Economics 1A PDF

ECONOMICS 1A
Module Guide
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MANAGEMENT COLLEGE OF SOUTHERN AFRICA
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This Module Guide,
Economics 1A (NQF level 5)
will be used across the following programmes:
 Bachelor of Commerce in Accounting (New)

 Bachelor of Business Administration
 Bachelor of Commerce in Public Administration
 Bachelor of Commerce in Entrepreneurship
 Bachelor of Commerce in Financial Management
 Bachelor of Commerce in Human Resource Management
 Bachelor of Commerce in Information and Technology Management
 Bachelor of Commerce in Marketing Management
 Bachelor of Commerce in Retail Management
 Bachelor of Commerce in Supply Chain Management
 Bachelor of Commerce in International Business (New)
 Bachelor of Commerce in Retail Management
Economics 1A
ECONOMICS 1A
Preface.................................................................................................................................................................... 2
Unit 1: Introduction to the Microeconomics ............................................................................................................. 9
Unit 2: A Closer Look at the Economic Problem of Scarcity ................................................................................. 15
Unit 3: The Circular Flow of Income and Spending ............................................................................................... 23
Unit 4: Demand, Supply and Prices ...................................................................................................................... 28
Unit 5: Demand and Supply in Action ................................................................................................................... 43
Unit 6: Elasticity .................................................................................................................................................... 55
Unit 7: The Theory of Production and Cost (Background To Supply) ................................................................... 65
Unit 8: Perfect Competition ................................................................................................................................... 75
Unit 9: Imperfect Competition................................................................................................................................ 87
Bibliography ........................................................................................................................................................ 100
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Economics 1A
List of Content
List of Figures
Figure 2-1 A production possibilities curve for the Wild Coast community........................................................ 13
Figure 4-1 The production possibilities curve once again ................................................................................. 17
Figure 2-2 Improved technique for producing capital goods ............................................................................. 18
Figure 2-3 Improved technique for producing consumer goods........................................................................ 19
Figure 4-1 Anne Smith`s weekly demand for tomatoes .................................................................................... 31
Figure 4-2 The market demand curve............................................................................................................... 32
Figure 4-3 A movement along a demand curve ................................................................................................ 33
Figure 4-4 Two substitutes: butter and margarine ............................................................................................ 35
Figure 4-5 Johnny`s annual supply of tomatoes ............................................................................................... 38
Figure 4-6 A movement along a supply curve: change in quantity supplied ..................................................... 39
Figure 4-7 Shift of the supply curve: changes in supply.................................................................................... 40
Figure 4-7 Demand, supply and market equilibrium ......................................................................................... 41
Figure 5-1 Changes in demand ........................................................................................................................ 45
Figure 5-2 Changes in supply ........................................................................................................................... 47
Figure 5-3 Maximum prices .............................................................................................................................. 50
Figure 5-4 The welfare cost of maximum price fixing........................................................................................ 51
Figure 5-5 A Minimum price .............................................................................................................................. 52
Figure 5-6 The welfare costs of minimum price fixing ....................................................................................... 54
Figure 6-1 Price elasticity of demand at different points along a linear demand curve ..................................... 57
Figure 6-2 The relationship between price elasticity of demand and total revenue .......................................... 59
Figure 6-26 The different categories of price elasticity of demand ................................................................... 61
Figure 7-1: Total, average and marginal product of labour .............................................................................. 70
Figure 7-2: Marginal product and average product .......................................................................................... 72
Figure 7-3: Three total cost curves .................................................................................................................. 74
Figure 8-1: The demand curve for the product of the firm under perfect competition ...................................... 78
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Figure 8-2: The total revenue curve ................................................................................................................. 79
Figure 8-3: Total short-run costs of the firm ..................................................................................................... 80
Figure 8-4: Total revenue, total cost and total economic profit ........................................................................ 81
Figure 8-5: Marginal revenue and marginal cost of a firm operating in a perfectly competitive market ........... 82
Figure 8-6 (a): Surplus (Economic) Profit ......................................................................................................... 83
Figure 8-6 (b): Normal Profit ............................................................................................................................. 84
Figure 8-6 (c): Loss........................................................................................................................................... 84
Figure 8-7: The supply curve of the firm ......................................................................................................... 85
Figure 9-1:Marginal, average and total revenue under monopoly (or any other form of imperfect competition)92
Figure 9-2: The equilibrium of the firm under monopoly .................................................................................. 93
Figure 9-3: Comparison between monopoly and a perfectly competitive industry ........................................... 94
Figure 9-4: The equilibrium of the firm under monopolistic competition ........................................................... 96
Figure 9-5: The kinked demand curve ............................................................................................................. 98
List of Tables
Figure 6-1 Price elasticity of demand at different points along a linear demand curve ..................................... 57
Table 7.1 Production schedule of a maize farmer with one variable input ........................................................ 69
Table 7.2: Production schedule of a maize farmer with one variable input ...................................................... 71
Table 7.3: Total, fixed and variable cost schedules of a maize farmer ............................................................ 73
Table 9.1: Summary of market structure.......................................................................................................... 90
Table 9.2: Average, total and marginal revenue when the demand curve for a firm's product slopes
downward ........................................................................................................................................ 91
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Preface
A. Welcome
Dear Student
It is a great pleasure to welcome you to Economics 1A (ECO1A5). To make sure that you share our passion
about this area of study, we encourage you to read this overview thoroughly. Refer to it as often as you need to,
since it will certainly make studying this module a lot easier. The intention of this module is to develop both your
confidence and proficiency in this module.
The field of Economics is extremely dynamic and challenging. The learning content, activities and self- study
questions contained in this guide will therefore provide you with opportunities to explore the latest developments
in this field and help you to discover the field of Economics as it is practiced today.
This is a distance-learning module. Since you do not have a tutor standing next to you while you study, you need
to apply self-discipline. You will have the opportunity to collaborate with each other via social media tools. Your
study skills will include self-direction and responsibility. However, you will gain a lot from the experience! These
study skills will contribute to your life skills, which will help you to succeed in all areas of life.
We hope you enjoy the module.
B. Module Overview
 The module is a 15 credit module at NQF level 5
Aims of this module:

 Understand what is meant by microeconomics
 Understand the economic problem of scarcity
 Understand the interdependence of major sectors in the economy
 Analyse how market forces of demand and supply determine equilibrium
 Understand the concept of price and income elasticity
 Understand the theory of production and costs
 Understand the different market structures
 Compare the salient features of each market structure
 Understand the equilibrium position of each market structure
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C. Learning Outcomes and Associated Assessment Criteria of the Module
LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

MODULE
 Understand what is meant by microeconomics  Attempt the questions in the workbook after each
study unit. Both the study guide and workbook are
 Understand and illustrate the economic problem of
designed to help the student to study and prepare
scarcity and its implications
for the examinations.
 Understand the interdependence of major sectors
in the economy
 Analyse how market forces of demand and supply

determine equilibrium
 Understand the concept of price elasticity of

demand and implications on total revenue
 Understand the theory of production and costs
 Understand the different market structures
 Compare the salient features of each market

structure
Understand the short-run and long-run equilibrium

position of each market structure
D. Learning Outcomes and the Associated Assessment Criteria of the Units

You will find the Unit Learning Outcomes and the Associated Assessment Criteria on the introductory pages of
each Unit in the Module Guide. The Unit Learning Outcomes and Associated Assessment Criteria lists an overview
of the areas you must demonstrate knowledge in and the practical skills you must be able to achieve at the end of
each Unit lesson in the Module Guide.
E. How to Use this Module

This Module Guide was compiled to help you work through your units and textbook for this module, by breaking
your studies into manageable parts. The Module Guide gives you extra theory and explanations where necessary,
and so enables you to get the most from your module.
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The purpose of the Module Guide is to allow you the opportunity to integrate the theoretical concepts from the
prescribed textbook and recommended readings. We suggest that you briefly skim read through the entire guide
to get an overview of its contents. At the beginning of each Unit, you will find a list of Learning Outcomes and
Associated Assessment Criteria. This outlines the main points that you should understand when you have
completed the Unit/s. Do not attempt to read and study everything at once. Each study session should be 90
minutes without a break
This module should be studied using the prescribed and recommended textbooks/readings and the relevant
sections of this Module Guide. You must read about the topic that you intend to study in the appropriate section
before you start reading the textbook in detail. Ensure that you make your own notes as you work through both the
textbook and this module. In the event that you do not have the prescribed and recommended textbooks/readings,
you must make use of any other source that deals with the sections in this module. If you want to do further reading,
and want to obtain publications that were used as source documents when we wrote this guide, you should look
at the reference list and the bibliography at the end of the Module Guide. In addition, at the end of each Unit there
may be link to the PowerPoint presentation and other useful reading.
F. Study Material
The study material for this module includes tutorial letters, programme handbook, this Module Guide, a list of
prescribed and recommended textbooks/readings which may be supplemented by additional readings.
G. Prescribed and Recommended Textbook/Readings

There is at least one prescribed and recommended textbooks/readings allocated for the module.
The prescribed and recommended readings/textbooks presents a tremendous amount of material in a simple,
easy-to-learn format. You should read ahead during your course. Make a point of it to re-read the learning content
in your module textbook. This will increase your retention of important concepts and skills. You may wish to read
more widely than just the Module Guide and the prescribed and recommended textbooks/readings, the
Bibliography and Reference list provides you with additional reading.
The prescribed and recommended textbooks/readings for this module is:

 Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th edition) Pretoria: Van Schaik
In addition to the prescribed textbook, the following should be considered for recommended books/readings:
 Berg, D. And Ward, D. (2007). Economics For Business. Second Edition. United Kingdom: Mcgraw-Hill
Education.
 BEGG, D. Et Al. (2000). Economics. London: Mcgraw – Hill
 BLACK, P. And HARTENBERG, T. (2000). Economics Principles And Practice. Cape Town: Pearson
Education
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 CASE, K.E. And FAIR, R.C. (1999). Principles Of Economics. New Jersey: Prentice Hall International
 LIPSEY, R. G. And CHRYSTAL, K. A. (2002). Principles Of Economics. New York: Oxford University Press
 MOHR, P., FOURIE, L. And ASSOCIATES (2004), Economics For South African Students. Pretoria: JL Van
Shaik
 PARKIN, M. (1990). Microeconomics. Reading: Addison – Wesley
 SAMUELSON, P.A. And NORDHAUS, W.D. (1983). Economics. United States: Mcgraw Hill
 SCHILLER, B. R. (2013). Essentials Of Economics (13th Edition). New York: Irwin Mcgraw – Hill
 SCHILLER, B. R. (1999). Essentials Of Economics. New York: Irwin Mcgraw – Hill
 SCHILLER, B. R. (2008), The Economy Today (11th Edition), Boston: Mcgraw – Hill
 SCHILLER, B. R. (2006), The Economy Today (10th Edition), Boston: Mcgraw – Hill
 SMIT, P.C. And DAMES D. J. (1997). Economics A South African Perspective. Cape Town: Juta And Co
H. Special Features
In the Module Guide, you will find the following icons together with a description. These are designed to help you
study. It is imperative that you work through them as they also provide guidelines for examination purposes.
Special Feature Icon Explanation
LEARNING The Learning Outcomes indicate what aspects of the particular

OUTCOMES Unit you have to master and demonstrate that you have
mastered them.
ASSOCIATED The Associated Assessment Criteria is the evaluation of student

ASSESSMENT understanding with respect to agreed-upon outcomes. The
CRITERIA Criteria set the standard for the successful demonstration of the
understanding of a concept or skill.
THINK POINT A think point asks you to stop and think about an issue.
Sometimes you are asked to apply a concept to your own
experience or to think of an example.
ACTIVITY You may come across activities that ask you to carry out specific
tasks. In most cases, there are no right or wrong answers to
these activities. The aim of the activities is to give you an
opportunity to apply what you have learned.
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READINGS At this point, you should read the reference supplied. If you are
unable to acquire the suggested readings, then you are welcome
to consult any current source that deals with the subject. This
constitutes research.
PRACTICAL Real examples or cases will be discussed to enhance

APPLICATION understanding of this Module Guide.
OR EXAMPLES
SELF-TEST You may come across self-test questions at the end of each Unit
QUESTIONS that will test your knowledge. You should refer to the module for
the answers or your textbook(s).
REVISION You may come across self-assessment questions that test your
QUESTIONS understanding of what you have learned so far. These may be
attempted with the aid of your textbooks, journal articles and
Module Guide.
CASE STUDY Case studies are included in different sections in this module
guide. This activity provides students with the opportunity to
apply theory to practice.
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Unit
1: Introduction to the
Microeconomics
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Unit Learning Outcomes and Associated Assessment Criteria
LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:
 Define economics  Examine the problems that arise when individuals and
firms have consumption desires that are constrained
 Distinguish between macroeconomics and
by access to resource
microeconomics
 Answer the questions found in the workbook relating to
 Distinguish between wants, needs and
Unit 1
demand
 Explain the economic problem of scarcity
 Understand the concept of opportunity cost
 Illustrate the maximum amount of production

that can be produced by an economy with a
given amount of resources using a production
possibility curve
 Explain the reasoning why opportunity costs

increase along the production possibility
frontier
1.1 Introduction
1.2 Macroeconomics Versus Microeconomics
1.3 Limited Resources
1.4 The Problem of Scarcity
1.5 Opportunity Cost
1.6 The Production Possibility Curve
Prescribed Textbook
 Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th
edition) Pretoria: an Schaik Chapter1
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1.1. Introduction
Economics is a social science that studies human behaviour as a relationship between ends and scarce means
which have alternative uses. Consequently, economics examines the problems that arise when individuals and
firms have consumption desires that are constrained by access to resources. This problem is often referred to as
infinite wants and finite resources.
1.2. Macroeconomics versus Microeconomics

Microeconomics, on the one hand, focuses on the individual participants in the economy: producers, workers,
employers and consumers. Microeconomic policies focus on specific markets.
Macroeconomics on the other hand is concerned with the economy as a whole. It focuses on aspects such
as the stability of the general price level (commonly known as inflation), the maintenance of full employment,
economic growth, the distribution of income, government spending, and the nation’s money supply.
1.3 Limited resources

Before we continue, we need to distinguish between wants, needs and demand:
 Wants are our desires for goods and services, and are unlimited – we all want everything!
 Needs are necessities, essential for our survival, examples include food, water, shelter.
 Demand differs from wants, desires or needs. For there to be demand for a good or service, those who want
to purchase it must have the necessary means to do so. They must have the purchasing power. (Mohr and
Fourie, 2008:6)
1.4 The problem of scarcity

Now that we have distinguished between wants, needs and demand, attention should now be on the economic
problem of scarcity.
People’s unlimited wants cannot be met with the limited resources available, as such choices need to be made.
But what are these resources which are in limited supply? Resources are used to produce goods and services and
are referred to as factors of production. Since the factors of production (resources) used in the production of
goods and services are limited, it follows that the goods and services which can be produced with them are also
limited.
Factors of production are divided into four main categories:
 natural resources (land, minerals)
 labour
 capital
 entrepreneurship
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Natural resources and labour are also known as primary factors of production, whilst capital and
entrepreneurship are called secondary factors.
As these factors of production are scarce, we are forced to make difficult choices. The use of scarce resources to
produce a certain good or service, means that those resources are not available to produce other goods or
services. Stated differently, a decision to produce more of one good means that less of another good can be
produced. Because resources are scarce, their use is never costless. This point is captured in the economic saying,
“there ain’t no such thing as a free lunch”. There are always costs involved. This leads us to the principle of
opportunity cost.
1.5 Opportunity costs

“The opportunity cost of a choice is the value to the decision maker of the best alternative that could have been
chosen but was not chosen. In other words, the opportunity cost of a choice is the value of the best forgone
opportunity” (Mohr and Fourie, 2008:7).
Every time we make a choice, we incur opportunity costs. Economist use opportunity cost to measure the costs
incurred in choices. Opportunity cost is a key concept in economics as it captures the essence of scarcity and
choice. The economic principals of scarcity, choice and opportunity cost are captured in the production
possibilities curve.
Note: Scarcity should not be confused with poverty. Scarcity affects everyone.

“No matter how an economy is organized, there’s a limit to how much it can produce. The most evident limit is the
amount of resources available for producing goods and services.
One reason the United States can produce so much is that it has over 3 million acres of land. Tonga, with less
than 500 acres of land, will never produce as much. The U.S also has a population of over 300 million people.
That’s a lot less than China (1.3 billion), but far larger than 200 other nations (Tonga has a population of less than
125, 000).
So an abundance of resources gives us (U.S) the potential to produce a lot of output. But that greater production
capacity isn’t enough to satisfy all our desires.” (Schiller, 2008: 5)
As previously noted, the economic principals of scarcity, choice and opportunity cost are captured in the
production possibilities curve. The production possibility curve (Figure 1-1) shows the maximum amount of
production that can be produced by an economy with a given amount of resources.
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1Figure 2-1 A production possibilities curve for the Wild Coast community
(Mohr and Fourie, 2015:6)
The production possibility frontier (PPF) in Figure 1-1, shows the maximum amounts of potatoes and fish that can
be produced by our rural community when the community uses its resources fully and efficiently (refer to text for
detailed description).
At A, 100kg of potatoes can be produced per day by devoting all their time and available resources to gardening.
Likewise at F, 5 baskets of fish can be produced per working day, if all time and available resources are devoted
to fishing. By shifting resources from one production possibility to the other, the community can enjoy a diet of both
fish and potatoes.
In our example, in moving from C to D, the community actually transforms part of the production of potatoes into
fish. Combinations on the PPF represent the maximum amounts which can be produced by efficiently using all
available resources. The PPF demonstrates graphically, the principal of opportunity cost. In our example, the
opportunity cost of producing 40kg of potatoes is the basket of fish forgone. Similarly, the opportunity cost of
producing 4 baskets of fish is the 60kg of potatoes forgone. All points to the right of the curve, such as G are
unattainable. G is unattainable due to scarcity, a lack of resources to achieve that level of production.
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Choice is illustrated by the need to choose between the combinations available, and opportunity cost is illustrated
by the negative slope of the curve. The negative slope, showing that more of one good can only be obtained
by sacrificing the other good. Opportunity cost increases as we move along the PPF. This can be seen by paying
attention to concave shape of the curve.
1.7 Why do opportunity costs increase along the PPF?

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

or not to have a capital intensive or labour
intensive production process
 Explain the parties for whom goods and

services are produced
2.1 Improved techniques or increased resources

2.2 The three central economic questions
2.3 The Choice of Technique
2.4 For whom it should be produced
Prescribed Textbook:
Below is the prescribed reading for specific to this unit;
edition)Pretoria:Van Schaik Chapter 1
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2.1 Improved techniques or increased resources

Recall our example on the rural community who could either produce fish, or potatoes, or a combination of the two.
3Figure 4-1 The production possibilities curve once again

Figure 2-1. With a given level of resources and a given state of technology, the community can produce various
combinations of fish and potato output. However, they cannot move beyond the points ABCDEF (AF for short).
This is why the curve is sometimes called a production possibility boundary of frontier.
It shows the maximum attainable combinations of goods that can be produced, or potential output. Its concave
shape (from the origin) indicates increasing opportunity costs. Any combination within the frontier is attainable,
however, such combinations are inefficient because either available resources are not being used to their
full potential (inefficiently) or some of them are left idle (unemployment).
In the event that the economy is operating at less than potential output (actual output is therefore less than potential
output), this would be illustrated as a point inside the production possibility curve/frontier (PPF). Some of the
available resources are either unemployed or not employed efficiently.
Point H in figure 2-1 is an example of this. At a point such as H, more output of one good would not require less
output of the other, there would be no opportunity cost when output is expanded. It is therefore possible to expand
production by simply using the existing resources fully and more efficiently (given the state of technology).
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We need to fully and efficiently utilize scarce resources. This will occur when production is taking place on the
production possibilities curve. Actual output is equal to potential output when production takes place on the
production possibilities curve. Furthermore, when we are on it, it is impossible to produce more of one good without
sacrificing some production of the other good. “Production efficiency means more output of one good can be
obtained only by sacrificing output of other goods” (Begg, Fischer and Dornbusch, 2003:7).
A point such as G in figure 2-1 is unattainable. Any point beyond AF is unattainable. With the given available
resources and current production techniques, achieving a combination such as G or any combination outside of
AF is impossible. However, if over time the quantity of available resources increase, and/or production techniques
improve, then points beyond AF will be attainable. If this happens then the PPF will shift outwards. Outward
movements of the PPF illustrate economic growth.
Figure 5Figure 2-2 Improved technique for producing capital goods

Referring to Figure 2-2, an improved technique for producing capital goods has been developed. It is now
possible to produce more capital with the available factors of production. Assuming the available factors of
production and the technology for producing consumer goods remain the same, then maximum production of
consumer goods will remain at A.
If all available resource were used in the production of capital goods, then maximum production of capital goods
would increase from B to C, and the new PPF is AC. With the exception of point A, it is now possible to produce
more of both goods.
Production of both goods has increased, with the exception of the intercept point A. Remember, an improved
technique implies that less resources are required to produce the same level of output.
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Therefore, if there is an improved technique for producing capital goods, then for any given level of capital
production, more resources could be moved over to the production of consumer goods.
Likewise, with the same levels of resources, we can now produce more capital goods. Therefore, as we move
resources over to capital goods production, we produce more output than we previously could have.
6Figure 2-3 Improved technique for producing consumer goods

Referring to Figure 2-3. Similarly, new technique for producing consumer goods is developed. Available resources
and the technique for producing capital remains the same. Maximum potential output for consumer goods will
increase. PPF swivels around point B so the new PPF is DB. Except at point B, it is possible to produce more of
both goods.
Figure 2-4 below illustrates a shift in the PPF from AB to EF. A shift in the PPF occurs if the amount of available
resources (e.g.: labour, raw materials) and/or the productivity of available resources increase. There is now the
possibility of producing more of both capital and consumer goods. Potential output has increased.
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Figure 2-4 Increase in the quantity or productivity of the available resources

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

The three central questions (What? How? For whom?) are used to introduce a variety of concepts, distinctions,
factors of production, and economic systems.
2.2.1 What should be produced?
The purpose of economic activity is to satisfy human wants. Most wants are satisfied by goods and services.
Goods are tangible objects like food, clothing, houses and books. Services are intangible things like medical
services and legal services. We assume that all goods and services are useful and as such maximum production
is desirable. Please refer to prescribed text (Mohr and Fourie:2008:18-19) for definition of capital and consumer
goods and final and intermediate goods. You are required to know these for future reference in the module.
2.2.2. How it should be produced?

After deciding what goods and services are to be produced, the next step is to decide how the goods and services
will be produced?
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Scarce resources have to be used efficiently. What are these resources?

Resources used to produce goods and services are called factors of production. There are four main factors of
production are:
 natural resources (land, minerals) – primary
 labour – primary
 capital - secondary
 entrepreneurship –secondary
 Natural Resources (land)

Consists of gifts of nature, some examples are mineral deposits, water, natural forests, animal life and sunshine.
Natural resources are in fixed supply, however, it is possible to exploit more of the available resources. The
discovery of new mineral deposits is an example.
However, once used these resources cannot be replaced. As a result, minerals are referred to as non-renewable
or exhaustible assets. As is the case with all the factors of production, both quality and the quantity of natural
resources are important.
 Labour
Labour can be defined as the exercise of human and physical effort in the production of goods and services. The
quantity available depends on the size and proportion of the population which are willing and able to work. The
quality of labour is described by the term human capital, which refers to the skill, knowledge and health of the
workers. Education, training and experience are all determinants in human capital.
 Capital
Comprises of all manufactured resources (machines, tools and buildings), which are used in the production of
other goods and services. Capital goods are not produced for their own sake, they are produced to produce other
goods. When we talk about capital as a factor of production, we are referring to all those tangible things used in
the production process. When we produce capital goods, we sacrifice present consumption for future consumption.
 Entrepreneurship
Factors of production have to be combined and organized by people who see opportunities and are willing to take
risks by producing goods in the expectation that they will be sold. Entrepreneurs are the people who do this. They
are the initiators, the innovators and the risk bearers, and they do this in anticipation of making profits.
 Technology
Sometimes identified as the fifth factor of production. When new knowledge is put into practice, and more goods
and services are produced with a given level of natural resources, labour, capital and entrepreneurship, we say
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that technology has improved. Invention is the discovery of new knowledge, whilst innovation is the incorporation
of the new knowledge into actual production.
 Money as a factor of production?

Although money is important, it is NOT a factor of production. Goods and services cannot be produced with money,
to produce goods and services we need factors of production. Money is a medium of exchange, it facilitates the
exchange of goods and services.
2.3 The choice of technique

When deciding how to produce the goods and services chosen by society one has to make a choice as to what
will the best method of production be.
Production often involves more than one technique with which to produce the good or service, for example when
manufacturing shoes one may choose a process which is dominated by machines or a process which requires
more labour than machines. If the production process is dominated by machines, the production process is referred
to as capital-intensive. However, if the emphasis is on labour, the production process is labour-intensive.
In choosing whether or not to have a capital intensive or labour intensive production process certain factors play
a role in the decision, these factors include: the availability of resources, the quality of the resources available, the
relative prices of the resources available (ie the price of labour against the price of capital), the labour laws of the
country and other relevant laws.
2.4 For whom it should be produced

Good and services are produced for government (the public sector) and the rest of the economy (the private
sector). There is also a geographical distribution of the income between regions of a country and between
sectors (known as primary, secondary and tertiary sectors).
STUDY UNIT
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Economics 1A
Unit
3: The Circular Flow of
Income and Spending
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 Explain the Circular flow of income and  Answer the questions found in the workbook relating to
spending Unit
 Describe the flow of income in the circular  Answer the questions found in the workbook relating to
flow model Unit
3.1 Introduction
3.2 A Simple Circular Flow Model of Income and Spending
edition) Pretoria: Van Schaik
24 MANCOSA
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3.1 Introduction
The circular Flow of Income shows the flow of inputs, outputs and payments between households and firms
within an economy. This model captures the essential essence of macroeconomic activity. The economy is
seen as nothing more than:
 A revolving flow of goods,
 Production resources, and
 Financial payments.
The three major flows are (Mohr & Fourie: 2015:41):
Figure 7
The circular flow model illustrates the mechanism by which income is generated from goods and services and
how this income is spent. This is best understood by analysing the diagram below:
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Economics 1A
3.2 A Simple Circular Flow Model of Income and Spending
Figure 8
Mohr & Fourie: 2015:51)
Firstly, let us consider households who are buyers, and firms who are producers and sellers of goods and
services in the goods and services market: Firms are buyers of factors of production and households become
sellers of factors of production in the factor market.
The next participant that we introduce into the model is the government. The government is responsible for
providing public goods and services, such as roads, bridges, etc. for usage by households and firms.
In order for government to provide these public goods and services, it receives tax revenue from households
and firms. Hence, again we have flow of income in the form of tax paid by firms and consumers and tax received
by the government. In addition, government provides subsidies to firms and households - flow of income.
Next, we introduce the financial sector, which mainly comprises of financial institutions, where consumers and
firms deposit funds and earn interest on savings. In addition, firms and consumers take loans to invest in capital
goods and assets, and have to pay interest on loans. Finally, we introduce the foreign sector. In the foreign
sector, importing countries pay using foreign exchange for imported goods and services, and exporting
countries earn foreign currency for exporting goods and services.
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This simple circular flow model of income, output and spending represents the workings of a simple economy,
and illustrates the importance of economic interdependence. It further highlights the mutual dependence
between the micro economy and the macro economy.
STUDY UNIT
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Unit
4: Demand, Supply and Prices
28 MANCOSA
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 Conceptualise the importance of the  Answer the questions found in the workbook relating
study unit, as it lays the foundation for to Unit
most of the economic analysis in
 Answer the questions found in the workbook relating
Economics
to Unit
 Draw and read simple demand and
 Answer the questions found in the workbook relating
supply graphs
to Unit
 Explain the difference between change
 Stop at the THINK POINT - There must have been a
in demand or supplied and change in
time when you expected a sale at a store you liked
quantity demanded or supplied
and decided to wait for it, waiting to purchase
 Distinguish between movement and whatever item it is you wanted. This is the same
shifts along a demand and supply concept. These are things that we do on a daily
curve basis, all that is happening here is that it is given
structure and form.
 Identify the determinants of individual
demand and supply and market  Answer the questions found in the workbook relating
demand and supply to Unit
 Understand how the market arrives at  Answer the questions found in the workbook relating
a state of equilibrium we need to to Unit
understand disequilibrium
4.1 Introduction
4.2 Demand
4.3 Movements along the demand curve and shifts of the demand curve
4.4 Shifts in the demand curve
4.5 Supply
4.6 Market Equilibrium
 Mohr, P. & Fourie, L. (2015). Economics for South African Students.

(5th edition) Pretoria: Van Schaik Chapter 4
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4.1 Introduction
This is an important study unit, as it lays the foundation for most of the economic analysis in Economics 1.
4.2 Demand
In economics, demand for a good or service means that there is both the intent to buy it and the means (i.e.
purchasing power) to do so.
Therefore, demand refers to the quantities of a good or service that potential buyers are willing and able to
buy. Furthermore, demand relates to the plans of households, firms and other participants in the economy. It does
not relate to events which have already occurred. As demand is concerned with plans and not events which have
occurred, this means that the quantity demanded and the quantity actually bought may differ.
Quantity demanded may in fact be equal to, greater than, or less than the quantity bought.
4.2.1 Individual demand

We will use the case of Anne Smith, (Mohr and Fourie:2008:113) an imaginary consumer who demands tomatoes.
What are the determinants and properties which will determine the quantity of tomatoes that Anne plans to
purchase in a particular period?
 The price of the product
Anne will be willing and able to buy a larger amount of tomatoes the lower the price, ceteris paribus.
 The prices of related products.

The price of related products will also influence Anne’s decision on how many tomatoes to purchase. In the case
of related products, we have to distinguish between complements and substitutes
Complements are goods that are used together with the good concerned. In our case bread (for sandwiches) and
onions (for cooking) are examples of goods that would complement tomatoes.
Substitutes are goods that can be used instead of using the good concerned. For example, tomatoes can be
replaced with other ingredients in a salad.
 The income of the consumer.

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

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

As households grow in size, they tend to purchase more goods and services. Likewise, smaller households tend
to purchase less.
9Figure 4-1 Anne Smith`s weekly demand for tomatoes

(Mohr and Fourie, 2015: 63)
In figure 4-1 above, the price of tomatoes (rand per kg) is on the vertical (y) axis and the quantity of tomatoes
demanded (kg per week) is listed on the horizontal (x) axis.
Note, it is crucial that you label the axis of these graphs correctly as they form the basis of the diagram. Each point
on the diagram represents a combination of both price and quantity demanded. For example, at point a, 6kg of
tomatoes will be demanded if the price of tomatoes is R1 per kg.
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By joining all the various points which express the relationship between the price of a good and the quantity
demanded, we obtain the demand curve.
The negative slope of the demand curve (point e to point a), indicates that there exists a negative or inverse
relationship between price and quantity demanded (ie the law of demand).
We plot the demand curve for a good or service on the assumption that, all other determinants are constant (ie
ceteris paribus).
Market Demand
The market demand curve is simply the sum of all of the individual demand curves for a particular good or service.
Therefore, in a situation where the market consists of three prospective buyers, Anne Smith, Helen Rantho and
Purvi Bhana, to obtain the market demand curve we would add all their demand curves together.
The market demand curve is therefore obtained by adding the individual demand curves horizontally (ie at a price
of R5 Anne demands 2 tomatoes, Helen 0 and Purvi 1, therefore market demand at R5 = 3 tomatoes demanded).
This process of adding up the demand curves horizontally is demonstrated in figure 4-2 below, where the individual
demand curves are shown to the left and the market demand curve (the sum of the individual curves) is on the
right.
10Figure 4-2 The market demand curve

If the information for the market was available, i.e. if we had the information for the total quantity demanded per
period, then we could simply plot the market demand curve as we did with the individual ones (joining the price
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and quantity points plotted). As the market demand curve is simply all the individuals demand curves in that market
added together, the same factors which determine individual demand, also determine total quantities demanded.
4.3 Movements along the demand curve and shifts of the demand curve
Movements along the demand curve are related to changes in the price of the good or service. When the price of
a product changes, the quantity demanded will also change, ceteris paribus (all other factors remaining constant).
We can obtain the amount by which the quantity changed by comparing the relevant points on the demand curve.
Therefore, to determine by how much quantity demanded changed, we compare the movement along the demand
curve, i.e. we compare two points. (Refer to figure 4-3 below).
For example, if the price of tomatoes had to change from R4 per kg to R3 per kg, demand would change from 6
kg per week to 9 kg per week. Consumption of tomatoes is now 3 kg per week more than it was previously.
Remember, these conclusions are based on the assumption that all other things remain the same, i.e. ceteris
paribus! Therefore, when dealing with movements along the demand curve, we are dealing with the relationship
between the price of the product and the quantity demanded, ceteris paribus.
11Figure 4-3 A movement along a demand curve

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4.4 Shifts in the demand curve

We now turn our attention to shifts in the demand curve. Shifts in the demand curve occur when factors influencing
the nature of demand change.
Therefore, if a factor which determines the demand for a product changes (other than price of course), the demand
curve for the product will shift. This occurs because price has been placed as the cornerstone of the demand curve
(i.e. it is on the vertical axis). Changes in determinants other than price are therefore reflected as shifts of the
demand curve.
As mentioned earlier, there are a host of factors that influence demand other than the price of the product. We will
examine each one in detail:
4.4.1 The prices of related goods

Related goods fall into two categories, substitutes and complements.
Substitutes, are exactly what the name suggest, they are products which can be used in the place of another
good to satisfy the consumers wants. Examples of substitutes include, nike and reebok shoes, butter and
margarine, beef and mutton. Differences in the prices of these goods will determine, to an extent, the level of
demand for the product in question
Ceteris paribus, an increase in the price of a substitute will result in an increase in the quantity demanded for the
product in question.
This will result in a shift of the demand curve to the right, indicating that there is a greater quantity
demanded of the product at each price range. Increases in the prices of substitutes are therefore displayed as
shifts of the demand curve to the right for the product concerned, likewise decreases in the prices of substitutes
are displayed as shifts to the left. Remember, this is under the ceteris paribus condition, all demand curves are
plotted under this condition. Figure 4-4 below shows a graphical representation of how an increase in the price of
a substitute shifts the demand curve for the product concerned to the right.
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12Figure 4-4 Two substitutes: butter and margarine

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

In the case where consumer income changes, there will be a change in demand. Changes in income are shown
graphically as shifts in the demand curve. Ceteris paribus, an increase in income will lead to an increase in
demand and a decrease in income will lead to a decrease in demand. Therefore, increases in income are shown
graphically as shifts of the demand curve to the right and decreases in income are shown as shifts to the left.
4.4.3 Tastes and preferences

Whereas changes in the prices of related products and changes in the incomes of consumers are rather obvious
determinants of demand, a less obvious determinant is consumer tastes and preferences. Preferring Nike shoes
to Reebok is a good example of tastes and preferences. As these tastes and preferences change, so too does
demand. Many things can affect your tastes and preferences, advertising, a doctor’s advice or maybe a
conversation with a friend. In either case the demand curve responds by shifting either to the left or right. For
example, a negative change in tastes for pizza, due to an increase in the popularity of spaghetti, would shift the
demand curve for pizza to the left, whereas a positive change would do the opposite.
4.4.4 Household / population size

The demand for a product also depends on the size of the population that the market is serving. The larger the
population, the greater will be the demand for the product in question, ceteris paribus. The smaller the
population, the smaller the demand for the product, ceteris paribus. Graphically this can be illustrated as follows:
an increase in the population will shift the demand curve to the right, ceteris paribus. A decrease in the population
would shift the demand curve to the left, ceteris paribus.
4.4.5 Other possible determinants

 Expectations
Other important variables which influence demand are changes in expected future prices and the distribution of
income. Consumers’ expectations about future events form a critical part of economics, as expectations of future
events often translate into realities. In this case, should consumers expectations about any of the
determinants of demand change, then demand for product can change. Should consumers expect that the
future price of a good will fall, ceteris paribus, they will tend to reduce present consumption. The expectation of the
future price decrease means that if consumption is put on hold now, the good can be purchased cheaper at a later
stage.
Present consumption is therefore reduced. Graphically this will be displayed as a shift of the demand curve (for
the product) to the left, indicating that quantity demanded has decreased at all prices. If consumers expect future
prices to rise, ceteris paribus, then the opposite will occur. Present demand will be increased as to maximize the
opportunity to purchase the good cheaply (shift to the right).
36 MANCOSA
Economics 1A
Activity
There must have been a time when you expected a sale at a store you liked and
decided to wait for it, waiting to purchase whatever item it is you wanted. This is
the same concept. These are things that we do on a daily basis, all that is
happening here is that it given structure and form.
Try to relate to the concepts you read abou
 Distribution of Income
Changing the distribution of income among the households in the economy may also change demand.
Redistributing income from households with high incomes to households with low incomes changes the nature of
demand. Goods which are demanded by low-income households will increase (rightward shift) while goods which
are demanded by high-income households will decrease (leftward shift), ceteris paribus.
Distributing income influences the structure of the market, remember, the market serves us through the pricing
mechanism (for a market economy), and therefore those with money determine the composition.
4.5 Supply
The focus is now on supply. When dealing with supply it is useful to remember that supply has to do with
producers, so try to relate to it as if you were the business man/woman.
Supply is defined as, the quantities of a good or service that producers plan to sell at each price during a
period.
Just as demand refers to the plans of consumers who are willing and able to purchase, supply refers to the plans
of producers who are willing and able to supply the quantities of the product concerned.
Worth noting is the fact that producers are not guaranteed to sell the quantity that they supply, as this depends to
a large extent on demand.
4.5.1 What determines supply?

Individual supply is determined by a few factors; these include:
 The price of the product:
The higher the price, the greater the quantity supplied to the market. Remember, prices convey information to
market participants. High prices indicate that demand in the market is good and therefore there is profit to be
made.
 The prices of alternative products:
The decision to produce is not only dependent on the price of the product in question, it is also dependent on
the prices of alternative products. A producer will have to decide which products to produce with the given
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resources. Resources may be used to produce more than one product and as a result decisions have to be
made as to how much of a product to produce given the alternatives.
 Expected future prices:
Production decisions are not made over a period or periods of time and as a result plans have to be made with
the future in mind. Plans to produce are therefore made with the future in mind, i.e. producers make decisions
not only on the current market price but also on the prices they expect to receive in the future.
 The state of technology:
Technology plays an important role in the production process as it impacts directly on the cost of production.
Should there be technological developments which allow producers to produce at lower cost, then the quantity
supplied will increase at every price level.
13Figure 4-5 Johnny`s annual supply of tomatoes

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

Like we did in the case of market demand, to obtain the market supply we simply add the individual supply curves
horizontally. So if Peter, Jack and Paul are willing to supply 10, 20 and 30 pairs of shoes if the market price is
R100, then to obtain the market supply we simply add these values for the price of R100. Therefore at a price of
38 MANCOSA
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R100, the market supply will be 60 pairs of shoes. This can be done at all prices. The market supply is the
relationship between the price of the product and the quantities supplied, by all firms, over a specific period.
Market supply and individual supply are therefore very much the same, with the major difference being that market
supply refers to all the prospective sellers of a product in a particular market.
4.5.3 Movements along the supply curve and shifts of the curve
As can be seen in the diagram below (Figure 4-6), at a price of P1 the quantity demanded is Q1, these two values
are represented by point a on the graph. Should the price of the good concerned increase to P2 then the quantity
supplied will increase to Q2, point b. As can be seen, price changes result in movements along the supply curve,
just as price changes result in movements along the demand curve. Remember, movements along the supply
curve due to price changes, are subject to the ceteris paribus assumption. Changes in price therefore result in a
change in quantity supplied.
14Figure 4-6 A movement along a supply curve: change in quantity supplied

Shifts of the supply curve however, are not as a result of price changes, but are due to changes in the other
determinants of supply. Shifts in the supply curve are therefore due to changes in factors other than price.
Recall what was said earlier about the supply function and the factors which determine it. Therefore, should a
factor like technology change, and a more efficient process of production is discovered, this would shift the supply
curve to the right, ceteris paribus. What this shift indicates is that there will be a greater amount of the good supplied
at each price level. We refer to this as a change in supply.
Changes in supply can be both positive and negative and as such should there be a negative change in a
determining factor, other than the price of the product, then the supply curve will shift to the left. Remember,
changes in any of the determinants of quantity supplied, except for the price of the product, will result in a shift of
the supply curve.
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Table 4-5 in the prescribed text (Mohr and Fourie:2015:75) gives a good summary of what has been discussed.
Figure 4-6 below is a graphical illustration of shifts in the supply curve.
Note: How at a price of P1 the quantity supplied differs for each supply curve. The question that you should ask
yourself is: At a given price (P1 in this example) what will a change in a determinant (other than the price of the
product) do to the quantity supplied?
15Figure 4-7 Shift of the supply curve: changes in supply

4.6 Market Equilibrium

Remember, a market occurs where there is any contact or communication between potential buyers and potential
sellers of a good or service. It follows that markets therefore bring the forces of demand and supply in contact with
each other.
Market equilibrium occurs where the quantity of a good/service demanded is equal to the quantity supplied of
that good/service. Equilibrium between households (demanders) and firms (suppliers) will occur at a certain price,
known as the equilibrium price.
At the equilibrium price, the plans of households and the plans of firms will be one in the same, in that households
will plan to purchase X amount of a good/service and firms will plan to sell the same amount of the good/service.
The result of this matching of plans is that the market will come to a state of rest, this state occurs as the two
opposing forces (demand and supply) are in a state of balance. As such there will be no tendency for the conditions
to change. However, should the underlying forces change, the balance in the market will be upset and the market
will adjust accordingly.
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To understand how the market arrives at a state of equilibrium we need to understand disequilibrium.
Disequilibrium occurs when the price charged is at level other than the equilibrium price level, i.e. any price other
than the equilibrium price will bring about disequilibrium in the market.
16Figure 4-7 Demand, supply and market equilibrium

As can be seen in Figure 4-7 above, should a price above or below R5/kg be charged for tomatoes, then demand
and supply will not be equal (disequilibrium). At a price above R5/kg, the quantity supplied will be greater than the
quantity demanded, there will therefore be excess supply at prices above R5/kg.
This occurs as the higher price encourages producers to increase supply in the hope of making greater profits,
however, at prices greater than R5/kg consumers plan to purchase less of the good than they would have at R5/kg.
The result is that there will be more of the good on the market than consumers are willing and able to purchase,
excess supply. Similarly should the price fall below R5/kg then the quantity demanded will exceed the quantity
supplied. This occurs because (as you know) cheaper prices result in more of the good being demanded, ceteris
paribus (the law of demand).
Whereas consumers are demanding more, producers are now producing less than they would have if the good
was R5/kg (low prices signal low demand and less profits), there is now an excess demand in the market.
When the market is in disequilibrium, it goes through a process which leads it back to equilibrium. In the case of
excess demand there are too few goods on the market. Firms have therefore sold their total production but
households have not obtained the quantity of the good that they demanded at the particular price. As households
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wish to obtain more of the good (at the going price) they offer more money for the product (i.e. prices higher than
the market price) in an effort to outbid other households. The result is that the price of the product rises.
As the price starts to rise firms realise that they can obtain a higher price for their product and therefore increase
their production of the good. However, as the price rises demand starts to slow down (law of demand), and with it
the rising price, production will slow with demand and the process ends when equilibrium is obtained.
In the case of excess supply, there is not enough demand for the amount of goods on the market. Firms are
therefore unable to sell their products and as such are left with a surplus of unsold goods (market surplus). These
unsold stocks are also known as inventories, and as the level of inventories rise, firms cut their production of the
product in an attempt to sell off the rising levels of stock and to compete with the other firms for the limited demand.
By reducing their level of production, firms lower their cost and as a result can charge lower prices in order to
compete. Graphically, this can be shown as a movement down the supply curve towards the point of equilibrium.
At the same time, demand will increase as the price decreases and producers and consumers will move toward
the point where quantity demanded and quantity supplied are equal to each other.
Market equilibrium therefore occurs at the intersection of the demand and supply curves. This point is
characteristic of both buyers and sellers agreeing upon both the quantity of goods that will be exchanged on the
market and the price which these goods will be exchanged for. At equilibrium, there is no tendency for change.
STUDY UNIT
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Unit
5: Demand and Supply in Action
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LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF

THIS UNIT:
 Graphically illustrate how the changes in  Answer the questions found in the workbook
demand will affect the equilibrium price and relating to Unit
equilibrium quantity in the market
 Graphically illustrate how the changes in supply

will affect the equilibrium price and equilibrium
quantity in the market
 Graphically illustrate how the simultaneous

changes in demand and supply will affect the
equilibrium price and equilibrium quantity in the
market
 Show what happens if the government

intervenes in the price mechanism by setting
maximum and minimum prices
5.1 Changes in demand

5.2 Changes in supply
5.3 Simultaneous changes in demand and supply
5.4 Government intervention
edition) Pretoria:Van Schaik Chapter 5
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5.1 Changes in demand

As discussed earlier, should there be a change in any of the determinants of demand (except for the price) then
the demand curve will shift.
Recall that to shift the demand curve to the right, there would need to be a change in any of the determinants to
this effect:
1) increase in the price of a substitute, or
2) decrease in the price of a complementary product, or
3) increase in the consumer’s income, or
4) positive change in preferences towards the product, or
5) expectations of a price increase of the product.
17Figure 5-1 Changes in demand

Mohr and Fourie, 2015: 84)
Should there be a change in any of the determinants to this effect, then it will be termed as an increase in demand.
This can be seen on the left graph of Figure 5-1. Note that the change in demand has not affected the supply
curve. The change in demand from DD to D1D1 (right shift), results in excess demand at the current market price
of P0. This can be seen by extending the line P0E through to the demand curve D1D1. Therefore at a price of P0,
demand for the product is greater than the amount of product being sold and as such consumers bid up the price.
As the price rises, firms increase their quantity supplied of the good.
At the same time demand slows and eventually equilibrium is reached at point E1. The characteristics of point E1
are: a higher price (P1) and a larger quantity supplied (Q1). The move to equilibrium is therefore characterized by
a movement along the supply curve from E to E1 and a movement along the new demand curve (D1D1) from where
the extended P0E would intersect D1D1 to the point E1.
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Similarly, there is the case of a decrease in demand. Like the case before, this occurs when there is a change in
any of the determinants of demand, except the price of the product.
Therefore, should:
1) the price of a substitute fall
2) the price of a complementary product increase
3) the consumers income fall
4) there be a reduced preference for the product
5) the price of the product be expected to fall
then the demand curve would shift to the left.

Like in the case of an increase in demand, in the event of a decrease in demand there is a shift of the demand
curve from DD to D2D2 in our example, with the supply curve remaining unchanged. Looking at the graph on the
right, we see that at the market price of P0 there is now an excess supply of goods on the market. This can be
seen by looking at the difference in the quantity demanded at the point where P0E intersects D2D2 (the new demand
curve) and the quantity supplied at price P0 (this being Q0). This excess supply leads to a fall in the price of the
product, as producers have to compete to sell off their rising inventories. As producers cut back on production and
the price falls, demand for the product rises (law of demand) and equilibrium is reached at E2. E2 is characterized
by a lower price P2 and a lower quantity sold Q2.
The move to equilibrium is therefore characterized by a movement along the supply curve from E to E2 and a
movement along the new demand curve (D2D2) from where P0E intersects D2D2 to the point E2.
5.2 Changes in supply

We now turn our focus to changes in supply and their impact on the equilibrium position of the market. An increase
in supply results in a shift of the supply curve to the right and is the result of changes in any of the determinants of
supply, all determinants other than price that is.
Changes in the determinants that will result in an increase in supply:
1) should the price of an alternative product fall or should there be a rise in the price of a joint product
2) should there be a reduction in the price of any of the factors of production (ie should the cost of
production decrease)
3) should there be an improvement in the factors of production (the result of technological progress).
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18Figure 5-2 Changes in supply

In figure 5-2 above, an increase in supply can be seen on the graph of the left. Like in our examples of changes in
demand, changes in supply do not change the position of the demand curve. The increase in supply from SS to
S1S1 results in there being an excess supply of the product at the market price of P0.
This can be seen by extending the line P0E through to the new supply curve S1S1. As can be seen, the quantity
demanded at P0 is Q0 (corresponding to point E) whilst the quantity supplied would be greater (the quantity
corresponding to the point at which extended P0E intersects S1S1).
The result of the excess supply is that the price of the product will fall as firms compete for market share. The
falling price will result in a rise in the quantity demanded and the quantity supplied will slow. Market equilibrium will
be reached at point E1, this point characterized by a lower price P1 and a higher output Q1.
The move to equilibrium is therefore characterized by a movement along the demand curve from E to E 1 and a
movement along the new supply curve (S1S1) from where the extended line P0E would intersect S1S1 to the point
E1.
A decrease in supply is shown as a shift of the supply curve to the left. This can be seen on the graph on the right
hand side of figure 5-2, and is depicted as a shift from SS to S2S2. The shift in the supply curve results from a
change in any of the determinants of supply, other than price that is.
Changes in the determinants to the effect that:
1) should the price of an alternative product increase or should there be a fall in the price of a joint product
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2) should there be an increase in the price of any of the factors of production (ie should the cost of production
increase)
3) should there be a deterioration in the productivity of the factors of production (this raises the cost of
production).
The decrease in supply results in an excess demand at the original market price P0. This can be seen by referring
to the graph on the right of figure 5-2. If we look at the broken line P0E, what can be seen is that where it intersects
the new supply curve S2S2, the quantity which would be sold at that price is less than the quantity demanded or Q0
(the quantity corresponding to point E).
This excess demand drives up the price of the product as consumers bid up the price of the product in an attempt
to obtain the scarce product. The increasing price reduces the demand for the product and encourages producers
to increase production. Equilibrium is reached at point E2, where less of the product is sold (Q2) and the price of
the product has increased to P2.
The move to equilibrium is therefore characterized by a movement along the demand curve from E to E 2 and a
movement along the new supply curve (S2S2) from where P0E intersects S2S2 to E2.
Note: these movements occur simultaneously. When we speak about moving along the supply and the
demand curves, we are not talking about moving along one and then the other. What is in fact happening
is that all these forces are acting at the same time. The market is therefore tending to the equilibrium point
at the same time, i.e. producers and consumers are moving toward equilibrium at the same time.
5.3 Simultaneous changes in demand and supply

If we are dealing with changes in demand or supply, then it is possible to predict what will happen to equilibrium
prices and equilibrium quantities in the market. However, should both demand and supply change simultaneously,
then the precise outcome cannot be predicted.
For example, should there be an increase in demand (due to a positive change in preferences toward the product),
accompanied by a decrease in supply (due to an increase in the price of the factors of production), then only the
thing that is certain is that the price of the product will rise. This is due to the fact that both of the changes result in
an increase the equilibrium price in the market. What the equilibrium quantity will be however is uncertain. This is
due to the fact that as far as equilibrium quantity is concerned, the two forces work in opposition to each other. An
increase in demand works to raise the equilibrium quantity, ceteris paribus, whilst a decrease in supply lowers the
equilibrium quantity, ceteris paribus.
The outcome in the market therefore depends on the relative magnitudes of the changes. (Mohr and Fourie, 2008:
138). The reader is referred to Mohr and Fourie (2008:137) for a more detailed account of the topic.
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5.4 Government intervention

Markets are not always free to determine what the equilibrium prices and quantities will be. Governments have
various methods available with which to intervene in the market. This intervention can take the form of:
 setting maximum prices (also known as price ceilings)
 setting minimum prices (also known as price floors)
 subsidising certain products or activities
 taxing certain products or activities
We will deal with the first two interventions (price ceilings and floors) on our list of four.
Maximum prices (price ceilings) are often set for certain goods and not on the market as a whole.
Governments can set maximum prices with the intention of:
 keeping the prices of basic foodstuffs low (this may form part of policy to assist the poor)
 avoiding the exploitation of consumers by producers (producers may be charging “unfair” prices)
 combating inflation
 limiting the amount production of certain goods and services in times of war
Should the maximum price be set above the market clearing price (equilibrium price), then the intervention will not
have any effect on the outcome of the market. The market will therefore arrive at the equilibrium price and
equilibrium quantity. However, when the maximum price is set below the market clearing (equilibrium price), the
intervention disrupts the market mechanism (price mechanism) and therefore causes instability in the market.
In figure 5-3 below, we can see that if the market were left alone the forces of demand and supply (remember,
excess demand and excess supply) will result in the market achieving equilibrium with a price P0 and a quantity
supplied of Q0.
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19Figure 5-3 Maximum prices

In Figure 5-3 above, the government has set a maximum price of Pm which is below the equilibrium price of P0. At
the price Pm producers are willing to sell Q1 units whilst consumers are demanding a quantity of Q2, this can be
seen if we follow the line Pm across to the supply curve (point a) and then across to the demand curve (point b).
The quantity demanded by consumers at a price of Pm is clearly greater than the quantity which producers are
willing to produce (Q1). As such there is now excess demand in the market (market shortage) and this excess
demand is equal to the difference between Q2 and Q1, i.e. Q2 – Q1.
If the market were left alone then the market mechanism would raise the price until this excess demand was
eliminated (remember the example of excess demand earlier). However, as the price has been pegged artificially
this process cannot occur.
We are therefore left with the problem of how to allocate Q1 worth of product amongst people who demand Q2?
There are various ways for this allocation to take place, these are:
1) Consumers are served on a “first come first served”, the result is queues and waiting lists.
2) An informal rationing system may be set up by suppliers. This system can take the form of limiting the amount
of goods sold to each customer or only selling goods to regular customers.
3) Government itself may introduce an official rationing system. This can be done by issuing tickets or coupons
which have to be submitted when purchasing the product.
To summarise, should the government set a maximum price below the equilibrium price of a product it would:
1) cause excess demand in the market
2) prevent the market from allocating the quantity of product available among consumers
3) result in black market activity occurring in the market. A black market is an illegal market which occurs when
goods are sold at prices which are above the maximum price set by government.
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If we refer to figure 5-4 we can see that at a quantity of Q1 (the quantity which will be supplied), the price which a
consumer is willing and able to pay for the product is P1 and this price is clearly greater than Pm. Therefore, those
who have the product can charge prices in excess of Pm to those who are looking to purchase.
What also should be mentioned is the fact that setting the maximum price below the equilibrium price level results
in welfare costs to society.
Consider the case below, figure 5-4. In this case the government has set a price of Pm which is below the equilibrium
price of P1. The result is similar to that outlined earlier, there is excess demand in the market with the quantity sold
falling from Q1 to Qm. Recall what was said earlier about producer and consumer surplus.
In figure 5-4, at the equilibrium price of P1 consumer surplus is represented by the area DP1E and producer surplus
is represented by the area 0P1E. However, when the government implements the maximum price on the market
these areas change. Consumer surplus is now represented by the area DRUPm and producer surplus is now
represented by the area 0PmU. (Remember, consumer surplus is the area below the demand curve, above the
price line and with the quantity supplied. Likewise producer surplus is the area above the supply curve, below the
price line and within the quantity supplied). With the price maximum imposed, consumers have now lost the area
indicated by triangle A but have gained the area B. The loss of triangle A occurs as a result of the decrease in the
quantity supplied from Q1 to Qm, whereas the gain of the rectangle B occurs from the fact that the those who obtain
the product now pay less for it.
20Figure 5-4 The welfare cost of maximum price fixing

In the case of the new producer surplus, we have shown that the new producer surplus is now represented by the
area 0PmU as opposed to the area 0P1E. Producers have therefore lost the area represented by triangle C as a
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result of the loss of production and the rectangular area B as a result of it being transferred to consumers. The end
result is that the total welfare loss to society is represented by both triangles A and C, and this is referred to as a
deadweight loss. Worth noting is the fact that this area was not transferred, unlike the area represented by
rectangle B which was transferred from producers to consumers.
The area made up of triangles A and C has been lost to society and this comes about due to the fact that less is
being produced in society, and society itself is made up of both producers and consumers.
We now turn our attention to the case of minimum prices (price floors). In the case where a minimum price is set
by government, the minimum price will not impact on the outcome of the market if the price is set below the market
equilibrium price. However, should the minimum price be set above the equilibrium price then there will be excess
supply of products in the market. To illustrate the case of a minimum price set above the equilibrium price, your
attention should now be on figure 5-5 below.
21Figure 5-5 A Minimum price

In Figure 5-5 above, the market is at equilibrium at a price of R30 per kilogram and at this price a quantity of 7
million kilograms is being sold. The government sets a minimum price (price floor) of R40 per kilogram on the
product. At a price of R40 per kilogram consumers demand a quantity of 4 million kilograms, however producers
are producing 9 million kilograms of beef. Therefore, there is a surplus of 5 million kilograms of beef in the market
(the difference between point a and point b). By setting a minimum price above the equilibrium market price (market
clearing price) the government creates an excess supply in the market. This excess supply will usually require
further government intervention and the result may be one of the following:
 The surplus product may be purchased by government and exported
 The surplus product may be purchased by government and stored (provided it can be stored)
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 Production quotas are introduced by government to limit the quantity supplied to the quantity demanded (at
the minimum price). In our example government would try to limit production of beef to 4 million kilograms. In
doing so the surplus is illuminated.
 The surplus is purchased and destroyed by government
 Producers destroy the surplus
(Mohr and Fourie, 2015: 94-95)
The setting of minimum prices is often a characteristic of agricultural markets as these markets are characterized
by large fluctuations in supply. Although demand for agricultural products is stable, the large fluctuations in supply
result in the incomes of farmers being unstable as the prices received for the product fluctuate as well.
Governments therefore tend to set minimum prices to stabilize the incomes of farmers. However, this is not an
efficient way of assisting small or poorer farmers. Minimum prices are inefficient due to the following facts:
 All the consumers in the market have to pay artificially high prices (this includes the poor)
 .Large farmers receive the bulk of the benefits which are forthcoming
 Firms that are inefficient are now protected by the minimum price and manage to survive
 Disposal of the surplus which is generated from the minimum price usually imposes a further cost to tax
payers and results in welfare losses
The case of the welfare costs to society which occur as a result of the minimum price is similar to that of the costs
of the maximum price which was discussed earlier. Consider the case below, figure 5-6. In this case the
government has set a minimum price of Pm which is above the equilibrium price of P1. We will assume that
producers respond by supplying the market with the amount which is actually demanded (Qm).
In figure 5-6, at the equilibrium price of P1 consumer surplus is represented by the area DP1E and producer surplus
is represented by the area 0P1E. However, when the government implements the minimum price on the market
these areas change. Consumer surplus is now represented by the area DRPm and producer surplus is now
represented by the area 0PmRT. (Remember, consumer surplus is the area below the demand curve, above the
price line and within the quantity supplied. Likewise producer surplus is the area above the supply curve, below
the price line and within the quantity supplied). With the minimum price imposed, consumers have now lost the
area indicated by the rectangle A and triangle B. The loss of triangle B occurs as a result of the decrease in the
quantity supplied from Q1 to Qm, and the loss of the rectangle A occurs as a result of the fact that the those who
used to obtain the product at a price of P1 now pay a price of Pm.
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22Figure 5-6 The welfare costs of minimum price fixing

In the case of the new producer surplus, we have shown that the new producer surplus is now represented by the
area 0PmRT as opposed to the area 0P1E. Producers have therefore lost the area represented by triangle C as a
result of the loss of production, but gained the rectangular area A at the expense of the consumers. The end result
is that the total welfare loss to society is represented by both triangles B and C, this is referred to as the deadweight
loss. The area made up of triangles B and C has been lost to society and this comes about due to the fact that less
is being produced in society, and society itself is made up of both producers and consumers.
STUDY UNIT
54 MANCOSA
Economics 1A
Unit
6: Elasticity
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LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF

THIS UNIT:
 Define the concept of elasticity  Answer the questions found in the
 Understand the link between price elasticity and workbook relating to Unit
total revenue from sales
 Explain the meaning of specific elasticity (say
ep=1.5)
 Explain the determinants of price elasticity of
demand
6.1 Introduction
6.2 rice elasticity of demand and total revenue
6.3 Different categories of price elasticity of demand
6.4 Determinants of the price elasticity of demand
Mohr, P. & Fourie, L. (2015). Economics for South African Students. (5th
edition) Pretoria: Van Schaik Chapter 6
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6.1 Introduction
When we speak about elasticity, we are in fact referring to the responsiveness or sensitivity of a dependent variable
to changes in an independent variable.
The best known elasticity concept is price elasticity of demand, which is a measure of the responsiveness of the
quantity demanded to changes in price of the product. You are not required to calculate the price elasticity for
purposes of this course, but you must ensure that you can apply and interpret the formula.
Price elasticity of demand is calculated as follows:
ep = % change in the quantity of a products
% change in the price of a product
Where ep = price elasticity of demand
23Figure 6-1 Price elasticity of demand at different points along a linear demand curve
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As can be seen in figure 6-1 above, the price elasticity of demand (ep) varies from a infinity (∞) to zero.
The value of price elasticity of demand (ep) is infinity where the demand curve intersects (meets) the price axis and
zero where the demand curve intersects the quantity axis.
If we move down the demand curve, from left to right, the price elasticity of demand falls from infinity (∞) to zero.
It is worth noting that this will be the case for any demand curve which intersects both the price and quantity axis
(regardless of slope: this can be seen in figure 6-1).
In the case of any demand curve which intersects both axis, the value of the ep will be infinity (∞) where the graph
intersects the price axis, one in the middle of the curve (midpoint) and zero where the curve intersects the quantity
axis.
For a numerical example on how to obtain the different values of price elasticity of demand (ep), the reader is
referred to Mohr and Fourie (2015: 106).
6.2 Price elasticity of demand and total revenue

Price elasticity of demand is a useful tool because it can be used to show how much total expenditure by consumers
on a product will change should the price of the product change. Furthermore, total expenditure by consumers is
also the total revenue of the firms who produce that product. Because of its usefulness in analyzing the responses
of both consumers and producers to situations in the market, price elasticity of demand serves as a useful tool in
decision making.
We will focus on the usefulness of price elasticity of demand with respect to total revenue. The total revenue (TR)
that suppliers obtain from the sales of a good or service is calculated by multiplying the price of the product (P) by
the quantity of the product sold (Q).
Total revenue (TR) is therefore P x Q or PQ. Should a producer decide to change the price of the product then the
effect on total revenue will depend on the relative sizes of the change in price and the change in quantity
demanded, ie the size of the price change with respect to the size of the change in quantity supplied. Remember,
price and quantity demanded move in the opposite direction. How exactly do changes in the relative sizes of price
(P) and quantity supplied (Q) affect total revenue (TR)?
 In the case where a change in the price of a product leads to a proportionately larger change in the quantity
demanded (ie, if we change the price of the product by 10% and the result is that quantity demanded changes
by 20%, in the opposite direction of course), then the price elasticity of demand is greater than one or ep>1
and as such the total revenue will change in the opposite direction to the price change (ie, decrease price =
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increase total revenue). Remember, total revenue is calculated as TR = PQ. So long as the price elasticity of
demand is greater than 1 (ep>1), total revenue will increase as the quantity sold (Q) increases.
 In the case where the change in price leads to an equi-proportional change in the quantity demanded (ie if
we change the price of the product by 10% and the result is that quantity demanded changes by 10% as well,
in the opposite direction of course), then the ep = 1 and total revenue will remain unchanged. In the case
where the price elasticity of demand is equal to one (ep = 1) the total revenue (TR) of the firm has reached its
maximum.
 In the case where a change in the price of the product leads to a proportionately smaller change in the quantity
demanded (ie if we change the price of the product by 10% and the result is that quantity demanded changes
by 5%, in the opposite direction of course), then ep < 1 and total revenue will change in the same direction as
the price (ie, raise the price = raise the total revenue). If the price elasticity of demand is less than one (e p <
1) then total revenue (TR) will fall as the quantity sold (Q) increases. (Mohr and Fourie, 2015: 108-109)
 Figure 6-2 illustrates the relationship between total revenue (TR), price (P), quantity sold (Q) and price
elasticity of demand (ep).
24Figure 6-2 The relationship between price elasticity of demand and total revenue
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6.3 Different categories of price elasticity of demand

There are five categories into which we can place our price elasticity of demand (ep) values, these five categories
are:
 ep = 0 –––> perfectly inelastic demand
 0 < ep < 1 (ie, ep is greater than 0 but less than 1) –––> inelastic demand
 ep = 1 –––> unit elastic demand or unitary elasticity of demand
 1 < ep < ∞ (ie, ep is greater than 1 but less than infinity [∞]) –––> elastic demand
 ep = ∞ –––> perfectly elastic demand
In the case of perfectly inelastic demand (ep = 0), consumers will plan to purchase a fixed amount of the product
regardless of the price which is charged. This can be shown graphically by drawing the demand curve as a vertical
line, as illustrated in figure 6-3 (a). In this case, producers can raise their revenue by increasing the price charged
for the product. As the quantity demanded does not change, raising price results in an increase in total revenue.
Remember TR = PQ.
In the case of inelastic demand (0 < ep < 1), the percentage change in quantity demanded is smaller than the
percentage change in price (remember, in the opposite direction!). The demand curve which illustrates this case
is that of a steeply sloped demand curve (figure 6-3 b). The steep slope of the demand curve serves to illustrate
the fact that the percentage change in quantity is smaller than that of the price change. As a result of the fact that
the quantity demanded changes proportionately less than the change in price, producers have an incentive to raise
their prices in order to increase their revenue (remember what was said earlier). Likewise, there is no reason why
producers would decrease the price of their product as the revenue received from the increase in quantity
demanded will not offset the revenue lost due to the decrease in price.
In the case of unitary elasticity (ep = 1), the demand curve used to illustrate the properties of unitary elasticity is
a rectangular hyperbola, as illustrated in figure 6-3 (c). What this graph illustrates is that the percentage change in
quantity demand is equal to percentage change in the price of the product. In this case, as the proportional (ie
percentage) changes in quantity demanded and price are the same, producers would not gain anything by
increasing or decreasing the price of the product.
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25Figure 6-26 The different categories of price elasticity of demand

Elastic demand (1 < ep < ∞), is illustrated by a relatively flat demand curve (Figure 6-3 d). The demand curve
graphically illustrates the property of elastic demand, this being the fact that the percentage change is quantity
demanded is greater than the percentage change in price. When producers are faced with elastic demand,
decreasing the price of the product will raise the total revenue received by producers (this is as a result of the
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property of elastic demand, also remember TR = PQ). There is no incentive to raise the price charges for the
product as this would decrease total revue (the opposite of decreasing the price will occur).
Perfectly elastic demand (ep = ∞) is the case where consumers are willing to purchase any quantity of goods at
a certain price, raising the price of the good will result in the quantity demanded falling to zero (even if the price is
only raised slightly). Perfectly elastic demand is shown graphically as a horizontal line, as in figure 6-3 (e).
Note: It should be kept in mind that an increase in total revenue (TR) is not the same as an increase in total profit.
Total revenue is simply the income received from selling a certain amount of product (Q) at a price of (P), that is
why TR = PQ. Total profit however, is not only a function of these two variables, but also a function of cost, which
can change with output.
6.4 Determinants of the price elasticity of demand

In what follows the determinants of price elasticity of demand will be discussed.
There are three determinants if elasticity:
6.4.1 Number of substitutes
6.4.2 Degree of complementarity
6.4.3 Type of want satisfied
6.4.4 Time
6.4.5 Proportion of income spent
6.4.6 Definition of the market
6.4.1 Number of substitutes

A key determinant in the price elasticity of demand for a product is the availability of substitutes. If there are a
large number of substitutes for a product, and if these substitutes are close in quality (or better in quality), then the
price elasticity of demand will be large.
Therefore, the larger the amount of substitutes available, and the closer these substitutes are to the product (or
the better they are), the greater will be the price elasticity of demand, ceteris paribus. The end result is that if a
product has close substitutes, and the price of the product is increased, then consumers will tend to switch to the
substitutes available (this occurs as the substitutes have now become cheaper in relation to the product, ie when
compared to the product). The product will therefore have an elastic demand.
Examples of goods which tend to be close substitutes for each other include: mutton and beef, hamburgers and
hot dogs, Nike – Adidas and Reebok shoes, and bus and taxi services. In the same way that goods with close
substitutes tend to have elastic price elasticity of demand, goods with no close substitutes will tend to have demand
which is inelastic.
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6.4.2 Degree of complementarity

The degree of complementarity of the product is another determinant in the elasticity of the product. You may not
have noticed, but there are products which we use jointly with others (rather than on their own), for example salt
and food, petrol and cars and dvd’s and dvd players. In the case of complements, the price elasticity of demand
for a good tends to be low (inelastic), ie changes in quantity are not very responsive to changes in price.
Take salt for example, salt is used jointly with food, you do not purchase salt only for the purpose of consuming
salt on its own. As a result your demand for salt will not only depend on the fact that you want to consume salt, but
it will depend on other factors as well (it will also depend on your desire to consume other goods). As such, you
will not simply reduce your consumption of salt if the price of salt increases as there are a host of factors which go
hand in hand with its consumption (ie complements). The result is that your demand will be inelastic.
6.4.3 Type of want satisfied

The type of want satisfied by the product also plays a role in determining the how responsive demand will be to a
change in price, ie what the price elasticity of demand will be. Demand for necessities tends to be inelastic whilst
demand for luxury goods and services tends to be elastic.
There are no set rules for whether a goods or service is a necessity or a luxury good, however what can be stated
is that if a good or service has a relatively inelastic demand it is considered a necessity and if it has a relatively
elastic demand it is considered a luxury good. Examples of necessities include basic foods, electricity, petrol and
medical care. Examples of luxury goods include swimming pools, recreational activities and motor vehicles. (Mohr
and Fourie, 2008: 164)
6.4.4 Time
In the long run the price elasticity of demand for a product tends to be more price elastic. We therefore have to be
mindful of the time period under consideration. Price changes may take a while before their effects are fully felt by
the market.
Take petrol for example, when the price of petrol changes people will not immediately cut back on their
consumption of petrol, rather they will stick to their current usage of petrol. As time passes however, the full effects
of the price rise will be felt (people now realize the effect of the increase on their spending money), and then people
will start to adjust their habits to lessen their petrol consumption. The price elasticity of demand will therefore be
more elastic in the long run. A good example of why elasticity is low (demand is unresponsive) in the short run is
the case of airline tickets.
If you had to fly out on short notice (maybe it is an emergency), you will be desperate to obtain a ticket for travel
as shopping around may not be an option or the matter may be very urgent. In this case you will not be choosy on
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what the price may be as you will want to secure a ticket, ie your demand for the ticket will be price inelastic. In the
long run however you can consider other options to flying (bus, taxi, car) or spend more time looking for a better
deal, therefore your demand will be price elastic.
6.4.5 Proportion of income spent

The proportion of income spent on the product also plays a role in determining the price elasticity of demand of a
product. The reasoning behind this is that as the proportion of income spent on the product increases, so too does
the price elasticity of demand for that product. Therefore, as a greater percentage (proportion) of income is spent
on the product, price changes for that product have greater effects on the consumer’s budget and therefore the
consumer will be more likely to be sensitive to changes. Similarly, products which make up a small percentage of
the consumer’s budget are said to have lower elasticity’s (hardly any change in quantity demanded), as the impact
of a price change for the product would have a small effect on the budget.
Take matches for example, even if you are a smoker, matches contribute such a small portion of the budget (at 50
cents, even if 10 boxes are bought every month it is still only R5) that should the price of matches change (say by
10%), your consumption (usage) of matches is unlikely to change (you are now spending R5.50, still a small
amount).
6.4.6 Definition of the market

A broad definition of the market tends to make demand for the product more elastic. For example, as price of cars
increase, consumers still continue to buy cars, because they still find cars a best alternative than motor cycles.
STUDY UNIT
64 MANCOSA
Economics 1A
Unit
7: The Theory of Production
and Cost ground To Supply)
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 Understand the different types of firms and  Calculate the figures on page 155 of the prescribed
the goals of the firm text book
 Distinguish between short run and long run  Answer the questions found in the workbook relating to
Unit
 Distinguish between fixed and variable inputs
 Explain the law of diminishing returns
 Draw the total average and marginal product

cost curves
 Explain the relationship between production

and cost in the short run
7.1 Introduction
7.2 Types of Firms
7.3 Goal of the firm
7.4 The concept of Revenue
7.5 The concept of costs
7.6 Production
7.7 The concept of profit
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7.1 Introduction
This study unit deals with the fundamental income, cost and production concepts required to analyse the
decisions of firms about the quantities to supply at various prices. This is an important study unit which lays
the foundation for the analysis of the equilibrium position of firms under perfect and imperfect competition for
study units 8 and 9.
7.2 Types of Firms

The most common types of firms in South Africa are individuals, proprietorships, partnerships, close
corporations, cooperatives, trusts and public corporations. We also have the informal businesses like street
hawkers, vendors and illegal trading. Not all firms function the same way. Smaller businesses tend to have
only one product or service whilst larger businesses sell a variety of products.
7.3 Goal of the firm

The main goal of every firm is to maximize profits. If a firm is not profitable it will not be able to operate in the
long run.
7.4 The concept of Revenue

Total revenue(TR) is defined as the total value of sales and is equal to price (P) multiplied by quantity(Q).
TR = P X Q (or simply PQ)
Average revenue is equal to total revenue (TR) divided by the quantity.
AR = TR = PQ (=P)
Q Q
Marginal revenue (MR) is the additional revenue earned by selling an additional unit of the product.
MR = TR (or PQ)
Q Q
7.5 The concept of costs

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

Profit is the difference between revenue and cost:
Profit = Revenue - Cost

In other words, a firm's profit is the difference between the revenue it earns by selling its product and the cost of
producing it. The economist's definition of profit is, however, not the same as the accountant's definition of profit.
As economists, we distinguish between total (or accounting) profit, normal profit and economic profit:
- Total (or accounting) profit is the difference between total revenue from the sale of the firm's product(s) and
total explicit costs;
- Normal profit is equal to the best return that the firm's self-owned, self-employed
resources could earn elsewhere;
- Economic profit is the difference between total revenue from the sale of the firm's
product(s) and total explicit and implicit costs (i.e. the total economic, or opportunity,
costs of all resources)
Therefore, it can be stated that:

Accounting profit = total revenue - total explicit costs
= normal profit + economic profit
Economic profit = total revenue - total costs (explicit and implicit)

= accounting profit - normal profit
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7.6 Production
Production is the physical transformation of inputs into output.
7.6.1 Fixed and variable inputs

Firms use fixed inputs and variable inputs.
A fixed input is defined as an input of which the quantity cannot be altered in the short-run. By contrast, a variable
input is one of which the quantity can be changed in the short-run.
In the long-run there are no fixed inputs - all the inputs are variable. In other words, the long-run is a period that is
long enough to change the quantity of all the inputs into the relevant production process.
In the short-run, a firm can expand output only by increasing the quantity of its variable inputs. The relationship
between inputs and output is called a production function.
7.6.2 The short-run production function

In a given state of technology, there is a relationship between the quantity of inputs and the maximum output that
can be obtained from these inputs. This relationship is called a production function and can be expressed in the
form of a table (or schedule), an algebraic equation or a graph.
A maize farmer's simple production function is presented as a schedule in Table 7.1.\
2Table 7.1 Production schedule of a maize farmer with one variable input
The production function (or schedule) shows that if no labour is applied to the 20 units of land, no maize will be
produced. The production function further illustrates that if one unit of labour is employed, 16 tons of maize can
be produced.
The production schedule can also be represented in the form of a graph. The total product of labour in Table 7.1
is presented graphically in Figure 7.1 (a). To facilitate reference, Figures 7.1(a) and 7.1(b) are presented together.
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27Figure 7-1: Total, average and marginal product of labour
The table and graph show that as the quantity of labour is increased, total product (TP) increases from zero at an
increasing rate, then starts increasing at a decreasing rate until a maximum point is reached, after which TP
declines. This S-shape of the total product curve reflects the law of diminishing returns, or the law of diminishing
marginal returns.
To formulate the law of diminishing returns, we need to first explain average product and marginal product.
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7.6.3 Average and marginal product

The average product (AP) of the variable input is simply the average number of units of output produced per unit
of the variable input. It is obtained by dividing total output (TP) by the quantity of the variable input (N). The
calculation of AP is illustrated in Table 7.2
3Table 7.2: Production schedule of a maize farmer with one variable input
The highest average product (29 tons) is reached when 5 units of labour are employed. The figures in
column 4 clearly show that AP increases until the fifth labourer is employed and then declines to only
18,70 tons when 10 labourers are employed.
The marginal product (MP) of the variable input is the number of additional units of output produced by adding
one additional unit (the marginal unit) of the variable input.
The highest marginal product shown in Table 7.2, namely 35 tons, occurs when the fourth unit of labour is
employed. The marginal product of the fifth unit of labour is less than 35 tons. Once the maximum marginal
product is reached, it keeps on declining. The marginal product of 9 units is equal to zero. The marginal products
of additional units of labour are negative, which means that their employment causes total product to decline. Once
a limit is achieved, the workers get in each other's way, are given jobs too specialised to keep them occupied each
day, or get onto each other's nerves.
The information in columns 4 and 5 of Table 7.2 are depicted in Figure 7.1(b). From Figure 7.1 and Table 7.1 it is
clear that:
The law of diminishing returns states that as more of a variable input is combined with one or more fixed
inputs in a production process, points will eventually be reached where first the marginal product, then
the average product and finally the total product start to decline.
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7.6.4 Comparison of total, average and marginal product

The total, average and marginal product of labour are all based on the same basic information and are, therefore,
interrelated.
- TP is S-shaped. In other words, as the variable input is increased, TP increases from zero at an increasing
rate, then at a decreasing rate, reaches a unique maximum point and then decreases.
- AP and MP are shaped like inverted "U"s, i.e. as the variable input is increased, they
rise at declining rates, reach maximum points and then decrease at increasing rates.
- MP reaches its maximum before AP reaches its maximum. (Figure 7.2)
28Figure 7-2: Marginal product and average product
- Before AP reaches a maximum, MP lies above AP.

- MP equals AP at its maximum point.
- After the maximum point of AP is reached, MP lies below AP.
- MP equals zero where TP reaches its unique maximum.
7.7 Cost
A firm's costs consist of fixed and variable costs.
7.7.1 Fixed and variable costs

A fixed input cannot be altered in the short-run. Since the number of units of land is fixed and the price (rental) of
using a unit of land is given, the cost of using the land is fixed. Fixed costs remain constant irrespective of the
quantity of output produced.
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The quantity of the variable input can be varied in the short-run. In the case of the maize farmer, labour is the
variable input. The cost of labour to the firm for the relevant period can, therefore, be calculated by multiplying the
number of units of labour employed, by the price per unit of labour. Variable cost is defined as cost that changes
when total product changes - it represents the cost of the variable input(s).
Table 7.3 illustrates the relationship between the short-run production function and the short-run total cost
function of the maize farmer.
4Table 7.3: Total, fixed and variable cost schedules of a maize farmer
Assume that the cost of a unit of the fixed input (land) for the growth season is R450. Therefore, the cost of twenty
units is 20 x R450 = R9 000, irrespective of the quantity of maize produced during the growth season or the quantity
of the variable input (labour) used. This represents the total fixed cost (TFC) of producing the various quantities
of output indicated in Table 7.3.
Suppose the price of a unit of labour for the full growth season is R2 400. To obtain the cost of labour, we have to
multiply the units of labour (e.g. 3) by the price per unit of labour (e.g. 3 x R2 400 = R7 200).
The total cost (TC) is the sum of the total fixed cost (TFC) and the total variable cost (TVC) associated with each
level of production.
The three cost schedules can be represented in graphical form (Figure 7.3) as cost functions or cost curves.
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Total Product
29Figure 7-3: Three total cost curves
The total fixed cost function or curve (TFC) is a horizontal line with an intercept of
R9 000 irrespective of total product.
The total variable cost function or curve (TVC) has a reversed S-shape. It starts at the origin and increases at a
decreasing rate up to a point. Thereafter TVC increases at an increasing rate.
The total cost function or curve (TC) has the same shape as the variable cost function, but does not start at the
origin. It starts above the origin at the point on the vertical axis which represents the total fixed cost. Total cost
equals total fixed cost plus total variable cost.
YOU ARE REQUIRED TO UNDERSTAND HOW TO CALCULATE THE FIGURES ON PAGE 155 OF THE
PRESCRIBED TEXT
STUDY UNIT
74 MANCOSA
Economics 1A
Unit
8: Perfect Competition
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 Define perfect competition  Answer the questions found in the workbook relating to
Unit
 Understand the conditions necessary for
perfect competition to exist
 Explain the demand curve of a perfect

competitor
 Determine the short run equilibrium of a firm

under perfect competition
 Understand why profits are only maximized

along the rising part of the marginal cost
curve
 Distinguish and graphically illustrate

whether a firm is making an economic profit,
normal profit or an economic loss
 Explain the supply curve of the firm and

market supply curve
 Understand the long run equilibrium

position of the firm under perfect
competition
 Define perfect competition
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8.1 Introduction
8.2 Defining Perfect competition
8.3 Conditions necessary for perfect competition to exist
8.4 The demand for the product of the firm
8.5 The short run equilibrium of the firm under perfect competition
8.6 Equilibrium in terms of marginal revenue and marginal cost
8.7 The Supply curve of the firm and the market supply curve
8.8 The equilibrium of the industry under perfect competition
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8.1 Introduction
Since perfect competition is the benchmark against which all other market structures or types of competition
are measured, this is an important study unit.
This study unit explains what perfect competition means, and analyses the decisions of an individual firm
operating under conditions of perfect competition as well as the equilibrium position of a perfectly competitive
firm.
8.2 Defining Perfect competition

Perfect competition occurs when none of the individual market participants (i.e. buyers or sellers) can influence
the price of the product. The price is determined by the interaction of demand and supply and all the participants
have to accept the prices.
8.3 Conditions necessary for perfect competition to exist

Perfect competition exists if the following conditions are met:
- There must be a large number of buyers and sellers of the product. Each firm only
supplies a small quantity of the total market supply.
- There must be no collusion between sellers.
- All the goods in the market must be identical
- Buyers and sellers must be completely free to enter or leave the market.
- All the buyers and sellers must have perfect knowledge of market conditions.
- There must be no government intervention influencing buyers or sellers.
- All the factors of production must be perfectly mobile.
In these markets, no individual firm has any market power - all firms are price takers.
8.4 The demand for the product of the firm

The position of the individual firm under perfect competition is illustrated in Figure 8.1.
30Figure 8-1: The demand curve for the product of the firm under perfect competition
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The graph on the left shows that the price of the product is determined in the market by demand and supply. The
firm can sell its whole output at that price. This is indicated by the horizontal line on the right. This line is the
demand curve for the product of the firm.
It is also called the firm's sales curve, the firm's demand curve, or the total demand curve facing the firm. The
firm's average revenue (AR) and marginal revenue (MR) are equal to the price of the product (MR = AR = P). The
firm's total revenue can be represented graphically by a straight line which starts at the origin and which has a
slope equal to the price of the product, as shown in Figure 8.2.
31Figure 8-2: The total revenue curve
8.5 The short run equilibrium of the firm under perfect competition
We now examine the short run equilibrium (or profit-maximising) position of the firm under conditions of perfect
competition.
Since the firm under perfect competition does not have to make any pricing decisions (price-taker) - it can only
choose the output at which it will maximise its profits, i.e. where MR = MC or where the positive difference between
TR and TC is at its maximum.
8.5.1 Equilibrium in terms of total revenue and total cost

The total cost curve is shaped like a reversed S, as illustrated in Figure 8.3. In the short-run, the total cost curve
does not start at the origin, since part of the firm's cost is fixed.
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32 Figure 8-3: Total short-run costs of the firm
Total revenue of the firm under perfect competition was illustrated in Figure 8.2 as a straight line with a positive
slope which starts at the origin and has a slope equal to the price of the product. In Figure 8.4, we combine such
a total revenue (TR) curve with the total cost (TC) curve.
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33Figure 8-4: Total revenue, total cost and total economic profit
Economic profit is the difference between TR and TC. Graphically, it is measured by the vertical distance
between the TR curve and the TC curve. At levels of output below Q1 in Figure 8.4, TC is greater than TR and the
firm, therefore, incurs economic losses (indicated by the shaded area). At Q1, the firm's total economic profit is
zero (since TR = TC). Between Q1 and Q2, the firm makes an economic profit at each level of output (indicated by
the shaded area), since TR > TC.
At Q2, total economic profit is zero once more and at higher levels of output the firm again incurs economic losses.
The firm's profit will be maximised where the positive vertical distance between TR and TC is the greatest (i.e.
somewhere between Q1 and Q2).
8.6 Equilibrium in terms of marginal revenue and marginal cost

It has been explained earlier that any firm maximises its profits where marginal revenue (MR) is equal to marginal
cost (MC). In Figure 8.1 we showed that the firm's marginal revenue (MR) is equal to the market price (P) of the
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product. The profit maximising rule in the case of a perfectly competitive firm can, therefore, also be stated as P
= MC (since MR = P). This rule is further clarified in Figure 8.5 below.
34Figure 8-5: Marginal revenue and marginal cost of a firm operating in a perfectly competitive market
Marginal revenue (MR) is equal to the price (P) of the product. Marginal cost (MC) increases as more units of the
product are produced. Profit is maximised where MR (or P) = MC, i.e. at an output level of 4 units. At lower levels
of production, profit can be increased by expanding production. If more than 4 units of the product are produced,
profits start falling.
The firm's profit position can be illustrated clearly by adding average cost (AC) to the diagram showing average
revenue (AR), marginal revenue (MR) and marginal cost (MC). A firm's profit per unit of output (or average profit)
is equal to the difference between average revenue (AR) and average cost (AC).
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As long as AR is greater than AC, the firm is earning an economic profit. When AR is equal to AC, the firm only
earns a normal profit. The normal profit is the opportunity cost of self-employed resources (such as the owner's
time and capital) and that normal profit is included in the firm's cost.
In Figure 8-6, there are three different possibilities. The same set of unit cost curves is used throughout, but
there are three different market prices, and, therefore, three different AR and MR curves.
Figure 8-6: Different possible short run equilibrium positions of the firm under perfect competition
35Figure 8-6 (a): Surplus (Economic) Profit
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36Figure 8-6 (b): Normal Profit
37Figure 8-6 (c): Loss
In Figure 8-6 (a), the market price is P1 which is equal to the firm's AR and MR. Profit is maximised where MR (=
P1) is equal to MC. This occurs at a quantity of Q1. At Q1, the firm's average revenue AR (=P1) is greater than its
average total cost AC (C1). The firm thus makes an economic profit per unit of production of P1 - C1.
The firm's total profit is given by the shaded area C1P1E1M which is equal to the profit per unit of output (P1- C1)
multiplied by the quantity produced (Q1). Alternatively, the area representing total profit can be obtained by
subtracting the firm's total cost from its total revenue. The firm's total revenue is equal to the price of the product
P1 multiplied by the quantity produced (and sold) Q1. This is equal to the area OP1E1Q1. Similarly, the firm's total
84 MANCOSA
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cost is obtained by multiplying its average cost C1 by the quantity produced Q1. This is equal to the area OC1MQ1.
The difference between these two areas is the shaded area C1P1E1M, which represents the firm's total economic
profit.
In Figure 8-6 (b), the market price is P2. It is equal to MC at the point where MC intersects AC. The corresponding
level of output is Q2. At that level of output AR is equal to AC and the firm does not earn an economic profit. It
does, however, earn a normal profit since all its costs, including the opportunity cost of self-owned, self-employed
resources are fully covered. Point E2 in Figure 8-6 (b) is called the break-even point.
In Figure 8-6 (c) the market price (firm's AR and MR) is equal to P3. MR or price is equal to MC at a quantity of
Q3. At Q3, the firm's average revenue AR is lower than its average cost AC. It, therefore, makes an economic
loss per unit of output, equal to the difference between C3 and P3. If the price P (=AR) lies above the minimum
AVC (not shown in diagram), the firm will continue production in the short-run. If it lies below the minimum AVC,
the firm will close down.
The equilibrium condition of the firm under perfect competition may be summarised as follows:
Profit is maximised when a firm produces an output where marginal revenue equals marginal cost,
provided that marginal cost is rising and lies above the minimum average variable cost.
8.7 The Supply curve of the firm and the market supply curve
The rising part of the firm's MC curve above the minimum of AVC is the firm's supply curve. In Figure 8-
7, this is illustrated by the part of the MC curve above point b.
38 Figure 8-7: The supply curve of the firm
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The rising portion of the firm's marginal cost curve above the minimum of its average variable cost curve at point
b is the firm's supply curve. If the price is P5, the firm will not produce at all. If the price is P4, the firm will be at its
close-down point (b) and it is immaterial if it shuts down or continues production. If the price is P3, the firm will
minimise its economic losses by producing a quantity Q3, corresponding to point c. If the price is P2, the firm will
make normal profit (i.e. it will break even) at point d, which corresponds to a quantity Q2. If the price is P1, the firm
will maximise economic profit at point e, i.e. it will produce a quantity Q1.
8.8 The equilibrium of the industry under perfect competition

To conclude the analysis of perfect competition, we refer briefly to the equilibrium of the industry (i.e. the
collection of firms that supply a specific product in the market). The industry will only be in equilibrium in the
long-run if all the firms are making normal profits. Only then will there be no inducement for new firms to
enter the industry or for existing firms to leave the industry. With complete freedom of entry and exit, there will
always be some movement (i.e. disequilibrium) in the industry when firms are making economic profits or losses.
STUDY UNIT
86 MANCOSA
Economics 1A
Unit
9: Imperfect Competition
MANCOSA 87
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 Understand the differences and  Answer the questions found in the workbook relating to
similarities between the different Unit
market structures
 Explain the equilibrium position of

each market under imperfect
competition i.e. monopoly,
monopolistic competition, and
oligopoly
 Compare the above to a firm under

perfect competition
9.1 Introduction
9.2 The different market structures
9.3 Monopolistic competition
9.4 Oligopoly
 Mohr, P. & Fourie, L. (2015) Economics for South African Students. (5th
88 MANCOSA
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9.1 Introduction
In the previous study unit, we examined the behaviour of a firm in a perfectly competitive market.
Perfect competition is a theoretical construct, which serves as a standard, or norm against which we can compare
other types of markets. In the real world, there are many different types of markets.
Economists distinguish between four broad sets of markets (or different types of competition): perfect
competition, monopoly, monopolistic competition and oligopoly.
In this section, we examine the last three types, which are usually collectively referred to as imperfect
competition.
The theory of the behaviour of firms (i.e. the theory of the supply side of the goods market) is called the theory
of the firm. This theory is usually based on the assumption that all firms seek to maximise their profits.
In this section, we examine the behaviour of firms under conditions of imperfect competition.
Imperfect competition refers to a situation in which at least one of the conditions of perfect competition listed in
8.3 is not satisfied.
The three broad categories of imperfect competition are
 Monopoly
 Monopolistic competition
 Oligopoly
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9.2 The different market structures

The key features of the four different types of market structure are summarised in Table 9.1.
5Table 9.1: Summary of market structure
9.2.1 Monopoly
In its pure form, monopoly is a market structure in which there is only one seller of a good or service that has
no close substitutes. Another requirement is that entry to the market should be completely blocked. The
single seller is called a monopolist and the firm is called a monopoly.
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 The equilibrium (or profit-maximising) position of a monopoly

In principle, the profit maximising decision of a monopoly is exactly the same as that of any other firm. Like any
other firm, a monopoly should produce where marginal revenue (MR) is equal to marginal cost (MC) - (the profit
maximising rule), provided that average revenue (AR) is greater than minimum average variable cost (AVC) - (the
shut-down rule).
 Total, average and marginal revenue under monopoly

Since the monopoly is the only supplier of the product of the industry, the demand curve for the product of a
monopolistic firm is the market demand curve for the product of the industry. Since the market demand curve
slopes downward, the monopoly can only sell an additional quantity of output if it lowers the price of its product.
(See Table 9.2)
6Table 9.2: Average, total and marginal revenue when the demand curve for a firm's product slopes
downward
Figure 9.1 demonstrates that under monopoly, a firm faces a downward-sloping demand curve which is also its
average revenue curve AR, as shown in (a).
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39 Figure 9-1: Marginal, average and total revenue under monopoly (or any other form of imperfect
competition)
The marginal revenue curve MR is also downward-sloping and lies halfway between the AR curve and the price
axis. The corresponding total revenue curve TR is shown in (b). When MR is positive, TR increases; when MR is
zero, TR remains unchanged; and when MR is negative, TR falls. These relationships apply to all forms of
imperfect competition.
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 The equilibrium of the firm under a monopoly

The equilibrium position of the firm under monopoly is illustrated in Figure 9.2.
40 Figure 9-2: The equilibrium of the firm under monopoly
The figure shows the average revenue AR, marginal revenue MR, average cost AC and marginal cost MC of a
monopoly. The monopolist's profit is maximised by producing a quantity Q1 at a price P1. The economic profit
per unit is the difference between M1 and K1 (or between P1 and C1). The firm's total economic profit is the
shaded area C1P1M1K1.
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 Monopoly verse perfect competition
41 Figure 9-3: Comparison between monopoly and a perfectly competitive industry
AR is the demand curve for the product of the industry and MR is the monopoly's marginal revenue curve. Marginal
cost MC is also the supply curve S for the perfectly competitive industry. Under perfect competition, long-run
equilibrium Ec is established by the interaction of demand AR and supply S at a price Pc and a quantity Qc.
Equilibrium for the monopolist Em is at a price Pm and a quantity Qm.
Under monopoly, the equilibrium price is higher, and the equilibrium quantity lower, than under perfect
competition, ceteris paribus.
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9.3 Monopolistic competition

Between the extremes of monopoly and perfect competition, there is a range of actual market organisations.
Some industries (like the brick manufacturing industry) consist of a few large firms and a large number of small
ones. Other industries (like motor manufacturing) consist of a few large firms only. In some industries (like the
clothing industry), there are many firms producing a variety of similar products. In other industries (like the
cement industry), a few large firms produce virtually identical products.
The first type of market in the spectrum between the extremes of perfect competition and monopoly is
monopolistic competition. The conditions for monopolistic competition can be summarised as follows:
- Each firm produces a distinctive, differentiated product;
- Each firm, therefore, faces a downward-sloping demand curve for its particular product;
- There is a large number of firms in the industry; and
- There are no barriers to entry (or exit).
9.3.1 The equilibrium of the firm under monopolistic competition

The short-run equilibrium and the long-run equilibrium of a monopolistically competitive firm is illustrated in
Figure 9-4.
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42 Figure 9-4: The equilibrium of the firm under monopolistic competition
Short-run and long-run equilibrium positions of a monopolistically competitive firm are illustrated in (a) and (b),
respectively. In both cases, D is the demand curve for the product of the firm (or average revenue AR), MR is
marginal revenue, MC is marginal cost and AC is average cost. The firm is in equilibrium where MR = MC. In the
short-run conditions illustrated in (a), the firm is in equilibrium at output Q1 and price P1. The firm's total profit is
illustrated by the shaded rectangle.
In the long-run, however, the firm only makes a normal profit at an output of Qe and a price of Pe. At that price-
output combination, AR is tangent to AC, MR = MC and AR = AC.
9.3.2 Monopolistic competition versus perfect competition

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

Different oligopoly models are not discussed in this module, but to give you some idea of what oligopoly models
are, one of the classic oligopolistic theories (the kinked demand curve) is outlined.
The kinked demand curve, as illustrated in Figure 9.5, does not explain how price and output are determined under
oligopoly, but it does illustrate the importance of interdependence and uncertainty in oligopolistic markets. It is
one of the possible explanations for the observed degree of relative price stability under oligopoly.
MANCOSA 97
Economics 1A
43 Figure 9-5: The kinked demand curve
The kink in the demand curve is at the market price P1 with the amount which the firm produces at Q1; this is the
point of profit maximisation. The significance of P1 is that oligopolists will be wary of moving away from it
individually because they cannot be certain of the reactions of their rivals. The curve is relatively elastic above P1
and inelastic below it. Hence, if firms raise prices and their rivals do not follow, they will lose market share; if they
cut prices, their rivals will follow to protect their own position, which means that all firms will end up with lower
prices and profits on unchanged market shares. Consequently, prices will be inflexible at P1.
There are three inferences that can be made:
- There is unlikely to be permanent price competition under oligopoly;
- Firms will compete through non-price methods such as advertising, promotions
and product development; and
- Firms may engage in collusive agreements and form cartels or consent to price
leadership arrangements.
98 MANCOSA
Economics 1A
9.4.2 The shortcomings of the kinked demand curve model are as follows:
- The theory is difficult to test effectively because it does not actually explain
how the price is initially determined;
- The model takes no account of non-price competition which is an important feature
of the market; and
- There are other reasons for infrequency of price adjustments such as their cost
and lost customer goodwill which may be as equally important as the more specific
market pressures.
STUDY UNIT
MANCOSA 99
Economics 1A
Bibliography
 Berg, D. And Ward, D. (2007). Economics For Business. Second Edition. United Kingdom: Mcgraw-
Hill Education.
 BEGG, D. Et Al. (2000). Economics. London: Mcgraw – Hill
 BLACK, P. And HARTENBERG, T. (2000). Economics Principles And Practice. Cape Town: Pearson
Education
 CASE, K.E. And FAIR, R.C. (1999). Principles Of Economics. New Jersey: Prentice Hall International
 LIPSEY, R. G. And CHRYSTAL, K. A. (2002). Principles Of Economics.New York : Oxford University
Press
 Mohr, P. & Fourie, L. (2015). Economics For South African Students. (5th Edition) Pretoria: Van Schaik
 MOHR, P., FOURIE, L. And ASSOCIATES (2004), Economics For South African Students. Pretoria:
JL Van Shaik
 Parkin, M. (1990). Microeconomics. Reading: Addison – Wesley
 Samuelson, P.A. And Nordhaus, W.D. (1983). Economics. United States: Mcgraw Hill
 Schiller, B. R. (2013). Essentials Of Economics (13th Edition). New York: Irwin Mcgraw – Hill
 Schiller, B. R. (1999). Essentials Of Economics. New York: Irwin Mcgraw – Hill
 Schiller, B. R. (2008), The Economy Today (11th Edition), Boston: Mcgraw – Hill
 Schiller, B. R. (2006), The Economy Today (10th Edition), Boston: Mcgraw – Hill
 Smit, P.C. And Dames D. J. (1997). Economics A South African Perspective. Cape Town: Juta And Co
100 MANCOSA
Economics 1A
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ECONOMICS 1A

 Bachelor of Commerce in Accounting (New)

MANCOSA - BBA Year 1 i ii

Figure 4-1 The production possibilities curve once again ................................................................................. 17

Figure 2-2 Improved technique for producing capital goods ............................................................................. 18

Figure 2-3 Improved technique for producing consumer goods........................................................................ 19

Figure 4-1 Anne Smith`s weekly demand for tomatoes .................................................................................... 31

Figure 4-2 The market demand curve............................................................................................................... 32

Figure 4-3 A movement along a demand curve ................................................................................................ 33

Figure 4-4 Two substitutes: butter and margarine ............................................................................................ 35

Figure 4-5 Johnny`s annual supply of tomatoes ............................................................................................... 38

Figure 4-7 Shift of the supply curve: changes in supply.................................................................................... 40

Figure 4-7 Demand, supply and market equilibrium ......................................................................................... 41

Figure 5-1 Changes in demand ........................................................................................................................ 45

Figure 5-2 Changes in supply ........................................................................................................................... 47

Figure 5-3 Maximum prices .............................................................................................................................. 50

Figure 5-4 The welfare cost of maximum price fixing........................................................................................ 51

Figure 5-5 A Minimum price .............................................................................................................................. 52

Figure 5-6 The welfare costs of minimum price fixing ....................................................................................... 54

Figure 6-26 The different categories of price elasticity of demand ................................................................... 61

Figure 7-1: Total, average and marginal product of labour .............................................................................. 70

Figure 7-2: Marginal product and average product .......................................................................................... 72

Figure 7-3: Three total cost curves .................................................................................................................. 74

Figure 8-2: The total revenue curve ................................................................................................................. 79

Figure 8-3: Total short-run costs of the firm ..................................................................................................... 80

Figure 8-6 (a): Surplus (Economic) Profit ......................................................................................................... 83

Figure 8-6 (b): Normal Profit ............................................................................................................................. 84

Figure 8-6 (c): Loss........................................................................................................................................... 84

Figure 8-7: The supply curve of the firm ......................................................................................................... 85

Figure 9-2: The equilibrium of the firm under monopoly .................................................................................. 93

Figure 9-5: The kinked demand curve ............................................................................................................. 98

Table 9.1: Summary of market structure.......................................................................................................... 90

We hope you enjoy the module.

Aims of this module:

C. Learning Outcomes and Associated Assessment Criteria of the Module

LEARNING OUTCOMES OF THE MODULE ASSOCIATED ASSESSMENT CRITERIA OF THE

 Analyse how market forces of demand and supply

 Understand the concept of price elasticity of

 Understand the theory of production and costs

 Understand the different market structures

 Compare the salient features of each market

Understand the short-run and long-run equilibrium

D. Learning Outcomes and the Associated Assessment Criteria of the Units

E. How to Use this Module

G. Prescribed and Recommended Textbook/Readings

The prescribed and recommended textbooks/readings for this module is:

Special Feature Icon Explanation

LEARNING The Learning Outcomes indicate what aspects of the particular

ASSOCIATED The Associated Assessment Criteria is the evaluation of student

PRACTICAL Real examples or cases will be discussed to enhance

Unit Learning Outcomes and Associated Assessment Criteria

LEARNING OUTCOMES OF THIS UNIT: ASSOCIATED ASSESSMENT CRITERIA OF THIS UNIT:

 Explain the economic problem of scarcity

 Understand the concept of opportunity cost

 Illustrate the maximum amount of production

 Explain the reasoning why opportunity costs

1.2. Macroeconomics versus Microeconomics

1.3 Limited resources

1.4 The problem of scarcity

1.5 Opportunity costs

1.6 The Production Possibility Curve

1.7 Why do opportunity costs increase along the PPF?

Unit Learning Outcomes and Associated Assessment Criteria