined as a rest of time.

Rather, they are unique to each firm. Long run costs have no fixed factors of

production, while short run costs have fixed factors and variables that impact

production.

7.5.1. Fixed and Variable Costs

Fixed cost is formally deﬁned as cost that remains constant irrespective of the

quantity of output produced. Fixed costs are sometimes also called overhead costs,

indirect costs, or unavoidable costs.

Table 7.3 illustrates the relationship between the short-run production function and the

short-run total cost function of the maize farmer. This represents the total ﬁxed cost

(TFC) of producing the various quantities of output indicated in column 3. TFC is

shown in column 4 of Table 7.3. Columns 3 and 4 together are known as the total fixed

cost schedule, because they indicate the relationship between total product (TP) and

total ﬁxed cost (TFC).

Table 7.3: Total, Fixed, and Variable Cost Schedules of a Maize Farmer

Source: Mohr (2020:166)

7.5.2. Average and Marginal Cost

Since there are three measures of total cost, there are also three measures of average

cost:

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• Average fixed cost AFC (i.e., total ﬁxed cost TFC divided by total product

TP)

• Average variable cost AVC (i.e., total variable cost TVC divided by total

product TP)

• Average cost AC (i.e., total cost TC divided by total product TP)

Average cost is obtained by dividing total cost by total product (not by units of labour,

as in the case of average product). Average cost AC is sometimes called average total

cost and abbreviated to ATC. However, to avoid this somewhat cumbersome term, we

simply refer to average cost AC. Just remember that AC includes average ﬁxed cost

and average variable cost.

Average cost could easily be calculated from the total cost ﬁgures in Table 7.4; it is

not so straightforward to calculate marginal cost from such ﬁgures. The reason is that

the total product ﬁgures in the table do not increase by one unit at a time, as required

by the deﬁnition of marginal cost. The marginal cost must be approximated by ﬁrst

calculating the increases in total cost and total product, and then dividing the increase

in total cost by the increase in total product, as shown in Table 7.5. Marginal cost is

not deﬁned for ΔTP = 0.

Table 7.4: Short-Run Total and Unit Cost Schedule for a Firm with One Variable

Input

Source: Mohr (2020:168)

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Table 7.5. Calculation of Marginal Cost

Source: Mohr (2020:168)

The average and marginal cost schedules are collectively referred to as unit cost

schedules, to distinguish them from the total cost schedules. The unit cost schedules

are depicted in Figure 7.3. Total product is measured on the horizontal axis and cost

on the vertical axis. Note that the AVC, AC, and MC curves are U-shaped. Recall that

the average and marginal product curves, AP and MP, are shaped like inverted “U”s

(see Figure 7.3). As in the case of total, average and marginal product, from which the

cost functions are derived, there are mathematical relationships between the cost

functions. If the total cost curve is smooth, the average and marginal cost curves will

also be smooth. In this case, the curves will exhibit the following properties.

• AFC is L-shaped. In other words, as TP increases from zero, it starts at a

very high value and then keeps on declining until the maximum TP is

reached.

• AVC, AC and MC are U-shaped. In other words, as TP increases from zero,

they start at high values, decline at decreasing rates, reach minimum points

and then increase at increasing rates.

• AC lies above AFC and AVC, because it includes them both. The vertical

distance between the AC and AFC curves is equal to AVC, and the vertical

distance between the AC and AVC curves is equal to AFC. As AFC declines,

the vertical distance between AC and AVC becomes smaller.

• MC reaches its minimum point before AVC.

• AVC reaches its minimum point before AC.

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• MC equals AVC and AC at their respective minimum points. Before these

points are reached, MC lies below AVC and AC respectively. Beyond these

points, that is, when total product is increased further, MC lies above AVC

and AC respectively.

Figure 7.3: Marginal and Average Cost

Source: Mohr (2020;169)

Figure 7.4: Marginal and Average Cost

Source: Mohr (2020:169)

7.5.3. The Relationship Between Production and Cost in the Short Run

The average and marginal product of labour, which each represents a relationship

between the quantity of labour (N) (on the horizontal axis) and output per unit of input

(on the vertical axis). Marginal product (MP) reaches a maximum of MP1 at N1 units

of labour. The average product of labour (AP) reaches a maximum of AP1 where it

intersects the marginal product (MP) at N2 units of labour.

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Figure 7.5: The Relationship Between Production (or Productivity) and Cost

Source: Mohr (2020:170)

In (a), we show the average and marginal product of labour, and in (b), we show the

corresponding average variable cost and marginal cost of production. The maximum

of MP (at N1) corresponds to the minimum of MC (at Q1). Similarly, the maximum of

AP (at N2) corresponds to the minimum of AVC (at Q2). The ﬁgure shows how the

inversely U-shaped product curves give rise to the U-shaped cost curves. Both are

grounded in the law of diminishing returns. When marginal product (MP) is increasing,

the marginal cost (MC) of producing a good is falling, but when MP declines, MC

increases.

7.6. Production and Costs in the Long Run

In the long run, there are no ﬁxed inputs – all the inputs (including all the factors of

production) are variable. In the long run, there are thus no ﬁxed costs – all the costs

are variable. Moreover, the law of diminishing returns does not apply. In production

theory, the long run is deﬁned as a period that is long enough for the ﬁrm to change

the quantities of all the inputs in the production process as well as the process itself.

In the long run, a ﬁrm has to make decisions about the scale of its operations, the

location of its operations, and the techniques of production it will use. All these

decisions will affect the cost of production.

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7.6.1. Returns to Scale

Returns to scale refer to the long-run relationship between inputs and output. Returns

to scale are measured by varying all the inputs by a certain per centage and comparing

the resulting per centage change in production with the per centage change in the

inputs. Three possible situations can be distinguished:

• Constant Returns to Scale. This is where a given per centage increases in

inputs will give rise to the same per centage increase in output

• Increasing Returns to Scale. This is where a given per centage increases in

inputs will lead to a larger per centage increase in output

• Decreasing Returns to Scale. This is where given per centages increase in

inputs will give rise to a smaller per centage increase in output

7.6.2. Economies of Scale

When more units of a good or service can be produced on a larger scale, yet with (on

average) fewer input costs, economies of scale are said to be achieved. Alternatively,

this means that as a company grows and production units increase, a company will

have a better chance to decrease its costs. According to this theory, economic growth

may be achieved when economies of scale are realized.

Understanding Economies of Scale

Economist Adam Smith identified the division of labour and specialization as the two

key means to achieving a larger return on production. Through these two techniques,

employees would not only be able to concentrate on a specific task but with time,

improve the skills necessary to perform their jobs. The tasks could then be performed

better and faster. Hence, through such efficiency, time and money could be saved

while production levels increased.

Just like there are economies of scale, diseconomies of scale also exist. This occurs

when production is less than in proportion to inputs. What this means is that there are

inefficiencies within the firm or industry, resulting in rising average costs (Heakal,

2019).

Economies and diseconomies of scale can be classiﬁed into two broad groups:

internal and external economies or diseconomies. Internal economies or

diseconomies are those pertaining to the speciﬁc ﬁrm – they can be controlled by the

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ﬁrm. External economies or diseconomies, on the other hand, are outside the ﬁrm’s

control and relate to conditions and events in the industry and the broader environment

within which the ﬁrm operates (Mohr, 2020).

Student Activity:

Discuss the following inputs relating to economies of scale and provide examples

• Lower Input Costs

• Costly Inputs

• Specialised inputs

• Techniques and Organizational Inputs

• Learning Inputs

Source: (Heakal, 2019)

7.6.3. Economies of Scope

The cost savings achieved by producing related goods in one ﬁrm rather than in two

separate ﬁrms are called economies of scope. A good South African example is Sasol,

which produces a wide range of related products.

7.6.4. Long-Run Average Costs

In the long run, all inputs are variable, and economies or diseconomies of scale may

be experienced. Long-run average cost (LRAC) curves can, therefore, take various

shapes. The three basic possibilities are illustrated in Figure 7.6. If economies of scale

are experienced, the ﬁrm’s LRAC curve will fall as output (i.e., the scale of production)

increases. This is illustrated in Figure 6.6(a). On the other hand, if diseconomies of

scale predominate, LRAC will rise as output increases. This is illustrated in Figure

7.6(b). The third possibility is that neither economies nor diseconomies of scale are

experienced. In this case, as illustrated in Figure 7.6(c), the LRAC curve is horizontal,

indicating constant costs.

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Figure 7.6: Alternative Long-Run Average Cost Curves

Source: Mohr (2020:172)

If cost per unit of output falls as output increases, economies of scale are experienced,

as illustrated in (a). If cost per unit of output increases as output increases,

diseconomies of scale are experienced, as illustrated in (b). The third possibility,

illustrated in (c), is that cost per unit of output remains constant as output increases.

Figure 7.7. A Typical Long-Run Average Cost Curve

Source: Mohr (2020:172)

As long as economies of scale are experienced, average costs fall. This is followed by

a range of output over which average costs remain constant. At some level of output

diseconomies of scale may set in resulting in an increase in average costs.

7.6.5. Long-Run Marginal Cost

The relationship between long-run average cost (LRAC) and long-run marginal cost

(LRMC) is similar to that between any other set of average and marginal variables. If

there are economies of scale, the LRMC curve must lie below the LRAC curve. The

only way in which LRAC can decline is if the cost of additional units of output (LRMC)

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is lower than the current average cost, thus pulling it down. This is illustrated in Figure

7.8(a). On the other hand, if there are diseconomies of scale, the LRMC curve must

lie above the LRAC curve. The only way in which LRAC can increase is if the cost of

additional units of output (LRMC) is higher than the current average cost, thus pulling

it up. This is illustrated in Figure 7.8(b). If constant costs are experienced, the LRAC

curve is horizontal. In this case, the LRMC curve must coincide with the LRAC curve.

The only way in which LRAC can remain unchanged is if the cost of any additional

units of output (LRMC) is the same as the current average cost, thus keeping it

constant. This is illustrated in Figure 7.8(c). If economies of scale are experienced only

up to a certain level of output, followed by diseconomies of scale. As long as LRMC is

below LRAC, LRAC will fall. When LRMC is above LRAC, LRAC will rise. It follows,

therefore, that the LRMC curve will intersect the LRAC curve at the minimum of the

LRAC curve. This is illustrated in Figure 7.8(d). If the LRAC curve has a horizontal

section, as in Figure 7.7, then LRMC will coincide with LRAC along that section before

rising above LRAC.

Figure 7.8: The Relationship between Long-run Average and Marginal Costs

Source: Mohr (2020:173)

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7.6.6. The Relationship Between Long-Run and Short-Run Average Cost Curves

In the long run, all inputs are variable. The ﬁrm can choose to use any quantity per

period of, for example, land, buildings, machinery, and management. In the long run,

there are thus no total or average fixed costs. In the short run at least one input is

ﬁxed, and the ﬁrm is thus faced with total and average ﬁxed costs. The long run can

be envisaged as a set of alternative short-run situations between which the ﬁrm can

choose. In each short-run situation, the ﬁrm faces a given set of short-run costs. In

Figure 7.9 SRAC1, SRAC2, and SRAC3 represent three different short-run average

cost curves, each pertaining to a situation in which at least one input is ﬁxed. For

example, SRAC1 may refer to a situation where the ﬁrm operates only one factory. If

the ﬁrm builds another factory, the average cost curve (for the two factories) is SRAC2

and if it builds a third factory, then average cost (for the three factories) is represented

by SRAC3. The long-run average cost (LRAC) curve is obtained by joining the lowest

portions of the three short-run average cost curves, as indicated by the heavy line in

the ﬁgure. The ﬁrm will never operate at the light portions of the SRAC curves in the

long run because it will always be able to reduce costs by changing the size of the

ﬁrm. The heavy line in Figure 7.9 thus represents the long-run average cost, which

illustrates the least-cost method of production for each level of output. The LRAC curve

is called an envelope curve since it envelops a series of SRAC curves. If we assume

that the short run ﬁxed inputs can be varied by any amount, in the long run, there will

be an unlimited number of SRAC curves, and the LRAC curve will become smooth, as

in Figure 7.10.

Figure 7.9: A Long-Run Average Cost Curve for Three Scales of Production

Source: Mohr (2020:174)

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Figure 7.10: The Long-Run Average Cost Curve When Short-Run Fixed Inputs can

be Varied by Any Amount (in the Long Run)

Source: Mohr (2020:174)

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CHAPTER EIGHT:

Market Structures

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Describe the main characteristics of the four standard forms of market

structures in an economy

• Provide a detailed description of the profit maximising condition of a firm

using marginal analysis

• Distinguish between the short-run and long-run profit maximising positions

of firms in some of the markets

This chapter focuses on the equilibrium positions of firms. The focus is on production

profitability based on what quantities of the product the firm should supply at different

prices of the product. As a result, demand conditions are also looked into.

8.1. Introduction

In this chapter and the next one, we derive the equilibrium positions of ﬁrms. We want

to determine whether or not it is proﬁtable for a ﬁrm to produce and, if so, what

quantities of the product the ﬁrm should supply at different prices of the product. To

do this, we have to consider demand conditions as well. In other words, we have to

consider both supply and demand.

This chapter will also discuss the four standard forms of market structures: perfect

competition, monopoly, monopolistic competition, and oligopoly. Furthermore, a

thorough analysis of a firm that operates under the competition.

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8.2. Market Structure: An Overview

The behaviour of a ﬁrm depends on the features of the market in which it sells its

product(s) and on its production costs. The major organisational features of a market

are called the structure of the market (or market structure). These features include

the number and relative sizes of sellers and buyers, the degree of product

differentiation, the availability of information, and the barriers to entry and exit.

Figure 8.1: Market Structures

Table 8.1: Summary of Market Structures

Source: Mohr (2020:180)

8.2.1. The Equilibrium Conditions (for any ﬁrm)

Firms operating in any market structure want to maximise proﬁt. Economic proﬁt is

the difference between revenue and cost (which includes normal proﬁt). To examine

the behaviour of ﬁrms, we, therefore, have to examine and combine their revenue

and cost structures. Once these are known, two decisions have to be taken:

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• Decide whether or not it is worth producing at all.

• If it is worth producing, the firm must determine the level of production at

which profit is maximized.

Two rules for profit maximization which apply to all firms, irrespective of the market

condition that they operate in are:

• The Shut-Down Rule:

The ﬁrst rule is that a ﬁrm should produce only if total revenue is equal to, or greater

than, total variable cost (which includes normal proﬁt). This is often called the shut-

down (or close-down) rule, but it can also be called the start-up rule because it does

not just indicate when a ﬁrm should stop producing a product – it also indicates when

a ﬁrm should start (or restart) production. The shut-down rule can also be stated in

terms of unit costs – a ﬁrm should produce only if average revenue (i.e., price) is

equal to, or greater than, average variable cost.

In the long run, all costs are variable. Production should therefore take place in the

long run only if total revenue is sufﬁcient to cover all costs of production. This is quite

straightforward. But what about the short run, when certain costs are ﬁxed? Should

production occur only if total revenue is sufﬁcient to cover total costs (i.e., total ﬁxed

costs and total variable costs)? The answer is no.

• The Profit Maximising Rule:

The second rule is that ﬁrms should produce that quantity of the product such that

proﬁts are maximised, or losses minimised. Since the same rule applies for proﬁt

maximisation and loss minimisation, we usually refer to proﬁt maximisation only, and

we do not always mention that the aim is also to minimise losses.

Proﬁt maximisation can be explained in terms of total revenue (TR) and total cost

(TC) or in terms of marginal revenue (MR) and marginal cost (MC). Since proﬁt is the

difference between revenue and cost it is obvious that proﬁts are maximised where

the positive difference between total revenue and total cost is the greatest. However,

it is usually more useful to express the proﬁt-maximisation condition in terms of

revenue and cost per unit of production. The rule is that proﬁt is maximised where

marginal revenue (MR) is equal to marginal cost (MC).

To understand why proﬁts are maximised where MR = MC, it is useful to consider

what happens if MR is not equal to MC. If marginal revenue MR (i.e., the addition to

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revenue as a result of the production of an extra unit of the product) is greater than

marginal cost MC (i.e., the cost of producing that extra unit), the ﬁrm is still making a

proﬁt on the last (extra) unit produced. The ﬁrm can therefore add to its total proﬁt by

expanding its production until no extra proﬁt is made on the last unit produced, that

is, until the revenue earned from the last unit (MR) is equal to the cost of producing

the last unit (MC). At that quantity the ﬁrm’s proﬁt is maximised.

If the ﬁrm continues producing beyond that point, the cost of producing each

additional unit of output (MC) will be greater than the revenue gained from selling it

(MR). In other words, the ﬁrm will make a loss on the production of each additional

unit of output, and its proﬁt will therefore decrease. Proﬁts are maximised when

marginal revenue MR is just equal to marginal cost MC. Different possibilities may be

summarized as follows:

• MR > MC, output should be expanded

• MR = MC, profits are maximized

• MR < MC, output should be reduced.

8.2.2. Perfect Competition

We start our analysis of the behaviour of ﬁrms by assuming that there is perfect

competition in the goods market. Recall from earlier chapters that a market consists

of all the buyers (demanders) and sellers (suppliers) of the good or service

concerned. Also, recall that competition occurs on each side of the market. In the

goods market, the buyers compete to obtain the good, and the sellers compete to sell

the good to the buyers.

Perfect competition occurs when none of the individual market participants

(i.e., buyers or sellers) can

inﬂuence the price of the product. The price is

determined by the interaction of demand and supply and all the

participants have to

accept that price. In perfectly competitive markets all the participants are, therefore,

price takers – they have to accept the price as given and can only decide what quantities

to supply or demand at that

price.

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Student Activity

1. Students are to research and provide two examples of an economies that

operate under perfect competition conditions.

The Demand for the Product of the Firm

Under perfect competition the price of a product is determined by supply and demand.

The individual ﬁrm is a price taker and can sell any quantity at the market price. No

ﬁrm will charge a price higher than the prevailing market price because it will then

lose all of its customers. Nor will a ﬁrm gain anything by charging a price that is lower

than the existing market price, since it can sell as many units of its output as it wishes

at the market price.

Under perfect competition the individual ﬁrm is faced by a demand curve, which is

horizontal (or perfectly elastic) at the existing market price. We call this curve the

demand curve for the product of the ﬁrm. It is sometimes also called the ﬁrm’s

sales curve, the ﬁrm’s demand curve, or the demand curve facing the ﬁrm. The

position of the individual ﬁrm under perfect competition is illustrated in Figure 8.2. The

graph on the left shows that the price of the product (P1) is determined in the market

by the forces of supply (SS) and demand (DD). The position of the individual ﬁrm is

shown in the graph on the right. The ﬁrm can sell any quantity at the prevailing market

price. At higher prices, the quantity demanded will fall to zero. The firm will also not

charge a lower price than P1 because it can sell all its output at a price of -P1. The

horizontal curve P1 is the demand for the product of the firm.

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Figure 8.2:

The Demand Curve for the Product of the Firm under Perfect Competition

Source: Mohr (2020:185)

Under perfect competition, the firm receives the same price for any number of units of the

product that it sells.

Its marginal revenue (MR) and average revenue (AR) are thus

both equal to the market price, that is, MR =

AR = P. We know that a firm’s total revenue

(TR) is equal to the price of the product (P) multiplied by the quantity

sold (Q), i.e. TR = P ×

Q (= PQ). Under perfect competition the price is given, thus for each additional unit that

the firm sells, total revenue will increase by an amount equal to the price of the product.

This is simply another way of stating that MR = AR = P.

8.2.3. The Equilibrium of the Firm under Perfect Competition

The ﬁrm can only decide to sell or not to sell at the ruling price. This means that the

ﬁrm does not have to make any pricing decisions – it can only choose the output

(quantity) at which it will maximise its proﬁts (or minimise its losses). That quantity, we

have seen, is where the positive difference between total revenue TR and total cost

TC is at a maximum, or (which amounts to the same thing) where marginal revenue

MR is equal to marginal cost MC, provided, of course, that average revenue AR (= P)

is at least equal to short-run average variable cost AVC (the shut-down rule).

We explained that any ﬁrm maximises its proﬁt (or minimises its losses) where

marginal revenue MR is equal to marginal cost MC. In Figure 8.2, we showed that

the ﬁrm’s marginal revenue MR is equal to the market price P of the product (since

each unit of output has to be sold at the market price, over which the individual ﬁrm

has no control). The proﬁt-maximising rule in the case of a perfectly competitive ﬁrm

can, therefore, also be stated as P = MC (since MR = P).

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8.3. Short Run Equilibrium Positions Under Perfect Competition

Figure 8.3: Different Possible Short-Run Equilibrium Positions of the Firm Under

Perfect competition

Source: Mohr (2020:189)

In (a), the market price is P1. This is, of course, equal to the firm’s AR and MR. Profit

is maximised where MR (= P1, in this case) is equal to MC. This occurs at a quantity

of Q1. "U Q1 the firm’s average revenue AR (= P1) is greater than its average total

cost AC (which is indicated as C1 on the vertical axis). The firm thus makes an

economic profit (or supernormal profit) per unit of production of P1 – C1. The firm’s

total profit is given by the shaded area C1P1E1M, which is equal to the profit per unit

of output (P1 – C1) multiplied by the quantity produced (Q1).

In (b), the market price (and therefore, also the firm’s AR and MR) is P2. It is equal to

MC at the point where MC intersects AC (i.e., at the minimum point of AC). The

corresponding level of output is Q2, where AR is equal to AC (and TR-TC), and the

firm does not have economic profit. It does earn a normal profit since all its costs,

which include normal profits, are fully covered. E2 in (b) is usually called break-even

point.

In (c), the market price (and therefore also the firm’s AR and MR) is equal to P3. MR

or price is equal to MC at a quantity of Q3. "U Q3 the firm’s average revenue AR is

lower than its average cost AC. It, therefore, makes an economic loss per unit of

output, equal to the difference between C3 and P3. The total economic loss is

indicated by the shaded area P3C3ME3. Whether or not the firm should continue

In the short run a ﬁrm’s economic proﬁt may be positive, zero or negative. In (a) we show a situation in which

the ﬁrm makes an

economic proﬁt, equal to the shaded area. In (b) the ﬁrm just breaks even. It earns a normal

proﬁt but no economic proﬁt. In (c) the

ﬁrm incurs an economic loss, equal to the shaded area. If the price P

(= AR) lies above the minimum AVC (not shown in the ﬁgure)

the ﬁrm will continue production in the short

run. If it lies below the minimum AVC, the ﬁrm will close down.

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production will depend on the level of AR (i.e., P3) relative to the firm’s average

variable cost AVC, which is not shown in the figure. If AR is greater than AVC, the firm

will be able to recoup some of its fixed costs and should therefore continue producing

in the short run. However, if AR is lower than AVC, the firm should close down in the

short run, thereby restricting its losses to its fixed costs.

8.4. The Supply Curve of the Firm and the Market Supply Curve

The market supply curve is obtained by adding the supply curves of the individual ﬁrms

horizontally. Earlier, we simply assumed that the ﬁrm’s supply curve and the market

supply curve slope upward from left to right. In the present chapter, we have explained

why this is the case. The supply curves slope upward because the marginal cost

curves slope upward, that is, because of marginal cost increases as output increases.

(The marginal cost curves, in turn, slope upward because the marginal product curves

slope downward – on account of the law of diminishing returns).

8.5. Long-Run Equilibrium of the Firm and the Industry under

Perfect Competition

In the long run, two things can change. First, new ﬁrms can enter the industry, and

existing ﬁrms can leave. Second, all factors of production become variable (recall

the deﬁnition and analysis of the long run in the previous chapter), and existing ﬁrms

earning economic proﬁt in the short run may decide to expand their plant sizes to

realise economies of scale. These two changes are now examined.

We start, in Figure 8.6, by showing the long-run equilibrium of the ﬁrm and the industry.

In Figure 8.6(a), we show that the individual ﬁrm is making only a normal proﬁt. It is

therefore covering all its costs (including normal proﬁt). The ﬁrm is doing just as well

as it could if its resources were employed elsewhere. There is thus no incentive for

existing ﬁrms to leave the industry or for new ﬁrms to enter the industry. In Figure

8.6(b), we show the market demand and supply of the product, which determines the

market price (and, therefore, the AR and MR of the individual ﬁrm). The vertical axes

in (a) and (b) are exactly the same – both measure the price per unit of the product.

The horizontal axes both measure quantities, but the horizontal scales are different

since each ﬁrm supplies only a small, insigniﬁcant part of the whole market. In the

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ﬁgure, this is indicated by using units on the horizontal axis in (a) and thousands of

units on the horizontal axis in (b). (The reason why the price is labelled P2 will become

obvious as we proceed)

In Figure 8.7 we show a situation in which the individual firm initially earns an economic

profit. The initial demand and supply curves in (b) are D1 and S1, respectively, and

the market price is P1. The individual firm in (a) makes an economic profit at E1 (i.e.,

at price P1). However, because the existing firms are making economic profits, new

firms enter the industry, and the market (or industry) supply curve shifts to the right.

This process will continue until the new supply curve is S2, and the market price is P2

(corresponding to the equilibrium point E2). "U E2 (i.e., at a price of P2) the individual

firm earns only a normal profit and there is no reason for more new firms to enter the

industry. The industry and each individual firm is in equilibrium at a price of P2. This

corresponds to the equilibrium at price P2 in Figure 8.6.

Figure 8.6: The Firm and Industry in Long-Run Equilibrium

Source: Mohr (2020:191)

Equilibrium occurs when the price determined in the market (P2 in (b)) is just sufficient

for the individual firm to earn a normal profit. This is shown in (a) where MR = MC and

AR = AC at the same quantity (Q2).

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Figure 8.7: The Individual Firm and the Industry when the Firm Initially Earns an

economic Profit

Source: Mohr (2020:191)

The original demand and supply curves in (b) are D 1 and S 1, yielding a price of P1.

At P1 the individual ﬁrm earns an economic proﬁt where MR 1 = MC, since AR > AC

at that point (E 1). At E 1 the industry is in disequilibrium. The economic proﬁts attract

new ﬁrms to the industry, thus shifting the supply curve in (b) to S 2 in the long run.

The price falls to P2, where industry equilibrium is established, since the individual

ﬁrm is only earning a normal proﬁt and there is no incentive for ﬁrms to enter or leave

the industry.

To summarise, economic proﬁts in a competitive industry are a signal for the entry of

new ﬁrms; the industry will expand, pushing the price down until the economic proﬁts

fall to zero (i.e., only normal proﬁts are earned). Economic losses in a competitive

industry are a signal for the exit of loss-making ﬁrms; the industry will contract, driving

the market price up until the remaining ﬁrms are covering their total costs (i.e., until

normal proﬁts are earned).

8.6. The Impact of Changes in the Scale of Production on the

Equilibrium of the Firm and the Industry

If an existing firm is earning an economic profit and it can realise economies of scale

(i.e., if the average cost can be reduced), it will expand its scale of production. This is

illustrated in Figure 8.9. Initially, the firm is producing at scale 1, with short-run

marginal cost SRMC1 and short-run average cost SRAC1. The market price is P1 and

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the firm maximises economic profit (indicated by the shaded area) by producing Q1

units of the product. In the long run, all the factors of production are variable, and the

firm can realise economies of scale (i.e., reduce average costs) by expanding to scale

2, indicated by the new short-run marginal and average costs, SRMC2 and SRAC2,

respectively. The firm expands since it will increase profits at the original market price

(P1) if its average costs are reduced. However, the existence of positive economic

profits in the industry attracts new entrants (as explained earlier) and also gives other

existing firms an incentive to expand.

Figure 8.8: The Individual Firm and the Industry when the Firm Initially Makes an

Economic Loss

Source: Mohr (2020:192)

Figure 8.9: Increasing the Firm’s Scale of Production to Realise Economies of Scale.

Source: Mohr (2020:193)

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In the long run, therefore, existing firms will continue to expand as long as there are

economies of scale to be realised (i.e., as long as average costs can be reduced), and

new firms will continue to enter the industry as long as positive economic profits are

being earned. This process will continue until only normal profits are earned. In the

long run, the firm is thus in equilibrium where P = SRMC = SRAC = LRAC, as at price

P2 and quantity Q2 in Figure 8.9. Only where P = SRMC = SRAC = LRAC, will

economic profit be zero and will the industry be in equilibrium.

8.7. Monopoly

In its

pure form, monopoly is a market structure in which there is only one seller of a

good or service that has no close substitutes. A further requirement is that entry to the

market should be completely blocked.

Monopoly is at the opposite extreme to perfect

competition in the spectrum of market structures.

Whereas a perfectly competitive industry consists of a large number of small ﬁrms, the

monopolistic industry consists of a single ﬁrm (i.e. the monopolistic ﬁrm is also the

industry). This means that the demand for the product of the industry (or the market

demand) is also the demand for the product of the single ﬁrm (or monopolist). The

monopolistic ﬁrm faces a downward-sloping demand curve and can ﬁx the price at

which it sells its product. In other words, it can choose the point along the demand

curve at which it wants to operate. However, once it decides on a price, the quantity

sold depends on the market demand. A monopolist cannot set its sales and its price

independently of each other. In other words, a monopolistic ﬁrm is always constrained

by the demand for its product. This demand, however, might be highly priced inelastic,

thereby creating scope for the monopolist to exploit consumers by reducing the

quantity supplied.

Like any other ﬁrm, a monopolist should produce where marginal revenue (MR) is

equal to marginal cost (MC) (the proﬁt-maximising rule), provided that average

revenue (AR) is greater than minimum average variable cost (AVC) in the short run or

average total cost AC in the long run (the shut-down rule).

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8.8. Total, Average, and Marginal Revenue Under Monopoly

Since a monopolist is the only supplier of the speciﬁc product, the demand curve for the

product of a monopolistic ﬁrm is

the market demand curve for the product of the

industry.

For example, if TP Cement is the sole supplier of cement in a particular

market, the market demand for cement in that area is also the demand for TP

Cement’s product. Because the market demand curve slopes downward, the

monopolist can only sell an additional quantity of output if it lowers the price of its

product. But the lower price will usually apply to all units of output, which means that

the marginal revenue from the sale of an extra unit of output is less than the price at

which all units of the product are sold.

8.9. Short Run Equilibrium of the Monopolistic Firm

The short-run equilibrium position of a monopolistic ﬁrm is illustrated in Figure 8.10.

The ﬁrm faces a downward-sloping demand curve (D), which is also its average

revenue curve (AR). The ﬁrm’s marginal revenue (MR) is lower than its average

revenue, and the MR curve lies halfway between the AR curve and the price axis. The

monopolist’s marginal cost MC and average cost AC curves have the same shape as

those of any other ﬁrm.to maximise proﬁt (or minimise loss), the monopolist has to

produce where MR = MC. In Figure 8.10, this is indicated by E, which points to an

output of Q1. At lower levels of output than Q1, the ﬁrm’s marginal revenue MR is

greater than its marginal cost MC. The ﬁrm will, therefore, be able to add to its proﬁt

by expanding production. At Q1 the additional revenue generated by the last unit of

output is equal to the additional cost of producing that unit. At that quantity, the ﬁrm’s

proﬁt is maximised.

If it increases its production beyond Q1, the cost of each additional unit of output (MC)

is greater than the additional revenue (MR) earned by selling it. Total proﬁt will

therefore decline if the ﬁrm continues producing beyond Q1. Like any other ﬁrm, a

monopolist maximises proﬁt by producing that quantity where MR = MC.

At what price should that output be sold? The answer is quite simple. The monopolist

sells its output at the price that consumers are willing to pay for that particular quantity,

as indicated by the demand curve. In Figure 8.10, point M1 is the relevant point on the

demand curve. It shows that consumers are willing to pay a price of P1 for a quantity

of Q1. The equilibrium price is thus P1 and the equilibrium quantity Q1.

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Figure 8.10: The short-run equilibrium of the firm under monopoly

Source: Mohr (2020:202)

The figure shows the average revenue AR, marginal revenue MR, average cost AC

and marginal cost MC of a monopolist. The monopolist's profit is maximised by

producing a quantity Q1 and a price P1. The economic profit per unit of output in the

difference between M1 and K1 (or between P1 and C1). The firm's total economic profit

is the shaded area C1P1M1K1.

8.10. The Long-Run Equilibrium of the Monopolistic Firm

The monopolistic ﬁrm can thus continue to earn economic proﬁts (also called

monopoly proﬁts) in the long run, as long as the demand for its product remains intact.

8.10.1. Monopolistic Competition

One type of market in the spectrum between the extremes of perfect competition and

monopoly is monopolistic competition. As the name indicates, monopolistic

competition combines certain features of monopoly and perfect competition.

In a monopolistically competitive market, a large number of ﬁrms produce similar but

slightly different products. Whereas both a monopolist and a perfectly competitive ﬁrm

produce a homogeneous (standardised, identical) product, monopolistically

competitive ﬁrms produce heterogeneous (differentiated) products. The act of making

a product that is slightly different from the product of a competing ﬁrm is called product

differentiation.

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8.10.2. Oligopoly

An oligopoly is an industry dominated by a few large firms. For example, an industry

with a five-firm concentration ratio of greater than 50% is considered a monopoly.

• Examples of oligopolies

Car industry – economies of scale have cause mergers so big multinationals

dominate the market. The biggest car firms include Toyota, Hyundai, Ford, General

Motors, VW.

o Petrol retail – see below.

o Pharmaceutical industry

o Coffee shop retail – Starbucks, Costa Coffee, Cafe Nero

o Newspapers – In UK market share dominated by tabloids Daily Mail, The

Sun, The Mirror, The Star, Daily Express.

o Book retail – In UK market share is dominated by Waterstones, Amazon and

smaller firms like Blackwells.

• The main features of oligopoly

An industry which is dominated by a few firms.

o Interdependence of firms – companies will be affected by how other firms

set price and output.

o Barriers to entry. In an oligopoly, there must be some barriers to entry to

enable firms to gain a significant market share. These barriers to entry may

include brand loyalty or economies of scale. However, barriers to entry

are less than monopoly.

o Differentiated products. In an oligopoly, firms often compete on non-

price competition. This makes advertising and the quality of the product are

often important.

o Oligopoly is the most common market structure

Pettinger (2019).

• The Kinked Demand Curve

The kinked demand curve does not explain how price and output are determined under

oligopoly, but it does illustrate the importance of interdependence and uncertainty in

oligopolistic markets.

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Figure 8.11: The kinked demand curve

Figure 8.11 illustrates the position of an oligopolistic firm. Instead of explaining the

price of the product and the level of output, we start by assuming that the price of the

product is P1 and that the quantity supplied is Q1. This is indicated by point a which

is a point on the demand curve for the product of the firm. If the oligopolistic firm raises

or reduces the price of its product, the outcome will depend on the reactions of its

competitors. According to this particular theory, the oligopolist assumes that its

competitors will not react to a price increase by also raising the prices of their products.

A price increase will therefore lead to a relatively large fall in the quantity demanded

of the firm’s product ( consumers switch to the relatively cheaper products).This is

indicated by the demand curve Da. The oligopolistic firm thus believes that it will lose

market share if it increases the price of its product. However, the oligopolistic firm

assumes that its competitors will react to a price decrease by lowering their prices as

well. Therefore the oligopolistic firm will not be able to increase its market share by

lowering the price of its product. The quantity demanded of the firm’s product will

increase, but not to the same extent as it would decrease as a result of a comparable

increase in the price of its product. This is indicated by the demand curve ad. This

assumption of competitors reaction to a price increase and a price decrease gives rise

to a kinked demand curve, with the kink at the level of the ruling price of the product.

In effect the oligopolist is assuming that there are two demand curves for its product –

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one if competitors do not react to a price change (DD), and one if they do react (dd).

The kinked demand curve Dad thus consists of portions of two different demand

curves. The demand curve for the product of the firm is also its average revenue (AR)

curve, and its marginal revenue (MR) curve lies halfway between the AR curve and

the price axis. In the figure we also show the marginal revenue curve corresponding

to Dad. It consists of two separate portions, MR (corresponding to Da) and mr

(corresponding to ad). We know that profit is maximised at the level of output where

MR = MC. In the figure we also show a marginal cost (MC) curve which passes through

the gap between the two marginal revenue curves. Profit is thus maximised at the

existing quantity and price (Q1 and P1). The significance of the kinked demand curve

lies in the fact that MC can increase or decrease significantly without affecting

equilibrium output and price – any MC curve which passes through the gap between

MR and mr will yield the same equilibrium quantity and price. According to the theory

of the kinked demand curve, this is the result of the high degree of interdependence

among oligopolists, and the uncertainty about how competitors will react to price

changes. It should be emphasised, however, that the kinked demand curve is but one

of a wide range of theories explaining oligopolistic behaviour.

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CHAPTER NINE:

Labour Market

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Identify the main differences between the labour market and the goods

market

• Explain the main determinants of the supply of labour

• Explain how the demand for labour is derived

• Explain how a perfectly competitive labour market functions

• Analyse various labour market imperfections.

• Explain why wages differ

This chapter focuses on the labour market differs from the goods market. The

discussion and introduction of the supply of labour, the demand for labour and wage

determination in the labour market is discussed.

9.1. Introduction

Labour (the wage) is determined by supply and demand. Labour is an important factor

of production. The cost of labour is the largest cost factor in the economy. Changes in

the cost of labour therefore have a significant impact on cost and price trends in the

economy. The cost of labour depends on the wages and salaries paid to workers and

on the productivity of labour. If higher wages and salaries are not matched by

increased productivity, the cost of labour, which is usually expressed as labour cost

per unit of output, rises. But cost levels are unaffected if productivity rises to the same

extent as wages and salaries. It is, therefore, obvious that the productivity (or quality)

of labour is an important determinant of the cost of labour.

Labour issues are often highly politicised. This is quite understandable, given that

these issues involve human beings, their hopes, aspirations, and fears. South Africa

is no exception. At the height of apartheid, certain jobs were reserved for whites, while

a number of further restrictions were placed on black workers. In the 1970s and 1980s,

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trade unions representing mainly black workers played an important role in the political

struggle against apartheid. Since the 1990s affirmative action, black economic

empowerment and employment equity have been major issues and have had a

significant impact on the functioning of the labour market in South Africa.

9.2. The Labour Market

9.2.1. The Labour Market Versus the Goods Market

Like any other market, the labour market is a link between potential sellers (suppliers)

and potential purchasers (demanders). Individuals (or households) supply their labour

services to firms and the government, who hire these services at a price, called wages

and salaries (or wages for short). As shown in Figure 9.1 below, households sell their

labour to firms, that is, they supply labour (SS) on the labour market. The firms buy

the labour, that is, they demand labour (DD). The interaction of supply and demand

determines the price of labour, the wage (w1) and the quantity of labour employed

(N1).

Figure 9.1: The Interaction between Households and Firms in the Labour Market

Source: Mohr (2020:228)

The following are some of the differences between the labour and goods market:

• Workers usually have to be physically present when their services are used.

• Labour services are embodied in people and are not transferrable, unlike

goods that are transferrable between buyers and sellers.

• Labour services are always rented, and not sold unlike goods which can be.

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• Labour services can be affected by non-economic factors, for example,

fairness, loyalty, justice, appreciation, etc.

• Labour services involve organisations such as trade unions, employees’

associations, collective bargaining units, and government intervention when

being analysed.

• Labour is provided on a long-term, contractual basis unlike goods that can

be traded at short notice.

• Labour is heterogeneous in that it cannot be classified or standardized like

goods are.

• There is a variety of labour markets that can be segmented, each with its

own characteristics.

• Labour remuneration does not only involve price (wage) but also other non-

monetary benefits.

9.3. A Perfectly Competitive Labour Market

In a perfectly competitive labour market, where the wage rate is determined in the

industry, as opposed by the individual firm, each firm is a wage taker. This means

that the actual equilibrium wage will be set in the market, and the supply of labour to

the individual firm is perfectly elastic at the market rate. (Economics Online, n.d.)

9.3.1. Requirements for Perfect Competition

In the case of the goods, market we used perfect competition as a benchmark against

which the performance of other market structures could be compared. Likewise, we

start our analysis of the labour market by examining a perfectly competitive labour

market. The requirements for perfect competition in the labour market include the

following:

• There must be a large number of buyers (employers) and sellers (employees)

in the market.

• Labour must be homogenous.

• Workers must be completely mobile, being able to move freely from one

employer to the next.

• There must be no government intervention influencing employers or workers.

• All participants must have perfect knowledge of market conditions.

• There must be perfect competition in the goods market.

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9.3.2. Equilibrium in the Labour Market

In a perfectly competitive labour market, the equilibrium wage rate and equilibrium

quantity are determined by the interaction of supply and demand. Figure 9.2 shows

this below.

Figure 9.2: Equilibrium in a Perfectly Competitive Market

Source: Mohr (2020:230)

9.3.3. The Individual Supply of Labour

The individual labour supply labour curve is called a backward-bending supply curve,

as shown in Figure 9.3 below.

Figure 9.3: The Individual Supply of Labour

Source: Mohr (2020:231)

The shape of this curve is due to two factors, as explained below:

• Substitution effect, where, as the wage rate increases, workers will work more

hours.

• Income effect, where workers will work marginally less as their income, and

hence, desire for leisure activities, increase.

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9.3.4. The Market Supply of Labour

As quantity of labour supplied will increase as the wage rate increases. The curve will

shift upwards or downwards if the following non-wage determinants of the supply of

labour changes, for example:

• New workers enter the market (e.g. because the population has increase or on

account if immigration)

• The number of workers decreases as a result of the impact of a disease or

epidemic.

• The wages that can be earned in other occupations change, thereby making

the particular occupation less or more attractive.

• The non-monetary aspects of the occupation change (e.g. if the job becomes

more pleasant or less dangerous as a result of the introduction of new safety

measures, the market supply will tend to increase; likewise, if the fringe benefits

like holidays, the degree of job security, status or power change, the market

supply will also change).

9.3.5. An Individual Firm’s Demand for Labour

The most important aspect of the demand for labour is that it is a derived demand.

This means that labour is not demanded for its own sake, but rather the for the value

of goods and services that can be produces when labour is combined with other factors

of production. Firms will only demand and employ labour when there is a

corresponding demand for goods and services that can be produced by that labour,

and where it is profitable for them to do so.

When deciding on whether to employ labour, a firm will compare the marginal benefit

against the marginal cost. As long as the marginal benefit exceeds the marginal

costs involved, the firm will continue to employ additional units of labour. This will

cease once the marginal benefit is equal to the marginal cost.

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Figure 9.4: A Perfectly Competitive Labour Market

Source: Mohr (2020:233)

9.3.6. The Market Demand for Labour

The market demand for a particular type of labour is obtained by adding all the

individual forms' demand curves. The market demand will change if any of the non-

wage determinants of the quantity of labour demanded changes. This is illustrated by

a shift of the market demand curve. The market demand will change if:

• The number of firms (employers) changes.

• The price of the product changes. A change in the price of the product will

change the marginal revenue product (MRP) and therefore also change the

quantity of labour demanded.

The marginal Physical Product (MPP) of labour changes, since this will change

MRP, ceteris paribus.

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The demand curve for Labour DD is given

by the marginal revenue product of labour

(MRP). It slopes downwards from left to

right like a normal demand curve for a

product.

Figure 9.5: The Individual Firm’s Demand for Labour

Source: Mohr (2020:235)

The firm is in equilibrium where MRP,

which represents the firm's demand for

labour, is equal to the wage rate We,

which represents the supply of labour to

the firm. This occurs at an employment

level of Ne.

Figure 9.6: The Equilibrium Position of a Firm Operating in a Perfectly Competitive

Labour Market

Source: Mohr (2020:235)

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Student Activity

Labour markets

Question 1

The following figures relate to the demand and supply of office cleaners at certain

wage rates. The demand and supply figures are in (000s):

WAGE RATE

(R per hour)

DEMAND

(000)

SUPPLY

(000)

100

In reference to the table above,

• Plot the demand and supply curves and show the market wage rate and

employment level.

• Illustrate and comment on the likely impact of a national minimum wage of

R9.00 per hour for all workers.

• On your graph, sketch the likely effect of increased migration of cleaners

from a low wage economy.

Question 2

1. Draw a graph to show the effect of a labour strike on the wage rate and the

quantity of labour employed. What determines how big or small the effect

will be?

What is the likely effect on the wage rate of dentists and the quantity of dentists

employed if they become more skilful and productive, while at the same time fewer

students apply to study dentistry at university.

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9.3.7. Changes in Labour Market Equilibrium

A change in any of the non-wage determinants for or supply of labour will give rise to

a shift of the demand curve or the supply curve, as seen in Figure 9.7 and Figure

9.8(a). These depict an increase in the demand for labour.

The magnitude of changes in the wage rate and the level of employment will depend

on the elastics of demand and supply. For example, if the demand for labour

decreases, the impact will depend on the elasticity of the supply of labour. The more

inelastic the supply of labour, the greater the impact on the wage rate and the smaller

the impact on the level of employment will be. Likewise, the impact of a change in the

supply of labour will depend on the elasticity of the demand for labour.

In Figure 9.7 it is assumed that the labour market adjusts fully and instantaneously to

changes in demand or supply. In other words, the labour market is completely flexible.

In practise, however, adjustment takes time and also need not to be complete. In fact,

most of the labour markers are imperfect and characterised by various rigidities and

deviations from the perfectly competitive model.

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Figure 9.7: Changes in Labour Market Equilibrium

Source: Mohr (2020:237)

In all cases the initial equilibrium is illustrated by the intersection of the demand curve

(D0D0) and the supply curve (S0S0). The equilibrium wage rate is Wo and the

equilibrium level of the employment No. In (a) the demand for labour increases,

illustrated by a rightward shift of the demand curve to D1D1. The wage rate increases

to W1 and the level of employment to N1. In (b) the demand for labour decreases,

illustrated by a leftward shift of the demand curve to D2D2. The equilibrium wage rate

and employment level fall to W2 and N2 respectively. In (c) the supply of labour

increases, illustrated by a rightward shift of the supply curve to S3S3. The wage rate

falls to W3 but the level of employment increases to N3. In (d) the supply of labour

decreases, illustrated by a leftward shift of the supply curve to S4S4. The wage rate

increases to W4, but the level of employment falls to N4.

9.4. Imperfect Labour Markets

Most goods markets are not characterised by perfect competition. Likewise, most

labour markets are not characterised by perfect competition. We do not live in a world

of perfect information, or in a world with perfectly competitive input and output markets.

In this section, we examine some of the reasons why labour markets tend to be

imperfect, and we analyse some of these imperfections. Some of the reasons that

labour markets may be imperfect are the following:

• Workers in certain markets are organised in a trade union which acts as a

monopolistic supplier of labour.

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• There is only one buyer of labour. This is called monopsony.

• Labour is heterogeneous, not homogenous and each worker has certain

abilities, education, training that differs him or her from the next.

• Labour is not completely mobile. Workers cannot move freely from one

occupation to another, from one employee to another or from region to region.

The labour market is a segmented market and workers often cannot move

freely between different segments.

• Government intervenes in the labour market by legislating conditions of

employment, minimum wage..

• Employers and employees have imperfect knowledge about market conditions.

9.5. Trade Unions

Economists argue that trade unions raise wages at the cost of increased

unemployment. It is often claimed as such that trade union pressure for higher wages

has caused certain workers to be priced out of the market and replaced by machines.

Some observers also argue that unions cause so much hassle that employers prefer

to replace people with machines, which cannot go on strike or disrupt the process in

other ways.

Collective bargaining is not concerned with only wages. It addresses issues such as

hours of work, job security, overtime, fringe benefits, job evaluation, and procedures

for setting grievances.

Figure 9.8: Ways in which a Trade Union can attempt to Increase the Wage Rate

Source: Mohr (2020:239)

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Trade unions can attempt to raise the wage rate by (a) restricting supply, (b) enforcing

a higher disequilibrium wage or (c) assisting firms to raise the demand for the product

of the industry. The restriction of supply is illustrated in part (a) by a leftward shift of

the supply curve to S1S1. Part (b) illustrated a situation in which the union succeeds in

raising the wage rate to W2, which is higher than the equilibrium wage. As in (a), this

is accompanied by a decline in employment. Part (c) illustrated a situation in which the

union succeeds (in conjunction with firms) in raising the demand for the product of the

industry. This results in an increase in the derived demand for labour (to D1D1). The

wage rate increases (to W3) and the level of employment also increases.

Professional bodies can influence the wage rate in a similar fashion. These bodies can

control the supply of skilled labour in particular trades or professions by restricting

membership, controlling the length of training or apprenticeships programmes, or by

raising the standards for entry.

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CHAPTER TEN:

Fiscal and Monetary Policy

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Outline the functions of money

• Describe the main functions of the South African Reserve Bank

• Determine the basic instruments of monetary policy

• Describe why government participates in economic affairs

• Understand how government intervenes in the economy

• Describe why governments, like markets, can fail

• Differentiate between nationalisation and privatisation

• Describe what ﬁscal policy means

• Interpret government spending and the ﬁnancing of such spending

• Examine the criteria for a good tax

This chapter focuses on money. The aspects of the monetary and fiscal policy is also

discussed. In this discussion of money, the chapter further focuses on government

spending. The aspect of money and the function is more so discussed along the

function of money and the kind of money. The circulation of money is also an important

concept and discussed with in terms of the role and function of the South African

Reserve Bank.

10.1. Introduction

Monetary policy involves changing the interest rate and influencing the money supply.

Fiscal policy involves the government changing tax rates and levels of government

spending to influence aggregate demand in the economy. They are both used to

pursue policies of higher economic growth or controlling inflation. This chapter deals

with this aspect in more detail.

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10.2. The Functions of Money

10.2.1. Money as a Medium of Exchange

To explain the importance of money, we look at the functioning of a barter economy,

that is, an economy that functions without money. In a barter economy, goods can

only be exchanged for other goods. Before the exchange of two goods can take place,

there has to be a double coincidence of wants between the parties concerned. Money

functions as a medium of exchange.

Money is what people in a society regularly use when purchasing or selling goods and

services. If money were not available, people would need to barter with each other,

meaning that each person would need to identify others with whom they have a double

coincidence of wants—that is, each party has a specific good or service that the other

desires. Money serves several functions: a medium of exchange, a unit of account, a

store of value, and a standard of deferred payment. There are two types of money:

commodity money, which is an item used as money, but which also has value from its

use as something other than money; and fiat money, which has no intrinsic value, but

is declared by a government to be the legal tender of a country. (Hogendorn and

Johnson, 2003)

10.2.2. Money as a Unit of Account

A unit of account is an agreed measure for stating the prices of goods and services.

In a money economy the prices of all goods and services are expressed in monetary

terms. We need a common measure of the cost of various goods and services to be

able to decide how best to spend our income. The fact that income and prices are all

expressed in rand and cents enables us to calculate what we can afford.

10.2.3. Money as a Store of Value

In any society, there is a need to hold wealth (or surplus production) in some form or

another. A common form for holding wealth is money, since it can always be

exchanged for other goods and services at a later date. Wealth can, however, also be

held in other forms, such as ﬁxed property, real assets, stocks and shares. The

advantage of using money as a store of value lies in the fact that it is usually more

convenient and can be used immediately in exchange for other assets. We therefore

say that money is the most liquid form in which wealth can be kept. The store of value

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function also implies that money serves as a standard of deferred payment. By this we

mean that money is the measure of value for future payments. If you borrow money to

buy a house, your future commitment will be agreed to in rand and cents. Money is

also the means whereby credit is granted.

Student Activity

Answer the following questions:

1. What are the four functions served by money?

2. How does the existence of money simplify the process of buying and

selling?

3. What is the double-coincidence of wants?

4. What role might technology play in our definition of money?

5. Imagine that you are a barber in a world without money. Explain why it would

be tricky to obtain groceries, clothing, and a place to live.

10.3. The South African Reserve Bank

The Reserve Bank is the main monetary authority in South Africa, and its current

functions can be grouped into the following four major areas of responsibility:

• formulation and implementation of monetary policy

• service to the government

• maintaining ﬁnancial stability.

10.3.1. Formulation and Implementation of Monetary Policy

The SARB is responsible for formulating and implementing monetary policy. The way

in which the Bank’s other functions is fulﬁlled is determined mainly by the goals of

monetary policy at that juncture. The Bank’s accommodation policy (also referred to

as the Bank’s refinancing system or more commonly the repo rate tender system) is

the main instrument through which monetary policy is conducted in South Africa.

Through its reﬁnancing system the Bank meets the daily liquidity needs of private

banks.

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10.3.2. Service to the Government

The services provided by the SARB to the central government are threefold:

• Bank and advisor - the Reserve Bank is still the main banker for the

government. It grants credit, deals with the weekly issues of Treasury bills on

behalf of the Treasury, advises the government with regard to monetary and

ﬁnancial matters and is responsible for the administration of all exchange

control regulations.

• Custodians of gold and foreign exchange reserve - With the exception of

necessary balances held by banks and the Treasury, the Reserve Bank keeps

all the country’s gold and foreign exchange reserves. Gold coins and gold

bullion are added to the reserves at a market-related price.

• Administration of exchange control - The Reserve Bank is responsible for

exchange control in South Africa. Exchange control restricts the movement of

foreign exchange in order to protect an economy from disruptive ﬂuctuations in

capital movements and other international economic shocks.

10.3.3. Maintaining Financial Stability

The SARB presently regards ﬁnancial stability (particularly price stability) as its most

important objective. In pursuit of this objective, the Bank plays a pivotal role in the

following areas:

• Bank supervision - The purpose is to achieve a sound, efﬁcient banking

system in the interest of depositors of banks and the economy as a whole. This

function is performed by issuing banking licenses to banking institutions and

monitoring their activities.

• The national payment system - The main aim is to reduce interbank

settlement risk with the objective of reducing the potential of a systemic risk

crisis emanating from settlement default by one or more of the settlement

banks.

• Banker to other banks - The Bank acts as custodian of the minimum cash

reserves that banks are legally required to hold or prefer to hold voluntarily with

the Bank. By exerting control over the level and composition of these reserves

the Reserve Bank can, to a certain extent, affect the quantity of money. The

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reserves are also used to clear the banks’ mutual claims and obligations to one

another. In this way the Reserve Bank acts as a clearing bank.

• Banknotes and coins - The Reserve Bank has the sole right to make, issue

and destroy banknotes and coins.

10.4. Monetary Policy

As the measures taken by the monetary authorities to inﬂuence the quantity of money

or the rate of interest with a view to achieving stable prices, full employment and

economic growth.

10.4.1. The Instruments of Monetary Policy

A high priority is currently given to market-oriented policy instruments. The key

instruments are:

• Accommodation policy (or the refinancing of the liquidity requirement)

A crucial element of the classical cash reserve system is the fact that banks are

obliged to hold 2,5 per cent of their total liabilities to the public in the form of

cash reserves with the Reserve Bank. When a bank experiences a shortage of

cash reserves, it can either change other ﬁnancial assets into cash or borrow

funds on the interbank market to eliminate the shortage. Normally one would

expect banks that are in need of funds to make use of the overnight interbank

market where they borrow from other banks that have excess funds at their

disposal. These funds are obtained at the interbank overnight rate. However, if

all banks have the same liquidity problems, the Reserve Bank, as bankers’

bank, acts as lender of last resort and the banks can then obtain funds by

means of the repo system. The accommodation policy of the Reserve Bank

thus mainly comprises changes in the repo rate and other conditions on which

cash is made available to banks. It is therefore an instrument by which the

SARB can regulate the quantity of money through variations in the cost of

credit. Changes in the repo rate lead to adjustments in the interest rates at

which credit is made available by the banks to their clients. The cost of credit in

the economy is therefore directly linked to the repo rate. Other interest rates

(e.g. deposit rates and mortgage rates) also tend to move in sympathy with the

repo rate.

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• Open market policy

Open-market transactions as an instrument of monetary policy consist of the

sale or purchase of domestic ﬁnancial assets (mainly Treasury bills and

government bonds) by the central bank in order to exert a speciﬁc inﬂuence on

interest rates and the quantity of money, via its inﬂuence on the cash reserves

of the banks. The central bank uses open-market transactions to ensure such

persistent shortages of liquidity, also called the money market shortage. If it

wishes to create or enlarge the banks’ liquidity shortage, the central bank sells

government bonds or other securities to the banks, thereby reducing their cash

reserves (directly or indirectly). In this way the banks are compelled to make

use of the central bank’s ﬁnancing facilities through repurchase agreements,

thereby rendering the central bank’s accommodation policy more effective.

10.5. Bank Supervision

In addition to the cash reserve requirement of 2,5 per cent of banks’ total liabilities,

which forms the basis of the Reserve Bank’s accommodation policy, banking

institutions must also adhere to various requirements in respect of their capital and

liquid asset holdings. These requirements are more of a prudential (supervisory)

nature and do not form part of the normal monetary policy arsenal of the Reserve

Bank.

10.6. The Government or Public Sector

The government or public sector in South Africa consists of the following:

• Central government, which is concerned mainly with national issues such as

defence and our relationship with the rest of the world (i.e., foreign affairs)

• Regional (or provincial) government, which is concerned mainly with

regional issues such as housing, health services, and education

• Local government, which deals with local issues such as the provision of

sewerage, local roads, street lighting and trafﬁc control

• Public corporations and other government business enterprises such as

Eskom, Transnet and Rand Water.

Mohr (2020)

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Typically, the government purchases factors of production (mainly labour) from

households in the factor market, and goods from ﬁrms in the goods market.

Government provides public goods and services to households and ﬁrms. Government

spending is ﬁnanced by taxes paid by households and ﬁrms.

10.7. Fiscal Policy and the Budget

Every government purchases goods and services and raises taxes and borrows funds

to ﬁnance its expenditure. Every government must, therefore, regularly decide how

much to spend, what to spend it on and how to ﬁnance its expenditure. It must

therefore have a policy in respect of the level and composition of government

spending, taxation and borrowing. This is called ﬁscal policy. The main instrument of

ﬁscal policy is the budget and the main policy variables are government spending and

taxation.

The budget is essentially a reﬂection of political decisions about how much to spend,

what to spend it on and how to ﬁnance the spending. But the size and composition of

government spending and the way in which it is ﬁnanced can have signiﬁcant effects

on important macroeconomic variables such as aggregate production, income and

employment and the price level, as well as on the distribution of income. Whereas

ﬁscal policy refers to the use of government spending, taxation and borrowing to affect

economic activity, monetary policy entails the manipulation of interest rates. Fiscal

policy is controlled directly by the government, while monetary policy is conducted by

the central bank. But these policies have to be applied in harmony; otherwise the one

may counteract or negate the effects of the other.

When the economy is in a recession, the tendency is therefore to apply expansionary

ﬁscal and monetary policies to stimulate economic activity. As far as ﬁscal policy is

concerned, this usually means that government spending is raised and taxes reduced

(or not increased). The difference between government spending and taxation, called

the budget deﬁcit, will therefore tend to increase. In contrast, when the economy is

expanding too rapidly and inﬂation and balance of payments problems are being

experienced, the appropriate response is to apply restrictive or contractionary ﬁscal

and monetary policies. As far as ﬁscal policy is concerned, this means that government

spending has to be reduced and/or taxes have to be increased.

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10.8. Government Spending

The government’s involvement in economic activity is often measured by the share of

government spending in total spending in the economy. Government spending can be

classiﬁed economically or functionally. Economically, we can distinguish between

consumption spending and investment spending. Table 10.2 shows two measures of

government spending in South Africa: ﬁnal consumption expenditure by general

government and total expenditure (i.e., consumption plus investment) by general

government, both expressed as a percentage of gross domestic expenditure (GDE).

Table 10.2: Government Spending in South Africa as a Percentage of Gross Domestic

Expenditure, 1960- 2013

Source: Mohr (2020:324)

• Changing consumer preferences. A ﬁrst possible explanation is that income

growth is accompanied by a proportionally greater growth in the demand for

public goods and services.

• Political and other shocks. Severe political or other shocks (e.g. wars) are

important causes of increased government spending.

• Redistribution of income. In a democratic society in which the majority of the

population have relatively low incomes, income redistribution tends to be an

important explanation of the growth of the public sector.

• Misconceptions and entitlement. Society often has certain misconceptions

about the ﬁnancial and administrative capacity of the public sector.

• Population growth and urbanisation. Rapid population growth in South Africa

has resulted in large increases in the demand for public goods and services like

education and health services.

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10.9. Financing of Government Expenditure

There are basically three ways of ﬁnancing government spending: income from

property, taxes, and borrowing

Income from property includes the interest and dividend income that is derived from

government’s full or partial ownership of enterprises such as Eskom, Telkom and

Transnet, proﬁt earned from government production and the sale of agricultural,

forestry and ﬁshing products, rent (for example in the form of mining rights), and other

license fees and user charges.

The main source of revenue is taxation. But taxation is not sufﬁcient to ﬁnance all

government spending. The difference between government spending and current

revenue (including taxes) is called the budget deﬁcit. This deﬁcit is ﬁnanced by

borrowing. Government borrowing increases the public debt. The recent trends in

these three interrelated variables (the budget deﬁcit, the public debt and the interest

on public debt) are shown in Table 10.3.

Table 10.3: Budget Deficits, Public Debt, and Interest on Public Debt in South Africa,

1997-2013

Source: Mohr (2015:292)

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10.10. Taxation

Taxes are compulsory payments to government and are the largest source of

government revenue. Taxation is one of the most emotional of all economic issues.

People do not like paying taxes, and every taxpayer feels that he or she is bearing the

brunt of the overall tax burden.

Company Tax

Companies are separate legal entities and are taxed independently from their

shareholders and other individuals. In the case of companies, the calculation of

taxable income (i.e., the tax base) is quite complicated. This is because the calculation

of company profits, on which company tax is levied, requires specialist knowledge of

accounting techniques and tax law.

Value-Added Tax (VAT)

VAT is an important and effective source of revenue for government, but it is a

regressive tax. Most goods and services are taxed at the same standard rate.

However, since low-income consumers spend a greater proportion of their income on

goods which carry VAT than high-income consumers (who save part of their income),

the ratio between tax paid and income is greater for low-income households than for

high-income households. The tax burden increases as income decreases (or falls as

income rises). Politically it is therefore difficult for government to increase VAT,

particularly in a country like South Africa, which has a vast number of poor households.

Student Activity

Please read the following questions below and select the most appropriate choice

choices with regards to Tax:

Q1. Income tax is-

a) Money your employer pays to you

b) Money you earn and put into the bank

c) tax paid on the money you earn each year

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Q2. Sales Tax is-

a) Tax on things you buy or purchase

b) tax on the house you own

c) tax take out of your paycheck

d) tax that you pay once a year on your income

Q3. Property Tax is-

a) Tax on things you buy or purchase

b) tax on the house you own

c) tax take out of your paycheck

d) tax that you pay once a year on your income

Q4. Billy gets charged tax every time he buys a new pair of shoes. What kind of tax

is this?

a) Income

b) Property

c) Payroll

d) Sales

Q5. The county charges the Henry family a tax on the value of the house they own.

What kind of tax is this?

a) Income

b) Property

c) Payroll

Q6. Mr. Carrier is starting his own business. He will hire 12 people. He will have to

take taxes out of each person’s paycheck to pay the government. What type of

tax is this?

a) Income

b) Property

c) Payroll

d) Sales

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Q7. When the tax rate increases as income increases, the tax is called

a) progressive

b) situational

c) proportional

d) regressive

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CHAPTER ELEVEN:

Aggregate Demand and Aggregate Supply

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Apply aggregate demand and supply curves to analyse changes in aggregate

demand and supply, including the impact of monetary and ﬁscal policy

• Elaborate how changes in interest rates can affect important macroeconomic

variables such as total production and the price level

• Use the AD-AS model to illustrate the policy dilemma in the open economy

• Explain the major features of monetarism and supply-side economics

This chapter focuses on the aggregate supply and demand in an economy. Firms

make decisions about what quantity to supply based on the profits they expect to earn.

11.1. Introduction

The most popular macroeconomic model used nowadays is the aggregate demand–

aggregate supply model (abbreviated as the AD-AS model), which allows for all these

changes and which can be adapted to incorporate the views of different schools of

thought about macroeconomics. The AD-AS model also serves as a guide to

policymaking.

11.2. The Aggregate Demand-Aggregate Supply Model

The AD and AS curves have much in common with the demand and supply curves

that you are familiar with. It is important to emphasise, however, that we are now

dealing with the economy as a whole and not with a particular commodity or service.

The AD-AS model deals with the general level of prices in the economy), instead of

the price of a particular good or service. Likewise, the model deals with the total

production of goods and services in the instead of the quantity of a particular good or

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service. Moreover, the AD and AS curves are not simply summations of market

demand and supply curves for the different goods and services produced in the

economy.

In Figure 11.1 we show an aggregate demand (AD) curve as sloping down from the

left to right just like any normal demand curve. The general price level (P) and total

production or income (Y)1 are drawn on the vertical and horizontal axes respectively.

The AD curve indicates the levels of total expenditure (or aggregate demand) at

various price levels. Similarly, the AS curve slopes upward to the right and indicates

the various levels of output which will be supplied at different price levels. The

equilibrium price level (P0) and the equilibrium level of real production or income (Y0)

are determined by the interaction between aggregate demand and aggregate supply.

Figure 11.1: Aggregate Demand and Aggregate Supply

Source: Mohr (2020:405)

On the vertical axis we have the general level of prices P in the economy (represented

by a price index). On the horizontal axis we have the real value of total production or

income Y in the economy. AD is the aggregate demand curve which shows the

relationship between the total real expenditure on goods and services and the price

level. AS is the aggregate supply curve which shows the relationship between real

production or output and the price level. The equilibrium is indicated by E0. The

equilibrium price level is P0 and the equilibrium output level is Y0.

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11.2.1. The Aggregate Demand Curve

Aggregate demand is an economic measurement of the total amount of demand for

all finished goods and services produced in an economy. Aggregate demand is

expressed as the total amount of money exchanged for those goods and services at

a specific price level and point in time (Kenton, 2020).

• The Slope of the Ad Curve

The three main reasons for the downward slope of the AD curve are the wealth effect

(due to a change in the price level), the interest rate effect (due to a change in the

price level) and the international trade effect (due to a change in the price level).

1. The Wealth Effect (also called the real balance effect)

When prices fall, the income in consumers’ pockets may be used to purchase

more goods and services than before, that is, the real value of their incomes

increases.

2. The Interest Rate Effect

When the price level falls, this may lead to a decline in interest rates, which will

stimulate investment spending. The result is an increase in the quantity of

goods and services demanded.

3. The International Trade Effect

If a fall in the price level results in a decline in interest rates, the latter may result

in an increased outﬂow of capital in pursuit of higher interest rates overseas

and/or a decline in capital inﬂows, because domestic interest rates are less

attractive than before. This would result in a greater demand for foreign

currency and a lower demand for the rand, which will give rise to a depreciation

of the rand against the major currencies. The weaker rand, in turn, will tend to

boost exports X and dampen imports Z, resulting in an increase in the quantity

of domestic goods and services demanded. The change in the prices of

domestic goods relative to the prices of foreign goods will reinforce this effect.

The Aggregate Supply Curve

The aggregate supply (AS) curve illustrates the total quantity of goods and services

supplied at each general price level in the economy. In contrast to the AD curve, we

distinguish between a short-run AS curve and a long-run AS curve (which we label as

the LRAS curve). In the short run, the AS curve slopes upward from left to right, as in

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Figure 11.1, but in the long run, the LRAS is vertical. We start by examining the short

run AS curve, which is also the one that we shall use most frequently.

11.2.2. The Slope of the Short-Run as Curve

Like the microeconomic supply curve, the AS curve is primarily governed by the costs

of production. The main difference, of course, is that the AS curve is concerned with

the total production of goods and services in the economy, whereas a microeconomic

supply curve deals only with a specific good or service. The costs of production are

governed by the prices and productivity of the various factors of production. For a

given set of factor prices (rent, wages and salaries, interest and profit) and the prices

of imported capital and intermediate goods, and for a given level of productivity, there

is an AS curve that slopes upward from left to right in the short run.

The Long-Run Aggregate Supply Curve (LRAS)

Total production in the long run depends essentially on the quantity and quality

(productivity) of the available factors of production (natural resources, labour, capital

and entrepreneurship). According to this widely held view, the price level does not

affect the level of production in the long run. The long-run level of output is also called

potential output, full-employment output, or the natural rate of output. The fact that the

LRAS curve is believed to be vertical does not imply that it cannot shift. Changes in

the availability and productivity of the factors of production will give rise to shifts of the

LRAS curve – to the right if their quantity or productivity increases or improves and to

the left if they decrease or deteriorate.

Figure 11.2: The Long-Run Aggregate Supply Curve

Source: Mohr (2020:409)

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Changes in Aggregate Demand

In Figure 11.3, the increase in aggregate demand is illustrated by a rightward shift of

the AD curve, from AD0 to AD1. The original equilibrium was E0. The new equilibrium

is indicated by E1. The result is an increase in the equilibrium level of real output or

income from Y0 to Y1 and an increase in the equilibrium price level from P0 to P1. The

authorities can therefore still use expansionary monetary and fiscal policies to

stimulate production and income, as well as employment (since employment increases

along with real production and income), but this is achieved at the cost of an increase

in the price level.

Figure 11.3: Expansionary Monetary and Fiscal Policy in the AD-AS Framework

Source: Mohr (2020:409)

The original aggregate demand and supply curves are indicated by AD0 and AS0. The

original equilibrium is at E0 with the price level at P0 and output at Y0. The authorities

then apply expansionary monetary and fiscal policies to stimulate aggregate

expenditure, production and income. This is illustrated by a rightward shift of the AD

curve to AD1. The new equilibrium is indicated by E1. Production increases to Y1 but

the price level also increases, to P1.

Changes in Short-Run Aggregate Supply

In Figure 11.4, AS0 is the original aggregate supply curve. Given the aggregate

demand curve (AD0), the equilibrium levels of production and the price level are Y0

and P0 respectively, as indicated by the original equilibrium point (E0). As a result of

the increase in the oil price, the costs of production increase. This is illustrated by a

shift of the AS curve to AS1. The equilibrium point shifts to E1. The equilibrium price

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level increases to P1 while the equilibrium level of production falls to Y1. This is clearly

a very undesirable situation. An increase in the cost of producing the total product (e.g.

GDP) results in higher prices, lower production, income and employment and higher

unemployment. What we have here is a situation of stagflation, which describes a

situation of stagnation plus inflation.

Figure 11.4: An Increase in the Price of Imported Oil in the AD-AS Framework

Source: Mohr (2020:410)

To illustrate the benefits of an increase in productivity without any concomitant

increase in the remuneration of the factors of production (e.g., capital and labour). By

now, we know that such a decrease in the costs of production can be illustrated by a

downward (rightward) shift of the AS curve, as in Figure 11.5.

Figure 11.5: An Increase in Productivity without any Increase in Renumeration

Source: Mohr (2020:411)

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11.3. Other Approaches to Macroeconomics

The Development of Macroeconomic Thought

Monetarism

Another distinguishing feature was a belief that there were no strong links between the

monetary sector of the economy and the real sector of the economy. This separation

of the monetary sector and the real sector is known as the classical dichotomy. The

classical economists believed that a change in the quantity of money ('M) would lead

to a proportional change in the price level ('P)

Supply-Side Economics

One of the reasons is that supply-siders place greater emphasis on the microeconomic

aspects of economic policy and particularly on the incentive effects of taxation. As the

name indicates, the distinguishing feature of supply-side economics is an emphasis

on aggregate supply, which had been largely neglected during the previous decades.

The focus is therefore on policies aimed at increasing the aggregate supply of goods

and services in the economy. The major problems identified by the supply-siders relate

to the role of government in the economy.

• First, they believe that government spending in general is too high;

• Second, they argue that there are too many rules and regulations which inhibit

private initiative; and,

• Third, they believe that tax rates are too high (partly because government

spending is too high).

They therefore recommend cuts in government spending, deregulation and lower tax

rates. Supply-siders argue that cuts in government spending on goods and services

will release some resources which can then be used by the private sector. Supply-

siders believe that the private sector uses resources more productively than the public

sector. They therefore believe that such a transfer of resources from the public sector

to the private sector will raise total production in the economy. For the same reason

they also believe in the privatisation of state assets. The second element of the supply-

side programme is deregulation. This means that all rules and regulations which

restrict the exercise of entrepreneurship should be reviewed and preferably scrapped.

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New Classical Economics

Macroeconomics must have solid microeconomic foundations. In fact, to them

macroeconomics is simply the sum of the microeconomic parts. Their key assumptions

are that all economic agents have rational expectations and that all markets always

clear. Their theory of rational expectations extends the neo-classical assumption of

rationality to the formation of expectations. More formally, rational expectations can

be defined as extending the application of the principle of rational behaviour to the

acquisition and processing of information and the formation of expectations. The

theory is that people form their views of the future by taking account of all available

information, including their understanding of how the economy works.

New Keynesian Economics

The new Keynesians responded to the new classical challenge by combining certain

aspects of new classical economics with more traditional Keynesian ideas. Like the

new classical economists, they argue that macroeconomics requires solid

microeconomic foundations and most (but not all) accept the idea of rational

expectations. However, new Keynesians strongly reject the notion of continuous

market clearing in a perfectly competitive environment. Instead, they believe that a

typical market economy is characterised by numerous imperfections. They spend a lot

of time and effort on explaining why wages and prices tend to be inflexible and on

investigating the implications of wage and price stickiness.

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CHAPTER TWELVE:

Economic Growth, Unemployment, and Inflation

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Discuss the three macroeconomics challenges and the macroeconomic

objectives thereof

• Explain the importance of economic growth

• Explain how economic growth is measured

• Explain the business cycle

• Discuss the relationship between inflation and unemployment using the Philips

curve.

• List the various types of unemployment

This chapter focuses on the measurement and importance of economic growth. There

is also a detailed discussion on the business cycle, that is, the fact that economic

growth (or decline) does not occur smoothly but is characterised by upswings and

downswings. One such is unemployment, the costs and implications of it and the

aspect of inflation.

12.1. Introduction

The five main macroeconomic objectives are: Economic growth, full employment (low

unemployment), price stability (low inflation), balance of payments stability (external

stability), and socially acceptable (equitable) distribution of income. This chapter will

discuss the first three and will, later on, show the relationship between inflation and

unemployment.

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12.2. Inflation

12.2.1. What is inflation?

Inflation is the continuous rise in prices in general. Inflation is a continuous process,

where there is an annual increase in the price level of most goods and services. In

order for inflation to exist, the price increase in must be significant. For instance, a

mere increase in prices by 1%-2% makes it difficult to conclude that there is inflation.

Finally, the definition of inflation refers to prices in general. An increase in the price

level of a specific good, for example, meat, does not mean that there is inflation.

Reading Activity: On Inflation

Food prices still on the rise, according to Stats SA

By Mwangi Githathu Time of article published Apr 23, 2020

Cape Town - It will cost more to put food on the table after South Africa’s food price

inflation accelerated to 4.4% year on year (y/y) in March, from 4.2% y/y in the

previous month. The key drivers behind this uptick were meat, fruit, milk, eggs and

cheese.

Despite this increase however, according to Statistics SA, the annual consumer

price index (CPI) inflation nudged lower to 4.1% in March, down from 4.6% in

February, ending a run of increases since November.

CPI is calculated based on the weighted average price of a basket of goods and

services, but because all data for the CPI are collected in the first three weeks of

each month, data collection for March was completed before the lockdown.

Stats SA chief director for price statistics Patrick Kelly said: “The lockdown

regulations in effect till the beginning of May have dramatically restricted the goods

and services available for purchase by consumers.”

Chief economist of the Agricultural Business Chamber of South Africa Wandile

Sihlobo said: “What will matter most for the direction of food price inflation this year

are developments in the grains, meat markets and fruit.

"These three food categories account for nearly two-thirds of South Africa’s food

price inflation basket.

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“There are prospects of good fruit harvests this year, with the citrus industry noting

a 13% y/y increase in available supplies for export markets.

"Amid Covid-19, especially within the EU and Asia region - important markets for

South African fruit exports - any glitches in supply chains would result in an

increased supply for the local market, lowering prices.

"This would be good for a consumer, but the inverse can be said for farmers.”

The March data included the quarterly survey of rental and owners’ equivalent

rent inflation, which account for a combined weight of 16.8% of the CPI basket

Source: Githathu ,2020

Measurement of Inflation

Inflation can be measured using the Consumer price index, producer price index, or

the GDP deflator. These will be discussed below.

The Consumer Price Index

The consumer price index (CPI) is the most commonly used indicator of the general

price level. It is the cost of a representative basket of goods and services. The

unadjusted CPI is referred to the headline CPI. By calculating the percentage change

in CPI from one year to another we can calculate the inflation rate. (Shah, 2020) There

are two methods to calculate the change in CPI, monthly, and annually. In South

Africa, the most common practice is to compare the index of a particular month,

against the same month of the previous year.

Example 12.1: Annual CPI between 2012-2013

2012

2013

December

100

103,4

CPI (month on same month during the previous year) = 

  

= 5,4%

The inflation rate can also be calculated annually. This compares the annual average

CPI against the annual average CPI of the previous year.

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Example 12.2: Monthly CPI January 2012-December 2013

Source: Mohr (2020, pp.427)

CPI (annual average on annual average) = 

  

= 5,7%

Produce Price Index

The Producer Price Index (PPI) measures the prices at the level of the first significant

commercial transaction. For instance, manufactured goods are priced when they leave

the factory, not when sold to customers. PPI also includes capital and intermediate

goods but excludes services.

The Implicit GDP Deflator

The Implicit GDP deflator is an implicit index as it is a side-effect of the calculation of

economic growth. Real GDP measures GDP in terms of the prices ruling in a certain

base year (at constant prices). This provides the basis for calculating economic

growth. Although the major purpose of the transformation of GDP at current prices to

GDP at constant prices is to measure economic growth, it also yields a measure of

inﬂation. This is because the difference between nominal GDP and real GDP

indicates what happened to prices.

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12.2.2. The Effects of Inflation

Inflation has various effects such as distribution effects, economic effects, social and

political effects. These will be discussed below:

Distribution Effects

Inﬂation affects the distribution of income and wealth among the various participants

in the economy. The ﬁrst signiﬁcant distribution effect is the redistribution between

creditors and debtors. The basic rule is that inﬂation beneﬁts debtors (borrowers) at

the expense of creditors (lenders). To understand this, you have to remember that the

real value (or purchasing power) of money falls when prices increase. The

redistribution between creditors and debtors can be explained by using a simple

example. Suppose Peter borrowed R10000 from Paul on 1 January 2012 on the

understanding that the principal amount of R10000 was to be repaid on 31 December

2013. In addition, Peter would pay Paul interest at 10 per cent per annum, that is,

Peter would pay Paul interest of R1000 per year. Table 20-1 shows that the CPI rose

from 95,2 in January 2012 to 105,4 in December 2013. The real value or the

purchasing power of the R10000 (in January 2012) therefore fell to R10000 u

95,2/105,4 = R9 032 in December 2013. In real (or purchasing power) terms Paul thus

did not receive the full amount he loaned to Peter in January 2012 when the loan was

repaid in December 2013. This clearly indicates a redistribution of wealth from the

lender (Paul) to the borrower (Peter).

Peter can also gain in another way. If the interest rate that he has to pay Paul is lower

than the inﬂation rate, Paul will also receive less real interest (i.e., in terms of

purchasing power) than the R1000 per year they had agreed to. The difference

between the nominal interest rate (10 per cent in this case) and the inﬂation rate is

called the real interest rate. If the nominal interest rate is lower than the inﬂation rate,

then the real interest rate is negative. In such a case, the lender is prejudiced in two

ways by inﬂation: the real value of his wealth (the R10000) declines, and the interest

income he receives is also not sufﬁcient to compensate him for inﬂation. However, if

the real interest rate is signiﬁcantly positive, the redistribution of income (interest) falls

away, and only wealth is redistributed.

Apart from the redistribution between private lenders and private borrowers there is

also a signiﬁcant redistribution from the private sector to the government. In this case,

there is no doubt as to who beneﬁts from inﬂation – it is always the government. The

government is always a debtor – in South Africa, the total debt of the government was

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more than R1 560 billion on 31 December 2013. During inﬂation, the government,

therefore, gains at the expense of the holders of the public debt (e.g., the holders of

government stock). The government can also gain via the tax system.

Inﬂation also tends to affect poor households more than those who are better off,

especially when the prices of necessities are increasing relatively quickly. The basic

problem is that the poor have to spend all their income to survive and have no means

of “defending” themselves by adjusting their spending behaviour (e.g., through

substitution or by postponing certain purchases), or by saving part of their income.

Economic Effects

Inﬂation has various economic effects, which may result in lower economic growth and

higher unemployment than would otherwise have occurred. For example, decision-

makers in the private sector tend to become more concerned with anticipating inﬂation

than with seeking out proﬁtable new production opportunities. The efforts of

entrepreneurs are diverted, from innovation and risk-taking, to anticipating inﬂation.

Inﬂation also stimulates speculative practices that do not add to the country’s

productive capacity. People try to outwit others by speculating in shares, property

(real estate), foreign currencies, precious metals, works of art, antiques, postage

stamps and other existing assets which may have a good chance of at least

maintaining their real value during inﬂation. Such speculative activity often occurs in

place of productive investment in new factories, machines and other equipment. By

reducing the value of existing savings, inﬂation may also discourage saving in

traditional forms such as ﬁxed deposits and pension fund contributions. One of the

most serious economic effects of inﬂation is that it can produce balance of payments

problems.

Inﬂation increases the costs of export industries and import-competing industries. If

inﬂation in South Africa is higher than in the economies of our major trading partners

and international competitors, the result will be a loss of international competitiveness.

This can be compensated for in the short run by a depreciation of the rand against

foreign currencies, but such a depreciation will again feed into the inﬂation process by

raising the cost of imported goods. Since most of South Africa’s imports consist of

capital and intermediate goods, the depreciation will raise production costs and prices

even further. This process will continue as long as South Africa’s inﬂation rate remains

out of step with the inﬂation rates of the most important trading countries in the world.

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The weakening of the currency will occur even if no balance of payments problems

are experienced initially. If the domestic inﬂation rate is higher than the inﬂation rates

in the economies of our major trading partners, the domestic currency will inevitably

depreciate sooner or later to re-establish the so-called purchasing power parity with

the different currencies

Social and Political Effects

Price increases make people unhappy and different groups in society start blaming

one another for increases in the cost of living. When rents, service charges, bus fares,

or taxi fares go up, the frustration often gives rise to social and political unrest,

especially among the poor. Inﬂation creates a climate of conﬂict and tension, which is

not conducive to economic progress.

Expected Inflation

There is a great deal of evidence to support the view that an increase in the rate of

inﬂation often leads people to expect that it will increase further. They, therefore, try to

be compensated for the expected higher inﬂation. If they succeed, this results in

raising the actual rate of inﬂation. For example, unions may base their wage claims on

the expected higher inﬂation. If these claims are granted, production costs and prices

will rise more rapidly than during the previous period. Similarly, ﬁrms may raise the

prices of their products in anticipation of expected cost increases. They may also

increase prices because of the need to raise sufﬁcient funds to purchase materials,

which they expect to be more expensive in the future. When the rate of inﬂation is

expected to increase, consumers may also rush to buy things now instead of later.

This will put further upward pressure on prices. If unchecked, such a process may

eventually result in very high inﬂation or hyperinﬂation. Hyperinflation occurs when the

inflation rate becomes very high.

12.2.3. Causes of Inflation

Inﬂation is a complex, dynamic process that cannot be ascribed to a single cause. We

can explain some elements of this process by examining three approaches to

diagnosing (or explaining) inﬂation. These are:

• Demand-pull and cost-push approach

• The structuralist approach

• The conflict approach.

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Demand-Pull and Cost-Push Inflation

Demand-pull inﬂation occurs when the aggregate demand for goods and services

increases while aggregate supply remains unchanged. This type of inﬂation is often

described as a case of “too much money chasing too few goods.” The excess demand

pulls up the prices of goods and services. Demand-pull inﬂation can be caused by any

(or a combination) of the various components of aggregate demand:

• Increased consumption spending by households (C), for example, due to

greater availability of consumer credit or cheaper credit because of lower

interest rates.

• Increased investment spending (I), for example due to lower interest rates.

• Increased government spending (G), for example in order to combat

unemployment or to provide better services to the population.

• Increased export earnings (X), for example as a result of improved economic

conditions in the rest of the world.

All these causes of demand-pull inﬂation tend to be accompanied by increases in the

money stock. Increases in the money stock do not simply happen – they are usually

related to increases in one or more of the components of aggregate demand in the

economy.

Figure 12.2: Demand-Pull Inflation

Source: Mohr (2020:433)

Demand-pull inflation is illustrated in the graph above, by a rightward shift of the AD

curve.

• Increase in AD Increase in Price (P) and Increase in Production

and Income (Y).

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• Increase in AD Improvement in employment provided there is

still scope for improvement.

• To combat demand-pull inﬂation, the authorities have to keep the aggregate

demand for goods and services in check. This can be done by applying

restrictive monetary and ﬁscal policies.

• Restrictive monetary policy entails raising interest rates and limiting the

increase in the money stock. This raises the cost of credit and also reduces the

availability of credit to the various sectors of the economy.

• Restrictive ﬁscal policy entails a reduction in government spending and/or

increased taxation. These policies will tend to reduce aggregate demand. This

will result in a fall in prices, but it may have costly side-effects since production,

income, and employment will also tend to fall.

Cost-Push Inflation

As the term indicates, cost-push inﬂation is triggered by increases in the cost of

production. Increases in production costs push up the price level. There are ﬁve

main sources of cost-push inﬂation.

• Increases in wages and salaries. Wages and salaries are the largest single

cost item in any economy – in South Africa, the remuneration of labour

constitutes about 50 per cent of the cost of producing the gross domestic

product. Increases in wages and salaries are therefore an important

potential source of cost-push inﬂation.

• Cost of imported capital and intermediate goods. These goods are essential

to the functioning of the domestic economy, particularly the manufacturing

sector. When the prices of imported goods such as oil, machinery and

equipment increase, the domestic costs of production are raised. The

increases in import prices could be the result of price increases in the rest

of the world or of a depreciation of the domestic currency against the

currencies of the exporting countries.

• Increases in proﬁt margins. Like wages, interest and rent, proﬁt is also

included in the cost of production. When ﬁrms push up their proﬁt margins

they are therefore raising the cost of production (and the prices that

consumers have to pay).

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• Decreased productivity. If the various factors of production become less

productive while still receiving the same remuneration, the costs of

producing each unit of output increases.

• Natural disasters. They raise the cost of production and prices of agricultural

and related products.

Figure 12.3: Cost-Push Inflation

Source: Mohr (2020:434)

Cost-push inﬂation can also be illustrated with the aid of the AD-AS model, as

illustrated above. Cost-push is reﬂected in an upward (or leftward) shift of the AS

curve.

• Increase in the cost of production Increase in the price level (P)

and a decrease in production and income (Y).

• Cost-push inﬂation thus has a negative impact on production, income and

employment. This is known as stagflation, since price increases (inﬂation) are

accompanied by increased unemployment (stagnation).

• To avoid cost-push inﬂation, measures have to be taken to avoid increases in

the costs of production.

• Increases in wages and salaries and proﬁts, therefore, have to be kept under

control. Increases in productivity can also help to avoid or combat cost-push

inﬂation.

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12.3. Unemployment

Unemployment occurs when a person who is actively searching for employment is

unable to find work. Unemployment is often used as a measure of the health of the

economy. The most frequent measure of unemployment is the unemployment rate,

which is the number of unemployed people divided by the number of people in the

labour force. (Investopedia Staff, 2020)

12.3.1. What is Unemployment?

The level or rate of unemployment is a stock concept, that is, it is measured at a

particular date. The rate of unemployment is obtained by expressing the number of

unemployed persons as a percentage of the labour force (i.e. the number of people

who are willing and able to work, also called the economically active population, or

EAP). There are, however, continuous ﬂows in and out of unemployment as people

enter and leave the unemployment pool. A person may enter the unemployment pool

for one of four reasons:

• The person may be a new entrant into the labour force, looking for work for the

ﬁrst time, or a re-entrant – someone returning to the labour force after not

having looked for work for some time.

• A person may leave a job in order to look for other employment and will be

counted as unemployed while searching.

• The person may be laid off. A lay-off means that the worker is not ﬁred but might

return to the old job if the demand for the ﬁrm’s product recovers.

• A worker may lose a job to which there is no chance of returning, either on

account of being retrenched (or ﬁred) or because the ﬁrm closes down.

12.3.2. Measuring Unemployment

According to the strict deﬁnition, unemployed persons are those persons who, being

15 years and older:

a) are not in paid employment or self- employment,

b) were available for paid employment or self-employment during the seven days

preceding the interview and

c) took speciﬁc steps during the four weeks preceding the interview to ﬁnd paid

employment or self-employment.

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The expanded deﬁnition, on the other hand, omits requirement (c).

12.3.3. Costs of Unemployment

Unemployment entails signiﬁcant costs – to the individuals who are unemployed as

well as to society at large. The individual who becomes unemployed suffers a loss of

income, shock, and frustration. In certain circumstances, unemployment can result in

hunger, cold, ill health, and even death. In the industrial countries, the private or

individual costs of unemployment have been considerably reduced by the availability

of unemployment beneﬁts and other social welfare programmes. The unemployed also

suffer psychological costs: enforced joblessness is demoralising and results in a loss

of conﬁdence and self-esteem. Increased unemployment tends to result in an increase

in psychological disorders, divorces, suicides, and criminal activity. Unemployment

also means a loss of experience and human development.

12.3.4. Types of Unemployment

The most basic distinction is between voluntary and involuntary unemployment. The

unemployment rate is expressed as the percentage of the labour force (i.e. people

who are willing and able to work) who cannot ﬁnd a job. Strictly speaking, all

unemployment should therefore be classiﬁed as involuntary unemployment.

Economists usually distinguish between frictional unemployment, seasonal

unemployment, structural unemployment and cyclical (or demand-deﬁciency)

unemployment. Frictional unemployment (sometimes also called search

unemployment) arises because it takes time to ﬁnd a job or to move from one job to

another. Seasonal unemployment arises because certain occupations require workers

for only part of each year. Cyclical (or demand-deﬁciency) unemployment occurs when

a slump or recession in the economy (as a result of a temporary lack of demand) gives

rise to unemployment. Structural unemployment occurs when there is a mismatch

between worker qualiﬁcations and job requirements or when jobs disappear because

of structural changes in the economy.

12.3.5. Unemployment and Inflation: The Philips Curve

In the AD-AS model, an increase in AD (illustrated by a rightward shift of the AD curve)

usually leads to an increase in production and income (Y) and a simultaneous increase

in the price level (P). Similarly, a decrease in AD (illustrated by a leftward shift of the

AD curve) results in a decrease in production and income (Y) and a simultaneous

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decrease in the price level (P). Since the level of employment is related to the level of

production, we expect employment to increase (and unemployment to fall) when

production increases. Likewise, we expect employment to fall (and unemployment to

increase) when the level of production falls. This suggests that there may be a

relationship between changes in prices (inﬂation) and changes in unemployment.

Table 12.2: AD, Production, Prices, and Unemployment

Change in

Aggregate

Demand (AD)

Merge on

Production

Price Level

Unemployment

Increase

Decrease

Increase

The table above summarises the links amongst AD, production, prices and

employment. From the table, it can be seen that an increase in the price level (P) is

accompanied by a decrease in unemployment, vice versa. Therefore, there is an

inverse relationship between inflation and unemployment. When inflation increases,

unemployment falls and vice versa.

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Phillips’s work suggested that the statistical

relation between inﬂation and unemployment

could be illustrated by a curve running

downwards from left to right. According to

what became known as the Phillips curve,

lower unemployment levels are associated

with higher rates of increase in the general

price level, and vice versa.

Figure 12.4: The Phillips Curve

Source: Mohr (2020:442)

In the 1970s, inﬂation and unemployment

increased at the same time. Recall that this

phenomenon is called stagﬂation. This is

associated with a supply shock, which is

illustrated by a leftward movement of the

aggregate supply curve or cost-push inflation.

In terms of the Phillips curve, stagﬂation is

illustrated by a rightward shift of the curve as

illustrated in the graph above. The same

factors which cause a leftward shift of the AS

curve give rise to a rightward shift of the

Phillips curve.

Figure 12.5: Simultaneous Increase in Inflation and Unemployment

Source: Mohr (2020:443)

Incomes Policy

Cost-push inﬂation or stagﬂation creates a policy dilemma which cannot be solved by

demand management (i.e. monetary and ﬁscal policies that are aimed at inﬂuencing

aggregate demand in the economy). If the problem has its origin on the supply side,

then the solution must also be sought on the supply side. This means that steps have

to be taken to reduce production costs. In terms of our ﬁgures, measures have to be

found to shift the AS curve downwards (to the right) or, what amounts to the same

thing, to shift the Phillips curve to the left. If an absolute reduction in production costs

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is not feasible, then costs should be contained. In terms of our ﬁgures this means that

the policies should prevent the AS and Phillips curves from shifting any further.

An incomes policy implies some form of government intervention in the determination

of wages and prices. For any incomes policy to be successful, it has to appear

equitable to all parties involved. It also requires a tripartite agreement (between the

government, employers and trade unions) on how national income is to be distributed.

An incomes policy usually entails a call to workers to limit their demands for nominal

wage adjustments to the average productivity increase in the economy, and to ﬁrms

to limit their proﬁt margins. If prices can then be kept constant, such an agreement

ensures that the relative shares of wages and proﬁts in the economy also remain

constant. In practice, however, it is extremely difﬁcult to implement an incomes policy

successfully.

12.4. Economic Growth and Business Cycles

A nation’s economy shifts back and forth between periods of expansion and

contraction. Levels of employment, productivity, and the total demand for and supply

of the nation’s goods and services are what causes these changes. In the short-run,

these changes lead to periods of expansion and recession. However, in the long-run,

economic growth can occur, allowing a nation to increase its potential level of output

over time (Khan Academy, 2020).

12.4.1. What is Economic Growth?

Economic growth is traditionally deﬁned as the annual rate of increase in total

production or income in the economy. This deﬁnition has to be qualiﬁed in two

important respects. First, the production or income should be measured in real terms,

that is, the effects of inﬂation should be eliminated. Second, the ﬁgures should also be

adjusted for population growth. In other words, they should be expressed on a per

capita basis. Positive economic growth actually occurs only when total real production

or income is growing at a faster rate than the population.

Total real production is commonly represented by real gross domestic product (real

GDP). Recall that real GDP means that the measurement is at constant prices.

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Some Problems with Using GDP:

• Non-market production. It is difﬁcult to measure or estimate the value of

activities that are not sold in a market.

• Unrecorded activity. A more serious problem is that many transactions or

activities in the economy are never recorded. Such transactions or activities are

described by terms such as the unrecorded economy, the underground

economy, the shadow economy and the informal sector.

• Data revisions. Another problem associated with GDP and the other national

accounting aggregates is that the original estimates are frequently adjusted as

new and better data become available.

• Economic welfare. Many economists argue that GDP and the other national

accounting totals are not good measures of economic welfare.

12.4.2. Calculating Economic Growth

Economic growth is usually calculated on an annual basis.

Table 12.3: Economic Growth in SA

From the table, the two bases used to measure GDP are real GDP, and real GDP per

capita-which is real GDP adjusted for population growth.

To obtain a ﬁgure for economic growth in 2001, real GDP (i.e., GDP at constant prices)

for 2001 is compared with real GDP for 2000, and the difference is expressed as a

percentage of the 2000 ﬁgure.

The Business Cycle

The business cycle is the pattern of upswing (expansion) and downswing (contraction)

that can be discerned in economic activity over a number of years. One complete cycle

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has four elements: a trough, an upswing or expansion (often called a boom), a peak,

and a downswing or contraction (often called a recession).

Figure 12.6: The Business Cycle

Source: Mohr (2020:463)

The different elements of a business cycle can be seen in the graph above. Point A

and C are troughs, and point B is a peak. Point A to point C represents one complete

business cycle. After the trough A, there is an upswing, indicated by AB. After the peak

is reached at B, there is a downswing from B to C.

Measuring Business Cycles

Economists try to identify certain critical variables or indicators that possibly reﬂect or

predict movements in overall economic activity. These variables are called business

cycle indicators. The most important indicators are the so-called leading indicators,

which tend to peak before the peak in aggregate economic activity and reach a trough

before the trough in aggregate economic activity. To establish which indicators are

leading indicators, economists examine the movements of different variables in

relation to the overall changes of economic activity. Leading indicators used in South

Africa include the number of new motorcars sold, the number of new companies

registered and merchandise exports. Data on these variables become available

relatively quickly (compared to the national accounting data).

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Sources of Economic Growth

Sources of economic growth may be grouped into two broad categories: supply factors

and demand factors. Economic growth requires an expansion of the production

capacity of the economy, as well as an expansion of the demand for the goods and

services produced in the economy. Both the supply factors and the demand factors

are, therefore, necessary for sustained economic growth.

Supply Factors

The supply factors are those which cause an expansion in production capacity, also

called the potential output of the economy. As you have probably guessed, they relate

to the factors of production: natural resources, labour, capital, and entrepreneurship.

An expansion of the country’s production capacity requires an increase in the quantity

and/or quality of the factors of production.

Natural Resources

Minerals have to be discovered, either by accident or through exploration; arable land

has to be cultivated, and so on. In addition, new techniques or price increases may,

for example, make it proﬁtable to exploit certain mineral deposits that were previously

impossible or unproﬁtable to exploit. It is, therefore, always possible to increase the

exploitation of the available natural resources. On the other hand, minerals are non-

renewable or exhaustible assets, and the deposits may become exhausted or too

expensive to exploit.

Labour

The size of the labour force depends on factors such as the size and the age and

gender distribution of the population. The growth of the labour force depends on the

natural increase in the population and migration between countries. The supply of

labour can also be increased by increasing the number of working hours (e.g., by

working overtime). Even more important, however, is the quality of the labour force.

The quality of the labour force depends on factors such as education, training, health,

nutrition, and attitude to work. The size and quality of the South African labour force

will continue to be affected signiﬁcantly by the prevalence of HIV/Aids. Most observers

agree that the size, composition, and productivity of the labour force will be affected

by the pandemic through absenteeism, illness, and a loss of skills and experience.

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Another important determinant of the size and quality of the South African labour force

is the net migration rate. On the one hand, South Africa is losing many young

professionals to countries such as Australia, Canada, the United Kingdom, the United

States and countries on the European continent.

Capital

An increase in the capital stock may take the form of either capital widening or capital

deepening. Capital widening occurs when the capital stock is increased to

accommodate an increasing labour force. For example, if the stock of capital is

expanded by 10 per cent in response to a 10 per cent increase in the number of

workers, there is capital widening. In this case, the average amount of capital per

worker remains unchanged. Capital deepening occurs when the amount of capital per

worker is increased, that is, when the growth in the stock of capital is greater than the

growth in the number of workers. Such a situation is referred to as an increase in the

capital intensity of production.

Entrepreneurship

A country needs people who can identify opportunities and exploit them by combining

the other factors of production. The entrepreneur is the driving force behind economic

growth. Entrepreneurial talent should therefore be fostered

Demand Factors

As we have seen, the total demand for goods and services consists of consumption

demand (C), investment demand (I), government demand (G), and net exports (X –

Z). The various components of aggregate spending or demand may be used to

distinguish between three sets of demand factors:

• Domestic demand, which consists of consumption (C), investment (I) and

government spending (G)

• Export demand (X)

• Import substitution, which involves attempts to reduce imports (Z)

Economic growth can thus be stimulated by a rise in domestic demand (C + I + G), a

rise in exports (X), or a reduction in imports (Z).

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Domestic Demand

Consumption (C) is primarily a function of income (Y), investment spending (I) is a

function of the expected proﬁtability of investment projects (and therefore also of the

interest rate), and government spending (G) is determined by government policy. In

principle it is always possible to increase domestic demand by increasing government

spending. Any expansion in domestic demand should, however, be matched by an

increase in supply, otherwise it could result in inﬂation and balance of payments

problems.

Exports

An increase in exports raises the growth rate and also relieves the balance of

payments constraint. It is therefore generally accepted that the promotion of exports

is a sensible growth strategy.

Import Substitution

Another growth strategy linked to the balance of payments is to reduce imports by

manufacturing previously imported goods domestically. This is called import

substitution, and it played a signiﬁcant role in the initial growth of the South African

manufacturing sector. Nowadays, many of the consumer products that were previously

imported are manufactured in South Africa.

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CHAPTER THIRTEEN:

The Foreign Sector

Learning Outcomes

Upon completion of this chapter, the student should be able to:

• Show a basic understanding of the theoretical notions, principles and protective

measures involved in countries building strong economic links with the rest of

the world

• Provide a detailed description of tariffs and quotas imposed as part of trade

policy by the government of a country to protect local industries

In this chapter focus on the foreign sector. The understanding in foreign trade

and trade policy is looked into. Aspects of the meaning and significance

of exchange rates and terms of trade are explained.

13.1. Introduction

There is broad consensus that the most successful economies are those that have

strong economic links with the rest of the world and are able to compete successfully

in international markets. Economies that are not able to compete will either stagnate

or decline. South Africa’s development has depended heavily on exports, imports and

international capital movements. This is only possible due to international or global

trade.

13.2. Why Countries Trade?

Is it necessary for countries to trade? Is it possible for a single country to produce

everything? Microeconomics explains that it is better for an individual to specialise in

the activities that the individual does best. This principle also applies to countries,

where all countries gain if every country specialises in the production of certain goods,

exporting the surplus which is not consumed domestically and importing those goods

that are not produced domestically.

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International trade exists because factors of production are not distributed evenly

amongst countries. Therefore, no individual country possesses every natural

resource, leading to countries trading with each other to possess resources that are

lacking. South Africa for instance, is rich in platinum which other countries lack. On the

other hand, it does not have high reserves of crude oil. This leads to South Africa

exporting platinum and importing crude oil.

Other countries like Japan, have large supplies of capital, entrepreneurship and skilled

labour, therefore producing and exporting electronic equipment which require capital

and skilled labour.

Absolute and Comparative Advantage

What if two countries produce the same goods, is trade still possible? For example,

let’s assume Zimbabwe and South Africa produce shirts and cellphones. One worker

in Zimbabwe can produce 100 shirts or 5 cellphones per week, whilst in South Africa,

one worker can produce 50 shirts and 10 cellphones per week. Since Zimbabwe is

more efficient in producing shirts and South Africa is more efficient in producing

cellphones, Zimbabwe is said to have an absolute advantage in shirt production and

South Africa has an absolute advantage in cellphone production. Therefore, both

countries only gain if they specialise in the good they are efficient at and trade with

each other.

Absolute advantage is not a prerequisite for international trade. David Ricardo(1772-

1823) formulated the law of comparative advantage. According to him, countries

benefit from trade when the opportunity costs of production (or relative price) differ

between two countries.

Suppose in Germany and South Africa, a German worker can produce 2 cars or 8

barrels of wine per day, while a South African worker can produce 1 car or 6 barrels

of wine per day. It takes fewer resources in Germany to produce a car or a barrel of

wine than in South Africa. Therefore, Germany has an absolute advantage over

South Africa in the production of both goods.

It appears that Germany has nothing to gain from trading with South Africa as

Germany can produce goods with fewer resources. This leads to calculating the cost

of production of cars and wine., using the opportunity cost principle. In Germany the

cost of producing 2 cars is 8 barrels of wine. By using its scarce labour resources to

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produce 2 cars, Germany forgoes the opportunity to produce 8 barrels of wine.

Assuming constant opportunity costs, this means that the cost to Germany of

producing 1 car is 4 barrels of wine. But in South Africa 6 barrels of wine have to be

sacrificed to produce 1 car. Thus it costs relatively less to produce cars in Germany

than it does in South Africa. Germany has to give up fewer barrels of wine to produce

a car than South Africa.

Therefore, the opportunity cost of producing wine is lower in South Africa than in

Germany. To produce 6 barrels of wine, South Africa has to sacrifice 1 car. The

opportunity cost of producing a barrel of wine in South Africa is thus 󰩅 of a car. In

Germany the cost of producing 4 barrels of wine is 1 car. The opportunity cost of

producing 1 barrel of wine in Germany is thus ¼ of a car. It thus costs relatively less

to produce wine in South Africa than it does in Germany.

Thus, although Germany has an absolute advantage over South Africa in the

production of both goods, it does not have a relative advantage in both. Put differently,

Germany is in absolute terms twice as efficient in producing cars as South Africa, but

it is only marginally more efficient in producing wine. This implies that Germany is

relatively more efficient in the production of cars, whereas South Africa is relatively

more efficient (or relatively less inefficient) in the production of wine. Germany has a

relative or comparative advantage in the production of cars, while South Africa has a

relative or comparative advantage in the production of wine.

Import Tariffs

Import tariffs are duties or taxes imposed on products imported into a country. They

are used to protect domestic firms against competition from imports (protective tariffs)

or to raise government revenue (revenue tariffs). There are two categories of

tariffs: specific tariffs and ad valorem tariffs. A specific tariff is a fixed amount that

is levied on each unit of the imported commodity. For example, a tariff of R5.00 levied

on each imported bottle of wine is a specific tariff. An ad valorem tariff is a tariff that is

levied as a percentage of the value of the imported item. For example, a tariff of 20

per cent on the price of an imported motor car is an ad valorem tariff.

Revenue tariffs are usually imposed on items that are not produced in the domestic

economy. In South Africa this includes certain specialised computer and other

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electronic equipment. Protective tariffs, on the other hand, are imposed to protect a

local industry or sector of the economy from foreign competition. Import tariffs can be

quite high, placing foreign producers at a disadvantage (since the tariffs raise the

prices of their products in the domestic market), but they are usually not sufficient to

prevent imports altogether.

Other measures include quantitative restrictions (import quotas), subsidies, other non-

tariff barriers, exchange controls, exchange rate policy and general comments.

Arguments for the use of trade barriers

Governments intervene to create barriers to free international trade. The various

reasons to support trade barriers are as follows:

• Balance of Payments

Tariffs and other controls may be imposed as a short-term method of correcting a

deficit in the balance of payments. How successful measures that raise the prices

of imports are, will depend on the price elasticity of demand for imports.

• Dumping

Closely connected with the balance of payments motive is the imposition of trade

barriers to counteract the practice of dumping. Dumping occurs when a firm sells

its product in a foreign market at a lower price than in the domestic market or at a

lower price than in other export markets. Dumping may also mean that the price

the firm charges in the protected domestic market is raised and part of the proceeds

of the higher price is used to subsidise exports so that it can undercut competitors

in the world market. This is known as predatory dumping and it is generally agreed

that this type of dumping is unfair and that governments are entitled to impose

protective tariffs, called countervailing duties, to counter it

• Export Subsidies

Free trade is desirable only if all countries play according to the same rules. When

a country subsidises some or all of its exports or export industries, firms in other

countries call for retaliatory measures (eg in the form of countervailing duties).

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• Infant Industries

The “infant industry” argument is probably the best known and the oldest of the

economic arguments for protection. According to this argument, many developing

countries have a potential comparative advantage in manufacturing, but new

manufacturing industries in such countries cannot initially compete with well-

established industries in developed countries. It is argued that, to allow

manufacturing to establish a foothold, governments should temporarily support

new industries (with tariffs, import quotas and subsidies) until they have grown

strong enough to meet international competition.

• Employment

Perhaps the most common political argument for the imposition of trade barriers is

that they are necessary to protect jobs and industries from foreign competition. If

tariffs are prohibitive, they would exclude imports altogether and thus maintain a

high level of employment in the domestic industry. Given that unemployment in

South Africa is very high, this argument is favoured by trade unions, which regularly

call upon government to intervene in international trade flows for the purpose of

conserving jobs

• Government Revenue

In developing countries, the import tariff is frequently not only a means of industrial

protection but also a crucial source of government revenue. For developing

countries, tariffs are often extremely efficient forms of revenue collection.

Production, consumption, income and property cannot be effectively taxed or

subsidised when they cannot be measured and monitored, and with import tariffs

revenue can be raised more cheaply than through more elaborate kinds of taxes.

Many low-income countries receive between one-quarter and three-fifths of their

government revenue from customs duties, whereas in industrial countries the

average figure is about two per cent.

• National Security

For obvious reasons, governments prefer not to be entirely dependent upon foreign

suppliers for essential resources. It is therefore often argued that industries that

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produce products that will be essential in times of war or international crisis should

be protected. South African examples include the protection afforded to Armscor

and Sasol during the country’s international isolation under the Nationalist

government.

Arguments against trade barriers

Some of the most common arguments against trade barriers are the following:

• Retaliation by Trade Partners

Trade restrictions tend to invite retaliation. For example, if South Africa imposes

import controls on Japanese motorcars, then it is more than likely that Japan may

do the same and impose import controls on South African products. Any gain to

South African firms that compete in the domestic market with Japanese firms would

then be offset by the losses made by South African firms that export to Japan. The

overall result could well be a tit-for-tat trade war with no real winners.

• Welfare Cost to Society

Protectionist measures, particularly tariffs, impose a cost on society. Remember

that an introduction of a tariff would be followed by an increase in the price paid by

domestic consumers, a fall in the consumer surplus and a loss of welfare to society.

• Inefficiency

Since import controls protect particular industries from foreign competition, it

means that these industries have less incentive to reduce their costs and increase

their efficiency.

In general, the net gains and losses from trade barriers are largely unpredictable.

Consumers in the protected economy lose since prices are higher than they would

be otherwise; producers in the protected economy gain since demand for their

products increases; and foreign producers lose since they are deprived of a

market.

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13.3. Exchange Rates

Foreign trade involves payment in foreign currencies such as the euro (€), pound

sterling (£), United States dollar ($) and Japanese yen (¥). South

African importers have to pay in these currencies for the goods they buy or import and

are therefore obliged to exchange South African rand for these currencies. Therefore

there is demand for foreign currency on South Africa’s part. On the other hand,

importers in other countries, such as Germany and the UK, have to pay in rand for

South African exports and must therefore exchange euros, pounds, etc for rand.

Therefore, South African exports lead to a supply of foreign currency. The rate at which

currencies are exchanged is known as the rate of exchange or exchange rate. The

rate of exchange therefore represents a ratio, that is, the price of one currency in terms

of another currency. Like any other price, the exchange rate can be explained and

analysed with the aid of supply and demand curves.

A foreign exchange market is the international market in which one currency can be

exchanged for other currencies. The foreign exchange market does not have a specific

location. The South African foreign exchange market consists of all the authorised

currency dealers, among whom are included all the major banks.

13.3.1 The Foreign Exchange Market

In Figure 13.1 we show the South African market for US dollars. The quantity of dollars

is measured on the horizontal axis and the price of dollars (in South African rand) is

measured on the vertical axis. The figure shows the demand and supply curves for US

dollars. Financial institutions, firms, governments, investors, speculators, tourists and

other individuals exchange rand for dollars and dollars for rand every day.

The Demand for Dollars

Those who demand dollars are holders of rand who are seeking to exchange them for

dollars. The demand for dollars (which is the same as the supply of rand) comes from

various sources. A first source is South African importers who import goods and

services for which they pay in US dollars. A second source is South African residents

who wish to purchase dollar denominated assets, such as shares of American

companies. Another example is American investors who sell their South African assets

(eg shares, bonds) and wish to convert the proceeds into US dollars. A fourth source

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is South African tourists who buy dollars or dollar denominated travellers’ cheques.

Another important source is speculators who anticipate a decline in the value of the

rand relative to the dollar.

Figure 13.1: The foreign exchange market

Source: Mohr (2020:4)

In Figure 13.1 we show three exchange rates. When the exchange rate is $1 = R16 it

means that a tractor which costs $100 000 in the United States will cost R1 600 000

in South Africa (if we ignore transport and other costs of importing the tractor).

However, at an exchange rate of $1 = R12 the same tractor will cost only R1 200 000

in South Africa. The lower the price of dollars, the cheaper American goods will

become and the greater the quantity of American goods and therefore also of dollars

that will be demanded in South Africa. The demand curve therefore has a negative

slope. The exchange rate determines the domestic price of the goods, services and

assets and the foreign price of domestic liabilities, and therefore affects the quantity

of foreign currency demanded.

The Supply of Dollars

Those who supply dollars are holders of dollars seeking to exchange them for rand.

The supply of dollars comes from various sources. A first source is South African

exporters who export goods and services. The foreign buyers of South African exports

whose prices are quoted in dollars supply dollars which are then exchanged for rand.

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A second source is foreign holders of dollars who purchase South African assets (eg

shares on the JSE or government stock). They also supply dollars. Another example

is South African investors who sell foreign assets denominated in dollars and convert

the proceeds back into rand. Further sources include foreign tourists in South Africa

who exchange dollars or dollar denominated travellers’ cheques for rand, and

speculators who anticipate a rise in the value of the rand relative to the dollar.

The supply of dollars is positively related to the rand/dollar exchange rate. For

example, at an exchange rate of $1 = R16 a South African product which costs R800

000 will cost an American purchaser $50 000, but at an exchange rate of $1 = R15 the

same product will cost $53 333 in the United States. As the rand price of the dollar

falls, the quantity of South African exports demanded by Americans and therefore also

the quantity of dollars supplied will fall. The supply curve therefore has a positive slope.

The Equilibrium Exchange Rate

The equilibrium exchange rate is the rate at which the quantity of dollars demanded

equals the quantity of dollars supplied. In Figure 13.1 this is indicated by an exchange

rate of $1 = R16. The quantity exchanged at this exchange rate is $10 billion. At a

higher price of the dollar (eg $1 = R20) there will be an excess supply of dollars. At a

lower price of the dollar (eg $1 = R12) there will be an excess demand for dollars.

This example shows how market forces determine an exchange rate. We chose the

dollar because the rand/dollar exchange rate is the basic exchange rate in the South

African foreign exchange market. The rates against all other currencies (eg pound

sterling, euro or yen) are derived from those currencies’ exchange rates with the dollar.

For example, if $1 = R16.00 and $1 = €0.80 then South African currency dealers will

quote an exchange rate of €1 = R(16.00 ÷ 0.80) = R20.00. Similar calculations are

made in respect of other currencies. (The actual rates may, however, differ somewhat

due to certain costs and margins that have to be taken into account.)

Changes in Supply and Demand: Currency Depreciation and Appreciation

Anything that causes a change in the supply or demand of foreign exchange will result

in a change in the exchange rate, ceteris paribus. When dollars become more

expensive, the dollar has appreciated against the rand, or that the rand has

depreciated against the dollar. A fall in the price of a dollar implies that the dollar has

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depreciated against the rand or the rand has appreciated against the dollar. A change

in the supply or demand will reflect a shift of the relevant curve.

The supply of dollars decreases, for example, when households, firms or the

government in the United States import fewer South African goods, or when the price

of gold falls on the world market. In the case of a decrease in South African exports to

the United States, fewer dollars will be earned. Since the gold price is quoted in dollars,

a fall in the gold price also means that fewer dollars will be earned (ie supplied on the

South African foreign exchange market) for a given volume of gold exports. In Figure

13.2 the original supply (SS), demand (DD), equilibrium exchange rate or price ($1 =

R16) and equilibrium quantity ($10 billion) are all the same as in Figure 13.1. The

subsequent decrease in supply is illustrated by a leftward shift of the supply curve

to S1S1. The new equilibrium exchange rate is $1 = R18.00 and the equilibrium

quantity falls to $8 billion.

Figure 13.2: A decrease in the supply of dollars

Source: Mohr (2020, Chapter 16.4)

Therefore, the dollar has become more expensive in terms of Rands, that is , the dollar

has appreciated against the rand.

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Table 13.1: Summary of changes in supply and demand of dollars

Change

Illustrated by

Impact on Rand/Dollar

exchange rate (ceteris parabis)

Rand

Dollar

Demand for dollars increase

A shift of the demand curve

to the right

Depreciates

Appreciate

Supply of dollars increase

A shift of the supply curve to

the right

Appreciates

Depreciate

Supply of dollars decrease

A shift of the supply curve to

the left

Depreciates

Appreciate

Demand for dollars decrease

A shift of the demand curve

to the left

Appreciates

Depreciate

Source: Mohr (2020, Chapter 16.4)

Table 13.2: Impact of changes in rand/dollar exchange rate for South Africa

Change in R/$ exchange rate

Impact on

Export prices

(in dollars)

Import prices

(in dollars)

Current

Account

Domestic

Prices

Rand depreciates against dollar

Decrease

Increase

Improves

Rise

Rand appreciates against dollar

Increase

Decrease

Worsens

Fall

Intervention in the foreign exchange market

If the foreign exchange market is left to its own devices, exchange rates tend to

fluctuate quite considerably, since the demand for and supply of foreign exchange are

not synchronised on a day-to-day basis. A freely floating exchange rate is also subject

to speculation. Because of the potential volatility of exchange rates, and because the

authorities often wish to use the exchange rate to pursue particular policy objectives,

exchange rates are often managed or manipulated to some extent by central banks.

This is called managed floating.

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Figure 13.3: Managed floating

Source: Mohr (2020, Chapter 16.4)

The original demand and supply curves (DD and SS respectively) are the same as

in Figure 13.1, as are the original equilibrium exchange rate ($1.00 = R16.00) and

quantity traded ($10 billion). Suppose that the demand for dollars increases (eg

because of an increase in South African imports from the United States), illustrated by

a rightward shift of the demand curve to D1D1 in Figure 13,3. At the original exchange

rate ($1.00 = R16.00) there is now an excess demand for dollars of $1 billion, indicated

by the difference between E0 and E2 (ie the difference between $11 billion and $10

billion).

In the absence of any intervention the excess demand for dollars will result in an

increase in the price of dollars to $1.00 = R18.00, illustrated by the new equilibrium

at E1. In other words, the rand will depreciate against the dollar. Suppose that the

SARB wishes to avoid such a depreciation of the rand (eg because it may result in

inflationary pressure). What can it do?

If it has the necessary reserves, the SARB can supply $1 billion to the market. This

can be illustrated by a rightward shift of the supply curve to S1S1. A new equilibrium

is established at E2 and the exchange rate remains at $1.00 = R16.00. What will

actually happen in practice is that the SARB will be willing to supply additional dollars

at the original exchange rate to avoid the development of an excess demand for dollars

and a consequent appreciation of the dollar (ie depreciation of the rand).

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This is how managed floating works. The central bank monitors developments in the

foreign exchange market and decides whether or not to intervene. If it decides to

intervene, it can also do so on a limited scale. For instance, in our example the SARB

can supply fewer than a billion dollars. In such a case the exchange rate will settle

somewhere between R16.00 and R18.00 per dollar, depending on the amount of

intervention.

On the other hand, if an excess supply of dollars develops at the original exchange

rate (eg because of a decrease in the demand for dollars, ie a decrease in the supply

of rand), and the SARB wishes to avoid a depreciation of the dollar (ie an appreciation

of the rand), it will purchase the excess dollars at the original exchange rate and add

them to the foreign exchange reserves.

While it is relatively easy for a central bank to purchase foreign exchange in an attempt

to avoid an appreciation of the currency (because such an appreciation might, for

example, stimulate imports and hurt exports), it is much more difficult to try to avoid a

depreciation. A central bank can only intervene to stabilise a depreciating currency if

it has sufficient foreign exchange reserves to do so. This further illustrates the

importance of a country’s gold and other foreign reserves. However, given the

extremely large daily net turnover on the foreign exchange market (which has

exceeded $25 billion in South Africa) it is doubtful whether the SARB, or for that matter

any other central bank, except possibly that of China, will ever have sufficient reserves

to effectively manage the international value of the currency. In earlier years it was still

possible (albeit not indefinitely), but the explosion of international financial transactions

has almost eliminated this policy option.

Exchange rate policy

Exchange rates are among the most important prices in the economy. Movements in

exchange rates can have a significant impact on economic growth, employment,

inflation and the balance of payments as well as on the wellbeing of individuals (eg

people who have invested abroad or in rand hedge equities and people who wish to

travel abroad). During the past few decades the rand depreciated significantly against

the major currencies, and exchange rates were often quite volatile and both the

depreciation of the rand and the volatility of exchange rates have frequently been

major causes for concern.

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How can policy makers react in such circumstances? This will depend on the

exchange rate system that is in force. The most fundamental element of exchange

rate policy is the choice of an exchange rate system or regime. The gold standard and

the Bretton Woods system of fixed but adjustable exchange rates were both variations

of fixed rate systems. In the new millennium, however, such systems are no longer

feasible, at least not on a global scale. At the time of writing, most of the larger

countries, including South Africa, had floating currencies (ie if one includes the euro,

the common currency of a number of European countries).

With a floating currency, there are basically only three policy options:

1. Do nothing, that is, allow market forces, including the actions of currency

speculators, to determine exchange rates.

2. Intervene in the foreign exchange market by buying or selling foreign

exchange, that is, practise managed floating. However, as explained above,

such a course of action is subject to severe limitations, especially in view of the

large turnover in the foreign exchange market.

3. Use interest rates to influence exchange rates. For example, if the SARB

wishes to avoid a depreciation of the rand against the major currencies, it can

raise interest rates relative to the rates in the rest of the world. This will

encourage an inflow of foreign capital and will also raise the costs of

speculators who want to speculate against the rand. The result will be an

increase in the demand for rand, relative to what it would have been otherwise,

and therefore a stronger rand (than in the absence of intervention).

All three of these approaches have been used in South Africa in recent decades.

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