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    Economics Textbook-Fundamentals of Economic Theory For Business

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    This is an Economics textbook published by L Greyling, H Van Zyn and A Wentzel.

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    Economics Textbook-Fundamentals of Economic Theory For Business

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    This is an Economics textbook published by L Greyling, H Van Zyn and A Wentzel.

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    ~ L GREYLING ~ HVAN ZYL ~ AWENTZEL Theory for Busii 2nd Edition Copyright © 2018, Arnold Wentzel, Lorraine Greyling & Hardus van Zyl Graphic design and layout: Kay-Bee Creatives cc, Johannesburg Publishers: ECORIG cc, Johannesburg Library of Congress Cataloguing-in-Publication Data Fundamental Economics ISBN 978-0-620-77198-6 Allrights reserved. No part of this publication may be reproduced, stored in ‘a retrieval system, of transmitted in any form, or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior permission, in writing, from the authors. Post Box 64; Heiderand; 6511 CHAPTER 1: ECONOMICS IS THE SCIENCE OF CHOICE What defines choice? 2 Why is choice inevitable? 3 How do you know you made a good choice? 4 Trade-offs as a way to represent choice problems 6 Using simple trade-offs to make better choices 9 Using trade-offs to approach more complicated choices 10 Models of trade-offs 13 Breaking through trade-offs - the secret to innovation 14 CHAPTER 2: BASIC CONCEPTS IN ECONOMICS 17 The scarcity problem 18 Economicmeans 18 Economicends 19 Objective 1: High and sustained economic growth 19 Objective 2:Price stability 19 Objective 3:High employment 20 Objective 4:Balance of payments stability 20 Objective 5: Equitable distribution of income 21 Ways to approach the scarcity problem 22 Free markets 22 Kinds of markets 22 How perfect markets work 23 How markets fail 24 The role of the government ina mixed economy 25 Government spending 25 Toxation 26 National budget 26 Government intervention through economic policy 27 The grammar of economic models 30 Economic objects 37 Economic subjects 33 Households 33 Firms 34 Table of Contents i Financialintermediaries 34 Government 36 Foreign sector 36 Verbs 37 CHAPTER 3: UNDERSTANDING CHANGES INTHE ECONOMY 39 How economists make sense of the economy 40 Modelling the economy 40 How we build economic models 40 Greularflow 40 Measuring the economy 43 Price stability 43, Measures of inflation 43 Problems in measuring inflation 45 The importance of measuring inflation 45 Other kinds of inflation 47 Economic growth 47 National accounts 47 Calculating GOP in national accounts 49 Real & nominal GDP 50 Going beyond GDP 52 Problems with measuring economic growth 52 Employment 53 Measures of unemployment 53 Kinds ofunemployment 55 Balance of payments stability 56 Balance ofpayments 56 Exchangerates 57 Income distribution 8 Sources of economic data 59 CHAPTER 4: THE BUSINESS ENVIRONMENT OF THE FIRM. ¢p Market demand conditions 61 The linear demand function 67 Consumer sensitivity analysis 69 Understanding rational consumer behaviour 78 wv Fundamental conomleTheart for Business Cost and supply/capacity conditions. 95 ‘The concept of supply and market-clearing 95 Importance of production and input efficiencies 104 Cost efficiency of the firm in the short- andlongrun 126 he competitive environment of the firm 143 Concepts of normal profit, economic profit and measurement of level of competitiveness 143 Ahighly competitive business environment | 143 ‘The monopoly business environment 154 Mote realistic business environment: The case of monopolistic competition and oligopoly formation 162 Regulation of uncompetitive firm behaviour 170 Selective pricing practices 172 CHAPTER 5: MANAGING THE CHANGING ECONOMIC ENVIRONMENT 175 Why economic forces should inform strategy 176 Fundamentals of the business cycle 176 Phases ofthe business cycle 177 Policy responses to the business cycle 179 Indicators of the business cycle 187 Why we have business cycles 183 Business cycle and firm strategy 184 Functional view 184 Business cycle and different sectors 190 Some caution 191 CHAPTER 6: MONEY, INTEREST RATES AND FINANCIAL MARKETS | 192 Moneyand credit 193 Defining and measuring money 193 Nature of money 194 Money creation 195 Interest rates and fiat money 197 How central banks try to control the finan inflation 200 Maintaining stability in the banking system 22? maging interest rate movements 204 cle 204 ial system 200 Understanding and mar Understanding the short ~ term interest cy" Relationship between interest rates 205 Conducting business during and after financial crises 207 | able ofContents |v CHAPTER 7: INTERNATIONAL TRADE AND FINANCE Why dowe trade 270 Trade between countries 212 Trade restriction between countries 213 Institutions that promote international trade 215 International investment 216 Engaging in foreign investment 217 Countries’ responses to foreign investment 218 Recording international transactions 219 Foreignexchange 227 Basics of exchange rates 227 Trade, capital flows and exchange rates 22? Making money with floating exchange rates 223 How exchange rates are determined | 224 Managing foreign exchange risk 227 Why acountryisnota company 228 CHAPTER 8: THE ROLE OF GOVERNMENT 229 Rationale for the role of government | 230 & The allocation function 232 The distribution function 236 The stabilisation function 236 Government expenditure 240 Real expenditures versus transfers 247 Current expenditures versus capital expenditure 245 Taxation 243 Nature and functions of taxation 243 Principles of taxation 243 ‘The classification of taxation 246 Microeconomiceffects of tax changes 247 Taxation in South Africa 248 Other sources ofincome 749 Privatisation and deregulation 249 The budget as an economic document 250 Functions of the budget 250 Some basic fiscal concepts 250 ‘The South African budget 253 Ww Fundamental Economic Theory for Business Government debt 254 The growth of the public debt 254 CHAPTER 9: THE TOTAL EXPENDITURE MODEL 257 Consumption and savings by households 258 Keynesian psychological law 258 Planned consumption expenditure and savings 259 Capital formation 265 Returns 267 Costs 267 Planned capital formation 267 Simple two-sector model of income determination 271 Income and expenditure 271 Savings and capital formation 272 Income determination and the multiplier effect 273 ‘The government sector 275 Athree-sector model of income determination 275 Income determination and the multiplier effect 277 Theforeign sector 279 Income determination and the multiplier effect in the extended model 287 CHAPTER 10: TARGETS, INSTRUMENTS AND GOALS OF 22 MACROECONOMIC POLICY Policy interaction 284 Monetary and real sector interaction: Keynesian transmission Monetary and real sector interaction: crowding-out 287 Fiscal spending crowding-out 287 Financial crowding-out 289 sian full model: domestic economy, balance of payments and exchans mechanism 264 gerates 290 Keyne: Imports 290 Exports 297 Capital flows 297 Balance of payment: Exchange rates 293 Balance of payments adjust unintended consequences Expansionary monetary policy 295 Expansionary fisce! policy 296 n trade impact: improving foreign conditions 297 1s 292 ment process in the Keynesian model: law of 294 Foreigt Table of Contents vil - Aggregate market analysis: AD-AS analysis 298 Aggregate demand 298 Shifts of the aggregate demand curve 300 Factors affecting aggregate demand 301 Factors affecting consumption expenditure 307 Factors affecting investment expenditures 302 Factors affecting government expenditure 302 Factors affecting net exports (NX) 302 Aggregate supply 303 Shifts of the aggregate supply curve 305 Equilibrium in the AD-AS model 306 Macroeconomic adjustment process using the AD-AS model 307 Increase in aggregate demand 307 Decrease in aggregate demand 309 Supply-side shock: increase in supply 309 Supply-side shock: decrease in supply 317 GLOSSARY 312 \d this book... are you really? Think about it - are you exercising So, you are choosing to reat 32 What makes one thing a choice, and another thing 4 choice now? How do you know thi ‘no-brainer’? Understanding choice is where economics starts, and it is from this understanding that it develops a set of tools for making better choices. The skill of making better choices is not something to be underestimated. If you believe in free will, you will agree that life is a series of choices, The success (oF failure) experienced by individuals and firms can be largely ascribed to quality of their choices. In this book we will take you on a journey through the subject of Economics and its application to business. After studying it you will not only be able to understand the media reports about the economic environment, but more importantly, you will also be able to make better choices within this environment. Itall starts with knowing what it means to make a choice. This chapter explains what choice is and uses that idea to show how one can make better choices simply by thinking like an economist. Unlike the first chapters in other Economics textbooks, this chapter addresses few concepts, but discusses them in depth (the concepts are chaice, opportunity-cost, trade-off, marginal thinking and economic. models). The reason for this is that these concepts are threshold concepts - if you understand them, then all other economic concepts become easier to understand because you will be thinking like an economist. These threshold concepts are also the most useful concepts when making business decisions. Choice is defined by the act of sacrifice. Every time you choose you sacrifice the opportunity to pursue one or more real alternatives. For a choice to exist there must be alternatives. For things to be alternatives it has to be impossible to pursue them at the same time, so that choosing one involves sacrificing the others. Reading this book is a choice because you have many alternatives that cannot be Pursued at the same time. You are probably sacrificing the opportunity to sleep or spend Quality time with a loved one. Compare that to breathing. Breathing is not a choice - you do not have to give up reading this book while breathing, If an alternative is clearly better in all respects than other apparent alternatives, there is again no choice because it is obvious what to do. Or in other words, alternatives that are clearly worse in all respects are not real alternatives. Suppose | offer you R100 or R200 for the same job under the same conditions. There is no choice — less of one good thing is not areal alternative to more of the same thing, Taking the R200 is a no-brainer (meaning you dont have to think about it) Consider the act of breathing again, Breathing is nat a choice ~ there are no real alternatives. Breathing is a no-brainer. When you choose, you experience the Pain of giving uy le in some way so that there is the possibili, Fer os comething you find desirable Y of regret. For example, when someone chooses 1? a no-brainer. There is choice if she reali desires but has to give up when she | 2 | Fundamental Economic Theory fer Business il: 7 a rome bas Z : TO Oy AMbbrantonn ¢ eactly the same benefits or m i i fs alah april lore, then there would be no sacrifice required, and buying Economists fepresent choices as trade-offs, so that the sacrifice becomes clear. Consider figure 1.1 below. Points A and B in figure 1.1(a) show the consequences two different jobs igen oe red objectives: income and leisure time. Job A offers an income of R50,000 er month and 200 hours of leisure, while job B offers an income of R30.000 per month and 250 hours of leisure. A person would have to choose between job A and job B - whatever he chooses, he gives up something desirab ; : time, but gives up R20,000 per * le. If he chooses job B, he gains 50 hours of leisure In contrast, figure 1.1(b) does not involve a choice. Job D offers the same income and more leisure time than job C. Job C is clearly inferior and therefore not a real alternative. Taking job Dis ano-brainer. insummary, life isa series of choices. A choice occurs when one sacrifices the opportunity to pursue real alternatives. So, are you choosing to read this book? mal life or run a business without making choices. Choices It is impossible to live a no! u require the use of resources (means) in order achieve specific objectives (ends). The problem .d since resources are limited, so that achieving some ‘ts call this the scarcity problem and itis commonly subject of Economics is organised. is that not all objectives can be achieve objectives need to be sacrificed. Economist regarded as the central problem around which the s The original conception of the scarcity problem was by Lionel Robbins (1932) andis worth repeating here:*Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses’ (emphasis added), We have to choose because our means are too limited to be used to achieve all possible ends. to alleviate the scarcity problem by finding ways to achieve limited resources (means) available. Scarcity of resources means that hard choices need to be made regularly, but it also means that if we can make better choices then we will be able to achieve more with our limited resources. For example, a company with a human resources constraint may have to choose between a customer Economic theory seeks ways more objectives (ends) with th Chapter 1 3 loyalty Programme or it extending an existing product [in reat ie i However, if it can find ways to innovate or us agai hing a ne f w able todo tio atthe thee e the available skills more efficiently itn Let us return to the issue of whey Fesources (such as time) which your time is limited, you have your time. ther you are choosing to read this book, You have linn you can spend to achieve Many alternative Obje a have 1 ctives, sj to choose to read the book and Sacrifice alternatives ‘ | 2h How do. The word sacrifice has been deliberately repeated over the last few Pages, because'choices Sacrifice’ forces you to look at choice differently and so make better choices. When choosine you are likely to make a better choice if you consider what you are Sacrificing rather thar Possibly the best statement of this idea comes from the Dalai Lama: “Measure your success not by the things that you have gained, but by the things that you needed to give upin order to achieve your success” If you understood this, you would take sacrifices more seriously when making choices. him 8% interest per year. Managing the franchise is a full-time job, so he would have to resign his current job which pays R400 000 per year after tax. Vernon estimates that he will do better by buying the franchise because it is estimated to produce an annual net profit after tax of R450 000. i il is ? If he simply looks at income gained lewnaad apnea thal buying the teaches berms bemenaeties eat feat he eee hi Id be the wrong choice. He will end up i nt job in the first year. But that wou ic N a ee enae actually lose R14 000 in the first year! By buying the franchise Vert ; ves up his salary income of R400 000 plus the interest he oud Le oie le Hed 00 he would sacrifice income ot sult. ich comes to R64 000), so : f R464 ( hapaatie oie ma 000 more than he gains from the franchise, so leaving his job and buyi t franchise is a bad choice. a i look at it from another angle. By staying in his job he gains gt eon pings in interest. At the same time he sacrifices the aa oe regjobhe C en is ‘h the same conclusion again. i . He would reacl na B Ke Ea Ceo eaten he gains, so he should not leave his job. This may be su a sacrifices Ss as follows in Table 1.1. Table 1, Sacrifice relative to gain Riel. Sacrifice 450000 464 000 Gain _ 464000 450000 Sacrifice: gain ratio 0.9: j1031 What this table tells us is that if Vernon stays in his job, he sacrifices 97¢ for every R1 he earns, so he comes out ahead. But if he buys a franchise, he sacrifices R1,03 for every R1 he earns, so he loses out, From this we can draw a general rule when it comesto making choices: choose the alternative with the smallest sacrifice relative to the gain. But be careful ~ not all sacrifices need to be monetary. There are also intangible sacrifices such as time, freedom or flexibility that you need to value when considering the total sacrifice involved, Economists label this idea that choice involves sacrifice as‘opportunity cost’since every choice involves giving up the opportunity to gain something else. More formally, opportunity cost is the value of the next best alternative sacrificed as a result of making a choice. To evaluate a choice it is not necessary to compare it against all possible alternatives, only the best alternative sacrificed need to be considered. To illustrate: to be crowned world champion in boxing, the champion does not have to defeat all boxers, only the best one. The same with choices — you only need to consider the best alternative. The value of the next best alternative is the benefit you would have derived from that alternative minus the cost you would have incurred to pursue that alternative. This may seem simple, but many economists appear to complete miss it. Some years ago Robert Frank presented a large group of economists in the USA with this now classic puzzle which tested their understanding of opportunity cost. Only 22% of them got it right! Can you do better than the economists? Here it is: “You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50." it i i | value of everything The opportunity cost of going to the Eric Clapton concert is the total r you sacrifice to attend his concert. In this case, your next best alternative is attending the Dylan concert, and the value of that concert is $10 to you. This is the difference between the $50 that seeing his concert is worth to you (benefit) and the $40 you would have to pay for a ticket (cost). So (b) is correct. So, do you think you have made a good choice by reading this book? sing opportunity cost to think about your firm’s core business Firms try to establish what their core business is as a way to manage their scarce resources. Intelligen; firms will allocate most of their scarce resources to their core business because that is where they get the “most bang for their buck." Finding the core business is not easy, but thinking in terms of opportunity cost makes it easier. Afirm consists of many different activities that help the firm to achieve its mission. Some of these activities are core, and some are not. Instead of thinking what a particular activity adds to the business, it is more fruitful to think what the firm would sacrifice ifthat activity was removed. | This leads us to categorise business activities along a continuum as follows: pee ikea oc) HI s1 s2 NI _ N2 _ Lose basis for Lose Lose No difference Improved survival ‘competitive profit and experienced performance | advantage profitability Satisfice or Actively Actively Cut costs, Separate outsource nurture and nurture and outsource, brand or control decentralise separate divest or outsource brand or disinvest A firm cannot survive without its hard-core activities so obviously resources should go to these activities first. But these activities don’t give the firm any advantage, so that the firm need not be better than its Competitors in these activities. As a result the firm simply needs to ‘satisfice’ here — or in other words allocate resources until a satisfactory performance is achieved (as defined by its customers).Some of these activities could even be outsourced, Spending too many resources on hard-core activities will leave little for other activities and severely constrain the firm's growth, ‘The question is where most of the firms scarce resources should go if anything is left over, The most critical activities are those in $1, activities that if removed will cause the firm to sacrifice its competitive advantage, These activities should be actively nurtured and contiolled within the firm, Soft-core £2 activities do not add to competitive advantage but would cause aloss of profitifremoved. These activities are not fundamental othe frm, so they may be actively nurtured although it would probably be better to decentralise or outsource them. Lastly, non-core activities elther make no differes when removed (N2). N1 activities should eit removed from the firm. N2 activities should b Source: Adapted from Wentzel (2001) nce when removed (N1] or lead to improved performance her be made more profitable by cost cutting, or else be € removed as soon as possible, ions of scarcity, ‘ou may recall from earlie rthata trade-off s| ee " 7 exchange for some sactfice (Cost) ae nes POM 2 Choice involves some gain (bene i ited ji " Medicated in figure 1.1(a). There are many such trace iment cone Tey ugg Figure 1.2: Trade-offs: Equals and not equal (a) Choice (b) Not equat Income, Income 50000 50.000 40.000 0.000 30000 200 250 Leisure 200 250 Leisure offs in business, for example: increasing quality versus reducing cost, gaining market share versus improving customer loyalty, cost of purchasing versus cost of storage or issuing equity versus borrowing, to name but a few. In figure 1.2 we refine the idea of a trade-off. When two points on a trade-off are connected witha line, it means those points are somehow equivalent in the mind of the person making the choice. Jobs A and B are connected by a line, which signals that the decision-maker would get the same value from both combinations. In other words, the gain of 50 more hours of leisure in job B exactly compensates for the loss of R20 000 per month. By contrast, job C in figure 1.2(b) is not connected to either A or B, because it is not valued as equal to them. Itis easy to see why. Job C offers less income than job A. While job C offers higher income than job B, it does not offer enough extra income to compensate for the loss of leisure time. Job C is therefore seen as inferior to A and B, and lies on its own line, well below the A-B line. By similar logic, it is clear that job D is superior to jobs A, B and C, and should therefore lie on a different line. From figure 1.2(b) we can once again derive a general rule about trade-offs between desired ends: points that lie below a trade-off line are inferior to points on the trade-off line (point C isinferior to points A and B). Points that lie above such a trade-off line are superior (point D is superior to points A and B). People prefer to maximise what they desire, and would therefore prefer to be on the highest possible trade-off line. Returning to the definition of choice as involving the sacrifice of a real alternative, you may have noticed that all points on the same line are regarded as real alternatives to each other. hey are not on the sami {e-off line, there noice between them. So, there is no hoice between Cand D if D were possible, then D would be a no-brainer. ‘A trade-off line allows us to view all possible choices at once, and to quickly compare one alternative to another. When comparing choices, economists only consider the change in costs and benefits from one choice to another. In words, we ignore the actual level of costs or benefits when comparing choices. This practicé of focusing on changes is called thinking atthe margin’ or marginal thinking: Its called marginal because it focuses on the margin orthe edge where the change'ls faking place. So when comparing job C to job B [in figure 1.2(b)] we don't ask whether we like R40 000 and 200 hours of leisure (C) more or less than R30 000 and 250 hours of leisure (B), Instead, we creo | 7 start from one point and consider the change to another point. pis rater ake is the extra R10 000 I gain as | move from job B to job C worth the 50 hours of leisut oa Since Cligs on a lower trade-off line, it seems that this person shi hind of funkiest Of R10 000 is not worth the loss of 50 hours of leisure time. Thi g u think more intelligently about choices since it focuses our attention on the relative sacrifice, Another useful aspect of marginal thinking is that it presents us with a way ( valde ditferen ends. Suppose you were offered a job that would cause you to lose ‘ jours of llsute a month (perhaps because you would have to work on Saturdays as well), foe mu would have to be added to your salary to compensate you for that loss? Consider that fora moment. Ifyou have ints on the same trade-off line that question is easy to answer. In figure 1a} seared Person needs an extra R20 000 per month to compensate for the loss Of 50 hours of leisure. We can say this because points A and 8 are on the same trade-off line and therefore equally valued. So by looking at the ratio between income and leisure time we can conclude that every extra hour of leisure time is worth R400 to this person, or that every R1 of extra income is worth 0.0025 of an hour (about 9 seconds). But does it really matter whether we make choices based on the ‘as Opposed to changes in costs and benefits? It makes a huge have suffered great financial harm by making decisions based o The harm that is crea level of costs and benefits difference. Many businesses n levels rather than changes ted by neglecting marginal thinking is known as‘sunk cost bias” Sunk costs are costs (in terms of time or money) that have already been incurred and can no longer be recovered. For example, once an employee has been trained, those training costs egupc Sts: Other examples may be spending on research, consultants, advertising and ‘equipment. ‘Suppose a firm spent R5 million on developing @ new product, and the product is not Performing as expected. The CEO has to decide whether to Spend another R2 million on the Product to try and fix the Problems that keep on appearing or to rather spend the R2 million on an advertising campaign for an existing product. The CEO refuses to put an end to this product's development because the firm has already spent so much on the product. Sound familiar? While we can't say whether the CEO Is making the right choice, we can say The only thing to take into accoi bring about an increase in profit advertising campaign He should co an the expected increase due to the ; mpletely di fnctssimply don't matter anymore baca set regard thi © sunk costs already spent — those the product sehen pene i ale ey or ‘change.The tight reason to stick with ofthe best alternative 'ng about a more sirable change than that unt is whether the product devel that is more or less th ted at JS expected to 8 | ‘nmetal omc ery for buines By recommending that you avoid sunk cost bias, economists are not suggesting that qu quit every time things don't work out. What we are saying is that if you stick to some course of action in business or your personal life, you should do it for the right reason, or er financial harm or unhappiness. So, are you reading this book for the right reasons? 5. Using simple hrade-ofs le mahe bellen choices When faced with difficult choices, the instinct of the economist is to start simply and then to gradually get into the complexities. This instinct is executed by building models. Like maps, models are simplifications of reality, and they force us to eliminate unnecessary detail and focus on what is critical Economic models are simplifications of economic reality (the world of scarcity and trade- offs). While this makes economic models unrealistic, it also makes them useful. Nobody will be able to use a map that is 100% realistic; in fact, people prefer maps that only show them the essential details. This skill of getting to what is essential is very useful when faced with often complicated business decisions. To derive a model of a decision problem,the first step isto identify.the two most important afernatives. This could be between two alternative objectives (ends) which compete for the same resources (means), or it could be between two alternative means to achieve the same end. Figure 1.315 a trade-off between two ends. When choosing a job, you have limited rheans (your time) and you will try to maximise on two objectives (salary income and leisure time). These alternatives are then placed on the two axes - one on the vertical axis (salary income) and one on the horizontal axis (leisure time). Figure 1.3: Constructing a simple trade-off ‘Steps 1and2 Steps 3.and4 Income Income 18000 |-----~ 10000 }------ - 160 230 300 Leisure 160 300 Lelsure The second step is to find one point on a trade-off line. The easiest way to do this is to map a known alternative against the two axes. Suppose, my existing job pays me R18 000 and affords me 160 hours of leisure time per month, then | would map it as point A. The third step isto find another point on the same trade-off line. The procedure is 10 reduce the desirably of the variable on the one axis and then to ask yourself how much the other Vatiable has te change to compensate you for that sacrifice. In figure 1.3 we let the income fallby RB G00 (from R1@ 000 to R10 000) and then ask how much more leisure time we would need to feel compensated for the loss. If we conclude that we need another 140 hours of Cchopeer 9 a then we have found another poi leisure time (from 160 to 300) to feel equally happy, : nt on the trade-off line. In figure 1.3 this is labelled B. We can now connect A and B since we are equally satisfied with both. The fourth step is to use the trade-off to make choices. Suppose | am offered a job paying R15 000 per month and allows me 230 hours of leisure time — should I take it? Ifwe map this point on the diagram (point F) we can see that it lies above our existing trade-off line, which means it is superior. Job F is therefore better than job A, and if | accept it | would be better off By now you may have wondered if all choices can really be reduced to two dimensions. Most choices in business are not so simple, and involve trade-offs on three or more dimensions. Such trade-offs cannot simply be mapped on a diagram. Fortunately, these more complicated choices can be simplified using the very same tools we used to construct simple trade-offs. The technique of reducing complicated choices to a simple trade-off is called ‘even swaps’ and was developed by Hammond, Keeney and Raffia (1998). What makes business choices difficult is not only the multiple dimensions against which a choice must be evaluated, but also the fact that each dimension is often measured differently. Some can be measured precisely in rands, numbers or percentages, while others only more vaguely by rank or range (e.g. high, medium, low). Even so, all of these difficulties can be surmounted with the aid of our simple trade-off tools, When confronted with a complex choice situation, the first step should be to construct a consequences table. Create a table with all the objectives or criteria listed vertically and all the alternatives horizontally (as in table 1.2). Table 1.2 shows the consequences table for an office location decision, This company has found four possible office spaces in four different cities and needs to make a choice. The alternative cities are Benoni, Kempton Park, Sandton and Centurio i horizontally at the top of the table. mand they are listed r, So instead one (customer parking, cleaning, security and ae and security) and C (only customer parking). B es mer parking, cleaning the country itisalso looking fors locates 9), Because all ofits consultants have to fly around z n close i j i size, monthly cost (rent), services Offered and dj rane oe objectives ae listed he rest of the process involves a gradual elimination a i are two rules of elimination: of objectives and alternatives. There « Rule 1 (to eliminate objectives or criteria): if all alternatives euler objective, then that objective is not relevant and SoS eeu sunpose-one advertising company charges you R300 000 for a campaign that will reach 50 000 people, and another one charges you R300 000 for a campaign that will reach 60 000 people. Both charge you the same, so that objective does not make a difference and should be eliminated. It is obvious that the choice should be made based on number of people reached since both charge you the same. The choice now becomes a no-brainer. « Rule 2 (to eliminate alternatives): if one alternative is clearly worse than any other alternative, then that alternative is dominated, and should be eliminated. Suppose one bank offers to lend you R1 million at an interest rate of 5% and another offers to lend you R900 000 at an interest rate of 6%, itis clear the second bank is dominated by the first bank. The choice becomes a no-brainer. Sometimes, an alternative does only slightly better in one objective, but generally worse in others. In such a case the alternative may stillbe regarded as being dominated, and can be eliminated. Let us apply the rules to table 1.2 to see how it helps the company to decide where to locate its office. It is immediately clear that all locations offer the same size office space, so size is irrelevant and should eliminated (using rule 1). The result is table 1.3. 3g the irelevant objective Table 1.3: Consequences table after eliminatin: Erne Cc Meuse) | Centurion _|Monthly cost R22 500 R20 000 34.900 R19 800 Services offered | a CS { A + € Distance to airport | 4km 4km 25 km. 30km ive is dominated by the Kempton Park wn Park in terms of distance to airport, htly cheaper, but the R200 difference for the fact that it is so much further 1, so that we are left with table 1.4, From table 1.3 we can see that the Centurion alternat alternative, Notice that it is much worse than Kempto} andthe same in terms of services offered. It is only sti in tent is so small that it cannot possibly compensate from the airport, We can therefore eliminate Centuriory Table 1.4: Consequences table aftr eliminating the dominated alternative Cin re eel pee Monthly cost R22 500 B Services offered a Ln Distance to airport Chapter nv a the others, which makes jt i clearly superior to her deb hem. We follow the same procedure that Now there oer gage aki .d of trade between them. ¥ proce erate ca So aaple teats we change one objective and ask how much we need we followed wil it. to change another objective to compensate for tha if ‘them more similar imi let us see if we can make P kare fairly similar, so A Gv wtiald we b Seon ang on ass offered. Toa] company cou a elie Ledimaiee that ili services offered fri a Fe A wulling a leh nee eel R3 500 a month to obtain the adiione pet ta the ceivces offered in Kempton Park to B, and increase the rent by we may R23 500, as shown in table 1.5. A268 Table 1: consequences table after eliminating the dominated alternative | | coo Ponca eerie | -R26-600- 34900 , Monthly cost R22 500 R23 500 i Services offered 8 [eB A | Distance to airport 4km 4km 25km Now it is obvious that Benoni dominates Kempton Park, so Kempton Park should be eliminated and we are left with table 1.6. Table Consequences table after eliminating the dominated alternative cat Ere [Monthly cost 22500 34.900 ices offered 8 aA | (Sas waa — 25 km We can again focus on the objective of services offered, How much would the company be willing to pay extra to upgrade the services offered from B to A? The difference between B and fis that A includes reception services. if the company has to hire its own receptionist i would cost around R7 000 Per month. So we may raise 8 to Ain Benoni and add R7 000 to its monthly cost. With that table 1.7 emerges. Both alternatives are now the same in terms of services offered, so that objective can be eliminated, The choice boils down to monthly cost and di 0 the airport, and the choice of Benoniis a no-brainer, ¥ nddlstance Table 1.7:The result Monthly cost ‘Services offered Distance to airpo: Understanding trade-offs makes even diff; choices easier, 0 hting of en difficult i i hee i sier. No complicated weighting criteria is needed, since thin the importance of i iterion Teo forces yo i : relative value, and breed objective OF criterion. The Process a ie hee fond , ‘0 Makes it easier for you to explain you he cetootenn erm r choice to others, 2 Fundamental Moret keene Peory for Business low to make better choices given the relative scarcity of resources, the most fundamental conomic models all involve trade-offs, There are three ways to map trade-offs: (1) trade-offs between ends; (2) trade-offs between means; and (3) relationships between means and ends, as shown in figure 1.4, Figure 1.4 shows the shapes of some of the most fundamental trade-offs in economic theory. Figure 1.4: Some of the fundamental models of trade offs Marginal 8 Laptops output Labour Capital desirable ends, in this case two different a trade-off between two eee cok sie would ke to consume, However, there has to be a choice between Products that pi hore are not sufficient resources to produce unlimited quantities. The emi because’ there a {ike labour, capital or land) means that if country ora firm wants Fe peodues ects phones nifzeto Uivelt some jesourees hom the producterey laptops. As Sane praduction of phones increase, the production of laptops decline i ies frontier and it is the best . ¥ led the production pos: . [his trade-off is comment) a scarcity problem, The line isthe frontier which shows the Bre icreeseniaon eee given the available resources. Anything above the line is BS roel ise festival tian posable SheatreneteRe resources, Anything rior bul below the line is inferior because more output is possible so the available resources are not used efficiently. Figure 1.4(d) shows a trade-off between two resources that a firm needs to buy in et to produce 2¢ ut at the lowest cost is the end, and is oeeie there has to be a choice between the two inputs, because the ormvan 2 use the two inputs (capital and labour) in the most cost efficient combination to pea ues e cl sen output level. Suppose the line represents a chosen output of 300 units. I e firm wants to use more labour that will increase its costs, so that it needs to reduce its use of capital in order to keep costs under control. This trade-off is commonly called the isoquant and the line shows the most cost efficient combinations of inputs needed to produce the same output level. (The ‘iso’ means the same’ and the ‘quant’ stands for ‘quantity of output!) Because with isoquant the firm wants to use the fewest inputs possible at the lowest cost, points below the isoquant are superior because those points involve fewer inputs. Points above the isoquant are not cost efficient because they involve using more inputs than are needed to produce a certain output level. means (or inputs); in this case two different produce a certain level of output. To produce ‘hieved by using the fewest inputs Figures 1.4(b) and 1.4(c) are mirror images of each other, because they both say exactly the same thing from different perspectives. Their message is: even if some means were unlimited, we would still have a scarcity problem and will therefore continue to face trade-offs. Both of them convey this message by showing a relationship between means and ends. Figure 1.4(b) shows the law of diminishing marginal returns. Even if we had unlimited labour we would not be able to produce an unlimited amount of output. As we employ more labour initially, the change in output (marginal output) will initially be positive, but as we employ an increasing number of workers, the change in output will eventually become negative. This happens because other inputs (like the amount of land) remain fixed. After all, there are only so many workers you can employ ina limited space. If you try to fit too many workers into a limited space, your output will all. So employing more inputs will eventually deliver lower returns as you employ more of them, Figure 1.4(c) shows the law of increasing cost. if employi it f be ploying more inputs leads to lower returns, it means that those inputs are becoming less Productive, inputs that are less productive contribute less to the firm, but the firm still Needs to pay them. So, in effect th cost of employing those more inputs rise compared to the contribution they make. ° 8. Breaking Unough brade-offs- wn in figure 1,2 ; igo to ~a pol -2(b) - a breakthrough cbjectives To identity areas ripe for breaktnoccs port that delivers more of bath: destiable breakthrough ideas, Wen i 5,and inspired by Goldratt (19a *alfferent amps Figure 1.5: Generic representation for finding breakthroughs A > EL we cr Bore Di ' es What figure 1.5 shows is that means are used in order to achieve ends, and that we need diferent means to achieve different ends (arrows A and B). Choices either involve a conflict beween means (arrow C) or a conflict between ends (arrow D). The key to finding breakthrough ideas lie in finding ways to: + Reduce the means required by combining them to achieve both ends (arrow C) + Combine ends so that both may be achieved with the same means (arrow D) + Achieve both ends with a smaller set of means (arrows E and F). Ary one of these would lead to a higher attainment of both ends, and thus break through the existing trade-off line, to a point that lies on a superior trade-off line. ronson coat Asan example, consider the trade-off between cost reduction and quality improvement so effectively broken through by the Japanese. This trade-off is represented as figure 1.6. Figure 1.6: Cost reduction versus quality improvement A Enhance Reduction of cost profitability . E-7 : g 2 i c e Dp ra Fos. Improvement Enhance loyalty of quality B # P i: i ility (End,) and improve quality Firms reduce costs (Means) in order to raise their profitability (End, , (Means,) in order 7 enhance customer loyalty (End). To find breakthrough ideas, a firm Should ask itself the following questions: + Hows it possible to reduce costs and improve qua * Howis it possible to improve profitability and enhai (arrow D)? ; * Hows it possible to raise profitability by imp! ! , * How is it possible to enhance customer loyalty by reducing costs (arrow F)? lity at the same time (arrow C)? nce loyalty at the same time roving quality (arrow E)? These four simple questions led to a wide range of innovations in business, from Quali Circles and Six Sigma (arrow C) to loyalty schemes (arrow D and F) to different approach, to marketing brands (arrows E and F), All of these innovations allowed firms to reduce cox while also increasing quality, or raise profitability while also enhancing customer loyalty. Most of the time these questions bring a new perspective that reveal a breakthrough Witho the need to employ more inputs. That is the story behind technological advances and oth kinds of progress. And it all starts by learning to think like an economist. u don't know the terminology commonly ns in the subject. Economics is ng 5 own terminology, and if yo! vanced topics, we first review the n't follow the conversatio! ome of the more a bsequent chapters. aims to achieve and what it consist; he resources that can be ct has it || find that you wo! before continuing with s take for granted in sul my to see what i bjectives and allt Every subjec used, you wi exception. So, basic concepts we In this chapter we look inside the econo! of. The economy consists of everyone who has ol used to achieve these objectives. Those who are already familiar with the basic ¢ To make it easier to identify these basic concepts, first time it is defined. _ - 7. The scancity problem As explained in Chapter 1, the central problem of Economics is the scarcity problem. Simply stated it tells us that we do not have enough resources (means) to achieve all our objectives (ends). To start, let us then dig a bit deeper into ‘the main resources in an economy and the objectives which tells us whether we are succeeding in alleviating the scarcity problem. * Economic means conomics may skip this chapter, oncepts in E every new concept in bold the we mark The means by which we achieve our ends are scarce, and economists classify them into four production factors. Production factors are those resources that we use in order to produce goods and services that can satisfy needs. They are: + Labour -which comes from the physical and intellectual abilit ty of humans to do work. All working people together are called the labour force; “ee Capital - these are goods made by humans that can be u: 2 y sed to produce even mi goods and services. Examples of capital are machinery, buildings, roads or harbours, ond such physical capital is called real capital or capital goods; Natural resources - this includes everythin i ni water, minerals, animals, plants or any eee cre natarewolecmele and cant, lat are not changed by labour or Entrepreneurs — people who identify ; : opportunitis i predcton factors in such away to protuce procucts that ethers en ene ene examp eto broduce Jerseys, a person first needs to identify a mead Want to buy: For entrepreneur wh i len she acts on this Opportuni shear the sheep and to operate the machines, the She also needs some land to build her factory. tnatural resources entrepreneur on which to Keep the shaves (labour. | Fundamen Yal Economie Theory for . Ifyou own some land and allow someone to rent it from you, you are providing the production factor called natural resources and earn income in the form of rent. « Ifyou own capital goods, you could lend the production factor called capital to others and earn income in the form of interest. . If you start your own business, you are providing the production factor called entre- preneurship and earn income in the form of profit. ‘The scarcity problem can be solved in a number of ways, all of which involve choices. One could try and increase the resources available, for example by reclaiming land from the ocean or by improving people’s skills. The choice is in deciding which resources to expand. Jere Is a trade-off here — for example, the more money we spend on reclaiming land, the less money we have left to spend on education, We could also try to use Our resources more eficiently so that we can produce more products, for example through biotechnology that allows us to harvest more maize from a piece of land. Once again there isa trade-off and the question is which resources we should focus our efforts on. Or we could find ways to spread the resources in such a way that more people's needs are satisfied. The choices now are in deciding who should get what Economic ends we will come closer to solving the scarcity problem. How do weknow whether we are making progress in solving the scarcity problem? We need to have specific objectives or targets to work toward and measures that tell us how well we are doing. Economists have decided on five macroeconomic objectives that countries should pursue if they want to make economic progress. onomic because they look at the big economic picture mine how close an economy (of a country or a region) iew these objectives now. If we make the right choices, These objectives are called macroec (macroeconomy) and help us to dete is coming to alleviating the scarcity problem. We shall revi a) Objective 1: High and sustained economic growth fhe production of final goods and services in a country is nomic growth rate was 1.9% in South Africa in a particular ‘and services were produced in that year compared to must be produced for people to satisfy their needs, ‘the closer the country comes to solving its scarcity duction of final goods and services is called its Economic growth means that t increasing, For example, if the eco! year it means that 1.9% more good: the previous year. Goods and services so the higher the economic growth rate, problem. The total value of a country’s prot gross domestic product (or simply GDP). Although the aim is high economic growth, ni : " economic growth for long periods. This is because the change in a country’s production follows an up-down pattern - or a business cycle. When 2 country's total production increases (economic growth is positive), we say the country experiences an upswing phase, and when total production falls economic growth is negative), the country experiences a downswing (recession). Governments should aim to keep the business cycle as stable as Possible, while trying to keep economic growth at least above the population growth rate. 6) Objective 2: Price stability Prices tend to increase in any econo! 10 country has been able to maintain high my that uses money. Since the price is a rough indicator of a product's value, we want prices to be an accurate reflection of how scarce a product is compared to other products. If prices change all the time or increase too fast, it becomes very difficult to judge the scarcity and value of products. | Ghepter2 | 19) When the prices of most products ina country increase, we say there is inflation. A ¢ inflation rate tells us how fast the prices of final products ina country are increas wty average. For example, if the inflation rate in South Africa in a particuley year was 5 gc, means that prices of consumer goods in that year were on average 5.8% higher than the Prices in the previous year. The inflation rate can also tell us how stable prices are. ‘ Teasing The objective is not to have no inflation at all - the objective is price stability, because stability allows people to plan for the future. Inflation will harm an economy ifit is unstabs and out of control. Fast increasing prices reduce the purchasing power of people's income Purchasing power measures how many products People can buy with their income. Fo example, if your income is R60, and the price of a loaf of bread is RS, you can buy 12 loave, with that income. If there is a 20% inflation rate, the price of bread May increase to R6, The Purchasing power of your fixed income will fall because you will now only be able to buy 10 loaves. However, if inflation is moderate and stable, and people's income increase at the same rate as inflation, inflation will not necessarily cause people to be ina worse Position, Most countries have central banks whose main purpose is to protect the purchasing power of their countries’ money and this involves controlling inflation. South Africa's central bank is the South African Reserve Bank and it aims to keep the inflation rate between 3% and 6% ¢) Objective 3: High employment When someone who is willing and able to work does not have a job and is also not selt. employed, that person is said to be unemployed. A country with many unemployed people faces the danger of increasing poverty and crime. The unemployment rate tells us what Percentage of people who are willing and able to work cannot find ajob or self-employment. For example, if the official unemployment rate in South Africa is 28%, it means that 28% of those willing and able to work were not employed. Aiming for high employment is similar to aiming for low unemployment. The ideal is obviously 0% unemployment or full employment, but most economists agree that this i: Not possible. The lowest unemployment rate that is possible in an economy is called the natural rate of unemployment. Economic growth is usually linked to employment. there is economic growth because firms produce more, they need more people to work, and so employment increases. The higher the employment, the more people in the economy will earn an income. f more people earn an income, they can buy more products to satisfy their needs, and this brings us closer to solving the scarcity problem. ) Objective 4: Balance of payments stability A country’s transactions with the rest of the world are recorded in a set of accounts that we call the balance of payments. The transactions that are recorded are exports and imports, and inflows and outflows of foreign investment. Exports are when foreign countries buy our country’s products, and imports are when we buy the products of foreign countries. Foreign investment occurs when individuals or firms from other countries buy assets (like shares in local firms or land) in South Africa. Other countries’ unit of money (for example the US dollar) is called foreign currency or foreign exchange. We have to pay for imports with foreign exchange and when we export we receive foreign exchange, When foreigners invest in South Africa, they also bring foreign exchange into the country. Foreign currencies can be exchanged for each other ata given 20 | FundamentetEeonamie Theory for Business 1 1 1 i lai the be eal inr Fai exchange rate. For example, if the R/S exchange rate is R7=$1, it means that you need to offer R7 if you want to buy $1. ifthe R/S exchange rate changes from R7/ to R10/$, we say the rand depreciated, because weneed more rand to buy the same amount of §. In other words, the same amount of rand now buys us less $ than before. If the R/$ exchange rate changes from R7/S to R4/S, we say the rand appreciated, because we need fewer rand to buy the same amount of $. In other words, the same amount of rand now buys us more $ than before, so clearly the rand gained in value. Exports are good because they earn foreign exchange for the country; money that we can use to buy more products to satisfy our needs. Imports are also good because we may be able to get a wider variety of products, that may be cheaper and of a higher quality, from foreign countries. If people can buy quality products more cheaply from foreign countries, they will have more money left to spend on even more products, and so satisfy more of their needs. If foreigners invest money in South Africa (for example by building new factories), it also helps us because they may need to employ more people to help them (for example to workin their new factories). However, a problem may arise if our exports and imports are not equal. High exports and lowimports can also be a problem, because it is a waste if you earn lots of foreign exchange but you don’t use it to buy products that can satisfy needs. Likewise, high imports and low exports can be a problem - maybe more serious - because imports must be paid for in foreign exchange and we earn foreign exchange mainly from exports. Low exports mean that we are not earning enough foreign currency to pay for crucial imports. It is therefore important that exports and imports be in balance. We also want our country's foreign investment transactions to be stable and predictable, for reasons that will be explained in later chapters. We can therefore phrase the economic objective as: balance of payments stability, aS €) Objective 5: Equitable distribution of income A country could meet all the previously mentioned objectives and still be economically unsuccessful unless the income of the country is fairly spread between all members of the Population. This does not mean that income should be spread equally. There is a difference between fair (or equitable) and equal. If all wealth was spread equally, people would lose their motivation to work harder or to innovate, since any extra income they earned would be given to others. To be fair or equitable, income must be spread in such a way that people earn income in relation to their contribution to the economy. People who work hardest or | innovate the most, deserve to earn more income than those who don't, Fairness j hieve because people are often poor due to no fault of their ot Nay es) tethers For example wher wots hardin frm knitting jerseys, it is not fair if her employer only pays her enough to survive and takes the rest of the income generated from selling the jerseys for himself. People must get a fair share of the income from production that reflects the amount of effort and initiative they put in, We therefore state the last economic objective as follows: equitable distribution of income. The production factors as given here are not the only economic means, but just the most

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