College of Business and Economics

School of Economics

Economics and Econometrics

Learning Guide
The Economic and Business
Environment A
EBE3111/EBE00A1

Frederich Kirsten and Mduduzi Biyase

2023

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INTRODUCTION
This module relates primarily to economics and covers core themes in
combination with academic development elements and skills in order
to prepare learners for the relevant regular first year modules in
Economics.

CRITICAL OUTCOMES OF THIS COURSE

After this course, you should be able to:
 Understand why economics falls in the category of social sciences.
 Have knowledge about the different thinking processes used to
formulate argumentations and mental experimentations in
economics.
 Have knowledge concerning the different tools, ranging from
numerical to graphical, which is used in economics.
 Be aware of the main problems that are experienced in economics
as well as possible solutions for these problems.
 Have an understanding of the main microeconomic aspects of
economics.
 Have an understanding of the main macroeconomic aspects of
economics.
 Have a better understanding of the core themes studied in the
course through the application of real world examples.

LECTURERS

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 LECTURER OFFICE CONTACT

Mr F Kirsten (Coordinator) D Ring 210 fkirsten@[Link]

Dr M Biyase D Ring 240 mbiyase@[Link]

LECTURE TIMES
Tuesday 08:00 – 09:35

LECTURE SCHEDULE (This schedule is a guideline and students

should use this to prepare BEFORE classes)
Week TOPIC Chapter
Section 1
13 Feb - 19 Feb Economics in context and how to think and Unit 1
reason in Economics
20 Feb - 26 Feb Analytical and other tools used in Economics Unit 2
27 Feb – 5 March Economic problems and how they may be solved Unit 3

6 March – 12 March Economic problems and how they may be solved Unit 3
13 March -19 March Economic problems and how they may be solved Unit 3
20 March -26 March Unit 1 to 3 revision Unit 1-3
27 March -2 April Test week (Test date is on the 28th of March) Unit 1-3
4April – 9 April Mid semester recess
Section 2
10 April - 16 April Microeconomic aspects Unit 4
17– 23 April Microeconomic aspects Unit 4
24 April – 30 April Macroeconomic aspects Unit 5
1 May – 7 May Macroeconomic aspects Unit 5
8 May – 14 May Test week (Test is on the 9th of May) Unit 4 and 5
15 May– 21 May Real world application Unit 6
23 May Sick test 1 and 2
22 May -28 May Real world application and Revision session Unit 6
17 June Final examination Unit 1-6

PRESCRIBED LITERATURE

2
There is no prescribed textbook to buy this module. You need to use
the notes as provided in the study guide.
Articles and resources as provided in class and on Blackboard

ASSESSMENT
Tutorial Assignments - Continuous evaluation via Tutorial
Assignments
Semester test 1 - 28 March 2023
Semester test 2 - 9 May 2023
Sick tests - 23 May 2023
The sick test is only for students that have missed test 1 or test 2 with
a valid excuse and that have applied, using the correct form, and been
granted permission to write the special test

ADMISSION TO THE LAST SUMMATIVE ASSESSMENT

OPPORTUNITY

A minimum module (semester) mark of 40% is required in order to

obtain entry to the last summative assessment opportunity
(examination) for a module. Furthermore:

“A minimum student attendance of 80% of scheduled contact sessions

for a module in the Department of Economics and Econometrics, over
and above other specific requirements, is required in order for a
student to get access to the last summative assessment opportunity of
that module. A concession may be considered for students who in the
event of illness, for compassionate reasons, on religious grounds or for
similar legitimate reasons, could not adhere to this requirement.”

Note: All other related academic regulations continue to apply.

EXAMINATION PASS MARK AND DISTINCTION

Candidates must achieve a final mark of at least 50% in order to pass
the course. To pass with a distinction, candidates must obtain at least
75% in the final mark.

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COMPOSITION OF FINAL MARK

Test Contribution to final mark

Semester test 1 40%
Semester test 2 40%
Other small online Assessments 20% detailed breakdown will be
(dates will be announced on provided
Blackboard)
Total (Semester mark) 100%

Final mark calculation

Semester mark 50%
Final June examination mark 50%
Final mark for EBEA 100%

4
METHOD OF STUDY

TYPE OF LEARNING

Learning will be primarily conducted within a lecture situation by using

the prescribed literature. As indicated in this study guide, the formal
work programme is divided into six study units. A set of objectives has
been carefully defined for the student at the commencement of each
study unit. The student must ensure that he/she acquaints
himself/herself with those objectives.

A lecturing programme is also provided in this guide to enable students

to read relevant sections of the notes before coming to class. A
student that acquaints him/herself with the relevant section and
concepts before coming to class will definitely relate better to the
lesson. During the lesson the student will be better equipped to ask
questions, make comments and seek clarification on aspects that
he/she found difficult during his/her reading.

As a follow-up to the lesson, the student should compile well-structured

notes to use when preparing for tests and the examination. A student
should compile his/her own notes and not ask fellow students or the
lecturer for their notes. This study guide provides a set of guidelines
and references to relevant aspects for each study unit, which may be
used as a guide when reading and compiling notes. A set of
questions/tasks is also provided at the end of each study unit for the
purpose of self-evaluation.

Try to identify and answer the questions. Repeat this proposed

method of study until you know the study unit, and then proceed to the
next.

INTEGRATED ASSESSMENT

Learners are assessed through a written modular test and also need to
complete written assignments and answer questions which you will
then self-assess on the basis of answers given. As a student you
should know exactly what is expected when certain verbs are used in
questions. The required response to each verb can be classified
according to its level of difficulty, but often differ only in degree. A
table of action verbs, requiring a response varying from least difficult
(knowledge) to most difficult (evaluation), is provided.

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 Competency Action Verb

1. Knowledge Name, list, identify, define, state

2. Insight/ Comprehension Explain, discuss, interpret, classify,

indicate, describe, specify.

3. Application Determine, demonstrate, illustrate,

calculate, draw.

4. Analysis Differentiate, distinguish, analyse,

compare, contrast.

5. Synthesis Construct, formulate, recommend,

integrate, agree/disagree, develop,
criticize.
6. Evaluation
Indicate choice and motivate, debate,
assess, contest.

The required response to each verb would be:

 Name
To name means that the required information should be provided
in the form of single words or short sentences, preferably
numbered.

 Define
This requires giving the precise meaning of a concept; very often
definitions have to be memorized verbatim (word for word).

 Explain
An explanation requires that a certain outcome be made clear, in
economics often with the use of a diagram. Clarify or give
reasons for something, usually in your own words.

 Describe
To describe is to say exactly what something is like; to give an
account of the characteristics or nature of something; to
explain how something works. No opinion or argument is normally
needed.

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 Discuss
To discuss is to comment on something in your own words. This
often requires debating two viewpoints or two separate
possibilities.

 Compare/Contrast
In this case point out the similarities and differences between
objects, ideas or points of view. When you compare two or more
objects you should do so systematically - completing one aspect
at a time.

 Distinguish
To distinguish is to point out the differences between objects,
different ideas or points of view. This usually requires you to use
your own words.

 Demonstrate
To demonstrate means to include and discuss examples. You
have to prove that you understand how a process works or how a
concept is applied by giving examples of real-life situations.

 Analyse
Analyzing means to identify parts or elements of a concept and
describing them one by one.

 Criticize
This means that you should indicate whether you agree or
disagree with a particular statement or view. You should
then describe what you agree/disagree with and give reasons for
your view.

Reference: Smith, D.P.J. (ed.) 1996: Orientation in aspects of

education, Johannesburg, RAU

7
LEARNING UNITS

Learning unit 1
Economics in context
How to think and reason in Economics
Learning unit 2
Analytical and other tools used in Economics
Learning unit 3
Economic problems and how they may be solved
Learning unit 4
Microeconomic aspects
Learning unit 5
Macroeconomic aspects
Learning unit 6
Real world application

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 Learning unit 1

Learning unit topics

Economics in context

The focus of economics as a discipline in the social sciences

 Nature of economics as a social science
 Normative and positive statements
Key concepts, principles and branches of study
 Main fields in economics
 Important terminology used in economics
Economics’ place in [Link] degree studies
 Why should you do economics in a [Link] degree?
 Where do economics fit in with other subjects?
The relevance of economics for careers in the economic sciences
 Possible careers
 Further study opportunities

How to think and reason in economics

The nature of logic and argumentation in economic theory and

models, mental experimentation and the role of assumptions in
economic theory
 Use of models in economics
 Assumptions and implications of models
 Logic, argumentation and mental experimentation
 Chain reasoning and awareness of fallacious reasoning when
exploring economic relationships through causation.
 Common pitfalls in economics

9
  Appropriate study techniques in economics
 General tips

ECONOMICS IN CONTEXT

1.1 Study Objectives

After this section, you should be able to:
 Understand and explain why economics is classified as a social
science.
 Understand and explain basic economic terminology.
 Distinguish between different branches of economics.
 Understand why you have to do economics for your [Link]
degree and what value it will add to your studies.
 Understand what the link between economics and other [Link]
subjects is.
 Know what careers you can perform if you completed a degree in
economics.

1.2 Introduction

This section attempts to give a better understanding of what

economics is all about and explain why we call it a social science.
Furthermore fundamental economic jargon will be identified and
explained.

We will also be concentrating on where economics exactly fits in

[Link] degree studies and how it is linked to other subjects.
Seeing that economics is a very diverse subject field we will also
concentrate on the different branches of economics. In addition
we will point out prospective careers that can be practised if you
complete a degree in the economic sciences.

1.3 Economics as a social science

10
 ECONOMICS SOCIAL HUMAN
BEHAVIOUR
SCIENCE

Observation & Develop statements

measurement which describe
relationships

So we can answer the

question: WHY?

Economics is a social science which studies the behaviour of how

people use their limited resources to satisfy their unlimited needs.

Think for yourself: It is lunch time at the university and you have R20
with you. There are various ways that you can spend the R20
depending on how hungry you are and what you are generally in the
mood for.
 The R20 represents the limited resources – why do we say it is
limited?
 If resources are limited what problems does this create for you and
for the economy as a whole? What do we normally do in these
circumstances?
 After lunch you are normally not hungry anymore and therefore you
have satisfied your needs. But why do we say that people have
unlimited needs?

11
Task:
After reading the definition of economics – why do you think economics
is called a social science?
________________________________________________________________________
________________________________________________________________________
________________________
Can you name any other social sciences?
________________________________________________________________________
________________________________________________________________________
________________________

Economics is classified as a social science because economic facts are

studied and it is assumed that man, in his economic actions, is a
reasonable being which acts rationally. The study of economics
investigates reality in a specific manner, called a scientific approach.
Four different steps can clearly be distinguished in this scientific
approach to economics.

Observation
Man’s economic actions are so complex and are influenced by so many
factors that it is impossible to observe the economy as a whole both
simultaneously and exactly. A specific aspect of reality is selected as a
starting point. The observation of a specific economic aspect is not
only the first step in the scientific approach to economics, but is also
one of the most important sources of economic knowledge. Years after
the fact the historical data of a particular economic event can still be
analysed and interpreted in order to determine the causes and
consequences of a specific phenomenon.

Analysis
The second step in the scientific approach to economics is the analysis
of the recorded empirical data. Economic analysis consists of the
prediction of economic subject’s behaviour based on specific
predetermined assumptions. For example a decline in the rate of
personal income tax may lead to an increase in consumer spending in
particular as a result of the spending patterns of consumers in general.

Statistical Analysis
The third step in the scientific approach to the study of economics,
namely statistical analysis, is necessitated by the scope of the field of
study. An analysis of the spending patterns of all South Africans is an
impossible task. However, statistical analysis provides the instruments
of random testing so that we can make general statements regarding
the spending patterns of consumers in South Africa.

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Controlled Experiments
The fourth step in the scientific approach is controlled experiments,
such as those that are frequently used in the natural sciences.
However, controlled experiments in economics are more difficult
because economic variables cannot be precisely measured. During the
last two decades economists made intensive efforts, with partial
success, to indicate the degree to which changes to the government’s
social programmes influenced individuals’ working habits and their
propensity to save. It seems that it is almost impossible to exactly
measure what the effect of increased government spending is on
individuals in the economy.

A scientific approach to the study of economics includes all four steps

to a greater or lesser degree. Certain economic phenomenon can be
studied comprehensively by means of observation and analysis, while
a statistical analysis and/or controlled experiments are indispensable
for others.

Think for yourself: In economics (as a science) economists would for

example like to determine how consumers and firms would react if
there is an increase in the interest rate. Why would economists then
be interested on how the subsequent behaviour of consumers and
firms impact the future?

Positive versus Normative Economics

At this stage it is important to distinguish between two types of
statements, namely positive and normative statements. One needs to
distinguish between the two in order to comprehend the differences of
opinion which sometimes occur between economists. Economists as
social scientists usually try to confirm positive statements by observing
what is happening in real life.
 Positive statements deal with facts, it is statements about what
is or was or will be. The statement “Gauteng is a province in
South Africa” is an example of a positive statement. By looking
at the facts one can resolve immediately whether a statement is
true or false.
Positive economics is the objective analysis of the economy as it
exists in reality. In other words, positive economics is a
study of the choices which people make, without making a
value judgement about these choices. It is therefore a non-
judgemental and objective science.
 Normative statements are related to opinions; it is statements
about what ought to be. The statement “more aid should be
given to developing countries” is an example of a normative
statement. Unlike positive statements, normative statements
cannot be verified by looking at the facts. These statements are
13
 thus based on value judgements and are based on the views or
opinions of the parties involved.
Normative economics is concerned with the design and
implementation of policy measures which aim to change the
economic behaviour of people. It is therefore not objective but
judgemental.

Task:
State whether the following statements are examples of positive or
normative statements:
1. If the government decides to lower the tax rate on individuals it will
lead to an increase in the active labour supply.
________________________________________________________
2. The American stock market has boomed in recent years.
________________________________________________________
3. A national minimum wage is totally undesirable as it does not help
the poor and causes higher unemployment and inflation.
________________________________________________________
4. Protectionism is the only proper way to improve the living standards
of workers whose jobs are threatened by cheap imports.
________________________________________________________

1.4 Branches of Economics

Economics can be divided in several sub-fields, the main ones being:

 Microeconomics (Think: Micro = small = individuals) –
concentrates on the economic behaviour and response of
individuals (households and businesses) facing scarcity, how
they make choices and how they react to actions taken by
government.
 Macroeconomics (Think: Macro = big = entire economy) –
focuses on the interaction of economic aggregates on the
economy and each other.
 Econometrics is a combination of mathematics, statistics and
economics. An econometrician would typically use statistics to
build numerical models of the economy and use these models to
forecast what will happen in the future.

Other sub-fields in economics include: international economics,

development economics, labour economics, financial and monetary
economics, public finance and environmental economics.

14
1.5 Key concepts in Economics

As we proceed with this course you will be introduced to more and

more terminology that is used in Economics. For now we need to get
the basic fundamental ones out of the way. If you want to fully
understand the definition of economics and comprehend what
motivates economic activity it is important that you understand what is
meant with unlimited needs, limited resources and scarcity.

Economics is also known as the science of choices. The definition of

economics with which you were presented also determines that society
should exercise choices. However the choices made by societies and
individuals are merely a symptom of the most fundamental concept in
economics, namely scarcity.

The law of scarcity determines that goods and services are scarce
because on the one hand man’s material needs are unlimited and
insatiable, and on the other hand economic resources or means are
limited or scarce.

Unlimited needs
The definition of economics determines that man has many and varied
needs. Nobody ever had enough means to fulfil all his/her needs. Even
if a person had sufficient resources to fulfil all his/her need for clothes,
food and housing, he/she would still have the problem that the need
for food, and to a lesser extent, clothes, is insatiable. It is not true that
all people are greedy but an hour or two after a meal, most people will
again become hungry or thirsty. Most clothes also wear after a period
of time or fashion change and therefore clothes have to be replaced at
various intervals.

Man’s needs are dynamic and develop gradually. Man has always had
a need for heat to protect him/her from the winter cold. Initially, Stone
Age man found protection against the cold in open fires and the hides
from animals that had been hunted for food. Modern man no longer
uses hides and furs; instead he uses blankets which are woven from
wool. However, twentieth century man not only needs shelter from the
cold night air, but he/she also does not want a heavy load of blankets
on him/her, and therefore he/she developed a ‘need’ for an electric
blanket.

In addition to his physical needs, man also has psychological needs

such as education, relaxation and status, which, just like physical
needs, are unlimited and insatiable. Physical and psychological needs
are also important to the economist, because those same scarce

15
resources which have to be used to satisfy man’s physical needs, also
have to serve to satisfy man’s psychological needs.

Limited resources
The law of scarcity determines that scarcity is the result of two factors,
namely unlimited needs and limited resources. It is a fact that ever
since man had to leave paradise, he has had insufficient means or
resources to satisfy his countless needs. The resources which are at
man’s command can be divided into three categories, namely natural,
human and man-made resources. In economics these resources are
known as production factors when they are utilised in the production of
goods and services. Natural resources include everything nature
offers man, namely land, water, minerals, fauna and flora and are
known as the natural resources production factor.

Man-made resources include all those resources which are used in a

further production process and are known as capital goods
production factors. Capital includes goods such as machines, plant,
buildings, roads and bridges which are utilised in the production of
other goods and services. Human resources are supplied by man. The
labour production factor includes all man’s physical and intellectual
capabilities. Man’s ability to combine and coordinate the use of labour,
natural resources and capital goods at the right time, place and
quantity in the manufacturing process, and to do this in such a manner
that the value of the final product is higher than its production costs, is
known as the entrepreneurial production factor.

Production factors
 Natural resources
 Labour
 Capital goods
 Entrepreneurship

Opportunity cost
Opportunity cost reflects the true cost of the choices that you make. It
can be defined as whatever you have to give up in order to satisfy a
specific need. For example by attending a lecture you are foregoing
possible extra leisure time like going to the movies or working full
time.

16
1.6 Economics’ place in [Link] degree studies

In most [Link] degree studies followed, economics is usually a

compulsory subject in the first year of study. Obviously if you decide
to do a [Link] degree in economics specifically your second and third
year will also comprise of economics and you will also be introduced to
econometrics in your second and third year. Furthermore if you go the
finance route you will also have economics as a subject in your second
year.

A simple example will serve to point out the links with other [Link]
subjects. Let’s consider an increase of the prime rate. Although the
increase is generally analysed in economic terms the change can also
be traced through to different fields.

Accounting
Accounting records transactions of individuals/firms. An increase in
the prime rate would lead to higher interest costs for both firms and
individuals. Accountants would therefore subsequently need to adjust
their budget amount for interest as well as record a higher amount for
interest in their balance sheets.

Finance
If we look at investment in terms of finance – a higher prime rate will
lead to higher rates of return on investments especially interest-
bearing financial products.

Economics is therefore a very important subject to complete especially

when doing a [Link] degree study. Economics is not only linked to
various other fields but also give you an extensive background in
terms of economic sciences as well as very useful tools that can be
used for a vast array of fields.

1.7 Relevance of Economics for careers

If you decide to follow a career in economics and/or econometrics

some of the jobs that you will be able to apply for in the future include:
 Economist
 Econometrician
 Journalist
 Analyst (Financial, Business)
 Lecturer / Teacher
 Investment Banker
 Stock Broker
 Private Equity / Venture Capitalist
 Macroeconomic Modeller (Forecasting)

17
However if you decide to continue your studies in economics, you can
always do an honours degree in one of the following fields:
 Economics
 Econometrics

1.8 Questions

Improve your understanding by writing your own definitions in the

space provided:
Economics

Scarcity

Needs

Resources

Natural resources

Opportunity cost

Macroeconomics

Microeconomics

Econometrics

Ceteris paribus

Positive
economics

Normative
economics

18
State whether the following statements are true or false:
a. Economists presume that man’s economic behaviour is
predominately rational.
b. We assume that it is possible to satisfy all human wants.
c. Moral judgments play an important role in positive scientific
reasoning.
d. Controlling for outside influences is one of the few problems for
which social scientists are better equipped to cope than natural
scientists.

Think for yourself:

Introducing the Desert Island Economy and Its Economic

Problems

You have a problem. Together with 90 other people, your boat sunk
during a heavy storm, somewhere in the middle of the vast Pacific
Ocean. Fortunately, all of you survived and made it to a small-
undiscovered island. The only supplies that washed up with your
group were an economics textbook, a couple of tools and about 10
large crates of canned food, assorted vegetable seed and bottled
water. Fortunately, the island seems to be large and fertile enough to
support all 90 people and their future children, provided they use the
available resources economically.

Everyone is very happy about finally finding him or herself on a

paradise island. Some people start opening the crates and help
themselves to the food and water. At the risk of being seen as a
spoiler, you decide to explain to everyone that things are not as rosy
as it may seem. You do this by explaining the economic problem on
this island

Write your explanation to your fellow islanders here

19
You also point out how people helping themselves indiscriminately to
the food and water in the crates, may worsen the problem. Your fellow
islanders immediately recognise your natural leadership qualities and
superior economic thinking skills, and they ask you to take
responsibility for managing the prosperity of the island. Suddenly you
are glad for the economics textbook that washed up with the other
supplies.

You send men out in groups of five to explore the island. All of them
return safely, and report that coconut trees are the most common
plant. The interior is arable and large portions can be cultivated to
plant vegetables. They also found a few smaller animals and edible
berries spread throughout the island. There is enough to sustain
everyone, provided everything can be organised to utilise the
resources. The main products that can be produced are coconuts and
vegetables. With this information, you start to think about the island’s
economy.

What are the resources available on this island?

Classify them according to production factors

What are the needs of the islanders?

Sort the needs from most important to least important

20
21
HOW TO THINK AND REASON IN ECONOMICS

1.9 Study objectives

After this section, you should be able to:

 Understand the nature of logic and argumentation in economic
theory and models.
 Be aware of mental experimentation and understand the role of
assumptions in economic theory.
 Understand what is meant with chain reasoning and be aware of
fallacious reasoning when exploring economic relationships.
 Have knowledge of appropriate study techniques in economics.

1.10 Introduction

This section gives you background in terms of how to think and reason
in economics so that it will aid your understanding of economics. We
will specifically concentrate on the roles of logic, argumentation,
mental experimentation and chain reasoning. You will also realise the
important part that assumptions play in economics and that chain
reasoning can easily become misleading. Lastly we will concentrate on
study methods specifically aimed at studying economics.

1.11 The Use of Models in Economics

We use models in economics to help us explain what happens in a

specific economy. An economic model is similar to other more familiar
(physical) models in the sense that they resemble the real thing in
appearance (like a model car) but they do not work like the real thing
that they represent. They include only those features needed for the
purpose at hand and they leave out any unnecessary details. What a
model includes and what it leaves out results from a conscious and
careful decision. Most models are ‘physical’ models and their purpose
is to enable us to visualize the real thing. Some models like economic
models are not physical. We cannot look at the real thing and look at
the model and simply decide whether the model is a good or bad
representation of the real thing. But the idea of a model as an
abstraction from reality still applies to an economic model.

22
1.12 Assumptions and Implications of Models

Economic models have two components:

 Assumptions
 Implications

Assumptions form the base on which a model is built. They usually

indicate to us which things are relevant and need to be included in the
model. Implications on the other hand, are the outcomes or results of
a model. The link between a model’s assumptions and its implications
is a process of logical reasoning.

We can illustrate the components of a model by building a simple

model of a student’s daily taxi journey to campus. The purpose of this
model is to find the latest time the student can catch a taxi to be on
time for his economics lecture. There are four relevant assumptions:

1. The lecture starts at 7:30 a.m.

2. Taxis leave from the student’s home every half hour (i.e. 6:00, 6:30,
7:00 etc.).
3. The taxi ride takes approximately 30 minutes.
4. The walk from the taxi drop off point to the university takes 15
minutes.

The implication of this model is that to be on time for lectures, the

latest taxi the student can catch is 6:30 a.m. (the student will arrive at
7:15 a.m. on campus).

The assumptions made when constructing a model depend on the

model’s purpose. The purpose of the model just described was to see
what the latest time is that the student could catch a taxi.

The purpose of an economic model is to understand how people make

choices in the face of scarcity. So in building an economic model, we
simplify the model by ignoring things that are not important to us. The
result might end up being unrealistic but it will still be useful to us by
giving us an indication of how the economy works and we can make
forecasts from it.

23
1.13 Logic, Argumentation, Mental Experimentation and Chain
Reasoning

The usefulness of models are only realised when we make use of logic,
argumentation, mental experimentation and chain reasoning. If we set
up a specific scenario with certain assumptions we have to use mental
experimentation to reason or argument what the resultant implications
will be (which is exactly how a model works). Unfortunately we cannot
place a certain item in isolation, like the natural sciences, and
subsequently see what the effect will be on the item. You have to use
your head.

Task: Use your logic and argument what will happen in the economy
when the government decides to increase unemployment benefits to
the population.

1.14 Pitfalls in the Study if Economics

A scientific approach to the study of economics does not necessarily

guarantee success. Caution must be exercised in the formulation and
interpretation of economic laws, as there are a variety of pitfalls. The
most important of these pitfalls are subjectivity, causality, the fallacy
of composition, the dynamics of economics, the assumption of ceteris
paribus and uncertainty related to the economy.

Subjectivity
The limited applicability of controlled experiments in the economy
forces economists to formulate their scientific theories and laws on the
basis of their personal perceptions of reality. An individual’s
perception of the phenomenon is determined by the perspective from
which he studies a particular reality. A South African who was raised in
a privileged home and who completed his studies without any financial
obligation will probably have a specific perception of the government’s
role in the curbing of unemployment. A person, who had to walk
fifteen kilometres to school, had no electricity with which to study at
night and could only complete his studies with the aid of bursaries and
loans because his parents were unemployed would probably have a
completely different perception. The proverbial colour of the lenses
through which one looks at a problem like unemployment could even
give rise to conflicting policies to solve the same problem. The
problem of subjectivity is aggravated by complexity and
interdependence of economic reality.

24
Causality
The Latin phrase post hoc ergo propter hoc, which also applies to
economics, means that what is perceived first does not necessarily
cause that what is perceived second. Causality can therefore not be
determined by the order of perception. The fact that the annual
mortality rate in old age homes is higher than that in school boarding
houses does not mean that an old age home is a more dangerous
place to live.

A comparison between the average age of residents of school boarding

houses and that of old age home residents with the average life
expectancy of the population and other variables would give a better
indication of the risks associated with an old age home.

The fallacy of composition

A fallacy of composition is made when one assumes that which holds
true for the individual, self evidently holds true for the group or
totality. If a single wheat farmer achieves a record harvest while most
other wheat producing farmers experience a crop failure, he will
probably enjoy a record income. However, if all wheat farmers have a
record harvest, there will probably be a surplus of wheat and the
wheat producing farmers’ income will decrease as a result of the lower
wheat price.

A single South African motorist who in 2006 travels double the distance
which he travelled in 2005, will not influence the international fuel
price if all other motorists travel the same distance in 2006 as in the
previous year. However, if all the motorists in the world travel twice
the distance in 2006 that they travelled in 2005, the fuel price will
probably increase.

The dynamics of economics

Economics is classified as a social science because it studies human
behaviour. Economic theories and laws which applied in the year 1500
do not necessarily apply in the year 2015. Man’s economic behaviour
is not static, but is dynamic and continuously adapts to changing
circumstances. Economic theories must be investigated constantly to
determine whether or not they still give a valid rendering of reality.

The assumption of ceteris paribus

The complexity of the economic reality necessitates the assumption of
ceteris paribus (i.e. that all things remain constant), when studying the
effects of a specific economic phenomenon. If one wishes to
investigate the effects of an increase in the demand for red meat on

25
the price of red meat, the consumer’s spending patterns; income and
diet have to be kept constant.

Uncertainty in economics
The economic behaviour of households may exhibit extreme variation.
An increase in the price of petrol may lead to a significant decrease in
the amount travelled by Household A, while Household B may not
travel less at all. As a result of the uncertainty relating to the
economic behaviour of individuals, a specific economic relationship
cannot always be predicted over a period of time. The law of averages
determines that the average behavioural pattern of groups can be
predicted with a greater degree of accuracy than that of individuals.

1.15 Study techniques in Economics

Although there are various techniques and tips that can be used to
study economics – the key is to find a method that works specifically
for YOU. Specific methods that can be used to study specific learning
areas will be discussed weekly. Some general study tips include:

 Prepare for class by reading through the material that will be

covered in the lecture.
 Take notes in class – especially about concepts that you did not
understand when you were reading through the material.
 Ask questions! If you do not understand something ask the lecturer
to explain it again. The chances are very good that somebody else
also wants further explanations but are too shy to ask.
 Go through your class notes as soon as possible after class and fill
in parts that are incomplete. If you never look at your class notes
until you are ready to begin reviewing for the exam, then chances
are that you will not understand them.
 Always read the material “actively” by:
o Making notes in the margins, especially if you start
understanding a difficult concept try to write it in your own
words in the margin.
o Read with a pen and paper. Make notes of new concepts and
definitions. Also make notes of concepts that you still don’t
understand so that you can ask the lecturer or a tutor later.
o Economics uses lots of models, which are usually represented
with a graph. Every time your text introduces you to a new
model, write in your notes the following things:
 The name of the model.
 The purpose of the model.
 Draw a copy of the graph or diagram that goes with the
model. Carefully label the axes and the curve(s).

26
 For each of the curves, write down what that curve

shows and explain why it has a positive, negative,
horizontal, or vertical slope.
 For each curve, write down a list of things that will shift
the curve, and briefly explain how each of these things
shifts the curve.
 Practice and test yourself by using assessment questions given in
the study guide as well as on Edulink.

1.16 Questions

a. Complete the following crossword puzzle by using the clues given:

1 2 3 4 5

10

11 12

13

14

15

ACROSS DOWN

7. The best foregone alternative. 1. Positive statements only deal

8. Economics is classified as a with __________.
__________ science. 2. One of the components of an
9. A ____________ of composition economic model.
occurs when one assumes that 3. The South African currency.
what holds true for the individual 4. ____________________ examines
self-evidently also holds true for an economy as a whole.

27
 the group as a whole. 5. The first component of all
10. Microeconomics deal with sciences is careful and
____________ units such as systematic _______________ and
households. measurement.
11. It is people's wants rather 6. Econometrics is the application
than their _________ which provide of ____________ techniques to
the motive for economic activity. measuring economic phenomena.
13. The Latin phrase "ceteris 12. The problem of ____________
paribus" means holding forces people to make choices.
everything else _____________.
14. South Africa is hosting the
____________ world cup in 2010.
15. Statements about what ought
to be in science is known as
____________ statements.

b. Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
a. Who is the person and what does he do?
b. What role does he play in the South African economy?
c. What is the MPC and what role does the person of the week
play in it?

28
 Learning unit 2

Learning unit topic

Analytical and other tools used in Economics

Basic numerical and algebraic tools

 Equations
 Basic calculations
Statistical tools
 Measures of central location and dispersion
Graphical tools
 Line graphs and their interpretations
 Other graphical methods
Flow diagrams
 Use in economics
 Examples
Computer applications
 Excel
 Eviews

2.1 Study Objectives

After this learning unit, you should be able to:
 Know what an equation is and interpret it.
 Do basic calculations.
 Know about different statistical tools used in economics and
interpret them.
 Represent information in graphic form and make conclusions
from graphs.
 Represent processes in terms of flow diagrams.

29
  Understand how to interpret flow diagrams.
 Have basic knowledge of Excel and Eviews.

2.2 Introduction
Basic calculations, graphs, tables, and equations are all useful in
describing economic relationships. Knowledge about all four
techniques is important to understanding economics. Learning how
graphs work is a lot easier than trying to memorize all the graphs that
you will come across in economics. It is important that you know how
graphs are developed, what they symbolize, how to read them and
how to draw a graph.

2.3 Basic numerical and algebraic tools

When two mathematical expressions are equated with each other, we

speak of an equation, for example the equation of a straight line can
be represented as follows:

Y = a + bX

Y is known as the dependent variable because it is dependent on the

variables on the right-hand side.
a is known as the constant or the intercept value.
b is called the gradient or the slope of the equation. It can either be
negative or positive.
X is called the independent or explanatory variable.

We can also relate the above mentioned equation to a specific

economic relationship, for example:

Consumption = a + b (Income)

Our dependent variable in this case is consumption seeing that it is

dependent on income.
The constant or intercept value an in this instance represents the
amount that people will consume if they receive zero income.

Think for yourself: Do you think people will still consume anything if
they do not receive any income?

The slope specifically represents the amount that consumption will

change with if there is a change in income.
Income is the independent variable in this specific model because it
explains what will happen to consumption.
30
Task:
Consider the following equation:
Consumption = 123 + 0.98 Income
Identify the dependent and independent variables.
Interpret the intercept.
Interpret the slope.

2.4 Statistical tools

Jamie sells fudge after school to earn some extra pocket money. The
following table represents the profits that he makes each month. What
conclusions can you make by looking at the following set of data?

Mont Profit
h
Jan R 700
Feb R 750
Mar R 750
Apr R 700
May R 800
Jun R 800
Jul R 800
Aug R 900
Sep R 900
Oct R 950
Nov R 1,000
Dec R 1,200

Statistical methods can help you to analyse the data better. The first
step is usually to create a graph of the data so that you can have a
clearer picture of what is really happening, for example (graphs will
also be discussed in the next section):

31
 Jamie's Fudge Sales

R 1,200

R 1,100

R 1,000
Profit

R 900

R 800

R 700

R 600
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Month

From this graph we can see that Jamie makes the highest amount of
profit in December (why?). We can also see that there has been a
steady increase in his profits over the sample period. What else can
you deduce?

The next step is to take a closer look at the numbers. The statistical
tool that we will use for this is called measures of central location.
The purpose of a measure of location is to pinpoint the centre of a set
of values or in other words to look at the different averages of the data
set. There are three measures of central location:

32
Measure of Mean Mode Median
central
location
What is it? A simple The value of the The midpoint of
average of the observations the values.
data given. that appears
most
frequently.
How do we Sum of all the The value that Order the data
calculate it? values / occurred the from the
Number of most is the smallest to the
values mode. largest, the
middle value is
called the
median.
Example: R10250 / 12 R800 R800
Jamie’s Profits = R854.17
How do we Jamie’s average The amount of The middle
interpret it? profit for the profit that Jamie value of profits
year is R854.17 made most that Jamie
months was made is R800.
R800.

2.5 Graphical tools

Graphs are snapshots of information that can be used descriptively or

analytically in order to understand economic theory better. More
specifically a graph is a picture of a relationship between two or more
variables (items that can be described by numbers and include things
such as time, distance, income, prices etc.). In some situations it is
more useful to represent something in graphical form than in words.
We can see a much clearer picture of how per capita (per head)
income for a country has changed over time if we represent it with a
graph.

33
Graphs are usually drawn on a set of axes, represented as follows:
Y- axis

0 X - axis
Origin

The axes are usually drawn with arrows on either side to show that the
line can be extended infinitely. It is very easy to draw a graph. A graph
is usually drawn from specific data given, for example:

P 1 2 3 4 5 6 7 8 9 10
Q 20 18 16 14 12 10 8 6 4 2

For this specific table P represents the price of a certain product and Q
is the quantity of the product required at that specific price. It is quite
clear that the quantity required will depend on the price of the product,
and therefore Q (which will be shown on the x-axis) is the dependent
variable and P (which will be shown on the y-axis) is the independent
variable.

The first given value of P is 1 and that of Q is 20. Since P is on the y-

axis, we move 1 unit upwards where the value of P is 1. From the
point where P is 1, we move 20 units to the right. At this specific point
the value of P is 1 and the value of Q is 20. The other points can now
be found in the same way on the set of axes. The complete graph can
be represented as follows:

34
 Graph

12

10

6
P

4
P = 1 and Q
= 20
2

0
0 5 10 15 20 25
Q

Task: Construct a graph for the following data:

Q 20 18 16 14 12 10 8
P 2 4 6 8 10 12 14
Does your graph have a positive or a negative slope? How do you
know?
A very important part of graphical analysis is the interpretation of
graphs. For example if the following graph is given you need to be
able to read from it:

A
8

5 B

Q
0 6 10

The quantity at A is determined as 6 and the corresponding price will

be R8. The same goes for B – the quantity will be 10 and the
corresponding price will be R5.

35
Different types of graphs:

The straight line graph are frequently used in economics, however

there are various other types of graphs that can be used to represent
data. For example:

 Histogram
A histogram is a graph in which classes are used in order to represent
a certain distribution with its frequencies.

GDP per capita in $ for 2003

50000
40000
GDP per capita, $

30000
20000
10000
0

Country

 Pie Charts

Employment by Industry, September 2005

Agriculture

Mining

Manufacturing

Utilities

Construction

Trade

Transport and
communication
Financial services

Services

Private households
36
Unspecified
Pie charts are very useful for representing the “individual slice of the
total pie” that every component consists of.

You will encounter various other graphical methods that are used to
represent data in your studies of economics.

37
2.6 Flow diagrams

A flow diagram / chart in economics is a representation of the

sequence of operations in an economic system. Each flow chart
concentrates on a specific process. A simple flow diagram of the
scarcity problem can be represented as follows:

Economics

Problem of scarcity

Unlimited needs Limited resources

Choices

As you progress with your economics course you will encounter various
other (more complicated) flow charts that will represent specific
economic processes.

2.7 Computer applications

The main computer programmes that are used in economics are

Microsoft Excel and an econometrics programme called Eviews. These
programmes are mainly used for the quantitative analysis part of
economics. Economist’s also frequently make use of the internet in
order to do research.

38
2.8 Questions

a. Construct an economic model in the form of a mathematical

equation representing the relationship between investment and
interest rates.

b. Take a look at the following graph and answer the questions that
follow:

Gold price

800.00

700.00

600.00

500.00

400.00

300.00

200.00

100.00

0.00
Nov-75

Nov-76

Nov-77

Nov-78

Nov-79

Nov-80

Nov-81

Nov-82

Nov-83

Nov-84

Nov-85

Nov-86

Nov-87

Nov-88

Nov-89

Nov-90

Nov-91

Nov-92

Nov-93

Nov-94

Nov-95

Nov-96

Nov-97

Nov-98

Nov-99

Nov-00

Nov-01

Nov-02

Nov-03
i. What is the maximum price (approximately) that the gold
price reached in the sample period?
ii. In which unit is the gold price usually measured?
iii. Comment on the general trend of the graph.

c. Take a look at the following table, representing statistical

information on the gold price, and answer the questions that
follows:

Measure of Valu
central location e
Mean 345.8
1
Mode None
Median 355.0
5

39
 i. Interpret the mean for the gold price.
ii. What does the fact that there is no mode mean?
iii. How is the median calculated?
iv. Interpret the median for the gold price.

d. Plot the relationship between variable X and variable Y by using the

data in the following table:

Variable X Variable Y
1 3
2 4
3 5
4 6
5 7
6 8

i. Is the relationship between X and Y positive or negative? Why

do you say so?
ii. Suppose that X represents income and Y represents savings.
Do you think that the relationship you have plotted is
realistic? Why or why not?

e. Take a look at the following pie chart, representing a specific

student’s preferences in terms of movies, and answer the following
questions:

40
 Preferences in terms of movies

Science fiction
Foreign 8% Comedy
8% 27%
Horror
11%

Drama
Action
14%
18%
Romance
14%

i. What type of movies do the student like the most?

ii. What types of movies do the student like the least?
iii. Explain in your own words what a pie chart represents.

f. Inspect the following histogram and answer the questions that

follows:
Queuing times for shoppers

5
Frequency

0
1 2 3 4 5 6 7 8 9

Minutes

41
 i. How many shoppers waited for 5 minutes in the queue before
being helped?
ii. How many shoppers waited for 7 minutes or longer in the
queue?
iii. How many shoppers waited for 2 minutes or less in the
queue?
iv. How many shoppers were there in total?

g. Your lectures for the day finished early and you are now faced with
several choices (e.g. you can go home, go the library, go to the
movies etc). Construct your own flow diagram which represents
different alternatives that you can choose from as well as
advantages and disadvantages for each.

h. Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
i. Who is the person and what does he do?
ii. What role does he play in the South African economy?
iii. When is he going to read the annual budget speech?

42
 Learning unit 3.1

Learning unit topic

Economic problems and how they may be solved

The problem of scarcity and how it relates to the main economic

problems.
 Allocation – What to produce?
 Production – How to produce?
 Distribution – For whom to produce?
The problem of choice and the related concept of opportunity cost.
 Connection between economic problems, choice, scarcity and
opportunity cost
 Production possibilities
Alternative economic systems that address economic problems, with
particular attention to the market system and variations thereof.
 Tradition
 Central planning
 Market system
 The origin and development of the market

3.1 Study Objectives

After this section, you should be able to:

 Distinguish and discuss the main economic problems
experienced in the economy.
 Know how scarcity, choice and opportunity cost relate to the
economic problems.
 Draw and interpret production possibility curves in terms of
choice and opportunity cost.
 Distinguish and discuss economic systems as solutions to
economic problems.
 Discuss the origin and development of the market.

43
3.2 The Economic Problem of Scarcity

It is clear from the definition of economics that the goods and services
which the individual requires to satisfy his needs are scarce while his
needs are unlimited. The individual constantly has to make choices to
ensure that he is able to satisfy his needs within these limitations. He
will therefore constantly attempt to achieve maximum prosperity
within the limitation of scarce resources. Individuals’ needs vary and
the decision as to what is going to be produced (in order to satisfy
these needs) must therefore be made. The resources and means with
which to produce are scarce and therefore it must be decided how
production is going to take place, in other words, what technology is
going to be used, who is going to produce the goods and services and
which resources are going to be used. Once the goods have been
produced, a decision has to be made about the distribution of these
goods and services.

3.3 Key Economic Problems

Scarcity compels any economy to find solutions to three basic

economic problems, i.e. the problems of what to produce, how to
produce and for whom to produce.

Allocation – What to produce

The available resources and technology place a limit on total output
and the combination of outputs. That is to say – increased production
of one product means less production of another product. For
example, more food might mean less housing, and more relaxation
might mean less education. Given these resource constraints,
efficiency of allocation is achieved when the basket of goods and
services produced is in accordance with the preferences of the
individuals making up the community.

Production – How to produce

Resources can normally be combined in various ways to produce a
given volume of goods and services. For example, the hole for a
swimming pool can be dug in one day by a front-end loader and one
driver, or by 50 labourers with spades in a week, or by 500 labourers
with teaspoons in a year. This somewhat ridiculous example illustrates
the choice between labour-intensive (relatively more labour than
capital) or capital-intensive (relatively more capital than labour)
production techniques. The objective of production efficiency implies
that the maximum output must be obtained from a minimum input of
resources. By contrast, production inefficiency occurs when factor

44
inputs are excessive or factor combinations are incorrect. Productive
inefficiencies give rise to excessive production costs, and less profits.

Think for yourself: Use your own example to illustrate the difference
between a labour-intensive and capital-intensive production process.

Distribution – For whom to produce

In addition to solving the allocation and production problems, the
economy must also determine who will get income and how much, i.e.
for whom goods and services are produced. Distribution efficiency is
obtained when the specific goods and services produced are consumed
by those who attach the highest relative value to them. By relative is
implied the preference for certain goods as compared with other
goods. Individuals will attempt to obtain the maximum satisfaction
from their limited income or means.

In a market economy in which prices and quantities are governed by

demand and supply, allocation and distribution occur automatically.
However, a critical problem for any economy is the concept of
fairness or equity. A person’s income gives him the advantage of
being able to enter the market to purchase goods and services. Thus,
both the well-off lady with a cat and the less affluent mother with a
small baby would wish to claim a part of the limited amount of milk
available. In a market economy the cat will be satisfied and the baby
goes thirsty. The distribution problem thus implies that the distribution
of income generated by the market system might not be accepted as
fair or equitable, thus requiring attention from government.

3.4 Choice and Opportunity cost

Whenever a choice is made about what will be produced, other options

or opportunities are excluded and these would be viewed as sacrifices
or economic costs of the first option (remember this is known as
opportunity cost – you have been introduced to this term already).

It is important to realise that economic decisions are based on

opportunity costs. That is to say, in allocating resources to the
production of a particular commodity, consideration must be given to
the opportunity costs, i.e., the benefit foregone by not committing the
resources in question to another commodity. Opportunity cost is
measured by relative prices. Relative prices are the prices of goods
or resources expressed in terms of each other, in other words the price
of product A in comparison to the price of product B. The buying of
one CD for R100 means that, say five visits to the cinema at R20 each
must be sacrificed. The opportunity cost of one CD is therefore five
movies.
45
In a similar way, economic decisions regarding how to produce output,
or for whom to produce, will involve opportunity costs.

3.5 Production possibilities

Economists use the concept of production possibilities to illustrate the

role of scarcity, choice and opportunity costs in economics. For the
purposes of this description, the calculation of production possibilities
relies on three assumptions:

 The quantity of the factors of production (natural resources,

labour, capital and entrepreneurship) is fixed but can be applied
in different combinations to produce a given output.
 All resources are fully and efficiently employed, there is thus for
example no unemployment.
 The state of the technology is assumed constant.

Given these assumptions, when production possibilities are presented

graphically, it is possible to construct a production possibilities curve,
representing the allocation choices available to the economy. A
production possibilities curve reflects the concepts of scarcity, choice
as well as opportunity cost. An economy can produce any combination
of output on the production possibility curve (known as full
employment), or inside the production possibilities curve (known as
unemployment).

Bread

A
B F

C
E

D
0
Televisions

46
Points on this production possibilities curve show alternative
combinations of bread and televisions that can be produced from
available resources, when no other products are made. The specific
production possibility curve shown above represents an economy
which produces only two types of goods: bread and televisions. If the
hypothetical economy chose to be at point A, it would be producing
no televisions and allocate all factors of production to the production of
a maximum amount of bread. At point D the economy would be
producing no bread and a maximum number of televisions. Points B
and C represent different combinations of bread and televisions that
could be produced. Point B represents relatively more bread
production and point C relatively more television production.

This hypothetical economy is capable of producing output

combinations A to D on the production possibilities curve, using all the
resources and technology available. Production combination F is
unattainable because it requires more resources than what is
available. It can, however, produce the output combination at point E,
which is inside the production possibilities curve. However, output at
point E is not ideal, since not all resources are employed in production.

The production possibility curve can now help to understand choice

and opportunity cost better. Suppose the country is currently at point
A, but now wants to produce some televisions as well. To produce
more televisions would require resources, but what if all the resources
were already used for producing bread? Some land and labour will
have to be taken away from the production of bread and moved to the
production of televisions. If you take a certain amount of resources
away from producing bread, bread production will automatically fall.
The resources taken from bread production can now be allocated to
the production of televisions, and so the number of televisions
produced rises. The economy will then end up at a point like B. The
choice to produce more televisions involved a sacrifice of bread. The
opportunity cost of the extra televisions produced is therefore the
bread. If the economy wanted even more televisions, it would have to
sacrifice the production of even more bread.

It is not necessary for a country to accept the given trade-off between

bread and televisions. There are actions that could be taken to move
the country to a higher production possibility curve, like in the
graph below, say from B to G. In doing so, the country will produce
more bread AND more televisions than before. The trade-off does not
disappear, so the choice between producing bread and televisions
remain. However, on the higher production possibility curve, more
bread and televisions will be available for every choice the country

47
makes. When the production possibility curve shifts outwards, there is
more production in the country so that it comes closer to solving the
scarcity problem.

Bread

A G
B

D
0
Televisions

A country could move to a higher production possibility curve if it

obtained more resources or if the quality of its resources increased. In
the figure the economy could move to point G if, for example workers
in the country gain better skills (quality of resources increases) or if
there is an improvement in technology (which affects both the quantity
and quality of resources).

Remember that we always have to add the condition of ceteris

paribus (everything else remains constant). The shift of the
production possibility curve will only occur if nothing else changes. Let
us say for example that workers gain better skills but the country is
also hit by severe floods which affects the economy negatively. In this
instance the production possibility curve might not shift outwards. It is
thus very important to always add the ceteris paribus assumption
when making conclusions from a specific model.

Task: State whether the following statements are true or false:

 A production possibilities curve (PPC) demonstrates combinations
of goods or services which can be produced when the
community’s resources are fully and efficiently employed.
___________________________________________________
 Any point on the PPC symbolizes an attainable combination of
goods and services.

48
 ___________________________________________________
 Any point outside the PPC curve symbolizes an impossible
combination of goods and services.
___________________________________________________
 Any movement from one point on a PPC to another point on the
curve involves opportunity cost.
___________________________________________________
 An increase in the available resources can be illustrated by a
rightward shift of the PPC.
___________________________________________________

49
Think for yourself:

Introducing the Desert Island Economy and Its Economic Problems

(This is a continuation of the desert island economy example as was
used in Learning Unit 1).

According to your calculations, this island can produce a maximum of

2000 coconuts per year if no vegetables are grown, and 10 tons of
vegetables if all the coconut trees are removed. Draw a production
possibility curve (PPC) for the island.

 No vegetables are currently grown on the island. Indicate where

the island would find itself on the PPC if production had to start
today.

 To grow vegetables some of the coconut trees will have to be

removed. Indicate this situation on the PPC.

 In one of the crates, you find a number of tools that can be used to
cultivate the land. This will increase the maximum production of
vegetables to 30 tons per year. Show how this will change the PPC.

Some islanders do not agree with you. They say that surely it should
be possible for the island to produce 30 tons of vegetables and 2000
coconuts at the same time. Explain to these islanders why they are
misguided.

Write your explanation here. Refer to concepts such as limited

resources, choice and opportunity cost.

50
Being stranded on a lost island was a blessing in disguise to you. Your
knowledge of economics is already helping the survivors secure a
prosperous future for, as long you remain stuck on the island. It may
be because of your newly found status, but you are also attracting the
attention of some of the best-looking members of the opposite sex.
This is going to be an interesting time indeed!

3.6 Economic systems that address economic problems

Historically the basic economic questions of what, how and for whom
to produce have been resolved in a variety of ways. The oldest, and
probably the most common way of resolving these issues have been to
act in accordance with tradition. By contrast, in much of the
industrialized world the market system now dominates. However,
central planning has played an important role in many countries. All
three mechanisms are to some extent found in most countries.
Generally societies everywhere have mixed economic systems
containing elements of markets, central planning and tradition.

Tradition
Tradition is probably the oldest and the most common behaviour
pattern both locally and within the family. Business enterprises solved
their production and distribution problems according to procedures
which flowed from a long and costly tradition of trial and error.
Successful procedures were fixed in legislation, custom and even
religion.

Modern economies are not devoid of traditional behaviour either. For

example in modern times the economic class in which one grows up
can significantly influence one’s eventual career choice. An
advantage of tradition is that it has undoubtedly brought a certain
amount of order to many communities, and still continues to do so
today. The biggest costs associated with tradition are the static
solutions it offers for the problems of production and distribution. The
result is that there is often little in traditional communities to
encourage economic development.

Central planning (Government intervention)

Economic problems can also be solved by means of central planning.
Central planning means solving the problems associated with the
production and distribution of goods by means of central authority, and
is usually accompanied by some form of state coercion. In modern
societies one comes across many instances where the authorities
interfere, for instance to develop disadvantaged communities or favour
51
exporters etc. In the former communist countries (like the Soviet
Union) entire economies were organised on the basis of central
planning.

Central planning often tends to increase the rate of economic

development more than would be the case with tradition. The
disadvantage of this system, especially when it is accompanied by a
dictatorship, is the fact that the members of society lack basic
freedoms and that economic power is often abused in the interest of a
few.

Market system
A third way in which the economic problem can be solved, and a
method which often may seem chaotic, is the market system. In the
market system the solution to the problem of production and
distribution arises spontaneously from the individual’s self-interest.
This means each individual will, by pursuing his own interests, actually
serve the community as a whole.

According to Adam Smith, the functioning of the market mechanism

implies that we cannot, for example, credit the goodwill of the baker
for lunch, but the baker’s own self-interest. This means that if many
bakers all pursue their own self-interest by supplying what consumers
need, and make a profit out of it, it will result in competition amongst
them. This characteristic ensures that the limited resources are
allocated efficiently and that the welfare thus created is properly
distributed.

It should be noted that every market is somewhat unique, but that

they all share certain characteristics. Markets consist of buyers who
demand goods and services and sellers, who make goods and services
available. Market prices are therefore determined by demand and
supply.

Prices freely determined by demand and supply, act as the regulator

in the market mechanism. Prices assign a value to relative scarcity as
well as to the opportunity costs of alternative needs. In a competitive
situation anyone who charges too high a price, will be undercut by
another, so that he will be unable to sell his product. This will act as a
signal to lower the price. By contrast, when a price is set too low,
demand will increase and so will the price. Hence, it is as if there is an
“invisible hand” which harmonises the self-interest of the individual
and prevents the chaos that one would expect.

It is apparent that personal freedom is essential for markets to

operate. A market system can only function within a community where

52
personal freedom is highly valued but where the freedom is also
exercised in a responsible manner in other words where freedom is not
exercised at the expense of another individual.

It is important to note that markets do not necessarily satisfy all the

needs of the economy. The existence of a government could be seen
as a rational response to the fact that the market system cannot
perform all the functions of the economy.

The origin and development of the market

In traditional or primitive markets barter was the predominant method
of trading. In barter, sellers and buyers meet to exchange goods or
services. Buyers are thus also sellers, and vice versa. In barter trade,
goods are exchanged at pre-determined ratios, depending on the value
placed on commodities and the extent of competition. It is important
to keep in mind that in early barter trade all surpluses traded in this
fashion were purely coincidental (there was no deliberate surplus
production).

With the passage of time markets started to play an increasingly

important role in economies, to the point where today markets, as a
social institution dominate Western economies. Whilst only
coincidental surpluses existed on the primitive markets, and these
were removed from the market by means of barter, deliberate
production for the market now takes place with money acting as a
means of exchange, thus making the functioning of markets much
more efficient than under a barter regime.

Whilst the modern markets function according to the same principles

of demand and supply as the traditional markets, their form and scope
have changed significantly. On the one hand, technological
advances have made it unnecessary for buyers and sellers to
physically share the same space to exchange goods, services or
economic information. Indeed, some markets, like the international
currency markets, have begun to take on a very abstract form. On
the other, modern markets are characterised by their specialised
nature, and the large degree of technical knowledge that is required
to participate in them.

Think for yourself:

Desert island economy continued:

You have been able to instil some sanity on the island. Due to your
efforts, everyone now understands that they have to be careful how
they utilise the resources they have available. They understand that

53
their resources are limited, while their needs and wants are unlimited.
It is therefore necessary for them to choose the most important needs
and wants to satisfy. This means they will also have to make choices
about how to use their resources and how to distribute the production
of the island. Whenever a choice is made other opportunities are
sacrificed, and the best choice is thus the one that requires you to
sacrifice the least (opportunity cost). Every choice therefore has a cost
of sacrifice - as the economists like to say: “TANSTAAFL” or “There
Ain’t No Such Thing as a Free Lunch”.

Now that the islanders understand these basic principles, the time has
come to organise the economy of the island. The better it is organised,
the easier it will be to make the right choices. At the first Island
Economic Forum, those present suggest three alternative economic
systems:

 Let everyone do the same work they did before they were stranded
on the island. You name this the Traditional System;
 Let everyone decide for him or herself what work they want to do on
the island. You name this system the Free Market System;
 Appoint one person (such as yourself) to decide what the island
needs and what work every person has to do. You name this the
Command System.

Since you are the person with the economic knowledge, the islanders
have appointed you to investigate the three systems. You are required
to report back at the next Forum and make a recommendation as to
which system you believe will generate the greatest prosperity for the
island. In your presentation, you have to discuss what you believe to
be the greatest benefits and problems of every system. You have to
give clear reasons for your choice of system, and suggest how some of
the system’s inherent problems can be overcome. Of course, you are
very tempted to recommend the Command System as it will give you
even greater power and status, but you decide to tackle the decision
objectively.

Prepare five sheets for your presentation:

 Why an economic system is important for this island
 Critical view of the Traditional System on this island
 Critical view of the Free Market System on this island
 Critical view of the Command System on this island
 Final recommendation with reasons

The islanders voted on your recommendations, and decided to adopt a

mixed system. The doctors and teachers will continue to do the work
they did before. Other people may decide for themselves how they are

54
going to contribute to the island’s prosperity, while you are formally
appointed as the island’s Chief of Prosperity. You will oversee the
management of the island’s economy.

55
3.7 Questions

a) State whether the following statements are true or false:

i. The purpose of an economic system is to solve the three central
economic problems.
ii. Economic systems are based on any or a combination of three
mechanisms: tradition, central planning and free market.
iii. Many countries have switched to a central planning system in
recent years.
iv. For a market to exist there must be physical contact between
buyers and sellers.
v. Most economic systems are mixed systems, rather than pure
tradition, central planning or market systems.
vi. South Africa has a pure central planning system.

b) Can the PPC move outward? If so give two situations in which it can
happen.

c) Suppose that most of the resources of Kuwait are well suited to the
production of oil and not at all well suited to the production of
vegetables. How would this situation be represented on a PPC?

d) Improve your understanding by writing your own definitions in the

space provided:
Allocation

Production

Distribution

Production
possibilities curve

Tradition

Central planning

Market system

Relative prices

Price regulator

56
e) Draw a production possibility curve for: SLEEP on the x-axis
(horizontal) and STUDYING on the y-axis (vertical). Use this diagram
to explain opportunity cost and how different choices will influence
your studying patterns and exam results.

f) Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
i. Who was this person and what role did he play in economics?
ii. What do you think was his most valuable contribution to
economics?

57
 Learning unit 3.2

Learning unit topic

Economic problems and how they may be solved

Circular flow of income and expenditure as an illustration of market-

oriented system
 Economic subjects as participants in the circular flow
 Circular flow with consumers and producers
 Circular flow with financial intermediaries
 Circular flow with the government sector
 Circular flow with a foreign sector
Microeconomic demand
 Definition of demand and the law of demand
 Factors that influence demand
 Change in demand
 Change in quantity demanded

3.8 Study Objectives:

After this section you should be able to:
 Distinguish between the different role-players (economic
subjects) in the circular flow of income and expenditure.
 Know how the different subjects interact with each other in terms
of various circular flows.
 Know what demand is and explain the law of demand.
 Derive an equation for the demand function.
 Draw and interpret a demand curve.
 Know what the difference is between a change in quantity
demanded and a change in demand.
 Know the different factors that influence demand.

3.9 Introduction

58
Modern economies are very complicated in nature and the interaction
between allocation, production and distribution is sometimes very
confusing. Therefore a simplified model of the economy will be used to
explain the reasoning behind the market system. Thereafter supply
and demand will be used to illustrate the operation of the price
mechanism.

3.10 Economic Subjects

In a market-oriented economic system, like we have in South Africa,

buyers and sellers remain the major players in the markets. However,
buyers and sellers appear in different “disguises”. Although
households and business enterprises, respectively, are the major
consumers and producers, the government, foreign sector and
financial intermediaries also play an important role in the various
markets. They are jointly known as economic subjects. Economic
subjects are the decision-makers and the main role players in the
economy. They will form part our simplified model of the economy.

Households
Households normally consist of groups or families of persons who are
dependent on a joint income. A household can also consist of a single
person. Labour is the major asset of most households. Factor services
are made available by households to business enterprises or the
government in exchange for income.

Business Enterprises
Business enterprises are formally the producers of final goods and
services. Their aim is to employ capital and other resources in such a
way that profits are maximised. This is in effect done by producing
and selling goods and services in agreement with consumer
preferences, and by using the best available techniques of production.
Firms use their sales revenues to pay for the resources that
households provide.

Government Sector
The government sector of an economy consists of all the legislative
and executive bodies brought about by the political process, and
includes government departments (like the department of finance) and
government business enterprises (like ESKOM which is state-owned).
Government directly provides some goods and services and indirectly
influences the allocation of resources and the distribution of income,
and the production and consumption of goods, through its ability to
spend, levy taxes and borrow.

Foreign Sector

59
The foreign sector consists in principle of all foreign residents doing
business with South Africans. The transactions between South Africans
and foreign residents in goods and services are known as foreign
trade, whilst financial transactions are recorded as capital movements.
Foreign trade is motivated by expectations of gain for trading partners,
and consists of both exports and imports of goods and services.

Financial Intermediaries
Financial intermediaries are essentially the “storeroom” of the nation’s
savings and money supply. Although there are a variety of types of
institutions in the financial sector, each specialising in satisfying its
clients’ needs, one of their overall functions is to act as intermediary
between surplus units and the deficit units of the economy, thus
mobilising savings in the economy effectively. The financial
institutions are broadly divided into the Monetary Authorities (South
African Reserve Bank), banks, insurers, pension funds and other non-
banking financial institutions.

3.11 Circular Flow of Expenditure and Income

In a market-oriented system goods or services and payments flow

between the different parts of the economy. Goods or services flow
from the producers to the consumers, while labour and other factor
services in turn flow from their owners to the producers, while
expenditures and incomes flow in the opposite direction. Each flow
goes through either a goods market, where goods and services are
traded, or through a factor market, where factor services are made
available to the producers in return for income in the form of wages,
interest or rent.

60
Circular flow with consumers and producers

Goods
market

Business
Households Enterprises

Factor
Market

From the figure it can be seen that households who, in a market-

orientated economy are the major owners of the factors of production,
offer their resources on the factor market for compensation. Business
enterprises use the production factors to manufacture goods and
services designed to satisfy the households’ needs. The real flow of
factor goods and services are shown by the inside dashed line. The
reverse monetary flows are shown by the solid lines on the outside.

The households receive compensation from the business enterprises

for the use of the production factors in the production process.
Remember the households receive wages for their labour, earn interest
on their capital and are paid rent for their natural resources, while if
there are any profits it is due to the entrepreneur. The households in
turn use their factor incomes that they receive to pay for the goods
and services that they require in order to satisfy their needs.

This simplified model of the economy is in equilibrium because all the

factor incomes received by the households are spent on goods and
services in the final goods market. The result is a continuous circular
flow of real income earned in the factor market, balanced by equal real
spending in the goods market.

The big question now is how does this system solve the main economic
problems experienced by the economy?

61
  Allocation – what should be produced?
Resolved by the mark mechanism – producers will allocate
production factors to the production of those goods and services
demanded by the households, with the greatest profit potential,
as represented in the market price of the final goods and
services.
 Production – how should it be produced?
The production process is also solved by the market mechanism
because the market will not tolerate inefficiency. The prices of
the production factors and the techniques available to produce
will dictate what input combinations will be used. Input
combinations may be capital or labour intensive depending on
the input costs.
 Distribution – for whom to produce?
The market mechanism solves the distribution problem as well
by giving the owners of the production factors a competitive
reward for their participation in the production process. The
above figure shows how rent, profit, interest and wages flow
back to the households, who are the owners of the various
production factors.

Task: Explain the role of households and business enterprises in the

economic cycle.

Circular flow with financial intermediaries

The simplified model used above will now be extended to make it a bit
more realistic regarding the real world. The concepts of saving and
investment will be included to accommodate for the role that financial
intermediaries play in the economy.

62
 Goods
market

Business
Households S Financial Intermediaries I Enterprises

Factor
Market

Households do not necessarily spend all the income they receive,

because a portion of their income may be saved. Savings represent a
leakage from the circular flow of income and expenditure. So instead
of all income being used to purchase goods and services a portion
might be kept in the form of savings, which is not only a leakage, but
actually give the households the ability at any point in the future to
enter the market again and purchase goods and services. Thus
expenditure is injected again in system. Savings thus presents a real
potential for disequilibrium in the circular flow.

Financial intermediaries exist to mobilise and make available the

surplus funds to members of the community, who are experiencing a
shortage, whilst the saving earns interest, the borrowers pay interest
for the use of the funds. Since business enterprises do not necessarily
have sufficient own funds at their disposal to fulfil all their investment
needs, they borrow the savings of households through the medium of
financial intermediaries.

Investment spending represents an injection into the circular flow

because it does not originate in the budgets of households.
Investment represents the acquisition of capital equipment like plant,
machinery and equipment whereby the production potential of a
business enterprise can be expanded. As long as the savings leakage
is of the same quantity as the expenditure (investment) injection, the
circular flow remains in equilibrium. The success of the market system
is affected by the efficiency with which the financial institutions
channel savings into investment.

63
Task: Explain the role of financial intermediaries in the economic
cycle.

Circular flow with government sector

Goods
market

S Financial Intermediaries I Business

Households
Enterprises

Factor
Market

Government
Sector

The government is an economic decision-maker which actively

participates in all the markets. The government employs labour and
other factors and produces, purchases and supplies goods and services
of all kinds. It is also an active borrower and lender of funds.

When government purchases factor services or final goods and

services, it is mostly in respect of its obligation to provide collective
goods (like national defence), mixed goods (like education) and
influences the redistribution of income or wealth (like health and social
welfare). The government is a substantial spender at local, provincial
and national level. This spending represents an injection into the
income stream. The government also makes transfers to households
and business, in the form of pensions, other income support, interest
on public debt and subsidies. Since such payments are income

64
transfers, without any direct quid pro quo in return, they are in the
nature of negative taxes, and in the circular flow are deducted from
tax revenues.

Taxation is the governments’ most important source of revenue, which

enables the government to provide collective goods etc. to the
community. The direct taxes which the government levies on the
income of individuals and on the profits of companies, and the indirect
taxes (like VAT) which are levied on transactions, are therefore
leakages from the circular flow.

Government also borrows to finance budget deficits. Thus government

also absorbs some of the savings of the community during the year,
when they run budget deficits. If this is the case, the government
must borrow either directly or through the financial system.

The market mechanism does not automatically equate government

spending (injection) and revenues (leakage). This creates the potential
for government to destabilise the circular flow. It also creates an
opportunity for government to use its budget to off-set disequilibria
originating elsewhere.

Task: Explain the role of the government in the economic cycle.

Circular flow with a foreign sector

The foreign sector is the fourth major group of economic subjects in

the circular flow requiring separate treatment. Goods purchased by
South Africans are not necessarily manufactured here and South
African goods are also exported to other countries. There are also
substantial capital flows across South Africa’s borders.

When a portion of domestically generated income is used to buy

imported goods and services, such spending represents a leakage from
the domestic circular flow, like savings and taxes. The export of
domestic goods is an additional source of income to local business
enterprises and is thus seen as an injection into the circular flow.

When imports equal exports, the country runs a balanced foreign trade
situation. When imports (goods are imported and money thus flow out
of the country) exceed exports (goods are exported and money thus
flow into the country) there is a trade deficit. Then obviously when
exports exceed imports there is a trade surplus. The market system
does not contain a mechanism to automatically equate imports and
exports, thus requiring government intervention.

65
The foreign sector is also linked to the factor and financial markets.
The link with factor markets exists on account of the cross-border
movement of production factors, especially labour, entrepreneurship
and technology. The link with financial markets is because
government and private enterprises are usually substantial borrowers
from abroad, in order to finance deficits in its budget or local
investment spending.

Foreign
Sector

Goods
market

Business
Households S Financial Intermediaries I Enterprises

Factor
Market

Government
Sector

Task: Explain the role of the foreign sector in the economic cycle.

66
3.12 Demand

The theory of demand and supply will be simplified by limiting price

determination to only one product under competitive conditions.
Competitive conditions refer to a situation where there are many
buyers and sellers and no single seller can set the price in the market.

Demand can be defined as the quantities of a specific product that will

be demanded at various prices, during a specific time period, ceteris
paribus. The demand for a particular product is based on the law of
demand. The law of demand states that there is a negative relationship
between the price of a good and the quantity demanded. An increase
in price will therefore result in a decrease in the quantity demanded
and vice versa.

Think for yourself: Does the law of demand make economic sense?
Explain.

The demand for a specific product is also influenced by a number of

other variables, such as the income of consumers, the prices of other
products and consumer tastes and preferences. We can even
represent it as an economic model:

QD = f (PX, I, PR, T)

In words the above model reads as follows: The quantity demanded of

a product is a function of (it depends on) the price of the specific
product (PX), the income of the consumer (I), the price of related goods
(PR) and the tastes and preferences of consumers (T). Q D is thus the
dependent variable while the independent variables consist of P X, I, PR
and T.

We will however make use of the ceteris paribus assumption in the

sense that all other variables are assumed constant except the price of
the product itself. This enables us to derive a demand curve for a
specific product, with the price of the specific product serving as the
only independent variable, thus QD = f (PX).

Let us consider the following table which contains an assumed price

and quantity demand structure for a product Z.

67
 Price of product Quantity demanded
0 8.5
50 6
100 3.5
130 2
170 0

The corresponding graph will thus look as follows:

P

170

130

100

50

0 2 3.5 6 8.5 Q

The algebraic equation of a straight-line demand curve is represented

by Y = a – bX, where Y is the price variable, a the price intercept, b the
slope (why is it negative?) and X the quantity demanded. The specific
demand equation for product Z can thus be represented by:

P = 170 – 20Q

The slope of the curve is the change in the price (the vertical distance),
divided by the change in the quantity demanded (the horizontal
distance).

ΔP 130−100 30
= = =−20
ΔQ 2−3.5 −1.5
(Remember you can use any two points on the demand curve to work
out the slope)

68
Task: Consider the following table and answer the questions that
follow:
Price of Wilson Quantity
toffees in cents demanded
10 600
20 380
30 220
40 130
50 50
 Draw a graph of the demand curve.
 Derive an equation for the demand of Wilson toffees.

Change in the quantity demanded vs. a change in demand

It is very important to distinguish between a change in the quantity

demanded of a product and a change in demand. A change in quantity
demanded refers to the effect of a change in price. If the price of a
product changes there will only be a movement along the same
demand curve, ceteris paribus. The demand curve itself will not move.
It is only the quantity demanded that will move (like in the figure below
from point A to B).

By contrast, a change in demand refers to a situation where the

demand curve itself will shift. The other factors that influence the
demand curve (income of consumers, prices of related products,
consumer preferences and tastes) can all cause the whole demand
curve to shift. How they individually affect the demand curve will be
discussed shortly.

P
Movement along the demand
A curve

0 Q

Task: Make a list of variables that play a role in the quantity of a

product that is purchased.

Factors that cause the demand curve to move:

69
  A change in the income of consumers
In the case of a normal good, an increase in income will result in
a shift of the demand curve to the right. By contrast, if the
income of the consumers increases and the total demand at
every price level decreases as a result thereof, such a product is
referred to as an inferior good. So in the case of an inferior
good, an increase in the income of the consumers will thus
result in a leftward shift of the demand curve. We can thus say
that the effect of a change in income will be positive for normal
products and negative for inferior products.

P
An increase in the income of
consumers – normal product
situation

D2
D1
0 Q

Task: Draw the figure for an increase in the income of consumers for
the inferior product situation.

 Related products – Substitute products

Substitute products are products that can be used in the place
of, or as substitute for the other product like butter and
margarine. A change in the price of one substitute product will
have an impact on the sales of the other product. If the price of
butter increases, the quantity demanded of butter will, ceteris
paribus decrease and the demand for margarine (the substitute
product) will increase at every price level. This means the
demand curve of margarine will shift to the right.

70
 P
Rama Margarine

D
0 Q

P
Flora Margarine

D2
D1
0 Q

The relationship between substitute products is thus positive. If

the price of Rama Margarine increases, the demand for Flora
margarine increases.

Task: What will happen if the price of butter decreases? Draw

the relevant graphs to illustrate.

 Related products – Complementary products

Complementary products are products that are used jointly to
satisfy a particular need. An example is DVD’s and DVD-players.
The one product cannot normally be used without the other
product – you cannot play a DVD without a DVD-player. Assume
that the price of DVD-players increases. The first effect will be a
decrease in the quantity demanded of DVD-players (because it
is more expensive). When less DVD-players are sold it implies
that fewer DVD’s will be sold. The second effect is thus a
decrease in the demand for DVD’s at every price level. The
demand curve of DVD’s will thus move to the left. The inverse is
also true.

71
 P
DVD-players

D
0 Q

P
DVD disk’s

D1
D1
D2
0 Q

Task: What will happen if the price of DVD-players decreases?

Draw the relevant graphs to illustrate.

 A change in consumer preferences and tastes

In certain product lines consumer preferences is an important
variable that might have an important impact on the demand of
a product. The clothing industry is a good example. Changes in
consumer tastes will have an impact on the fashion ranges that
a clothing firm might choose. If consumer tastes and
preferences turn positive towards a certain fashion line the
effect will be a parallel rightward shift of the demand curve at
every price level and vice versa.

P
Positive change in consumer
preferences and tastes

D2
D1
0 Q

72
Task: Can you distinguish when the position of the demand curve will
change (i.e. the whole curve moves), and when there will only be a
movement on the existing curve?

3.13 Questions

a. Improve your understanding by writing your own definitions in

the space provided:
Economic subjects

Households

Business
Enterprises
Government

Financial
Intermediaries
Investment

Savings

Collective goods

Imports

Exports

Foreign sector

Demand

Law of demand

Complementary
products
Substitute
products
Normal goods

Inferior goods

b. State whether each of the following statements are true or false:

73
 a) The two basic sets of participants in any economy are
households and business enterprises.
b) There are two sets of markets in the economy, the goods
market and the factor market.
c) The major flows associated with the government are
government spending and taxes.
d) Business enterprises purchase in the factor markets and sell
in the goods markets, while households sell in the factor
markets and purchase in the goods market.
e) An open economy is an economy in which there is no
government intervention.
f) The foreign sector is linked to the domestic flow of income
and spending through imports and exports.
g) Exports are leakages from the circular flow while imports are
an injection.
h) Taxes and savings are leakages from the circular flow while
government spending and investment are injections.
i) The demand for a product refers to the quantities of the
product that potential buyers are willing and able to buy.
j) The quantity demanded of a product depends on a range of
factors, including the price of the product, the price of related
products and the income of households.
k) A change in the price of cucumbers will result in a change in
the demand for cucumbers, that is, the demand curve will
shift.
l) The demand curve for product Y will shift if there is a change
in the price of a substitute, product Z.
m) An increase in the income of households is one of the possible
causes of a rightward shift of a demand curve.
n) A leftward shift of a demand curve indicates that a smaller
quantity of the product is demanded at each price.
o) If butter and margarine are substitutes, a decrease in the
price of butter will result in a leftward shift of the demand
curve for margarine.
c. Use a diagram to explain how a change in income can change
the market demand for a normal product and an inferior product.

d. Use diagrams to explain how an increase in the price of tennis

balls will affect the demand for tennis racquets.

e. List the main features of the 2007 Budget for South Africa.
f. How do you think the budget will influence you in the coming
year?

74
 Learning unit 3.3

Learning unit topic

Economic problems and how they may be solved

Microeconomic supply and equilibrium in the market to illustrate the

market mechanism
 Definition of supply and the law of supply
 Change in supply
 Change in quantity supplied
 Equilibrium in the market
 Simultaneous shifts of demand and supply curves
 Maximum and minimum prices

3.14 Study Objectives

After this section you should be able to:
 Know what supply is and explain the law of supply.
 Derive an equation for the supply curve.
 Draw and interpret a supply curve.
 Know what the difference is between a change in quantity
supplied and a change in supply.
 Know the different factors that influence supply.
 Understand when equilibrium will be established in the market.
 Know what will happen when we have simultaneous shifts of the
demand and supply curves.
 Define and understand the concepts of maximum and minimum
prices.

3.15 Supply

The market supply of a product can be defined as the quantities of the

product that will be supplied at various prices, during a certain time
period, ceteris paribus.

The supply of a particular product is based on the law of supply, which

states that there is a positive relationship between the price of a

75
product and the quantity supplied. An increase in price will thus,
ceteris paribus, lead to an increase in the quantity supplied and vice
versa.

Task: Do you think the law of supply makes economic sense? Explain.

The supply of a particular product is, however, influenced by various

other variables, such as the prices of inputs and the level of
technology. A comprehensive supply function can thus be stated as:

Qs = f (PX, Pf, Ty)

In this supply equation the dependent variable is Q s and the

independent variables are PX = price of the product, P f = price of inputs
and Ty = level of technology. We will first employ the ceteris paribus
(except for the price of the product) assumption to analyse the supply
function. Given this assumption, the quantity supplied is thus only a
function of the price of the product and the supply function may thus
be stated as Qs = f (PX).

Let us consider the following table which contains an assumed price

and quantity supply structure for product Z.

Price of product Quantity supplied

10 0
50 5
90 10
130 15

The corresponding graph will thus look as follows:

P S

130

90

50
10
0 5 10 15 Q

The algebraic equation of a straight-line supply curve is represented by

Y = a + bX, where Y is the price variable, a the price intercept, b the

76
slope (why is it positive?) and X the quantity supplied. The specific
supply equation for product Z can thus be represented by:

P = 10 + 8Q

The slope of the curve is calculated exactly in the same way as the
demand curve’s slope.

Task: Consider the following table and answer the questions that
follow:

Price of Wilson Quantity

toffees in cents supplied
10 100
20 190
30 220
40 380
50 560
 Draw a graph of the demand curve.
 Derive an equation for the supply of Wilson toffees.

Change in the quantity supplied vs. a change in supply

As before with the case of demand, it is important to distinguish

between a change in supply and a change in quantity supplied. A
change in the quantity supplied refers to the effect of a change in
price. If the price of the product changes, there will, ceteris paribus,
only be a movement along the given supply curve, so the supply curve
itself will not move. It is only the quantity supplied that will change as
shown in the figure below:

P S

130

90

0 10 15 Q

77
If any other variables changes while the price of the product remains
unchanged, the supply curve itself will shift. An improvement in the
level of technology will, for example, result in a rightward shift of the
supply curve at every price level. Deterioration in the productivity of
the labour force will result in a decrease in supply, resulting in a
leftward shift of the supply curve at every price level. An increase in
the prices of the factors of production will result in a decrease of
supply, and a leftward shift of the supply curve.

Task: Make a list of possible variables that play a role in the quantity of
a product that is supplied.

P S
S1 Improvement in the
level of technology
will result in a
rightward shift of the
supply curve.

0 Q

Task: Illustrate the following situations on a supply graph/s.

 Decrease in the productivity.
 Increase in input costs.

Task: Can you distinguish when the position of the supply curve will
change (i.e. the whole curve moves), and when there will only be a
movement on the existing curve?

3.16 Equilibrium in the market

Equilibrium will be established in a competitive market where total

market demand equals total market supply. The equilibrium is
dynamic, in the sense that market forces will tend to push price and
quantity to this equilibrium condition. In the following figure
equilibrium is attained where PE and QE intersects.

78
 P
Excess
Supply S

P
a b
H
Equilibrium!
PE

c d
PL
D
Excess
Demand
0 Q Q
E

If the market price is higher than the equilibrium price, for one or other
reason, a situation of excess supply will exist. At price P H, the excess
supply will equal ab. Market forces will push the price down to P E. The
reason is that sellers will have to lower their price in order to motivate
consumers to purchase more of the product.

If the market price is lower than the equilibrium price, for one or other
reason, a situation of excess demand will exist. At price P L the excess
demand will equal cd. Market forces will, however, exert upward
pressure on the price until it reaches P E. The reason is that sellers will
only be motivated to supply more if the price increases, and
unsatisfied buyers will be willing to pay a higher price in order to
obtain part of the limited supply.

Task: Consider the following table and answer the questions that
follow:
Price Quantity Quantity
demanded supplied
10 600 100
20 380 190
30 220 220
40 130 380
50 50 560
 Illustrate the demand and supply curves on a graph.
 What is the equilibrium price?
 What is the equilibrium quantity?

79
  What will happen in the market if the price is above the
equilibrium price?
 What will happen in the market if the price is below the
equilibrium price?

3.17 Simultaneous shifts of the demand and supply curves

When analysing the effect on prices and quantities of simultaneous

changes in demand and supply, two basic rules should be kept in mind:

 Rule 1: An increase in demand will, ceteris paribus, result in an

increase in the equilibrium price and quantity. A decrease in
demand will, ceteris paribus, result in a decrease in the
equilibrium price and quantity.
P
S
Increase in demand
→ increase in price
and quantity

D1
D
0 Q

Task: Show that a decrease in demand will, ceteris paribus, result in a

decrease in the equilibrium price and quantity.

 Rule 2: An increase in supply will, ceteris paribus, result in a

decrease in the equilibrium price and an increase in the
equilibrium quantity. A decrease in supply will, ceteris paribus,
result in an increase in the equilibrium price and a decrease in
the equilibrium quantity.

P
S
S Increase in supply →
1 increase in quantity
and decrease in price

D
0 Q

80
Task: Show that a decrease in supply will, ceteris paribus, result in a
increase in the equilibrium price and decrease in the equilibrium
quantity.

However when both demand and supply change, the outcome is not
always obvious.

 Simultaneous increase in supply and demand

When both supply and demand increase, the equilibrium quantity
will increase, but the new equilibrium price cannot be
determined a priori. The increased supply will push down the
equilibrium price, but the increase in demand will push up
the price. If the increase in supply in relative terms is greater
than the increase in demand, the equilibrium price will decrease.
However, if the increase in demand in relative terms is greater
than the increase in supply, the equilibrium price will
increase. If the increases in relative terms are equal, the
equilibrium price will remain unchanged.

 Simultaneous decrease in supply and demand

When both supply and demand decrease, the equilibrium
quantity will decrease, but the new equilibrium price cannot be
determined a priori. The decreased supply will raise the
equilibrium price, while the decreased demand will lower the
price. If the decrease in supply in relative terms is stronger than
the decrease in demand, the new equilibrium price will be
higher. If the decrease in demand in relative terms is stronger
than that of supply, the new equilibrium price will be lower. If
the decreases in supply and demand are equal in relative terms,
the price will remain unchanged.

 Simultaneous decrease in supply and increase in demand

When supply decreases, but demand increases, the equilibrium
price will increase. However, the new equilibrium quantity
cannot be determined a priori. If the decrease in supply, in
relative terms, is stronger than the increase in demand, the
equilibrium quantity will be lower. However, if the increase in
demand is relatively stronger than the decrease in supply, the
new equilibrium quantity will be higher. If the changes in
demand and supply are relatively the same, the equilibrium
quantity will remain unchanged.

 Simultaneous increase in supply and decrease in demand

When supply increases but demand decreases, the equilibrium
price will decrease. However, the new equilibrium quantity
81
 cannot be determined a priori. If the increase in supply, in
relative terms, is greater than the decrease in demand, the new
equilibrium quantity will be greater. If the decrease in demand
in relative terms is greater than the increase in supply, the new
equilibrium quantity will be lower. When the relative changes
are the same, the equilibrium quantity will remain unchanged.

Task: Graphically show what will happen in the market in the following
circumstances:
 The country is plagued by various strikes that have an extensive
effect on the economy while, at the same time there is generally
a small decrease in income.
 For some or other reason Sony Play station is experiencing a
dramatic decline in productivity in their factories. At the same
time they decided to have a small sale on their Play station
games.

3.18 Maximum and minimum prices

Governments often intervene in the market mechanism even though

prices are regarded as important indicators of relative scarcity. The
aim of such intervention is usually to protect either consumers or
producers against possible negative effects of the market.

A maximum price might be set by government with the ultimate aim of

protecting consumers. The maximum price must be set lower than the
market equilibrium price in order to be effective, like illustrated in the
figure below:

E
PE

f g
PMa
x D

0 Q

The effect of the maximum price in a market is the creation of excess

demand (fg). Some consumers would be willing to pay a higher price

82
for the product than others. The result would be more informal market
transactions, where some consumers might pay the higher prices.
Sellers in the formal market would not have the privilege of higher
prices.

A minimum price might be set with the aim of protecting producers.

The minimum price would be higher than the market equilibrium price
in order to be effective, like illustrated in the graph below:

PMin
h i
PE E

0 Q

The effect of the minimum price is the creation of excess supply (hi).
The result is usually wastage. Producers would not normally like to see
that surpluses find their way into the informal sector. Excess crops
resulting from minimum prices are thus frequently destroyed, in an
effort to eliminate or reduce informal transactions.

Task:
 Explain, with the aid of a diagram, what will happen in a market
if government imposes a maximum price below the equilibrium
price. Can a black market develop in such a case? Explain.
 Explain with the aid of a diagram, what will happen in a market if
government fixes a minimum price above the equilibrium price.

3.19 Questions

a. Improve your understanding by writing your own definitions in the

space provided:
Supply

Equilibrium price

83
Equilibrium
quantity
Excess demand

Excess supply

A priori

Maximum prices

Minimum prices

b. State whether the following statements are true or false:

i. Supply refers to the quantities of a good or service that
producers plan to sell at different prices.
ii. An increase in the price of potatoes will result in an increase in
the supply of potatoes.
iii. An upward movement along a supply curve is called an increase
in supply.
iv. A fall in the price of milk used in the production of ice cream will
cause an increase in the supply of ice cream (rightward shift of
the supply curve).
v. The equilibrium price is the price at which both buyers and
sellers are willing to do business for a given quantity.
vi. A market can only be in equilibrium if the quantity demanded is
equal to the quantity supplied.
[Link] any price above the equilibrium price there will be an excess
demand for the good in question.
viii. Excess demand for a good will put downward pressure on
the price of the good.

c. Use a diagram (or diagrams) to explain what will happen to the

equilibrium price and equilibrium quantity of a normal product if
demand and supply increase simultaneously.

d. Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
i. Who was this person and what role did he play in economics?
ii. What do you think was his most valuable contribution to
economics?

84
 Learning unit 4.1

Learning unit topic

Microeconomic Aspects

Consumer behaviour and utility maximization

 Utility
 Total Utility
 Marginal Utility
 Law of diminishing marginal utility
 Consumer equilibrium

Study Objectives
After this section you should be able to:
 Explain and understand the concept of utility.
 Explain and understand what is meant with total utility.
 Calculate total utility by means of an example.
 Explain and understand what is meant with marginal utility.
 Calculate marginal utility by means of an example.
 Understand what is meant with the law of diminishing marginal
utility and discuss it.
 Know when consumer equilibrium is attained in the market.

4.1 Introduction

Seeing that economics is a social science, economists are often

interested in consumer behaviour and how it influences demand
curves. They generally want to find out why the consumer or
individual household decide to increase their consumption of meat
when their income increases, for example. This component of
economics is known as utility theory.

85
4.2 Utility

Utility is defined as the satisfaction that a person gets from the

consumption of goods and services. As a customer you will buy a
specific product because you feel it gives you satisfaction or utility.
The more you buy of a specific product the more total utility you will
receive from that specific product. Utility has nothing to do with the
usefulness of a specific product; if it provides satisfaction to a
particular individual then that individual can attach a certain level of
utility to it. A consumer can for example get utility from an object
even though the use of it may be considered as useless or even
detrimental (tobacco provides utility for smokers, but not for non-
smokers).

The theory of utility is explained by assuming that utility is

measurable. Utility is thus a number which is expressed in “utils”
which indicate the level of satisfaction that the consumer obtains from
the consumption of a specific product. In reality a consumer can
compare the utility he gets from different goods and services and
decide from which product or service he is going to get the most utility.

The first unit of a product that is consumed will give you a certain
amount of utility. If you consume a second unit your total utility will go
up because it gives you some additional or extra utility. What do you
think will happen in terms of utility if you consume a third and a fourth
unit?

Task: Explain utility in your own words.

4.3 Total Utility & Marginal Utility

Total utility refers to the total satisfaction that is obtained from the
consumption of a product. Marginal utility can be defined as the extra
satisfaction that is obtained due to a one unit increase in the quantity
of the product consumed.

Total utility and marginal utility will be better understood with the help
of an example: Charles has a very sweet tooth and has a craving for
chocolates. He decides to have a few Bar-one bite-size bars. Even
after the very first bite Charles may not yet be fully satisfied but he is
one bite closer to being so and thus he “needs” a chocolate less than
he did so before his first bite. After the fourth bar, he has satisfied his
sugar craving and is no longer really in the mood for chocolates. We
can thus rank Charles’ utility with the first bar adding more satisfaction
to his total utility than the second, the second adding less than the
third and so on. The point must therefore be reached where eventually
86
an additional chocolate will add no more satisfaction to the total where
at this point Charles is fully satisfied and does not want another
chocolate. Should Charles continue to consume beyond this point he
will actually feel worse than he did, his marginal utility becomes
negative and his total utility begins to fall. The point at which Charles
reaches the highest total satisfaction is therefore when his marginal
utility is zero and no further utility is added to the total.

Number of Total Marginal

Chocolate Utility Utility
s
consumed
0 0 -
1 8 8 (8 – 0)
2 15 7 (15 – 8)
3 21 6 (21 – 15)
4 26 5 (26 – 21)
5 30 4 (30 – 26)
6 32 2 (32 – 30)
7 32 0 (32 – 32)
8 30 -2 (30 – 32)

The marginal utility in the last column is calculated by working out the
difference between the total utility obtained from the consumption of
chocolates at a certain quantity and the total utility can be calculated
by adding the marginal utilities together. Total utility is the sum of the
marginal utilities where marginal utility is the change in the total utility
that results from the consumption of one more chocolate.

From the above example we can see that total utility increases up to a
certain point and then it starts to decrease. We can thus assume that
as soon as a consumer (like Charles) has had enough of a product
(chocolates) the consumption of an additional unit no longer gives him
any utility. As soon as the extra utility (i.e. marginal utility) that the
consumer attains from the consumption of a product reaches zero, the
consumer will most likely say no to the product. We can thus also say
that total utility increases with every additional unit that is consumed
but the total utility does not increase in proportion to the quantity of
products. Total utility will reach a maximum when marginal utility
reaches zero.

Task: Explain in your own words what the difference between total and
marginal utility is.

87
4.4 The law of diminishing marginal utility

It is logical to assume that as a person consumes more and more of a

certain product that he will reach a satiation point. This will cause a
decrease in marginal utility. From the above table it can be seen that
marginal utility at first start rising, reaches a maximum and then starts
decreasing. Marginal utility can even become negative. This example
illustrates the law of diminishing marginal utility which states that:
 If a consumer consumes more and more of a certain product,
ceteris paribus, the marginal utility of that product will decrease.

Task: Complete the following table and answer the questions that
follow:
Cans of Total Marginal
Coke Utility Utility
consumed
0
1 60
2 110
3 152
4 32
5 208
6 16
7 236
8 8
9 248
10 2
11 250
12 -6
 At which unit does total utility reach a maximum?
 What is the corresponding marginal utility value?

4.5 Consumer Equilibrium

Consumer behaviour and consumer utility is based on the notion that

consumers act rationally. A rational consumer is someone who
optimally utilizes his/her budget. In other words it is someone who will
maximize his/her satisfaction (utility) given his/her income. The
consumer is restricted by his income, his own tastes and preferences
and the prices of substitutes and compliments.

88
According to theory there is an equation that represents the
attainment of maximum satisfaction from limited means, namely:

MU A MU B
=
PA PB
Where MUA represents the marginal utility of product A and MU B
represents the marginal utility of product B. P A signifies the price of
product A per unit and PB the prices of product B per unit. The
equation indicates that the consumer’s income must be spent in a way
that the marginal utility of products purchased (related to their prices)
must be equal, only then will consumers attain equilibrium. We can
MU A
also say that PA represents the marginal utility derived from the last
MU B
rand spent on product A and in the same way PB represents the
marginal utility derived from the last rand spent on product B.

4.6 Conclusion

The utility that a consumer attains from a product will determine how
much of that particular product the consumer will buy. When total
utility begins to decrease, a saturation point is reached and this will
also be the point where marginal utility is equal to zero and thereafter
it becomes negative (disutility). After that a particular product will
have no value anymore to the consumer. Consumer equilibrium is
reached when the consumer spends his income in such a way that the
marginal utility of each product purchased (in relation to its price) is
equal.

4.7 Questions

a. Improve your understanding by writing your own definitions in the

space provided:

Utility

Total Utility

Marginal Utility

Law of diminishing
marginal utility
Satiation point

89
Consumer
equilibrium

b. State whether the following statements are true or false:

i. Utility is the degree of satisfaction that a consumer obtains or is
expected to obtain from the consumption of products and/or
services.
ii. It is possible to compare the utility attained by two different
consumers from the consumption of a specific product.
iii. Marginal utility is the extra utility that a consumer obtains from
the consumption of one additional unit of a good.
iv. Consumer equilibrium is attained when marginal utility is at a
maximum.
v. Total utility is obtained by adding all marginal utilities.
vi. Consumer equilibrium is obtained when marginal utilities per
rand are equal for all goods which the consumer can afford to
purchase.
[Link] following series of total utilities is in agreement with the law
of diminishing marginal utility: 25, 40, 53, 65, 75, 83, 90, 95, 98,
100.

c. Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
iii. Who was this person and what role did he play in economics?
iv. What do you think was his most valuable contribution to
economics?

90
 Learning unit 4.2

Learning unit topic

Microeconomic Aspects

Producer Behaviour
 Producers
 Objectives & Constraints
 Production Function
 Costs
 Revenues
 Profits

4.8 Study Objectives

After this section you should be able to:

 Describe what is meant with producers;
 Explain what the main objective is of producers and describe the
type of constraints they face;
 Define a production function and its related concepts;
 Distinguish between different costs that producers face;
 Distinguish between different revenues that producers can
make;
 Distinguish between different profits that producers can make.

4.9 Introduction

This section deals with producers and their need satisfaction in the
economy. Their main aim is to maximise profits by keeping costs as
low as possible and by getting as high as possible revenues for their
products. There are, however a few limitations that influences
producers’ key objective.

4.10 What are producers?

A producer is an organization that buys or hires inputs and manages

them to produce goods, which are in turn sold as outputs. Their
inputs consist of production factors (natural resources, capital, labour
and entrepreneurship) as well as intermediary products like raw
materials which are used in the production of other goods. Outputs
can consist of a wide range of products and services. It is important to

91
distinguish between fixed and variable inputs. A fixed input is one in
respect of which the quantity cannot be changed in the short run and a
variable input is one in respect of which the quantity can change in
the short run.

Producers exist due to scarcity. They make it possible for consumers

to get more out of their scarce resources by facilitating production.
But each producer has to solve its own economic problems by
optimally controlling the scarce resources it has. Every producer has
to decide what products or services they want to produce specifically
and in what quantities. They also need to decide which inputs and
techniques they are going to use for production. Furthermore they
need to arrange their organisation in terms of management.

4.11 The Objectives and Constraints of Producers

The traditional as well as most common objective of producers is to

maximise profits, in other words they strive for the highest possible
profit that they can get. Profit maximization is a direct result of
scarcity. By making the best possible use of scarce resources goes
hand in hand with trying to maximize profits. There is however a few
constraints that can limit the amount of profit that a producer can
make.

The first group of limitations are known as market constraints.

Market constraints comprises of conditions that arise from the buying
of inputs and the selling of outputs. On the input side producers have
a limited amount of production factors that they own. If they want
more production factors they need to compete with other producers in
the market for it. As far as the output side goes, consumers have a
limited demand for goods and services (due to limited resources) and
they will only demand more of a specific product or service if they can
attain it at a lower price. Due to competition a producer has no other
choice but to sell at the same price as other producers.

Technological constraints are the second group of limitations on

profit maximization. Producers need to decide whether they are going
to employ a labour- or capital-intensive technique in their production
process. In order to maximise profits, producers need to choose a
production technique that is technologically efficient. A method is
technologically efficient when no more outputs can be produced
without using more inputs. It is not necessary to have the latest and
newest technology for a technique to be technological efficient. As
long as the technology that is owned is used optimally without waste,
the producer is producing in a technologically efficient way.

92
Think for yourself:
 Why do we need producers in the economy?
 What is the main objective of most producers?
 How do they normally attain this objective?
 What constraints do producers face?

4.12 The Production Function

The relationship between the amount of different inputs that is used to

produce a specific good or service and the amount of outputs produced
from these outputs is known as a production function. It takes for
example approximately 1 manager, 2 shop assistants, lots of the latest
DVDs out on the market, a computer system, a cash register, other
equipment and of course a shop to operate a Blockbusters DVD-shop.
When producing a service or product, the firm does not have to use all
the related inputs in fixed proportions. In most cases a firm can decide
whether to use more labour than capital for example. Inputs can thus
be used in varying proportions depending on the specific product or
service and the preference of producers.

Varying proportions play an important role when we have to

distinguish between the short run and the long run in economic terms.
The short run can be defined as the period in which some of a
producer’s inputs are fixed and cannot be changed. A producer can
therefore in the short run change the amount of its variable inputs like
labour but it cannot change the amount of fixed inputs like land. In the
short run if producers want to produce more (or less) they can adjust
their quantities of labour, raw materials and power (i.e. variable input)
on a fixed supply of land (i.e. the fixed input) The long run in contrast
can be defined as the period in which all the inputs are variable.

The production function can be represented by a table, a mathematical

equation and a graph. A typical production can be represented by the
following table:

93
No. of Total Marginal Average Cost of Cost of Total
workers Output Output Output Factory Workers Cost
0 0 - - 30 0 30
1 50 50 50 30 10 40
2 110 60 55 30 20 50
3 160 50 53.33 30 30 60
4 200 40 50 30 40 70
5 230 30 46 30 50 80
6 250 20 41.67 30 60 90
7 260 10 37.14 30 70 100
8 260 0 32.5 30 80 110
9 250 -10 27.78 30 90 120

Suppose that producer “ABC-Cookies” produces chocolate-chip cookies

and the above mentioned table represents the amount of cookies they
produce per hour (total output). Obviously if there are no workers
whatsoever in the factory they will produce zero cookies in total. If only
one worker is present in the factory they produce 50 cookies in total
per hour and so on. If we graphically represent this data the figure will
look as follows (please note that this represent a general production
function):

Cookies per hour

(Physical output)

Production
function

Number of
workers

The shape of the production function is extremely important. The

curve slopes upward at first at an increasing rate, then at a decreasing
rate, reaches a maximum and thereafter decreases.
The third column of the table represents the marginal output (or
marginal product). Marginal output can be defined as the addition to

94
total output due to an increase of one unit of the variable input (labour
in the cookie example) to the production process. For example when
the amount of workers increases from 1 worker to 2 workers, total
output increases from 50 to 110 yielding a marginal (additional) output
of 60 cookies.

Total output and marginal output plays a very important role in the
determination of how many workers to hire as well as how much
output to produce. Note that as the number of workers increases, the
marginal output (or marginal product) first increases and thereafter
decreases. This characteristic is known as diminishing marginal
product. At first the amount of workers work optimally in the kitchen
of ABC-cookies but as the amount of workers increase, some of the
workers now have to share equipment and work in more crowded
conditions. As the amount of workers increase, each additional worker
contributes less to the production process of cookies. The slope of the
production function represents the process of diminishing marginal
product. That is, as the number of workers increases, the marginal
product first increases, reaches a maximum at 60 and then declines
(where the production function becomes flatter). Please note that we
make the assumption of ceteris paribus when we interpret the law of
diminishing marginal product, factors like technology for example is
assumed to remain unchanged.

The concept of average output is also a very important in the

analysis of microeconomics. The average output of production is the
total output divided by the quantity of the variable input, which is used
to produce the output. Average output is represented by the 4 th
column in the table above. Average output is thus calculated as
follows:
AO = TO / N, where AO = Average output, TO = Total output and N =
quantity of the variable input, labour. Both average and marginal
output initially increase, reach a maximum and then decreases.
Task: Complete the following table:
Units of labour Total output Average output Marginal output
(N) (TO) (AO) (MO)
1 20
2 45
3 66
4 21

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4.13 Costs

The expenditure of a producer on the necessary inputs involved in the

production process (like wages, rent, interest, money paid for raw
materials, fuel etc.) is known as costs. When we refer to costs as
economists we define the cost of something as whatever you have to
give up to get that item. Opportunity cost is thus involved in an
economist’s definition of costs.

As economists we take into account implicit as well as explicit costs.

Explicit costs are input costs that require that actual money is paid
by the producer to another party, for example when ABC cookies pay
wages to their workers it is an example of explicit costs. Implicit
costs are input costs that do not require that actual money is paid by
the producer to another party, for example the manager of ABC
cookies could actually be a computer programmer for another
company where he could earn R1000 per hour. The R1000 per hour
opportunity cost is an example of implicit costs.

Accountants who have the job of keeping track of money flowing in

and out of the firm’s accounts will only take explicit costs into
consideration and ignore any implicit costs incurred by the producer.

We can distinguish between various types of costs. The most

important distinction should be made between costs made in the short
run and costs incurred in the long run (remember that in the short run
only some of a producer’s inputs are fixed and in the long run all inputs
are variable).

4.13.1 Short run costs

Total fixed cost (TFC) – These are costs connected to the fixed
factors of production, it includes items like rent and interest on loans.
For ABC Cookies TFC would be the cost of their factory. In the table
above it can be seen that even if ABC Cookies do not produce a single
cookie that they still have to pay their rent of R30 every month. Fixed
costs are thus not influenced by changes in output. A graphical
representation of total fixed cost for ABC cookies will look as follows:

96
 Cost
(R)

30 TFC

0 Output

Total variable cost (TVC) – In contrast to TFC, total variable costs

are related directly to the output of the producer, so if the producer
decides to produce more output TVC will increase accordingly. A
producer can adjust its output level in the short run by using more or
less of the variable inputs. The most common example of variable
costs is the wages of labour, electricity and the costs of raw materials.
TVC is calculated by multiplying the number of units of the variable
input with the price of the variable unit. ABC Cookies pay their workers
R10 per month, from the above table it can be seen that when no
cookies are produced the cost of workers (TVC) is equal to R0. As the
output level increases, the TVC also increases accordingly as can be
seen in the following graph:

Cost
(R) TVC

0 Output

Total cost (TC) – Total cost in the short run is equal to the sum of TFC
and TVC. Thus TC = TFC + TVC. When output is zero (i.e. no cookies
are produced), total cost will be equal to TFC because TVC is then
equal to zero. As more and more units are produced, total costs will

97
begin to increase as variable costs also increases. TC will continue to
increase as production increases, as more and more variable inputs
are used in the production process. Graphically TC can be represented
as follows:

Cost TC
(R)

30

0 Output

No. of Total TFC TVC TC AFC AVC ATC MC

workers Output
(Q)
0 0 30 0 30 - - - -
1 50 30 10 40 0.6 0.2 0.8 0.2
2 110 30 20 50 0.27 0.18 0.45 0.17
3 160 30 30 60 0.19 0.19 0.38 0.2
4 200 30 40 70 0.15 0.2 0.35 0.25
5 230 30 50 80 0.13 0.22 0.35 0.33
6 250 30 60 90 0.12 0.24 0.36 0.5
7 260 30 70 100 0.115 0.27 0.385 1
8 260 30 80 110 0.115 0.31 0.425 Infinity
9 250 30 90 120 0.12 0.36 0.48 -1

Average fixed cost (AFC) – AFC is TFC divided by the corresponding

total output level. Thus AFC = TFC/Q. Seeing that TFC remains
constant irrespective of the output, AFC will decrease on a continuous
basis (because the fixed costs are spread over a greater and greater
output). The ABC Cookies example is continued in the table above.
The AFC graph can be illustrated as follows:

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 Cost
(R)

30

AFC

0 Output

Average variable cost (AVC) – AVC is TVC divided by the

corresponding total output level. Thus AVC = TVC/Q. As can be seen
from the table above AVC first decreases, reaches a minimum point
and then increases again. The AVC curve is thus U-shaped:

Cost
(R)

AVC

0 Output

Average total cost (ATC) – can be defined as TC divided by total

output. Thus ATC = TC/Q. It can also be calculated by adding AFC and
AVC. The ATC curve is very similar to the AVC curve:

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 Cost
(R)

ATC

0 Output

Marginal cost (MC) – MC is the change in total costs when output is

changed by one unit. It can thus be calculated as follows: MC =
∆TC/∆Q. Marginal cost initially decreases with low level of output,
reaches a minimum and then increases sharply as output increases
further. The marginal cost curve also has a U-shape:

Cost
MC
(R)

0 Output

The short-run cost curves can be summarised as follows:

1. Total cost = Total fixed cost + Total variable cost
2. Average total cost = Total cost / Total output OR
= Average fixed cost + Average variable cost
3. Average fixed cost = Total fixed cost / Total output
4. Average variable cost = Total variable cost / Total output
5. Marginal cost = Change in total cost / Change in output

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Task: Complete the following table:
Output Total Marginal Total Total Average
(units) cost cost fixed variable total
(TC) (MC) cost cost cost
(TFC) (TVC) (ATC)
0 100
1 110
2 130
3 166
4 220
5 300

4.13.2 Long run costs

As was mentioned previously, all inputs are variable in the long run. In
the long run therefore producers can not only increase or decrease
their usage of workers but also the size of their factories for example.
There are therefore no fixed costs. In general, the long run aim of
producers is mainly to produce a desired level of output at the lowest
cost possible. In the long run we need only to concentrate on the
characteristics and the shape of the long run average cost curve.

The long run average cost curve shows the minimum per unit cost
at every output level, when all inputs are variable and any desired
production facility can be created. The following figure will help to
explain the changing cost structure of a producer as it decides to
change its scale of production:

Average
cost

SAC(6)
B SAC(1)
A SAC(5)
LAC
C
SAC(2) SAC(3)

SAC(4)

0 Output
Q1 Q2 Q3

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When a producer starts its operations as a small business, its initial
short-run average cost curve will be represented by SAC(1). If
conditions look up for the producer and it is successful it will probably
decide to increase its size. This will cause a new short run average
cost curve to be effective for the enterprise like SAC(2). The producer
thus faces a new effective short run cost curve [like SAC(2), SAC(3),
SAC(4), SAC(5) and SAC(6)] for each particular scale of production.
Each individual short run cost curve represents different combinations
of capital and other factors. It is important to note that the number of
factory sizes is infinite (not 6 as indicate by the above graph).

It is rational to assume that a producer will always aim to choose the

size of a factory and equipment so that the costs of producing any
given output is minimised. If for example a producer starts off on
SAC(1) in the above figure, it will producing an output of Q 1 and an
average cost of AQ1. Now in order to meet increasing demand the
output of the producer increases to Q 2. With the producer’s existing
factory and equipment, the mentioned change in output would raise
the average cost to BQ2. However if the producer is able to increase
the size of its enterprise it will be able to move to cost curve SAC(2)
where an output of Q2 can be produced at an average cost of CQ 2
(which is significantly lower than BQ 2). The same reasoning can be
used to explain the movements to cost curves SAC(3), SAC(4), SAC(5)
and SAC(6). Instead of moving up an existing cost curve (and have an
increase in the average costs of the producer), the producer can attain
lower costs of production if it moves on to a cost curve with greater
capacity.
The long run average cost curve (LAC) comprise of a series of points on
six (in the above graph) different short run cost curves. These (short
run) points reflect the lowest costs possible for the production of any
given output. The LAC curve will thus assume a similar shape to the
one reflected in the above graph (remember that it is assumed that
there are many such short run curves).

When a producer expand its capacity it is likely that it will experience

economies of scale. Economies of scale are the cost advantages of
operating on a larger scale, for example larger producers normally find
it cheaper and easier to buy in bulk, raise money (i.e. through loans
etc.) and they can make use of more efficient machines. In the above
figure, the producer can only experience economies of scale until it
reaches Q3 on SAC(4). This also signifies the optimal size of the
producer since any further extensions in terms of the scale of
production will lead to an increase in average cost and diseconomies
of scale. There are thus actually disadvantages that arise when
producers grow too large. In some situations in the long run average
cost will increase due to diseconomies of scale. For example a

102
producer might be so big that it takes much longer for decisions to be
made and implemented in the enterprise.

The U-shape of the LAC curve shows that the creation of larger
production facilities up to Q3 can lead to economies of scale due to
greater efficiency and lower unit cost. Any extension of the production
facility beyond Q3, will lead to diseconomies of scale due to less
efficient utilization of the inputs and therefore unit cost will be higher
as well.

4.14 Revenues

Revenue is the payment that producers / firms receive for selling a

good or service. Government will also receive revenue in the form of
taxes. There exist various types of revenues, which will be discussed in
short hereafter. We will go into more detail concerning revenues in the
next section when different market structures will be discussed.

4.14.1 Total revenue

Total revenue (TR) can be defined as the total amount of earnings

received by a firm from the selling of product and/or services. TR can
thus be calculated by multiplying the price of the product or service
with the corresponding quantities that was sold of that specific product
or service.
4.14.2 Average revenue

Average revenue (AR) is just another name for the price of a product
seeing that it is equal to the revenue received per unit sold. The
demand curve is therefore also frequently referred to as the AR curve.

4.14.3 Marginal revenue

Marginal revenue (MR) is the additional or extra revenue obtained

when sales are increased by one unit. We can also say that it is the
change in TR when the quantity sold is changed by one unit.

Task: Complete the following table:

Output Total revenue Average Marginal
(units) (TR) revenue (AR) revenue (MR)
1 10
2 15
3 6
4 10
5 42.5

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 6 2.5

The different types of revenue can thus be summarised as

follows:
1. TR = P x Q
2. AR = TR / Q = P
3. MR = ∆TR / ∆Q

4.15 Profits

As economist’s we normally assume that the main aim of most firms

are to maximise their profits. Profits are defined as the difference
between a firm’s total revenue and its total cost. We can thus state
that: Profit = TR – TC. Please bear in mind that in some situations TC
can actually be higher than TR. In this situation the firm will thus be
“making” a negative profit or a loss.

As was mentioned previously economists and accountants measure

costs differently and therefore they measure profit differently as well.
As an economist we would define economic profit as the firm’s TR
minus explicit AND implicit costs (related opportunity costs) of
producing the specific goods and services sold. Accountants will
measure accounting profit as the firm’s TR minus (only) explicit
costs. Seeing that economists take into account implicit costs as well,
accounting profit will always be larger than economic profit.

104
4.16 Questions

a. Improve your understanding by writing your own definitions in the

space provided:

Producer

Inputs

Outputs

Fixed input

Variable input

Profit maximisation

Market constraints

Technological
constraints
Production function

Short run

Long run

Total output

Marginal output

Average output

Diminishing marginal
product
Explicit costs

Implicit costs

Short run costs

Long run costs

Total fixed costs

105
Total variable costs

Total costs

Average fixed costs

Average variable
costs
Average total costs

Marginal costs

Economies of scale

Diseconomies of
scale
Total revenue

Average revenue

Marginal revenue

Profit

Economic Profit

Accounting Profit

b. State whether the following statements are true or false:

i. A firm’s TR is equal to the total value of its sales, that is, price
multiplied by quantity sold.
ii. A firm obtains a TR of R50 by selling 4 units and a TR of R60 by
selling 5 units. The MR of the 5th unit is thus R10.
iii. In number ii. above the AR of 5 units is also R10.
iv. Economic costs of production are based on the principle of
opportunity cost.
v. When a firm’s total costs are less than its total revenue, the firm
is making a loss.
vi. Average cost is the TC of production divided by the number of
units of the product produced.
[Link] cost is the addition to total cost required to produce one
additional unit of a product.
viii. TC = TFC + TVC
ix. In the long run all inputs are variable.

106
c. Distinguish, with example, between a firm’s fixed and variable
costs.

d. What is the difference between the short run and the long run?

e. What is meant by economies and diseconomies of scale?

f. What is the relationship between a firm’s TR, TC and profit?

g. What is marginal product, and what does it mean if it is diminishing?

h. Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
i. Who was this person and what role did he play in economics?
ii. What do you think was his most valuable contribution to
economics?

107
 Learning unit 4.3

Learning unit topic

Microeconomic Aspects

Producer Market Structures

 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly

4.17 Study Objectives

After this section you should be able to:

 Define and distinguish between the different market structures of
producers;
 Know the specific characteristics of the different producer market
structures;
 Discuss production, costs, revenue, profit and related aspects
specifically of the perfect competition market structure.

4.18 Introduction

This section deals with the different market structures that occur in
every economic system around the world. Market structures indicate
how individual producers act under different market circumstances.
We begin with perfect competition. Even though this market structure
does not strictly exist anywhere in the world, it is a very useful
structure to study as it is normally the ideal against which all other
structures are measured. The other structures (monopoly,
monopolistic competition and oligopoly) will also be defined and their
characteristics will be discussed.

4.19 Perfect competition

Perfect competition normally arises when there are so many buyers

and sellers that no single individual can influence the price. A closer
look at the characteristics of perfect competition will give us a better
idea of this market structure.
4.19.1 Characteristics

108
 A large number of buyers and sellers – the behaviour of any
single buyer or seller have no influence on the market price, seeing
that one organisation is only a very small part of the total market.
We can also say that such a firm is a price-taker.
 Homogenous products – i.e. a specific product in question is
exactly identical (in terms of packaging, trade mark etc.) to another.
If this is the case a consumer will have no preference for a product
sold by a specific seller, the price of the product will be the only
factor that influences the buyer’s decision.
 Free entry and exit – the entry of producers and consumers to
and from the market should be free. There should thus be no legal
or any other barriers that can prevent firms and consumers to
participate in any sector.
 Perfect mobility of production factors – this means that all
production factors are completely free to move from one firm to
another.
 Perfect knowledge – Producers and consumers have perfect
information of market conditions, for example they have knowledge
of prices and quantities of products and therefore there is no need
for advertising.

Think for yourself: By looking at the different characteristics of the

perfect competition market structure, why do you think this market
does not really exist in the real world?

4.19.2 The individual producer and the market in perfect competition

conditions

As was mentioned earlier an individual producer operating under a

perfect competition market structure is a price-taker. We also know
from demand and supply that the price in the market is determined
by the intersection of the market demand and market supply curves.
Graphically we can represent the two situations as follows:

109
 P Market P Individual producer
S

P=AR=MR
P
1

0 Q 0 Q
Q1 1 2 3 4 5 6 7 8 9
As can be seen from the above figure – the price of the individual
producer is externally determined (by the market) and is therefore a
horizontal line at the market price of P 1. The producer has no influence
on this price. He can however decide how much he is going to supply
in the market. If the producer decides to ask a higher price than P 1, he
will not be selling anything because buyers will simply do business with
another producer. On the other hand if the producer decides to drop
his price below P1, he will not benefit from this action at all seeing that
he can sell his production at a higher price anyway and will therefore
make less profit.

Keep in mind that the individual producer only represents a very small
insignificant part of the whole market. That is why if he decides to
change his individual price it will have no effect in the market and
buyers will simply move to another producer.

Task:
 Explain in your own words why we call a perfectly competitive
producer a price-taker?
 Does a perfectly competitive producer have a choice of how much
he is going to supply in the market?

4.19.3 Revenues of the perfectly competitive producer

The fact that the individual producer is faced with a horizontal demand
curve has various implications for the revenues of the firm. A perfectly
competitive producer will face similar revenues as indicated by the
following table:

110
 Price per Quantity TR AR MR
unit
10 0 0 0 0
10 1 10 10 10
10 2 20 10 10
10 3 30 10 10
10 4 40 10 10
10 5 50 10 10
10 6 60 10 10
10 7 70 10 10
10 8 80 10 10
10 9 90 10 10

We now know that the individual producer’s price is determined by the

market and it is also constant. The price in the above case is assumed
to be R10 and we assumed that the producer can supply anything up
to 9 units of a specific product. Total revenue is calculated by
multiplying the producer’s price with its corresponding quantity
supplied. This producer’s TR can thus range from R0 (if he supplies 0
units) up to R90 (if he supplies 9 units).

Average revenue is calculated by dividing TR with the corresponding

quantity of units that is supplied. It can be seen from the table that
whatever amount is supplied by the producer, average revenue stays
constant at R10. Average revenue under conditions of perfect
competition is always constant and AR is always equal to the price per
unit.

Marginal revenue is the additional or extra revenue obtained when

sales are increased by one unit. Seeing that the producer under
perfect competition sells every unit of his production at the same price,
his marginal revenue is also constant. We can thus say that under
perfect competition P = AR = MR.

Task:
 Explain in your own word the relationship between price, average
revenue and marginal revenue.

4.19.4 Equilibrium in the short run

The main objective of a producer is to maximise his profits (or

minimize his losses if there are any). Seeing that profits are the
difference between total revenue and total cost, the producer will aim
to find the level of output that will maximise the difference between
the two.

111
We can distinguish between two types of profits under the perfect
competition market structure. In the short run a producer can earn
normal profit at a level of production where the price per unit (AR) is
equal to the cost per unit (ATC). The normal profit is included in the
total cost of the producer. Normal profits are the minimum level of
profit which will convince a current producer to stay in business and at
the same time it provides no incentive for new producers to enter the
industry.

Task:
 What does it mean when we say that normal profit in included in the
total cost of the producer?

In contrast, a producer can earn excess profit in the short run when
his AR exceeds ATC. Excess profit in a market will convince new
producers to enter the industry. A situation of abnormal losses occurs
when ATC exceeds AR and this situation will convince producers to
leave the industry. We can illustrate the short run conditions with the
help of the following graph:
P
ATC
A MC C
P
3
G

B C E F I
P MR=AR=P
2
P
H
1
D

0 Q
Q1 Q2 Q3 Q4 Q5

Remember that price for the individual producer is determined by the

market (P2 in this case) and the producer can decide how much he is
going to supply.

Consider now that the producer decides to supply Q 1. The ATC (cost
per unit) at this output would be AQ 1 and the AR (remember that
AR=MR=P) will be BQ1. At Q1 the producer will thus suffer a unit loss of

112
AB and a total loss of the area P 2BAP3. It is thus quite obvious that if
the producer is not satisfied with this loss that he simply needs to
supply more in the market to increase his profitability.

If the producer now decides to supply Q 2, his ATC (cost per unit) will be
equal to the market price of P2 and the producer will be making normal
profits. However remember that individual producers aim to maximise
their profits. If we take a look at the price per unit (AR) and the cost
per unit (ATC) we can see that the producer can increase his
profitability by producing more than Q 2 (the AR line is above the ATC
line after Q2, indicating that the difference between the two would be
positive, reflecting profits). At what level do you think would the
producer be able to maximise profits (keeping in mind that profit is
maximised when the producer aim for the highest possible revenue
and at the same time the lowest possible costs)?

It is clear that maximum profit per unit would be attained when ATC
reaches a minimum (at point D where output supplied is Q 3) because
revenue stays constant. At an output level of Q 3 the producer realises
an excess profit of ED. The question is now whether this specific output
will enable the firm to maximise its total excess profit? A producer
strives to maximise total profit and not only the profit per unit.

The general rule that is used to determine where a producer

maximises his total profit is when marginal cost is equal to marginal
revenue. Under the perfect competition market structure it means
that profit is maximised when MC=MR=AR=P. So what happens at Q 3?
The producer’s total profit will still be increasing because for each
additional unit produced, the increase in TR (in other words MR) is
greater than the increase in TC (in other words MC). Profit can thus be
increased by raising the production by at least one unit.

Profit will be maximised at output level Q 4 (where MC=MR). If the

output level is increases beyond Q4, total profit will decrease because
for each additional unit produced, the increase in TR (MR) is less than
the increase in TC (MC). Short run equilibrium is reached for the
producer at output level Q4.

Task:
 When is equilibrium attained (i.e. profit is maximised) for the
perfectly competitive producer in the short run?
 Explain the difference between profit per unit and total profit.

4.19.5 Equilibrium in the long run

113
If a perfectly competitive producer earns excess profit in a specific
market in the short run, it will convince new producers to enter the
industry. As more and more firms enter into the market it will cause a
rightward movement of the supply curve since the total capacity of the
market is increased. The situation can be represented as follows:

Individual producer Market

P LMC P
S1
LAC S2
E1 P1 E1
P1
P2 E2
P2
E2

0 Q 0 Q

In the figure LMC = the long run marginal cost curve, LAC = the long
run average cost curve. You can see from the above figure that the
supply curve moves to the right from S 1 to S2 due to new producers
entering the market. Consequently the equilibrium market price will
decrease from P1 to P2, ceteris paribus. The result of this decrease in
equilibrium price is that excess profits for the individual producers in
the market will decrease.

The increase in the market supply, the decrease in the equilibrium

market price will only come to an end once all the excess profits in the
industry have been abolished. This means that all producers in the
specific market will only make normal profits in the long run. To attain
equilibrium in the long run the following condition needs to be met:
P=LMC=minimum LAC. We can see from the figure that the long run
price P2 is equal to the minimum of the long run average cost curve.

Task:
 When is equilibrium attained for the perfectly competitive producer
in the long run?

4.20 Other producer market structures

114
Other producer market structures can be categorized under imperfect
competition. In the imperfect market suppliers and buyers strives
towards greater control of the market. We will be looking specifically at
monopolies, monopolistic competition as well as oligopolies.

4.20.1 Monopoly

A monopoly is in essence the complete opposite of perfect competition

due to the total absence of competition. A pure monopoly exists in a
market when there is a sole supplier of a certain good and/or service
and there is normally no substitute for this product and/or service. A
monopolist normally has the power to determine the price at which
he/she will sell the product or the quantity that he/she wishes to sell.

Monopolies in the market usually come into existence due to various

restrictions on entry, namely:
 A key resource (it could be a natural resource or capital etc.) is
owned or under control by a single producer.
 The government gives a single producer the exclusive legal right to
produce a specific good and/or service. This is especially the case
with utilities, i.e. producers which are responsible for providing
public services like electricity.
 The extensive costs of production (could be due to specific
technology that is needed or a large amount of capital that is
needed to set up the market) make a single producer more efficient
than a large number of producers. Sometimes the market for these
types of products is also limited, so then usually only one producer
will be able to survive financially.

Think for yourself:

Can you think of an example of monopoly producers that came into
existence due to each of the above restrictions on entry?

A monopoly has its own unique demand curve, marginal revenue

function, average revenue function, and short and long run
equilibriums in the market. It is however beyond the scope of this
learning unit and will be covered in Economics 1 next year.

4.20.2 Monopolistic competition

Monopolistic competition is a market structure in which there are a

large number of producers making similar products. Whereas perfect
competition and monopolies are two opposites, monopolistic
competition fits in somewhere in between. Monopolistic competition
thus has some features of a competitive market and some features of

115
a monopoly. A closer look at the specific characteristics of
monopolistic competition will shed some light on this market structure:

 As was already mentioned, there are a large number of producers

due to the fact that these producers have unrestricted entry into
and exit from the market.
 Although the products produced are similar, each producer’s
product is differentiated from those of other competitors and is thus
in some way unique. Producers make their product unique with the
help of brand-names, packaging, quality of the product, general
appearance, colour, conditions of sale etc. A good example would
be toothpaste. Although Colgate, Aquafresh and Mentadent P all
sell toothpaste, each one has different characteristics (i.e. you get
toothpaste with micro granules or whitening agents etc.)
 A producer uses advertising to make his/her products seem
“different” from other producers and in this way he tries to attract
new buyers.
 Producers act independently from each other, so an increase in the
price of a product by one producer will not make the producer lose
its share of the market to its competitors since some buyers will still
prefer the other product (due to loyalty, better conditions of sale
etc.).

A monopolistic competitor has its own unique demand curve, marginal

revenue function, average revenue function, and short and long run
equilibriums in the market. It is however beyond the scope of this
learning unit and will be covered in Economics 1 next year.

4.20.3 Oligopoly

Oligopolies are the most common market form in a large number of

production sectors. It refers to a situation in the market where a small
number of producers collectively dominate the market. The
characteristics of this market structure are considerably more realistic
than perfect competition and monopolies. Characteristics of this
market structure include:

 There exists a certain extent of interdependence among oligopolies.

If one thus decides to change the price of his product, it will
influence the sales and profits of the other oligopolies in the market.
 Entry to this market is usually quite difficult and/or expensive
seeing that the competing producers are already established.
 Oligopolies normally come into existence in the market due to
economies of scale and a limited market size.
 Prices are likely to be sticky, in other words, they are unlikely to
change very often. It is also not unusual that producers in an

116
 oligopoly change their prices at the same time, seeing that
producers monitor each others’ actions very carefully.

An oligopoly has its own unique demand curve, marginal revenue

function, average revenue function, and short and long run
equilibriums in the market. It is however beyond the scope of this
learning unit and will be covered in Economics 1 next year.

Task:
 Compare the characteristics of the following market structures:
monopoly, monopolistic competition and oligopoly

4.21 Questions

a. Improve your understanding by writing your own definitions in the

space provided:

Producer market
structures
Perfect Competition

Homogenous
products
Heterogeneous
products

Price-taker

Horizontal demand
curve
Profit maximisation

Normal profit

Excess profit

Abnormal losses

Monopoly

Monopolistic
competition
Total output

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Oligopoly

b. List the requirements for the existence of perfect competition.

c. Explain with the aid of a diagram, the relationship between average

revenue and marginal revenue under conditions of perfect
competition.

d. Explain the meaning and shape of the demand curve for the
individual producer under perfect competition. Also relate it to the
position on the market and the average and marginal revenue of
the firm.

e. Use a diagram to explain the short run equilibrium position of a

perfectly competitive producer which makes excess profit. Clearly
indicate the excess profit per unit of output and the producer’s total
economic profit.

f. What is meant with imperfect competition?

g. Give three different types of imperfect competition.

h. Define monopolistic competition and explain how it differs from

i. perfect competition
ii. monopoly
iii. oligopoly

i. Consider the “Person of the week” as discussed in the lecture and

answer the following questions:
iii. Who was this person and what role did he play in economics?
iv. What do you think was his most valuable contribution to
economics?

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 Learning unit 5.1

Learning unit topic

Macroeconomic Aspects

Macroeconomic problems and goals

 Introduction to macroeconomics
 Macroeconomic objectives

5.1 Study Objectives

After this section you should be able to:

 Explain what is meant with macroeconomics;
 Describe and explain each of the five main macroeconomic
objectives (as well as the general concepts that go along with
them) of most economies around the world.

5.2 Introduction

Economics is traditionally divided into two main branches, namely

microeconomics and macroeconomics. Microeconomics (which was
covered in Learning Unit 4) studies the behaviour of individual decision
makers (like consumers and producers) whereas in contrast,
macroeconomics concentrates on the behaviour of the total economy.
For example in Learning Unit 3.2 we covered the basic circular flow of
an economy. Microeconomics basically studies the individual parts of
this circular flow in microscopic detail (for example concentrating on
individual consumers and their behaviour) and in macroeconomics the
details of the circular flow are suppressed and the flow is considered as
a whole (things like the factors that determine the scope of total
income is studied).

5.3 Macroeconomic objectives

Macroeconomic economists are interested in the performance of an

economy as well as how a specific economy is performing in terms of
another. There are usually five main objectives that are used in order
to judge the state of a specific economy, namely:

 High and sustainable economic growth

 High or full employment

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 Price stability
 Balance of payments equilibrium
 Equitable distribution of income

We will now be discussing each of them individually.

5.3.1 High and sustainable economic growth

The primary objective of all economic activities, whether they occur in

a traditional, central planning, market or mixed system, is to produce
goods and services for current and/or future consumption. A country’s
economic achievements are therefore measured against its ability to
provide goods and services to the population on a sustained basis.
Therefore, the attainment of the highest possible rate of growth in
production is the primary macroeconomic objective of most countries.

The most comprehensive and basic measure of a country’s total

economic activity is the gross domestic product (GDP). The GDP is the
market value of all final goods and services that are produced during a
specific period (usually one year) within the boundaries of a country.

GDP can be measured at current prices or constant prices. When GDP

is valued at the actual market price which prevailed in the period
during which production took place, it is known as nominal (current)
GDP. GDP can also be measured at a set of prices which prevailed in a
specific base year (for example 2000), in which case it is known as
real (constant) GDP. The difference between the two is thus that
inflation is taking into account with real GDP.

Think for yourself: Which one is usually higher in the real world: real or
nominal GDP? Explain.

Movements in the real GDP are the best measure available of the
growth in a country’s production. The growth of an economy is
therefore the rate at which the real GDP increases. If the nominal
growth rate differs from the real growth rate, it means that prices
generally increased or decreased (not that the economy has
necessarily grown).

We can calculate the growth rate from real GDP by using the following
formula:

[
Economic growth rate 2006=
Re al GDP 2006
Re al GDP 2005 ]
−1 x 100

Task: Calculate the economic growth rate for 2003, 2004 and 2005.

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 Year GDP
2002 245581
2003 252889
2004 264193
2005 277074

If we examine the growth rate of the South African economy, it

becomes clear that the real GDP on average exhibited a positive
growth rate. The lowest growth rate was experienced during 1991 to
2000 when the South African economy recorded a growth rate of
1.84%.

Period % Growth
1961 – 1970 5.73
1971 – 1980 3.39
1981 – 1990 1.56
1991 – 2000 1.84
2001 2.76
2002 3.66
2003 3.13
2004 4.82
2005 5.11
2006 4.97

The importance of a high real growth rate lies in the fact that an
increase in the production of goods and services would make a higher
standard of living possible for the country’s population. A country’s
average standard of living also depends on the rate of population
growth. We measure a country’s standard of living by looking at per
capita GDP (also known as GDP per head). GDP per capita is
calculated by dividing the GDP with the size of the population. For
example in 2006 South Africa’s nominal GDP was R1 727 billion and
the population was estimated at 47.4 million, therefore the nominal per
capita GDP was R36 428 (test this!).

The economic growth rate in a market oriented economy such as South

Africa’s is usually not even. The growth rate tends to fluctuate
cyclically around a long term growth trend. Such cyclical movements
are known as the business cycle: periods of expansion and
contraction in the real GDP which occur at fairly regular intervals. A
typical business cycle can be presented as follows:

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 Source: [Link]

A period in which the total production in a country falls is known as a

recession or slump. When an economy is in a downward
(recessionary) phase, many people may lose their jobs, and large
drops in output often occur. As a result of the existence of surplus
productive capacity and increased unemployment, prices are inclined
to rise more slowly during a recession.

During a period of economic recovery or boom (known as an upswing)

a decrease in unemployment and surplus productive capacity usually
occurs, so that prices would increase more rapidly.

Think for yourself: How do you think South Africa is doing in terms of
this objective?

5.3.2 High or full employment

The second important objective of a country’s macroeconomic policy is

the maintenance of a high level of employment of labour. There is
generally a positive correlation between employment and economic
growth. Therefore, the higher the economic growth rate, the higher
the level of employment (and the lower the rate of unemployment).
High unemployment is a serious economic and social problem.
Unemployment firstly causes a loss of production which cannot be
recovered at a later stage. On the social level, unemployment leads to
a lowering of the standard of living of those directly involved as well as
their dependents, which leads to feelings of insecurity and anxiety that
could even result in increased crime. The total social cost of
unemployment therefore extends much wider than the direct loss in
production. In South Africa, unemployment also has important political

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implications as a result of the fact that unemployment is higher among
certain racial groups.

The objective of full employment has gained importance in most

industrialised countries across the world. The concept of full
employment is controversial because it is not always clear what is
meant by it. Is a person who cannot obtain employment at an
unrealistically high wage really unemployed? Should a person who
resigned from his job to find a better one really be classified as
unemployed? Should the concept of unemployment be reserved for
those cases where people lose their jobs because the economy is in a
recession, i.e. as a result of an insufficient demand for goods and
services?

Full employment is never completely attainable in a dynamic economy.

There will for example always be persons who change jobs and are
temporarily unemployed as a result, or persons whose skills have
become outdated as a result of technological advances and have to be
retrained. New entrants to the employment market, such as people
who previously were at school or who were housewives, may also need
time to obtain employment. For this reason a state of full employment
is conventionally regarded as less than 100 percent of the potential
labour force.

So when is a person exactly classified as unemployed? We can

distinguish between two ways of defining unemployment. The first one
is called the strict definition (which is also currently the official rate
of the South African economy) of unemployment. It stipulates basically
that a person is classified as being unemployed if he/she is 15 years
and older and:
1. Is not currently employed and getting paid for it by someone or is
also not self-employed;
2. Was available to be employed or self-employed during the week
before the interview; and
3. Took active steps during the four weeks before the interview to find
employment or self-employment.
The expanded definition is exactly the same as the strict definition;
the only difference is the last part which changes to:
3. A person should only have the desire to work and to take up
employment or self-employment.
Discouraged workers are therefore not included in the strict definition
of unemployment.

Think for yourself: Do you think the official definition of unemployment

is a true reflection of the amount of people that are unemployed in
South Africa?

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We can distinguish between various types of unemployment:
 Frictional – Unemployment that arises because of the time needed
to match qualified job seekers with available job openings. A good
example would be when a person is between jobs.
 Seasonal – Unemployment caused by seasonal shifts in labour
supply and demand
 Cyclical – Unemployment that fluctuates with the business cycle,
increasing during recessions and decreasing during expansions.
 Structural – Unemployment that arises because the skills
demanded by employers do not match the skills of the unemployed.

Task: Think of examples of each of the above mentioned types of

unemployment.

In South Africa the unemployment figures are unreliable for a variety of

reasons. A significant amount of South Africans are employed in the
informal sector of the economy making it especially difficult to
acquire accurate information regarding employment. Furthermore the
considerable amounts of illegal immigrants that enter the country
yearly as well as questionable population data distort the employment-
data picture even more.

In recent years the informal sector in South Africa has gained even
more importance especially because it is so difficult for some people to
find a job in the formal sector. Other reasons why people participate in
the informal sector include the fact that they do not want to pay tax
and they are involved in illegal activities. Informal sector activities on
the legal side include craft makers, hawkers and taxi-operators and on
the illegal side producers of drugs and burglars.

Factors which might possibly give rise to a high level of unemployment

are the lack of savings and risk capital, the low level of education of a
large proportion of the population, the discriminatory practices of the
past, harmful trade union practices and the inflexibility in the labour
market. As a result of the high unemployment in South Africa the
problem will probably remain high on the country’s economic agenda
for many years to come.

Think for yourself: How do you think South Africa is doing in terms of
this objective?

5.3.3 Price stability

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The third important macroeconomic objective is that of stable prices.
Price stability implies that the general level of prices does not increase
or decrease too fast. The generally accepted measure of the general
level of prices is the so-called consumer price index, commonly known
as the CPI. The CPI is used by the South African Reserve Bank
([Link]) to target the rate of inflation. The current
target range for inflation used by the Reserve Bank is 3 to 6%.

The CPI (also known as headline inflation) measures the costs of a

fixed basket of consumer’s goods and services (including items such as
housing, food, clothing, medical services, transport etc.) which are
purchased by an average household. Fluctuations in the general level
of prices are indicated by the percentage increase or decrease in the
CPI. Inflation refers to a continuous increase in the general level of
prices. The inflation rate can undergo large fluctuations. Deflation
occurs when prices decrease, or when the inflation rate is negative.

There are also two sub-indices of CPI that are also used in economics.
They are:
 Core inflation – It is CPI without certain items excluded on the
basis that their prices are highly volatile, inclined to temporary
influences and influenced by government intervention and policy.
Core inflation is usually calculated in order to capture the
fundamental inflationary pressures in the economy.
 CPIX – Is also CPI but this time it is excluding interest rates on
mortgage bonds. The South African economy instituted a policy of
inflation targeting in 2000 and CPIX was created for this purpose.
The CPIX was used by the Reserve Bank to target inflation up until
the end of 2008 but since January 2009 they have reverted to using
the CPI as the primary inflation indicator.

How do we calculate an inflation rate from an index? If we have to

calculate the inflation rate for 2006 we would calculate it as follows:

[(
Inflation rate 2006= )
CPI 2006
CPI 2005 ]
−1 x 100

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Think for yourself: Calculate the inflation rate for 2003, 2004 and
2005.
Yea CPI
r
2002 116.15
2003 122.125
2004 124.05
2005 128.325

An important question which arises from the above is why price

stability is an objective. The answer is that market prices are a
measure of economic value; if this measure changes too rapidly as a
result of a too rapid increase or decrease in the general price level,
contracts and other financial agreements are distorted. The result of
this distortion is a misallocation of the factors of production and a
biased distribution of income. Moreover, if a country’s rate of inflation
is higher than that of its trading partners, it will also be less
competitive in international markets, which therefore could negatively
influence its balance of payments.

Price stability does not imply absolutely rigid prices. In fact, the
objective of stabilising prices in reality consists of a subtle compromise
between the pursuit of the flexibility of (relative) prices and the pursuit
of the (relative) stability in the general level of prices. On the one
hand, it is undesirable to force absolutely rigid (relative) prices on the
economy because it will impede the functioning of Adam Smith’s
“invisible hand”: fixed prices will make it impossible for the price
system to fulfil its basic function, namely to allocate scarce resources
optimally between various alternative applications. On the other hand,
very rapid increases in the general level of prices (hyperinflation)
should also be avoided, because it will render the price system useless
and might even cause the collapse of the entire monetary system. In
such an extreme situation the economy would resort to barter, which
will drastically restrict the level of economic activity.

Think for yourself: How do you think South Africa is doing in terms of
this objective?

5.3.4 Balance of payments equilibrium

The fourth macroeconomic objective which most countries pursue is a

satisfactory balance of payments situation. A healthy balance of
payments is one of the most sought after objectives of economic
policy. Its importance increased particularly in the post-war period as

126
a result of the increase in the volume of international trade and the
development of international financial markets which no longer respect
international borders. All economies are open in the sense that all
countries participate in the international trade in goods and services;
their citizens travel all over the world for business and other purposes;
and individuals, companies and governments lend and borrow money
over international borders.

A country’s transactions with the rest of the world are recorded in the
balance of payments. A balance of payments is therefore a record
of a country’s international transactions over the course of a particular
period (quarter or year). It is commonly divided into two sections or
accounts. The trade in goods and services and other current items
such as international transfers are recorded in the current account of
the BoP, while financial transactions such as loans and exchange of
financial assets and liabilities are recorded in the financial account.

When the monetary values of a country’s exports exceed the monetary

value of its imports, it has a surplus in the current account. If a
country’s imports exceed its exports, it experiences a deficit in its
current account. Unless a deficit in the current account of the balance
of payment is off-set by an inflow of capital from abroad, the country’s
supply of international liquid reserves will normally decline and the
foreign value of its currency tends to drop.

Therefore, a country should keep a watchful eye on its exchange rates.

The exchange rate of a country is the rate at which its own currency
(for example, the rand) can be exchanged with that of another country.
If a country’s exchange rate increases (its currency becomes more
expensive in terms of foreign currencies, depreciates) its exports will
become more expensive and therefore less competitive in the world
markets, which will lead to its exports declining relative to its imports.
However, if a country’s exchange rate decreases (its currency
becomes cheaper in terms of foreign currencies, appreciates) its
international competitiveness will improve, but the costs of imports
and the internal rate of inflation will be inclined to increase. Because
of these and other influences on the economy exchange rates are very
important to most countries.

Think for yourself: How do you think South Africa is doing in terms of
this objective?

5.3.5 Equitable distribution of income

Another important macroeconomic objective is a reasonable or more

equitable distribution of a country’s income and wealth. The
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distribution of income in a market economy is determined by the
ownership distribution of the factors of production and the prices of the
factors of production as determined by supply and demand. In a
perfectly competitive market prices are determined by factors such as
the supply of productive factors, the state of technology and consumer
preferences. In an imperfectly competitive market, as is mostly the
case, there are many additional factors which could influence the
reward for the use of productive factors, for example conventional
salary structures, social status, family connections, race, gender etc.
Other factors which could influence the distribution of income and
wealth in a country are marriage patterns, laws of inheritance and the
propensity to save of individuals and groups. Unemployment and
inflation could further aggravate the problem of the unequal
distribution of income.

As a result of the abovementioned factors the distribution of income

and wealth is very inequitable in most market-oriented economies, and
the maintenance of a fair distribution of income has consequently
become an important objective. This applies especially in South Africa
as the distribution of income and wealth is unusually skewed as a
result of various historical and other factors. The acceptance of this
objective implies two things. Firstly, even if the distribution of income
is not a specific policy objective, the government should always
consider the implications of its own actions for the distribution of
income. Secondly, policy makers could make a conscious effort to
render the distribution of wealth more acceptable by eliminating some
of the worst inequalities.

Various instruments are available with which to achieve greater equity.

The government can firstly make use of progressive taxation, i.e.
assessing the higher income groups at higher tax rates than the lower
income groups. South African’s taxation on personal income is highly
progressive.

Value added tax (VAT), on the other hand, is probably slightly

regressive, because the lower income groups probably contribute a
larger portion of their income to this taxation than do the higher
income groups. What is important to the distribution of income,
however, is whether the system of taxation in its entirety is
progressive or regressive. The system of taxation as a whole naturally
includes all forms of taxation, including the taxation levied at the level
of central, provincial and local government.

The government also employs income transfers. These money

transfers, such as aid to the aged, the disabled and the unemployed,
serve as a so-called safety net. Occasionally the government will also

128
assist the lower income groups by directly subsidising food, medical
services and housing. Even the provision of free education and
medical services to everyone on an equal basis can be regarded as a
facet of the government’s policy to bring about a more equitable
distribution of income.

Income distribution in the economy is measured by using mainly two

measures, namely the Lorenz curve and Gini coefficient. The Lorenz
curve is a simple figure that shows the extent of inequality in the
distribution of certain variables. The Gini coefficient is derived from
the Lorenz curve, it is thus also an instrument that shows the degree of
inequality.

Think for yourself: How do you think South Africa is doing in terms of
this objective?

5.4 Questions

Improve your understanding by writing your own definitions in the

space provided:

Macroeconomics

Macroeconomic
objectives

Economic growth

Employment

Unemployment

Balance of payments

GDP

Current / Nominal
Prices
Constant / Real
prices
Per capita GDP

Business cycle

129
Recession

Recovery

Downswing

Upswing

Strict unemployment

Expanded
unemployment
Frictional
unemployment
Seasonal
unemployment
Structural
unemployment
Cyclical
unemployment
Formal sector

Informal sector

Price stability

Inflation

Headline inflation

Core inflation

CPI

CPI(X)

Current account of
BoP
Financial account of
BoP
Surplus in current
account
Deficit in current
account

130
Exchange rate

Depreciation

Appreciation

Lorenz curve

Gini coefficient

131
 Learning unit 5.2

Learning unit topic

Macroeconomic Aspects

Macroeconomic policy instruments

 Monetary policy
 Fiscal policy
 Balance of payments policy
 Wage and price policy

5.5 Study Objectives

After this section you should be able to:

 Understand what is meant with a policy instrument and know why
we need policy instruments in the economy;
 Differentiate between different policy instruments available to
government to influence the economy;
 Define and describe the four main macroeconomic policy
instruments individually.

5.6 Introduction

Most countries strive to achieve a combination of the five

macroeconomic objectives (discussed in Learning Unit 5.1), although it
may happen that not one of the various objectives is fully realised as
such. We need to investigate the different instruments or tools that
are available to achieve the macroeconomic objectives and it is here
that macroeconomic policy instruments play a role.

A policy instrument is an economic variable like the money supply,

interest rates, taxation etc. which the government controls or can
control, either directly or indirectly. The expectation is naturally that
changes in the policy instruments will favourably affect one or more of
the macroeconomic objectives. In other words, by affecting changes to
for example the money supply or interest rates, the government can
attempt to steer the economy in the desired direction. In this way it
may be possible to bring about an improved combination of
production, prices, employment or imports and exports.
5.7 Monetary policy

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Monetary policy is the first important instrument of macroeconomic
policy. It refers to the management of the country’s money and credit.
Monetary policy includes inter alia any attempt by the central bank to
change the money supply and/or interest rate by means of
adjustments to the official repo rate. In South Africa the South African
Reserve Bank (SARB) is the central bank and the repo rate is the
rate at which commercial banks (like ABSA, Standard Bank & FNB)
borrow money from the SARB. The repo rate is thus the borrowing cost
of money for banks. The average rate at which commercial banks lend
money to their clients is called the prime rate.

Monetary policy also includes any attempt to influence the money

supply and the granting of credit by adjustments to the banks’
prescribed cash reserves, or by influencing the volume of outstanding
treasury bills or government bonds by means of the central bank’s
open market transactions.

The objective of monetary policy is to influence total expenditure and

GDP by means of changes in the money supply, interest rates and the
availability of credit. When excessive expenditure occurs, restrictive
monetary measures (high interest rates and a smaller money
supply) aim to bring about a reduction in expenditure, a decrease in
production and a lower inflation rate.

The opposite occurs (i.e. expansionary monetary measures) when

the level of economic activity is regarded as too low. In that case an
increase in the money supply would cause interest rates to drop, which
in turn would encourage expenditure on the creation of new production
capacity and durable consumer goods such as motor vehicles.

It must, however, be kept in mind that monetary policy, including the

SARB’s control over the money supply, as well as the interaction
between the money supply, production and prices are very complex
and controversial issues. This makes the study of the topic very
interesting.

5.8 Fiscal policy

The second macroeconomic policy instrument which the central

government has at its disposal is fiscal policy. Fiscal policy comprises
all adjustments in the level, composition and timing of taxation and
government spending which are aimed at achieving one or more
macroeconomic objectives.

The first dimension of a fiscal policy is government expenditure.

Traditionally, government expenditure is divided into two

133
components: expenditure on goods and services, and transfers. The
government’s expenditure on goods and services determines firstly
what percentage of GDP will be allocated to the provision of collective
goods (defence, police and foreign policy) and what percentage to the
satisfaction of demand for private goods. Government expenditure
includes all outlays which absorb scarce resources, such as the
purchase of weapons, electricity, stationary, roads etc. Government
expenditure on goods and services also constitutes part of total
expenditure in the economy and therefore has an important influence
on the level of the GDP. An increase in government spending will
ceteris paribus have an expansionary effect on the GDP, while a
decrease in government spending (restrictive effect) will reduce
GDP.

The government’s transfers include old age and disability pensions and
grants, as well as subsidies to producers, interest on public debt and
loans and credit granted to private organisations. Transfers increase
the income (or liquidity in the case of loans) of the recipients and
therefore their ability to spend. The transfer of income by its very
nature also has an important effect in the distribution of income.

Taxation is the second dimension of fiscal policy. It plays three key

roles in macroeconomics:
1. It reduces the taxpayer’s disposable income. The usual expectation
is, therefore that an increase in taxation will decrease consumption
and/or investment, total demand and, eventually the level of GDP.
The opposite applies in the case of a lowering in the rate of
taxation. This will normally increase the consumer’s disposable
income, total demand and GDP.
2. It also has an important effect on the prices of goods and services,
and therefore on the behaviour of economic subjects. Consider the
impact of sales taxes such as VAT and excise duties on the prices of
consumer goods. An income tax on wages again reduces workers’
net income, which in turn, influences their willingness to work.
Certain tax exemptions granted to industrialists may also lower the
prices of capital goods, which may encourage business enterprises
to purchase new equipment in order to expand their production
capacity. Many provisions in the various tax laws influence
economic activities in this manner.
3. It also has an effect on the distribution of income, which in turn has
implications for the level of total expenditure in the economy. If
higher income earners exhibit a higher propensity to save than the
lower income group, progressive taxation, which brings about a
more equitable distribution of income, will cause total consumption
expenditure from the same total income to increase.

134
5.9 Balance of payments policy

The openness of economies has compelled countries to focus

increasingly on the management of their foreign economic relations.
Balance of payments policy includes all measures which aim to
influence a country’s foreign accounts.

These measures fall into two categories: trade policy and exchange
rate policy. Trade policy consists of measures such as tariffs, quotas,
import deposit schemes, import surcharges and other attempts to
expand or restrict the imports and exports of a country.

Exchange rate policy comprises the management of the country’s

exchange rate, including the decision as to whether a country should
have a fixed or floating exchange rate, and in the case of a fixed
exchange rate, decisions regarding the appropriate level at which the
exchange rate should be fixed from time to time. In the case of a
floating exchange rate policy the rate is left to find its own levels in
the foreign currency markets without any intervention from the
government. In such cases changes in the exchange rate are referred
to as appreciation and depreciation. A country’s currency
appreciates when the exchange rate rises. If the exchange rate
drops, the currency depreciates, it becomes cheaper on the foreign
currency market.

5.10 Wage and price policy

When a country’s inflation rate is too high, the government will of

course attempt to stabilise prices by making use of traditional
measures, such as restrictive fiscal and monetary policy including
restrictions on the growth in the money supply, higher taxes and lower
government spending. However, experience has taught that the
effectiveness of these “indirect” strategies is subject to long delays,
and that the cost of implementation in terms of the loss in production
and employment can be very high. That is why many countries turned
to alternative instruments in the post-war period, in the hope that they
will have the desired effect on wages and prices more quickly, and at a
smaller cost in terms of production and employment.

These alternative strategies cover a wide array of measures which vary

from formal wage and price control (income policies) which are
statutorily enforced, to much less drastic informal and voluntary
controls over prices and wages. The latter for instance include
attempts at moral persuasion by means of official calls on employers
and trade unions to exercise self-restraint, inflation campaigns which
are often accompanied by extensive publicity, and other attempts to

135
create a higher level of awareness of the problems among employers
and trade unions.

The formal control of wages and prices is one of the most controversial
macroeconomic policy instruments. Their application in the past was
rewarded with mixed success. Although some economists still favour
direct controls from time to time, most economists tend to regard it as
a very blunt instrument which can cause a lot of damage to the
economy, mainly because the fixing of wages and prices impedes the
market mechanism, suppressing inflationary tendencies, instead of
eliminating them.

5.11 Questions

Improve your understanding by writing your own definitions in the

space provided:

Macroeconomic
policy instruments
Monetary policy

Fiscal policy

Balance of payments
policy
Wage and price
policy
Repo rate

Prime rate

Restrictive measures

Expansionary
measures
Trade policy

Exchange rate policy

Fixed exchange rate

Floating exchange
rate
Appreciation

136
Depreciation

137
 Learning unit 6.1

Learning unit topic

Real world applications

Details will follow

138
 Learning unit 6.2

Learning unit topic

Real world applications

Details will follow

139