BACHELOR OF BUSINESS ADMINISTRATION (YEAR 1)

ECONOMICS 1A

Study Guide

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Economics 1A

Table of Contents COURSE INTRODUCTION ..................................................................................................................... 2 STUDY UNIT ONE .................................................................................................................................. 4 INTRODUCTION TO THE MICROECONOMICS .................................................................................... 4 STUDY UNIT TWO ................................................................................................................................ 11 A CLOSER LOOK AT THE ECONOMIC PROBLEM OF SCARCITY .................................................... 11 STUDY UNIT THREE ............................................................................................................................ 20 THE CIRCULAR FLOW OF INCOME AND SPENDING ....................................................................... 20 STUDY UNIT FOUR .............................................................................................................................. 25 DEMAND, SUPPLY AND PRICES ........................................................................................................ 25 STUDY UNIT FIVE ................................................................................................................................ 43 DEMAND AND SUPPLY IN ACTION .................................................................................................... 43 STUDY UNIT SIX .................................................................................................................................. 58 ELASTICITY .......................................................................................................................................... 58 STUDY UNIT SEVEN ............................................................................................................................ 69 THE THEORY OF PRODUCTION AND COST ..................................................................................... 69 STUDY UNIT EIGHT ............................................................................................................................. 82 PERFECT COMPETITION .................................................................................................................... 82 STUDY UNIT NINE................................................................................................................................ 93 IMPERFECT COMPETITION ................................................................................................................ 93

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Economics 1A GENERAL OUTCOMES Aims of this module:



Understand what is meant by microeconomics



Understand the economic problem of scarcity



Understand the interdependence of major sectors in the economy

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Analyse how market forces of demand and supply determine equilibrium

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Understand the concept of price and income elasticity



Understand the theory of production and costs

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Understand the different market structures

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Compare the salient features of each market structure



Understand the equilibrium position of each market structure

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Economics 1A

COURSE INTRODUCTION

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Economics 1A How to use the Manual Don’t try to complete the manual in a few long sessions. You will study more effectively if you divide your study into two-hour sessions. If you want to take a break, it would be a good idea to stop at the end of a study unit. Use the study guide in conjunction with the prescribed text book and the workbook which consists of questions that will equip you in the understanding of each study unit. Attempt the questions in the workbook after each study unit. Both the study guide and workbook are designed to help you to study and prepare for the examinations. Module Assessment 

Assignment You will be required to complete and submit an assignment. This assignment is assessed as part of your coursework. Therefore, it is very important that you complete it.



Examination An examination will be written at the end of each semester. The assessment strategy will focus on application of theory to practice.

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Economics 1A

STUDY UNIT ONE INTRODUCTION TO THE MICROECONOMICS

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 1

1.

Introduction to the Microeconomy

Learning Outcomes: After studying this unit you should be able to: 

Distinguish between macroeconomics and microeconomics



Explain the economic problem of scarcity



Understand the concept of opportunity cost



Explain the economic problem using a production possibility frontier

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Economics 1A 1.1. Introduction Economics is a social science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. Consequently, economics examines the problems that arise when individuals and firms have consumption desires that are constrained by access to resources. This problem is often referred to as infinite wants and finite resources. 1.2. Macroeconomics versus Microeconomics Microeconomics, on the other hand, focuses on the individual participants in the economy: producers, workers, employers and consumers. Microeconomic policies focus on specific markets. Macroeconomics is concerned with the economy as a whole. It focuses on aspects such as the stability of the general price level (commonly known as inflation), the maintenance of full employment, economic growth, the distribution of income, government spending, and the nation’s money supply. 1.3 Limited resources Before we continue, we need to distinguish between wants, needs and demand: 

Wants are our desires for goods and services, and are unlimited – we all want everything!



Needs are necessities, essential for our survival, examples include food, water, shelter.



Demand differs from wants, desires or needs. For there to be demand for a good or service, those who want to purchase it must have the necessary means to do so. They must have the purchasing power. (Mohr and Fourie, 2008:6)

1.4 The problem of scarcity Now that we have distinguished between wants, needs and demand, attention should now be on the economic problem of scarcity.

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Economics 1A People’s unlimited wants cannot be met with the limited resources available, as such choices need to be made. But what are these resources which are in limited supply? Resources are used to produce goods and services and are referred to as factors of production. Since the factors of production (resources) used in the production of goods and services are limited, it follows that the goods and services which can be produced with them are also limited. Factors of production are divided into four main categories: 

natural resources (land, minerals)



labour



capital



entrepreneurship

Natural resources and labour are also known as primary factors of production, whilst capital and entrepreneurship are called secondary factors. As these factors of production are scarce, we are forced to make difficult choices. The use of scarce resources to produce a certain good or service, means that those resources are not available to produce other goods or services. Stated differently, a decision to produce more of one good means that less of another good can be produced. Because resources are scarce, their use is never costless. This point is captured in the economic saying, “there ain’t no such thing as a free lunch”. There are always costs involved. This leads us to the principle of opportunity cost. 1.5 Opportunity costs “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” (Mohr and Fourie, 2008:7). Every time we make a choice, we incur opportunity costs. Economist use opportunity cost to measure the costs incurred in choices. Opportunity cost is a key concept in economics as it captures the essence of scarcity and choice. The economic principals of scarcity, choice and opportunity cost are captured in the production possibilities curve. Note: Scarcity should not be confused with poverty. Scarcity affects everyone. 7

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Economics 1A 1.6 The Production Possibility Curve “No matter how an economy is organized, there’s a limit to how much it can produce. The most evident limit is the amount of resources available for producing goods and services. One reason the United States can produce so much is that it has over 3 million acres of land. Tonga, with less than 500 acres of land, will never produce as much. The U.S also has a population of over 300 million people. That’s a lot less than China (1.3 billion), but far larger than 200 other nations (Tonga has a population of less than 125, 000). So an abundance of resources gives us (U.S) the potential to produce a lot of output. But that greater production capacity isn’t enough to satisfy all our desires.” (Schiller, 2008: 5) As previously noted, the economic principals of scarcity, choice and opportunity cost are captured in the production possibilities curve. The production possibility curve (Figure 1-1) shows the maximum amount of production that can be produced by an economy with a given amount of resources.

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Economics 1A Figure 1-1 A production possibilities curve for the Wild Coast community

(Mohr and Fourie, 2015:6) The production possibility frontier (PPF) in Figure 1-1, shows the maximum amounts of potatoes and fish that can be produced by our rural community when the community uses its resources fully and efficiently (refer to text for detailed description). At A, 100kg of potatoes can be produced per day by devoting all their time and available resources to gardening. Likewise at F, 5 baskets of fish can be produced per working day, if all time and available resources are devoted to fishing. By shifting resources from one production possibility to the other, the community can enjoy a diet of both fish and potatoes. In our example, in moving from C to D, the community actually transforms part of the production of potatoes into fish. Combinations on the PPF represent the maximum amounts which can be produced by efficiently using all available resources. The PPF demonstrates graphically, the principal of opportunity cost. In our example, the opportunity cost of producing 40kg of potatoes is the basket of fish forgone. Similarly, the opportunity cost of producing 4 baskets of fish is the 60kg of potatoes forgone. 9

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Economics 1A All points to the right of the curve, such as G are unattainable. G is unattainable due to scarcity, a lack of resources to achieve that level of production. Choice is illustrated by the need to choose between the combinations available, and opportunity cost is illustrated by the negative slope of the curve. The negative slope, showing that more of one good can only be obtained by sacrificing the other good. Opportunity cost increases as we move along the PPF. This can be seen by paying attention to concave shape of the curve. 1.7

Why do opportunity costs increase along the PPF?

This occurs for the most part, because it is difficult to move resources from one industry to another. Resources do not adapt easily. Workers may not have the same skills across the industries, so as we move them from one industry to the other we get fewer of one good for every other good that is given up. There are difficulties in transferring labour, skills, capital and entrepreneurship between industries. These difficulties are so well known that they are often referred to as the law of increasing opportunity cost. The law states that ever increasing quantities of other goods and services need to be given up in order to get more of a particular good. This law is not solely based on the lack of movement of skilled labour. The mix of factors required to make a certain good is also a factor. One good may require a more capital intensive production process as opposed to the other (Schiller, 2008: 8). YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT TWO

A CLOSER LOOK AT THE ECONOMIC PROBLEM OF SCARCITY

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 1

2. A closer look at the economic problem of scarcity Learning Outcomes: After studying this unit you should be able to:



Illustrate using a production possibility curve, how a better production technique, or increased resources affects demand and supply.



2.1

Understand the three central economic questions Improved techniques or increased resources

Recall our example on the rural community who could either produce fish, or potatoes, or a combination of the two.

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Economics 1A Figure 2-1 The production possibilities curve once again

(Mohr and Fourie, 2015:6)

Figure 2-1. With a given level of resources and a given state of technology, the community can produce various combinations of fish and potato output. However, they cannot move beyond the points ABCDEF (AF for short). This is why the curve is sometimes called a production possibility boundary of frontier. It shows the maximum attainable combinations of goods that can be produced, or potential output. Its concave shape (from the origin) indicates increasing opportunity costs. Any combination within the frontier is attainable, however, such combinations are inefficient because either available resources are not being used to their full potential (inefficiently) or some of them are left idle (unemployment). In the event that the economy is operating at less than potential output (actual output is therefore less than potential output), this would be illustrated as a point inside the production possibility curve/frontier (PPF). Some of the available resources are either unemployed or not employed efficiently. Point H in figure 2-1 is an example of this. At a point such as H, more output of one good would not require less output of the other, there would be no opportunity cost when output is expanded. It is therefore possible to expand production by simply using the existing resources fully and more efficiently (given the state of technology). 13

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Economics 1A

We need to fully and efficiently utilize scarce resources. This will occur when production is taking place on the production possibilities curve. Actual output is equal to potential output when production takes place on the production possibilities curve. Furthermore, when we are on it, it is impossible to produce more of one good without sacrificing some production of the other good. “Production efficiency means more output of one good can be obtained only by sacrificing output of other goods” (Begg, Fischer and Dornbusch, 2003:7). A point such as G in figure 2-1 is unattainable. Any point beyond AF is unattainable. With the given available resources and current production techniques, achieving a combination such as G or any combination outside of AF is impossible. However, if over time the quantity of available resources increase, and/or production techniques improve, then points beyond AF will be attainable. If this happens then the PPF will shift outwards. Outward movements of the PPF illustrate economic growth. Figure 2-2 Improved technique for producing capital goods

(Mohr and Fourie, 2015:9)

Referring to Figure 2-2, an improved technique for producing capital goods has been developed. It is now possible to produce more capital with the available factors of production. Assuming the available factors of production and the technology for producing consumer goods remain the same, then maximum production of consumer goods will remain at A.

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Economics 1A If all available resource were used in the production of capital goods, then maximum production of capital goods would increase from B to C, and the new PPF is AC. With the exception of point A, it is now possible to produce more of both goods. Production of both goods has increased, with the exception of the intercept point A. Remember, an improved technique implies that less resources are required to produce the same level of output. Therefore, if there is an improved technique for producing capital goods, then for any given level of capital production, more resources could be moved over to the production of consumer goods. Likewise, with the same levels of resources, we can now produce more capital goods. Therefore, as we move resources over to capital goods production, we produce more output than we previously could have. Figure 2-3 Improved technique for producing consumer goods

(Mohr and Fourie, 2015:10)

Referring to Figure 2-3. Similarly, new technique for producing consumer goods is developed. Available resources and the technique for producing capital remains the same. Maximum potential output for consumer goods will increase. PPF swivels around point B so the new PPF is DB. Except at point B, it is possible to produce more of both goods.

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Economics 1A Figure 2-4 below illustrates a shift in the PPF from AB to EF. A shift in the PPF occurs if the amount of available resources (e.g.: labour, raw materials) and/or the productivity of available resources increase. There is now the possibility of producing more of both capital and consumer goods. Potential output has increased. Figure 2-4 Increase in the quantity or productivity of the available resources

(Mohr and Fourie, 2015:10)

In the case where the amount of resources or their productivity (efficiency) decrease, there will be a decline in potential output. This decline can be illustrated by an inward shift of the PPF. In our case it would result in a reversal of Figures 2-2, 2-3 and 2-4. The PPF illustrates potential output, however, it does not indicate which of the possible combinations of output should be produced. The final choice will depend on the preferences of society. 2.2 The three central economic questions The three central questions (What? How? For whom?) are used to introduce a variety of concepts, distinctions, factors of production, and economic systems.

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Economics 1A 2.2.1

What should be produced?

The purpose of economic activity is to satisfy human wants. Most wants are satisfied by goods and services. Goods are tangible objects like food, clothing, houses and books. Services are intangible things like medical services and legal services. We assume that all goods and services are useful and as such maximum production is desirable. Please refer to prescribed text (Mohr and Fourie:2008:18-19) for definition of capital and consumer goods and final and intermediate goods. You are required to know these for future reference in the module. 2.2.2. How it should be produced? After deciding what goods and services are to be produced, the next step is to decide how the goods and services will be produced? Scarce resources have to be used efficiently. What are these resources? Resources used to produce goods and services are called factors of production. There are four main factors of production as previously stated are: 

natural resources (land, minerals) – primary



labour - primary



capital - secondary



entrepreneurship –secondary

2.2.2.1 Natural Resources (land) Consists of gifts of nature, some examples are mineral deposits, water, natural forests, animal life and sunshine. Natural resources are in fixed supply, however, it is possible to exploit more of the available resources. The discovery of new mineral deposits is an example. However, once used these resources cannot be replaced. As a result, minerals are referred to as nonrenewable or exhaustible assets. As is the case with all the factors of production, both quality and the quantity of natural resources are important.

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Economics 1A 2.2.2.2 Labour Labour can be defined as the exercise of human and physical effort in the production of goods and services. The quantity available depends on the size and proportion of the population which are willing and able to work. The quality of labour is described by the term human capital, which refers to the skill, knowledge and health of the workers. Education , training and experience are all determinants in human capital. 2.2.2.3 Capital Comprises of all manufactured resources (machines, tools and buildings), which are used in the production of other goods and services. Capital goods are not produced for their own sake, they are produced to produce other goods. When we talk about capital as a factor of production, we are referring to all those tangible things used in the production process. When we produce capital goods, we sacrifice present consumption for future consumption. 2.2.2.4 Entrepreneurship Factors of production have to be combined and organized by people who see opportunities and are willing to take risks by producing goods in the expectation that they will be sold. Entrepreneurs are the people who do this. They are the initiators, the innovators and the risk bearers, and they do this in anticipation of making profits. 2.2.2.5 Technology Sometimes identified as the fifth factor of production. When new knowledge is put into practice, and more goods and services are produced with a given level of natural resources, labour, capital and entrepreneurship, we say that technology has improved. Invention is the discovery of new knowledge, whilst innovation is the incorporation of the new knowledge into actual production.

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Economics 1A 2.2.2.6 Money as a factor of production? Although money is important, it is NOT a factor of production. Goods and services cannot be produced with money, to produce goods and services we need factors of production. Money is a medium of exchange, it facilitates the exchange of goods and services. 2.3 The choice of technique When deciding how to produce the goods and services chosen by society one has to make a choice as to what will the best method of production be. Production often involves more than one technique with which to produce the good or service, for example when manufacturing shoes one may choose a process which is dominated by machines or a process which requires more labour than machines. If the production process is dominated by machines, the production process is referred to as capital-intensive. However, if the emphasis is on labour, the production process is labour-intensive. In choosing whether or not to have a capital intensive or labour intensive production process certain factors play a role in the decision, these factors include: the availability of resources, the quality of the resources available, the relative prices of the resources available (ie the price of labour against the price of capital), the labour laws of the country and other relevant laws.

2.4 For whom it should be produced Good and services are produced for government (the public sector) and the rest of the economy (the private sector). There is also a geographical distribution of the income between regions of a country and between sectors (known as primary, secondary and tertiary sectors). YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT THREE

THE CIRCULAR FLOW OF INCOME AND SPENDING

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 3

3.

The Circular flow of income and spending

Learning Outcomes: After studying this unit you should be able to:



Understand the major role players in the economy



Describe the flow of income in the circular flow model

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Economics 1A 3.1 Introduction The circular Flow of Income shows the flow of inputs, outputs and payments between households and firms within an economy. This model captures the essential essence of macroeconomic activity. The economy is seen as nothing more than: 

A revolving flow of goods,



Production resources, and



Financial payments.

The three major flows are (Mohr & Fourie: 2015:41):

The circular flow model illustrates the mechanism by which income is generated from goods and services and how this income is spent. This is best understood by analyzing the diagram below:

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Economics 1A 3.2

A Simple Circular Flow Model of Income and Spending

(Mohr & Fourie: 2015:51)

Firstly, let us consider households who are buyers, and firms who are producers and sellers of goods and services in the goods and services market: Firms are buyers of factors of production and households become sellers of factors of production in the factor market. The income flow or flow of rands of factors of production is denoted by the outer line (clockwise direction of the arrow), whereas the inner line (anticlockwise direction of the arrow) represents the flow of spending on goods and services in the economy. The next participant that we introduce into the model is the government. The government is responsible for providing public goods and services, such as roads, bridges, etc. for usage by households and firms.

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Economics 1A In order for government to provide these public goods and services, it receives tax revenue from households and firms. Hence, again we have flow of income in the form of tax paid by firms and consumers and tax received by the government. In addition, government provides subsidies to firms and households - flow of income. Next, we introduce the financial sector, which mainly comprises of financial institutions, where consumers and firms deposit funds and earn interest on savings. In addition, firms and consumers take loans to invest in capital goods and assets, and have to pay interest on loans. Finally, we introduce the foreign sector. In the foreign sector, importing countries pay using foreign exchange for imported goods and services, and exporting countries earn foreign currency for exporting goods and services. This simple circular flow model of income, output and spending represents the workings of a simple economy, and illustrates the importance of economic interdependence. It further highlights the mutual dependence between the micro economy and the macro economy.

YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT FOUR

DEMAND, SUPPLY AND PRICES

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 4

4. Demand, Supply and prices After studying this unit you should be able to:



Draw and read simple demand and supply graphs



Explain the difference between change in demand or supplied and change in quantity demanded or supplied



Distinguish between movement and shifts along a demand and supply curve



Identify the determinants of individual demand and supply and market demand and supply

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Economics 1A 4.1 Introduction This is an important study unit, as it lays the foundation for most of the economic analysis in Economics 1. 4.2 Demand In economics, demand for a good or service means that there is both the intent to buy it and the means (i.e. purchasing power) to do so. Therefore, demand refers to the quantities of a good or service that potential buyers are willing and able to buy. Furthermore, demand relates to the plans of households, firms and other participants in the economy. It does not relate to events which have already occurred. As demand is concerned with plans and not events which have occurred, means that the quantity demanded and the quantity actually bought may differ. Quantity demanded may in fact be equal to, greater than, or less than the quantity bought. 4.2.1 Individual demand We will use the case of Anne Smith, (Mohr and Fourie:2008:113) an imaginary consumer who demands tomatoes. What are the determinants and properties which will determine the quantity of tomatoes that Anne plans to purchase in a particular period? 

The price of the product Anne will be willing and able to buy a larger amount of tomatoes the lower the price, ceteris paribus.



The prices of related products. The price of related products will also influence Anne’s decision on how many tomatoes to purchase. In the case of related products, we have to distinguish between complements and substitutes

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Economics 1A Complements are goods that are used together with the good in concerned. In our case bread (for sandwiches) and onions (for cooking) are examples of goods that would complement tomatoes. Substitutes are goods that can be used instead of using the good concerned. For example, tomatoes 

can be replaced with other ingredients in a salad.

The income of the consumer. Income also affects Anne’s plans as it determines her purchasing power (her ability to purchase). A higher income means that she can afford (plan) to buy more tomatoes.



The taste (or preference) of the consumer. Anne’s decision on how many tomatoes to purchase will also be influenced by her tastes. If Anne has a liking for tomatoes or foods which require tomato then she will plan to buy more tomatoes. However, if she doesn’t like tomatoes, or if she has been ordered not to eat them by a doctor, this too will affect her decision. These influences are non-measurable and are lumped together under “taste”. They may also have a negative or positive impact on the quantity demanded.



The size of the household. As households grow in size, they tend to purchase more goods and services. Likewise, smaller households tend to purchase less.

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Economics 1A Figure 4-1 Anne Smith`s weekly demand for tomatoes

(Mohr and Fourie, 2015: 63)

In figure 4-1 above, the price of tomatoes (rand per kg) is on the vertical (y) axis and the quantity of tomatoes demanded (kg per week) is listed on the horizontal (x) axis. Note, it is crucial that you label the axis of these graphs correctly as they form the basis of the diagram. Each point on the diagram represents a combination of both price and quantity demanded. For example, at point a, 6kg of tomatoes will be demanded if the price of tomatoes is R1 per kg. By joining all the various points which express the relationship between the price of a good and the quantity demanded, we obtain the demand curve. The negative slope of the demand curve (point e to point a), indicates that there exists a negative or inverse relationship between price and quantity demanded (ie the law of demand). We plot the demand curve for a good or service on the assumption that, all other determinants are constant (ie ceteris paribus). 29

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Economics 1A Market Demand The market demand curve is simply the sum of all of the individual demand curves for a particular good or service. Therefore, in a situation where the market consists of three prospective buyers, Anne Smith, Helen Rantho and Purvi Bhana, to obtain the market demand curve we would add all their demand curves together. The market demand curve is therefore obtained by adding the individual demand curves horizontally (ie at a price of R5 Anne demands 2 tomatoes, Helen 0 and Purvi 1, therefore market demand at R5 = 3 tomatoes demanded). This process of adding up the demand curves horizontally is demonstrated in figure 4-2 below, where the individual demand curves are shown to the left and the market demand curve (the sum of the individual curves) is on the right. Figure 4-2 The market demand curve

(Mohr and Fourie, 2015: 65)

If the information for the market was available, i.e. if we had the information for the total quantity demanded per period, then we could simply plot the market demand curve as we did with the individual ones (joining the price and quantity points plotted). As the market demand curve is simply all the individuals demand curves in that market added together, the same factors which determine individual demand, also determine total quantities demanded.

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Economics 1A 4.3

Movements along the demand curve and shifts of the demand curve

Movements along the demand curve are related to changes in the price of the good or service. When the price of a product changes, the quantity demanded will also change, ceteris paribus (all other factors remaining constant). We can obtain the amount by which the quantity changed by comparing the relevant points on the demand curve. Therefore, to determine by how much quantity demanded changed, we compare the movement along the demand curve, i.e. we compare two points. (Refer to figure 4-3 below). For example, if the price of tomatoes had to change from R4 per kg to R3 per kg, demand would change from 6 kg per week to 9 kg per week. Consumption of tomatoes is now 3 kg per week more than it was previously. Remember, these conclusions are based on the assumption that all other things remain the same, i.e. ceteris paribus! Therefore, when dealing with movements along the demand curve, we are dealing with the relationship between the price of the product and the quantity demanded, ceteris paribus. Figure 4-3 A movement along a demand curve

(Mohr and Fourie, 2015: 66)

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Economics 1A 4.4 Shifts in the demand curve We now turn our attention to shifts in the demand curve. Shifts in the demand curve occur when factors influencing the nature of demand change. Therefore, if a factor which determines the demand for a product changes (other than price of course), the demand curve for the product will shift. This occurs because price has been placed as the cornerstone of the demand curve (i.e. it is on the vertical axis). Changes in determinants other than price are therefore reflected as shifts of the demand curve. As mentioned earlier, there are a host of factors that influence demand other than the price of the product. We will examine each one in detail: 4.4.1 The prices of related goods Related goods fall into two categories, substitutes and complements. Substitutes, are exactly what the name suggest, they are products which can be used in the place of another good to satisfy the consumers wants. Examples of substitutes include, nike and reebok shoes, butter and margarine, beef and mutton. Differences in the prices of these goods will determine, to an extent, the level of demand for the product in question Ceteris paribus, an increase in the price of a substitute will result in an increase in the quantity demanded for the product in question. This will result in a shift of the demand curve to the right, indicating that there is a greater quantity demanded of the product at each price range. Increases in the prices of substitutes are therefore displayed as shifts of the demand curve to the right for the product concerned, likewise decreases in the prices of substitutes are displayed as shifts to the left. Remember, this is under the ceteris paribus condition, all demand curves are plotted under this condition. Figure 4-4 below shows a graphical representation of how an increase in the price of a substitute shifts the demand curve for the product concerned to the right.

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Economics 1A Figure 4-4 Two substitutes: butter and margarine

(Mohr and Fourie, 2015: 67)

Have you ever felt for ice-cream on a hot day and as a result bought yourself an ice-cream cone? Although you may not think it at the time, these are two separate goods that are complementing each other. You are therefore using these two goods jointly to satisfy your want. This is the nature of complements, goods that tend to be used jointly to satisfy the want of the consumer. Other examples are golf clubs and golf balls, motorcars and petrol, and DVD players and DVD’s. In the case of a complement, a fall in the price of a complementary good results’ in an increase in demand for the good concerned, ceteris paribus. Graphically, this is shown as a shift to the right of the demand curve for the product. The opposite is true for an increase in the price of a complementary good, in this case the demand curve for the good will shift to the left. Remember, shifts in the demand curve indicate that the quantity demanded has changed at every price, i.e. there is more/less quantity demanded of the good at every price.

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It was mentioned earlier that we all have infinite wants, but these wants need to be distinguished from demand. For there to be demand, the consumer must be willing and able to purchase the product. Clearly, our ability to purchase affects the amount of goods we purchase. 4.4.2

Changes in income

In the case where consumer income changes, there will be a change in demand. Changes in income are shown graphically as shifts in the demand curve. Ceteris paribus, an increase in income will lead to an increase in demand and a decrease in income will lead to a decrease in demand. Therefore, increases in income are shown graphically as shifts of the demand curve to the right and decreases in income are shown as shifts to the left. Whereas changes in the prices of related products and changes in the incomes of consumers are rather obvious determinants of demand, a less obvious determinant is consumer tastes and preferences. Preferring Nike shoes to Reebok is a good example of tastes and preferences. As these tastes and preferences change, so too does demand. Many things can affect your tastes and preferences, advertising, a doctor’s advice or maybe a conversation with a friend. In either case the demand curve responds by shifting either to the left or right. For example, a negative change in tastes for pizza, due to an increase in the popularity of spaghetti, would shift the demand curve for pizza to the left, whereas a positive change would do the opposite. The demand for a product also depends on the size of the population that the market is serving. The larger the population, the greater will be the demand for the product in question, ceteris paribus. The smaller the population, the smaller the demand for the product, ceteris paribus. Graphically this can be illustrated as follows: an increase in the population will shift the demand curve to the right, ceteris paribus. A decrease in the population would shift the demand curve to the left, ceteris paribus.

Other important variables which influence demand are changes in expected future prices and the distribution of income. Consumers’ expectations about future events form a critical part of economics, as expectations of future events often translate into realities. In this case, should consumers

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Economics 1A expectations about any of the determinants of demand change, then demand for product can change. Should consumers expect that the future price of a good will fall, ceteris paribus, they will tend to reduce present consumption. The expectation of the future price decrease means that if consumption is put on hold now, the good can be purchased cheaper at a later stage. Present consumption is therefore reduced. Graphically this will be displayed as a shift of the demand curve (for the product) to the left, indicating that quantity demanded has decreased at all prices. If consumers expect future prices to rise, ceteris paribus, then the opposite will occur. Present demand will be increased as to maximize the opportunity to purchase the good cheaply (shift to the right).

THINK POINT There must have been a time when you expected a sale at a store you liked and decided to wait for it, waiting to purchase whatever item it is you wanted. This is the same concept. These are things that we do on a daily basis, all that is happening here is that it is given structure and form. Try to relate to the concepts you read about.

Changing the distribution of income among the households in the economy may also change demand. Redistributing income from households with high incomes to households with low incomes changes the nature of demand. Goods which are demanded by low-income households will increase (rightward shift) while goods which are demanded by high-income households will decrease (leftward shift), ceteris paribus. Distributing income influences the structure of the market, remember, the market serves us through the pricing mechanism (for a market economy), and therefore those with money determine the composition. 4.5

Supply

The focus is now on supply. When dealing with supply it is useful to remember that supply has to do with producers, so try to relate to it as if you were the business man/woman.

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Economics 1A Supply is defined as, the quantities of a good or service that producers plan to sell at each price during a period. Just as demand refers to the plans of consumers who are willing and able to purchase, supply refers to the plans of producers who are willing and able to supply the quantities of the product concerned. Worth noting is the fact that producers are not guaranteed to sell the quantity that they supply, as this depends to a large extent on demand. 4.5.1

What determines supply?

Individual supply is determined by a few factors, these include:  The price of the product: The higher the price, the greater the quantity supplied to the market. Remember, prices convey information to market participants. High prices indicate that demand in the market is good and therefore there is profit to be made.  The prices of alternative products: The decision to produce is not only dependent on the price of the product in question, it is also dependent on the prices of alternative products. A producer will have to decide which products to produce with the given resources. Resources may be used to produce more than one product and as a result decisions have to be made as to how much of a product to produce given the alternatives.  Expected future prices: Production decisions are not made over a period or periods of time and as a result plans have to be made with the future in mind. Plans to produce are therefore made with the future in mind, i.e. producers make decisions not only on the current market price but also on the prices they expect to receive in the future.

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Economics 1A  The state of technology: Technology plays an important role in the production process as it impacts directly on the cost of production. Should there be technological developments which allow producers to produce at lower cost, then the quantity supplied will increase at every price level. Figure 4-5 Johnny`s annual supply of tomatoes

(Mohr and Fourie, 2015: 73)

The positive slope in the graph above indicates that more goods/services will be supplied to the market as the price of the goods/services increase. Remember what was said earlier, price is an indicator of profitability, producers use prices as an indicator of market activity. Figure 4-5 is simply a graphical representation of this relationship. Figure 4-5 graphically illustrates the law of supply, which states that the relationship between price and supply is a positive one. More goods will be supplied at higher prices and fewer goods will be supplied at lower prices, ceteris paribus.

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Economics 1A 4.5.2

Market Supply

Like we did in the case of market demand, to obtain the market supply we simply add the individual supply curves horizontally. So if Peter, Jack and Paul are willing to supply 10, 20 and 30 pairs of shoes if the market price is R100, then to obtain the market supply we simply add these values for the price of R100. Therefore at a price of R100, the market supply will be 60 pairs of shoes. This can be done at all prices. The market supply is the relationship between the price of the product and the quantities supplied, by all firms, over a specific period. Market supply and individual supply are therefore very much the same, with the major difference being that market supply refers to all the prospective sellers of a product in a particular market. 4.5.3

Movements along the supply curve and shifts of the curve

As can be seen in the diagram below (Figure 4-6), at a price of P1 the quantity demanded is Q1, these two values are represented by point a on the graph. Should the price of the good concerned increase to P2 then the quantity supplied will increase to Q2, point b. As can be seen, price changes result in movements along the supply curve, just as price changes result in movements along the demand curve. Remember, movements along the supply curve due to price changes, are subject to the ceteris paribus assumption. Changes in price therefore result in a change in quantity supplied.

Figure 4-6 A movement along a supply curve: change in quantity supplied

(Mohr and Fourie, 2015: 74)

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Economics 1A

Shifts of the supply curve however, are not as a result of price changes, but are due to changes in the other determinants of supply. Shifts in the supply curve are therefore due to changes in factors other than price. Recall what was said earlier about the supply function and the factors which determine it. Therefore, should a factor like technology change, and a more efficient process of production is discovered, this would shift the supply curve to the right, ceteris paribus. What this shift indicates is that there will be a greater amount of the good supplied at each price level. We refer to this as a change in supply. Changes in supply can be both positive and negative and as such should there be a negative change in a determining factor, other than the price of the product, then the supply curve will shift to the left. Remember, changes in any of the determinants of quantity supplied, except for the price of the product, will result in a shift of the supply curve. Table 4-5 in the prescribed text (Mohr and Fourie:2015:75) gives a good summary of what has been discussed. Figure 4-6 below is a graphical illustration of shifts in the supply curve. Note: How at a price of P1 the quantity supplied differs for each supply curve. The question that you should ask yourself is: At a given price (P1 in this example) what will a change in a determinant (other than the price of the product) do to the quantity supplied?

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Economics 1A Figure 4-7 Shift of the supply curve: changes in supply

(Mohr and Fourie, 2015: 76)

4.6 Market Equilibrium Remember, a market occurs where there is any contact or communication between potential buyers and potential sellers of a good or service. It follows that markets therefore bring the forces of demand and supply in contact with each other. Market equilibrium occurs where the quantity of a good/service demanded is equal to the quantity supplied of that good/service. Equilibrium between households (demanders) and firms (suppliers) will occur at a certain price, known as the equilibrium price. At the equilibrium price, the plans of households and the plans of firms will be one in the same, in that households will plan to purchase X amount of a good/service and firms will plan to sell the same amount of the good/service. The result of this matching of plans is that the market will come to a state of rest, this state occurs as the two opposing forces (demand and supply) are in a state of balance. As such there will be no tendency for the conditions to change. However, should the underlying forces change, the balance in the market will be upset and the market will adjust accordingly. To understand how the market arrives at a state of equilibrium we need to understand disequilibrium.

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Economics 1A Disequilibrium occurs when the price charged is at level other than the equilibrium price level, i.e. any price other than the equilibrium price will bring about disequilibrium in the market. Figure 4-7 Demand, supply and market equilibrium

(Mohr and Fourie, 2015: 77)

As can be seen in Figure 4-7 above, should a price above or below R5/kg be charged for tomatoes, then demand and supply will not be equal (disequilibrium). At a price above R5/kg, the quantity supplied will be greater than the quantity demanded, there will therefore be excess supply at prices above R5/kg. This occurs as the higher price encourages producers to increase supply in the hope of making greater profits, however, at prices greater than R5/kg consumers plan to purchase less of the good than they would have at R5/kg. The result is that there will be more of the good on the market than consumers are willing and able to purchase, excess supply. Similarly should the price fall below R5/kg then the quantity demanded will exceed the quantity supplied. This occurs because (as you know) cheaper prices result in more of the good being demanded, ceteris paribus (the law of demand). Whereas consumers are demanding more, producers are now producing less than they would have if the good was R5/kg (low prices signal low demand and less profits), there is now an excess demand in the market. When the market is in disequilibrium, it goes through a process which leads it back to equilibrium. In the case of excess demand there are too few goods on the market. Firms have therefore sold their total production but households have not obtained the quantity of the good that they demanded at the particular price. As households wish to obtain more of the good (at the going price) they offer more 41

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Economics 1A money for the product (i.e. prices higher than the market price) in an effort to outbid other households. The result is that the price of the product rises. As the price starts to rise firms realise that they can obtain a higher price for their product and therefore increase their production of the good. However as the price rises demand starts to slow down (law of demand), and with it the rising price, production will slow with demand and the process ends when equilibrium is obtained. In the case of excess supply, there is not enough demand for the amount of goods on the market. Firms are therefore unable to sell their products and as such are left with a surplus of unsold goods (market surplus). These unsold stocks are also known as inventories, and as the level of inventories rise, firms cut their production of the product in an attempt to sell of the rising levels of stock and to compete with the other firms for the limited demand. By reducing their level of production, firms lower their cost and as a result can charge lower prices in order to compete. Graphically, this can be shown as a movement down the supply curve towards the point of equilibrium. At the same town, demand will increase as the price decreases and producers and consumers will move toward the point where quantity demanded and quantity supplied are equal to each other. Market equilibrium therefore occurs at the intersection of the demand and supply curves. This point is characteristic of both buyers and sellers agreeing upon both the quantity of goods that will be exchanged on the market and the price which these goods will be exchanged for. At equilibrium, there is no tendency for change. YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT FIVE DEMAND AND SUPPLY IN ACTION

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 5

5. Demand and Supply in action

Learning Outcomes: After studying this unit you should be able to:



Graphically illustrate how the changes in either demand or supply or simultaneous changes in demand and supply will affect the equilibrium price and equilibrium quantity in the market



Graphically illustrate the interaction between related markets



Show what happens if the government intervenes in the price mechanism by setting maximum and minimum prices

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Economics 1A 5.1 Changes in demand As discussed earlier, should there be a change in any of the determinants of demand (except for the price) then the demand curve will shift. Recall that to shift the demand curve to the right, there would need to be a change in any of the determinants to this effect: 1) increase in the price of a substitute, or 2) decrease in the price of a complementary product, or 3) increase in the consumers income, or 4) positive change in preferences towards the product, or 5) expectations of a price increase of the product.

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Figure 5-1 Changes in demand

(Mohr and Fourie, 2015: 84)

Should there be a change in any of the determinants to this effect, then it will be termed as an increase in demand. This can be seen on the left graph of Figure 5-1. Note that the change in demand has not affected the supply curve. The change in demand from DD to D1D1 (right shift), results in excess demand at the current market price of P0. This can be seen by extending the line P0E through to the demand curve D1D1. Therefore at a price of P0, demand for the product is greater than the amount of product being sold and as such consumers bid up the price. As the price rises, firms increase their quantity supplied of the good. At the same time demand slows and eventually equilibrium is reached at point E1. The characteristics of point E1 are: a higher price (P1) and a larger quantity supplied (Q1). The move to equilibrium is therefore characterized by a movement along the supply curve from E to E 1 and a movement along the new demand curve (D1D1) from where the extended P0E would intersect D1D1 to the point E1. Similarly there is the case of a decrease in demand. Like the case before, this occurs when there is a change in any of the determinants of demand, except the price of the product.

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Economics 1A Therefore, should: 1) the price of a substitute fall 2) the price of a complementary product increase 3) the consumers income fall 4) there be a reduced preference for the product 5) the price of the product be expected to fall then the demand curve would shift to the left. Like in the case of an increase in demand, in the event of a decrease in demand there is a shift of the demand curve from DD to D2D2 in our example, with the supply curve remaining unchanged. Looking at the graph on the right, we see that at the market price of P 0 there is now an excess supply of goods on the market. This can be seen by looking at the difference in the quantity demanded at the point where P0E intersects D2D2 (the new demand curve) and the quantity supplied at price P0 (this being Q0). This excess supply leads to a fall in the price of the product, as producers have to compete to sell off their rising inventories. As producers cut back on production and the price falls, demand for the product rises (law of demand) and equilibrium is reached at E2. E2 is characterized by a lower price P2 and a lower quantity sold Q2. The move to equilibrium is therefore characterized by a movement along the supply curve from E to E 2 and a movement along the new demand curve (D2D2) from where P0E intersects D2D2 to the point E2. 5.2 Changes in supply We now turn our focus to changes in supply and their impact on the equilibrium position of the market. An increase in supply results in a shift of the supply curve to the right and is the result of changes in any of the determinants of supply, all determinants other than price that is. Changes in the determinants that will result in an increase in supply: 1) should the price of an alternative product fall or should there be a rise in the price of a joint product 2) should there be a reduction in the price of any of the factors of production (ie should the cost of production decrease) 3) should there be an improvement in the factors of production (the result of technological progress). 47

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Figure 5-2 Changes in supply

(Mohr and Fourie, 2015:86)

In figure 5-2 above, an increase in supply can be seen on the graph of the left. Like in our examples of changes in demand, changes in supply do not change the position of the demand curve. The increase in supply from SS to S1S1 results in there being an excess supply of the product at the market price of P0 . This can be seen by extending the line P0E through to the new supply curve S1S1. As can be seen, the quantity demanded at P0 is Q0 (corresponding to point E) whilst the quantity supplied would be greater (the quantity corresponding to the point at which extended P0E intersects S1S1). The result of the excess supply is that the price of the product will fall as firms compete for market share. The falling price will result in a rise in the quantity demanded and the quantity supplied will slow. Market equilibrium will be reached at point E1, this point characterized by a lower price P1 and a higher output Q1. The move to equilibrium is therefore characterized by a movement along the demand curve from E to E1 and a movement along the new supply curve (S1S1) from where the extended line P0E would intersect S2S2 to the point E2.

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Economics 1A A decrease in supply is shown as a shift of the supply curve to the left. This can be seen on the graph on the right hand side of figure 5-2, and is depicted as a shift from SS to S2S2. The shift in the supply curve results from a change in any of the determinants of supply, other than price that is. Changes in the determinants to the effect that: 1) should the price of an alternative product increase or should there be a fall in the price of a joint product 2) should there be an increase in the price of any of the factors of production (ie should the cost of production increase) 3) should there be a deterioration in the productivity of the factors of production (this raises the cost of production). The decrease in supply results in an excess demand at the original market price P 0. This can be seen by referring to the graph on the right of figure 5-2. If we look at the broken line P0E, what can be seen is that where it intersects the new supply curve S2S2, the quantity which would be sold at that price is less than the quantity demanded or Q0 (the quantity corresponding to point E). This excess demand drives up the price of the product as consumers bid up the price of the product in an attempt to obtain the scarce product. The increasing price reduces the demand for the product and encourages producers to increase production. Equilibrium is reached at point E2, where less of the product is sold (Q2) and the price of the product has increased to P2. The move to equilibrium is therefore characterized by a movement along the demand curve from E to E2 and a movement along the new supply curve (S2S2) from where P0E intersects S2S2 to E2. Note: these movements occur simultaneously. When we speak about moving along the supply and the demand curves, we are not talking about moving along one and then the other. What is in fact happening is that all these forces are acting at the same time. The market is therefore tending to the equilibrium point at the same time, i.e. producers and consumers are moving toward equilibrium at the same time.

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Economics 1A 5.3 Simultaneous changes in demand and supply If we are dealing with changes in demand or supply then it is possible to predict what will happen to equilibrium prices and equilibrium quantities in the market. However, should both demand and supply change simultaneously, then the precise outcome cannot be predicted. For example, should there be an increase in demand (due to a positive change in preferences toward the product), accompanied by a decrease in supply (due to an increase in the price of the factors of production), then only the thing that is certain is that the price of the product will rise. This is due to the fact that both of the changes result in an increase the equilibrium price in the market. What the equilibrium quantity will be however is uncertain. This is due to the fact that as far as equilibrium quantity is concerned, the two forces work in opposition to each other. An increase in demand works to raise the equilibrium quantity, ceteris paribus, whilst a decrease in supply lowers the equilibrium quantity, ceteris paribus. The outcome in the market therefore depends on the relative magnitudes of the changes. (Mohr and Fourie, 2008: 138). The reader is referred to Mohr and Fourie (2008:137) for a more detailed account of the topic. 5.4 Government intervention Markets are not always free to determine what the equilibrium prices and quantities will be. Governments have various methods available with which to intervene in the market. This intervention can take the form of:  setting maximum prices (also known as price ceilings)  setting minimum prices (also known as price floors)  subsidising certain products or activities  taxing certain products or activities (Mohr and Fourie, 2008: 143) We will deal with the first two interventions (price ceilings and floors) on our list of four. Maximum prices (price ceilings) are often set for certain goods and not on the market as a whole.

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Economics 1A Governments can set maximum prices with the intention of: 

keeping the prices of basic foodstuffs low (this may form part of policy to assist the poor)



avoiding the exploitation of consumers by producers (producers may be charging “unfair” prices)



combating inflation



limiting the amount production of certain goods and services in times of war (Mohr and Fourie, 2008: 144)

Should the maximum price be set above the market clearing price (equilibrium price), then the intervention will not have any effect on the outcome of the market. The market will therefore arrive at the equilibrium price and equilibrium quantity. However, when the maximum price is set below the market clearing (equilibrium price), the intervention disrupts the market mechanism (price mechanism) and therefore causes instability in the market. In figure 5-3 below, we can see that if the market were left alone the forces of demand and supply (remember, excess demand and excess supply) will result in the market achieving equilibrium with a price P0 and a quantity supplied of Q0. Figure 5-3 Maximum prices

(Mohr and Fourie, 2015: 91)

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Economics 1A In Figure 5-3 above, the government has set a maximum price of P m which is below the equilibrium price of P0. At the price Pm producers are willing to sell Q1 units whilst consumers are demanding a quantity of Q2, this can be seen if we follow the line Pm across to the supply curve (point a) and then across to the demand curve (point b). The quantity demanded by consumers at a price of P m is clearly greater than the quantity which producers are willing to produce (Q 1). As such there is now excess demand in the market (market shortage) and this excess demand is equal to the difference between Q 2 and Q1, i.e. Q2 – Q1. If the market were left alone then the market mechanism would raise the price until this excess demand was eliminated (remember the example of excess demand earlier). However, as the price has been pegged artificially this process cannot occur. We are therefore left with the problem of how to allocate Q 1 worth of product amongst people who demand Q2? There are various ways for this allocation to take place, these are: 1) Consumers are served on a “first come first served”, the result is queues and waiting lists. 2) An informal rationing system may be set up by suppliers. This system can take the form of limiting the amount of goods sold to each customer or only selling goods to regular customers. 3) Government itself may introduce an official rationing system. This can be done by issuing tickets or coupons which have to be submitted when purchasing the product. (Mohr and Fourie, 2015: 91) To summarise, should the government set a maximum price below the equilibrium price of a product it would: 1) cause excess demand in the market 2) prevent the market from allocating the quantity of product available among consumers 3) result in black market activity occurring in the market. A black market is an illegal market which occurs when goods are sold at prices which are above the maximum price set by government. MANCOSA - BBA Year 1

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Economics 1A If we refer to figure 5-4 we can see that at a quantity of Q1 (the quantity which will be supplied), the price which a consumer is willing and able to pay for the product is P 1 and this price is clearly greater than Pm. Therefore, those who have the product can charge prices in excess of P m to those who are looking to purchase. What also should be mentioned is the fact that setting the maximum price below the equilibrium price level results in welfare costs to society. Consider the case below, figure 5-4. In this case the government has set a price of P m which is below the equilibrium price of P1. The result is similar to that outlined earlier, there is excess demand in the market with the quantity sold falling from Q1 to Qm. Recall what was said earlier about producer and consumer surplus. In figure 5-4, at the equilibrium price of P1 consumer surplus is represented by the area DP1E and producer surplus is represented by the area 0P1E. However, when the government implements the maximum price on the market these areas change. Consumer surplus is now represented by the area DRUPm and producer surplus is now represented by the area 0P mU. (Remember, consumer surplus is the area below the demand curve, above the price line and with the quantity supplied. Likewise producer surplus is the area above the supply curve, below the price line and within the quantity supplied). With the price maximum imposed, consumers have now lost the area indicated by triangle A but have gained the area B. The loss of triangle A occurs as a result of the decrease in the quantity supplied from Q1 to Qm, whereas the gain of the rectangle B occurs from the fact that the those who obtain the product now pay less for it.

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Economics 1A

Figure 5-4 The welfare cost of maximum price fixing

(Mohr and Fourie, 2015: 94)

In the case of the new producer surplus, we have shown that the new producer surplus is now represented by the area 0PmU as opposed to the area 0P1E. Producers have therefore lost the area represented by triangle C as a result of the loss of production and the rectangular area B as a result of it being transferred to consumers. The end result is that the total welfare loss to society is represented by both triangles A and C, and this is referred to as a deadweight loss. Worth noting is the fact that this area was not transferred, unlike the area represented by rectangle B which was transferred from producers to consumers. The area made up of triangles A and C has been lost to society and this comes about due to the fact that less is being produced in society, and society itself is made up of both producers and consumers. We now turn our attention to the case of minimum prices (price floors). In the case where a minimum price is set by government, the minimum price will not impact on the outcome of the market if the price is set below the market equilibrium price. However, should the minimum price be set above the equilibrium price then there will be excess supply of products in the market. To illustrate the case of a minimum price set above the equilibrium price, your attention should now be on figure 5-5 below.

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Economics 1A Figure 5-5 A Minimum price

(Mohr and Fourie, 2015: 94)

In Figure 5-5 above, the market is at equilibrium at a price of R15 per kilogram and at this price a quantity of 7 million kilograms is being sold. The government sets a minimum price (price floor) of R20 per kilogram on the product. At a price of R20 per kilogram consumers demand a quantity of 4 million kilograms, however producers are producing 9 million kilograms of beef. Therefore, there is a surplus of 5 million kilograms of beef in the market (the difference between point a and point b). By setting a minimum price above the equilibrium market price (market clearing price) the government creates an excess supply in the market. This excess supply will usually require further government intervention and the result may be one of the following: 

The surplus product may be purchased by government and exported



The surplus product may be purchased by government and stored (provided it can be stored)



Production quotas are introduced by government to limit the quantity supplied to the quantity demanded (at the minimum price). In our example government would try to limit production of beef to 4 million kilograms. In doing so the surplus is illuminated.



The surplus is purchased and destroyed by government



Producers destroy the surplus (Mohr and Fourie, 2015: 94-95)

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Economics 1A The setting of minimum prices is often a characteristic of agricultural markets as these markets are characterized by large fluctuations in supply. Although demand for agricultural products is stable, the large fluctuations in supply result in the incomes of farmers being unstable as the prices received for the product fluctuate as well. Governments therefore tend to set minimum prices to stabilize the incomes of farmers. However, as we have seen, this is not an efficient way of assisting small or poorer farmers. Minimum prices are inefficient due to the following facts: 

All the consumers in the market have to pay artificially high prices (this includes the poor)



.Large farmers receive the bulk of the benefits which are forthcoming



Firms that are inefficient are now protected by the minimum price and manage to survive



Disposal of the surplus which is generated from the minimum price usually imposes a further cost to tax payers and results in welfare losses (Mohr and Fourie, 2015: 95)

The case of the welfare costs to society which occur as a result of the minimum price is similar to that of the costs of the maximum price which was discussed earlier. Consider the case below, figure 5-6. In this case the government has set a minimum price of Pm which is above the equilibrium price of P1. We will assume that producers respond by supplying the market with the amount which is actually demanded (Qm). In figure 5-6, at the equilibrium price of P1 consumer surplus is represented by the area DP1E and producer surplus is represented by the area 0P1E. However, when the government implements the minimum price on the market these areas change. Consumer surplus is now represented by the area DRPm and producer surplus is now represented by the area 0PmRT. (Remember, consumer surplus is the area below the demand curve, above the price line and within the quantity supplied. Likewise producer surplus is the area above the supply curve, below the price line and within the quantity supplied). With the minimum price imposed, consumers have now lost the area indicated by the rectangle A and triangle B. The loss of triangle B occurs as a result of the decrease in the quantity supplied from Q1 to Qm, and the loss of the rectangle A occurs as a result of the fact that the those who used to obtain the product at a price of P1 now pay a price of Pm.

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Economics 1A

Figure 5-6 The welfare costs of minimum price fixing

(Mohr and Fourie, 2015: 95)

In the case of the new producer surplus, we have shown that the new producer surplus is now represented by the area 0PmRT as opposed to the area 0P1E. Producers have therefore lost the area represented by triangle C as a result of the loss of production, but gained the rectangular area A at the expense of the consumers. The end result is that the total welfare loss to society is represented by both triangles B and C, this is referred to as the deadweight loss. The area made up of triangles B and C has been lost to society and this comes about due to the fact that less is being produced in society, and society itself is made up of both producers and consumers.

YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT SIX

ELASTICITY

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 6

After studying this unit you should be able to:



Define the concept of elasticity



Explain the meaning of specific elasticity (say ep=1.5)



Understand the link between price elasticity and total revenue from sales



Explain the determinants of price elasticity of demand



Define and explain the concept of income elasticity of demand

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Economics 1A 6.1 Introduction When we speak about elasticity, we are in fact referring to the responsiveness or sensitivity of a dependent variable to changes in an independent variable. The best known elasticity concept is price elasticity of demand, which is a measure of the responsiveness of the quantity demanded to changes in price of the product. You are not required to calculate the price elasticity for purposes of this course, but you must ensure that you can apply and interpret the formula.

Price elasticity of demand is calculated as follows: ep = % change in the quantity of a products % change in the price of a product Where ep = price elasticity of demand

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Economics 1A Figure 6-1 Price elasticity of demand at different points along a linear demand curve

As can be seen in figure 6-1 above, the price elasticity of demand (ep) varies from a infinity (∞) to zero. The value of price elasticity of demand (ep) is infinity where the demand curve intersects (meets) the price axis and zero where the demand curve intersects the quantity axis. If we move down the demand curve, from left to right, the price elasticity of demand falls from infinity (∞) to zero. It is worth noting that this will be the case for any demand curve which intersects both the price and quantity axis (regardless of slope: this can be seen in figure 6-1). In the case of any demand curve which intersects both axis, the value of the e p will be infinity (∞) where the graph intersects the price axis, one in the middle of the curve (midpoint) and zero where the curve intersects the quantity axis. For a numerical example on how to obtain the different values of price elasticity of demand (e p), the reader is referred to Mohr and Fourie (2015: 106).

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Economics 1A 6.2 Price elasticity of demand and total revenue Price elasticity of demand is a useful tool because it can be used to show how much total expenditure by consumers on a product will change should the price of the product change. Furthermore, total expenditure by consumers is also the total revenue of the firms who produce that product. Because of its usefulness in analyzing the responses of both consumers and producers to situations in the market, price elasticity of demand serves as a useful tool in decision making. We will focus on the usefulness of price elasticity of demand respect to total revenue. The total revenue (TR) that suppliers obtain from the sales of a good or service is calculated by multiplying the price of the product (P) by the quantity of the product sold (Q). Total revenue (TR) is therefore P x Q or PQ. Should a producer decide to change the price of the product then the effect on total revenue will depend on the relative sizes of the change in price and the change in quantity demanded, ie the size of the price change with respect to the size of the change in quantity supplied. Remember, price and quantity demanded move in the opposite direction. How exactly do changes in the relative sizes of price (P) and quantity supplied (Q) affect total revenue (TR)? 

In the case where a change in the price of a product leads to a proportionately larger change in the quantity demanded (ie, if we change the price of the product by 10% and the result is that quantity demanded changes by 20%, in the opposite direction of course), then the price elasticity of demand is greater than one or ep>1 and as such the total revenue will change in the opposite direction to the price change (ie, decrease price = increase total revenue). Remember, total revenue is calculated as TR = PQ. So long as the price elasticity of demand is greater than 1 (ep>1), total revenue will increase as the quantity sold (Q) increases.



In the case where the change in price leads to an equi-proportional change in the quantity demanded (ie if we change the price of the product by 10% and the result is that quantity demanded changes by 10% as well, in the opposite direction of course), then the e p = 1 and total revenue will remain unchanged. In the case where the price elasticity of demand is equal to one (ep = 1) the total revenue (TR) of the firm has reached its maximum.

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Economics 1A 

In the case where a change in the price of the product leads to a proportionately smaller change in the quantity demanded (ie if we change the price of the product by 10% and the result is that quantity demanded changes by 5%, in the opposite direction of course), then ep < 1 and total revenue will change in the same direction as the price (ie, raise the price = raise the total revenue). If the price elasticity of demand is less than one (e p < 1) then total revenue (TR) will fall as the quantity sold (Q) increases. (Mohr and Fourie, 2015: 108-109)



Figure 6-2 illustrates the relationship between total revenue (TR), price (P), quantity sold (Q) and price elasticity of demand (ep). Figure 6-2 The relationship between price elasticity of demand and total revenue

(Mohr and Fourie, 2015: 109)

6.3 Different categories of price elasticity of demand There are five categories into which we can place our price elasticity of demand (e p) values, these five categories are:  ep = 0

–––> perfectly inelastic demand

 0 < ep < 1 (ie, ep is greater than 0 but less than 1) –––> inelastic demand

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Economics 1A  ep = 1 –––> unit elastic demand or unitary elasticity of demand  1 < ep < ∞ (ie, ep is greater than 1 but less than infinity [∞]) –––> elastic demand  ep = ∞ –––> perfectly elastic demand

In the case of perfectly inelastic demand (ep = 0), consumers will plan to purchase a fixed amount of the product regardless of the price which is charged. This can be shown graphically by drawing the demand curve as a vertical line, as illustrated in figure 6-3 (a). In this case, producers can raise their revenue by increasing the price charged for the product. As the quantity demanded does not change, raising price results in an increase in total revenue. Remember TR = PQ. In the case of inelastic demand (0 < ep < 1), the percentage change in quantity demanded is smaller than the percentage change in price (remember, in the opposite direction!). The demand curve which illustrates this case is that of a steeply sloped demand curve (figure 6-3 b). The steep slope of the demand curve serves to illustrate the fact that the percentage change in quantity is smaller than that of the price change. As a result of the fact that the quantity demanded changes proportionately less than the change in price, producers have an incentive to raise their prices in order to increase their revenue (remember what was said earlier). Likewise, there is no reason why producers would decrease the price of their product as the revenue received from the increase in quantity demanded will not offset the revenue lost due to the decrease in price. In the case of unitary elasticity (ep = 1), the demand curve used to illustrate the properties of unitary elasticity is a rectangular hyperbola, as illustrated in figure 6-3 (c). What this graph illustrates is that the percentage change in quantity demand is equal to percentage change in the price of the product. In this case, as the proportional (ie percentage) changes in quantity demanded and price are the same, producers would not gain anything by increasing or decreasing the price of the product.

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Economics 1A Figure 6-3 The different categories of price elasticity of demand

(Mohr and Fourie, 2015: 111)

Elastic demand (1 < ep < ∞), is illustrated by a relatively flat demand curve (Figure 6-3 d). The demand curve graphically illustrates the property of elastic demand, this being the fact that the percentage change is quantity demanded is greater than the percentage change in price. When producers are faced with elastic demand, decreasing the price of the product will raise the total revenue received by

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Economics 1A producers (this is as a result of the property of elastic demand, also remember TR = PQ). There is no incentive to raise the price charges for the product as this would decrease total revue (the opposite of decreasing the price will occur). Perfectly elastic demand (ep = ∞) is the case where consumers are willing to purchase any quantity of goods at a certain price, raising the price of the good will result in the quantity demanded falling to zero (even if the price is only raised slightly). Perfectly elastic demand is shown graphically as a horizontal line, as in figure 6-3 (e). Note: It should be kept in mind that an increase in total revenue (TR) is not the same as an increase in total profit. Total revenue is simply the income received from selling a certain amount of product (Q) at a price of (P), that is why TR = PQ. Total profit however, is not only a function of these two variables, but also a function of cost, which can change with output. 6.4 Determinants of the price elasticity of demand In what follows the determinants of price elasticity of demand will be discussed. There are three determinants if elasticity: 6.4.1 Number of substitutes 6.4.2 Time 6.4.3 Definition of the market 6.4.1 Number of substitutes A key determinant in the price elasticity of demand for a product is the availability of substitutes. If there are a large number of substitutes for a product, and if these substitutes are close in quality (or better in quality), then the price elasticity of demand will be large. Therefore, the larger the amount of substitutes available, and the closer these substitutes are to the product (or the better they are), the greater will be the price elasticity of demand, ceteris paribus. The end result is that if a product has close substitutes, and the price of the product is increased, then consumers will tend to switch to the substitutes available (this occurs as the substitutes have now become cheaper in relation to the product, ie when compared to the product). The product will therefore have an elastic demand. MANCOSA - BBA Year 1

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Economics 1A Examples of goods which tend to be close substitutes for each other include: mutton and beef, hamburgers and hot dogs, Nike – Adidas and Reebok shoes, and bus and taxi services. In the same way that goods with close substitutes tend to have elastic demand, goods with no close substitutes will tend to have demand which is inelastic. The degree of complementarity of the product is another determinant in the elasticity of the product. You may not have noticed, but there are products which we use jointly with others (rather than on their own), for example salt and food, petrol and cars and dvd’s and dvd players. In the case of complements, the price elasticity of demand for a good tends to be low (inelastic), ie changes in quantity are not very responsive to changes in price. Take salt for example, salt is used jointly with food, you do not purchase salt only for the purpose of consuming salt on its own. As a result your demand for salt will not only depend on the fact that you want to consume salt, but it will depend on other factors as well (it will also depend on your desire to consume other goods). As such, you will not simply reduce your consumption of salt if the price of salt increases as there are a host of factors which go hand in hand with its consumption (ie complements). The result is that your demand will be inelastic. The type of want satisfied by the product also plays a role in determining the how responsive demand will be to a change in price, ie what the price elasticity of demand will be. Demand for necessities tends to be inelastic whilst demand for luxury goods and services tends to be elastic. There are no set rules for whether a goods or service is a necessity or a luxury good, however what can be stated is that if a good or service has a relatively inelastic demand it is considered a necessity and if it has a relatively elastic demand it is considered a luxury good. Examples of necessities include basic foods, electricity, petrol and medical care. Examples of luxury goods include swimming pools, recreational activities and motor vehicles. (Mohr and Fourie, 2008: 164) 6.4.2

Time

In the long run the price elasticity of demand for a product tends to be more price elastic. We therefore have to be mindful of the time period under consideration. Price changes may take a while before their effects are fully felt by the market.

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Economics 1A Take petrol for example, when the price of petrol changes people will not immediately cut back on their consumption of petrol, rather they will stick to their current usage of petrol. As time passes however, the full effects of the price rise will be felt (people now realize the effect of the increase on their spending money), and then people will start to adjust their habits to lessen their petrol consumption. The price elasticity of demand will therefore be more elastic in the long run. A good example of why elasticity is low (demand is unresponsive) in the short run is the case of airline tickets. If you had to fly out on short notice (maybe it is an emergency), you will be desperate to obtain a ticket for travel as shopping around may not be an option or the matter may be very urgent. In this case you will not be choosy on what the price may be as you will want to secure a ticket, ie your demand for the ticket will be price inelastic. In the long run however you can consider other options to flying (bus, taxi, car) or spend more time looking for a better deal, therefore your demand will be price elastic. The proportion of income spent on the product also plays a role in determining the price elasticity of demand of a product. The reasoning behind this is that as the proportion of income spent on the product increases, so too does the price elasticity of demand for that product. Therefore, as a greater percentage (proportion) of income is spent on the product, price changes for that product have greater effects on the consumer’s budget and therefore the consumer will be more likely to be sensitive to changes. Similarly, products which make up a small percentage of the consumer’s budget are said to have lower elasticity’s (hardly any change in quantity demanded), as the impact of a price change for the product would have a small effect on the budget. Take matches for example, even if you are a smoker, matches contribute such a small portion of the budget (at 50 cents, even if 10 boxes are bought every month it is still only R5) that should the price of matches change (say by 10%), your consumption (usage) of matches is unlikely to change (you are now spending R5.50, still a small amount). 6.4.3 Definition of the market A broad definition of the market tends to make demand for the product more elastic. For example, as price of cars increase, consumers still continue to buy cars, because they still find cars a best alternative than motor cycles. YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT MANCOSA - BBA Year 1

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Economics 1A

STUDY UNIT SEVEN THE THEORY OF PRODUCTION AND COST (BACKGROUND TO SUPPLY)

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 9

After studying this unit you should be able to:



Understand the different types of firms and the goals of the firm



Distinguish between short run and long run



Distinguish between fixed and variable inputs



Explain the law of diminishing returns



Draw the total average and marginal product cost curves



Explain the relationship between production and cost in the short run

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Economics 1A 7.1 Introduction This study unit deals with the fundamental income., cost and production concepts required to analyse the decisions of firms about the quantities to supply at various prices. This is an important study unit which lays the foundation for the analysis of the equilibrium position of firms under perfect and imperfect competition for study units 8 and 9. 7.2 Types of Firms The most common types of firms in South Africa are individuals, proprietorships, partnerships, close corporations, cooperatives, trusts and public corporations. We also have the informal businesses like street hawkers, vendors and illegal trading. Not all firms function the same way. Smaller businesses tend to have only one product or service whilst larger businesses sell a variety of products. 7.3 Goal of the firm The main goal of every firm is to maximize profits.. If a firm is not profitable it will not be able to operate in the long run. 7.4 The concept of Revenue Total revenue(TR) is defined as the total value of sales and is equal to price (P) multiplied by quantity(Q). TR = P X Q (or simply PQ) Average revenue is equal to total revenue (TR) divided by the quantity. AR = TR = PQ (=P) Q

Q

Marginal revenue (MR) is the additional revenue earned by selling an additional unit of the product.

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Economics 1A MR = TR (or PQ) Q

Q

7.5 The concept of costs To the economist, the cost of using something in a particular way is the benefit foregone by not using it in the best alternative way. This is called opportunity cost. Whereas accountants and business people consider only the actual expenses incurred to produce a product, the economist measures the cost of production as the best alternative sacrificed (or foregone) by choosing to produce a particular product. The economist uses the opportunity cost principle to determine the value of all the resources used in production. The difference between accounting costs and economic costs can be clarified by distinguishing between explicit costs and implicit costs. Accountants 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 also opportunity costs, since the payments for the inputs reflect opportunities that are sacrificed. For example, if a firm pays R2 million for a certain machine, it means that it has decided not to do something else with the money (like purchasing a different machine, purchasing a building or depositing the money 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 which are not reflected in monetary payments. They include the costs of self-owned or self-employed resources. For example, the owner of a one person business must consider what he/she would have earned if he/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). The true economic cost of using the resources in a particular way is the value of the best alternative uses (or opportunities) sacrificed.

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Economics 1A The concept of profit

Profit is the difference between revenue and cost: Profit = Revenue - 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 definition of profit. 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 self-owned, self-employed resources could earn elsewhere; - 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). Therefore, it can be stated that: Accounting profit = total revenue - total explicit costs = normal profit + economic profit Economic profit

= total revenue

- total costs (explicit and implicit)

= accounting profit - normal profit

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Economics 1A 7.6 Production Production is the physical transformation of inputs into output. 7.7.1

Fixed and variable costs

Firms use fixed inputs and variable inputs. A fixed input is defined as an input of which the quantity cannot be altered in the short-run. By contrast, a variable input is one of which the quantity can be changed in the short-run. In the long-run there are no fixed inputs - all the inputs are variable. In other words, the long-run is a period that is long enough to change the quantity of all the inputs into the relevant production process. In the short-run, a firm can expand output only by increasing the quantity of its variable inputs. The relationship between inputs and output is called a production function. 7.7.2 The short-run production function In a given state of technology, there is a relationship between the quantity of inputs and the maximum output that can be obtained from these inputs. This relationship is called a production function and can be expressed in the form of a table (or schedule), an algebraic equation or a graph.

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Economics 1A A maize farmer's simple production function is presented as a schedule in Table 7.1.

Table 7.1 Production schedule of a maize farmer with one variable input

The production function (or schedule) shows that if no labour is applied to the 40 units of land, no maize will be produced. The production function further illustrates that if one unit of labour is employed, 16 tons of maize can be produced. The production schedule can also be represented in the form of a graph. The total product of labour in Table 7.1 is presented graphically in Figure 7.1 (a). To facilitate reference, Figures 7.1(a) and 7.1(b) are presented together.

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Economics 1A

Figure 7-1: Total, average and marginal product of labour

The table and graph show that as the quantity of labour is increased, total product (TP) increases from zero at an increasing rate, then starts increasing at a decreasing rate until a maximum point is reached, after which TP declines. This S-shape of the total product curve reflects the law of diminishing returns, or the law of diminishing marginal returns.

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Economics 1A To formulate the law of diminishing returns, we need to first explain average product and marginal product. 7.7.3 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 total output (TP) by the quantity of the variable input (N). The calculation of AP is illustrated in Table 7.2

Table 7.2: Production schedule of a maize farmer with one variable input

The highest average product (29 tons) is reached when 5 units of labour are employed. The figures in column 4 clearly show that AP increases until the fifth labourer is employed and then declines to only 18,70 tons when 10 labourers are employed. 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. The highest marginal product shown in Table 7.2, namely 35 tons, occurs when the fourth unit of labour is employed. The marginal product of the fifth unit of labour is less than 35 tons. Once the maximum marginal product is reached, it keeps on declining. The marginal product of 9 units is equal to zero. The marginal products of additional units of labour are negative, which means that their employment 77

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Economics 1A causes total product to decline. Once a limit is achieved, the workers get in each other's way, are given jobs too specialised to keep them occupied each day, or get onto each other's nerves. The information in columns 4 and 5 of Table 7.2 are depicted in Figure 7.1(b). From Figure 7.1 and Table 7.1 it is clear that: 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 start to decline. 7.7.4 Comparison of total, average and marginal cost The total, average and marginal product of labour are all based on the same basic information and are, therefore, interrelated. -

TP is S-shaped. In other words, as the variable input is increased, TP increases from zero at an increasing rate, then at a decreasing rate, reaches a unique maximum point and then decreases.

- AP and MP are shaped like inverted "U"s, i.e. 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. (Figure 7.2)

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Economics 1A Figure 7-2: Marginal product and average product

-

Before AP reaches a maximum, MP lies above AP.

-

MP equals AP at its maximum point.

-

After the maximum point of AP is reached, MP lies below AP.

-

MP equals zero where TP reaches its unique maximum.

7.7 Cost A firm's costs consist of fixed and variable costs. 7.8.1 Fixed and variable costs A fixed input cannot be altered in the short-run. Since the number of units of land is fixed and the price (rental) of using a unit of land is given, the cost of using the land is fixed. Fixed costs remain constant irrespective of the quantity of output produced. The quantity of the variable input can be varied in the short-run. In the case of the maize farmer, labour is the variable input. The cost of labour to the firm for the relevant period can, therefore, be calculated by multiplying the number of units of labour employed, by the price per unit of labour. Variable cost is 79

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Economics 1A defined as cost that changes when total product changes - it represents the cost of the variable input(s). Table 7.3 illustrates the relationship between the short-run production function and the short-run total cost function of the maize farmer.

Table 7.3: Total, fixed and variable cost schedules of a maize farmer

Assume that the cost of a unit of the fixed input (land) for the growth season is R450. Therefore, the cost of twenty units is 20 x R450 = R9 000, irrespective of the quantity of maize produced during the growth season or the quantity of the variable input (labour) used. This represents the total fixed cost (TFC) of producing the various quantities of output indicated in Table 7.3. Suppose the price of a unit of labour for the full growth season is R2 400. To obtain the cost of labour, we have to multiply the units of labour (e.g. 3) by the price per unit of labour (e.g. 3 x R2 400 = R7 200). The total cost (TC) is the sum of the total fixed cost (TFC) and the total variable cost (TVC) associated with each level of production. The three total cost schedules can be represented in graphical form (Figure 7.3) as cost functions or cost curves.

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Economics 1A Figure 7-3: Three total cost curves

Total Product The total fixed cost function or curve (TFC) is a horizontal line with an intercept of R9 000 irrespective of total product. The total variable cost function or curve (TVC) has a reversed S-shape. It starts at the origin and increases at a decreasing rate up to a point. Thereafter TVC increases at an increasing rate. The total cost function or curve (TC) has the same shape as the variable cost function, but does not start at the origin. It starts above the origin at the point on the vertical axis which represents the total fixed cost. Total cost equals total fixed cost plus total variable cost. YOU ARE REQUIRED TO UNDERSTAND HOW TO CALCULATE THE FIGURES ON PAGE 155 OF THE PRESCRIBED TEXT YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT EIGHT PERFECT COMPETITION

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Economics 1A

Reading: Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 10

After studying this unit you should be able to:



Define perfect competition



Understand the conditions necessary for perfect competition to exist



Explain the demand curve of a perfect competitor



Determine the short run equilibrium of a firm under perfect competition



Understand why profits are only maximized along the rising part of the marginal cost curve



Distinguish and graphically illustrate whether a firm is making an economic profit, normal profit or an economic loss



Explain the supply curve of the firm and market supply curve



Understand the long run equilibrium position of the firm under perfect competition

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Economics 1A 8.1 Introduction Since perfect competition is the benchmark against which all other market structures or types of competition are measured, this is an important study unit. This study unit explains what perfect competition means, and analyses the decisions of an individual firm operating under conditions of perfect competition as well as the equilibrium position of a perfectly competitive firm. 8.2 Defining Perfect competition 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 the prices. 8.3 Conditions necessary for perfect competition to exist Perfect competition exists if the following conditions are met: -

There must be a large number of buyers and sellers of the product. Each firm only supplies a small quantity of the total market supply.

-

There must be no collusion between sellers.

-

All the goods in the market must be identical.

-

Buyers and sellers must be completely free to enter or leave the market.

-

All the buyers and sellers must have perfect knowledge of market conditions.

-

There must be no government intervention influencing buyers or sellers.

-

All the factors of production must be perfectly mobile.

In these markets, no individual firm has any market power - all firms are price takers. MANCOSA - BBA Year 1

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Economics 1A 8.4 The demand for the product of the firm The position of the individual firm under perfect competition is illustrated in Figure 8.1.

Figure 8-1: The demand curve for the product of the firm under perfect competition

The graph on the left shows that the price of the product is determined in the market by demand and supply. The firm can sell its whole output at that price. This is indicated by the horizontal line on the right. This line is the demand curve for the product of the firm. It is also called the firm's sales curve, the firm's demand curve, or the total demand curve facing the firm. The firm's average revenue (AR) and marginal revenue (MR) are equal to the price of the product (MR = AR = P). The firm's total revenue can be represented graphically by a straight line which starts at the origin and which has a slope equal to the price of the product, as shown in Figure 8.1. 8.5 The short run equilibrium of the firm under perfect competition We now examine the short run equilibrium (or profit-maximising) position of the firm under conditions of perfect competition. Since the firm under perfect competition does not have to make any pricing decisions (price-taker) - it can only choose the output at which it will maximise its profits, i.e. where MR = MC or where the positive difference between TR and TC is at its maximum.

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Economics 1A 85.1.

Equilibrium in terms of total revenue and total cost

The total cost curve is shaped like a reversed S, as illustrated in Figure 8.2. In the short-run, the total cost curve does not start at the origin, since part of the firm's cost is fixed. Figure 8-2: Total short-run costs of the firm

Total revenue of the firm under perfect competition was illustrated in Figure 8.2 as a straight line with a positive slope which starts at the origin and has a slope equal to the price of the product. In Figure 8.3, we combine such a total revenue (TR) curve with the total cost (TC) curve illustrated in Figure 8.3.

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Economics 1A Figure 8-3: Total revenue, total cost and total economic profit

Economic profit is the difference between TR and TC. Graphically, it is measured by the vertical distance between the TR curve and the TC curve. At levels of output below Q 1 in Figure 8.3, TC is greater than TR and the firm, therefore, incurs economic losses (indicated by the shaded area). At Q 1, the firm's total economic profit is zero (since TR = TC). Between Q 1 and Q2, the firm makes an economic profit at each level of output (indicated by the shaded area), since TR > TC. At Q2, total economic profit is zero once more and at higher levels of output the firm again incurs economic losses. The firm's profit will be maximised where the positive vertical distance between TR and TC is the greatest (i.e. somewhere between Q1 and Q2).

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Economics 1A 8.6 Equilibrium in terms of marginal revenue and marginal cost It has been explained earlier that any firm maximises its profits where marginal revenue (MR) is equal to marginal cost (MC). In Figure 8.1 we showed that the firm's marginal revenue (MR) is equal to the market price (P) of the product. The profit maximising rule in the case of a perfectly competitive firm can, therefore, also be stated as P = MC (since MR = P). This rule is further clarified in Figure 8.4 below.

Figure 8-4: Marginal revenue and marginal cost of a firm operating in a perfectly competitive market

Marginal revenue (MR) is equal to the price (P) of the product. Marginal cost (MC) increases as more units of the product are produced. Profit is maximised where MR (or P) = MC, i.e. at an output level of 4 units. At lower levels of production, profit can be increased by expanding production. If more than 4 units of the product are produced, profits start falling.

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Economics 1A The firm's profit position can be illustrated clearly by adding average cost (AC) to the diagram showing average revenue (AR), marginal revenue (MR) and marginal cost (MC). In the previous section, it was ascertained that the firm's profit per unit of output (or average profit) is equal to the difference between average revenue (AR) and average cost (AC). As long as AR is greater than AC, the firm is earning an economic profit. When AR is equal to AC, the firm only earns a normal profit. The normal profit is the opportunity cost of self-employed resources (such as the owner's time and capital) and that normal profit is included in the firm's cost. In Figure 8-5, there are three different possibilities. The same set of unit cost curves is used throughout, but there are three different market prices, and, therefore, three different AR and MR curves. Figure 8-5: Different possible short run equilibrium positions of the firm under perfect competition

Figure 8-5 (a): Surplus (Economic) Profit

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Figure 8-5 (b): Normal Profit

Figure 8-5 (c): Loss In Figure 8-5 (a), the market price is P1 which is equal to the firm's AR and MR. Profit is maximised where MR (= P1) is equal to MC. This occurs at a quantity of Q1. At Q1, the firm's average revenue AR (=P1) is greater than its average total cost AC (C1). The firm thus makes an economic profit per unit of production of P1 - C1.

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Economics 1A 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). Alternatively, the area representing total profit can be obtained by subtracting the firm's total cost from its total revenue. The firm's total revenue is equal to the price of the product P1 multiplied by the quantity produced (and sold) Q1. This is equal to the area OP1E1Q1. Similarly, the firm's total cost is obtained by multiplying its average cost C1 by the quantity produced Q1. This is equal to the area OC1MQ1. The difference between these two areas is the shaded area C1P1E1M, which represents the firm's total economic profit. In Figure 8-5 (b), the market price is P2. It is equal to MC at the point where MC intersects AC. The corresponding level of output is Q2. At that level of output AR is equal to AC and the firm does not earn an economic profit. It does, however, earn a normal profit since all its costs, including the opportunity cost of self-owned, self-employed resources are fully covered. Point P2 in Figure 8-5 (b) is called the break-even point. In Figure 8-5 (c) the market price (firm's AR and MR) is equal to P3. MR or price is equal to MC at a quantity of Q3. At 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 C 3 and P3. If the price P (=AR) lies above the minimum AVC (not shown in diagram), the firm will continue production in the short-run. If it lies below the minimum AVC, the firm will close down. The equilibrium condition of the firm under perfect competition may be summarised as follows: Profit is maximised when a firm produces an output where marginal revenue equals marginal cost, provided that marginal cost is rising and lies above the minimum average variable cost. 8.7 The Supply curve of the firm and the market supply curve The rising part of the firm's MC curve above the minimum of AVC is the firm's supply curve. In Figure 8-6, this is illustrated by the part of the MC curve above point b.

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Economics 1A Figure 8-6: The supply curve of the firm

The rising portion of the firm's marginal cost curve above the minimum of its average variable cost curve at point b is the firm's supply curve. If the price is P 5, the firm will not produce at all. If the price is P4, the firm will be at its close-down point (b) and it is immaterial if it shuts down or continues production. If the price is P3, the firm will minimise its economic losses by producing a quantity Q3, corresponding to point c. If the price is P2, the firm will make normal profit (i.e. it will break even) at point d, which corresponds to a quantity Q2. If the price is P1, the firm will maximise economic profit at point e, i.e. it will produce a quantity Q1. 8.8 The equilibrium of the industry under perfect competition To conclude the analysis of perfect competition, we refer briefly to the equilibrium of the industry (i.e. the collection of firms that supply a specific product in the market). The industry will only be in equilibrium in the long-run if all the firms are making normal profits. Only then will there be no inducement for new firms to enter the industry or for existing firms to leave the industry. With complete freedom of entry and exit, there will always be some movement (i.e. disequilibrium) in the industry when firms are making economic profits or losses. YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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Economics 1A

STUDY UNIT NINE IMPERFECT COMPETITION

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Reading: Mohr, P. & Fourie, L. (2015) Economics for South African Students. (5th edition) Pretoria:Van Schaik Chapter 11

After studying this unit you should be able to:

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Understand the differences and similarities between the different market structures

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Explain the equilibrium position of each market under imperfect competition i.e. monopoly, monopolistic competition, and oligopoly

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Compare the above to a firm under perfect competition

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Economics 1A 9.1 Introduction In the previous study unit, we examined the behaviour of a firm in a perfectly competitive market. Perfect competition is a theoretical construct, which serves as a standard, or norm against which we can compare other types of markets. In the real world, there are many different types of markets. Economists distinguish between four broad sets of markets (or different types of competition): perfect competition, monopoly, monopolistic competition and oligopoly. In this section, we examine the last three types, which are usually collectively referred to as imperfect competition. The theory of the behaviour of firms (i.e. the theory of the supply side of the goods market) is called the theory of the firm. This theory is usually based on the assumption that all firms seek to maximise their profits. In this section, we examine the behaviour of firms under conditions of imperfect competition. Imperfect competition refers to a situation in which at least one of the conditions of perfect competition listed in 8.3 is not satisfied. The three broad categories of imperfect competition are

9.2

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Monopoly

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Monopolistic competition

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Oligopoly The different market structures

The key features of the four different types of market structure are summarised in Table 9.1.

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Economics 1A Table 9.1: Summary of market structure

9.2.1

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. Another requirement is that entry to the market should be completely blocked. The single seller is called a monopolist and the firm is called a monopoly.

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Economics 1A 9.2.1.1 The equilibrium (or profit-maximising) position of a monopoly In principle, the profit maximising decision of a monopoly is exactly the same as that of any other firm. Like any other firm, a monopoly 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) - (the shut-down rule). 9.2.1.2 Total, average and marginal revenue under monopoly Since the monopoly is the only supplier of the product of the industry, the demand curve for the product of a monopolistic firm is the market demand curve for the product of the industry. Since the market demand curve slopes downward, the monopoly can only sell an additional quantity of output if it lowers the price of its product. (See Table 9.2) Table 9.2: Average, total and marginal revenue when the demand curve for a firm's product slopes downward

Figure 9.1 demonstrates that under monopoly, a firm faces a downward-sloping demand curve which is also its average revenue curve AR, as shown in (a). 97

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Figure 9-1: Marginal, average and total revenue under monopoly (or any other form of imperfect competition)

The marginal revenue curve MR is also downward-sloping and lies halfway between the AR curve and the price axis. The corresponding total revenue curve TR is shown in (b). When MR is positive, TR increases; when MR is zero, TR remains unchanged; and when MR is negative, TR falls. These relationships apply to all forms of imperfect competition.

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Economics 1A 9.2.1.3 The equilibrium of the firm under a monopoly The equilibrium position of the firm under monopoly is illustrated in Figure 9.2.

Figure 9-2: The equilibrium of the firm under monopoly

The figure shows the average revenue AR, marginal revenue MR, average cost AC and marginal cost MC of a monopoly. The monopolist's profit is maximised by producing a quantity Q1 at a price P1. The economic profit per unit is the difference between M1 and K1 (or between P1 and C1). The firm's total economic profit is the shaded area C1P1M1K1.

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9.2.1.4 Monopoly verse perfect competition Figure 9-3: Comparison between monopoly and a perfectly competitive industry

AR is the demand curve for the product of the industry and MR is the monopoly's marginal revenue curve. Marginal cost MC is also the supply curve S for the perfectly competitive industry. Under perfect competition, long-run equilibrium Ec is established by the interaction of demand AR and supply S at a price Pc and a quantity Qc. Equilibrium for the monopolist Em is at a price Pm and a quantity Qm. Under monopoly, the equilibrium price is higher, and the equilibrium quantity lower, than under perfect competition, ceteris paribus.

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Economics 1A 9.3 Monopolistic competition Between the extremes of monopoly and perfect competition, there is a range of actual market organisations. Some industries (like the brick manufacturing industry) consist of a few large firms and a large number of small ones. Other industries (like motor manufacturing) consist of a few large firms only. In some industries (like the clothing industry), there are many firms producing a variety of similar products. In other industries (like the cement industry), a few large firms produce virtually identical products. The first type of market in the spectrum between the extremes of perfect competition and monopoly is monopolistic competition. The conditions for monopolistic competition can be summarised as follows: -

Each firm produces a distinctive, differentiated product;

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Each firm, therefore, faces a downward-sloping demand curve for its particular product;

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There is a large number of firms in the industry; and

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There are no barriers to entry (or exit).

9.3.1 The equilibrium of the firm under monopolistic competition The short-run equilibrium and the long-run equilibrium of a monopolistically competitive firm is illustrated in Figure 9-4.

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Economics 1A Figure 9-4: The equilibrium of the firm under monopolistic competition

Short-run and long-run equilibrium positions of a monopolistically competitive firm are illustrated in (a) and (b), respectively. In both cases, D is the demand curve for the product of the firm (or average revenue AR), MR is marginal revenue, MC is marginal cost and AC is average cost. The firm is in equilibrium where MR = MC. In the short-run conditions illustrated in (a), the firm is in equilibrium at output Q1 and price P1. The firm's total profit is illustrated by the shaded rectangle. In the long-run, however, the firm only makes a normal profit at an output of Qe and a price of Pe. At that price-output combination, AR is tangent to AC, MR = MC and AR = AC.

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Economics 1A 9.3.2 Monopolistic competition versus perfect competition A market structure is efficient if marginal cost MC is equal to price P and if production occurs where average cost AC is at its minimum. These two types of efficiency are called allocative efficiency and productive efficiency. The long-run equilibrium of a monopolistically competitive firm occurs when only normal profits are made. In this respect, there is no difference between monopolistic competition and perfect competition. However, in long-run equilibrium, illustrated in Figure 6.4 (b), the monopolistically competitive firm produces where price is higher than marginal cost and where average cost is not at a minimum. Therefore, monopolistic competition is neither allocatively nor productively efficient. Although the monopolistically competitive firms do not make economic profits in the long-run (as monopolists do), monopolistic competition is also characterised by an inefficient use of resources. Consumers pay a higher price and less output is produced than under perfect competition. 9.4 Oligopoly Under oligopoly, a few large firms dominate the market. A duopoly exists when there are only two firms in the industry. The product may be homogeneous (e.g. steel, cement, petrol) but it is mostly heterogeneous (e.g. motorcars, cigarettes, household appliances, electronic equipment, household detergents). When the product is homogeneous, the market is described as a pure oligopoly, and when the product is heterogeneous (or differentiated) the market is called a differentiated oligopoly. Oligopoly is the most common market form in modern economies. When people talk about "big business" and "market power", they are usually referring to oligopolists. The main feature of oligopoly is the high degree of interdependence between the firms. Each oligopolist, therefore, always has to consider how its rivals will react to any action that it takes. The other important feature of oligopoly is uncertainty. To reduce this uncertainty, oligopolistic firms often collude (enter into agreements) about prices and output. Like a monopolist and a monopolistic competitor, the oligopolist faces a downward-sloping demand curve. However, the slope of the curve is uncertain, since this depends on how its competitors will react to price changes - they may decide to follow or not to follow any price change. Since oligopoly is 103

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Economics 1A dominated by a small number of powerful firms, the entry of new firms is more difficult than under perfect competition or monopolistic competition. However, in contrast to monopoly, entry is possible. Competition is often intense, although it tends to be non-price competition, rather than price competition. The more intensely oligopolists compete, the closer they are likely to come to perfectly competitive output. 9.4.1 A theory of oligopolistic behaviour: The kinked demand curve Different oligopoly models are not discussed in this module, but to give you some idea of what oligopoly models are, one of the classic oligopolistic theories (the kinked demand curve) is outlined. The kinked demand curve, as illustrated in Figure 9.5, does not explain how price and output are determined under oligopoly, but it does illustrate the importance of interdependence and uncertainty in oligopolistic markets. It is one of the possible explanations for the observed degree of relative price stability under oligopoly. Figure 9-5: The kinked demand curve

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Economics 1A The kink in the demand curve is at the market price P 1 with the amount which the firm produces at Q1; this is the point of profit maximisation. The significance of P1 is that oligopolists will be wary of moving away from it individually because they cannot be certain of the reactions of their rivals. The curve is relatively elastic above P1 and inelastic below it. Hence, if firms raise prices and their rivals do not follow, they will lose market share; if they cut prices, their rivals will follow to protect their own position, which means that all firms will end up with lower prices and profits on unchanged market shares. Consequently, prices will be inflexible at P1. There are three inferences that can be made: -

There is unlikely to be permanent price competition under oligopoly;

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Firms will compete through non-price methods such as advertising, promotions and product development; and

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Firms may engage in collusive agreements and form cartels or consent to price leadership arrangements.

9.4.2 The shortcomings of the kinked demand curve model are as follows: -

The theory is difficult to test effectively because it does not actually explain how the price is initially determined;

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The model takes no account of non-price competition which is an important feature of the market; and

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There are other reasons for infrequency of price adjustments such as their cost and lost customer goodwill which may be as equally important as the more specific market pressures.

YOU ARE NOW READY TO ANSWER THE QUESTIONS FOUND IN THE WORKBOOK RELATING TO THIS STUDY UNIT

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