ECONOMICS 1A

Only study guide for ECS1501

DEPARTMENT OF ECONOMICS

UNIVERSITY OF SOUTH AFRICA

© 2017 University of South Africa

All rights reserved

Printed and distributed by the

University of South Africa
Muckleneuk, Pretoria

Compiled by the Department of Economics

ECS1501/1/2018-2018
 iii ECS1501/001

Contents
Page

Introduction ............................................................................................................................................. iv

Learning unit 1
What economics is all about ................................................................................................................... 1

Learning unit 2
Economic systems ................................................................................................................................ 20

Learning unit 3
Production, income and spending in the mixed economy .................................................................... 24

Learning unit 4
Demand, supply and prices .................................................................................................................. 34

Learning unit 5
Demand and supply in action ............................................................................................................... 66

Learning unit 6
Elasticity................................................................................................................................................ 79

Learning unit 7
The theory of demand: the utility approach .......................................................................................... 87

Learning unit 8
Background to supply: production and cost ........................................................................................ 101

Learning unit 9
Market structure: Overview and perfect competition .......................................................................... 116

Learning unit 10
The factor markets: the labour market ................................................................................................ 137
 iv

Introduction
Welcome to Economics 1A the first part of the introduction to Economics. We hope that you will find
this module mentally stimulating and worthwhile.

PURPOSE OF THE
MODULE

The purpose of this module is to gain insight into

■ how the basic economic problem is solved in different economic systems,

■ how households and firms take decisions and
■ how prices are determined under conditions of perfect and imperfect competition.

This module will prepare you to analyse, interpret and apply knowledge relating to basic
microeconomic concepts and principles.

MODULE OUTCOMES

After you have studied this module, you should have a fundamental understanding of what economics
is all about. You should be able to

■ demonstrate your understanding of basic economic concepts

■ analyse how market forces of demand and supply determine equilibrium

CRITICAL CROSS-
FIELD OUTCOMES

As a student enrolled for a tertiary qualification, you will be exposed to a formative learning experience
that should not only educate you in the chosen discipline but also form your character.

The formative nature of the qualification is described in the critical cross-field outcomes that all tertiary
qualifications aim to achieve. Critical cross-field outcomes refer to broad generic outcomes
encompassing various areas, which all qualifications and standards should aim to promote.

After you have completed this tertiary qualification, you should be able to

■ identify and solve problems in such a way that you display responsible decision making using
critical and creative thinking
■ work effectively with others as a member of a team, group, organisation or community
■ organise and manage yourself and your activities responsibly and effectively
■ collect, analyse, organise and critically evaluate information
■ communicate effectively using visual, mathematical and/or language skills in the modes of oral
and/or written persuasion
■ use science and technology effectively and critically, showing responsibility towards the
environment and health of others
■ demonstrate an understanding of the world as a set of related systems by recognising that
problem solving does not happen in isolation
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In order to contribute to your full personal development as a student (and to that of every other
student) as well as the social and economic development of society as a whole, any programme of
learning should have the underlying intention of making an individual aware of the importance of

• reflecting on and exploring a variety of strategies to learn more effectively

• participating as responsible citizens in the life of local, national and global communities
• being culturally and aesthetically sensitive across a range of social contexts
• exploring education and career opportunities
• developing entrepreneurial opportunities

THE PRESCRIBED
BOOK

The following book is prescribed for this module:

Mohr, P, Fourie, L & Associates. 2015. Economics for South African students.
5th edition. Pretoria: Van Schaik.

The prescribed book can be obtained from the University's official booksellers (refer to the list of
official booksellers and their addresses listed in the my Studies @ Unisa brochure). If you have
difficulty in locating the book at these booksellers, please contact the Prescribed Book Section at
telephone 012 429-4152 or e-mail [email protected]

STUDYING
ECONOMICS

For many of you, this is probably your first encounter with the formal study of economics. Economics
is an interesting, challenging and topical subject, and we trust that you will find it worthwhile and
stimulating.

When paging through the textbook, some of you may be alarmed to see symbols, equations and
graphs. However, this module requires no specialised knowledge of mathematics. Apart from drawing
and interpreting simple graphs, all that is required is addition, subtraction, multiplication and division.
Each time you come across equations or calculations you are shown in detail how to obtain the
answer.

The main requirements for the study of economics are a willingness to think and an active approach to
learning. Economics is not a subject that can simply be memorised – it has to be understood. This
means that you will always have to think about what you are studying and that you must try to
understand the work. The solution is to study actively. Use a pen and paper to work out each
argument by drawing diagrams, doing calculations, and writing down the logic of the argument. It is
not sufficient simply to read the prescribed book and underline or highlight the key concepts.

Do not omit any of the prescribed chapters. These chapters follow a logical pattern and if you skip
some chapters, you will not be able to follow or understand the reasoning in the module as a whole.
 vi

THE STUDY GUIDE

This study guide has three basic functions:

• It outlines the contents of the module, in other words, it indicates which parts of the prescribed
book are compulsory for the examination.
• It indicates how you should approach each chapter and shows the most important topics and
diagrams (figures) you will have to master.
• It provides a series of questions you must answer to assess your progress and to prepare for the
examination.

It has been designed in such a way as to guide you through the prescribed book in a systematic and
informative way and to help you get to know the economist's analytical toolkit. Therefore, you cannot
study the prescribed book without consulting this guide. We have tried as far as possible not to
duplicate any of the prescribed book material in this guide.

You will be required to study only some parts of the prescribed book. The prescribed sections are
clearly indicated in this guide. Those sections of the prescribed book, which are not referred to in this
guide, do not form part of the prescribed material.

This guide is divided into ten learning units which cover the compulsory chapters of the prescribed
book:

Prescribed textbook Topic

Chapter 1 Learning unit 1 What economics is all about
Chapter 2 Learning unit 2 Economic systems
Production, income and spending in
Chapter 3 Learning unit 3
the mixed economy
Chapter 4 Learning unit 4 Demand, supply and prices
Chapter 5 Learning unit 5 Demand and supply in action
Chapter 6 Learning unit 6 Elasticity
The theory of demand: the utility
Chapter 7 Learning unit 7
approach
Background to supply: production
Chapter 9 Learning unit 8
and cost
Market structure: Overview and
Chapter 10 Learning unit 9
perfect competition
Chapter 12 Learning unit 10 The factor markets: the labour market

Note: Only Chapters 1, 2, 3, 4, 5, 6, 7, 9, 10 and 12 of the precscribed book are prescribed for this
module. (Chapters 3, 13, 14, 15, 16, 17, 18, 19, 20, 21 and 22 are prescribed for ECS1601).
 vii ECS1501/001

Each learning unit comprises the following sections:

■ Outcomes

Pay close attention to the outcomes of each learning unit. Remember one of the main funtions of the
the examinations is to evaluate whether you have mastered the outcomes of the module. (Also see
the Checklist bullet below).

■ Contents

The contents section guides you through the study material. Each subsection has a heading and
study instruction. If the study instruction tells you to study a section, you need to make sure that you
know the particular section well because your knowledge and understanding of the topic covered in
the subsection will be tested in the examination.

Some of us learn by memorising definitions or formulas. However, only by actually doing something,
you will realise that you can describe or define it. Therefore, after each section or subsection we will
introduce you to activities to help you practise your newly acquired knowledge, skills and values. At
the end of each learning unit we will provide answers to some of the questions.

■ Solutions

Take care to work through the solutions. You should then get an idea of whether you have mastered
the particular sections.

■ Checklist

The checklist is based on the learning unit outcomes. In other words, it indicates the things you should
be able to do. The outcomes are divided into different categories: Concepts, Explanations, Diagrams
and Calculations. These should give you a good indication of the kind of questions you can expect
from each learning unit.

Next to the items in the checklist are a number of check boxes: "Well", "Satisfactory", "Must redo" and
"Need help". If you think you are able to do something really well, for instance, explaining the role of
prices in a market economy, mark the "Well" box. If you think you are able to explain it but are unsure
about certain aspects or find it a bit difficult, mark "Satisfactory". If you are a bit lost but know
something about the topic and will benefit from spending more time on it, mark "Must redo". If you
really do not know what is going on, mark the "Need help" box. In so doing you will get an indication of
what you know well, what you are coping with, on which of the sections you need to spend more time,
and with what you need help. Do not hesitate to contact one of the lecturers should you need help.
See Tutorial Letter 101 for the contact details of the lecturers. (Do not leave this until the evening
before the examination.)
 viii

IMPORTANT VERBS

As a student you should know exactly what is expected when certain verbs are mentioned in an
activity or examination question. The verbs generally used in economics are as follows:

compare Identify the similarities or differences between facts, viewpoints,

concepts or ideas
contrast/distinguish/what Point out the differences between certain objects or concepts
is the difference
between?
define Give a short and concise definition of a subject or topic
describe Name the characteristics of an object or topic
discuss Discuss a topic by examining its various aspects
explain Explain and clarify to ensure that the reader clearly understands you
explain with the aid of (a) Draw a fully annotated diagram. Make sure all the axes and curves are
diagram(s) labelled. Then explain the diagram in such a manner that the reader can
follow and understand it, in other words, tell the reader what is
happening in the diagram
give/identify/list/name Give only the facts without any discussion
illustrate (Usually) explain your answer with the aid of a diagram (or figure)
summarise State the main points in a brief account

USING DIAGRAMS

To be able to use a diagram (or figure) correctly you must learn to read, to draw and to explain a
diagram:

Read: This means you have to understand the determinants (or factors) of each curve and how they
affect the specific curve.

Draw: Each diagram, and all its axes and curves, must be labelled. The initial point of equilibrium must
be indicated. If it changes, this must also be noted on the diagram.

Explain: You should be able to explain the diagram in words.

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What economics is
all about
LEARNING UNIT

The purpose of this learning unit is to give you a better understanding of what the science of
economics comprises, how you can benefit from studying it and what the basic economic problem is.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ define the term economics

■ explain the difference between wants, needs and demand
■ identify the three main elements of the basic economic problem
■ define the concept of opportunity cost
■ explain the economic problem by using a production possibilities curve
■ describe the different kinds of goods in the economy
■ distinguish between the different types of goods by giving examples of each
■ illustrate, by using a production possibilities curve, the different combinations of goods and
services which can be produced, and distinguish between efficient, inefficient and
unattainable combinations
■ illustrate, by using a production possibilities curve, how a better production technique or
increased resources (or the better utilisation of them) affects production
■ explain why economics is a social science
■ distinguish between microeconomics and macroeconomics
■ distinguish between positive and normative statements
■ distinguish between levels and rates of change

CONTENTS

The introductory chapter of the textbook explains what economics is all about and introduces a
number of fundamental concepts in economics.
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1.1 What is economics

STUDY

Section 1.1 of the prescribed book

This section gives us a brief introduction to economics and what it is all about.

ACTIVITY 1.1
Short question

(a) Define economics (in one sentence).

1.2 Scarcity, choice and opportunity cost

STUDY

Section 1.2 of the prescribed book

Section 1.2 introduces the important concepts of wants (desires), needs, demand, choice and
opportunity cost.

ACTIVITY 1.2
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Scarcity and choice are central elements of economics.
(2) Scarcity is a problem in poor countries only.
(3) The problem of scarcity arises because wants are unlimited and the resources
(or means) to fulfil these wants are limited.
(4) An economy's capacity to produce is limited by the quantity and quality of the
available resources.
(5) The opportunity cost of a choice is the value of the best foregone opportunity (or
alternative).
(6) Leisure time sacrificed to study Economics is an example of an opportunity cost.
(7) If Johannes resigns from his salaried job to open his own business, the salary
he earned previously must be included in the opportunity cost of the business.
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Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) What is the difference between wants and demand (in one or two sentences)?

(b)* In Table 1-1 below, make a tick in the appropriate column to indicate which of the items are
needs and which are wants.

TABLE 1-1
Item Need Want

Food
Satellite TV
A five-bedroom house at the coast
A Pajero 4x4 vehicle
Shelter
Clothes
A Raymond Weill watch

(c)* What is the relationship between wants (on the one hand) and means or resources (on
the other)?

(d)* Can you think of an example from your own life that explains opportunity cost?

(e) Use the principle of opportunity cost to explain why students watch more television during the
week after the examination than the week before it.

1.3 Illustrating scarcity, choice and opportunity cost: the production

possibilities curve

STUDY

Section 1.3 of the prescribed book

Opportunity cost (the trade-off between two goods), can be illustrated graphically with the aid of a
production possibilities curve.

Figure 1-1 is important. Make sure that you are able to draw this figure and also explain it. Note the
difference between wants, means, scarcity and choice — the essential elements of the economic
problem.
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ACTIVITY 1.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) A production possibilities curve indicates combinations of goods or services
which can be produced when the community's resources are employed fully and
efficiently.
(2) A country's production possibilities curve illustrates a particular combination of
goods and services that is most desirable for the inhabitants of that country.
(3) Any point on the production possibilities curve represents an attainable
combination of goods and services.
(4) Any point outside or to the right or beyond the production possibilities curve
represents an unattainable combination of goods and services.
(5) Any movement from one point on a production possibilities curve to another
point on the curve illustrates the principle of opportunity cost.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a)* Answer the following questions based on Figure 1-1 below:

FIGURE 1-1

i. What is the title of the above figure (or diagram)?

ii. What is 0 on the diagram called?
iii. Label the horizontal axis.
iv. Label the vertical axis.
v. Label the curve indicated by JN.

(b)* Use a production possibilities curve to illustrate scarcity, choice and opportunity cost.

(c)* Answer the questions based on Figure 1-2 below which illustrates an economy’s production
possibilities curve for pillows and blankets.
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FIGURE 1-2

i. What does the movement from point B to point C on the curve represent?
ii. Look at the movement from point D to point E. How many pillows need to be sacrificed in
order to produce more blankets per day?
iii. Study the movement from point D to point C. How many blankets need to be sacrificed in
order to produce how many more pillows per day?
iv. What principle is illustrated by the movement from point B to point C or from point E to
point C in the above diagram?
v. What does this principle mean?
vi. How would you describe the shape of curve AF?
vii. What does the shape of curve AF imply?

The production possibility curve (PPC) is very important not only for this module, but also for other
economics modules that you may study in future. You must be able to analyse this diagram. The axes
of the PPC represent quantities. This differs from other graphs because the quantity is normally
represented on the horizontal axis. You may name the axes as you wish, since both represent
quantity. Ensure that your intervals are similar for each axis. In other words, consecutive numbers
must increase by the same amount. If we provide you with a PPC, then you should be able to show
which movement represents opportunity cost. A movement from point A to point B in figure 1-2, or vice
versa, represents opportunity cost since you have to reduce the production of one of the products in
order to increase the production of the other product. The PPC line is very important because it
indicates the effective use of resources. This implies that we are using our resources, for example,
labour and capital to their optimum levels and that points A to F represent the maximum combination
of blankets and pillows that we can produce given the available resources.
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1.4 Further applications of the production possibilities curve

STUDY

Section 1.4 of the prescribed book

Box 1-2 Goods and services

Various categories of goods and services that can be produced are defined in Box 1-2. Note, in
particular, the definition of capital goods and the distinction between final goods and intermediate
goods. These concepts are used on numerous occasions in the rest of the module.

As far as the production possibilities curve is concerned, the important point here is the significance of
points not situated on the curve. What does a point lying inside the curve indicate? What do points
beyond the curve indicate? You should also understand the possible causes of shifts of the production
possibilities curve. Figures 1-2 to 1-4 are important. Make sure that you can indicate economic growth
and unemployment (in other words, the inefficient use of the production factor labour) graphically by
means of the production possibilities curve.

ACTIVITY 1.4
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The distinction between goods and services is that goods are tangible while
services are intangible.
(2) Capital goods are goods that are used in the production of other goods.
(3) Consumer goods are goods that are used in the production of goods which are
ultimately purchased by consumers.
(4) Capital goods lose their value (depreciate) over time.
(5) Intermediate goods are goods that are used as inputs in the production of other
goods.
(6) The beans bought by a factory to produce tins of baked beans are intermediate
goods.
(7) The beans bought by Mrs Jones to prepare bean soup for her family are
intermediate goods.
(8) All the goods purchased by a family for own consumption at Pick 'n Pay are final
goods.
(9) All the goods purchased at a Shoprite Checkers store are not private goods,
since any member of the public may purchase goods at such a store.
(10) Scarce goods are called economic goods.
(11) Goods that are not scarce and therefore have no price are called free goods.
(12) Washing powder is a heterogeneous good since there are different varieties or
brands of washing powder, like Omo, Surf and Skip.
(13) An increase in the available resources can be illustrated by a rightward shift of
the production possibilities curve.
 7 ECS1501/001

T F
(14) Economic growth can be illustrated by a rightward shift of the production
possibilities curve.
(15) The utilisation of previously unemployed resources will shift the production
possibilities curve outward (to the right).
(16) Unemployment is indicated by a leftward shift of the production possibilities
curve.
(17) Unemployment is indicated by a rightward shift of the production possibilities
curve.
(18) Unemployment is indicated by a point inside the production possibilities curve.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Explain the difference between:

i. consumer goods and capital goods

ii. final goods and intermediate goods
iii. private goods and public goods
iv. economic goods and free goods
v. homogeneous goods and heterogeneous goods

(b)* “Air, seawater, sunshine and free education and health services cannot always be regarded as
free goods.” What do you think of this statement? Can you think of reasons why this may be
true?

(c) Complete the following table:

TABLE 1-2
Kind of good Give one example of each
Consumer good
Capital good
Final good
Intermediate good
Private good
Public good
Economic good
Free good
Homogeneous good
Heterogeneous good

(d)* Use a production possibilities curve to distinguish between:

i. maximum attainable combinations
ii. attainable but inefficient combinations
iii. unattainable combinations of the production of two goods.

(e)* Use production possibilities curves to illustrate unemployment and economic growth.

(f)* Use Figure 1-3, which indicates a production possibilities curve, to indicate the changes that are
asked:
 8

FIGURE 1-3

i. Indicate an improvement in the production techniques of only pens.

ii. Indicate an improvement in the production techniques of only pencils.
iii. Indicate an improvement in the production techniques of both pens and pencils.

(g) Mention two possible reasons for a rightward shift of the production possibilities curve.

It is important to focus on the shift of the PPC in the above activity. You must be able to differentiate
between the two shifts, namely where the production technique of one of the products improve. This
shift implies that the quantity produced of only the product with the improved production technique
increases, while the output of the other product remains the same (see figure 1-2 in the prescribed
textbook). If the productivity of the inputs improves or more resources are available, then the quantity
produced of both products will increase (see figure 1-4 in the prescribed textbook). The rightward shift
of the PPC represents economic growth. Questions (a) to (d) are very important exercises in this
regard.

1.5 Economics is a social science

STUDY

Section 1.5 of the prescribed book

This section deals with certain aspects of economics as a science. Note the differences between
economics (as a social science) and the natural sciences.
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ACTIVITY 1.5
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Economics studies human behaviour and is therefore classified as a social
science.
(2) Economics studies human behaviour and is therefore classified as a natural
science.
(3) The ceteris paribus assumption means “all other things equal”.
Short question

(a) What is the difference between a natural science and a social science?

1.6 Microeconomics and macroeconomics

STUDY

Section 1.6 of the prescribed book

Box 1-3: Microeconomics versus

macroeconomics: some examples

The field of economics can be divided into two parts, namely microeconomics and macroeconomics.
In this module the focus is on microeconomics. In Economics 1B we turn our attention to
macroeconomics.

ACTIVITY 1.6
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Macroeconomics deals with phenomena such as total production, total
employment and inflation.
(2) Microeconomics focuses on specific parts of the economy while
macroeconomics is concerned with the economy as a whole.
(3) The study of the total output of the motorcar industry is an example of
macroeconomics.
(4) In respect of the motorcar industry, microeconomics is only concerned with the
output of a specific factory (eg the Volkswagen factory in Uitenhage).
(5) An increase in the price of tomatoes is a macroeconomic issue.
(6) The total production of beer in South Africa is a macroeconomic issue.
 10

Short questions

Note: The solutions to the question marked with an asterisk (*) is provided at the end of this learning unit.

(a) What is the difference between microeconomics and macroeconomics?

(b)* Why do we consider the total production and export of maize as a micro-economic issue?

(c) Give one example each of a microeconomic issue and a macroeconomic issue.

1.7 Positive and normative economics

STUDY

Section 1.7 of the prescribed book

It is important to distinguish between positive and normative economics. The fact that economics is a
social science implies that value judgements or opinions (normative statements) play a vital role in
many economic issues. This is one of the main reasons why economists disagree on certain matters.
Positive statements, on the other hand, are objective facts that can be proved right or wrong on the
basis of science or facts.

ACTIVITY 1.7
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) If somebody says that the current Minister of Finance is doing a good job, he or
she is making a positive statement.
(2) “Unemployment is the only important economic problem in South Africa” is an
example of a normative statement.
(3) “In 1995 the official unemployment rate in South Africa was 29,3 per cent” is an
example of a positive statement.

Short questions

(a) What is the difference between:

i. positive economics and normative economics?
ii. value judgements and objective facts?

(b) Distinguish between positive and normative statements and give an example of each.
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1.8 A few points to note

STUDY

Section 1.8 of the prescribed book, only the last

section, Levels and rates of change

Box 1-5: Percentages and percentage changes

When dealing with numbers you must be very careful. One of the most common mistakes is to
confuse levels with rates of change (or percentages). You should note the difference between levels
and rates of change.

ACTIVITY 1.8
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Rates of change are usually indicated in percentages (%).
(2) Maria earns R5 000 per month and Sarah earns R10 000 per month. Maria
receives an increase of 20 per cent and Sarah an increase of 10 per cent. Both
Maria and Sarah therefore receive an increase of R1 000 per month.
(3) If the economic growth rate in Uganda is 10 per cent in a particular year and the
economic growth rate in Australia is 2 per cent in the same year, it follows that
the level of production in Uganda is higher than the level of production in
Australia.
(4) 40 per cent of 100 is greater than 76 per cent of 50.
(5) An increase from 150 to 165 is an increase of 10 per cent.
Short question

Note: The solution to the question is provided at the end of this learning unit.

(a) Suppose you earn R8 000 per month while your friend earns R15 000. Your annual salary
increase is 10 per cent (%), while your friend receives only 8 per cent (%).
i. What is 10% of R8 000?
ii. What is 8% of R15 000?
iii. Why is your friend’s salary increase, in rand terms, more than your increase in rand terms?

The above calculations are important practice for the assignment and the examination. You can
expect similar questions and you are allowed to use a non-programmable calculator for these
calculations, even in the examination. If you battle with these calculations, you should once again work
through the examples in Box 1-5 of the prescribed textbook.

Appendix 1-1 of the prescribed book is not prescribed for this module, but you are
strongly advised to work through it.
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SOLUTIONS

ACTIVITY 1.2
TRUE/FALSE STATEMENTS

(1) T
(2) F It is a problem facing all countries: rich or poor, developed or underdeveloped; it also
applies to all people.
(3) T
(4) T
(5) T
(6) T
(7) T

SHORT QUESTIONS

(b) The completed Table 1-1 should look like this:

Item Need Want

Food X
Satellite TV X
A five-bedroom house at the coast X
A Pajero 4x4 vehicle X
Shelter X
Clothes X
A Raymond Weill watch X

(c) Wants are numerous (unlimited), while the available means to satisfy these needs are scarce
(limited).

(d) Consider the choices you make about your leisure time: watch television or play football; to
study Economics rather than Accounting; work full time and study part time or study full time; or
choose between two products like ice cream and chocolates.

ACTIVITY 1.3
TRUE/FALSE STATEMENTS
(1) T This is the definition of the production possibilities curve.
(2) F See the definition of the production possibilities curve.
(3) T
(4) T
(5) T

SHORT QUESTIONS

(a) i. The production possibilities curve.

ii. The origin. Here the two axes (horizontal and vertical) cross (or intersect) at the value 0.
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iii. The horizontal line (the “flat” line from left at the origin to right in the graph) is called the
horizontal axis (or x-axis). In this module we only work with positive values (like 1, 2, 3, 4,
etc). To the right of the origin (the value of 0), the values become positive and increase as
we move to the right. The production of two goods or services is indicated on the two
axes of the production possibilities curve. You could therefore indicate any good or service
on the horizontal axis, such as apples (as in the diagram below).

iv. The vertical line (the line going upwards from the bottom to the top in the graph) is called
the vertical axis (or y-axis) and is measured from the bottom to the top. Because we only
use positive values in this module, the values increase from 0 at the bottom (or the origin)
to plus (or positive) infinity at the top (in the above diagram, 5, 10, 15, 20, 25, 30, 35 ...).
You could indicate any good or service on this axis (in our diagram above we used the
production of pears — see the above diagram).
v. The production possibilities curve.

(b) See Figure 1-1 in your textbook.

Scarcity is illustrated by the fact that all the points to the right of the curve (like point G) are
unattainable.

Choice is illustrated by the need to choose between the available combinations along the curve
(in this case a choice between two products, potatoes and fish), (eg choose between point B or
point C).

Opportunity cost is illustrated by what we refer to as the negative slope of the curve, which
 14

means that more of one good can only be produced by producing less of the other.

(c) See Figure 1-2

i. It means that the production of a certain number of pillows per day has to be sacrificed in
order to produce more blankets per day — in other words, more of one product and less
of the other.
ii. The production of 15 pillows (35 minus 20 = 15) has to be sacrificed daily (which means
we have to produce fewer of them) in order to produce 1 more blanket (4 minus 3 = 1)
daily.
iii. We have to sacrifice the production of 1 blanket (3 minus 2 = 1) in order to produce 7 more
pillows daily (42 minus 35 = 7).
iv. The principle of opportunity cost. The opportunity cost principle is illustrated by any
movement from one point to another point on the production possibilities curve.
v. It means that more of one product can only be produced if less of the other is produced.
vi. The curve bulges outwards from the origin (0). We say the curve is concave to the origin. It
is therefore not a straight line, but an inverse, non-linear (or curvilinear) relationship
between the production of two goods, in this case pillows and blankets.
vii. As we move from point A to point B and to point F on the production possibilities curve, the
production of blankets increases while the production of pillows decreases. In order to
produce the first blanket, society has to sacrifice 3 blankets (from 50 to 47). To produce
the second blanket, another 5 pillows have to be sacrificed (from 47 to 42). For the third
blanket, 7 pillows have to be sacrificed. Thus, as we move from point A to point F on the
production possibilities curve the opportunity cost increases and the form of the
production possibilities curve indicates increasing opportunity cost.

ACTIVITY 1.4
TRUE/FALSE STATEMENTS
(1) T
(2) T
(3) F Consumer goods are not used in the production of goods. Consumer goods are
meant for final consumption.
(4) T
(5) T For example, the flour used by the baker to bake bread which will be sold later, is an
intermediate good.
(6) T See statement 5.
(7) F It is a final good.
(8) T
(9) F It is bought and consumed by individuals or households and is therefore a private
good.
(10) T Because it is scarce, there is cost linked to it.
(11) T
(12) T
(13) T
(14) T
(15) F Previously unemployed resources are indicated by a point inside the production
possibilities curve. The utilisation of such unutilised resources will move the point inside
the curve closer to the curve — or even onto the curve — but it will not move the curve.
(16) F See statement 18.
(17) F See statement 18.
(18) T A point inside the curve indicates unemployment, an inefficient combination.
 15 ECS1501/001

SHORT QUESTIONS

(b) Normally, air and sea water are regarded as free goods. However, clean air and sea water are
actually hard to find nowadays, because of pollution! Polluted air is a particularly serious
problem in some parts of South Africa in winter, for example in cities like Alexandra, Soweto
and, Vanderbijlpark. If we really want completely clean air and water, we might have to do
something like boil the water (which takes electricity), or purify the air with a humidifier. This will
cost something, and therefore the clean air and water will not be entirely free.

The same argument is true of sunshine. Sunshine can be scarce in cities with high buildings, for
example New York in the USA. If you want to enjoy more sunshine in these cities, you cannot
stay in a ground floor flat, you have to rent a flat on the top floor of the building. Normally these
flats are more expensive than those on the ground floor. In such a situation sunshine will
therefore actually cost something.

Education and primary health services are classified as free services. But how does the
government manage to provide these services? It uses the taxpayer's money. These services
are therefore not actually free, because taxpayers bear the expense of providing them.

(d) You should have drawn a figure like Figure 1-1 in the textbook.
i. Points A, B, C, D, E and F are maximum attainable combinations.
ii. Point H is an attainable, but inefficient combination.
iii. Point G is an unattainable combination.

(e) Unemployment refers to an inefficient combination.

Point D indicates unemployment. Any point inside the production possibilities curve indicates
that some resources are unemployed or not fully or efficiently utilised. See also Figure 1-1 in the
textbook. Point H also indicates unemployment.
Economic growth is indicated by Figure 1-4 in the textbook. More of both goods (consumer and
capital goods, in this example) could be produced because the quantity and/ or quality of
production factors increased. The whole curve moves to the right.
 16

(f)

i.

ii.

iii.
 17 ECS1501/001

ACTIVITY 1.5
TRUE/FALSE STATEMENTS

(1) T
(2) F See statement 1.
(3) T

ACTIVITY 1.6
TRUE/FALSE STATEMENTS

(1) T See Box 1-3.

(2) T
(3) F The motorcar industry is one specific industry and thus a microeconomic issue.
(4) F The motorcar industry would include all manufacturers of motorcars, eg Volkswagen,
MW, Audi.
(5) F Tomatoes are one product and thus a microeconomic issue.
(6) F Beer is one product and thus a microeconomic issue.

SHORT QUESTION

(b) Microeconomics studies individual goods and services, like wheat and bananas. The example is
about the total production and exports of an individual good, namely maize production and
exports. Macroeconomics deals with the production and export of the total (all) products and
services in the economy (see Box 1-3).

ACTIVITY 1.7
TRUE/FALSE STATEMENTS

(1) F It is an opinion or value judgement.

(2) T It is an opinion or value judgement.
(3) T It is a fact.

ACTIVITY 1.8
TRUE/FALSE STATEMENTS

(1) T
(2) T 20% of R5 000 is R1 000 and 10% of R10 000 is also R1 000

20 5 000 10 10 000
x  1 000 and x  1 000
100 1 100 1

(3) F Uganda grows from a much lower level than the level of production in Australia.
(4) T 40% of 100 is 40 and 76% of 50 is 38. 40 is more than 38
 18

40 100 76 50
x  40 and x  38
100 1 100 1

 165  150 100 15 100 

(5) T  x  x  10% 
 150 1 150 1 
SHORT QUESTION

(a) i. 10 per cent (%) of R8 000 is R800 (rate of change is expressed in %).
ii. 8 per cent (%) of R15 000 is R1 200 (rate of change is expressed in %).
iii. It is important to note the initial levels of your salaries. Your salary of
R8 000 is lower than the initial level of your friend’s salary of R15 000. A large percentage
of a low number is still a low number, while a small percentage of a large number can be
quite large.

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
describe the term economics
define the terms wants, needs and demand
identify the three main elements of the basic economic
problem
describe the concept of opportunity cost
distinguish between consumer goods and capital goods and
to give examples of each
distinguish between different categories of consumer goods
and to give examples of each
distinguish between final goods and intermediate goods and
to give examples of each
distinguish between private goods and public goods and to
give examples of each
distinguish between economic goods and free goods and to
give examples of each
distinguish between homogeneous and heterogeneous
goods and to give examples of each
distinguish between social science and natural science
distinguish between microeconomics and macroeconomics
and to give examples of each
distinguish between positive and normative statements and
 19 ECS1501/001

Well Satis- Must Need

factory redo help
to give examples of each
distinguish between levels and rates of change and to give
examples of each

Explanations
I am able to
explain the difference between wants, needs and demand
explain the economic problem by using a production
possibilities curve
explain why economics is a social science

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
scarcity, choice and opportunity cost (Fig 1-1)
distinguish, by using a production possibilities curve,
between maximum attainable combinations, attainable but
inefficient combinations and unattainable combinations (Fig
1-1)
illustrate, by using a production possibilities curve,
unemployment and economic growth (Fig 1-1)
distinguish, by using a production possibilities curve, an
improvement in the production techniques of only one good
or both goods
(Fig 1-2, 1-3, 1-4)

Calculations
I am able to
calculate rates of change
 20

Economic systems

LEARNING UNIT

The purpose of this learning unit is on how the three central economic questions of what, how and for
whom to produce, are answered within the different economic systems.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ describe the three central economic questions

■ describe the main characteristics of a traditional economy, a command economy, a market
economy and a mixed economy

CONTENTS

2.1 Different economic systems

STUDY

Sections 2.1 to 2.6 of the prescribed book

Box 2-1 Classifying economic systems

Box 2-4 The functions of prices in a market

economy

The three central economic questions (What? How? For whom?) are used to introduce the different
types of economic systems. There are essentially three mechanisms which provide answers to the
three central questions. These mechanisms are tradition, command and the market and they form the
basis of the three fundamental types of economic systems: the traditional system, the command (or
centrally planned) system and the market system. In practice, however, all systems are mixed
systems which contain elements of tradition, command and the market. Nowadays there is a widely-
held view that the market should be the most important ingredient of this “mix”. Note the definition of a
market and make sure that you understand how this institution (which Adam Smith compared with an
invisible hand) provides answers to the three central questions.
 21 ECS1501/001

ACTIVITY 2.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The purpose of an economic system is to solve the three central economic
questions (What? How? For whom?).
(2) Economic systems are based on any or a combination of three coordinating
mechanisms: tradition, command and the market.
(3) Many modern economic systems are based largely on tradition.
(4) The distinction between socialism and capitalism is to be found in the
predominant type of ownership of the productive assets.
(5) The distinction between a market economy and a centrally planned economy
lies in the type of coordinating mechanism used to solve the central economic
questions.
(6) Many countries have switched to command systems in recent years.
(7) Many countries have moved from planned socialism to market-oriented
economic systems in recent years.
(8) For a market to exist there must be physical contact between the prospective
buyers and the prospective sellers of the good or service in question.
(9) In market capitalism each participant in the economic process pursues his or her
self-interest.
(10) In a market system there is no agency that instructs the various participants
about what to produce and how to produce it.
(11) Competition and negotiation are synonymous (have the same meaning).
(12) Competition occurs on one side of the market (ie between buyers or between
sellers) while negotiation occurs across the different sides of the market (ie
between buyers and sellers).
(13) Most economic systems are mixed systems, rather than pure traditional,
command or market systems.
(14) South Africa has a mixed economic system.

Short questions

Note: The solutions to the question marked with an asterisk (*) is provided at the end of this learning unit.

(a) Name the three basic coordinating mechanisms which can be used to solve the three central
economic questions.

(b) What is the essential difference between capitalism and socialism?

(c) Name two characteristics of a capitalist market economy.

(d) What is a mixed economy?

(e)* Compare the advantages of the market system over the traditional system and command
system.

Section 2.7 of the prescribed book is not prescribed for this module
 22

SOLUTIONS

ACTIVITY 2.1
TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) F It rests mainly on mixed systems. Also see statement 13.
(4) T
(5) T
(6) F See statement 7.
(7) T
(8) F Contact can be personal, by means of telephone or computer, etc.
(9) T Own interest is the main driving force behind economic activities in market
capitalism.
(10) T
(11) F See statement 12.
(12) T
(13) T
(14) T In practice, most systems are mixed, although one of the mechanisms usually dominates.

SHORT QUESTION

(e) Traditional system:

i. A rigid system, slow to adapt to changing conditions.
ii. Subsistence economies tend to stagnate.
iii. Economic activity is secondary to religious and cultural values.

Command system:
i. Political planners decide what to produce. They own all the factors of production – no
motive for improvement.
ii. No profit motive – leads to inefficient production relative to the market system.

Market system:
i. Adapt and innovate in the pursuit of profit.
ii. Self-interest promotes economic activity.
iii. Co-ordination occurs without any planning.

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
describe the three central economic questions (what?, how?
and for whom?)
distinguish between the different economic systems
 23 ECS1501/001

Well Satis- Must Need

factory redo help
define the term market
list the conditions for a market to exist
distinguish between privatisation and nationalisation

Explanations
I am able to
explain the main features of a traditional economy, a
command economy, a market economy and a mixed
economy
explain the differences between the three economic
systems
 24

Production, income
and spending in a
mixed economy LEARNING UNIT

The purpose of this learning unit is to emphasize the interdependence between households and firms,
to introduce the most important markets and flow variables and to show how these elements are
interdependent.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ identify the three major flows in the economy and show the relationship between them
■ distinguish between a flow and a stock and give examples of each
■ distinguish between the four factors of production and their incomes
■ distinguish between the two production techniques
■ explain the interdependence between households and firms
■ distinguish between the goods market and the factor market
■ explain the interaction between households and firms by means of the circular flow of goods
and services and the circular flow of income and spending

CONTENTS

3.1 Production, income and spending

STUDY

Sections 3.1 and 3.2 of the prescribed book

Box 3-1 Stocks and flows

You will find the three major flows that are important in the economy in Figure 3-1. Note that
economists view total production and total income as two sides of the same coin (in other
words, they are always equal), while total spending is a completely different concept. This is a
diagrammatic illustration of the economic process without the participants. This process is valid for
South Africa and all other countries.

You must also understand the difference between a stock and a flow.
 25 ECS1501/001

ACTIVITY 3.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The three major flows in the economy as a whole are total production, total
income and total spending.
(2) The two basic sets of participants in any economy are households and firms.
(3) Production is a stock and income is a flow.
(4) The annual maize harvest is a flow variable.
(5) The total number of motor vehicles manufactured in South Africa in 2005 is a
stock variable.
(6) The number of parking bays available at Unisa's main campus is a stock
variable.
(7) The monthly expenditure of a household is a flow variable.
(8) The balance on your savings account on a particular day is a stock variable.
(9) The number of foreign visitors to the country during a particular year is a stock
variable.
(10) Consumption is a flow variable.
(11) Investment is a stock variable.
(12) Capital is a stock variable.

Short questions

(a) What is the difference between production and income?

(b) What is the difference between production and income (on the one hand) and spending (on the
other)?

(c) Name the three major flows in the economy as a whole and explain how they are related.

(d) What is the difference between a stock variable and a flow variable? Give one example of each.

3.2 Sources of production: the factors of production

STUDY

Section 3.3 of the prescribed book

This section deals mainly with the different factors of production, which are among the most important
basic concepts in economics.

Study this section carefully. The first two factors, natural resources and labour, require little
explanation, but capital as a factor of production has a very specific meaning which you must study in
 26

detail. Note that money is not regarded as a factor of production. Make sure that you know what
entrepreneurship means. You should also know the distinction between capital-intensive and labour-
intensive production.

ACTIVITY 3.2
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The four factors of production are natural resources, labour, entrepreneurship
and money.
(2) There is an unlimited supply of natural resources.
(3) The term “human capital” refers to the number of workers.
(4) The entrepreneur is the driving force behind the production process.
(5) Capital refers to all tangible goods that are used to produce other goods.
(6) A pair of scissors used in a factory where clothes are produced, is an example
of a capital good.
(7) A pair of scissors used at home to cut paper, is an example of a consumer good.
(8) The N3 highway connecting Johannesburg and Durban is an example of a
capital good.
(9) Money is a means of exchange and not a factor of production.
(10) A labour-intensive production process is dominated by capital.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Name the four factors of production.

(b)* Read the example below and then fill in the table.

One of the best known entrepreneurs in South Africa is Sol Kerzner, who developed the Sun City/Lost
City hotel complex near Rustenburg. He saw the opportunity to provide a service with which he could
help to satisfy people's needs for tourism and entertainment. He bought land to build the hotel
complex on. He then bought or hired the necessary machines and tools to have the complex built, and
employed people to construct the hotels and maintain them afterwards. Services are constantly being
supplied to the guests with the help of devices such as cleaning equipment, refrigerators, buses, boats
for pleasure rides, and so on.
 27 ECS1501/001

Complete the table below by giving examples of each of the types of production factors that were used
in building the complex.

Production factors Examples from the building of the Sun City complex
Natural resources
Capital
Labour
Entrepreneurship

(c)* In the table below, show which goods are capital goods and which are not by marking the
relevant column.

Item Capital goods Not capital goods

A printing machine used by book printers
Cement (to construct an office building)
Bread
A teacup (at home)
A shop
A cash register in a shop
A highway

(d)* Why is money not regarded as a factor of production?

3.3 Sources of income: the remuneration of the factors of production

STUDY

Section 3.4 of the prescribed book

This section covers the income earned by the different factors of production and how this income
is used. These are some of the most important core concepts in economics. Note, in particular, the
terms that are used for the income earned by the various factors of production (ie rent, wages and
salaries, interest and profit).

ACTIVITY 3.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Rent is the income earned by the production factor capital.
(2) Interest is the income earned by the production factor capital.
 28

T F
(3) Wages and salaries are earned by the production factor labour.
(4) The production factor entrepreneurship earns profit.
(5) Wealth and income have the same meaning.
(6) Wealth, for example, includes a large house and a savings account at a
commercial bank.
(7) Income is earned by the four factors of production.

Short question

(a) Name the four factors of production and the income earned by each.

3.4 Sources of spending: the four spending entities

STUDY

Section 3.5 of the prescribed book – only the

subsections dealing with households and firms

Section 3.6 of the prescribed book

Section 3.7 of the prescribed book – only the

subsection dealing with households and firms

Box 3-4 The goods market and the factor market

Households and firms are the two basic sectors in a market economy, as well as the goods market
and the factor market. The households and firms are interrelated via the circular flow of goods and
services and the circular flow of income and spending.

Figure 3-1 does not show the participants, only the process. Figures 3-2, 3-3 and 3-4 give the
participants as well as the markets. These figures can be used to put most of the textbook in
perspective. It is imperative that you understand how the two basic sectors and the goods market and
factor market are related.

Note the subsections on the government and foreign sectors and financial institutions are not
prescribed for this module. They form part of Economics 1B.
 29 ECS1501/001

ACTIVITY 3.4
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Members of households are called consumers.
(2) Consumers are rational, in other words they will always try to maximise their
satisfaction, given the means at their disposal.
(3) Households are responsible for the spending on consumer goods.
(4) Capital goods are purchased by firms.
(5) Firms are mainly involved in consumption while households are mainly involved
in production.
(6) There are two sets of markets in the economy, goods markets (eg the market for
tomatoes) and factor markets (eg the labour market).
(7) Firms purchase in the factor markets and sell in the goods markets.
(8) Households sell in the factor markets and purchase in the goods markets.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) What are the two basic sets of markets in the economy?

(b)* Study the example below and then answer the questions.

Imagine that you have a friend, James, who works for a furniture factory called Oregon Pine
Manufacturers. He is a skilled carpenter and helps to make tables, wall units, TV cabinets and
so on. On the last Saturday of every month, James takes his family to the Hyperama where they
do their monthly shopping. At the tills, James usually pays cash for the food and other products
they are buying.

i. Make a list of all the transactions that take place in this example. A transaction can be
described as a business activity that takes place when something is exchanged for
something else. (Hint: There are two transactions here, not only one!)
ii. We say that transactions take place in a market. In the example, there are two markets
involved in the transactions that take place. Try to think what these markets could be and
give them each a name. This may sound difficult, but it's really just common sense!

(c)* Explain the goods and services circular flow by means of a figure.

(d)* Explain the income and spending circular flow by means of a figure.

(e)* What is the difference between the circular flows in questions (c) and (d) above?

(f)* Does the monetary value differ between the two circular flows?

Section 3.8 and Appendix 3-1 of the prescribed book are not prescribed for this
module
 30

SOLUTIONS

ACTIVITY 3.1
TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) F In economics, production and income are always equal. They are both flows.
(4) T “Annual” refers to a period.
(5) F The production of the motorcars took place throughout the year. It is therefore a flow
variable.
(6) T It can be measured at a specific moment.
(7) T “Monthly” refers to a period of time.
(8) T It can be measured at a specific moment.
(9) F “In a specific year” refers to a time period. It is thus a flow variable.
(10) T It can only be measured over a period of time.
(11) F Investment is measured over a period of time.
(12) T It is measured at a specific moment.

ACTIVITY 3.2
TRUE/FALSE STATEMENTS

(1) F Money is a means of exchange and not a factor of production — see also statement 9.
(2) F It is limited.
(3) F The term refers to the quality of labour.
(4) T
(5) T Capital is the same as capital goods.
(6) T
(7) T
(8) T
(9) T
(10) F It is dominated by the use of labour.

SHORT QUESTIONS

(b) The completed table should look like this:

Production factors Examples from the building of the Sun City complex
Natural resources Land
Machines, tools, cleaning equipment, buses, refrigerators,
Capital
boats
Labour People to construct the building and rendering services
Entrepreneurship Planning, organisation, decision-making, controlling
 31 ECS1501/001

(c) The completed table should look like this:

Item Capital goods Not capital goods

A printing machine used by book printers x
Cement (to construct an office building) x
Bread x
A teacup x
A shop x
A cash register in a shop x
A highway x

(d) Money is a means of exchange because we can exchange it for goods and services (buy goods
and services with it). Money is not a factor of production, because you cannot use money on its
own to produce goods and services. In order to produce, the factors of production, such as
natural resources, labour, capital and entrepreneurship are required.

ACTIVITY 3.3
TRUE/FALSE STATEMENTS

(1) F See statement 2.

(2) T
(3) T
(4) T
(5) F Wealth is a stock variable that includes all assets, while income is a flow variable including
the income of all production factors. Also see statements 6 and 7.
(6) T
(7) T

ACTIVITY 3.4
TRUE/FALSE STATEMENTS

(1) T
(2) T Consumers aim at maximum satisfaction or maximum total utility, while firms strive for
maximum profit.
(3) T Households buy on the goods market.
(4) T
(5) F Firms are involved in production and households in consumption.
(6) T
(7) T Firms buy factors of production in the factor markets.
(8) T Households sell their factors of production in the factor markets.
 32

SHORT QUESTIONS

(b) i. The most obvious transaction in the example is, of course, that James and his family buy
goods from the Hyperama. James takes some of the Hyperama's goods, and gives the
shop money in exchange. What is the other transaction? Consider how James got his
money in the first place. It obviously comes from the wages he is paid by Oregon Pine
Manufacturers. What does James give them in turn? His skills as a carpenter, in other
words, his labour. The second transaction, thus, is the money James receives in exchange
for his labour.
ii. The market that is created between James's household and the Hyperama concerns the
selling and buying of goods, and is called a market for goods and services, or the goods
market. But what kind of market is present in the transaction between James and his
employer, Oregon Pine Manufacturers? Remember that labour is a factor of production.
Here a factor of production is therefore bought and sold, and we call this market the
market for factors of production, or the factor market.

The relationship between households and firms, which involves two different markets, is
the most basic element of the circular flow.

(c) See Figure 3-3 in the textbook. A short explanation is given below the figure.
(d) See Figure 3-4 in the textbook. A short explanation is given below the figure.
(e) The flow is reversed (in the opposite direction). The one flow is of goods and services while the
other is a monetary flow (a flow of money).
(f) No, in money terms, the magnitudes are the same. The value of what is produced (in money
terms) is equal to (or the same as) what is spent (or bought).

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
name the three major flows in the economy
distinguish between a stock variable and a flow variable and
to give examples of each
define the four factors of production and to give examples of
each
distinguish between the incomes of the factors of production
distinguish between the two production techniques
distinguish between income and wealth
identify the different participants in the economy
define households
define firms
distinguish between the two basic markets in the economy
 33 ECS1501/001

Explanations
I am able to
identify the three major flows in the economy and explain the
interdependence between them
explain the difference between production and income (on
the one hand) and spending (on the other)
explain why money is not seen as a factor of production
explain the interdependence between households and firms
explain the difference between the circular flow of goods and
services and circular flow of income and spending

Diagrams
I am able to show and explain the following with the aid
of a diagram:
the major flows in the economy (Fig 3-1)
the circular flow of goods and services (Fig 3-3)
the circular flow of income and spending (Fig 3-4)
 34

Demand, supply
and prices
LEARNING UNIT

The purpose of this learning unit is to familiarise yourself with the basic elements and methods of
microeconomic analysis by focusing on demand, supply and the determination of equilibrium prices in
goods markets.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ draw and read simple graphs

■ distinguish between theory and reality
■ understand the concepts ceteris paribus and equilibrium
■ understand the interaction between households and firms
■ show how demand can be expressed in words, numbers, graphs and equations
■ define the law of demand
■ explain the difference between demand and quantity demanded
■ distinguish between a movement along a demand curve and a shift of a demand curve
■ identify the determinants of individual demand and market demand
■ show how supply can be expressed in words, numbers, graphs and equations
■ define the law of supply
■ explain the difference between supply and quantity supplied
■ distinguish between a movement along a supply curve and a shift of a supply curve
■ identify the determinants of individual supply and market supply
■ explain how the equilibrium price and equilibrium quantity are determined in the goods market
■ identify the function of prices in a market economy

CONTENTS

This is a vital learning unit which lays the foundation for most of the economic analysis in Economics
1. The chapter in the textbook is fairly long, mainly because the various concepts are introduced
systematically in a step-by-step fashion. For emphasis all the important elements are explained in
various ways and repeated from time to time.

The analysis should not be difficult to follow but you should not rush through it. Take your time and
make sure that you follow the arguments and understand the different approaches to economic
analysis. If you master the basic concepts and techniques introduced in this chapter, you should have
 35 ECS1501/001

no trouble with the rest of the economic analysis in this module. The basic requirements are to keep
thinking as you go along and to get plenty of practice in working with the various techniques.

In this learning unit we are dealing with economic theory. What is the difference between theory and
reality? Theory is not a popular word. Most people are not interested in theory. They want to deal with
the real world, not with some theory about how the world is supposed to function.

Everyone wants to deal with reality, but economic reality is extremely complex. Economists study
human behaviour (as explained in a world in which almost everything is related to everything else, and
often in more than one way). To deal with this complex reality we have to simplify. We have to scale
things down to manageable proportions by focusing on the essential elements only. Theory is used by
all scientists, not only economists.

Theory involves simplification. It captures only details which are regarded as essential or crucial for
analysing a particular problem. A theory is like a map. A map is a simplified version of reality — it is an
abstraction which focuses on the essential information the user needs in order to locate a certain
place or address.

Theories are sometimes called models, laws, principles, explanations or hypotheses. An economic
model is a formal statement of a theory. Economic theory has three main purposes:

■ to explain how different elements are related in the complex real economic world
■ to predict what will happen if something changes
■ to serve as a basis for the formulation and analysis of decisions on economic policy

4.1 Demand and supply: an introductory overview

STUDY

Section 4.1 of the prescribed book

Before you start this section, go back to the circular flow diagrams presented in Learning unit 3. You
will find this interaction between households, firms and the goods market in Figure 4-1 of the textbook.
For example, it indicates that firms (businesses) sell their goods and services to households in the
goods market. This market actually consists of thousands of individual markets for particular goods
and services. In microeconomics we examine each of these markets more closely. This is what this
learning unit is all about. We examine the functioning of a specified market by considering the
decisions of the households that demand (or intend to purchase the product), the decisions of the
firms that supply (or intend to sell) the product, and the way in which the decisions of households
and firms combine to establish the price and the quantity that is exchanged in the market.
 36

4.2 Demand

STUDY

Section 4.2 of the prescribed book

Box 4-1 The importance of relative prices

Table 4-3: The market demand curve: a summary

As far as demand is concerned, the first important point to note is the distinction between demand and
wants, needs, claims or desires. Also note that demand is a flow concept which relates to the plans
of households.

The subsection on individual demand serves as an introduction to market demand, which we

eventually want to explain. Carefully work through the example provided in the textbook and note the
various determinants (or factors) of demand and quantity demanded and the four different ways of
expressing individual demand by means of words, schedules (numbers), equations and graphs. Pay
particular attention to the law of demand, the ceteris paribus assumption and the practice of
placing a bar above variables which are held constant for analytical purposes. Make sure that you
know what a demand curve is and that you can draw one. Always remember to label the origin, the
axes and the curve, otherwise your diagram will not make any sense.

Once you are sure that you know what individual demand represents, you can proceed to the
subsection on market demand. Market demand is obtained by adding the relevant individual
demands horizontally, using schedules or graphs. Note the determinants of market demand and then
proceed to the distinction between:

■ movements along the demand curve (which points to changes in the quantity demanded)
and
■ shifts of the demand curve (which point to changes in demand)

The distinction between a movement along a curve and a shift of a curve is the most important
distinction in graphical economic analysis and you should study it in detail. If you understand this
distinction, you will be able to follow most of the other graphical analyses in the course, but if you do
not, then you will find economic theory extremely difficult to follow.

A movement along a demand curve simply indicates what will happen to the quantity demanded if
the price of the product changes, while all other factors are held constant (the ceteris paribus
assumption). It is called a change in the quantity demanded.

A shift of a demand curve indicates what will happen to the whole demand curve (ie the relationship
between the price of the product and the quantity demanded at each price) if one of the other
determinants (ie any determinant except the price of the product) changes. It is called a change in
demand. Various possible causes of a change in demand are explained in the textbook.

Figures 4-2 to 4-7 are important. Practice drawing them – the ability to use diagrams is essential for
your understanding of markets.

Also note the distinction between substitutes (eg butter and margarine) and complements (eg DVD
players and DVDs).
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Table 4-3 summarises the determinants (factors) of demand and the effect of each on the market
demand curve.

ACTIVITY 4.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Demand is simply another term for wants — in other words, if a consumer
demands a good it simply means that he or she wants the good.
(2) The demand for a product refers to the quantities of the product that potential
buyers are willing and able to buy.
(3) Demand is a stock concept.
(4) Demand refers to plans of households, not to events that have already occurred.
(5) The quantity demanded of a product can differ from the quantity actually bought
or sold.
(6) The demand for a product depends on the availability of the product.
(7) The determinants of demand include a range of factors, such as the price of the
product, the prices of other products and the income of households.
(8) The law of demand states that the quantity demanded of a good will fall if the
price of the good increases, irrespective of what happens to the other factors
which may influence the quantity demanded.
(9) A change in the price of potatoes will result in a change in the demand for
potatoes, that is, the demand curve will shift.
(10) A change in the price of potatoes will result in a change in the quantity of
potatoes demanded, that is, there will be a movement along the demand curve.
(11) If the demand curve for good B shifts if there is a change in the price of good A,
good B can be either a complement or a substitute of good A.
(12) An upward movement along a given demand curve is referred to as a decrease
in the quantity demanded.
(13) If A and B are complements, a fall in the price of A will lead to an increase in the
demand for B, that is, the demand curve for B will shift to the right.
(14) An increase in the income of households is one of the possible causes of a
rightward shift of a demand curve.
(15) The market demand curve is the horizontal sum of all the individual demand
curves.
(16) A rightward shift of a demand curve (ie an increase in demand) indicates that a
greater quantity of the good is demanded at each price.
(17) If peas and green beans are substitutes, a decrease in the price of peas will
result in a leftward shift of the demand curve for green beans (ie a decrease in
demand for green beans).
Note: Statements 18 to 22 are based on Figure 4-1 below which illustrates two demand curves for
peanuts, D1 and D2.
(18) A movement from point a to point b could be the result of an increase in the
income of households.
(19) A movement from point c to point d could be the result of an increase in the
price of a substitute (say, pecan nuts).
(20) A movement from point a to point c could be the result of a decrease in the price
of raisins, a complement.
 38

T F
(21) A movement from point c to point b could be the result of a decrease in the price
of peanuts.
(22) A movement from point d to point c could be the result of an increase in the
price of peanuts.

FIGURE 4-2

Short questions
Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Mention any three determinants of an individual household's demand for a particular good or
service.

(b) i. Mention the four ways in which demand can be expressed.

ii.* Which method is used most often in this module?

(c)* Explain the meaning of the term ceteris paribus.

(d) Explain the relationship between individual demand and market demand.

(e)* The following information on Peter Marais’s demand schedule for cookies (per packet) is given:

Price of cookies (per Number of packets of

packet) cookies demanded
1 50
2 40
3 30
4 20
5 10

i. Use the above information and the axes in Figure 4-1 below to draw the demand curve for
cookies. Remember to label the axes and curve.
 39 ECS1501/001

FIGURE 4-2

ii. Which variable is indicated on the horizontal axis? Is it the dependent or independent
variable?
iii. Which variable is indicated on the vertical axis? Is it the dependent or independent
variable?
iv. What is the quantity demanded (in packets of cookies) at a price of R2?
v. What is the quantity demanded (in packets of cookies) at a price of R5?
vi. What happens to the quantity of packets of cookies demanded when the price declines?
vii. What happens to the quantity of packets of cookies demanded when the price increases?
viii. What relationship is illustrated between the two variables (P and Qd)? What does it mean?
ix. This relationship between P and Qd is so important that it carries the status of a “law”.
What is this law called? Define it.
x. The answers to vi and vii indicate a negative or inverse relationship between the price of
cookies (per packet) and the quantity demanded. How do we indicate such a negative
relationship graphically?
xi. Was there any shift of the demand curve in this example? Explain.
xii. Was there any movement along the demand curve in this example? Explain.

(f)* Mention any two factors that can lead to the rightward shift of the demand curve.

(g)* Mention any two factors that can lead to the leftward shift of the demand curve.

(h)* What determinant (factor) will cause a movement along the demand curve?
 40

(i)* Complete the following table. The first example has been done for you.

Determinant Effect on the market Graphical

Change
(Factor) demand curve Illustration

● Population Increase Rightward shift

● Income Decrease
(normal good)

● Taste Lower desire to buy

the product

● Price of the Increase

specific
product
Decrease
● Expected future
price of the
specific product

(j)* Explain, by using two figures, how the decrease in the price of one product (eg tea) will influence
the demand of a substitute (eg coffee).

(k)* Explain, by using two figures, how the increase in the price of a complement (eg shoes) will
influence the demand of another product (eg socks).

Note: In the following learning unit the interaction between different markets (substitutes and
complements) will be investigated in more detail.

4.3 Supply

STUDY

Section 4.3 of the prescribed book

Table 4-5: The market supply curve: a summary

All the basic concepts and techniques introduced in Section 4.2 are applied in Section 4.3 to analyse
the supply side of the market. The analysis again starts with an example of individual supply. Work
through the example, note the determinants of supply, and how supply (like demand) can be
expressed in words, schedules (ie numbers), equations (ie symbols) and graphs (diagrams).
 41 ECS1501/001

Market supply, like market demand, is also obtained by adding individual supply curves. Note the
determinants of market supply and pay particular attention to the difference between changes in the
quantity supplied (illustrated by movements along a supply curve) and changes in supply (illustrated
by shifts of a supply curve).

This distinction is based on the same principles as the distinction between changes in the quantity
demanded and changes in demand.

Figures 4-8 to 4-10 are important. Practice drawing them.

Note the difference between substitutes in production (eg beans and cabbage) and complements
in production (eg beef and leather). Remember that we are dealing with the supply (or production)
side of the market.

Table 4-5 summarises the determinants (factors) of supply and quantity supplied and the effect of
each on the market supply curve.

ACTIVITY 4.2
Indicate whether the following statements are true (T) or false (F):
Note: Answers are provided at the end of this learning unit.
T F
(1) Supply is a flow concept.
(2) Supply refers to the quantity of a good that is available in a shop on a particular
day.
(3) Supply refers to the quantities of a good or service that producers plan to sell at
different prices.
(4) A supply curve is an illustration of the quantities supplied at different prices, on
the assumption that all the other factors that can influence the quantity supplied,
remain unchanged.
(5) An increase in the price of any of the factors of production will result in an
upward (or leftward) shift of the supply curve.
(6) An increase in the price of potatoes will result in an increase in the supply of
potatoes (ie a rightward shift of the supply curve).
(7) A decrease in the price of potatoes will result in a leftward (downward)
movement along the supply curve (ie a decrease in the quantity of potatoes
supplied).
(8) A supply schedule is a table which shows the different quantities supplied at
different prices of the good.
(9) The market supply curve is the horizontal sum of all the individual supply curves.
(10) In their supply decisions, producers take account of the prices of all the
alternative products which they can produce.
(11) An upward movement along a supply curve is also called an increase in supply.
(12) An increase in the price of potatoes will lead to an increase in the quantity of
potatoes supplied.
(13) A decrease in the quantity of oranges supplied is illustrated by an upward or
leftward shift of the entire supply curve.
(14) A fall in the price of milk, used in the production of ice cream, will cause an
increase in the supply of ice cream, that is, a downward or rightward shift of the
supply curve.
 42

T F
(15) A change in the price of apples will not cause the supply curve in respect of
apples to shift.
(16) An increase in the wages of workers at the Volkswagen factory in Uitenhage will
result in a movement along the supply curve of Volkswagens.
(17) An increase in the production of beef will lead to a decrease in the production of
leather (made from cattle hides).
Note:Statements 18 to 22 are based on Figure 4-3 below which illustrates two supply
curves of cabbage, S1 and S2.
(18) A movement from point a to point b could be the result of an increase in the
wage rate paid to farm workers.
(19) A movement from point c to point d could be the result of an increase in the
price of cabbage.
(20) A movement from point b to point d could be the result of a decrease in the price
of beans, an alternative product (or substitute in production).
(21) A movement from point a to point c could be caused by an increase in the
number of cabbage producers.
(22) A movement from point c to point a could be caused by a decrease in the price
of cabbage.

FIGURE 4-3

Short questions
Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a)* What is the opposite force of demand in the market? Which of the economic participants
represent this force, and what are their aims?

(b) Define the supply of a good.

(c) Explain the relationship between individual supply and market supply.

(d)* Mention six determinants that would shift the market supply curve to the right.
 43 ECS1501/001

(e)* The following information represents Jack Makwela’s supply schedule in terms of cookies (per
packet):

Price of cookies Number of packets of

(per packet) cookies supplied
1 10
2 20
3 30
4 40
5 50

i. Use the above information and the axes in Figure 4-4 below to draw the supply curve for
cookies. Remember to label the axes and curve.

FIGURE 4-4

ii. Which variable is indicated on the horizontal axis? Is it the dependent or independent
variable?
iii. Which variable is indicated on the vertical axis? Is it the dependent or independent
variable?
iv. What is the quantity supplied (in packets of cookies) at a price of R2?
v. What is the quantity supplied (in packets of cookies) at a price of R5?
vi. What happens to the quantity of packets of cookies supplied when the price declines?
vii. What happens to the quantity of packets of cookies supplied when the price increases?
viii. What relationship is illustrated between the two variables (P and Qs)? What does it mean?
ix. The relationship between P and Qs is so important that it carries the status of a “law”. What
is this law called? Define this law.
x. The answers to vi and vii above indicate a positive relationship between the price of
cookies and the quantity supplied. How do we indicate such a positive relationship
graphically?
xi. Was there any shift of the supply curve in this example? Explain.
xii. Was there any movement along the supply curve in this example? Explain.

(f)* Use a figure or figures to explain the difference between a movement along a supply curve and
a shift of the supply curve. Mention a possible cause for each.
 44

(g)* Complete the following table. The first example has been done for you.

Determinant Change Effect on the market Graphical

(Factor) supply curve illustration

● Number of firms Decrease Leftward shift

● Prices of inputs Decrease

● Technology Cost-saving
technological
improvement

● Price of the specific Increase

product

● Price of a substitute Increase

(in production)

● Price of a Increase
complement (in
production)

● Expected future Decrease

price of the specific
product

(h)* Below are some extracts from newspaper headlines or reports. In each case, the supply of a
product or products will be affected. Explain how the supply will be affected. Where applicable,
also mention which factor caused the change in supply.
i. “Meat prices will decrease due to good rains experienced in the cattle producing areas of
the county.” What will the effect be on the supply of leather?
ii. “Price of copper wire increases.” What effect will this have on the availability of portable
radios?
 45 ECS1501/001

4.4 Market equilibrium

STUDY

Section 4.4 of the prescribed book

Box 2-4 The functions of prices in a market

economy

Demand and supply are combined in this section to obtain the equilibrium price and the equilibrium
quantity in the market.

The concept of equilibrium plays a central role in economic theory. It represents a situation where
none of the participants has any incentive to change his or her behaviour — everyone is content to
continue with things as they are.

In economic theory we examine all the forces at work in a particular situation that we are investigating
and then formulate the conditions under which there will be equilibrium. Equilibrium can be described
as a state of balance — that is, a state in which all opposing forces are balanced and there is no
tendency to change. Equilibrium is thus a state of rest. Equilibrium can be explained by a physical
example. Suppose you sit motionless on a swing. All the forces are balanced and there is no tendency
for things to change. Then someone gives you a push. You start swinging to and fro. If you are not
pushed again, your movements will become progressively smaller until you are motionless again.
Equilibrium is thus restored and things will remain this way until equilibrium is again disturbed.

Figure 4-11 is important. Ensure that you understand why there is only one equilibrium price and why
there is disequilibrium (in the form of excess demand or excess supply) at any other price. Also
make sure that you can identify excess demand and excess supply in a graphical representation of
demand and supply curves. Finally, note the functions of prices in a market economy.

ACTIVITY 4.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Equilibrium is often observed in our daily lives.
(2) Equilibrium is a balanced situation where all opposite forces are balanced out.
(3) A market can only be in equilibrium if the quantity demanded is equal to the
quantity supplied.
(4) A market can only be in equilibrium if demand is equal to supply.
(5) At any price above the equilibrium price there will be an excess demand for the
good in question.
(6) Excess demand for a good will put downward pressure on the price of the good.
(7) If the price of television sets is lower than the equilibrium price, there will be an
excess demand for television sets.
(8) If the price of running shoes is above the equilibrium price, there will be an
excess supply of running shoes.
(9) If there is excess supply in the market, then the market cannot be in equilibrium.
 46

T F
(10) A market can only be in equilibrium if there is no tendency for things to change
(as long as the underlying factors remain the same).
(11) The allocative function of prices means that prices can ration the scarce supply
of goods and services.
(12) The allocative function of prices implies that prices act as signals to allocate
production factors between different uses in the economy.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a)* Use a diagram to illustrate

i. market equilibrium
ii. excess supply
iii. excess demand

(b)* Use Figure 4-5 below to answer the following questions:

FIGURE 4-5

i. How many units are supplied at a price of R80?

ii. How many units will be sold at a price of R80?
iii. What is the excess supply at a price of R80?
iv. What will happen to the market price if there is excess supply?
v. What will happen to the quantity produced if there is excess demand in the market?
vi. How many units are supplied at a price of R40?
vii. Why do we not have market equilibrium at a price of R20?
viii. Why do we not have market equilibrium at a price of R80?
ix. At what price do we have market equilibrium?
x. What is equilibrium quantity?
xi. What does market equilibrium mean?
 47 ECS1501/001

(c) Name the two most important functions of prices in a market economy.

4.5 Consumer surplus and producer surplus

STUDY

Section 4.5 of the prescribed book

The concepts of consumer surplus and producer surplus arise from the fact that some consumers pay
less at the prevailing market price than they are willing to pay and some producers receive more than
the minimum they are willing to accept.

The consumer surplus concept has a number of interesting applications. In the next learning unit it is
used to show how society is worse off by the imposition of maximum and minimum prices.

ACTIVITY 4.4
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The consumer surplus is what is left after consumers have bought their monthly
groceries.
(2) The consumer surplus is what consumers have left after all their monthly needs
have been satisfied.
(3) The consumer surplus is the difference between what consumers earn and what
they spend.
(4) The producer surplus is always greater than the consumer surplus.
(5) The producer surplus is the difference between the price that producers receive
and the lowest prices at which they are willing to supply the different quantities.
(6) The producer surplus is simply another term for profit.

Short questions

Note: Solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Use a diagram to explain what consumer surplus means.

(b) Use a diagram to distinguish between the consumer surplus and the producer surplus.
(c) “At market equilibrium both the consumer surplus and the producer surplus are zero.” Do you
agree? Explain, using a diagram.
 48

4.6 Algebraic analysis of demand and supply

STUDY

Appendix 4-1 of the prescribed book

As stated earlier in this learning unit demand and supply can be expressed in words, tables, graphs
and equations. In this section we take a closer look at equations.
.

ACTIVITY 4.5
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) If Qd = 30 – 2P and Qs = 10 + 2P, then the equilibrium price is 5.
(2) If Qd = 40 – 2P and Qs = 25 + 4P, then the equilibrium quantity is 30.

Short questions

Note: Solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) *Calculate the equilibrium price and quantity if the demand and supply curves are represented
by the following equations: Qd = 100 – P and Qs = 50 + P.

(b) *If the equation for a market demand curve is Qd = 100 – 0,5P and the equation for a market
supply curve is Qs = –20 + P, calculate the market equilibrium price and quantity.

SOLUTIONS

ACTIVITY 4.1
TRUE/FALSE STATEMENTS

(1) F Demand and wants are not the same. Also see Learning unit 1.
(2) T
(3) F It is a flow variable.
(4) T
(5) T
(6) F The supply or availability of the product is not a determinant of demand — see Table 4-3.
(7) T A price change causes a movement along the curve; all other factors will shift the curve.
(8) F What happens to other factors should also be considered. The ceteris paribus principle
applies and should not be disregarded.
(9) F See statement 10.
(10) T
 49 ECS1501/001

(11) T The demand curve shifts. The direction is unknown, because the direction of price change
was not given. Also see statement 13.
(12) T
(13) T Complements are used in combination and a lower price of A will cause a higher quantity
demanded for A and a higher demand for B.
(14) T
(15) T
(16) T
(17) T Substitutes replace each other. One is used in the place of the other. If the price of peas
decreases, more peas will be demanded and fewer green beans.
(18) F An increase in income will shift demand to the right.
(19) F If the price of a substitute increases, more peanuts will be demanded and the demand
curve for peanuts will shift to the right.
(20) T
(21) F There will be a movement along the same demand curve — see statement 22.
(22) T

SHORT QUESTIONS

(b) ii. The graphic method (in other words, diagrams/figures).

(c) Ceteris paribus means “all other things being equal” that all other factors or forces remain the
same or constant. Only the one factor we want to study may change. In the real world, most
things change all the time, but in order to predict the result of a change we can allow only one
thing to change at a time. Remember that no change in an economic variable can be explained
by only one other variable. Therefore the ceteris paribus assumption will always be used in
economic theory and analysis. To simplify things, this assumption is not always stated explicitly,
but is implicitly always accepted to apply.

(e) i. Look at the given information. Note that all the values are positive. The origin is where the
vertical and horizontal axes meet and should be marked by a 0. Now number vertical
upwards in equal units until you get to 5 and label the vertical axis as the price axis (with a
P). Go back to 0 (the origin) to complete the horizontal axis (or the quantity axis). The
maximum value on the horizontal axis is 50. Start at the origin and number to the right in
equal units from 10 to 20, 30, 40 to 50 and label the axis with a Q (for quantity). Now you
have constructed the axes of the graph.

Note from the above figure that we do not use the same scale on both axes — in other
 50

words, the division on the vertical and horizontal axes is not the same. We do this because
the magnitude of the two variables (price per packet of cookies and quantity demanded)
differ considerably. On the horizontal axis we measure up to 50 units while the vertical axis
only goes to 5 (price in rands). Note that equal distances or segments on each axis must
reflect equal quantities. On the horizontal axis, the distance between 20 and 30 must be
the same as the distance between 30 and 40.

Similarly, on the vertical axis, the distance between 1 and 2 should be the same as
between 4 and 5.

The next step is to plot the data. To explain this we take two of the combinations from the
table. The first combination, which we will call combination a in the figure above, is 50
packets of cookies at a price of R1. To plot this combination, we go to 50 units/quantity on
the horizontal axis and draw a vertical line at that point. At each point along that line, the
number of packets of cookies is equal to 50. In the same way, draw a horizontal line at a
price of R1 per packet of cookies. At each point along this line the price per packet of
cookies is equal to R1. At the point where these two lines intersect (and only at that point),
the number of packets of cookies is equal to 50 and the price per packet of cookies equal
to R1. This point, indicated by a in the above figure, represents a combination of 50
packets (quantity) and R1 (price). This procedure can be repeated to plot a combination of
40 packets of cookies at a price of R2, and call it point b. We have now used two of the
given combinations to plot points a and b. Repeat this process to plot combinations 30 and
R3 (point c), 20 and R4 (point e) and 10 and R5 (point f). Note that the points are
marked a, b, c, e and f. D (in this case d) is not included because D refers to demand in
economics.

Having explained how different points are plotted, we can now start drawing the line or
curve. In the above figure we use all the information in the table to plot five combinations of
the quantity of packets of cookies demanded and the price per packet of cookies. We then
join these points to form a line or curve that we call D. (D refers to demand.) In this case it
is a straight line. Such a straight line is also called a linear relationship.
ii. The quantity of packets of cookies demanded (Qd or just Q). Qd is the dependent
variable because it is the variable that is explained. The change or reaction of this variable
“depends” on another variable or determinant. Thus, the change in Q depends on the
change in P. (A variable is anything that is measurable and varies, like time, speed,
distance. Economic examples include prices, profit and quantities.)
iii. The price per packet of cookies (P). P is the independent (or explanatory) variable
because it is the variable determining Qd, in other words if P changes, Qd (the dependent
variable) will react to this change.
iv. 40 packets.
v. 10 packets.
vi. More packets are demanded.
vii. Fewer packets are demanded.
viii. A negative (or inverse) linear relationship exists. A negative relationship means that the
value of the dependent variable (Qd or only Q) increases when the value of the
independent variable (P) decreases; or that the value of the dependent variable (Qd or just
Q) decreases when the value of the independent variable (P) increases. In other words, a
negative or inverse relationship implies that the two variables change in opposite
directions. Remember that linear means a straight line. The relationship between the two
variables (P and Qd or just Q) is represented by a continuous, perfectly straight line.
ix. The law of demand. If all other things remain equal (ceteris paribus), a higher (or lower)
price will lead to a lower (or higher) quantity demanded of the product.
x. See the above graph. It is a straight line from the top left to the bottom right.
xi. No. Only the price per packet of cookies changed. All other factors remained unchanged.
xii. Yes. If the price of a specific product changes (cookies in this example), there will be a
 51 ECS1501/001

movement along the curve and not a shift of the curve.

(f) You could have given any two of the following:

- an increase in the price of substitutes
- a decrease in the price of complements
- an increase in income
- a stronger desire to buy
- a larger population
- an increase in the expected future price of the product
Also see Table 4-3 in the textbook.

Note that the direction of change is important. If you did not indicate the direction (increase or
decrease), your answer would have been wrong and you would have lost marks in the
examination. For example, if your answer only referred to a change in income, you would not
have received any marks.

(g) See Table 4-3. The same determinants apply as in question (f) above. However, the direction
will differ and be the opposite.
Note that the direction is also important in answering this question. Read the questions carefully
before you start to answer them.

(h) Only the price of the specific product.

 52

i) See the completed table below:

Determinant Change Effect on the Graphical

(Factor) market demand Illustration
curve

● Population Increase Rightward shift

● Income Decrease Leftward shift

(normal good)

● Taste Lower desire to Leftward shift

buy the product
 53 ECS1501/001

Determinant Change Effect on the Graphical

(Factor) market demand illustration
curve

● Price of the Increase Upward movement

specific along the demand
product curve
(from point a to
point b)

● Expected Decrease Leftward shift

future price of
the specific
product

Note: Look at the above graphical illustrations. Which determinant is indicated on the vertical axis?
Yes, the price of the product (P). If there is a change in the determinant on the vertical axis (ie P),
there will always be a movement along the curve. All the other determinants (factors) will shift
the demand curve.

(j) Substitutes
Figure A (tea) Figure B (coffee)

Figure A: A lower price for tea will increase the quantity of tea demanded (a movement along
the curve). See also the law of demand.
Figure B: Tea and coffee are substitutes — you can use the one rather than the other. You have
to choose between the two. If more tea is demanded because of the lower price (in Figure A),
 54

less coffee will be demanded (at each price) and the demand for coffee will decrease (the
demand curve in Figure B will shift to the left).

(k) Complements
Figure A (shoes) Figure B (socks)

D 

Figure A: If the price of shoes increases, the quantity of shoes demanded will decrease (law of
demand).
Figure B: Shoes and socks are complements — in other words, you need both products
together to satisfy a need. If fewer shoes are demanded because of the higher price (in Figure
A), fewer socks will also be demanded (at each price), because the two are used together. The
demand for socks will decrease (the demand curve shifts to the left in Figure B).

ACTIVITY 4.2
TRUE/FALSE STATEMENTS

(1) T
(2) F See statement 3.
(3) T This is the definition of supply.
(4) T
(5) T Look at the impact of prices of inputs on the supply curve.
(6) F A higher price will lead to an upward movement along the supply curve.
(7) T
(8) T
(9) T
(10) T
(11) F It is called an increase in the quantity supplied.
(12) T It is an upward movement along the supply curve.
(13) F It is represented by a downward movement along the supply curve.
(14) T
(15) T
(16) F Wages of workers refer to the determinant, prices of inputs. Increasing wages will shift the
supply curve to the left. See Table 4-5.
(17) F Meat and leather are supplied together. Higher beef supply means more cattle are
slaughtered and more hides are available to produce leather.
(18) F Wages refer to prices of inputs — it will shift the supply curve.
(19) T
 55 ECS1501/001

(20) T Less beans are supplied because the price of beans has decreased. Relative to the price
of beans, the price of cabbage is now higher and therefore more cabbage will be
produced.
(21) T
(22) F A lower price will cause a downward movement along the same supply curve.

SHORT QUESTIONS

(a) The opposite of demand is supply, which is represented by producers in the market. While
consumers try to maximise the utility they obtain from products, producers always try to
maximise their own profits. To make as large a profit as possible, firms try to minimise their costs
and maximise their revenue (income).
(d) Also see Table 4-5 in the textbook.
- a decrease in the prices of substitutes in production
- an increase in the prices of complements in production
- lower input cost (eg the cost of labour)
- prices expected to increase in future
- cost-reducing technological change
- an increase in the number of firms entering the market
The direction of change is important.

(e) The graph should look like this:

i. If you had trouble drawing the supply curve, work through Activity 4.1 (question e), again.
There we explained in detail how to draw a graph. The curve should be labelled S
(referring to supply).
ii. The quantity of cookies supplied (Qs or just Q). This is the dependent variable.
iii. The price of cookies (P). This is the independent variable.
iv. 20 packets of cookies.
v. 50 packets of cookies.
vi. The quantity of cookies supplied decreases.
vii. The quantity of cookies supplied increases.
viii. A positive (or direct) linear relationship. A positive relationship means that the value of the
dependent variable (Qs or just Q) increases when the value of the independent variable (P)
increases; or that the value of the dependent variable (Qs or just Q) decreases when the
value of the independent variable (P) decreases. Thus, a positive or direct relationship
implies that the two variables change in the same direction. Linear means a straight line,
like the supply curve depicted above.
ix. The law of supply. The higher the price of a product the higher the quantity supplied will
be; the lower the price of a product the lower the quantity supplied will be.
 56

x. A straight line from bottom left to top right. See the curve in the above figure.
xi. No. Only the price per packet of cookies changed. All other factors remained unchanged.
xii. Yes. A change in the price of the product (packets of cookies) will lead to a movement
along the existing curve and will not shift the curve. All the other determinants (listed in
Table 4-5) will shift the supply curve SS.

(f) Movement along a supply curve Shift of the supply curve

Only the price of the specific product Any one of the following:
- a change in the price of
production substitutes
- a change in the price of
production complements
- a change in input cost
(such as labour cost)
- a change in expected
future prices
- a technological change
- a change in the number of
firms entering the market
 57 ECS1501/001

(g) The table should look like this:

Determinant Change Effect on the market Graphical illustration

(Factor) supply curve

● Number of Decrease Leftward shift

firms

● Prices of Decrease Rightward shift

inputs

● Technology Cost-saving Rightward shift

technological
improvement

● Price of the Increase Upward movement along

specific supply curve (from point a
product to
point b)
 58

Determinant Change Effect on the market Graphical illustration

(Factor) supply curve

● Price of a Increase Leftward shift

substitute
(in production)

● Price of a Increase Rightward shift

complement (in
production)

● Expected future Decrease Leftward shift

price of the
specific product

(h) i. Meat and leather are complements in production. When the supply of meat increases due
to good rains in the cattle producing areas of the country, the supply of leather will
therefore also increase, and producers will supply the leather at lower prices. The supply
will shift to the right.
ii. Copper wire is a production input for portable radios. If it becomes more expensive, its
supply will decrease. The total production cost of portable radios will increase, causing
producers to supply less. The supply curve will shift to the left.

ACTIVITY 4.3
TRUE/FALSE STATEMENTS

(1) F Equilibrium is not often observed.

(2) T
(3) T
(4) F See statement 3.
 59 ECS1501/001

(5) F Excess supply will prevail.

(6) F Excess demand leads to upward pressure on the price of the product.
(7) T
(8) T
(9) T
(10) T This is what equilibrium means.
(11) F It is the rationing function of prices. Also see statement 12.
(12) T

SHORT QUESTIONS

(a) You should have drawn a figure like Figure 4-11 in the textbook. Remember to clearly indicate
the excess demand and supply, as was done in the figure.

(b) i. 200 units will be supplied (read it from the supply curve SS).
ii. 100 units will be sold (read it from the demand curve DD).
iii. Excess supply is: 200 units minus 100 units = 100 units.
iv. Price will decrease until equilibrium is reached (there is downward pressure on prices).
v. The quantity produced will increase.
vi. 100 units are supplied (read it from the supply curve SS).
vii. Excess demand of 200 units; quantity demanded is 250 units while only 50 units are
supplied.
viii. Excess supply of 100 units; quantity supplied is 200 units while only 100 units are
demanded.
ix. R60, where Qd = Qs = 150.
x. 150 units.
xi. Where quantity demanded (Qd) equals quantity supplied (Qs).

Note: equilibrium is not where demand equals supply. For this to happen, the two curves will
have to coincide.

ACTIVITY 4.4
TRUE/FALSE STATEMENTS

(1) F
(2) F
(3) F
(4) F
(5) T
(6) F
 60

ACTIVITY 4.5
TRUE/FALSE STATEMENTS

(1) T Given: Qd = 30 – 2P and Qs = 10 + 2P

At equilibriu m Qd  Qs
30  2P  10  2P
 2P  2P  10 - 30
- 4P   20
4P  20
20
P
4
5

Substitute P = 5 into

Qd  30  2P
 30  2(5)
 30 - 10
 20

or

ac
P
d b
30  10

22
20

4
 5

and

 ac 
Q  a  b 
d b
 30  10 
 30  2 
 22 
 20 
 30  2 
 4
 30  10
 20
 61 ECS1501/001

(2) F Given: Qd = 40 – 2P and Qs = 25 + 4P

At equilibrium Qd  Qs
40  2P  25  4P
 2P  4P  25 - 40
- 6P   15
6P  15
15
P
6
 2,5

Substitute P = 2,5 into

Qd  40  2P
 40  2( 2,5)
 40 - 5
 35

or

ac
P
d b
40  25

24
15

6
 2,5

and

 a c 
Q  a  b 
d b
 40  25 
 40  2 
 24 
 15 
 40  2 
6
 40  5
 35
 62

SHORT QUESTIONS

(a) Given: Qd = 100 – P and Qs = 50 + P

At equilibrium Qd  Qs
100  P  50  P
 P  P  50 - 100
- 2P   50
2P  50
50
P
2
 25

Substitute P = 25 into

Qd  100  P
 100  25
 75
or
ac
P
d b
100  50

11
50

2
 25

and

 a c 
Q  a  b 
d b
 100  50 
 100  1 
 11 
 50 
 100  1 
 2
 100  25
 75
 63 ECS1501/001

(b) Given: Qd = 100 – 0,5P and Qs = -20 + P

At equilibrium Qd  Qs
100  0,5 P   20  P
 0,5P  P  - 20 - 100
- 1,5P   120
1,5P  120
120
P
1,5
 80

Substitute P = 80 into

Qd  100  0,5 P
 100  0,5(80)
 100  40
 60
or
ac
P
d b
100  ( 20)

0,5  1
120

1,5
 80

and

 ac 
Q  a  b 
d b
 100  ( 20) 
 100  0,5 
 0,5  1 
 120 
 100  0,5 
 1,5 
 100  40
 60
 64

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
distinguish between theory and reality
list the main purposes of economic theory
define demand
name the various ways in which individual demand and
supply can be expressed
distinguish the determinants of individual demand
define the law of demand
distinguish the determinants of market demand and quantity
demanded
define supply
distinguish the determinants of individual supply
define the law of supply
distinguish the determinants of market supply and quantity
supplied
distinguish between substitutes and complements in
consumption and between substitutes and complements in
production and give examples of each
define market equilibrium
define excess demand
define excess supply
list the functions of prices in a market economy

Explanations
I am able to
explain the concept ceteris paribus
explain the concept equilibrium
explain the relationship between individual demand and
market demand
explain the difference between a movement along a curve
and a shift of a curve
explain the relationship between individual supply and
market supply
 65 ECS1501/001

Well Satis- Must Need

factory redo help
explain the difference between excess demand and excess
supply
explain how equilibrium is determined in the goods market
explain what will happen to prices and quantities in order to
reach equilibrium when excess demand occurs
explain what will happen to prices and quantities in order to
reach equilibrium when excess supply occurs

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the interaction between households and firms
(Fig 4-1)
a demand schedule (Fig 4-2)
how the market demand curve is obtained (Fig 4-3)
a movement along a demand curve (Fig 4-4)
a shift of a demand curve (Fig 4-7)
the effect of a change in the most important demand factors
and quantity demanded on the market demand curve (Table
4-3, Fig 4-5, 4-6)
a supply schedule (Fig 4-8)
a movement along a supply curve (Fig 4-9)
a shift of a supply curve (Fig 4-10)
the effect of a change in the most important supply factors
and quantity supplied on the market supply curve (Table 4-5)
market equilibrium, excess demand and excess supply (Fig
4-11)
consumer surplus (Fig 4-12)
producer surplus (Fig 4-13)
consumer and producer surplus at equilibrium (Fig 4-14)

Calculations
I am able to
calculate equilibrium price and quantity
 66

Demand and supply

in action
LEARNING UNIT

The purpose of this learning unit is to show how changes in either demand or supply or simultaneous
changes in demand and supply will affect the equilibrium price and equilibrium quantity in the market
and to discuss the consequences of different forms of government intervention on price determination.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ illustrate how a change in either demand or supply or simultaneous changes in demand and
supply will affect the equilibrium price and equilibrium quantity (equilibrium position) in the
market
■ illustrate the interaction between related markets
■ show what happens if the government intervenes in the price mechanism by setting minimum
or maximum prices
■ illustrate the fluctuations in agricultural prices on farmers' total income

CONTENTS

This learning unit indicates how demand and supply can be used to analyse certain situations in the
economy. The focus is on predicting what will happen if something changes. The effects of various
forms of government intervention in price determination are also discussed.

5.1 Changes in demand

STUDY

Section 5.1 of the prescribed book

In Learning unit 4 you were introduced to demand, supply, market equilibrium, changes in demand
and changes in supply. In this section they are combined to show what happens if demand changes. If
you understood the contents of Learning unit 4, you should have little difficulty understanding the
analysis in this section. If not, then you should revise Learning unit 4 before continuing with the rest of
this learning unit.

Note: We work with normal products in our examples, except when we state that it is an inferior
 67 ECS1501/001

product. If any question merely refers to a specific product, you should know that it is a normal
product.

Figures 5-1 and 5-2 are important. Again note the determinants affecting demand (see Table 4-3).

ACTIVITY 5.1
Indicate whether the following statements are true (T) or false (F):
Note: Answers are provided at the end of this learning unit.
T F
(1) If the demand for watermelons were to increase, there would be a decrease in
the price of watermelons.
(2) An increase in the income of households will lead to an increase in the price of
meat.
(3) A decrease in the price of CD players will lead to an increase in the price of
CDs.
(4) An increase in the price of chicken will lead to a decrease in the quantity of
chickens demanded.

Short questions
Note: The solutions to the questions are provided at the end of this learning unit.

(a) Use a diagram to explain what will happen to the equilibrium price and quantity of a (normal)
product if the demand of the product increases.

(b) What will happen to the equilibrium price and quantity of a (normal) product if the demand of the
product decreases?

5.2 Changes in supply

STUDY

Section 5.2 of the prescribed book

In this section demand, supply and market equilibrium are combined to show what happens if supply
changes. Figures 5-3 and 5-4 are important. Again, note the determinants affecting supply (see Table
4-5).
ACTIVITY 5.2
Indicate whether the following statements are true (T) or false (F):
Note: Answers are provided at the end of this learning unit.
T F
(1) If the supply of oranges decreases, there will be an increase in the price of
oranges.
(2) An increase in the wages of workers in the clothing industry will lead to an
increase in the price of clothing.
 68

T F
(3) An increase in the productivity of workers in the motorcar industry will lead to a
fall in the price of new motor vehicles.

Short questions

Note: The solutions to the questions are provided at the end of this learning unit.

(a) Explain by means of a figure how the equilibrium price and quantity of a normal product will be
affected if the supply of this product decreases.

(b) What will happen to the equilibrium price and quantity if labour cost increases?

5.3 Simultaneous changes in demand and supply

STUDY

Section 5.3 of the prescribed book

In this section, simultaneous changes in demand and supply are covered. When only demand or
supply changes, it is possible to predict what will happen to equilibrium price and equilibrium quantity
in the market. However, if demand and supply change simultaneously, the precise outcome cannot
be predicted, because the changes may have the opposite effect.

Figure 5-5 is important. The results of various combinations of simultaneous changes in demand and
supply on the equilibrium price and quantity are summarised in Table 5-1.

ACTIVITY 5.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) If the supply of peaches were to increase and the demand to decrease
simultaneously, there would be a decrease in the price of peaches but the
direction of the change in the equilibrium quantity of peaches would be
impossible to predict accurately.
(2) If the supply and demand of bananas were to decrease simultaneously, both the
equilibrium price of bananas and the equilibrium quantity would definitely
decrease simultaneously.

Short questions

Note: The solution to this question is provided at the end of this learning unit.

(a) Use three diagrams to explain what will happen to the equilibrium price and equilibrium quantity
of a normal product if demand and supply increase simultaneously.
 69 ECS1501/001

5.4 Interaction between related markets

STUDY

Section 5.4 of the prescribed book

Many products are related to one another in some or other way. Some are substitutes or
complements (in consumption), while others are substitutes or complements (in production).
You will remember that we touched on this aspect in Learning unit 4. In this section you will find more
practical examples and see how equilibrium price and quantity are affected — Figures 5-6 and 5-7
are important.

ACTIVITY 5.4
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) A lower milk price (complement for tea) will shift the demand curve for tea to the
left.
(2) A higher milk price (complement for tea) will shift the demand curve for tea to
the left.
(3) A higher coffee price (substitute for tea) will shift the demand curve for tea to the
left.
(4) A higher coffee price (substitute for tea) will shift the demand curve for tea to the
right.
(5) A lower coffee price (substitute for tea) will shift the demand curve for tea to the
right.
(6) A lower coffee price (substitute for tea) will shift the demand curve for tea to the
left.

Short question

Note: The solutions to the questions marked are provided at the end of this learning unit.

(a) Explain, with the aid of two diagrams, how an increase in the supply of good A will affect the
equilibrium price and quantity of good B if A and B are complements.

(b) Explain, with the aid of two diagrams, how an increase in the supply of good A will affect the
equilibrium price and quantity of good B if A and B are substitutes.
 70

5.5 Government intervention

STUDY

Section 5.5 of the prescribed book book – except

the subsections dealing with subsidies, taxes, the
welfare implications of a specific excise tax,
quotas and import tariffs

This section explains the consequences of government intervention in price determination. One
important thing to note about government intervention in price fixing is that those who are supposed to
benefit are often among those who eventually suffer the worst consequences of the introduction of
price controls. The government can intervene in the market system by, say, setting maximum prices.
A maximum price will only have an impact on the market if it is set below the equilibrium price.
Similarly a minimum price should be set above equilibrium price in order to have an effect on the
market.

In the examination you should be able to explain the consequences of government intervention using
diagrams such as Figures 5-8, 5-9, 5-10 and 5-11.

ACTIVITY 5.5
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Governments set maximum prices in order to protect consumers from the
exploitation of producers.
(2) Fixing a maximum price for meat above the equilibrium price will result in an
excess supply of meat.
(3) Fixing a maximum price for soccer tickets below the equilibrium price will lead to
an excess demand for soccer tickets.
(4) Fixing a maximum price below the equilibrium price may lead to queues and
black market activity.
(5) Fixing a maximum price at the level of the equilibrium price will give rise to an
excess demand for the product concerned.
(6) Fixing a maximum price below the equilibrium price will prevent the market
mechanism from allocating available quantities of a specific good and/or service
to consumers.
(7) Fixing a minimum price for wheat above the equilibrium price will result in an
excess supply of wheat.
(8) Fixing a minimum price for oranges below the equilibrium price will lead to an
excess demand for oranges.
(9) Fixing a minimum price for maize above the equilibrium price will give rise to the
problem of how to dispose of the resultant surplus of maize.
(10) Fixing a minimum price for maize above the equilibrium price is an ineffective
way of supporting poorer farmers because inefficient producers are protected
and survive financially to continue farming.
 71 ECS1501/001

Short questions

Note: The solutions to the questions are provided at the end of this learning unit.

(a) Explain, with the aid of a diagram, what will happen in a market if government imposes a
maximum price (price ceiling) below the equilibrium price. Can a black market develop in such a
case? Explain.

(b) What will happen in a market if government imposes a maximum price above the equilibrium
price?

(c) Explain, with the aid of a diagram, what will happen in a market if government fixes a minimum
price (price floor) above the equilibrium price.

5.6 Agricultural prices

STUDY

Section 5.6 of the prescribed book

This section deals with some of the problems experienced in the agricultural sector – Figure 5-18 is
important.

ACTIVITY 5.6
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The prices of agricultural products fluctuate much more than the prices of
manufactured products.
(2) Supply conditions and the reaction of farmers may reduce the income of farmers
producing a specific product in a specific season.

Short question
Note: The solution to this question is provided at the end of this learning unit.

(a) i. What would happen to the supply curve for maize next year if farmers were to decide to
plant more maize next year?
ii. Explain by means of a figure why maize producers (as a group) would be worse off if all
farmers were to decide to plant more maize in a specific year.

Section 5.7 of the prescribed book is not prescribed for this module
 72

SOLUTIONS

ACTIVITY 5.1
TRUE/FALSE STATEMENTS

(1) F Higher demand means that the demand curve shifts to the right. Decreasing price will
cause a movement along this same curve — influencing the quantity demanded — and not
demand.
(2) T
(3) T CD players and CDs are complements. More CD players will be demanded because of the
lower price, and more CDs will therefore also be demanded. The demand curve for CDs
shifts to the right — leading to a higher CD price.
(4) T It is the law of demand.

SHORT QUESTIONS

(a) You should have drawn a figure like Figure 5-1(a) in your textbook. Increasing demand causes a
rightward shift of the demand curve (from DD to D1D1), indicating a higher equilibrium price (to
P1) and a higher equilibrium quantity (to Q1).
Note: If a question refers to equilibrium price and/or equilibrium quantity you will have to draw
both a demand and supply curve. Without these two, there can be no equilibrium.
(b) Both the equilibrium price and quantity would decrease. See Figure 5-1(b).

ACTIVITY 5.2
TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) T Higher productivity will shift the supply curve to the right; more new vehicles will be
supplied to the market leading to a decrease in prices. See Figure 5-4(d).

SHORT QUESTIONS

(a) You should have drawn a figure like Figure 5-3(b) in the textbook. Lower supply causes a
leftward shift of the supply curve (from SS to S2S2), indicating a higher equilibrium price (to P2)
and a lower equilibrium quantity (to Q2).
(b) See Figure 5-4(a). Do you remember the four factors of production and their incomes? Labour
cost (or salaries and wages) is the price (or income) of the factor of production labour. Higher
labour cost will shift the supply curve to the left (from SS to S1S1) with a higher equilibrium price
(to P1) and lower equilibrium quantity (to Q1).

ACTIVITY 5.3
TRUE/FALSE STATEMENTS

(1) T See Table 5-1.

(2) F See Table 5-1.
 73 ECS1501/001

SHORT QUESTIONS

(a) If demand and supply increase simultaneously, three figures/diagrams are needed to
determine the effect on equilibrium price and quantity.

FIGURE A: Relative changes in demand and supply are equal

 74

FIGURE B: Increase in demand is relatively more than the increase in supply

FIGURE C: Increase in demand is relatively less than the increase in supply

From the above figures it is clear that the change in equilibrium price is uncertain (in Figure A it did
not change, in Figure B it increased and in Figure C it decreased). In all three figures, however, the
equilibrium quantity increased.

Also see Figure 5-5 of the textbook where there is a simultaneous increase in demand and decrease
in supply. In this case the equilibrium price increased in all three figures, while the equilibrium
quantity was uncertain (in Figure (a) it was unchanged, in (b) it decreased and in (c) it increased).
 75 ECS1501/001

ACTIVITY 5.4
TRUE/FALSE STATEMENTS

(1) F
(2) T
(3) F
(4) T
(5) F
(6) T

SHORT QUESTIONS

(a) The figures should look like this:

Good A Good B

In the market for good A, the increase in the supply of A is illustrated by a rightward shift of the supply
curve. The result is a lower equilibrium price and a higher equilibrium quantity than before.

Since goods A and B are complements, the increase in the equilibrium quantity of A and the lower
equilibrium price of A will stimulate the demand for B. In the market for good B, the demand curve will
therefore shift to the right. The increase in the demand for B will result in an increase in the equilibrium
price of B as well as an increase in the equilibrium quantity of good B.
 76

(b) The figures should look like this:

Good A Good B

Since A and B are substitutes, a fall in the price of A will reduce the demand for B. Consumers would
rather purchase the substitute (A) which has become relatively cheaper. The demand curve of B will
thus shift to the left, resulting in a lower equilibrium price and a lower equilibrium quantity than before.

ACTIVITY 5.5
TRUE/FALSE STATEMENTS

(1) T
(2) F It will have no impact on the market — maximum price should be below the equilibrium
price in order to affect the market.
(3) T
(4) T
(5) F It will have no impact on the market.
(6) T
(7) T
(8) F To have an impact on the market, a minimum price always have to be set above — and
not below — the equilibrium price.
(9) T
(10) T

SHORT QUESTIONS

(a) The graph should look like Figure 5-8 in the textbook. When government imposes a maximum
price which is below the equilibrium price (such as Pm) an excess demand (the difference
between Q2 and Q1) will develop. The quantity traded will be equal to the quantity supplied at the
maximum price (Q1 in the figure). Consumers are willing to pay a higher price (P1) in order to
obtain this quantity. Any consumer who succeeds in obtaining the product at price Pm (the official
price) can therefore try to sell it to other consumers at a much higher price (P1), thus making a
profit. Think, for example, of a big sporting event like the World Cup Soccer Final and the price
some potential spectators are willing to pay for a ticket. This is what black market activity is all
about and the reason why it exists in a case like this.
 77 ECS1501/001

(b) If a maximum price is set above the equilibrium price, it will have no effect on the market price or
the quantity exchanged. Prices and quantities will still be determined by the interaction between
demand and supply (market forces).

(c) You should have drawn a figure like Figure 5-10. The essential point is that a surplus (or excess
supply) of 5 million (9 million minus 4 million) kg beef will develop at the artificially high minimum
price of R20. Ways and means will therefore have to be sought to get rid of this surplus. This
situation is often encountered when governments intervene in agricultural markets.

ACTIVITY 5.6
TRUE/FALSE STATEMENTS

(1) T Prices of agricultural products are influenced by changing conditions like the weather,
diseases and the perishable nature of such products.
(2) T

SHORT QUESTION

(a) i. Supply of maize will increase — supply curve shifts to the right.

ii. The figure should look like Figure 8-18 in the textbook. As indicated in the figure, the
supply of maize increases (supply curve shifts to the right from S1S1 to S2S2). Equilibrium
quantity increases from Q1 (initial equilibrium) to Q2 while the price decreases from P1 to
P2.
Suppose the values were as follows: P1 = R10; P2 = R8; Q1 = 8 and Q2 = 9. Farmers’ initial
income stood at 0P1E1Q1 (R10 x 8 = R80), but in the following year it decreases to
0P2E2Q2 (R8 x 9 = R72), which was lower than the previous year’s total income.

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
list the demand factors
list the supply factors
distinguish between substitutes and complements and to
give examples of each
distinguish between minimum prices and maximum prices
name the different forms of government intervention
give reasons why governments set maximum prices
list the ways in which excess demand (as a result of the
fixing of maximum prices) can be allocated between
consumers
 78

Well Satis- Must Need

factory redo help
name the ways in which the government can get rid of a
market surplus because of the fixing a minimum price above
the equilibrium price
give reasons why the fixing of a minimum price above the
equilibrium price is a highly inefficient way of assisting small
or poorer farmers

Explanations
I am able to
explain the reasons why governments set maximum prices
explain the development of black market activities

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the impact of a change in a demand factor on the equilibrium
price and equilibrium quantity
(Fig 5-1, 5-2)
the impact of a change in a supply factor on the equilibrium
price and equilibrium quantity
(Fig 5-3, 5-4)
the impact of simultaneous changes in demand and supply
on the equilibrium price and equilibrium quantity (Table 5-1,
Fig 5-5)
the interaction between related markets (substitutes) (Fig 5-
6)
the interaction between related markets (complements) (Fig
5-7)
the influence of the fixing of a maximum price lower than the
equilibrium price on the market and the development of
black market activities (Fig 5-8)
the influence of the fixing of a minimum price higher than the
equilibrium price on the market
(Fig 5-10)
the fluctuations in agricultural prices on the total revenue of
farmers (Fig 5-18)
 79 ECS1501/001

Elasticity

LEARNING UNIT

The purpose of this learning unit is to predict how consumers will respond to changes in the price of a
product and/or changes in the income of consumers in terms of the quantities of the product that they
demand.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ describe the concept elasticity

■ define price elasticity of demand
■ explain the meaning of a specific elasticity coefficient (say ep = 1,5)
■ identify the value of ep at different points on a linear demand curve
■ explain the link between price elasticity of demand and total revenue from sales (or total
expenditure on the product)
■ distinguish between five different categories of price elasticity of demand, explain the
meaning of each and the impact on total revenue if the price of the product changes in each
case
■ explain the impact of a change in supply when demand curves display different price
elasticities
■ explain the determinants of price elasticity of demand
■ define the income elasticity of demand and explain what it means
■ define the cross elasticity of demand and explain what it means

CONTENTS

This learning unit introduces elasticity, an important concept in economic analysis. Economists do not
only want to know the direction of changes in response to changes in demand (or supply), they also
want to know what the magnitudes of the changes will be — in other words, with how much the price
and quantity will change if the demand (or supply) changes. This, in turn, requires knowledge about
the responsiveness of the quantity demanded (or the quantity supplied) to the determinants of demand
(or supply). This responsiveness is indicated by the elasticity of demand (or supply) with respect to the
determinant concerned.
The emphasis is on the meaning, significance and uses of price elasticity and the reasons for the
differences in the price elasticities of the demand for different products rather than the calculation of
price elasticity.
 80

6.1 A general definition of elasticity

STUDY

Section 6.1 of the prescribed book

Section 6.2 of the prescribed book

Before dealing with specific elasticities, the elasticity concept is first defined in general terms. Study it
carefully. Elasticity is not a complicated concept — it is simply a measure of the responsiveness of
one variable to changes in another variable.

6.2 The price elasticity of demand

STUDY

Section 6.3 of the prescribed book

Table 6-2 Price elasticity of demand: a summary

Box 6-1

Box 6-2 Price elasticity of demand, price changes

and changes in total revenue

The best-known elasticity concept is the price elasticity of demand, which is a measure of the
responsiveness of the quantity demanded to changes in the price of the product. Box 6-1 provides
an excellent example of how to calculate the arc elasticity of a demand curve and is prescribed for the
examination. In the examination, you must use the arc elasticity method if we require you to calculate
the price elasticity of demand.

Figure 6-1, Figure 6-2 and Figure 6-3 are important. Table 6-2 and Box 6-2 summarise the five
different categories, their meaning and the impact they have on total revenue if the price changes.

ACTIVITY 6.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Elasticity is simply a measure of the responsiveness or sensitivity of a
dependent variable (eg the number of motor accidents) to changes in an
independent variable (eg the average following distances maintained by
motorists).
(2) Price elasticity of demand is a measure of the responsiveness of quantity
demanded to changes in price.
 81 ECS1501/001

T F
(3) Price elasticity of demand varies from point to point along a linear normal
demand curve.
(4) Producers are interested in the price elasticity of the demand for their product
because it indicates what will happen to their total revenue (= P x Q) when the
price of the product changes.
(5) If the price elasticity of the demand for chocolates is greater than one, then the
manufacturers of chocolates can increase their total revenue by raising the price
of chocolates.
(6) If an increase in the price of sugar leaves the total expenditure on sugar (which
is also the total revenue of the suppliers of sugar) unchanged, then the price
elasticity of the demand for sugar is equal to one.
(7) A perfectly horizontal demand curve has a price elasticity of one all along the
curve — this case is referred to as unitary elasticity.
(8) A perfectly inelastic demand curve is vertical (ie parallel to the price axis).
(9) The producers of a product with an elastic demand will have a strong incentive
to reduce the price of their product.
(10) If a 10 per cent increase in student fees results in a 15 per cent drop in student
enrolment at university it can be concluded that the demand for university study
is elastic.
(11) If a 10 per cent increase in the price of good A results in a 5 per cent reduction
in the quantity of A demanded, then the price elasticity of the demand for A is
more than one.
(12) If a 5 per cent fall in the price of bananas results in a 2 per cent increase in the
quantity of bananas demanded, then the price elasticity of the demand for
bananas is relatively low.
(13) In elastic demand, as price falls, total revenue of suppliers rises.
(14) A perfectly elastic demand curve is horizontal (ie parallel to the quantity axis).
(15) If price elasticity is less than one, a fall in price lowers the total revenue of the
suppliers in question.
(16) The more (or better) substitutes a good has, the greater the price elasticity of the
demand for the good will be.
(17) One of the reasons why petrol (fuel) has a low price elasticity of demand is that
it has no close substitutes.
(18) One reason why petrol has a low price elasticity of demand is because it is
complementary to motor vehicles (if you have a car you have to purchase
petrol).
(19) Necessities tend to have a low price elasticity of demand while luxury goods
tend to have a high price elasticity of demand.
(20) The longer the time period under consideration, the lower the price elasticity of
demand tends to be.
(21) Bread has the same price elasticity of demand as food.
(22) The price elasticity of the demand for wholewheat bread is lower than the price
elasticity of the demand for all kinds of bread.
(23) The price elasticity of the demand for steak will be greater than the price
elasticity of demand for meat (ie all types of meat).
(24) Elasticity and slope are not the same.
 82

Short questions
Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Give a general definition of elasticity and then define price elasticity of demand.

(b)* Explain why it is important for a supplier of a good or service to have information about the price
elasticity of the demand for his or her product.

(c)* List the five different categories of price elasticity of demand and explain the significance of each
category. (Note: the impact on total revenue is not asked.)

(d)* Consider the information in Figure 6-1 and answer the following questions:

FIGURE 6-1

i. At which of the specified prices is price elasticity of demand larger than one (ie relatively
elastic)?
ii. At which of the specified prices is price elasticity of demand less than one (ie relatively
inelastic)?
iii. At which of the specified prices is price elasticity of demand equal to one?
iv. The price elasticity of demand at point a is ______________.
v. The price elasticity of demand at point e is ______________.
vi. At which of the specified prices will total revenue from sales be maximised? Explain why.
vii. Suppose price is equal to R10. Should the producer increase or decrease the price in
order to maximise revenue? Give a reason for your answer.
viii. Suppose price is equal to R30. Should the producer increase or decrease the price in
order to maximise revenue? Give a reason for your answer.

(e)* Give three possible reasons for a price elasticity of demand for a good that is less than one (ie
inelastic demand).

(f)* Give three possible reasons for a price elasticity of demand for a good that is greater than one
(ie elastic demand).
 83 ECS1501/001

6.3 Other demand elasticities

STUDY

Section 6.4 of the prescribed book

Table 6-4 Different elasticities: a summary – except the

last row dealing with price elasticity of supply

This section contains a brief description of two other demand elasticities: the income elasticity of
demand and the cross elasticity of demand. At this stage, you should have a good idea of what
elasticity means, so these elasticities should not present any problems.

We calculate the income elasticity of demand to determine how the quantity demanded for a product
changes when the income of consumers changes. The positive or negative income elasticity value is
an indication of whether consumers view goods as inferior or as normal. As far as the income elasticity
of demand is concerned, you must note the definitions of normal goods and inferior goods, as well as
the distinction between luxury goods and essential goods which is regarded as normal goods. Make
sure that you can interpret the positive and negative income elasticities in table 6-4.

Cross elasticity of demand is calculated to determine how price changes affect the quantity demanded
of related products. Therefore, the positive or negative cross elasticity value indicates whether
products are substitutes or complements to each other.

ACTIVITY 6.2
Indicate whether the following statements are true (T) or false (F):
Note: Answers are provided at the end of this learning unit.
T F
(1) Income elasticity of demand is a measure of the responsiveness of quantity
demanded to changes in consumers' incomes.
(2) If good A has an income elasticity of demand greater than one, then good A is
classified as a luxury good.
(3) If good B has a positive income elasticity of demand, then good B is classified
as an inferior good.
(4) A good with an income elasticity of demand which is positive but less than one is
classified as an inferior good.
(5) A good with an income elasticity of demand which is positive but less than one is
classified as an essential good.
(6) In South Africa the income elasticity of the demand for biltong for high-income
households has been estimated at 1,36. This implies that biltong is a normal
good and also a luxury good.
(7) In South Africa the income elasticity of the demand for meat for high-income
households has been estimated at 0,32. This implies that meat is an inferior
good.
(8) In South Africa the income elasticity of demand for candles in low-income
households has been estimated at -0,20. This implies that candles are an
inferior good.
(9) In South Africa the income elasticity of demand for paraffin in low-income
households has been estimated at -0,51. This implies that paraffin is a luxury
good.
 84

T F
(10) If we refer to an inferior good, it means that the quality of the product is poor.
(11) If we refer to an inferior good, it means that the demand for the product will
decrease if consumer income increases.
(12) When two goods are totally unrelated, the cross elasticity of demand value will
be negative.
(13) Apples and pears are substitute goods to each other. The cross elasticity value
for apples and pears will be negative.

Short question

Note: The solution to the question marked with an asterisk (*) is provided at the end of this learning unit.

(a) Define the income elasticity of demand and use this concept to distinguish between (i) normal
and inferior goods and (ii) essential and luxury goods.

(b)* Explain why it is important to suppliers of a product to have information about the income
elasticity of the demand for their product.

Section 6.5 of the prescribed book is not prescribed for this module

SOLUTIONS
ACTIVITY 6.1
TRUE/FALSE STATEMENTS

(1) T
(2) T Also see statement 1.
(3) T
(4) T See Figure 6-2.
(5) F Greater than one refers to the elastic part of the demand curve. Thus, the price of
chocolates should be lowered in order to increase total revenue. Also see Figure 6-2. If the
price in this case increases from R14 to R18, total revenue will decrease from R84 000 to
R36 000.
(6) T It is the meaning of unitary elasticity.
(7) F It is perfectly elastic. See Figure 6-4(e).
(8) T See Figure 6-4(a).)
(9) T Total revenue is maximised where ep = 1.
(10) T 15% ÷ 10% = 1,5; this is greater than one and elastic. Note: this is an application of the
general formula because the individual prices and quantities were not given.
(11) F 5% ÷ 10% = 0,5 or ½; this is smaller than one and inelastic. Note: this is an application of
the general formula because the individual prices and quantities were not given.
(12) T The percentage change in quantity (Q) is less than the percentage change in price (P).
(13) T
(14) T See Figure 6-4(e).
(15) T
(16) T
(17) T
(18) T
(19) T
(20) F Price elasticity of demand will tend to be higher.
 85 ECS1501/001

(21) F A more broadly defined product tends to be less demand elastic.

(22) F See statement 21.
(23) T See statement 21.
(24) T

SHORT QUESTIONS

(b) Price elasticity of demand indicates to the producer what will happen to his of her total revenue
(= P x Q) when the price of the product or service changes — in other words, it indicates
whether revenue will increase or decrease.
(c) See Table 6-2, the first two columns: category and meaning.
(d) i. R30 (at R40 ep = perfectly elastic).
ii. R10 (at 0 ep = perfectly inelastic).
iii. R20.
iv. Perfectly elastic (= ∞). You do not have to calculate the answer.
v. Perfectly inelastic (= 0).
vi. R20, where ep = 1 (in the middle of the linear demand curve). Total revenue (TR) is at a
maximum where price elasticity of demand is equal to one.
vii. Increase to R20. At R20 ep = 1 and the producers’ total revenue will be maximised.
viii. Decrease to R20. At R20 ep = 1 and the producers’ total revenue will be maximised.
(e) You will find the answers in the section, Determinants of the price elasticity of demand.
Three possible reasons include, for example: the product has no close substitutes, the product is
an essential product and the product is habit forming (eg cigarettes).
(f) You will find the answers in the section, Determinants of the price elasticity of demand.
Three possible reasons include, for example: the product has good substitutes, the product is a
luxury and the product is durable.

ACTIVITY 6.2
TRUE/FALSE STATEMENTS

(1) T It is a definition of income elasticity.

(2) T
(3) F
(4) F
(5) T
(6) T The income elasticity is positive and greater than one.
(7) F 0,32 is still positive — but less than one — thus meat is a normal product.
(8) T Goods with a negative income elasticity are classified as inferior goods.
(9) F It is an inferior good.
(10) F “Inferior” does not refer to any physical characteristic of the product. It merely means that
demand increases when income decreases, or demand decreases when income
increases.
(11) T See statement 9.
(12) F Unrelated products have a cross elasticity of demand value of zero.
(13) F Apples and pears are substitute products and have a cross elasticity value which is
positive.

SHORT QUESTIONS

(b) The producers want to know how the quantity demanded, of the products or services they
supply, will be affected when consumers' income increases. (Will it increase or decrease?)
 86

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
give a general definition of elasticity
define the price elasticity of demand
distinguish between the five categories of price elasticity of
demand
name the difference between elasticity and slope
define income elasticity of demand
distinguish between a positive and a negative income
elasticity of demand
define cross elasticity of demand
distinguish between positive and negative cross elasticity of
demand values

Explanations
I am able to
explain the meaning of a specific elasticity coefficient (say ep
= 1,5) – in other words, to apply the general formula
distinguish between the five different categories of price
elasticity of demand, explain what each means and what
happens to total revenue in each case if the price of the
product changes. (Table 6-2, Box 6-2)
explain the most important determinants of price elasticity of
demand

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the value of ep at different points on a linear demand curve,
from the point where the curve meets the quantity axis to
where it meets the price axis
the link between price elasticity of demand and total revenue
from the sales of a product (or the total spending on that
product). (Table 6-1, Fig 6-2)
the different categories of price elasticity of demand (Fig 6-3)
 87 ECS1501/001

The theory of
demand: the utility
approach LEARNING UNIT

The purpose of this learning unit is to examine consumer behaviour and to provide an explanation for
why demand curves slope downward from top left to bottom right.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ explain the concept utility

■ define marginal utility and weighted marginal utility
■ distinguish between cardinal and ordinal utility
■ explain the relationship between total, average and marginal magnitudes
■ formulate the law of diminishing marginal utility
■ state and briefly explain the two conditions for consumer equilibrium in the utility approach
■ determine consumer equilibrium given the income of the consumer, the prices of the products
and the marginal utilities of the products
■ use the utility approach to derive an individual demand curve

CONTENTS

Consumer behaviour is analysed in more detail. There are two different approaches to explaining
consumer choice: the utility approach and the indifference approach. This learning unit covers a few
aspects of the utility approach ─ it shows how to analyse an individual consumer's choice between
different consumer goods and services and how to derive an individual demand curve, using the utility
approach. The indifference approach is studied in the second-year module in microeconomics.

7.1 Utility

STUDY

Section 7.1 of the prescribed book

This section introduces utility, a concept developed in the 18th century and refined in the 19th century
to analyse economic behaviour. The aim of consumer behaviour can be described as the
maximisation of utility, given the available means and alternative consumer options.
 88

ACTIVITY 7.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Utility is the degree of satisfaction that a consumer derives or is expected to
derive from the consumption of a good or service (eg beef).
(2) Economists use scientific techniques to measure utility on an objective scale.
(3) It is possible to compare the utility derived by two different consumers from the
consumption of a good (eg shoes).
(4) Utility is an abstract and subjective concept.
(5) It is possible to compare one consumer’s level of utility (or satisfaction) with that
of another consumer.
(6) Cardinal utility is based on the idea that utility can be measured in some way.
(7) Ordinal utility involves the ranking of the satisfaction derived from different
bundles of consumer goods or services in order of preference.
(8) The utility approach rests upon the idea of cardinal utility.

7.2 Marginal utility and total utility

STUDY

Section 7.2 of the prescribed book

Box 7-1 Total, average and marginal magnitudes

This section deals with the law of diminishing marginal utility. Remember that the extra (or
additional) utility that a consumer derives from the consumption of one additional unit of the good is
called the marginal utility.

Total, average and marginal magnitudes are explained in Box 7-1 which is probably the most
important box in this module. You should study the box in detail (except for the mathematical
interpretation) since you will be referred back to it on a number of occasions in later learning units.
Note the definitions of total, average and marginal values and, in particular, the relationships between
them.

ACTIVITY 7.2
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Negative utility is also called disutility.
(2) The law of diminishing marginal utility is sometimes called Gossen’s first law.
 89 ECS1501/001

T F
(3) According to the law of diminishing marginal utility, the marginal utility of a good
or service increases as more units are consumed during a specific period.
(4) Marginal utility is the extra or additional utility that a consumer derives from the
consumption of one additional unit of a good.
(5) Total utility is the cumulative sum of all marginal utilities.
(6) When a marginal value is positive, the corresponding total value increases.
(7) When a marginal value is positive and larger than the previous average value,
the average value increases.
(8) When the total value decreases, the corresponding marginal value is negative.
(9) When the total value decreases, the corresponding marginal value is positive.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a)* Maria Nakala is a learner at school and in grade 12. During 2006 she wrote seven tests in
economics. She obtained the following marks in these economic tests:

TABLE 7-1
Test Marks obtained Total marks Marginal mark Average mark
1 30
2 50
3 70
4 50
5 80
6 50
7 90
(The purpose of this question is to test your knowledge of the calculation of the three
magnitudes — total, average and marginal.)

Complete the above table and answer the following questions:

i.Why did Maria’s average mark for the first 6 tests decrease relative to the first 5 tests?
ii.
Why was Maria’s average mark up to test 4 the same as for the first 3 tests?
iii.
Why did Maria’s average mark up to test 3 (relative to the first 2 tests) and up to test 7
(relative to the first 6 tests), respectively increase?
(b)* Complete the following table:

TABLE 7-2
Unit Total value Average value Marginal value
1 10
2 10
3 39
4 12
5 7
 90

(c)* The table below indicates Peter Khoza’s marginal and total utility derived from the consumption
of chicken drumsticks during a specific period. Use the information provided to answer the
following questions:

Units of chicken Marginal utility (MU) Total utility (TU)

drumsticks consumed (utils) (utils)
1 50 50
2 35 85
3 29 114
4 18 132
5 12 144
6 6 150
7 2 152
8 0 152
9 -4 148

i. Peter’s additional utility from the consumption of the third drumstick is ______ utils.
ii. Peter’s additional utility from the consumption of the seventh drumstick is ______
utils.
iii. What happens to total utility as Peter consumes more and more drumsticks?
iv. What happens to marginal utility as Peter consumes more and more drumsticks?
v. At what unit of drumsticks is Peter satiated?
vi. At what unit of drumsticks is disutility (or negative utility) reached?
vii. The column for marginal utility indicates the law of ____________ .
viii. What law is indicated by the column for total utility?

7.3 Consumer equilibrium in the utility approach

STUDY

Section 7.3 of the prescribed book

This section deals with consumer equilibrium (ie the point where the consumer maximises the utility
derived from a given income). To derive consumer equilibrium, the marginal utilities have to be
weighted by the prices of the products concerned and the consumer's available income also has to be
taken into account. The consumer is in equilibrium when the weighted marginal utilities are equal for
an affordable combination of goods (in other words, when the consumer spends his/her total available
income). The consumer then derives the same utility from the last rand spent on each product and
cannot improve his or her position by switching from one consumer good to another.

When will a consumer be in equilibrium according to the utility approach?

■ When weighted marginal utilities are equal and

■ when all available income is spent (in other words, the combination of goods purchased has to
be affordable)
 91 ECS1501/001

ACTIVITY 7.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The aim of the consumer is to maximise profit.
(2) The aim of the consumer is to reach the maximum level of total utility.
(3) A consumer is in equilibrium if his or her total utility is at a maximum and the two
equilibrium conditions are met.
(4) Both the conditions of affordability and equal weighted marginal utilities should
be met for a consumer to be in equilibrium.
(5) A consumer is in equilibrium if his or her marginal utility is at a maximum.
(6) A consumer is in equilibrium if his or her weighted marginal utility is at a
maximum.
(7) A consumer is in equilibrium if the marginal utility per rand is equal for all
products he or she can afford to buy.
(8) A consumer is in equilibrium if the weighted marginal utility is equal for all
products he or she can afford to buy.
(9) Weighted marginal utility is the marginal utility per unit divided by the price of the
specific product or service.
(10) To derive consumer equilibrium, only prices of products should be considered.
(11) To derive consumer equilibrium, both the prices of products as well as consumer
income should be considered.
(12) Equal weighted marginal utilities of two products A and B can also be written as:
MUA ÷ PA = MUB ÷ PB.
(13) Equal weighted marginal utilities of three products A, B and C can also be
written as: MUA ÷ PA = MUB ÷ PB = MUC ÷ PC.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) State the law of equalising the weighted marginal utilities.

(b) Mention the two conditions which have to be met before a consumer can be said to be in
equilibrium.

(c)* Suppose the following data reflect the utility derived by a consumer, Violet, from two goods, X
and Y. Good X costs R10 per unit and good Y costs R5 per unit.

Units Total utility (TU) of X Total utility (TU) of Y

1 60 20
2 110 38
3 150 53
4 180 63

If Violet has R35 available to spend on X and Y and spends the full amount, how many of X and
Y should she purchase to maximise her utility?
 92

(d)* The following table represents Samuel Makwela's marginal utilities of good A (MUA) and good B
(MUB) respectively and the total utilities of good A (TUA) and good B (TUB) respectively. The
price of good A is R2 per unit and the price of good B is R4 per unit. Samuel has R16 available
to spend.

Complete the table and answer the following three questions:

Good A Good B
Units
MU TU MU ÷ P MU TU MU ÷ P
1 80 68
2 132 8
3 10 28
4 16 152
5 176 5

i. At which combination of good A and good B will Samuel be in equilibrium if he spends his
total income of R16?
ii. Give two reasons why Samuel is not in equilibrium at 5 units of good A and 5 units of good
B where total utility is at a maximum.
iii. What do we call the approach used in this question to analyse consumer behaviour?

(e)* Suppose Gregory Fortuin has R13 to spend on bananas and apples. The price of bananas is R2
per kilogram, while the price of apples is R1 per kilogram. The following table represents
Gregory's total utilities of bananas (TUB) and apples (TUA) respectively. Use the information in
the table to answer the following true/false questions:

Total utility (TUB) of Total utility (TUA) of

Units
bananas apples
1 52 50
2 92 75
3 120 95
4 140 109
5 154 119

Indicate whether each of the following statements is True (T) or False (F).

T F
i. When spending his total income of R13 on bananas and apples, Gregory is in
equilibrium if he buys 3 kilogram of bananas and 4 kilogram of apples.
ii. When spending his total income of R13 on bananas and apples, Gregory is in
equilibrium if he buys 2 kilogram of bananas and 3 kilogram of apples.
iii. When spending his total income of R13 on bananas and apples, Gregory is in
equilibrium if he buys 4 kilogram of bananas and 5 kilogram of apples.
iv. When spending his total income of R13 on bananas and apples, Gregory is in
equilibrium if he buys 5 kilogram of bananas and 5 kilogram of apples.
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T F
v. Gregory will be in equilibrium if his total utility is equal to 273 utils.
vi. Gregory will be in equilibrium if his total utility is equal to 129 utils.
vii. Gregory will be in equilibrium if his total utility is equal to 259 utils.
viii. Gregory will be in equilibrium where his total utility is at a maximum, given the
prices of bananas and apples and his available income.

7.4 Derivation of an individual demand curve for a product

STUDY

Section 7.4 of the prescribed book

The law of equalising the weighted marginal utilities can be used to derive an individual demand
curve. Work through the example to make sure you understand why a fall in the price of a product will
lead to an increase in the quantity demanded.

ACTIVITY 7.4
Short questions

Note: The solution to this question is provided at the end of this learning unit.

(a) The following table represents Maria Da Costa's marginal utilities of bread (MUB) and meat
(MUM) respectively. The price of bread is R1 per unit and the price of meat is R3 per unit. Maria
has R10 available to spend.

Complete the columns MU ÷ PB (R1) and MU ÷ PM (R3) and answer the following question (i):

Bread Meat
Units
MU ÷ PB MU ÷ PB MU ÷ PM
MU MU
(R1) (R2) (R3)
1 30 39
2 20 30
3 14 24
4 10 18
5 6 15
6 0 9
 94

i. At which combination of bread and meat will Maria be in equilibrium if she spends her total
income of R10?

Suppose the price of bread increases to R2 per unit.

Complete the column MU ÷ PB(R2) in the above table to show the new weighted marginal
utility of bread.

ii. What is the new equilibrium position of Maria if she spends her total income of R10?
iii. Indicate the quantity of bread which Maria bought at each price on the following set of
axes. Draw Maria's demand curve for bread.

iv. Is the following statement true or false?

The marginal utility approach cannot be used to derive the individual demand curve for a
good.

SOLUTIONS

ACTIVITY 7.1
TRUE/FALSE STATEMENTS

(1) T It is the definition of utility.

(2) F Utility cannot be measured objectively.
(3) F Remember that the utility approach assumes that it is possible to compare the utilities of
individuals. In reality, utility of different persons cannot be compared. Also see statements
6 and 7.
(4) T
(5) F See statement 3.
(6) T
(7) T
(8) T
 95 ECS1501/001

ACTIVITY 7.2
TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) F Marginal utility will decrease as more units are consumed.
(4) T (It is the meaning of marginal utility.
(5) T
(6) T See Box 7-1 as well as the table in question (c), Activity 2 below.
(7) T See Box 7-1.
(8) T See Box 7-1.
(9) F See statement 6.

SHORT QUESTIONS

(a) The completed Table 7-1 should look this this:

Test Marks obtained Total marks Marginal mark Average mark

1 30 30 (30 − 0)30 (30 ÷ 1)30
2 50 (30 + 50)80 (80 − 30)50 (80 ÷ 2)40
3 70 (80 + 70)150 (150 − 80)70 (150 ÷ 3)50
4 50 (150 + 50)200 (200 − 150)50 (200 ÷ 4)50
5 80 (200 + 80)280 (280 − 200)80 (280 ÷ 5)56
6 50 (280 + 50)330 (330 − 280)50 (330 ÷ 6)55
7 90 (330 + 90)420 (420 − 330)90 (420 ÷ 7)60

Note: If you had difficulty completing the table you should work through Box 7-1 in the
textbook again. The calculations are shown in brackets.

i. The marginal mark of test 6 (50) is less than the previous average mark of 56.
ii. The marginal mark of test 4 (50) is equal to the previous average mark of 50.
iii. The marginal mark of test 3 (70) is more than the previous average mark of 40 and the
marginal mark of test 7 (90) is more than the previous average mark of 55.

(b) The completed Table 7-2 is as follows:

Units Total value Average value Marginal value

1 10 10 (given) 10
2 (10 x 2) 20 (given) 10 (20 − 10) 10
3 (given) 39 (39 ÷ 3) 13 (39 − 20) 19
4 (12 x 4) 48 (given) 12 (48 − 39) 9
5 (48 + 7) 55 (55 ÷ 5) 11 (given) 7

(c) i. 29 utils.
 96

ii. 2 utils.
iii. Total utility increases, but at a decreasing rate (see MU), until it reaches a maximum and
then total utility decreases.
iv. Marginal utility decreases as increasingly more drumsticks are consumed.
v. At the 8th unit.
vi. At the 9th unit.
vii. .... diminishing marginal utility.
viii. The law of diminishing marginal utility.

ACTIVITY 7.3
TRUE/FALSE STATEMENT

(1) F It is the aim of firms or producers. It is explained in detail in the next learning unit.
(2) T
(3) T
(4) T
(5) F See statements 7 and 8.
(6) F See statements 7 and 8.
(7) T
(8) T
(9) T
(10) F See statements 4 and 11; both conditions should be satisfied at the same time.
(11) T
(12) T
(13) T

SHORT QUESTIONS

(c) To obtain the answer, the weighted marginal utilities (MU ÷ P) of X and Y have to be calculated.
The completed table should look like this:

Good X (R10) Good Y (R5)

Units
TU MU MU ÷ P TU MU MU ÷ P
1 60 (same as TU) 60 (60÷10) 6 20 (same as TU) 20 (20÷5) 4
2 110 (110−60) 50 (50÷10) 5 38 (38−20) 18 (18÷5) 3,6
3 150 (150−110) 40 (40÷10) 4 53 (53−38) 15 (15÷5) 3
4 180 (180−150) 30 (30÷10) 3 63 (63−53) 10 (10÷5) 2
(The figures in bold are given.)

Violet will maiximise her utility when she buys buy 3 units of X and 1 unit of Y. Her total utility
equals 170 (150+20). Note the weighted marginal utilities are both equal to 4 in this case and
the total income of R35 is spent.
 97 ECS1501/001

(d) The completed table should look like this:

Good A = R2 Good B = R4
Units
MU TU MU ÷ P MU TU MU ÷ P
(same as (same as
1 80 (80÷2)40 68 (68÷4)17
MU)80 TU)68
2 (132−80)52 132 (52÷2)26 (8x4)32 (68+32)100 8
3 (10x2)20 (132+20)152 10 28 (100+28)128 (28÷4)7
4 16 (152+16)168 (16÷2)8 (152−128)24 152 (24÷4)6
5 (176−168)8 176 (8÷2)4 (5x4)20 (152+20)172 5
(The figures in bold are given.)

i. Samuel will be in equilibrium at 4 units of good A and 2 units of good B because he

spent his total income of R16, the weighted marginal utilities of good A and good B are
equal (= 8) and no other affordable combination can yield a higher level of satisfaction (TU
= 168+100 = 268 utils).
ii. At this combination Samuel will spend more than his available income of R16, in other
words the combination of goods is not affordable and the weighted marginal utilities of the
two goods are not equal at 5 units of good A (= 4) and 5 units of good B (= 5).
iii. The marginal utility approach.

(e) The completed table should look like this:

(Note: unit = kilogram in this case.)

Bananas (R2 per kg) Apples (R1 per kg)

Units
TU MU MU ÷ P TU MU MU ÷ P
(same as (same as
1 52 (52÷2)26 50 (50÷1)50
TU)52 TU)50
2 92 (92−52)40 (40÷2)20 75 (75−50)25 (25÷1)25
3 120 (120−92)28 (28÷2)14 95 (95−75)20 (20÷1)20
4 140 (140−120)20 (20÷2)10 109 (109−95)14 (14÷1)14
5 154 (154−140)14 (14÷2)7 119 (119−109)10 (10÷1)10
(The figures in bold are given.)

i. F Gregory spends only R10.

ii. F Gregory spends only R7.
iii. T Gregory spends his total income R13, the weighted marginal utilities of bananas and
apples are equal (= 10) and no other affordable combination can yield a higher level
of satisfaction.
iv. F
v. F
vi. F
vii. T Total utility at 4 kilogram of bananas plus the total utility of 5 kilogram of apples are
equal to 140 + 119 = 259.
viii. T
 98

ACTIVITY 7.4
SHORT QUESTIONS
(a) To obtain the answer, the weighted marginal utilities (MU ÷ P) of bread at a price of R1 and meat
at a price of R3 have to be calculated. The completed table should look this:

Bread Meat
Units
MU ÷ PB MU ÷ PB MU ÷ PM
MU MU
(R1) (R2) (R3)
1 30 (30÷1)30 (30÷2)15 39 (39÷3)13
2 20 (20÷1)20 (20÷2)10 30 (30÷3)10
3 14 (14÷1)14 (14÷2)7 24 (24÷3)8
4 10 (10÷1)10 (10÷2)5 18 (18÷3)6
5 6 (6÷1)6 (6÷2)3 15 (15÷3)5
6 0 (0÷1)0 (0÷2)0 9 (9÷3)3

i. Maria will be in equilibrium at 4 units of bread and 2 units of meat because the weighted
marginal utilities are the same (= 10) for bread and meat and Maria has spent her total
available income of R10. No other affordable combination can yield a higher level of
satisfaction.
ii. After you have completed the MU ÷ PB (R2) column, you must compare the new MU ÷ PB
(R2) with the MU ÷ PM (R3).
After the price increase to R2 for bread, Maria will be in equilibrium at 2 units of bread
and 2 units of meat because the weighted marginal utilities are the same for bread and
meat (= 10) and Maria has spent her total available income of R10. No other affordable
combination can yield a higher level of satisfaction.
 99 ECS1501/001

iii.

Note: At a price of R1, 4 units of bread are demanded (point A) and at a price of R2,
2 units are demanded. The demand curve slopes downwards from top left to bottom
right as explained in Learning unit 4.

iv. F See the figure above.

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
describe the aim of consumer behaviour
define the concept disutility
define marginal utility and weighted marginal utility
formulate the law of diminishing marginal utility

Explanations
I am able to
explain the concept utility
explain the relationship between marginal utility and total
utility (Table 7-1)
explain the relationship between total, average and marginal
 100

Well Satis- Must Need

factory redo help
values (Box 7-1)
state and briefly explain the two conditions for consumer
equilibrium in the utility approach

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the derivation of an individual demand curve for a product by
using the utility approach
(Tables 7-4, 7-5, Fig 7-1)

Calculations
I am able to
calculate total, average and marginal values
calculate consumer equilibrium, given the income of the
consumer, the prices of the products and their marginal
utilities and/or total utility
(Tables 7-2, 7-3)
 101 ECS1501/001

Background to
supply: production
and cost LEARNING UNIT

The purpose of this learning unit is to examine the cost structure of a firm (or the theory of the firm).

OUTCOMES

After you have worked through this learning unit, you should be able to

■ list the different types of firms and the goal of the firm
■ define the various revenue, cost and profit concepts
■ calculate the various revenue, cost and profits
■ distinguish between the short run and the long run
■ distinguish between fixed and variable inputs
■ explain the relationship between different cost concepts
■ explain the law of diminishing returns
■ draw the total, average and marginal product curves
■ draw the average and marginal cost curves
■ explain the relationship between production and cost in the short run

CONTENTS

The learning unit deals with the fundamental income, cost and production concepts required to
analyse the decisions of firms about the quantities to supply at various prices. This is an important
learning unit which lays the foundation for the analysis of the equilibrium position of firms under perfect
competition in Learning unit 9. This learning unit provides the building blocks for what is usually called
the theory of the firm.

8.1 Introduction

STUDY

Section 9.1 of the prescribed book

Box 9-2 Total, average and marginal revenue

The introductory section covers the types of firms, the goal of the firm, an overview on profit,
 102

revenue and cost and the time periods under consideration, that is, the short run and the long run.

Box 9-2 is important. Make sure that you understand the basic principles and relationships and that
you can do the calculations.

ACTIVITY 8.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Supply theory tries to explain the behaviour of consumers.
(2) A firm's total revenue is equal to the total value of its sales, that is, price
multiplied by quantity sold.
(3) Average revenue is total revenue (TR or PQ) divided by the quantity of products
sold (Q).
(4) Marginal revenue is the same as average revenue.
(5) If marginal revenue is zero, total revenue remains unchanged.
(6) If marginal revenue is greater than average revenue, average revenue
increases.
(7) A firm obtains a total revenue of R50 by selling 4 units and a total revenue of
R60 by selling 5 units. The marginal revenue of the 5th unit is thus R10.
(8) In the above statement (7) the average revenue from 5 units is also R10.
(9) If the price per unit is R10 and 20 units are sold, then total revenue equals
R200.
(10) If total revenue equals R200 while 20 units are sold, the average revenue is R10
per unit.
(11) The short run is defined as the period during which at least two of the inputs are
fixed.
(12) The difference between the long and the short run in production and cost theory
depends on the variability of inputs.

Short questions
Note: The solutions to the question marked with an asterisk (*) is provided at the end of this learning unit.

(a) Name any three formal types of firms in South Africa.

(b) What is the goal of the firm?

(c) Define profit.

(d) i. Give the formula to calculate total income.

ii. Give the formula to calculate average income.
iii. Give the formula to calculate marginal income.
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iv.* Use, where possible, the above formulas to complete Table 8-1 below:
TABLE 8-1
Production Total income Average income Marginal income
(units) (Q) (R) (R) (R)
1 10
2 15
3 6
4 10
5 42,5
6 2,5

8.2 Basic cost and profit concepts

STUDY

Section 9.2 of the prescribed book

This section introduces a variety of revenue, cost and profit concepts, including total, average and
marginal cost, and total (or accounting), economic and normal profit. The relationships between the
total, average and marginal magnitudes are particularly important and are covered in Box 7-1 of the
prescribed book. If you have any difficulty with these relationships, refer back to Box 7-1.

As far as the cost concepts are concerned, you should carefully note the difference between
accounting (or explicit) costs and economic costs (which are based on the opportunity cost
principle and include implicit and explicit costs). Make sure that you understand the difference
between normal profit (which forms part of a firm's economic costs) and economic profit. This
distinction plays a vital role in the analysis of firms' behaviour in Learning unit 9. Figure 9-1 is also
important.

ACTIVITY 8.2
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Economic costs of production are based on the principle of opportunity cost.
(2) When a firm's total revenue is greater than its total economic costs, the firm is
earning an economic profit.
(3) When a firm's total revenue is less than its total economic costs, the firm is
earning a normal profit only.
(4) Normal profit refers to a situation in which only explicit costs are covered.
(5) When a firm's total economic costs are less than its total revenue, it is incurring
an economic loss.
 104

T F
(6) Patricia de Leeuw works as a bank clerk at a salary of R60 000 per year. She
resigns her job to start her own financial consultancy. The salary she earned as
a bank clerk forms part of her economic cost of running the consultancy.
(7) Patricia withdraws R10 000 from her savings account (on which she earns
interest of 10% per annum) to purchase a new computer which she will be able
to use in her consultancy for a period of five years. The full R10 000 forms part
of her economic costs of production in the first year.
(8) Patricia withdraws R10 000 from her savings account (on which she earns
interest of 10% per annum) to purchase a new computer which she will be able
to use in her consultancy for a period of five years. The interest that she would
have earned (10% per annum) forms part of her economic costs of production in
the first year.
(9) Explicit costs are all the monetary payments made by a firm, such as paying the
water and electricity account, buying stock and paying salaries to workers.
(10) Implicit costs are those costs which are not reflected in monetary payments,
such as the salary a person gives up in order to start his/her own business.
(11) If a firm has a total revenue of R100 000 per annum and economic cost of
R80 000, it earns an economic profit of R20 000.
(12) If a firm has a total revenue of R80 000 per annum and economic cost of
R110 000, it earns an economic profit of R30 000.
(13) If a firm has a total revenue of R80 000 per annum and economic cost of
R80 000, it earns a normal profit.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) What is the difference between explicit cost and implicit cost?

(b) What is the difference between accounting profit and economic profit?

(c) When does a firm realise normal profit?

(d)* i. Complete Table 8-2 below:

TABLE 8-2
Production Total cost Average cost Marginal cost
(units) (Q) (R) (R) (R)
1 10
2 15
3 6
4 10
5 42,5
6 2,5

ii. What do you observe after completing Table 8-2, and Table 8-1 in Activity 1 of this learning
unit?
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(e)* The following information on firm A is provided:

Total revenue = R100 000
Total implicit cost = R50 000
Total explicit cost = R30 000

Use the above information to

i. calculate firm A’s accounting profit.
ii calculate firm A’s economic profit.
iii. Why is the accounting profit more than the economic profit?

(f)* Solomon Tladi is an experienced woodwork teacher who earns R90 000 a year, and who has
managed to save R50 000. Solomon decides to resign from his teaching post to start his own
furniture business, Yellow Wood Manufacturers (YWM's). He uses the R50 000 in his savings
account to buy the necessary machinery and equipment.

Suppose Solomon buys timber to the value of R180 000 in the first year, pays his employees
R60 000 in wages, and buys hinges, glue, screws, oil, and staining material to the value of R15
000. He incurs electricity and telephone costs of R3 000, and transport costs of R17 000, and
estimates the depreciation of his machinery and equipment to be R5 000.

As a teacher Solomon would have earned R90 000 and, say R5 000 interest on his savings of
R50 000. In the first year of YWM's operations, his total revenue from sales is R400 000.

i. Calculate Solomon's explicit and implicit costs.

ii. Calculate Solomon's accounting profit and economic profit.

8.3 Production in the short run

STUDY

Section 9.3 of the prescribed book

This section is concerned with production (ie the transformation of inputs into outputs). In the short
run, certain inputs are fixed, but in the long run, all inputs are variable.

Figures 9-2 and 9-3 are important. Note the definition of a production function and the meaning of
the law of diminishing returns. Make sure that you understand the meaning of total, average and
marginal product as well as the interrelationships between them. Some of these relationships are
summarised in Figure 9-3, which illustrates the inverted U-shape of the average and marginal product
curves.

ACTIVITY 8.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) The essence of the law of diminishing returns is that the marginal product of a
variable input will eventually decline from a certain point in the short run
(because all or some of the other inputs are fixed).
 106

T F
(2) If marginal product is zero, total product is at a maximum.
(3) If marginal product is less than average product, average product falls.
(4) Marginal product reaches a maximum at a lower level of output than average
product does.
(5) Total cost is the additional cost of producing an extra unit of output.
(6) Marginal cost is the addition to total cost required to produce one additional unit
of a product.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Define the production function.

(b)* How can firms increase production in the short run?

(c)* Complete Table 8-3 below:

TABLE 8-3
Units of labour Total product Average product Marginal product
(N) (TP) (ton) (AP) (ton) (MP) (ton)
0 ─ 0
1 12
2 20
3 35
4 108
5 17
6 22
7 18

Use the above completed table and answer the following questions:

i. The highest total product (TP) is reached at how many units of labour?
ii. The highest marginal product (MP) is reached at how many units of labour?
iii. The highest average product (AP) is reached at how many units of labour?
iv. What relationship between AP and MP can you derive for a variable input such as labour
from the above table? (Assume that the quantities of all other factors of production are
fixed.)
v. MP is negative at how many units of labour?

(d)* State the law of diminishing returns according to

i. total product.
ii. marginal product.
iii. average product.
iv. in general.
 107 ECS1501/001

8.4 Costs in the short run

STUDY

Section 9.4 of the prescribed book

The various cost concepts are explained in this section.

Figures 9-4, 9-5 and 9-6 are important. You will recall that economic costs are opportunity costs,
which include the implicit costs of self-owned, self-employed resources. In the short run, we
distinguish between fixed and variable costs (because certain inputs are fixed in the short run). This
means that we have to distinguish between average fixed cost (AFC), average variable cost (AVC)
and average total cost (AC or ATC).

Marginal cost (MC), however, is by definition always variable and we can therefore not distinguish
between fixed and variable marginal cost. Make sure that you know how to calculate the various total,
average and marginal cost concepts.

The relationships between the three average cost concepts and marginal cost are summarised in
Figure 9-5. Note that the average and marginal cost curves (AC and MC) are U-shaped (because the
average and marginal product curves from which they are derived are shaped like inverted “U”s) -
see in Figure 9-6.

ACTIVITY 8.4
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Marginal cost reaches a minimum at a lower level of output than average cost
does.
(2) A firm produces 6 units of a product at a total cost of R60 and produces 7 units
at a cost of R72. The marginal cost of the seventh unit thus is R12.
(3) If marginal cost equals zero, the average cost remains unchanged.
(4) If marginal cost equals zero, the total cost remains unchanged.
(5) If total cost increases, the marginal cost is positive.
(6) If marginal cost is less than average cost, average cost decreases.
(7) Total revenue can decrease while marginal revenue is still positive.
(8) Total cost = total fixed cost + total variable cost.
(9) Average cost = average fixed cost + average variable cost.
(10) Average fixed cost decreases, reaches a minimum and then increases.
(11) Average cost is obtained by dividing total cost by total product.
(12) In the long run, all inputs are variable.
 108

T F
(13) The basic reason for the rising part of the short-run marginal cost curve is the
declining part of the marginal product curve which, in turn, is the result of the law
of diminishing returns.
(14) The law of diminishing marginal return applies to the short run only (ie to a
situation in which at least one of the firm's inputs is fixed).
(15) Total fixed cost changes as output changes.
(16) Average fixed cost changes as output changes.
(17) Production is plotted against units of labour.
(18) Cost is measured in terms of units of labour.
(19) Both product curves and cost curves are based on the law of diminishing
returns.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a)* Use a diagram to illustrate the relationship between average fixed cost, average variable cost,
average (total) cost and marginal cost.

(b)* Use two diagrams to illustrate the relationship between a firm's cost structure and production
(product/productivity) of its variable input.

(c)* Complete Table 8-4 below:

TABLE 8-4
Output Total cost Marginal Average fixed Average Average
(units) cost cost variable cost (total) cost
(Q) (R) (R) (R) (R) (R)
0 100
1 110
2 130
3 166
4 220
5 300

Now that you have worked through this learning unit, you should have a better understanding of the
different revenue, cost and profit concepts and also be able to calculate them. The relationship
between total, average and marginal revenue is the same as the relationship between the other total,
average and marginal values, like cost and production.
 109 ECS1501/001

The following diagram should help you with the cost concepts:

Short-run cost

Total cost Marginal cost Average cost

(TC) (MC) (AC or ATC)

Cost to produce a
certain quantity of a ∆TC TC
firm’s product ∆Q
(TFC + TVC) Q

Total Total Average Average

fixed cost variable cost fixed cost variable cost
(TFC) (TVC) (AFC) (AVC)

TC − TVC TC − TFC TFC TVC

Q Q

Section 9.5 of the prescribed book is not prescribed for this module.

SOLUTIONS

ACTIVITY 8.1
TRUE/FALSE STATEMENTS

(1) F The aim of the theory of supply is to explain the behaviour of firms.
(2) T
(3) T
(4) F See the formulas.
(5) T See Box 9-2.
(6) T See Box 9-2.
(7) T TR increases from R50 to R60.
(8) F 60 ÷ 5 = 12
(9) T 10 x 20 = 200
(10) T 200 ÷ 20 = 10
(11) F At least one — and not two — of the inputs cannot change.
 110

(12) T

SHORT QUESTIONS

(d) iv. The completed Table 8-1 should look like this:

Production Total revenue Average revenue Marginal revenue

(units)
(Q) (R) (R) (R)
1 (given) 10 10 10
2 (15 x 2) 30 (given) 15 [(30 − 10) ÷ (2 − 1)] 20
3 (30 + 6) 36 (36 ÷ 3) 12 (given) 6
4 (10 x 4) 40 (given) 10 [(40 − 36) ÷ (4 − 3)] 4
5 (given) 42,5 (42,5 ÷ 5) 8,5 [(42,5 − 40) ÷ (5 − 4)] 2,5
6 (42,5 + 2,5) 45 (45 ÷ 6) 7,5 (given) 2,5
Note: The values in brackets show the calculations.

ACTIVITY 8.2
TRUE/FALSE STATEMENTS

(1) T
(2) T This is the meaning of economic profit.
(3) F The firm is making an economic loss.
(4) F Implicit and explicit cost should be covered to realise normal profit.
(5) F The firm is making an economic profit.
(6) T It is implicit cost and forms part of her economic cost.
(7) F Remember: she now has equipment to the value of R10 000, instead of R10 000 in the
bank. She therefore has not “lost” the money. The full R10 000 paid for a new computer
must not be taken into account because acquiring an asset is not a cost. You merely swop
one asset (cash) for another (computer).
(8) T
(9) T This is included in explicit cost, among other things.
(10) T
(11) T
(12) F Make an economic loss of R30 000.
(13) T
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SHORT QUESTIONS

(d) i. The completed Table 8-2 should look like this:

Production Total cost Average cost Marginal cost

(units)
(Q) (R) (R) (R)
1 (given) 10 10 10
2 (15 x 2) 30 (given) 15 [(30 − 10) ÷ (2 − 1)] 20
3 (30 + 6) 36 (36 ÷ 3) 12 (given) 6
4 (10 x 4) 40 (given) 10 [(40 − 36) ÷ (4 − 3)] 4
5 (given) 42,5 (42,5 ÷ 5) 8,5 [(42,5 − 40) ÷ (5 − 4)] 2,5
6 (42,5 + 2,5) 45 (45 ÷ 6) 7,5 (given) 2,5

ii. To complete the two tables, you used the same methods/formulas, although the one table
dealt with revenue and the other with cost.

Thus, to calculate total, average and marginal values, the same principles and formulas
apply. Note that the same values were used in both tables since the aim of the
question was to improve your understanding of the principles and relationships of
total, average and marginal values.

(e) i. Accounting profit = total revenue ─ total explicit cost

= R100 000 ─ R30 000
= R70 000

ii. Economic profit = total revenue ─ (total implicit cost + total

explicit cost)
= R100 000 ─ (R50 000 + R30 000)
= R100 000 ─ R80 000
= R20 000

iii. Accounting profit is higher because the implicit cost was not taken into account — in other
words, it was not subtracted from total revenue.
(f) i. Explicit cost = Value of timber R180 000
= Total wages paid R 60 000
= Hinges, glue, screws,
oil, staining material R 15 000
= Telephone costs R 3 000
= Transport costs R 17 000
= Depreciation of
equipment R 5 000
R280 000

Implicit cost = Salary R90 000

= Interest on
R50 000 R 5 000
R95 000

Solomon's total economic cost is therefore R375 000 (R280 000 + R 95 000)
 112

ii. Accounting profit = total revenue ─ total explicit costs

= R400 000 ─ R280 000
= R120 000

Economic profit = total revenue ─ (explicit + implicit costs)

= R400 000 ─ R375 000
= R25 000

ACTIVITY 8.3
TRUE/FALSE STATEMENTS
(1) T
(2) T See Table 9-2.
(3) T See Table 9-2.
(4) T See Table 9-2.
(5) F See statement 6.
(6) T

SHORT QUESTIONS

(b) In the short run, firms can increase production by increasing the quantity of the variable input
(like the number of workers).

(c) The completed Table 8-3 should look like this:

Units of Total product Average product Marginal product

labour (TP) (AP) (MP)
(N) (ton) (ton) (ton)
0 0 − (given) 0
1 (given) 12 (12 ÷ 1) 12 [(12 − 0) ÷ (1 − 0)] 12
2 (20 x 2) 40 (given) 20 [(40 − 12) ÷ (2 − 1)] 28
3 (40 + 35) 75 (75 ÷ 3) 25 (given) 35
4 (given) 108 (108 ÷ 4) 27 [(108 − 75) ÷ (4 − 3)] 33
5 (108 + 17) 125 (125 ÷ 5) 25 (given) 17
6 (22 x 6) 132 (given) 22 [(132 − 125) ÷ (6 − 5)] 7
7 (18 x 7) 126 (given) 18 [(126 − 132) ÷ (7 − 6)] −6

i. At the sixth unit of labour.

ii. At the third unit of labour.
iii. At the fourth unit of labour.
iv. AP increases if MP is more than AP.
AP decreases when MP is lower than AP.
v. At the seventh unit of labour.

(d) As more of a variable input is combined with one (or more) fixed inputs in a production process,
i. total product(ion) increases, reaches a maximum and starts decreasing.
ii. marginal product increases, reaches a maximum and starts decreasing.
iii. average product increases, reaches a maximum and starts decreasing.
 113 ECS1501/001

iv. production levels are reached where first the marginal product, then the average product,
and finally, total product starts to decrease.

ACTIVITY 8.4
TRUE/FALSE STATEMENTS
(1) T See Table 9-4.
(2) T (72 − 60) ÷ (7 − 6) = 12 ÷ 1 = 12).
(3) F See statement 4.
(4) T
(5) T See Box 9-2, Tables 9-4 and 9-5.
(6) T See Box 9-2, Tables 9-4 and 9-5, and Figure 9-5.
(7) F Total revenue increases; see Boxes 7-1 and 9-2.
(8) T
(9) T
(10) T Because TP decreases according to the law of returns; see Table 9-4 at 9 and 10 units of
labour.
(11) T See Table 9-4.
(12) T
(13) T See Figure 9-6.
(14) T
(15) F Total fixed cost remains fixed regardless of the quantity produced; see Table 9-4.
(16) T Average fixed cost changes because you divide by total product; see Table 9-4.
(17) T See Figure 9-6(a). Note the horizontal axis.
(18) F Cost is expressed in terms of quantity produced — see Figure 9-7(b). Note the horizontal
axis.
(19) T

SHORT QUESTIONS

(a) You should have drawn a figure like Figure 9-5. (Note the U-shape.)
(b) You should have drawn figures like the two in Figure 9-6.
(c) NOTE: Remember that only total cost is given. You have to calculate average fixed and average
variable cost. In order to do this, you need columns for total fixed cost and total variable cost
respectively. To answer the question, you need to draw two extra columns.

At this stage you know that total fixed cost + total variable cost = total cost.

Look at the table: If 0 (zero) units are produced, the total cost is R100. What is the implication of
this cost? Of course, it is fixed cost, because fixed cost is defined as cost that remains constant
regardless of the level of production! Now you know that fixed cost should be 100 for 0 to 5 units
in the table. The total variable cost is the difference between total cost and total fixed cost.
 114

The sequence of the columns differs, because the calculations make more sense if we do it this
way.
Production Total fixed Total Total Average Average
(units) cost variable Cost variable fixed
(extra cost cost cost
column) (extra column)
(Q) (R) (R) (R) (R) (R)
0 100 (100 − 100)0 100 (0 ÷ 0) − (100 ÷ 0) −
1 100 (110 − 100)10 110 (10 ÷ 1)10 (100 ÷ 1)100
2 100 (130 − 100)30 130 (30 ÷ 2)15 (100 ÷ 2)50
3 100 (166 − 100)66 166 (66 ÷ 3)22 (100 ÷ 3)33,3
4 100 (220 − 100)120 220 (120 ÷ 4)30 (100 ÷ 4)25
5 100 (300 − 100)200 300 (200 ÷ 5)40 (100 ÷ 5)20

AND
Production (units) Average (total) cost Marginal cost
(Q) (R) (R)
0 (100 ÷ 0) − [(100 − 0) ÷ (0 − 0)] −
1 (110 ÷ 1)110 [(110 − 100) ÷ (1 − 0)]10
2 (130 ÷ 2)65 [(130 − 110) ÷ (2 − 1)]20
3 (166 ÷ 3)55,3 [(166 − 130) ÷ (3 − 2)]36
4 (220 ÷ 4)55 [(220 − 166) ÷ (4 − 3)]54
5 (300 ÷ 5)60 [(300 − 220) ÷ (5 − 4)]80

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
name the different types of firms
identify the goal of the firm
define total revenue, average revenue and marginal revenue
and identify the relationship between them (Box 9-2)
define total, average and marginal cost
distinguish between explicit and implicit costs
define economic costs of production
define profit, total (or accounting) profit, normal profit and
economic loss
distinguish between the total (or acounting), normal and
economic profit (Fig 9-1)
 115 ECS1501/001

Well Satis- Must Need

factory redo help
distinguish between the short run and the long run
distinguish between fixed and variable inputs (or costs)
list the assumptions for production in the short run
define the law of diminishing returns

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the relationship between total, average and marginal product
of labour (Fig 9-2, 9-3)
the law of diminishing returns (Fig 9-2)
the relationship between marginal cost, average cost,
average variable cost and average fixed cost (Fig 9-4, 9-5)
the relationship between production and cost in the short run
(Fig 9-6)

Calculations
I am able to
calculate total, average and marginal revenue
calculate total, average and marginal cost
calculate total, average and marginal product (Table 9-5)
calculate explicit and implicit costs
calculate accounting, normal and economic profit and
economic loss
calculate economic costs of production
calculate marginal cost, total fixed cost, total variable cost,
average fixed cost and average variable cost (Tables 9-3, 9-
4, 9-5)
 116

Market structure:
Overview and
perfect competition LEARNING UNIT

The purpose of this learning unit is to be able to identify the type of market structure in which a firm is
operating, given the key features of the market. The equilibrium position of the firm under perfect
competition is then derived. In other words it is determined whether or not it is profitable for a firm to
produce and, if so, what quantities of the product the firm should supply at different price levels. The
latter provide an explanation why supply curves slope upward from left to right.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ distinguish the most important differences and similarities between the different market
structures: perfect competition, monopolistic competition, oligopoly and monopoly
■ name and explain the criteria/characteristics of the different market structures
■ define perfect competition
■ list the conditions necessary for perfect competition to exist
■ give reasons why perfect competition is studied if it is only approximated in a small
percentage of markets
■ explain the demand curve under perfect competition
■ draw the demand curve for the product of a firm under perfect competition
■ draw the marginal and average cost curves of a firm
■ determine the short-run equilibrium condition for a perfectly competitive firm
■ explain why profits are only maximised along the rising part of the marginal cost curve
■ distinguish and graphically illustrate whether a firm is making an economic profit, a normal
profit or an economic loss
■ explain the supply curve of the firm and the market supply curve
■ describe the equilibrium position of the industry under perfect competition (in other words the
long-run equilibrium position)
 117 ECS1501/001

CONTENTS

The focus of this learning unit is on the behaviour of a firm in a perfectly competitive market. Perfect
competition is a theoretical model which serves as a standard benchmark or norm against which we
can compare other types of markets. In the real world there are many different types of markets.
Nearly every market or industry is unique, and no simple classification system can accurately reflect
this enormous variety. Nevertheless, economists usually distinguish between four broad sets of
markets: perfect competition, monopoly, monopolistic competition and oligopoly.

We start our analyses of markets by looking at the key features. Regardless of the market structure
firms want to maximise profits, which allows us to set a general equilibrium rule for firms . We then
explain what perfect competition means, and analyse the decisions of an individual firm operating
under conditions of perfect competition as well as the equilibrium of a perfectly competitive industry.

9.1 Market structure: an overview

STUDY

Section 10.1 of the prescribed book

Table 10-1 Summary of market structures

By looking at the features of markets four different types of market structures can be distinguised.
Table 10-1 gives a brief summary of these features – some of which will become more clear as we
proceed with the rest of the learning unit.

ACTIVITY 9.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Perfect competition is a market structure with many buyers but only a few
sellers.
(2) A precondition for perfect competition is that the product should be
homogeneous.
(3) Under perfect competition no individual buyer or seller can influence the price of
the product.
(4) It is assumed that buyers and sellers have perfect information (or knowledge) of
market conditions in a perfect competitive market.
(5) A monopoly produces a heterogeneous product.
(6) There are no barriers to entry into the market under monopoly .
(7) A monopoly is a market structure with only one buyer and many sellers.
(8) A monopoly is a market structure with many buyers and only one seller.
(9) The only seller of shoes in a rural town is an example of a monopoly.
 118

T F
(10) A monopolist can determine the price of his product and the quantity sold
independently of each other.
(11) The monopolist is a price taker.
(12) Monopoly and monopolistic competition are two different market structures.
(13) Monopolistically competitive firms produce differentiated products.
(14) Under monopolistic competition there should be many buyers and many sellers.
(15) Monopolistic competition is a market structure with many sellers selling a
homogeneous product.
(16) An oligopoly is a market structure with many buyers and only a small number of
firms selling a differentiated or homogeneous product.
(17) Collusion, like cartel formation, is possible under oligopoly.
(18) Imperfect competition refers to a situation in which at least one of the
requirements for perfect competition is not satisfied.
(19) Firms under perfect competition have some influence over the prices of their
products.
(20) Under perfect competition and monopolistic competition the product is
homogeneous, but not in the case of monopoly.
(21) One similarity between monopolistic competition and oligopoly is that entry by
new firms is completely free.
(22) One difference between monopoly and oligopoly lies in the information about
market conditions available to market participants.
Short questions

(a) Name the two extreme market structures.

(b) Name the two categories of imperfect competition.

9.2 The equilibrium conditions

STUDY

Section 10.2 of the prescribed book

Box 10-1 Short-run decisions of a firm

The conditions for profit maximisation, explained in this section, are extremely important and need to
be studied carefully.

These conditions are dealt with in a general way (ie in a way which applies to any firm, irrespective of
the type of market in which it operates). Make sure that you understand why a firm should operate
only if average revenue (AR) is greater than average variable cost (AVC) – the shut-down rule – and
why profits are maximised (or losses minimised) when marginal revenue (MR) is equal to marginal
cost (MC) – the profit maximizing rule.
 119 ECS1501/001

ACTIVITY 9.2
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) A firm is in equilibrium if it maximises its profit — in other words, where
MR = MC.
(2) When a firm decides not to produce any output (ie when it decides to shut down)
its loss equals total fixed cost.
(3) The equilibrium position of the firm is also its profit-maximising position.
(4) Profits are maximised where average cost is equal to marginal cost.
(5) To maximise profits a firm should produce a level of output where marginal
revenue is equal to marginal cost.

9.3 Perfect competition

STUDY

Section 10.3 of the prescribed book

This section deals with the definition of perfect competition. The main distinguishing feature of
perfect competition is that all the market participants (ie buyers and sellers) have to accept the market
price as given (ie they are all price takers). Study the formal requirements for the existence of
perfect competition carefully.

The subsection on the Relevance of perfect competition explains to you why this market form is
studied even though it is a theoretical construct, rather than an accurate description of the way in
which most markets actually operate.

ACTIVITY 9.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) One of the requirements of perfect competition is that there must be a large
number of buyers and sellers of the product.
(2) Under perfect competition, each firm sets the price of its product independently
from other firms supplying the same product.
(3) Perfect competition can only exist if the goods sold in the market by the different
sellers are identical or homogeneous.
(4) If there are barriers to entry and exit there cannot be perfect competition.
(5) No buyer or seller in a perfectly competitive market has perfect knowledge of
market conditions.
 120

T F
(6) Perfect competition is characterised by a large degree of government
intervention.
(7) Perfect competition represents a standard or norm against which the functioning
of all other markets can be compared.
(8) Perfect competition is studied because it is the most acceptable form of
competition.
(9) The agricultural sector more or less complies with the requirements of perfect
competition.
(10) Perfect competition represents a clear and meaningful starting point for
analysing the determination of price and output.

Short questions

Note: The solution to the question marked with an asterisk (*) is provided at the end of this learning unit.

(a) List seven formal requirements for the existence of perfect competition.
(b)* What does it mean if we describe all market participants under perfect competition as
price takers?

9.4 The demand for the product of the firm

STUDY

Section 10.4 of the prescribed book

Box 10-2 Total, marginal and average revenue

This section introduces an important concept, the demand curve for the product of the firm. When
we analyse the position of an individual firm, the relevant demand is the demand for the product of that
firm, rather than the market demand (which applies to all the sellers of the product, as a group). Make
sure that you understand why the demand curve for the product of the perfectly competitive firm is
horizontal at the level of the market price and why the firm's marginal and average revenue (MR and
AR) are both equal to the market price. Box 10-2 is important. Note the price (P), average revenue
(AR) and marginal revenue (MR) have the same value. This implies that on a graph (see Figure 10-2)
the demand curve for the product of the firm is horizontal since the price remains the same
irrespective of the quantities sold. This demand curve also represents the AR and MR curves as P =
AR = MR = D.

ACTIVITY 9.4
Indicate whether the following statements are true (T) or false (F):
Note: Answers are provided at the end of this learning unit.
T F
(1) A seller in a perfectly competitive market faces a perfectly elastic demand curve
for his or her product.
(2) Under perfect competition the market price is determined by demand and
supply.
 121 ECS1501/001

T F
(3) Under perfect competition the market price also represents the marginal
revenue and average revenue of each firm.
(4) In a perfectly competitive market a firm can sell more of its product by raising the
price.
(5) Under perfect competition each individual firm faces a vertical demand curve for
its product.

Short questions
Note: The solution to this question is provided at the end of this learning unit.

(a) i. Assume that the firm Success functions under conditions of perfect competition. The
market price is R10 per unit.

Complete Table 9-1 below using the formulas we introduced to you in Learning unit 8:

TABLE 9-1
Quantity Price Total revenue Marginal Average
per unit revenue revenue
(Q) (P) (R) (TR) (R) (MR) (R) (AR) (R)
0 10
1 10
2 10
3 10
4 10
5 10

ii. From the table, what do you observe about the market price, MR and AR?
iii. How would you graphically represent the relationship between the market price, MR and
AR?

9.5 The equilibrium of the firm under perfect competition

STUDY

Section 10.5 of the prescribed book

Box 10-3 Marginal cost and profit maximisation

The conditions for profit maximization, as discussed in section 10.2 of the prescribed book, are
applied in this section to the firm in a perfectly competitive (or only perfect) market.

You should study it in detail and be able to draw a diagram like Figure 10-3 to show that profit
maximisation takes place where MR = MC, and Figure 10-4 to indicate the various possible short-run
equilibrium positions. In each case you must also be able to show the economic profit (or loss)
per unit of production, the firm's total economic profit (or loss), and the break-even point.
 122

ACTIVITY 9.5
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Under perfect competition each firm can decide how much to supply at the
existing market price.
(2) In a perfectly competitive market, a firm maximises profit by producing a level of
output where marginal revenue is equal to marginal cost (ie where price is equal
to marginal cost).
(3) If a perfectly competitive firm is producing where marginal revenue equals
marginal cost, it can increase its profit by increasing its output.
(4) A perfectly competitive firm maximises its profit by choosing the optimal price.
(5) A perfectly competitive firm maximises its profit by choosing the output level
where revenue (or production) is maximised.
(6) A firm's economic profit per unit of output is given by the difference between
marginal revenue and marginal cost.
(7) If a firm's average revenue is greater than its average cost, it is earning an
economic profit.
(8) If a firm's average revenue is equal to its average cost, it is earning a normal
profit.
(9) Total economic profit is equal to the profit per unit of output multiplied by the
quantity of units produced.
(10) If a perfectly competitive firm is earning a normal profit only, it follows that its
average cost, marginal cost, average revenue and marginal revenue are all
equal at the equilibrium quantity and also equal to the market price.
(11) In the short run, a perfectly competitive firm can only earn normal profit.
(12) If a perfectly competitive firm is producing a level of output where price is R5,
average variable cost is R4, average (total) cost is R4,50 and marginal cost is
R5, this firm should increase its output to maximise profit.
(13) Suppose a perfectly competitive firm is currently producing an output level
where price is R5, average variable cost is R3, average (total) cost is R4 and
marginal cost is R4. In order to maximise profits, the firm should increase
production.
(14) A perfectly competitive firm is currently producing an output level where price is
R6, average variable cost is R4, average cost is R5,55 and marginal cost is R7.
In order to maximise profits, this firm should decrease output.
(15) Perfectly competitive firms can incur economic losses in the short run.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a)* Explain, with the aid of a diagram, why a firm's profit is maximised (or loss minimised) where
marginal cost (MC) is equal to marginal revenue (MR).

(b)* Use a diagram to explain the equilibrium position of a firm under perfect competition which
makes an economic profit in the short run. Clearly indicate the economic profit per unit of output
and the firm's total economic profit.
 123 ECS1501/001

(c)* i. Do the same as in question (b) above but for a firm which makes an economic loss in the
short run.
ii. Why would a firm continue to produce while it is making an economic loss?

(d)* Explain why the falling part of the marginal cost curve of a perfectly competitive firm can be
disregarded when the equilibrium position of the firm is analysed.

(e)* A firm produces a product which it sells in a perfectly competitive market. The price of the
product is R60 per unit and the firm's cost structure is given in Table 9-2:

TABLE 9-2
Units Total fixed Total Total cost Average Marginal
produced cost variable cost (total) cost cost
(Q) (R) (R) (R) (R) (R)
0 24
1 16
2 50
3 108
4 52
5 44
6 282

i. Complete Table 9-2.

ii. Calculate how many units the firm should produce and sell to maximise its profit.

9.6 The supply curve of the firm and the market supply curve

STUDY

Section 10.6 of the prescribed book

This section explains why the rising part of the firm's MC curve above the minimum of AVC is its
supply curve.

You must study this section in detail. The industry (or market) supply curve is obtained by adding all
the individual supply curves horizontally. Figure 10-5 is important. You should be able to explain why
the firm will produce, or not, at different given prices. This decision is determined by the profit and/or
loss position, given the market price.
 124

ACTIVITY 9.6
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Under perfect competition, the rising part of a firm's marginal cost curve above
the minimum average variable cost, represents the firm's supply curve.
(2) In a perfectly competitive market, the market supply curve is the horizontal sum
of the individual supply curves of all the firms in the industry.

(3) Look at the figure below and then indicate whether each of the following
statements is True (T) or False (F):

i. The break-even point is at e.

ii. The firm will produce at a price of R10.
iii. The firm will not produce at a price of R30.
iv. The close-down point is at point b.
v. At a price of R40 and Q3 the firm makes an economic profit.
vi. At a price of R50 and Q4 the firm makes an economic profit.
vii. At a price of R20 and Q1 the firm makes a normal profit.
viii. At prices R20 and R30 (Q1 and Q2 respectively) the firm incurs an
economic loss.
ix. No production will take place at point e.
x. The firm’s supply curve starts at price R20 and Q1 because there it does
not matter if the firm produces or not.
 125 ECS1501/001

Short question

Note: The solution to this question is provided at the end of this learning unit.

(a) Use Figure 10-5 in the textbook to explain why the rising part of a perfectly competitive firm’s
marginal cost curve above the minimum of average variable cost is also its supply curve.

9.7 Long-run equilibrium of the firm and the industry

STUDY

Section 10.7 of the prescribed book – except for the

subsection dealing with the impact of changes in the
scale of production on the equilibrium of the firm and
the industry

Box 10-1 Short-run decisions of a firm

In this section the long-run equilibrium of the industry under perfect competition is examined.

In production theory, the long run is defined as a period that is long enough for the firm to change the
quantities of all the inputs in the production process as well as the process itself.

In the long run, two things can change. Firstly, firms can enter or leave the industry or, secondly, firms
may decide to expand their plant sizes to realise economies of scale. In this module only the first
change is examined. Changes in plant size and cost are covered in a second-year module.

ACTIVITY 9.7
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) All the firms supplying a specific product in the market together form the
industry.
(2) In the long run only one thing can change: new firms can enter the industry and
existing firms can leave.
(3) The industry in the long run can only be in equilibrium if all the firms are making
normal profits.
(4) A perfectly competitive industry can only be in equilibrium if all the firms are
earning economic profit.
(5) If all the firms in a perfectly competitive industry earn economic profits, new
firms will be attracted to the market. The supply of the good will increase, thus
lowering the price. Eventually all the firms will be earning normal profit only.
(6) If all the firms in a perfectly competitive industry incur economic losses, existing
firms will leave the industry. The supply of the good will decrease, thus raising
the price. Eventually all the firms will be earning normal profit only.
(7) In the long run all factors of production are variable.
 126

Section 10.8 of the prescribed book is not prescribed for this module.

SOLUTIONS

ACTIVITY 9.1
TRUE/FALSE STATEMENTS

(1) F There are many buyers and sellers.

(2) T
(3) T All buyers and sellers are price takers.
(4) T
(5) F A monopoly usually produces a homogeneous product without good substitutes.
(6) F Entry is blocked.
(7) F See statement 8.
(8) T
(9) T
(10) F Price and quantity cannot be determined independently of each other.
(11) F The monopolist is a price maker.
(12) T
(13) T
(14) T
(15) F Heterogeneous or differentiated products are supplied.
(16) T
(17) T
(18) T
(19) F The market price under perfect competition is given — price takers.
(20) F Under monopolistic competition, the product is heterogeneous or differentiated.
(21) F Under oligopoly, entry varies from free to limited.
(22) T

ACTIVITY 9.2
TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) T
(4) F
(5) T

ACTIVITY 9.3
TRUE/FALSE STATEMENTS

(1) T
(2) F All firms are price takers; prices cannot be determined independently.
(3) T It is one of the requirements for perfect competition.
(4) T It is one of the requirements for perfect competition.
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(5) F All buyers and sellers have perfect knowledge.

(6) F There should be no government intervention.
(7) T
(8) F It is not necessarily the most acceptable form of competition.
(9) T
(10) T

SHORT QUESTIONS

(b) All market participants should accept the price which is determined as a given by the interaction
of market demand and supply. They cannot change the price; they can only decide what
quantities to supply or demand at that price.

ACTIVITY 9.4

TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) T Also see Table 9-1below
(4) F The market price should be accepted as a given; the product cannot be sold at a higher or
lower price. See Figure 10-2.
(5) F It is a horizontal demand curve.

SHORT QUESTIONS

(a) i. The completed Table 9-1 is as follows:

Quantity Price per Total revenue Marginal revenue Average

unit (TR) (MR) revenue (AR)
(Q) (R) (R) (R) (R)
0 10 (0 x 10)0 – –
1 10 (1 x 10)10 [(10 – 0) ÷ (1 – 0)]10 (10 ÷ 1)10
2 10 (2 x 10)20 [(20 – 10) ÷ (2 – 1)]10 (20 ÷ 2)10
3 10 (3 x 10)30 [(30 – 20) ÷ (3 – 2)]10 (30 ÷ 3)10
4 10 (4 x 10)40 [(40 – 30) ÷ (4 – 3)]10 (40 ÷ 4)10
5 10 (5 x 10)50 [(50 – 40) ÷ (5 – 4)]10 (50 ÷ 5)10

Note: The values in brackets show the calculations. In the examination, only the answers
are required if the calculations are not asked for.

ii. The values for the market price, MR and AR are exactly the same at R10.
iii. Like Figure 10-2 in the textbook. It indicates a horizontal demand curve for the product at
the level of the market price. In this case (ii above) the market price is R10.
 128

ACTIVITY 9.5
TRUE/FALSE STATEMENTS

(1) T Each firm can decide on the quantity, but not the price. The demand curve is horizontal.
(2) T Profit maximisation is at MR = MC.
(3) F Profit maximisation is at MR = MC.
(4) F Cannot choose the price; has to accept the given market price.
(5) F Profit maximisation is at MR = MC.
(6) F It is the difference between average revenue (AR) and average cost (AC).
(7) T
(8) T See Figure 10-4(b)
(9) T
(10) T See Figure 10-4(b).
(11) F Firm can realise economic profit, economic loss or normal profit in the short run.
(12) F Price = R5; thus MR = R5 and Marginal cost (MC) = R5. Maximum profit is where
MR = MC, thus the firm’s position of maximum profit.
(13) T Price = R5; thus MR = R5 and Marginal cost (MC) = R4. Therefore MR (R5) is
greater than MC (R4) and the firm should increase production to reach maximum profit.
(14) T Price = R6; thus MR = R6 and Marginal cost (MC) = R7. Therefore MC (R7) is
greater than MR (R6) and the firm should decrease production to reach maximum profit.
Questions 12, 13 and 14 are descriptions of profit maximisation in Figure 10-3.
(15) T

SHORT QUESTIONS

(a) You should have drawn a figure like Figure 10-3.

You could have explained the graph as follows:
As long as MC is below MR (see points a, b and c on the MC curve), the firm should increase
production and profit increases.
At point d, MR = MC, and profit is maximised.
If the firm increases production beyond point d (see point e), MR is lower than MC and the firm’s
profit will decrease.

(b) You should have drawn a figure like Figure 10-4(a). Note: to realise an economic profit,
average revenue (AR) should be higher than average cost (AC). AR (or the price line) is
therefore above the AC curve. Do you remember that profit is defined as the positive difference
between revenue and cost?
The graph can be described as follows:
Equilibrium is at E1 where MC = MR.
The economic profit per unit is P1 – C1 (or the difference between P1 and C1) .
Total economic profit is indicated by the grey area C1P1E1M .

(c) i. You should have drawn a figure like Figure 10-4(c). Note: to realise an economic loss,
average cost (AC) should be more than average revenue (AR) and therefore the AC curve
should be higher than the AR curve (or the price line).
The graph can be described as follows:
Equilibrium is at E3 where MC = MR.
The economic loss per unit is P3 – C3 (or the difference between P3 and C3).
The total economic loss is indicated by the grey area P3C3ME3.
ii. Because the loss is less than fixed cost. (Part of the firm’s fixed cost is covered.)

(d) See Box 10-3. The last paragraph in the box gives a detailed answer to this question.
 129 ECS1501/001

(e) i. The completed Table 9-2 will look like this:

Total Total
Units fixed Variable Total cost Average Marginal
produced cost cost (total) cost Cost
(Q) (R) (R) (R) (R) (R)

0 24 0 24 – –

1 24 16 (24 + 16)40 (40 ÷ 1)40 16

2 24 50 (24 + 50)74 (74 ÷ 2)37 [(74 – 40) ÷ (2 – 1)]34

3 24 84 108 (108 ÷ 3)36 [(108 – 74) ÷ (3 – 2)]34

4 24 136 (108 + 52)160 (160 ÷ 4)40 52

5 24 196 (44 x 5)220 44 [(220 – 160) ÷ (5 – 4)]60

6 24 282 (24 + 282)306 (306 ÷ 6)51 [(306 – 220) ÷ (6 – 5)]86

If you had problems completing the table, remember that

■ total cost = total fixed cost plus total variable cost

■ total fixed cost (per definition) remains the same, right through, at R24. If 0 units are
produced, total cost is R24. This cost represents fixed cost
■ marginal cost is the cost added to total variable cost or total cost
■ variable cost only comes into effect once the first unit is produced (per definition)
■ average total cost is equal to the total cost divided by the number of units produced

ii. The firm should produce and sell 5 units in order to maximise profit. Remember, the
firm maximises its profit by the production and sale of that quantity where marginal
revenue (or price in this case; under perfect competition is P = MR = AR = D) is equal to
marginal cost. The price per unit is R60, and 5 units will therefore be produced, because
the MC of 5 units = R60. Thus P = MC = R60.

ACTIVITY 9.6
TRUE/FALSE STATEMENTS

(1) T
(2) T
(3) i. F Point d is the close-down point.
ii. F No production will take place.
iii. F The firm will produce because part of its cost is covered.
iv. F It is the break-even point.
v. F Firm realises normal profit.
vi. T AR is greater than AC.
vii. F AC is not equal to AR at a price of R20.
viii. T All the costs are not covered at these two prices.
ix. T
x. T

SHORT QUESTIONS
 130

(a) The following explanation is based on Figure 10-5.

– P5 : the firm will not produce at this price, because costs (average
fixed and average variable) are not covered completely.
– P4 and Q4 : the firm is at close-down point (point b) and it does not matter
if it continues production or closes down, because it covers at least its average
variable cost (AVC). The loss is equal to total fixed cost irrespective of it
continuous production.
– P3 and Q3 : at this price the firm minimises its economic loss by
producing quantity Q3, because it covers at least its average variable cost
(AVC) as well as part of its average fixed cost (AFC). Remember that AVC +
AFC = AC. Therefore the vertical distance between AC and AVC is equal to
AFC.
– P2 and Q2 : the firm realises normal profit at this price (also the break-
even point) — in other words, AC = AR and the firm will continue with
production.
– P1 and Q1 : the firm realises economic profit at this price, because AR
(the price line) is higher than the AC curve and it will continue with production.

Therefore the increasing part of the firm’s MC curve under perfect competition above the
minimum point of AVC (starting at point b) is also its supply curve (indicating the quantity that will
be supplied at each price).

ACTIVITY 9.7
TRUE/FALSE STATEMENTS

(1) T
(2) F Existing firms can also increase production.
(3) T See statement 4.
(4) F
(5) T
(6) T
(7) T

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
name the four market structures
name the two categories of imperfect competition
distinguish between the two extreme market structures
distinguish between the features of perfect competition
distinguish between the features of monopoly
distinguish between the features of monopolistic competition
 131 ECS1501/001

Well Satis- Must Need

factory redo help
identify the essential difference between monopolistic
competition and monopoly
identify the essential difference between monopolistic
competition and perfect competition
distinguish between the features of oligopoly
distinguish the most important differences and similarities
between perfect competition, monopolistic competition,
oligopoly and monopoly
define perfect competition
list the conditions necessary for perfect competition to exist
give reasons why to study perfect competition if it exists only
in a small percentage of markets
identify the three different short-run equilibrium positions of
the firm under perfect competition
define the equilibrium position of the firm under perfect
competition
identify two factors that can change in the long run
define economies of scale

Explanations
I am able to
explain the difference between a price taker and a price
maker
explain the short-run equilibrium conditions for the firm by
means of the shut-down rule and the profit-maximising rule
explain the effect of entry and exit on the equilibrium of the
firm and the industry

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the marginal and average revenue curve of the firm under
perfect competition (Fig 10-2)
the demand curve for the product of the firm under perfect
competition (Fig 10-2)
the profit-maximising (or equilibrium) position of the firm
under perfect competition according to marginal revenue
and marginal cost
(Table 10-2, Fig 10-3)
 132

Well Satis- Must Need

factory redo help
marginal cost and profit maximisation (eg why profits are
only maximized along the rising part of the marginal cost
curve) (Box 10-3)
a firm’s economic profit, normal profit or economic loss (Fig
10-4)
the supply curve of the firm (Fig 10-5)
given different prices, the economic profit, normal profit,
economic loss, close-down point and break-even point (Fig
10-5)
the equilibrium position of the industry (eg the long-run
equilibrium position) under perfect competition (Fig 10-6, 10-
7 and 10-8)

Calculations
I am able to
calculate total, marginal, and average revenue under perfect
competition (Box 10-2)
calculate, with given prices and quantities, the profit and/or
loss position of the firm in the short run
 133 ECS1501/001

The factor markets:

the labour market
LEARNING UNIT

The purpose of this learning unit is to examine the labour market.

OUTCOMES

After you have worked through this learning unit, you should be able to

■ identify the most important differences between the labour market and the goods market
■ explain the difference between nominal (or money) wages and real wages
■ list the requirements for a perfectly competitive labour market
■ explain, with the aid of a diagram, equilibrium in a perfectly competitive labour market
■ explain what can cause the market supply curve of labour to shift
■ explain the individual firm's demand for labour
■ explain why the firm maximises profits (is in equilibrium) when it employs workers up to the
point where MRP equals the wage rate
■ explain what can cause the market demand curve of labour to shift
■ illustrate graphically the changes in labour market equilibrium
■ provide reasons why labour markets can be imperfect
■ distinguish between two broad categories of trade unions
■ explain, with the aid of diagrams, the three ways in which a trade union can try to increase the
wage rate
■ explain, with the aid of a diagram, the impact of the imposition of a minimum wage (ie
government intervention in the labour market) in a perfectly competitive labour market

CONTENTS

In the circular flow model we have seen that the goods markets and the factor markets are
interrelated. The principal factor market is the labour market, which is introduced in this learning unit.
 134

10.1 Labour market versus the goods market

STUDY

Section 12.1 of the prescribed book

Section 12.2 of the prescribed book

Box 12-1 Some basis concepts

Make sure that you know the main differences between the labour market and the goods market.
The difference between money (or nominal) wages and real wages is important.

ACTIVITY 10.1
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) There are no essential differences between the labour market and the market for
(say) tomatoes. In both cases, prices are determined on a daily basis by the
forces of demand and supply.
(2) The functioning of the labour market is affected by non-economic
considerations.
(3) Goods are transferable, while labour services are embodied in the persons
concerned.
(4) The remuneration of labour is profit.
(5) The remuneration of labour includes benefits such as medical and pension
benefits.
(6) If money wages increase by an average of 10 per cent (10%) per annum and
the inflation rate is 7 per cent (7%), this implies an increase in both nominal and
real wages.
(7) Real wages refer to the purchasing power of wages.
(8) Nominal wages and real wages are synonymous (in other words, they have the
same meaning).
(9) Nominal wages and money wages are synonymous.
(10) Money wages and real wages are synonymous.
(11) If money wages rise by an average of 10 per cent per annum and the prices of
goods and services increase by an average of 6 per cent, this implies a fall in
real wages of approximately 4 per cent.
(12) If money wages rose by an average of 10 per cent during a particular year, while
the prices of goods and services rose by an average of 15 per cent, then real
wages fell by approximately 5 per cent.
 135 ECS1501/001

Short questions

Note: The solutions to the question marked with an asterisk (*) is provided at the end of this learning unit.

(a) Name any five differences between the labour market and the goods market.

(b)* Use a simple numerical example to explain the difference between an increase in nominal
wages and an increase in real wages.

10.2 A perfectly competitive labour market

STUDY

Section 12.3 of the prescribed book – except for the

subsection dealing with the individual supply of labour

The six requirements for perfect competition are extremely restrictive and it is doubtful whether any
labour market actually meets these requirements. Nevertheless, the assumption provides a useful
starting point for analysis of the labour market.

In a perfectly competitive labour market (Figure 12-2), the wage rate is determined by the
interaction between labour demand and labour supply - as is the case with any perfectly
competitive market.

The market supply of labour, is illustrated in Figure 12-4. Note that the market supply curve has a
positive slope. The factors that can change the market supply are also significant.

The most important aspect of the demand for labour is that it is a derived demand.

Ensure that you understand why all participants in the labour market are wage takers and why the
supply of labour to the firm is represented by a horizontal line at the level of the equilibrium wage rate
(Figure 12-5). Also ensure that you understand what physical product, revenue product, marginal
physical product and marginal revenue product mean and how these concepts are related. After you
have studied this section you should be able to explain why the firm maximises profit by employing the
number of workers indicated by the point where MRP = wage rate (Table 12-1 and Figure 12-6) and
graphically illustrates the equilibrium position of a firm operating in a perfectly competitive labour
market (Figure 12-7).

Study the factors which can cause a change in the market demand for labour. (see Figure 12-8).

ACTIVITY 10.2
Indicate whether the following statement is true (T) or false (F):

Note: The answer is provided at the end of this learning unit.

T F
(1) A change in wages will shift the market supply curve for labour.
(2) The market supply curve for labour will be shifted by a change in the non-wage
determinants of the quantity of labour supplied.
 136

T F
(3) The demand for labour is a derived demand, which implies that there will only be
a demand for labour to produce a certain product if there is a demand for the
product itself.
(4) The marginal revenue product (MRP) curve represents the demand curve for
labour.
(5) The supply curve facing the firm is horizontal at the level of the wage rate
determined in the labour market.
(6) The market supply curve of labour has a positive slope.
(7) MRP is obtained by multiplying MPP by the selling price of the product in
question.
(8) The slope of the MPP curve reflects the law of diminishing returns.
(9) A firm will continue to hire labour until MRP is equal to the wage rate.
(10) If the MRP is greater than the wage rate it will be profitable for a firm to employ
additional labour.
(11) A firm will employ workers as long as MPP is greater than the wage rate (w).
(12) In a perfectly competitive market the firm will maximise its profit where the price
of labour (wage rate) equals the MRP.
(13) An increase in the wage rate will shift the labour demand curve upwards to the
right.
(14) A decrease in the wage rate will shift the labour demand curve downwards to
the left.
(15) A change in the wage rate will leave the labour demand curve unchanged.
(16) A fall in the price(s) of the product(s) manufactured by the workers will shift the
labour demand curve downwards to the left.
(17) An increase in the productivity of the workers will shift the labour demand curve
upwards to the right.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) List six requirements for perfect competition in the labour market.

(b)* Use a diagram to indicate equilibrium in a perfectly competitive labour market.

(c)* Name two factors that can cause an increase in the market supply of labour.

(d)* Henry Ford, the famous American entrepreneur who started the Ford Motor Company, once
said: “It is not the employer who pays wages – he only handles the money. It is the product that
pays wages.”
Explain this statement.

(e)* Explain what the effect will be of each of the following events on the labour market in the
computer manufacturing industry:
i. The SA government buys personal computers for all South African students.
ii. More tertiary students major in engineering and computer science.

(f)* Explain, with the aid of a diagram, the equilibrium position of a firm operating in a perfectly
competitive labour market.
 137 ECS1501/001

(g)* Complete the following Table 10-1 and answer the questions.

TABLE 10-1
Number of Total physical Marginal Price per pair Marginal
workers product physical of shoes revenue
(pairs of shoes product (pairs (R) product
per week) of shoes per (R per
week) week)
(N) (TP) (MPP) (P) (MRP)
0 0 70 0
1 12 70
2 22 700
3 9 70
4 5 70 350
5 40
6 2 70

i. The firm will maximise its profit where the wage rate equals the _____________.
ii. From the table above, how many labourers will be employed at a wage rate of R700?
iii. The MRP of the sixth labourer equals ___________.
iv. The firm will maximise its profit at a wage rate of R280 by employing __________ workers.
v. Will it be profitable for the firm to employ the fourth worker at a wage rate of R300? Give a
reason.
vi. How would you graphically represent the relationship between the number of workers and
the marginal revenue product?

(h)* Give three possible reasons for a decrease in the market demand for labour.

(i)* Illustrate, with the aid of a diagram, what will happen to the supply curve of labour if
new workers enter the labour market.

10.3 Imperfect labour markets

STUDY

Section 12.4 of the prescribed book – except for the

subsections dealing with monopsony, bilateral
monopsony and labour immobility and imperfect
information

Labour markets, like most goods markets, are also not perfectly competitive. Make sure that you know
why labour markets tend to be imperfect.

The existence of trade unions is one of the market imperfections. Make sure that you can distinguish
between the two broad categories of craft unions and industrial unions. Figure 12-9 is important.

In this module we focus on only one form of government intervention intervention, namely the
imposition of a minimum wage in a perfectly competitive market. Study this section carefully. You
should be able to use a diagram (Figure 12-11) to show the effects of the imposition of a minimum
wage (above the equilibrium wage) in a perfectly competitive labour market. Note that this is simply an
application of minimum price fixing studied in Learning unit 4.
 138

Note the subsection on a minimum wage in a monopsonistic labour market and Figure 12-12 are not
prescribed for this module.

ACTIVITY 10.3
Indicate whether the following statements are true (T) or false (F):

Note: Answers are provided at the end of this learning unit.

T F
(1) Trade unions consist of workers with common aims to serve as a countervailing
force to the bargaining power of employers.
(2) Collective bargaining only has to do with wage issues.
(3) A craft union does not limit its members to workers with specific skills or
qualifications.
(4) Workers often go on strike to enforce their demands.
(5) Pressure by trade unions for higher wages can lead to the substitution of people
by machinery.
(6) A productivity agreement between employers and workers implies lower
productivity by workers in exchange for higher wages.
(7) Fixing a minimum wage in a perfectly competitive labour market can prevent the
attainment of an equilibrium wage.
(8) Introducing a minimum wage below the equilibrium wage in a perfectly
competitive labour market will result in an excess demand for labour.
(9) If a minimum wage is fixed above the equilibrium wage in a perfectly competitive
labour market, an excess supply of labour (ie unemployment) will develop.
(10) The introduction of a minimum wage below the equilibrium wage in a perfectly
competitive labour market will have no impact on the level of wages and the
level of employment.

Short questions

Note: The solutions to the questions marked with an asterisk (*) are provided at the end of this learning unit.

(a) Give six reasons why labour markets can be imperfect.

(b) Explain, with the aid of a diagram, how certain trade unions can control the supply of skilled
labour in specific trades or professions by restricting membership.

(c) Explain, with the aid of a diagram, how trade unions can try to increase wages and employment
by trying to raise the demand for the product of a specific industry.

(d) Explain, with the aid of a diagram, the impact of the imposition of a minimum wage above the
equilibrium wage in a perfectly competitive labour market. Clearly indicate any possible excess
supply or excess demand of labour.

Section 12.5 and Appendix 12-1 of the prescribed book are not prescribed for this
module.
 139 ECS1501/001

SOLUTIONS

ACTIVITY 10.1
TRUE/FALSE STATEMENTS

(1) F The labour market is a factor market and differs from the goods market.
(2) T
(3) T
(4) F The price of labour is wages and salaries.
(5) T
(6) T See the explanation in question (b) below.
(7) T
(8) F See statement 9.
(9) T
(10) F See statement 9.
(11) F It implies an increase of approximately 4% in real wages.
(12) T

SHORT QUESTIONS

(b) You could have used any numerical example.

The nominal wage is the actual wage (at current prices) received by the worker. If the wage
increased by, say, R2 000 per month to R2 200 per month, the nominal wage increased by 10%.
The real wage refers to the purchasing power of money. To determine whether the real wage
increased, the rate of increase in the nominal wage should be compared with the inflation rate.

For example:

- if the nominal wage increases by 10% while prices in general increase by 10%, the real
wage remains unchanged
- if the nominal wage increases by 10% while prices in general increase by 12%, the real
wage will decrease
- if the nominal wage increases by 10% while prices in general increase by 7%, the real
wage will increase — that is, the purchasing power of the money wage (or nominal wage)
increases

ACTIVITY 10.2
TRUE/FALSE STATEMENTS

(1) F Wage is the price of labour and will cause a movement along the supply curve.
(2) T
(3) T
(4) T
(5) T See Figures 12-5(b) and 12-7.)
(6) T See Figure 12-3.)
(7) T
(8) T
(9) T Equilibrium is at this point.
(10) T
(11) F See statement 10.
 140

(12) T See statement 9.

(13) F The demand curve will not shift; there will be an upward movement along the demand
curve.
(14) F There will be a downward movement along the demand curve.
(15) T
(16) T
(17) T More goods will be produced. At the same wage (w) more workers can be employed
because they are more productive and produce more. The demand for labour will therefore
increase.

SHORT QUESTIONS

(b) You should have drawn a diagram like Figure 12-2 of the prescribed book:

Equilibrium is determined by the interaction between the demand for labour (DD) and the supply
of labour (SS). Equilibrium is reached where the quantity of workers demanded equals the
quantity of workers supplied. This is indicated by the intersection of the demand and supply
curves (point E). The equilibrium wage rate (ie the price of labour) is we and the equilibrium
quantity (ie the level of employment) is Ne. (The same principles are applied in the goods
market.)

(c) You could have mentioned any two of the following factors:

- an increase in the number of workers

- lower wages earned in other occupations can make the particular occupation more
attractive and can increase the market supply of labour in the specific occupation
- an improvement in the non-monetary aspects of the occupation, for example improved
pension and medical benefits, can lead to an increase in the market supply of labour.

Note: the direction of change is important, because the question specifically refers to
factors increasing the market supply of labour.

(d) Labour is not demanded for its own sake but rather for the value of the goods and services that
can be produced when labour is combined with other factors of production. Firms will therefore
demand and employ labour only if there is a demand for the goods and services produced by
labour and if it is profitable for them to do so.

(e) i. If the SA government buys computers for all South African students there will be a
higher demand for computers and consequently the demand for labour in the
computer industry will increase.
ii. If more students major in engineering and computer science, then the supply of the
labour force in these industries will increase. The supply of labour curve will then
shift to the right.

(f) You should have drawn a diagram like Figure 12-7 of the prescribed book:

The firm is in equilibrium where marginal revenue product (MRP), which represents the firm's
demand for labour, is equal to the wage rate we, which represents the supply of labour to the
firm. This occurs at an employment rate of Ne.
 141 ECS1501/001

(g) The completed Table 10-1 should look like this:

Number of Total physical Marginal Price per Marginal

workers product physical product pair of revenue
(pairs of shoes (pairs of shoes per shoes product
per week) week) (R) (R per week)
(N) (TP) (MPP) (P) (MRP)
0 0 0 70 0
1 (0+12)12 12 70 (12x70)840
2 22 [(22–12)÷(2–1)]10 70 700
3 (22+9)31 9 70 (9x70)630
4 (31+5)36 5 70 350
5 40 [(40–36)÷(5–4)]4 70 (4x70)280
6 (40+2)42 2 70 (2x70)140
(The figures in bold are given.)

i. Marginal revenue product (MRP).

ii. 2 labourers (because at a wage rate of R700, the MRP is also equal to R700).
iii. R140.
iv. 5 labourers (because at a wage rate of R280, the MRP is also equal to R280).
v. Yes, because the MRP is equal to R350 and the wage rate is equal to R300 (MRP is still
higher than the wage rate).
vi. The diagram should look like this:

(h) Three possible reasons for a decrease in the market demand for labour are:
- a decrease in the price of the final product (not the price of labour!)
- a decrease in the productivity (or MPP — marginal physical product)
- a decrease in the price of a substitute production factor, like the cost of capital.

(i) See Figure 12-8(c) of the textbook.

 142

ACTIVITY 10.3
TRUE/FALSE STATEMENTS

(1) T
(2) F Wages and other conditions of service are negotiated.
(3) F A craft union exists primarily to unite workers with the same skills or qualifications.
(4) T
(5) T It may be cheaper for the employer to use machinery instead.
(6) F The emphasis is precisely on higher productivity in exchange for higher wages.
(7) T
(8) F A minimum wage must be imposed above the equilibrium wage to have any influence on
the market; also see statements 9 and 10.
(9) T
(10) T

SHORT QUESTIONS

(b) You should have drawn a figure like Figure 12-9(a) of the prescribed book:

The original demand and supply are represented by D0D0 and S0S0 respectively with w0 as the
equilibrium wage and N0 as the level of employment. If the union succeeds in lowering the
supply of skills by limiting membership, the supply of labour decreases and the supply curve
shifts to S1S1. Consequently, the wage rate increases to w1 and the employment level (quantity
of labour) decreases to N1.

(c) You should have drawn a figure like Figure 12-9(c) of the prescribed book:

If the union succeeds (together with the firms) in increasing the demand for the product in the
industry, the demand for labour (a derived demand) will increase from D0D0 to D1D1.
Consequently, the wage rate increases from w0 to w3 and the employment level increases from
N0 to N3.

(d) In answering the question, you should give a complete diagram with explanatory notes, as given
in Figure 12-11 of the prescribed book. Clearly indicate the equilibrium wage (like we in the
textbook), the minimum wage (above the equilibrium wage, like wm), the quantity demanded at
the minimum wage (Nm), the quantity supplied (N1) and the excess supply of labour (or
unemployment) which is equal to the difference between N1 and Nm. You could also indicate the
excess supply of labour on the diagram.
Note: Fixing a minimum wage below the equilibrium wage of we will have no influence on the
price or quantity of labour.
 143 ECS1501/001

CHECKLIST

Well Satis- Must Need

factory redo help
Concepts
I am able to
identify the most important differences between the labour
market and the goods market
define some basic concepts (wage, wage rate, earnings,
nominal wage and real wage) relating to the remuneration of
labour (Box 12-1)
list the requirements for a perfectly competitive labour
market
give reasons why labour markets can be imperfect
distinguish between the categories of trade unions and to
define each

Explanations
I am able to
explain the difference between nominal and real wages
explain why the demand for labour a derived demand is
explain why the firm maximises profits (is in equilibrium)
when it employs workers up to the point where MRP equals
the wage rate (Table 12-1)

Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
equilibrium in a perfectly competitive labour market (Fig 12-
2)
the market supply of labour (Fig 12-4)
the factors that can cause the market supply curve of labour
to shift (supply factors) and the factor that causes a
movement along the curve (Fig 12-4)
a perfectly competitive labour market and the position of the
individual firm’s supply of labour (Fig 12-5)
the individual firm’s demand for labour (Table 12-1, Fig 12-6)
the equilibrium position of a firm operating in a competitive
labour market (Fig 12-7)
the factors that can cause the market demand curve for
 144

Well Satis- Must Need

factory redo help
labour to shift (demand factors) and the factor that causes a
movement along the curve (Fig 12-6)
the changes in labour market equilibrium (Fig 12-8)
three ways in which a trade union can attempt to increase
the wage rate (Fig 12-9)
the impact of the fixing of a minimum wage (eg government
intervention in the labour market) in a perfectly competitive
labour market (Fig 12-11)

Calculations
I am able to
use a numerical example to distinguish between nominal
(money) wages and real wages