GAUTENG DEPARTMENT OF EDUCATION

ECONOMICS TERM 2 - MICROECONOMICS

NOTES FOR LEARNERS

Contents
MODULE 2: UNIT 1 ...............................................................................................................................2
PERFECT MARKET / COMPETITION.........................................................................................................3
MODULE 2: UNIT 2 .............................................................................................................................14
ELASTICITIES ..........................................................................................................................................14

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...............................................................................................................................................................20
IMPERFECT MARKETS / COMPETITION ................................................................................................14
Explain relevant concepts, deducing, interpretation, drawing of profit curves (short – and long run)
and explaining and interpreting graphs. ...............................................................................................14
To explain relevant imperfect markets and comparing them with a perfect market...........................14
MODULE 2 / UNIT 3 .............................................................................................................................33
MICRO ECONOMICS - MARKET FAILURE & COST BENEFIT ANALYSIS (CBA) ...................................25

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PERFECT MARKET / COMPETITION
Introduction
The circular flow introduced the learners to the economic participants, and some of their
interactions were analysed. Different types of markets and their roles in an open economy were
discussed. Here we turn to the markets in which they interface. Markets owe their origin to the
interactions of buyers and sellers. Markets are the centre of economic activities and provide the
dynamics for the performance of economies. We distinguish between four broad types of market
structures, namely perfect competition, monopolistic competition, oligopoly and monopoly. Perfect
competition occurs in a market structure with many participants where no single buyer or seller can
influence the price of the goods or services. The topic of perfect competition starts in grade 10 and
progresses to grade 11 and 12.

Overview
The focus is on the review of costs and revenue schedules and curves, characteristics, market
structure, output, profits, losses and supply as well as competition policies.

Specific Objectives
• Use various teaching methodologies and assessment methods to teach the learners how to
calculate costs and profits.
• Draw graphs relating to costs and revenue curves, the demand curve of an industry, demand
curve of an individual supplier, economic profit, normal profit, economic loss, long-run profit
and the shut-down point of a perfect competitor.
• Give the participants the opportunity to design assessment activities that meet the standards set
in the 2017 Examination Guidelines based on perfect competition.

Content (big Ideas on the topic)

You will study this module through the following units:

Unit 1: Perfect competition

Content Progression
• Every year, it is indicated in the matric diagnostic analysis that grade 12 learners lack the skill
to draw and interpret graphs. Micro-economics is a topic which must be taught with the aid
of graphs.
• More emphasis should be given to topics which progress from lower grades (7-11) to grade
12.
• Such topics should be taught in-depth by lower grades (7-11) teachers.
• Team planning and team teaching is highly recommended amongst the EMS and Economics
teachers.
• Baseline assessment is required to test prior knowledge of the learners.
• The learners should be encouraged to use calculators.

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NOTE:

1. Review cost and revenue tables and curves done in Grade 11.
2. Differentiate between the short and long run.
3. The examination of individual business and industry should be accompanied by an analysis of
tables and graphs.
4. Comparison and contrasting of four market structures should be discussed in detail after the
completion of all four market structures.
5. Relate the industry equilibrium positions to the individual firm’s equilibrium positions with
graphs, i.e. how entry and exit into the market influence equilibrium position from the short run
to the long run.
6. Give your opinion about the successes / failures of the competition policy. (Relate to current
examples).

TERM DESCRIPTION
Economic profit Profit that is made in addition to normal profit. When average revenue is
greater than average cost the firm makes an economic profit.
Economic loss When total costs are greater than total revenue. When average revenue is
lower than average cost the firm makes an economic loss.
Explicit cost Actual expenditure of business, e.g. wages and interest.
Implicit cost Value of inputs owned by entrepreneur and used in the production process
(forfeited rental, interest + salary).
Long run The period of production where all factors can change. The time is long
enough for variable and fixed factors to change.
Market An institution or mechanism that brings together buyers and sellers of goods
or services.
Market structure How a market is organised.
Normal profit The minimum earnings required to prevent an entrepreneur from leaving the
industry. When average revenue equals average cost the firm makes a normal
profit.
Perfect A market structure with large numbers of producers and buyers.
competition
Price taker Has no influence on price. Takes price that is determined by the market.
Short run The period of production where only the variable factors of production can
change while at least one factor is fixed.
Shut-down point Business will close where MC = AVC
The Competition An institution whose main functions is to review orders made by the
Appeal Court Competition Tribunal and amend or confirm these orders.
The Competition An institute that investigates restrictive business practices, abuse of dominant
Commission positions and mergers in order to achieve equity in the South African
economy.
The Competition An institution whose main function is to approve large mergers, adjudicate in
Tribunal the case of misconduct and issue orders on matters presented to it by the
Competition Commission.

BRIEF EXPLANATION

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Briefly describe the concept Perfect competition
Perfect competition occurs when none of the individual market participants can influence the
market price of the product. A participant in a perfect market is insignificant, because it is a very
small part of the total market. For an example, an individual business is so small that it has no
control over the market price.

Examine the following characteristics of a perfect market:

➢ Many buyers and sellers
➢ Many sellers are price-takers
➢ No preferential treatment
➢ No collusion between sellers
➢ Complete freedom of entry and exit
➢ Buyers and sellers have full knowledge
➢ Products are homogenous
➢ All factors of production are completely mobile
➢ Effective transport and communication
➢ No government intervention

The demand for a product of a firm in a perfect market

In a perfect market, the market price of a product is determined by supply and demand (Figure 1),
the individual firm is a price taker and can sell as many of the products as it chooses to at the market
price. None of the firms will sell the same product at a higher price than the current market price, as
they will lose customers to competitors. Firms will not lower the price of the product below the
current market price either, as they can sell as many of the product as they want to at the higher
market price. The demand curve for the individual firm will run horizontally (Figure 2).

The perfect market - Figure 1

Price
D S

P1

Quantity
The individual firm - Figure 2

Price

P1 D = AR = MR

Quantity

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The cost concepts

Economists determine the cost of production by taking both implicit and explicit costs into account.
Explicit cost is the actual expenditure incurred by the enterprise to buy or hire inputs.
Implicit cost refers to the value of inputs owned by the enterprise itself utilised in the production
process.
Short run

The short run refers to a period of time that is so short that the enterprise is not able to alter the
size, but only the utilization of its production plant. Though the capacity of the firm remains
unchanged, production is easily increased (decreased) by altering the amount of labour and raw
material used in the production process.

Fixed and variable costs

The costs incurred by a firm comprise both fixed and variable costs.

The quantity of fixed inputs utilised in the production process cannot be changed in the short run.
The price of rent for the land is fixed and represents the opportunity cost of the land.

The quantity variable inputs utilised in the production can be changed in the short run. The price per
labour unit is given and represents the opportunity cost of labour. The cost of labour for a firm is
calculated by multiplying the price per labour unit by the quantity of labour units employed.
Although the price per labour unit is fixed, the quantity of labour can easily be changed and,
therefore, the cost of labour is variable

The total fixed cost curve is represented through a straight line parallel to the x-axis. The fixed cost
remains constant, regardless of the level of production.

The total variable cost curve has a reverse s-shape that starts from the origin and increases with a
decreasing rate up to a point, from where it will decrease at an increasing rate.

The total cost curve has the same shape as that of the total variable cost curve, except that it does
not start form the origin of the curve but from the same point on the y-axis as the fixed cost curve.
Thus, the vertical distance between the fixed total cost curve and the total variable cost curve will
always be equal to the fixed cost.

Long run costs

The long run refers to a period of time that is long enough for enterprises to change the quantities of
all their inputs utilized in the production process. This means that the capacity of the plant can be
altered in the long run.

In the long run, all inputs are variable. This means that all of the inputs utilised in the production
process can be altered. Businesses can expand their capacity with the purchase of new equipment or
bigger premises. There will be no fixed cost, total fixed cost and average fixed cost in the long run.

Revenue

The primary objective of all enterprises is to maximise their profit.

Total revenue (TR)

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Businesses earn money by selling their output. Total revenue is calculated by the number of
products sold (Q) multiplied by the price of the product (P).

TR = P x Q

Average revenue (AR)

Average revenue is the amount that is earned by the firm for every unit of output sold and is
calculated by dividing the total revenue (TR) by the quantity of output. AR = TR
(Q)
Marginal revenue (MR)

Marginal revenue is the extra income earned from selling one additional unit. It is calculated in the
same way as marginal cost: the change in total revenue divided by the change in output.

ΔTR
MR =
ΔQ

Summary of market structures

Criteria Perfect Monopolistic

Competition Competition Oligopoly Monopoly
Number of firms So many that no So many that each So few that each One
firm can influence firm thinks others firm must
the market price will not detect its consider the
actions others’ actions
and reactions
Nature of Homogeneous Heterogeneous / Homogeneous or Only one product
product differentiated heterogeneous with no close
substitutes
Entry Completely free Free Varies from free Completely blocked
to restricted
Information Complete Incomplete Incomplete Complete
Collusion Impossible Impossible Possible Unnecessary
Control over the None Some Considerable, Considerable, but
price but less that in limited by goal of
monopoly profit maximisation
Demand curve Horizontal Downward sloping Downward Equals market
(perfectly elastic) sloping, may be demand curve:
kinked downward sloping
Long run Zero Zero Can be positive Can be positive
economic profit
Decision Making Decisions have no Use non–price Level of They decide on
impact on other measures to dependence on production levels.
suppliers - profit influence consumer each other
driven decisions
Examples International Fast food outlets/ Cell phone / Eskom
commodity markets Clothes / Cars Banking market
e.g. oil and gold /
Farmers

Note: this part should be discussed in detail on completion of all four market structures.

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Profit and loss

Different perspectives on calculating profit - Simply stated, profit is equal to revenue minus cost. The
enterprise makes a profit when revenue exceeds cost and incurs a loss when cost exceeds profit.

We can also express profit as average revenue (AR) minus average costs (AC).

The formulae for calculating profit are:

TP = TR – TC

Profit/Economic profit – Figure 3

MC

Figure 3 - A firm making a profit (as shown by grey rectangle) under perfect competition when the
price of the product is above the total average cost curve.

Normal profit – Figure 4

Normal profit: This occurs when AC = AR

Explanation: Please note normal profit is the amount that the business must make in order to keep
its doors open. Once all costs such as the running costs and fixed costs are covered the business can
keep its doors open.

In this instance (figure 4) the firm makes zero profit because the average total cost is equal to total
revenue. The firm breaks even. Point e.

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In the case below the firm is making a loss because the price is below the total average cost. The loss
is indicated by the shaded area P3C3ME3 – grey area.
➢ In the long run, the firm is not hindered by fixed inputs.
➢ The long-run is the period of time where all of the factor inputs are variable and can be
increased.
➢ An economic loss occurs when the average cost of the business is greater than the average
market price. The business will minimise its loss at the level of output where the marginal
revenue is equal to the marginal cost.
➢ Figure/Graph 5 below illustrates the position of a business that is making an economic loss.

Figure 5

➢ In the graph, the market is determined independently at P₃ per unit. The business cannot
change or influence this price and therefore the market price should be accepted as given.
➢ The MC intersects AC at its lowest point (M) on the graph.
➢ The MC curve intersects the MR at point E₃. This will determine the level of output that the
business is willing to produce at the given price.
➢ This firm will produce Q₃ at a market price of P₃. The total cost is represented by C₃. Therefor
TC of the business is greater than the TR. The business is making an economic loss.
➢ The economic loss is represented by the shaded area in Figure 5.
➢ The business will not close down immediately, since it is still able to pay some of its production
costs. It will try to minimise its loss by reducing the level of output according to the profit
maximising or loss minimising rule.

Profit and loss using total cost and total revenue

➢ Figure (graph) 6 below illustrates short-run profits using Total revenue (TR) and total cost (TC).
➢ At an output of Q₁, the TR and TC are equal to each other at point a. This is called a break-even
point. At a slightly higher output level (Q₂) at point c, the TR is increasing at a faster rate than
the TC. However, eventually the TC catches up with the TR at point d; and the break-even point
is reached again at Q₃. Any quantity beyond Q₃ will result in a situation where TC exceeds TR.
➢ A break-even point is a point at which revenue of the firm from selling its product is just
enough to cover all costs.

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Figure 6

TC
TR \ TC

TR
d

c
TR1
b
a

Q1 Q2 Q3 Output

The shut-down point

Figure 7

➢ In figure 7, the firm has to make decisions regarding the level of output every time the
market price changes.
➢ If the market price is R40, this means AR and MR of the business is also R40. Under perfect
market P = AR = MR.
➢ The MC curve intersects the MR curve at point b. The MC curve also intersects the AC curve
at point b.
➢ If the market price is R40, the firm will make a normal profit by producing an output of Q₃,
since the MC curve intersects the AC curve at point b – its lowest point. Point b is also known
as the break-even point since the business is able to realise a normal profit at this price
level.
➢ If the market price is increased to R50 , the MR curve intersects the MC curve at point a.
Point a lie above the AC curve. This implies that if the market price is above the AC curve,
the business will increase its level of production to Q₄. Due to the increase in the level of
output the business will realise an economic profit at a market price of R50.

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➢ The economic profit will attract new businesses to the market. This will increase the market
supply. If the market demand remains constant while the market supply increases, the
market price will decrease, and all the businesses will make normal profit. New businesses
will no longer be interested in entering the market.
➢ If the market price decreases to R30, the businesses will make an economic loss. Profit
maximisation will take place at point c where MR = MC.
➢ Point c lies underneath the AC curve. The business is no longer able to cover all its
production costs. However, the business owners will not close down the business
immediately. They will introduce the means to minimise the loss by reducing output to Q₂.
➢ At the market price of R30, the business can still pay its average variable costs and part of its
fixed costs. Although they are making a loss the business will be kept operational with the
hope that the market price will increase in the near future and the business will break-even
once more.
➢ At a market price of R20, the quantity produced will be Q₁ since MR = MC. The market price
is now so low that the business is only able to pay its variable costs. At point d, the business
should close down or shut down. Point d is known as the close-down or shut-down point
because MC intersects with AVC at its lowest point. This is where the supply curve (MC)
begins.
➢ The business will not produce at point e because the market price (R20) is less than the AVC.

The supply curve of the firm

➢ Refer to figure 7 above. The rising part of the businesses’ marginal cost curve above the
minimum of its average cost curve represents the supply curve of the business.
➢ The supply curve of the business starts at point b and slopes upward from there.
➢ The reasons why the supply curve of the business slopes upward is because the marginal
cost increases as output increases.

The long-run equilibrium output level

Figure 8

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In the long run, two things can change:
➢ New firms can enter the industry and existing firms can leave.
➢ All factors of production became variable and existing firms earning economic profit in the
short run may decide to expand their plant size to realize economies of scale.
Economic profit
➢ In Figure 8- Suppose the business's short-term plant is represented by SAC .
1
➢ If the market price is P the business is making an economic profit of P E FP with the short-
1 1 1 2
term plant-size represented by SAC .
1
➢ At a price of P the business will maximise profit in the short-term at point E where the
1 1
profit maximisation (MR = MC) applies, and the quantity q will be produced.
1

Bigger plant, lower unit cost

➢ If the producer does a cost estimate, he/she will realize that, if he/she will be able to
produce at a lower unit cost in the long run.
➢ As illustrated by the downward sloping portion of the LAC curve in Figure 8.
➢ The prospect of increased profit would therefore encourage the producer to build a bigger
plant.
➢ The business would however not be interested in producing output levels greater than those
presented by the minimum point E
2.
➢ Of the LAC because such output levels are only possible at higher cost levels – internal scale
disadvantages cause the LAC to rise to the right of point E .
2

New entrants, increased supply

➢ The economic profit that businesses make is likely to attract new businesses to the industry.
➢ Because the quantity offered on the market increases as a result of expansion by existing
businesses and the entry of new businesses. Figure 8 - The supply curve on the market will
shift to the right from S to S and the price will drop until it eventually reaches P.
1
➢ At the price P, which is at the same level as the minimum point of the LAC curve, total
revenue (0P X 0q) is equal to total cost 0q X q E ).
2 2 2
➢ And the business is making normal profit, because it is exactly covering its total cost.
➢ Over time all the businesses in the industry will make normal profit and will be in long-term
equilibrium.
Initial losses
➢ Individual firms can be in equilibrium in the short run where it makes an economic profit or
an economic loss.
➢ These positions, however, are not sustainable in the long run under conditions of perfect
competition.
➢ If the market price is below the minimum point of the long-term average cost curve, the
adjustment process simply works the other way around.
➢ Eventually the LAC curve will also form a tangent with the demand curve and the businesses
that have remained in the industry will be making normal profit.
Price in the long term
➢ The above analyses lead to the conclusion that under perfect competition the price of a
product in the long term will settle at a level that corresponds to the lowest point of the LAC
curve.

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 ➢ Figure 8 - A point such as E represents the equilibrium point of the business in the long run.
2
➢ The business is making normal profit and there will be no incentive to leave or enter the
industry.
➢ When a market price has been established under perfect competition at a level where each
business is in equilibrium at the minimum point of its LAC curve and only making normal
profit, the industry will also be in long-term equilibrium.
Equilibrium
➢ Once long-term equilibrium has been achieved, and provided that there are no changes in
the technology or the factors of production, there will be no further entry or exit of
businesses.
Competition policies
The main objective of the Competition Commission is to investigate and evaluate restrictive business
practices.
The main aim:
• To prevent abuse of monopoly power.
• To regulate the market through mergers and takeovers.
• To prevent price fixing and collusion.
The Competition Act of 1998 makes provision for the Competition Commission and the Competition
Tribunal. The Competition Tribunal accepts or rejects the investigation and recommendation of the
Competition Commission. The Competition Appeal Court accepts or rejects the recommendation of
The Competition Tribunal.

---oOo---

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IMPERFECT MARKETS / COMPETITION
Introduction
IMPERFECT COMPETITION
Topic 5 in Grade 10 - Dynamics of Markets and Topic 6 – Dynamics of markets: Relationship between
markets in Grade 11. Learners should know what the difference is between perfect markets and
imperfect markets and the characteristics of the four-market structure.

Overview
Explain relevant concepts, deducing, interpretation, drawing of profit curves (short – and long run)
and explaining and interpreting graphs.
To explain relevant imperfect markets and comparing them with a perfect market.

Specific Objectives

• Show participants how to explain the imperfect markets revenue and costs curves.
• Show participants how to examine the characteristics of the monopoly, oligopoly and
monopolistic competition markets in detail, how to explain, with the aid of graphs, economic
profit, economic loss and normal profit of the imperfect market structures.
• Show participants how to compare the imperfect market structures with a perfect market.

KEY CONCEPTS

TERM DEFINITION
Imperfect Occurs in a market where some of the producers and/or consumers are
Competition able to affect the price and quantity of goods by their action alone. Any
market or industry that does not match the criteria for perfect competition
is an example of imperfect competition.
Monopoly A market structure where only one seller operates. Entry is blocked and
the product has no close substitute.
Oligopoly Exists when a small number of very large firms produce similar or identical
products.
Monopolistic A market structure with many buyers and sellers where entry is relatively
competition easy, but the product is differentiated, e.g. toothpaste
Allocative efficiency When the market produces the BEST possible MIX of goods and services
desired by consumers.
Technical (or When the market produces the maximum quantity goods and services from
productive) a given set of resources.
efficiency
Collusion Formal or informal agreement between two or more firms to divide the
market, set prices or limit production in order to gain unfair advantage in
the market.
Cartel A group of producers who make a formal agreement to collude in order to
fix prices, limit supply and limit competition.
Price discrimination When a seller charges different prices for the same product for different
groups
Price leadership When one business in the industry makes price decisions on behalf of the
whole group of oligopolists

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 TERM DEFINITION
Duopoly When there are only two oligopolies in the market
Merger When two firms join together to form a single firm
Acquisition When one firm takes over another firm and that firm then ceases to exit
Patent Gives the holder the exclusive rights to produce a product for as long as
the patent right are valid
Differentiated Products that differ slightly in physical appearance, packaging, service
products and/or brand names

BRIEF EXPLANATION

Discuss the monopoly in detail (Possible long Question as per Exam Guidelines -2017)

• Briefly describe the concept

- Emphasise and highlight good practical examples of businesses in this market

• Examine the characteristics in detail

• Distinguish between natural and artificial monopolies

• Explain the downward slope of the demand curve (AR)

• Explain the marginal revenue curve (Show the relationship between the demand curve (AR) and
the MR curve graphically)

• Explain, with the aid of graphs, economic profit and economic loss

• Explain the long-run equilibrium position with the aid of a graph

• Compare the monopoly with a perfect competitor in terms of demand curves, products, prices,
output, and equilibrium positions

Monopolies
A pure monopoly exists when a single firm is the sole producer of a product for which there are no
close substitutes.

Types of monopolies

• Legal monopoly – It is based on laws preventing other companies from competing (State
monopoly).
• Local monopoly – A local monopoly will control the market in a particular area or town, e.g. if
there is only one petrol station.
• Natural monopoly – This arises in industries where economies of scale are so large that a single
business can supply the entire market, e.g. electricity. High development costs prevent others
from entering the market and therefore the government supplies the product

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• Horizontal monopoly – This occurs when a parent company takes control over several smaller
companies, e.g. Naspers in the printing business.
• Vertical monopoly – This occurs when 1 firm will supply and produce the product, e.g. Eskom.
• Coercive monopoly – This occurs as a result of any activity that violates the principles of a
market economy.
• Artificial monopolies – the barriers to entry are not economic of nature. A patent restricts
Characteristics of a monopoly
NUMBER OF FIRMS
• The monopoly consists out of one single firm.
• The monopoly is also the industry.
• Example: Eskom or De Beers – diamond-selling
NATURE OF PRODUCT
• The product is unique with no close substitute.
• Example: Diamonds are unique.
MARKET ENTRY
• Refers to how easy or difficult it is for businesses to enter or to leave the market
• Is entirely/completely blocked.
• A number of barriers to entry that may give rise to monopoly can be:
- Economies of scale
- Limited size of the market
- Exclusive ownership of raw materials
- Patents
- Licensing
- Sole rights
- Import restrictions
THEY DECIDE ON THEIR PRODUCTION LEVEL
• The monopolist cannot set the level of output and the price independently of each other.
• If a monopolist wants to charge a higher price, it has to sell fewer units of goods.
Alternatively, a reduction in price will result in a higher output sold.
A MONOPOLIST IS CONFRONTED WITH A NORMAL MARKET DEMAND CURVE
• The demand curve slopes downwards from left to right.
• Any point on the monopolist’s demand curve (D) is an indication of the quantity of the
product that can be sold and the price at which it will trade.
THEY ARE EXPOSED TO MARKET FORCES
• Consumers have limited budgets and a monopoly can therefore not demand excessive prices
for its product.
• The monopolist’s product has to compete for the consumer’s favour and money with all
other products available in the economy.

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THEY FACE SUBSTITUTES
• There are few products that have no close substitutes.
• For example, cell phones can compete with telephone services.
THEY MAY ENJOY FAVOURABLE CIRCUMSTANCES
• Sometimes an entrepreneur may enjoy favourable circumstances in a certain geographical
area.
• For example, there may be only one supplier of milk in a particular town.
THEY MAY EXPLOIT CONSUMERS
• Because a monopolist is the only supplier of a product, there is always the possibility of
consumer exploitation.
• However, most governments continually take steps to guard against such practices.
MARKET INFORMATION
• All information on market conditions is available to both buyers and sellers.
• This means that there are no uncertainties.
CONTROL OVER PRICE
• In the case of a monopoly there are considerable price control but limited by market
demand and the goal of profit maximisation.
LONG-RUN ECONOMIC PROFIT
• Can be positive
• Because new entries are blocked, and short-run economic profit therefore cannot be
reduced by new competing firms entering the industry
• The monopoly can thus continue to earn economic profit as long as the demand for its
product remains intact
Revenues
• Any point on the demand curve (D) represents the amount of the unique product that will be
sold and at what price it will be sold.
• The monopolist’s demand curve is also his average revenue curve (AR). Total revenue (TR) is
calculated by repeatedly multiplying the price (P) by the amount (Q). Marginal revenue (MR)
reflects the changes in total revenue that result from selling one additional unit of the
product.
• The demand curve for a monopolist is the market demand curve and slopes downwards from
left to right.
• The monopolist will try to fix the price above the centre of the demand curve, because only
then will his total revenue increase.
• The main constraint for the monopoly is the demand curve for the product – the monopoly is
controlled by the demand curve.
• Monopolist should have adequate knowledge of the market in order to predict how
consumers will react to a price change and accordingly choose the quantity to supply and the
price of the product.
Short-run profits and losses
• If a monopolist wants to sell more goods, he will have to lower his prices.
• In the short run, the monopoly firm can make economic profits, normal profits or economic
losses. It is possible but unlikely that a monopoly makes an economic loss.

17
 Long-run equilibrium
• The monopolist strives to make a maximum profit, like any other business, and will therefore
increase his output until MR = MC. It will charge the highest price per unit at which this
quantity of output can be sold.
• In the long run, a monopoly can make economic or normal profits only.
• Example of things changing is consumers’ tastes and that reduces the demand. This results in
a fall in:
• The price
• The profit maximising output
• The monopoly’s profit
A long-run equilibrium only exists when there are no changes in the demand for the product or in
the cost of production.

HOW TO DRAW GRAPHS

YES, then it is a perfect competition

1. Horizontal Line
NO then it is an imperfect competition

MR AR/D

2. A tick or Nike sign for Marginal cost

3. A smile or u-shape bakkie for Average costs

4. The MC cuts through the AC at its lowest point and only once

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 5. The FOUR STEPS

1. Find MC = MR this is profit maximisation point

2. Find AC

3. Find AR

4. If AC AR, then Economic Profit

If AC AR, then Economic Loss

If AC = AR, the Normal Profit

Short run/Long run

Cost, Cost,
Revenue Revenue

AC AC

AR
AR

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Comparison with perfect markets

The crucial difference between a pure monopolist and a purely competitive seller lies on the demand
side of the market.
• The purely competitive seller faces a perfectly elastic demand at the price determined by
market supply and demand.
• Because the pure monopolist is the industry, its demand curve is the market demand curve.
• Because market demand is not perfectly elastic, the monopolist’s demand curve slopes
downwards.
• The quantity demanded increases as the price decreases, as the typical supply curve you
know declines from the top of the left-hand side to the bottom of the right-hand side.
Examine the oligopoly in detail (Possible long question as per exam guidelines 2017)
• Briefly describe the concept
- Emphasise and highlight good practical examples of businesses in this market
• Examine the characteristics of the oligopoly
• Briefly discuss non-price competition
• Briefly discuss collusion (relate to current examples of collusive behaviour)
- Distinguish between overt collusion (cartels) and tacit collusion (price leadership)
• Broad outline of prices and production levels
• Broad outline of the rationale of the kinked demand curve
• Use the graph and briefly explain why oligopolists are reluctant to compete on prices.
• Compare the oligopoly with a perfect competitor in terms of demand curves, products, prices,
output, equilibrium positions and non-price competition.
Oligopolies
An oligopoly is a market dominated by a few large producers of a homogeneous or differential
product.

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Characteristics of an oligopoly
Nature of the product
• Products sold may be homogenous or differentiated.
• If products are homogeneous it is called a homogeneous oligopoly– many industrial products
are standardised for example steel products.
• If products are differentiated it is a differentiated oligopoly– these firms produce goods such
as household appliances, electronics equipment, breakfast cereals.
Control over price
• Producers have considerable control over the price of their products, although not as much
as in a monopoly.
• Oligopolies can frequently change their prices in order to increase their market share.
• This can result in a price war.
Collusion
• Collusion takes place when rival firms cooperate by raising prices and by restricting
production in order to maximise their profits.
Cartel
• When there is a formal agreement between firms to collude, it is called a cartel.
• A cartel is a group of producers whose goal is to form a collective monopoly in order to fix
prices and limit supply and competition.
• In general, cartels are economically unstable because there is a great incentive for members
not to stick to the agreement, to cheat by cutting prices, illegally and to sell more than the
quotas set by the cartel.
• Although there is an incentive to collude there is also an incentive to compete.
• This has caused many cartels to be unsuccessful in the long term. Some well-known cartels
are the Organisation of Petroleum Exporting Countries (OPEC) and De Beers diamonds in
South Africa.
Overt/formal collusion
• Overt/Formal collusion e.g. cartels are generally forbidden by law in most countries.
• However, they continue to exist nationally and internationally.
Tacit collusion
• Sometimes in an oligopoly market, a dominant firm will increase the price of a product in the
hope that its rivals will see this as a signal to do the same
• This is referred to as price leadership.
• Limited competition – Only a few suppliers of the same product dominates the market.
• Interactivity – If one company makes a decision, it influence the decisions the other
companies make.
• Price changes – They will more frequently change their prices in order to increase their
market share.
• Cost advantage – They have an absolute cost advantage over the rest of the competitors.
• Joint decision making – It is a key instrument to make decisions together in order to
dominate the market.
• Difficult entry – New firms will experience high barriers to enter.
• High profits – Abnormal high profits may be result of joint decisions.
• Examples: Cell phone industry, Banking industry

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Kinked demand curve for the oligopolist
• An oligopolist faces a kinked demand curve. This demand curve consists of two sections.
• The top section, the section that relates to high prices is a very elastic slope (i.e. demand is
very sensitive to a price change.)
• The bottom section, the section that relates to lower prices is very inelastic (i.e. demand is
not sensitive to a price change)

R12

E
R10

R8

2 9 10

• Suppose the oligopolist is selling at the original / present price of R10 and 9 units of output are
sold. Total revenue is R10x9=R90
• If the firms tries to increase profits by increasing the price by R2 toR12, quantity demanded
would fall to 2 units and total revenue would decrease to R24 (R12x2) This will happen as the
other companies did not increase their price and the customers will go to them to buy their
cheaper similar product.
• If the firm tries to increase profit by reducing the price by R2 to R8 and increasing sales, total
revenue would be R80. Not ‘n big increase in demand as all the other companies will also lower
their price and their customers will not come to this firm’s lower price as they are also receiving a
lower price from the other firms.
Non-price competition
The oligopolist often uses methods other than price wars to win a market for his products.
Non-price competition includes the following:
• Product differentiation: product is slightly different from the others.
• Product proliferation: different range of products to cater for many different markets.
• Advertising: oligopoly firms advertise their products heavily.
• Extended shopping hours and business hours
• Doing business over the internet
• After-sales service
• Offering additional services

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 • Loyalty rewards for customers
• Door-to-door deliveries
• Brand loyalty
• Product proliferation – each firm produces a range of products to cater for as many different
markets as possible.

Oligopolies can increase their market share by using various strategies such as:
• Engaging in product differentiation, where the products are made to be slightly different in
terms of physical appearance, packaging etc.
• Improving after-sale-services that are far more important to customers and will ensure a
long-term relationship with that business
• Aggressive advertising to lure consumers onto their side
• Establishing brand loyalty, because oligopolies want consumers to believe that its brand is
the best and to buy only that brand
• Engaging in product proliferation whereby oligopolies produce many different ranges of
products to cater for many different markets
• Extending shopping hours to encourage greater flexibility to households
• Selling products online to make it easier for customers to shop around without any
additional costs and a variety of goods is made available to make comparisons.
• Paying loyalty rewards to customers for continued support
Collusion
• Collusion means co-operation with rivals. Suppose an industry consists of only two
businesses.
• One way of increasing profits is to lower prices in order to acquire a larger share of the
market.
• The alternative is to enter into an agreement with your competitor so that both businesses
follow a high pricing strategy.
Explicit collusion / Overt collusion
• Is open and happens when oligopolies formally meet to decide on prices and production.
• It is usually illegal.
Cartel
• When there is a formal agreement between firms to collude, it is called a cartel.
• A cartel is a group of producers whose goal is to form a collective monopoly in order to fix
prices and limit supply and competition.
• They act together to determine market share, advertising strategies and product
development.
• Example - The Organisation of Petroleum Exporting Countries (OPEC).
Implicit collusion / Tacit collusion
• Is hidden and unspoken collusion amongst oligopolies.
• They act together to determine the price and the output, but they do it in such a way that it
is very difficult to prove that they have colluded.
Price leadership
• Sometimes in an oligopolist market, a dominant firm will increase the price of a product in
the hope that its rivals will see this as a signal to do the same and this is an example of a tacit
collusion.

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 • One business in the industry makes price decisions on behalf of the whole group.
• The price leader is normally the largest business in the industry.
Interdependence
• Another key characteristic of oligopoly firm is that they are interdependent.
• The decisions that an oligopoly firm makes with respect to quantity, marketing strategies
and location, for example, depend largely on what it thinks the other firm in the industry will
do in response to its actions.
• Each seller is influenced by the actions of the other sellers.
Comparison with perfect markets
• Contrary to the perfect market, the oligopolies can also make an economic profit in the long
run.
• The consumers do not get their products at the lowest possible prices as in the case of
perfect competition, because the oligopolies will probably stop producing before his long-
run average cost curve (LAC) reaches its lowest point.
• The price of a product in an oligopoly is higher than the marginal cost (P>MC). The
community therefore adds more value to an additional unit than to the resources necessary
to produce it. Resources are therefore not applied as effectively as possible.
• Once the price has been set in the oligopoly, it is more stable than in perfect competition.
This is because the oligopoly is reluctant to change the price because it may initiate a price
war.
Monopolistic competition
Characteristics of a Monopolistic competition
• There are a large number of firms in the market.
• Each firm produces a different product, though similar to products of other firms.
• There are no restrictions that hinder entry to, or exit from, the market.
• There are many sellers, however, each firm has the monopoly of its own differentiated
product and is therefore able to exercise some market power.
• Freedom to enter or exit the market.
• Incomplete knowledge about the market,
• Make economic profit only in the short term (same as perfect competition) Can only make
normal profit in the long term (same as perfect competition)
• Examples: McDonalds, Steers, Sterns
Comparing monopolistic competition and perfect competition
• Prices are higher and output levels are lower in monopolistic competition than they would be
in perfect competition markets.
• Some consumers are excluded from this market.
• In both cases only normal profits are made in the long run. The monopolistic competition
leads to less efficient allocation of resources than a perfect competition.

---oOo---

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MICRO ECONOMICS - MARKET FAILURE & COST BENEFIT ANALYSIS (CBA)
Introduction
Market failure occurs when the resources of the community are allocated inefficiently. It is
important to expose the learners to the terms and concepts found in this unit in order to equip them
with the relevant Economics vocabulary. This subtopic is divided into the following sections: the
causes of market failures, inefficiencies, externalities, consequences of market failures and the Cost-
benefit analysis. It is important that this unit should be taught with the aid of graphs and practical
examples. Inefficiencies and public-sector involvement and intervention are also taught in grade 10
during term 2. Therefor baseline assessment and liaison between the grade 10 and 12 teachers is
required.

Overview
The focus is the causes and consequences of market failures, government intervention and Cost
Benefit Analysis.

Specific Objectives

• Use various teaching methodologies and assessment techniques to demonstrate to the

participants how market failures and CBA can be made practical with the aid of cost and revenue
curves.
• Demonstrate to the participants how various cognitive levels can be used to design assessment
activities which meet the standards set in the 2017 Examination Guideline based on market
failures and CBA.
• Give the participants the opportunity to design assessment activities which meet the standards
set in the 2017 Examination Guideline based on market failures and CBA.

Content (big Ideas on the topic)

You will study this module through the following units:

Unit 3: MARKET FAILURES & COST BENEFIT ANALYSIS (CBA)

Prior knowledge of grade 10 graphs is a pre-requisite for this topic. Knowledge of demand and
supply curves as well as the shifts in demand and supply curves will enable the grade 12 learners to
draw and interpret graphs for negative and positive externalities, taxation, subsidies, minimum
wages, minimum prices and maximum prices.

The topic of production possibility curve (PPC) starts in grade 10 but it is not taught in grade 11 and
it progresses to grade 12. In grade 12 PPC is used to explain inefficiencies as consequences of
market failures. This is the same with the grade 10 topic of government involvement and
intervention which is not taught in grade 11 but progresses to grade 12. Public sector involvement in
grade 10 is related to consequences of market failures in grade 12. As a result, grade 10 teachers
must teach all public sector involvement sub-topics thoroughly in order to build / lay a good
foundation for grade 12 teachers.

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 CONTENT PROGRESSION FROM GRADE 10 TO GRADE 12
Grade 10 Grade 12
The effects (in terms of prices and quantities) of the Explanation of the reasons for and consequences
public sector’s involvement and intervention in the of market failures.
market, with the aid of graphs.
Consequences of market failures:
Methods of involvement:
• Inefficiencies
• Indirect taxes
• Externalities
• Subsidies
• Direct control
Kind of subsidies:
• Imperfect markets
➢ producer
• Minimum wages
➢ consumer
➢ export • Maximum prices

➢ employment • Minimum prices

➢ income • Taxes and Subsidies

• Maximum and minimum prices (with a graph) • Subsidies on goods and services

• Production (without graph) • Redistribution of wealth

• Minimum wages (without graph) • Government involvement in production
• Welfare (without graph)

KEY CONCEPTS
TERM DEFINITION
Positive externalities The benefit gained by a third party which is not included in the
market price.
Negative externalities A cost to a third party which is not included in a market price of a
good. The difference between social cost and private cost.
Social benefit The benefit gained by society from the use of a good or service. It
is calculated by adding the private benefit and the positive
externalities.
Social cost The cost of a good or service which is paid by society. It is
calculated by adding the private cost and negative externalities
together.
Private benefit The gain a consumer gets from the use of a goods or the gain a
producer gets from the sale of a product.
Private cost The actual cost paid by a consumer when a good is purchased.
Price discrimination When identical goods and services are sold at various prices to
different consumers.
Public goods Goods that the free market does not provide because they have
non-rivalry and non-excludability.

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 TERM DEFINITION
Merit goods Are goods that society feels should be consumed by its citizens
because it increases the welfare of the individual person and of
society as a whole.
Demerit goods Are goods that society feels its citizens should not consume, they
are regarded as harmful.
Non-rivalry The consumption of a product by one person will not prevent
other from enjoying it too.
Non-excludability Users who do not pay to use goods (free riders) cannot be
excluded from using them.
Productive / technical Occurs when businesses do not allocate resources correctly and
inefficiency produce goods and services that consumers do not want.
Allocative inefficiency Occurs when businesses do not maximise output from the given
inputs.
Market failure Market failure occurs when the resources of the community are
allocated inefficiently.
Cost-benefit analysis A CBA is a method used to compare the total social cost and
benefits of alternative projects, activities or investments.
Pareto efficiency Refers to the situation where resources cannot be reallocated to
make one person / group better off without making another
person / group worse off.
Black market An illegal market in which illegal goods are bought and sold or
illegal prices are charged.

GRADE 10

The Production Possibility Curve (PPC) / Production Possibility Frontier (PPF)

• The PPC/PPF starts in grade 10 according to the Annual Teaching Plan (ATP).

• The Production possibility curve (AA) below, shows a combination of two goods that can be
produced using all the available resources e.g. wheat and flour.

• The producer may allocate all its resources to produce only sweetcorn or produce flour only.

• However, it is possible for the producer to allocate his resources and produce a combination of
sweetcorn and flour.

• Any output to the right of the PPC is impossible, because the producer does not have the resources
due to scarcity problem.

• Any point on the curve shows a combination of goods where resources will be used efficiently.
However, whenever the producer chooses to produce at any point on the PPC, opportunity cost
comes into play. What the producer gains from producing extra units of sweetcorn, it sacrifices in
the production of flour and vice versa.

• The indifference curve (I1) shows a combination of two goods which gives the consumer the same
level of satisfaction.

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Externalities
Externalities are costs not included in the pricing of goods/services, and consequently there is a
difference between the private costs/benefits and the social costs/benefits of production.
• Private costs: the cost of producing the good or service which translates into the prices that
consumers pay. Also called internal costs.
• Private benefits: internal benefits that accrue to those who produce goods and buy these goods,
e.g. producing a bicycle (for producer) and using the bicycle (consumer).
• Social costs: these are total costs incurred by society as a whole. For example, the social cost of
electricity includes the cost of capital, labour, inputs and the cost of the externalities such as dirty
water and air. Social cost = private costs plus external costs.
• Social benefits: this includes the total benefit experienced by society as a whole. For example,
municipalities provide clean water to society which results in fewer illnesses. Social benefits =
private benefits plus external benefits.
Negative externalities are things like pollution, tobacco smoking and alcohol abuse. The costs of
negative externalities are paid by society rather than by the producers. For example, Stuyvesant
produces cigarettes, many illnesses are related to smoking. The treatment for these illnesses is paid
for by society.
Positive externalities are the positive effects of products to third parties which are not paid for.
Negative externalities are often over-produced while positive externalities are under-produced. This
leads to market failure.
STATE INTERVENTION AS A CONSEQUENCE OF MARKET FAILURE

a) Direct controls

b) Imperfect markets

c) Establishing minimum wages

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 • When the government enforces a minimum wage, it means workers have to be paid a
certain wage amount and not anything less than this.
• The Figure below shows that if the wage rate is set at W, the corresponding demand and
supply of labour will be Q.
• If a minimum wage of W1 is set, the demand for labour will decrease from Q to Q1. Some
people may become unemployed due to the introduction of a minimum wage.
• However, the quantity of labour supplied will increase from Q to Q 2.
• More people will offer their labour because of the higher wage.

MINIMUM WAGES

d) Setting maximum prices/price ceilings

• The government sets a maximum price ceiling below the market price to make goods more
affordable.
• Maximum prices allow the poor greater access to certain goods and services.
• A maximum price is set on goods such as basic foods, housing and transport.
• In South Africa the price of petrol, diesel fuel and paraffin are controlled at their maximum
prices.
MAXIMUM PRICES

• Initially the market equilibrium price is P and equilibrium quantity is Q.

• The government intervenes and passes a law that milk cannot be sold for more than P 1.
• The effect of this maximum price is that quantity supplied decreases to Q 1, and quantity
demanded increases to Q2.
• There is a shortage of milk equal to the difference between Q 1 and Q2.

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 • A shortage creates a problem of how to allocate milk to consumers.
• Black markets often develop where people can obtain milk. A black market is an illegal
market in which either illegal goods are bought and sold, or illegal prices are charged.
• Maximum prices may cause a shortage of goods, but they do improve the welfare of some
consumers since goods can be purchased at lower prices.

e) Setting minimum prices/price floors

• The government sets a minimum price at some point above the market price.
• This is done to enable producers to make a comfortable profit and thus encourages them to
supply important essential goods.
MINIMUM PRICES

• Consider the market for wheat.

• The market equilibrium price is P and the equilibrium quantity is Q.
• If the government sets a minimum price at P1, farmers will be earning greater profits and
supply more wheat. Quantity supplied will therefore increase to Q 2.
• However, quantity demanded will decrease to Q1.
• There would be a surplus of wheat equal to the difference between Q 2 and Q1.
• A surplus means the government will have to buy the extra wheat and dump it locally or
abroad.
• Although minimum prices may cause a surplus, they do encourage the supply of important
food stuffs.

f) Taxes and subsidies

Merit and demerit goods

• Merit goods – a good that is underprovided by the market mechanisms or goods that the
government or society deem good for people, something they should have, e.g. education,
health services.
• Demerit goods - a good that is overprovided by the market mechanisms or goods that the
government or society deem bad for people, something they should not have, e.g. drugs,
alcohol, tobacco.

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g) Redistribution of wealth

• Traditional methods e.g. the levying of various taxes and the provision of free services,
services in kind and cash benefits to the poor.
• Implementing Redress methods e.g. the use of law to enforce redistribution. It includes
BBBEE, affirmative action, empowerment, land restitution, land redistribution and property
subsidies (for RDP houses).

The government can use other ways to improve income distribution and overcome market failure:

• Transfers income directly to the poor e.g. child support grants, unemployment benefits, etc.
• Provides goods free of charge e.g. community goods, education, etc.
• Implements employment creation programmes e.g. public works programme.
• Subsidising merit goods e.g. subsidising arts and cultural events.
• Imposes taxes and laws on demerit goods to discourage consumption.
• Uses fiscal and monetary policy to achieve macroeconomic stability.
• Makes sure that consumers are informed about products through legislation. The South
African Bureau of Standards (SABS) checks consumer goods in South Africa.
• Tries to prevent misleading advertising. (Advertising Standards Authority)

h) Government involvement in production

Government are involved in producing goods and services themselves.

Public goods
• In incomplete markets government will intervene and supply the desired goods directly.
• They raise taxes to provide these goods.
• Community goods are provided free of charge, examples police, defence force, etc.
• Collective goods are provided for a user fee examples refuse removal, waste disposal, etc.

Macroeconomic stability

• If the Macroeconomic aims of government (economic growth, employment, price stability,

exchange rate stability and income equality) are not achieved government will see this as
market failure and intervene.
• The focus will be on either the demand-side or the supply-side of the economy.
• The demand-side: they will use monetary and fiscal policies to stimulate or cool down
demand.
• The supply-side focuses on the capability of the economy and on policies to expand the
stock of factors of production, infrastructure and the flexibility of markets.

COST-BENEFIT ANALYSIS

a) The concept of cost-benefit analysis

• Cost-benefit analysis (CBA) is a standard method used to compare the social cost and benefits
of alternative projects or investments.
• Cost and benefits are measured and then weighed up against each other in order to generate
criteria for decision-making.

• We use one of 3 decision criteria:

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 Internal rate of return Benefit-cost ratio
Net present value (NPV) (IRR) (BCR)
The present value of an investment The interest rate at which The BCR for a
project, found by discounting all present the net present value of a project is the ratio
and future receipts and outgoings at an project is zero (0); a between the sum
appropriate rate of interest; if the net project is worth investing of expected
present value calculated is positive, it is in if its IRR is greater than benefits and its
worthwhile investing in a project. the rate of interest. cost.

• CBA is, in essence, an accounting procedure for investment whereby the total cost of the
particular project is weighted against its total benefits. Government usually uses CBA to see
whether they should undertake a certain project.

b) The reason for cost-benefit analysis

This includes understanding the rate of return on a project and the idea that future costs and
benefits can be discounted in reverse to give its present value. This determines the rate of return on
a project and allows informed decisions to be made that are in the best interests of society.

Price mechanisms

• The procedure involves estimating the money equivalent of the benefits of a project and
comparing these benefits estimates with the cost of providing the good or service.
• It is relatively easy to measure private costs and benefits as they go through the price
mechanism.
• But in practice, it is more difficult to attach monetary values to external costs and benefits.
• One way is by using shadow prices, based on opportunity costs.
• Description of shadow prices: Relative prices of goods, services and resources that are
proportional to their true opportunity cost for the economy, taking account of any external
economies and diseconomies.
• E.g. to place a value on the benefits drivers would receive on completion of a new freeway, we
could estimate the driving time that would be saved, and then multiply this by the average wage
rate.
• Money now is worth more than money later.
• The relative levels of costs and benefits as well as the distribution of these must be considered.
E.g. a project should go ahead if the investors (those who gain) can compensate those who lose,
and still experience a net gain.

c) Cost-benefit analysis in practice

• The calculation of a CBR is often the end result of the study.

• The numerator of this ratio is defined as the present value of all of the expected economic
benefits attributable to a proposed undertaking.
• E.g. to calculate the monetary value for a public park or an art museum, shadow prices (benefits)
may be used to calculate the value of the enjoyment of these facilities.
• The denominator of the CBR is defined as the present value of the cost of undertaking and
operating the project. If it is a large capital investment project there are 2 types of costs: capital
cost and operation, maintenance and repair cost.
• Capital costs occur before the project begins to produce outputs; the remaining costs are future
expenses.

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• Based on these definitions, the CBR is defined as the value of benefits of a programme to the
value of the programme’s cost:

CBR = Present value of economic benefits

Present value of economic costs

• If the ratio is greater than 1, the project is judged economically worthwhile.

• If the ratio is equal to1, public expenditure adds nothing.
• If the ratio is below 1, it detracts from economic well-being.

In practice, a CBA tries to answer the question: ‘Do the gains to the people exceed the sacrifices
required of them?’
• If the answer is yes – CBA >1
• If no – CBA < 1

---oOo---

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